Chief Financial Officer NatwarM. GandhiDebt Burden and Borrowing ConstraintsLetter to Mayor Adrian Fenty and City Council Chairman Vincent GrayJune 20, 2007

Government of the District of Columbia

Office of the Chief Financial Officer

1350 Pennsylvania Avenue, N.W., Suite 203

Washington DC
20004 (202) 727-2476

www.cfo.dc.gov 

Natwar M. Gandhi

Chief Financial Officer

June 20, 2007

The Honorable Adrian M. Fenty


Mayor of the District of Columbia

1350 Pennsylvania Avenue, NW – Suite 327 

Washington, DC
20004

The Honorable Vincent C. Gray 

Chairman

Council of the District of Columbia

1350 Pennsylvania Avenue, NW – Suite 504 

Washington, DC
20004

Dear Mayor Fenty and Chairman Gray:

The purpose of this letter is to provide advice to the
Mayor and the Council regarding the District’s debt burden and its
borrowing constraints. It is an update to a letter to former Mayor
Williams and former Council Chairman Cropp on the same topic dated
November 22, 2005. This subject matter is critical to the District’s
on-going financial health, and one that the Office of the Chief
Financial Officer (OCFO) continually monitors and seeks to effectively
manage.

It is crucial that the District implement and adhere to
policies and practices that ensure current and long-term financial
health. Therefore, the OCFO urges strict adherence to a debt cap in
order to avoid negative impacts on the District’s financial future. The
District currently has a legal debt cap, but it is the view of the OCFO that this
legal debt cap allows for a higher debt burden than is financially
prudent. As such, I recommend a "management" debt cap that is
lower than the legal debt cap.

The District has the highest debt per capita of any major
municipality in the nation ($10,429 projected as of the end of FY 2007),
and a high debt-to-full (property) value ratio (5.9% projected as of the
end of FY 2007) compared to industry norms. These are two commonly used
ratios for assessing a jurisdiction’s debt burden.

The District’s ratio of debt service-to-total
expenditures (or revenues) is approximately 9%, and it is still
reasonable compared to industry norms. This ratio is particularly
important because it not only provides a statistical measure of a
jurisdiction’s debt burden, but it also directly reflects debt
affordability and the extent to which a jurisdiction is consuming, and
limiting the flexibility of, current and future operating budget
resources.

Out of concern for the District’s financial health and
future, I recommend two targets and two firm caps with respect to the
District’s debt ratios. The firm caps should not be exceeded:

• First, based on an assessment of the District’s debt
  burden in relation to industry standards and in the context of its
  broader financial characteristics, I recommend that the District
  establish a target of 10% and a firm cap of 12% on its debt
  service-to-total (General Fund) expenditures ratio. While this
  recommended 12% firm cap is obviously higher than the recommended 10%
  target (the level recommended in my prior letter), given the District’s
  current debt levels and the various already-approved, important
  infrastructure projects and plans (some of which are associated with
  economic development projects), this revised cap recommendation allows
  for a modest amount of additional debt and should still prevent the
  District from jeopardizing the hard-earned improvements in its bond
  ratings and its financial health achieved in recent years. This level of
  debt could, however, limit further improvements in the District’s credit
  ratings.
• Second, I also recommend that the
  District establish a target of 6% on its debt-to-full value ratio, with
  a firm cap of 8% on this ratio.

It would be ideal for the District’s debt ratios to be
significantly lower than the recommended firm cap levels, which is why
the (lower) target levels are also recommended. Still, the firm cap
levels would allow the District to fund its substantial, already-planned
and already-budgeted capital infrastructure needs (including schools
modernization) while providing a reasonable level of additional future
annual capital project expenditures, which should not produce debt
levels that would, in and of themselves, adversely impact the District’s
bond ratings or compromise its long-term financial health. New
initiatives that call for high levels of borrowing (via tax supported debt) may have to displace currently-planned
project(s) in order for the District to remain within the recommended
caps.

