Category Archives: Finance (government)

Dominion Offers New Investment Option

Dominion Energy has launched a new financing program, Dominion Energy Reliability Investment, that will allow investors to purchase debt issued directly by the company.

The offering bears similarities to money market funds in that investors can put in and withdraw money freely. The big advantage is that they earn significantly higher interest rates — 1.75% for accounts with balances less than $10,000, $2.0% for balances over $50,000, and $1.8% for balances in between. But in contrast to money market funds, which invest in a diversified portfolio of notes, investors enjoy no diversification and do not benefit from federal regulations protecting money market funds, so they do take on a modicum of additional risk.

The program is administered by the Northern Trust Company, so Dominion presumably does pay an administrative fee. Otherwise, middleman are cut out of the transactions to the benefit of both Dominion and its investors.

The idea is not unique to Dominion. Duke Energy, and the financial arms of Ford, GM, Caterpillar and others all have comparable programs, says Dominion spokesman C. Ryan Frazier. The initiative provides “diversified and cost-competitive funding for capital investment programs,” he says.

The company prospectus states that the company can float up to $1 billion in notes outstanding.

Bacon’s bottom line: There is a fringe benefit to this initiative that may or may not have factored into Dominion’s thinking: Expanding the number of investors in the company enlarges its political constituency. Virginians who own Dominion stock often attend public hearings and speak on the company’s behalf. This new program creates a new investment vehicle that should appeal to a new class of investor. If those investors believe they are getting a better deal from Dominion than they can from bank CDs or money market funds, it is not a stretch to think they might be more favorably inclined to Dominion’s public policy positions.

Some observers might find this insidious. I’m perfectly OK with it. I think large companies should do more to expand the investor class and build support for America’s market-based economic system, and if they cut out big bank/big finance intermediaries in the process, all the better. Anything that helps Main Street over Wall Street is a good thing.

The Virginia529 Board Should Be Lauded, Not Criticized

Participation in Virginia 29 pre-paid tuition plan has declined in recent years as measured by the number of accounts and semester-units sold. Graphic credit: Joint Legislative Audit and Review Commission.

State government, local government, universities and independent authorities in Virginia are larded with debt and unfunded liabilities. No one, to my knowledge, has compiled a total inventory of public institutions’ exposure to pension obligations, leases, maintenance backlogs, infrastructure debt, economic development loans, and other long-term obligations. Institutions’ exposure to the vagaries of the economy and fluctuations of interest rates is largely hidden from public view.

One fund operating in the shadows is Virginia529’s tax-advantaged, pre-paid college tuition program. In contrast to the many entities that take on unwarranted risk, however, Virginia529 is a rare instance of sterling governance. The $2.7 billion fund for the prepaid tuition plan is defensively invested to guard against market downturns. It makes a conservative assumption about future returns on its investment portfolio — only 6.25% annually rather than 7.0% for the Virginia Retirement System. And rather than being chronically underfunded as the General Assembly has allowed the VRS to be, Virginia529 is 138% funded. Indeed, the plan is in such solid shape that actuaries judge that it has a 98% likelihood of meeting future obligations to the parents who are trusting that it will deliver on promises to pay for their children’s educations.

Apparently, that’s a problem.

In a review of the 529 plan, the Joint Legislative Audit and Review Commission (JLARC) suggested that the plan is too conservatively run. Its intolerance of risk means that has built up unnecessarily large reserves that make the program unnecessarily expensive. By reducing the size of the pricing reserve on future contract sales from 10% to 7%, JLARC says, Virginia529 could lower the price of an eight-semester contract by $1,851.

Key lawmakers strongly favor the JLARC recommendations, reports the Richmond Times-Dispatch, and they have pressured Virginia529 CEO Mary Morris to adopt the recommendations. Said Senate Majority Leader Tommy Norment, R-James City ominously: “Sometimes there’s a very thin line between defiance and supreme independent confidence.”

True enough, the cost of participating in the Virginia529 plan has surged as the cost of college tuition has consistently outpaced inflation and income growth — a fact that can be attributed (a) to the General Assembly’s cutbacks in support for higher education, and (b) administrative bloat, mission creep and other policies pursued by colleges and universities themselves. Rather than price its plans over-optimistically as, say, long-term care insurers did a decade or two ago only to increase their premiums in order to maintain plan solvency, Virginia529’s governing board prices its product based on the conservative — one might say, cynical — assumption that tuition and fees at Virginia four-year institutions will increase by 5% in the 2018-19 academic year and by 6.5% each year thereafter.

