Build America Bonds: Implementing an Efficient and Effective Subsidy for State and Local Borrowers

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1 Build America Bonds: Implementing an Efficient and Effective Subsidy for State and Local Borrowers Increasing state and local funding for capital projects doesn't just help rebuild our aging infrastructure. It gets Americans back to work. Build America Bonds is an innovative approach to augment the ailing tax-exempt bond market and shows the Administration's commitment to economic recovery for Main Street. - Treasury Secretary Tim Geithner Part I Creating a New Program Introduction to Build America Bonds An Innovative Lower-Cost Borrowing Tool In response to fiscal challenges facing state and local governments in the financial crisis, Congress, via the American Recovery and Reinvestment Act of 2009 (ARRA) created the Build America Bond (BABs) program as an innovative lower-cost borrowing tool available to state and local governments to promote economic recovery and job creation through investments in public capital projects, such as roads, bridges, hospitals, and water systems. In contrast to traditional tax-exempt bonds in which the federal government provides a borrowing subsidy indirectly through a federal tax exemption to investors for interest received on the bonds, BABs represent the first program in which the federal government delivers borrowing subsidy payments directly to state and local governments. BABs are taxable bonds in which the federal government makes direct payments to issuers for 35 percent of the coupon interest. The bonds can be used solely to fund capital expenditures and can be issued in an unlimited amount until December 31, 2010 when the program sunsets. Implementation Challenges Before state and local governments could begin to use BABs as a lower-cost borrowing tool to invest in America s public infrastructure, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) faced significant challenges to get the program up and running. Implementation would have several moving parts. Guidance This case was written by Andrew Kvam and Sandra Westin, U.S. Department of the Treasury, as part of the Recovery Act Case Program. The case is intended solely as a vehicle for classroom discussion, and is not intended to illustrate either effective or ineffective handling of the situation described. The Electronic Hallway is administered by the University of Washington's Daniel J. Evans School of Public Affairs. This material may not be altered or copied without written permission from The Electronic Hallway. For permission, hallhelp@u.washington.edu, or phone (206) Electronic Hallway members are granted copy permission for educational purposes per Member s Agreement (hallway.evans.washington.edu). Copyright 2011 Electronic Hallway

2 would need to be issued. New processes would need to be developed and tested. Forms would need to be created. Extensive legal and policy decisions would need to be made. All these components were interdependent and all had to be implemented promptly in order to help struggling state and local governments facing the most severe credit crunch in decades. Municipal Finance Municipal finance is an essential component of state and local economies. The continued ability of municipalities to obtain financing at favorable rates ensures that citizens receive necessary services without interruption and that critical infrastructure projects, such as roads, hospitals, and schools continue. The Census Bureau reported that state and local governments employed more than 16 million people in 2009, including teachers, police, firefighters, and highway workers. i Just like any other organization from small businesses to multinational corporations, the ability of state and local governments to supply jobs and to support the economy is largely dependent upon their ability to obtain the credit needed to finance weekly payrolls and public infrastructure projects. Short-term borrowing helps to meet day-to-day cash flow needs while long-term borrowing allows the cost of public projects to be shared by both current and future taxpayers who will enjoy the benefits. Municipal debt is a $2.8 trillion dollar market, excluding private placements, that is mostly comprised of traditional tax-exempt bonds. Tax-exempt debt delivers an indirect subsidy to state and local governments that allows them to borrow at lower rates. By making the interest on the bonds exempt from federal income tax, investors are willing to accept lower rates, allowing municipal governments to borrow at lower costs. In recent years, state and local governments have averaged issuances of over $300 billion annually in the tax-exempt debt market. This debt has financed projects ranging from transit systems and schools to highway and sewer projects. The ability of municipalities to finance these projects is critical to keeping people employed and maintaining the infrastructure that fosters America s future. Credit Crisis and the Municipal Market Beginning in 2007, an unprecedented financial crisis started to unfold. As large firms began to weaken under the pressure of highly leveraged portfolios with assets that were deteriorating, a liquidity and credit crisis ensued. Credit became an ever scarcer commodity as counterparty risk forced investors into the safest assets. Trouble in the municipal markets began in early 2008 as a part of the broader disruption caused by the sub-prime mortgage crisis. At that time, given the wide diversity of over 50,000 different state and local governmental credits, state and local governments relied significantly on credit enhancement from third-party municipal bond insurers for access to the capital markets. Generally, a municipal bond s AAA credit rating was dependant on credit enhancement in the form of bond insurance provided by one of the large monoline bond insurers. Those bond insurers heavily invested in sub-prime mortgage 2

