Muni Bonds to Builders Are Probed

Michael Jordan does it. Paul Newman does it. Even Mario Cuomo did it.

So when the tiny town of Mendota was asked to endorse a product--in this case a new type of bond financing--city officials jumped at the chance.

The desperately poor farming city, the self-proclaimed Cantaloupe Center of the World, earned an $80,000 fee by lending its tax-free borrowing privileges to private developers for real estate projects hundreds of miles away--including one near Malibu.

But as athletes, movie stars and even politicians know, lending a name to somebody else’s product can have an unexpected downside.

In this case, the bonds issued by Mendota, along with a handful of other California cities and a few Native American tribes, have triggered state and possibly federal probes.

State investigators are scrutinizing whether a series of California bonds offered from 1995 to 1996 by one underwriting firm, Pacific Genesis Group Inc. of San Francisco, are illegal because they violate restrictions on the use of tax-exempt bonds for private economic development.

David Fitzgerald, company president, said attorneys involved in underwriting say the deals are allowable under California state law and that cities are entitled to bestow tax-exempt status on bonds for purposes outside their jurisdiction in exchange for fees. Moreover, Fitzgerald says the deals represent a boon to financial troubled cities.

So far, the deals involve a quirky cast of characters, including Native American tribes, a U2 rock band fan, poor Central Valley cities and hundreds of investors who have bet their money on the municipal bonds.

Nine tax-exempt bond deals worth more than $65 million sold for projects near such cities as Calabasas, Fresno and San Clemente violate current laws, the state attorney general has said.

The state has taken the unusual step of asking the Securities and Exchange Commission to investigate the deals as well. SEC officials declined to confirm or deny whether they are doing so.

Although the Pacific Genesis bond deals are not widespread, critics want to block the strategy before it gains momentum. The state is only now recovering from the battering its municipal bond market took two years ago in the aftermath of the high-risk speculation that sent Orange County into Bankruptcy Court.

State Treasurer Matt Fong already sees parallels between Orange County’s debacle and the new bond deals, which he believes are a clear violation of state law.

“Cities are in a crunch, I know,” Fong said. “But Bob Citron [former treasurer of Orange County] used very similar arguments” to rationalize his financial moves, Fong said. If cities want the ability to do this type of investing, they should have the laws changed, he said.

At the extreme, the new strategy could portend a rush of potentially risky deals with unknown consequences for the nation’s $1.3-trillion tax-exempt bond market.

But Pacific Genesis and its attorneys vigorously defend their financings as legal and say they have not been contacted by regulators about any investigations. Rather, they believe the deals will eventually be praised. The firm says all principal and interest payments on their bonds have been made and that the bonds in two of the deals were completely paid off.

Pacific Genesis, a licensed broker dealer that sells and underwrites the bonds, says the tax-exempt financings help spur economic growth, such as buying land for developers.

David Fitzgerald, the 36-year-old founder of Pacific Genesis, said he is just tweaking existing practices--but he has attracted just the sort of controversy he says he always wanted to avoid.

The brash and aggressive UC Berkeley graduate and New Jersey native is being called everything from a genius to just plain wrong. Before founding Pacific Genesis, Fitzgerald worked for another firm that has stirred controversy, First California Capital Markets in San Francisco, whose deals have been investigated by the SEC over the last year, according to attorneys close to the case. So far, the SEC has taken no action.

In August, Fong and the California Debt and Investment Advisory Commission, a small state agency, asked the attorney general to investigate the nine deals offered by Fitzgerald.

But Fitzgerald said his firm is being unfairly singled out, saying: “We’ve asked for audiences with the state, and they won’t even see us or talk to us. They are more concerned that bond issues don’t go into default.”

Fitzgerald says, his bonds have foreclosure clauses so that if land developers fail to make payments to bondholders, the cities are not held responsible.

The debt commission has adopted its own “moral authority” that makes “public policy decisions on behalf of the state of California behind closed doors,” Fitzgerald said.

But Peter Schaafsma, executive director of the debt commission, responded: “That’s absolutely not true. And if there was anyone else doing the same thing, they’d be on the hook too.”

