Friday, August 10, 2012

More market failures in Munis

America's $2.7 trillion municipal bond market is infamously opaque and has witnessed several failures and defaults. But even by its standards, as Gillian Tett writes, the case of Poway Unified, one San Diego educational district, in issuing so called "capital appreciation" bonds, is scandalous,
Last year, it 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.
This is no exception among California's school districts. Other San Diego school authorities have indulged themselves similarly - Oceanside Unified (borrowed $30m but will need to repay $280m), Escondido Union (borrowed $27m, faces $247m repayments) and San Diego Unified (borrowed $164m, will repay $1.2bn). In fact, while California may be an extreme case, the situation is not thought to be much better elsewhere.

These are classic regulatory failures. None of these bonds are backed by any credible repayment revenue streams. The issuers gambled on capital appreciation to finance repayments. The credit rating agencies who rated these bonds failed to signal the glaring deficiencies in the bonds issue. Regulatory gatekeepers who were supposed to ensure that issuers adhere to certain basic principles of prudent financial management looked the other way.

It is yet another reminder to those who claim that financial markets regulate themselves that financial markets cannot function effectively without strong regulation.

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