Speaking Notes

PADM 5301

April 6, 2010

Dr. Neubauer

WHERE WE ARE

• I plan to cover chapters 14 prior to the in class final on April 20.
• The final will be comprehensive.
• You should study the midterm.
• I have or will make study suggestions for the final examination available soon.

CHAPTER 13 -- CAPITAL FINANCE AND DEBT MANAGEMENT

Many state and city governments are in a financial crisis now.

• High pension obligations (and it is going to get worse).
• Medical insurance costs for present employees are increasing.
• The need for police, fire and emergency services tend to increase in hard economic times.
• Many capital improvement projects are likely on hold.
• There is probably a lot of DEFERRED MAINTENANCE now of buildings, roads, bridges, sewerage systems, storm water systems and the like.
• Revenue flows from other governments are likely to be cut back in hard times because those governments are also stressed.
• State and Federal MANDATES force money to be spent in particular ways and limit the DISCRESSION of local leaders.
• All forms of local revenue (including sales tax and property tax) are down now.

It is possible for a city to declare bankruptcy as per a Federal law in 1934. This is good reason to THINK TWICE before investing in the bonds of a city in crisis.

http://www.nytimes.com/2008/10/07/us/07citybudgets.html?pagewanted=1&_r=1

http://www.citymayors.com/report/usfiscal_crisis.html

http://www.planetizen.com/node/35621

SO, WHAT ARE LOCAL LEADERS LIKELY TO DO?

• Cut back programs in the arts and recreation.
• Sell vehicles, equipment and parks.
• Increase user fees.
• Cut back essential services including police and fire protection.
• Reduce number of government employees.
• Postpone schedule maintenance.
• Delay capital projects.
• BORROW MONEY IF POSSIBLE

Our textbook might be better titled BUDGETING AND FINANCE.

Local governments are not supposed to borrow for their operating budgets but sometimes have to do so. Like individuals and families, they often look to local banks for short term loans.

Bank loans can help cities through immediate problems (associated with operating budgets and VARIANCES) but for CAPITAL PROJECTS the reasonable approach is to "float" a bond.

• Bonds are difficult to offer (financial consulting, underwriting, legal fees and so forth).
• Bonds are appropriate for CAPITAL PROJECTS that will benefit future generations.
• Bonds can save the city a lot of money over other means of borrowing because of federal (and state) tax laws.

http://en.wikipedia.org/wiki/Municipal_bond

MOST BONDS MUST BE PAID BACK TO INVESTORS AT THE END OF THE TERM AND MUST PAY INTEREST TO OWNERS ANNUALLY. Depending upon the bond, a part of the principle is likely to be paid to the investor each year also. Zero coupon or capital appreciation bonds, accrue interest until maturity at which time both interest and principal become due.

Investors sell bonds (previously issued) to one another at discounted rates in THE SECONDARY MARKET (market for "used" bonds). The discount can be either negative or positive depending upon market conditions and available returns from other investments at the time.

REVENUE BONDS VS. GENERAL OBLIGATION BONDS

A General Obligation Bond requires prior approval by voters. The benefit (to investors) is that the city itself is obligated to do whatever it takes to pay back the money, plus interest.)

Revenue bonds are to be used to build something that will produce a flow of revenue, from which the money plus interest can be paid back. This might be a way to finance a sewer system (but probably not a storm water system).

TAX EXEMPTION FOR THE INTEREST EARNINGS ON BONDS IS THE CORNERSTONE OF THE U.S. SYSTEM FOR FINANCING PUBIC INFRASTRUCTURE FOR STATE AND LOCAL GOVERNMENTS.

For high-income people, a rate of 6% return untaxed is the same as about 9% taxed. General obligation bonds are relatively safe investments because if necessary the local government can raise taxes to pay them back.

It is unclear whether Municipal bonds should be allowed to be used to finance the creation of INDUSTRIAL PARKS. The city benefits only indirectly. The more direct benefit is to the FOR PROFIT organizations that move into the industrial park.

• The Tax Reform Act of 1986 attempted to make this kind of thing less frequent.

SECURITIZATION -- borrowing money (a bond) against almost any anticipated future flow of revenue, such as delinquent taxes. It allows the jurisdiction to get the money (discounted) now rather than later. (Tobacco settlement money.) (This is as if you win a big lottery and instead of accepting the pay out over time you borrow a lump sum now and the loan is paid off by the stream of money coming in from the winning over time. You don't get as much but you get it all NOW.)

Revenue bonds are as safe as the stream of income that will be produced by whatever the money is to be used to build.

THE BOND ISSUANCE PROCESS (PAGE 537)

• The city gets a credit rating that will affect the rate of interest it must pay to borrow from investors. By buying insurance the city may be able to get a higher credit rating.
• An UNDERWRITER bundles and actually sells the bond.
• Vote approval is likely to be necessary -- always for GENERAL OBLIGATION BONDS (because the result may be a local tax increase some day).
• There may be an INSURANCE COST to guarantee timely payback.
• The government may be required to create a SINKING FUND account in which to put money needed to meet its obligation to repay the money plus interest.
• Paperwork may have to be fined with the SEC (Securities and Exchange Commission) of the federal government.

HOW TO ASSESS THE CREDIT WORTHINESS OF A CITY

• Social and economic factors such as population and unemployment rates, and civil unrest.
• Political factors such as educations of local political leaders.
• Debt history.
• Present level of indebtedness (often measured per capita).
• CONDITION OF PENSION FUNDS for its own employees.
• Likely future condition of the tax base -- are properties gaining value.

WHO BUYS MUNICIPAL BONDS?

• Individuals
• Property and casualty insurance companies
• Mutual funds (professionally managed collections of investments allowing investors to invest in diversified portfolios of investments so as to balance out risk and return)

MAJOR ALTERNATIVES TO BOROWING (without raising taxes)

"Pay as you go" -- save the money first (and generate some earnings through safe investing of it until time of need) and then "pay cash" for the new capital project. This is a VERY CONSERVATIVE approach and in a sense burdens people now for what others will have in the future.

Sell existing assets

• Possibly sell a local road and let the buyer charge tolls.
• Chicago sold four downtown parking garages to Morgan Stanley, an investment firm.
• Chicago offered to sell Midway Airport.

CONCESSION CONTRACTS

• Basically, a for-profit spends its own money to build something for the government with the agreement to provide something like a utility service to citizens.
• The idea is to save the citizens having to pay to construct something that the government would otherwise have to provide at taxpayer's expense.
• Can take three to five years to design, bid out and negotiate.