Posts Tagged ‘California’

The Grand Jury of San Diego issued a report of this title yesterday.  Also, at yesterday’s GFOA (Government Finance Officers Association) business meeting, the group voted  that the Government Accounting Standards Board should stay away from the topic of sustainability.  The only conclusion one can draw from the Grand Jury report is: the city of San Diego’s current trajectory is UNSUSTAINABLE.  Here, are a few choice passages (please read as if these too, were fully capitalized):

The City has yet to articulate structural solution to close the multi-million dollar budget deficit in fiscal year 2010.  More than 50% of this gap in financing was filled by using one-time solutions, such as skipping reserve payments and deferring projects.

In summary, this investigation is presented to the City and its citizens because the status quo is not going to resolve the crisis of financial instability, unbalanced budgets and reduction of the city’s obligations, liabilities and debts.

One of the underlying causes of the current structural budget imbalance is the underfunding of the City’s pension obligation by previous City administrations.

Ok, we know this.  This is true among states and municipalities across the country.  But what to do?  In some (not all) places the pitch of the problem has reached a scream – CONTINUING GOVERNMENT OPERATIONS ARE UNSUSTAINABLE.  Amazingly, the choice to cut critical services has become the lesser of two evils – the other being pension and benefit reform.  Elected officials, charged with managing cities like San Diego would rather have fewer cops, less trash pick-up, deteriorating infrastructure and higher taxes, than deal with runaway benefit spending.  Even if you believe that the benefits are deserved, earned and righteous, the city simply does not have the resources to pay these costs and also maintain a livable city.  So what’s the decision?  Give up the livable city?  The City’s Independent Budget Analyst stated:

Structural deficits require structural solutions.

The report suggests using the federal bankruptcy courts to determine what can and cannot be restructured.  Investors, along with public employee unions (strange bedfellows) hate this solution and prefer to stay in one-shot-land, or stand by while the deterioration mounts (see stories on Vallejo’s increasing crime.)  The courts could also decide to trim back debt obligations in the same restructuring process.  This has happened in Vallejo, where there is a moratorium on debt service payments (at least with the current intent of re-paying in full at the end of the moratorium period).  Vallejo’s bankruptcy tackled the city’s ability to reject union contracts, a key step, but they did not touch the pension issue.  The San Diego Grand Jury suggests a bankruptcy court could help sort out this benefits conundrum.

Finding 26: A proactive dialogue as to the efficacy of a Chapter 9 reorganization cannot be removed from any discourse as to the City’s financial health

Finding 27:  A Chapter 9 filing would result in a federal determination of which fringe benefits and collective bargaining agreements could be restructured.  The fringe benefit total is $423.7 million, according to the FY 2011 Proposed Budget.

RECOMMENDATION

The 2009/2010 San Diego County Grand Jury recommends that the Mayor of the City of San Diego and the San Diego City Council:Convene a panel of bankruptcy experts to discuss the legal and financial ramifications of a Chapter 9 declaration of bankruptcy, in the context of a publicly noticed City Council or Council Committee meeting. 

In this context, the municipal credit analyst, the investor and the taxpayer, need a new tack on fiscal review.  Unfunded pension liabilities must be included as a long term debt in debt ratios.  The rating agencies discuss these burdens but they are not included in the numbers. Medians that include all long term and contractually obligated costs should be developed to correctly compare cities and identify outliers like San Diego Vallejo.  The long term cost of these obligations should clearly be disclosed so that ratios may be calculated.  For example, red flags of fiscal trouble are waving fervently in San Diego’s case and the Grand Jury mentions Vallejo as well:

In 1994, the city’s budget for pension expense was 6% of payroll cost.  Today, sixteen years later, the cost is 28% of payroll, and growing.

For FY2009, the City’s fringe benefits rate was 52.5% of budgeted salaries of $728 million (IBA Report #09-10 issued February 24, 2009, p.2).  On average, privately operated companies spend 35% of budgeted salaries on fringe benefits. 

Some 76% of Vallejo’s operating budget went to salaries and benefits.  The norm is 50%.  Pensions were not an immediate issue since Vallejo had funded its pension obligation.  Vallejo’s most significant liability was $135 million of unfunded health care.  Vallejo officials brought the unions back to the bargaining table after the federal bankruptcy judge ruled collective bargaining agreements can be voided. 

