Taxpayers Face Specter of Mello-Roos Defaults : Bonds: Financing tool is a boon to developers while placing an unfair burden on home buyers, critics say.

They’ve formed a financial backbone for California’s suburban sprawl--helping for nearly a decade to buy new streets, schools, fire stations and libraries in dozens of emerging communities.

Called Mello-Roos revenue bonds, they’ve been a $3.4-billion boon for local governments and developers, whose ability to pay for expansion was otherwise constrained by California’s anti-tax revolt.

Especially in growing Orange, Riverside and San Bernardino counties, the bonds have been a staple of development: Thousands of buyers have moved into new homes in Mello-Roos districts--their roads, curbs and other amenities built with bond money that the residents must repay through sharply higher property taxes.

Named after two state lawmakers, Mello-Roos financing was designed to promote growth without violating Proposition 13--the 1978 ballot initiative that cut property taxes and restrained governments from imposing new ones. Local officials typically sell the tax-exempt bonds to large blocs of investors.

But questionable handling of some of the bonds and California’s weakening economy may be combining to quiet the Mello-Roos party--leaving a hangover of taxpayer risk.

Financial consultants have told The Times that up to 10 of California’s 226 Mello-Roos districts could default within the next two years--failures that may hurt all taxpayers and send bond buyers stampeding to less-risky investments.

Officials say taxpayer bailouts of troubled Mello-Roos bond districts may soon be under way to prevent defaults in at least eight additional California communities. In San Diego County, the city of Oceanside is already picking up the slack for a $7-million Mello-Roos district that otherwise would be in default.

“The city is doing what it can to keep the thing solvent,” said city property agent Dick Nagler, adding that Oceanside’s general fund is contributing $230,000 a year to help pay off the bonds.

And in Whittier and in the swelling Riverside County community of Temecula, officials are fighting to recover $27 million worth of Mello-Roos bonds. The monies are now frozen because the officials placed them in “guaranteed investment” contracts offered by the now-bankrupt Executive Life insurance firm.

In Orange County, where $746 million of the bonds have been issued, serious tax delinquencies have occurred in at least three of the 45 Mello-Roos districts, according to records obtained by The Times.

Most alarming to experts is that Mello-Roos bonds are secured by California real estate that suddenly is shrinking in value. The bonds regarded at highest risk are for developments in areas where homes are either not yet built or are sitting empty--with no homeowners to start paying the special taxes.

“I think this next year is going to have the first defaults,” said Harry Clark, who manages Muni Financial Services, a financial consulting firm with 85 public-agency clients statewide. Clark said he expects that as many as 10 Mello-Roos districts will fail over the next two years.

Added Dean J. Misczynski, a senior consultant to the state Senate’s research office who helped draft the original Mello-Roos law: “If the recession continues, then there almost has to be some defaults.”

Clark, Misczynski and others warn that Mello-Roos defaults--in addition to costing taxpayers--would downshift what has been an engine for California’s growth.

“If a bunch go into default, then we’ve got a real problem, because Wall Street won’t buy any of these” bonds, said David O. Taussig, an Irvine consultant who has drafted tax formulas for more than 150 Mello-Roos districts throughout the state.

From Wall Street to Riverside County’s Interstate 215, where billboards for new homes lure buyers with the promise of “No Mello Roos,” the situation is causing worry:

* For the bond investors whose investments are at risk.

* For the Mello-Roos homeowners faced with paying even higher property taxes if adjoining homeowners or landholders go under and don’t pay their taxes.

* For the government agencies trying to prevent defaults--defaults that could ruin credit ratings and cause bailouts that would indirectly cost all taxpayers, regardless of whether they live within a Mello-Roos district.

Clearly, the downside of Mello-Roos bond financing is emerging. It reveals an imperfect financing tool that, while helping to place people in new homes, has imposed what critics view as unfair taxation.

In this three-day series, a Times examination of Mello-Roos financing will show that:

* Local government officials have often allowed developers to devise taxation formulas that shift their building costs to the tax bills of the people who buy homes in Mello-Roos districts. As a result, developers have gotten free financing, according to a recent report by the California Debt Advisory Commission.

“It seems very hard to justify,” said Stephen Shea, director of policy research for the commission. “These public improvements do benefit undeveloped property, so the owners of the undeveloped property should pay for them.”