3 investments and their credit ratings declined significantly in the financial crisis, which indirectly had a severe affect on the municipal market. At the time, monoline bond insurers insured about 60 percent of the municipal market (compared with the 10 percent they cover today). The effects of the downgrades were most notable in the roughly $300 billion auction rate security market, which was one of the many markets facing serious liquidity constraints at the time and virtually ceased functioning after auction failures in early Treasury and the IRS responded promptly to this early phase of the financial crisis in the municipal sector through a series of public notices to provide tax guidance that aimed to give state and local governmental issuers flexibility to restructure municipal debt that had been adversely affected by the illiquidity of auction rate securities market and the ratings downgrades of the bond insurers. While the bond insurers were not the cause of the crisis in 2008, their credit rating downgrades were the primary reason municipal issuers could not sell their bonds. Issuers often had underlying ratings that were generally in better shape than the companies that guaranteed their debt. At the height of the crisis, municipal rates rose from their historical averages of roughly 80 percent of comparable taxable debt to more than 100 percent of those levels. At this point, municipal governments were facing extreme financing constraints as they looked to borrow the money needed to continue both day-to-day operations and ongoing infrastructure projects. A Reuters article from October 2008 noted: The [municipal debt] market has all but frozen up over the past three weeks. Buyers have been scarce and tax-exempt yields have skyrocketed. Few deals have been priced and scores of issuers such as states, hospitals, school districts and others have postponed their bond sales awaiting a market turn around. ii As 2008 drew to a close, municipal yields continued to rise, forcing many states and local governments to delay financing for critical projects. Policy Formulation to Address the Crisis In late 2008, as the new Administration began to assume responsibility for addressing the crisis, President-Elect Obama asked to have an economic stimulus bill on his desk the first day that he took office. The legislation that would become the American Recovery and Reinvestment Act of 2009 began to take shape at the end of Many of the tax components were crafted by congressional tax-writing staff working closely with a small number of transition officials. In drafting the legislation, it was clear that something needed to be done to help struggling states and municipalities in need of financing, and this is when the idea of the direct pay Build America Bond surfaced. In general, three different approaches could be considered to subsidize state and local governmental borrowing costs: (1) traditional tax-exempt bonds in which investors accept lower interest rates because the interest is tax-exempt to investors; (2) tax credit bonds in which investors receive federal tax credits to cover a portion of the borrowing costs; and (3) direct payment bonds in which the federal government makes direct subsidy payments 3

4 to state and local governments to subsidize a portion of their borrowing costs. Traditional tax-exempt bonds have been viewed as less efficient in that federal revenue costs (in lost taxes) are greater than state and local governmental benefits (in lower borrowing costs) due to inefficiencies associated with the fact that the value of the interest exemption depends on the investor s tax bracket. Tax credit bonds are viewed as more efficient than tax-exempt bonds in that a federal tax credit of $1.00 should have the same value of $1.00 to any investor with a federal tax liability. Both tax-exempt bonds and tax credit bonds provide federal borrowing subsidies indirectly through tax benefits to third-party investors. By comparison, direct payment bonds involve direct subsidy payments to issuers with respect to conventional taxable bonds and do not depend on the tax needs of investors. (Ultimately, the BABs program enacted in ARRA included both a direct payment option and a tax credit option, but only the direct payment version of BABs saw widespread usage.) Alternatives to traditional tax-exempt debt had been proposed in a number of different forms prior to 2008, starting with a 1969 House of Representatives proposal that was substantively identical to BABs. In 1978 the Carter Administration had a proposal for tax credit bonds as well, and in the years leading up to ARRA, a number of different tax credit bond programs had been created by Congress. The tax credit bond market, however, remains undeveloped and illiquid for various reasons, including the relatively small authorizations, limited investors, and uncertain future demand for tax credits. Because the benefit of tax-credit bonds is related to the bondholder s income and tax rate, the demand for these bonds dropped with the state of the broader market and sharply falling incomes in As a result, policymakers considered the BABs model of providing a state and local borrowing subsidy through a simple taxable debt instrument and direct borrowing subsidy payments to issuers. The BABs direct payment model offered a number of different benefits, including efficiency, relative simplicity, a streamlined compliance program focused directly on state and local governments (rather than third party investors), and, perhaps most notably, a much broader market of investors without regard to tax preferences (including pension funds, sovereign funds, and foreign investors) with attendant potential for better pricing. In comparison to the approximately $2.8 trillion traditional tax-exempt bond market, the taxable bond market is an approximately $30 trillion market (including corporate, mortgage-backed, U.S. Treasury, federal agency, money market, and other asset-backed debt). There were a number of different issues to consider in developing a taxable bond program that would successfully provide relief to state and local governments, including significant challenges that faced municipal issuers entering the traditionally institutional corporate taxable market. Those challenges included the larger average transaction size in the corporate bond market, the larger and more well-known nature of corporate issuers (about 2,500 large corporate issuers versus more than 50,000 diverse state and local governments), the general institutional nature of investors in the corporate bond market in comparison to the more retail nature of investors in the tax-exempt bond market (about 70 percent of tax-exempt bond investors are individual retail investors and mutual funds), 4