A few other red flags that can be identified with a bit of extra work:

Is the municipality/state postponing annually required benefit contributions?  Is the government making its “annually required contribution” or ARC?  If not, this will catch up quickly as evidenced in San Diego (see separate post on the state of Illinois)

Are judgments and claims high and increasing?  This points to the government’s poor risk management practices and sloppiness.  This is a low-hanging fruit that cities should tackle with gusto.  The Grand Jury found in San Diego’s case:

Funding of the City’s (self-insured) public liability fund against lawsuits that could drain the General Fund for years to come.  As of June 30, 2009, the City faces $129 million in claims.

Funding the city (self-insured) worker’s compensation fund against outstanding claims, currently estimated at $161 million.

As the press and blogosphere keep telling us, there will be more municipal defaults and bankruptcies.  But there is a difference between painting all securities with the same brush and rigorous analysis.  We believe the flags are identifiable. 

We are coming out of a period when investors bought municipal bonds with their eyes closed.  The mantra that municipals don’t default and the once widespread presence of bond insurance convinced the investing community that analysis was irrelevant.  No more.  On the other hand, Congress has pressured newly contrite rating agencies to upgrade municipals at perhaps the worst time in history. 

San Diego’s GO ratings?  Moody’s: Aa3; Fitch: AA- and Standard and Poor’s: A 

There is a table at the end of the Grand Jury report with a September 6, 2010 deadline for city officials to respond to the specific recommendations.  The Mayor, the City Council, the Retirement System’s administration, the Audit Committee and Independent Auditor are required under the state of California Penal Code to do so. Looks like a busy summer.

See this post on Reuters for discussion about Antioch, latest city in California to talk bankruptcy.  There is a bill, sponsored by state senator Mendoza, AB155, that would require cities to go through the state (via the California Debt and Investment Advisory Commission, CDIAC).  The bill was referred last week by the Senate appropriations committee — but now appears there will be some further review.  The pros and cons line up as follows;  cities strongly against state involvement in order to preserve local autonomy; unions and bondholders in favor in order to prevent reduction of obligations, whether they are union contracts or debt obligations.  Interesting line-up.  Many states have had oversight programs for their distressed communities for years.  Distressed designation may trigger  grants or aid to distressed municipalities that would not be present in a federal bankruptcy.  Some states map out a “receivership” process that gives the state certain intervention rights to reorganize the municipal government and bring finances back into balance.  Cities oppose any additional intervention by the state that encroaches on their powers.  Pro-union forces in the legislature want to prevent the cities from filing bankruptcy since it may result in reduction of  contract provisions (which was determined to be possible in the Vallejo case).  So far the pension albatross has yet to be tested.  According to Antioch’s 2009 audit the city is obligor on about $27 million certificates of participation, paid through lease agreements, current underlying ratings are Standard and Poor’s “A” and there is MBIA insurance on at least some (maybe all, we didn’t check each series) of the certificates.

Tight financial margins are not kind to political squabbles.  In the last few weeks the city of Los Angeles has been engaged in a squabble with the city council and its utility, the Los Angeles Department of Water and Power (LADWP).  The city’s mayor wants the utility to implement green power, the utility asked for a rate increase to cover additional expenses, the council refused and the utility held hostage a transfer to the city of funds.

Each of these events has its own logic, but when the “b”-word (as in “bankruptcy”) got thrown around, the city’s rating was downgraded and put on negative watch. 

Looked at from a different perspective, when one body of government promotes green power or makes a regulatory change, utilities either get some kind of financial incentive or are simply required to comply.  They could file a rate increase request with their state Public Utilities Commission.  Or at the municipal level the utility would pass along the extra costs to the consumer – assuming the local council goes along.  The PUC could grant the increase (or not) and the utility would charge higher rates or alternatively eat the loss through lower profits (or maybe find savings!).

