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November 16, 1979

CaliforniaBonds- After Prop. 1 3
California's voters went to the polls last week
and gave Proposition 4-the spendinglimitation initiative-an
even more resounding victory than they gave Proposition 13
a year ago. But these draconian citizens'
initiatives sometimes have unexpected side
effects. As an example, Proposition 13 has
had some strange financial consequencesaside of course from such highly visible
effects as a $7-billion reduction in property
taxes and a $4 V2-billion transfer offunds from
the state to local governments in its first year
of operation.
Proposition 13 has raised the cost of many
kinds of municipal debt. Even more important, it has eliminated the option of newlyapproved general-obi igation bonds of local
governments, school districts, and other
special districts. Restoration of such capitalfinancing capabilities would require another
constitutional amendment, essentially
amending Proposition 13. Meanwhile, any
local governments and special districts wishing to use debt financing are being forced
to shift to higher-cost bonds. The amendment
particularly affected tax allocation debt
issued by redevelopment agencies, requiring
subsequent legislative attempts to protect this
outstanding debt from default.
Under Proposition 13, 1978-79 taxes on all
property have been rolled back to -, percent
of 1975-76 market value. Tax rates subsequently are held at the 1-percent ceiling,
while assessed values may rise no more than
the annual percentage increase in the consumer price index or 2 percent per year,
whichever is less. (However, properties sold,
traded, or newly constructed after 1975-76
may be reassessed at current market values.)
The amendment also attempts to prevent
other taxes from rising to offset the lost
property-tax revenues. It requires that statetax increases be passed by a two-thirds vote
of all members ofthe legislature, and requires

that local (non-property) tax increases gain
the approval of two-thirds of aliI/qualified
electors" in the affected municipality.
Proposition 13 specifically exempts tax
increases needed to service prior voterapproved
debt.Thus, payments on debt
approved voters
by
prior to the effective date
of Proposition 13 (JuIy 1, 1978) are not subject to the specific tax constraints placed
on property. But payments on all new debt
approved after that date, and on all prior debt
not voter-approved, are constrained by the
tax-limitation provisions of the amendment.
Types of debt
To understand the amendment's consequences, we should consider some of the
structural aspects of the debt market. State
and local government debt is issued not only
by states, cities, and counties, but also
by special districts (such as school, utility,
or special-assessment districts) and redevelopment agencies.
The default risk of municipal bonds depends
on their security-that
is, the legal and
economic constraints affecting the cash flow
available for debt service and retirement.
At one extreme, a general-obligation bond
is secured by the overall cash flow of the
issuing entity. By law such bonds must
be secured by unlimited taxing authority, and
their security depends on the agency's power
to tax, as well as its fiscal solvency and the
strength of its tax base. At the other extreme,
a pure revenue bond is secured solely by the
revenue generated by the financial project.
Hence its security comes from the anticipated
cash flow ofthe project, notthatofthe issuing
entity.
But other kinds of debt also must
be considered. Often a municipality creates
an artificial distinction between revenues

II
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if

11

Opinions expressed in this nevvsletter do not
necessarilv reflect the vievvs of the rnanagement
of the Federal Reserve Bank of San Francisco,
nor of the Board of Covernors of the Federa!
Reserve
the general-obligation rate. Thus, Proposition
13 has meant an increased cost of state debt,
although the future trend could go in either
direction depending on the state's overall
fiscal management.

of a project and general revenues, thereby
creating a "hybrid" revenue bond payable
out of a specific revenue but backed secondarily by the issuing entity's general cash
flow. An extreme example of this concept
is a lease-revenue bond of a "leaseback"
corporation that issues its own debt, builds
a facility (such as a stadium), leases the facility to the municipality, and then uses the
lease proceeds to payoff the bonds. Again,
there are tax-allocation bonds issued
by redevelopment agencies, which are
secured by the incremental property-tax
revenues resulting from increased land
values in redevelopment projects. Because
of the restrictions surrounding these and
similar types of bonds, they normally pay
yields in excess of those on generalobligation securities.

local debt costs
Proposition 13 has exerted an even stronger
impacton local debt financing. Traditionally,
the power of local governments to tax has
been interpreted as the power to increase
property-tax levies, their
sour,ce
of income. For that reason, Proposition 13 s
tax-rate ceiling has been considered
tantamount to removal of local government's
legal authorization to issue "new" generalobligation debt-debt for which voter
approval was obtained after June 30, 1 978.
With that avenue closed, local governments
and other entities wi" have to finance construction through current revenues, state
assistance, or debt other than generalobi igation bonds. Revenue bonds have
proven to be a viable instrument in those
cases where a facility can generate enough
to pay the debt service, but otherwise, governments have had to rely on other forms
of higher-cost financing such as leaserevenue bonds.

