Hearing of The Select Revenue Measures Subcommittee of the House Ways and Means Committee - Tax-Exempt and Taxable Governmental Bonds
Chaired By: Rep. Richard Neal
Witnesses: Alan Krueger, Assistant Treasury Secretary for Economic Policy; Robert Culver, President and Chief Executive Officer, MassDevelopment; Patrick McCoy, Director of Finance, NYS Metropolitan Transportation Authority; Michael Decker, Co-Chief Executive Officer, Regional Bond Dealers Association; James Esposito, Managing Director, Goldman Sachs & Co.; Gary Bornholdt, Counsel, Nixon Peabody LLP
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REP. NEAL: Let me call this meeting to order, and I hope all will take their seats.
Today, the subcommittee will consider federal tax incentives for state and local financing needs. As a former mayor of a mid-sized city -- and, I'd like to point out, a real mayor, I personally know the value of tax exempt financing for community needs. Our federal government has a long-recognized and acknowledged the important role that cities play in our civilized society.
President Lyndon Johnson put it this way, "The American city should be a collection of communities where every member has a right to belong. It should be a place where each of us can find the satisfaction and warmth which comes from being a member of the community of man. This is what man saw at the dawn of civilization, it's what we seek today."
The economic downturn has been felt at every level of government, but especially in or cities. The Ways and Means Committee heard from governors and mayors at a hearing last October and responded with the stimulus package, including a number of expansions and improvements for state and local borrowing. Today, we welcome a number of experts to tell us how these bond programs are working and what remains to be done.
One of my proudest moments, as mayor of the City of Springfield, was the largest development ever in the history of Western Massachusetts, today known as Monarch Place. As those of you who are involved in local government know, you scrape together every dollar you can find for these projects, from more sources than you care to count. At the heart of these deals is always municipal bonds.
Monarch Place spurred a revival of the downtown, and more bonds were then used for housing and a local theater. It really is a perfect example of how bonds can be utilized to rebuild a community. From roads, bridges and energy projects, our witnesses will tell us today that Congress is on the right track with some of the new and innovative ways for local governments to build the kind of community that Lyndon Johnson spoke of.
Let me, at this moment, recognize my friend, Mr. Tiberi, for his opening statement.
REP. PAT TIBERI (R-OH): Thank you, Mr. Chairman, and thank you for calling this hearing today. If you would have asked me in 2001, when I got sworn in, that I would be part of a hearing on bonds, I would have thought of major league baseball and not what we're talking about today, Mr. Chairman. But, it's so important, as we know that the principal ways that state and local governments finance their activities is through issuance of bonds to the public.
It's generally agreed that liquidity -- the liquidity crisis and the accompanying economic downturn have made it more difficult for state and local governments to find ways for buyers to buy their bonds. Indeed, in 2008 total issuances of long-term state and local bonds decreased in comparison to their levels in 2007. It's important that we review this area of the tax law periodically, and it's especially important now, given the state of the economy and in light of the dramatic changes we've seen in bond programs with the enactment of last year's TARP legislation and this year's stimulus package.
Thank you, again, Mr. Chairman.
I'd like to also thank the witnesses for being here today. We're looking forward to your testimony. I yield back.
REP. NEAL: Thank you, Mr. Tiberi.
Let me welcome our witnesses today. First, I want to welcome assistant secretary for economic policy, Alan Krueger. Secretary Krueger was only confirmed by the Senate a few weeks ago but has kindly agreed to come before us today to discuss this important topic, and we are most appreciative of his time. I also want to thank him for agreeing to be in the panel format today, and allow him, at the right time, to conclude promptly.
I also want to welcome Bob Culver, president and CEO of MassDevelopment in Boston. I worked with Bob for many years and have always found his comment instructive.
I would also point out that he has been most helpful to me in a reuse of the old federal courthouse in Springfield, because we built a new federal courthouse in Springfield. And I thought that, for gap financing, he figured it out and was right there. So, I'm, indeed, grateful for his presence and we'll hear from him shortly as well.
Let me next welcome Patrick McCoy, the director of finance for the Metropolitan Transit Authority of New York. The MTA is one of the largest issuers of municipal debt in the country.
Next, we will hear from Michael Decker, who is the co-CEO of the Regional Bond Dealers Association, a trade association which represents security firms active in bond markets -- (audio break) -- we'll hear from Jim Esposito, a managing director at Goldman Sachs in New York. Mr. Esposito leads the Municipal and Corporate Investment Grade New Issue Financing Business at Goldman Sachs.
And finally, we will hear, before the committee, from Gary Bornholdt, who served this committee as a tax adviser to Joint Tax for many years, and now is a counsel at Nixon Peabody here in Washington.
We look forward to the testimony that we will hear today, and we want to thank you all for your participation.
Without any objection, any other members wishing to insert statements as part of the record may do so. All written statements by the witnesses will be inserted into the record as well.
Let me recognize Secretary Krueger for his opening statement.
MR. KRUEGER: Thank you. Good morning, Chairman Neal, Ranking Member Tiberi, and other members of the subcommittee. I appreciate the chance to appear before you today to discuss changes in federal tax subsidies to lower borrowing costs for state and local governments and other public agencies.
State and local governments confront difficult challenges in the current economic environment. The American Recovery and Reinvestment Act of 2009 provides a number of new and expanded bond financing subsidies for state and local governments. In general, these bond financing tools will support infrastructure investment, job creation and economic recovery. I commend this committee for its work in leading the successful legislative efforts for these bond financing tools in the Recovery Act.
In my remarks, I will briefly compare the economic effects of different ways of providing a federal subsidy to reduce state and local borrowing costs, with a focus on the broadest new bond program called "Build America Bonds." And finally, I will highlight the Treasury's efforts to provide prompt guidance for the new bond programs.
There are currently three different ways of providing federal subsidies to reduce state and local borrowing costs. First, traditional tax exempt bonds are an important financing tool for state and local governments. There are over $2.7 trillion in outstanding tax exempt bonds. Tax exempt bonds lower state and local borrowing costs by making the interest on the bonds tax exempt for investors.
From an economic perspective, however, tax-exempt bonds can be viewed as an inefficient subsidy in that the federal revenue cost of the tax exemption is often greater than the benefits the state and local governments achieved through lower borrowing costs. This inefficiency arises because the bonds have a different value to different investors. Investors in higher tax brackets receive a greater tax benefit.
The market interest rate of tax-exempt bonds is determined by the tax rate of the marginal investor. The marginal investor is the investor who is just indifferent between buying a tax-exempt bond and buying a taxable bond or another security. To sell enough bonds, tax- exempt bonds often have marginal investors who are below the highest tax bracket. As a result, tax-exempt bonds tend to give excess benefits to investors in higher tax brackets.
This conclusion is consistent with the fact that since 1986 interest rates on long-term tax-exempt bonds have been about 20 percent lower that the yields on high-grade taxable bonds, whereas the federal revenue cost has been large enough to finance a 25 to 30 percent reduction in interest rates.
Tax-credit bonds are a second way of supporting state and local government borrowing costs. With these bonds investors receive tax credits for a portion of their borrowing costs. The Recovery Act expands the use of tax-credit bonds significantly. Tax-credit bonds are more efficient than tax-exempt bonds in that tax credits have comparable value to all investors with tax liabilities.
The third, and most recent, innovation in subsidizing state and local government borrowing costs are Build America Bonds. There are two types of Build America Bonds -- tax-credit and direct-payment. I will focus on the direct-payment Build America Bonds.
They are fully taxable to investors and the federal government makes direct payments to issuers equal to 35 percent of the -- (inaudible) -- interest. For example, if a state or local government were to issue Build America Bonds at a 10 percent taxable interest rate, the Treasury Department would make a direct payment to the government of 3.5 percentage points of that interest and the issuer's net borrowing costs would, therefore, we 6.5 percent.