Transfers from municipally owned utilities are also common practice.  Think of them as “payments in lieu of taxes” (PILOT).  Most investor owned utilities (IOU’s) pay taxes to the local government.  The PILOT or tax covers the cost of the usual stuff – police, fire, sanitation, roads that benefit the utility, as well as an economic environment that allows the utility to grow or maintain its customer base.  In some parts of the country, where municipally owned utilities are more common, these transfers are made below the line – after all other expenses have been paid – so that the security covering utility bonds is not compromised.  For IOU’s, not paying the corporate taxes – is out of the question.  Non-payment could result in penalties or shut-off of power.

Not so in Los Angeles where all of this is up for negotiation.  In tight economic times, when reserves are thin and maintaining monthly cash flow is essential to the government function, a hold-up could spell disaster.  The LA city council opted to play a high stakes game and in the current environment, the mayor’s counter-offer of bankruptcy or shutting down city government added fuel to the fire.  Factors that are not up for negotiation elsewhere got caught in the political crossfire in Los Angeles.

I am posting Municipal Utility Transfers , an article I wrote  some time ago on this topic – covering Los Angeles under Mayor Riordan – that still has merit today. For municipal history buffs (a small and nerdy group), today bears a strong resemblance to the 1992 period: a run-up in asset values followed by a bubble-burst; taxpayer protests; downgrades and economic recession, particularly in southern California not to mention the Clinton mid-term elections.  Keep in mind that the city of Los Angeles and its utility are large, diverse and wealthy and will be able to manage through the storm.

Here’s a clip from the California League of Cities concerning AB 155.  AB155 (and its parallel, SB88) briefly, would prevent California cities from filing bankruptcy without going through the state — California Debt Investment Advisory Commission (CDIAC).  Numerous other states have adopted similar provisions, which puts the state in the middle of helping with a workout and prevents a municipality from directly filing for bankruptcy with the federal courts (the government level where bankruptcy is handled).  The bill has been around but appears to be picking up momentum.  The League opposes this bill.

Midterm congressional elections will be lively this year.   Conditions are ripe for tax and spending initiatives and numerous recall elections are also on the popular agenda.  Budget deficits, rising taxation and runaway spending are factors leading to tax and spending limitations.  Anger at the federal government sometimes gets played out at the state and local level where people can air their views in the local media and have greater influence on budgets, tax levies and spending. 

The combination of denied credit, deeper debt, harsh taxation…led the discontented to suspect a conspiracy by the moneyed interests of the country to enslave them in a web of economic servitude.

(From David Schmidt, on the rise of the initiative and referendum movement in the 1880’s. Citizen Lawmakers: The Ballot Initiative Revolution, Temple University Press, 1991)

The same characteristics that showed up in the 1970’s and today were present in the original initiative movement.  Indebted farmers and frontiersmen who had moved out west felt that they were subject to the special interests of industrialist bankers, railroad barons and land speculators.  The boom and bust cycles of westward development left a rift between the farmers and frontiersmen and the groups that they saw as the exploiters.  It was the farmer’s belief that these greedy influences had corrupted the legislatures and that they were being taxed to help those special interests. 

In the late 1880’s the number of farm foreclosures exploded and a vast number of farms were taken over by the loan companies.  Out of this era came the Farmer’s Alliance which later developed into the Populist Party.    The right of citizens to directly create laws through the initiative movement – “direct democracy” — stems back to this time and later with the Progressive Party.  These groups were strongest in Texas, the Dakotas, Kansas, Oklahoma, Alabama, California, Colorado and elsewhere in the South and West.  Ballotpedia, a “wiki”, or open electronic encyclopedia, (like “wikipedia”) shows the following map of states that permit initiatives, referenda and constitutional amendment.

Click twice to enlarge

Click twice to enlarge

In the 1970’s rapidly rising real estate values accompanied by a tax structure that captured an increasing proportion of homeowner’s income in property taxes again led to significant voter unrest.  That time period gave us California’s Proposition 13 in 1978, passed by two-thirds of the state’s voters and reducing property taxes 57%.  In the 1960’s and 1970’s California had experienced an extraordinary growth in property values and in tax bills, largely due to inflation and dramatic increases in population.  In Massachusetts, prior to passage of Proposition 2 ½, state and local taxes grew from 103% of the national average to 124% of the national average.  Idaho, which passed Petition No 1 in 1978, had seen residential taxes nearly double between 1969 and 1978.  Later, Colorado voters passed the “taxpayer bill of rights” or TABOR which sought to significantly limit government (1992).  (TABOR has subsequently been loosened but a movement is afoot to roll back the liberalization of the original law.)