5 and the preference for noncallable bonds in the corporate bond market versus the general preference for early optional call provisions by municipal issuers. In general, corporate issuances are much larger than those in the tax-exempt market (average corporate bond transaction size of about $250 million versus average municipal bond transaction size of about $25 million), and there was concern about how the market would react to the small and relatively unknown municipal issuers. These fears subsided as the concept was tested when a number of small municipalities used BABs to access the taxable market with issuances of as little as $1 million. The ARRA legislation was first introduced six days after President Obama took office and was enacted soon thereafter on February 17, ARRA included eight different state and local bond provisions to facilitate lower cost borrowing: BABs, Recovery Zone Bonds (Economic Development and Facility), Qualified School Construction Bonds, Qualified Zone Academy Bonds, Qualified Energy Conservation Bonds, New Clean Renewable Energy Bonds, and Tribal Economic Development Bonds. BABs constituted the broadest new bond program. Each of these bond programs had its own Internal Revenue Code (the Code) structural program eligibility requirements and borrowing subsidy delivery method (tax exemption, tax credits, or direct payments). With the exception of BABs, each of these bond programs required volume cap allocations before they could be issued. Thus, separate guidance was required for each type of bond program. The sheer number of new bond programs posed a host of legal, policy, operational, timing, and implementation challenges. Implementation As the legislation began to take shape at the end of 2008, it became clear that for Treasury and the IRS to effectively implement this program there would need to be highlevel planning and coordination to address challenges and concerns. From the beginning it was clear that the BABs implementation would be a substantial undertaking. And given the state of the market and the sunset date at the end of calendar year 2010, it would be critical to implement the program expeditiously to enable state and local governments to use the program effectively to invest in public infrastructure projects to promote economic recovery and job creation. In order to accomplish this quickly, key individuals within IRS and Treasury had to form new collaborations that would allow for program guidance to be issued within 90 days of the legislation s enactment and the program would need to be fully functional within six months. The task would also require the formulation of both a fraud prevention program and a new compliance program. Legal Issues The new BABs program introduced a new set of legal issues that related generally to the statutory treatment of the federal direct payments to issuers as being in the nature of tax refund payments. While treatment of these borrowing subsidy payments as tax credits had the important attendant effect of enhancing certainty of payment through the 5

6 statutory continuing appropriation for tax refunds, these payments have unique ongoing characteristics that are unlike typical tax refund payments. Treasury and the IRS Chief Counsel provided guidance specifically regarding the payments in terms of the applicability of a statute of limitations, interest, and penalties that would apply. Operational challenges arose from the requirement to make contemporaneous interest payments with the issuer s actual interest payment date. When a bond is issued with a fixed rate, the issuer knows in advance the amount of interest to be requested. However, when a bond is issued with a variable rate, it is not possible to know the subsidy amount in advance of the interest payment date. ARRA provided that the payment may be made either in advance or as a reimbursement for interest paid. As a result Treasury and the IRS eventually determined that aggregation of payments on variable rate bonds on a quarterly basis met the statute s requirements. Given the state of the market at the time, it was clear to those working on these issues at Treasury and the IRS, including the IRS Chief Counsel s office, that potential issuers needed unambiguous information on the BABs program as fast as possible. Although the direct pay concept had been proposed before, nothing had ever been implemented, so state and local governments had serious questions about the subsidy payments. Their questions were especially critical for those issuers that were looking to enter the market with multi-billion dollar issues. A clear challenge was to establish confidence among issuers that the program would work. Payment of the Direct Subsidy The statutory characterization of the direct payment subsidy as a refundable tax credit under the Code clearly brought it within the purview of the IRS. This characterization had considerable potential consequences for purposes of various tax procedural provisions of the Code and presented issues regarding potential tailoring of procedures needed for BABs. From the beginning it was determined that all solutions should be examined in-depth given that these payments would be made regularly for the next 30 years. In order to explore the subject in greater depth, a working group was convened that included participants from Treasury, the IRS, and the Bureau of the Public Debt (BPD). The group examined the feasibility of all possible solutions that could streamline the payment process including the capacity of each agency to make the payments. With BABs, there would be a regular stream of payments over an extended period of years, but those payments would be subject to change for a number of reasons including variable interest rates, redemptions, and maturing serial bonds. If BPD made the payments, those adjustments would have to be made through the IRS personnel processing the forms and the IRS computers. After thorough review of all possible options, it was determined that the payments would be coordinated by IRS and issued by the Financial Management Service (FMS) in a similar manner to all other tax refunds. Forms and Processing 6

