Archive for December, 2009

In a recent report about Mello-Roos Community Facility Districts (CFD’s) the California Debt and Investment Advisory Commission (CDIAC) stated:

Despite the potential impacts of evolving mortgage conditions, CFD’s have not reported higher default rates, at least through 2007-2008, but have reported a recent rise in the number of their draws on reserves.

(Mello-Roos bonds are post-proposition 13 financings that are secured by “special taxes” rather than more typical ad valorem taxes.  They are mostly issued by school districts, cities and towns and are a popular version of California’s land secured tax exempt finance.) 

To date CFD’s have held their own on the default scene, certainly doing better relative to Florida community development districts which are defaulting in droves.  We believe the lag in defaults is too lightly appreciated and there will be an elevated default pattern in the next two years. 

Like other corners of the real estate markets, Mello-Roos borrowings soared in the 2000-2007 time period.  We show CDIAC’s summary for Mello-Roos activity.   Nearly 60% of all issuance from 1992-93 was sold during this time period.

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CLICK TWICE TO OPEN LARGER

A look at the 1990’s downturn in the California real estate market compared with Mello-Roos defaults is instructive.  The Calculated Risk blog posted the following chart in 2005:

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CLICK TWICE TO OPEN LARGER

Calculated Risk shows the early 1990’s real estate boom had positive growth until 1991 then went negative until finally turning positive 1996. 

Now look at the default chart from the CDIAC report.

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CLICK TWICE TO MAKE LARGER

Two observations: first, as expected, draws on reserves peaked ahead of defaults.  Draws hit their high in 1995-96, just when real estate was beginning to climb out of the trough.  Second, defaults didn’t peak until 1997-1998 and remained elevated until the 2001-2002 year.

 

Bill Huck, CEO of S&Y Capital Group points out that building permits are a better indicator of trouble.  Building permits began their steady and steep decline in 1985-86 and didn’t trough until 1993. 

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CLICK TWICE TO MAKE LARGER

Baked into this relationship is the assumption that land development must continue for the districts to remain solvent – underscoring the “speculative” nature of this type of finance.  So a drop off in building permits correlates with a prediction of future defaults – with a longer lag period than the asset value decline that is grabbing so many headlines today.  Once a home is sold, even if it has lost value or is in foreclosure you are most likely to get the Mello-Roos tax payments, Huck commented. 

 

A few factors slow down the default timeline.  First, some counties where Mello Roos predominates, such as Orange (but not Riverside) includes districts in the “Teeter” program.  Under Teeter the counties pay 100% of the property taxes to the local agencies and then receive penalty and interest payments.  The counties have the right to kick out an agency from the program in the next year, so this source of cash flow is not ironclad.   Most counties would rationally kick out delinquent payers rather than lose money on their Teeter programs.   Second, many CFD’s have debt service reserve funds, so reserve draws are an important early indicator of trouble.  Finally, many CFD’s are less leveraged than special districts in other states.  The awareness of payment problems has led financial managers to be pro-active, whether through bond refinancing or more aggressive foreclosure resolution.  Given that reserve draws are elevated again we expect to see defaults climb in the next few years – or sooner if covering counties exit the Teeter plan.

From the trough of recession it can take up to two more years for cities (and other local governments) to reach their revenue low point, according to research by the National League of Cities and the Brookings Institution.  If the overall economy has hit bottom, we’re looking at another few years for local government to find the low point.  State revenues, such as income taxes, lag the downturn in jobs and corporate activity.  A budget cycle later, state actions to close their gaps trickle down to the local level.  What’s the message here?  Local governments should be aggressively planning their out-year budget actions today, thinking creatively to find cost savings and not expecting the state or federal government (or the taxpayer) help out.  Those that set aside some funds today and continue to improve efficiency will best weather the next two years.  We quote Christopher W. Hoene (National League of Cities) and Mark Muro (Brookings), co-authors of the recent report:

Because most city tax revenue is collected only at a few specific points during the year, or over the course of several years in the case of property tax revenue, there is usually a time lag of 18 months to two years before economic shifts register their full impact on city fiscal conditions. This means that cities will be navigating the implications of the downturn for quite a while longer, even if the business climate improves quickly. For instance, drawing upon city experiences in the past two recessions, the low point, or “trough,” in those recessions came in 1991 and 2001 respectively. But the low point for city revenues came in 1993 and 2002. The implication: America’s cities, towns, and suburbs will likely be struggling with the effects of the current downturn throughout 2010 and 2011 and most likely beyond that.

  Their chart is worth a thousand words. 

Double Click chart to enlarge

Double Click chart to enlarge

State legislatures, required to balance their budgets, are up against the wall.  Budget gaps have worsened mid-year.  When you total the gaps going into the budget for FY2010 with mid-year fissures you come up with more than $190 billion according to a recent report from the Center for Budget and Policy Priorities. This is after the benefit of the federal stimulus monies.  (Note that many states have either raised taxes or cut the budget to address the pre-budget gaps – CBPP has several studies on these actions.  The National Conference of State Legislatures also chronicles the current status of budget gaps.)  Another think tank, the Rockefeller Institute, looked at the revenue side of the gap and how states are coping with the current recession.  State revenues, compared with local government, are more volatile, reacting faster and deeper in the current recession.  Sales and income taxes are most volatile.  Also volatile, but a smaller percent of the budget are capital gains taxes and the all-but-gone mortgage recording taxes.  With most economists predicting a jobless recovery, income taxes and sales taxes are likely to remain depressed for some time.

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