Opinion

Felix Salmon

Poway: It’s not too late to unwind

By Felix Salmon
September 7, 2012

Remember the Poway school district? They did a horrible bond deal, borrowing $105 million now and promising to repay a total of $981 million by the time 2051 rolls around. The deal was broken up into lots of tranches, none of which start paying back any money at all before 2033. The most egregious tranche of all was the longest one: a bond with an original principal amount of $13,986,037.80, which matures in 2051, when bondholders will receive a total of $321,740,000. That’s more than $22 of interest for every dollar borrowed today.

One of the most distasteful parts of the deal — whose prospectus can be found here — comes in a short and bold-faced single-sentence clause right at the front:

No Optional Redemption

The Series B Bonds are not subject to optional redemption prior to their fixed maturity dates.

In other words, Poway has no call option on these things, and now that they’re issued, it has no choice but to pay up the whole $321,740,000 in 2051.

But that doesn’t mean it’s too late to fix this mess. Matt Levine has an absolutely wonderful post up about SunTrust’s stake in Coca-Cola — a true marvel of clear, funny, approachable prose explaining highly-recondite concepts. In this case, SunTrust, a bank based in Atlanta, has agreed to sell off a stake in Coca-Cola which it has held since 1919. Even though, at least as far as US regulators are concerned, it already sold off that stake, back in 2008.

But the way that deal was structured, SunTrust got some but not all of the proceeds in 2008, and was still massively exposed to Coca-Cola shares: so long as the shares were worth more than $33 each (they’re now at $38), SunTrust was due another $14 per share between 2014 and 2015. And this deal, too, could not be undone. Here’s the language, from Levine’s footnote:

SunTrust generally may not prepay the Notes. The interest rate of the Notes will be reset upon or after the settlement of the Agreements, either through a remarketing process or based upon dealer quotations. In the event of an unsuccessful remarketing of the Notes, SunTrust would be required to collateralize the Notes and the maturity of the Notes may accelerate to the one year anniversary of the settlement of the Agreements. However, SunTrust presently believes that it is substantially certain that the Notes will be successfully remarked.

But in light of new regulations, SunTrust decided it that it did want to prepay the notes after all. And — guess what — it has found absolutely no difficulty in doing so.

And if SunTrust can prepay obscure and highly-illiquid equity-derivative instruments, you can be quite sure that Poway, if it put its mind to it, would be able to prepay some of those horrible 2051 bonds. One obvious way of doing so would be to just go out into the market and buy them: they’re trading pretty much at par, and my guess is that if they offered to pay say 105 cents on the dollar, they’d be able to buy back many if not most of the outstanding debt. Which is a hell of a better deal than paying back 2,300 cents on the dollar, which is what they’re currently contracted to do.

Since the details of this bond deal were made public, the San Diego population has reacted as you might expect — with no little outrage. They want the deal unwound. And although there’s nothing in the letter of the contract which makes that possible, a decent banker should be able to get them out of this dreadful obligation at relatively little expense. Especially compared to the cost of staying in it.

Comments
12 comments so far | RSS Comments RSS

As someone so demonstrably financially literate, why did you decide in this post to reinforce the most naive interpretations of the time value of money? There are many ways to value a bond deal, the total amount of interest paid (ignoring the time to maturity) is not one of them. I quickly calculated the interest rate of the $13,986,037.80 tranche maturing in 2051 to be about 6.6%. Is this a bad deal? I have no idea, because you made zero effort to evaluate this question in a financially sophisticated way. Newer readers are probably worried about your retirement savings, given the Rand study you referenced yesterday.

Posted by Stevensaysyes | Report as abusive
 

As someone so demonstrably financially literate, why did you decide in this post to reinforce the most naive interpretations of the time value of money? There are many ways to value a bond deal, the total amount of interest paid (ignoring the time to maturity) is not one of them. I quickly calculated the interest rate of the $13,986,037.80 tranche maturing in 2051 to be about 6.6%. Is this a bad deal? I have no idea, because you made zero effort to evaluate this question in a financially sophisticated way. Newer readers are probably worried about your retirement savings, given the Rand study you referenced yesterday.