Direct-payment bonds offer four important advantages over traditional tax-exempt bonds: First, they are a fully efficient subsidy. Second, the amount of federal support to bond issuers can be varied by project type, offering the opportunity to tailor federal subsidies to provide different levels of support for different programs. Third, they are potentially attractive to the entire universe of bond investors. And, fourth, the benefit of participating is democratized in that not only those in the highest tax brackets benefit the most.
Because Build America Bonds convey no tax benefits to investors, they have yields comparable to taxable debt instruments, and they should therefore appeal to all bond investors, including pension funds and foreign investors, and investors in lower tax brackets. Expanding the market should result in lower borrowing costs.
The early market reception for Build America Bonds has been very positive, as other members of this panel can comment. Guidance for Build America Bonds was released in early April of this year. Between mid-April and mid-May, approximately 36 issues of Build America Bonds were made, totaling about $9.5 billion in volume. This represents about 20 percent of the total issuance of tax-exempt bonds during this period. Moreover, investor demand and sales orders for many of the initial offer -- initial issues appears to have been strong.
Preliminary indications suggests that the significant sales volume over the past month may have reduced the supply of tax-exempt bonds somewhat and possibly contributed to declining interest rates on tax-exempt bonds. It is difficult, however, to separate out the effects of other factors that also influence tax-exempt bond rates.
The Build America Bonds program has just begun, but the early signs are positive. The Treasury will track developments to ascertain whether Build America Bonds can be an effective additional tool to serve the diverse financing needs of state and local governments.
Finally, I want to assure the committee that the Treasury Department is committed to providing prompt guidance to implement the new bonds -- the new bond financing tax incentives. A major part of guidance was issued through five IRS notices released publicly in early April. This guidance implemented the direct-payment procedures on the Build America Bond program and provided volume cap allocation guidance for four additional targeted tax-credit bond programs for schools and energy projects.
In the next several weeks we expect to provide priority guidance on the Bond Volume Cap Allocations for the Recovery Zone Bond programs and the Indian Tribal Economic Development Bonds.
In the coming years, as we move forward beyond the current economic challenges, the administration is committed to working closely with the Congress to determine how best to provide federal support for lower borrowing costs to state and local governments in the most efficient, workable, uniform, simply and sustainable way. Thank you.
REP. NEAL: Thank you, Mr. Krueger.
MR. CULVER: Chairman Neal, Ranking Member Tiberi, members of the committee, thank you for inviting me to testify and for holding this hearing. I cannot overstate the importance of the American Recovery and Reinvestment Act of 2009, but would suggest that more can be done to maximize its impact.
I'm Bob Culver, president and CEO of the Massachusetts Development Finance Agency, a quasi-public finance and development entity in the Commonwealth of Massachusetts. Having issued private- activity bonds that generated more than $2 billion in investment in Massachusetts last year, MassDevelopment knows this market, which aids affordable housing, higher education, manufacturing and waste recovery.
I speak this morning as a representative of my agency only. I have submitted a written statement to the committee from which I will summarize six main topics. I call your attention to two themes that run through my testimony: First, standardizing allocation processes using the well-vetted and understood volume-cap method as a model; and secondly, extending allocations of special issuance capacity and making permanent enhancements to eligibility to allow more borrowers to use these programs.
Briefly, the first of the six subjects I would like to touch on concerns the expanded definition of manufacturing facilities for qualified manufacturing bonds, to include the production of intangible property, such as software. ARRA also eliminated the 25 percent limit on directly-related and ancillary property. Both of these provisions expire in 2011.
These enhancements are key to supporting modern manufacturing facilities, thereby expanding the economy. However, many companies will not use them today but will need them as the economy rebounds. MassDevelopment supports making these enhancements permanent to bring manufacturing bonds into the 21st century.
Secondly, ARRA creates Recovery Zone Facility Bonds, a new PAB category with a national limit of $15 billion. Uses include acquisition and construction of property in designated Recovery Zones. The provision expires on December 31, 2011.
After Treasury allocates cap amounts, each state must implement a process and identify projects, and large-scale redevelopment projects may take more than a year to be ready for permanent financing. To maximize this program's potential, MassDevelopment urges Treasury to give state governments control of allocating issuance capacity among eligible projects and asks Congress to allow unexpended capacity to be carried forward through 2015.
Third, ARRA increased the national issuance capacity for clean renewable energy bonds, but reduced the allowable tax credit. Issuance capacity is awarded by the IRS and favors smaller issues over larger, less costly ones.
MassDevelopment used its entire allocation in 2006 to support 12 solar projects at state facilities, but may not be able to do so again because of the constrained tax-credit market and reduced tax credit. Giving states a pro-rata share of the overall issuance capacity and the ability to select projects could save time and money. Giving the program a "direct pay" option from the federal government could speed use of the program and deliver more benefits by eliminating structuring costs.
Fourth, ARRA increases the issuance capacity of Qualified Energy Conservation Bonds. These bonds are also dependent on a vibrant tax- credit market. Giving states control over where to allocate issuance capacity could enhance the program.
And because these projects take years to advance, unused issuance capacity should be carried forward to 2015.
While MassDevelopment applauds Congress for providing this option, creating a new category of private-equity activity, tax-exempt facility bonds would give renewable energy developers the certainty of a permanent tax code provision.
Next, ARRA increases the bank qualified bond provisions to apply to issuers of less than $30 million a year, and include 501(c)3s that borrow through a conduit issuer like MassDevelopment. This provision will increase the market for tax-exempt bonds by enlisting more banks as potential purchasers while allowing them to pass through lower interest rates. MassDevelopment supports these provisions, but recommends eliminating the 2011 expiration date and extending them to other types of private activity bonds, in particular, manufacturing.
Finally, in 2008, Congress authorized the Federal Home Loan Banks to confirm bank-issued letters of credit on tax-exempt private activity bonds beyond affordable housing. This levels the playing field for smaller and mid-sized banks to support tax-exempt bonds, and helps offset the collapse of bond issuers and credit ratings of such -- of some larger banks.
We support this program and recommend it be made permanent so that a market can develop. It comes with no significant cost to the federal government, makes the market more efficient and puts more banks to work.
I appreciate the opportunity to speak to the committee and look forward to your questions. Thank you, Mr. Chairman.
REP. NEAL: Thank you, Mr. Culver.
MR. MCCOY: Good morning, Mr. Chairman, Ranking Member Tiberi and members of the subcommittee. I want to thank you for the opportunity to testify today on taxable and tax-exempt municipal government bonds, and in particular the newly created Build America Bonds program.
Mr. Chairman, as you know, the MTA transportation network is one of the largest in the world. MTA provides 8.7 million subway, bus and commuter and railroad rides daily -- or 2.7 billion rides per year, accounting for nearly one-third of all transit riders in the United States. MTA also operates seven bridges and two tunnels that carry nearly 300 million vehicles per year, the most heavily trafficked bridge and tunnel system in the nation. MTA accomplishes this mission with over 69,000 dedicated employees.
Investment in this vast regional transportation network has resulted in the MTA being one of the largest issuers of municipal debt in the United States, with over $26 billion in debt outstanding at this time.
Since 1982, MTA has invested over 72 billion (dollars) in capital improvements through a series of five-year capital programs that are funded from city, state, federal grants, as well as our bond financing program. MTA has replaced or overhauled nearly the entire system, including restoration of Grand Central Terminal and Long Island Rail Road's Penn Station.
