Long-Term Debt Control
Accurate debt records--including auditable ledgers as to the identity, purpose, and amount of debt commitments associated with capital projects and the debt service payments made--are vital to short-term and long-term fiscal operations. From these records, it should be possible to determine quickly and accurately the principal and interest requirements on the total debt over the full maturity of all issues. Such computations are needed to determine the financial capacity to meet the requirements for future capital improvement and to plan the retirement schedule for any new borrowing.
Long-term debt can best be controlled through a subsidiary ledger, such as a bond and interest register. By collecting in one place all pertinent information regarding individual bond issues, this ledger allows management to trace the complete history of each issue. It also assists in establishing a schedule of debt service requirements and in posting transactions to the general ledger, bonded debt ledger, and interest payable ledger.
A subsidiary bonded debt ledger contains a sheet for each bond issue, showing the project title and purpose, amount of bond originally out-standing, date of bonds, interest rates, amount retired to date, and balance outstanding. A separate sheet is maintained on each bond issue in an interest payable ledger. As interest payments come due, they are entered in the "credit" and "balance" columns. As payments are made, the amount is entered in the "debit" column, and the balance payable is reduced by a corresponding sum. An overall schedule of debt service requirements can be readily computed from these records, and a maturity and interest calendar for all debt can be compiled to monitor revenue needs for debt service on a month-to-month basis. The calendar must be adjusted and updated as new issues are marketed.
All fixed assets purchased, constructed, or obtained by contract are recorded at cost in the general fixed assets account group. Fixed assets obtained by gift should be recorded at the fair market value when donated. Assets obtained through foreclosure should be recorded at the appraised value of property or the total taxes or assessments plus costs, whichever is lower. Cash or liability transactions involved in the buying or selling of the asset are not recorded in the general fixed asset account group, however. Although not maintained for external reporting purposes, depreciation should be recorded in supplemental records for internal costing purposes.
An asset that is sold, destroyed, or otherwise rendered valueless is removed from the account group by debiting the general fixed assets account for the original amount recorded and crediting the particular fixed asset. Improvements to an asset--adding to its value--require an entry comparable to the original entry, but only for the amount of the improvement. General repairs--needed to keep the asset in the same operating condition--are not considered improvements and should not be added to the value of the fixed assets in the account group.
The long-term debt account group is used to maintain records of long-term liabilities, such as serial bonds, long-term notes, and long-term commitments arising from lease or purchase agreements. Separate records of long-term debt are maintained for special assessment funds, proprietary funds, and profit-type fiduciary funds.
Over the years, a sinking fund is built up by transfers from the general fund and interest on investments to an amount equal to that needed to pay off the bonds. The data in Exhibit 3 illustrate the final year transactions. At the beginning of the year 20, the fund balance should equal $745,026.66. This fund balance will earn $44,701.60 (at 6 percent), and a transfer of $10,271.75 will be made from the general fund at year-end to bring the total in the sinking fund to $800,000. Upon recording the matured bonds payable in the debt service fund, the amount in the general long-term debt account group would be closed out.
Financial analysts often point out that the annual financial reports concerning public debt is a major point of weakness in the management of government resources. Such reports are important to the basic credit rating of the governmental unit and are of major interest to bondholders, public officials, and ordinary citizens. If adequate debt records are maintained throughout the year, the preparation of such annual reports can be a relatively simple procedure.
Annual financial reports concerning debt should cover several basic categories of information:
(1) A listing of all outstanding debt by type of issue (general obligation, special assessment, or revenue bonds). The following information should be provided for each bond issue: date of issue, original amount, date of maturity, coupon (interest) rate, total interest, amount of principal and interest presently outstanding, and the amount carried in sinking funds, if any. This information can be taken directly from the bond and interest register.