The bonds are issued under provisions of a 10-year-old law known as the Marks-Roos Local Bond Pooling Act, which has been used in a variety of ways in California to help boost economic development.

But critics say Fitzgerald’s deals are an unexpected outgrowth of the legislation. Nobody anticipated, for example, that the Chukchansi tribe near Yosemite would be issuing tax-free bonds for projects far from its home.

The notion that cities are not liable to investors for defaults on their bonds, a cornerstone of municipal finance, is especially troubling to critics.

“That’s the problem,” said Schaafsma of the debt commission. “We’re concerned that no one is on the hook if these go bad. There’s no one around to clean up the mess. Then where will investors be?”

Even more alarming, Schaafsma said, is that while the bonds are for speculative real estate projects, they are being mass-marketed through radio and television ads to retail investors who might not understand the risks.

William Milwitt, 72, a longtime California bond investor who has bought into several of Fitzgerald’s deals, finds the controversy nerve-racking. He liked the high returns promised by Fitzgerald and the exemption from taxes, but is worried that his bonds might lose value if regulators find problems.

“Both state and federal governments give you an incentive to invest in these bonds,” Milwitt said. “So there’s the sense they are recommending them.”

Fong said his intention is to preserve that sense of integrity in the California bond market, especially in light of the Orange County bankruptcy, which chilled the market in 1994.

Fitzgerald, who says other deals have been done that resemble his, believes the criticism is being fueled by envious competitors and that his deals represent the future for many beleaguered local governments in California.

“I think municipal finance is dead,” Fitzgerald said during an interview in Los Angeles. “The industry is transforming, it’s changing. That’s why we’re going to see different kinds of financing.”

Fitzgerald said the public finance business is undergoing massive changes as cities increasingly find their revenue-raising abilities curtailed by voter-approved measures. Cities will become more entrepreneurial and, as business enterprises, should be entitled to innovative--but more risky--types of financing, he said.

“The fundamental problem here is every year we hamstring local governments’ ability to finance themselves,” said Timothy J. Schaefer, a financial advisor in Long Beach who works with local governments throughout California. “And desperate people seek desperate solutions.”

An examination of Pacific Genesis’ deals reveals that they have generated controversy across the state.

San Clemente

Paul Gudgeirsson, city treasurer of San Clemente, had never even heard of Fitzgerald or Pacific Genesis until about 100 investors began calling his office wanting more information about the “San Clemente municipal bonds” they had seen advertised on cable TV.

The commercials promised big returns on tax-exempt bonds sold to develop a parcel of land within the city limits.

“I was more than surprised; I was shocked,” Gudgeirsson said of the phone calls. “I told them, ‘We aren’t selling any bonds.’ ”

Investors heard the bonds being touted on a financial advice show. A picture of a broker on a phone flashed on the television screen as he touted the bond’s high returns.

“There aren’t that many bonds left, folks” he said. “These are almost sold out.”

In this case, the agency selling the nonrated bonds was not San Clemente at all.

Fitzgerald had asked the Merced County Board of Education and the city of Waterford to agree to sell their “tax-exempt status” to create the Pacific Ocean Estates Authority so the developer could get low-interest financing to buy and develop land for a major retail development.

In another twist, a portion of the San Clemente development’s profits would flow to Fitzgerald and two partners through a firm called U2 Consulting, named after Fitzgerald’s favorite rock band. The profits are intended to be used to balance possible losses on other deals, Fitzgerald said.

State officials say the highly unusual profit plan raises ethical questions. Firms that sell bonds typically don’t get direct profits from the development, but Fitzgerald said this strategy helps strengthen his deals.

Nonetheless, the deal fell apart in November.

Merced

The Merced County Board of Education was interested in the Pacific Ocean Estates deal because it had already pocketed a $54,000 fee on financing to buy land for a Palm Springs golf course.

In the Palm Springs deal, Merced joined with Waterford and the Shoalwater Bay Indian Tribe from Washington state to create a partnership called the California Desert Public Financing Authority. The authority sold $10 million of bonds earlier this year, and all payments to investors are up-to-date.

