by Nick Khouri, Vice President
|Michigan’s School Bond Loan Fund (SBLF) needs repair. It is the state’s only program to assist local schools with the financing of capital expenditures, yet it is unknown to most policy makers and the general public. Moreover, this subsidy has exploded in recent years, increasing the cost to the state budget and creating a potential long-term financial liability for state taxpayers. The program also has problems at the local school level. Some schools have abused the system, turning a loan program into an outright grant. Other K–12 districts, in need of major infrastructure investments, have been excluded from or allowed only limited access to the program.
This Advisor explains the SBLF, describes its current problems, and offers a partial list of solutions.
The overall purpose of the Michigan School Bond Loan Fund is to make it financially possible for every school district in Michigan to build needed schools when they are needed, while providing relief to taxpayers.
—Louis Schimmel, 1967
Debt factors of [Michigan] are favorable, with all ratios below the medians; however, contingent debt issued through the School Bond Loan Fund program has grown rapidly and is outstanding in amounts that exceed direct state debt.
—Moody’s Investor’s Service, 1997
From the Depression to the mid-1950s, Michigan schools financed the construction and repair of buildings by issuing “limited tax” bonds. The property tax millage rate levied to pay principal and interest on these bonds was subject to a 15-mill limitation. Added to the state constitution in 1932, this 15-mill cap applied to property taxes levied for all government purposes and could only be increased, for no more than five years, by a two-thirds vote of the electors.1 In 1948 an amendment permitted an increase for up to 20 years and reduced the voting requirement to a simple majority.
By the mid-1950s, many school administrators and public finance professionals were complaining that issuing debt supported by a capped millage rate severely limited their ability to finance new construction, just as the first baby boomers were reaching school age. After much debate, in 1955 Michigan voters approved a constitutional amendment that greatly expanded the ability of schools to issue debt.
- School debt would be exempt from all millage limitations, as long as the last bond matured at least 25 years from the date of issuance.
- The SBLF was established, with principal and interest payments for local school bonds to be guaranteed by the state, up to a statewide maximum of $100 million.
- Any school district could borrow from the state for annual debt service requirements (principal and interest) as long as it levied 13 mills for debt.
The 1955 amendment created two types of school bonds—”limited tax” debt, subject to existing millage restrictions, and “general obligation/unlimited tax” bonds. The latter enabled school boards to levy each year whatever millage was necessary in order to pay all principal and interest when due. The amendment contained an expiration date of July 1, 1962.
In 1960 Michigan voters extended and expanded the SBLF. The 1960 constitutional amendment (1) removed the $100 million limitation, (2) allowed the state to issue unlimited debt to fund the SBLF, and (3) gave the legislature the flexibility to set the maximum local school millage rate below 13 mills (by 1964 the legislature had reduced the minimum to 7 mills).
These provisions were incorporated into the 1964 constitution and have remained intact for the last 30 years.
The SBLF is established in the constitution (Article IX, Section 16) and implemented by state law (M.C.L. 388.921 to 388.984). All K–12 school districts have the option of applying to the state to have their upcoming debt “qualified.” This has two advantages to schools.
- If at any time and for any reason, a school does not make principal and interest payments on the bonds, the state is required to lend it the amount of the shortfall. In effect, the state guarantees the qualified debt of a local school district. The practical implication is that a district can borrow under the state’s credit rating.
- If a school district levies the required maximum mills for debt service, it has the option of borrowing the additional amount needed for annual debt service directly from the state. For example, if a school owes $500,000 this year in principal and interest on qualified debt, and 7 mills generate only $300,000, then the school is automatically eligible to receive a $200,000 state loan. This interest-bearing loan must be fully repaid after the bonds have matured.
Article IX, Section 16, contains both the state guarantee and the borrowing provisions of the SBLF.
