CHICAGO — Iowa, an earlier user of Build America Bonds, won't draw on that program again for two upcoming sales because the savings are not worth the worries over heightened scrutiny from the Internal Revenue Service, Treasurer Michael Fitzgerald said yesterday.

The state on Tuesday will sell $140 million of revenue bonds backed by its moral obligation pledge to finance construction of a new maximum security prison authorized by the Legislature last year. The deal also will retire $6 million of notes issued in April 2009 to fund initial planning for the facility.

William Blair & Co. is the book-running senior manager and Bank of America Merrill Lynch is co-senior manager. Public Financial Management Inc. is financial adviser and Dorsey & Whitney LLP is bond counsel. Strong retail demand is expected as interest on the bonds carry an exemption from both state and federal income taxes.

The bonds mature in 17 years, so Fitzgerald said the BAB program's savings are limited over a tax-exempt structure, given that the most economical benefits of the taxable program remain on the long end of the yield curve. Recent IRS comments over future audits and federal offsets involving subsidy payments have, however, curbed the state's interest.

Iowa more likely would have considered BABs in its $150 million sale of I-JOBS bonds expected as soon as September. The sale is a follow-up to $600 million the state issued last July to fund a new infrastructure program. The 2009 deal included a mix of tax-exempt and BABs that were created in the federal stimulus program.

"We just don't think the savings are significant enough, with Treasury looking at audits and looking at withholding payments. We don't want the difficulty unless the savings are significant," Fitzgerald said.

"With the help of our finance team and bond counsel, we certainly have dotted every 'i' and crossed every 't' on our BAB sale last year, but when you hear they are going to audit 50% of deals, it looks like a witch hunt and that they are trying to wrestle with the states. We don't want the red tape. If we had a large deal with more savings involved, we would consider it."

Fitzgerald said he does not know of any subsidy payments withheld to offset payments owed by the state to the federal government.

An IRS official initially said last month that half of BABs might be audited, but the agency has since backed away from that assertion and officials have sought to ease issuer concerns, calling worries over the level of audits and the withholding of BAB interest payments overblown.

The deal next week was assigned a Aa2 by Moody's Investors Service and AA by Standard & Poor's. Iowa, which does not issue direct general obligation bonds, carries top issuer ratings from both agencies. It has $770 million of rated debt that either carries its moral obligation pledge or its appropriation pledge.

Iowa broke ground earlier this month on the new prison. The state has pledged towards repayment of the bonds revenues raised from court fines, fees, and forfeited bail from criminal cases. The pledge is subordinate to repayment of a 2002 bond issue that matures in 2016 with annual debt service of $8 million. Pledged revenues totaled $83 million last year and have grown 8% annually since 1995. They will provide five times debt service coverage once the 2002 bonds are retired.

The rating on the prison bonds is supported by the strength of the state's moral obligation pledge, adequate debt-service coverage and reserve fund, but is challenged by the narrow pledged revenues and the use of a subordinate pledge.

"Iowa's financial position has strengthened in recent years, allowing the state to be better prepared for the sudden economic shift," Moody's noted.

The state ended fiscal 2009 with an unreserved, undesignated fund balance of $802 million, or roughly 9.1% of fiscal 2009 revenues. Gov. Chet Culver cut spending by 10% in fiscal 2010 to deal with reduced revenues. The March forecast projected a 9% drop in revenues in fiscal 2010 before returning to modest revenue growth of under 1% in fiscal 2011 which begins next month.

The state expects to close out fiscal 2010 with $807 million in its cash reserve fund and an economic emergency fund which represents 15% of revenues. The state earlier this year adopted a $5.28 billion budget for fiscal 2011.

The I-JOBs deal was originally set for sale in late spring or early summer, but was postponed as the state does not yet need the proceeds, Fitzgerald said. Bank of America Merrill Lynch will serve as senior manager on that deal, with William Blair acting as co-senior. PFM is also advising on that transaction. The state is still working on structural details.

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