* People who bought the Mello-Roos homes will for the next 20 or more years have to pay related taxes that vault their overall property-tax bills beyond those of neighbors who live in nearby communities. Residents in Orange County’s Mello-Roos districts typically pay a few hundred dollars to $2,000 more per year in property taxes than do people occupying similar houses a mile or two away.

* If large landholders fold and walk away from their tax obligations, homeowners in some Mello-Roos districts must pick up some of the slack by paying even higher taxes.

“That’s one of the worst problems of Mello-Roos,” Clark said. “It’s bad public policy. Capital B, bad. It allows (officials and developers) to shift the tax burden.”

* The homeowners paying the Mello-Roos taxes have no say in how those dollars are spent. In Orange County’s Aliso Viejo community, homeowners are paying for a toll road that many residents ardently oppose.

* Mello-Roos taxes do not always relate to services or benefits received. In Temecula, prospective residents of a senior citizens village would be expected to pay off with their taxes a $27.5-million Mello-Roos bond. The public purpose for the bond issue? Construction of two elementary schools and expansion of a high school.

In the San Joaquin Delta town of Tracy, Mello-Roos residents are outraged because others--but not all of their children--are allowed to attend new schools paid for by their higher tax dollars.

* Officials who arrange Mello-Roos districts often rely on salesmen/specialists who stand to enrich themselves from bond-related fees. “Rapacious financial consultants and bond counsels can prey on these small cities that don’t have the sophistication,” said James Hendrickson, a veteran city manager who helped organize a Mello-Roos district in San Clemente.

And, as the fees for the attorneys and other consultants subtract from the bonds, they drive up homeowners’ ultimate tax bills.

* Despite the increased risk of default, officials in Orange and Riverside counties have consummated $29.7 million of Mello-Roos bond deals with two development firms owned by savings and loans that already were in serious financial trouble, public documents show. One deal was approved in November, 1988, by the Orange County Board of Supervisors. The other was issued last January, by the city of Lake Elsinore in Riverside County.

Bert Ely, a nationally recognized banking consultant, questioned the wisdom of the California Legislature for allowing local governments such wide discretion in structuring bond projects.

“When states get into these kinds of things, they set up the potential for lots of abuse and lots of defaults,” said Ely, who often testifies before congressional banking committees. “And that has to have an effect on genuinely sound projects.”

* Local governments often have allowed developers to select and pay for their own property appraisers--a major risk because the Mello-Roos bonds are secured by the value of the land. According to specialists in the field, the danger is that rosy appraisals create collateral with inflated value--spelling trouble if the land must be foreclosed upon and sold to pay off the taxes and the Mello-Roos bond investors.

“Who is the appraiser working for and answerable to?” asked Carl Kadie, president of a San Diego financial consulting firm that represents public-sector clients. “It’s a conflict of interest. . . . I would be scared to death to take a developer’s appraisal to the bond market.”

By spring, 1978, California homeowners were fed up.

They had watched for years as their property taxes soared while their state Legislature failed to act. It had gotten so bad that many people were at risk of losing their homes because they couldn’t pay the taxes.

So voters took matters into their own hands, passing the ballot initiative that remains known as Proposition 13. The measure helped existing homeowners by lowering their property taxes.

But growth-promoting local government officials soon found it far more difficult to get tax money to provide the infrastructure of roads, curbs, gutters, schools, fire stations or sewage plants needed to serve expanding populations.

Enter two state legislators--Sen. Henry J. Mello, Democrat of Watsonville, and then-Assemblyman Mike Roos, Democrat of West Hollywood. Mello and Roos won passage in 1982 of a bill that would revolutionize how residential development is paid for.

The law authorized a form of municipal bond financing--now called Mello-Roos--that gives local governments and developers the authority to sell tax-exempt bonds and to spend the proceeds on a panoply of projects.

From south Orange County to the once-rural outback of Riverside County, Mello-Roos districts have most frequently been formed in areas where no more than a handful of owners control significant acreage.

With the sponsorship of a local government agency, those landowners then band together to support formation of a Mello-Roos bond district. The districts are usually formed this way because if 12 or more residents live in an area, a two-thirds vote of approval is required.

Developers’ affinity for Mello-Roos bonds can be attributed, in a word, to capital. When developers are faced with providing the infrastructure needed for residential tracts, they typically have three ways to pay for those facilities:

* Their own cash.

