Tax lien securitization: putting nonperforming assets to work.
Several local governments have taken advantage of financing approaches to convert tax receivables into up-front cash payments. A number of states permit local governments to liquidate property tax receivables by selling tax liens attached to properties for nonpayment of property taxes or other assessments. When a tax lien is created, the unpaid taxes accrue at high interest rates until they are paid. Penalties also may be imposed. Tax liens are removed when all unpaid taxes, accrued interest, and penalties have been paid.
The sale of tax liens has proven beneficial for governments that are able to use this approach. Rather than wait until the taxpayer makes up delinquent payments, governments authorized to sell tax liens are able to covert these receivables into up-front cash payments. Some governments find the sale of tax liens is preferable to foreclosure on properties on which taxes are due. These jurisdictions may not be able to afford the legal fees associated with foreclosure or may be unwilling to expose the government to negative political fallout which may accompany this action. Additionally, with the foreclosure option, governments end up with a portfolio of properties that do not generate taxes, impose added liabilities for the government, and must be disposed of at some point.
Securitization of Tax Liens
In recent years, the practice of selling tax liens has been done on a larger scale. In 1993, the City of Jersey City, New Jersey, became the first local government to securitize its tax liens. Tax lien securitization is accomplished through the creation of a trust which purchases outstanding liens of one or more jurisdictions. The trust then issues bonds that are purchased by investors. A portion of the proceeds is used to pay the jurisdiction for the sale of the tax liens. In a typical securitized lien transaction, the amount of bonds issued is less than the par amount of the liens (e.g., 70 percent). This over collateralization provides comfort to investors but with little or no cost to the government.
In addition to an up-front payment, the jurisdiction selling the liens also receives a subordinate position with respect to the balance of the value of the liens (e.g., 30 percent). The effect of the subordinate position is to give bondholders first priority in receiving delinquent taxes as they are collected. Any collections in excess of the principal and interest amounts to be paid to bondholders would then revert to the jurisdiction. Since tax liens are usually a relatively small percentage of the value of the property (5 to 20 percent), property owners or banks holding the mortgage will generally want to extinguish the tax lien rather than risk foreclosure on the property. Redemption rates of tax liens that have been sold to investors have historically been in excess of 90 percent.
This structure differs from traditional bulk sales of tax liens in which outstanding liens are pooled by local governments and sold to investors. State laws vary with respect to tax lien sales, but one approach permits investors to bid on a portfolio of tax liens, including interest and penalties, through a public auction. The sale price of the liens is often less than the value of the liens but higher than the up-front payment to the government if the liens were securitized (e.g., 80 percent) depending on the number of bidders. On the other hand, bulk sales typically do not provide the government with a subordinate position which potentially allows it to recover the full amount of delinquent taxes plus much of the accrued interest.
A second difference between securitization of tax liens and bulk sales is the interest rate required by the market. Purchasers of liens through bulk sales typically have been mortgage market firms that demand high rates of return on lien portfolios. With the securitization structure, investors in the trust are more likely to be institutional investors who expect a return that is closer to taxable rates. Thus, in the current market, bonds sold through the trust may have a coupon in the 7 to 8 percent range.
An important element of tax lien securitization is that a private collector, or servicer, takes over the role of ensuring that delinquent tax revenues are recovered. The servicer is generally charged with disposition of the assets, including keeping track of all monies associated with the tax lien investment. The servicer is expected to take actions to maximize the return on the investment and minimize losses. Firms selected to serve in this capacity must have a thorough knowledge of state and local laws governing tax liens. They also must have experience with developing procedures for collecting delinquent tax revenues, evaluating whether to obtain title to properties, and managing foreclosed properties.
Jersey City's Experience
The 1993 Jersey City transaction packaged approximately $44 million of tax liens such that institutional investors could purchase bonds collateralized by these liens. In order to undertake this type of transaction, the city first needed to get enabling legislation passed by the state. The State of New Jersey historically had permitted jurisdictions to sell tax liens but required that tax liens be sold at par. In other words, when assigning the lien to an investor, municipalities would need to receive 100 percent of the value of the lien. Because the structure contemplated by Jersey City would result in an up-front payment that was less than the value of the portfolio of liens, the city needed to obtain a change in state law to accommodate this type of structure.