Statedebt costs
Proposition 13 apparently has boosted the
cost of California's debt financing. The
amendment does not fix a strict ceiling
on state tax rates, but it does require a twothirds vote of the entire legislature (not just
those voting) to increase statutory rates. This
. restriction alone shou Id not threaten the
state's debt, although it conceivably could
make it impossible to raise taxes if default
were imminent. Since Proposition 13's
passage, however, the state has channeled
. well over $4 billion per year in "bail-out"
funds to local governments and special districts, and has also passed two temporary
income-tax cuts. It has thus drawn down most
of its budget surplus.

In this situation, the prognosis is for reduced
capital expenditures and increased costs
of debt financing. School districts, already
blocked from issuing new general-obligation
bonds, will be unable to issue pure revenue
bonds because they do not normally
construct self-supporting facilities-nor wi"
they be able to impose additional property
taxes to finance lease-revenue bonds. Thus,
legislation has been
to p.rovide for .
state support of schools new capital
tures. Meanwhile, despite the lack of Issues
of "new" general-obligation debt, local governments have been in no rush to issue large
amounts of revenue or lease-revenue bonds
in its place-and of those bonds issued, the
average rise in risk premiun has been approximately 40 to 45 basis points.

Despite the thinner budget cushion, fiscal
restraint has enabled the state to retain its high
rating-Aaa Moody's and AAA Standard and
Poor's-on general-obligation debt.
However, the cost of state general-obligation
debt has increased by an average of 25 basis
points (.25 percentage points), after
for changes in the general level of mUnlclpalbond rates. Furthermore, compared with
.
1 977 -the last year prior to Proposition 1 3the state has relied more heavily on revenuebond financing tied to specific facilities, with
rates averaging roughly 80 basis points over

Redevelopment agencies have suffered the
most, because of their primary reliance
2

off pre-existing tax-allocation bonds. The bill
may be criticized for stretching the legal use
of special assessments,but it has allowed
redevelopment agencies to reinstitute higher
property-tax rates where needed to avoid
default on outstanding debt.

on property-tax receipts. Anticipating the
problem, agencies rushed to issue this type
of debt before they cou Id be caught by the
passage of Proposition 13. In the eight
months prior to the election, they brought
45 issues of tax-allocation bonds to market,
tota'iling $420 million, but issued no bonds
at all in the eight months following the election. In the pre-election bulge, interest costs
increased more than 250 basis points (to the
legal rate ceiling) and some issues never
received bids. Because of the turmoil created
by Proposition 13, many observers predicted
default for over half of existing tax-allocation
debt -but that fate was averted through the
passage of new state legislation.

Separate legislation has been enacted to deal
with the fact that Proposition 13 left school
districts with no economic means of financing large capital expenditures. In July 1 979,
the Governor signed Assembly Bill 8 (the
Emergency School Classroom Law) to provide special state funds for portable
classrooms and, over a longer period,
to reallocate certain taxes toward
district capital projects. The bill also allows
a school district to impose a "development
lien" (special assessment)on all property
within the territory directly benefitted by the
school. Because such a lien requires consent
of property owners, it probably wi II be practicable only where an area is being newly
developed, in which case liens would
be attached to homes prior to sale.
On balance, most capital expenditures for
schools will probably have to be state-funded
in future years.

New directions
The authors of Proposition 13 may have had
debt limitation as well as tax limitation
in mind. Butthere are less disruptive ways
of limiting debt than restricting the sources
of funds needed for its repayment. By taking
the latter route, Proposition 13 has effectively
eliminated local general-obligation debt
entirely and has constrained other debt
financing only indirectly, and in the process
has made it more risky and costly. Furthermore, the amendment has impaired the
security and hence the market value of outstanding (pre-Proposition 13) debt that was
issued without voter approval.

