Good Bond Rating Not Always Good For Citizens

From time to time this blog features posts about "bonds", which many people will remember are secret tools of high finance that are given to people who are either (1) awarded an MBA or (2) sworn into public office.

The city, possessing access to these bonds, can periodically issue them for the purpose of raising money to pay for things. Since the bond is a loan from an investor, the city must repay the value of the bond plus interest in order to attract said investors.

So, how do we know how much interest is paid? One determinant is the city's bond rating, which is issued by Fitch's, a company that gets paid to come up with bond ratings. The city recently issued $26,970,000 in bonds, which were rated at AA+. (The highest rating is one level above this: AAA).

The city was quick to tout the AA+ rating, and the story is featured on the city website. From the whole report, the city selected some excerpts that they use to propagandize the public:

Fitch Ratings assigns an 'AA+' rating to Annapolis, Maryland. The 'AA+'
rating reflects the city's stable employment and tax base, strong financial
position, and moderate direct debt burden.

The city's financial condition is strong, characterized by ample
reserves in the general fund.

The Stable Outlook reflects Fitch's expectation that the city will
maintain a healthy level of financial flexibility through prudent fiscal
management, despite broader recessionary pressures and a softening real estate
market.

Now, a higher bond rating typically means a lower interest rate that the taxpayers have to pay back to the investors, which is a good thing. And, the report points out several features of city finance that are indeed good. BUT, a good bond rating is not always a good thing!

A bond rating is solely a measure of the city's ability to repay its bondholders in the future. Potential investors can then use the rating to assess the default risk of a bond, and can determine the rate of return they need to receive to take on the risk of loaning money to the city. A bond rating is a pricing mechanism--it reflects certain financial practices of the city, BUT IT ALSO REFLECTS THE CITY'S ABILITY TO STICK IT TO THE TAXPAYERS. A spend-happy city could still receive a good rating if they've proven they are committed to raising more taxes. This could be accomplished through rising home values, higher tax rates, or development of new taxable properties. Take a look at some of Fitch's specific observations:

City efforts to expand and diversify the tax base through redevelopment and
periodic annexations have been successful, with the recent opening of the Park
Place mixed-use development, which includes a 225-room Westin hotel.

Long-term development prospects are constrained due to the limited land
area and the large portion of the city that is considered historic.

So, to maintain a good bond rating, the city's first option is to expand the tax base by allowing development. Is this a good thing for citizens? Many would say no--think 1901 West. As the land becomes more scarce, the city will be pressured to either reduce spending or raise the tax rate. Which do you think they will do?!

Beware the sound of one hand clapping.

A Healthy Debate

I must admit, that although this blog generally purports to cover local issues, it sometimes ventures in to other realms of discussion. Capital Punishment, which does a very good job in staying local and is the only other blog that I know of that covers Annapolis city issues, has offered some comments regarding posts that I have made. This is exiting to me, and hopefully is to you also, because now I can post some comments on the previous comments, and before you know it we've got interested people debating how to make the city better (rather than blaming various people for various things in press releases)!!

To begin, CP wonders what if any good a low interest rate on bonds is for we citizens. He is referring to a 4.27% interest rate that the city recently got on some $29 million in bonds:

This sounds like great news, and CP is sure every homeowner can appreciate what a good rate such as this means, but not being an economist, it is very hard to say how this translates into solid benefits for taxpayers. CP inquired of Mr. Weaver in his role as PIO, but was told to contact the Finance Director for such details. Perhaps staff reporters at newspapers, or maybe even ERIC SMITH, can take the time to delve into this, but CP thinks it is incumbent upon our own government to explain this is real terms to real people. What standard ratios are used in small cities to determine solvency and debt ratios? Will this mean our budget growth is slowed? How many dollars per year does it save over having a higher rate?

As a degree-holding amateur economist, and as an amateur participant in the city's budget process, I will try and offer some understanding to the process.

Bonds are issued for capital projects---big ones, like rebuilding a parking garage or building the outer west street gateway. The city doesn't pay for these right away, and they are not paid for out of the general fund. When the city council approves a capital expenditure, the finance director basically plans that he will need this money eventually, and when the time comes, he issues bonds in the private market, at the market rate. For more on the bond process, click here.

So how does this affect taxpayers? Well, our property taxes go to the city's general fund, and a portion of the general fund goes to debt service. Just like we pay money every month for our credit cards, the city pays money every month (or year) for bonds. The bonds are money that the city borrows on credit, just like our credit cards. And just like our credit cards, if the interest rate is lower, the debt service that the city has to pay is lower.

As far as the standard ratios used to determine a municipality's solvency, its what you might expect. Property tax base, a good amount of debt in relation to annual taxes, and willingness by the city council to impose taxes even if they are unpopular are all some things used. As far as the benchmark statistics, I don't know, but the city is doing well here because we have the second best bond rating possible.

