8 minute read
Not All Debt is Bad
Look at risk associated with debt, and choose projects carefully
by Robert Inzer
This is the fourth and last article in a series discussing managing risk and what you as an elected official should know. In prior articles, we provided an overview of risks your city may incur and ways to protect your city. We’ve addressed the need for reserves to fund immediate costs incurred through hurricanes and other unexpected expenditures. We’ve addressed liability concerns and how to protect your city. The last article covered the risks associated with investing surplus funds and how your city can mitigate these risks through oversight, review of performance and participation in professionally managed pooled programs.
This article will discuss risks associated with debt. How much debt is appropriate for your city? What are the advantages and disadvantages of internal funding of projects versus funding projects through bond proceeds? And, what are the opportunities for your city to mitigate risk during the debt issuance process and the management of this debt once issued?
In conversations over the years with city commissioners, I’ve heard them advocate for issuing debt and also be opposed to incurring any debt. Debt is not good or bad. It is a tool, and like all tools, it can be used effectively or can be abused. There are advantages and disadvantages to funding a project through debt.
By issuing debt and building the project today, you are enhancing the quality of life in your community by making the improvements available to your citizens sooner. You are also not subjecting the project to inflationary risks of deferring construction until adequate internal reserves can be accumulated to build it. Issuing debt also ensures that future citizens who have access and use the project will pay for it.
Pay as you go financing may take many years to accumulate the needed resources to fund a project, and yesterday’s citizens that paid taxes to build the project may or may not be tomorrow’s users. Debt spreads the costs out over the future so that future users will be paying for the project. As an example, consider an expansion to your sewer system. If you are building an expansion of your treatment facility to potentially accommodate future growth, then issuing debt ensures those future users will be paying for that facility in their sewer bills.
One of the main disadvantages is debt reduces future flexibility. A portion of your future budgets will be fixed, and if there is a need to reduce future budgetary expenditures, it will be more difficult since debt repayment of the bonded debt is not optional. Another disadvantage is that future taxpayers have no voice in the project or the repayment of the debt. Lastly, you are paying interest on the borrowed funds. We are currently in a period of exceptionally low interest rates, with interest rates on municipal bonds being around 2%, which is below the rate of inflation for the past 10 years.
Under Florida law, all capital expenditures are eligible for debt financing. The fact that they are eligible does not suggest that they should be financed through debt. A fiscally prudent city provides for a balance between pay-as-you-go financing and debt financing. As a general rule, cities that are growing rapidly have large capital programs and will generally have a higher debt level than mature, fully built-out cities that are maintaining their infrastructure.
The Florida Constitution and Florida Statutes limit local governments in what you can pledge for security for your debt. Unlike the private sector, cities cannot pledge assets as security for their bonds. Unless you have passed a referendum allowing you to pledge the full faith and credit of the city, you will be limited to pledging specific revenue sources. Debt sold to support an expansion of a utility can and generally does pledge the revenues from such utility.
The Florida Legislature has identified specific general fund revenues that can be used as security for your general government debt. These include, among others, sales taxes, state revenue sharing and telecommunication and utility taxes. These are very constraining and provide limited access to the market for growing cities. Some larger, high credit quality cities have been able to find market acceptance for debt secured by a covenant to budget and appropriate. Cities can also enter into lease purchase agreements for equipment whereby they lease the equipment and, at the end of the lease, acquire the equipment for a nominal amount. Due to the aforementioned restrictions, Florida local governments tend not to abuse debt and have less debt than cities in other states.
The risks associated with debt are not limited just to the loss of budgetary flexibility but also the debt instruments used and the subsequent management of the debt until it is retired. Default by cities on their bonded debt is relatively rare, and the recovery rate is very high. There have been some spectacular defaults in the municipal market, including New York City in 1975, Washington Public Power Supply System in 1983 and more recently, Stockton, CA (2012); Jefferson County (Birmingham), AL (2012); and Harrisburg, PA (2010). These are not all the governments that have defaulted but are some of the more high-profile government agencies.
Studies have shown that the leading cause of default tends to be in areas of high growth where the local government was overly optimistic in their projections of future growth that did not materialize. This study finding is true of Jefferson County and Washington Public Power Supply System. It was also true of many community development districts (CDDs) in Florida that sold bonds in anticipation of building new communities in 2004-2009. When we entered the Great Recession, the housing market collapsed, and many of these CDDs fell into default. In 2009 in the Hillsborough County area alone, over 50 CDDs with debt exceeding $1 billion were in or near default on their debt.
How do you ensure your city is not tomorrow’s poster child for mismanagement of debt? While the examples listed are high-profile large governments, most cities that get into debt trouble are smaller cities. Small cities have staff that wears multiple hats. One person may be the treasurer, finance director, debt manager and budget director. The breadth of responsibilities precludes the staff member from becoming a specialist in any of these responsibilities, so the person becomes a generalist in each of them. Only a handful of cities in Florida have sufficient outstanding debt to warrant an employee dedicated to managing the debt function.
Beginning in 1985, the Florida League of Cities (FLC) recognized the need to provide cities assistance in their debt management programs. The League sold their first bond issue of $300 million more than 35 years ago and loaned the proceeds to qualifying cities to finance their capital requirements. From this first bond issue and the League’s current programs that started in 1998, the FLC has assisted over 60 cities and closed over 175 loans using fixed-rate, variable-rate, bank loans and equipment financing in aggregate of more than $1.5 billion.
The League has developed standardized templates that have proven successful over the years, so you are not starting your financing with a blank sheet. While it begins with standardized documents, your financing will be customized to meet your specific needs. The League created this program to help cities, and it has continued to operate with that focus.
The League understands that debt management does not end when you close your bond issue, but it is just beginning. Your obligations continue for the next 20 to 30 years until the debt is retired. Your city will have ongoing obligations of disclosure and arbitrage rebate, and the League has developed protocols to assist you. They have retained the services of DAC Bond to ensure that your required filings are done properly and in a timely manner. The League staff is also coordinating with DAC to follow up with your staff to remind them of upcoming filing requirements.
Different issuers have different needs, and the League’s program may not be best for all cities. If you are a large, frequent issuer with staff dedicated to monitoring the market and staying up with regulations, then you may not need the League’s service. However, if you are an infrequent, small- to medium-size issuer with limited staff resources, the League’s debt program may be an attractive alternative for issuing your debt.
As a city leader, you are an owner and partner with the League. I think if you talk to representatives of cities that have participated, they will speak highly of the program and the services they’ve received.
Robert Inzer is an advisor to the Florida League of Cities. He has 47 years of municipal finance experience that includes 30 years with the City of Tallahassee, 20 years of which was spent as City Treasurer-Clerk.
*The Florida League of Cities and the Florida Municipal Loan Council are not registered investment advisors.
