Seth Rosenblatt
We’ve seen this pattern time and again. Some public agency or public official gets negative press for apparent bad behavior. Often it is deserved, and sometimes not. But far too frequently the press oversimplifies the situation and reduces the story to sensational sound bites. Then politicians jump into the fray, promising to fix the situation and “protect taxpayers” (who wouldn’t support that?). But it’s likely that the issue is more nuanced than at first perceived, and policymakers risk overreacting. And the worst part is that often the cure is worse than the disease.
Such may be the case regarding the recent legislative proposals on Capital Appreciation Bonds (CABs). The lack of critical thinking and thoughtful dialog on this issue has been scary, and we are in serious danger of doing more harm than good to both taxpayers and responsible school districts across the state. The net result of this potential legislation is that it will likely (a) reduce the bond capacity of school districts, (b) delay receipt of proceeds to use for construction projects, and/or (c) increase the present-value cost to taxpayers.
Quick primer: There are generally two types of bonds that school districts issue. The first, called Current Interest Bonds (CIBs), require the borrower to pay the interest payments each year, and then at the end of the term pay back the entire principal amount. The other, Capital Appreciation Bonds (CABs), just have the interest accrue over time, and then both the principal and all of the accrued interest is paid back at the end of the term. Naturally CABs will have a greater total payment at the end of their term, as interest payments were accrued rather than paid along the way, and CABs will likely have slightly higher interest rates because of the lack of current income to the investor. In both cases, all payments are made from a tax assessment on property owners—the tax collected becomes the money available to “service” the bond. If a district issues a Proposition 39 bond (the ones which only need 55% to pass), there is a statutory limit on that tax assessment allowed (the “tax rate limitation”). This inherently limits the “bonding capacity” of the district. Also, some bonds have “call” provisions which allow the principal amount of the bond to be paid back early. Most districts build bond programs to layer the bond repayment schedules to create a relatively level tax burden over time (structured around previously issued bonds to maintain tax rate targets) and spread that burden over the life of the facilities (essentially it’s a combination of many individual bonds with different structures and terms to create these level payments over time and within existing bonding capacity limits). This often requires both CABs and CIBs to make the math work, and of course it’s dependent upon when funds are needed, the interest rates at the time, the total amount of bonds authorized, and the overall tax rate limitations.
The current controversy stems from the fact that the Poway Unified School District issued CABs that will cause them to repay ten times the original bonds’ proceeds at their maturity in 40 years. Other districts have had similar issues with the seemingly high “repayment ratios” (the total amount of the repayment divided by the original amount) with CABs.
To be clear, I’m not defending Poway—nor, frankly, do I have any of the details or context about their situation—but even if their actions were improper or ill-advised in any way, that hardly means that the zeal to avoid such situations in the future should cause us to enact a single standard across the state that could be very damaging for many public schools. While well intentioned, some of the proposals coming from Sacramento are problematic because they (a) apply a one-size-fits-all approach to financings that disregard a district’s unique characteristics and prior debt issuances, (b) disregard market factors, and (c) ignore basic finance principles such as the time value of money.
It’s a basic principle of finance that money today is worth more than money tomorrow (and less than money yesterday). This is illustrated a few ways. The most common way is to look at inflation of goods and services. The price of milk was a lot cheaper decades ago than it is now, and will be more expensive in the future. The median home price in the U.S. is about eight times what it was 40 years ago. The other common way to illustrate this principle is interest on money (which has been historically higher than inflation). For example, if you were to take out a loan, at a 6% interest rate, making no payments along the way and compounded over 40 years, you will accumulate a balance ten times the amount you borrowed. Does that mean you got a bad deal? Not necessarily, because effectively (if interest rates averaged 6% over those four decades), the money you’ll be repaying with is worth one-tenth the amount of the money you borrowed.
Unfortunately, the proposal to limit the repayment ratio to 4-1, while intended to reduce nominal borrowing costs, ignores how bond series are structured. The first issuance of a bond program typically has the lowest repayment ratio because districts have more taxing capacity (i.e., they may issue shorter term bonds). As bonds get issued and upfront tax capacity is utilized, later bond financings tend to have higher repayment ratios. Moreover, due to the time value of money, repayment ratios are meaningless absent information on the term of such repayment. They measure “nominal” dollars spent (meaning the total of all money spent ignoring that a dollar today is worth more than a dollar tomorrow).
Additionally, the proposal in Sacramento to limit all school bonds—not just CABs—to a 25-year maturity ignores the simple fact that almost all school facilities last a lot longer than 25 years (in our district, we’re about to remodel or replace some facilities more than 50 years old!). Limiting the term of these bonds would have the effect of forcing current taxpayers to subsidize future taxpayers, who will still enjoy use of an asset for which they didn’t pay.
In the absence of context, bond term limits and repayment ratios are both inherently arbitrary. In addition, these proposals also ignore the fact that most districts issue Prop. 39 bonds, which already have a tax rate limitation that prevents the district from having a bond program with excessive repayments in any given year and hence serves as a protection to taxpayers and a limit on borrowing. And given that such tax rate limitations are always disclosed in Prop. 39 bond elections, there is transparency. To my knowledge, these proposals coming from Sacramento do not distinguish between Prop 39 bonds and other general obligation bonds. Districts with Prop. 39 bond programs may be most negatively affected by the current legislative proposals, as existing tax rate limitations combined with a reduced ability to use capital appreciation bonds will limit districts’ flexibility to structure bond series in the most rational way and address needed modernization or safety projects.
Two of the other proposals coming out of Sacramento are less onerous but still require discussion. These include giving greater oversight responsibilities to county offices of education as well as requiring that bonds be “callable,” i.e., they can be paid off prior to maturity. While the former proposal adds another layer of administration and bureaucracy to the process, this could be a reasonable check and oversight on districts that step over the line—at a minimum it will force a public dialog about special circumstances. A call option on all bonds would of course be a benefit to districts, but it’s important to point out that requiring bonds to have this feature would increase their price to taxpayers as investors are forgoing certainty in future interest payments and would have to be compensated for this (another basic principle of finance).
I have been disappointed by much of the press on this topic with attention-grabbing headlines about repayment ratios that simply ignore the time value of money and simple principles of finance. In addition, many school districts are extremely concerned that, in reaction to perceived poor decisions by a handful of school districts, the state is considering far-reaching and one-size-fits-all legislation that could adversely impact responsible school districts.
Of course the big irony in all of these discussions is that many districts’ more aggressive stance in bond financing is a direct result of the failure of our state to provide proper funding for building and remodeling aging school facilities, particularly in an era where we desperately need new 21st century facilities. In the absence of the state taking responsibility, many local communities have stepped up to pass bond measures to support their struggling local schools. And now we may be stifling that.
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Seth Rosenblatt is a member of the Governing Board of the San Carlos School District. He also serves as the president of the San Mateo County School Boards Association and sits on the Executive Committee of the Joint Venture Silicon Valley Sustainable Schools Task Force. He has two children in San Carlos public schools. He writes frequently on issues in public education, including in both regional and national publications as well as on his own blog.
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