The presence of a committed and zealous individual or group is another key ingredient.  Although some dismiss these individuals or groups as “cranks”, they will persist in introducing ballot measures year after year, until something passes.  Howard Jarvis in California and Bill Sizemore in Oregon are two well-known names.  Today’s Tea Party groups are spawning new leaders in this effort. 

Demographics play a part in initiative and referenda movements as well – states with lots of retirees like Florida, Arizona and California – have ready workers with time on their hands to get petitions signed and talk with the neighbors.  In addition, the continuous migration of people from place to place has intensified demographic differences. 

The “pick-up-and-go” mindset in the U.S. has led people to sort themselves into like-minded communities – reinforcing particular political viewpoints.  “Over the past thirty years, the United States has been sorting itself, sifting at the most microscopic levels of society, as people have packed children, CDs, and the family hound and moved…When they look for a place to live, they run through a checklist of amenities: Is there the right kind of church nearby? The right kind of coffee shop? …When people move, they also make choices about who their neighbors will be and who will share their new lives. Those are now political decisions, and they are having a profound effect on the nation’s public life…In 1976, less than a quarter of Americans lived in places where the presidential election was a landslide.  By 2004, nearly half of all voters lived in landslide counties.”  (Bill Bishop, The Big Sort, Houghton Mifflin, 2008)  Another of Bishop’s key points is that interacting primarily with like-minded people tends to make a group’s political viewpoint and perspective more extreme.  Electronic social media also plays this role.  The use of the Internet, blogs, Twitter and YouTube for grass roots campaigns has made it easier to create, inform and activate like-minded communities.

The sorting, polarizing and intensifying of political views has created gridlock in many state and the federal legislatures. Maintaining the primacy of one’s political party and political viewpoints often win out over collaborating to create effective policy. “California’s primary system and gerrymandered Assembly and Senate districts, both parts of the Constitution, consistently produce candidates from the ideological extremes.  In such an atmosphere, party orthodoxy rules all, and crossing the line to compromise is political suicide.  For this reason, real, desperately needed change is blocked at every turn, and only bills like regulating tanning booths actually escape alive.”  This is from Jim Wunderman in the San Francisco Chronicle last summer.     Examples are easy to find in the state legislatures, notably California and the embarrassing New York State Legislature where Democrats physically locked out the Republicans last summer.  At the Federal level too, Republicans’ refusal to vote on any proposals from the Democrats or collaborate on sensible solutions is a further example of this polarization.

Finally, funding for initiatives and referenda has become big business for some proponents.  In California and elsewhere, gathering petitions and paying for advertising campaigns has spawned a well-funded cottage industry.  The recent Supreme Court decision permitting corporations and unions unrestricted campaign funding will inevitably reinforce the trend. 

Grassroots groups are reacting.  The Tea Party is an example of the tension between the grassroots and organized parties.  The Tea Party is a loose and in some areas unaffiliated collection of organizations.  Tea Party Nation, Tea Party Express and Tea Party Patriots are among the few national organizations.  Tea Party Patriots has accused Tea Party Nation of co-opting the name from the grassroots movement and receiving support from the GOP.  Teapartynation.org is sponsoring the first national convention on February 4-6 in Nashville, Tennessee and Sarah Palin is the featured speaker.  Complaints about the hefty registration and GOP support are common.  A lawsuit erupted in Florida over the registration of the name as a political party.  The defendants argue that the name stands for “taxed enough already”.  The blog site “TPM Muckraker” has some interesting coverage of these various party disputes.

Whatever your affiliation, ballot initiatives will likely affect state and local government finance as well as governance in the next year.  It is worth following these trends.  Along with Ballotpedia, we recommend the Initiative and Referenda Institute at the University of Southern California as a good resource, as well as the National Conference of State Legislatures.

A particularly toxic form of adjustable rate mortgage is going to hit the headlines in the spring and summer of 2010 with defaults, foreclosures and workout discussions extending into 2012.  “Option ARMs” also known as “Pick-a-pay” allow the borrower to choose how much to pay each month and reports indicate 94% of all borrowers paid the minimum.  What’s the catch?  The difference between the minimum and the actual loan rate gets added to the loan balance creating “negative amortization”. 

