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February 15, 2005 > Vehicle license fee gap receivable financing - What is it and will it work?

Vehicle license fee gap receivable financing - What is it and will it work?

An interview with finance director Harriet Commons of the city of Fremont

TCV: What are vehicle license fees and why do California cities care about them?

Commons: The motor vehicle license fee (VLF) is a fee on the ownership of a registered vehicle in California. It has been in existence since 1935 and was created to take the place of taxing vehicles as personal property. Although the VLF has always been administered by the state, it has also always been passed through to local governments. The VLF is the third largest source of general purpose tax revenues for California cities (after property and sales taxes). Proposition 47, passed by the voters in 1986, constitutionally guarantees that VLF revenues are sent to local governments. However, the state retains authority over both the amount of revenues collected and the method of their distribution.

The VLF has historically been assessed at the rate of 2 percent of a vehicle's depreciated market value. Beginning in 1999, the VLF paid by vehicle owners was reduced to an effective rate of .65 percent. In order to hold local governments harmless from this VLF reduction, the state legislature authorized appropriations from the state general fund to "backfill," or make up for, this reduced amount.

TCV: When are these fees paid to the city?

Commons: These fees (including the "backfill") are generally paid to cities every month.

TCV: Were fees withheld? Why?

Commons: In June 2003, the state director of finance under Governor Davis ordered the suspension of VLF "backfill" payments because he determined that there was not enough state general fund money available to make those payments. This suspension was reversed by Governor Schwarzenegger in November 2003, and VLF "backfill" payments resumed. However, the state did not repay local governments for those VLF "backfill" payments withheld between June 2003, when the payments were suspended, and the end of October 2003, when the payments resumed. The state has acknowledged its obligation to make that payment, which totals $1.2 billion statewide. Fremont's share is $3,544,040.

TCV: When is the money that has been withheld due to be paid to from the state?

Commons: As part of the 2004/05 state budget, the state has promised to repay the withheld VLF "backfill" money in August 2006. However, there is a provision that allows cities to sell the right to this repayment (their "VLF Gap Receivable") through the VLF Gap Receivables Program and receive their money sooner, rather than waiting until 2006 - or, possibly, later, depending on the state's willingness and ability to make this payment.

TCV: In a recent meeting of the Fremont city council, you recommended participation by the city in a VLF Gap Receivables Program. Basically, how does this program work?

Commons: The VLF Gap Receivables Program was created by Senate Bill (SB) 1096 to enable cities and counties to sell their receivable from the state for withheld VLF "backfill" payments (VLF Gap Receivables) to the California Statewide Communities Development Authority (CSCDA) for an upfront fixed purchase price. The way the program works is that participating cities and counties will relinquish their right to the VLF Gap Receivable from the state, in exchange for cash now. These receivables will form a pool to secure notes to be sold to investors. The amount the city will actually receive on this transaction will depend on the interest rate on the notes at the time they are issued. In addition, the notes will be insured to protect the investors should the state fail to pay its obligation on time. Because of that insurance and the way in which the city's sale of its receivable is structured, neither the investors nor CSCDA will be able to go after city funds should the state fail to make its payment on time.

TCV: What is the California Statewide Communities Development Authority (CSCDA)?

Commons: The CSCDA is a joint powers authority sponsored by the League of California Cities and the California State Association of Counties. CSCDA member agencies include approximately 230 cities and 54 counties. The city of Fremont became a member in May 2002.

TCV: What rate will Fremont set on its participation? Why?

Commons: In order to participate in this program, the city has to specify the minimum amount we will accept now in lieu of collecting the full amount in August 2006. If, at the time of sale of the notes by CSCDA in March 2005, this minimum amount will not be achieved, then the city will be automatically eliminated from this round of the program. If the sale results in more than that minimum amount being achieved, then the city will receive those additional proceeds.