The need to maintain our extensive transportation infrastructure and keep it in a state of good repair requires stable and predictable capital investment. But dramatic ridership growth over the past 10 years -- nearly 50% across the board -- has also required us to undertake the first major expansion of our service in over 60 years through the construction of the Second Avenue Subway, Number Seven Line extension and connecting Long Island Rail Road with Grand Central Terminal. Our existing, current 2005 through 2009 capital program, which covers both maintenance and state-of-good-repair investment, as well as expansion needs, is over $22 billion.
Like many other issuers, MTA uses a variety of funding sources to meet its capital program requirements, including bond financing, which accounts for about 40 percent of our current capital funding needs. Bond financing for large capital expenditures matches the funding of the asset with the useful life of the asset. If a subway car, for example, lasts for 30 years, we like to finance that with a 30-year debt. MTA is slated to issue roughly $2 billion per year in the foreseeable future to continue these investments, just our bond financing portion of funding.
The ongoing global credit crisis has had a devastating effect on the municipal bond market over the past year, and that has hampered state and local governments across the country from being able to access the market affordably. For example, state and local governments, including the MTA, have seen their access to liquidity severely constrained at increasing costs. This is a trend that appears to be continuing for the foreseeable future. While, however, it does appear, though, the credit markets are slowly recovering, ensuring long-term stability should be a vital priority for Congress and the administration.
One of the more positive developments that has taken hold of the market this year are the many bond provisions that were included in the American Recovery and Reinvestment Act of 2009, especially the newly created Build America Bonds program. We were one of first issuers to take advantage of this program and I'd like to talk a little bit about that now.
In April, we announced plans to issue 200 million (dollars) in Build America Bonds under our Dedicated Tax Fund credit -- double-A by S&P and A+ by Fitch. We planned to enter the market at the same time with 400 million tax-exempt bonds. And as you know, these markets that we issue into, the taxable and the tax-exempt markets are different and they're structured and priced differently.
Traditional tax-exempt bonds are structured with serial maturities, or with part of the principal amount due each year, much like a mortgage. And often, there are also larger maturities, referred to as term bonds, at the end of the amortization schedule, similar to a balloon payment on a mortgage. Serial and term bond structure allows the issuer to repay part of the principal and interest each year until the bond is repaid. Traditional tax-exempt bonds are generally priced relative to an index of triple-A-rated municipal bonds.
Tax credit bonds, including Build America Bonds are -- generally need to be issued with long-dated, bullet maturities which are common in the corporate taxable bond market. In other words, the entire principal amount would be due in one lump-sum payment. Build America Bonds, like corporate, taxable bonds, are priced relative to the 30- year Treasury, and we express that as a spread to Treasury's. MTA was optimistic that this structure would expand the pool of investors and increase market access for our debt.
Other issuers that came the same week as the MTA were the state of California and the New Jersey Turnpike. We all priced our bonds on different days, and we watched how these other issues came to market and worked aggressively to price our bonds as efficiently as possible at that time. Our initial offer of 200 million (dollars) was increased to 750 million (dollars) due to very strong investor interest at the time of the issue.
I'll sum up now. The Build America Bonds program has expanded the investor base for municipal bonds. And there were approximately 35 new investors that came into the MTA deal that had never participated in our borrowings before. By attracting these new investors, MTA was able to expand and diversify the investor base, which we believe will help achieve more efficient pricings in the future.
The rest of my testimony's on record, and I'll be happy to take questions at that time, after concluding. Thank you.
REP. NEAL: Thank you, Mr. McCoy.
MR. DECKER: Thank you, Chairman Neal, Ranking Member Tiberi and other members of the subcommittee. I appreciate the opportunity to be here today.
Like all other sectors of the capital markets, the municipal bond market has been acutely affected by the global financial crisis. Last fall, for a time at the height of the crisis, it became nearly impossible for most states and localities to access the capital markets to finance investment projects.
The market has recovered significantly since then, in part with the help of legislation advanced by the Ways and Means Committee, but now state and local governments are dealing with the sometimes severe fiscal stress brought about by the recession and the downturn in real estate markets.
The American Recovery and Reinvestment Act includes a number of provisions that have helped states and localities weather the financial crisis. My written statement offers comments on all the municipal finance provisions included in the law. In the interest of time, I will focus my comments here on three provisions that have had the most positive effect: Build America Bonds, expansion of bank investment in the tax-exempt bond market, and AMT relief.
I'm going to admit, Mr. Chairman, that when I first heard about Build America Bonds, I was skeptical that they would offer real benefits for states and localities. However, based on the experience of the last two months, I'm now a believer. By allowing states and local governments to tap the taxable bond market without losing the generous interest subsidy associated with tax-preferred financing, Build America Bonds offer state and local governments a tool that often provides lower-cost financing than they can obtain through any other means.
Moreover, Build America Bonds have had the unanticipated effect of lowering borrowing costs in the tax-exempt bond market as well. They are, in short, a huge hit.
That's not to say that Build America Bonds haven't raised some questions among market participants. They are challenging some of the standard structures that have been popular among municipal-bond issuers for decades like serial maturities and 10-year call provisions. Also, there are doubts about whether Build America Bonds will be as effective for state and local governments when the interest subsidy rebate expires at the end of 2010 and the tax credit on the bonds accrues to investors rather than issuers.
While we don't think Build America Bonds can or should displace tax-exempt bonds as the dominant way for states and localities to finance capital investment, they're a great tool to help bond issuers weather the crisis.
Two other provisions of the stimulus legislation that have helped states and localities are expanding bank investment in tax-exempt bonds and exempting bond interest from the AMT. The bank investment provisions have helped restore the role of commercial banks as tax- exempt bond investors. Before the 1986 Tax Reform Act, banks were dominant buyers of tax-exempt debt. The 1986 act included tax law changes that effectively took banks out of the market for all but a small number of bonds. By bringing banks back and thereby increasing demand for bonds, you have made it easier for states and localities to find investors for their debt at good terms.
Lifting the AMT on tax-exempt bond interest has helped reopen an important sector of the market that had been effectively closed since last year. It had become exceedingly difficult for issuers of private activity bonds for facilities like airports and economic development projects to obtain bond financing. The spread or difference in interest rates between AMT and non-AMT bonds had increased to historical levels. The AMT holiday has addressed these issues and made it possible for private activity bonds to be issued once again.
With respect to another set of provisions from the stimulus bill, authority for targeted tax-credit bonds such as clean, renewable energy bonds and Qualified Energy Conservation Bonds, I think it's useful to point out to the subcommittee that in many cases, borrowers have had a hard time using this authority to raise financing. The subcommittee may want to consider diverting all or a portion of the revenue cost associated with some tax credit bond authority to other, more conventional types of financing, such as private activity tax- exempt bonds for energy utilities.
Also, I would like to bring to the subcommittee's attention legislation that even as we speak is being discussed in the Financial Services Committee. Two bills under consideration there to help state and local bond issuers include provisions to exempt some new proposed programs from the Section 149 tax code prohibition on federal guarantees of tax-exempt bonds. While these proposals -- when these proposals come before the Ways and Means Committee, we urge you to approve them quickly.
The stimulus bill has certainly been successful in providing tools to state and local governments to continue to raise capital in a distressed market. We appreciate the work you all did in ensuring that state and local finance received meaningful attention in the stimulus legislation.
Thank you again for the opportunity to be here. I look forward to your questions.
REP. NEAL: Thank you very much, Mr. Decker. The AMT holiday that you referenced was my amendment, and I was amazed at how quickly it appeared in advertising.
MR. DECKER: Absolutely.
REP. NEAL: Mr. Esposito?
MR. ESPOSITO: Chairman Neal, Ranking Member Tiberi and members of the committee, my name is Jim Esposito, and I lead the municipal and corporate financing business at Goldman Sachs. Given my leadership role across both the taxable and tax-exempt capital markets business, I have a broad perspective on the new programs enacted by Congress as a part of the American Recovery and Reinvestment Act.
