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Securitization Of Tax Liens Jolts New Life Into Sagging City
Originally appeared in
the The Bond Buyer on June 7, 1995
When Bret Schundler took over as mayor of Jersey City in November 1992, he said
the time was ripe for radical change in the postindustrial, fiscally troubled Democratic
stronghold that in 1991 had issued bonds to fund the city's operating expenses.
By radical change, the former Salomon Brothers Inc. bond salesman meant a neoconservative and very Republican reform based on school vouchers, privatization
of city services, and tax
lien securitization.
Now 35 years old and named recently by Time
as one of America's "most promising
leaders age 40 and under," the fresh
faced Harvard graduate continues to focus on cleaning
up Jersey City even as his Democratic opponents in the City Council throw
obstacles in his path.
One plan of Schundler's that has undeniably worked is the use of securitized property
tax liens to rejuvenate the city's finances. Taking a page from the Wall Street book on
mortgage
backed securities, Schundler created a new market by bundling the city's delinquent
tax liens and successfully selling them to institutional investors.
With Jersey City's tax collection rate now up to 94%, and the local property tax cut by
$7 million, other cities, including New York City and Waterbury, Conn., have taken notice
and done their own tax
lien securitizations.
Recently, in a wide
ranging conversation that touched on Rousseau's notion of a blissful
state of nature and Hobbes' reflections on man's fallen nature, the mayor, who once thought
of becoming a Presbyterian minister, spoke to staff reporter Joyce Hanson about how he
tapped the market to save Jersey City.
Q: Was it through your experience on Wall Street that you got the idea for the Jersey City
tax
lien financing?
A: Sure. I was at Salomon when they effectively initiated the mortgage bond market.
Before that time most mortgages were actually held by the original lender, and the secondary market didn't really take off until the early 1980s. First they developed mortgage
backed
securities, then you saw things like auto loan receivable securities. They even packaged
things like mobile homes. I would argue that Salomon was the pioneer in asset
backed
securities. When I came to Jersey City as mayor, [liens were] just another receivable, and
you can certainly make them into an institutional investment. The problem we had was we
couldn't get banks to buy liens because each lien was so small. It may be a $3,000 or $4,000
lien. So by putting $44 million liens together, we got a sizable pool which was worth doing
some due diligence on.
Q: How did you explain the financing to Jersey City taxpayers?
A: Well, if you send out a bill and someone doesn't pay their taxes, you're going to
have to charge taxpayers more so that they will pay for the person who is not paying. A lien
is created for the taxes owed by a taxpayer, and that is effectively like a mortgage. So if you
can get somebody else to invest in that mortgage, you can get from an investor the money
you need to run your operations and you don't have to increase the tax rates. Now the problem
with that is when you have a lot of liens created, you end up having more liens than there are
individuals buying them. So when you began to have more liens than you had individuals,
you had a market that wasn't clearing. What happens when a market doesn't clear? You have
all these taxes that are owed and not being paid with nobody investing in
them. What then
ends up happening is you have to increase the tax rate on everybody else to get the money
you need to run your operation. So we said to ourselves, this is going to become a vicious cycle.
Q: So what did you do?
A: We figured out a way to effectively clear our inventory of liens, and that was by
creating one big pool that we'd sell into a trust account that we
created.. With $44 million of liens in that trust account ...the city decides okay, and we'll accept $25 million in cash and
$19 million in a [subordinated] note for the $44 million of liens that we're selling. Now where
does the trust account get the cash? The trust account sells a senior note to outside investors for
$25 million, the trust gets that cash, and it passes it through to Jersey City. The trust account
also issues a subordinated note for $19 million and they give that to the city. T he outside
investor who bought the senior note, he's got a senior note which has $25 million in face value,
collaterized by $44 million worth of lien. Now that you have an investment which has got a
face value of $25 million, it's worth investing in for institutional
investors. So you've got a whole new entrant into the market, and any time you expand your buyers you are able to
lower the yield you have to provide.
Q: And now you have a much better collection rate on your delinquent taxes.
A: Right.
Q: Will you be able to securitize the liens in the future?
