State Paying a Premium to Renew Debt

As California’s financial crisis worsened in January 2002, state Treasurer Phil Angelides found a way to make a billion-dollar debt disappear -- at least temporarily.

To avoid coming up with $1.1 billion to pay off bonds and short-term loans that were coming due, Angelides issued new bonds to pay off the old.

That allowed the state to continue spending the money on programs rather than debt payments. But the deal will prove costly to California taxpayers in the long run.

By the time the new bonds are paid off, in 28 years, the state will have spent $1 billion in interest on them. The total cost of paying off $1.1 billion in bonds: $2.1 billion.

Even when adjusted for inflation, the deal will cost taxpayers roughly $751 million.

Moreover, Angelides has used the same save-now, pay-later idea to radically change how California borrows money. For decades, the state paid off principal in equal amounts every year. That approach steadily reduced the amount owed and limited the interest that the state paid on bonds.

Acting on his own authority, however, Angelides has embarked on a new course. Since 2002, the treasurer has been issuing billions of dollars in long-term bonds on which the state pays no principal -- only interest -- for as long as five years.

In such tight financial times, that approach has proponents who say it will give California more flexibility to address its pressing budget problems. But others disagree, saying it is unwise to delay paying off the bonds now.

Angelides, a Democrat, said a prudent amount of borrowing makes sense, particularly at a time of historically low interest rates. And he said borrowing now can allow the state to keep spending money on such services as education, health care and law enforcement.

Senate President Pro Tem John Burton (D-San Francisco) defended the treasurer’s approach. He likened the debt restructuring to what businesses and individuals do when faced with financial problems.

“If you have a debt that you can’t deal with at the present, you stretch out your mortgage,” Burton said. “You refinance your house.”

But others said the practice is more akin to signing up for a new credit card to pay off an old one. While a typical bond issue requires the state to build something of value, the government will not have anything tangible to show for the extra cost of this borrowing, said Ted Gibson, former economist for the state Department of Finance.

“We don’t have a new freeway. We don’t have a new school,” Gibson said. “We’re simply taking current spending and financing it with a long-term mortgage.... That is purely cash-flow borrowing.”

Angelides’ policy also prompted a warning from Edward Leamer, a respected economist and director of UCLA’s Anderson Forecast.

“The idea of postponing this for five years is kind of dangerous,” he said. “You’re borrowing from the future.”

Leamer said the state cannot count on the kind of rapid economic growth and future increases in tax revenues that it experienced in the boom years of the late 1990s.

“Now is the time to recognize limits and budget accordingly,” he said.

And David Hitchcock, director of the State and Local Government Ratings Group at Standard & Poor’s in New York, warned that stretching out the debt could deepen California’s problems in the future. “By pushing out the debt, your total interest payments will be larger over time,” he said.

Before Angelides adopted his new approach, Hitchcock said, California was unusually conservative in paying off its bonds. It has now joined the majority of states in paying off new bonds by making the same annual payment every year.

But Hitchcock said that Angelides’ decision to defer all principal payments on the new bonds for five years sets California apart from other states. Calling the decision evidence of a “place in distress,” he added: “That’s an unusually long period of time to defer.”

The treasurer’s new approach to managing the state’s debt is part of a pattern of short- and long-term borrowing that has allowed officials in Sacramento to avoid making tough decisions about how to balance the state budget.

For the last two fiscal years, they have been restructuring the state’s long-term debt; engaging in larger and more costly short-term borrowing; cashing in on tobacco settlement funds that would have paid for a quarter-century of health programs; and raiding special funds, particularly those set aside for highway and transit projects.

The treasurer unveiled his “Strategic Debt Management Plan” in a January 2002 letter to Gov. Gray Davis and legislative leaders. Angelides said the new plan -- particularly refinancing bonds that were coming due -- would save the state $2.1 billion in debt service payments over three years ending in June 2004.

“The debt service savings over the next three years can be utilized to help close the state’s projected budget shortfall, reducing potential cuts in critical public services, such as education, health care and law enforcement,” Angelides said.

In a single sentence on the second page of the three-page letter, Angelides added: “These savings over the next three years will be offset in later years.”

Angelides said that his plan was developed partly as an alternative to a more costly proposal made by the governor last year that would have involved borrowing money from employee pension plans.

Since Angelides announced his plan, the treasurer has sold $6.95 billion in new bonds to build schools, parks, water projects and other facilities. The new bonds will cost in excess of $1 billion more to repay than they would have under the old approach.

As with the $1.1 billion in bonds that he refinanced last year, all of the new bonds defer principal payments for as much as five years. In June, Angelides also expects to refinance another $832 million in bonds using the same method.

Angelides said that using the higher interest expense is “not an accurate representation of the true cost” because inflation reduces the value of money over time. Since “a dollar today is worth more than 30 years from now,” the treasurer said, the state actually will save money by waiting until the future, when dollars are worth less, to pay off some of the debt.As a result, Angelides said, his plan ultimately will save taxpayers $118 million.

To reach that conclusion, Angelides assumed that the value of the dollar would decrease at a rate greater than that of inflation.

Specifically, the treasurer assumed that today’s dollars would devalue at roughly 5% a year, which he said is equal to the average rate of inflation over the last 30 years. But inflation has not been that high in many years, and most recent forecasts anticipate that inflation is more likely to run about 3% a year in the foreseeable future.

While Angelides’ method makes sense for private investors who search for a higher rate of return on investments, economists disagree about whether that is an appropriate way to calculate the value of money over time when state government is the borrower.

And even if Angelides’ predictions are borne out, one effect is not in dispute. In 2008, when the state will be required to make payments on the principal that it has put off for five years, the new bonds issued since early 2002 alone will cost California an additional $189 million.

That day, however, will not come until well after the next statewide election.

Angelides is one of several candidates who already have expressed interest in running for governor in 2006.