Mello-Roos bonds threatened by sluggish reform; investors may shun bonds without fuller disclosure.

The real estate credit crunch and regional recession have made special assessment bonds, known as Mello-Roos bonds, more important than ever as a means of financing construction of public schools and infrastructure in Los Angeles County.

But if the California Legislature does not pass heightened public disclosure requirements on the bond offerings this session, investors may quit buying them, bond analysts claim. If that happens, developers planning to build new projects in Los Angeles County's high desert and west San Fernando Valley will not be able to proceed on schedule, thereby prolonging the local construction slump, said industry experts.

Mello-Roos bonds are tax-exempt debt instruments sold by local bonding authorities, such as cities and school districts. Their proceeds are used to pay for roads, streets, sewers, fire stations and schools usually located within designated "Mello-Roos assessment districts."

Property owners in those districts must pay fees twice a year, along with their property taxes. The special Mello-Roos taxes are then passed through to bond holders.

Problems arise, however, when housing developments funded with Mello-Roos bonds do not sell quickly enough. Owners of the slow-selling developments often own most of the lots that are assessed. So they have to dip into their reserves to pay the Mello-Roos fees. And when bad times last long enough, developers' reserves run out. When that happens, bonds could ultimately go into default, unless enough parcels have been sold that the additional obligation can be spread amongst property owners within the district who have the ability to pay. In cases such as those, where some property owners in a Mello-Roos district pay extra to make up for those who default, the property owners who pay extra are reimbursed when additional parcels are sold by the developers in default, said bond experts.

The threat of Mello-Roos bond failures and their souring impact on the Mello-Roos bond market prompted the municipal bond market community, including California State Treasurer Kathleen Brown, to call for Mello-Roos reform.

Just last year, Sen. Henry Mello, D-Watsonville, sponsored SB 1464, a bill that requires Mello-Roos bond issuers to make annual financial reports to their bond holders. The law, which takes effect Feb. 1, requires reports that specify the amount of assessment fees collected, the amount paid out to bond holders and the amount of reserves held by the Mello-Roos district.

Mello and former Assemblyman Michael Roos, D-Los Angeles, co-authored the enabling legislation for the Mello-Roos bonds in 1982.

Mello-Roos reformists -- such as homeowner groups, developers and bond analysts -- say SB 1464 was a step in the right direction but that further restrictions are needed. If they are not undertaken, the important source of development infrastructure financing will dry up, and that would particularly hurt Los Angeles County.

Mello-Roos bonds were widely considered as safe, tax-free investments from the time they were first issued in 1982 until 1988. During that initial six-year period, infrastructure projects funded with Mello-Roos bond proceeds were built out quickly, assessments were collected and bond payments made.

But beginning in 1988, developers started having trouble selling their parcels within Mello-Roos districts. That left them holding the bag for higher assessment fees than they had budgeted for. When developers started missing payments, other property owners in the Mello-Roos district are required to pay higher assessment fees to make up the deficiency, according to state regulations.

Higher assessments have become a sore subject with property owners, some of whom are already paying as much as 3.5 percent of their property's assessed value each year in property taxes and Mello-Roos assessments, according to records at the Los Angeles County Assessor's Office. Since the state's property tax rate is 1 percent of assessed value, that would mean some property owners are paying Mello-Roos assessments equal to 2.5 percent of their properties' assessed value.

Property owners typically worry most about developers defaulting on their Mello-Roos assessments during the first few years of a district's formation. In those early years, developers are paying assessments for all their unsold subdivision parcels. As time goes on, however, developers' exposure declines, as individuals buy those parcels and assume responsibility for the assessment fees.

Statistics show that Los Angeles County has been issuing more Mello-Roos bonds in recent years. For the first 10 months of 1992, $104.4 million in Mello-Roos bond sales were authorized by various governmental agencies for districts inside Los Angeles County. That compares with $62.9 million for all of 1991, $78.4 million for 1990 and $52.8 million for 1989, the year the present construction slump started, according to data from the Los Angeles County Assessor's Office.

The increase in Mello-Roos bond sales by governmental agencies with bonding authority inside Los Angeles County is contrary to the statewide trend. Mello-Roos bond sales statewide have dropped steadily since peaking at $977 million in 1990, according to data compiled by the Palm Springs-based California Municipal Bond Advisor, a monthly newsletter targeted to bond traders. From that 1990 peak of $977 million, statewide Mello-Roos bond issues fell to $827 million in 1991, and tumbled to $445 million for the first three quarters of 1992, the most recent figure available.

Zane Mann, publisher of the bond traders' newsletter, attributed the decline in statewide sales to bond analysts bad-mouthing Mello-Roos bonds because the bonds can be passed without challenge by an individual or small group of landowners.

"In the past, city councils have been too quick to believe the fairy tales of developers that their projects will generate plenty of new taxes to repay the bonds," Mann said.

Despite all the suspicion and the call for change in Mello-Roos bonding laws, only the Temecula Valley Unified School District in Riverside County has defaulted on a Mello-Roos issue. That happened in 1989, when $27.2 million raised from Temecula's bond issue was invested in Executive Life junk bonds so high interest could be earned until developments proposed for the area could proceed, Mann said.

Nevertheless, such horror stories worry some bond buyers, who caution that the long California recession could ultimately cause cash-poor developers to miss their semi-annual Mello-Roos bond payments, Mann said.

Dean Misczynski, transition director of the California State Library, which keeps track of legislation in progress, said the increasing pressure for more Mello-Roos restrictions is real.

"Traders in the secondary bond market say we need further Mello-Roos reform this session. The underwriters want reports on the reserves and the payments every six months instead of every year," Misczynski said.

Misczynski helped draft the original legislation that created Mello-Roos districts, according to Sen. Mello staffers. Misczynski said that in the coming year, Mello-Roos districts will probably be required to report to all bond holders in no less than 10 days if the reserves are severely drawn down due to nonpayment of assessments.

"The proposal floating around is that these stricter reporting requirements would stay in effect for the first five years of the bond's life," Misczynski said.

Sen. Mello's aides said they have heard of the proposal but have not studied it in detail.

Despite the call for more Mello-Roos bond reporting requirements, the County of Los Angeles approved $57 million in Mello-Roos bonds last July for the so-called Community Facilities District #4 in Calabasas. Those funds will be used to build an interchange for the Ventura (101) Freeway and Parkway Calabasas, and to acquire land in the Santa Monica Mountains. That land will be dedicated to open space and to some lesser community developments, said John Edmisten, an L.A. County senior finance analyst.

"We looked at the proposal in great detail so we could control the Mello-Roos assessment and homeowners won't get surprised," Edmisten said.

Orange County-based Baldwin Co. plans to build 500 homes in the area, and a partnership between Ahmanson Commercial Development and Kilroy Industries Inc. plans to build a 1.5 million-square-foot office/retail complex. Also, long-time area land owner Paul Ebensteiner plans to develop a small industrial park, Edmisten said.

Steve Heanen, a partner in the Los Angeles office of San Francisco-based Stone and Youngsberg, an investment and securities brokerage, said Mello-Roos bond holders should not panic from the bad publicity the bonds have recently received or because of the lingering construction slump in Southern California.

"The next payments on Mello-Roos bonds are due at the end of January. We won't know which districts become delinquent on their payments until late February or early March," Heanen said.

"In most cases, there are enough reserves and the developments were phases. So, if they have 30 percent of the homes sold, they are getting enough in assessments to stay current on the payments," Heanen said.