An End Run Around The Taxpayer

In 1989, politicians in Brevard County, Fla., decided they needed a new headquarters building for the county government. There was only one problem: Tax-sensitive county voters were unlikely to approve a bond issue to raise the money. What to do? The politicians opted for a novel ploy to bypass the voters. First, they had a trustee, a state bank, issue $24 million worth of tax-exempt securities to pay for construction of the building. The county then agreed to make what amounted to yearly lease payments to the bank to pay the interest on the bonds. Unlike interest on conventional munis, lease payments are not a binding obligation on a municipality, so no voter approval is required.

It should be no surprise that municipal lease financing is booming. With demand for services growing at the same time that voters are becoming more unwilling to cough up or approve raising the necessary cash, state and local governments have been resorting to lease financing to fund such needed capital projects as schools, prisons, and courthouses. Issuance of lease-backed securities, known as certificates of participation or lease revenue bonds, has doubled since 1985 and hit a record high of more than $13 billion in 1991 (chart). Since 1980, $66.9 billion worth of lease-backed securities have been issued. Hobbled by Proposition 13, California has been the biggest issuer, with over 50% of all new issues in 1991.

ANGRY VOTERS. Yet the Brevard example illustrates the increasingly visible downside of the lease-financing trend. For one thing, voters don't always like being bypassed. Last year, Brevard County residents organized a vigorous protest against the building that focused not only on their lack of input in making decisions but also on the structure's location. "Voters thought they had the budget in check by different voter referendums," says Robert B. Lamb, professor of municipal finance at New York University's Stern School of Business. "But the inventiveness of investment bankers, lawyers, and issuers to, in effect, do an end run around constraints, has enabled tremendous growth in municipal leasing."

Stung by the protests, Brevard's politicians floated the idea of holding areferendum on whether to stop the lease payments on the nearly completed building. But that, in turn, provoked theire of a second and perhaps even more dangerous group of protesters: the municipal-bond industry. A referendum would highlight for investors the un-comfortably nonbinding nature of lease payments.

Muni underwriters have been very successful in selling lease-backed issues to investors, since interest on the bonds can be 30 basis points higher than the same issuer's straight debt. Unlike conventional municipal bonds, however, they aren't backed by the "full faith and credit" of the muncipality. And since payments often must be made from operating funds, and compete with expenditures for, say, police, they are vulnerable in times of fiscal stress. Still, underwriters and investors assume government-sponsored issuers have a moral responsibility to keep up the payments. "Issuers have to realize that there's a real obligation here, even though the documents state that they have a real right" to stop payment, says John J. Hallacy, manager of municipal research for Merrill Lynch & Co. "No one buys these things if they think they won't get paid."

Incensed by the possibility that Brevard might renege on that obligation, muni underwriters, ratings agencies, and the giant Municipal Bond Insurers Assn., which insures the lease issue, descended on county officials. Warnings flew of possible downgrades of the county's outstanding debt and restrictions on its access to debt markets. Chastened, Brevard nixed the referendum proposal.

SHOCK THERAPY. Yet some cash-strapped communities may have no choice but to stop lease payments. The Richmond (Calif.) Unified School District has missed two $558,000 payments since last July. Rather than bail the district out, as many expected, the state seems to want to make it an example to dissuade other school districts from issuing risky debt and to encourage greater scrutiny of such issues by underwriters and investors. The various parties are now negotiating.

That, in turn, has raised the murky question of what happens if a municipal lessee goes bankrupt. Because of the weak structure and security of some lease financings, the legal recourses for bondholders of issues that have defaulted and/or filed for bankruptcy are few and undefined. "Bankruptcy is a pretty gray area in municipal leasing," says Barbara Flickinger, manager of California local ratings at Moody's Investors Service Inc. "A lot of people are concerned."

Given the negative attitude of voters to anything that hints of taxation, municipal lease financing is expected to keep growing. "This market is here to stay and will continue to expand in importance for government financing," says Sally Rutherford, a senior vice-president with Standard & Poor's Corp. But there will be bad times. "I expect we'll have some near misses" where payments will be in jeopardy, says Richard A. Ciccarone, of the National Federation of Municipal Analysts. "And some will not be near misses, but hits." If that happens too often, the high-flying market may lose a lot of altitude.