California agency's guide for land-backed debt may be too strict, lawyer says.

LOS ANGELES -- Local governments in California could have difficulty issuing some land-secured bonds if they follow new appraisal standards developed by the California Debt Advisory Commission, a public finance lawyer asserted this week.

New guidelines by the state agency recommend that issuers require a minimum value-to-lien ratio of 4-to-1 on Mello-Roos bond financings, according to an interpretation by Daniel C. Bort, a lawyer with Orrick, Herrington & Sutcliffe.

Bort said those guidelines are much stricter than the accepted industry practice of using a 3-to-1 ratio.

While a discussion of appraisal standards for land-secured financings might appear to be somewhat esoteric, the topic is growing more important. More and more dirt-backed bond deals are hitting the market in California as the state slowly emerges from a recession, market participants said.

During the first nine months of this year, 45 Mello-Roos issues totaling $611.9 million have been sold, compared with 29 issues totaling $236.6 million for all of 1993.

Moreover, since Jan. 1, a new law has required that issuers of Mello-Roos bonds establish a 3-to-1 value-to-lien requirement for the bonds. Issuers can adopt the commission's "Appraisal Standards for Land-Secured Financings" to fulfill their obligation under the law.

The value-to-lien ratio, also known as the value-to-debt ratio, refers to the relationship between the value of land and improvements in a Mello-Roos community facilities district relative to the amount of public debt secured by liens on property in the district.

The value-to-lien ratio essentially measures the collateral of the bondholders in a land-secured financing. For example, if the value of property within a community facilities district is $6 million, a $2 million Mello-Roos bond can be secured by that property, and the value-to-lien ratio is 3-to-1. But, if issuers adopt the commission standards, Bort believes that means they must establish a much-tougher 4-to-1 value-to-lien requirement. On a property valued at $6 million, only $1.5 million in Mello-Roos bonds could be issued, to create the 4-to-1 ratio.

A 4-to-1 standard is "clearly the local agency's right" to require, but in practical terms it would disqualify many projects, Bort said.

Stephen Shea, director of research for the debt advisory commission and the author of the publication containing the appraisal standards, said it is "not true" that the 4-to-1 ratio is a requirement for issuers to follow.

If an issuer is trying to sell bonds for a marginal deal, "and they can't get these appraisal standards to pencil out, they do have the option of adopting different appraisal standards," Shea said.

But Shea acknowledged that the commission is hoping to promote more stringent appraisals that might eliminate some marginal development projects, and added that local agencies that follow the commission appraisal standards "lose their likelihood of getting into trouble down the line."

In an interview Wednesday, Bort agreed with Shea that the commission's appraisal standards "aren't compulsory" for issuers to use when they created community facilities districts -- they can adopt their own standards.

The commission's standards "are simply advisory -- you can use them or not," Bort said. But the commission is "influential," he added. "I am advising my clients to adopt the [commission] standards, but amend them in certain respects."

The 3-to-1 value-to-lien requirement has served as an informal issuance standard in California for many years, but state lawmakers elevated this requirement to state law to address investor concerns arising from the collapse in real estate values in many community facilities districts during the early 1990s.

The new law amended the MelloRoos Community Facilities Act of 1982, which authorizes cities, counties, school districts, special districts, and joint powers authorities to form community facilities districts for the purpose of financing infrastructure. The districts are authorized to issue bonds secured by special taxes.

Mello-Roos bonds played a large role in financing public infrastructure in new development projects during the real estate boom of the 1980s. But the creditworthiness of some Mello-Roos bonds has been called into question, and the 3-to-1 value-to-lien ratio required by the new law is designed to address some of those problems.

Shea and Bort had an hour-long phone conversation last week in which Bort recommended guideline modifications to the commission appraisal guidelines publication. Shea, author of the guidelines, turned down the suggestion. Their conversation was a follow-up to an eight-page letter Bort sent the commission last August shortly after the commission's appraisal standards were published.

"What [Shea] has done in the interest of conservatism is he has in the guidelines transformed essentially a 3to-1 ratio into a 4-to-1 ratio, all on his on," Bort said. "When I say that is not the historical standard, he says, 'Well, it is not clear to me that there was a historical standard.'"

In his letter to the commission, Bort said its appraisal recommendations "will have changed the 3-to-1 standard to a 4-to-1 standard without local agencies perhaps even realizing that they have done so, and the ratios for the various bond issues will be even less consistent than they are today -- clearly not your purpose."

In an interview, Bort said the commission's appraisal standards "as a whole are actually very, very good -- the document is really excellent. But, in this one area ... I don't know if [Shea] just feels he knows better than all those guys out there making money off this stuff and he represents the public interest ..."

In response, Shea said he makes no apology for what Bort sees as conservative appraisal standards.

"We recommend a more conservative standard because we think that's appropriate, and he wants a more liberal standard," Shea said. "The more conservative approach is going to conflict with the financial interests of people who make money off of doing the deals ."

"Mello-Roos bonds are unrated debt," Shea said. "These are not investment-grade securities .... The value-to-lien ratio is really the only analytical tool on which these bonds are traded off of. It is almost like a proxy for the credit rating."

Moreover, becau. tse many mutual funds have prohibitions against buying noninvestment-grade securities, "it is a very speculative market -- out on the cusp of the tax-exempt market," Shea said.

"As an advisory commission, we have an interest in trying to help maintain the integrity of the municipal marketplace" in California, Shea said.

"Even a few defaults can have major repercussions for the industry and threaten the availability of Mello-Roos bonds as a financing tool," Shea said.

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