(2) For each broad classification of debt, information should be presented as to the annual schedule of debt service, including interest, amortization requirements, and total debt service requirements. This statement should also include data as to the level of unfunded debt, that is, short-term borrowing that constitutes an obligation payable out of current revenues
(3) The overlapping debt of the jurisdiction--that portion of the debt of the school district, county, township, or special districts payable from taxes levied by the reporting jurisdiction.
(4) A computation of the jurisdiction's legal borrowing status.
(5) If term bonds are outstanding, a sinking fund balance sheet should be included in the financial report to record the relation of sinking funds to actuarial requirements and a listing of current holdings.
Debt arising from the issuance of revenue bonds in proprietary funds must also be shown, including complete information on the facilities that support such debt. The report should include, as appropriate, the name of the corporate trustee, consulting engineers, and attorneys approving the legality of the issue. Revenue bond ordinances may require an annual report by an independent certified public accountant, including a current balance sheet and a statement of any contingent liabilities not shown on the balance sheet. Particular types of revenue bonds (e.g., for water or sewer utilities) often require supplemental information, such as average daily supply and consumption, storage capacity, number of customers, consumption per customer, method of billing, legal provisions, and so forth. Special assessment bonds guaranteed by the jurisdiction should also be shown in the schedule of debt.
Accurate and complete reporting on public debt develops confidence on the part of investors and the general public as to the fiscal management of a jurisdiction or public organization. In addition to the annual report, an interim report covering much of the same information should be prepared midway in each fiscal year for distribution to those interested in the financial status of the jurisdiction. The relatively small investment of time and expense in preparing such reports is often repaid many times over through lower interest rates.
Distribution of Revenues and Issuance of Additional Bonds
A reserve fund is established in most cases, into which all receipts and income derived from the operation of a self-supporting project are deposited. Moneys in the reserve fund are then distributed monthly by the trustee or other handler of funds in the order established by the bond resolution or trust indenture (see Exhibit 4). Moneys remaining in the reserve fund after the required distributions have been made may be placed in a surplus fund, to be divided among various categories such as:
o Redemption account to retire bonds in advance of maturity.
o Payment in lieu of taxes--When an authority purchases an operation that had been a corporate unit, payments may be made in lieu of taxes either by legislative requirement or to create good will.
o Other lawful payments, including improvements and extensions to the facility or support of other bond interest.
When a facility is being constructed, it is not always possible to foresee just what the future will hold. It may be necessary to increase the size of the facility or to make other improvements that will require additional financing. Sufficient leeway should be provided in the bond indenture or resolution to permit the issuance of additional bonds.
If bonds of equal rank are permitted, safeguards must be established to prevent the undue dilution of the security of the original bonds. The two basic types of trust indentures are: (1) the closed-end indenture, which does not permit the issuance of parity bonds except as necessary to complete the project if initial financing proves insufficient; and (2) the open-end indenture, which permits the issuance of additional bonds but provides a formula prescribing the conditions to be met. In the first case, additional bonds must be "junior" in lien to the then outstanding bonds, that is, have a secondary claim on the revenues of the facility.
Exhibit 4. Distribution of Revenues from Self-Supporting Projects
(1) Operations and maintenance have first claim on the reserve fund. Without proper O&M funds, a facility may experience severe loss of income. Revenue bonds are commonly payable from net revenues--that is, gross receipts less operating and maintenance costs.
(2) The bond service account should receive monthly payments sufficient to cover the next semiannual interest payment, as well as the next principal payment on serial bonds.
(3) A sinking fund is sometimes required in the case of term bonds, in lieu of principal payments on serial bonds.
(4) The debt service reserve fund is gradually built up to equal a full year's maximum principal and interest in the case of serial bonds, or two year's interest in the case of term bonds.
(5) A renewal and replacement fund (sometimes called a replacement reserve) is established to replace equipment and provide necessary repairs beyond normal maintenance. Funds are paid into this account in amounts recommended by the consulting engineer and may be cumulative.
(6) A reserve maintenance fund may be established to meet unusual or extraordinary maintenance charges that have not been budgeted. Some jurisdictions combine the reserve maintenance fund with the renewal and replacement fund.