All three of the rating agencies (Moody’s, Standard &
Poor’s, and Fitch) have indicated that they consider the District’s debt
burden to be relatively high. Such high debt burden is a contributing
factor to limitations on the potential for further bond rating upgrades.
Bond ratings have a direct financial effect because they are a key
determinant of the amount of interest that the District must pay on its
debt, and bond ratings also represent a broad indicator to investors and
other stakeholders of a jurisdiction’s current and long-term financial
health.

Debt-funded projects that create or enhance tax base and
therefore create or improve a tax revenue stream can eventually have a
positive effect on the debt-to-full (property) value ratio, which is
currently high. And from a budget perspective, a project that has an
associated tax revenue stream is financially preferable to those that do
not.

Debt-funded projects with an associated, new stream of
tax revenue, however, negatively impact the ratio of debt service to
expenditures as calculated by rating agencies and other credit analysts,
because they are considered net tax-supported debt. For example, if an
issuer has $100 of revenues and spends $10 on debt service, its debt
service ratio is 10%. If it uses another $10 of debt service to create a project that is
"self-supporting" – that is, it generates $10 in additional
revenues – the total revenues are then $110 and the total debt service
is $20, causing the debt service ratio to increase to over 18%. Although
the project is "self-supporting", the debt service ratio has
increased significantly. This is not to say that the District should not
take on projects that are expected to be paid from newly generated tax
revenues, but decision makers must be aware that rating agencies and
other credit analysts consider nearly all borrowing, with the few
exceptions noted below in the attached appendix, tax supported debt.

In light of the distinct analysis and management that is
warranted for debt that is to be supported by revenues directly related
to the project(s) that such debt finances, the OCFO is also recommending
the establishment of an Economic Development Capital Fund (EDCF). This
recommended Fund, also described as an Internally Self-Supporting Debt
Fund, would be a separate pool of funds for capital projects for which
the debt service on such borrowed funds is expected to be covered by
future revenues directly associated with the respective projects
financed by such borrowing. As existing projects are repaid from the new
revenues, this fund would restore borrowing capacity that could be used
for new projects.

The debt issued pursuant to the EDCF would be subject to
the overall debt caps, but would have a distinct borrowing capacity
associated with it, as a subset of the District’s overall borrowing
capacity as determined by the debt caps. The OCFO recommends an EDCF cap
of $1.5 billion. This can be accomplished within the overall firm cap of
12% along with all other currentlyplanned authorized debt. This $1.5
billion cap is roughly the total amount (existing plus planned) that is
already incorporated into our debt burden projections. This level
recognizes that EDCF debt does benefit the city via the associated
economic growth. Approximately $350 million of this $1.5 billion has
been borrowed to date, but substantial amounts have been approved or are
pending approval, which would utilize most of this $1.5 billion.
Approximately $200 million (in TIFs/PILOTs) remains unearmarked and at
the disposal of policymakers, so long as the Community Benefits Fund
operates in part on a pay-as-you-go basis, the proposed District CIP
proceeds with no additional debt in the financial plan years beyond what
is already planned, and a 12% cap is imposed on total debt service to
total expenditures.

The OCFO will continually monitor the debt ratio levels
in relation to the recommended caps, and advise the Executive and the
Council on an on-going basis accordingly.

If you have any questions regarding this matter, please
do not hesitate to contact me. 

Sincerely,

Natwar M. Gandhi

Chief Financial Officer

Attachment: Debt Burden and Borrowing Constraints

cc:   The Honorable Carol Schwartz
(At-Large)

The Honorable David Catania (At-Large) 

The Honorable Phil
Mendelson (At-Large) 

The Honorable Kwame R. Brown (At-Large) 

The
Honorable Jim Graham (Ward 1) 

The Honorable Jack Evans (Ward 2) 

The
Honorable Mary M. Cheh (Ward 3) 

The Honorable Muriel Bowser (Ward 4) 

The
Honorable Harry Thomas Jr. (Ward 5 ) 

The Honorable Thomas Wells (Ward 6)

The Honorable Yvette M. Alexander (Ward 7) 

