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.

In a brief news article, tucked neatly towards the bottom was one sentence with incredible global implications:

“The big drop in China’s holdings meant that it lost the top spot in terms of foreign ownership of U.S. Treasuries, dropping to second place behind Japan”

Chin ahas long been the largest holder of US Treasuries.  They are (were) our go-to group when we (the US) needed to raise some cash.  If the demand for our Treasuries from China drops off, that could lead to the US paying higher interest rates and a double dip recession for our economy.

It now appears that they are in fact reducing their holdings.  In fact, China has been reducing its exposure to US Treasuries for some time now.  While they are not out in the market selling them (that we know), they are trending towards purchasing shorter  duration notes.  This gives them a quicker “out” when the time comes.

When will that time be?  Well, that’s the $64,000 question.  If they were to dump their holdings onto the market at once, they would devalue the holdings they are trying to sell and do more harm to themselves than they care to.  If they become gradual sellers, they would damage the US economy and potentially we would not be able to buy as many Chinese made goods – again hurting their economy.

What China is doing is making every effort to create a burgeoning middle class that can replace the US as the consumer of their manufactured goods.  With 2 billion people to work with, that shouldn’t take too long to replace the 300 million or so US consumers.  Once that middle class is in place, China has much more freedom in their financial policy because they are not as tied to the US consumer.

This is one that will definitely take some time to play out, but it will play out and it will have dramatic consequences for our economy.

It seems like the worst may yet be over.  The Congressional Oversight Panel recently released its February Oversight Report entitled, “Commercial Real Estate Losses and the Risk to Financial Stability”.  You can read the full report HERE.  While the initial wave of destabilization came from the larger institutions (think AIG, Lehman Brothers, Etc.), this looming round could come from the nations’ small to mid-sized banks.

The report estimates that in the next 4 years over $1.4 trillion (with a “T”) of commercial loans will come due and need to be retired or refinanced.  In one half of those cases, the value of the underlying asset is now worth less than the amount owed on the loan.  They are “underwater” and they are a problem.  Losses to the lending institutions could total over $300 billion.  That’s not the amount that will default.  That’s the loss realized after foreclosing on the property, finding a buyer and selling it for whatever can be achieved.

But wait, we ran the Stress Test and our banks have the capital reserves to weather this storm.  Unfortunately, the Stress Test only looked through 2010.  The vast majority of these loans will become a problem for the banks in 2011-2014.  Plus, the Stress Test was only run on the larger banks.  The small and mid-sized banks were never subjected to the Stress Test.

On the plus side, there has been an insane amount of equity raised to acquire these troubled assets.  Once the banks have foreclosed on the assets and they are brought to market, there should be a willing pool of buyers.  The question then becomes, will there be so many buyers that the value get bid up to a point where the “distressed buyers” are no longer interested.  My best guess is that you see an initial round of sales at very attractive pricing.  As buyers flock to this sector, the demand and valuations will go up and the transaction volume will go down.

The worst may not be over yet for the US Municipal Bond market.  That’s according to a recent report from the ratings agency Moody’s Investors Service.  The report shows that in 2009, the agency downgraded 279 state and local government tax-backed bonds.  That is up 244% from 2008 when Moody’s downgraded only 81 such entities.  Overall, the ratings fell for 300 revenue debt issuers, up from 133 in 2008.

While the struggles that state and local governments are facing to balance their budgets is nothing new, we are beginning to see the hardship take a toll on their credit ratings.  Those lower credit ratings will make it much more difficult and costly to issue bonds, exacerbating the problems they are facing.

Econstories.tv has posted a very entertaining video comparing the economic theories of John Maynard Keynes and the free market theorist Friedrick von Hayak.  It’s a little long at over 7 minutes, but well worth investing the time.

So, who do you side with?  Keynes or Hayak?

I recently came across this bleak outlook for the US Municipal Bond Market written by Frederick J. Sheehan (see link below).  While this is just one man’s opinion, it’s enough to give a bond investor at least a few sleepless nights.  Some of the historical precedents he points out, especially those from the Depression Era, are chilling.

