lending to municipalities by robin russell to municipalities by robin russell chapter 13 i....

i ROBIN RUSSELL

© 2016

LENDING TO MUNICIPALITIES By Robin Russell

CHAPTER 13

I. INTRODUCTION................................................................................................................ 1 Overview .................................................................................................................................1 Lease Financing ......................................................................................................................1 Municipal Bonds .....................................................................................................................2 Revenue Financing .................................................................................................................2 Short-Term Financing .............................................................................................................2 Tax Exempt Status ..................................................................................................................3

II. TERMINOLOGY ................................................................................................................ 3 Ad Valorem Tax .....................................................................................................................3 Anticipation Loan ...................................................................................................................3 Appropriation ..........................................................................................................................3 Assessed ValuE.......................................................................................................................3 Authority .................................................................................................................................3 Enterprise Activity ..................................................................................................................3 Enterprise Fund .......................................................................................................................4 General Obligation ..................................................................................................................4 Fund Accounting.....................................................................................................................4 General Fund...........................................................................................................................4 Intergovern-mental Revenue ...................................................................................................4 Millage Rate ............................................................................................................................4

III. AUTHORITY TO BORROW ............................................................................................ 4 Laws ........................................................................................................................................4 Key Questions .........................................................................................................................4

IV. LOAN POLICY ................................................................................................................... 5 Overview .................................................................................................................................5 Policy Issues ...........................................................................................................................5

V. SHORT TERM LENDING ................................................................................................. 6 Overview .................................................................................................................................6 Special Revenue Financing .....................................................................................................6 Interim Financing for Public Improvements ...........................................................................7 Bond Anticipation Loans ........................................................................................................7

VI. LEASING.............................................................................................................................. 7 Overview .................................................................................................................................7 Advantages..............................................................................................................................8 Documentation ........................................................................................................................8 Recourse..................................................................................................................................8 Option to Purchase ..................................................................................................................9 Lease Structuring Provisions ..................................................................................................9 Lease Underwriting.................................................................................................................9

ii ROBIN RUSSELL

© 2016

Documentation ......................................................................................................................10 VII. FINANCIAL STATEMENTS........................................................................................... 10

Overview ...............................................................................................................................10 Fund Accounting...................................................................................................................10 General Fund.........................................................................................................................11 Special Revenue Funds .........................................................................................................11 Debt Service Funds ...............................................................................................................11 Other Funds...........................................................................................................................11

VIII. CREDIT ANALYSIS ......................................................................................................... 12 Overview ...............................................................................................................................12 Revenue ................................................................................................................................12 Historic Revenue...................................................................................................................12 Debt Capacity .......................................................................................................................13 General Fund Balance ...........................................................................................................13 General Fund Balance/Total Expenditures Ratio .................................................................13 Fund Balance/ Annualized Payment .....................................................................................13 Annual Debt Service/Total Revenues ...................................................................................13 Debt Outstanding to Assessed Valuation..............................................................................14 Liquidity................................................................................................................................14 Trends ...................................................................................................................................14 Population .............................................................................................................................14 Net Debt Per Capita ..............................................................................................................14 Taxpayer Concentrations ......................................................................................................14 Comparable Ratios ................................................................................................................14 Evaluating Financial Operations ...........................................................................................14 Organizational Strength ........................................................................................................15 Internal Controls ...................................................................................................................15 Evaluating Local Economy ...................................................................................................16

IX. CUSTOMER RELATIONS .............................................................................................. 17 Leadership Structures ...........................................................................................................17 Administrative, Political and Governmental Considerations ...............................................18

X. BANKRUPTCY ................................................................................................................. 19 Overview ...............................................................................................................................19 Who May File Chapter 9? .....................................................................................................19 States in which Municipalities May File ..............................................................................19 Priority of Payment ...............................................................................................................20

XI. DUE DILIGENCE ............................................................................................................. 21 Form ......................................................................................................................................21

13-1 ROBIN RUSSELL

© 2016

LENDING TO MUNICIPALITIES AND OTHER GEOGRAPHICALLY DEFINED AREAS

I. INTRODUCTION

OVERVIEW: • A municipality has been defined as “A town or district having local government” and as “a primarily urban political unit having corporate status and usually powers of self-government.”

• Political subdivisions and related entities include:

– counties – cities – towns – villages – townships – boroughs – school districts (systems) – special assessment (SADs) districts – business improvement districts (BIDs) – redevelopment districts

• These provide a variety of services, including:

– Fire Protection – School Systems – Port Authorities – Public Health – Airports – Lighting – Roads and Bridges – Hospitals – Industrial development – Housing development – Environmental projects – Public buildings – Libraries

• There are three basic types of Bank financing to political entities:

– General Obligations – Special Revenue or Enterprise Fund Obligations – Lease Financing

LEASE FINANCING: • Leases are perhaps the most significant municipal lending opportunity for banks due to proven record of low risk and

13-2 ROBIN RUSSELL

© 2016

reasonably attractive rewards (due to tax-exempt interest income).

MUNICIPAL BONDS: • Municipalities can have short, medium and long term debt needs which can include full or limited obligations with and/or without third party credit protection.

• Municipalities prefer to issue long-term bonds at low rates. Banks are rarely involved in long-term credit to municipalities, although some pooling of loans too small to be a public offering has developed.

REVENUE FINANCING:

• Medium term financing usually involves financing improvements to be operated by third parties (airports, seaports, shortline railroads) where repayment will come from revenue received by the third party as higher rents or user fees. Such deals rarely involve the financial guarantee of the city, county state or other municipality in which improvements are located. This type of financing is referred to as revenue financing.

