Tuesday, August 7, 2007

Bonds (Municipal, Not Barry)

In this post, I will carefully traverse down the overgrown path that is the city's finances. The point of this somewhat torturous exercise is to properly analyze a recent story in The Capital concerning the city's pursuit of a triple-A (AAA) bond rating.

The city's budget is actually comprised of two parts: the operating budget and the capital budget.

Operating budget:
This is where most of the action happens. Money comes from property taxes, government transfers, fees, parking tickets, grants, and from a special tree in Ward 5 near where I live. (No, I will not tell you where the money tree is). Money is spent on all city business: mostly on salaries and benefits for city employees, but also on supplies, city expenses, etc.

Capital budget:
This is slightly harder to wrap your mind around because the city is not actually spending this money, at least not right away. The capital budget plans the spending for BIG projects: typically city expenditures of several millions of dollars, but sometimes as low as one hundred thousand dollars. The nature of these expenditures are not the day-to-day or recurring expenses of the city; rather, they tend to be one-time investments in infrastructure that are very expensive. For example, some capital projects for FY2008 are: building a recreation center, fixing a roof, and undergrounding electrical wires. If the city has extra money in the general fund, it pays for capital projects with that money. If not, the city issues bonds to raise money.

Now for the confusing part. The city will take in about $75 million this year. But, the capital budget calls for spending of $129 million, and that's not even including the operating budget spending (such as salaries for police).

How are the capital projects paid for? 3 ways:

1. operating fund money. some of the $75 million the city will take in goes to these projects, usually determined by #2 (read below)
2. state or federal money, which usually requires matching. so let's say a bridge costs $20 million and the state helps pay for it, but only with a 50% match. if they pay $1o million, the city must kick in their $10 million as well. this is how the amount of city operating budget money spent on capital projects is determined
3. if #1 and #2 are not enough, the city issues bonds to raise money

The bond process:
When the city issues bonds, it essentially is using a very high limit credit card--they are borrowing money just like we borrow money from the credit card companies when we use our credit cards. The difference is, we know the interest rate we will have to pay when we use our credit card, and the city does not know until after the transaction is made. Three characteristics of the bond issuance process determine the interest rate:

1: face value--the total amount of the bond(s) that the city is issuing
2. term--the amount of time that the city will take to repay the whoever buys the bond
3. sale price--the amount that the buyer of the bond pays for it

Let me try and illustrate an example. Let's say that the city of Annapolis needs $1 million to build a 24 karat gold statue of Al Hopkins, but they don't have the money to pay for it. They will, through a broker, sell a $1 million bond at auction. (For simplicity's sake we will say the term is 1 year.) People who would buy the bond are investors. The investors will never pay the face value of the bond....if they pay $1 million for the bond, and get paid back $1 million, they will have earned 0% interest on their money. If they paid only $950,000 for the $1 million bond, they will be paid back $50,000 on their $950,000 investment, or 5% return on investment. Since you can earn interest on savings accounts at banks, or on many other investments, you would never willingly earn 0% because you would be wasting an opportunity.

The amount of return (interest) that investors demand in exchange for lending their money depends on the risk of the investment. The safest investment that you can make is to buy a bond from the United States Treasury. The chance of the United States of America defaulting on bond payments is next to zero. There are infinite amounts of riskier investments you can make, but the important point is that Annapolis is on the safer side. While it cannot print money, and therefore is not as safe as a federal bond, the city of Annapolis is reasonably unlikely to default.

Which brings us to the rating system. Instead of a credit score like you and I get, governments (and corporations) are rated by 3 major rating agencies. The highest rating you can get is AAA. Annapolis has the next highest rating, AA+.

The theory is, if our rating improves to AAA, investors will see that Annapolis is very unlikely to default, and will be willing to bid a higher price for the bond, therefore lowering the interest rate the city has to pay and saving the taxpayers money.

As the case is, this won't matter much. According to Tim Elliot, the finance director, we never have problems selling bonds. Most bonds are bought immediately by brokers, who then sell the bonds to their clients. The price that we get for the bonds is near AAA level already.

So, in summary, it is noble to pursue a AAA rating, but not of extreme importance. It would save us a lot more money if the government didn't spend so much money so we didn't have to borrow so much money in the bond market, then would wouldn't have to pay that interest at all.

That's just about enough for this post. I am not bored with it, because I am an ECON geek, but I can see the looks on your faces. Email me if you would like more info.