THOMAS W. KELTY, Chief Counsel,
Illinois Municipal League

A RARE OPPORTUNITY

Rarely do municipalities have the opportunity to take advantage of sale prices. And, almost never does a municipality have the opportunity to buy its own loans at sale prices. However, the privatization movement that was spawned during the Reagan administration has provided just such an opportunity for certain municipal borrowers.

Privatization is the practice of contracting for or returning to the private sector certain functions (in this case government loans) that private industry can perform more economically or functions that various levels of government have assumed from the private sector because of a lack of interest by the private sector in providing those functions or services. The contracting for services function was discussed in the June, 1987 edition of this column. A current program of the United States Government illustrates the latter function, return of certain functions to the private sector.

For many years, municipalities have had the option of borrowing for municipal projects through the sale of its bonds to the Farmers Home Administration of the United States. Among the advantages of Farmers Home Administration borrowing were lower interest rates and extended terms for the debt. Certain disadvantages, including more stringent reporting and higher reserve requirements, are the "price" that was exacted in exchange for the more liberal payment terms. Dozens of municipalities and other units of government took advantage of the loans, amassing in Illinois alone over $140 million in debt owed to the Farmers Home Administration.

In 1986, Congress adopted the Omnibus Budget Reconciliation Act (OBRA). The purpose of OBRA was to direct the executive branch and its agencies (like the Farmers Home Administration) to liquidate certain "assets" owned by the United States. Included in the items to be sold were loans held by the Farmers Home Administration. And, in accordance with the direction of Congress, the Farmers Home Administration has sold loans during each of the last two years. 1989 is the last year that the Farmers Home Administration has the authority to conduct such a sale, so it may well be that this is the last year that this opportunity will be available to Illinois municipal borrowers.

The Farmers Home Administration is selling loans held by them through a program called the "Discount Purchase Program" (DPP). Although there are few "strings" attached to the program, the time frame in which purchases must be identified and closed is brief, therefore municipal borrowers must act quickly in order to participate in the program.

The DPP has two critical deadlines; March 9, 1989 and May 9, 1989. On or before March 9, a borrower must close on the purchase of a loan OR submit an "Indication of Interest" form to the Farmers Home Administration. If the Indication of Interest form is submitted, it MUST be accompanied by a "good faith" payment. The amount of the good faith payment is five percent of the current balance of the loan. Any loan that is indicated for purchase must be closed by May 9, 1989.

In the event that the borrower does not close on the purchase, the good faith payment is applied to the principal balance of the loan. Therefore, unless a municipality is certain that it will complete the purchase, it should not divert funds from other users to make such a payment. In the event that the municipality has insufficient funds to make the payments, a short term borrowing pursuant to paragraph 8-1-3.1 of the Municipal

February 1989 / Illinois Municipal Review / Page 9

Code could be employed for such a purpose. According to DPP guidelines, borrowers may not use funds on deposit in reserve accounts or other accounts held in connection with the loan.

After the "good faith" payment is made, the final price for the purchase of the loan is determined by two factors, the terms of the current loan and the method by which payment will be made to the Farmers Home Administration. The discount percentage is calculated through the use of tables provided by Farmers Home Administration. These tables require the borrower to determine the percentage rate of interest being paid on the loan and the final maturity date of the loan. After locating the discount factor, the factor times the outstanding balance for the loan equals the amount of the discount. The amount of the discount subtracted from the principal balance of the loan equals the price at which the loan may be purchased. The second factor affecting the purchase price is whether the borrower will use taxable or tax-exempt debt for the purchase of the loan from Farmers Home Administration. Different tables are used depending upon which choice the borrower makes. Discounts for purchasers using taxable debt are greater, but the savings realized from a purchase using taxable debt may be partially or totally offset by the higher interest cost of taxable debt. Finally, the tables that are used for calculation of the discount change monthly, therefore a borrower should insure that discounts are being calculated using currently effective tables.

An example illustrates the savings that can be realized by a borrower. A municipality having an outstanding debt of $100,000, due in twenty years at seven percent interest would be able to purchase its loan for $84,173 if the purchase was made before February 9 and made with tax-exempt funds. At the time that the loan was purchased, any or all of the reserve funds that had previously been deposited could be used to further reduce the amount of money that would be required to complete the purchase. Therefore, in the example, if $10,000 was on deposit in a reserve fund and applied to the purchase, the cost would be reduced to $74,173.

Municipalities that have previously participated in the program have experienced substantial savings that are reflected by either lower annual debt service or a shortened term of borrowing. When bonds are to be issued and sold for the purpose of providing the funds to participate in the program, the borrower can negotiate either of these options with the proposed purchaser of the bonds. Depending upon the option chosen, the revenues needed for debt services can be either reduced or the length of time that the revenue is necessary is shortened. Finally, if the borrower has additional borrowing needs that are consistent with the original purpose of the loan, additional bonds can be issued to provide the funds for the purpose. For example, some issuers that originally borrowed Farmers Home Administration funds for water or sewer improvements have issued bonds both to purchase loans through DPP and to make repairs, improvements or extensions to local systems. If the new bond issue is properly structured, both purposes can often be accomplished without a rate increase to the system users.

The savings that can be realized through participation in this program can be substantial. However each borrower should carefully review its financial position prior to electing to participate in the program. Not often does the Federal Government create a program that is as simple or that has such immediate impact as the DPP. Because of its simplicity and impact, it merits consideration by all Illinois municipalities who have outstanding loans owed to Farmers Home Administration. •

Page 10 / Illinois Municipal Review / February 1989