• Lending to municipalities can be significant and profitable and can help your bank build a strong and positive image and reputation in your community, especially in difficult times like the present.

Banks will typically extend credit to non-profit organizations (municipalities) to finance capital projects or improvements or purchases of equipment or facilities.

SHORT-TERM FINANCING:

• Short-term borrowings in anticipation of receipt of other revenues are acceptable to most Banks. Beyond that, credit for working capital should not be needed, such requests should be a huge “red flag.”

• If the transaction is for a private activity it will lose its tax exempt status, significantly lowering the yield to the Bank. There are two tests to be met in order to be a private activity (not the goal of a Bank):

– Private Use Test. A transaction will be considered private Business use if more than 10% of net proceeds are used in a trade/business operated by an individual. As an example, a lease of FF+E with a contract to manage the property with a private individual would cause the lease to meet the private use test. Also a 10% occupancy by private business would also meet the private use test.

– Private Security or Payment Test. A transaction will meet the private payment test if payment of more than 10% of the proceeds used for payment of the principal component

13-3 ROBIN RUSSELL

© 2016

of, or interest component of, the lease is directly or indirectly secured by an interest in property used in a private business use.

• There are two exceptions:

– If 95% of the net proceeds are used for a qualified purpose (i.e. sewage facility, low income housing), or

– If the transaction is with a 501(c)(3) charitable organization.

TAX EXEMPT STATUS:

• In order to be legally able to exclude interest on loans and leases to municipalities, the Bank must file IRS form 8038-G within first 15 days of calendar quarter after the close of the calendar quarter in which the transaction was entered into. For example, if the transaction closed on February 10 the form must be filed by April 15 of the same year.

II. TERMINOLOGY

AD VALOREM TAX:

• A tax calculated “according to value.” Ad valorem tax is based on an assigned market, appraised or assessed valuation of real property. This type of tax is the most significant tax that local government can raise or lower without higher level government approval. Accordingly, ad valorem taxes are often the budget balancing factor in local annual budgets.

ANTICIPATION LOAN:

• A short-term loan with agreed upon repayment source being revenue from a specific source “anticipated” (i.e., expected) in the near term, such as collected taxes, another loan, or revenue for a state or federal government source.

APPROPRIATION: • Local government authorization permitting the local government to incur obligations and make expenditures.

ASSESSED VALUE: • The appraised worth of property set by a taxing authority for ad valorem taxation. The value established may or may not be close to the fair market value of the property.

AUTHORITY: • A unit or agency of government established to perform specialized functions, usually financed by service charges, fees or tolls. The authority may have taxing “authority.”

ENTERPRISE ACTIVITY:

• An enterprise activity that generates revenue needed to pay debt service from service provided (examples: water and sewer plants, electrical supply facilities, airports, toll roads, port or rail

13-4 ROBIN RUSSELL

© 2016

terminals, etc.)

ENTERPRISE FUND:

• A governmental accounting fund used to account for operations of an enterprise activity.

GENERAL OBLIGATION:

• A general obligation debt is a debt issued by local government units and typically secured by a pledge of the borrower’s ad valorem taxing power. General obligation debt usually requires electorate approval. In the event of default, holders of general obligation debt have the right to compel a tax levy in order to provide funds to pay defaulted debt.

FUND ACCOUNTING:

• A specialized type of accounting used by municipalities.

GENERAL FUND: • A governmental accounting fund used to account for most of the entity’s revenue sources: property taxes, licenses and permits, local taxes, service charges, etc. The general fund includes most of the basic operating services, such as fire and police, finance, parks and recreation, libraries and general administration.

INTERGOVERN-MENTAL REVENUE:

• Revenue received from other governments for grants, shared revenues or payments in lieu of taxes.

MILLAGE RATE: • A mill is a rate of tax equal to $1 for each $1,000 of assessed property value. The millage rate is the total number of mills assessed against this value.

III. AUTHORITY TO BORROW

LAWS: • Laws governing creation and powers of municipalities vary from state to state and may have roots in English, Spanish or French law. Accordingly, it is imperative that lenders be certain of proper authority and power to enter into a proposed credit transaction. Experienced and competent counsel may well be needed on a much more frequent basis than is the case with normal commercial- type ending.

• Muni-type entities are bound by their charter plus state and federal laws along with covenants in previous debt arrangements and borrowing resolutions.

KEY QUESTIONS: • Has authority to borrow been confirmed? Some muni-type entities have not been granted borrowing authority and must rely on established sources of revenue.

13-5 ROBIN RUSSELL

© 2016

• Are proposed terms of the credit arrangement permitted? Many muni-type units can only borrow long-term. Operating needs cannot be met by debt.

• Is the purpose of the loan permitted? Borrowing for capital purposes or specific capital needs may be the only type of credit permitted/authorized.

• Is additional approval of other governmental units or voters required?

• Can revenues or assets be legally pledged to secure debt? Many revenue sources are dedicated to specific uses only.

• Is interest on the debt tax exempt? Has the potential, future tax status of the borrowing entity been considered. Under current tax law not all interest on municipal borrowings is tax exempt.

IV. LOAN POLICY

OVERVIEW: • Policy is drafted to meet each bank’s unique market situation, underwriting requirements, discipline and risk-to-reward tolerance.

• The Bank should consider and document its intentions and preferences with regard to lending to municipalities and other non-profit organizations.