Build America Bonds have had a positive impact in three specific areas. First, they've lowered borrowing costs for state and local governments. Second, they've provided issuers a needed source of capital to fund infrastructure projects. And third, they're improving the functionality of the capital markets for issuers and investors alike.
Historically, the $2.5 trillion municipal debt market had provided states and municipalities access to capital at affordable borrowing rates. The capital market deterioration during 2008 created an exceptionally challenging environment where only the highest-rated municipalities and corporations had access to the capital markets. Certain institutional investors exited the market permanently, and others sat on the sidelines, simply willing to ride out the storm. It became clear that expanding the traditional tax exempt buyer base was needed to restore stability and long-term viability to the municipal market.
The Build America Program has provided municipal issuers access to a separate and distinct buyer base. Access to this new taxable investor base has helped municipal issuers lower their overall borrowing costs and diversify their funding streams.
Build America bonds have not eliminated the need for a tax-exempt market, but rather have provided an alternative through 2010. A positive effect of the BAB program to date is the visible resurgence of the traditional tax-exempt market. As taxable investors grow more comfortable analyzing municipal credits, we are starting to see signs of an increased amount of structuring flexibility and pricing power.
The other large taxable program recently created is the qualified school construction bonds, otherwise known as QSCBs. The size of this program, as well as the ability for large school districts to fund education capital needs on an interest-free basis, will be two key components that will drive the ultimate success of this program.
If I can turn your attention a second to the monitors, I appended an exhibit to my testimony and they say a picture is worth 1,000 words, and I think this exhibit is rather powerful and really speaks to the success of the Build America Bond program. Now just a brief explanation as to what you see in this exhibit. If you follow along the horizontal access, those navy blue bar charts are tax-exempt issuance volumes dating back to September 2008 on a weekly basis. If you move all the way to the right of the horizontal access, the lightish blue color is issuance volumes under the Build America Bond program. And, to date, we've seen 9 and a quarter billion (dollars) issued under the Build America program in the past month alone.
Now, more importantly, on this chart is the red line. The red line represents the cost of borrowings to states and local governments. That's a AAA rated composite of municipal bond yields as a percentage of overall Treasury yields. Historically, municipal yields have traded at about 80 (percent) to 90 percent of Treasury yields. And as you can see if you go back to the time of the Lehman Brothers bankruptcy filing in September of 2008, issuance volumes from municipal clients started to really dry up and just as importantly, borrowing costs really spiked, reaching a peak at year-end 2008 and we saw municipal yields trading at almost two times the rate of underlying Treasury yields.
So market access really seized up and borrowing costs spiked.
Now, as we get into the new calendar year, you can see borrowing costs starting to fall significantly. I think it's important to point out as a part of the market anticipating the positive impact of the American Recovery and Reinvestment Act, yields started to fall and they continued to fall during the period of which the Build America program actually got rolled out.
It's not just issuers who have financed debt under the Build America program who have benefited with borrowing costs falling in a taxable market, whether if you used the program or not, all municipal clients have been beneficiaries of this program.
In conclusion, the taxable bond options recently enacted have had the immediate effect of lowering borrowing costs to state and local governments while providing investors with a compelling opportunity to diversify their portfolio holdings. Congress, and this committee specifically, should be commended for providing municipalities' access to new liquidity sources during these challenging times.
We encourage Congress to monitor the stimulus-related financing programs to determine if at the end of 2010, any or all of these programs warrant extension or even expansion.
On behalf of Goldman Sachs, I appreciate the opportunity to appear before the committee today and I look forward to taking your questions.
REP. NEAL: Thank you very much, Mr. Esposito.
MR. BORNHOLDT: Good morning, Mr. Chairman, Ranking Member Tiberi and members of the subcommittee.
Thank you for holding this important hearing today, and thank you for giving me the opportunity to testify.
While I was with joint counsel a little over a year ago, I had the opportunity to work on many of the tax-exempt and tax bond provisions that we're discussing here today. In my current position as a tax-exempt bond attorney with Nixon Peabody, I now have the opportunity to assist state and local governments in their efforts to utilize many of these new programs. But the past year has certainly presented challenges in that regard.
As we've heard from other witnesses today, the global credit crisis and the economic downturn has made it significantly difficult for state and local governments to access the capital markets. This, in turn, has had a significant impact on the ability of state and local governments to finance essential government services and facilities.
We are seeing some improvements for higher rate initial issuers. However, access to the bond market continues to be a problem for many state and local governments.
The American Recovery and Reinvestment Act provided state and local governments with a number of new financing tools and modifications to existing programs that have the potential to increase the demand for municipal bonds and improve the overall efficiency of the markets. And as we heard from the other witnesses today, we are already seeing improvements due to some of the provisions that have been enacted. Yet not all of the bond provisions have been full utilized as of yet. For example, the Recovery Act authorized a $25 billion bond program for economically distressed areas that can not be used until initial guidance is issued by Treasury. More generally, because many of the bond programs in the Recovery Act are so innovative, issuers would benefit from additional guidance clarifying that the existing regulatory framework that applies to tax-exempt bonds and that has been in place for more than 20 years would also apply to many of the new bonds that have been established under the Recovery Act. This would also help to remove some of the uncertainties with respect to the new programs.
With that said, I would like to note that Treasury and IRS chief counsel have been incredibly responsive to issues that have developed regarding implementation of these new programs. The ability of Treasury to respond to these questions on a prompt basis is, obviously, of critical importance given the temporary nature of many of these programs and I'm confident that the open dialogue that the Treasury and the IRS have had with the industry can continue.
As we've heard, the tactical solution that's provided under the Internal Revenue code for state and local government bonds helps to lower borrowing costs, and traditionally, this has provided state and local governments with an efficient source of capital for their financing needs. In contrast, recent tax credit bond programs, which date back to about 1997, have tended to be illiquid and a market has not -- an efficient market has not yet developed for these programs. And I think this is for a number of points that I would just like to summarize briefly. For one, most of the tax credit bonds under present law share a common feature in that the credit rate is set by the Department of the Treasury and it's generally intended to be set at a level that provides deeper subsidy than provided for tax-exempt bonds. However, as Treasury has acknowledged, it has not always managed to set the credit rate at the intended subsidy level, which has required tax credit bonds to go out at a discount, which lessens the value of the intended subsidy.
In addition, there has been a lack of demand for tax credits in general. Currently, a liquid market for tax credits does not exist. In the current economic climate, there has not been a strong demand for tax breaks among taxable investors. In addition, rules that would allow investors to sell the underlying tax credits separately from the principle component of the bond, which should, in theory, improve the marketability of the tax credit bonds, have not yet been released by the Department of the Treasury.
In addition, all of the existing tax credit bonds have been temporary or limited in size. The Clean Renewable Energy Bond Program, for example, was initially capped at 800 million (dollars) when enacted in 2005. This amount has been increased over the years and is currently at 2.4 billion (dollars) after the Recovery Act. But this is still a relatively small program when contrasted with the approximately 19 billion (dollars) of tax-exempt debt that was issued for public power in 2007 alone.
In addition, some of the tax credit bond programs have expired over time. For example, the QZA program, Qualified Zone Academy bonds has expired only to be reauthorized on a retroactive basis. These issues have made it difficult for efficient markets to develop with respect to the existing tax credit bond programs.
Recently, Congress has enacted standardized rules for many of these existing tax credit bonds, which should help to address some of these issues regarding efficiencies, but Treasury guidance will probably need to be issued with respect to many of the new rules before the market can get comfortable with respect to the standardized rules that would apply to all tax credit bonds.
