Citing an excessive amount of existing debt, Fitch Ratings cut the rating for the State of Connecticut’s $956 million bond issuance.  Already the state with the highest level of tax supported debt, Connecticut is issuing these bonds to close a nearly billion dollar budget gap.  Last year the state borrowed over $947 million to cover a  similar budget gap rather than cut spending.  Fitch, apparently, had seen enough and reduced the States rating one level to AA.

“The downgrade reflects the state’s reduced financial flexibility, illustrated by its reliance on sizable debt issuances during the current biennium to close operating gaps in the context of already high liabilities,” Fitch said.

While Connecticut does have the largest amount of outstanding tax supported debt of any of the 50 states at over $13.7 billion, it also boasts being the wealthiest of the 50 states with a per capita personal income of $54,397 in 2009.  I believe much of Fitch’s concern is due to how the state is using the funds it borrows.  Spending for long term capital improvements that benefit Connecticut citizens is one thing.  At least then you have a hard asset to show for it.  What Connecticut is doing, borrowing to finance a budget deficit, is akin to running up your credit card debt to finance a lavish lifestyle.  Frankly, it is unsustainable.

One has to wonder if this is the first of many such downgrades to come as we witness the consequences internationally (Think PIIGS – Portugal, Ireland, Italy, Greece and Spain) of excessive borrowing to support an unsustainable spending pace.

I know I’ve been talking about this for a while and now Moody’s has weighed in on the subject – Build America Bonds are fraught with peril.  In their most recent Credit Outlook newsletter, Moody’s has an article about how the IRS’ meddling into Build America Bonds may cause them to be seen as a “negative” on the credit of the issuing entities.  Their concern, rightfully so, is that if the IRS does not pay 100% of the interest rate subsidy that the issuing locality was expecting that the locality will have to divert funds from other projects and services to keep the bond holders whole.  In a time when all funds are scare, this diversion of funds to supplement bondholders may significantly reduce the quality of services provided and thus negatively affect their credit rating.

According to the IRS, the interest rate subsidy provided via the Build America Bond structure is considered a “tax refund” and is subject to the IRS’ right of offset or counterclaim.  One of the really troubling aspects of this is that the locality could owe the IRS for programs totally unrelated to the bond issuance yet the bond payments will be garnered.

“Conceivably, if the federal government believes that an issuer is in violation of an environmental regulation or any other federal disallowance or repayment, the IRS will also withhold the subsidy.” – Moody’s Credit Watch – May 31, 2010

In addition, the IRS has indicated that it plans to review ALL of the Build America Bonds that have been issued to date to see if they had been priced properly at issuance.  In question is the BABs had been issued with a premium greater than the “de minimus” amount allowed by law.  Issuing the BABs with a greater premium would increase the interest rate payed making them more attractive to investors, but also increasing the amount of subsidy provided by the federal government.  Should the IRS determine that a BAB was indeed issued with an out-sized premium, they will disallow ALL interest rate subsidies for that bond.  That could have a very significant negative impact on localities if they are forced to continue to pay bondholders 100% of the interest promised, but not be able to receive the 35% subsidy they had planned on.  At that point, they would either default on the bonds or reallocated funds away from other programs.

All in all, I believe it would be wise for investors and localities alike to be very cautious of Build America Bonds going forward.  For the localities, you may end up paying more out of pocket than you expected.  For the investors, BABs may carry a greater than normal risk of default if the locality runs afoul of the IRS.