Capital Appreciation Bonds: Disturbing Repayment Terms (Section 5 of 9)
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Capital Appreciation Bonds: Disturbing Repayment Terms
In 1993, California law was changed so that school and college districts could use an innovative form of debt finance called zero-coupon bonds, also known as Capital Appreciation Bonds. These bonds allow school and college districts to borrow now for construction and pay it back — with compounded interest — many years later. The borrowing strategy has been a tempting and dangerous lure for elected school and college boards.
Some people think Capital Appreciation Bonds are a “ticking time bomb” or the “creation of a toxic waste dump.” Others regard critics as uninformed and contend that these debt finance instruments are beneficial for school and college districts. Since the people who will be paying off many of these Capital Appreciation Bonds are now children or not even born yet, there isn’t much incentive to stop the flow of borrowed money that doesn’t need to be paid back for a generation or two.
Capital Appreciation Bonds Get Attention: Some Welcomed It, Some Didn’t
There was a brief time in the last half of 2012 when California news media and even national news media alerted the public to a neglected but long-festering problem involving municipal bonds sold by many California school districts and community college districts. These educational districts chose to borrow money for construction using an unconventional debt finance instrument called a Capital Appreciation Bond.
Capital Appreciation Bonds allow school and college districts to circumvent state laws that limit taxes and debt relative to the total value of property in the districts. But they also subject future generations of Californians to potentially burdensome taxes and debt.
Explaining and Contrasting Current Interest Bonds and Capital Appreciation Bonds
The traditional Current Interest Bonds (also called Fixed Rate Bonds) are relatively easy to understand. If someone buys a Current Interest Bond and holds it until it matures (reaches the end of its time period for borrowing), that buyer receives interest on a regular basis (usually semi-annually). The buyer gets the original principal paid back when the bond reaches the end of its term of maturity.
Here’s an example of how a Current Interest Bond works:
- An entity buys a $1000 Current Interest Bond issued by a school district at face value (also known as par value) with a 25-year term to maturity at a 2.5 percent interest rate.
- Each year, for 25 years, the buyer gets $25 in interest from the school district, because 2.5% of $1000 is $25.
- When the bond matures, the buyer gets the principal of $1000 back from the school district.
- The total interest earned over 25 years is $625, because $25 times 25 is $625.
- Although the $625 is income, the buyer will never have to pay tax on that interest if the bond is tax-exempt, as is typical with municipal bonds.
Obviously the school district must levy taxes on property owners each year throughout the 25-year term to maturity so that it has enough money to pay interest each year (and ultimately pay back the principal at the maturity date).
Capital Appreciation Bonds (also called Zero Coupon Bonds) are more difficult to understand. Someone who buys a Capital Appreciation Bond pays for it at a price deeply discounted from the face value (par value) of the bond. The buyer does not receive interest payments until the bond reaches maturity, at which point the buyer is paid the face value of the bond, which is the deeply-discounted price (the principal) plus all of the interest earned during the term to maturity.
During the term to maturity period of the Capital Appreciation Bond, interest accumulates over time. The interest is compounded, meaning interest for a time period is earned on the original amount of money and also earned on any of the interest that has already been accumulated up to that time period.
Compound interest that accumulates as a Capital Appreciation Bond grows in value is called “accreted interest.” “Accreted” (a word derived from the Latin accrescere, to increase) means accumulated over time.
Here’s an example of how a Capital Appreciation Bond works:
- An entity buys a $5000 Capital Appreciation Bond with a 25-year term to maturity at an interest rate of 5 percent.
- The discounted price of the bond is $1477.
- When the bond matures, the buyer gets $5000 back from the school district.
- The total earned over 25 years is $3,523.
- Although the $3,523 is income, the buyer will never have to pay tax on that interest if the bond is tax-exempt, as is typical with municipal bonds.
The school district benefits because for many years it does not need to levy taxes on property owners in order to make interest payments. It can borrow much more money through bond sales without being restricted by tax and debt limits established in state law. The community can enjoy the benefits of the bond sales without having to pay for them — at least for a while.
And although the buyer does not get a regular interest payment, the accumulated (“accreted”) interest is compounded over many years, making the wait a worthwhile investment. The cliché about “the power of compound interest” for an investor is accurate.