The next step was to identify liens to place into a portfolio. In order to make the portfolio more attractive, certain types of properties were eliminated from the pool. For example, sites that were known or expected to have environmental problems and sites whose owners had declared bankruptcy were not included in the portfolio. These liens were excluded from sale to mitigate investor concerns that the liens would not be redeemed.
The city's $44 million tax lien portfolio was securitized by placing the liens in a trust. The trust then issued $30 million of bonds through a private placement sale, of which $25 million of bond proceeds was paid to the city. The bonds carried a coupon of 8 percent. The city also received a subordinated promissory note for $19 million. As delinquent taxes were collected, they would first be paid to bondholders; however, any collections in excess of the amounts to be paid to bondholders would be paid to the city.
The remainder of the proceeds were used in part to fund various reserve funds. One of these was an interest reserve. Since payments to bondholders were derived from the redemption of tax liens as well as installment payments from delinquent taxpayers, there was some uncertainty as to when these revenues would be available. In order to ensure that periodic interest payments were met, a reserve was created that could be tapped if incoming revenues fell short of scheduled payments.
Bond proceeds also were used to fund an environmental reserve. One reason that property owners may owe taxes is if environmental problems requiring costly cleanup are present, such as site contamination. In the event that foreclosure is necessary and environmental problems are discovered, the assessed value of the property could not be recovered, potentially resulting in a loss for bondholders. The environmental reserve was established to cover this type of loss.
Investor risk was further mitigated by fact that the bonds were well-collateralized. As noted earlier, the city's subordinate position for $19 million of liens means that its claim to this portion of tax receipts would only be satisfied after bondholders were repaid. Additionally, the underlying value of real property to which liens were attached was estimated at $300 million. Thus, if taxes were not repaid, the lienholders could initiate foreclosure proceedings on the properties.
Securitization of tax liens has had clear benefits for the city. First, the city was able to balance its budget while cutting the tax levy. This was accomplished using a financing mechanism that potentially permits the city to recover the full value of delinquent tax revenues plus much of the interest that subsequently accrues on the liens. Finally, the property tax collection rate has significantly improved, jumping from approximately 80 percent in 1992 to 94 percent currently.
Other Securitized Transactions
Since this transaction was completed, other similar transactions also have been done. The City of Jersey City completed a second transaction in 1994, and the City of New Haven, Connecticut, sold $23 million of liens in the fall of 1995. These deals were structured in much the same way as the original Jersey City transaction.
The City of New Haven sale of liens was initiated by the mayor, who was interested in improving tax collection rates. Unlike many jurisdictions who see tax lien sales as a means to meet operating budget deficits, the mayor saw this financing technique as an opportunity to acquire sorely needed funding for the capital program - in this case, construction of new schools. The State of Connecticut offers a program that provides 80 percent funding toward school construction to local governments who contribute 20 percent of their own funds. In securitizing tax liens, the city received approximately $19 million in up-front bond proceeds, with a subordinate position for the remaining $4 million. The city's share of the bond proceeds could then be applied toward their share of school construction costs, bringing in nearly $80 million in additional state funding.
While it has been only a few months since the completion of the transaction, the city's controller has already seen evidence of improved collection rates. One problem that has been noted by city officials relates to the city's revaluation of property, in which some cases undergoing appeal were not reported to agencies involved in developing the lien pool. As a result, the city has had to take back liens on properties for which owners have contested property revaluations.
New York City is moving forward on what is expected to be the largest securitization of a lien portfolio to date, with liens valued in excess of $100 million. Monies generated from the sale will be used to plug budget gaps. The city also is interested in moving away from its traditional enforcement mechanism, a foreclosure process that has generated high administrative costs relative to the delinquent taxes that are owed. In March 1996, the mayor signed enabling legislation authorizing the New York City Department of Finance and the New York City Water Board to engage in these types of transactions. The sale of tax liens was expected to occur in May or June.
