Bloomberg ran an article (see link here) this week about how the state of Florida has temporarily suspended the issuance of Build America Bonds due to a potential glitch in the refunding mechanism.  For those that aren’t as fmailiar with the Build America Bonds, or BABs as they are known, they are a product of the ARRA Stimulus legislation and represent the fastest growing segment of the $2.8 trillion municipal debt market.  The BABs are unique in that they are issued as taxable bonds with taxable equivalent yields, yet the issuing locality receives a refund from the IRS equal to 35% of the interest costs.  This, effectively, makes the cost to the issuer on par with tax free options.

Florida, however, has some concerns about how that 35% subsidy will be paid and has put its $255 million upcoming issuance on hold.  In a recent call with the Internal Revenue Service, the IRS reiterated that any subsidy due to the locality will be reduced by any amount that the issuer owes the federal government for other programs, including Medicare.  This is not a new provision of the BABs and has been a condition since their inception.  However, many of the localities are just now catching on to the fact that they may not get the full subsidy they have been expecting.

This becomes especially relevant as Congress seeks to pass the Healthcare Reform that could dramatically increase an issuers payments to the federal government for Medicare and similar type programs.  Should an issuer not be able to make its Medicare payments, the IRS will still get “theirs” through the BAB subsidy, leaving the locality in a death spiral of interest obligations.

According to the article, the largest issuer of BABs, California, is aware of the IRS claw-back provision and is continue to utilize BABs as a viable funding source.  It will be very interesting to see how many other states join Florida in taking a wait and see attitude.