So far this week, the tax-exempt market has just been drifting without much conviction. Blame it on the Dow soaring to a new record high of 15,000. Blame it also on the fact that most tax reform proposals floating around in political circles would curtail, in varying degrees, the tax exemption on muni bond interest. The latest example is the Joint Committee on Taxation Reform Report, released this Monday, which listed the complete repeal of municipal tax exemption as one of several viable reform options. In the face of such uncertainty, is it any wonder market participants have chosen to focus more on the rising supply of taxable municipal debt?
This week may also herald the return of one of the once-dominant bond insurers, MBIA, or more correctly, the new municipal-only version of MBIA called National Public Finance Guarantee. Yesterday’s legal settlement with both Bank of America ($1.7 billion) and Societe Generale ($350 MM) opens the door for National to obtain an “A” rating from S&P. However, hasn’t the municipal market already moved on and thrived in a world without bond insurance? One could make that argument quite easily.
Financing Public Education Reform
We promised we’d fill you in on some of the more interesting topics covered at last week’s National Federation of Municipal Analysts (NFMA) Conference.
To start, I had the privilege of moderating an excellent panel on “Financing Public Education Reform.” My co-panelists hailed from both the academic and institutional investment worlds: Larry Picus, Professor of Education Finance and Policy at the USC Rossier School of Education; Michelle Dougherty, Senior Analyst and Head of the Education team at Nuveen Asset Management; and Mary Kay Shields, Chief Deputy Director of The John Engler Center for Charter Schools at Central Michigan University (the first university authorizer of charter public schools in the country). Yes, the titles were a mouthful but suffice to say, all three speakers were recognized national experts in the field of public education finance.
State funding for education collapsed from a peak of $20 billion in 2007-2008 to a negative $14 billion by fiscal 2010.
First, to put things in the proper perspective, public K-12 education in the U.S. is big business. In fiscal 2012, the American public K-12 system had aggregate revenues of some $686 billion, compared to $452 billion for Exxon Mobil, the largest corporation in the Fortune 500. The State of California K-12 system alone is a $67 billion behemoth.
How school expenditures are funded has also evolved over the past century: back in the 1920s, more than 80% of school revenues were derived from local property taxes, with the balance from state aid. The states’ contribution to K-12 funding started to increase steadily in the late 1930s until it hit 45% or so in the late 1980s and has held steady at that level ever since. The federal government also increased its role from virtually nothing in the 1920s to a little over 10% of the pie by 2007.
The Great Recession of 2008 changed the whole picture. State funding for education collapsed from a peak of $20 billion in 2007-2008 to a negative $14 billion by fiscal 2010. The federal government stepped in and largely made up for all the cuts at the state level until state revenues started to recover in 2011.
In spite of the recent stabilization at the state level, local governmental entities and certainly local school districts are still very much in the throes of a fiscal crunch. Right here in our home state of Illinois, the City of Chicago recently announced the closing of up to 54 schools; if fully implemented, this would be the largest mass school closing in history. Furthermore, the state’s pension reform efforts may include a proposal to downstream teacher pension obligations down to the local district level.
Beyond the new fiscal realities of declining tax revenues and rising pension obligations, school districts are also facing a new grass roots movement to improve program outcome, promote school choice and pay only for performance. The public’s frustration with the traditional educational system (and perhaps with entrenched teachers unions) has spurred the growth of the charter school industry. As you may know, charter schools are independent public schools which circumvent the traditional public education bureaucracy. They receive public funding through an authorizing state or local agency and educate students according to their own specialized curriculums. Their teaching staff is generally not unionized. This concept has clearly struck a chord with impassioned parents and dedicated educators around the nation: charter school growth in the U.S. has almost doubled from 2,009 establishments in 2002 to 5,714 in 2012.
Yet, in spite of their rising popularity, charter schools continue to struggle to find a viable business model. While a school district is forever tied to its local community, a charter school operates under the terms of a renewable charter for a specified time frame, usually from one to twenty years. Because it has no taxing power, charter school operators are exposed to the cyclicality of state funding. The school may close down if it violates its charter, fails to meet performance standards, cannot control its costs or even runs afoul of the local political establishment. Due to these inherent risks, charter schools are still very much considered a “high yield” sector in the municipal market.
This seismic shift in public school funding mechanisms holds serious implications for municipal bond investors, particularly those who have traditionally found comfort in the stability of school district finances. As Mary Kay Shields aptly pointed out, up until recently, “geography” has been the only thing that matters. A school district’s creditworthiness largely depended on the local property tax base and local socio-economic characteristics (employment, income, debt burden etc…) Going forward, investors will increasingly have to worry about “performance” factors: demand for the school’s programs, student outcomes and management practices, among other things. All of these may lead to greater credit volatility.
While in the past, school dollars belonged to the district, school funding control will now shift to the students and their families. Schools will become pure service providers. In the past, school expenditures were made to benefit the entire local student body. Going forward, they will be made to benefit individual learners. The individual student will then have a choice of where to spend his or her education dollar: at a public charter school, a private school (through a voucher system) or even a cyber institution (through online programs).
Over the past decade, many school districts have taken advantage of declining interest rates and embarked on massive capital spending programs. They now risk being stuck with the debt while their revenues may walk out the door at any time with any individual student. Now there’s one lesson that needs to be learned, sooner rather than later.
Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
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