Also true, participation in the plan has declined in the past 10 years as the price has risen, as seen in the chart above. Since fiscal 2009, the number of plan participants has declined from 71,800 to 63,900. Meanwhile, participating families are buying less coverage. The number of annual “semester units sold” has tanked 43% from 18,800 to 10,700 over the same period. Admittedly, that is a disappointing trend.

Virginia529’s investment performance has lagged industry benchmarks over one-, three- and five-year time horizons, says the JLARC report, although it has met or outperformed benchmarks for the 10-year period. “Virginia529 staff, the investment advisory committee, and the program’s investment consultant indicate that the fund is defensively positioned with the intention of protecting assets in down markets and periods of market instability.”

The JLARC report seems to accept that explanation. Staff has a bigger problem with Virginia529’s large pricing reserve. The pricing reserve is a portion of the contract price in excess of the amount needed to pay future contract benefits; the reserve generates surplus revenue to protect the fund against risk. JLARC recommends a guideline that would reduce the pricing reserve as long as the Virginia529 fund has assets in excess of 130% of liabilities. “Reducing the pricing reserve from 10 percent to seven percent would improve affordability of Prepaid529 contracts but would have only a minor impact to the fund.”

Virginia529 staff disagrees. First, reducing the pricing reserve on future contracts creates equitability concerns for those who already purchased contracts. In effect, risk would be shifted to people who paid higher premiums so newcomers could enjoy lower premiums. Second, future dips in portfolio performance could affect actuarial soundness and necessitate returning the reserve to a higher percentage, creating contract pricing volatility. And third, reducing the pricing reserve would have only a modest impact on contract prices. Slashing the reserve to 7% would reduce the price of an 8-semester contract of $67,880 by only $$1,851.

Bacon’s bottom line. Here’s what JLARC and Virginia legislators seem to miss: Virginia529 signs a contract with Virginia families locking in college tuition at a certain price. Virginia529 doesn’t promise to “try real hard” to fulfill the terms of the contract. It will fulfill the contract. It doesn’t have the luxury of raising taxes, or diverting revenue from other programs, or literally borrowing from its investment portfolio and promising to pay it back later, as the General Assembly has done with the VRS. The program should be applauded for adopting an actuarial gold standard.

While JLARC raises reasonable points worthy of discussion by the Virginia529 board, legislators need to butt out. They have no skin in the game. They don’t pay a price if Virginia529 fails to fulfill its promises. If lawmakers want to make college tuition more affordable, they should either (a) increase state funding for public institutions, or (b) do the really hard work of driving costs out of the higher-ed system. Otherwise, brow-beating the Virginia529 board is cheap grandstanding.

A World Awash in Capital

Lawrence H. Summers

Shifts in the global supply and demand for capital are depressing interest rates over the long term, with momentous implications for investors and borrowers, argues Lawrence H. Summer, former Treasury Secretary under President Clinton and former president of Harvard University.

For many years, it has been the conventional wisdom among managers of pension funds, foundation endowments, and other large investment portfolios that it is prudent to operate on a payout ratio of 5%. That wisdom was predicated on the assumption that funds could earn at least 5% annually on a long-term basis after accounting for year-to-year fluctuations in performance. But Summers contends that the payout ratio should be “somewhere under 3%.”

“Payout ratios should be far less, or expected return assumptions should be far lower, than has been the case historically,” he said at a conference sponsored by the National Bureau of Economic Research, “New Developments in Long-Term Asset Management.”

If global finance is in fact experiencing a capital glut, it is excellent news for the United States government, which is the world’s largest debtor. Interest payments on the $21 trillion national debt are a huge driver of budget deficits, and an increase in interest rates could prove calamitous. If Summers is correct, my Boomergeddon scenario could take considerably longer materialize than I suggested in my recent post, “Moody’s Reaffirms AAA Rating. Don’t Get Cocky, Virginia.”

On the other hand, if Summers is correct, chronic low interest rates could depress returns for the Virginia Retirement System and universities like the University of Virginia. The VRS assumes that its assets will average returns of 7% annually over the long term.

Summers argues that the global economy is undergoing a “de-massification” in which technology substitutes for capital-intensive in investment in equipment and real estate. The trend, which is driven by the declining cost of computing power and the rise of Artificial Intelligence, means that businesses need to invest less capital to achieve economic growth. Thus, law firms have shrunk the office space per attorney from 1,200 square feet to 600. And Apple, the world’s most valuable company, decided recently to funnel $100 billion into dividends and share buybacks instead of investing in new capital projects. “Something very important and structural is happening,” he said, when a global innovation leader is deploying its capital that way.