Most importantly, this absolutely does not mean that the rate of our budget growth will slow. Debt service is about 4% of the operating budget--around $3 million per year. (I couldn't look up the exact number because the PDF file on the city's web site was messed up.) Eliminating debt service completely would help, but paying a 4.27% interest rate as opposed to a 4.4% interest rate doesn't help much. For a $10 million bond amortized over 10 years, a 4.27% interest rate as opposed to a 4.4% rate would save the taxpayers about $74,850--over 10 years*. I would guess that if the city were to re-finance every penny of outstanding debt we had at the best rate ever--like the rate, say, Microsoft gets--we might be talking about saving $100,000 per year, or .1% of the annual budget.

(*I used an online mortgage calculator to figure this out. There are probably nuances that differentiate mortgage lending with bond financing, but I am confident that these numbers make my point just as well.)

A way more important factor is the city council and mayor spending so much money! If they didn't spend as much, we wouldn't have to issue as many bonds and we could really save some money.

So I guess this first part wasn't really a debate with CP as much as some general info on the subject.

Moving on, CP had this to say about one of my recent posts:

CP must respectfully disagree with AP. The R party is not a party of ideas, but like all parties, is a party with some ideas, but in the case of the R's, most of them are bad. For example, invading Iraq. Would that be under the good idea list or the bad idea list?

How about privatizing social security. Hmmm....social? private? social? private? Well, which one?

As for this supposed R belief in lack of governmental control wherever possible, that always seems to end when someone wants to, say for example, smoke a joint, or when a man wants to have sex with a man, or when an unmarried man and woman have sex, or when anyone wants to do anything in their bedroom or what an R thinks is immoral, etc., etc.....

And let's not forget that it was President Bill Clinton himself who said, "the era of big government is over" (not that we actually believed it, but he did bring the deficit to almost ZERO) while Dubya himself has presided over the largest military and bureaucratic expansion in history and raised our deficit to astronomic levels. Oh--and Bush did all this with R's running Congress. And finally, do you feel that our bigger and bigger government under all these years of R domination has led to more or to less governmental control in our lives???

Well, I will of course concede the the GOP does not have a monopoly on ideas, but the bigger point that I want to make is that we (at least I) would prefer to debate on ideas, and ideas only.

Take Martin O'Malley. By most accounts, his record as a public servant did not merit his election to governor--based on ideas, he was not the best candidate. Using the platform "I am a Democrat, GW Bush is a Republican, Ehrlich is a Republican", O'Malley won. Many politicians, admittedly R's also, refuse to talk about ideas and have these nonsense talking points that accomplish nothing.

Now take the state budget debate as an example. The governor is prepping us for a huge tax increase. The Republicans complained, but also came up with THEIR OWN IDEA for how to solve the problem without raising taxes. Does this matter to the Democrats in Maryland? We will see soon enough, but my guess is no.

Unfortunately the Republican party has been parting ways with some of its principles. However, using the same lesser of two evils argument that CP uses, the Republican party is clearly the party more likely to favor reduced government and individual responsibility. And while this may not be the fundamental Republican ideology, it certainly is the defining characteristic of conservative ideology, which is precisely the claim I made.

As for CP's contention that Republicans are not the 'stay out of your life' party because of ethical dictum on social issues, he is slightly off of my point. So said I:

The problem is: the social issues that the right of our party espouse in no way define a conservative, or a Republican. And if our party narrows the scope of our appeal, we have no chance in this state.

So let me repeat, moral superiority is not the platform of the Republican party. There is no way around the fact that all governments must make some social policies based on value judgements and morals held by individuals. Many such morals are based on religion, and in aknowledgement of the numerous world-wide discrepancies concerning what is right and wrong, a definition of one's political philosophy cannot be determined by his/her interpretation of moral correctness.

In other words, my views on many social issues are determined by my religion, and not by my political ideology. So yes, value judgements made by some Republicans may equate to restrictions of choice for some people. But in general, Democrats want way more controls on everything, which makes the Republican party the party of individual freedom, even if not perfectly so.

And lastly, a quick round-up of the national issues mentioned:
-Iraq: perhaps, repeat perhaps, a bad decision in hindsight, decision was made on best available info, can't surrender now.
-Social security: there is nothing "social" about a pay-as-you-go system that takes your money and gives it to someone else. You should not be forced to give your money to the government so they can promise to administer your retirement plan, then spend the money whatever they want.
-The Bush/Clinton deficit comparison is invalid because there is always a deficit in wartime.

I applaud CP, as he actually admitted that he does not hate either party, which many people cannot do. And as long as we debate in the realm of ideas (like me, the Republican!), we will be better off for it.

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.