Decade of Debt: Capital Appreciation Bonds
Uncover how much high-interest debt school districts, community colleges and government agencies have issued. Each circle represents a public entity. The larger the circle, the greater the debt. The redder the circle, the higher the interest that entity will pay.
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Herb Calderon stood on the campus of Hillcrest High School, staring at a wall that cost $10 million to build.
The mile-long barrier was constructed to prevent the hillside above from sliding into the new school during a heavy storm. The state-of-the-art campus with its extravagant sculpted concrete wall, he said, has helped upgrade the image of the downtrodden district.
“They wanted a beautiful high school, and we gave them a beautiful high school,” said Calderon, assistant superintendent for business services of the Alvord Unified School District in Riverside. “If people knew how much it cost, I’m sure we’d get some flak.”
The school, including the wall, cost $110 million to build, but by 2046, when it is finally paid for, it will have cost taxpayers at least $485 million.
Alvord is one of at least 1,350 school districts and government agencies across the nation that have turned to a controversialform of borrowing called capital appreciation bonds to finance major projects, a California Watch analysis of bond financing data in the U.S. shows. Relying on these bonds has allowed districts to borrow billions of dollars while postponing payments in some cases for decades.
This form of borrowing has created billions of dollars in debt for taxpayers and hundreds of millions of dollars in revenue for financial advisers and underwriters. Voters are usually unaware of the bonds’ high interest. At least one state, Michigan, has banned their use.
In California, where rules governing the loans are among the loosest, more than 400 school districts and other agencies have racked up greater capital appreciation bond debt in the past six years than in any other state.
They have borrowed $9 billion that will cost taxpayers $36 billion to repay over the next 40 years, according to data compiled by California Treasurer Bill Lockyer. He called it “debt for the next generation.”
“The average tenure of a school superintendent is about three and a half years, so they aren’t going to be around in most instances to worry about paying that off,” Lockyer said in an interview.“Nor will the voters, probably, that enacted it in the first place.”
The capital appreciation bondbusiness in California has been lucrative for dozens of private financial advisers, banks and credit rating firms that have charged government entities nearly $400 million for financial services since 2007, state data show.
The bonds are unusual in public finance because they postpone debt far into the future. Typical school bonds require borrowers to begin making payments immediately and cost two to three times the principal amount to repay. But with deferred payments, districts have ended up paying as much as 23 times the amount borrowed.
The decision to issue these bonds instead of traditional bonds typically is made by district officials after voters have approved bond measures, and the public usually has no knowledge of how much they will cost to repay.
Earlier this month, Lockyer and Tom Torlakson, the state superintendent of public instruction, called for a statewide moratorium on capital appreciation bonds until new legislation limiting their use is in place.
The issue first came to light last year after the Voice of San Diego and a Michigan bloggerreported on a questionable capital appreciation bond issued by the Poway Unified School District.
But a California Watch analysis shows that the issue is not unique to California.
Since 2007, school districts and government agencies in at least 27 states and Puerto Rico have financed projects with capital appreciation bonds.
In Texas, 590 districts and other government entities have issued these bonds over the past six years – more than any other state, according to a California Watch review of a database maintained by the Municipal Securities Rulemaking Board, a federal regulatory agency that oversees the municipal bond market. California was second, with 404, followed by Ohio, with 202.
Nationally, the total amount of debt generated by these bonds is unclear. States rely on varying methods for reporting, and in some cases the data is incomplete. Many capital appreciation bonds were issued in packages with other types of bonds, and national databases do not tally their independent values.
In California, some of the most dubious deals occurred in San Diego County, where the Poway Unified School District in 2011 used the bonds to borrow $105 million that will cost $982 million to pay back, a repayment rate of about 9.4 to 1. The same year, the Santee School District borrowed $3.5 million that must be repaid at $58.6 million, or 16.6 times the principal.
Besides school districts, four agencies that receive tobacco-company payments from a court settlement have issued these bonds to construct health care facilities and operate programs. The largest was issued by the Inland Empire Tobacco Securitization Authority – a $206.4 million bond that will cost $3.8 billion to pay back, or more than 18 times the principal.
To finish building Hillcrest High School, the Alvord district issued a $57 million bond in 2011. By 2046, when the loan is paid off, Calderon said, it will have cost taxpayers $375 million – 6.6 times the principal.
Calderon, who joined the Alvord district as chief business officer in July, called the deal “a necessary evil” and said falling property tax revenue and dwindling state funding had left districts with no choice but to engage in risky borrowing.
“If this was a mortgage, you would run,” he said. “But this type of creative financing is what we’re forced to do.”
David Bauman/The Press-EnterpriseHerb Calderon, Alvord Unified School District’s assistant superintendent, walks the football field at Hillcrest High School in Riverside. The district issued a controversial $57 million capital appreciation bond but ran out of money to build bleachers.
