How NOT to finance public works: The Capital Appreciation Bond Saga

Capital appreciation bonds God help school board members. They don’t get paid for their service, and they certainly aren’t compensated for the bombastic late night calls from irate parents when Little Fauntleroy isn’t selected for the lead in the annual 5th grade play.  That said, let’s explore one more reason for them to go gray while doing their civic duty: Swimming with Financial Sharks.

In late 2012 the Los Angeles Times reported that approximately 200 California school districts and community colleges had been talked into Capital Appreciation Bonds which promised to mitigate the problems associated with financing school construction costs. So, what could go wrong?

“CABs, as the bonds are known, allow schools to borrow large sums without violating state or locally imposed caps on property taxes, at least in the short term. But the lengthy delays in repayment increase interest expenses, in some cases to as much as 10 or 20 times the amount borrowed.”

Only, it wasn’t 10 or 20 times the amount borrowed – given the $500 billion borrowed could turn into $2 trillion in future repayments.

“Wall Street exploited the school boards’ lack of business acumen and proposed the bonds as blank checks written against taxpayers’ pocketbooks. One school administrator described a Wall Street meeting to discuss the system as like “swimming with the big sharks.”

Wall Street has preyed on these school boards because of the millions of dollars in commissions. Banks, financial advisers and credit rating firms have billed California public entities almost $400 million since 2007. Lockyer described this as “part of the ‘new’ Wall Street,” which “has done this kind of thing on the private investor side for years, then the housing market and now its public entities.” [SF.com]

This was lucrative business for such firms as Piper Jaffray, which pocketed some  $31.4 million in fees for brokering 165 CAB deals, or for Goldman Sachs which earned $1.6 million for a single deal in San Diego. [SF.com]

The argument in favor of Capital Appreciation Bonds is deceptively simple.  Most bond issues have steady repayment schedules and are limited to 30 years or less.   Capital Appreciation Bonds assume that the asset will appreciate in value or generate revenue for longer than 30 years or less – so, why not spread out the repayment schedule over a longer period? Here’s why, and here are two things to watch as the sharks circle:

(1) Watch for interestingly engineered estimates of future revenues.  If you are looking at property values that are expected to increase exponentially, then imagine the shark grin facing in your direction.  “Gee,” sayeth the Shark, “The recession can’t last forever, and property values will increase. Therefore, why not spread your borrowing costs over a longer period when you’ll be generating larger incomes?”

(2) Watch for the piling up of fees and interest.  Yes, the repayment schedules were such that school districts in California could construct gyms, classrooms, and other facilities that couldn’t get past voter disapproval of bond issues – but as with all loans the longer the repayment schedule the more interest will be paid. For example, the Savanna School District (Anaheim) took on $239,721 in CAB obligations in 2009 on which it will pay approximately $3.6 million by the 2034 maturity date. [Alter]  There are, unfortunately, other examples in Orange County, CA:

“Over the next 40 years, these bonds are projected to cost districts $2 billion as they repay them at rates of 1.1 times to 15 times the principal, according to figures provided by the state treasurer’s office. Conventional bonds typically carry a 2-to-1 or 3-to-1 debt ratio.” [OCR]

It’s entirely possible to call for more infrastructure construction and asset enhancement without having the specter of the Capital Appreciation Bond salesman showing all fifteen rows of teeth in each jaw.  We should also call this kind of dealing what it is – predatory lending.  The Roosevelt Institute provides a summary:

“The financialization of the United States economy has distorted our social, economic, and political priorities. Cities and states across the country are forced to cut essential community services because they are trapped in predatory municipal finance deals that cost them millions of dollars every year. Wall Street and other big corporations engaged in a systematic effort to suppress taxes, making it difficult for cities and states to advance progressive revenue solutions to properly fund public services. Banks take advantage of this crisis that they helped create by targeting state and local governments with predatory municipal finance deals, just like they targeted cash-strapped homeowners with predatory mortgages during the housing boom. Predatory financing deals prey upon the weaknesses of borrowers, are characterized by high costs and high risks, are typically overly complex, and are often designed to fail.” [RooseveltInst]

High cost, high risk, overly complex, and sold to the school boards as a way to finance capital projects without breaking the “no new taxes” pledges.  The thought of paying out at 15:1 when the debt costs should have been no more than 3:1 is possibly worse than the ranting of Fauntleroy’s mother after the 5th grade play cast was announced. And so we come to the camel’s nose into Nevada’s tent with a recommendation for infrastructure funding:

“Along these same lines, there may be instances where changing legislatively imposed requirements relating to bonding may benefit from increased flexibility. For instance, bonds for capital projects are generally limited to terms of less than 30 years. However, in a limited number of cases, such as projects which generate user fees or for which the useful life of the asset extends beyond 30 years, there may be instances where longer financing terms may be useful to accelerating the timeline of a needed capital project.” [Applied Analysis]

What is Applied Analysis (client list includes Chambers of Commerce) recommending?  “More flexibility” in bonding requirements? This sounds ominously like California’s infamous AB 1388 which launched the CAB craze in our western neighbor.  Lengthen the repayment period to the life of the asset? The average functional life of a school building is 40 years. [NCES] So, a capital appreciation bond could be issued for 40 years – go back to the unfortunate example of the Poway School District, wherein borrowing $150 million ended up costing $1 billion.

School board members, as well as city and county officials, should approach suggestions that they want “more flexibility” and “longer repayment schedules” with exactly the same trepidation they’d approach the water when the shark alert sign goes up.

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