- To receive qualification, the bonds must be “general obligation bonds of school districts issued for capital expenditures, including refunding bonds.” All general obligation/unlimited tax bonds must be approved by local voters before issuance.2
- “The legislature shall have the power to prescribe and to limit the procedure, terms, and conditions for the qualification of bonds, for obtaining and making state loans, and for the repayment of loans.” This flexibility is important to the discussion of changes in the SBLF.
- In any year that principal and interest payments exceed the revenue generated from 13 mills, or a lower millage set by the legislature, the school district may borrow all or part of the excess from the state. It must continue to levy a millage for debt until the state loan is repaid, even after the bonds have been retired.
- The state may pledge its full faith and credit to issue notes or bonds to make loans to school districts. There is no limit on the amount of debt the state can issue to fund the SBLF.
- If a school district fails to make timely payments on its debt, then it must borrow the shortage from the state, which must lend a sufficient amount to avoid default.
State law (P.A. 108 of 1961) implements the SBLF and details the requirements for qualification.
- The final maturity of a school district’s bonds must be greater than 15 years (except for energy bonds and a few high-debt schools).
- The cost of construction projects must be within “reasonable standards.”
- The school district must demonstrate that a need, based on projected student enrollment, exists for the project.
- The proposed construction must be designed to provide additional school facilities adequate to meet the projected enrollment.
State law also establishes the minimum number of mills that must be levied by a school to enable it to borrow from the SBLF for debt service. Since 1991 the maximum has been set by formula but always is 7 to 13 mills. The school must levy sufficient millage to repay the SBLF within five years of the final maturity of the qualified bonds.
By statute, interest must be paid on the loans made by the state to a school. The interest rate is identical to the rate paid by the state on debt issued to fund the program.
Finally, in the event a school district does not make timely debt payments and the state must intervene, no money shall be appropriated to that school from the School Aid Fund until the state is fully repaid.
How the SBLF Works
More than 80 percent of the outstanding debt issued by Michigan school districts is “qualified,” or guaranteed by the state. Only about 20 percent of districts actually borrow from the state for debt service.
Prior to ballot preparation for a local election, a school district applies to the Michigan Department of Treasury for preliminary qualification.3 The department staff works with the school to review each construction project to assure that the statutory guidelines are met. The application must include detailed information on specific projects, costs, student enrollment, and debt service. If preliminary qualification is granted, the district can place the issue before the electorate. If the voters approve, the district may apply to the state for final qualification. Once this is granted, the bonds can be sold to investors.
For most districts, that is the end of the SBLF process. Qualification is seen by the market as a state guarantee; in the absence of a default, a district does not need to notify the state until the next proposed bond issue.
In the 40 years of the SBLF, there has been only one case of potential default. In the early years of the program, a legal challenge to a school district’s ability to levy property taxes forced the state to step in and make a debt service payment. As soon as the legal challenge was resolved, however, the state was repaid.
School districts wishing to use the second feature of the SBLF—a loan for debt service once the minimum millage has been levied—must file with Treasury in August each year.
The typical borrowing pattern is depicted in Exhibit 1. Suppose a school district wishes to issue debt to fund new construction or major renovation: Without the SBLF, it would need to levy 12 mills in the first year, declining each year to zero mills in year 30, when the bonds mature. The millage necessary to service the debt declines each year as property values, and therefore the tax base, increases. If the district opts to borrow from the SBLF, it needs levy only 7 mills, but the millage is in effect for more years, in this example 35. Current taxpayers see lower taxes but at the expense of future taxpayers.
This back-loading of debt through the SBLF is similar to issuing Capital Appreciation Bonds (which the legislature outlawed for schools in 1994). In either case, more of the total cost of a new construction program is pushed into future years and interest payments are increased.
Exhibit 2 shows the recent surge in qualified school debt. Outstanding debt guaranteed by the state was flat from the mid-1970s to the late 1980s, but beginning in 1990 there was an explosion. From 1990 to 1996, the state-guaranteed debt of local school districts rose by 150 percent, from $2.5 billion to $6.3 billion. In 1996 alone, the increase was 25 percent. Based on information to date, a similar increase can be expected for 1997.
