the world turned upside down: the contemporary revolution in state and local government capital...

The World Turned Upside Down: The Contemporary Revolution in State and LocalGovernment Capital FinancingAuthor(s): Randy HamiltonSource: Public Administration Review, Vol. 43, No. 1 (Jan. - Feb., 1983), pp. 22-31Published by: Wiley on behalf of the American Society for Public AdministrationStable URL: http://www.jstor.org/stable/975296 .

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22

The World Turned Upside Down: The Contemporary Revolution in State and Local Government Capital Financing

Randy Hamilton, Golden Gate University

Hard-pressed for capital funding, American state and local governments have turned to new, creative, or previously little-used financing devices which are largely unmentioned in the literature on public finance and which, for the most part, did not exist as little as two or three years ago. Traditionally, the long-term state and local bond market has been supported primarily by large institutions with profits to shelter. But, many of these institutions such as fire and casualty companies have curtailed their state and local government bond buying because of reduced profit margins. The lack of institutional buying has forced tax-exempt bond yields to unprecedented highs, or, putting it another way, has vastly increased the interest cost to bond issuers because they have been forced to make the yields on state and local bonds attractive to the remaining buyers-indi- viduals with less concern about the tax-sheltered aspects of public bonds. Yields for 20-year obligations hover near an all-time peak of about 13 percent.

The world has turned upside down. Traditionally, three out of every four state and local government debt service dollars went to repayment of principal and one went to pay interest. That ratio is now reversed.

There are more than a dozen new fiduciary or fiscal instruments which have turned the staid, sedate bond world into an exciting, innovative aspect of public administration that bears scant relationship to the un- changing practices of the past. Confronted with non- traditional circumstances, both issuers and buyers of bonds have responded in non-traditional ways. In the constant quest for capital funds, necessity and hardship have become the mother and father of invention and in- novation. State and local governments faced with his- torically high interest rates have frequently been unwilling to commit to long-term obligations that result in interest payments of three times the original amount borrowed. By the same token, buyers are unwilling to lock into fixed returns, feeling uncertain about inflation, tax liabilities and yield curves. However, governments still need to borrow; investors still need to earn returns. "Creative financing" seeks to marry the two, meeting their respective needs.

The Tax Equity and Fiscal Responsibility Act of 1982, effective July 1, 1983, is an additional impetus to the revolution. Following the lead of the U.S. Treasury, which issued its first "registered" bonds in September

1982, state and local government bonds must now be issued in registered form. Gone is the traditional form of "bearer" bonds, payable to whoever presents the paper for redemption. In addition to increasing state and local government costs necessitated by the keeping and updating of the registers, public bond issuers will have to report the interest paid, to whom, and when. This will reduce the attractiveness of tax-exempt bonds to some buyers, undoubtedly forcing bond issuers to pay higher interest to make the bonds saleable.

Faced with . . . federal aid cutbacks, shrinking tax sources, and high interest rates, state and local governments have been forced to consider new methods of financing capital improvements.

Additionally, the act mandates a 15-percent reduction in the tax deduction that banks are currently allowed for interest they pay on debt to purchase or carry tax- exempt bonds. Banks will be permitted to deduct only 85 percent of their interest costs, instead of the presently allowable 100 percent. This will reduce the attractiveness of tax-exempt bonds to the banks, reducing their demand for state and local government bonds with a conservative estimate that borrowing costs for issuers will rise by 1 percent.

Finally, the Tax Equity and Fiscal Responsibility Act of 1982 seriously restricts the use of state or local government Industrial Development Bonds (IDBs):

* A public hearing and approval by an issuer's highest elected official or his designee (who must also be elected) is required before the IDB can be issued;

* Issuers must report all IDB interest quarterly to the Internal Revenue Service;

* IDBs cannot be issued for projects in which 25 percent or more of bond proceeds are used for food and beverage sales, automobile sales and service, or entertainment and recreational facilities;

Randy Hamilton is dean of the Graduate School of Public Administra- tion at Golden Gate University and a past-president of ASPA.

JANUARY/FEBRUARY 1983



FROM THE PROFESSIONAL STREAM 23

* IDB maturities are limited to 120 percent of the useful economic life of projects they finance, which must be depreciated on a straight-line schedule writ- ten into the law.

Faced with these developments as well as federal aid cutbacks, shrinking tax sources, and high interest rates, state and local governments have been forced to consider new methods of financing capital improvements. A new lexicon has been added to the public finance field. The most important and successful innovations are discussed below.

Zero Coupon Bonds

Unknown to the tax-exempt bond market five years ago, the zero coupon bond has become, perhaps, the "hottest" item in public finance. Zero coupon bonds are a form of original investment discount bonds. It is expected that they will become increasingly popular as a method of financing state and local government capital projects. Individual bond buyers greatly favor them and the bond market can be expected to respond to this market condition.

Federal laws entitle the bond holder willing to forego tax-free income over the life of their investment to receive a tax-exempt capital gain upon maturity; a sort of tax-free income which has been accreted annually from the time the bonds are first issued. Because zero coupon bonds pay no income, they sell at substantial discounts from the customary par value of $1,000. By paying par upon maturity, they offer capital gains that may be equal to 25 times the original investment, depending on the length of the issue. Held to maturity, a 17-year zero coupon bond purchased for $150 will provide a tax-free capital gain of $850, or, according to the IRS, $50 in tax-exempt income each year ($850 divided by 17). If, as public finance theory would have it, supply responds to market demand, more state and local governments can be expected to start issuing zero coupon bonds.