Why Did Capital Appreciation Bonds Become Popular?
The public first became aware of Capital Appreciation Bonds in 2012 when news media reported on a 2011 debt financing arrangement at the Poway Unified School District. Most reports insinuated that limits on taxes and debt established by the legislature in 2000 in conjunction with Proposition 39 had forced schools and community colleges to borrow money by selling Capital Appreciation Bonds. Allegedly these limits were constraining school and college districts from implementing necessary construction programs at a time of plummeting property values. Educational districts saw Capital Appreciation Bonds as the only debt financing option available to alleviate school overcrowding and ensure children’s safety.
But in reality, Capital Appreciation Bonds have been a component of bond issues by California educational districts for over twenty years. Signed into law in 1993, Senate Bill 872 authorized school and college districts to sell them. Voters in the Windsor Unified School District approved a bond measure on April 12, 1994, and the district proceeded to sell $5,054,761 in Capital Appreciation Bonds in its first series of bond sales. The Old Adobe Unified School District and the Oakland Unified School District soon followed.
Capital Appreciation Bond Origins
The first sentence in a 1982 article in the New York Times declared, “Give Wall Street a headache like double-digit interest rates, and someone will invent an aspirin like the zero-coupon bond.” According to this article, in 1981 J.C. Penney became the first corporation to issue Capital Appreciation Bonds. In 1982, E.F. Hutton became the first bond broker to underwrite Capital Appreciation Bonds for municipal governments.
A survey of news coverage on Capital Appreciation Bonds during the 1980s reveals that the focus of journalistic concern for this new form of municipal debt finance was the risk to investors. Needless to say, Capital Appreciation Bonds endured past the era of high interest rates, and the aspirin for investors became a headache for taxpayers.
Who Buys Capital Appreciation Bonds?
Capital Appreciation Bonds are not necessarily a wise decision for an investor, so who sees an investment advantage in buying them? James Estes, Professor of Finance at California State University, San Bernardino tried to answer this question and reported the results of his investigation in a 2013 paper. After observing that Charles Schwab & Co, Inc. does not offer or sell Capital Appreciation Bonds, he contacted twelve companies that offer municipal bond funds. All twelve claimed they don’t market funds featuring Capital Appreciation Bonds. Company representatives told Estes that Capital Appreciation Bonds were undesirable to their investors because of their lack of current interest payments, their poor yield, and their high risk.
Estes also investigated rumors on the web that CalPERS might be holding many municipal Capital Appreciation Bonds. CalPERS spokesperson Danny Brown denied that CalPERS holds them and cited their risk. Finally, Estes mentions the claim of a finance reporter that international banks hold Capital Appreciation Bonds in a trust administered by Bank of America.
In response to a Twitter inquiry from the author of this report, a former reporter for Voice of San Diego tweeted that he never learned who held the district’s Capital Appreciation Bonds during his 2½ years reporting on Poway Unified School District’s Capital Appreciation Bond fiasco: “The word was that the debt had likely been sold and resold and resold. Also no repository for that info…I always wanted to know.”
In 2014, a municipal bond advisor named Dale Scott of Dale Scott & Company presented a plan to Poway Unified School District for the district to buy back some of its Capital Appreciation Bonds using funds from a property tax increase. One challenge for this district is identifying who owns the bonds so offers can be made to buy them back. Scott pointed out that he had managed to find owners of Capital Appreciation Bonds issued by the Stockton Unified School District and buy back about 30 percent of them. According to an August 20, 2014 article in the San Diego Union-Tribune, “Scott said there is a myth that capital appreciation bonds are impossible to acquire once they are sold, but the reality is the bond holder may have many reasons for selling bonds that may take decades to mature.”
Tax and Debt Limits Meant to Assure Property Owners that a 55% Approval Threshold for School Bond Measures Wouldn’t Crush Them
From a school district’s perspective, Capital Appreciation Bonds are attractive because they enable the district to borrow more within its tax and debt limits. California Education Code Sections 15268-15270 sets the current limits. The state has not changed the limits since the enactment of Assembly Bill 1908 in conjunction with Proposition 39 in 2000, although Governor Brown proposed increasing them in his 2015-16 budget. (See Section 2 for background.)
