Home > #OWS, finance > Someone explain to me how accountants think about Capital Appreciation Bonds (#OWS)

Someone explain to me how accountants think about Capital Appreciation Bonds (#OWS)

October 28, 2013

Book Club

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.

Zero coupon

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?

Conclusion

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.

Categories: #OWS, finance
  1. SamChevre
    October 28, 2013 at 8:09 am | #1

    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.

    Things I’m not an expert on: municipal accounting, which is it’s own marvel. (Hey–I can do insurance accounting 4 different ways–isn’t that enough.)

    But that sounds like standard zero-coupon accounting; you start with the borrowed amount (not the face) on the balance sheet, and it grows with interest every period over time. Do you have a reference for the “other similar zero-coupon bonds show the ultimate payment?” (I’ve never seen that treatment, but as I said–municipal accounting is genuinely different.

    • FogOfWar
      October 28, 2013 at 8:58 am | #2

      Agree–listing $1bn as a liability in the above example would be both economically incorrect and inconsistent with standard accounting.

      I think the interesting action might take place in how you treat the accrued but unpaid interest. So at the end of year 1, a $100 regular bond would pay out $5 interest. Dr. interest expense, Cr. Cash. Balance sheet -$5 assets (cash) -$5 Equity. If the $5 compounds, Dr. Interest expense, Cr. Accrued but unpaid interest (liability). So Balance Sheet: +$5 accrued but unpaid interest (liab). -$5 equity.

      I think the point is that over time your leverage ratio is going to predictably balloon way out by the compounding of the interest, and that’s a violation of the spirit of the leverage ratio covenants if not necessarily the letter.

      FoW

      • FogOfWar
        October 28, 2013 at 9:41 am | #3

        Ooh..or it might be a more subtle question of geography.

        Any accounting nerds remember whether accrued but unpaid interest is categorized as a per-se short-term liability? If so, that’s what’s really going on here. The accrued interest (only $5 in year 1 in the above example, but it’s going to grow and compound every year, which explains the long duration in the trade) may well be treated as a short-term liability rather than long term and that would impact various liquidity ratios.

        Can anyone confirm?

        FoW

  2. E.L. Wisty
    October 28, 2013 at 9:13 am | #4

    Reblogged this on Pink Iguana.

  3. October 28, 2013 at 9:43 am | #5

    Are capital appreciation bonds funding the explosion of construction projects on college campuses? I’d hate to think how easily university administrators could be led astray by financier promises and “gifts.”

  4. Guest2
    October 28, 2013 at 9:46 am | #6

    Municipal bonds are the playground of corrupt politicians — that also have a stake in the bank handling the loans!

    ” the towns only have to write the original loan down on the balance sheet as a liability, not the eventual pay-out” This depends on how you handle encumbrances. If there is a loophole that avoids listing this on the balance sheet as a liability, then blame GASB 34.

    http://www.michigan.gov/documents/SGuideGASB34_13350_7.pdf

    Here is a discussion of suggestions for recording capital appreciation bonds (pages 8 and 9).
    Ultimately (and this may be the answer to your question) it is up to the Chief Financial Officer and the auditors how this gets recorded.

  5. October 28, 2013 at 1:11 pm | #7

    I don’t know anything about accounting, but you seem to have fallen prey to a common US fallacy, what I call the “fallacy of the nominal dollar”. It seems to me that US policy-making is based on the ideal that “a dollar is a dollar”, ignoring both inflation and the time value of money. For example, the 30th root of 5 is about 1.055. The US long-term inflation rate is more than 3%, so $200M against $1B repayment in 30 years reflects less than 2.5% real interest. You may argue that this rate is high, but it’s not exorbitantly so.

    If I had to set the accounting rule, then municipalities should account for the present value of their future obligation, using a standardized discount rate not open to local manipulation — and certainly not for the nominal value of the future obligation. Moreover, if the cost to settle the loan today is less than the present value of the future obligation (which seems to be the case here), then it non-obvious which of the two amounts is the corrent one to account for, and I’m not going to say anything about it.

    For other occurences of the fallacy note that the AMT was for a long time set at a dollar amount not indexed to inflation, and that capital gains are calculated in nominal rather than real dollars, making the tax on long-term investments (say a house to live in) a tax on capital, not on gains.

  6. quasihumanist
    October 28, 2013 at 3:21 pm | #9

    Here is the most reasonable rule for this problem, though it will take a while for the effects to kick in:

    Every high school graduate (and hence most voters) should learn enough accounting to completely understand the balance sheet and income statement for an average small town and have some idea what is going on in the same documents for a city.

  7. October 28, 2013 at 11:22 pm | #10

    like I said before when you decided to study accounting, you should study bookkeeping first, so you won’t be confused by the lying that enters in when you move on to accounting. what you are asking to have explained is a concessionary and convenient treatment purchased with money or favors at a standards board meeting. it’s not logical, not meant to be logical, meant only to conveniently mischaracterize. welcome to accounting.

  8. Kaleberg
    October 31, 2013 at 12:33 am | #11

    If you buy a taxable bond with a similar structure, no interest payments, but accumulated interest and principal paid on maturity, then you have to pay income tax on the interest you didn’t receive but otherwise would have. Even though the transaction might look like a long term capital gain, you have to treat the unreceived interest as ordinary interest income.

    But these are tax exempt bonds, so obviously the buyers don’t have to report any income and I assume they don’t have to report the capital gain received in lieu of income at redemption. Is there some kind of weird symmetry involved. If no income is being reported, then there is no interest owed accrual? It’s like something out of quantum mechanics where empty space can cause a phase shift, even if it doesn’t change the paths.

    I agree with Lior Silberman that a 5.5% nominal, perhaps 2.5% adjusted, rate is not all that bad. The issue is that no accounting is being done towards eventual repayment. In the 1930s US Rubber was losing money but paying dividends. They were making payments on their commercial paper; they had to. However, they had stopped accounting for depreciation, but who was going to know.

  9. November 15, 2013 at 12:13 pm | #12

    Here in central Texas I have been arguing this very topic for 2 years. The LEANDER Independent School District has 35,000 students and a staggering $3.7 BILLION in total debt thanks to the abuse of Capital Appreciation Bonds. Last month the school board issued an additional $206 million in new CAB debt with a total repayment of $1.1 Billion.

    The school board absolutely refuses to have any discussion on debt whatsoever. They maintain their mantra that they “must” use CABs because “we are a fast-growth district” yet we are situated in Williamson County, Texas, which was recently named the #1 Fastest -growing county in the Nation by Forbes. Williamson County, Texas, has NEVER issued new debt as a CAB.

    “It’s for the children” is the usual play by the board… the only thing the children will get is the bill.

    Debt service payment for this year alone – $62 million or roughly 20% of the district’s total budget. In three years that payment tops $80 Million…. per year…

    Here is perhaps the most comprehensive look at the history of CABs and the devastating effects it can have.. this was first reported in 2009 and really is a must read!

    http://www.joelontheroad.com/?p=1508

    The whole process is just sickening.

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