Public Finance Update - December 2010 December 22, 2010
In This Issue

No BABs Extension in Tax Compromise Bill

President Obama recently signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, an $858 billion compromise tax bill that does not include an extension of the Build America Bonds (“BABs”) program past its scheduled expiration on December 31, 2010.

BABs provide tax credits and interest subsidies that enable state and local governments to finance capital projects with taxable bonds, which bonds appeal to a wider universe of investors. BABs represent one of the more successful programs created under the American Recovery and Reinvestment Act of 2009 (“ARRA”). Over $160 billion in BABs have been issued since the inception of the program.

Although the new tax bill allows the BABs program to expire at the end of 2010, the bill includes a few provisions that will benefit the bond industry. For instance, the bill authorizes $400 million in additional qualified zone academy bonds ("QZABs"), but only as tax-credit bonds, and extends that program through 2011. In addition, the bill does not prohibit issuers from selling qualified school construction bonds (“QSCBs”), qualified energy conservation bonds (“QECBs”), and clean renewable energy bonds (“CREBs”) with the direct-pay option if the bonds are already allocated, even after 2010. The bill also extends through December 31, 2012, the authority to issue tax-exempt private-activity bonds outside state volume caps, in amounts up to $10 per capita or $5 million, for public school facilities owned by private, for-profit corporations but operated by public entities.

Meanwhile, municipalities are scrambling to issue BABs before the December 31, 2010, deadline, in order to take advantage of the 35% federal tax credit/interest subsidy. In fact, the volume of BABs is rising so quickly, the monthly volume of taxable debt in the municipal market may exceed the volume of tax-exempt debt for the first time in history.

California Governor-Elect Warns of Budgetary Austerity

California Governor-elect Jerry Brown is expected to deliver his proposed budget by January 10, 2011. To mitigate the anticipated emotional reaction, Brown has been making the rounds, describing to key constituents the severity of California’s economic crisis and the cuts that may be necessary for the state to survive.

At a recent speech in Los Angeles to an audience of educators, Brown warned “if you’re in a car, fasten your seat belt … it’s going to be a rough ride, but we’ll get through it.”

The California Legislative Analyst’s Office (“LAO”) recently projected a general fund budget deficit of $28 billion over the next 18 months. According to the LAO, the upcoming deficit is a direct consequence of the short-term solutions used to balance the last three state budgets, such as short-term borrowing.

Due to the passage of Proposition 25 in November 2010, the new budget will require only a simple majority vote to pass the Legislature. However, a two-thirds vote is still required for many legislative actions, including any tax increases or to place a proposition on the ballot.

CBIA Negotiates Additional School Construction Funds

The California Building Industry Association (“CBIA”) recently announced that, after months of negotiation with the State Allocation Board (“SAB”), over $200 million in bonding authority has been made available to California school construction projects. The SAB, which is responsible for allocating state funds for the new construction and modernization of local public school facilities, unanimously approved a deal whereby $211 million in remaining bond authority will be transferred into the state’s new school construction account. These funds had been previously reserved for urban districts.

This deal comes in the wake of the SAB’s recent adoption of accelerated funding rules, which prioritize shovel-ready school construction projects for state funding. The new funding rules, adopted by the SAB in May 2010, give funding priority to school projects that are able to start construction within 90 days. Two rounds of funding allocations have taken place under the new rules – $408 million allocated in August 2010, and $1.4 billion allocated in December 2010. According to the SAB, the rules are intended to give a boost to the economy by creating much-needed construction jobs across the state.

Bond Market Snapshot

This month, municipal bond spreads continued to recover. The December 2010 yield on AAA-rated municipal bonds increased from 4.55% to 4.89% for 30-year bonds and from 3.14% to 3.38% for 10-year bonds. Yields on treasuries also increased from 4.20% to 4.44% for 30-year bonds and from 2.80% to 3.34% for 10-year notes, staying slightly below the yield on 10-year municipal bonds. Despite the increases in yields, municipal bond mutual funds are still losing investors at historical rates (e.g., $548.1 million sell-off during the week of December 8, 2010), due in part to the impending expiration on December 31, 2010, of the Build America Bonds and other federal subsidy programs.

 Yield Comparison Chart

Source: Bloomberg (www.bloomberg.com)