The Honorable
Marion Barry (Ward 8)

Dan Tangherlini, Deputy Mayor and City Administrator

Eric Goulet, Budget Director, Council of the District of
Columbia

Back to top of page

BACKGROUND AND ANALYSIS 

Types of Bonds

General Obligation Bonds

The District finances a majority of its capital projects
via the issuance of long-term general obligation bonds, as do many other
municipal jurisdictions. The term general obligation bonds (G.O. bonds)
indicates that they are obligations payable from any available
"general" revenues of the government, and that they are backed
by the "full faith and credit" of the District. The debt
service (principal and interest) payments on the bonds are a part of the
District’s annual General Fund operating budgets. The District currently
has approximately $3.8 billion of G.O. bonds outstanding, and the annual debt service on those
bonds was $371 million in FY 2006.

Enterprise Revenue Bonds

Another major category of bonds are issued to support
public enterprises like the District’s water and sewer system bonds
issued by WASA. WASA functions as a public enterprise, or business,
supplying water and sewer services in exchange for fees based on usage.
It does not have taxing power, only the revenues generated by operation
of the systems. Other examples of public enterprises include airports, municipal electric systems,
and toll facilities, none of which the District currently owns or
operates. Public enterprises, if they are to be considered "self-supporting"
by rating agencies, must pay for all operating and capital expenses as
well as debt service, from their own revenue streams, without transfers
from a municipal General Fund. The enterprise revenue bonds issued by
WASA do not count as part of the District’s debt ratios, either as debt
per capita, debt to full value or debt service as a percent of revenues
or expenditures.

Tax-Supported Revenue Bonds

The other major category of bonds that the District
issues is tax-supported revenue bonds, meaning that the debt service on
them is payable from defined, limited revenue stream(s). Such bonds are
not payable from all available District revenues, but only the
particular revenue stream(s) identified, and are not backed by the full
faith and credit of the District. Examples of District revenue bonds are
a) bonds issued by the Washington Convention Center Authority (WCCA) to
build the new convention center, payable from certain District tax
revenues assigned to WCCA and pledged to pay debt service on the WCCA
bonds; b) bonds issued by the District to finance pre-development costs
associated with the construction of the MCI Center, payable from the
"Arena Fee" (gross receipts tax) levied on District businesses
(the Arena bonds have been fully repaid), c) Ballpark Revenue Bonds
payable from sales tax revenues at the stadium, utility taxes on
non-residential customers, lease payments and revenues from the Ballpark
Fee (gross receipts tax), and d) Tax Increment Financings (TIFs) and
Payment-In-Lieu-of-Taxes (PILOT) financings.

Although tax-supported revenue bonds are not general debt
of the District like G.O. bonds, they are governmental debt, and must be
considered in any assessment of the District’s debt burden and its
associated ramifications. More specifically, any debt that is payable
from District tax revenues or General Fund revenues, whether G.O. bonds
or tax-supported revenue bonds, is considered by the credit rating
agencies as a part of the District’s "tax-supported debt",
which is their primary measurement in assessing a jurisdiction’s debt
burden.

Analysis

Bond Ratings and Debt Burden

Rating agencies assign credit ratings to the District’s
bonds, which directly reflect the agencies’ views on the risk of
non-payment of debt service by the District to bondholders. More
broadly, however, the ratings reflect their assessment of the overall
financial condition or financial health of an entity. Bond ratings are a
key determinant of the interest rates that an entity must pay to borrow
funds, and therefore such ratings have direct financial implications in
addition to the broader implications regarding the status and direction
of an entity’s financial health and wellbeing. In determining the
ratings assigned to an entity’s bonds, the rating agencies assess a
number of debt ratios that measure the level of its debt burden as part
of assessing its overall financial condition.