(7) The working capital fund, to cover unforeseen contingencies, should be equivalent to about one-tenth of the annual gross revenues.
Debt Service and Retirement
Prompt payment of all principal and interest requirement is the most direct evidence of sound debt administration. Consequently, the way in which a jurisdiction services its debt is one of the most important factors in determining its credit standing for future borrowing. Even temporary defaults may adversely affect a municipality's ability to borrow at optimal interest rates. Well-defined procedures--including advanced planning regarding the payment calendar and sound management of sinking funds and capital reserves--are essential to ensure regularity in the payment of interest and redemption of principal.
The first step is to establish an information system regarding interest and redemption requirements over the life of the issue. For this purpose, the bond and interest register and the ledgers for bonded debt and interest form a ready basis for the development of a payment calendar. Whenever a new issue is marketed, a schedule should be prepared showing the amount due on each principal and interest date, and this schedule should be incorporated into the consolidated payment calendar to show the timing of total cash requirements. If sinking funds or other debt service funds are involved, these must also be taken into account in the annual budget process.
The allotment of funds for principal and interest payments must be timed to provide cash when it is needed. Budget officials must plan ahead to ensure that early payments required in the following year can be met, that is, that a sufficient fund balance is carried over from the previous fiscal year and/or provision is made in the tax collection system to generate adequate funds in the early part of the new fiscal year.
Payment of all principal and interest requirements should be made through a single agency, for example, the City Treasurer's office or some other designated fiscal agent. In many cities, such payments also require authorization by the Director of Finance or the Controller. It is usually a good administrative practice to appoint a bank or trust company in the financial center in which a municipality's bonds are marketed to serve as its paying agent. Funds are deposited with the paying agent in advance of interest (and principal) due dates, and the agent oversees the payment of coupons and matured bonds as they are submitted. This arrangement is preferred by investors. It saves the municipality considerable routine work, and the paying agent is equipped to handle this function at a relatively low cost.
A major problem in the use of sinking funds (and one contributing to severe restrictions on this method of financing in a number of states) stems from the technical difficulties of managing the trust accounts. In most states, local governments are restricted by law as to the types of sinking fund investments that can be made--usually being limited to federal, state, and municipal bonds. Within these categories, investments should be limited to high-grade issues and should exclude revenue bonds on projects with unproven earning power. Bonds with equal security at times vary in terms of their yield, and the relationship of maturity to yield tends to vary with changes in market conditions. Analysis of the bond market, therefore, is essential to secure the maximum earnings for sinking funds compatible with the safety of investment.
While some controversy surrounds the practice, investment of sinking funds by a municipality in its own securities has certain advantages. It avoids the complex analysis required when selecting bonds of other jurisdictions, it simplifies the administration of the sinking fund and lowers costs, and it affords a ready market for a municipality's borrowing that may be particularly important when the general market is uncertain. The principal argument against this practice is that the sinking fund may become a dumping ground for excessive amounts of tax notes issued to offset inadequate administration. Under such conditions, the security for payment is little more than a collection of IOU's. With proper safeguards, however, this investment practice remains a viable alternative to other forms of sinking fund investments. When a municipality invests in its own bonds, it does not increase its net debt any more than if it sold these bonds to outside investors. And when it buys back its outstanding bonds, it decreases its net debt just as much as if it invested in other municipals. In either case, the taxpaying capacity in relation to net debt is not affected.
In addition to security, sinking fund investments must have liquidity --the maturities of the various investments must be so timed that funds will be readily available to retire the term bonds when they come due. Without careful investment planning, it may become necessary to sell the holdings of the sinking fund in the open market, with the possibility of taking a loss. Greater flexibility often can be attained by investing in several different types and sizes of offerings.
