An interesting thing happened on the way to the bond market: As I mentioned earlier, the state of Illinois went to market with $900 million in “Build America Bonds,” which are federally subsidized debt instruments intended to be used for infrastructure projects — building bridges, blacktopping roads, and the like. Which is to say, right in the middle of a fiscal meltdown, Illinois is launching a major construction campaign — basically, it’s a make-work jobs project, a chance to get a piece of all the money that the stimulus bill has left on the table and put it in the hands of politically connected union bosses. Thanks to Barack Obama, Nancy Pelosi, and Harry Reid, you and I will be covering a 35 percent federal tax credit for investors in those bonds. (Most of the investors, that is, but not all — more on that development in a second.)
Illinois, already sitting on top of $5 billion in unpaid bills and an imploding pension system, is borrowing money everywhere it can, having already tapped into the bond markets three times in recent years just to cover its unfunded retirement obligations for state employees. (Illinois state-government pension? You should have a retirement so fat.) So the chance to go even deeper into debt, with a federal subsidy to sweeten the deal, was irresistible.
Strangely, the market went crazy for those Build Americas. Illinois is already paying a premium in the debt markets; its credit was downgraded in June and its finances are just abject. But the yield demanded on those Build Americas came in 15 basis points lower than expected, meaning Illinois will pay a little less interest on that $900 million bond obligation. Why did the markets cut Illinois a break? Did they forget the Land of Lincoln is the land of Obama, Blago, and George Ryan? That it has the worst credit rating of any state in the Union? That it’s currently considered a greater default risk than Iceland and that it’s only one spot behind Iraq in the default-risk ratings? (And only three behind Pakistan!) What gives?
The most obvious explanation is that the yield on the Build Americas is nearly 7 percent, and there’s not much out there paying 7 percent right now.
Investors also get a 35 percent federal tax credit on those returns, so the real rate is even higher. [See correction below.] But what about the risk? My own suspicion is that, even though the law explicitly says otherwise, there is some suspicion on the part of investors that the Obama administration would, in a crunch, stand behind those Build Americas — especially from a big state like California or from a politically sensitive state like the president’s home turf of Illinois.
Addison Wiggin has an interesting observation: 29 percent of the bids for those Build Americas came in from overseas, where investors don’t even enjoy the tax subsidy. They’re just looking for a yield and not paying much attention to the risk. Investors are liking governments: Capital inflows into municipal bonds are way up — $2.7 billion this week vs. $676 million last week, with similarly strong increases in the four-week rolling average — and junk-rated municipal bonds are popular, too. Wiggin sees a bubble and reports:
Allstate (perhaps not ironically headquartered in Illinois) has trimmed its muni holdings by 13% over the last three quarters. An insurance giant holding $20 billion in munis is seeing the same subprime-style risks we outlined in the last issue of Apogee Advisory:
- Widespread investor acceptance
- Complicated derivatives
- Intense incentive for banks to make deals
- Boneheaded assumptions of endless return on investment
- Loads of underqualified borrowers
- Stunning amounts of leverage and debt
- Social and political pressure to grow at all costs
The multi-trillion-dollar muni market remains loosely regulated, and despite high-profile mishaps in the subprime market, municipal bonds still carry overstated credit ratings from Wall Street’s finest firms.
The latest stimulus under consideration, Stimulus V, is a state-and-local bailout in disguise. If Illinois, California, and the others keep borrowing like this, they won’t even be able to disguise the coming bailout when the municipal-bond bubble bursts.
I wonder, Where will the money come from?
UPDATED: Reader Prayin’ for Reagan (nice name) sends in a correction, which I’m still trying to confirm. In short: There are two kinds of Build America bonds: one in which the 35 percent interest subsidy is paid directly to the bond issuers, and another in which the subsidy is passed on to the bond investors in the form of a tax credit. Either way, the investors receive a higher real yield and the issuers get the benefit of a federal subsidy to offset their risk. I thought Illinois was issuing tax-credit bonds, PfR says I’m wrong. Am checking out now, will update.
UPDATED AGAIN: Prayin’ for Reagan is indeed correct, and I am wrong.
– Kevin D. Williamson is deputy managing editor of National Review.