Complex Debt for Financing Infrastructure

In this paper, Jeffrey Chapman, professor at Arizona State University, examines certificates of participation, community facility district debt, and tax credit bonds. The certificate of participation (COP) is a financial scheme based on complex leasing agreements. It is usually used to finance the construction of public facilities such as prisons, courthouses, parking garages, and power plants. In 2008 over $13.1 billion of COPs were sold by 27 states.

There are two types of COPs. In an asset-transfer COP, a city issues a long-term lease (tantamount to a sale) of its asset to a private investor, who finances the transaction by borrowing funds from private credit markets, for a lump-sum leasehold payment. After the transfer of the property rights, the private investor will lease the asset back to the city for payments of annual rent. These leasing arrangements enable the city to tap private capital from the financial markets using the private investor as an intermediary. Because the city in principle is not the borrower, the debt created by the leasing agreement will not be reflected in its budget. The problem with this method is that any early termination of leasing agreements by contracting parties could cause the municipality huge financial losses, as happened in 2004 when the U.S. Treasury denied all depreciation deductions for sell-in-lease-out deals.

A COP for a construction project is more complicated. A public agency wanting to construct a facility enters into an agreement with an investor who will acquire or lease the required site from the government and build the facility. To finance the development, the investor will agree to lease the facility to the public agency upon completion of the project and assign the rights to receive future lease payments from the agency to a trustee. The trustee will then recruit an underwriter to sell these rights to interested buyers in the form of COPs that guarantee the receipt of future lease payments with a portion designated as tax-exempt interest. The proceeds from selling the COPs will then be used to pay for the project. Although COPs may raise capital for financing public facilities more quickly, their issuance costs could be higher than that of general obligation bonds because they are not backed by the full faith and credit of the government agency.

Like TIF districts, community facility districts are special submunicipal governments that have the power to tax property owners in the designated areas and to issue debt to finance public infrastructure such as parks, schools, libraries, public utility lines, and open-space facilities. To establish a community facility district, approval from two-thirds of the affected property owners is required. Bonds issued by the district are sometimes not rated or government insured, and thus bear higher interest rates. The exceptions are bonds issued by Mello-Roos districts in California that are secured by the unimproved site for the public facility construction. The repayment of the debt is by revenue generated from a special levy or tax imposed on property owners within the neighborhood. Unlike TIF districts, there is no overlapping jurisdiction in community facility districts, thus avoiding the complication of partitioning the tax base. More importantly, a neighborhood does not need to be declared to be blighted to form a community facility district.

Tax credit bonds allow a local government to receive immediate cash from issuing the debt but to repay the principal only at maturity. The federal government subsidizes the borrowing by paying 100 percent or less of interest for the security to bondholders in income-tax credits. Bondholders must report the tax credit as income, but can subtract the amount of the credit from the tax due. If there is no restriction on the use of the proceeds, the bond-issuing government can invest some of the proceeds from the bonds’ sale for future repayment of the principal at maturity. Current tax-credit bonds operated under the American Recovery and Reinvestment Tax Act include qualified school construction bonds, clean renewable energy bonds, qualified energy conservation bonds, build America bonds, and recovery zone economic development bonds. Details of these debt instruments can be found in this paper.

This paper was presented at the Lincoln Institute’s Land Policy Conference of 2009 and is Chapter 13 of the book Municipal Revenues and Land Policies.