Bypassing state tax cap
Some California districts, including Alvord, have used the bonds to get around a state limit on property taxes. To pay off bonds, unified school districts are allowed to tax residents no more than $60 per $100,000 of their assessed property valueeach year. By issuing capital appreciation bonds, districts that have reached that limit can push the tax burdens of new bonds far into the future.
When districts issue these bonds, they are betting that property values will increase enough over time to pay their debts. They often hire private firms to calculate property value projections and structure the deals.
The private firms are paid to determine how much money is safe for districts to borrow, but Lockyer said some financial advisers appear to have exaggerated property value growth projections to get the deals approved.
Although private firms are not obligated to report their fees to state regulators, the state treasurer’s office has compiled some fee information found in official bond statements. At least 42 financial firms have charged school districts and other agencies in California a total of $389 million since 2007, Lockyer’s office reported.
According to data available to the treasurer, Caldwell Flores Winters, a California-based company specializing in public finance, made the most money advising on California’s capital appreciation bonds – $6.8 million on 84 deals. Second was Dale Scott & Co. in San Francisco, with 55 deals worth $4.6 million. California Financial Services, a financial planning firm, was third with $3.5 million on 28 deals.
Financial advisers have been meeting with Lockyer and state legislators to discuss a measure that would limit repayment rates to as little as four times the amount borrowed with capital appreciation bonds, also known as CABs.
“Even though CABs can be a useful tool in managing a district's debt, it appears there have been a number of abuses,” said Dale Scott, whose firm was hired by Alvord last year to help manage the district’s debt. “That's why we strongly support the proposed legislation that would provide significant taxpayer protections.”
While financial advisers help districts structure the bonds, underwriters – typically large banks and investment firms – broker the deals for a commission, selling the bonds whole or breaking them into smaller pieces and selling them to multiple investors.
According to state records, Piper Jaffray was the busiest underwriter since 2007, brokering 165 capital appreciation bondsfor a price of $638,045. Goldman Sachs made the most money as an underwriter during the same time period – $1.6 million on a single deal with the San Diego Unified School District.
Both firms declined to comment for this story.
Brian Cragin/California Watch
Highly leveraged deals
Nationwide, falling property values have hurt districts’ tax revenues, prompting some to turn to long-term bonds. Outside California, however, tighter regulations helped curb their use.
Ohio, for instance, prohibits the type of ballooning debt structures found in many California deals by requiring bonds to maintain a flat debt service. That means the annual payment must remain roughly the same each year.
California removed its flat debt service requirement on long-term bonds in 2009 with the passage of AB 1388. The bill was sponsored by the California Public Securities Association, which lobbies state lawmakers on behalf of financial consultants and underwriters. An association official declined to comment.
While districts have been relying on capital appreciation bonds for more than a decade, there was a slight increase in their use after the bill took effect, state data shows.
“Looking back, the Legislature's decision to eliminate the flat debt service requirement in 2009 is what led to a lot of these highly leveraged deals,” said Scott, the financial adviser.
School districts that issued these bonds fall into two categories: those that could not issue standard bonds because they had reached the $60 state tax cap, like Alvord, and others, like the Napa Valley Unified School District, that simply promised voters they would keep their tax rates low.
Napa issued its bonds in 2009 and 2010, in part, because officials had pledged to keep the tax rate well below the state limit.
“Our promise to the voters of Napa was to keep their tax bill at or below $36, and we were able to accomplish that,” said Jose Hurtado, a Napa school board member.
In 2006, Napa voters authorized $183 million to repair old school buildings and build a new high school in American Canyon, a rapidly growing area in southern Napa County.
By 2009, when the high school was nearly completed, property values had dropped and the district suddenly found itself short of cash.
On the advice of KNN Public Finance, an Oakland firm, Napa issued a nearly $22 million capital appreciation bond. The loan will cost $154 million – seven times the principal – when it is paid off in 2049.
Three months later, the district issued another bond for $7 million that will have cost $28 million by 2033.
Hurtado said the board did not explain to voters the high cost of repaying the bonds, as far as he knows.
“I don’t recall any of those conversations going on,” he said. “It doesn’t mean they didn’t happen, I just don’t recall.”
KNN charged the district $156,000 for advising on the deals, according to state records.Advisers at KNN declined to be interviewed, but Dave Olson, a managing director for the firm, said in a statement to California Watch that, ultimately, districts set their own fiscal policies.
“The role of the financial advisor is to present the full range of reasonable alternatives to implement that policy,” the statement said. “We hope that the district feels we did so in this case.”
Some officials have criticized districts like Napa for shifting debt to future taxpayers instead of asking voters to pay now.
