Current Problems in School Bonding

The municipal bond industry as a whole generally enjoys a sound reputation of trust and value to investors and of service to issuers. Even so, industry observers note some problem areas: local government defaults; near-defaults and bankruptcies; payoffs and kickbacks to local officials; "pay to play" campaign contribution schemes; high risk investments involving "derivatives"; "yield burning," or profiteering by securities dealers; conflict of interest; lack of disclosure; exorbitant fees; and excessive reliance on negotiated deals.6

Public school bonding in Michigan has problems of its own. These include the following:

  • school electioneering;

  • School Bond Loan Fund borrowing;

  • excessive debt levies and bond fund surpluses;

  • capitalization of expenses;

  • lack of competition in school bonding; and

  • conflict of interest in debt issuance.

Each of these areas is discussed in greater detail below. Some of the points raised here represent opinion and may be subject to debate, but to dismiss the concerns raised by these issues would be a disservice to taxpayers, parents, schools, and the students themselves.

School Electioneering

Units of government may not engage in electioneering—the spending of tax dollars or the use of public resources, either directly or indirectly, to influence elections.7 This is a legal and ethical fact that Michigan’s Attorney General has repeated on several occasions.8

In spite of this, some Michigan schools have reportedly used school telephones, computers, mailing lists, facilities, on-duty personnel, and even children in the classroom to "get out the yes vote" in bond or millage elections. Some schools even appear to have used or been solicited by private consultants for "election assistance" services to help in winning their bond elections.

Bond proposals should stand on their own merits without any direct or indirect government promotion. Responsible governments leave it to private groups, civic organizations, or ballot committees to run election campaigns. Certainly governments may provide objective, unbiased information regarding their bond proposals, but there should be a distinct line between voter education and covert electioneering and the astute administrator knows when it is crossed.

Public schools have a duty to uphold a posture of neutrality toward their elections, particularly since they themselves are in charge of running the elections. Purity of elections is a cornerstone of democracy, and when schools cut corners on this process, they risk undercutting the broad community support necessary for their success.

School Bond Loan Fund Borrowing

The School Bond Loan Fund (SBLF) is a Michigan state bonding program established in 1955 ostensibly to help schools "build necessary facilities when they are needed."9 It lets schools borrow from the state the difference between what their debt levy produces and the amount actually needed to make their annual bond payments.10 The idea was to allow growing schools to bond for more construction than their existing tax base could reasonably support. The assumption underlying SBLF loans is that the borrowing district’s tax base will grow over time, and that eventually the loans can be paid off, on top of the district’s bonds.

Originally, a school had to levy at least thirteen mills to tap into the SBLF, but in 1964 the threshold was lowered to seven mills, making it easier for schools to borrow from the Fund. Borrowing districts must levy at least seven mills until their SBLF loans are fully repaid. A district’s bond proposal must also be "prequalified" by the Michigan Department of Treasury to be eligible. Qualified bonds are backed by the state’s full faith and credit, which results in lower interest rates. However, construction financed by qualified bonds is subject to Michigan’s Prevailing Wage law, which requires (for all practical purposes) that union-scale wages be paid for construction labor.11 Michigan’s SBLF program appears to be unique in the nation.12

The SBLF is analogous to an annual cash advance to help make home mortgage payments. Interest is effectively paid on interest, and the total cost of borrowing is increased accordingly—sometimes by millions of dollars in the case of some SBLF borrowers. Consequently, some districts are projected to make repayments for decades and others are projected not to be able to repay the Fund at all.13 The financial liabilities inherent in such a scheme should be obvious, but the SBLF’s basic premise of borrowing to repay borrowing has remained largely unquestioned for over four decades.

SBLF borrowing appeals to some districts because it helps them get bond proposals passed while avoiding unpopular tax increases. It does this by reducing the relative tax burden on current taxpayers and shifting it onto future taxpayers.

But there are significant drawbacks. An SBLF-funded bond is like a variable rate balloon mortgage of unknown total cost and duration. It can add excessive interest cost and is highly sensitive to future increases in interest rates. Its effect in terms of interest is similar to capital appreciation bonds (CABs)— a type of delayed-repayment bond—which were outlawed under Proposal A of 1994 due to their exorbitant interest cost.14 A bond funded by SBLF borrowing gambles on continuous growth of tax base and continually favorable interest rates well into the future. It locks future taxpayers into higher tax rates than would otherwise be necessary, sapping their ability to build facilities when they need them.

Some in Michigan’s education community are now publicly admitting that some schools will have difficulty meeting required SBLF repayments.15 Schools that are serious about incurring debt at the least possible cost should be very cautious about borrowing from the School Bond Loan Fund.

