By Sharon Simonson
Business people have calculated the merits of strategic debt default and bankruptcy-protected reorganization for a long time. The financial and housing crises have introduced the tactic to private individuals, who have embraced the upside in walking away from an overvalued home mortgage.
That’s the question being raised by a New York-based municipal bond expert, Bart Mosley, co-president of Trident Municipal Research. “From pure game-theory considerations, a city like San Jose has the most to gain from looking at all options—which is a euphemism for bankruptcy options—and the most to lose from waiting for things to get better,” Mosley said.
Not quite two weeks ago, Trident published a research report dissecting the circumstances surrounding bankruptcy filings and fiscal distress at California cities and towns such as Bell, Stockton, Mammoth Lakes and San Bernardino. “The specific municipalities that are pursuing Chapter 9 are the cases where longstanding economic strains, in many cases reaching back to the early 1990s, created the underlying fiscal stress that the recent housing crisis and the state’s fiscal pressure drove past the tipping point into crisis,” the report says.
In an aside, San Jose is mentioned as a candidate for Chapter 9, and the comment has “raised eyebrows,” Mosley said in an interview with The Registry. This week Trident published a follow-up report on San Jose that casts additional light. Mosley spent four years as head of the municipal proprietary trading desk at UBS ending in 2008 and before that was a senior trader on Citi’s proprietary trading desk for a decade.
The focus of Trident’s attention is the San Jose Redevelopment Agency. More particularly, it is the San Jose RDA’s “successor agency,” which carries more than $2.3 billion in outstanding debt, backed by “tax increment” property assessments.
Annual debt service on the $2.3 billion exceeds $160 million through 2023, according to public records. After that, it falls gradually for another 15 years to $140 million, then $120 million and finally to less than $20 million in 2037. “If the successor agency is not insolvent, it is very close,” Mosley said.
Not so, say Julia Cooper, acting finance director for the city of San Jose, and Arn Andrews, acting assistant finance director. For the fiscal year that began July 1, the city’s general operating fund budget included $16 million in outlays to service the debt on four line items where the city shares financial responsibility for repayment with the RDA successor agency, Andrews said. Those debts include $137.8 million owed on the city’s convention center, and $36.7 million owed on the Fourth Street Garage, Cooper said.
But bondholders on the remaining roughly $2 billion in redevelopment agency debt have no recourse to the general fund, and in time, as property values revive and the successor agency’s revenues climb, the city’s general fund should be repaid, Cooper said.
In the interim, the delta between the agency’s revenues and debt service is being considered a “structural deficit,” which is estimated to persist and then be resolved over the next five years, Andrews said. The amount of that deficit is not estimated to climb above $25 million a year, which is the maximum amount that the city’s general fund could legally be required to pay of the redevelopment successor agency debt. “So that is not insolvent because it is within the legal limits of what the city is legally required to pay,” Andrews said. “And over time the city will be reimbursed.”
The ultimate irony, of course, is that the purpose of California redevelopment agencies and “tax increment” financing was to help improve property values by diverting property taxes above a baseline level and using that revenue stream to finance public projects. The formula was supposed to yield faster and greater property value increases than would be the case with solely private-sector investment. That increase in time was to help better support schools and other municipal and social services. That San Jose’s tax increment revenue is insufficient to support the debt issued against it means private investment and property values have not increased at the same rate as public debt.
The Chicago-based Counselors of Real Estate, an invitation-only credentialing community with 1,100 members worldwide, identified municipal and public-sector financial stress as one the 10 greatest worries for real estate investors and owners in the next 30 years. “Underfunding of state and local retirement systems in the trillions of dollars provides extreme challenges to the provision of basic local and state services critical to real estate properties and markets,” the group said. Members provide advisory services to a spectrum of clients including investment funds, financial institutions, universities, cities and corporations.
Distress has rained hard on San Jose over the last decade. Silicon Valley recovered more slowly than the nation at large after the 2001 dot-com bust. Countywide employment and incomes are still below dot-com highs. San Jose itself has had a long-running structural operating deficit, Mosley said.
In the recession just passed, the city’s industrial and property base lost value at a steeper rate than the county as a whole. The taxable value of real estate and business equipment in San Jose dropped 3.1 percent in 2010 compared to a 2.4 percent decline countywide. 2010 was the first year since the Great Depression that taxable real and business property value fell countywide. Taxable values have recovered some in the last two years, but San Jose’s rate of increase is slower than the county’s at large. The events have flogged not only city finances but also those of the San Jose Redevelopment Agency.
The RDA’s debt load was a concern for rating agencies as early as 2003. Then last year both Moody’s Investors Service and Fitch Ratings dramatically lowered their expectations. Moody’s “judged [RDA debt] to have speculative elements” and to be “subject to substantial credit risk.” Both raters still considered the debt investment grade, though just barely.
Everyone agrees—city officials and Trident’s Mosley—that neither the city nor the redevelopment successor agency is in imminent danger of default. But Mosley’s points are clear. “Since 2008, the unrestricted assets of the city—the assets of the city unencumbered by debt—have been deteriorating rapidly,” he said. That means the city’s buildings and other physical stock is depreciating faster than it is being replaced.
San Jose has about $500 million in general-obligation debt. GO debt is its most senior and important and is backed by recourse to the city’s main operating fund. It has another $1 billion in debt issued through the City of San Jose Financing Authority, which includes debt guaranteed by city lease payments on buildings it occupies including the Richard Meier City Hall and employee parking garage and the Hayes Mansion. Some Financing Authority debt also has recourse to the city’s main operating fund.
The city should safeguard those debt sources, and take all action to ensure the successor redevelopment agency’s debt does not somehow land on its list of obligations, Mosley said, something that he believes could happen. “In San Jose’s case, the successor agency is now part of the city. What is not clear is if the city takes those obligations onto its own balance sheet, does that become part of the city’s overall obligation or is it separable?”
“We would like to see that made clear,” he said.
For their part, Cooper and Andrews are clear. The redevelopment agency debt has always been priced differently and with higher yields than general obligation debt and Financing Authority debt. That reflects investors’ understanding that it is higher risk and a different investment than either of the other two. For the city to assume responsibility for repaying RDA successor agency debt now is to invite moral hazard, Andrews said. Debt holders are “sophisticated investors.”
“Why would we go back and undo what was a professional agreement?” he asks.