Opponents of Proposition 39 in 2000 pointed out in their ballot arguments that these tax and debt limits were not part of the constitutional amendment enacted through Proposition 39 and therefore could be amended or repealed by the state legislature at any time. This is true.
Districts can set a lower tax or debt limit in the ballot statement for a bond measure. And K-12 school districts can get waivers from State Board of Education to impose higher tax or debt limits. (See Section 6 for background on waivers.)
Tax and Debt Limits Make Funding of Construction Programs Highly Dependent on Assessed Property Valuation
Because tax and debt limits are based on annual assessed property valuation in a district, the limits change yearly as a reflection of the real estate market. If property values increase compared to the previous year, the amount of money that can be borrowed increases relative to the previous year. If property values decline compared to the previous year, the amount of money that can be borrowed that year decreases. Educational districts hope (and usually project) property value to increase at a respectable rate for many years to come.
If the substantial increase in home prices during the mid-2000s gave school and college districts several years to borrow a lot more than perhaps originally anticipated, the dramatic drop in the following years hindered school and college districts, especially those with ongoing construction programs. From 2007 to 2011, assessed property valuation in some regions of California declined by as much as 50%, especially in exurban areas of California that grew rapidly in population during the 2000s as young families sought home ownership at prices they could afford.
Not surprisingly, these same regions needed new school construction to accommodate the children in these young families. Because of tax and debt limits, educational districts could not raise tax rates or borrow more money using traditional Current Interest Bonds to compensate for the loss in revenue resulting from the decline in property values.
Capital Appreciation Bonds are a clever way to circumvent the debt limits. A school or college district can take on a long-term debt obligation of $5000 by selling a bond but declare the debt to be $1300 because the bond was sold at the deeply discounted “principal” of $1300. And by deferring payment to bond investors until the bonds mature, the district can borrow money without exceeding the tax limit.
Hoping for the Best with Capital Appreciation Bonds
Of course, school districts will eventually have to collect a lot of money through levying taxes on property owners to pay principal and accreted interest to the buyers of Capital Appreciation Bonds. Essentially, Capital Appreciation Bonds represent a district’s gamble that assessed values will climb rapidly enough to produce sufficient tax revenue to allow issuers to pay off the bonds when they become due. If the anticipated increase in assessed property valuation fails to occur during the term of maturity, the district cannot pay principal and interest owed in future years.
There is little political disincentive for elected board members to borrow money today for school construction and impose a commitment on future generations to pay it off in 25, 30, or even 40 years. Only the elected board members of the Poway Unified School District have suffered political consequences from approving this kind of debt finance. But future school and college board members (who are children today) may be unjustly subjected to voter ire when the bill on Capital Appreciation Bonds is finally due.
2013: An Incomplete Fix for the Excesses of Capital Appreciation Bonds
Assembly Bill 182 was an attempt to restrain the worst excesses of Capital Appreciation Bonds while still allowing school and college districts to use them as a debt finance tool. It developed out of a proposal from San Diego County Treasurer-Tax Collector Dan McAllister as a response to high-profile Capital Appreciation Bond sales by school districts in his county.
Supporters of this bill were prominent critics of unrestrained Capital Appreciation Bond sales: California State Treasurer Bill Lockyer, the aforementioned San Diego County Treasurer-Tax Collector Dan McAllister, the California Association of County Treasurers and Tax Collectors, the California League of Bond Oversight Committees, the Howard Jarvis Taxpayers Association, and the California Taxpayers Association. Several rural county boards of supervisors supported the bill, as well as the board of supervisors for Contra Costa County, where the West Contra Costa Unified School District, the Mt. Diablo Unified School District, and the Acalanes Union High School District received local attention for risky bond finance schemes, including Capital Appreciation Bonds.
California State Treasurer Bill Lockyer wrote the following in support of Assembly Bill 182:
…many districts face a critical need to build or modernize facilities for their children, and I recognize that falling property tax assessments, revenue losses, and statutory debt service limits have all combined to reduce districts’ debt financing options, at least at the present time. However, we cannot continue to use debt financing tools, such as CABs, that force tax payers to pay, at times, more than 10 times the principal to retire these bonds. In too many cases, these transactions have been structured with 40-year terms that delay interest and principal payments for decades, resulting in huge balloon payments. Moreover, school board members and the public have not always been fully informed about the total costs and risks associated with issuing capital appreciation bonds. As a result of such CAB deals and lack of transparency, our future generations in many California school districts will be burdened with heavy taxes for years and years to come.
