By: Frank D. McPhillips fmcphillips@maynardcooper.com (205) 254-1045

1. TAX CREDIT BONDSNational League of CitiesFinance, Administration and Intergovernmental RelationsSteering Committee MeetingGadsden, AlabamaJune 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? • As borrowing demands grew, investor market was not large enough to support it. • 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. • 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. • 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 • Taxable bonds with direct subsidy to government issuer of 35% of each interest payment. • Subsidy treated exactly like tax refund. • 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. • No volume cap. • Recovery Zone Economic Development Bonds • Species of Build America Bonds with 45% direct subsidy. • Intended to “turbo-charge” recovery by jumpstarting capital projects. • Limited volume cap. • Tax Credit Bonds Without Direct Subsidy • 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 dramaticallyincrease 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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