Capital Appreciation Bonds: Delaying the Inevitable

By:  Bob Adelmann
02/05/2013
       
Capital Appreciation Bonds: Delaying the Inevitable

Capital appreciation bonds, when combined with economic ignorance and political expediency, make up a toxic brew that is likely to explode long before they come due.

An action that California’s Napa Valley Unified School District took in 2009 is just now getting exposure, and at least one board member said that if it had been a private deal (not a taxpayer-backed one), he would be running for cover. Jose Hurtado, a NVUSD board member, said he stands by the deal he voted for — to borrow $29 million and put off paying it back until 2049 — but if it were a traditional mortgage, he “would run” away from it.

Back in 2006, the board made promises it couldn't keep, and when it ran out of money it found a “workaround” to push the problem into the future. It promised taxpayers a new high school in 2006, and it authorized $183 million to build it. But the Great Recession shrunk tax revenues to the point where the school couldn't be completed without more borrowing. However, the board also promised taxpayers that it wouldn't raise tax assessments above the current $36 per $100,000 of assessed valuations.

Enter KNN Public Finance, which, in return for a small fee — $156,000 to be exact — introduced the board members to a new concept: capital appreciation bonds (CAB). By recommending that the board issue CABs to complete the high school, payments on the new debt wouldn't start until the year 2049. Voila! Problem solved: new high school, no new taxes to pay for it.

The trick to CABs is something called compound interest. Since no payments are needed for 40 years, the principal owed accrues interest which, over time, accrues additional interest on itself. It is sometimes called a “zero coupon bond” or a “payday loan” or a “balloon payment” loan. Others refer to CABs as “surprise” loans in that the amount due can be many times the size of the original loan. In the Napa Valley case, it’s $182 million, or more than six times the original loan amount.

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