POLICY ISSUES: • Does the Bank want to encourage loans to municipalities and other non-profit types of organizations? Will it enhance the Bank’s reputation within the community? Such organizations are usually created and dedicated to public health, safety, welfare, cultural and arts, religious purposes, schools, governmental activities and services.

• Credit should be used for capital projects, facility improvements or large equipment purchases. Minor equipment purchases should be funded by normal operations and not require financing. Loans for working capital are not in compliance with bank policy.

• Repayment terms should be tied to the economic life of the asset being financed. This should be consistent with amortization terms used for for-profit customers.

• Real property of such an organization is often single purpose (i.e., a sports stadium, museum, town hall, police vehicle

13-6 ROBIN RUSSELL

© 2016

garage). Loans secured by real estate are typically for construction of or improvement to such facilities. In the event of default, the Bank would have to foreclose and sell the property to another user at a reasonable price. Bank policy may require shorter amortizations (15-20 years) with maximum 10 year balloon maturities. Appraised values should be discounted if the property is a single purpose building. The Bank may require LTV to 70% of cost or 75% of appraisal, whichever is less.

• Should loans only be made to entities with specified number of years of operating history (for example, five)? Mitigating factors such as high tax values may offset a lack of operating history.

• Three fiscal years’ financial statements should be required as well as budget information for the next year. The Bank should require the loan file receive a resume on each key management person.

V. SHORT TERM LENDING

OVERVIEW: • Short term lending needs of a municipality often result from a timing mis-match between the need for funds and revenue receipts. For example, educational funding from the state or federal government may not come before the municipality’s need for funds. Or, funds may be desired to start a project which has approved bond financing, but the bond proceeds have not been received.

SPECIAL REVENUE FINANCING:

• Special revenue financing involves the following:

– Receipts derived from the ownership, operation, or disposition of projects or systems of the debtor that are primarily used or intended to be used primarily to provide transportation, utility, or other services, including the proceeds of borrowing to finance the projects or systems;

– Special excise taxes imposed on particular activities or transactions;

– Incremental tax receipts from the benefited area in the case of tax-increment financing;

– Other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions; or

– Taxes specially levied to finance one or more projects or systems, excluding receipts from general property, sales, or income taxes (other than tax-increment financing) levied to

13-7 ROBIN RUSSELL

© 2016

finance the general purposes of the debtor.

INTERIM FINANCING FOR PUBLIC IMPROVEMENTS:

• Local entities may wish to borrow interim construction funds for capital improvement projects for which other general obligation or revenue bonds have been authorized or for which a state or federal grant has been approved.

BOND ANTICIPATION LOANS:

• Credit is provided to construct local improvements for which takeout financing is anticipated to be from sale of bonds based on either:

– unlimited tax pledge – assessment bonds secured by a limited pledge of taxes – assessments only on the financed properties.

In these situations the lender must carefully examine the project because if the bonds are not sold the repayment will be based upon the assessments which will make the credit long-term. The asset is not pledged, only the revenues/assessments.

VI. LEASING

OVERVIEW: • Long-term bond financing has historically been the main source of municipal financing for facilities and equipment. Bonds require voter approval and may be subject to state government imposed debt limitations. As a result, a municipality may have debt limitations which can prevent acquiring needed equipment and facilities.

• Most municipalities have authority to lease equipment or real property. Funding for repayment may be subject to annual appropriation for the lease payments by the municipality’s governing body. Appropriation is usually not a problem. The body is not legally obligated to make the appropriation. As a result, if there is a default because funds are not appropriated, the lender’s only recourse is repossession.

• Failure to appropriate funds for debt service will adversely affect a municipality’s credit rating.

Accordingly, assuming the property being leased is truly needed by the entity, no-appropriation is rare making lease financing only a moderate risk.

• Never forget that the borrower’s credit or bond rating (if any) has very little relevance to the short-term credit being considered by your bank It is good that the entity has a good long-term debt

13-8 ROBIN RUSSELL

© 2016

paying rating, but credit extended by banks is usually not supported by the general obligation of the entity.

ADVANTAGES: • Lease financing offers several advantages to municipalities:

– Avoid debt limitations, – Avoid voter approval, – Save time and expense, – Due to requirement of annual appropriation of lease

payments, lease payments are not considered as debt and are not subject to voter approval (confirm this is true in your state),

– Simpler underwriting and documentation, than for bond financing,

– Bank is “secured” by the property or equipment acquired by the bank and leased to the municipality (unlike with bonds)

DOCUMENTATION: • Competent accounting and legal advice should be obtained. Proper documentation of a lease transaction is necessary to ensure legality, enforceability, and lien priority. Care must be taken to structure the lease so that it is not considered debt. This is typically accomplished through a clause that makes the lessee’s obligation to make payments contingent on appropriation of funds by the municipality.

• Normally, there is also a clause in the lease agreement that provides the lease is terminable at the end of each year, but with automatic renewal, as per the following:

The original term of each Individual Payment Schedule shall commence on the accrual date as indicated therein and shall terminate the last day of the Lessee’ then current fiscal year. The term of the lease will be automatically renewed at the end of the original term or any renewal term for an additional one year, unless the governing body of the Lessee fails to appropriate sufficient funds for the making of rental payments for the next occurring renewal term.

RECOURSE: • The Bank’s recourse in a municipal lease transaction will be

repossession of the leased property. Some structuring terms (agreements) that will mitigate risk on non-appropriation include:

– Limit financing to essential equipment, which will reduce possibility of non-appropriation.

