U.S. state and local governments face a surge in borrowing costs after lawmakers refused to renew the federally subsidized Build America Bonds program used to fund infrastructure projects and create jobs.

Lawmakers had considered the $858 billion deal on the so-called Bush tax cuts the best vehicle for extending BABs, which expire with the stimulus plan at year end. The U.S. House of Representatives killed the possibility of an extension when it approved the deal late Thursday. President Barack Obama signed it into law on Friday.

With the end of BABs, the $2.8 trillion municipal bond market could see depressed prices and greater volatility. The bonds made up more than a quarter of all new municipal debt sold this year and have been largely attributed with restarting stalled municipal credit markets.

New York City, for example, has issued $8.9 billion of BABs, saving about $50 million a year in interest costs.

We are still in a recovery period, it helped us access badly-needed capital, capital that we needed to reinvest in our infrastructure, and we certainly have benefited from the BAB program in New York City, said New York City Comptroller John Liu.

Issuers like California, the single biggest BABs seller at about $14 billion, receive federal rebates equal to 35 percent of the bonds' interest costs. Most issuers hoped the program, which debuted in April 2009, would be extended for a year or two beyond its December 31 expiration. .

There was talk on Capitol Hill that BABs could be reincarnated, next year, most likely through a sweeping transportation bill. But that legislation has yet to be introduced.

Not being able to issue BABs, will have a very real impact on communities, either with increased taxes or decreased building, Maryland State Treasurer Nancy Kopp said. What that does to the workforce, I don't know.

Kopp said the state saved $55 million through selling BABs and other direct rebate bonds from the stimulus plan instead of tax-exempt debt. The amount, she said, was large enough to cover the costs of building three or four elementary schools.

That said, in the municipal bond market prices rose for a second consecutive day on Friday as the market got over a supply hump spurred by the end of BABs.

It has been a very tough couple of weeks for the municipal bond market. As prospects for a continuation of BABs dimmed over the last few weeks, top-rated 30-year tax-exempt bond prices dropped, pushing yields to their highest in nearly two years, according to Municipal Market Data.

On Friday, yields on MMD's triple-A scale were cut 2 to 12 basis points, with 30-year yields, which hit 4.84 percent earlier in the week, dropping to 4.66 percent.

The end of the BABs story has been priced in at this point, said Troy Willis, a vice president and portfolio manager at Oppenheimer Rochester Funds.

Typically, BABs were sold with maturities of 15 years or longer. Issuer preference for taxable BABs ate into supplies of longer-term tax-exempt debt creating a scarcity factor that boosted prices and depressed yields on that part of the tax-free yield curve.

That will now change, Michael Decker, managing director and co-head of the Securities Industry and Financial Markets Association's Municipal Securities Division, told Reuters' Insider on Friday.

The problem is we're going to see significantly higher yields, especially for long-dated tax-exempt bonds, which translates into higher borrowing costs for state and local governments, like we're seeing in the market over the last couple of days, he said.

Issuers have been rushing to sell BABs. So far in December they have sold nearly $14 billion of BABs, compared to $8.1 billion in all of December 2009, according to Thomson Reuters data on Friday. This year they have sold $115.4 billion, and over the life of the program they have brought nearly $180 billion of BABs to market.

(Additional reporting by Karen Pierog in Chicago, Michael Connor in Miami, Joan Gralla and Edith Honan in New York and Jim Christie in San Francisco; editing by James Dalgleish, Theodore d'Afflisio and Diane Craft)