February 4, 2023

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SEC muni chief warns issuers away from ‘problematic structures’

3 min read
SEC muni chief warns issuers away from 'problematic structures'

State and local governments experiencing times of fiscal surplus and strong credit ratings should be careful not to ignore certain bond structures that came around to bite issuers during the global financial crisis a decade ago.

That’s according to Dave Sanchez, director of the Securities and Exchange Commission’s Office of Municipal Securities, speaking at the Government Finance Officers Association’s 4th annual Minimuni conference. Sanchez returned to lead the office this year after serving as an attorney fellow from 2010 to 2013, and noted the stark contrast in the financial conditions of state and local governments from then to now.

“It is always better for you to shut these deals down before they get off the ground in the first place rather than waiting for regulatory attention,” Sanchez said.

“One of the downsides of having a period of relative calm and strong credit for governmental issuers is that people forget about problematic structures that caused so much heartache in the last financial crisis,” Sanchez said. “Issuers and their advisors are perhaps not as skeptical about potentially problematic structures now as they were when the last financial crisis was more of a clear memory,” he added. “They let their guard down.”

“Although state governments have in many cases worked to curtail or limit structures like capital appreciation bonds that often have long term financial costs that far outweigh the benefits of immediate capital,” Sanchez said. “When you work with a debt team, they can generally always find a debt solution, even if that solution is not the best from an overall financial perspective of the issuer.”

Capital appreciation bonds pay a compounded interest rate and principal upon maturity instead of through regular payments over time. They allow issuers to defer debt-service payments in the short-term and avoid near-term property tax rate increases.

CABs became notorious a decade ago when Poway Unified School District in San Diego County sold $105 million in CABs and it became clear that they would eventually require $1 billion in debt service at their 40-year maturity.

He also singled out structures such as auction rate bonds and gift agreements from the last financial crisis, which seemed like good ideas in times of prosperity.

“There was not sufficient attention paid to how things might look and operate if the rosy outlook in which these structures perform well does not come to pass,” Sanchez said. “As an example, right now, a lot of communities are struggling with affordable housing issues and we see some new structures being used or proposed that might just be too good to be true in solving these affordable housing problems,” he added. “It’s always tempting to try to solve a pressing policy issue like affordable housing, especially with a seemingly ready made solution. But again, just reminding you to all maintain your economic discipline and a healthy skepticism.”

He urged listeners to follow GFOA’s best practices, which he noted he’s noticed many issuers do not follow, and urged issuers to go through every possible scenario with your financial team so that the Commission doesn’t have to step in.

“It is always better for you to shut these deals down before they get off the ground in the first place rather than waiting for regulatory attention,” Sanchez said. “One way to do this is to remind your financial team of their responsibility to provide you with a full and objective assessment of the structure they’re proposing, not a sales pitch,” he added. “Make sure that the potential downsides and not just the potential upsides are fully and fairly disclosed to you.”