But there was also significant opposition to the bill from groups heavily involved in promoting bond measures for school construction, including California’s Coalition for Adequate School Housing (C.A.S.H.), the Association of California School Administrators, the California Association of School Business Officials, and the Small School Districts’ Association. The first legislative analysis written for a committee about AB 182 described the basis for the opposition:
All of the opposition letters submitted to the Committee have an “oppose unless amended” position. Generally, the opposition supports more transparency, but is concerned that the bill will inhibit school districts’ ability to secure funding to house students and provide for renovations as promised to voters through their bond initiatives. While some of the opponents do recognize the need to establish some parameters to prevent extreme CABs, they argue that CABs, if done appropriately and in a limited way, are effective. The requested amendments vary from organization to organization. They include expanding the term of CABs to 30 years, restoring the term of 40 years for CIBs, increasing the total debt service to principal ratio to 6 to 1 and applying the ratio to bond authorization, grandfathering in bonds that are already approved but not issued, and allowing districts to seek a waiver from the SBE to increase the tax rates.
In the end, the bill passed the State Senate 36-0 and passed the State Assembly 78-0. Soon after the bill was signed into law, governing boards of school and college districts were already initiating the sale of more Capital Appreciation Bonds under the new guidelines. This method of debt finance for school and college construction is not going away.
Case Study: Poway Unified School District’s Egregious Debt Finance
Poway Unified School District created a special School Facilities Improvement District in 2007 and asked voters in February 2008 to authorize $179 million in bonds to finance capital improvements. The bond measure passed with 63.9% support, as it qualified under Proposition 39 for a 55% voter approval threshold.
As a campaign strategy, the district promised voters that the bond measure would not require a tax increase, supposedly because assessed property values would rise enough over time to bring in more tax revenue and pay off the debt service. To keep this promise, the school board subsequently adopted some excessive debt financing schemes.
From 2008 through 2011, the district borrowed the $179 million by issuing four series of bonds, including Current Interest Bonds and non-callable Capital Appreciation Bonds, with some bonds issued to refund earlier bond issues. It even sold some 40-year bonds at the maximum legally allowed interest rate of 8 percent. It used numerous controversial debt finance practices, such as selling bonds at a 20 percent premium over face value, and ended up incurring issuance fees totaling more than $6.7 million.
Perhaps people in the Poway Unified School District did not comprehend the dangers at the time, but the school board realized the district was doing something questionable. In 2010 it filed a validation lawsuit to subvert future lawsuits against their next bond finance deal. This provoked a warning letter from the California Attorney General, but in the end no party chose to be a defendant, thus giving the district legal cover to proceed.
Property owners in the School Facilities Improvement District now have the burden of paying $1.27 billion in debt service through 2051 for the privilege of borrowing $179 million. Poway Unified School District was described in the news media as having “shot to fame” as a “poster child for an era of reckless and risky school bond borrowing” through bond sales that have “reached legendary status.” And it became a rare example of voters making school board members accountable for its decisions on bond finance.
Three of the five board members who voted for the Capital Appreciation Bond deal in 2011 have lost their reelection campaigns, and a fourth chose not to run for re-election. The only remaining board member from 2011 may still be in office because only three candidates (two incumbents and a challenger) ran to fill two seats in the 2012 election. Seeing the popular demand for change, eight candidates ran for three seats in 2014.
Michigan Banned Capital Appreciation Bonds When California Legalized Them
On April 27, 2012, a former reporter for the Detroit Free Press newspaper named Joel Thurtell published a post on his blog entitled “Muni Bomb Ticks in California.” Thurtell wrote about the popularity of Capital Appreciation Bond sales by California educational districts.
