October 22, 2008 > Certificates of Participation - finding cash for city projects
Certificates of Participation - finding cash for city projects
In order for cities to secure cash for capital projects, bonds called Certificates of Participation (COP) are issued secured by assets. These financial instruments can be sold for a fixed rate of return or on a variable basis. Fremont sold fixed rate COPs in September of this year to refund COPs issued in 1990, 1991 and 2003. Just as loan costs can fluctuate for individuals when mortgage debt is incurred on a variable basis, this is also a risk for public entities as well. Bond ratings and insurance can have a dramatic effect on the costs.
The City of Fremont (COF) has used variable rate COPs to lower its debt service costs but faces difficult challenges in the current economic environment. It has been proposed to sell variable rate COPs to retire additional COPs from 2990, 1991, 2002 and 2003 as well as raise additional capital project money. TCV spoke with Fremont Finance Director/Treasurer Harriet Commons and Revenue & Treasury Manager Don Dorman about the use and risks of variable COPs.
TCV: Recently you reported to the city council that Fremont's 2002 and 2003 series COPs spiked to 10% and should be retired. What caused this?
Commons: Fremont's rating was fine. The bond insurer was having problems because they were involved in the sub-prime mortgage mess. This caused the variable rate to increase dramatically.
Dorman: We will take the money from the new COPs that we are selling and 'call' or early redeem the outstanding COPs. We are essentially replacing the older loans with new money.
TCV: Will this exchange create additional funds for Fremont?
Commons: The new variable rate issue will create additional money. In the Capital Improvement Plan adopted a year ago, there were some projects that were intended to be debt financed including Fire Station 11, fire apparatus and an emergency generator project. Funds are limited to specific capital expenditures and cannot be used for other capital expenditures or the general fund.
Dorman: The city also issues Tax Revenue Anticipation Notes to help with cash flow. Proceeds of these can be used for operational purposes. The maximum amount that can be bonded is 85 percent of anticipated revenues.
TCV: If we are calling some bonds, why not redeem all of them?
Commons: We structure debt so it doesn't all mature all at once.
Dorman: Bonds issued in 2001 have been at about two percent backed by a letter of credit at a bank. The new bonds we are about to issue will be at a variable rate but backed by letters of credit from a bank and not influenced by bond insurer problems. This works better for investors because they do not have to worry about the credit rating of an insurer.
TCV: What is the term of these bonds?
Commons: 30 years.
TCV: What has been the effect of recent market turmoil on the sale of Fremont's COPs?
Commons: Because of the insurer problems and a flood of municipal bonds on the market, there is currently no market for our COPs. The remarketing agent has bought them back and we are currently paying much more interest than we would otherwise. We have bought back the bonds held by the letter of credit bank and are, in essence, paying ourselves interest. The net effect is that we currently do not have the money we would have realized from the sale of the bonds. This should not affect the General Fund.
In the future, we expect to market the refunding bonds and retire those we are holding. The market is so unsettled at this time that investors are having a difficult time sorting out where to put their money. We have a small portion (about $2 million) of our portfolio tied up in the Lehman Brothers bankruptcy but overall we are secure and have the cash necessary to continue the functions of government.
TCV: The principal balances for the new variable rate COPs is projected to be $48.580 million. Is the city changing the amount of indebtedness it carries?
Commons: We are adding about $16 million of new debt. Council policy looks at this as a percentage of debt service to total expenditures in the budget. They have set a policy of no more than 7 percent of budget can be debt service.
Dorman: This will be about 5.8 percent at current interest rate levels. We use this form of evaluation because in government, assets are usually not revenue generating rather they are service generating. The likelihood of not being able to use many of these assets is low since many are specialized such as a fire station.
TCV: Will this change create more efficient use of money?
Dorman: We will be more efficient with these new issues. Some bonds have matured over time and created an inefficient use of assets. For instance, the Development Services Center is valued at $20 million. One hundred percent of that building was committed to the 1990 COPs but only $3.5 million is outstanding. We have freed almost $17 million in value by this refinancing.
TCV: What happens if interest rates increase dramatically? Can these variable COPs convert to fixed rate instruments?
Dorman: Yes. There is a provision built into the contract that allows conversion to a fixed rate contract without even going to the market. We can give notice to the bondholders that we are going to a fixed rate to put a cap on the interest rate.
TCV: In this scenario, will debt service remain below 7 percent?
TCV: Is money from COPs vulnerable to state take aways?
Commons: No. There is an obligation between those who buy this debt and COF. This overrides the ability of the state to take the money.
TCV: The State of California is poised to take money from redevelopment agencies based on their gross income. This is debt service money so why is that not exempt?
Commons: Not all of this money is secured by bonded indebtedness since only a portion of the tax increment is used to pay down the bonds. It is our understanding that the calculation will be based on the gross. Only money collected in excess of debt service can be used to pay the state. If the redevelopment agency does not have the funds to make up the difference, the General Fund can be used.
TCV: If the city refuses to use its General Fund for a shortfall, what happens?
Commons: The redevelopment agency can be shut down. Some cities may be in the situation where their redevelopment agency will not have sufficient funds to pay the bill. We do not believe this will be the case in Fremont however the number from Sacramento keeps moving.
TCV: When does COF receive tax money?
Commons: We get property taxes in two installments each year. People pay their property taxes in December and April; we receive it about a month after that from the county. So far assessed evaluation of property continues to increase but it has slowed. Sales tax is received as an estimate during the first two months of a quarter and then a "clean-up" follows. The most recent sales tax information we have is from the first quarter of calendar '08. We work with a sales tax consultant to analyze and project our income based on trends, industry data and other factors. It is as much an art as a science.
TCV: Do you see an end to some of the more esoteric tax manipulations such as the "Triple Flip" of the State?
Commons: It is hard to say, but one thing we have learned is not to underestimate the creativity of folks in Sacramento. We are about as well positioned as we can be at this time and remain cautiously optimistic about the future.
Dorman: The COF has a strong structure but we cannot control how money flows through that structure. That depends on the local economy.