To the extent permitted by state law, sinking funds should be consolidated to simplify transactions, to save time in putting the funds to work, and to secure a better investment position. Separate fund accounts should be maintained, however, for administrative purposes in calculating annual contributions. Since they are negotiable instruments, securities purchased from sinking funds should be kept in a safe deposit box., covered by fire and theft insurance, and with limited access by responsible officials. Whenever possible, sinking fund investments should be registered. An independent audit of the sinking fund should be made annually in addition to regular auditing by the controller of all sinking fund transactions.
It should be evident from this discussion that the management of a sinking fund is a complex task that should not be undertaken without adequately trained personnel and proper safeguards to protect the integrity of the funds. As has been noted, a number of states have legislated against term bonds secured by sinking funds insofar as general obligation borrowing is concerned. However, such funds remain as a viable means of financing many revenue-producing projects, whereby annual contributions to the fund are generated by the self-supporting facilities. In such cases, adherence to the guidelines outlined above is especially important since such debts often are outside the protection of the full faith, credit, and taxing power of the jurisdiction.
Recording and Canceling Coupons and Bonds
The final step in servicing a municipal debt involves the recording and canceling of coupons and bonds that have been paid. Following each scheduled payment, coupons and bonds must be checked to determine if any have not been redeemed. Some will always be slow in coming in, and occasionally, some may be missing permanently. Records must be maintained for several years after the final maturity date in most cases. Canceled coupons and bonds usually are kept for several years, after which they are destroyed by shredding or burning.
Many commercial banks and trust companies that serve as paying agents for municipal bonds include as part of their services all phases of recording and cancellation. These banks and trust companies provide the municipality with a certified list of the canceled and destroyed bonds and coupons. Many municipalities mandate that the disposition of these documents take place in the presence of the Director of Finance or the Controller and at least one other municipal official. The "mortgage burning" ceremony is one that still has considerable significance for many small communities.
Refunding, Conversions, and Defaults
The process of issuing new bonds to retire outstanding debt is called "refunding." The refunding bonds may be sold for cash and the outstanding bonds redeemed in cash, or the refunding bonds may be exchanged with the holders of the outstanding bonds. In the case of financial difficulties, such as default, a refunding plan is part of the reorganization of debt that may be mandated and supervised by the courts.
Refunding Callable Bonds
Refunding is generally developed through the issuer's exercise of the call provision that was incorporated into the original bond issue. When outstanding bonds bear interest rates substantially higher than those currently obtainable in the municipal bond market, it may be appropriate to determine whether a refunding can be carried out to the advantage of the issuing government--either of the full amount outstanding or some portions thereof.
Bonds may be issued with the provision that they may be "called" for payment prior to their maturity date. Bonds may be made callable at any time after the date of issue; in practice, however, the call normally is exercised with appropriate notice only on interest payment dates. A bond issue may be made part callable and part noncallable. Bonds may be made callable at par or at a premium.
Callable bonds may afford greater flexibility in the jurisdiction's debt structure. If the initial retirement schedule provides too rapid, or a period of declining revenues is encountered, bonds may be recalled and refunded at the most favorable terms. During periods of high interest rates, the call feature permits bonds to be issued and then refunded at lower rates at some time during their term if the market changes or the jurisdiction's credit rating improves. The callable feature permits debt retirement to be accelerated if the project's revenue capacity expands.
Since most investors insist on a premium for callable bonds, the resultant net savings must be carefully considered. The steps required include a determination of:
(1) The probable interest rate that could be achieved on the refunding bonds if offered in the prevailing market;
(2) The gross amount of interest to be saved in terms of: (a) current dollars payable in the years in which the savings will occur; and (b) present worth of dollars to be saved at future dates; and
(3) The cost of refunding--the call premiums payable and the costs incident to the issuance of refunding bonds.
The apparent difference between gross interest costs on the old and new bonds, after allowance for the refunding costs (including all premiums) is not the most critical consideration. Failure to reduce all factors to a net present worth can result in a refunding which is apparently favorable but which, in fact, is disadvantageous to the issuing jurisdiction. 