In mid-1982, the state of Massachusetts came to market with a variation of the zero coupon bond, a $2?2 million (face value) general obligation bond with a 1 percent coupon due July 1, 1999 and "callable" (see below) from July 1, 1994. Offered at $240 per $1,000 face value, a buyer of say $12,000 worth of bonds will receive $500 a year, federal tax free and $50,000 federal tax free on July 1, 1999, with no capital gains payable at maturity. This variation on the zero coupon bond is called an original issue discount bond.

Compound Interest Bonds

Compound interest bonds are beginning to rival zero coupon bonds in popularity. These bonds do not pay annual or semi-annual interest. Instead, the return to the investor at maturity is the principal plus interest compounded at a specified rate. The bonds, however, sell at their face values, unlike zeros which sell at dis-


count from face value. An investor in compound interest bonds still pays much less for the bond than it will be worth at maturity. For instance, a recent issue of single-family mortgage revenue bonds from the Virginia Housing Development Authority was priced at $250 per $1,000 maturity amount to yield 11.83 percent in 1994. Like zeros, the longer the maturity of a compound interest bond, the higher the yield. The Virginia issue also included bonds priced at $100 to yield 12.45 percent in 2001, as well as some priced at $20 to yield 12.58 percent in 2014.

The main advantage of the compound interest bonds, sometimes known as municipal multipliers, over regular coupon bonds is that an investor knows exactly what the total return will be. With an ordinary, traditional coupon bond, the holder must re-invest the semi-annual interest at the then-prevailing rates, thus causing uncertainty as to total return, which depends on market conditions in the unknown future.

The municipal multiplier guarantees today's high rates of return for 15 to 20 years. They do not pay periodic interest as do traditional bonds. This new type of bond combines the investment multiplying power of compound interest with the income sheltering feature of traditional tax-exempt bonds. Compound interest bonds are especially useful fiscal instruments for state and local government issuers of single-family housing bonds. Housing authorities are limited in the principal amount of bonds they are allowed to issue in any one year. To generate a fixed-dollar amount of bond proceeds, a housing authority would have to issue substantially more deep discount bonds or zero coupon bonds than compound interest bonds. For example, the New Hampshire Housing Finance Agency in mid-1982 marketed its first zero coupon bond totalling $168 million. The issue produced slightly more than $52 million in proceeds. By contrast, the Brevard County (Florida) Housing Finance Agency, which used municipal multipliers, realized about $29 million in lendable funds on an issue of just $30 million in bonds.

The state of Washington in early 1982 marketed $13.45 million general obligation bonds in compound interest form. The compounding on the earliest maturity, in 1997, raises the value of a $10,000 bond to $57,434 by that date, paying 12 percent compounded. The longest bond in the issue, due in 2002, would produce $88,421 at maturity on a $10,000 face amount for an 11.2 percent compound rate of return. There is no federal tax on the appreciation provided by the income at any time, not even at maturity.

Stripped Coupon Bonds

Stripped coupon bonds, bonds sold with their interest coupons removed, are the latest alternative for those issuers who favor zero coupon bonds. In effect, the zero coupon bond is a regular bond that sells at a discount from the par price because the coupon interest rate is well below market rates. In contrast to zero coupon bonds, which carry no current interest rate and sell at



24 PUBLIC ADMINISTRATION REVIEW

even deeper discounts, stripped coupon bonds appeal to investors who wish to lock in today's relatively high yields. Some who buy them are betting that interest rates will decline in the future. If interest rates do decline, investors in the normal coupon bonds will not earn the yields they contemplated at the time they bought the bonds, because the reinvestment of coupon income would take place at yields lower than the original yield on the bond, assuming the bond holder chooses to invest in comparable quality obligations. Holders of stripped coupon bonds have an assured compound interest rate over a specified time and thus avoid the reinvestment problem.

What the leading brokerage firms have done is to buy traditional coupon-bearing, long-term issues and strip the coupons from the bonds. Each component is sold separately. The bond itself becomes a zero coupon bond with the guarantees of the issuing public agency. With- out coupons, the value of what is called the "corpus" is much reduced. For example, a 14-percent "corpus" maturing in the year 2011 can be obtained in the current market for around $40 per $1,000 bond face amount, which provides a yield to maturity of 11.5 percent, because of the compounding feature. Putting it another way, over 30 years, each $40 invested will increase about 25 times to maturity in the year 2011.

Stepped Coupon Bonds

One of the most innovative of the recent debt struc- turing techniques is the stepped coupon bonds (SCB). Stepped coupon bonds are serial bonds, but, unlike traditional serial bonds, all the bonds in the issue bear the same rate of interest in any given year with coupon rate changes from time to time; as often as each year. First issued by Lee County (Florida) in April 1982, this type of bond features a maturity structure and interest coupon designed to lower the interest cost to the issuer and protect the principal of the investor. A major benefit of the SCB would be for revenue bonds issued to finance public projects requiring capitalized interest.

A stepped coupon bond coupon uses a serial maturity schedule with coupon rates that start at lower levels and progressively increase to higher levels even though all the bonds in the issues are sold at par. This stands in contrast to the traditional bond where each maturity has a single coupon rate payable over the life of the maturity.