These loans were originated in the 2004-2007 bubble period with a majority sold during the peak year, 2006.  They were popular in high cost areas, typically more exurban and inland places where houses were slightly more affordable.  A Moody’s report mentions that 54% of these loans were made in California and another 13% in Florida. The next largest origination states were Arizona and Nevada.  About 28% of all home loans originated in the 2004-2008 period in Vallejo-Fairfield (Solano County) California were option ARMs.  One quarter of the home loans originated in Santa-Rosa-Petaluma in Sonoma County were Option ARMs.  These figures are according to the San Francisco Chronicle

The following chart shows the top-10 MSA’s by size of outstanding option ARM balance, including negative amortization, thanks to Alla Sirotic of Fitch Ratings. Note that these are as of August, 2009 so the balances may be different today.  Also, these represent Non-agency RMBS (residential mortgage backed securities).

CLICK TWICE TO ENLARGE

CLICK TWICE TO ENLARGE

The payment option mortgage lured buyers into thinking a big, new house could be affordable.  The pitch?  The borrower thought he/she could re-finance into a more sensible structure or in the worst case, sell the house and pocket some additional equity.  Many of these loans were also used by speculators who hoped to make a profit on the sale and by holders whose files were poorly or fraudulently documented.  Articles citing homeowners who were told the loans had no risk abound.  The housing bust is driving down values and some of the 2006 vintage loans now have a loan-to-value (LTV) of 163%, making the refinance or resale prospect out of the question.

Many of the loan structures had a period of five years before the loans re-cast to fully amortizing and fully loaded interest – hence the toxic brew hitting in 2010-2012.  Around 78% of the option ARMs have yet to recast, and of those loans, 93% have negative amortization, according to a recent Standard and Poor’s teleconference.  The structures also typically carry an amortization trigger when the loan exceeds 110%-125% of the original balance, which could happen before the five year period.  The recast payments could be significantly higher than the monthly amount the homeowner deemed affordable at origination. 

A popular chart that has been circulating among the housing bubble blogs comes from Credit Suisse and shows the timeline for adjustable rate mortgage resets and option ARM recasts.  While the bulk of sub-prime adjustable interest rate mortgages have been re-structured, or are making their way through the foreclosure process, the chart illustrate how option ARMs recasts have yet to hit the fan.  (This version from the “Mortgage Insider, Matthew Padilla of the Orange County Register, updated through April 2009.)

CLICK TWICE TO ENLARGE

CLICK TWICE TO ENLARGE

The solution?  Moody’s concludes that loan adjustment is really the only feasible solution, short of major additional dislocation for homeowners and additional heavy mark-to-market write-downs for the institutions holding this paper.  Wells Fargo is reportedly doing just this on mortgages it owns on the books (accounting for some of the discrepancy in the numbers).  On the political front, the prospect of loan modification is highly controversial.   Some elected officials do not want to look like they favor one group of troubled homeowners over another.  Hmmm. 

Finally, the size of this coming problem is also controversial.  Credit Suisse had to make some assumptions regarding recast dates.  Since payment amounts are, well, optional, the level of negative amortization must be estimated and the time when these loans hit the trigger ahead of the five-year period is also estimated.  Some loans were 40-year, rather than 30-year, complicating the calculations further.  Moody’s and Fitch’s numbers show about $200 billion will be recast in the 2010-2012 period.  The Wall Street Journal cited $750 billion originated between 2004 and 2007 (according to Inside Mortgage Finance).  Some of the discrepancy is between publicly held RMB (residential mortgage-backed) securitizations, loans held on bank balance sheets and agency securities. Sirotic points out that Non-Agency RMBS volume is approximately 17% of the overall outstanding US mortgage market and securitized Option ARMs represent about 13% of the Non-Agency RMBS.  There are definitely more Option Arms loans that are held in bank portfolios, she commented.  So the rest are in federal agency securities, FNMA, FHLMC and GNMA, now a federal balance sheet problem.

