Saturday, June 27, 2009

Still More With the Bonds

My anonymous Mt. Lebanon-native / current Wall Street banker commenter sent in another comment that I can't post (which s/he knows, but s/he wanted to communicate with me anyway). But the comment is detailed enough on the subject of municipal debt financing that I want to summarize it very quickly - so that I can respond again. It's weird to have this kind of sort-of-one-sided "conversation" with an anonymous correspondent, especially on a blog that has a strong "no anonymity" comment policy, but the blogosphere is weird sometimes, and this is an important topic. To be clear, I'm using the anonymous comment only as a basis to float and respond to some important substantive arguments.

The comment makes few key points:

(1) Debt financing for municipal projects is often a good idea, because (i) it allocates the cost of improvements to the full range of taxpayers who will benefit from them and (ii) it creates a stable pool of resources to manage improvements, rather than leaving improvements to the vagaries of annual tax collections. (ii) is a valid point, and I said so in my earlier post, so we agree on that. In this case, however, there's no evidence that the Mt. Lebanon Commission is motivated by that argument. (i) is true in cases where we're talking about a true capital improvement, rather than something that's an operating expense, but it isn't related to (ii), that is, it can be sensible to create a debt-financed budget pool that isn't linked to the life of particular assets. Whether we're talking about version (i) or version (ii) of this argument depends, therefore, on a classification question. It wouldn't be smart to finance repairs to fire trucks with debt, but it might be smart to create a financing pool. It would be stupid to build a bridge with anything other than debt, and it would be smart to match that debt to the life of the bridge. Mt. Lebanon is using debt financing to financing street repaving and sidewalk repairs. Are these more like fire engine maintenance, or more like building a bridge? My answer is below.

(2) Debt financing can always be refinanced down the road (the bonds can be called, assuming that a call option is written into the bonds), and often is. That's true again, but of course you don't know up front whether market conditions will make it smart to exercise the option (that's what makes it an option). If rates go down, then call; if rates don't, then don't call. Right now, it strikes me that history is a particularly poor guide to what we expect in all debt markets, including muni bond markets. In other words, you might argue that the current 20-year-bonds are really 10-year-bonds with an option. But I suspect that markets are going to be much more unpredictable in the future than they have been in the past, which makes that recharacterization less plausible.

(3) Wrapping is an market-standard approach to municipal debt. The Street wraps bonds because clients want wrapping -- it's cheaper. This is a semi-persuasive defense of the banks, but it doesn't mean that wrapping is smart policy, and that's what the debate is all about. Of *course* local governments love to issue wrapped bonds -- that's because politicians can avoid having to deliver bad news (sorry! your taxes are going up while I'm in office!) to their constituents. Wrapping and call-options are "kick the problem can down the road" policies that permit local governments to avoid having to account to the voters for the true short-term costs of their decisions. [Update: My anonymous correspondent read this post and wrote again, disagreeing with my characterization of the politics of wrapped bonds. In his/her view, "wrapping" limits potential abuse of debt financing by politicans. I don't have time or energy to explore the details here, so I'll note the point and punt on whether she/he's right, or I'm right, or some of both.]

That's why forcing local governments to anticipate and plan for the cost of ordinary maintenance -- vehicles, buildings, roads, parks -- is so important, and and why it should be (in the ideal world that doesn't exist) comparatively easy. Bridges and trucks need to get replaced only once in a great while. Borrow for those, and spread the one-time cost over the life of the asset. Roads and sidewalks need to get repaired every year (obviously, the same road or sidewalk doesn't get repaired each year, but treat "roads" and "sidewalks" as assets, rather than as groups of assets (each road isn't an asset, in other words, for this purpose), and it's easier to see that "roads" get repaired every year. Trucks need to get repaired every year. So this goes into the budget. Again, per the above, it might be rational to borrow to create a pool to finance the budget - but if that's the case, the "life of the asset" rationale disappears.

With respect to the current paving/sidewalk bonds, there's no evidence that the Commission approached the decision in a way that reflects these kinds of judgments. That's what bothers me and a lot of people more than anything else: The sense, judging from publicly-available information, that the Commissioners are merely reacting, and reacting without consideration, to whatever information happens to be in front of them at any given moment in time.

Demand better.
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Anonymous Arthur d'Arrigo said...

My initial reaction to the issuance of this bond issue was that it was a lazy response to the road improvment needs, and that the commission was getting overly aggressive "financial advice." Your anonymous commenter illustrates the rationale underlying the "pitch" for Debt Financing very well indeed. But, his/her arguments are generalized "text book" scripts about the general benefits of debt financing. Couched in whatever language you like there is nothing revelatory here. There are lots of benefits to Debt Financing, but it is very difficult to find justification for the specific application of debt financing in this case.

If this is the type of "advice" the commissioners are getting, then it is pretty easy to see how they slid into such a lazy solution. It is a lazy sales pitch, not real advice. This is particularly clear when you look at the "wrapped" vs "serial issue" discussion. There is no good justification for wrapping such a small bond issue, the current benefits are insignificant compared to the long term costs. Again all the evidence points to a generic "solution" rather than a consdieration of the facts pertaining to this particular issue.

