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Rick Santelli vs. Congressman Mica
December 29, 2010, David Kotok, Chairman and Chief Investment Officer

Rick Santelli is wrong.

A few hours ago, Larry Kudlow asked Rick about the muni market and the Build America Bonds program (CNBC, 11:20 AM, December 29, 2010, see CNBC.com).  Rick responding by reporting the press comments about Florida Republican Congressman Mica and his attempt to bring back the BABs. 

Rick said, “I don’t think that’s a good idea.  It helps subsidize states in more imprudent-type budget and debt scenarios.”

Does it, Rick?  Let's examine the facts. 

BABs were structured as a reimbursement.  The issuer was able to obtain 35% of the interest expense from the federal government via that reimbursement.  If the issuer did not pay the interest because of delinquency or default, the federal government didn’t reimburse.  In addition, the federal government could set off any other claim against the issuer before paying.  

So where is the subsidy there?  No reimbursement money if you don’t pay your share first.

BABs were issued as taxable bonds and were subject to federal income taxation.  They were an option for an issuer who would otherwise be issuing tax-free municipal bonds.  The issuer would net the federal reimbursement against the gross interest cost.  Then the issuer would choose either traditional tax-free munis or taxable BABs, depending on which was cheaper for the issuer. 

I do not see any subsidy yet.  In fact, Rick, the true subsidy is in the tax-free bond. 

Let’s look at the tax-free side.  I’m in a 35% federal income tax bracket.  I can buy a tax-free muni today and get a yield of close to 6%.  I will pay no income tax on the interest.  I can choose that investment or some other one.  If BABs were available today the interest rate would be close to 8% on a like kind and quality issue.  If I bought the BABs and received the taxable 8% instead of the tax-free 6%, my after-tax yield would be lower with BABs than with the tax-free bond.

Where is the subsidy?  It is coming to me in the tax-free status of the bond I buy.  That is why I buy them and that is why Bill Gross and others do too. 

As a tax-free bond buyer, I benefit because  the BABs program was eliminated, since it will result in a higher tax-free yield to me.  During their two-year history BABs substituted a taxable interest rate for a tax-free rate on about $186 billion of state and local debt.

However, the fact is I would not buy BABs because of the very reason outlined above.  Instead, I would put BABs into my IRA or some other place where I would put a taxable bond.  When I did that, I essentially transferred the benefit of the tax-free bond to others or I transferred it to myself (my IRA), but the transfer reduced the actual subsidy I was receiving from the income tax code.   Remember, when I take my IRA payment, I pay full income taxes on it.

What about foreigners who do not pay US federal income taxes?

They never bought tax-free bonds, because it made no sense.  However, they did buy BABs.  So foreigners helped finance the infrastructure of America under the BABs program.  Remember that America runs a current account deficit and is borrowing heavily from foreigners.  Note that the US Treasury pays interest to foreigners.  If it is via the BABs program, the US only pays 35% of the interest rate on the issue and the municipal issuer pays the other 65%.

I still do not see the subsidy that Rick describes.

What the BABs program was doing is clear.  It expanded the sources of financing for state and local government at a time when they desperately needed it.  It lowered the interest rate they paid.  It encouraged employment by focusing on infrastructure projects.  It attracted foreigners to lend to many American states and cities and counties and agencies and universities and many others in our entire country and in nearly every congressional district. 

Congressman Mica is to be praised for attempting to reinstate this program.  No Rick, this time we disagree.  Build America Bonds are a good idea.

David Kotok, Chairman and Chief Investment Officer