The Street Responds

I hope you read my recent piece concerning my local school district and the ridiculous bonds it issued.  To reiterate, the Poway Unified School District borrowed money at 6.8 percent tax-exempt (necessary despite its Aa2/AA- ratings due to its unusual terms) last year via a bond which provided for no debt service payments for more than two decades.   Talk about creative financing!  These so-called “capital appreciation bonds,” which raised $105 million in 2011 for needed improvements to district facilities, will require $877 million in interest payments between 2033 and 2051.  To make matters worse, the bonds are non-callable; to add call provisions would have added about $100 million in costs due to the higher coupon the bond would have been required to offer.

Barry Ritholtz of The Big Picture wrote a nice follow-up this morning linking my post and emphasizing that, once again, “a group of rubes got rolled by The Street.”  Not surprisingly, an analyst at one of The Street’s leading purveyors of municipal bond investments, Nuveen Asset Management, has rushed in to try to explain why the deal isn’t so bad after all. Let’s take a quick look at his argument.

Initially the Nuveen argument notes that “the district generated $21.36 million of premium, increasing total proceeds available to the district to $126.36 million – or an additional 20% above the stated par value of the bonds.” We get that the terms of the bond gave the district more money to work with than a typical bond offering.  The interest and repayment information in all reports (press and otherwise) all reflect it.  Moreover, the simple fact remains that $981.5 million of debt service repayment compared with $126.36 million in proceeds is a terrible deal.

The essence of the argument relates to a claim that these bonds provide for repayment more equitably by those who actually reap the benefits of the bonds:

As the district contemplates how to finance the construction of significant new capital investment in a short time frame, they are forced to consider what is the most equitable way to finance assets with expected lives of 50 or more years. In other words, should today’s residents pay for the entire cost over the next 15 or 20 years, or should future generations of residents that will also benefit from the facilities share some of the burden? The former strategy may be less expensive to the district as a singular entity but more expensive to today’s residents. By comparison, the latter strategy is more expensive to the district as a singular entity but may well be the more affordable option for residents that don’t intend to live in the community for 40 years or would rather maintain lower taxes over time. This is a tough public policy call and not all bond issuers make the same choices when faced with such a dilemma.

That’s certainly creative and perhaps even plausible sounding, but it’s wrong on its face.  This bond offering didn’t finance the building of facilities with expected useful lifespans of “50 or more years.”  It financed upgrades to facilities and those upgrades — very generously — can be expected to have a useful life of 10-15 years. Indeed, the upgrades to my local elementary school were not even completed before the money ran out (again!) and will likely be obsolete in well less than a decade. The bond also risks crippling the ability of the district to perform future upgrades — those needed before these bonds are repaid.

Moreover, “intergenerational equity” and an alleged effort to “smooth” payments over 50 years (dealt with in my earlier post) had absolutely nothing to do with the district’s actions.  It was all about political realities.  The money was needed and no bond issue requiring tax hikes could pass. With no debt service until other bonds were repaid, the district could claim that taxes were not being raised.  By “kicking the can down the road” the district thought it might get away with having its cake and eating it too (to mix metaphors but in a way you’ll no doubt understand).

Finally, the Nuveen argument focuses on the financial health of the area and optimistically hopes that on account of inflation, these bonds will be able to be repaid with ease.  That argument may turn out to be correct.  The district may well be able to repay these bonds using devalued dollars.  And since the district is part of a relatively affluent community, the money will likely be available to repay the bonds in any event. But there is no prudence in banking on such future inflation and future affluence rather than taking the “sure thing” of much lower financing costs by issuing conventional bonds. The ability to repay doesn’t turn a bad bond deal for the issuer into a good one.

Just to add a little “kicker,” note that the Nuveen argument is made using an illustration involving “a home that is worth $300,000 in 2017,” even though the median value of a home in the district today is nearly $500,000.  So the actual numbers are (of course) far worse than advertised.  But even then, the “monthly contributions to the annual levy” according to that analysis go from $5.04 to $74.49 over the life of the bond, and that’s a fifteen-fold increase.  If you think that’s a reasonable increase, you must work for the underwriter or want to buy more of these bonds.

So an obligitory defense has been offered, weak though it is.  Of course, given the substance of what was available, “The Street” (via Nuveen) did a pretty good job because there is no good defense to be made. This deal stinks to high heaven.

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The Day of Reckoning

One year ago today, analyst Meredith Whitney predicted gloom and doom for municipalities and for municipal bonds. She claimed that we should expect at least 50-100 “sizable” muni bond defaults totaling hundreds of billions of dollars in 2011. Whitney’s prediction evoked great fanfare and was highlighted on 60 Minutes.  “I think next to housing this is the single most important issue in the United States, and certainly the largest threat to the U.S economy,” she said. Whitney’s argument was that state and local governments were running huge deficits with federal stimulus dollars in their coffers; when that stimulus ended, the massive defaults would begin.

New Jersey Gov. Chris Christie famously claimed that “the day of reckoning” had arrived.   I disagreed and have been correct (at least thus far).  I argued that the situation wasn’t as dire as Whitney forecast and that judicious municipal investments ought to pay-off handsomely (I suggested focusing on quality generally and pre-refunded issues and revenue bonds backed by reliable revenue streams more specifically as well as overall caution with respect to general obligation bonds).  An investor who bought $10,000 of muni bonds the day after Whitney’s December 19 60 Minutes appearance would have made a returns well in excess of 10 percent on that money in one year (based upon the Merrill Lynch Municipal Master Index, which calculates price changes and interest income). Lower interest rates and overblown credit risk claims both contributed to this performance, which beats U.S. Treasuries, stocks, corporate bonds and commodities over the same time period. This return is better still as a practical matter because muni interest income is tax-exempt.

At least to this point, we have seen no “day of reckoning” — even for Whitney.