The bond industry calls them CABs, for “Capital Appreciation Bonds.”
To lay people, the meaning is not easy to parse.
The result for taxpayers is simple: CABs are a sleeping monster waiting to gouge property owners 10, 15 or 20 years from now.
Would you buy a $100,000 house where interest would amount to $200,000, $300,000, $500,000 or even $1 million?
That is the kind of “creative” financing Michigan school officials were doing in the late 1980s and early 1990s.
But this was public business.
Not school officials, but taxpayers were left holding the bag.
It’s happening now in California.
Over the next days, I’ll be re-posting my April 5, 1993 Detroit Free Press articles outlining the horrendous municipal bond mess Michigan schools got themselves into. The following year, these stories won the Michigan Education Association’s School Bell Award for waking Michiganders up to the huge scam posed by CABs and few greedy financial charlatans. Six stories in one day showed how in just four years, Michigan’s school debt doubled from a stable $2 billion to more than $4 billion headed for the sky. The California bond industry has had 12 years to “help” schools issue $22 billion in Capital Appreciation Bonds that could cost $70 billion to repay.
As you read these stories, Californians, ask yourselves who were the villains? Is there perhaps a small cartel made up of colluding bond salesmen, bond attorneys and financial advisers who steer school officials into debt that in one case has interest exceeding principal by a factor of 10?
Are school officials corrupted?
Are board members and financial officers wined and dined, taken on golf outings or junkets as Michigan officials were stroked with trips to New York, stays in fancy hotels, tickets to Broadway plays and dining in only the best restaurants?
California taxpayers and law enforcement agencies would not be crazy to keep an eye out for corrupt behavior.
Corruption was part of the process in Michigan, as you will learn by reading these stories, republished with permission of the Detroit Free Press.
Headline: MICHIGAN SCHOOLS LOAD THE FUTURE WITH DEBT
Byline: JOEL THURTELL FREE PRESS STAFF WRITER
Memo: BUYING NOW, PAYING LATER; SEE CHARTS ON MICROFILM,
PAGES 8A AND 9A
Text: Buy now, pay later. Pay much later, but pay millions more.
That’s the deal for taxpayers in dozens of Michigan school districts that
are using a heavy-interest form of bonds to stretch out paying for new
buildings, football fields, swimming pools — even buses and computers that
are likely to be outdated long before the bill for them is paid.
Since such financing was made legal in 1986 by the Legislature, 82
districts have borrowed $571 million that will require $2 billion to repay –
about 2 1/2 times more interest than conventional bonds would require.
In most cases, districts won voter approval of the bonds with a pledge
that little or no additional property taxes would be needed to pay them off.
But the payoffs will at least require extending debt- service taxes by 10
or 20 years, and could force tax increases if property values are stagnant or
assessments are held in check by state law.
The schools’ rush for such borrowing has alarmed financial experts who see
a huge balloon of debt settling over Michigan education around the year 2000.
They are warning that some districts are so much, so long in debt that
they will be unable to borrow money to meet future needs. But, they say, the
people who engineered the financial decisions won’t be around to face the next
generation of taxpayers, the ones stuck with the bill for buildings and
equipment that could be worn out or obsolete.
School officials, however, defend the bonds as one way to meet current
needs in a climate of voter ire over property taxes, the major source of money
for schools. They also say it is smart to project that a growing tax base
will enable them to meet future debt without a tax increase, and to ask the
next generation of school users to help pay for facilities and equipment.
Asked about the enormous interest, Gary Kemp, assistant superintendent for
finance in the Lowell schools near Grand Rapids, where a $29.8-million bond
issue for a new high school will cost $97 million by the time it’s paid off
in 2020, said: “I try not to think about it.”
The bonds are known as CABs, short for capital appreciation bonds.
They were authorized in 1986 legislation sponsored by then-state Rep.
Jerry Bartnik of Temperance, a former teacher who was looking for a way to
help school districts raise money.
Bartnik, currently a member of the state Natural Resources Commission,
said he was misled by the Legislature’s fiscal analysts and others into
thinking CABs were a smart option for borrowing.
Now, he said in a recent interview, it is plain that CABs are just a way
of “pushing all the debt back . . . and somewhere down the line, you’re going
to pay the bill.”
“It doesn’t lower borrowing costs,” Bartnik said. “It just raises it.”
He said the heavy long-term debt explains why school districts adamantly
opposed last year’s ballot Proposal C, which would have cut and limited
property taxes without a guarantee that the lost revenue would be replaced.