7 The IRS and their Chief Counsel quickly went to work on draft versions of Form CP, Return for Credit Payments to Issuers of Qualified Bonds, on which the issuers were to request their refundable credits. Because the payments were deemed a refundable credit, this form was characterized as a return bringing in new layers of complexity to the process. The BABs statute provided that The Secretary shall pay contemporaneously with each interest payment date... to the issuer of such bond (or to any person who makes such interest payments on behalf of the issuer) 35 percent of the interest payable under such bond on such date. This language allowed the issuer to designate a trustee to receive payments. Form CP had to provide a separate section for the trustee s information. The IRS also needed an authorization to send payments to the designated trustee. Further, the IRS needed consent from the issuer to contact the trustee and to disclose the issuer s return information in order to validate and process the return. It became clear that the trustee could not sign Form 8038-CP, even if it was the recipient of the subsidy. Again, IRS Chief Counsel provided valuable assistance in drafting appropriate consent language so that the IRS could appropriately address these issues with the form. IRS Chief Counsel s office needed to coordinate the Form 8038-CP with Business Systems Programming (BSP) to determine, given the timelines and system limitations, the minimum information needed that could be collected and programmed. This involved telephone conversations with BSP and with the programmers of Modernization and Information Technology Services (MITS). It involved a line-by-line negotiation of the information required, what information needed to be transcribed, what codes, and what edit functions were required. Form 8038-CP had to be submitted to IRS Forms and Publications (F&P) to be produced. F&P s procedure requires that each draft of the form clear four different functions a coordinator, a tax law specialist, composition, and a proofreader. The final Form 8038-CP was posted to the IRS s website on April 9, In addition to the new Form 8038-CP, the BABs statute required that the issuers be subject to information reporting, which requires issuers to file a one-time information report regarding the issuance of their bonds. Although some of the information is generic, for each type of bond issue different criteria had been established for issuers to report. In the end, the new Form 8038-B, Information Return for Build America Bonds and Recovery Zone Economic Development Bonds was created for reporting BABs. However, initially, due to time constraints BABs were simply added to the existing Form 8038-G, Information Return for Tax- Exempt Governmental Obligations. Notice , the initial BABs guidance, provided instructions to issuers on how to adapt the form in order to meet their reporting requirements. It also required issuers to attach debt service schedules showing the amount of interest and principal payments due on each interest payment date for fixed rate bonds and variable rate bonds, and to attach schedules showing the interest payment dates and the amount of principal expected to be 7

