Almost three weeks before former City Manager Nelson Oliva officially signed his employment contract in April 2007, he began charting a course that would ultimately bring Hercules to the edge of where it teeters today.
The first step was convincing City Council members that big redevelopment dreams require big money. That was quick and easy.
It took less than eight minutes at a March 27, 2007, meeting for the council to give Oliva, then assistant city manager, approval for a $25.9 million bond issue—the first of seven trips to the Wall Street ATM that would eventually obligate Hercules to repay $146 million.
There was little explanation, no debate and no questions. The entire proceeding could have been easily overlooked on the council's agenda, tucked away at the bottom of the consent calendar and described in opaque language. In fact, former Mayor Ed Balico, who was presiding, seemed impatient about the process: “Boy, there’s got to be a shortcut on this thing,” he smiled. “But we gotta do it anyway.”
Hercules had already borrowed $78 million for redevelopment projects during the six years before Oliva became city manager—much of this paid to developers for projects such as Victoria By The Bay, the new bus terminal, infrastructure improvements and the beginning of what was supposed to have been New Town Center. Some of it went to Oliva's own company, then a city contractor.
What the council did this March evening was approve borrowing even more money to build 102 residential units, both market rate condos and low-income rentals, in the Sycamore Downtown redevelopment area and to reimburse developer Catellus.
Thus dawned the go-go era of aggressive redevelopment that Oliva envisioned would remake this once bustling and now decaying industrial city into a vibrant suburban beacon for upscale commuters.
The bond sale approved in March 2007 was conducted that July by Kinsell, Newcomb & De Dios, a Carlsbad brokerage firm that hired outgoing City Manager Mike Sakamoto shortly after the bond sale was approved. Ultimately some of the bond proceeds would end up going to NEO Consulting Inc., doing business as , a company Oliva had owned, but claimed he sold to his two young daughters when he grabbed the reins at City Hall.
In pursuing its redevelopment dream the city embarked upon a borrowing and spending spree it soon discovered could not be sustained. During the ensuing years it became apparent Oliva’s vision for Hercules would prove much bigger than the city’s pocketbook.
As this rush to redevelop shifted into high gear, the city made critical missteps in accurately projecting the real costs of remaking itself, resulting in unrealistic budget assumptions that were later described as “fantasy” numbers by , the consultant brought in last October to run the city after Oliva went on medical leave.
“The budget was written in a way that failed to provide information,” Long told Hercules Patch. “The tax increment in the budget was not even sufficient to pay debt. I saw that in the first week I was there.”
Tax increment revenue—that portion of property taxes attributed to the increased value of land improved by rehabilitation and new construction—is the mother’s milk of redevelopment. It’s this additional money that’s used to pay the principal and interest on funds borrowed to finance affordable housing and other activities that increase property values.
Critics like Gov. Jerry Brown, who would like to do away with redevelopment agencies in California, say cities and towns get on a merry-go-round of debt: Development increases tax revenue, which, in turn, increases a city’s ability to borrow more. Too often, projects funded by these agencies fall short of realizing their economic promise.
Priming the Hercules money machine
Redevelopment on the scale envisioned by Hercules required bundles of money, a commodity then readily available on Wall Street just for the asking.
Hercules had been regularly taking advantage of this largesse since 2003. But more was needed, and by accelerating its borrowing and spending, Hercules today finds itself obligated to make principal and interest payments over the next 30 years that total of $350 million.
The Hercules general fund, $18 million for 2010-11, is normally used to pay for things like police, fire and parks. But as the debt load increased over the past decade this fund has become a piggybank “of last resort” for helping to pay Hercules' long-term debt, according to a by Municipal Resource Group (MRG), the Danville consulting firm hired this year to help the city sort through its tangled finances.
Many of the problems discovered by MRG and other outside consultants have not gone unnoticed on Wall Street.
Last month, Standard & Poor’s lowered its rating on the city’s 2005 and 2007 tax allocation bonds—$116.8 million worth—from “BB” to “CCC,” a rating below junk bond status. Like consumers with a bad credit score, the new rating likely means the city can’t continue borrowing to bail itself out.
Yet back in 2007, raising money on Wall Street was almost too easy, and the city appears to have given little thought to the consequences of its profligate spending. Real estate prices had reached their peak in 2006 and things looked rosy indeed. It looked like the property tax spigot would continue spewing unabated.