Until recently, only larger jurisdictions have been able to take advantage of better prices obtained through securitization of tax liens. This is because high transaction costs, including institutional investors' due-diligence expenses and other fees, have limited the benefits for governments with smaller amounts of tax liens. A minimum amount of $10 million of tax liens is considered necessary for a cost-effective transaction.
A recently completed transaction may pave the way for securitizing liens of smaller governments. In this transaction, a private firm sold $69 million of taxable bonds secured by a pool of tax liens from more than 300 jurisdictions. The pool included both residential and commercial property liens from New Jersey, Florida, and Connecticut that had previously been purchased by the firm. The offering was well-received in the market, due in part to the perception that the lien pool largely consisted of high-quality liens. Including liens from different geographic areas was considered another positive feature, creating the benefit of a diversified lien portfolio.
Participants in the transaction have suggested that this approach may be utilized in the future by states to assist smaller jurisdictions to participate in the securitized market. States could facilitate the pooling of liens of various jurisdictions that on their own would not have a sufficient amount of liens to undertake a cost-effective transaction.
As more jurisdictions engage in tax lien securitization, investor appetite for these products is increasing. In response to growing interest in these types of securities, two of the rating agencies, Standard & Poor's and Fitch Investors, have produced a set of criteria to analyze and assign ratings to bonds secured by tax liens. Among the criteria considered in rating bonds secured by tax liens are the following:
* redemption profile, or the likelihood that liens in the portfolio will be extinguished as delinquent taxpayers pay uncollected taxes, interest, and penalties;
* market conditions in the area in which the properties are located; and
* experience of the servicer in terms of knowledge of state or local laws governing tax liens, ability to maximize redemptions, and development of strategies to limit investor losses.
Based on their assessment of the redemption rates for liens in the pool, an assessment is made as to whether there is sufficient collateralization for bonds backed by the liens and whether additional credit enhancement is needed. Establishment of appropriate reserves, including reserves to pay interest on bonds and to pay for losses due to environmental problems or liquidation, and foreclosure costs, may be required to enhance credit quality.
Advice for Governments
Tax lien securitization offers an opportunity for jurisdictions with relatively large pools of uncollected tax receivables to convert a dormant asset on the balance sheet to cash. It is important to consult state or local laws, however, before moving forward on this type of transaction to ensure that it is legally authorized. The City of New Haven's controller also provides the following advice for governments contemplating securitization of the tax lien portfolio.
1) Know the pool. It is essential to understand what types of properties are in the lien pool in order to weed out properties that will be unacceptable to investors. These include properties for which owners have declared bankruptcy, properties involved in a court appeal process, or properties known to be contaminated.
2) Make sure the pool is large enough to be cost effective. Fees paid to various consultants to securitize tax liens are costly and are well in excess of what would be paid for a bulk lien sale. In comparing the costs of a bulk sale versus securitizing tax liens, the bulk sale discount should be weighed against the fees paid to securitize tax liens.
3) Use an open process to find qualified financial professionals to assist in structuring the transaction. Selecting professionals with demonstrated expertise in asset-backed transactions is essential to the success of the deal. A well-written RFP can help select the best financing team.
4) Anticipate the amount of time needed. Governments engaging in this type of transaction for the first time will need four to six months to undertake a review of the lien pool, draft legal documents, and educate the governing body on the nature of the transaction.
Author PATRICIA TIGUE is a manager in GFOA's Government Finance Research Center. The author wishes to thank Alan Anders, treasurer of the New York City Municipal Water Finance Authority and a member of the GFOA's Committee on Debt and Fiscal Policy, for his assistance in preparing this article.
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|Title Annotation:||Innovations in Debt Financing|
|Publication:||Government Finance Review|
|Date:||Jun 1, 1996|
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