"We firmly believe that local governments should understand what they are doing when issuing debt, and that they should tell the citizens and disclose all the risk involved," said Tennessee Comptroller Justin Wilson, who sought a law requiring his office to approve local governments' use of backloaded debt.

BRADENTON, Fla. — In Tennessee, new laws protect the state's credit ratings and strengthen local public financing rules.

The state is now prohibited from spending its funds on debt owed by a municipality, and starting July 1, local governments issuing balloon or backloaded debt must get the comptroller's approval first.

The General Assembly addressed those issues in separate bills this year that the governor signed into law.

House Bill 1398, the spending prohibition on municipal debt, is aimed at protecting the state's credit ratings.

Tennessee has about $2 billion of outstanding general obligation bonds rated triple-A by Fitch Ratings and Moody's Investors Service, and AA-plus by Standard & Poor's. All three agencies assigned stable outlooks.

HB 1398 prohibits state funds from being spent to pay the indebtedness of a municipality, but it does not prevent a city from using its allocation of state-shared taxes to pay its obligations.

While the state has never paid debt owed by a local government as a matter of practice, Rep. Mike Carter, R-Ooltewah, said that he sponsored the bill because he thought it needed to be codified in the law.

Carter, a businessman and attorney who has worked on bond issues, said he came to the conclusion that the law was necessary after hearing the comptroller report on meetings with analysts in New York, who asked questions about the state's liability for municipal debt.

Comptroller Justin Wilson said during rating reviews analysts ask about the status of local governments, if they are performing, and what supervisory authority the state has over them.

"All the rating agencies ask about this," said Wilson. He did not ask for Carter's legislation to address those questions, but supported it, he added.

Wilson said that since becoming comptroller in 2009 that he is unaware of any local government "coming to the state asking to be bailed out of a direct obligation."

Carter said he sponsored the new law to clarify the state's position and allow the comptroller to point to it when meeting with analysts.

"The purpose was simply to protect the stellar bond ratings of the state," he said.

If a city defaults or otherwise cannot pay its debt, "then they cannot come to the state and ask to be bailed out as Detroit did," Carter told the House Finance Ways and Means Committee in a March 24 review of the bill.

"Certainly it was an attempt to distinguish us from Detroit," he said in an interview with The Bond Buyer Monday.

There are no cities in Tennessee that are near the kind of financial distress that prompted Detroit to file the largest-ever Chapter 9 bankruptcy case in July 2013, Carter said.

Tennessee law does not authorize municipalities to file for bankruptcy.

But the state does have a program that allows fiscally distressed local governments to request emergency loan assistance from the comptroller's office.

Carter said HB 1398 was amended before passage to make it clear that the comptroller's emergency funding program is still in force, though it requires that the distressed local government request assistance before a default occurs.

"No city has ever done that because when a city makes that request for assistance, the state takes over the city," Carter said. "The elected officials lose all authority, and if they are willing to do that, we're willing to help them."

Carter also said that he hopes the new law will help improve the state's bond ratings.

The legislature also took action this year to strengthen the state's oversight of debt issued by local governments.

House Bill 1446 requires that the comptroller's office approve the use of "balloon" debt by local governments, which includes incorporated cities and towns, metropolitan governments, counties, and utility districts.

The law goes into effect July 1, and the comptroller's office has proposed guidelines to implement the approval process. The guidelines are undergoing public comment, and are posted on the comptroller's website.

The legislation is designed to increase transparency and accountability, according to Wilson, whose office asked for HB 1446 to be passed.

"We firmly believe that local governments should understand what they are doing when issuing debt, and that they should tell the citizens and disclose all the risk involved," he said.

The law was not in response to specific problems, though Wilson said his office has noticed an increase in borrowing with deferred payment of principal.

Balloon debt — or backloading debt service to defer the repayment of principal on bonds beyond a normal amortization schedule — is a policy that Tennessee does not support unless a local government has a good reason, Wilson said.

The burden is on local governments to explain why such a structure is appropriate.

Wilson said a reason for using such a structure could be the need to borrow after a natural disaster or flood, and there are other circumstances where backloading could make sense, such as the structure of outstanding bonds.

The new law is "really designed for transparency, accountability, and not for a government to simply say, 'I don't want to pay for this now, so I'll let someone else pay for it later,'" he said.

Under the law, "balloon indebtedness" is defined as one or more of the following — debt having a final maturity date 31 or more years after issuance, bonds that delay principal repayment for more than three years after issuance, the use of capitalized interest beyond the construction period, or structuring a deal without substantially level or declining debt service.

Wilson said his office has seen offerings with maturities that extend past 30 years, and some deals are suitable if justified.

"It's not unusual to have longer than 30 years but it means further inquiry is appropriate," he said.

The state grants a blanket exemption for federal loans through the U.S. Department of Agriculture, which are typically for more than 30 years.

"It's important that governments be very transparent to the public when issuing debt, especially when principal repayment is deferred," Wilson said. "These guidelines will provide guidance to local governments regarding the information my office needs to properly review proposed transactions."

Wilson has successfully proposed legislation and rules aimed at strengthening local public financing in Tennessee since he was appointed comptroller in January 2009.

By October of 2009, Wilson recommended state-mandated guidelines for the use of derivatives, which were adopted by the Tennessee State Funding Board.

The requirements were in response to the financial crisis that started in 2008 when bond insurers were downgraded, the auction rate securities market fell apart, and many swaps failed, causing some issuers — particularly smaller governments — to make large payments to counterparties or terminate the swaps at high costs.

After the derivatives guidelines went into effect, Wilson successfully proposed that local governments establish debt management policies that included setting limits on debt maturities, discouraging the use of backloaded debt, limiting the use of variable-rate debt to 25% in their portfolios, using independent financial advisers, and including strategies to avoid conflicts of interest.

The debt management policies were tweaked in 2011 to require that all local governments adopt policies by the end of that year.

The policies also require local government decision-makers to clearly understand their transactions and to make offering details available to the public, including the costs and risks of each deal.

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