With regards to the Recovery Act, we see some of the most significant changes to the tax rules that went into municipal bonds since the Tax Reform Act of 1986. The Recovery Act contains provisions that should help improve the demand for tax and financing such as the temporary elimination of the application of the AMT to -- (inaudible) -- bonds, which are issued in 2009 and 2010 and the relaxation of bank deductibility restrictions also for bonds issued in 2009 and 2010. These demand side incentives are already providing benefits to the market and there are sound policy reasons for making these provisions permanent.
The biggest program from the standpoint of state and local governments is probably the Build America Bond program, which we've heard about here today. And as we've heard, there are two types of Build America Bonds, the tax credit bond version, which operates similar to existing tax credit structures, as well as the direct pay version.
I'm not going to go through the technical details of the two types of the programs, but as we've heard here today, we have seen significant interest in the direct pay version of the Build America Bonds. And I think this is, in part, due to the fact that, in some cases, there may, in fact, be a deeper subsidy for the Build America Bonds direct pay than associated with tax exempt bonds, but I think it's also due to the fact that for this new product, investors have had to digest so many of the new rules that would apply to tax credit bonds generally. Rather, the market is purchasing the taxable bond and it is the issuer that is receiving the direct benefit from the federal government in this case.
Finally, in conclusion, I would like to say that, due to the temporary nature of these programs, it may be difficult for robust markets to develop in the short period of time we have to issue bonds under the Recovery Act programs. So I think it is necessary to extend many of these programs in order for Congress to get a full sense of the value that they could provide as a compliment to tax-exempt bond financing generally.
In addition, I would like to mention that, today, there is also a hearing going on in the Financial Services Committee addressing some of the liquidity issues that still remain in the tax exempt bond market, and some of these issues will also impact tax-exempt bond requirements. For example, there were issues relating to federal guarantees, which are generally prohibited under the Internal Revenue code. Some of the proposals that are being considered by the Financial Services Committee, for example, would require amending these federal guarantee prohibitions in order for these new liquidity proposals to operate efficiently.
Thank you for the opportunity to testify, and I look forward to your questions.
REP. NEAL: Thank you, Mr. Bornholdt.
Secretary Krueger, I'm interested in the guidance you've referenced for the Recovery Zone Bond program. We've heard from some witnesses that we should consider extending the time for these programs. Do you expect this initial guidance will be comprehensive, especially for those jurisdictions, which we may be receiving a direct allocation such as Springfield?
MR. KRUEGER: Our goal is to produce the guidance as quickly as we can, which I think will be in a matter of a small number of weeks and to make the program as administratively easy as possible for Springfield and other communities.
REP. NEAL: Thank you. And Mr. Culver, let me follow up on the line of questioning with you. I understand MassDevelopment has issued bonds on behalf of smaller jurisdictions in Massachusetts. As you know, the Recovery Zone Bond program will not only have allocations for states, but for large cities and counties with severe job losses.
Do you expect MassDevelopment to assist with the Recovery Zone Bond offerings? And if so, what preparations have you made for the pending Treasury guidance that could come in a small number of weeks?
MR. CULVER: Right. We are -- you know, we work with all 351 of the cities and towns in the Commonwealth of Massachusetts as well as smaller banks. And we are really, right now, working with them to make them aware of the new programs, how they might use them and how we can assist them, in fact, in making filings to take advantage of them and also expressing to them their need to get their projects ready to go, if, in fact, they're going to use this type of debt financing.
REP. NEAL: And Mr. McCoy, we've heard from other witnesses that the Build America Bonds may have been priced inefficiently perhaps due to the fact that they were a new product in the market. As someone who has issued the Build America Bonds, what's your experience in terms of pricing your bonds?
MR. MCCOY: We went into the pricing of our bonds -- again, both taxable and tax-exempt -- on the same day and evaluated significant amounts of information, market data from our financial advisor, as well as from our underwriters. And we felt that given the fact that we were improving pricing relative to tax-exempt bonds, the Build America Bonds were -- delivered the kind of savings we needed and wanted.
We've certainly heard those criticisms about -- particularly secondary market trading and how that has improved the pricing relative to the primary issuance. I think given our experience, we were satisfied with the outcome and would evaluate the issuance of BABs again in the future with the same process and the same methodology that we used the first time.
REP. NEAL: And Mr. Decker, your testimony highlights support for the safe harbor provision, allowing banks to invest in tax-exempt bonds. You've stated that many banks have not followed through, and as you know, I pushed hard for this provision in the stimulus bill. It's disappointing to hear what you've suggested and can you explain to me why more banks have not increased their holdings?
MR. DECKER: I think part of it is inertia. I think many bank investment officers are used to buying bonds that have an explicit opinion, tax opinion associated with bonds that their bank qualified. And in expanding the eligibility for bank investment to non-bank qualified bonds to any bonds that are available in the market, I think it's just going to take a little time for bank investment officers and tax directors to get used to the idea that they can buy non-bank qualified bonds and still not take a tax hit.
Forums like this, I think, are good for publicizing that.
REP. NEAL: This is very informative. Just listening to your testimony, all of you this morning, very, very helpful.
Mr. Esposito, I was interested in the chart you presented. It shows a peak at the end of 2008 for municipal yields as a percentage of the 30-year Treasuries. You refer to this as a dislocation, and first, have you seen this sort of dislocation before? And what amount of municipal borrowing usually occurs in the last quarter of the year? And what happened at the end of 2008?
MR. ESPOSITO: Yeah. Let me start by saying the dislocation that we saw in the capital markets was not specific to the tax-exempt market. There was a dislocation globally across all asset classes, other parts of the debt markets, the equity markets. So this was a dislocation and a severe lack of liquidity. Liquidity left the system through a very violent de-leveraging process. While over the years volume certainly slip into year end, the end of 2008 for the municipal market were some of the thinnest volumes we've seen in the past decade.
In terms of the success of the Build America program and what that meant for issuance volumes and lowering the cost of borrowing for municipal clients, I think the graph is very telling -- and bear in mind, the markets were anticipating the passage of the act. So while the line started to fall at the beginning of the year, at that point in time, market participants were already expecting the passage of the Build America program. So I think in a lot of ways, the program should get credit for the decrease in yields starting at the beginning of the year.
REP. NEAL: Okay. Thank you. And Mr. Bornholdt, you suggest that Congress should look to extend the Build America Bonds direct payment model to other types of tax credit programs. Others have suggested that private activity bonds might be expanded to include these tax credit programs.
Mr. Houten, a former member of this committee, we worked hard on that very issue and were very successful -- (audio break) --
MR. BORNHOLDT: Regarding either expanding the direct payment version --
REP. NEAL: Yes.
MR. BORNOLDT: -- or expanding Build America Bonds to productivity bonds?
REP. NEAL: Yes.
MR. BORNHOLDT: Well, that's a good question. I mean, I think, Congress has identified certain priorities in authorizing the clean renewable energy bond programs and school construction bond programs by providing these particular programs with a deeper subsidy than provided generally through tax-exempt bonds or even provided through direct pay for Build America programs; for example, with the clean renewable energy bonds, Congress provides a subsidy that's approximately equivalent to 70 percent of the interest costs.
So to the extent Congress continues to view renewable energy as a priority, school construction as a priority and worthy of deeper subsidies than some other types of programs, the direct pay, which would provide a direct pay equivalent to the intended subsidy under the tax credit rate would probably be preferable in terms of delivering that deeper subsidy, in terms of long-term with respect to just general purpose activities. For example, we've seen programs similar to the Recovery Act facility bonds, which are essentially a type of private activity bond for any type of business purpose -- that is any depreciable property. We've seen those programs successful in other recovery areas, such as the New York Liberty Zone and the Gulf Opportunity Zone.