Refunding to Adjust Contract Terms
Revenue bond issues often involve complex and lengthy indentures. It may become necessary to issue additional debt at some time prior to the maturity of the outstanding bonds. However, the terms of the existing contract may unduly restrict the issuance of new bonds. The restrictions may have been appropriate to carry out the original financing, but under the current conditions, they impede the accomplishment of the present objectives. Therefore, the issuing authority may find it desirable to arrange for the refunding of the outstanding debt in order to eliminate or modify the restrictive covenants.
Refunding to eliminate restrictive covenants frequently results in substantial additional costs. This fact underlines the importance of holding the restrictive elements in each bond indenture to a minimum, consistent with the original intent of the bond issue.
Refunding to Consolidate Debt
It may be possible to use refunding to consolidate the jurisdiction's debt. To illustrate this approach, assume that a major additional must be made to a city's sewage treatment facilities to be in compliance with revised state and federal standards regarding effluent discharges. The Sewer and Water Commission and City Council agree that an adjustment should be made in the sewer service charges sufficient to meet the debt service.
In Exhibit 5, it is assumed that, with the authorized increase, the annual yield from the sewer service charge will be $1 million, with an estimated increase in this yield at a compound rate of 2% per annum. The city still has $6 million in bonds outstanding from a previous issue for the sewer treatment system, bearing a 5% interest rate and maturing serially in annual amounts of $500,000. The new sewage treatment facilities will cost $8 million with the new bonds issued for 30 years with a uniform coupon rate of 5%.
It would not be possible to finance additional bonds under these conditions because the debt service in the first year would be $800,000 on the old bonds and $520,000 on the new bonds, which exceeds the total available revenues for the first year of $1,000,000. The refunding of the outstanding bonds along with the issue of new bonds might be a viable approach. If the total funding required to achieve this consolidation is $14,200,000, including the refunding costs, one plan for accomplishing the consolidation is shown in Exhibit 4. Under this approach, it would be possible to pay off all of the bonds in 20 years (10 years earlier than under a separate issue), with a cost savings of $487,480. This plan offers a suitable method of consolidating the old and new debt under the outlined parameters.
|Debt Service||on $14 Million||Consolidated Debt||Outstanding Principal|
|Year||Estimated Annual Revenue @ 2% / Annum||Debt Service Requirements on Existing $6 Million Debt||Debt Service Requirements on New $8 Million Debt||Principal||Interest @ 5%||Total Debt Service||$14,200,000|
Refunding Mature Bonds
The practice of refunding mature or maturing bonds should be avoided if at all possible, and if necessary, should be undertaken with great discretion. Conditions may arise, however, that force refunding to eliminate irregularities in the existing debt schedule. Such irregularities result from overly optimistic retirement schedules or from sudden shifts in economic conditions beyond the local control that lead to changes in the municipality's revenue system. Refunding may also be preferable to emergency borrowing, particularly when a good credit relationship has been established in connection with outstanding debt.
Refunded bonds should be scheduled into the debt retirement program as soon as possible within the jurisdiction's fiscal capacity. An excessively long retirement period might seriously limit future borrowing. On the other hand, the retirement period of the refunding bonds should be of sufficient duration to avoid the need for further refunding.
At times, a municipality may find it absolutely necessary to refund outstanding debts to avoid default on bonds or serious disruption of fiscal operations. Unfortunately, such forced refunding often encountered unfavorable market conditions, since the economic factors that give rise to the need for refunding may be widespread. This situation confronted many cities during the depression years of the thirties. Under such circumstances, a municipality--unable to sell refunding bonds to new investors--may be forced to negotiate with existing bondholders for the exchange of their holdings for new maturities. Since bonds may be widely held and bondholders difficult to locate, this undertaking can be a most cumbersome, particularly if the issue has turned over in the secondary trading market.
Forced refunding should never be unduly postponed. It is a matter of good fiscal administration to anticipate such emergencies and to take the necessary steps with sufficient lead time to resolve the problem in an orderly and businesslike manner. A frank and open presentation of the municipality's fiscal problems is necessary to secure understanding and cooperation from major bondholders.