What was Merced doing?

The county, situated smack in the middle of the state, posted unemployment of 16.9% in 1995. Its per-capita income of $15,110 in 1994 is well below the $22, 345 average statewide. At one point, it was so financially strapped it threatened to close down its entire library system, which would have left it the only state county without a library.

“There’s always a need for money here,” said William Gnass, attorney for the Merced education office and for Waterford. Still, Gnass said officials in both Waterford and Merced are surprised by the controversy and said they might have done things differently had they known.

Waterford, a tiny city about 12 miles east of Modesto, participated in all nine deals being investigated by the state. Gnass said the city is trying to be proactive and “spur economic growth” with the more than $200,000 in fees it received.

Dick Michaelsen, who is both the city manager and police chief of Waterford and was involved in the bond financings, said the city hopes to build a new city hall and police station with the fees it received.

“We think we have the authority to enter into these types of agreements. They’ve been a win-win for developers and our city and the community as well,” Michaelsen said.

Mendota

Mendota, like its Central Valley neighbors, also made money by lending its name to two bond deals. And like most of the Central Valley, its finances are bleak.

Mendota has an annual per-capita income of $4,900, one of the lowest in the state. Its unemployment skyrockets to more than 40% in winter months when the cantaloupe, cotton and bell pepper crops are dormant. The city has been running a deficit since mid-1989 and as of June 30 was $152,000 in the red.

Mayor Robert Silva and the City Council received assurances from their own attorney and from Pacific Genesis that both financings were legal and could be done at no risk to the city, according to the city’s finance director, Elena Martin.

Pacific Genesis and the city attorneys “said it was OK,” Martin said.

The city received $80,000 from two bond deals. One was sold by Pacific Genesis to buy 100 acres of land in Los Angeles County for housing and a retail center between Calabasas and Malibu. The other was sold to buy land for single-family housing near Fresno.

“Even $80,000 is a lot of money to us,” Martin said. With its fees from Pacific Genesis, Mendota reduced its deficit, paid for a new phone system for City Hall and bought some new computers, Martin said.

“The state doesn’t care whether cities live or die,” said Randy Risner, city attorney for Mendota. “We have to be creative to finance ourselves and stay afloat.”

Fresno

Yet another controversial financing by Pacific Genesis originated near Fresno. Pacific Genesis helped set up the Sierra Central Valley Public Financing Authority, which sold nearly $17 million of bonds in late 1995 to buy land for a golf course, a casino and other uses.

The Chukchansi tribe, situated in the hills near Yosemite, became a member of the so-called joint powers authority that obtained tax-exempt status. The authority included several municipalities.

The tribe received a $300,000 fee, but it hasn’t yet broken ground on the casino because it’s still negotiating to get construction funds.

“Here is a large tribe with no economic resources, no land base, no source of revenues,” said George Foreman, lawyer for the tribe. “It wanted to take advantage of the one asset it had.”

State Treasurer Fong says a Native American tribe is not a local agency, so it can not participate in a financial authority that issues tax free bonds.

Despite all the controversy, these days Fitzgerald says he is busy fielding calls from other cities and developers eager to raise money through his firm.

Meanwhile, the California municipal bond market continues to shake, with some concerned that Congress will revoke the tax-exempt status given to local cities, school districts and other public agencies.

Joe Mysak, editor of Grant’s Municipal Bond Advisor in New York, said that what Fitzgerald does “raises all sorts of questions,” but he also acknowledges Fitzgerald “might be a genius.”

Mysak sees problems with cities getting involved in deals hundreds of miles away and earning fees for issuing bonds, particularly for speculative real estate deals.

“He’s come out with the most creative deals the market has ever seen,” Mysak said. “Daily, they test the limits of the market. But every time the market is expanded like this, someone somewhere says, ‘Let’s make the whole municipal market taxable.’ And when that happens, everyone’s taxes will go up.”

Still, Fitzgerald says he isn’t worried.

“What is the real purpose of municipal bonds?” he said. “I don’t ask that question. I am a transaction-oriented sort of person.”