A Barclay’s report mentions that many of these loans are already in default ahead of the recast and so should be removed from the numbers. (So is this good news or bad news?)  Housing Wire further reinforces this point:  “The prospect of option ARMs swollen with negative amortization coming to recast and defaulting on a massive scale inspires bond investor fear — and hysterical headlines — but the real fallout might be dimmed by the share of loans that have already foreclosed and no longer remain in the pool.”  Stephen Berg, MD of Lender Processing Services told Housing Wire that they only had about 800,000 active option ARMS.   Whether you think 800,000 loans and $750 billion are small or large numbers, the option ARM will punch more holes in household, government and institutional balance sheets in the coming months.

The slowdown in migration in the U.S. has significant consequences for municipal finance.  New population growth in a community has been the driving force in municipal infrastructure finance since the beginning – and the slowdown we have seen over the last two years will affect bond volume in previously high growth centers.  Borrowing to meet the needs of growth is politically easier when expectations for repayment fall on the new beneficiaries.  Borrowing for maintenance is more challenging and we expect capital spending to fall in the near term both from internally and externally generated funds.  In addition, problems from high foreclosures and developer bankruptcies have cropped up on the suburban frontier, where the slowdown in migration is pronounced.  A look at the recent census report adds an important dimension to our understanding of state and local fiscal condition.

Local movers – people who move from city to suburb and suburb to suburb are typically first time homebuyers, mover-uppers and those whose family circumstances have changed (births, deaths, and divorce).  The stimulating tax credit for first-time homebuyers plus reduced downpayment requirements (which combined to allow zero downpayment for many) has offset some of the downturn in the housing industry over the last six months – first the threat of tax credit expiration pushed some into the market and then the extension brought in some additional buyers. 

People move long distance mainly for jobs.  With many economists predicting a slow recovery for employment, long distance moves are unlikely to pick up near term.  “Long-distance migration acts as an engine of growth in many metropolitan areas…younger adults are far more likely to move than older individuals,” according to William Frey of the Brookings Institution.  (There is a small peak in migration among people in their early sixties who move for retirement.) Long distance movers tend to be college educated and professional. 

Florida:  Frey peeled back the demographics on Florida’s net out-migration, a historic trend and a surprise to many.  “The shift from net in-migration to net out-migration in Florida was especially strong for whites, Hispanics, younger people, married couples and persons with some college education…Despite its total net out-migration, Florida still attracted people ages 55 and over in 2007-2008.”  Sales taxes and health care services may perform satisfactorily under this demographic shift to older residents.  But older migrants on fixed incomes will reinforce anti-property tax sentiment in the state and there will be even less interest in supporting stressed school finances.

California: More people are staying put.  The state is the mirror image to Florida – a reflection of softening real estate costs and the weak job market in magnet states such as Arizona, Nevada and Oregon. 

Arizona and Nevada: These states’ dependence on construction will hurt in the current environment.  Arizona’s net in-migration, while still positive, has fallen by more than 54% from its peak in 2006 to 2008.  Nevada’s net in-migration has fallen more than 75% from its peak in 2006 to 2008.  At the peak of Nevada’s building boom in April, 2006, more than 11% of all employment in the state was in construction.  Arizona’s construction employment was next highest at 9.3% followed by Florida at 8.6%.  This compares with a U.S. level of 5.6%.  Managing through this drop-off is critical.  The negative comment in Moody’s downgrade report on Arizona’s upcoming COP sale caught our attention: “lack of institutionalized best financial management practices”. 

Trouble in suburbia: The outer suburbs are suffering the fall in migration with increased crime and squatters in empty houses.  Some writers, such as Christopher Leinberger declare that exurban communities will become the next slums.  ABC Australia covered this phenomenon last spring: “…it is easy to find signs that America’s relentless suburban expansion may have petered out…Streets remain incompletely paved and poorly lit, the legacy of a builder that declared bankruptcy.  And transient renters have replaced homeowners who were forced out by the foreclosure crisis.”  Prince William County, where the subject community is located saw a nearly 40% drop in property values according to the county’s 2010 budget message.  The “Aa1” rated county is entering the year well-positioned for the challenge, but has cut the budget across the board, eliminated services and increased classroom sizes.  The county has taken down its capital improvement budget by 64% since last year.  Other governments that are less well managed may not fare as well. 

