In 2009 and 2010, cash-strapped cities facing expensive environmental mandates for cleaning up sewer overflows snapped up a new type of taxable bond created under the American Recovery and Reinvestment Act that appeared to offer them a cheaper way of complying.
The Build America Bonds were meant to lure private investors such as pension funds and life insurance companies that don't see much benefit from the tax-exempt status that municipal bonds typically carry. Taxable BABs offered an attractive higher interest rate for investors. And the federal government more than made up for these steeper costs to municipalities by offering to refund 35 percent of the interest paid.
The plan worked: Between April 2009 and the end of 2010, more than $180 billion worth of BABs were issued by municipalities and utilities and other entities.
But now, with construction projects funded by those bonds well underway, the government's checks to issuers are being slashed, thanks to the mandatory, across-the-board federal spending cuts enacted by sequestration.
"We think that's a breach of promise by the United States," said Tom Curtis, deputy executive director of government affairs for the American Water Works Association. "Cities issued these bonds in good faith and with the expectation that the federal government would be able to stand behind its promised subsidy payment, and now that that promise is being breached, it raises difficult questions for the utility."
Sanitation District No. 1 of northern Kentucky, which serves 400,000 customers in three counties, sold more than $190.3 million in BABs and a similar government-backed bond in 2009 and 2010 to help fund more than $1 billion worth of projects required under its consent decree with U.S. EPA. Then, in early February, the district was notified that reimbursement payments would be reduced by 8.7 percent. For the northern Kentucky district, that was a cut of $342,000 per check.
"It was a surprise," said David Rager, the district's executive director. "We run break-even operations. There is no profit in our business. So if we incur a cost, that cost has to be passed on to the ratepayer one way or another."
Rager said his district has just completed two 15 percent rate increases, which were preceded by three 20 percent rate hikes. If the 8.7 percent decrease to the subsidies were to stay in place over the remaining life of the 30-year bonds, Rager said, the district would be out $10.8 million. For ratepayers to cover that gap would require an 18 percent rate increase over the same period.
It likely won't come to that for most bond issuers. At least two cities -- Columbus, Ohio, and Monona, Wis. -- have taken steps toward replacing their BABs with tax-exempt bonds, and analysts say many more are likely to follow.
Replacing the bonds is done through a process similar to how a personal home is refinanced -- new, tax-exempt bonds are issued to buy back the BABs -- but it comes with a cost. In Rager's case, that could pose a problem, since his district has a major construction project underway.
"We don't want to raise rates again, so paying the cost of redeeming is an issue for us right now," he said. For the time being, he is waiting and watching.
Mounting problems for water utilities
The cuts to Build America Bonds subsidies come as one more blow to water utilities, which are already facing strict obligations to meet EPA mandates at the same time that local budgets are tight and customers are reaching the limits of what they are willing to pay for water services.
The U.S. Conference of Mayors and others have for years been arguing that EPA's formula for calculating how quickly it can require a community to implement upgrades is flawed (Greenwire, Jan. 18).
In an issue brief this week, the Conference of Mayors and two water groups said EPA relies too heavily on median household income in its affordability calculations, underestimating the impact of rising water bills on low-income, fixed-income and renter-occupied households.
"For residents and businesses in affected cities, the costs associated with federal mandates are often reflected in water and wastewater bills that must grow faster than household income and the general rate of inflation," CEO and Executive Director of the Conference of Mayors Tom Cochran said in a statement.
Meanwhile, a key tool for communities to finance upgrades is sliding off the table. EPA's low-interest loan programs that help cities cover the cost of upgrades to water systems have been coming under an increasingly sharp knife in recent years. President Obama's fiscal 2014 budget blueprint calls for a combined cut of $472 million to the Clean Water and Safe Drinking Water State Revolving Funds.
And utility operators are also worried that tax-exempt municipal bonds, which they have traditionally relied on to finance upgrades that aren't covered by the SRFs, may be altered, too. As part of broader changes to the tax system proposed in Obama's 2014 budget, the administration again calls for a change to the tax-exempt status of municipal bonds. Under the proposal, interest on municipal bonds would no longer be entirely tax-exempt for individuals taxed in the top three brackets -- 33, 35 and 39.6 percent. Instead, the tax exemption would be limited to 28 percent, meaning that an investor in the 39.6 percent tax bracket would now pay 11.6 percent in taxes on municipal bond interest income (Greenwire, April 11).
"From our perspective, the tax-exempt financing market works extraordinarily well," said Michael Decker, managing director and co-head of municipal bonds for the Securities Industry and Financial Markets Association. "It would be very troubling if Congress or the administration continue to pursue curtailing the value of tax-exempt bonds."
The Obama budget offers a supplement for the changes to municipal bonds: a new government bond program modeled on Build America Bonds.
Utility operators, however, are skeptical. Aurel Arndt, general manager of Lehigh County Authority in Pennsylvania, which issued more than $11 million in BABs in 2010 and is now seeing its reimbursements cut, said the experience has left a sour taste in his mouth.
"You have to really look at that askance," he said. "Fundamentally, I think if the federal government hopes to make a credible argument for trading [the new bonds] as an alternative to tax-exempt financing, I think they in many ways shot themselves in the foot."