13-9 ROBIN RUSSELL

© 2016

– Include in the lease agreement a non-Substitution clause which states that if lessee decides not to appropriate payments for the upcoming year, the lessee will not be able to replace the equipment with same or similar property, or retain others to provide the same or similar services, until the next occurring renewal term ends. This is a very powerful and essential covenant.

– The lease agreement should also have a covenant requiring the lessee to give notice 90 days prior to the end of the current lease term of its decision to not appropriate funds for the next fiscal year. This will obligate the lessee to appropriate funds for the next 12 months, if the 90-day notice is not given.

Although non-appropriation is a risk, the historical rate of non- appropriation is quite minimal.

OPTION TO PURCHASE:

• Leases are commonly structured so that at the end of the lease term there is an option to purchase at a normal cost or the title simply passes to the municipality at the end of the lease term. As a result, the lessee builds equity each year of the lease which incentivizes it to pay until the end.

LEASE STRUCTURING PROVISIONS:

• In addition to clauses related to non-appropriation and non- substitution, the lease agreement should also require the lessee to:

– Use the leased property for the purpose of performing governmental functions consistent with the allowable scope of the lessee’s authority, and

– The equipment will not be used in any trade or business other than that of the lessee.

• The goal with the above covenants is to help avoid the lease being classified as a private activity bond.

• There should also be a prohibition from subleasing equipment to any non-governmental organization and a covenant stating lessee is authorized under law to enter into a lease arrangement.

LEASE UNDERWRITING:

• While lease covenants are critical, credit always drives the decision to lend. Financial statements should be analyzed like all other commercial credits. Cash flow adequacy and financial solvency are primary focuses of municipal financial statement analysis.

13-10 ROBIN RUSSELL

© 2016

• Municipal leases are usually repaid from the General Fund, but if other “Funds” have been established as the source of lease payment then that fund must be analyzed.

DOCUMENTATION: • A lease agreement incorporates the financial arrangement. There is no promissory note, bond or security agreement.

• Although the Bank owns the asset being leased, the filing of a UCC-1 describing both the lease agreement and the assets being leased is allowed under the UCC to put the world on notice that the assets are owned by the Bank not the lessee.

VII. FINANCIAL STATEMENTS

OVERVIEW: • The Governmental Accounting Standards Board (GASB) sets accounting standard for governmental entities. Its publication What You Should Know about Your Local Government’s Finances, A guide to Financial Statements is recommended reading.

FUND ACCOUNTING:

• Municipalities use what is known as Fund Accounting in which revenues for a specified purpose or with legal restrictions are recorded in a set of segregated accounts set up to prove money was spent (expenses) in accordance with stated objectives or legal restrictions. A local government can have any number of “funds.”

• A fund is defined as an independent fiscal and accounting entity with a self-balancing set of accounts recording cash and/or other resources together with all related liabilities, obligations, reserves, and equities which are segregated for the purpose of carrying on specific activities or attaining certain objectives in accordance with special regulations, restrictions or limitations.” Funds are created in order to allow a separate accounting record of each specific function or activity.

• Governments usually use what is known as the modified accrual basis of accounting to record revenues and expenditures which is very similar to cash basis accounting. Under this method, Revenues are recorded when measurable and available and expenditures are recorded rather than cost and expenses. Depreciation which is a non-cash expense in conventional commercial GAAP is not recorded.

13-11 ROBIN RUSSELL

© 2016

GENERAL FUND: • The General Fund includes the accounting results for most of a municipality’s traditional government services-police, fire, roads and highways, etc.

• A majority of revenue and expenditures pass through the General Fund because this is the fund used to account for day-to-day operations. Fixed assets are likely to be accounted for in a separate fund account created for this purpose.

• When underwriting a loan to a municipality, a significant surplus in the General Fund would indicate favorable financial results and operations. The “surplus” is like a “savings account” for unforeseen or emergency situations. The entity’s financial strength (and bond rating) is usually determined by the strength of the General Fund account. As a general measure of financial strength, a Bank would expect to see an Unrestricted Fund Balance-to-Revenue Ratio greater than 5%.

SPECIAL REVENUE FUNDS:

• Special Revenue Funds are created to separately account for specific revenue sources or to finance activities or special projects defined or created by law or administration.

DEBT SERVICE FUNDS:

• Debt Service Funds are created to account for payment of principal and interest on long-term debt other than special assessments and revenue- supported bonds. Often a new separate fund is created with each revenue bond with 10% of bond proceeds placed into the account to provide for debt service. Stability of revenue source and amount is the key.

OTHER FUNDS: • There could also be funds for capital projects, enterprise activities, trust and agency funds, intergovernmental service funds and/or special assessment funds expected to be relatively permanent activities which should be controlled by budgets.

• A Bank should become familiar with all funds in order to understand the size and scope of the borrower’s operations. However, unless the funds directly impact sources of repayment (and most will not) it is not necessary to spend great amounts of time in analysis.

• “Due from other accounts” and transfers between accounts occur frequently and may or may not be legitimate. Inquiry should be made and confirmed as legitimate because such “moves” may indicate financial problems.

13-12 ROBIN RUSSELL

© 2016

VIII. CREDIT ANALYSIS

OVERVIEW: • Credit evaluation should include defining and analyzing:

– Extent and nature of the municipality’s debt; – Financial operations of the municipality; – Economic and social characteristics of the community; – Administrative factors.

• A Due Diligence Worksheet appears at the end of this Chapter.

