When a loan is not a loan and is a lease. Municipal leasing for banks.
A municipality is a public administrative division (counties, school districts, cities, etc) that is incorporated, has powers of self-government, and the ability to tax. We live in difficult times for municipalities in the United States, as I write this article several small cities in California have declared chapter 9 bankruptcy, and there is concern that many more are in the brink of filing due to mounting liabilities, and decreased tax revenue. This is further complicated by the fact that the citizenry is openly hostile to any type of tax increase or additional debt.
The traditional method of financing essential equipment for municipal entities has been the issuance of bonds. However, bond financing usually requires the approval of the voters, and the increase of taxes for the payment of the bond associated debt service. On top of that a lot of municipalities have strict debt limitations imposed by the State that prohibits excessive borrowing.
A way to finance the acquisition of essential equipment for municipalities is to lease it. My employer has become a lot more active in this market, and I have had the opportunity to be part of several deals. The municipal leasing market is a mature one with many participants as it has benefits for both the financial institution and the municipalities.
Why would a municipality lease instead of buy?
- As mentioned earlier, there are a lot less hoops to jump through. The voters do not have to approve it, and the leases are not considered debt for statutory debt limitation purposes.
- There are no significant costs associated with a lease. There are no investment bankers involved, and the documentation required is much less than on a bond issuance.
- Immediate funding. A good underwriter can prepare an analysis in a few working days, and approval can be obtained as soon as the underwriting is performed.
- The acquisition of a lot of different items can be structured as a lease. I have personally worked on leases for ambulances, special transportation vehicles, computer software and hardware, communication equipment for police departments, and energy efficiency equipment used to retrofit old schools.
Why would a financial company want to lease to municipalities?
- Well it comes down to opening a new market. Municipalities that lease are usually doing so because they are prohibited from borrowing. If your financial institution wants to access that market, they need to provide a product to meet their needs.
- Leases are usually a tax exempt asset for the financial institution. The rate charged on the lease is usually smaller than the loan portfolio, but after accounting for the lack of taxes, the yield becomes competitive.
- In spite of the recent well publicized bankruptcies, most municipalities are good credit risks. In addition, most are required to provide audited financial statements, which means that good quality financials are readily available.
About Non-appropriation and Essentiality.
While it is a little confusing to reconcile the fact that a municipality can enter into a long-term liability without it being considered debt, the fact is that these types of leases are not really long-term, and are actually yearly commitments whose repayment is subject to being approved by the governing body of the municipality on a yearly basis as part of their budget. The process of setting aside the tax revenue to pay the lease payments every year is called appropriation, and every one of these leases allows the municipality to walk away by non-appropriating funds.
The non-appropriation risk is a real source of concern for the financial institution on the other end of the lease. Remember that in a lease ownership of the equipment remains with the financial institution, and it does not want to get stuck with used equipment. The way that the financial institution mitigates this risk is by assessing the following:
a) The financial condition of the municipality. If the municipality is not under stress there will be no pressure to walk away. Although it will be legally possible to break the lease, there would be repercussions as the future cost of financing would increase as a result.
b) How essential is the use of this equipment for the operations of the municipality. This is called the “essentiality” factor. Since the municipality would need to hand back the equipment, the higher the essentiality of that equipment, the more difficult for the municipality to break the lease.
As noted above, the municipality financial condition and performance needs to be analyzed just like a regular loan. However, understanding government accounting might be difficult if your experience is mostly with for profit businesses. For more information on this type of accounting, I found this book to be a good source of information Governmental Accounting Made Easy