Someone explain to me how accountants think about Capital Appreciation Bonds (#OWS)
Yesterday we had a great discussion in our Alternative Banking Book Club about municipal financing, based on the sixth chapter in our book Occupy Finance called A Civics Lesson: Wall Street Feasts on the Commons. The conversation was kindly led by Tom Sgouros, a policy analyst and author from Rhode Island, which seems to be a hotbed of super terrible muni financing.
It was explained that shady deals in muni finance is all over the map, from price fixing in municipal bond deals, which is corruption strictly on the side of the big banks who finance the town’s deals to accounting tricks, where it takes the collusion of town officials to enter into shady and inappropriate contracts.
The thing I’d never really understood until yesterday was how people used Capital Appreciation Bonds to play tricks with their accounting, and specifically with their town’s debt limits.
Context around muni financing
A little more context, although I’m no expert (experts, please add details or correct me if I’ve misrepresented anything). Please also read the chapter, which is excellent and much broader.
First of all, by “municipalities” we mean towns and cities (actually, states and counties, too, not to mention water authorities, economic development agencies, school departments, and all the rest of the “not-federal-not-corporate”). So a town needs to borrow money for something, maybe to pay its workers, maybe to build something or maintain its roads. It borrows money from investors by issuing a muni bond, and the big banks help set that up. Investors invest in these bonds because they have special tax treatment, because they rarely default, and because they want to support their local communities.
But as you can imagine, the big banks have much more expertise on what kind of prices to expect and the level of sophistication it requires to do due diligence, and then if you add into that mix the fact that local town officials are often temporary, ignorant, and desperate, we get a toxic environment. There are lots of examples of this problem, and often they are covered up by the local towns because of associated embarrassment, complicity, and shame. Seriously, it’s awful, and we only hear about some of them like in Detroit and Stockton, when things are incredibly awful. Matt Taibbi has done an amazing job chronicling this stuff.
Anyhoo, with that backdrop, you can imagine that there are bad situations handed to town officials when they enter office, and they are confronted with a major league problem: they need to come up with money now to pay something basic like school teachers or firemen, but there’s no cash. And plus there’s a debt limit which they’re already pushing up against.
Enter the Capital Appreciation Bond (CAB). It’s a zero-coupon bond, which is already weird. For most muni bonds, towns regularly – quarterly or annually – pay interest or so-called amortizing sums, very much as an individual homeowner might pay monthly for their mortgages, where most of it goes to interest but every month a little bit of the principal is paid off too.
But for CABs, you get some money now and you pay nothing at all until it’s due, at which point you pay it all back at once.
Very very long term debt
You may have even forgotten about it by then, though, because the second weird thing about CABs is that the loans are often very very long term – as in 30 or 40 years. So, given the nature of the set-up and the nature of compound interest, you can end up paying something like 7 times the original amount after that much time.
For example, we see a school district like San Mateo in California borrowing $190 million recently that, when the bond comes due, will owe $1 billion. And it’s widespread in California: according to this article, 200 California school and community college districts issuing these bonds will end up paying 10 to 20 times more than they borrowed.
Accounting practices and CABs
That brings me to the third weirdest property of CABs, namely how they look on balance sheets for accounting purposes.
Namely, and here I need to confess that I’ve been a very bad accounting student, the towns only have to write the original loan down on the balance sheet as a liability, not the eventual pay-out. This is in contrast with other kinds of very similar zero-coupon bonds where you have to write down the eventual payment you will owe, not the amount you start with.
Someone please explain this discrepancy in the field of accounting!! It makes no sense to me. If the cash flows are the same for two different kinds of bonds, how do you get to account for them differently?
In any case, the consequences of this accounting trick are real. In particular it means that, for desperate town officials trying to pay their workers, or even shady town officials trying to get away with stuff, CABs are very attractive indeed, because it looks kind of innocuous and their overall debt limits don’t get breached even though they’ve essentially sold the future of the town to a big Wall Street bank. Plus they won’t be in office when that bill comes due, and they might well be dead.
Some California officials are trying to make CABs illegal or at least restricted, and some states like Michigan and Ohio have already passed laws against them. But given how much money they make for big banks, there are serious headwinds for reasonable rules.