REVENUE: • Municipality income statements should break down revenue by source:

– ad valorem property taxes – sales taxes – income taxes – licenses and fees – franchise taxes – service charges – fiscal aid – revenue sharing – tuition – grants/donations

• Property tax assessments are typically the largest revenue source.

• A banker should understand and consider property values in the area plus the historical and current trends. Risk is increased if there is a concentration of tax base in property assessments. Optimally revenue from commercial property will be greater than residential because of the greater potential for growth in commercial property tax base.

• Federal or state grant money may be significant (20-35% of total revenue). Government grants may slow, be reduced or eliminated, so exercise caution in relying on these revenues.

• In general, a lender is looking for balance among revenue (income) sources. Concentration of revenue from one source may affect ability to repay if that source is reduced or lost.

• The Bank should carefully consider whether those who receive community-provided services perceive the cost as fair. If not, litigation or “flight” of citizens and/or businesses may result.

HISTORIC • Credit analysis should focus on historical revenue.

13-13 ROBIN RUSSELL

© 2016

REVENUE: – Sales tax should be analyzed for seasonality with revenue projects validated based upon evaluation of the community’s economic health.

– Property tax revenues from previous years can be compared with tax assessments, and then forecast based upon current property tax assessments.

– Timing of property tax receipts from previous years can be used in forecasting.

– Stability of revenues should be considered since different revenues are affected by seasonal, local economic conditions. For example, a hotel tax is less stable in the short term than a tax on property values.

DEBT CAPACITY: • In general, total debt service should not exceed 8-10% of entity revenues.

GENERAL FUND BALANCE:

• The General Fund Balance is calculated as follows:

Beginning Fund Balance + Current Year Revenues -Current Year Expenditures +Financing Sources -Financing Uses +Transfers In -Transfers Out = Ending Fund Balance

GENERAL FUND BALANCE/TOTAL EXPENDITURES RATIO:

• This ratio shows the percentage of a municipality’s expenditures that can be covered by the fund balance before revenues are received. “Transfers out” to other funds should be considered expenditures. A lender should expect to see a ratio less than 10%, with a ratio of 7.5% or more considered to be superior, 5-7.5% considered to be good and 2.5-5% considered satisfactory. If the trend for several years is less than 2.5% the lender should investigate further.

FUND BALANCE/ ANNUALIZED PAYMENT:

• This is a debt service type ratio which shows how much of the municipality’s fund balance is available to cover debt service. 7.5X should be considered superior, 3.0-7.5X is considered good, and l.0-3.0X is considered satisfactory. If the ratio is less than l.OX, the municipality does not have enough funds in its fund balance to cover the first year’s appropriation. The Bank should investigate what can be done to meet debt service requirements.

ANNUAL DEBT SERVICE/TOTAL REVENUES:

• This ratio shows the percentage of total revenues that will be earmarked toward lease payments. Transfers into the General Fund are excluded from total revenues. Low is better, 0-4% is

13-14 ROBIN RUSSELL

© 2016

superior, 4-7% is good, and 7-10% is satisfactory. If the ratio is over 10%, the Bank should investigate trends because the ratio suggests the entity is overextended financially.

DEBT OUTSTANDING TO ASSESSED VALUATION:

• This ratio is the equivalent of the leverage ratio. Total Debt (including lease payments) divided by aggregate property values. Ratio of 0-4% is superior, 4-7% is considered satisfactory, and 7-10% may indicate a highly leveraged municipality.

LIQUIDITY: • This ratio is the Current Ratio: Current Assets divided by Current Liabilities. A ratio of 2X is superior, 1.5X-2X is considered good, and l.OX-1.5X is considered satisfactory.

TRENDS: • As is always the case in financial ratio analysis, trends matter. It is not unusual for a municipality to have one- time events that can be both favorable or un-favorable.

POPULATION: • Population trends over several years should be analyzed as a basis for predicting future revenue growth or shrinkage.

NET DEBT PER CAPITA:

• Net debt excludes bonded debt with a specific revenue source such as water or sewer bonds. Trend analysis is key with this ratio because what is considered acceptable will vary by the size, wealth and other economic factors related to each municipality.

TAXPAYER CONCENTRATIONS:

• Taxpayer concentration should be investigated. Concentration is significant if more than 15% of tax revenue comes from a single taxpayer, or 30% of tax revenue comes from the top 10 taxpayers.

COMPARABLE RATIOS:

• Certain ratios can be calculated and compared to other cities of comparable size in data published by agencies that rate public debt.

EVALUATING FINANCIAL OPERATIONS:

• A lender should evaluate financial operations to determine if there is consistency and stability evidenced in the financial affairs of the entity. To do so, the following questions should be considered and answered favorably:

– Does the municipality balance its budget each year?

– Is there a healthy fund balance?

– Is there a “rainy day” fund to help get the entity through Economic fluctuations?

– Is financial reporting timely and reliable?

13-15 ROBIN RUSSELL

© 2016

– Have annual financial reports received the Government Finance Officers Association certificate of excellence?

– Has the bank tracked the relationship between the entity’s budget and the actual financial statements for the past three years?

– What are the primary revenue sources? Are they diversified?

– How much of tax revenues come from residential, commercial and industrial sources?

– How and how well does the entity collect its taxes?

– Does the community have a poor track record of delinquent taxes and properties abandoned for taxes?

ORGANIZATIONAL STRENGTH:

• The integrity and quality of organizational administration and stewardship is an important factor in determining the level of credit risk. A Bank’s credit confidence is supported by a strong system of internal controls which should always be confirmed by the Bank.