Exhibit 3 lists the number of bond propositions that were on the ballot each year from 1985 to 1996, as well as the percentage of elections in which the proposals passed. The number of propositions averaged 57 annually through 1990, rose to 87 in 1991, and mushroomed in 1995 and 1996 to 182 and 164, respectively. Despite many more elections, the success rate has stayed fairly constant at 50 percent.
Exhibits 4, 5, and 6 reveal greater use of the borrowing provisions of the SBLF and the increased financial burden for the state. Exhibit 4 shows the number of school districts with loans from the state. In 1996 the number of schools that had outstanding state loans rose from 46 to 66, a 50 percent increase. By the end of 1997, at least 110 districts will owe the SBLF. Meanwhile, the outstanding loan balance has increased from $57 million in 1994 to approximately $200 million by the end of 1997.
Exhibit 5 shows state-issued debt to fund SBLF loans. Initially, short-term notes were used, but in 1971, $57.5 million in long-term bonds was issued to pay off the existing notes and make new loans. Over the next two decades, long-term debt totaled $139 million, a figure exceeded in 1995 alone by the issuance of $180 million, and another $150 million will be issued in 1998.
This increase in state debt has led directly to a rise in General Fund/General Purpose debt service costs (see Exhibit 6). In FY 1994–95, the state was not required to pay SBLF debt service, but debt service will rise to an estimated $30.4 million in FY 1997–98 and remain at least that high until the bonds mature in 20 years.
From the state’s perspective, in terms of both direct budget costs and potential financial liability, the SBLF burden is growing at an unsustainable rate. Local school district borrowing from the SBLF is forecast to jump 500 percent—from $118 million in 1996 to $733 million—by 2009. Exhibit 7 graphs the projected SBLF balance over the next 35 years. Assuming no new debt, SBLF loans will average $50 million annually for the next six years. The outstanding balance peaks in 2009 and then declines, but that scenario requires the very conservative assumption of no new qualified school debt. What already is in the system will become a significant fiscal burden for state taxpayers.
Since the assumption of no new school debt is unrealistic, actual borrowing probably will be substantially higher than depicted in Exhibit 7. Furthermore, that graph does not include projections for the City of Detroit school district. Two years ago, Detroit schools received voter approval to issue $1.5 billion in debt over the next 10–15 years. Exhibit 8 shows an estimate of these borrowings if they eventually qualify. As much as $800 million may be needed from the state over the next 30 years. Given a conservative set of property tax assumptions and the current spending plan of the district, the state may have to finance loans averaging about $20 million a year for more than a decade.
What explains the dramatic increase in school debt and the corresponding costs of the SBLF? There are at least five reasons.
- Demographics Exhibit 9 shows the changes in Michigan’s school-age population since 1979. After many years of decline, student enrollment turned upward in 1990. From 1983 to 1990, the number of K–12 students fell by 114,000. Since then, the student population has risen by 105,404. With more pupils comes the need for additional classroom space.
- School finance reform Proposal A in 1993 lowered the average homeowner’s millage rate for school operating purposes from 35 mills to 6. This sharp drop was seen by many school administrators as an opportunity to ask voters to replace part of the reduction with an increase in debt mills. As noted earlier, the number of elections with school bond ballot propositions rose from 59 in 1993 to 182 in 1995.
- Changing curriculum needs Schools are adapting to new technology. The demand for machine shop has been replaced by demand for hands-on computer training. In an effort to keep up, many schools have issued bonds to purchase computers and information technology.
- The 1991 refunding The state faced a large budget deficit in 1991, and part of the solution was to “refund” SBLF loans. The net effect was to increase revenues by $121.9 million in FY 1991–92 and increase state expenditures by up to $16 million annually for the next 20 years. Exhibit 10 shows the budget projections made at that time.