These legislative developments have
corrected some of the most pressing capitalmarket problems resulting from Proposition
13, but clearly they have not solved the basic
long-term problem of funding capital projects
in a low-cost and efficient manner. In this
connection, it is noteworthy that the newlypassed Proposition 4 (the Gann Amendment)
has been carefully designed to avoid the
capital-market problems of its predecessor.
However, it does not solve the problems
created by Proposition 13. Another state
constitutional amendment will be required
to enable local governments, school districts,
and other special districts to issue new
general-obligation debt. Until thattime, local
capital spending probably will be limited
to whatever qm be financed through the state
(thereby causing a further loss of local
autonomy), through pure revenue bonds
where feasible, or through more costly forms
of debt financing.
J kB b

California's legislators have acted since the
passage of Proposition 13 to deal with this
problem -and indeed, to restructure the
entire financial environment of California
government. The two annual "bail-out" bills
represent the most important of such efforts.
These bills have not only transferred funds
from the state to local governments, but also
have redistributed tax revenues among local
governments and special districts.
Meanwhile, new legislation has begun to
clarify the situation resulting from Proposition
13' s dramatic threat to the tax-allocation debt
of redevelopment agencies. In April 1 979,
the governor signed Senate Bill 55, which
enables redevelopment agencies to levy
"special assessments" within their project
boundades up to the amount needed to pay

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CD)

BANKINGDATA-TWELfTH FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)

Selected
Assets Liabilities
and
largeCommercial
Banks
Loans (gross, adjusted) and investments*
Loans (gross, adjusted)
total #
Commercial and industrial
Real estate
Loans to individuals
Securities loans
U.S. Treasury securities*
Other securities*
Demand deposits - total#
Demand deposits
adjusted
Savings deposits - total
Time deposits - total#
Individuals, part. & corp.
(Large negotiable CD's)

WeeklyAverages
of Daily Figures
MemberDankReserve
Position
Excess Reserves(+ )/Deficiency (- )

Amount
Outstanding

10/31/79

10/24/79

135,109
112,063
31,390
41,719
23,846
1,705
7,396
15,650
45,179
31,222
29,264
56,638
48,333
20,737

+
+
+
+
+

Change from
year ago @
Dollar
Percent

Change
from

-

+
+
+
-

+
+

+ 17,739
+ 16,929
+ 3,455
+ 8,677

660
776
394
194
268
45
171
55
2,158
188
573
800
820
185

-

+
+
+
-

+
+
+

Weekended

10/31/79

10/24/79

+ 114

15.11
17.79
12.37
26.26

NA
NA

Weekended

NA
NA

759
1,569
2,249
574
1,211
8,432
9,544
1,781

9.30

+ 11.14
+ 5.24

+

1.87
3.97
+ 17.49
+ 24.60
+ 9.40

-

Comparable
year-ago period

1
179
180

125
11

-

138

+ 669

+ 185

21

Borrowings
Net free reserves (+ )/Net borrowed( - )

+
+
+
+

44
45

Federal
Funds Seven
Large
Banks
Net interbank transactions
[Purchases (+ )/Sales (-)]
Net, U.s. Securities dealer transactions
[Loans (+ )/Borrowings (-)]

* Excludes trading

-

-

218
608

account securities.

# Includes items not shown separately.
@ Historical
dataarenot strictlycomparable to changes thereporting
due
in
panel;however,
adjustments

havebeenapplied 1978datato remove muchaspossible effects thechanges coverage.
to
as
the
of
in
In
addition,for some
items,
historical
dataarenotavailable to definitional
due
changes.
Editorial
comments be addressed theeditor(WilliamDurke) to theauthor ... Free
may
to
or
copies
of
thisandotherFederal
Reserve
publications be obtained cMling writingthePublicInformation
can
by
or
Section,Federal
Reserve
Bankof SanFrancisco,
P.O.Box 7702,SanFrancisco
94120,Phone
(415)
544-2184.