Thurtell revealed that the practice was not new; in fact it was common at Michigan school districts in the late 1980s and early 1990s:
There’s a school bond scandal brewing as California schools load taxpayers with horrendous debt for the next generation of taxpayers. The blight is called CABs — short for Capital Appreciation Bonds. It hit Michigan in 1988. Within four years of the first CAB issue, Michigan public school debt had doubled to reach more than $4 billion. That was just principal. The interest on the CABs amounted to 200 percent — 300 percent — even 575 percent of principal, depending on the terms of the individual bond issue. Nineteen years ago, I delved into this fascinating but arcane world with its private argot strewn with obscure words like “zeroes” and “basis points” describing fairly simple things in language you need a special dictionary to comprehend. It’s an industry with specialized documents that seem encrypted so that people like you and I will have trouble understanding them.
Thurtell had spent many days of difficult, tedious research at the Michigan State Treasurer’s office scrutinizing paper copies of “Official Statements” produced for Michigan school districts. He produced a “Big Chart” that quantified the prevalence of Capital Appreciation Bond sales and accumulated debt service. On April 5, 1993 the Free Press published the first of a series of Thurtell’s articles about how Michigan school districts were borrowing their money for school construction. The articles changed public policy in Michigan:
Because of my Free Press stories…the state Legislature banned future issues of Capital Appreciation Bonds and ordered that future bond issues be competitively bid rather than rigged through a process the underwriters euphemistically termed “negotiation.” It was huge that CABs were banned, because as you will read in these stories, schools were piling up enormous debt to be paid by future taxpayers. Imagine the predicament schools would have found themselves in had such debt been allowed to continue accumulating into today’s depressed economy. Debt payback was predicated on rosy assumptions called “present value” that predicted large increases in real estate valuation ad infinitum.
At the May 2012 annual conference of the California League of Bond Oversight Committees, the Los Angeles County Treasurer-Tax Collector Mark Saladino and Alicia Minyen, a school bond expert and certified fraud examiner, made presentations that included discussion of Capital Appreciation Bonds. Saladino had written a May 16, 2011 white paper about risky municipal debt finance that referenced school districts issuing Capital Appreciation Bonds. Minyen was a prominent critic of a few school districts in Contra Costa County that had issued Capital Appreciation Bonds in irresponsible ways.
Minyen referenced Joel Thurtell’s articles and blog posts. The author of this report then wrote articles for his personal blog about the Capital Appreciation Bond presentations, and local taxpayer activists throughout the state began contacting him with questions and concerns about Capital Appreciation Bond sales going on in their local school and college districts. Californians who paid close attention to tax and government finance issues from a critical perspective were confused — and suspicious.
Graphic Depictions of Poway Unified School District Bond Debt Inspire Limited Reforms
Finally a breakthrough in bringing public awareness to the issue occurred in August 2012, when a journalistic web publication called Voice of San Diego published a series of investigative pieces written by reporter Will Carless about the 2011 Poway Unified School District bond sales. The first article hit on August 6, 2012: “Where Borrowing $105 Million Will Cost $1 Billion: Poway Schools.”
It’s possible that Voice of San Diego was successful in bringing sudden and dramatic attention to the practice because of the simple and colorful graphics produced by Keegan Kyle and included with the articles. These graphics portrayed the deals in a way much easier to understand than the analytical writing of policy experts.
These articles and the associated graphics were the catalyst for intense statewide public criticism. Voice of San Diego created a spreadsheet, the Los Angeles Times created a database, and other news media outlets compiled information revealing that a couple hundred community college and K-12 school districts in California had issued Capital Appreciation Bonds, with many starting long before property values began to decline in 2007.
California and national news media, state and local taxpayer organizations, and many state and local politicians spent the next year criticizing California educational districts for poor decisions about borrowing money via bond sales for school construction. About a dozen educational districts received a disproportionate amount of negative attention for their Capital Appreciation Bond sales. Criticism ebbed but did not disappear after Governor Brown signed Assembly Bill 182 in October 2013 to put limits and new oversight on Capital Appreciation Bonds.
Backers of Capital Appreciation Bonds Stubbornly Defend Them
Throughout the state and even at the Poway Unified School District, elected district officials and administrators defended their decisions to sell Capital Appreciation Bonds. Their response to criticism was common and consistent:
- Voters wanted school construction done as soon as possible.
- Capital Appreciation Bonds were the only way available to get the money.
