Bond Default Threatens Super Bowl XXXII *
By Bill Huck
Managing Director, Stone & Youngberg LLC
Now Managing Director & CEO, Common Bond Capital Partners
Before John Elway and the Denver Broncos could take the field in Super Bowl XXXII, the City of San Diego needed to get its house in order. In this case, the "house" was the 69,000 seat Qualcomm Stadium located about 8 miles northeast of downtown.
Among the conditions for granting the 1998 Super Bowl to America's Finest City, was the NFL's requirement for San Diego to extend its light rail line to Qualcomm Stadium. With the development of the Metropolitan Transit System's Green Line, fans could take bright red trolleys from downtown to the big game. The extension included building about 6 miles of rail line east from the existing Old Town station to a new station to be built in the parking lot at Qualcomm.
The proposed alignment for the Green Line ran along the banks of the San Diego River in Mission Valley. Between miles 4 and 5 on the proposed route was located the First San Diego River Improvement Project or FSDRIP ("Fizz-Drip"). That was a problem, because in 1995—two and half years before the kickoff for Super Bowl XXXII—$24 million of FSDRIP bonds defaulted because the largest land owner within a special assessment district was deeply delinquent in its property taxes and assessments.
How could San Diego keep its commitment to the NFL if the Transit Development Board was unable to lay track across tax-delinquent property tied up in bankruptcy and foreclosure? How could Denver snap its four game losing streak in the game with Roman Numerals if the Bronco's orange-clad fans couldn't take a trolley to Qualcomm?
FSDRIP was formed in 1987 by the City of San Diego as a means to finance $24 million in flood control work by dredging the River channel, building 3 River crossings and 8 small islands, restoring vegetation and creating pedestrian and bicycle paths a mile west of Qualcomm. FSDRIP was a special district formed using California's well-seasoned assessment district laws (adopted in 1913 and 1915) to issue bonds secured by assessments levied on property that derived special benefit from the public improvements being financed. (Today, most California communities use the Mello-Roos Community Facilities District Act of 1982 to finance similar infrastructure.) FSDRIP included about 225 acres of property owned by 4 different real estate developers.
A 32 acre parcel principally owned by a local developer was assessed $18 million of the total $24 million in FSDRIP. The proposed Park in the Valley project received two-thirds of the total assessment because it received the greatest benefit from the project: the parcel was literally created from the former flood plain. The Official Statement for the 1987 bonds stated that the Park in the Valley development "cannot be begun until the proposed relocation of the floodway channel has been assured and any proposed building site has been raised above flood level. It is estimated that phased construction will commence in 1987 and that the first phase will be completed in 1992".
It was the middle of 1993 when I received a call from the City Manager advising me that the still-undeveloped Park in the Valley property had not paid its assessments since 1990. As a result, the $24 million issue was headed toward becoming San Diego's first bond default in anyone's memory.
These days, the FSDRIP property is clogged with traffic and developed with hundreds of apartments, condos, restaurants, shops and offices. However, during the depths of the real estate recession that gripped California during the early 1990s, many real estate projects, including the proposed Park in the Valley, were put on hold or simply failed. Since Stone & Youngberg had purchased the FSDRIP bonds at a competitive sale in July 1987, the City Manager's office was both affording me the courtesy of making our firm aware of the impending default and asking for our advice on what to do next.In truth, I had no idea what steps might be useful in heading off a bond default. During my 12 years in the municipal bond business, the only bond default I could even remember reading about was the colossal $2.25 billion debacle of the Washington Public Power Supply System in the early 1980s. But WPPSS was just a series of headlines for me. This was personal: it was my city, my bond firm and our investors that were involved.
At my first of what would become at least two dozen finance team meetings on FSDRIP, I learned that the delinquencies on the Park in the Valley property then totaled about $4.5 million. From reading the bond law, I knew that the statutorily imposed 10% delinquency penalty and 1.5% per month redemption penalties would have grown to almost $2 million. I also knew that the FSDRIP bond documents required the City to commence foreclosure proceedings after a 150 day grace period. And, I had read the warning in the Official Statement that the City's foreclosure process could be stayed in the event a delinquent land owner filed for federal bankruptcy protection. Of course, that is exactly what the Park in the Valley ownership entities had done a year earlier.
At our first workout team meeting, we also learned that the debt service reserve originally funded at $2.4 million had been virtually depleted. There would be sufficient cash to make the March interest payment—if other land owners in the FSDRIP district continued to pay their assessments—but unless the Park in the Valley delinquency could be resolved soon, the City would have an actual bond default on its hands in September.
It's important to note that under California law, the City of San Diego and other issuers of assessment (or now Mello-Roos bonds) have absolutely no obligation to advance City funds to make payments to bond owners. Rather, the bond issuing agency is required to levy amounts due, receive from the County Tax Collector the assessments that are actually paid by property owners and pass these payments through to bond holders. The issuer is also required to ensure that bond funds are properly spent, keep appropriate records and attempt to foreclose on any delinquent land. The City of San Diego did all these things and much more—including advancing $2 million of City funds—in order to protect its bond holders.