The average yield on U.S. 10-year Treasury bonds and comparable debt for Japan and European nations arguably has shrunk by 250 to 350 basis points (2.5 to 3.5 percentage points) over the past 10 to 15 years, Summers said. In addition to de-massification, he suggested, slower rates of population growth around the world are dampening economic growth and reducing the demand for investment capital.

Writing in my book, “Boomergeddon,” eight years ago, I argued that aging populations, the draw-downs of pension funds, and the rising cost of government entitlements would lead to higher interest rates over the next two or three decades. I failed to consider that de-massification, slower population growth, and slower economic growth would simultaneously depress the global demand for capital.

I’m open to the possibility that an interest rate-led meltdown of U.S. government finances is less likely in a world awash in capital. Let’s just hope that the politicians never get the message, though: Otherwise, they are likely to ramp up deficit spending and the national debt higher than ever. Meanwhile, state governments, elite universities, insurance companies and people saving for their retirement need to adjust to the reality of lower returns on their investment portfolios.

Moody’s Reaffirms AAA Rating. Don’t Get Cocky, Virginia.

Storm clouds off the Virginia coast, circa February 2017. Photo credit: Strange Sounds.

Moody’s Investors Service, one of the nation’s three bond rating agencies, has reaffirmed Virginia’s AAA bond rating and stable financial outlook, the Richmond Times-Dispatch reports.

Moody’s had issued warnings that Virginia’s hallowed AAA status was looking fragile, due mainly to a sharp draw down in previous years of the Commonwealth’s budget reserves. The Revenue Stabilization Fund had shrunk to 1.5% of state general funds.

But the new budget, which awaits Governor Ralph Northam’s signature, appropriates an additional $90 million for the cash reserve, writes the T-D‘s Michael Martz, on top of the $156.4 million already pledged from excess revenues carried over from the fiscal year that ended June 30. The budget also will carry forward an expected $60 million in additional revenues from the current year into each year of the new biennium.

Moreover, said Secretary of Finance Aubrey Layne, a surge in income tax payments after the December tax cuts could produce $500 million in additional one-time payments of income taxes.

Bacon’s bottom line: Governor Northam has pulled off quite the trick, expanding Virginia’s Medicaid entitlement while shoring up state finances. While I am happy to see that Virginia remains one of the 14 states with the coveted bond rating, I regard AAA status as a minimal standard, not a mark of great fiscal probity.

Senate Majority Leader Tommy Norment, R-James City told Martz that the Moody’s report came as “no surprise.” He had characterized the warning about losing the AAA rating as “demogoguery and false assertion to try to scare legislators into voting for [Medicaid] expansion. Complete poppycock.”

I sympathize with Norment’s frustration over his inability to thwart the entitlement expansion, which will be paid for in part by a new tax on hospital revenue, which in turn, to an unknowable degree, will be passed on Virginians in the form of higher private health insurance premiums. I also resent that the public was not informed during the Medicaid-expansion debate of the full cost of the expansion, which will require additional revenues, as yet not identified, to increase reimbursement rates for physicians.

However, I also believe that numerous states and the U.S. government are building unsustainable mountains of debt that eventually will collapse during my lifetime with horrific consequences. The Medicare HI trust fund (for hospital payments) will run out in seven years, requiring Congress to come up with $52 billion (and more in future years) to maintain benefits. Social Security is dipping this year into its own trust fund for the first time since 1982; the trust fund will run out in 16 years, precipitating a 22% cuts to the program. Despite a tax-reform boost to revenues and a surge in economic growth, federal budget deficits are approaching $1 trillion a year. And an increasing number of states are one recession away from fiscal meltdown.

Incredibly, as the nation hurdles toward its rendezvous with Boomergeddon, national political leaders have abandoned any pretense of fiscal sanity. The Democratic Party is moving to the left, entertaining dreams of even greater entitlements. Trump-led Republicans fight increased deficit increases only fitfully, trading off increased domestic spending to pump up the military.

