Bonds as Good as Gold

Federal credit guarantees for taxable state bonds would lift the economy.
July 15, 2010 AT 3:00 AM
Bars of gold
Girard Miller
By Girard Miller  |  Finance Columnist
The finance columnist for Governing.

The economy is stuck in a rut. The private sector is struggling to create enough jobs every month to keep unemployment from rising. Voters are in a sour mood. Finance ministers from the world's leading economies are all talking about austerity, not stimulus. There is a growing risk that the Great Recession has not ended. Investors fret about a double-dip into a secondary recession similar to the early 1980s -- or worse, 1937.

President Obama has already pitched Congress for aid to the states to avert massive layoffs, but can't win enough votes to save teacher jobs and forestall further retrenchment. Meanwhile, investors worldwide are scrambling toward lower-risk investments with U.S. government bonds trading at very low yields. Mortgage rates have dropped to record lows. Despite these lower yields in government and mortgage bonds, however, the yields on state and municipal bonds have failed to follow along. With daily newspaper headlines chronicling the fiscal plight of the states with comparisons to Greece, it's no surprise that investors are demanding much higher interest rates on many state governments' bonds than U.S. Treasuries. California is the classic example: Despite its state constitutional pledge to pay bond principal and interest ahead of everything but school funding, investors are demanding very high rates. The Golden State's debt is severely tarnished.

To help stimulate state and local government spending on infrastructure, the stimulus bill of 2009 (ARRA as it's known) authorized the U.S. Treasury to provide direct interest subsidies to qualified infrastructure, construction and economic development bonds. The Build America Bonds (BABs) program has been popular. This year, some $130 billion of such issues are expected in the taxable bond market. Federal taxpayers will spend $30 to $40 billion over the life of this year's BABs before they are finally retired, in direct federal subsidies of their interest payments. There's a bill pending now that would extend this feature, with a slightly lower subsidy rate.

With Treasury bonds trading at 3 percent, there's a better way to stimulate and aid state governments than a direct interest subsidy. A federal loan guarantee to the 50 states and to qualifying local governments would be less costly and reduce their borrowing costs far more. Today's tax-exempt bonds carry interest rates well above U.S. Treasury bonds. The BABs program reduces those net costs by a sliver, but hardly enough to move the dial in terms of fiscal impact. In both cases, the federal taxpayer pays about three-tenths of the cost of those bonds. A federal guarantee program could cost the taxpayers very little or possibly even nothing. It would, of course have to be properly designed to assure credit quality and repayment to Uncle Sam by collateralizing the debt guarantees with strings on federal aid and a tax lien on the state.

A guaranteed alternative to BABs. As an alternative to subsidized taxable BABs (which can also be authorized as a cost savings to the U.S. Treasury when compared with tax-exempt bonds), Congress should authorize the federal guarantee of any state's qualifying taxable bonds used for public purposes in the next 18 months. Those bonds would trade at interest rates very close to U.S. Treasury bonds, which currently yield 3 percent for maturities of 10 years, and 4 percent for 30-year obligations. That's a lot lower than the states can borrow in the tax-exempt market. They can refinance their current debt and save interest costs, and they can build public projects at a lower cost. They could even sell taxable bonds to properly fund their pension and retirement plan benefits, investing the money in long-term portfolios that earn higher yields.

Municipalities could qualify themselves for a similar federal guarantee if they first secure private bond insurance and obtain credit ratings of at least AA. The federal guarantee would then be a backstop in the event the private insurance failed to cover the debts, which would be a doomsday scenario at which point federal intervention would be needed in any event.

Guaranteed taxable muni bonds would likely bear interest rates just a fraction over U.S. Treasury bond yields. They would be qualified investments for bank and insurance reserves, foreign central banks and government bond mutual funds, as well as state and municipal treasury portfolios. They would trade at levels similar to U.S. agency securities. And the IRS will collect taxes on the interest, unlike conventional municipal bonds, so federal taxpayers gain from their issuance.

Some limits are appropriate. Even with an 18-month issuance window, Congress should restrict the eligible yields on these taxable bonds to no more than 5 percent. If federally guaranteed bonds were to require an average issuance rate above that, it would suggest that either the issuer has underlying credit problems or the economy has rebounded enough that interest rates are moving back upward. In either case, guarantees would be ill-advised, imprudent or unnecessary. And an interest-rate cap would encourage shorter maturities, which is more structurally conservative.

Private-purpose activities that benefit corporations and individuals, like sports stadia and economic development projects, should be off-limits for this program. Likewise, revenue projects that do not include a general obligation of the state or municipality should not qualify because of their inherent project risks. To assure sound financial principles, these bonds must mature serially no later than five years after issue in a level debt service structure maturing no later than 25 years. Short-term debt should not be guaranteed to avoid mischief with operating deficits.

BOBs. As a retirement plan financial advisor, I think the time is ripe to seize the opportunity to put lower-cost public capital to work for the next 25-30 years in the financial markets. The uplift in stock prices that could follow an infusion of $1 trillion of capital from benefit obligation bonds (BOBs) would make a huge difference on Wall Street and in the capital gains taxes that governments collect at all levels. More importantly, the funding ratios of public retirement plans can be restored to healthy levels (not to exceed 80 percent to avoid future overfunding) at far less cost than conventional financing methods. This would save state and local taxpayers literally billions of dollars and dramatically improve the security of retirees' pension and health care benefits -- which are now under fire in many states and worrying retirees and employees in others.

In this anti-bailout era, the concept of federal credit guarantees is anathema to folks on the hard right. However, if they think about it long enough, they should realize that the taxpayer savings will be substantial as long as proper precautions are taken to secure Uncle Sam for co-signing the loans. That won't require rocket science as there are a half-dozen ways to attach strings to future federal aid -- and even a special federal income surtax in any state that ever defaults on its bonds.

Girard Miller
Girard Miller | Finance Columnist |