The Lee County issue had bonds due in 1985 with 8-percent coupons for 1982, 9-1/8-percent coupons for 1983, 10-percent coupons for 1984, and 11-percent coupons for 1985.

The bonds due in 1999 from the same issue had coupons identical to the 1985 bond for those same years. But, beyond that the coupons "stepped up" for each year-all the way up to 18 percent in 1999. The substantial increase in coupon payments each year is in- tended to provide a hedge against inflation and thus make the bonds more marketable, on the theory that as the purchasing power of paper money goes down annually, stepped coupons give the bond holder more

paper money each year, to keep pace with inflation. From the perspective of a state or local government, because of the lower early year coupon rates than otherwise attainable using a conventional bond, more bonds may mature in early years, thereby lowering the average life of the issue. The Lee County issue is estimated to save the county approximately $20 million in interest costs over the 24-year life of the issue.

Another feature of the Lee County issue is the call feature. The county can "call in" the bonds for redemption in 1992, 10 years from the date of issue. The prices at which the bonds can be called are quite high and unusual. The bonds of 2006 are callable in 1992 at a face value of $137.77. But if these same bonds are not called until 1999, the face value on redemption is $127.27. These odd call prices are created because they are calculated to produce yields at the time of the various calls equal to the original yields to maturity. Thus, the county has given the bond holder "call protection."

Tender Option ("Put") Bonds

The opposite bond feature to the "call feature" noted above is a "put bond," officially called a tender option bond. They are known as "put bonds" because the investor has the option to put his/her bond in for recemp- tion to get his/her money back before maturity-usually five years after the date of the issue and every anni- versary date thereafter. In return for the right to "put" the bond, the investor accepts a lower yield. The state or local government pays a lower rate of interest and consequently has less cost than for conventional, traditional bonds of the same maturity. The investor earns more than on other tax-exempt bonds that mature on the same date as the first put date. The public jurisdiction that issues put bonds usually pays about 1 percent less than usual for bonds of the same maturity but about 3/4

percent more than bonds that mature on the first pre- scribed date.

Usually, put bonds are also issued with a simul- taneous call date on which the issuer can call in the bond and pay it off. Thus, the issuer and the bond holder have equal right to cash them in when market conditions and interest rates dictate doing so. Obviously, if interest rates go down, a put bond will probably be called in at a time most favorable to the state or local government. Conversely, if interest rates go up, the bond holder can put the bond to be paid at face value by the issuer.

Super Sinker Bonds

Super-sinker bonds are similar to put bonds, but behave like bonds of shorter maturities. Instead of of- fering a "put" option, the state or local government is required to place any excess funds which must be used to call certain bonds in for early payment at face value, as sufficient funds become available. The public jurisdiction bond issuer redeems them by lottery. The individual bond holder does not know when or if his/her bond will be redeemed or called. When all the bonds to

JANUARY/IFEBRUARY 1983




be called from this fund are lumped together in one maturity, the maturity is referred to as a "super- sinker."

The major use of super-sinkers has been for mortgage revenue bonds where the excess funds to call the bond depend on the resale value of the homes, and because the mortgages are not transferable, to some extent on prepayment of mortgages. Obviously, if large-scale prepayment of mortgages occurs, it will happen only when interest rates have gone down, which means that super- sinkers have a likelihood of being called before maturity. This type of bond usually costs the state or local government issuer about 3/4 percent less interest than non-callable bonds of the same maturity.

Changes effective in January 1983, as a result of the Tax Equity and Fiscal Responsibility Act of 1982, will make mortgage revenue bonds more attractive to the market. Consequently, there will be an increase in the use of this new fiscal instrument. Current restrictions on tax-exempt mortgage revenue bonds (MRB), were eased in the new act. The difference between the yield on MRBs and the interest rate on the mortgages financed by the proceeds was increased to 1-1 /8 percent from 1 percent. Additionally, the maximum purchase price of a home that can be subsidized by MRBs was raised from 90 percent of the area average home price to 110 percent in targeted low-income areas. Finally, only 90 percent of the mortgagees must be first-time home buyers compared with 100 percent under the old law.

Floating Rate Bonds or Flexible Interest Bonds

An adaptation from the Eurocurrency markets, the idea of a state or local government tax-exempt floating- rate interest bond is to provide stability for both the issuer and the bondholder throughout the life of the bonds, particularly during times of interest-rate volatil- ity. They do so by changing their yields (interest paid by the public issuer) over the life of the bond, in contrast to the traditional, conventional fixed rate, long-term bonds which do not change interest rates but whose price (market value) may change when interest rates rise or fall. Consequently, they are much more marketable than the traditional, long-term bond. The return to the bondholder, or cost to the issuer, is dependent on various indices, printed on the bond itself. Most often cited on the bond is the average weekly rate of U.S. Treasuries during the preceding interest period. For example, a short-term floating rate bond might be pegged at 67 percent of the average weekly T-bill quote and a long-term one at 75 percent of the average weekly quote on 30-year Treasury bonds.

An additional feature of floating-rate interest bonds are "swing limits," a pre-established range in which their interest (cost to the public agency) may vary. In recent issues, for example, floating interest rate limita- tions have been set from a minimum of 7 percent to a maximum of 12.5 percent over the life of the bonds.