The minimum amount the city of Fremont will accept now has been set at $3,224,636. This figure was computed based on an assumed interest rate on the notes of 4.70 percent. This is significantly more than the actual interest rate for this type of note, which was 3.70 percent in late January, when the staff recommendation was prepared. As a result, we believe we will likely receive more than $3,224,636. In addition, because we will have the benefit of having this money 18 months earlier than if we waited to collect from the state, this money can be invested. Adding these estimated investment earnings to the minimum proceeds we could receive from the transaction results in total proceeds of approximately $3,394,000. In other words, the net cost of securing the promised payback from the state will not exceed $160,000, and it will likely be considerably less.

TCV: Why should Fremont participate?

Commons: The two main benefits of participating in this program are: The city receives cash in March 2005, rather than August 2006, and this cash can be invested and the very real risk of non-payment or delayed payment by the state is eliminated.

TCV: Who will buy the notes? Why would they be interested?

Commons: The total size of the note issue will be around $450 million. The notes will be fully insured and, as a result, will carry a AAA rating. Both individual and institutional investors will be potential purchasers because of the high credit quality of the investment. Because of that, we expect the notes will sell at a favorable interest rate, which means that we should receive proceeds greater than our required minimum.

TCV: Will each municipality set its own rate? What happens if the rate set is too high and no one is interested in buying the notes?

Commons: Each municipality determines the minimum amount that it will accept now in lieu of waiting for the state payback in August 2006, or later. If the interest rate on the notes at the time of sale is equal to or less than the interest rate associated with a municipality's minimum acceptable proceeds, the municipality will receive proceeds based on the actual interest rate. If the interest rate on the notes at time of sale is greater than the interest rate associated with a municipality's minimum acceptable proceeds, the municipality will be excluded from the sale because its minimum acceptable proceeds will not be achieved. The marketplace will determine the interest rate on the notes. Because the notes are insured and will carry a AAA rating, we expect the notes will be an attractive investment opportunity and, as such, they will sell at a favorable interest rate.

TCV: If Fremont is successful, where will the money go?

Commons: Given the significant financial challenges the city continues to face from both the state budget and the economy, the money from this transaction will be placed in the city's Budget Uncertainty Reserve.

TCV: Was the money due from the state included in the budget? If so, for what years?

Commons: The money due from the state was included in the city's budget forecast for fiscal year 2006/07, based on the state's promise to pay in August 2006. That is one of the reasons the money will be placed in the Budget Uncertainty Reserve when it is received in March 2005, because it will likely still be needed to balance the budget in FY 2006/07.

TCV: What do you expect the net cost of participation in this program to be for Fremont?

Commons: Based on the fact that proceeds will be received 18 months earlier than originally anticipated, and those proceeds can be invested, we estimate the net cost of participation to be somewhere between $100,000 and $160,000. To put it another way, in exchange for giving up our right to receive $3.5 million from the state in August 2006 (or later), we expect to receive $3.4 million (consisting of at least $3.2 million in March 2005 plus interest between March 2005 and August 2006).

TCV: What are the risks of the program to Fremont? To investors?

Commons: The risks of the program are minimal, both to Fremont and to investors. Because of the way in which the transaction is structured, and because the notes are insured, the investors will have no ability to seek city funds should the state fail to pay on time. Instead, the investors would receive their money from the insurers, who would then go after the state for payment. The benefit to Fremont is that we receive the funds in March 2005, rather than having to wait until August 2006 - or later.

TCV: What other cities are participating? Will they all use different rates? Will they all use a taxable basis?

Commons: There are approximately 155 cities and counties throughout the state who are participating in this program. Each agency determines its own minimum amount that it will accept from the program, and that amount will be compared against the actual amount to be realized based on the interest rate established for the notes at the time of sale. About 75 percent of the participating agencies are in the portion of the program that will issue taxable notes, 16 percent are participating in the portion of the program that will issue tax-exempt notes, and the balance (9 percent) had not yet declared their intent at the time the staff report was prepared.

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