“They knew they got all this debt coming,” he said.
A property tax-cut proposal that will go before Michigan voters in a June
2 special election provides a sales tax increase of 2 cents on the dollar to
make up money schools would lose.
The Michigan Department of Treasury had initial misgivings about CABs
because of the long-term heavy debt.
“It just didn’t seem fair to me that tomorrow’s taxpayers should pay more
than their fair share of the tax burden for today’s projects,” Robert Bowman,
state treasurer at the time, said last week.
But Bowman eventually signed off on the first CAB in 1988 — although he
insisted that the school district involved, Holt in suburban Lansing, begin
setting aside money immediately to meet the looming debt. The order was not
followed and Treasury now gives CABs routine approval with no such
requirement. Other states allow CABs if money to pay them off is being set
aside in the years before they come due.
How CABs work
With a conventional bond issue, a school district begins paying interest
to bondholders right away. That requires extra income and generally means a
With CABs, the district doesn’t have to pay anything for several years.
That means no immediate tax increase. But in the long run, taxpayers pay
dearly for the delay because interest piling on top of the principal, making
more and more interest due.
To understand the appeal and risk of CABs, imagine you are about to buy a
new house and are offered two methods of financing it.
One is a typical mortgage with equal payments each month for 30 years. At
first, you pay mostly interest and little toward the principal of the loan.
Over the years, that ratio changes until your last payment is virtually all
You consider your income and worry that the payments initially will be
too high for you to handle.
So you get a second option: Move in now. Enjoy the house. No payments are
due on your loan for 10 years, and when they come due, you will have 20 years
to pay it off. In the meantime, interest keeps piling up on the principal.
When you must begin paying, your debt is larger, and so are your payments.
You have figured, though, that your income will probably rise enough in the
meantime for you to handle it.
Of course, you’d also have a huge encumbrance on the house. No such home
mortgages are offered.
The big difference between this hypothetical and school CABs is that the
home buyer has a clear understanding of what’s involved.
School district voters may not, and the architects of a CAB deal may not
be around to cope with the consequences, such as:
* Livonia schools borrowed $7.4 million in one CAB deal that will cost $25.3
million in interest, or 342 percent of the loan amount.
* Brighton schools borrowed $23 million for two new schools, a child
development center and remodeling projects; the interest will be $64 million,
or 278 percent of the loan.
* The Romulus schools used $6.2 million in CABs to help equip classrooms with
computers. After 30 years, Romulus taxpayers will have repaid the $6.2 million
plus $35.8 million in interest, or 575 percent of the loan amount.
“By using that approach, we were able to do it without raising our tax
rate,” said Romulus Superintendent Bill Bedell. “If you had a choice, I think
a regular bond issue would be much preferable, but we would have had to jack
up our millage 2 or 3 mills and people on the front end would have had to pay
for it faster than people later on.”
But John Axe, a Detroit bond attorney and financial consultant who
refuses to get involved in CAB deals, asks: “Would you buy a house like this?
“Of course not — it’s not a sound way of doing it. I might never be able
to pay for it.Who would buy it with an overhead debt several times the sale
“These CABs are only five years old,” Axe said. “By the time the trouble
comes, the board members and administrators who did this will be gone and the
poor taxpayers are stuck with the bill.”
Michael Forrester, an analyst with the New York credit- rating agency
Standard & Poor’s, warned against CABs in a December 1990 article in
Creditweek magazine, under the headline, “Michigan schools’ hidden debt
“To many taxpayers, the promise of new school facilities for their
children, coupled with a pledge of ‘no new taxes,’ appears irresistible,” he
said. Because interest on the bonds continues to accrue, the true debt
burden is understated “and could leave a district and its taxpayers vulnerable
to unpredictable economic and financial conditions,” he said.
The bonds “may entice a district to issue more debt or undertake more
extensive projects than it might otherwise contemplate,” wrote Forrester. “The
steadily increasing debt burden could limit the district’s future debt
capacity and thereby restrict its ability to address future capital needs.”
In a newsletter last year for Michigan school business officials, Charles
Kishpaugh, an analyst with Moody’s Investor Service, another major
credit-rating service, wrote that because CABs “saddle future taxpayers with
the obligation of paying for facilities used today. . . . When the CABs
become due in 20 years, will residents be willing to begin substantial
repayment for an older, possibly obsolete facility?”
Richard Allen, a bond salesman for Kemper Securities and a former analyst
for the Michigan Department of Treasury, has been involved in 90 percent of
the school CAB deals in Michigan.