As with other state and local government bonds, the maturity of floaters varies, but floating rate interest bonds usually have call or demand features and/or put features. These specify the early dates when the bondholder can get his/her money back at par. Some recent floaters or flexibles have features structured so that the bondholder can get his/her money back at the end of any given calendar quarter. The 1981 general obligation flexible rate certificates of indebtedness of the state of Washington are a good example. Holders of the bonds, which pay interest each month, may elect either (1) a new interest payment date at the same rate as the previous month or (2) tender the bonds for purchase by the state at par on the 15th day of each month in which the interest payments are due. Some recent floating- interest rate bonds have demand features structured so that the bondholder can get his/her money back at the end of any given calendar quarter. Others have demand features that give the investor full payment of face value within seven working days after asking for it. Floating rate bonds with short demand features are often called "notes" or "certificates of indebtedness," although they are basically bonds.

The general obligation bonds of the state of Washing- ton are unusual. Almost all of the floating or flexible rate bonds issued to date have been IDBs, which are of lesser quality than general obligation bonds so that the float principal acts as an inducement for their purchase. Having less risk of principal erosion than traditional bonds, floaters or flexibles cost the state or local government less in interest costs than typical long term, conventional bonds. The savings in the cost of interest to the state or local government can be very substantial, with the difference between a traditional bond and a floater often being as much as 3 to 3 V2 percent.

With apparently endless varieties limited only by financial ingenuity, floating rate or flexible rate bonds have, within the last two years, come to be used for a multiplicity of purposes. For example, the already noted State of Washington Flexible G.O. Certificates of In- debtedness were issued as one-year notes but permit the bondholder either to tender the certificates every month or to roll them over at prevailing interest rates. Variable Rate Student Loan Revenue Bonds issued by the South Carolina State Education Assistance Authority are in the form of special obligations secured by insured student loan payments. The bonds have a life of 17 years and pay interest quarterly, calculated at a rate tied to Treasury bills. This new type of bond, similar to those issued by Virginia, has been issued by comparable agencies in Kentucky, Minnesota, and Kansas. The Ohio Air Quality Development Authority issued limited obligation 30-year Floating Rate Collaterized Revenue Bonds, secured by a pledge of loan payments from the Cleve- land Electric Illuminating Company. Interest is payable semi-annually, calculated on a formula based on prevailing rates during the preceding six months. Apache County, Arizona's Industrial Development Authority issued Floating Rate Demand Pollution Control Bonds on behalf of the Tucson Electric Power Company. They are 40-year bonds with interest payable monthly based




on a complicated multi-tiered formula using several interest rate indices to determine the monthly rate.

Detachable Warrant Bonds

A warrant is a right, so called because it gives the per- son who holds the warrant the "right" at a future, fixed date to purchase more of the same bonds to which the warrant is attached, at the original price and rate of return of the original bond. The first (1982) issuance of public tax-exempt detachable warrant bonds that came to market was from the Municipal Assistance Corpora- tion (MAC) of the City of New York, which gave bondholders the warrants that were exercisable for two years. In exchange for that right, MAC paid a lower rate of interest than was otherwise available on the bonds of about ?2 percent. MAC's expectation is that if interest rates decline during the two-year period, it will have saved about $11 million in interest payments over the life of the detachable warrant bond. Obviously, the marketability of such bonds depends on the opinion of the prospective bond buyer concerning fluctuations in interest rates. If they rise, the savings to the public agency become real because of the initial lesser interest cost. If they fall, the opposite is true.

In addition to the new concepts in bonding for capital investments by state and local governments, there has been an accompanying trend in the development of other kinds of fiscal instruments, usually short term in nature, which were also unknown to the state and local government bond market until the past couple of years. These have been mostly adaptations from the private sector, which has long used a variety of basically short- time capital raising techniques. Their use by public agencies is growing quite rapidly and any discussion of contemporary public finance must make note of them as part of the revolution in state and local government capital financing. They, too, are examples of the public capital finance world turned upside down.

Tax-Exempt Commercial Paper (TXCP)

Used by the private sector for more than a century, but adapted to the tax-exempt issuer only within the past two years, the advantages of the newly developed TXCP over bank borrowing and traditional local government notes include sharply lower interest costs, greater flexibility, and immediate access to a large pool of funds as well as increased "exposure" for the local government among major investor groups in today's highly competitive capital markets. Simply stated, TXCPs are short-term, unsecured promissory notes backed for liquidity purposes by a line of credit with one or more banks. Maturities normally range from one to 270 days with an average maturity now running 30 to 45 days.

The expansion of the traditional commercial-paper market to the tax-exempt market in the past 24 months has been astounding. Figures compiled by several leading brokerage houses indicate that starting from $0.00

in 1980, the market for TXCP is now about $2.5 billion with an increase of more than 57 percent during the first six months of 1982 alone. TXCP is the fastest growing segment of the tax-exempt market now totalling more than $3 billion and rising. Recent California issues of TXCP by various jurisdictions, for example, have been for $35 million in Ventura County, $45 million in Santa Clara County, and $200 million in Los Angeles County.