So for more general programs, the private activity bond program, which allows issuers to issue tax-exempt bonds for basically any purpose that the state or local government determines is a worthy financing opportunity, the private activity bond program may provide a better general purpose program. But with respect to those programs that Congress has specifically identified as worthy of a deeper subsidy, the direct pay is probably the more direct approach.
REP. NEAL: Thank you. Mr. Tiberi is recognized to inquire.
REP. TIBERI: Thank you, Mr. Chairman.
Starting with Mr. Krueger, over the last 20 years we've seen an expansion on the use of tax preferred bond financing through incentives in the amount of private activity bonds that states can issue in addition to activities as well, that qualify for tax preferred bond financing.
In your view, what impact has that had for state and local governments in financing, what we would all look at as traditional functions like building bridges and roads, if any?
MR. KRUEGER: I'm sorry, I'm not sure I understand the question. The question is how has the balance with private activity bonds --
REP. TIBERI: Yeah. How has that -- the expansion of activities and the use of these bonds for state and local government impacted the building of roads and bridges by local government?
MR. KRUEGER: This is not an area that I've studied directly.
REP. TIBERI: We can go to other panelists and come back to you. Mr. Culver?
MR. KRUEGER: But I would just emphasize that private activity bonds are subject to the volume cap, which is going to, you know, often be a constraint on the amount of private activity bonds that are issued and that take place.
REP. TIBERI: Thank you. Mr. Culver, any thoughts?
MR. CULVER: I agree. I mean, they are a good addition to the debt that's already -- needs to be incurred for these. If you look at our issue of the Big Dig and some -- sorry, I don't have this on -- of the Big Dig and other issues that we deal with, they will not affect us in that financing per se, if you will. I mean, we're still subject to a lot of other financing mechanisms.
But what is happening right now in terms of the new issuance that you're considering is really going to help us in terms of what I deal with, small businesses and assisting cities and towns by giving them access to tax-exempt debt that they have not heretofore had. It will take some time as has been noted for the markets to get used to this and it'll also take time for these businesses and the smaller cities and towns to believe that they have the cash flow to pay the debt service, even though it is becoming more efficient than the cost of issuance is becoming less for them. And that's why we're basically asking, please extend this, give us a little bit more time with this because this -- these new products will be more effective in the areas that we deal with as the economy begins to pick up and the markets begin to understand how to use these.
REP. TIBERI: Mr. McCoy?
MR. MCCOY: I think our experience with the Build America bonds issuance that we had last month was very successful.
We improved our cost of financing relative to tax-exempt financing. On a present value basis, we saved approximately $46 million using the Build America Bonds relative to doing that in a tax- exempt market. At the end of the day, we used both tax-exempt and taxable because we want to have flexibility. We want to be able to enter the market in ways that continue to tap into these different investor pools. I think to the extent that we'll come back to the market later in the year and certainly next year, again, with heavy issuance, we're going to continue to look at this program as a tool that we would absolutely look to use.
REP. TIBERI: Mr. Decker?
MR. DECKER: There are some uses for private activity bonds that are traditional infrastructure-type projects, not roads and bridges, but projects like water and sewer systems or airports that are eligible for productivity bond financing. And I think that those provisions in the code allow state and local governments to use public-private partnership arrangements, which are sometimes very efficient ways of financing traditional infrastructure projects when you have an element of private participation.
So, in that regard, I think the private activity bond -- (audio break) -- has been helpful in some cases in helping get those kinds of projects financed.
REP. TIBERI: Mr. Esposito?
MR. ESPOSITO: I have nothing additional to add.
REP. TIBERI: Okay. Mr. Bornholdt?
MR. BORNHOLDT: Just with respect to productivity bonds generally, I would note that, again, in the cases of the New York Liberty Zone and the Gulf Opportunity Zones, we saw pretty rapid utilization of the additional 30 that was provided in those particular cases. And I think it was more than just because of the economic distress those areas were under, but it was also because Congress provided fairly open-ended definitions of the type of property that could be financed; for example, state and local governments could decide what type of private property could be financed. We see this again in the Recovery Act with the recovery zone bonds. It's basically any depreciable property.
I think that has certain elements of efficiency that are more advantageous than the current structure of many of the productivity bonds. For one example, solid waste facilities, which are a defined type of productivity bond, the IRS and the industry have spent years and countless dollars arguing over what is the definition of a solid waste facility, and this is a definition that was established under regulations dating back to the early 1970s. And obviously, as times have changed, we have different needs with respect to solid waste and recycling facilities generally, but the code and the regulations have not kept up.
To the extent Congress provides more of these open-ended definitions of economic purposes that can be financed in state and local governments, I think that has real advantages.
REP. TIBERI: Thank you. I yield back.
REP. NEAL: Thank you, Mr. Tiberi. Mr. Thompson is recognized to inquire.
REP. MIKE THOMPSON (D-CA): Thank you, Mr. Chairman and thanks to all the witnesses for being here.
I'd like to carry on the discussion about the private activity bonds, and based upon what we did in the Recovery Act and the success that the expansion of the private activity bonds have had in regard to renewable green projects, I'm pursuing legislation that would even expand that. I plan to drop the bill here as soon as we get back from the break that would allow the use of the private activity bonds to fund to a greater extent renewable energy type of projects.
In my home state of California, our treasurer came to me and said, you know, I can use these to fund traditional energy facilities. But at a time when we're trying to decrease the amount of money we're paying for foreign oil to move towards more renewable energy, he believes it would be advantageous to extend that ability over to the green technologies.
I'd like to hear what you think about that in regard to two issues. One, what would it mean from an economic stimulus perspective; and two, any comments you might have on how this will help expedite our move to a renewable energy society. And we can start wherever you'd like.
MR. ESPOSITO: Why don't I start by trying to frame some guiding principles as you think about any changes or tweaks you make to existing programs as well as think about what has been successful with what's been rolled out to date.
I think we can glean some very important learning lessons from the Build America Program. We at Goldman Sachs are also confident that the qualified school construction program will ultimately prove successful. So what is it about these two programs that are going to lead to success and a lot of investor receptivity in the capital markets?
I think the first guiding principle that you need to bear in mind that the size of the program matters -- and I'm not just talking about the overall size of eligible debt that can be issued under it, but I'm talking about the actual issuance amounts by any one entity.
What we've seen to date is that investors are willing to embrace programs that either have a lot of eligible size behind it or at least individual issuance that will be of reasonable size that will merit their time, energy and attention.
So this is a place where size does matter.
REP. THOMPSON: And doesn't size differ between projects?
MR. ESPOSITO: It does, and that will be one of the issues that Congress will have to grapple with. And maybe there are other thoughtful ways that together we can think about efficiency gains, by thinking about ways to roll up various issuance strategies into more liquid debt issuances because, clearly, the marketplace is demonstrating a propensity to want to invest in more liquid alternatives. So that's point one.
REP. THOMPSON: Before you drill down too deep on the specifics, maybe I could get a commitment from you to work with my office to try and define some of these specifics that would make this bill an even better tool for what it is we want to do and because we're limited in time, maybe just hear generally what people think about the idea of whether or not the expansion will create economic activities and get us to where we need to go quicker.
MR. ESPOSITO: We'd be delighted to follow up with your office.
REP. THOMPSON: Thank you.
MR. : I think that'd be a very welcome piece of legislation, Congressman. Members of ours tell me -- bond dealers that work with state and local governments tell me that they've got projects that are ready to go that are related to energy generation or energy conservation, retrofitting buildings for energy conservation or alternative energy generating projects that are ready to go that don't make sense if the borrowing is taking place at 6 (percent) or 7 (percent) or 8 percent, but do, if the borrowing is taking place at 2 (percent) or 3 (percent) or 4 percent.
And so I think your idea would result in some very quick and meaningful investment activity.
