Monday, August 13, 2012

Poor Incentives and Predatory Lending in Municipal Finance

By Tim Husson, PhD and Olivia Wang, PhD

Last year, Poway Unified School District had a problem.  A decade earlier, it had started a program to modernize its aging schools.  In 2008, voters had approved additional funding for the project under the condition that the school board could not raise taxes further.  Unfortunately, by 2011, the project needed an additional $105 million to complete.  But because they could not raise taxes, they could not issue the kind of tax-backed bonds (called general obligation bonds) that usually fund large municipal expenditures.

The District's solution was to borrow the $105 million through a capital appreciation bond.  Under the terms of the bond, the District would defer interest payments for 20 years (ostensibly avoiding any need for tax increases), and pay the remaining amount over the next 20.  While this approach did indeed solve their immediate funding needs, it saddled future school boards with over $877 million in interest payments.  Needless to say, many are outraged.

This deal highlights an endemic problem in municipal finance.  Many school boards, county officials, city governments, and other community leaders are under intense budgetary pressure, and often have an incentive to fund current projects by placing massive liabilities on future generations.  In addition, many of these local officials are not sophisticated enough to recognize predatory lending practices or unsound investment strategies.

At SLCG, we have seen numerous instances of excessively risky or expensive financing options sold to community leaders across the country.  Powey Unified is not the only school district to have incurred such massive liabilities--in fact, it may not be the only school district in San Diego to have done so.  Unfortunately, municipal authorities often have insufficient expertise to manage the large budgets for which they are responsible.

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