INTERNAL CONTROLS:

• Internal control over financial reporting has always been a major area in the governance of an organization.

• Municipal and not-for-profit entities often exhibit internal control environments that are less than effective. Lack of funding, leadership not focused on this area of management responsibility, other short-term priorities or lack of knowledge are all factors contributing to the necessity for a lender to become confident the internal control environment of the entity is positive and effective.

If financial statements are audited, the Bank can have confidence that the entity’s internal control system was reviewed by the CPA for weaknesses as part of arriving at an opinion on the financial statements.

• Internal Control is a process, affected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding achievement of objectives in three categories:

– Effectiveness and efficiency of operations – Reliability of financial reporting – Compliance with applicable laws and regulations.

13-16 ROBIN RUSSELL

© 2016

• Sound and effective internal control systems and procedures are not a guarantee that organization goals will be accomplished (success). An effective internal control structure will keep the right people informed about the organization’s progress in achieving its objectives.

• Bankers should focus on five key issues:

Control environment. This is the foundation for all other components of internal control, providing discipline and structure. Referred to as the “tone at the top” of the organization meaning

– the integrity, ethical values, and competence of the entity’s people; – management’s philosophy and operating style; – the way management assigns authority and responsibility, and organizes and develops its people, and – the attention and direction provided by the board of directors.

Risk Assessment. Identification and analysis of risks must be managed.

Control activities. Control activities include approvals, authorizations, verifications, reconciliations, asset security, review of operating performance, and segregation of duties. Policies and procedures should exist to ensure that management directives are carried out at all levels in all functions.

Information and Communication. The organization should have a system to identify, capture and communicate information to the right people to enable then to carry out their responsibilities.

Monitoring. The internal control system must be monitored by management and others in the organization. Internal audit is a key function.

• Internal control will not guaranty the organization will be successful, but an effective control structure and environment within the entity will keep the right people (including the banker) informed about the organization’s progress in achieving objectives.

EVALUATING LOCAL ECONOMY:

• In municipal lending, there are a number of factors and questions beyond financial statement analysis which must be considered as part of determining repayment ability.

13-17 ROBIN RUSSELL

© 2016

– Does the municipality have a broad economic base or is it a one-industry or one-company town?

– How much of the real estate base depends on railroads, utilities or private corporations?

– What is the trend in building permits?

– What is the job trend over the past 5-l 0 years?

– What is the unemployment trend over the past 3 years?

– What is the impact of the imposition of federal or state mandates?

– Is out-migration an issue?

– What is impact of location?

– What is the per capita income levels versus state and national levels?

– What is the risk of socio-economic disasters?

– What is the risk of environmental problems or disasters?

– What programs or projects will voters support?

– What has been the growth in assessed valuation?

– Who are the major employers?

– What is the composition of employment by sector?

– Are there court decisions which could necessitate unanticipated expenditures?

• In municipal lending, understanding the community is, from a risk management perspective, more important than in other types of bank lending.

IX. CUSTOMER RELATIONS

LEADERSHIP STRUCTURES:

• Commission form combines legislative and executive powers. Elected commissioners usually hold specific duties in addition to collective duties.

13-18 ROBIN RUSSELL

© 2016

• Mayor-Council form separates executive and legislative powers between the mayor and city council. The mayor is the strong player.

• Council-Manager form involves an elected council that hires a city manager to carry out council’s polices and laws and prepare the city budget. Financial affairs are usually handled by an appointed director of finance, a key player from a banking standpoint.

• In each form or organization, the city charter specifies the procedure by which the city must obtain a loan. Charters vary from city to city which means sound banking requires knowledge of the legal aspects that might affect the status of a loan to the city.

• It is possible that the real power is not in the hands of elected officials. Business people, civic leaders and interest-group reps can play critical roles in a variety of municipal decisions. Discovering and getting to know key individuals is difficult and time consuming, but such efforts can payoff by not only achieving relationships with municipalities but also in developing valuable business associations with influential and wealthy community leaders. It is like multi-tasking.

ADMINISTRATIVE, POLITICAL AND GOVERNMENTAL CONSIDERATIONS:

• Judgment, discipline, and credit principles are important in any credit consideration, but as shown in the prior section, there are somewhat extraordinary additional considerations prudent lenders must position themselves to effectively evaluate:

– Administrative personnel and processes – Political environment and connections – Governmental expectations.

• Knowing the right people and knowing who really has the decision-making authority is key to creating and managing a banking relationship with a municipality or affiliate. Usually this requires considerable time. Politics is a constantly changing world which requires constant relationship building to achieve and maintain the primary goal of access to the key players.

▸ KEY POINT: This may be the most difficult part of lending to a municipality.

• Gaining access may be the most difficult aspect of lending to municipalities, unless the banker already knows a key or powerful person in the government or agency.

13-19 ROBIN RUSSELL

© 2016

• A Banker must be capable of adopting a political mind-set and understand local political processes as a key to gaining access.

• Knowing the people who are actually “calling the shots” (making decisions) will make the bank-municipality relationship a reality.

• Not all Bankers may wish to enter the “political world,” but establishing relationships with such people will also help develop valuable business associations with other influential and wealthy members of your community, who may also be influential or decision-makers in municipal affairs.

• In addition, although engaging with politicians, commission members and other leaders may be hard work, doing so provides an excellent opportunity to establish a positive public opinion or image of your bank.

