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Monday, October 4, 2010

Letter To The Editor: Measure J Poor Public Policy

Unsolicited Letter From Bond Analyst
Measure J Funded With
"VERY Expensive Money",
City "Duplicitous"

The following letter was received by the Tattler from a financial analyst who frequently consults municipalities about bond financing. The writer included a boiler plate schedule of debt service in the form of a non-electronic snail mail attachment that is referenced in the letter. The debt service schedule is not included here but readers may glean what the writer is meaning from the content of the letter below. The letter is verbatim. The writer has requested anonymity.

These types of projects tend to create short-term jobs (a good thing) and give the community an asset well beyond the life of the debt issued to finance it (a good thing). But they also come with maintenance costs that will suck money from either the City or the School’s general fund for years to come (a bad thing).

The project may possibly be promoted as a school bond because a) the voter approval threshold is only 55% (as compared to 66% for the City with general obligation bonds) and b) school bonds are far more likely to pass. I think this is duplicitous and poor public policy.

The cost of the financing is of concern. The school district is issuing zero coupon bonds (also known as capital appreciation bonds or CABs) to finance a portion of the project (See example). There may be multiple reasons why they are using CABs, but typically they are issued to delay the impact of debt service on property tax payers, meaning they won’t have to make any debt service payments until the bonds mature. This delay, however, does not come without a price. Example 1 shows annual debt service costs at any given maturity point for each $1 million repaid to bondholders. On page 1, which is titled “Debt Service Schedule”, the purple column is the amount of principal (i.e. the money the school district will actually receive from the financing) while the blue column is what they’ll pay back. In this example, for the $1 million in debt service paid in 2040, the school district will receive $263,140 today. All told, in this example, the school district will receive $8.94 million in bond proceeds but will pay $21 million in debt service over the life of the CABs.

This is VERY expensive money. If you turn to page 2, I’ve highlighted in yellow the Net Interest Cost of 7.335%. This is essentially the cost of the CABs, even though the interest rate at the time of issuance (or True Interest Cost) is stated as 4.500%. The difference between the Net Interest Cost and the True Interest Cost is the compounding of interest that occurs when a municipality sells CABs (remembering that they aren’t paying anything back until maturity).

By way of comparison, Example 2 is a basic bond structure where the municipality pays principal and interest annually over time. In this example, for the same $8.94 million in bond proceeds the school district receives, they will pay $16.46 million in debt service over the life of the financing. This is about $4.5 million (or 25%) less than the CABs scenario. And here, the True Interest Cost and Net Interest Cost are the same: 4.500%.

You can extrapolate these numbers to reflect the reality of Emeryville’s proposal.

CABs are not “exotic” as the [Tattler] says. They are fairly common and many (if not most) school districts use them to help lessen the impact of property tax increases. The theory is that assessed valuation of the city will grow at a higher rate than the True Interest Cost on the bonds and therefore there will not be the need to raise property taxes in the future to cover the cost of debt service when the CABs begin maturing. Additionally, the school district may have existing bonds maturity when the CABs begin to mature and therefore the property taxes used to pay the old, existing bonds simply start paying the new bonds and therefore no new property taxes are necessary. This theory, though generally true for much of the past 25 years, may not hold today given the state of real estate in California.


  1. This guy has his first point all wrong. He says that Measure J will produce an asset (the new school) that will have functionality well beyond the life of the debt used to finance it. The problem is the minimum pay back will be 45 years. That's older than the current school is and that's what the school district says we need desperately to replace because it's so old!

  2. If the building is built right, it will last more than 45 years. Construction technology has come a long way.
    The main problem with the current building is the infrastructure cant handle the amount of technology they are trying to cram into the building. There's also a serious lack of office space, but that's due to bad planning and Stephen Wesley, mostly.

    However, this bond is the wrong way to achieve the goal of improving the facilities.