So, in December 2007, the Hercules Redevelopment Agency (RDA) sold another in bonds to provide funds for, among other things, acquiring more land, building a multi-modal transit center and setting aside additional money to reimburse Catellus, the same developer that presumably had already received some proceeds from the July bond sale just five months before. Kinsell, Newcomb & De Dios, with Sakamoto still on its payroll and working out of a Bay Area office, was again the underwriter.
Sakamoto’s tenure with the bond underwriter lasted about 18 months. By October 2008 he was back in town, collecting $8,300 a month managing the Hercules Municipal Utility.
Although Hercules Patch has no evidence Sakamoto played a direct role in the July and December bond offerings, experts say relationships like this between incumbent and former city officials and the companies they hire or have hired raise thorny ethical questions.
“In some sense, if one is leveraging his position as city manager for his own personal interest, that’s not appropriate,” says Martha Perego, director of ethics for the International City/County Management Association (ICMA) in Washington, D.C. “There’s a whole slew of things that people could do that are not illegal, but still violate the public trust.”
Association members subscribe to a 12-point code of ethics adopted back in 1924 during the heyday of public corruption as a means for differentiating between “professional” public managers and those on the take. Members violating these standards can be publicly censured or even expelled from the organization. Oliva, however, was not a member.
Perego specifically pointed to Tenet 12: “Seek no favor; believe that personal aggrandizement or profit secured by confidential information or by misuse of public time is dishonest.”
Neither Sakamoto nor Oliva have returned phone calls or requests for comment over the past week.
Makings of a perfect storm
Like a ship sailing beneath the gathering clouds of a perfect storm, Hercules quickly found itself headed toward troubled waters and the treacherous shoals beyond.
Between October 2007, when the $60 million redevelopment bond issue was approved, and December 2007, when the bonds were actually sold, city officials apparently misread the economic tea leaves.
The real estate bubble was approaching its bursting point and telltale signals of a market collapse couldn’t be ignored—home prices were dropping and many large mortgage lenders (American Home Mortgage, Ameriquest, Countrywide Financial and NetBank) had either closed their doors, gone bankrupt or narrowly avoided bankruptcy with emergency bank loans. Foreclosures were up 75 percent over 2006.
It was easy to see why the warning signs might have been overlooked. At the end of the city’s fiscal year in June 2007, things still looked promising for redevelopment. The city reported a manageable general fund operating deficit of just $313,674 and the Redevelopment Development Agency sported a positive balance sheet, its assets exceeding liabilities by $7.4 million, although it did spent $3 million more than it received.
But within six months of the December bond sale, clear signs of stress appeared on the city’s financial ledgers—the first chapter of a story that would be told in the pages of Hercules’ financial statements over coming years.
The 2007-08 fiscal year was Oliva’s first full year as city manager. Although overall property tax collections had dropped slightly, the city reported its general fund operating deficit had more than quadrupled to $1.3 million and interest payments on long-term debt had jumped 65 percent. City spending on community development exceeded that of public safety and public works combined.
While the Hercules Redevelopment Agency's separate financial statements showed the agency spent $34.2 million more than it received in revenues, its balance sheet looked healthy, fattened considerably by the 2007 bond proceeds.
Much of this was an illusion. Some city accounts filled up like reservoirs in a cloudburst, only to be drained just as fast because the infusions of cash were only temporary. For example, the flailing city-owned electric utility, on the books at least, got $5.4 million in “infrastructure” funding after the bonds were sold, but two-thirds of that was quickly absorbed back into the city’s general fund as repayment of various “advances.”
In September 2008, four months into the city’s new fiscal year, the country’s real financial meltdown began in earnest with the failure of Wall Street giant Lehman Brothers, prompting credit markets to freeze and municipal bond insurers to topple and bringing Hercules redevelopment to a near standstill.
Just how seriously the shockwaves from Wall Street’s implosion impacted the finances of a small community 3,000 miles away were seemingly reflected in Hercules’ fiscal 2009 financial statements. According to Hercules’ audited financial report for that period, the city’s general fund operating deficit appeared to have almost doubled to $2.5 million and interest payments on long-term debt reached $8.8 million, more than doubling since Oliva was hired. Closer examination of the accounts two years later, however, would adjust the general fund shortfall downward.
Not so the redevelopment agency. Its financial statements were more ominous, with red ink dripping from the pages, suggesting the agency was starting to come unglued. Despite a positive operating fund surplus on paper, the agency had spent $39.6 million more than it took in and its assets had plummeted by $42.2 million, a decrease the agency attributed in large part to increases in the cost of tenant improvements on property it leased, $33 million in advances for City Hall construction, purchase of more land and financial assistance to the Hercules Municipal Utility.