A: Oh, anytime we want, if we need to. And what happens here is [the outside investor
is] only taking 8% interest on that , but the liens themselves are accruing interest at [a state
statutory interest rate of ] 18%. So what happens is you end up getting surplus interest
accumulating in the trust account beyond what has to be paid to senior noteholders, and all of
that will come back to the city. We also have a private collection firm now which is working
on collecting the $44 million worth of outstanding debt plus the interest that accumulates in
the future. So through a combination of lowering your tax rates and improving your collection
operation through privatization, you now have the necessary combo for increasing your ongoing
collection rate.
Q: So where do you see this program going as the collection rate improves?
A: Well, this program will be used repeatedly whenever you begin to see the collection
rate fall. Anytime that collection rate falls and a city builds up an inventory of liens, they'll
securitize the liens and that will give them a chance to immediately get
caught up.
Q: So essentially, a new market has been created .
A: Right. There's a market in the securities, but there's also more of a seller's market in
the liens. There's always been a market in individual liens, but we drew a lot of attention to the
lien market through the securitization of them. We created new classes of buyers and investors.
So by increasing the number of buyers and actually decreasing the supply of lien products, it
makes it a lot easier to sell the conventional ones.
Q: What are the sort of governments that would be most likely to benefit?
A: Anybody who has seen collection rates fall would want to do this because this is a way
to immediately get caught up ... Now you don't want your collection rate to fall. But if a city
allows its collection rate to fall through whatever set of circumstances, once you're into this
vicious cycle of
falling collections resulting in rising tax rates resulting in increased defaults and
falling collections how do you get out of it? Well, the way you get out of it is by taking the
whole bundle of inventory liens and securitizing them and getting a
massive revenue infusion. Drop
your tax rate and then privatize the collection effort so you keep people up to date. That's how
you get out of it. It's the equivalent of that electric shock
machine for heart attack patients. You can get cities back into health.
Q: What happens at the auctions?
A: As a delinquent taxpayer, if you don't pay your taxes, the state requires that the city charge you 18%. You go to this original auction and you hold up an individual lien on a person's
house, and say this person owes $3,000. Will anybody buy this lien? Will anybody pay off what
they owe to the city? If so, you can become entitled to have them pay you the money that's
owed, plus 18%. Now someone will say okay, I'll do it. Well, someone else might say, listen,
I'll pay off that person's taxes and take their mortgage, or lien, and I'll do it for 17%. Another
person says, I'll do it for 16%. If you have a very active market, with lots of buyers and not a
lot of liens, not only will you clear your inventory of liens, but the taxpayer will get a break
because the bidding will be heavy. Instead of having to pay 18%, the rate will be bid down to a
much more affordable rate. You can conceive of it getting bid down to approximately the
mortgage rate. You don't imagine it would ever go below that because, if
you were an investor, you would rather invest in a bank mortgage
backed security at 8% than an individual lien.
Q: So have you thought of any other ways to make Wall Street financing ideas work for
Jersey City?
A: That's the only thing in terms of securitization that we've done. But I would like
information on what various market participants are interested in. If you get good information on
what buyers will pay for, that gives you an incentive to go down to the state and ask for a waiver
to be able to, if you will, satisfy the more aggressive appetites of a given market. The first rule
of sales is know your customer. If we have good information on what investors want, that can
allow us as an issuer or a borrower to provide what the buyer really wants and get a higher price.
Q: Both you and New Jersey Gov. Christine Todd Whitman are reform
minded Republicans, but do you have conflicting goals about how much state aid Jersey City
should get?
A: We don't have conflicting goals. Our goals are 100% synonymous. The governor's
goal is to cut state taxes and she is doing that, and her goal is to cut state spending and I would
like to see that happen. That hasn't happened yet, but that's vitally important because what has
to happen is you want the state to maintain its municipal aid. Its municipal aid should continue
to grow at the rate of inflation.
Thus far she's frozen municipal aid and she is not cutting state
spending, so what happens is it becomes tougher for the cities. To
accommodate
her tax cuts, she's making life difficult for
mayors by cutting real state aid to municipalities.
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