- Prevailing wage In 1994 a U.S. District Court judge struck down the state’s prevailing wage requirement, which until then applied to all construction projects financed through the SBLF. Some school districts, especially in western Michigan, had not applied to the SBLF in order to avoid paying higher wages to construction workers. After 1994 many of these districts came to the SBLF for the first time. The U.S. Court of Appeals, however, recently reversed the lower court’s ruling.
Local Schools’ Perspective
The SBLF creates two problems at the local level.
First, the structure of the SBLF encourages some districts to issue new debt to avoid ever repaying an existing state loan. Once the SBLF’s minimum required millage rate is levied, in some sense additional debt is “free” for current taxpayers. Schools can issue new debt and pay for the first years of debt service by borrowing from the state. School administrators can sell a new high school or elementary school to the voters without an increase in taxes. The cost, of course, is borne by future taxpayers, who must repay the loan with higher future millage rates and higher total interest expense.
Repeat borrowing from the SBLF is common. In theory, the fund should not have any state budget costs, as the number of school districts borrowing in any year matches the number repaying previous loans. In reality, many districts issue new debt just as their SBLF loan is coming due. Clintondale school district, for example, has borrowed from the SBLF for many years without ever repaying. Eight of the 32 school districts that passed bond proposals in 1996 and will borrow from the SBLF will continue to levy the same millage that they levied before the new debt issue. Fowlerville, for example, levied 7.34 mills for debt before a recent $21.4 million bond issue and will levy the same next year, but it will need to borrow nearly $34 million from the SBLF over the coming 15 years.
Second, the state subsidy is unfocused. Districts with sufficient local property tax wealth to finance their own infrastructure are eligible for SBLF loans, while some of the poorest districts are excluded from the program. Hamtramck is a case in point. Last year, the school board requested preliminary qualification for a construction project of $55 million. Treasury agreed that the district needed the new facilities and put together a plan that met the “reasonable standards” rule. Yet, because of the very low tax base in the community, it was clear that the loan never could be repaid. At 13 mills, barely enough was generated to cover interest on the loan. The state treasurer was forced to turn the district down. During the same period, relatively well-off suburban districts such as Haslett and Howell received qualification.
The SBLF cannot sustain annual growth of 25 percent: It must be changed. The goal of reform should be to reduce the state’s financial burden while targeting aid to the districts in greatest need. Several steps are possible.
Increase flexibility of the state treasurer in approving SBLF qualification. Under current law, the state treasurer cannot take into account the effect of local school borrowing on state finances. In theory, any district that meets the “reasonable standards” of cost estimates and student enrollment growth is eligible. The denial of Hamtramck’s application, while a financially sound decision, probably was a violation of the SBLF statute. The law should be modified to require the state treasurer to assess the effect on the state at the preliminary qualification stage.
- Reduce SBLF abuse at the local level. All school districts should be required to levy additional mills when issuing new debt. It is unfair to future taxpayers to allow a district to borrow for 100 percent of the new debt service costs from the SBLF. Districts should be required to repay a prior SBLF loan before borrowing from the fund again.
- Restrict projects that qualify under the SBLF. The SBLF should be limited to basic classroom construction and equipment. Such facilities as swimming pools, athletic fields, stadiums, gymnasiums, and auditoriums should be excluded from the program.
- Target districts most in need. A single formula to set millage rates for all districts should be replaced with a direct subsidy for low-wealth/high-need districts. The SBLF could be restructured to lower the borrowing costs for poor schools while adding a surcharge for wealthy districts.
These first steps toward reform do not address the larger issue of how to help local schools meet their long-term infrastructure needs. The SBLF, no matter how it is structured, will not fulfill this broader policy goal. Other ideas, such as a direct state grant or a low-cost revolving loan program, may be necessary to augment the SBLF. Some analysts, in contrast, argue that construction and maintance of K–12 schools should remain a local taxpayer responsibility. In the meantime, the recommendations offered here will go a long way toward bringing an unchecked SBLF program under control.