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Calif. Capital Appreciation Bonds Have Unintended Consequences

SEP 20, 2012 6:59pm ET
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SAN FRANCISCO — The recent controversy over the way some California school districts use capital appreciation bonds may reflect the law of unintended consequences.

In this case the consequences stem from a law designed to protect taxpayers.

CABs got bad publicity recently when the publication Voice of San Diego detailed how the Poway Unified School District in San Diego County sold $105 million of the bonds this year that require nearly $1 billion in debt service at their 40-year maturity, without an option to call the bond.

CABs pay a compounded interest rate and principal upon maturity instead of through regular payments over time.

Some school districts turned to CABs as a way to finance construction projects despite sluggish property-tax revenues amid legal limits on the amount of debt they can take on. The bonds allow them to defer debt-service payments in the short term, avoiding near-term property-tax rate increases, but incurring much higher costs in the long run.

In California, issuance of outstanding and new general obligation bond debt may not exceed 2.5% of the assessed value of taxable property within a unified school district, according to a school finance guide published by law firm Orrick, Herrington & Sutcliffe.

Orrick says the state’s Proposition 39 — which passed in 2000 and dropped the voter threshold to approve local school bonds to 55% from two-thirds — requires the projected tax rate as the result of any single such election to be no more than $60 per $100,000 of taxable property value for a USD.

After property values dropped in the wake of the real estate bust some school districts found ways around the limits by issuing capital appreciation bonds or bond anticipation notes.

Timothy Schaefer, founder of public finance consulting firm Magis Advisors based in Newport Beach, Calif., said a main reason why school districts take on this kind of financing is because of unrealistic tax projections used to calculate how much debt they will ask voters to authorize.

“When assessed property values went down the levy rate to repay these bonds had to go up,” Schaefer said. “That is my primary complaint about these things: if you don’t properly inform the stakeholder, the voter, the property tax payer that they are at risk of this happening, then I just don’t think you have dealt fairly with them.”

If a district issues bond anticipation notes and then CABs, the cost of the notes are paid by proceeds from the CAB sale, which doesn’t result in debt service until the bonds are due. The farther in the future the CABs mature, the longer it is before the debt service payments that would count against a district’s tax limits.

Santee School District

In 2006, nearly 59% of the voters in San Diego County’s Santee School District approved a $60 million bond measure.

The district issued $18 million in GO bonds in 2007, with maturities going out 20 years and a top interest rate of 5%.

Then came the recession and property values began to fall. Santee then issued $23 million of capital appreciation bonds in 2008, $11.5 million of bond anticipation notes in 2009, $11.8 million of renewal bond anticipation notes in 2010, and finally $3.5 million of capital appreciation bonds in 2011.

By issuing the Bans and the CABs it kept the debt service on the bonds below the permitted $30 per $100,000, but the long-run cost to taxpayers is now much higher than traditional serial-bond issuances would have been.

According to the official statement for the 2011 renewal bond anticipation notes, the assessed valuation in the district declined by 3.97% from fiscal 2009 to fiscal year 2010 and future property values in the district would have to increase “significantly” for it to issue more general obligation bonds to pay of the notes in full.

Then the school district issued $3.5 million of CABs in 2011 that will cost $65 million in debt service, according to the state treasurer’s office.

“The district did not foresee or anticipate the cataclysmic drop in the economy which would erode assessed valuation growth and dry up or suspend access to major sources of revenue needed to pay for renovation of aging facilities,” Karl Christensen, assistant superintendent and head of business services for the Santee School District, said in an email. “A bond dollar spent today has considerably more purchasing power than the same bond dollar spent five, 10 or 20 years later and allows today’s students, as well as future generations, to receive educational benefits.”

Christensen said the district did its due diligence and understood the risks and benefits from the different types of borrowing.