In an interview, he said the higher cost of CABs is offset by the
declining value of money due to inflation over the life of the bonds.
Inflation hit double digits some years during the 1970s, but slowed to a
crawl during the 1980s and was only 2.9 percent last year.
Still, Allen was able to use the argument to convince state Treasury
analysts reviewing a Pontiac CAB that $27 million of additional interest would
really cost taxpayers only $102,000 in future dollars.
He said CABs keep tax rates down, and that taxpayers actually save more
money than they will owe when the CABs come due, if they invest the savings in
The state Treasury accepts that premise. But Linda Rairigh, a senior
Treasury analyst, acknowledged in a recent deposition for a lawsuit over the
Pontiac CABs that she was aware the savings really don’t exist.
“We know those figures are not realistic,” she said.
A bad beginning
Allen, whose job with the state was to analyze bond issues for the
Michigan Municipal Finance Commission, was by 1986 selling bonds for the firm
of Prescott, Ball & Turben when the CAB law sailed through the Legislature.
He said he is hazy about his role in the process. “We may have had some
But in a June 1991 interview with the Bond Buyer industry newspaper,
Allen described himself and the Prescott, Ball firm as “instrumental in
getting the legislation passed.”
He also said he was “instrumental in taking this over to the education
By 1988, Allen was a senior vice president with the underwriting firm of
Tucker Anthony, R.L. Day. He also was vice president of the school board in
Holt, and chairman of its finance committee when Holt issued the first CABs
Although the Tucker, Anthony firm was involved, Allen said he stayed clear
of the Holt deal because of his position on the school board.
But Bowman, state treasurer at the time, and Ronald VanErmen, the
district’s business manager, recalled Allen being very involved. VanErmen, in
fact, recently deferred questions about the bonds to Allen, saying, “the guy
who handled that for us is the guy to talk to.”
“Rich Allen knew the intricacies of that thing. I wasn’t involved, only to
the point where I was observing it. Rich handled the deal, and he’s really
knowledgeable . . .
“As school administrators, we don’t know that much about bonding,” said
VanErmen. “That’s why we rely on somebody like Rich Allen.”
Bowman said he “spent a great deal of time with Rich Allen and the school
district and everybody else. We thought whatever we did at Holt could be
When the Holt board approved the Tucker, Anthony plan, Allen abstained
from voting. Three months later, just before the bonds were issued, Allen made
a formal “declaration of interest,” stating that, due to his employment, he
might indirectly benefit from the deal.
Records show Allen’s firm made about $150,000 in service fees on the Holt
CABs. In an interview with the Free Press, Allen insisted there always was a
“Chinese wall” between him and the transaction.
“Personally,” he added, “I get nothing off these deals. I get a salary.”
At the Department of Treasury, analyst Anton Presecan — a former Allen
colleague — gave the Holt issue careful scrutiny, aware of its
In memos, Presecan said the CABs, intended to refinance about $5 million
in debt for buildings opened in 1967, would cost Holt taxpayers an extra
$14.3 million and extend debt service payments from 1997 out to 2016.
“The staff has serious reservations concerning the propriety of stretching
out of debt incurred by past or current taxpayers to a future generation of
taxpayers,” Presecan wrote. “Buildings financed with a 1967 bond issue will be
almost 50 years old before these refunding bonds are paid off, assuming the
buildings still have utility.”
Presecan suggested Holt set up an account known as a sinking fund, where
anticipated increases in state aid could be banked with interest, then used to
repay the bonds early, saving millions of dollars.
Treasury approved the Holt bond issue, with the provision that Holt set up
such a fund. Bowman said it would be “a way to ensure that today’s taxpayer’s
pay for today’s benefits.”
But Holt schools never did it.
“I’ve never heard of this,” VanErmen said when shown a copy of the order.
“That’s a shocker,” said Allen.
One of Holt’s bond attorneys, Thomas Nordberg of Thrun, Maatsch and
Nordberg, said the order was so vaguely worded that it was meaningless.
A similar order was issued a few months later when the Upper Peninsula’s
Munising School District issued CABs.
Munising Superintendent Steve Cromell said this month that he knew nothing
Bowman, now chief financial officer for IT&T in New York, said the state
has “no choice but to go back and enforce” such orders, “maybe not
retroactively, but progressively.” Treasury officials said they were unsure
how that could could be done.