Rates for TXCP are currently less than 50 percent of the bank prime borrowing rate, an obvious attractive rate advantage for local governments when compared to the usual bank borrowing at 60 to 70 percent of the prime rate or the issuance of municipal notes. TXCP has an inherent flexibility and cost savings through skill- ful management of maturities and by tailoring debt issuance to current and anticipated market needs.

Commercial paper is normally issued in bearer form (and still can be under the terms of the Tax Equity and Fiscal Responsibility Act of 1982). It is priced on either a discount from par or on an interest-to-follow basis. When sold on a discount basis, the investor's return is the difference between the purchase price and the par amount to be received at maturity. The interest paid to TXCP holder is, of course, tax exempt. The securities are particularly useful to state and local governments that have pollution control or other projects which can be funded with tax-exempt debt. TXCP is also being used by state and local governments as a temporary substitute for long-term financing during periods of high or rising interest rates or during uncertain markets, thereby reducing the ultimate net cost of financing a project.

TXCP can be sold on the specific date that funds are needed or with a specific maturity date that coincides with a known date for receipt of revenues. It enables state and local governments to raise incremental funds in smaller amounts than would be practicable or economic in traditional bond markets.

TXCP provides the flexibility needed to fund sea- sonal, peak borrowing requirements or unanticipated demands on working capital. State and local issuers of TXCP receive the proceeds from each sale in im- mediately available funds on the same day as the sale. By contrast, in the traditional note market, funds are received well after the day of sale. TXCP permits a growing asset base to be financed by issuing an increasing amount of short-term paper until such time as long- term financing becomes economical and advisable.

Assuming the state or local government has legal authority to issue TXCP, there are several requirements for successful issuance. State and local governments should have a continuing need for at least $25 million in short-term debt to justify the investment of management time required to establish and operate a TXCP program. Acceptable commercial paper ratings are essential to achieve the lowest borrowing costs in the TXCP market, usually a Moody's P-1, Standard and Poor's A-1, or Fitch's F-1. From the time of a formal presentation by a public jurisdiction to one of them, it normally takes about three weeks to obtain a TXCP rating. Once possessing an initial TXCP rating, the local





government must submit updated data, quarterly, on any significant changes in financial condition. As a pre- requisite to the rating, issuers of TXCP must obtain and maintain 100 percent coverage under a bank line of credit. The bank does not guarantee the debt; its main function is to provide back-up liquidity for a TXCP program. There are charges of about 3 / 8 to 1 /2 percent, with no requirement for the local government to have a compensating balance. A dealer in TXCP may also charge the state or local government a fee that ranges from 1 / 8 to 1 / 4 percent per year.

TXCP issue of $50 million, at 8 percent, the typical going rate in 1982, on a 30-day TXCP would have some- thing like the following costs associated with the issue: Interest rate ................. 8 percent Bank line of credit ..... ............ 1 / 2 percent Dealer fee ..................; 1/8 percent Legal opinions ................. $30,000 Ratings cost ................. $25,000 Issuing and paying agent ..... ............ $5,000 Note printing ................. $2,000

Once these arrangements are in place, it is not unusual for a state or local government issuer of TXCP to receive the necessary funds, in hand, within 24 hours.

Tax-Exempt Leveraged Lease Financing (TELL)

TELL is a fine example of how state and local governments have innovated new methods of financing major capital projects. To overcome high borrowing costs, the City of Oakland, California recently used tax-exempt leverage lease financing to fund the renovation of its municipal auditorium. TELL financing makes no new demands on either a public agency's budget or its taxing power.

More versatile and more cost effective than conventional tax-exempt borrowing on today's market, this type of financing can be used to fund, re-fund, and advance re-fund capital projects of $5 million or more. More importantly, TELL can greatly reduce public sector borrowing costs. This totally new approach to financing is substantially different from all other methods of lease-related borrowing. It is not a form of installment sale borrowing, nor is it a "Safe Harbor Lease" transaction. The Tax Equity and Fiscal Responsibility Act of 1982 does not affect the availability or effective- ness of this type of financing.

In the last decade, cities and counties have increasingly turned away from conventional general obligation bond financing toward revenue bond financing which uses lease payments to cover debt service. Vehicles known as installment sale financing, non-profit financing, and lease lease-back financing are now readily ac- cepted alternatives to general obligation bonds. All these methods have a common element-an installment sale lease-between a municipality and a financing agent which creates a stream of funds with which to repay bondholders. In all cases municipalities own the leased facilities upon retirement of the bonds. The lease

JA NUA RY/F<EBR UAR y 1983

payments represent the municipality's cost of financing the capital improvements.

In TELL financing, municipalities sell public facilities to generate capital funds. The sale is financed with tax- exempt revenue bonds. Once the buildings are sold, the municipalities lease them back at subsidized rates. This results in a sharply reduced cost of financing. In addition to these cost savings, TELL financing can create a new pool of unrestricted funds for capital related projects, providing greater financial flexibility for borrowers.

In TELL financing there are four primary participants: a public jurisdiction (for example, a municipality or county), a private equity investor (special purpose limited partnership), an underwriter (lender), and a qualified government financing agency (e.g., industrial development authority).

Any state or local government or public agency which is able to issue special purpose revenue bonds and/ or industrial development bonds may take advantage of leverage lease financing. Any other government unit which owns public facilities can also participate, if it has access to a financing authority. A state college can use a state dormitory authority as the financing agent, or the City of New York can actually sell the Brooklyn Bridge to its advantage.