Cities and dense metro areas well-positioned for economic recovery: “Migration matters,” according to the Economist December 19 edition.  “Economic growth depends on productivity and the most productive people are often the most mobile…When clever people cluster they can bounce ideas off each other.  This is why rents are so high in Manhattan.  Robert Lucas, a Nobel economics laureate, argues that the clustering of talent is the primary driver of economic growth.”

I have placed a longer discussion of these issues for download when you click Migration Report.

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.

CLICK TWICE TO OPEN LARGER

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:

CLICK TWICE TO OPEN LARGER

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.

CLICK TWICE TO MAKE LARGER

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. 

CLICK TWICE TO MAKE LARGER

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.

School districts are often considered the safest investments in the tax exempt markets. They receive from 20-90% of their funding from their state governments, most of the rest from property taxes.  So what to worry? Well, state governments, whose revenues react most quickly to economic changes, are having trouble. (Excellent coverage of state troubles at http://rockinst.org).

Take California for example. It is unlikely that school districts there will be spared the budget ax.  Districts teetering on the edge of financial balance will face the most trouble.   As California legislators battle to resolve their $20+ billion deficit, we took a look at that state’s school district watch list.  Every six months the California Department of Education examines school district fiscal status and posts a list of districts that have received a “negative certification” and “qualified certification”.   According to their website: http://www.cde.ca.gov/fg/fi/ir/second0809.asp:

“A negative certification is assigned to a school district or county office of education when it is determined that, based upon current projections, the school district or county office of education will not meet its financial obligations for fiscal year 2008-09 or 2009-10.”

Sounds dire.  19 districts received negative certification in the second half of 2008-2009. This is 12 more than last year at this time — although four came off last year’s list and one moved down to “qualified”.  Since it is every state’s obligation under the U.S. Constitution to maintain a free public school system we are not worried that the worst off will actually go out of business. They can’t. States have the ability to take over and run a failing school district whether for financial or operational reasons.  This type of receivership often also comes with emergency loans. But cutbacks and the latest emergency distraction will make it more difficult for districts to get attention in the statehouse.

In California, the Infrastructure Bank made loans to three school districts: Vallejo City USD, West Contra Costa USD and Oakland USD. The good news is that these school districts cannot file bankruptcy as long as the state Infrastructure Bank bonds are outstanding. (West Contra Costa did file Chapter 9 bankruptcy in 1991 under its former name, Richmond USD.)

We decided to pull one of these to look deeper into the status of the negative certification.  What’s in a name?  Vallejo City itself is is battling for its financial life in Chapter 9 bankruptcy so we decided to look at their school district (a separately financed and governed entity). The school district has been on the state’s negative list for a few years now.  In 2004 when the district faced a $27 million deficit, district leaders requested an emergency apportionment from the state. A state administrator was appointed with powers to:

terminate the employment of certain District personnel, to enter into agreements on behalf of the School District, and to change any existing District rules, regulations, policies or practices

According to June, 2008 state data Vallejo City USD had drawn down $60 million ($50 million in 2004 and $10 million in 2007) and has about $42.7 million outstanding loan balances. As of the district’s latest audit, June 30, 2007 (filed by the state in February 2009) the district had a total of $191 million long-term debt outstanding. About 60% is general obligation and debt from the Community Facilities District #2. District GO bonds are insured by Financial Security Assurance (FSA) and the CFD bonds are insured by Syncora.

Following takeover, the state’s “Fiscal Crisis and Management Assistance Team” (FCMAT) springs into action. FCMAT examines the district top to bottom each year until functions are able to be returned to the district. Most of Vallejo’s operating functions have shown enough improvement to be returned to district control. This is with the notable exception of financial management. Four years on, the FCMAT’s sixth progress report shows that budgeting and finance in the district is still below par. Two items that stand out: the district continues to have difficulty counting noses and has a lower than desirable ratio of ADA (average daily attendance) to enrollment (either too many kids are absent when they count or the district is failing to count all of their students in attendance). Counting noses accurately is key for receipt of per pupil state aid. Second, budget and financial management are still weak. There are now new people in the business office and there appears to be a trend of improvement.

With the state hunting for funds from every corner and distracted by its own fiscal troubles the oversight umbrella will likely weaken. Vallejo City USD and its watch-list neighbors have some tough times ahead.