The Broader Market

by Jordan Eizenga

(If the title did not scare you away from this article, then I applaud you.)

To begin, state and local governments have at their disposal a variety of options to finance important public works projects. One of these options is conduit financing in which a local public finance authority issues tax-exempt bonds on behalf of a non-profit or private enterprise that is financing a project deemed to generate “economic development.”

Because the interest on the bonds is free from federal income taxes, investors are willing to buy the bonds at reduced interest rates, thus, lowering borrowing costs for public works projects. The non-profit or private  borrower pays interest and principal on the debt, while the public finance authority receives a fee for issuing the bonds.

All fifty states have a public finance authority that issues tax-exempt bonds on behalf of private borrowers.

Recently, there has been some concern about the transparency of conduit bond issuances. The reason for this is that many buyers mistakenly assume that the debt is an obligation of the public finance authority. Buyers may believe they are buying debt from, for example, the California Municipal Finance Authority when they are actually buying the bonds of a private company - an innocent misunderstanding until a conduit borrower fails to meet its debt obligations.

And this is exactly what has happened with the California Statewide Communities Development Authority (CSCDA) - a public finance authority - which issued bonds  on behalf of organizations that failed to pay back the debt. In 2009 alone, a dozen of its borrowers encountered credit difficulties.

Similarly, in Texas, bonds issued by the Tarrant County Health Facilities Development Corp. for the development of hospitals in Brownsville and Houston defaulted within two years of issuance. Buyers found themselves perplexed, believing that the public finance authority owed them money.

“You see that public entity attached to it, so it is easy for someone to think the county is going to step up to the plate, and there lies the problem,” said Ernesto Lanzo, general counsel of the Municipal Securities Rulemaking Board, which regulates the muni market.

In fairness, these two examples may highlight the bad apples in the conduit financing industry. But, the fact remains that transparency is an ongoing concern with conduit issuers and lately, there have been calls for audits of public finance authorities.

With tens of billions of dollars of taxpayer support for these institutions, these audits are probably long overdue.

(Thanks for reading. I promise not to be as boring on my next post!)