Sale of Refunding Bonds
Five elements need to be considered: (1) the timing of the sale, (2) the maturity schedule of the refunding bonds, (3) the time of settlement on the new bonds, (4) the refunding costs, and (5) the redemption provisions for the refunding bonds. The security pledged in support of the refunding bonds should be the same as the original issue. Maturities may have to be rearranged to accommodate higher coupon rates on early maturities, or a rate limitation may have to be placed on those maturities to bring the debt service within the bounds determined in the planning of the issue. It may be appropriate to accelerate the maturity schedule on the refunding bonds to increase the interest savings at some future date. Such an acceleration is desirable if the issuing jurisdiction can afford to pay the refunding costs from current funds and is willing to forego the realization of the savings for a number of years.
Settlement on the refunding bonds should be a few days in advance of the due date on the called bonds in order that the issuing jurisdiction may be assured of having the cash in hand to meet the requirements for paying off the called bonds. Assuming no debt limit problems, the jurisdiction may prefer to complete settlement on the refunding bonds prior to the issuance of the call of the outstanding bond. This procedure is particularly appropriate in cases in where the likelihood of litigation might delay the delivery and settlement of the refunding bonds beyond the date for the redemption of the old bonds. While prior settlement involves the payment of overlapping bond interest, the net amount of such duplication can be reduced through short-term investments of the revenue from the new issue. If state laws permit, it might be appropriate to increase the amount of the refunding issue by the amount of the refunding costs. While this approach reduces the net savings in current dollars, it should have little effect on the overall savings realized in terms of present worth dollars.
Including a call option will increase interest costs and thereby, decrease the amount of interest savings that can be attained. On the other hand, a call option on bonds that will mature in several years (e.g., at least five) may be justified if the refunding is in a market of medium interest rates.
In the early 1960s, some jurisdictions engaged in the practice of "advanced refunding," that is, refunding bonds to take advantage of falling interest rates. Some jurisdictions had three sets of bonds outstanding on the same project--the original bonds, an initial set of refunding bonds, and a secondary set of advanced refunding bonds issued to refund a portion of the first set of refunding bonds. The effect was to have three sets of tax-exempt interest being paid on the same basic improvement. However, in August, 1966, the U.S. Treasury ruled that the interest on such bonds would not be considered tax-exempt:
(1) Where all or a substantial part of the proceeds of the issue (other than normal contingency reserves such as debt service reserves) are only to be invested in taxable obligations which are, in turn, to be held as security for the retirement of the obligations of the governmental unit.
(2) Where the proceeds of the issue are to be used to refund outstanding obligations which are first callable more than five years in the future, and in the interim, are to be invested in taxable obligations held as security for the satisfaction of either the current issue or the issue to be refunded.
No matter how satisfactorily resolved, defaults are likely to result in a decline in the jurisdiction's credit standing, producing skepticism among lenders and major difficulties in negotiating favorable interest rates on future bond issues. Even temporary defaults, if allowed to extend beyond the normal 90-day grace period, may result in the removal of a city from the listing of securities approved for fiduciary investments.
By far the largest number and most severe municipal defaults took place during the depression era from 1929 through 1938. The total debt of all governmental units whose defaults were recorded during this period was approximately $5.5 billion, or approximately 30 percent of the average net municipal debt outstanding at the time. The most prominent default of this period was that of the City of New York, with total indebtedness of slightly over $2.5 million. Lasting only a few days, the New York City default involved some general obligation notes issued in anticipation of delinquent tax collections. The $5.5 billion figure included approximately $160 million in default by the state of Arkansas, $190 million in default by local governmental units with less than 5,000 population, and $400 million in default by special purpose and special assessment districts.