8 outstanding on each such date. That information was crucial not only to the fraud prevention effort but also to project the amount of payments required to be made. The IRS needed to receive a Form 8038-G reporting the bond issue at least 30 days prior to receiving the first Form 8038-CP requesting payments to have time to process the initial bond issuance and set up payments. Moreover, parameters had to be set for when issuers could file Form 8038-CP. In consideration of the time required to process the payments and to ensure they would be made in a timely manner, issuers were given between 45 days and 90 days prior to an interest payment date to file a request for payment for fixed rate bonds. If that band of time were not in place, issuers could request the funds earlier and take advantage of the float. For variable rate bonds, the amounts would not be known before the interest payment date, so Form 8038-CP would be filed quarterly in arrears. Treasury and the IRS Chief Counsel issued expedited public guidance in Notice on April 3, 2009 to provide core interpretative guidance on BABs and to implement the direct payment procedures. The notice drew heavily from ARRA in making such detailed determinations as whether the restriction on issuing BABs with more than a de minimis amount of premium applied, whether proceeds could be used to fund a reserve, the timing of the payments, whether the interest payment date was the bond coupon payment date, and whether the yield calculation would be reduced by the interest subsidy. Further, it clarified that the ARRA statute referenced the treatment of erroneous payments of credit as negative amounts of tax or deficiencies, and the rules relating to overpayments of tax, such as credits against liabilities with respect to an internal revenue tax and offsets, interest on overpayments of tax and limitations on credit, or refunds of overpayments applied to credit payments of BABs. The notice also set forth the refundable credit implementation plan, a plan that had been coordinated among the IRS and FMS. It committed the IRS to begin processing Form 8038-CP on May 1, 2009 and to begin disbursements for interest payments dates on or after July 1, It set out how to file for fixed rate bonds versus variable rate bonds, how to file coordinating information returns, and the timelines for filing each in order to receive a payment. All of these elements were part of the clear message to markets that the plan was efficiently in place. Development of a New Compliance Program As an entirely new program, BABs required a new compliance program to monitor bond issuances and protect the taxpayer s investments. In order to accomplish this task, Treasury asked the IRS to perform risk assessments to detail vulnerabilities and create risk mitigation strategies to provide comprehensive solutions. Tax Exempt Bonds (TEB), a function at the IRS, continues to prepare a report tallying up various responses that it agreed to undertake with respect to identified risks and keeping track of which responses have been implemented, which are in process, and which are yet to start. In July 2010 TEB had accomplished every action it had agreed to undertake in response to the BABs 8

9 risk assessment. However, TEB continues to analyze risks inherent in all direct pay bonds. BABs Compliance Team As a part of the ongoing compliance effort, the IRS formed a team comprised of a number of individuals taking leadership positions with respect to certain aspects of BABs. The team was assembled so that each area of leadership could discuss compliance issues within a collaborative forum. The goal was to take a big picture view of all compliance work to ensure that all the pieces are working in a consistent and coordinated manner. This group was charged with referring policy issues to senior management together with input regarding those policy issues. Currently, the TEB compliance team performs an important role in identifying challenges on the horizon so that IRS can address them proactively. Voluntary Closing Agreement Program (VCAP) The IRS Chief Counsel in Notice updated procedures whereby issuers of taxexempt bonds and tax credit bonds can resolve violations relating to the requirements of their bonds. This voluntary closing agreement program (VCAP) is part of the TEB s broader voluntary compliance initiatives and provides appropriate remedies when issuers voluntarily come forward and express a desire to resolve violations. The program is described in the Internal Revenue Manual (IRM) posted on the TEB web site. VCAP is intended to encourage issuers to exercise due diligence in complying with the Code and provide a vehicle to correct violations. It is the continuing policy of the IRS to attempt to resolve violations of the Code without taxing bondholders. If a closing agreement is properly executed by the issuers, TEB will protect bondholders from including in their gross income any interest on the bonds or from recapturing tax credits during the period specified for any violation described. Because the new subsidy for BABs is a direct payment to the issuer of the bonds, the TEB is reviewing its VCAP program to determine how to adapt it for direct pay bonds. As part of its review, TEB is considering a report of recommendations made June 9, 2010 by the Advisory Committee on Tax Exempt and Governmental Entities (ACT), a committee of practitioners and experts within the Tax Exempt and Government Entities Division (TEGE) customer base. In addition to recommending specific changes to the IRM, ACT recommends additions to VCAP procedures for direct pay bonds including direct pay reduction procedures and specific streamlined additions for violations particular to BABs. Education and Outreach While TEB had an established annual education and outreach plan in place prior to BABs, a significant effort was made by the IRS, Treasury, and IRS Chief Counsel to advise potential issuers and market participants about the new program and its benefits. Further, TEB together with IRS Chief Counsel formulated a series of Frequently Asked Questions and Answers for issuers and practitioners that was posted on the IRS website. This tool was designed to help walk issuers through the new forms and procedures that 9