High Levels of Debt and Planned Borrowing

The following table depicts the District’s current and
projected future status with respect to three key debt ratios in
relation to the 2006 median of other large cities’ ratios as documented
by Moody’s Investors Service. The projected ratios include all currently
outstanding debt and assume that from now through 2011 the District will
issue debt for the following, most of which is included in the proposed
FY 2008 Budget and Financial Plan (and associated Capital Improvements
Plan):

• the FY07 Capital Improvements Plan (CIP) for general
  governmental capital projects, approximately $450 million annually),
  including the 15-year schools master facilities plan;
• the Master Equipment Lease/Purchase Program,
  providing shorter-term financing than bonds for assets with shorter
  (5-10 year) useful lives (approximately $50 million annually);
• Schools Modernization Act ($150
  million, separate from amounts included above);
• Department of Transportation
  projects (approximately $200 million, supported by parking tax
  revenues);
• Housing Production Trust Fund (HPTF)
  financing (approximately $225 million, supported by dedicated HPTF
  revenues);
• Government Centers project
  (approximately $175 million);
• various Economic Development Capital
  Projects (TIFs, PILOTs, etc.) (totaling an estimated $600 million):
• a Convention Center headquarters
  hotel and convention center expansion (approximately $300 million);
• Great Streets project (approximately
  $64 million, supported by bus shelter revenues);
• Consolidated Laboratory Facility
  (approximately $150 million);

(The projections in the table also account for the
reductions in debt that will occur as a result of regular debt service
payments on the current and projected debt over the indicated period.)

Effect of Projected Additional Debt on Debt Ratios – as
of May 2007

Analysis of Debt Ratios

As the ratios in the table indicate, the District’s
current and projected ratio for debt to estimated full (property) value
is quite high in relation to the current Moody’s Median. Despite the
escalation in District property values in recent years, this ratio is
still high at approximately 6"•u by the end of FY 2007, and is
projected to grow to approximately 7% by 2009, assuming the additional
debt indicated above.

In debt per capita (for which Moody’s no longer
calculates a median), the District is the highest in the nation, far
higher than most other jurisdictions, with overall estimated
tax-supported debt per capita at $10,429 by the end of FY 2007. (Some of
this is due to the District having to finance state-like capital
projects over the years.)

In terms of the overall debt service-to-total General
Fund expenditures ratio, the District will be at approximately 9% by the
end of FY 2007 and is projected to increase to approximately 12% by
2009. Traditionally, a debt service-to-total expenditures ratio above
10% has been viewed by many analysts in the industry as a "red
flag" indicating movement into the high range. While there are
numerous jurisdictions with ratios that exceed the 10% level, financial
prudence prudence dictates that the District
establish a policy limit or cap that is at or not far in excess of this
level.

Ideally, it would be preferable for the District to
establish a firm cap at the 10% level, but given the District’s current
debt position and taking all relevant factors into consideration, the
OCFO is recommending a target of 10% and a firm management cap at the
12% level. We believe that this recommended cap appropriately balances
the District’s current debt levels and planned important infrastructure
projects with the need to avoid future debt levels that would produce an
unhealthy financial future for the District.

In addressing debt policies that some jurisdictions put
in place to contain their debt burden, Fitch Ratings states that
"typical policies limit direct debt to 2-5% of full market value
and/or $2,000$3,000 per capita [and] debt service to 8-12% of budgeted
expenditures…." While these policy limits refer to direct debt and not all tax-supported
debt, and comparable policy limits were not cited for overall
tax-supported debt, Fitch also states "a comprehensive policy will
include all types of tax-supported debt."¹ Both Moody’s and
Standard & Poor’s also state that they analyze all tax-supported
debt in assessing a jurisdiction’s debt burden.

Based on this research and direct communication with the
rating agencies and advice from the District’s financial advisors
regarding the District’s debt burden, the OCFO recommends the
implementation of a management cap on its debt (in addition to the
District’s existing legal debt cap), utilizing the debt-to-full value
ratio and the debt service-to-total expenditures ratio as the determinants. This latter ratio is particularly important
because it not only provides a statistical measure of a jurisdiction’s
debt burden, but also directly reflects debt affordability and the
extent to which a jurisdiction is consuming, and limiting the
flexibility of, current and future operating budget resources. Specifics
associated with this recommendation are provided in the Conclusion
section of this attachment.

