Outside of the magical world of CPAs and other money mavens, the word defeasement is not used in casual conversation. I'm not sure it's used in conversation period. However, the good citizens of Morrisville have this word on their minds and tongues quite a bit lately. Do not forget the special board meeting on Wednesday, January 30, at 7:30 P.M. in the MHS LGI room. Please, please, click on that link and read the entire text. It will confuse many of us. Keep in mind that some of the board members are confused and uncertain as well. This is an important issue, maybe even more important than the farming issue.
The root of the word is in "defeat" and there are several dictionary entries and explanations I found for the word in Infoplease, the National Council of Health Facilities Finance Authority, Wikipedia, and a California public entity law firm.
The new school is dead and anyone who supported it must accept this reality.
So now we have money left over from the $30 million bond issue less the "two million dollars that were used for Lord knows what!" that the Stop the Schoolers fondly mention.
This money was borrowed for a period of years, for a purpose, at an interest rate, and it is obligated to be paid off. It's nothing more than a new car loan with lots more zeroes at the end, except that it's hard to repossess a building, and the taxpayers are footing the bill in the form of their taxes.
So, just like a mortgage or car loan, it can be repurposed and refinanced as needed providing the legal dotted Is and crossed Ts are all in place.
William Hellmann CPA maintains that the borrowing interest rate is too high. Yes, it is high. The more money you borrow, the higher the interest rate. Morrisville also pays its bills off the backs of homeowners rather than businesses. Even the accounting community recognises this as a bad thing and raises the interest rate accordingly. Takeaway from this: Morrisville is a less than excellent credit risk. Keep thinking car dealers for a moment: Where does your credit rating allow you to buy cars and what is your interest rate?
William Hellmann CPA also maintains, quite correctly, that interest rates are going to fall. The Federal Reserve just made an emergency interest rate cut to boost the economy, and I doubt that it was the last one for the short term. Returning the money now means 1) we can retire the high interest money now, but 2) we need better current interest rates to defease the debt because the lower the rates drop, the more money we need to put up to accomplish the defeasement. We can then 3) borrow less money (say, $10 million rather than $30 million) to continue renovating the school at a lower interest rate because the principal borrowed is smaller and we're using today's rates rather than the rates of two years ago.
Once the bond is defeased, it "goes away" and in theory, the tax millage increase that borrowing this money represented also goes away.
So far, this seems fairly straightforward, and perhaps the reasoning of the rules-bound Mr William Hellmann CPA is valid up to this point. A bond defeasement does seem to be the more prudent choice at this time if these criteria were the only issue. However, this is only the first part of a very complex situation.
There's a lot more to discuss, and I really would like to stimulate some serious discussion on this issue before the January 30 meeting. In the next post, I intended to cover the Morrisville angle of where we are, and what our current reality is. At this point, any of the defeasement options I described in the poll are possibilities. They each carry an element of risk, and I'm not sure which is "more right" than any others. I'm not sure that some of the board members will take the initiative to ask Emperor William to slow down and examine the issue more closely. But there's the challenge. It's out on the table for any of the eight remaining board members to pick up.
Saturday, January 26, 2008
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2 comments:
Can someone explain in layperson terms how we actually defease the bond? In other words, looking at the bond financing structure on the board website (http://www.mv.org/files/19655/Financing%20Structure.pdf), we need to pay off a variable mix of coupons with different interest rates and maturity dates that stretch out over 20 years. Principal + interest is on the order of $2.5 million/yr.
So to defease, we have to invest the bond money is some portfolio that yields enough to pay off this ~$2.5 million/yr in principal + interest. And it can't yield too much, because that's called arbitrage, and that's a no-no. But what if it yields too little, do we have rely on taxes or more borrowing to make up the shortfall? And with interest rates allegedly heading down, isn't it harder to find a portfolio that yields enough to pay off the allegedly "too high" bond rates? Do you have to invest in riskier things to get the yield you need? Or since our bond is a municipal bond (tax free?) with low yield relative to other investments, it's pretty easy to find something else that's not too risky and yields enough to pay it off? And doesn't someone have to babysit the money for the next 20 yrs to make sure the defeasement is successful?
To respond to the comment above. Once the bond obligation is written, unless there are certain call provisions (the right for the bond issuer to pay off the bond and cease paying interest to the bond investors who purchased bonds)then it is necessary to replace the cash flow of the original bond with the cash flow of a new bond.
This will require minimal supervision because the bond must be replaced with another bond. Even if interest rates are low, older bonds with appropriate maturity dates can be purchased at a premium in order to offer the correct yield to the current bond holders. This would, of course, require a capital premium.
I will offer a very simple example: Lets presume that I owed you 8% annually on a $100,000 bond for the next 10 years and interest rates were currently at 6%. I might look at the bond market and try to find a $100,000 bond that was issued at a time when interest rates were at 8% but had 10 years left on its maturity.
However, I wouldn't just pay $100,000 for this bond because it's interest rate (8%) is much higher than the current market interest rates (6%) so I would have to pay a premium for the bond. Lets say, just to make it simple (I'm not inclined to do the math right now so this is a random number), that I would pay $120,000 for the $100,000 bond. Thus, the bond sells at a $20k premium and would represent the defeasence cost.
Once I've paid for this bond I can replace the cash flow of the previous bond with this new bond and the old bond has now been defeased.
Typically, this has to be done with treasuries, as they represent zero default risk since the US Govt is the safest credit risk on the planet (and can always print more money to cover it's debts, albeit, at the risk of inflation).
This is an oversimplification but I think it gives you the general idea.
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