The Coming Collapse of the Municipal Bond Market (PDF)

It should come as no surprise that analyzing and quantifying “risk” are the name of the game in this economy.  The risk profile for Municipal Bonds is no exception.  Unfortunately, there may be some validity to the concept that Municipal Bonds carry more risk than anyone had anticipated.

According to a recent article in The Arizona Republic, some municipalities don’t see the benefits of the Qualified School Construction Bonds (QSCB’s) and are forgoing their use.  The American Recovery and Reinvestment Act, otherwise known as the ”Stimulus Plan”, created the QSCB’s as a way to incentivize new school construction.  The bonds are unique in that they pay no interest to the bondholders.  Instead, the bondholders receive a federal tax credit.  A deep investor market for these bonds has not yet emerged and many issuers are having to pay additional interest to bondholders to incentivize them to purchase the bonds.

In addition, the QSCB’s come with several requirements which may make them costly to implement.  The first requirement, and most punitive, is the requirement to utilize Davis Bacon Wage Labor rates.  Depending on the locality, this requirement alone can increase construction costs significantly.  It is not inconceivable that any interest savings achieved by using the QSCB’s could be eaten away via higher construction costs.  Secondly, there are significant and severe reporting requirements that go along with several of the ARRA created bonds, not just QSCB’s.  We have heard of some municipalities that are having to dedicate a full time staff person to handle the reporting requirements.  In a fiscal environment where every costs is being scrutinized, adding a position may not be palatable.

Much like most things in life, there are always pro’s and con’s associated with any decision.  Municipalities are well advised to lean heavily on their financial advisors as they work through the various funding options for new projects.

Boeing recently announced that they had chosen South Carolina as the location for a second production line for their 787 Dreamliner long-haul jet.  The Company current has a fuselage assembly and installation operation in South Carolina and this latest move will be a dramatic expansion of those capabilities.  According to Jim Albaugh, president and chief executive of Boeing Commercial Airplanes:

“This decision allows us to continue building on the synergies we have established in South Carolina with Boeing Charleston and Global Aeronautica”

Union officials in Everett Washington, the home of the current production line, were less than enthusiastic.  Union leader Tom Wroblewski said Boeing has:

“has betrayed our loyalty once again, walking away from our discussions.”

I guess you can’t please all of the people all of the time.  The Boeing announcement comes on the heals of the announcement by South Carolina that shipping giant Maersk has agreed to continue operations at the Port of Charleston (after announcing they would be leaving).  All in all, it’s been a great month for South Carolina economic development news.

Maersk Line announced yesterday that they continue operations in Charleston, South Carolina through 2014.  This is a reversal of a previous decision by the line to leave the east coast port.  This is obviously great news for Charleston and demonstrates their commitment to serving their shipping line clients in the best possible manner.

On the eve of September 11th, 2009 the United States fired the first shot in the trade war with China.  That was the day that the President signed an order to increase the tariff on imported Chinese tires by 875%!  With a swift stroke of the pen, the tariff went for 4% to 35% and the trade war had begun.  China responded almost immediately accusing Washington of “rampant protectionism”.  According to Beijing, the action is not only ill thought out in a time of economic mayhem, but also violates WTO rules and goes against specific promises made at the G20 summit this April.

China has promised a retaliatory action and is currently scrutinizing the imports of American poultry and autos.  The United States claims that any retaliatory effort would be “inappropriate”.

In signing the order, the President was responding to a petition from the United Steelworkers Union who was concerned about not being able to be competitive with Chinese tires.  The President stated that the new tariffs would save the jobs of 7,000 Americans.

What is interesting in all this is that the American consumer is left out of the discussion.  The consumer wants choices and value.  By implementing this order, the President is insisting that the American people pay more for their tires.  He has removed a low cost choice from their available options.  In the end, it is the consumer who pays more, buys less, and suffers the most.