(Bloomberg Markets) -- In March the University of California system decided to save itself some money. Just like a homeowner with a mortgage when better rates are available, it set out to refinance some of its debt. But then things got complicated. Current bondholders staged a revolt to stop the $1 billion deal, hiring a big-name law firm that threatened a lawsuit.

The drama surrounding UC’s bond offering is part of a bigger story: the messy demise of a financing program once hailed as a way to use markets to save the US economy. The university system had issued a Build America Bond, part of a federally subsidized program to get the economy moving again in the wake of the 2008 financial crisis. Lenders had pulled back from markets, and Congress and the administration of then-President Barack Obama were looking for creative ways to finance public spending that could generate jobs while upgrading the country’s infrastructure.

They came up with BABs as an alternative to traditional municipal bonds. Munis are a cheap way for states, cities and colleges to borrow because the interest they pay is usually exempt from federal and state income taxes. That means the borrower can offer investors a lower rate than a comparable taxable issuer can. The catch is that munis aren’t as attractive to a big investor outside the US, such as a Canadian pension plan or a Japanese insurer, because the foreign buyer doesn’t benefit from the tax break. BABs would come without the tax break but pay a higher rate, making them appealing to a broader group of global investors. To keep the loans affordable for borrowers, the federal government would pay them back in cash 35% of the interest cost each year.

Governments and public agencies, such as the UC system, ended up selling more than $180 billion of BABs in 2009 and 2010. At a ceremony in the White House’s Rose Garden in 2010, Obama called the bonds “one of the most successful programs” in his administration’s stimulus package, giving Americans “a better chance to invest in the future of their communities and of the country.” But the program would soon get tangled up in the hardball budget politics of that era. As part of a deal with Republicans to raise the debt ceiling, the federal government cut the annual subsidy. Currently it refunds only 33% of the cost each year instead of the original 35%.

That sounds like a small difference, but over the life of a bond, it could add up to millions of taxpayer dollars in extra interest costs, and it’s enough for many borrowers to want out of the loans. Many are looking to buy their bonds back at par value. Buybacks have foisted losses on investors who bought the securities at a high price and present an added challenge of replacing a valuable income stream. The controversial refinancings have been particularly painful for big institutional investors that don’t usually buy munis but were drawn in years ago by the higher rates.

BABs are orphans now: The window to issue them has closed, though some don’t mature until 2050. In May, a Democratic lawmaker reintroduced a bill in Congress to create an infrastructure financing program similar to BABs. But some analysts now fear that novel financing ideas will likely face more skepticism, just when big issues like climate change demand more spending. “We should abandon any notion that a direct-pay subsidy can substitute for the [tax] exemption as we know it,” says Justin Marlowe, a professor at the University of Chicago Harris School of Public Policy.

More than a dozen issuers have taken steps to refinance using an option known as an extraordinary redemption provision, according to a tally by JPMorgan Chase and Co. The provision gives borrowers the option to call—or buy back—their debt at a certain price when triggered by an “extraordinary event.” The language was included in bond offering documents to ease borrowers’ anxiety around selling taxable bonds that put them on the hook for higher payments.

While the option has been available to borrowers for years, most refrained from using it. First, it wasn’t clear if it was even legal. But sentiment shifted when Orrick, Herrington & Sutcliffe LLP, the largest municipal bond counsel, said in a February blog post it felt most outstanding bonds were eligible to be called, arguing that the government’s cuts to the subsidy counted as “extraordinary.”

Second, to raise the funds to buy back the bonds, issuers have to sell new debt. So the move makes sense only when yields on tax-exempt munis compared to taxable ones are low enough. That’s true now. The state of Washington recently saved $18.8 million by refinancing its BABs, though it drew ire from investors.

Jason Richter, Washington state’s deputy treasurer, says governments have been dealing with cut subsidy payments for over a decade. Shedding the old bonds eliminates both the higher interest payment and any risk that the subsidies will be further reduced or eliminated entirely in the future. “A lot of issuers thought the BABs subsidy payments would have the same credit quality as Treasury bond payments,” he says. “This wasn’t the case. In hindsight, it seems that the federal government wasn’t able to provide the kind of long-term guarantee it tried to provide state and local governments.”

Still, some issuers have hesitated to refinance out of fear of jeopardizing relationships with powerful investors. That anxiety escalated when a group of money management firms including PGIM Inc. and Mackay Shields LLC sent the letter threatening to sue the Regents of the University of California. The university system’s deal closed in March. A spokesperson did not respond to requests for comment, and as of late May, a lawsuit hadn’t been filed.

At first, the rancor seemed to cast a chill over deals. But more agencies are tiptoeing in. New York’s Metropolitan Transportation Authority has approved refunding some of its $3.7 billion of BABs.

The San Francisco Public Utilities Commission, which sold more than $1.3 billion in BABs in 2009 and 2010, is avoiding a refinancing for now. Since the subsidies were cut, the utility’s ratepayers have been saddled with $25 million in extra payments. “The Holy Grail would be the ability to extract ourselves from BABs that have been administratively burdensome and aren’t paying as promised,” says Nikolai Sklaroff, capital finance director for the commission. “While I’m eager for refunding savings, it’s not enough for me to know that I might prevail in court.” Sklaroff relies on investors to price its $11 billion in planned borrowing over the next decade as cheaply as possible. Still, he isn’t completely ruling out a refinancing.

Investors have argued that the subsidy cuts haven’t been material enough to legally justify the buybacks and that issuers shouldn’t have waited so long to use a call provision that was triggered over a decade ago. “Most people in my position were well aware” of the call provision, says Jim Conn, senior vice president and portfolio manager for Franklin Templeton Fixed Income. “What they didn’t really bank on is that they could be forced into realized losses.” He says his firm isn’t a big holder of such bonds, though it has some in separately managed institutional accounts.

Ben Watkins, Florida’s director of bond finance, says the program had a “defect” in it by allowing the federal government to wriggle out of the full subsidy payments. Watkins refinanced the state’s BABs in a more traditional way and saved an estimated $218 million. He says he wouldn’t participate in a similar program: “It’s certainly been a lesson for me—that is, not to trust the federal  government.”

Querolo and Albright are public finance reporters for Bloomberg News.

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