The ratios and projections shown above are a source of
serious concern to the OCFO, and have been considered in determining
recommended CIP borrowing levels and constraints to the Mayor and the
Budget Review Team over the past few years. These concerns are not new.
The OCFO understands the substantial District infrastructure needs,
particularly with regard to DC Public Schools, and has sought to balance
the infrastructure needs with the borrowing constraints in arriving at
our recommended borrowing levels. We have discussed these issues at
length with our financial advisors and with the rating agencies, and
have expressed our commitment to doing everything in our power to manage
the District’s debt burden in a responsible manner. We have argued the
District’s case of "structural imbalance", and have indicated
that a key component of the structural imbalance is the inability to
sufficiently fund the District’s vast infrastructure needs, including
schools.

"Mandatory Expenditures," including Debt Service, are
Consuming an Increasing Portion of Operating Budget

An additional, related concern that should be noted is
the trend of "mandatory expenditures," with debt service as
chief among them, increasing as a percentage of the District’s budgeted
expenditures. This obviously has the effect of reducing the Mayor’s and
the Council’s discretion regarding future budgeting flexibility and the ability to
fund various governmental functions and programs. The attached chart
shows that these expenditures were at a low point of 12.8% in 2001, are
currently at 15.6%, and are projected to increase to 19.2% by 2010.
These numbers provide another incentive to carefully manage the amount
of additional debt incurred by the District, in order to avoid unduly
constraining policymakers’ future budgeting options.

Conclusion

Implement Caps on Debt

As indicated above, in consideration of all relevant
information, the OCFO recommends that the District implement a firm
management cap on its debt, using as determinants two debt ratios that
the bond rating agencies have indicated that they highly value: the
debt-to-full (property) value ratio and the debt service-to-total
(General Fund) expenditures ratio on tax-supported debt. We recommend
that there be a target level and a firm cap for each of these ratios, at
6% and 8%, respectively, for the former ratio, and 10% and 12%,
respectively, for the latter ratio. This combination represents what the
OCFO believes are prudent debt levels to maintain the District’s solid
financial status, allow for continued financial progress, and avoid
jeopardizing its current bond ratings (and, as a result, increasing debt
service costs).

Even now, with its current debt ratios, the District’s
debt burden is considered relatively high. In addition, given that the
District has a financial foundation constrained by a limited tax base
and must perform city, county and state functions without the desired
level of resources or support (to which the high debt ratios are partly
attributable), it is our position that the recommended debt caps
represent debt levels above which the District would begin to risk
compromising and jeopardizing its financial health, future and bond
ratings. Declines in the District’s bond ratings would not only
represent regression in terms of the District’s financial viability as
judged by the financial marketplace, but would also mean that its future
financings would be at higher interest rates, costing the District
additional debt service dollars in its annual operating budgets. The
District has a statutory legal debt limitation on its G.O. debt, but not
for its overall tax-supported debt. Moreover, the G.O. debt limit, which
states that maximum annual debt service cannot exceed 17% of total
current-year revenues, provides a relatively liberal debt cap that does
not impose the level of fiscal prudence necessary to maintain the
District’s financial health.

In their most recent rating reports on the District, all
three of the rating agencies (Moody’s, Standard & Poor’s, and Fitch)
indicated that they consider the District’s debt burden to be relatively
high. In its 2005 assessment of the District’s financial condition
during the process of rating a new District general obligation bond
issuance, Fitch indicated that the District’s high current and projected
debt levels were a significant factor in their deciding not to further
upgrade the District’s rating at that time. Despite this fact, and
through the significant efforts and vigilance of the Mayor and the
Council that contributed to a strong economy and sound financial
management, the District has steadily improved its financial condition
and obtained a series of credit rating upgrades from the rating agencies
over the past several years. The District’s financial recovery since the
mid-1990s and its elevation from below investment-grade (or "junk
bond") status to its current "A" category credit ratings
was hard-earned, and the District must continue to be vigilant in maintaining financial policies
and practices that protect those hardearned gains and keep the District
progressing towards increased long-term financial health. The OCFO
believes that the recommendations provided in this letter are consistent
with staying on that course.