Municipalities whose general obligation bonds are rated A or better by either Moody's Investor Service or Standard and Poor's are eligible from a credit perspective for sale/leaseback financing. Political subdivisions with revenue bonds rated similarly can also qualify. For all participants, state and local law must be compatible with this type of lease financing.

To initiate this financing, a municipality sells a public building to private investors and simultaneously leases it back on a long-term basis for continued use. The municipality then makes lease payments to the investors. The investors, in turn, make a downpayment and contribute over a five-year period equity equal to 25-30 percent of the sales price. This infusion of equity radically reduces rents in the first five years. The balance of the sales price is financed by a tax-exempt revenue bond issue, issued on behalf of the partnership and loaned by a public financing authority. The lease serves as collateral for the loan, which in turn secures the bond issue. The sale proceeds then finance the in- tended capital improvements.

Changes effective in January 1953, as a result of the Tax Equity and Fiscal Responsibility Act of 1982, will make mortgage revenue bonds more attractive to the market.

Underwriters arrange the tax-exempt bond financing and structure the sale/leaseback transaction to meet the requirements of the bond market, the private investors, and the municipality. In purchasing the facility, the private investors obtain the tax benefits associated with




ownership. The subsidized base payments during the initial five years are a reflection of the value of these benefits. Lease payments represent the government unit's cost of financing. In reducing the magnitude of the lease payments, TELL successfully slashes the government unit's effective borrowing cost below the issuer's current tax-exempt rate.

TELL financing can reduce borrowing costs for public debt issuers by as much as 150-225 basis points- that is, by 1.5 percent to 2.25 percent per annum- depending on the structure and age of the buildings. If the interest rate on a conventional lease revenue bond is 12 percent for example, the cost of leasing (the effective cost of the borrowing) in a TELL financing is 9.75 percent.

Although investors own the building, the facility lease is carefully designed to provide the state or local government with maximum flexibility and control over the use and final disposition of the building. Increasingly, a municipality leases back the building it sells for a period of 30 years on a net basis. This permits the municipality to maintain long-term control of the day-to-day management and operations. In addition, the lease provides the local government with several renewal options and with rights to repurchase the facility. As a further protection, the public agency retains ownership of the land, leasing it to investors for a period of up to 65 years. At the end of the land lease, the land and improvements automatically revert to the state or local government.

The savings in the cost of interest to the state or local government can be very substantial, with the difference between a traditional bond and a floater often being as much as 3 to 35S percent.

In a TELL financing, the repurchase price cannot be negotiated in advance of a sale. However, lease provisions can shield the municipality from inflated real estate values at the time of repurchase. These safeguards include the land lease, the renewal options accorded the public jurisdiction, and the method of appraisal which defines the repurchase price at the end of 30 years. The land lease, for example, serves to encumber the facility and to limit its final value in the open market. These lease provisions offer the local government flexibility at the end of the initial lease period to choose among three viable alternatives: renewal of the facility lease, repurchase of the building, or abandonment of the project.

Almost all capital related activities, including the refunding of outstanding debt, can be financed with leveraged leases. The costs of new construction, facility acquisition, renovation, rehabilitation, and conversion are eligible expenditures. Facilities which can be con- sidered for TELL financing projects include schools, of- fice buildings, museums, convention centers, medical buildings, port and airport facilities, warehouses, and

other real property. The greatest financing cost savings can be gained by selling rehabilitated and/or converted historic buildings.

The major requirements for a TELL financed building are that it (1) be insured against natural hazards, (2) be convertible to private use (i.e., a school might be converted to a shopping center), and (3) cannot be subject to any sale restrictions (e.g., federal or state grant covenants restricting ownership of property, outstanding bonds, etc.).

Oakland, California was recently faced with a need to spend $10 million to renovate a deteriorating public auditorium, and proceeded to conduct an exhaustive analysis of financing alternatives. The city found that sale/leaseback financing, when combined with tax- exempt bonds, not only offered the lowest borrowing cost, but also required no general fund monies.

In January 1982, the city sold and leased back its art museum as the initial phase of a program to convert the auditorium into a modern convention center facility. The museum was sold to private investors for $22 million, financed with a 5-percent down payment and a $22,240,000 bond issue. This was the first time in his- tory for public sector use of tax-exempt leveraged lease financing.

Once construction starts, the city will begin the second phase of financing by selling the auditorium for $20 million plus the cost of renovation. That purchase will be financed through the sale of industrial development bonds. When completed, the auditorium will serve as an extension of the Oakland Convention Center, currently under construction.

To protect its long-term interest in the museum, the city entered into a 30-year net primary lease with four five-year renewal options. As a result, the city continues to control the management and operations of the facility. At the end of the primary lease and after the first renewal period, the city will have the opportunity to repurchase the museum at its fair market value or to outbid its competitors by $1.00. To Oakland's benefit, fair market value is defined in the lease by the "income method"-not as replacement cost, but as the value of future rental income limited by lease renewal options and other encumbrances.

A 30-year facility lease will also be structured for the auditorium. Throughout the financing period, the city will retain ownership of the museum and the auditorium land. Investors who purchase the facilities will lease the land for 65 years, at which time the land and all improvements will revert to the city. Upon the expiration of the primary leases, the city intends to reqcquire both facilities. To provide funds for the repurchase, savings from the TELL financing will be invested during the course of the 30-year primary lease.