Posted by Stevensaysyes | Report as abusive
 

Look, SunTrust appears to have language in their deal that contemplates early redemption. The Poway deal expressly forbids it – quite logical in a deal involving ‘zeros’/deferred-interest methodology. How the hell you could establish the strike-price in the written agreement?

I say – ‘Chill, Dude.’ Better than 50:50 that before too long Poway will be able buy-in on the open market a big chunk of these notes at less than ‘face’. That’s better for Poway than any ‘strike’ that could plausibly have been written into the funding contract.

Posted by MrRFox | Report as abusive
 

That “$13,986,037.80, which matures in 2051, when bondholders will receive a total of $321,740,000″ indicates a nominal compound annual return of 8.2%.

I wouldn’t buy that at par given the credit risk and inflation risk.

If you think it’s so outrageous, go ahead and stuff some of those bonds in your retirement account.

That said, yes, these municipalities do all kinds of bad deals so that they can avoid confronting current cash needs, kicking the can down the road for the next generation to deal with.

Posted by DerDoktor | Report as abusive
 

2,300 cents on the dollar sounds like a lot, it works out to a yield to maturity of 8.37%. Presumably it’s only worth paying off if Poway can borrow from someone else at a lower rate.

Posted by guanix | Report as abusive
 

LOL! My late father’s architectural firm designed a number of schools in the Poway school district but this was in the good old days when they taxed residents for school building. It paid part of my way through college. It really is foolish of them borrowing at such high interest rates and we may see them go the same way as the railroads did when they issued 100 year bonds! Of course the fine citizens of Poway always have the option of moving before the debt payment comes due but I wonder what will happen to real estate prices in the district when this gets priced in. Could be some real surprises in store particularly in 20 or so years from now.

Posted by Orange14 | Report as abusive
 

What still puzzles me is how, in a time when interest on invested capital ranges from 0% to 0.75% – even 30-year fixed-rate mortgages are at 3.5%, Poway got suckered into paying for a loan that costs them about10% compounded over 20+ years.

Like the old “Chargers ticket guarantee” signed by the SD City Council years ago, this could be described as “felony stupid” if you ask me.

Posted by Luke-John | Report as abusive
 

What still puzzles me is how, in a time when interest on invested capital ranges from 0% to 0.75% – even 30-year fixed-rate mortgages are at 3.5%, Poway got suckered into paying for a loan that costs them about10% compounded over 20+ years.

Like the old “Chargers ticket guarantee” signed by the SD City Council years ago, this could be described as “felony stupid” if you ask me.

Posted by Luke-John | Report as abusive
 

What still puzzles me is how, in a time when interest on invested capital ranges from 0% to 0.75% – even 30-year fixed-rate mortgages are at 3.5%, Poway got suckered into paying for a loan that costs them about10% compounded over 20+ years.

Like the old “Chargers ticket guarantee” signed by the SD City Council years ago, this could be described as “felony stupid” if you ask me.

Posted by Luke-John | Report as abusive
 

Felix

Nice shirt.

Posted by crocodilechuck | Report as abusive
 

Felix,

Good to see Reuters stump up for a haberdashery budget. Nice shirt.

Posted by crocodilechuck | Report as abusive
 

I agree with the basic idea here, which I take to be that this is lazy public financing. Zero coupon debt combined with a political desire to avoid current period taxation is a dangerous combination. However, I think that you are being somewhat misleading when you compare the zero coupon bond yields in the Poway structure to the spot treasury.

A 30 year treasury principal strip has a yield of about 3%, not 2.61% at the moment. Moreover, it sells for about $40.

Posted by Marked2Market | Report as abusive
 

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