Too bad legislators can’t simply pass a law saying, “Stop it!”
To grow is a natural law of government. Legal barriers to government growth are circumvented. Instead of complying with statutes designed to protect taxpayers from poor financial decisions, local government officials often seek workarounds.
Often, the fuel for enlarging government comes in the form of creative debt financing designed by Wall Street’s brilliant attorneys and financial wizards.
A few years ago, the in vogue creative debt instrument was capital appreciation bonds (CABs). Frequently issued by school districts, CABs allowed cash-strapped local governments to issue bonds and delay payment on principal and interest for decades, rolling the accumulated debt back to taxpayers not yet even born.
Lawmakers in Michigan were so concerned for the negative financial consequences of this form of financing that they voted to outlaw CABs in 1994. Texas followed suit in 2015 with H.B. 114 by Rep. Dan Flynn. Flynn, a banker, understood more than many lawmakers the danger posed by CABs. Flynn’s bill, in effect since September 2015, prohibited the issuance of property tax-secured CABs with maturities of longer than 20 years.
Prior to Flynn’s law, however, several school district in Texas and around the nation got in deep with CABs. Leander Independent School District earned a rare debt downgrade from Fitch, the bond rating agency, which wrote that Leander’s “very high debt levels” were likely to require “further restructurings” and that the district’s “amortization of principal” due to the “… extensive use of capital appreciation bonds to minimize tax rate impacts (would) shift the debt burden to future taxpayers.”
But Flynn’s H.B. 114 didn’t curtail local government appetite for exotic debt, it simply shifted debt-fueled growth from CABs to a different bond species known as Soft Put Bonds. What are they? They’re akin to those 5-1 hybrid adjustable-rate mortgages that start with a fixed rate for five years and then convert to a variable interest rate. The risk for public agencies, and taxpayers, is that the interest rate may rise significantly after the bond is issued, resulting, in the dry language of the financial world, “a stepped up coupon rate.”
Both CABs and Soft Put Bonds are of interest to local governments for two reasons: obtaining voter approval to issue more debt, typically resulting in higher property taxes; and short-term cash flow. The risk comes later when, as the result of deferring debt repayment or holding payments low, the greater debt obligations come due.
In Texas, the accumulation of deferred payment debt by local government, especially school districts, comes with the added issue of moral hazard. Moral hazard occurs when decision makers make risky decisions but don’t have to bear the consequences of those risky decisions—sorry, it was our mistake, but you have to pay.
A well-known national example of moral hazard occurred with the federally-chartered mortgage companies Fannie Mae and Freddie Mac. Their well-intended purpose was to increase home ownership. The problem was that they weren’t loaning out their own money, rather, they had the implied backing of U.S. taxpayer, allowing banks to make some $238 billion in what came to be bad loans to homebuyers with poor credit.
The moral hazard aspect of issuing debt with delayed payment obligations is two-fold: first, it increases financial risk to future taxpayers and future local elected boards; second, because the State of Texas backs some $75 billion in school bonds, up from $55 billion only four years ago, with the Texas Permanent School Fund’s Bond Guarantee Program, investors who buy Texas school district debt aren’t particularly at risk of losing their principal. This puts them in the position of encouraging more debt issuance and not worrying about vetting the ability of local districts to repay that debt, knowing that the State of Texas is guaranteeing that debt.
To that I say, “Stop it!”
This commentary was originally featured in Forbes on June 18, 2018.