I also question the size, term, and timing of this bond issuance. In the final analysis this is a rather small bond issue. A small issue like this contains the same type of fixed expenses (bank and legal fees in particular), and therefore a higher expense ratio than a larger bond issue. It is pretty cavalier to toss off small bond issues like this for elective projects. I feel the 20 year term is defensible, but stupid. The combination of factors smells bad. Basically this is appears that the commissioners were induced to take out a loan with no real value, poor rationale, and bad structure. This could be a case of "churning", but no one held a gun to the commissioners' collective head. More likely it is a bad decision made in an environment where no real analysis or forthought was applied to the situation here in Mt Lebanon. They were pitched.

June 27, 2009 1:11 PM  
Anonymous John Ewing said...

“The Street wraps bonds because clients want wrapping -- it's cheaper.” That is what Mike was told by a no-name municipal bond commentator.

I was in the securities business for 41 years and my experience includes selling municipal bonds to investors and banks. I also was Chair of an ad hoc investment committee for the school district for 13 years and our work included investing school district funds and we covered municipal bond issues at some points. I was the Finance Chair of the School Board when the Lincoln bonds were issued. Wrapping isn’t cheaper, it is a gimmick to lower current millage at great deal more long-term expense to the community.

Take the 2003 elementary school bond issue that paid off $75,000 in debt out of $50,000,000 between 2003 and 2017. We only paid interest on these bonds for 14 years and left the principle to be paid by long-term residents and parents with children in school in 2018.

Let’s use a simple example of 1000 residents putting $50,000 each on their own credit card to pay the elementary renovations. Over 14 years $75 of principle would have been paid on each $50,000 charged in 2003. The interest charges were huge.
The remaining balance would be principle of $49,925 to be paid with interest from 2018 forward.

The 2003 bonds were refinanced in 2005 for almost $53,000 on the credit cards and approximately $1,200 of the $53,000 was paid by 2017 leaving a credit card balance of $51,800 to be paid from 2018 forward.

Only Interest was paid on the debt from 2003 until 2018. A second commission and other fees were charged by the bond broker to the District to pay for the 2005 bond issue. Those commissions and fees run up the outstanding debt for the benefit of the brokers, not Mt. Lebanon. Bill Matthews has estimated the extra cost of the interest-only wrapping of these bonds at $10,000,000 to Mt. Lebanon taxpayers.

A second round of wrapping school bonds is expected with the issuance of $47,000,000 more school bonds at a cost of another $10,000,000.
According to your no-name municipal bond correspondent wrapping is cheaper but calculations show it is $20,000,000 more expensive on the school side. It is also more expensive on the municipal side too.

The financial advisors hired by the Municipality and the District are promoting their own business interests at Mt Lebanon’s expense and need to be replaced.

If the Financial Officers of the Municipality and the District won’t find better financial advice for our community then the Commissioners and the Board need to replace both Financial Officers for the financial health of our community.


John H. Ewing

June 30, 2009 12:29 PM  
Anonymous Bill Lewis said...

The Commissioners appointed an ad-hoc advisory committee in 2003 to analyze and make recommendations on budgets and financing options. The committee was comprised of six, I recall, local resident volunteers with strong financial backgrounds. One member was the Financial Advisor on this $2 million street reconstruction bond issue. The advisory committee recommendation for small capital projects to be debt financed (undoubtedly like this street reconstruction project) was to do it with a note from a bank rather than a bond issue.

Interesting, isn't it folks, when you pay attention to how even local governance is conducted.

July 01, 2009 1:39 PM  
Anonymous Arthur d'Arrigo, Jr. said...

Clearly the Ad-Hoc Committee was spot on with their recomendation in 2003. If anything the current climate and demographic trends in our city reinforces the need for prudent financial stewardship. But alas, advocating responsible financial vehicles is seldom as sexy as flipping deferred interest bonds.

I was happy to see that I am not alone in my assessment of this matter. However, I am fairly new to the city, and do not know all the players and history. But it is truly galling that in a city with such a wealth of human capital and expertise that the Commissioners would ignore the sound advice from the 2003 Ad-Hoc Committee.

I truly hope this is not a case of personal gain trumping the interests of Mt. Lebanon. But the alternative explanations are not much better. My opinion is that this whole affair smells bad, but I base that only on intuition and unrelated personal experience.

What can be honestly stated is that this is an instance where the Commissioners have been cavalier in their fiduciary obligations. While I am sure being Commissioner is a tough and often thankless job, they need to understand and respond to valid criticism. Surely none of us (commissioners included) are as brilliant as we sometimes think we are. Acknowledging mistakes is a sign of maturity and growth. It would be nice to hear from the Commissioners that they recognize problems with this Bond issue or make a defense against our criticism.

July 02, 2009 12:14 AM  

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