MR. KRUEGER: I would highlight that the administration has made renewable energy a priority. And the president, you know, has strongly supported cap-and-trade policy, and in the budget would use much of that revenue -- I think it was $15 billion a year, for renewable energy research and development and implementation projects. So, we very much agree with the goal of trying to expand renewable energy.
As far as private activity bonds, I think a very important issue has to do with the revenue costs -- which would have to be considered, how it relates to the current volume caps, and so on, which are issues that we would very much like to look at and work with after you do develop the bill.
The last question you raised, about the economic recovery, I think, as an economist, I would say that it depends upon the speed in which the programs are put in place. And --
REP. THOMPSON: Now, with the support of you and Goldman's, I think we can move it up pretty quick.
MR. KRUEGER: If you could let him go back to his office, yes.
REP. THOMPSON: Thank you.
REP. NEAL: (Off mike.)
REP. THOMPSON: If I may, in the spirit that "size does matter" -- especially when you're on the little side of "size matters," and for those of us that come from the New England states there are many smaller entities that will be seeking to issue under this, and they may have a different experience in the markets than the larger issuers would, and I hope that they would not be discriminated against because of their size.
MR. : And I would just like to briefly add that Congress has recently authorized two tax credit bond programs for renewable energy, the Clean Renewable Energy Bond program, which is a $2.4 billion program, as well as the recently enacted Energy Conservation Bond program, which is a $3.2 billion program.
And to the extent Congress is considering providing additional financing for these types of projects, I would urge Congress to continue to look at the existing programs and ways to enhance those tax credit bond programs.
For example, given the success with the Build America Bond programs, and the lack of a liquid market for tax credit bonds generally, additional refinements to both the CREBs, as well as the Clean Energy Conservation Bond program might be warranted in addition to -- echo the point regarding size, as I said, you know, there's $2.4 billion of Clean Renewable Energy Bonds authorized the entire program, but public power, you know, in one year issues approximately $19 billion.
And that $2.4 billion for Clean Renewable Energy Bonds is actually divided into three parts -- for both state and local governments, which has been used primarily, for example, to put solar panels on top of court houses; one third for cooperative entities; and one third for public powers.
Now, all those are obviously worthy goals, but by splitting that $2.4 billion among the three different classes of issuers it's obviously diluted some of the benefits of the program.
REP. NEAL: Mr. Linder, the gentleman from Georgia, is --
REP. LINDER: Thank you, Mr. Chairman.
REP. NEAL: -- recognized to enquire.
REP. JOHN LINDER (R-GA): Mr. Bornholdt, California's rating -- bond rating has been recently reduced to the lowest in the country of any state, from A-plus to A. What kind of difference does that make in their interest payments -- the cost of their money?
MR. BORNHOLDT: Well, as I said, and I think most of the witnesses said this morning, we are seeing some improvements in the markets, but that's generally been at the higher end of the ratings scale -- for example, at the double-A level. When we get into the A level, and triple-B level, and even lower we are still seeing some difficulties accessing the market, which has impacted costs.
But, I probably have -- other witnesses here are more qualified to testify today regarding the pricing, with respect to California's issues.
REP. LINDER: Mr. Esposito?
MR. ESPOSITO: Sure. I would just point out that investors rely upon a lot of different factors and judgments to make a decision whether to purchase a bond or not. And while, clearly, ratings are one of the important variables that goes into that decision, investors do a lot of their own credit work, and many of the investors had already factored into their analysis the credit conditions prior to the --
REP. LINDER: Maybe somebody could try and answer the question.
Would anybody like to take a shot at this? What difference would it make in the savings or costs to a state if their bond rating went from double-A to A?
MR. MCCOY: At the MTA we've been looking that this issue as our existing credits -- we've had stability over the past few years, but as we look forward and look at stress in our own system, we've looked at the scenarios that we would confront. And a simple one-notch downgrade for the MTA could cost us approximately 25 basis points. A two-notch downgrade, we estimate, could cost us approximately 75 basis points.
And these are estimates, but obviously we're very sensitive to that and work very closely with the rating agencies to maintain those ratings. But, given all the economic pressure that our revenue streams are under, you know, it's one of those scenarios that we have to be aware of and sensitive to.
REP. LINDER: What would happen if the federal government decided -- and this is just a matter of discussion right now, the Fed says no -- but, if our government decided to back, or backstop, or guarantee California's bonds, would it raise the rating? Would it just lower the interest rate? What would happen?
Mr. Bornholdt, do you want to take a shot at that?
MR. BORNHOLDT: Well, it wouldn't raise California's rating, per se, but it would certainly raise the rating on the underlying debt that the issuer -- because, obviously, investors in that case are looking through to the ultimate guarantor on the bonds, which would be the federal government.
REP. LINDER: Thus, it would save California money?
MR. BORNHOLDT: It would save money.
REP. LINDER: The equivalent of the 75 basis points?
MR. BORNHOLDT: I don't know that I can testify regarding --
REP. LINDER: Mr. Decker, do you --
MR. BORNHOLDT: -- pricing on that --
REP. LINDER: -- take a shot?
MR. DECKER: I'd say, based on where California is now, versus where they would issue if they got a full faith and credit federal guarantee on their debt, it would be significantly more than 75 basis points.
The credit spreads in the market now -- the difference in borrowing costs between different rating categories, are some of the widest that I've ever seen as a result of the credit crisis, and deleveraging, and illiquidity in the market. So, there are big differences between rating categories now, much bigger than there had been for a long time.
MR. KRUEGER (?): You can also look to the FDIC TLGP program as a proxy for what happened when the government started to guarantee individual commercial bank's debt. The savings to the banking system was more than 200 basis points in that example. I think that's a pretty good place to borrow, for what the impact would be on the State of California, as a place to look at for a judgment.
REP. LINDER: Thank you.
Mr. Esposito, I just can't -- this is not on the subject of our hearing, but I can't resist asking you, from Goldman Sachs. When the face value of credit default swaps exceeded the total economic output of all of this planet's nations, why didn't somebody day, "What the hell's going on?"
MR. ESPOSITO: One thing I would point out is, when you read about the amounts of credit default swaps outstanding, bear in mind those are notional amounts. Many investors, many commercial banks, many Wall Street market-makers have offsetting positions. So, while that headline number is obviously enormous --
REP. LINDER: $62 trillion.
MR. ESPOSITO: -- absolutely -- if we were to "net out" the actual economic counterparty exposures, it would be significantly less than the number you just referenced.
REP. LINDER: How is that hedging working so far?
MR. ESPOSITO: I think it depends on each instance. There have been places where credit default swaps have been an effective hedging tool, and clearly there have been other places where it's worked far less well.
REP. LINDER: Thank you, Mr. Chairman.
REP. NEAL: Thank you very much, Mr. Linder.
The gentleman from Connecticut, Mr. Larson, is recognized to enquire.
REP. JOHN LARSON (D-CT): Thank you, Mr. Chairman, and thank you for holding this hearing.
Thank the witnesses for their testimony.
My question is for Mr. Krueger. Both Mr. Culver and Bornholdt stated in their testimony that "direct payment" approach employed by the -- that class of Build America Bonds has resulted in strong demand, and both favor extending the "direct pay" option to other tax credit bonds. Could you please discuss Treasury's thinking on this matter?
MR. KRUEGER: Well, the program -- as I say in my testimony, is only in place for about a month. And while we're very pleased by the initial response, it's premature to say how successful the program will ultimately be.
The characteristics of the municipal bond market, tax exempt market tend to be different from the corporate taxable bond market. So, going forward, we need to study the reception of the bonds to reach a more informed judgment about the program after it's set to expire.
REP. LARSON: What would you quesstimate that to be, in terms of time?
MR. KRUEGER: How much time do we need?