The symbiotic relationship between the city, the redevelopment agency and the Public Financing Authority—a sister agency soon to crank up its own borrowing—was pushing Hercules toward the brink of functional insolvency. Despite continuing erosion in overall property tax collections during the year, the lack of completed redevelopment projects significantly reduced that portion of those taxes available to the redevelopment agency, further exacerbating its financial condition.
Suddenly facing a dilemma confronting many citizens who were then trying to make ends meet by taking cash advances on one credit card to make payments on another, Hercules embarked upon its own version of robbing Peter to pay Paul: continually moving money on accounting ledgers from one internal fund to another so the books would balance.
This practice confused at least one city councilman.
“There were so many inter-account transfers, it was really hard to understand what was going on,” recalled Don Kuehne, who had been elected in 2008 and now faces a recall vote next month. “People assume council members knew a lot more than they do.”
What caught the attention of MRG consultants trying to follow this convoluted money trail was the frequency with which transfers were made.
Examining these “inter-fund” transfers, MRG reported: “Occasionally a fund may end a fiscal year with a negative cash balance because a fund has spent more that it has received. In this event auditors will record a temporary "loan” from another fund. “The caveat is that no fund should regularly use the comingled cash or assets of other funds…” says the MRG report.
At the time, shifting numbers on paper was the least of Hercules’ worries. A considerably more pressing problem: actually having enough money in city checking and investment accounts to pay the bills. With debt service and other expenses spiraling upward, the city and its redevelopment agency were hard-pressed to come up with enough actual cash to repay Wall Street benefactors, let alone cover the more mundane expenses.
Oliva’s solution: Keep borrowing.
In July 2009, just days after Hercules closed its books on the 2008-09 fiscal year, the Public Financing Authority sold another $10 million in bonds, this time secured by lease payments from Bio-Rad on city-owned property the company occupies in the North Shore Business Park. These bonds were also underwritten by Kinsell, Newcomb & De Dios.
Last summer the financing authority sold even more bonds—an additional $24.9 million in three issues: $7.4 million in June to refinance debt from a 2003 Hercules Municipal Utility bond issue, although little money from those proceeds actually went to the utility; $11.7 million in July to fund upgrades to the city’s wastewater system; and $5.7 million in August to pay for a Hercules Municipal Utility substation that will never be built and has cost the city more than $300,000 in cancellation fees for equipment ordered to build the facility. Debt incurred on these bonds was to be repaid from the sale of electricity and wastewater services to city residents. All three of these bond issues were underwritten by Chilton & Associates, another Southern California broker.
At the time of the 2010 bond sales, Sakamoto’s company, Municipal Management Enterprises, was running Hercules Municipal Utility under contract with the city, and NEO, Oliva’s former company, was performing consulting services for the city’s wastewater system.
Another threat to the General Fund
But there was something very different about the 2009 and 2010 bond issues: They included an extra measure of security for investors in the form of “cooperation agreements” between the city and its Financing Authority, something with the potential for significant adverse impact on the general fund. These agreements, which are “absolute” obligations, required the city to advance money for principal and interest payments if needed and compelled the city to “… take such actions as may be necessary to amend the City's General Fund budget to include the City Advances, in whole or in part, and make the necessary appropriations therefor.”
With Hercules Municipal Utility consistently losing money and the city subsidizing Bio-Rad lease payments for the next seven years because they were not sufficient to cover debt service on the bonds, these obscure agreements could have drained additional millions from the general fund.
There is little collective insight at City Hall to explain how the city ended up in this precarious position. Former Mayor Ed Balico abruptly resigned when served with recall papers, and only one of the remaining council members presiding over those bond issues has chosen to speak to Hercules Patch about the matter. City Councilman Kuehne says he was left in the dark when he voted to approve the 2010 bond deals. “I was not aware of the cooperation agreements in last year’s bond issue,” he said.
Joanne Ward, who is also facing a , did not respond to requests for comment over the weekend. Neither did Balico nor a handful of former council members, including Joe Eddy McDonald, Kris Valstad and Frank Batara, who is serving on the Citizens' Finance Advisory Committee.
Implausible as it seems, Kuehne said there were no public hearings or council study sessions last summer providing council members with the opportunity to perform some sort of cost-benefit analysis on the risks involved in these big money deals. For example, he said, nobody asked why it made sense to hire underwriters from Southern California when there are many respectable underwriting firms in the Bay Area.