San Diego County Treasurer and tax collector Dan MacAllister has proposed legislation to limit the terms of CABs in California to 25 years and provide more transparency for taxpayers. State Treasurer Bill Lockyer has come out in support.

“The most problematic CAB deals are ones that provide maturities that extend beyond 25 years — in some cases up to 40 years — restrict early payment while interest compounds annually, and saddles taxpayers with balloon payments and borrowing costs that can reach more than 10 times the principal,” said Lockyer spokesman Tom Dresslar.

Since 2000, California school districts have issued nearly $20 billion of capital appreciation bonds, according to Lockyer’s office. Of the $19.73 billion of CABs school districts issued, $832.8 million, or 4.2%, had 40-year maturity lengths, while another $469.7 million, or 2.4%, had 39-year maturity lengths, according to data from the treasurer’s office.

Not Just CABs

Other concerns have dogged school-district debt financing, such as the use of special districts to get around tax-rate limits, misuse of federal subsidies from Build America Bonds or qualified school construction bonds for things other than debt service, and the use of bond premiums to pay the cost of issuance.

Many of these issues were raised by Los Angeles Treasurer Mark Saladino last year in a letter to municipal bond underwriters and advisors warning them about the questionable practices.

Also in 2011, California Attorney General Kamala Harris put the municipal industry on notice that the practice of paying for issuance costs using extra money made by the underwriters during the sale is illegal since the money should go towards the purpose approved by voters.

Some experts say such practices are a glaring example of the need for the Securities and Exchange Commission to issue  a final definition of “municipal advisor” and for the Municipal Securities Rulemaking Board to tighten its political contribution rules. Since the Dodd Frank Act passed declaring that advisers have a fiduciary duty — meaning a responsibility to put their client’ interests first — the muni bond industry has been waiting for the SEC to release its interpretation and thus definition of municipal advisor.

The SEC issued an initial definition in 2010, but dealers and other market participants said it was too broad, for example, requiring appointed members of state and local government boards to register.

The debate has extended to Congress, where the House this week passed a bill  that would narrow the definition of municipal advisor and exempt some market participants from advisor registration requirements.

While dealers support the bill, many non-dealer muni advisors and public advocacy groups oppose it, saying it has too many loopholes. And market participants now worry the bill will delay the SEC even further in crafting a final definition of muni advisor — it had set a Sept. 30 deadline, but that’s expected to slip.

“We have another election season, and nobody can do anything about it because the Securities and Exchange Commission is dragging its heels on defining the term ‘municipal advisor,’ ” said Robert Doty, president of Sacramento-based municipal consulting firm AGFS.

Once the commission releases its final definition the MSRB will issue rules that would enforce it. That could force financial advisors to refrain from giving advice that puts their own monetary interest first — as it stands, many collect a contingency fee that rewards them for the size and number of issuances done.

In August, the MSRB recommended draft amendments to Rule G-37 on political contributions that would require dealers to make quarterly disclosures of the timing of bond-ballot campaign contributions, the identity of the municipal issuer selling the bonds on the ballot, and primary offerings that result from the campaign.

Rule G-37 already requires dealers to disclose contributions to bond ballot campaigns and issuer officials, and dealers are banned from negotiated deals with an issuer within two years if they or their municipal finance professionals make a significant contribution to an issuer official who could influence the awarding of muni business.

Both Doty and Schaefer have urged the MSRB to implement stricter rules and more transparency on municipal advisors and underwriters to help prevent potential conflicts of interests tied to school district financing, such as bond ballot campaign contributions. The National Association of Independent Public Finance Advisors has urged the MSRB to limit or ban underwriters’ bond-ballot contributions.

Locally, Wayne Hammar, president of the California Association of County Treasurers and Tax Collectors, has also urged the board to go even further with an “outright ban” on contributions by brokers, dealers and muni professionals to bond ballot measures.

“There is no excuse for allowing this to go on,” said Doty.  “It is a real detriment to the market that the SEC has not acted.”

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