1. TAX CREDIT BONDS National League of Cities Finance, Administration and Intergovernmental Relations Steering Committee Meeting Gadsden, Alabama June 3, 2011 By: Frank D. McPhillips fmcphillips@maynardcooper.com (205) 254-1045

2. Overview of Presentation Profile of Municipal Bond Market prior to Financial Crisis. Effect of Financial Crisis on Municipal Bond Market. Introduction of Tax Credit Bonds (a.k.a. Build America Bonds) in ARRA. What are Build America Bonds? Legacy of Build America Bonds Current Status of Proposed Legislation to Extend BABs.

3. Profile of Municipal Bond Market – 2007 (Pre-Crisis) States and local governments could borrow cheaply for public works projects by paying tax-exempt interest rates. Federal subsidy of muni bonds = forfeited tax revenues. Over 70% of muni bond purchasers were mutual funds and high net worth individuals. Pension funds, tax-exempt organizations and foreign investors were absent. Total size of muni bond market = $2.8 trillion.

4. Profile of Municipal Bond Market – 2007 (Pre-Crisis) Rating agencies (Moody’s, S&P and Fitch) were considered reliable and trustworthy. Seven bond insurance companies were rated AAA. Large floating rate bond market was supported by letters of credit issued by healthy banks. Individual purchasers and money market funds relied on AAA ratings and bond insurance to get comfortable with their investment decisions.

5. Profile of Municipal Bond Market – 2007 (Pre-Crisis) Inefficient Subsidy: State and local governments did not receive 100% benefit of federal subsidy. Why not? 1)As borrowing demands grew, investor market was not large enough to support it. 2)Therefore, in order to attract buyers from lower tax brackets, yield on muni bonds had to increase relative to taxable yields. Higher yield makes tax-exempt bonds competitive with yield on taxable bonds for lower-income bracket bondholders. 3)Yield pushed up higher than a buyer in high-income bracket would demand, resulting in windfall for high-income bracket individuals and higher cost for states and local governments in form of higher interest rates. 4)Tax experts estimate 20% of subsidy goes to high net worth buyers and 80% of subsidy goes to governmental issuer.

6. What Happened in 2008? Demise of bond insurers – no more AAA-rated insurers. Loss of confidence in rating agencies. Commercial banks suffer severe financial stress, resulting in letter of credit downgrades and put bonds. $300 billion auction rate securities market explodes. Result: safety net for municipal bonds evaporates. By Q4 of 2008, monthly issuance fell to 68% of pre- crisis levels; cost of borrowing increased by more than 100%. Municipal bond market enters deep freeze in Q4-2008 and Q1-2009.

7. Introduction of Tax Credit Bonds (a/k/a Build America Bonds) Passage of American Recovery and Reinvestment Act – February 2009. Proposal for Build America Bonds enjoyed bipartisan support. Purpose: to allow government issuers to access larger market of taxable debt - $30 trillion market instead of $2.8 trillion.

8. What are Build America Bonds? Build America Bonds 1)Taxable bonds with direct subsidy to government issuer of 35% of each interest payment. 2)Subsidy treated exactly like tax refund. 3)Eligibility for BABs mirror eligibility for tax-exempt status of governmental bonds for capital projects. –Private activity bond tests apply. –Arbitrage rules apply. –Limitation in advance refundings apply. 4)No volume cap. Recovery Zone Economic Development Bonds 1)Species of Build America Bonds with 45% direct subsidy. 2)Intended to “turbo-charge” recovery by jumpstarting capital projects. 3)Limited volume cap. Tax Credit Bonds Without Direct Subsidy 1)Variation allowed under ARRA but never used by any issuer.

9. Legacy of Build America Bonds – Huge Success Over 50% of municipal bonds in December 2010 were BABs - $181 billion issued from April, 2009 through December, 2010. BABs issuers in all 50 states saved, on average, 84 basis points on interest costs on 30 year bonds. BABs issuers saved $20 billion in present value borrowing costs compared to tax-exempt bonds, which was significantly greater than net cost to federal government.

10. Legacy of Build America Bonds BABs took pressure off tax-exempt market, as lower volume could be supported by muni investors. More beneficial for states and local government issuers – 100% of federal subsidy benefitted issuer.

11. Legacy of Build America Bonds Wall Street Journal: (February 18, 2010) “A Stimulus Plan Success Story”: “The experiment worked. It helped revive the muni-bond market, keeping local construction projects going... Sometimes, the system works.”

12. Legacy of Build America Bonds Time Magazine: (November 17, 2009) “A Stimulus Success: Build America Bonds Are Working”: “When Congress wrote the Build America Bond program into February’s $787 billion economic- stimulus bill, many predicted a flop. Nine months later, the municipal bond program, which provides a federal subsidy to help states and other local governments raise funds, looks to be one of the economic recovery effort’s biggest successes.”

13. Current Status of Build America Bond Legislation Congress allowed BABs to expire on December 31, 2010. President Obama’s 2012 budget proposes making BABs permanent at reduced 28% subsidy rate; expands eligible uses to cover certain refundings, short-term working capital and non-profit entities such as hospitals. May 17, 2011 Senate Finance Committee hearing – CBO testified in support of BABs, stating they are “more cost-effective” and “transparent” compared to tax-exempt bonds.

14. Proposal – Using BABs to promote disaster recovery Bring back BABs for use in financing disaster recovery plans of states and local governments. Three examples of disaster relief legislation – New York Liberty Zone Act, post-9/11, post-Katrina, Gulf Opportunity zone Act and Heartland Disaster Relief Act – contain incentives which benefit private sector but provide very limited assistance to governments faced with task of rebuilding infrastructure. Unlike previous disasters, Alabama tornadoes struck just as local governments are still reeling from economic disaster of last several years. BABs have role to play in reducing cost of recovery for communities devastated by natural disasters. Cost of BABs for disaster relief can be calibrated by using (i) volume caps, (ii) lower subsidy levels and (iii) geographical limitations.

15. Proposals to Eliminate Tax-Exempt Bonds Deficit Commission Report proposes elimination of tax-exempt bonds without any substitute in the name of deficit reduction. Sen. Ron Wyden (D-Ore.) proposes elimination of tax-exempt bonds, replacing them with tax credit bonds (not direct payment variety). Both of these proposals would dramatically increase borrowing costs of local governments. Although ARRA permitted issuers to choose between direct payment bonds and tax credit bonds where holders receive tax credit, none of the latter variety ever issued. There is no existing market for pure tax credit bonds, so no efficiencies would be realized. New market would eventually develop consisting of subset of high net worth individuals which would be even thinner than existing tax- exempt market.

16. Bank-Qualified Bonds Effect of BQ status: allows banks to deduct 80% of interest expense allocated to carrying BQ debt. Incentivizes banks to purchase BQ debt. Prior to 1986 – all governmental issues were bank-qualified; therefore, banks were major market participants. 1986 Tax Act – BQ debt limited to cases where issuer and its subordinate entities issue less than $10 million in calendar year. ARRA raised $10 million cap to $30 million, greatly increasing willingness of banks to make loans to smaller issuers. Expiration of ARRA caused cap to return to $10 million. Municipal Bond Market Support Act of 2011 would restore $30 million cap – Sens. Bingaman, Cardin, Kerry, Crapo, Grassley and Snowe are sponsors.

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