Don Blubaugh says that’s not as far-fetched as it may sound.
Blubaugh, executive director of the Contra Costa Mayors' Conference and a former public official with 50 years of city administration under his belt, including a dozen as Walnut Creek city manager, nine in Hayward and seven in Palm Springs, said there is no yardstick by which to measure those elected to serve in public office.
“Occasionally, you run into some council members who are very much into detail,” he said. “But the rest are folks who don’t even take the time to read the fine print on their own insurance policies, let alone the details of bond closing documents.”
That, said Blubaugh, is what you have experts for.
“Have you read every detail of your last homeowner’s insurance policy, your warranties or your credit card disclosure statements?” he asked. “Some of these documents aren’t easy to comprehend, and that doesn’t mean you’re not bright.”
Blubaugh said a city manager’s fiduciary duty is to outline the potential and the risks associated with any endeavor, especially bond deals—which he believes should merit study sessions giving council members and citizens alike the chance to examine and analyze the implications and ask the experts questions.
Elected officials, said Blubaugh, operate from the implied premise that “the staff is going to present you with accurate information.”
Councilwoman Myrna de Vera, who was elected last November, says Hercules is changing its procedures to ensure public visibility into the decision-making process. “There’s so much we need to change,” she said. “I’ve proposed that we eliminate no-bid contracts.” She also wants to see any contract worth more than $25,000 taken off the consent calendar and placed on the agenda for public discussion.
Councilman John Delgado, also elected in November, says the city should consider selling off some of its assets, such as the Walmart property, and using a portion of those proceeds to buy down the city’s bond debt by purchasing its own bonds and retiring them. Some of those issues are selling for far less than their original purchase, and Delgado says that might be a means to retire debt.
The additional $7.4 million in bond debt incurred just days before Hercules closed its fiscal 2009-10 books appears to have further eroded the city’s financial condition, which approached a critical point during 2010. The actual situation remains a mystery until the city’s final Comprehensive Annual Financial Report (CAFR) is released. Already months overdue, there is a hint of how bad things might be.
According to a draft copy circulated among city officials earlier this year, the general fund operating deficit was reported at $2.3 million and the city’s interest payments on long-term debt had ballooned to $10.3 million, with the city’s total expenditures from all funds exceeding revenues by $46.3 million.
The redevelopment agency’s condition was no better: its operating deficit was $4 million, agency liabilities exceeded assets by $48.4 million, tax increment revenues fell $2.3 million, and the agency still owed millions to the general fund. Some of that debt was recently “repaid” when the agency transferred property to the city at its original purchase price, a value that may or may not be realistic in today’s market.
However, some parts of the city’s financial history may have to be rewritten—in accounting parlance, a process known as “restatement”—where previous financial reports are corrected due to honest error, misrepresentation or other irregularity.
According to updated financial information provided by Hercules’ finance department May 13, the general fund operating deficit for the 2008-09 fiscal year was $1.6 million, about $900,000 less that originally reported in its audited financial statements for that period. The 2009-10 deficit has been recalculated at $1.4 million, about $900,000 less than the amount reported in the draft financial statements distributed earlier this year. These corrections would be in addition to several restatements already contained in financial reports issued for 2007-08 and 2008-09.
Future not a pretty picture
What the city’s bottom line will look like for the current 2010-11 fiscal year ending in seven weeks is anybody’s guess. The financial data released Friday indicates the general fund operating deficit this year could skyrocket to $5 million—a shortfall exceeding the combined deficits of the previous three years.
The full financial impact of the three 2010 bond issues probably won’t be apparent until the annual report for the 2011-2012 fiscal year beginning July 1 is issued more than a year and a half from now. Due to the structure of those bond issues, the first debt service payments—totaling almost $1.4 million—won’t be due until August.
Still, the worst may be yet to come. A financial model created by MRG during its internal review of the city’s finances predicts Hercules will have continuing and increasing shortfalls for the next few years. One immediate action MRG recommended was for the city to stop relying on assumptions that the redevelopment agency would be making annual payments on what it owes to the general fund—money booked as revenue but never received.
Why the recommendation?
Hercules’ auditor, Moss, Levy & Hartzheim of Beverly Hills, in a letter accompanying a draft copy of redevelopment agency financial statements filed with the Municipal Securities Rulemaking Board in March, warned that the agency's financial condition raised “substantial doubt about its ability to continue as a going concern.”