REP. LARSON: Yeah.
MR. KRUEGER: You know, I don't think I could put a figure on that. I think, as I said, the initial reports that we're getting, and as you heard on this panel, have all been very enthusiastic, and it's seemed to be very successful. But, the financial markets are going through a serious evolution right now, and it's just very difficult to give you a precise timetable.
One thing I would point out, which is also, I think, worth paying attention to, is the way that the Treasury has been computing the credit for tax credit bonds has changed. In January, 2009, IRS implemented a new approach which changed the tax credit bonds from being linked to double-A corporate bonds to a blend of single-A, triple-B ratings in order to adjust the rates so that the credit bonds sell at par, as opposed to a discount.
So, hopefully, going forward, one of the issues which Mr. Bornholdt raised would be a less serious concern.
REP. LARSON: Now, are you referring to Mr. Bornholdt's notion that -- with the demand in liquidity in this market, could be increased if Treasury were the rule that underlying tax credits may be sold separately from principal component of the bonds?
MR. KRUEGER: Well, my comment was just on how the tax credits were established, and how the rates were set.
REP. LARSON: Well, would you agree with that? Would that work?
MR. KRUEGER: I agree that allowing investors to strip the credits would broaden the market for the bonds.
REP. LARSON: So, what can we determine will Treasury have for rulemaking with respect to that, with this notion?
MR. KRUEGER: Treasury has been working together with IRS to develop accounting rules and tax compliance rules to permit the stripping of the credits. And that's something that is a priority within the department.
REP. LARSON: How long a time frame on that, do you think?
MR. KRUEGER: I would, you know -- (audio break) -- forced to give you. As an economist, I try not to answer questions about time frame, but if I was forced to, I would probably say within the next few months.
REP. LARSON: Well, as legislators, you can understand why --
MR. KRUEGER: Yes.
REP. LARSON: -- you know, with the economy being where it is, we're interested in time. And that's why it's always distressing when everything seems open-ended, and we go back to our districts and people are looking for -- demand.
Just a -- thank you -- a follow-up with Mr. Esposito on Mr. Linder's question, as well, with regard to credit default swaps and derivatives, et cetera -- the "60 Minute" piece that was out there, et cetera. Some have noted with great interest that maybe those numbers are true, maybe they're not.
How do we ascertain those numbers? And would taxing those things be of interest, in terms of revenue, or a way of limiting the positions that are taken?
MR. ESPOSITO: Well, we at Goldman Sachs are supportive of some of the initiatives to establish a clearinghouse by which credit default swaps will be settled. And it'll be a very simple mechanism by which we can reduce the counterparty exposure between those that are engaging in trading of CDS and legitimate hedging activities.
In regards to your point about taxing the trading of CDS, clearly, any form of taxation will limit and reduce the activity. And I think it would just be a decision by Congress as to whether or not that's in the best interests of the marketplace. There are plenty of counterparties that require legitimate use of CDS for hedging and other purposes, and any form of a taxation will clearly limit the trading activity of those securities.
REP. LARSON: How do you distinguish between those that are regulated and those that have no regulation? And is this -- what would you put on a number, if it's not the $40 (trillion) to $60 trillion that Mr. Linder talked, where do you think the ball-park is? You said it wasn't there, but where do you think it is?
MR. ESPOSITO: I think it's significantly less. But, it's just not my area --
REP. LARSON: What's "significantly less" than $30 (trillion) to $40 trillion? Is it $20 trillion?
MR. ESPOSITO: It's just not my area of expertise at Goldman Sachs, so it's difficult for me to give you an estimate on that.
REP. LARSON: Who could give me an estimate on that?
MR. ESPOSITO: I will work with my colleagues back in New York and see if we can't come up with a netting number, which is I think what you're after -- not the notional amount of CDS outstanding, but what we think the real exposure is, and see if we can't come up with that estimate.
REP. LARSON: Thank you, Mr. Esposito.
And thank you, Mr. Chairman.
REP. NEAL: Thank you, Mr. Larson.
Perhaps we could get an answer in writing from Mr. -- Goldman. If we enquire, they could help us with that detail.
MR. ESPOSITO: We'll do our best to provide that.
REP. NEAL: Sure.
Mr. Heller, the gentleman from Nevada, is recognized to enquire.
REP. DEAN HELLER (R-NV): Thank you very much, Mr. Chairman. And I want to thank you for putting this panel of experts together. It's been a very interesting hearing.
I wanted to move back to this chart that he showed recently. And I guess if there was a comment to be made on that, I would say that it looks pretty volatile -- and going back from September of '08, through this month.
I guess, with the dislocations, and everything that you spoke of on this particular chart, I guess my question is, as I look at something like this I'm more concerned about where we're going to be a year from now, or two years from now. Is there any work that's being done in trying to anticipate, with our current economic conditions, what that red line is going to look like, as opposed to where it is today?
And the reason that I bring that up is that I think there's going to be an economic recovery, and I think most people agree that within -- perhaps by the end of the year, first part of next year, but they're also talking the impact of inflation and higher rates because of some of the activities in this Congress.
I'd like to know what is going to be the long-term impact of this red line, by decisions that are made in this Congress, as it pertains to unemployment, inflation, and perhaps higher rates -- if that's a fair question?
MR. KRUEGER: It is a fair question, and I think part of the answer to your question will also depend upon whether or not Congress considers expanding and extending a program like the Build America Bond program. You've successfully addressed the demand side of the equation. You've allowed states and local governments to tap into a much broader and larger pool of liquidity.
In a world where supply has remained somewhat static -- at least into 2009, by addressing the demand side of the equation you have helped lower that red line that represents the borrowing costs to municipalities.
If you consider extending that program, as we look out into 2010 and 2011 I think we would be much more optimistic that that red line can continue to trend lower and remain that way almost regardless of what the economic backdrop plays out to be.
That demand side of the equation is incredibly powerful. The investment grade corporate market is deep and it is liquid. And so if we can consider extending the program, I think you'll be much more successful, regardless of the economic backdrop, to keep borrowing rates low for states and local governments.
REP. HELLER: I don't know if there's anybody else that wants to comment on that.
But, I just wanted to bring up one other question, and that is that we seem to have an interest in what's going on in California right now based on the activities just this week of their inability to balance their budget. What impact is that going to -- and, keep in mind, I'm from Nevada, so we're right next door, what impact is this lack of -- the financial crisis in California right now, going to have in their municipal bond ratings and, perhaps, long-term impact nationally?
MR. : One thing I would say about California, it's simply too big not to cause any knock-on effects to the broader credit markets, and specifically to the municipal market.
REP. HELLER: I would agree.
MR. : And so that's just something I think Congress will need to bear in mind. We're not just talking specifically about California. There's no way we can isolate the credit situation in California from the broader markets. And we think that's going to be a very important consideration as we play forward over the coming months.
REP. HELLER: Thank you.
Any other comments?
If not, I'll yield back, Mr. Chairman.
REP. NEAL: Thank you very much, Mr. Heller.
Just a couple of thoughts: Certainly, the use of referendum questions comes to mind in the current crisis in California, and how they've been utilized. At the same time, I think that Mr. Esposito touched on a very key point -- that was the whole idea of stimulus, to address the issue of demand. And, slowly but surely, I think that we're making some progress on that front.
As panelists, you were terrific. And I think this is very, very help. You reminded me of my work with Mr. Houghton (sp) on Private Activity Bonds; the "AMT holiday," things that this subcommittee can accomplish. I'm very pleased with the dialogue today.
Are there other members of the panel that would like to ask additional questions?
If not, I want to thank you for your good time and good work today. We will, perhaps, have some follow-up questions, and you'll hear from members. And we hope that you'll respond promptly.
And if there are no further comments, the hearing stands adjourned.