10 had been put in place and has continued to be updated with subsequent informal information. Treasury and the IRS conducted a number of outreach programs to state and local governmental groups to educate market participants regarding BABs and other ARRA bond programs. These programs included webinars, teleconferences, and presentations by Treasury and IRS officials to the National Governors Association, the National Association of State Treasurers, the State Debt Management Network, the National Association of Counties, Indian Tribal Governments, the National Association of Bond Lawyers, and city and county officials. The general goal of this effort was to answer questions to help state and local governments become comfortable in entering the BABs market and realizing the positive benefits of the program. It was clear by the end of 2009 that outreach efforts had been successful in spreading the word, as total issuances surpassed $60 billion, representing nearly 20 percent of new municipal debt. Part II -Post Implementation Policy Perspectives on Positive Aspects and Challenges for the BABs Program In general, the BABs program has been a very successful program under ARRA. Most notably, the program has given state and local governments access to a bigger and broader taxable debt market to help finance their public infrastructure projects. In the long run, access to this broader market should foster greater liquidity, transparency, and lower costs. Reasons for the success and positive future potential for the program include, among others, the structure built on the use of plain vanilla taxable debt, the more efficient direct payment subsidy, the reliance on largely-known program eligibility rules based on the longstanding regulatory framework for tax-exempt bonds, the continuing appropriation for the federal borrowing subsidy payments attendant to treatment of these payments like tax refund payments, and the potential for a streamlined compliance program focused directly on state and local governmental beneficiaries (rather than thirdparty investors). The program has had the collateral benefit of also reducing tax-exempt bond rates by relieving supply pressures in the traditional tax-exempt bond market. For reasons such as these, the program has achieved a significant 20 percent share of the municipal market in a short period of time. In its Fiscal Year 2011 Budget, the Administration proposed to make the BABs program permanent at a 28 percent subsidy rate that was intended to be approximately revenue neutral in comparison to the expected future federal tax expenditure for tax-exempt bonds. The Administration s budget proposal would also expand eligible uses of BABs to include: (1) original financing of governmental capital projects, as under the original stimulus program; (2) current refundings of prior public capital project financings for interest cost savings where the prior bonds are repaid promptly (within 90 days after issuance of the refunding bonds); (3) short-term governmental working capital financings (e.g., for seasonal cash flow borrowings); and (4) financings for Section 501(c)(3) nonprofit entities, such as nonprofit hospitals and universities. 10

11 Predictability of Payments and Offsets Reasonable predictability of the BABs subsidy payments is important to confidence in the BABs program by state and local governments and the bond market. In general, one historic reason why an earlier version of the BABs program was not enacted into law after consideration by the House of Representatives in 1969 was because of concerns that the Federal Government would cease making the borrowing subsidy payments. In the BABs program, Congress addressed concerns about the predictability of subsidy payments in part by characterizing the BABs subsidy payments as refundable credits or overpayments of tax so that they benefit from a continuing Congressional appropriation for tax refund payments. Thus, these payments are fairly predictable and Congress would be required to change the law to cease the BABs subsidy payments. At the same time, however, both under general federal law and the Code, the federal government reduces or offsets certain federal payments by outstanding legally enforceable non-tax federal debts and outstanding federal tax liabilities. The federal direct subsidy payments on BABs are subject to these potential offsets. While this potential for offset should be considered a relatively minor and manageable risk attendant to prudent federal debt collection laws, this offset issue has generated some concern with a few state and local governments. The public guidance on BABs in Notice , the instructions to IRS Form 8038-CP, and the IRS website have provided information about the potential for these offsets. Additionally, in a speech before the National Association of State Treasurers on August 23, 2010, Assistant Secretary Alan Krueger presented data indicating that IRS had offset only.05 percent of the total BABs subsidy payments requested by states. Underwriting Fees and Costs In response to some early public attention to a concern about whether the underwriting fees and costs for BABs were unduly high, the Treasury Department prepared a report entitled Treasury Analysis of Build America Bonds and Issuer Net Borrowing Costs, iii dated April 2, This report generally indicated that, while BABs underwriting fees initially were higher than those for the more established tax-exempt bond program, the underwriting fees for BABs have declined to a level comparable to tax-exempt bonds over time. The report cited many possible reasons why BABs underwriting fees have decreased over time: 1) the market s reception to the initial BABs offerings was much more uncertain than the traditional tax-exempt bond offerings and as a consequence underwriters likely demanded higher fees for placing the bonds; 2) the initial launch of the BABs program required underwriters to incur start-up costs including developing legal framework, investment for education and writing placement documents; 3) institutional factors affected the cost as BABs were initially placed by corporate bond desks, which often charge higher underwriting costs, and that activity has now migrated to the tax-exempt desks; and 4) there has been a shift away from negotiated to competitive sales, especially for small deals that may have put downward pressure on commissions. Assistant Secretary Krueger noted in April 2010 that for BABs issued to 11