This leveraged lease financing allows the city to sell public buildings to investors and to use the proceeds to finance the rehabilitation of the auditorium. Measured in terms of borrowing cost savings, these two transactions provide a cost of leasing approximately 175 basis points-1 1/2 percent below the interest rate on Oak- land's conventional tax-exempt revenue bonds.

JANUARY/F4EBRUARY 1983




There are two major requirements for participation in TELL financing: that a state or local government be willing to sell one or more buildings, and that it have the necessary legal and financial powers to make the financing program work. In considering TELL financing, a state or local government must first thoroughly review and analyze proposed financing terms. The managing underwriter can assist in developing a feasibility study, which will include an analysis of the proposed project's impact on the local government's budget, an estimated rental schedule, and an outline of legal and financial transactions to be taken by the governmental jurisdiction. Upon completion of the analysis, the managing underwriter together with the state or local government's bond counsel and representatives of the equity partnership draft the necessary lease, purchase, and other financing documents. This is followed by submis- sion of a firm purchase contract within 60 to 90 days. The following chart illustrates the structure of TELL financing.

Tax-Exempt Leveraged Lease Financing Structure

Bond Holder

Bond Debt Proceeds Service

Financing Authority

Loan Loan Proceeds Payments

Limited Partnership

Sale Proceeds

Facility

Lease Payments

MunicipalityGround Lease Municipality < Payments

Refund Capital Outstanding Bonds Improvements


Tax-Exempt Demand Master Note (TXDMN)

Local governments have started to issue Tax-Exempt Demand Master Notes, following successful marketing of a Cook County (Illinois) issue of $67 million in August 1981, at interest savings to the county of approximately 40 percent over the then-prevailing conventional bond rates. Cook County's TXDMN was the first public sale of securities in which a local government was both the issuer and obligor.

Previously used by some tax-exempt institutions, Cook County's issue is the first known use of TXDMNs by a local government. The pioneering effort resulted in significant advantages to the county and to investors. TXDMNs provide a highly liquid, short-term, high- quality investment. Because of the liquidity and safety, the investor accepts a rate of return lower than he/she would accept with less flexible, more traditional fiscal instruments.

TXDMNs are sold to institutional investors, who have the right after some notice period to demand payment or redeem them at 100 percent of face value. While they are held by the investor, he receives a "floating rate" of interest which is a function of prevailing rates. Investors in these instruments are typically in the highest marginal tax bracket, further contributing to accepting a lower interest rate. Significant depreciation in bond portfolios has caused a shift in investor preference to the short-term market, in place of the traditional, longer-term one.

The expansion of the traditional commercial paper market to the tax-exempt market in the past 24 months has been astounding.... TXCP is the fastest growing segment of the tax-exempt market now totalling more than $3 billion and rising.

To assure that the public agency issuer can meet a demand for payment, the state, city, or local government enters into a credit arrangement with one or more commercial banks. When payment of the demand note is made, the issuer has the option to make payment from cash on hand or by borrowing the money from the banks which extend the credit.

Three basic structures of bank credit facilities support TXDMN programs. A line of credit is the most common type of banking facility. Basically, a bank providing a line of credit agrees, subject to certain conditions, to lend the issuer money at a given rate of interest for a certain period of time. Typically, usage, the actual amount of money borrowed, is permitted to vary over the period of the commitment within certain limits. For instance, the line of credit may be for $50 million. The issuer may borrow $10 million, pay it back, and then borrow $30 million. Lines of credit are generally issued for one to three-year periods. The analysis of the creditworthiness of a demand note supported by a line of credit is based




primarily on the creditworthiness of the issuer, since the bank's commitment is to the issuer, not the investor.

A letter of credit, the second type of facility, is the strongest bank credit facility. A letter of credit obligates the bank directly (through a trustee) to the investors to fund a demand for payment. The investor's analysis of a demand note supported by a letter of credit would be based on the banks providing the support rather than the issuer.

The final type of facility is an irrevocable line of credit. There are numerous ways to structure this type of bank facility to accommodate many types of transactions. The most common approach is to require the banks to notify the demand note holders before with- drawing their commitment to fund under the bank facility. The irrevocable line of credit is not as strong as the letter of credit but is designed to assure the demand note holders that they will have an opportunity to demand payment prior to extinguishment of the credit facility.

The bank facility is generally convertible into a term loan structured to allow amortization without refinanc- ing.

Maturity of TXDMNs should be between one and three years. Longer maturities are less marketable. The one to three-year demand notes are marketed at approximately 50 percent of the bank's prime rate, although pricing may vary. The cost to the public issuer of the credit facility varies, based on the credit of the issuer and the term of the commitment. Because of some of the costs of TXDMN programs, they should not be con- sidered for less than $15 million, with an upper limit of about $100 million. The costs or fees are subject to negotiation affected by the size of the transaction, its complexity, and the general credit of the borrower. They include:

* For the credit facility: annual fee and compensating balance.

* A placement fee: both initially and for loan maintenance.

* Trustee and paying agency fee: both initially and for loan maintenance.

* Legal fees: bank counsel, issuer's counsel, bond counsel.