Excessive Debt Levies and Bond Fund Surpluses

When voters approve a bond proposal, they approve the sale of a certain amount of bonds. They do not approve a debt millage rate. After voter approval, the government issuing the bonds has the power to tax "without limitation as to rate or amount" for the repayment of the bonds.16 This constitutional clause assures bondholders that they will be repaid. The actual debt levy (SBLF borrowing notwithstanding) is calculated by dividing the total payment of principal and interest to be made in a given year by the local unit’s taxable valuation—that is, its total tax base. A nominal amount may be added to cover delinquent taxes. By law schools must set their debt millage at whatever rate is "sufficient" to make annual principal and interest payments on their bonds.17 Excessive or surplus funds should not accumulate in bond repayment accounts.

Nonetheless, some Michigan schools have levied excessive debt taxes and accumulated surplus funds.18 Instead of annually calculating a debt levy which is merely "sufficient" to meet annual bond payments, they have held their debt levy constant over a period of several years. As their tax base grew, they were able to add hundreds of thousands of dollars to their bond repayment accounts. In the cases where this has occurred, it appears to have been part of an election strategy to avoid a bond millage increase after the anticipated passage of a bond proposal. Ostensibly, the bond is more appealing to the voters if it can be claimed that their taxes will not increase if it is approved.

This "debt service over-levy" strategy may be effective in winning bond elections, but it is ill-advised and unauthorized by law. School districts should calculate their debt millage each year and levy the minimum amount necessary to make their debt service payments.

Capitalization of Expenses and Technology and Equipment Bonds

School bonds were traditionally used for "bricks and mortar," that is, new construction. But over the years, the purposes of school bonding have been expanded. Today, schools can bond for "furnishing and refurnishing," "equipping and re-equipping," remodeling and partial remodeling, buses, computers, and even software.19 In other words, schools may now bond for numerous things which used to be paid for out of their annual operating budgets.

This trend may be traced to the fact that capital outlays for many schools’ annual operating budgets are inadequate for meeting essential maintenance, repair, and equipment needs. Because of ever-rising labor costs and operating expenses, some schools have found it expedient to "shift" costs formerly considered expenses onto bonds.

While much of this shift has occurred legally, some of it has not. Some Michigan schools have improperly used the proceeds of qualified bonds to purchase all manner of loose supplies, equipment, textbooks, software, and other highly depreciable items. Acting upon complaints, the Michigan Department of Treasury has in the past required offending schools to reimburse their bond funds with tens of thousands of dollars from their operating funds.20

Proposal A sought to address this issue by introducing certain common-sense requirements, but these requirements unfortunately have been easily evaded. For example, bonds cannot be issued for a term longer than the useful life of an asset.21 Accordingly, schools issuing bonds for "technology" or computers along with a building project may front-load their repayment schedules to pay off the computers. But instead of making concurrent payments on the building project, some schools delay building payments until after the computers are paid off.22 The net effect is that more interest is paid than if repayments were made on both computers and buildings from the start. The intent of Proposal A’s new provision (that is, good fiscal practice) is thereby skirted.

Similarly, bond proceeds may not be used for facility maintenance.23 Under the acquisition policies of many agencies, normal reroofing, repaving, repainting, recarpeting, and other work of a recurring nature and relatively limited life are classified as maintenance. But they are considered as remodeling under Michigan’s bond laws, and are eligible for bonding repayment periods of up to 30 years.

The lax attitude in some schools about the use of bond proceeds must be corrected. Whether legal or not, this "capitalization of expenses" is a bad habit.24 It was at the root of many public fiscal disasters, most notably the financial crisis of New York City in the 1970’s. Michigan’s public schools should not be put at risk through such poor fiscal habits.

Lack of Competition in School Bonding

There has been an excessive reliance on negotiated, or noncompetitive, issuance of school debt in Michigan in the recent past. The reasons for this include the wave of bond refinancings in the early 1990s, excessive use of CABs, and other factors. Fortunately, school bonding has become more competitive since the passage of Proposal A, but the majority of negotiated school bond deals in Michigan are still handled by only two broker/dealers, and the lion’s share of bond-related professional services goes to one bond counsel and one financial advisor. Clearly more can be done to increase competition in school bonding.

The potential benefits of increased competition include reduced debt, improved professional services, and overall savings to taxpayers. A sound debt policy could insure that bonds are issued competitively whenever possible, and that professional services are obtained openly and fairly, through formal qualifications-based selection.

Conflict of Interest in Debt Issuance

Public officials and their employees, agents, and consultants should not gain undue private benefits as a result of their official actions. They should stay clear of positions where they may gain such benefits or which compromise their ability to provide independent advice—advice that is in the best interest of the public they serve. This principle is the essence of avoiding conflict of interest. Most of those involved in public administration are very mindful of it.

In some Michigan schools, however, there have been lapses. When conflict of interest occurs in school bonding, the consequences can be serious, as one recent legal malpractice lawsuit in Michigan shows.25 Schools can never be too cautious about the issuance of debt. A formal debt policy with firm guidelines can help in avoiding the pitfalls of conflict of interest.