“If they’re trying to stay under a tax rate promised to the voters, that’s completely egregious,” said Glenn Byers, assistant treasurer of Los Angeles County, who has been critical of capital appreciation bonds that take longer than 25 years to repay.“If they’re not at the tax rate’s legal limit, it’s a slam dunk: They shouldn’t be doing (it).”
Complex finance plans
Whether Napa’s school board understood the long-term implications when it approved the dealremains unclear. When California Watchfirst asked school board member Joe Schunk about the deal in November, he said Napa had not issued any capital appreciation bonds.
A week later, he called backand said he had been mistaken.
Fellow board member Hurtado said that KNN had explained the deal but that “it was hard to understand.”
“When you’re trying to have discussions about CABs versus traditional (bonds) and tax rates, occasionally it all runs together,” he said.
Lockyer said the inability of district leaders to grasp complex municipal finance is a problem around the state.
“I’ve seen materials that went to a school board when they authorized the original issuance and there were blanks where the interest rate amount was to be determined someday,” he said. “But that’s what they saw when they agreed to a deal.”
Ben Johnson, a longtime school board member in Alvord, said he could not remember how the district’s $57 million deal was explained to the board when members approved it 2011.
“I think the thought process was that housing prices would increase,” he said. “If you’re asking me if I would do it in the future, I would not, but you can’t go back in time.”
Piper Jaffray charged the district $569,416 to underwrite the bond, according to state data.
Calderon, Alvord’s chief business officer, lamented the lack of financial expertise that leaves many districts unqualified to navigate complex bond deals – or to do business with high-powered financial advisers and Wall Street investors.
“They’re swimming with the big sharks,” said Calderon, who likened running a school district to heading up a large corporation. “These are principals and assistant superintendents of curriculum, and they’re being promoted in the role of a chief business officer.”
Unlike Napa, Alvord had reached the $60 tax cap at the time it decided to issueits capital appreciation bond.
Before Hillcrest High School opened in 2012, Calderon said, Alvord’s other two high schools were bursting at the seams. Postponing construction on the new school would have meant holding classes in portable structures, “like a tent city.”
With the district unable to borrow more money with traditional bonds and voters demanding a new school, district leaders began to feel the political heat.
“It’s one of those situations that people are forced into when there’s a lot of pressure put on by either boards or superintendents, that they want this building finished and they want it today,” Calderon said.
David Bauman/The Press-EnterpriseHillcrest High School was supposed to have an Olympic-size pool, but it was halved to 25 meters when construction funds ran short. A large concrete deck fills the space where the rest of the pool was meant to be.
Cycle of borrowing
Alvord’s financial troubles date back at least five years, when the district got stuck in a cycle of borrowing money to pay off previous loans.
“Our whole issue is that, technically, the district is bankrupt,” said Scott Andrews, an Alvord district resident who has led opposition to the district’s borrowing practices, which according to district officials have left taxpayers $500 million in debt. “No one has been able to explain to me how they’re going to pay this back in the future.”
Johnson brushed off criticism that the district had dug a hole for itself by spending more than it could afford.
“Alvord at times has been secondary in some people’s minds in the county of Riverside,” Johnson said. “We want to make sure our students don’t go without any opportunities, not just educational but in terms of facilities.”
Hence the extravagant design of Hillcrest High School.
Built into the side of a hill, the campus features state-of-the-art facilities, including a stadium, aquatic center and air-conditioned gym. But even after issuing the $57 million bond to complete the school’s construction, parts of the campus remain unfinished because the district ran out of money.
For starters, the stadium has no seats. The district could not afford them, so families bring lawn chairs to watch the school’s football games.
What was supposed to be an Olympic-size swimming pool was scaled down by half to 25 meters when construction money ran out, leaving a large concrete deck where the rest of the pool was meant to be.
When Calderon first toured the aquatic center after joining the district last summer, he was shocked. “The first words out of my mouth were, ‘Where is the rest of the pool?’ ” he recalled.
Although Hillcrest originally was designed to serve 2,500 students, the district had to scratch an entire wing of classrooms from the building plans due to budget shortages. The school now has space for 1,600 students.
Each classroom cost $10,000 to furnish with hardware and technology, including digital blackboards that likely will be obsolete when the district’s first bondpayment comes due in 2026.
The school sat empty for a year after it was built because the district did not have enough money to operate it.
Still, Calderon insists that Alvord didn’t overreach. Although the district is $500 million in debt, he said, it’s “good debt” put toward facilities that will enhance learning for generations of students.
“Maybe one of these years or one of these decades,” he said, “if we ever get to sell another bond or do fundraising, maybe we can break open that concrete and build ourselves a true 50-meter, Olympic-size pool.”
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