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Article in the Municipal Finance Journal

Housing development bonds popularly termed "dirt bonds" have been a feature of the municipal bond market ever since they became popular in fast growing states. Default waves occurred with the Texas MUDS and the Colorado Metropolitan Districts during the oil price collapse in the 199x and also in California's Mello/Roos projects in the early 1990s with the cut backs in the defense industry. However, the magnitude of these collapses, combined, does not come close to the meltdown currently going on in Florida. To date some 109 "Community Development Districts" or CDDs have defaulted on $3.4 billion of municipal bonds. Another 90 or so districts are expected to be added to this total before the crisis has passed in two or three years (See the website for more details). The default participants are quick to point out that these projects are simply victims of the nationwide housing collapse, but this is an over simplification. Others would point to the fact that real estate booms and busts are a common event in Florida going back to the early 1900s and are therefore almost a natural phenomenon much like hurricanes. These rationalizations, however, only disguise some of the systemic flaws in the CDD concept and how its bonds come into existence. An examination of the cause of these defaults is instructive in pointing to some remedies for avoiding a recurrence. . A Short History of CDDs Special districts have been a part of Florida's development for over a century. In the modern era legislation authorizing the formation of Community Development Districts was adopted by Florida in 1989 . Districts are authorized at the county level except that those over 1,000 acres need to be approved at the state level. The district is authorized to issue tax exempt bonds to finance infrastructure and amenities in support of a project for single family houses, apartments and condominiums. Districts for strictly commercial buildings or mixed use also exist. The bonds are serviced by a special assessment tax which is imposed on each property owner in the district. The tax is collected by the county on behalf of the district and carries with it the right to foreclose on the property and resell it at public auction in order to collect any arrearage. This foreclosure right supercedes any first mortgage claim on the property. It is this absolute right, even over the first mortgage holders, which gives bondholders confidence that any default will eventually be remedied. The bonds are not, however, an obligation of the county in which the district resides. Since 1989 some 600 districts have been formed and have issued over $13 billion in bonds, much of which has since been repaid. Prior to 2007, defaults were rare.

What Went Wrong The focus of CDD legislation was to provide a vehicle to finance the state's rapid growth. The legislation failed to anticipate a need for safeguards against the abuse likely to occur when a bond issuing process is driven by land developers and underwriters. The county commissioners authorities to approve the projects are generally not qualified to evaluate them and have no independent source for objective opinions. Yes a feasibility study is done, but this too is done by parties hired by the underwriter and often, seeking a management role in the district after it is formed. Since the county has no liability for the bonds the officials focus wholly on the possible upside benefits of the project with little concern for the risks. Added confidence comes from the dearth of failed projects and the mantra that population growth will remedy any over building. It can even remedy a little fraud. A major obstacle do remedying the current difficulties is that the CDD process has evolved from being used to provide basic infrastructure costs such as roads, sewers and electricity to much more. Many of today CDD bonds provide funding for land, golf courses, club houses, tennis courts, wetland mitigation fees, etc. all of which are assessed to the individual home owner. As a result over the years, the tax burden per lot has grown from a supporting a typical $3,000 or $4,000 of bonds to as much as $100,000 of bonds per lot. Housing development is generally a multi year lead time business. Hence, the industry collapse caught numerous projects with a lot of bare land on which roads, sewers, electric lines, clubhouses, golf courses and other amenities were in process or completed only to suddenly face a total lack of buyers.

As the build out phase was completed, the developer was faced with special assessment payments commencing and little prospect that lots could be sold. In short, the developer was on the hook for the entire assessment. Add into the mix a bank which has made a loan to the developer to finance development expenses not covered by the bond issue. The developer may or may not have spent this money, but in any case, must now decide if it is worthwhile making the assessment payments or just walking away. After all, with a large bank mortgage, he may actually have no equity in the project. The bank is in a difficult position in that their first mortgage claim would entitle them to foreclose on the land. However, this means assuming responsibility for the special assessment payments with few prospects for selling or developing the land in the short term. In this situation, the parties that remain in the development have conflicting goals and lack the expertise to remedy the problems. Adding to the CDD problem is the fact that most housing development in Florida is not done via CDDs, but rather, through construction loans from banks. Thus, it is fair to say that the magnitude of the distressed debt problem in Florida is several times the dollar volume of CDD defaults. This aspect of the problem means that banks will be in the position of restructuring their loans with the developers in order to complete distressed projects. By restructuring, I mean of course reducing the debt obligation in order to make the house prices cheaper. This in turn puts CDD backed projects at a huge disadvantage since the tax assessments cannot be reduced without restructuring the bonds and that normally takes a bankruptcy judge. Remedies Restructuring the CDDs can however be achieved without bankruptcy. It requires that someone first own a large majority of the bonds. With such an ownership position, it now becomes practical to take over the land since the assessment expense becomes the income earned on the bonds. This arrangement mitigates the major risk of salvaging a project, namely the uncertain time requirement. It also allows for a restructuring of the bonds, needed to bring down the homebuyers' cost, since a give up in the value of the bond issue is offset by the gain to be derived from the land sales and the enhanced market value of the restructured bonds.

The land sale gain can be substantial because a foreclosure sale will often result in a low acquisition price since the assessment liability being assumed is a huge obstacle to bidding by anyone other than the bond owners. Banks holding a first mortgage on the land are potential bidders and may have to be brought into the restructuring, however, most banks would rather sell their claims since bondholders can afford to wait them out should they take title to the land. We see some evidence that this remedy is under active pursuit by some of the major current bondholders. These bondholders are mutual fund families sponsored by Oppenheimer, Goldman Sachs, Nuveen, Van Kampen and the like. They were the original buyers of many of the issues and appear now to be consolidating their positions in select issues in order to maximize their control. Following such a step they would be in a position to partner with a developer to begin the restructuring process. Conclusion How soon then can we expect Florida to recover from this housing collapse? Unlike past collapses, the growth in the states' population cannot be solely relied on to bail things out. 2009 was the first year in which Florida had more people leaving the state than coming in. The principal reason for this is an exodus of retirees which is attributed to a rise in the cost of living brought on by the costs of hurricane protection, i.e. increased homeowners insurance and structural building costs. This means that growing ones way out of this problem is a much slower prospect than in previous meltdowns. This time the solution is going to require a restructuring of many failed projects, a restructuring which will probably include a reduction of the bond debt a project can reasonably service. As for the future, Florida state needs to examine the process by which CDDs and their bond issues come into being. It would behoove the state to form a department at the state level to oversee the CDD bond issuing process and provide objective input. Since bond issuance is an infrequent process at the county level, knowledgeable and objective oversight cannot be expected. Continuing to allow bond underwriters and land developers to drive this process without such oversight guarantees this will not be the last land bust in Florida. Richard Lehmann is President of Income Securities Advisor, Inc. publishers of the Forbes/Lehmann Income Securities Investor newsletter and The Distressed Debt Securities Newsletter. ISA maintains a historical database on municipal defaults and has established a website ( to provide continuing disclosure on the still evolving CDD problem. He is a columnist with Forbes magazine and a long time Editorial Advisor to the MFJ.