X. BANKRUPTCY

OVERVIEW: • Chapter 9 of the Bankruptcy Code applies to municipalities.

• The Bankruptcy Code allows states to determine whether their municipalities may file bankruptcy.

• Not all states allow their municipalities to file bankruptcy.

WHO MAY FILE CHAPTER 9?:

• An entity - that is a municipality

– Specifically authorized under state law to be a debtor

– Insolvent

– Willing to effectuate a plan

– Has obtained an agreement of creditors holding a majority amount of the claim of each class that will not be paid in full or has attempted to negotiate a plan in good faith but was unable to do so or it was impractical to negotiate with creditors or a creditor is attempting to obtain a preference.

STATES IN WHICH MUNICIPALITIES MAY FILE:

• Twelve states have statutes authorizing filing:

– Alabama – Arizona – Arkansas – Indiana – Minnesota – Missouri

13-20 ROBIN RUSSELL

© 2016

– Montana – Nebraska – Oklahoma – South Carolina – Texas – Washington

• Twelve states have given conditional approval for filing:

– California – Connecticut – Florida – Kentucky – Louisiana – Michigan – New Jersey – North Carolina – New York – Ohio – Pennsylvania – Rhode Island

• Three states grant limited authority

– Colorado – Oregon – Illinois

• Two states prohibit filing

– Georgia – Iowa

• The 21 remaining states are unclear

• Debts are paid according to a priority scheme.

PRIORITY OF PAYMENT:

• Debt secured by Pledged Revenue

• Debt Secured by Special Revenue

• Secured Bond Debt

• Debt Secured by Municipal Facility Lease Financing

• Administrative Expenses

• Unsecured Debt

13-21 ROBIN RUSSELL

© 2016

XI. DUE DILIGENCE

FORM: • The following form appears at the end of this chapter:

* Due Diligence Worksheet

ROBIN RUSSELL © 2016

13-22

DUE DILIGENCE1 WORKSHEET

A. Municipality:

A.1. What services is the municipality responsible for providing? The most common municipal responsibilities are listed below. Check all responsibilities that apply to the municipality being assessed. If known, check E (for exclusive responsibilities) or S (for shared responsibilities). Write down any other responsibility not listed in the table.

Responsibility √ / E / S Comments

Natural Resources Environment Social Welfare Pre School Primary & Secondary Education Higher & Adult Education Hospitals Other Health services Family Welfare Services Housing Libraries Parks and Recreation Electricity Supply Gas Water Supply Sewer Refuse Collection & Disposal Fire Protection Police Services Public Transportation Local Roads & Maintenance Highways Culture Local Markets

2. Relationship with higher level government:

Does the assignment of responsibilities differentiate between exclusive and shared responsibilities?

Yes No

(If yes, you should check E (exclusive) or S (shared) in the previous table of municipal service responsibilities)

In the cases of share responsibility, is there clarity in the respective roles of different levels of government? Decide.

What role does the state government have in regard to shared expenditure by the municipality?

1 Based on Annex 1 to Making Cities work Assessment and Implementation Toolkit 2006.


13-23

There are shared responsibilities: State government sets the policy strategy and lower levels decide on public services within that context.

Yes No

There are shared responsibilities: The state government sets the state-wide standards and the municipalities decide on public services with those constraints.

Yes No

State and municipalities governments’ responsibilities overlap. Programs implemented in the same sectors by different levels create duplications.

Yes No

There is a central assignment of responsibility and a decentralized provision of public services. Yes No

3. How much autonomy does the municipality enjoy in making service delivery decisions?

Describe the relationship between the municipalities with higher level governments regarding:

Municipal control over finances, organization, and operations. Are there special provisions for capital expenditures? Does the municipality have the autonomy to decide on the amount to be spent? Does the municipality have the autonomy to define the structure of the expenditure? Does the municipality have the autonomy to execute the expenditure? Does the municipality have the autonomy to supervise and set standards? A.2. Intergovernmental Transfer Mechanism: 1. What transfers does the law provide for the municipality to receive? If so, which level of government provides these transfers? Is the transfer system transparent and relatively simple? Are these transfers grants or loans? 2. Is the money transferred to the municipality? How predictable and reliable are the disbursements? Is there a schedule (i.e., 1st week of every fiscal quarter) for making transfers? Does the government follow this schedule?


13-24

Are the transfers predictable from year to year? 3. How empowered or constrained is the municipality in deciding how to spend these

transfers? In other words, do the transfers come with a lot of conditions or are they unconditional grants?

Determine (roughly) the proportion of total transfers that are unconditional. Determine the total number of grant programs. Determine the level of satisfaction with the transfer system currently in place. A.3 Environment for Municipal Revenues 1. What taxes, if any, is the municipality legally authorized to levy? Check all that apply. Add any not listed below.

Tax Assignment √ Comments (Level of tax autonomy)

Tax on: Personal Income Business Income Land & Property General Sales Tax Industry Commerce Professions Entertainment Licenses & Fees (marriage, Business, vehicle) User charge on: Water Electricity Gas Sewerage & drainage Collecting & disposing solid waste Excises (fuel, alcohol, etc.)

2. What is the municipality’s tax autonomy? In the table above, for each tax that the municipality levies, in the comment boxes,

indicate with the appropriate letter which level of autonomy applies to each of the taxes as follows:

Levels of Tax Autonomy

Set the tax rate and tax base A Set the tax rate only B Set the tax base only C Set neither the tax rate or tax base D Tax is shared/or piggybacked E


13-25

Other, please specify: 3. Check what applies: Are there municipalities authorized to administer its taxes? Yes No

Is there a municipal department of revenue administration Yes No

From the taxes that the municipality is legally authorized to levy, are there taxes that the municipality does not administer? If yes, which are these?

