RDA Financing: The Devil's In the Details

At first glance financing redevelopment projects in Hercules appeared simple: The city’s former redevelopment agency borrowed money by selling bonds to Wall Street investors and used a portion of local property taxes to repay the debt.

Twice each year the Contra Costa County treasurer would forward tax increment revenue to the city’s RDA, which in turn used 58 percent for its own activities – including setting aside an amount sufficient to make principal and interest payments on its bonds; set aside 20 percent for constructing or otherwise supporting affordable housing, including the repayment of any bonds issued to finance those projects, and passing along the remaining 20 percent to other agencies such as school districts.

However the mechanics of issuing redevelopment bonds, like most other municipal securities, is much more complicated, involving financial consultants, Wall Street investment bankers and lots of lawyers, all reaping substantial fees for putting the deals together. Hercules paid $2.7 million in fees to issue the bonds now the subject of litigation -- $1.3 million in 2005 and $1.4 million in 2007.

Investors don’t give money away. Before writing checks they want solid security features assuring that public agencies borrowing money can actually repay the principal and interest over periods that sometimes exceed 30 years. These guarantees are contained in scores of legal documents sometimes numbering hundreds of pages.

Where redevelopment and affordable housing project funding is concerned the basic level of investor security is the pledge to exclusively use, or allocate, a portion of tax increment revenues for repayment of the bonds. This future revenue stream is based upon projections of increases in the assessed value of new development and the attendant increase in property tax collections. The risk is that redevelopment projects will not be completed or property values will fall, or both.

As a further incentive for investors, and to lower interest rates, most issuers, including Hercules, will enhance the security of their bonds by purchasing insurance. If for some reason the city can’t make the periodic principal and interest payments on bond debt, the insurance company will. Until the near financial meltdown three years ago, insuring municipal debt was a lucrative business – few public agencies defaulted on bond payments and the premiums collected on policies were almost pure profit.

Reversal of Fortune

But now, the birds are coming home to roost in Hercules, and their arrival appears to be spooking the company that insured $117 million in non-housing redevelopment bonds. Suddenly Ambac Assurance Corp., a major player in municipal bond insurance, has become exposed to risk it couldn’t have imagined just a few years ago. An examination of insurance documents associated with the issuance of $56.3 million in bonds during 2005 (see attachment 1) and a $60.5 million bond issue in 2007 (attachment 2) suggest Ambac conceivably could end up paying out tens of millions to cover Hercules bond payments, a potential liability that may have prompted the company’s Jan. 30 lawsuit against the city.

Michael Fitzgerald, an Ambac spokesman in New York, said the company had no comment on any aspect of the current situation.

Each of Hercules’ non-housing RDA bond issues is secured by two separate Ambac guarantees – a Surety Bond and a Financial Guaranty Insurance Policy. The purchase of a surety bond is common practice with many municipalities who don’t want to set aside proceeds from bond sales to satisfy requirements for reserve accounts – that require depositing funds frequently totaling several million dollars – choosing instead to substitute a surety bond for actual cash.

Should the city not have money to meet a full bond payment – something that occurred last week – Ambac must provide the funds under its surety bond. If for any reason the amounts available under the surety bond are eventually exhausted, something that could happen Aug. 1 when the next bond payments are due, unless a spectacular rebound in tax increment receipts occurs, the financial guaranty policy kicks in and covers all required payments during periods tax revenues are insufficient – something that is theoretically possible until the bonds are fully paid off.

In some respects surety bonds are similar to revolving lines of credit – claims are paid up to the limit of the surety bond and those amounts must be repaid by the issuer, with interest – either in lump sum or over time. Once surety bond advances are repaid, additional claims can be paid. If a public agency is unable to repay surety bond claims, subsequent payments to bondholders are made under the insurance policy.

Hefty Premiums for Peace of Mind

Back in 2005 the Hercules RDA paid a $657,000 premium for the insurance policy and a $90,000 premium for the surety bond providing a maximum of $4 million in coverage. In 2007, the RDA paid a $606,000 insurance policy premium and an $87,000 premium for a surety bond with $3.8 million in maximum coverage.

Advances against the surety bonds, like those made last month, can be repaid only from tax increment revenue, a restriction with potential for significantly increasing the city’s costs for interest accumulating until the surety advances are repaid. Since bondholders must receive their money before surety bond repayments are made, any decline in tax increment collections could severely impact the city’s finances.

All disbursement of bond proceeds, debt service payments to bondholders and any other conditions applying to outstanding bonds are dictated by the “indenture” – a contract between the issuer and bondholder managed by a trustee legally required to enforce all terms and conditions. Bank of New York Mellon Trust Co. is trustee for both the 2005 (attachment 3) and 2007 (attachment 4) bond issues insured by Ambac.

Under normal circumstances when Hercules receives its tax increment money the funds are transferred to BNYM which in turn pays each bondholder. If the city fails to forward sufficient tax receipts, BNYM submits a claim to Ambac. It was this action that precipitated last week’s lawsuit.

Despite attempts to negotiate a settlement in hopes of resolving its dispute with Ambac outside the courtroom, the insurance company so far has refused to budge.

One proposed solution involved amending the indenture to permit other uses of the money held by BNYM for payments to Catellus Development Corp. required by an out-of-court settlement reached almost five years ago, just a few months before the 2007 bond sale. The Catellus restriction is contained in an amendment (attachment 5) to the original 2005 indenture (attachment 6) and required BNYM to put $26.3 million of the 2007 bond sales proceeds into a special reimbursement account earmarked solely for Catellus payments. That account, according to city officials, currently contains about $12 million, far less than the estimated $56.6 million owed to Catellus through 2044.

On January 10 the city council approved its version of an indenture amendment (attachment 7) that would permit Hercules to use Catellus funds when future shortfalls between tax revenues and bond payments occurred. However, before the city can get its hands on the money, approvals from both Ambac and BNYM must be obtained.