12 date, Even taking underwriter fees into account, state and local governments have still saved over $12 billion in present value from issuing BABs. Treasury Inspector General s Independent Review of BABs Program Treasury s Inspector General for Tax Administration (TIGTA) was established in 1998 to provide independent oversight of IRS activities. TIGTA promotes the economy, efficiency, and effectiveness in the administration of the internal revenue laws. It is also committed to the prevention and detection of fraud, waste, and abuse within the IRS and related entities. In March, 2010, TIGTA issued its report iv on initial guidance: The initial guidance published by the IRS in the form of notices was complete, accurate and consistent with the requirements of ARRA. The notices were issued quickly to help bond issuers understand how to issues tax-exempt and tax credit bonds intended to stimulate the economy by preserving and creating jobs. In reviewing the first subsidy payments to be issued, TIGTA found in a July 2010 report v that initial subsidy payments were made in a timely and accurate manner. The summary of the report below provides validation for the hard work and dedication of those involved in the program s implementation. TIGTA determined that, generally, all complete requests for payment of the Build America Bond Federal subsidies were processed accurately, timely, and without indications of fraudulent or erroneous disbursement. The total amount of Federal subsidy payments was more than $110 million for the 80 bond issuances requesting payment by the time of our review. To achieve this, Internal Revenue Service management provided instructions for using Information Returns for Build America Bonds, created the Subsidy Request Form for bond issuer use in requesting Federal subsidy payments, updated processing for Build America Bond forms, created manual processes, and programmed computer systems to process the Federal Subsidy payments. While minor problems were encountered when processing the initial Information Returns, the problems were identified and corrected, and all State and local governments submitting complete Subsidy Request Forms from May 2009 through September 2009 received the correct Federal subsidy payments. The HIRE Act The Hiring Incentives to Restore Employment Act of 2010 (HIRE Act) was enacted on March 18, The HIRE Act extended the BABs model for direct payment borrowing subsidies to four tax credit bond programs that were created or expanded under ARRA (direct pay tax credit bonds). Two school bond programs, Qualified Zone Academy Bonds and Qualified School Construction Bonds, were authorized with a refundable credit equal to the lesser of the amount of interest payable under such bonds, or

13 percent of the amount of interest payable if the interest were determined at the tax credit bond rate set by the Treasury. Two energy bond programs, New Clean Renewable Energy Conservation Bonds and Qualified Energy Conservation Bonds, were authorized with a refundable credit equal to the lesser of the amount of interest payable under such bonds, or 70 percent of the amount of interest payable if the interest were determined at the tax credit rate set by the Treasury. Treasury and the IRS Chief Counsel issued prompt public guidance on the HIRE Act bond programs in Notice on April 26, TEB also revised Form 8038-CP to include payments for the direct pay tax credit bonds at the new subsidy levels and posted the form on the IRS web site on June 25, Until it had time to produce a new Form 8038-TC, Information Return for Tax Credit Bonds and Specified Tax Credit Bonds, TEB adapted Form 8038, Information Return for Tax-Exempt Private Activity Bonds for issuers to report the initial issuance of these obligations. The IRS began processing payments for the direct pay tax credit bonds on July 12, 2010 and made payments beginning September 1, Within a short time, the forms were locked in, the work orders for BSP were in place, the forms were submitted to composition, and MITS programming was underway. Decisions regarding who was going to make payments and how they would be accomplished had already been determined from implementing BABs. It was clear from implementing the HIRE Act on the heels of BABs that significant changes had occurred in the way that programs were being implemented. Through extensive collaboration and communication, Treasury and IRS were able to implement programs quickly and efficiently that had tremendous impact on the municipal debt market. Conclusion The BABs program has been a successful ARRA program facilitating lower cost borrowing by state and local governments for needed public capital infrastructure projects. Through the end of December 2010, there have been 2,275 separate issues totaling more than $181 billion and representing roughly 23 percent of new municipal debt issued. The program has been utilized by all 50 states, the District of Columbia, and two territories. It is clear that through the efforts of dedicated civil servants at Treasury, the IRS, and IRS Chief Counsel, this program has had a tremendous impact on the municipal debt markets. BABs have allowed issuers to finance critical infrastructure at reduced borrowing costs, keeping people employed and stimulating economic growth. While the program itself will have a lasting effect on the market, the leadership that promoted rapid implementation of the program has opened up new lines of communication, facilitated new collaborations within Treasury, IRS Chief Counsel, and throughout the IRS. These new relationships and processes form the foundation of a new, integrated way of doing business, a part of BABs lasting legacy. 13