Yes No

4. Have regulatory structures been established to set utility rates, user charges, and rates for

other revenue sources? Does the framework specify: policies, procedures, pricing rules, regulatory system, billing and collection systems, periodic reviews and updates? Describe.

A.4. Environment for Municipal Borrowing 1. Fill out the following about municipal authority to borrow: Are municipalities legally authorized to borrow? Yes No

What law specifies the authority to borrow? Yes No

2. Fill out the following regarding the legal limitations on municipal borrowing. Are there legal limitations on the amount or purpose of municipal borrowing? (Most probably the answer is YES) Yes No

What laws or regulations set out these restrictions?

List the restrictions on municipal borrowing and the reasons for the restrictions. Add any other restriction(s) not listed below.

Are there restrictions on: X Reason

Amount they can borrow Yes No

Purpose of borrowing Yes No

Yes No

Yes No

Yes No

Yes No

3. Fill out the following regarding restrictions on municipal borrowing sources. Are municipalities restricted to borrowing from particular sources? Yes No

What laws or regulations set out these formal restrictions? Is borrowing from private financial institutions an option?


13-26

4. Answer the following regarding approval procedures for municipal borrowing: Is there an established procedure within municipalities for approving borrowing

decisions? What municipal and/or central government laws and regulations pertain to approval of

municipal borrowings? What procedures do municipalities follow to achieve the necessary approvals for

municipal borrowing? How is the public (at large) involved in the process of deciding on capital improvements

and their related financing? Explain. 5. Answer the following regarding municipal credit rating: Are credit ratings being prepared on the municipality? If yes, who is doing the credit ratings? B. MANAGEMENT OF MUNICIPAL FINANCIAL RESOURCES

1. Are the municipality’s budget, summary accounts, and financial reports made available to the public on a regular basis?

Are these accounts and reports regularly made available to other levels of government? 2. Have standards for municipal accounting and financial reporting been established? 3. Does the municipality have a financial management and reporting system that enables it

to establish meaningful expenditure budgets and revenue projections as well as monitor actual budgetary commitments, expenditures, and revenue collections? Explain.


13-27

4. Are the municipality’s accounts and financial reports audited on a regular basis? C. TRENDS IN MUNICIPAL FINANCES

C.1. Municipal Revenues Trends Fill out the following table. Data from this table will be used to answer questions 1 through 4 in section C.1. and, question 1 through 3 in section C.2.

Own Source Revenue: Year: Year: Year: Year: Year:

(A) Own Tax Revenue (B) Revenue from Property Tax (C) Revenue from User fees and charges (D) Total Own source revenue

Transfers:

(E) Grants and transfers (F) Total Recurrent Revenue (G) Total Revenue

Expenditures:

(H) Operating Expenditures (I) Capital Expenditures (J) Total Expenditures

Source(s) of information: 1. For all the taxes that the municipality is legally authorized to levy and collect, how do

actual collections compare to total municipal revenue? Fill out the following table based on data from the table above.

Year: Year: Year: Year: Year:

Own Tax Revenue/ Total Revenue [A / G] * 100

2. For all fees and user charges (including utility payments, if applicable) that the

municipality is legally authorized to levy and collect, how do actual collections compare to total municipal revenue? Fill out the following table based on data from the table above.


Revenue from user fees and charges/ Total Revenue [C / G] * 100


13-28

3. What percentage of the municipality’s total revenue comes from property taxes? Fill out the following table based on data from the table above.


Revenue from Property Taxes / Total Revenue [B / G] * 100

4. What percentage of the municipality’s annual budget comes from transfers from another

level of government? Fill out the following table based on data from the table above.


Total Grants and Transfers / Total Revenue [E / G] * 100

Total Grants and Transfers / Total Expenditures [E / J] * 100

C.2. Trends in Financial Operating Positions of the Municipality 1. What is the trend in the municipality’s budgets? Are they in surplus or deficit?


Total Expenditures / Total Revenues [J / G] * 100

Operating Expenditures / Recurring Revenues [H / F] * 100

2. Does the municipality fund recurrent (operating) expenditures through borrowing?

From the previous question indicate whether the current budget is in surplus deficit or balanced, if: > 100, then deficit (-) < 100, then surplus (+) = 100, then balanced (=)


Operating Expenditures / Recurring Revenues [H / F] * 100

Describe whether there are other sources that indicate that the municipality is funding

current expenditures through borrowing. Explain.


13-29

3. What percentage of total municipal expenditure is capital expenditure?


Capital Expenditures / Total Expenditures [I / J] * 100

C.3. Municipal Debt Trends 1. Answer the following regarding debt trends of the municipality being assessed: What is the total debt outstanding?


Debt outstanding

Municipal borrowing record:

Loan Transaction Amount Year Purpose Principal

Outstanding

$ $

2. How does total debt service (repayments of principal and interest) compare to total

revenue? How does total debt service compare to total expenditure?


(K) Repayments on Principal and Interest Debt Service / Total Revenue [K / G] * 100

Debt Service / Total Expenditure [K / J] * 100


13-30

3. Fill out the following on the trend on the municipality’s creditworthiness rating (if available):

Year Rating Rating Agent

HOU:3628130.1

lending to municipalities by robin russell to municipalities by robin russell chapter 13 i....

Documents