A decade ago, San Diego county in California was at the cutting edge of some dangerous financial games.
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As the housing boom got under way, bankers and mortgage brokers became adept at flogging subprime loans to households across the area using “innovative” structures. That episode, of course, ended in tears, not just in San Diego but elsewhere in America.
Now, some new financial games have come to light involving a dangerous cocktail of innovation and debt. This time, it is not private households involved but public sector bodies – specifically, schools.
The issue at stake revolves around some exotic bonds issued by San Diego educational authorities in recent years. Once upon a time (think six long decades ago), US school authorities used to finance themselves primarily by using taxes. Then they started to issue a swelling volume of bonds to supplement those taxes.
But as the fiscal situation in California has deteriorated, voters have become so upset they have imposed various fiscal straitjackets on educational boards. Worse, property tax revenues, which have been used to fund schools, have declined as the housing market has crashed.
That has left schools in a bind. So, local financial advisers have offered some “innovative” solutions. Last year, Poway Unified, one San Diego educational district, issued some $105m worth of “capital appreciation” bonds to finance previously planned investment projects.
These are similar to zero-coupon bonds, meaning the district does not need to start repaying interest or capital until 2033.
As a result, Poway’s local authority has been able to promise to keep local taxes unchanged while completing previously promised investments (building projects, computers and so on).
But, there is a big catch: to compensate for this payment deferral, these bonds are paying double-digit interest rates and cannot be redeemed early. When the bond is repaid in 2051, the total bill will be more than 10 times the initial loan.
The Poway local authorities insist this still makes sense. After all, they argue, their children cannot wait for new schools until tax revenues grow again. But the danger is clear. Though these bonds shield taxpayers (and politicians) from expenditure today, they create a headache later. At best, this is a case of kicking the can down the road; at worst, a case of the government dancing with loan sharks.
It is difficult to tell just how many other capital appreciation bonds exist. As the Securities and Exchange Commission pointed out last week, the $2.7 trillion municipal bond market is alarmingly opaque. In the Poway case, the details came to light because of some excellent investigative reporting by Joel Thurtell, a blogger, and Will Carless, a reporter at the Voice of San Diego, a local news group.
Carless has unearthed similar but slightly less extreme schemes at other San Diego school authorities, such as Oceanside Unified (which borrowed $30m but will need to repay $280m), Escondido Union (borrowed $27m, faces $247m repayments) and San Diego Unified (borrowed $164m, will repay $1.2 billion).
However, the really big unknown is the degree to which this reflects a bigger, national pattern. Optimists might argue California is an extreme example; after all, its fiscal woes are among America’s worst.
In some regions such as Michigan, state entities are banned from capital appreciation bonds, and even where these bonds are not explicitly banned, there are corners of America where local officials are trying to inject a new level of responsibility into their finances, often with a zeal that puts Washington to shame. Rhode Island is a case in point.
Yet, as a report from Dick Ravitch and Paul Volcker last month pointed out, the overall picture for local finances is dire. They estimate, for example, that the level of underfunding for local public pension schemes is about $3 trillion- $4 trillion.
While some regions are trying to tackle this, many others are burying their heads in the sand, hoping that either the problem remains under wraps until they leave office, or that a combination of growth, inflation and federal bailouts provides a future fix.
So I, for one, salute the efforts of local media groups such as the Voice of San Diego to scrutinize these opaque local financial structures. I also applaud the moves the SEC is making (albeit very belatedly) to force that murky muni bond world to become more transparent to investors and taxpayers alike.
The tragedy is that this scrutiny is probably too late to save San Diego residents from a nasty future fiscal shock, not to mention those other US taxpayers who may discover (as with subprime) that what starts in California ends up pointing to a wider pattern, which haunts us all.