- We didn’t do anything wrong.
- Look at the complete program instead of focusing on individual bond issues.
These claims generally echoed the arguments of parties involved in the preparation and sale of those bonds. These bond experts knew the obscure and complicated business of municipal bonds, but they also had a financial interest in seeing these bond sales continue.
Tables A-5 and A-6 are comprehensive lists of arguments for and against Capital Appreciation Bonds, with rebuttals.
“Text – SB 872 Local Agencies: General Obligation Bonds,” California Legislative Information, October 6, 1993, accessed June 28, 2015, www.leginfo.ca.gov/pub/93-94/bill/sen/sb_0851-0900/sb_872_bill_931006_chaptered
“Market Place; Zero-Coupon Municipals,” New York Times, March 21, 1982, accessed June 28, 2015, www.nytimes.com/1982/03/31/business/market-place-zero-coupon-municipals.html
“Capital Appreciation Bonds: The Creation of a Toxic Waste Dump in Our Schools,” Alpha Wealth Management, April 11, 2013, accessed June 28, 2015, www.alpha-wealth.com/resources/publications/CAB-Paper.pdf
Kevin Dayton @DaytonPubPolicy, May 9, 2015, accessed June 28, 2015 https://twitter.com/daytonpubpolicy/status/596934260381978624
Dale Scott & Company www.dalescott.com
“Questions & Answers from Capital Appreciation Bond (CAB) Public Forums,” Poway Unified School District, August 20, 2014, accessed June 28, 2015, https://www.powayusd.com/doc_library/2014-15/CommunityForumFAQs.pdf
“Plan Pitched to Lower Poway Bond Debt,” San Diego Union-Tribune, August 20, 2014, accessed June 28, 2015, www.utsandiego.com/news/2014/aug/20/poway-plan-bond-debt/
“Text – AB 182 Bonds: School Districts and Community College Districts,” California Legislative Information, October 2, 2013, accessed June 28, 2015, leginfo.legislature.ca.gov/faces/billNavClient.xhtml?bill_id=201320140AB182&search_keywords=
“Treasury: Capital Appreciation Bonds,” San Diego County Treasurer-Tax Collector, accessed June 28, 2015, www.sdtreastax.com/capital-appreciation-bonds.html
“AB 182 Bill Analysis – Concurrence in Senate Amendments,” Official California Legislative Information, September 5, 2013, accessed June 28, 2015, www.leginfo.ca.gov/pub/13-14/bill/asm/ab_0151-0200/ab_182_cfa_20130905_163723_asm_floor.html
“AB 182 Bill Analysis – Assembly Committee on Education,” Official California Legislative Information, March 20, 2013, accessed June 28, 2015, www.leginfo.ca.gov/pub/13-14/bill/asm/ab_0151-0200/ab_182_cfa_20130318_154906_asm_comm.html
“Citrus College OKs Capital Appreciation Bond Issuance,” San Gabriel Valley Tribune, May 6, 2014, accessed June 28, 2015, www.sgvtribune.com/social-affairs/20140506/citrus-college-oks-capital-appreciation-bond-issuance
“Re: Poway Unified School District v. All Persons Interested – Superior Court of California, County of San Diego, Case No. 37-2010-00106255-CU- MC-CTLAG,” California Attorney General letter to Poway Unified School District, Orange County Government, March 1, 2011, accessed June 28, 2015, http://cams.ocgov.com/Web_Publisher/Agenda11_05_2013_files/images/ATTORNEY%20GENERAL%20OPINION%20-%20POWAY%20BOND%20PREMIUM_9843497.PDF
“Muni Bomb Ticks in California,” Joel On the Road, April 27, 2012, accessed June 28, 2015, www.joelontheroad.com/muni-bomb-ticks-in-california/
“Find High-Interest School Bonds in Your District: A Five-Step Guide,” Voice of San Diego, August 8, 2012, accessed June 28, 2015, http://www.voiceofsandiego.org/investigations/find-high-interest-school-bonds-in-your-district-a-five-step-guide/
“Spreadsheet: Capital Appreciation Bonds,” Los Angeles Times, November 28, 2012, accessed June 28, 2015, spreadsheets.latimes.com/capital-appreciation-bonds/