Louis Schimmel, director of the Municipal Advisory Council and a CAB
critic, said other states require sinking funds and Michigan should, too. He
also said no further CABs should be permitted.
“You can’t make it retroactive and make all those bonds go in default –
that would be insane,” Schimmel said. “But I am proposing that we stop it
Big business for bonds
In the early and mid-1980s, the bond debt of public schools in Michigan
was steady or declining. In 1985, school districts sold 11 issues worth a
total of $154 million.
Last year, (1992) Michigan schools sold more than $1.3 billion worth of bonds,
including CABs, in 205 deals. The bond activity has increased in part because
of lower interest rates, and in part because CABs make bonds easier to sell to
voters, with the “no new taxes” pledge.
Government bonds are a powerful motor driving the national economy,
financing the construction of roads, schools, sewers, town halls, airports and
other public facilities.
Bonds, thus, are a very big business. State and local bond debt has been
estimated at more than $1 trillion — outweighing the $322 billion federal
deficit — by Donald Axelrod, an economics professor at the State University
of New York, Albany, and author of a book on public financing.
But bonds, with an arcane terminology all their own, are little understood
and barely regulated. Underwriters buy them wholesale and sell them at retail
to institutional or individual investors. The risk to investors is low when
bonds are government-backed, and the return can be substantial.
So can the underwriter’s profits. For example, the underwriters on a
$2.4-million CAB deal for the Rockford schools made $496,000, records show.
The Securities and Exchange Commission does not oversee bond markets,
leaving them to nominal self-policing through the National Association of
In Michigan, only the Department of Treasury has any watchdog role on
behalf of taxpayers, but does nothing to monitor bonds beyond reviewing and
approving proposed sales.
Treasury analyst Rairigh said it is not the state’s role to second-guess
local voters who approve the bonds.
“If local taxpayers don’t like it, they can recall the board,” she said.
A Free Press review of Treasury’s CAB files found that some underwriters
persuaded Treasury to approve a bond deal, then issued bonds that were very
For example, in a 1991 Lowell deal, Kemper’s Allen filed a spreadsheet
telling Treasury that $16 million in CABs would be issued, with payments due
beginning in 1997, and interest totaling $57 million. Records show the
actual sale was for $19.2 million, with payments due beginning in 2003.
Adding $3.2 million to the principal and delaying the pay- back by five
years increased interest on the bonds by $25 million.
In her sworn deposition for the Pontiac suit, Treasury’s Rairigh said the
Municipal Finance Division simply accepts underwriters’ spreadsheets without
running its own checks on them.
She said the state lacks the computers and work force to do independent
Rairigh said she has asked her superiors for guidelines on approving CABs
with large interest costs, but to date there are no criteria for accepting or
rejecting proposals for bond refunds which cost taxpayers more than the
Ralph Clark Chandler, a professor of politics and law at Western Michigan
University, had no idea he would spawn a $2 billion balloon in 1986 when he
suggested Jerry Bartnik take a look at bonds.
Bartnik, legislator at the time, was taking a graduate course from
Chandler and the two discussed what Bartnik might be able to do to help
schools raise money.
“We tend to look at bonds as instrumentalities of governments, and what
can be bad about bonds? There is a lot of naivete about that. . . . Your
average bear in this state would have no idea we’re talking about such a big
business,” Chandler said.
“It appears to me that the idea of CABs could work in an expanding
economy. If you’re in the Southwest, for example. But if you’re in the
Midwest, particularly in Michigan where the economy is at least cyclical and
at most depressed, then that’s not really a very good way to go.”
Bartnik said he’s disappointed to learn his class project has turned sour.
“It’s a tool,” he said, “but it’s not being used prudently.”
And of the school boards, administrators and underwriters who ventured
into CABs, “let’s be honest,” he said. “In 20 or 30 years, there isn’t one
person who’s still going to be there.”
* The financial community has grown alarmed about the debt awaiting the next
generation of Michigan taxpayers. Analysts predict some school districts
saddled with heavy-interest, delayed-payment bonds — known as CABs –
will be hard- pressed to borrow money for future needs.
* In one case, Romulus schools eventually will pay $35.8 million in
interest on a $6.2-million loan.
* Despite state orders, districts are setting aside no money to meet the
TOTAL SCHOOL DEBT
(In billions of dollars)
In the early and mid-1980s, the bond debt of public schools in Michigan was
steady or declining. Debt has risen dramatically since 1988, when districts
began financing projects with high- interest capital appreciation bonds.
SOURCE: Municipal Advisory Council of Michigan