In order to keep its debt within the recommended caps,
the District must, during the financial plan period, be very judicious
about adding new tax-supported debt-financed initiatives beyond what is
already included in the proposed FY 2008 Budget and Financial Plan,
unless such new initiatives are prioritized to displace
currently-planned project(s). The OCFO stands ready as a resource to
assist policymakers in conducting the necessary analysis on an on-going
basis to ensure that the District stays within the recommended caps.

Establish an Economic Development Capital Fund
(Internally Self-Supporting Debt)

In evaluating different types of debt, it is clear that
debt-related initiatives that have an associated revenue stream are
financially preferable to those that do not. In the case of TIFs and
PILOT financings, the ultimate goal is to increase the District’s tax
base. As a result, they can eventually positively impact one of the debt
ratios, namely, the debt-to-estimated-full (property) value ratio.

In light of the distinct analysis and management that is
warranted for debt that is to be supported by revenues directly related
to the project(s) that such debt finances, the OCFO is also recommending
the establishment of an Economic Development Capital Fund (EDCF). This
recommended Fund, which may also be described as an Internally
Self-Supporting Debt Fund, would be a separate pool of funds for capital
projects for which the debt service on such borrowed funds is expected
to be covered by revenues directly associated with the respective
projects.

Debt that qualifies as "self-supporting debt"
from the perspective of the rating agencies, such as Enterprise Revenue
Bonds as described above and certain other forms of revenue bonds that
are repaid solely from a project’s own revenue streams without transfers
from a municipal general fund, are excluded from the rating agencies’
calculation of "net tax-supported debt" as they assess a
jurisdiction’s debt burden. While the debt issued pursuant to the
recommended EDCF may not meet the criteria for being considered
self-supporting debt by the rating agencies, the District would consider
it internally self-supporting debt if it has or is expected to have
sufficient related revenues to cover the debt service on the bonds
issued to finance the project(s). The debt service on such debt would,
however, be included in the total of net tax-supported debt.

The OCFO recommends an EDCF cap of $1.5 billion. This can
be accomplished within the recommended overall firm cap of 12% along
with all other currently-planned authorized debt. This $1.5 billion cap
is roughly the total amount (existing plus planned) that is already
incorporated into our debt burden projections. This level recognizes
that EDCF debt does benefit the city via the associated economic growth.
Approximately $350 million of this $1.5 billion has been borrowed to
date, but substantial amounts have been approved or are pending
approval, vouch would utilize most of this $1.5 billion.   Approximately
$200 million (in TIFs/PILOTs) remains unearmarked and at the disposal of
policymakers, so long as the Community Benefits Fund operates in part on
a pay-as-you-go basis, the proposed District CIP proceeds with no
additional debt in the financial plan years beyond what is already
planned, and a 12% cap is imposed on total debt service to total
expenditures.

In cases in which it makes sense to issue revenue bonds
backed by these related revenues to cover the debt service on such
bonds, the District should do so. However, in most cases it would be
less expensive and more efficient to issue District G.O. bonds as
opposed to revenue bonds, and then allocate the associated revenue from
such projects to cover (pay for) the debt service associated with these
general obligation bonds. This would allow for better and more
coordinated management of the various economic development projects that
are proposed to be funded with debt, such as TIF and PILOT financings.
The OCFO, working with input from the Deputy Mayor for Planning and
Economic Development, will present a more detailed plan on this Economic
Development Capital Fund recommendation in the future.

Mandatory Local Expenditures As A Proportion of Budget: FY 1998 – FY
2011

FY 2006 total excludes financing transfers 

FY 2008/2009
totals include OPEB

Mandatory Expenditures Increasing as Proportion of
Budget, 1998-2011

1. Source: Fitch Ratings, "To Bond or Not to Bond: Debt
Affordability Guidelines and Their Impact on Credit", June 2005.