14 Attachment 1: Issuances by Month vi BAB Issuances and Volumes Volume Percent of Time Period Number Issues $Millions Muni Total 2009: April 12 7, May 41 2, June 87 4, July 70 3, August 107 9, September 112 6, October , November 106 7, December 99 8, April to December , : January 96 7, February 96 7, March , April 120 6, May 115 9, June 141 9, July 98 7, August 113 5, September 119 9, October , November , December , January to December 1, , Since BABs inception: April 2009 to December ,

15 Attachment 2: Issuances by State vii BAB Issuances and Volumes by State Between Program Inception (4/3/2009) and 12/31/2010 Total Amount Issued ($Millions) Total Amount Issued ($Millions) State Number of Issues State Number of Issues AK NC 36 1,623 AL ND 7 68 AR 3 40 NE 60 1,008 AZ 39 1,978 NH CA ,680 NJ 33 7,364 CO 63 4,074 NM CT 19 1,915 NV 25 2,562 DC 8 1,950 NY 59 20,630 DE OH 123 8,344 FL 75 5,537 OK GA 17 3,729 OR HI 7 1,268 PA 64 5,022 IA PR 5 1,013 ID RI 1 12 IL ,231 SC 32 1,193 IN 38 2,072 SD KS 55 1,629 TN 42 1,836 KY 105 2,975 TX 95 16,676 LA UT 47 2,900 MA 17 4,836 VA 45 3,821 MD 40 3,465 VI 1 37 ME 3 88 VT MI 70 2,625 WA 89 6,133 MN 115 1,495 WI 142 2,170 MO 120 2,992 WV 2 88 MS WY MT 1 30 Total 2, ,256 15

16 Attachment 3: Acronyms ACT ARRA BABs BPD BSP EMMA F&P FMS IRM IRS MSRB TEB TEGE TIGTA TOPS VCAP Advisory Committee on Tax Exempt and Government Entities American Recovery and Reinvestment Act Build America Bonds Bureau of Public Debt Business Systems Programming Electronic Municipal Market Access Forms and Publications Financial Management Services Internal Revenue Manual Internal Revenue Service Municipal Securities Rulemaking Board Tax Exempt Bonds Tax Exempt and Governmental Entities Treasury Inspector General for Tax Administration Treasury Offset Program Voluntary Closing Agreement Program 16

17 Attachment 4: Timeline of Implementation November 4, 2008 January 20, 2009 January 26, 2009 February 17, 2009 April 3, 2009 April 9, 2009 website May 1, 2009 July 1, 2009 issuers President-Elect Obama calls for a stimulus bill on his desk the first day he takes office President Obama s Inauguration American Recovery and Reinvestment Act introduced in Congress American Recovery and Reinvestment Act enacted IRS and Treasury issued Notice providing guidance on Build America Bonds and the Direct Payment Subsidy Implementation Form 8038-CP, to request direct payment subsidy posted on IRS IRS accepted 8038-CP for processing direct payment subsidy IRS began direct subsidy payments to state and local government 17

18 Attachment 5: Municipal Market and BABs viii 18

19 Attachment 6: BABs Underwriting Fees ix 19

20 Attachment 8: BABs Yield Curve x i U.S. Census Bureau. (2010, August 31). Government Employment & Payroll (2009 ed.). Washington, DC: U.S. Census Bureau. Retrieved September 12, 2010: ii Christie, Jim. California Hopes Rescue Bill Will Thaw Frozen Debt Market. October 3, Thomson Reuters. Retrieved: September 1, 2010: iii Available at: iv v vi Data compiled through Bloomberg. vii Data compiled through Bloomberg. viii Source: Department of Treasury tabulations of Bloomberg data. ix Source: Treasury tabulations based on Thomson Reuters data x Source: Department of Treasury estimates. Estimates based on a multivariate regression of average bond yields for average yield at various maturities for BABs and tax-exempt bonds that were issued by issuers that issued both types of bonds on the same day, controlling for other factors. Additional details of the estimation are available at: 20