Prior to the depression, municipal debt had increased at a very significant rate, in large measure, due to speculative over development of real estate in the twenties and the lack of realistic debt limits. In some cases, the officers of real estate companies became municipal officials and promoted bond issues to enhance their real estate holdings. Special assessment or local improvement districts often were created to finance the improvement of undeveloped and speculative areas. The issuance of debt in the name of an overlapping unit made debt limits ineffective.
The capacity of local government to pay these debts did not increase nearly as rapidly as the debts themselves. Municipal revenues rapidly declined as wealth, income, and assessed values plunged downward in the early years of the depression. The decrease in local tax revenues, for which there were no adequate substitutes, was not accompanied by commensurate declines in expenditures. Many governments were faced with rising debt service charges, the results of unwieldy debt structures contracted in the past, and with increased demands for unemployment relief payments.
Encouraged by the availability of capital at fairly low interest rates in the late twenties, many municipalities with unbalanced budgets were able to borrow enough to cover their operating deficits. This borrowing added to the already large fixed charges of many communities. In 1932 and 1933, however, municipal borrowing was greatly curtailed as a consequence of rapidly rising interest rates, bank failures, and the loss of public confidence in municipal bonds. Therefore, many local governments with deficit budgets were forced to default.
The defaults of the Depression led to the enactment of the Federal Municipal Bankruptcy Act. Under this act, any local government that has defaulted on its debt because of its inability to meet its commitments can apply for relief to the applicable Federal District Court which can approve a plan for the reorganization of the debt of the issuer. After the Second World War, several large bond issues to finance toll roads ran into difficulties in terms of covering debt service payments from net earnings. Such entities as the West Virginia Turnpike and the Calumet Skyway were eligible for reorganization under the Federal Municipal Bankruptcy Act; however, they did not resort to this course of action, relying on more conventional refunding procedures instead.
Types of Defaults
Minor or temporary defaults involve failure to meet the maturity payment of a single security or temporary postponement of interest payments. Such minor defaults may be the result of unanticipated declines in revenue collections, the shutting off of normal lines of bank credit, and/or a temporary inability to market refunding bonds. They usually can be corrected without disturbing the general debt structure or further interrupting debt service. Adjustment strategies include: (a) payment during the grace period from belated tax receipts; (b) short-term bank loans; (c) small issues of refunding bonds; or (d) security exchanges. This latter strategy is particularly effective for relatively recent bond issues. Bondholders are contacted and negotiations are conducted to effect an exchange of outstanding bonds for new securities that more closely fit the community's long-term ability to pay.
A second, more serious class of defaults involves municipalities that have encountered such fiscal problems as peak debt service in period of low-paying capacity, serious breakdowns in the local economic base, and/or abnormally high tax delinquency. Under such circumstances, the municipality may experience difficulties in meeting current accounts as well as long-term obligations. Adjustments usually are effected by refunding or partial refunding a few years' obligations in order to free up some fiscal resources to meet current operating costs. It may be possible to accomplish this adjustment without a major disturbance of the general debt structure and without any scaling of debt. Once current obligations are returned to a more balanced basis, attention can be redirected toward long-term obligations that may require further readjustments to reflect sound principles of debt administration.
The third class of debt involves situations in which the jurisdiction is confronted by abnormally high debt, severely curtailed revenues, and significant accumulation of operating deficits, with little or no prospect for correction except through a comprehensive refunding plan. Such a plan usually involves a complete reconstruction of the entire debt retirement schedule and a scaling down of interest and even principal payments.
Scaling of debt involves the actual reduction in the jurisdiction's commitments and becomes necessary when the total obligation is clearly beyond the local government's capacity to pay. Investors naturally are reluctant to forego any portion of their contractual rights and particularly so with regards to principal. Unless the situation is hopeless, they tend to prefer extensive postponements, with the expectation that subsequent community growth and development will eventually bring protection to their investment. Thus, when necessary, scaling can be more readily accomplished through a reduction in interest rates.