* Loan financing from a bank or a savings and loan.

* Tax-exempt municipal bond financing, such as a Mello-Roos issuance.

Of the choices, Mello-Roos bond financing is usually the most profitable for the developer and, in this era of S&L; failures and tightened credit, perhaps the most easy to obtain.

“Essentially, whatever the Mello-Roos cost is, (the developer) is saving right out of his own pocket,” said Clark of Muni Financial Services.

And for the developer, the advantages of Mello-Roos don’t stop there. Because the developer often exerts the most influence in shaping the taxation formula for individual Mello-Roos districts, they can shift even more of their costs directly to home buyers.

According to Clark, the Mello-Roos tax formulas can help large landowners in at least two ways:

* By taxing property with homes at a higher rate than adjoining, undeveloped land that may be envisioned for subsequent construction.

* By requiring that one to two years’ worth of interest outlays--to be paid twice annually to bond investors--be extracted from the original proceeds of the bond. Consequently, if the developer finishes his project within those two years, he would avoid paying any Mello-Roos taxes.

In that instance, “the developer never sees a tax bill,” Clark said. Said the California Debt Advisory Commission, in a report published in September: “Local government should recognize that (this) provides a source of subsidy to developers.”

However, Clark noted that Riverside County and other local governments have encouraged those tax formulas, believing that the money set aside through “capitalized interest” makes the bonds safer in the event a tract sits empty for the first year or more. Without the capitalized interest, the developer would have to make the tax payments for those empty homes.

“It’s very costly to the taxpayers,” Clark said. “That little assurance is costing the future homeowners almost 60% of the value of the bond issue (over 20 to 25 years). . . . That’s just horrible public policy.”

And what if large landholders or a high number of homeowners go bust and do not pay their Mello-Roos taxes?

In many districts, homeowners who have upheld their end of the bargain by paying their taxes on time will nevertheless see their taxes as much as doubled, to make up part of the difference. Again, the rules of the game are spelled out in the tax formula.

“Many (Mello-Roos) special-tax formulas allow delinquencies to be added into the revenue requirement for the subsequent year, raising the tax burden for taxpayers who pay their special taxes on time,” says the September report of the Debt Advisory Commission, headed by state Treasurer Kathleen Brown.

According to some consultants, the best way to ensure fairness for the homeowners who pay Mello-Roos taxes is to require extensive disclosure. Because of a 1988 change in law, potential first-time home buyers must now be informed that there will be a special Mello-Roos tax and the maximum level to which it could be raised.

Critics say the disclosure remains inadequate, with standards varying from one locale to another. For instance, when Mello-Roos homes are resold, state law requires only that the tax burden be disclosed in the title report--a technical document not apt to be read by many purchasers.

And the costs to home buyers come in ways other than the tax formulas.

Most notable are the fees paid to the stable of lawyers and consultants that participate in every bond issuance. The fees range from a flat amount, to hourly rates, to percentage cuts of the bond proceeds.

In the best circumstances, these specialists candidly pinpoint risks posed by forming a Mello-Roos district. They also should review the soundness of the landowner who is developing the property.

According to the state Debt Advisory Commission and others, cities should not fall into the trap of letting a developer with Mello-Roos intentions select the crucial experts: Bond counsel, tax consultant, land appraiser, underwriter and sales-absorption consultant, who predicts how quickly new homes might sell.

“The problem in most of these situations is the developer comes in and offers to be full service,” said Doug Ayres, a former city manager who now advises Rancho Mirage and other local governments in California and Arizona. “I advise the city, ‘Wait a minute: It’s your credit, it’s your tax exemption, and it’s your credibility that’s on the line. Why should they pick the people that are going to use you ?’ ”

How Mello-Roos Bonds Work

1) A local government board forms a community facilities district with the permission of a major landowner.

2) To raise money for roads, schools and other development needs, the community facilities district sells bonds to investors who earn interest, typically 7-10%.

3) New home buyers and businesses pay special Mello-Roos taxes based on the amount of bonds. The special taxes are needed to pay investors as the bonds mature, or come due. These taxes are supplemental and are listed separately on each property owner’s annual property tax bill.

4) Owners of undeveloped land within the community facilities district also pay the special taxes until the land is sold, although at rates that often are lower than those imposed on homeowners.