California law also provides that foreclosure on delinquent assessments is a judicial, rather than an administrative, process. Because of the Chapter 11 filing by the landowner entities, the City's lawyers could not push forward with the State court litigation until the federal bankruptcy court gave its approval. As the fall of 1993 ground into the winter and spring of 1994, the workout team listened as the City's bankruptcy counsel explained the challenges they had to overcome to obtain relief from the stay that precluded foreclosure. Finally, the federal judge appointed a receiver for the Park in the Valley ownership entities, the stay was lifted and the City's foreclosure attorneys were given the green light to proceed in the summer of 1994. Old-timers around the California muni bond business had always referred to the remedy protecting assessment bond holders as "fast foreclosure".
I can only conclude that these old hands had never actually been through a foreclosure process themselves. The legal proceedings may only be described as s-l-o-w. Land owners who are delinquent on their assessments and taxes are given more due process and protections that those hosting the Boston Tea Party could have ever imagined. The City's bond counsel firm had two cracker-jack attorneys working on the case. We believe they set a world record in moving the foreclosure case to a judgment and sale—but it still took 13 months.
While a room full of attorneys became excited about finally getting the delinquent land to the foreclosure auction block, we bean counters were growing concerned. State law requires that property with delinquent assessments must be offered at auction with a minimum bid equal to: A) the delinquent assessment installments + B) a 10% delinquency penalty + C) a 1.5% per month (that's 18% per annum!) redemption penalty + D) the legal/other costs of bringing the property to sale. And, oh by the way, the buyer must also assume E) the obligation to pay the outstanding balance of the assessment lien and F) any regular County taxes, penalties and interest that were due.
The legal process had dragged on for 3 years, during which time the delinquencies and penalties grew rapidly. By the time the Park in the Valley land would reach the auction block, we projected that the aggregate tax and assessment liens would exceed $26 million.
Our concern was this: the real estate experts said that the land's value had declined during the recession to about $19 million. State law required the City to set a minimum cash bid of $10 million plus the buyer must accept an additional $16 million in assessment and tax liens. Who was going to buy land worth $19 million for a total cost of $26 million? "San Diego, we have a problem."
The assessment bond law does provide that the minimum foreclosure bid may be reduced upon two-thirds consent of the bondowners. Stone & Youngberg had sold about 70% of the bonds to a single institutional account, with the remaining 30% sold to high net worth retail buyers. Upon initial contact with our institutional account to advise them of the pending default and request their consent to reduce the minimum bid, their attorneys acted like—well, like attorneys for a large institution: cautious. They suggested that the City first try to auction the $19 million piece of property for the required $26 million. Maybe, we'd get lucky. That did not seem likely.
On a bright sunny day in San Diego, a dozen of us stood on the courthouse steps as the Sheriff's deputy asked for a $10 million cash bid for the 32 acres of heavily delinquent property. After 90 seconds of complete silence, the sale was declared a failure and the workout team returned to the conference room to discuss Plan B.
The City of San Diego's workout team did not expect the foreclosure sale to succeed. We understood the numbers, but we first needed to pursue the judicial foreclosure remedy to satisfy our institutional investor and before City Staff felt it appropriate to ask the Mayor and Council to try a more creative approach. With the September payment date on the bonds looming, we felt as though we were watching a train wreck unfold in slow motion. We knew Plan B would take time. We knew there wasn't enough money left in the Reserve Fund to pay debt service. The City's team had given it our best shot and we couldn't yet reload. All we could do was watch as the FSDRIP bonds defaulted on September 2, 1995.
However, because the City workout team did, in fact, know the numbers, we had already prepared a Plan B that was destined to succeed. Our approach recognized two facts: (1) the City of San Diego and the Metropolitan Transit Development Board had already agreed on the alignment of the Green Line extension to Qualcomm Stadium—which ran across the Park in the Valley land and (2) the FSDRIP bond holders and County tax collector were not the only creditors on the Park in the Valley property: there was also a $12 million note secured by a deed of trust. Of course, the land owners were also delinquent on their payments to the note holder. The bean counters and legal minds all agreed on an approach that made both economic and legal sense:
Perhaps no one boarding the Green Line after Denver's 31–24 upset of Green Bay knew how Super Bowl XXXII and the new light rail line had contributed to resolving San Diego's only bond default. But, a handful of us on the City's bond workout team felt like we were part of the Bronco's offensive line: we helped John Elway get into the Qualcomm end zone that day.
* The Handbook of Municipal Bonds
Authors: Sylvan G. Feldstein and Frank J. Fabozzi
Published by: John Wiley & Sons, Inc. (2008)