Steps in Readjustment
Insofar as possible, the jurisdiction should take the initiative in readjustment and in planning and implementing the refunding plan. While serious defaults require time for careful deliberation before commitments are made, by exercising such initiative, the jurisdiction may gain the necessary cooperation from investors to successfully resolve the pending financial crisis. Attempting to cover up the fiscal crisis merely exacerbates the uncertainty, increases expenses, and ultimately may result in the municipality being placed in receivership. At this point, local officials no longer can control the readjustment process.
When it is evident that readjustment is unavoidable, an official statement should be issued to the municipality's creditors, giving notice of its inability to meet its obligations, identify the causes and probably duration, and outline the steps contemplated to correct the situation as expeditiously as possible. Municipal records should be opened to bond-holders, and a summary analysis should be distributed, outlining the municipality's financial status and capacity to pay. This analysis should be followed by frequent reports of financial and economic conditions and trends. Only by such means can the municipality retain the initiative and assure the most constructive negotiations with its creditors.
A complete investigation of all relevant factors--financial, administrative, and economic--is a prerequisite to the planning of corrective action. Reliable experts should be consulted and a competent fiscal adviser retained. The relationship between outstanding obligations and normal capacity to pay must be ascertained, and operating costs should be examined to determine if they afford any basis for adjustments. The municipality must evaluate its financial status and relation to resources and liabilities, both immediate and future. In short, the municipality should approach its creditors with full knowledge of where it stands and of the reasonable expectations regarding the capacity to recover from its financial difficulties.
To be successful, the refunding plan must provide: (1) mechanisms to release current accounts from accumulated deficiencies; and (2) financing procedures that will assure the maintenance of balanced operations. While a brief hiatus from full debt service obligations may be necessary, such postponement is valid only if it is used as a means of systematically adjusting current accounts. Such refunding as is necessary should postpone the retirement of as little debt service as possible. The replanning of the debt structure should not trade a difficult immediate situation for an impossible future one. Callable bonds should be used to the extent possible to permit the re-refunding at lower interest rates if justified by market conditions, as well as the potential of accelerating the retirement process when conditions improve.
Adjustment of serious defaults, at best, involves a process of compromise, in which there is little opportunity for impartial settlement. Furthermore, refunding arrangements may contain the potentialities for recurring financial difficulties for several decades in the future. The experiences of many communities in the thirties offer ample support for the necessity of sound debt policies.
Prompt payment of all debt service charges is the most direct evidence of sound debt administration. The establishment of an information system to track interest and redemption requirements over the life all outstanding bond issues is essential to achieve this objective. The effective management of sinking funds and other debt service funds forms a critical part of the debt administrator's responsibilities. Coupons and retired bonds must be recorded and canceled in an orderly manner to ensure the proper close out of debt obligations. The procedures of refunding and the safeguards against defaults should be clearly understood by local officials. Most states have adopted legislative measures to circumvent the financial catastrophe faced by many governments in the thirties. The ultimate responsibility, however, still rests with local officials to adopt debt administrative procedures that will protect their community from "mortgaging its future."
 Municipal bonds often are underwritten by large investment syndicates that provide the funds to the issuing jurisdiction and, in turn, reoffer the bonds to individual investors. For a discussion of the underwriting of municipal bonds, see Alan Walter Steiss, Local Government Finance (Lexington, MA: D.C. Heath, 1975), Chapter 7.
 Underwriters of municipal bonds must perform several calculations on the stated interest rates to determine a net interest cost (the bid that they will make on the bonds). Net interest cost equals the total cost of interest over the life of the bond issue (less any premiums) divided by the total number of "bond years"--that is, the sum of the number of years to maturity for each separate bond.
 Refunding merely to effect a temporary tax reduction has no justification. The motivation is usually political. In some flagrant cases, bonds have been refunded just prior to elections to "improve" the record of incumbent office holders even though existing debt commitments could be readily met under the established schedule. Such practices result in unstable fluctuations in the tax levy, rising debt trends, and serious disruptions of the jurisdiction's debt structure.
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