Capital appreciation bonds -– compound the interest on a bond for 20 years before starting to make any payments. How’s that for a wonderfully bad idea?

(Cross-post from my other blog, Outrun Change.)

If you thought zero documentation and 120% loans were good for the economy, you will love capital appreciation bonds.

Here’s the deal – what are schools and local governments in California to do once they have run out of cash to pay even the interest on bonds, can’t cover the principal on the cost of new buildings, and face huge voter resistance to any increase in spending? What to do when you just want to keep spending?

How about issuing capital appreciation bonds. That allows the government agency to keep spending whatever they want.

You can borrow money, make no payments for 20 years, compound the interest into principal, and burden the adult children of current students with the huge payments.

Article in The New York Times gives multiple examples in California Schools Finance Upgrades by Making the Next Generation Pay. Here’s just one:

So in 2009, the Santa Ana Unified School District borrowed $35 million using an inventive if increasingly controversial method known as capital appreciation bonds, which pushed the cost of the construction on to future taxpayers. Not a cent is owed until 2026. But taxpayers will eventually have to pay $340 million to retire that $35 million debt.

Short version of that math:

  • borrow $35M in 2009
  • compound interest until 2026
  • then make payments of $11.3M per year for 30 years
  • final payment in 2056, 47 years after borrowing the money

Via Meadia has an extended explanation of why this is a lousy idea – California: Already Stoking the Next Big Financial Crash?

Here is the high-level warning:

This is irresponsibility on steroids, but it represents a dream come true for crony capitalists and Wall Street I-bankers. Fat fees, enormous interest, and the taxpayers won’t even know what hit them when the whopping bills come due.

Here is the risk:

…While not all of these bond issues are equally bad, as a class these bonds are toxic and likely to bring serious pain to everyone connected to them. Some of the deals already done will likely blow up in the future; bankruptcy will loom when the pension squeeze and the bond bomb both hit at full force.

I fear this dangerous idea will spread. Think of it. School superintendents, school boards, local politicians, and Wall Street financiers will have long since retired by the time the payments begin and devastate the city’s finances. They won’t have to answer reporter’s questions or face the voters. They personally won’t suffer any blowback. But they get to maintain their high spending ways now in 2013 like it was 2005.

Check out the parallels to the mess we have in residential mortgages, which Via Meadia gets right, except for the misunderstanding of the major role that extensive regulation had in causing the mess:

Once upon a time, the mortgage market was a safe and staid place where widows and orphans could lend to responsible borrowers paying reasonable prices for sensible housing. But a combination of lax regulation, political opportunism, Wall Street (and Fannie Mae) greed, credulous investors and speculative borrowers turned the mortgage market into a horrible mess that cost this country as much money as a foreign war. Let’s try not to do the same thing with our municipal finance system, shall we?

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