The TXCMNs issued so far have been for capital projects. Proceeds are typically paid at closing to a construction account and invested until disbursement. If the demand notes are issued to fund receivables or for other operating purposes, then they would be issued as required and proceeds added to cash in the general set of accounts, with the demand notes being retired as payment on the receivables is made. Usually, TXDMNs have a "callable" feature at the option of the public agency after 30 or 60 days notice.

TXDMNs are sold without ratings. The market for them is generally focused on money management concerns. These investors typically purchase assets which are highly liquid and maintain market value. The TXDMN market is estimated to be between $6 and $7 billion. Thus far, demand for payment by investors has

been infrequent. Keeping the costs of the program low requires provision for remarketing securities prior to utilizing the bank credit facility. This requires con- tinuous contact with institutional investors who utilize these types of investments. Doing so allows rapid resale of the demand notes if the need develops. Public agencies using such programs should look carefully at the amortization back-up period agreed on with the bank. If the short-term market dries up, and the local government is forced to turn to the bank for credit, it will need to be certain that it has enough time to pay back its bank loan.

Tax-Exempt Certificates of Participation

Tax-exempt Certificates of Participation are a brand- new variation on traditional lease/ purchase agreements which have traditionally been for a short term (three to seven years) and which are not practical for the purchase of real property. These certificates are now being widely used in California, with issues for such public works as a new city hall in Santa Rosa, $3.46 million for a new police station in Los Angeles, $8.2 million for a methane gas facilities project in Fresno, the County Center Project of San Bernardino, and other uses in Los Angeles County and the City of Anaheim. By coupling lease/ purchase agreements with certificates of participation (in essence a tax-exempt real-estate investment trust) this innovative financing technique can be marketed to a pool of investors in a method similar to municipal bond underwritings. Additionally, a secon- dary market exists for their trading. Consequently, they have become an attractive and marketable investment for the general public as well as institutional investors in public securities. A typical certificate of participation issue will call for a city or other public agency to enter into a decade-long lease with a fiduciary agent for either a new or existing building. At the end of the lease term, the issuing jurisdiction purchases the real property for a nominal sum.

For the investor, the advantages are similar to those described for TXCPs because the structure of the financing makes all income earned from the certificates tax exempt. Los Angeles estimates that the net interest being paid on their certificates (11.5 percent) represents a considerable savings for the city over what it would have paid under the traditional method of lease/ financing and quite comparable to what it would have paid on a similarly rated bond issue. Ordinarily, the obligations of the issuing public agency do not constitute an obligation to levy or pledge any form of taxation, and the certificates do not constitute a debt of the political sub- division within the usual constitutional or legislative mandates. When used in conjunction with a facility such as the methane gas project in Fresno, the revenues from the facility may be pledged under terms similar to traditional revenue bond issues.

In late 1982, five small Northern California cities joined together to form the Redwood Empire Financing Authority (Aracta, Cloverdale, Sonoma, Sebastopol,





and Healdsburg). The city managers of the five cities, with a total population of about 35,000, serve as the authority's governing board. The authority intends to issue $2.14 million in tax-exempt certificates of participation. The certificates are backed by a letter of credit from two banks and offer affordable immediate term financing for a variety of projects which would be difficult or costly for each city to finance individually. The projects include a fire station, streets and storm drains, various water and sewer projects, an electricity project and the acquisition of a street lighting system from an investor owned utility. The innovative coupling of five small cities offers wide possibilities for small jurisdictions within a geographic area.

Conclusion

A final word of caution is necessary. Today and probably for the rest of the 1980s, governmental borrowers ought to develop a capital financing program tailored to their overall financial condition and fiscal philosophy.

Traditional general obligation bonds and revenue bonds are no longer always suited to market conditions. Use of the new fiscal instruments described in this article are a direct result of market uncertainty. An issuer should not turn to new financing techniques if conventional ap- proaches are available and acceptable, unless it is satis- fied that there is sufficient benefit compared to risk. But innovations resulting from the revolution in state and local government capital financing are available. Their use implies a willingness and ability on the part of state and local governments to accept and deal with future market uncertainty. Practical concerns are also part of the decision-making equation. These include political acceptability and public explaining, a government's technical ability to manage and structure creative financing mechanisms, and, of course, the laws that govern capital financing. While there are still no "free lunches" and interest payments are still the cost a state or local government must pay for the use of other peo- ple's money, careful and knowledgeable scrutiny of the new financing techniques may turn up real bargains or provide capital financing otherwise unavailable.

Insuring Administrative Leadership in Social Securiy,1935-54

Inequality by Jerry R.Cates

The establishment of the Social That conflict of values was played out "[This] analysis of the Social Security Security Administration in 1935 on a political stage marked by administrators' successful efforts to confronted administrators and policy infighting, deception, and short-sighted demean public-assistance pensions makers with basic value decisions. compromise. The result is the Social for the elderly poor is brilliant and Should the system serve to raise the Security system we know today - one poignant - and an exemplary piece of incomes of America's neediest citizens? which benefits those who need it least, organizational and political sociology." Or did that aim smack too much of the and one which is in a perpetual state of ideology of redistribution of wealth? financial difficulty. - THEDA SKOCPOL Would it rob workers of incentive to University of Chicago provide for their own futures and reward idleness?

The University of Michigan Press Dept. SS PO. Box 1104 AnnArbor, Michigan 48106




the world turned upside down: the contemporary revolution in state and local government capital...

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