Yes, America is enjoying greater economic growth right now, but the jury is out whether the latest rounds of tax cuts will “pay for themselves.” (I remain dubious.) Global growth has been fueled since 2008 by unprecedented credit creation and debt accumulation, and massive structural vulnerabilities lie beneath the relatively placid surface of international finance. Sooner or later, a gasket will blow — Argentinian bonds, Italian banks, the Venezuelan economy, Chinese real estate markets, war in the Middle East, a cyber attack on the electric grid, or a black swan that no one can even imagine — and the shock will cascade in unpredictable ways through the global economy as one debt domino topples another. Sooner or later, the U.S. will experience a recession, and it will be a doozey.

So, yes, there is every reason to question the ability of the federal government to stick to its Medicaid-funding promises. There is every reason to fear that fiscally crippled states like Illinois, New Jersey, Connecticut and Kentucky will slide down the path to Puerto Rico-style insolvency and throw themselves upon the mercy of an already-overextended federal government, even while the threat of massive defaults roils financial markets and drives up the cost of government borrowing. And there is every reason to think that Virginia will experience a repeat of 2008-style fiscal stress, if not worse — even as it is forced to confront multibillion-dollar shortfalls in public-employee pensions that can no longer be deferred. 

Virginia needs to bullet-proof its budget, not with any old army-surplus vest but ceramic-plated Kevlar-backed body armor. We need a AAA+ bond rating. We need to restructure our economy, our land-use patterns, our transportation system, our health care system, our K-12 and higher-ed systems, our criminal justice system, and every other sphere of state and local government to be more fiscally sustainable during bitter times.

I know this gloom-and-doom talk sounds bizarrely unreal in a growing economy with a 3.4% unemployment rate. But the time to prepare for the storm is when it is far offshore, not when it is upon us.

Seven Years and Counting…

Medicare’s Hospital Insurance Trust Fund (HI) will be depleted in seven years — three years sooner than forecast previously, according to the 2018 Annual Report of the Medicare Boards of Trustees. By 2026, Medicare Part A, which covers hospital payments, will be running a $52 billion annual deficit, a gap that will increase rapidly in successive years.

The forecast is based upon implementation of current policy and makes a variety of assumptions regarding employment, growth of payroll tax receipts, and hospital costs that may or may not be on target. However, the trustees note, shorter-term projections are more likely to be accurate than longer-term projects — and seven years is not that far away.

The trustees’ report triggers a formal Medicare funding warning. President Trump must submit to Congress proposed legislation to respond to the warning within 15 days after submission of the FY 2020 budget. Congress is then required to consider the legislation on an expedited basis.

The political problem is that successive Congresses and presidential administrations have kicked the can down the road for so long that any fix will be politically painful. Rather than phasing in remedies over time, allowing a smoother glide path to solvency and making it easier for affected parties to adapt, Congress will have to enact dramatic remedies…. unless it decides to kick the can down the road again, perhaps by funding the Medicare HI  gap with general revenues.

According to the Congressional Budget Office’s most recent forecast, the federal government is on track to be running a $1.076 trillion budget deficit by 2026. Maybe Congress will say, what the heck, what’s another $52 billion, let’s fund the HI deficit with borrowed dollars. But maybe it won’t. If there’s another recession between now and then, the fiscal outlook could be a lot more alarming than it is today.

Winter is coming. Reforming the federal government is hopeless. Virginia’s only hope is maintaining a fiscally robust state and local government.

No Compromise on the AAA Rating

Virginia Secretary of Finance Aubrey Layne talks fiscal responsibility. Photo credit: Richmond Times-Dispatch

A downgrade of Virginia’s AAA credit rating could cost the Commonwealth between $33.9 million to $72.7 million in additional interest costs on its roughly $4.8 billion in state debt, says Secretary of Finance Aubrey Layne.

“If S&P downgrades and the other two follow, which they usually do, it could cost us millions,” Layne said, as reported by the Daily Press. “No governor, no secretary of finance, no legislator wants to be the guy on whose watch we lost the triple-A.”

Layne based his remarks on a preliminary assessment by the Public Resources Advisory Group, a New York-based consultancy hired by the state. The fragility of the state’s top bond rating has become an issue as the Governor Ralph Northam and the General Assembly continue to tangle with deep structural divisions over the fiscal 2019-20 biennial budget.

Thirty-four million dollars ain’t chump change. But in a two-year state budget of $114 billion, it’s a rounding error. OK, it’s a big rounding error, but it’s still a rounding error. Why do Virginians worry about the bond rating so much?

“Maintaining Virginia’s Triple-A bond rating is more than saving on the cost of borrowing, it is a recognition of being one of the best managed states in the country,” House Appropriations Chair Chris Jones, R-Suffolk, said, as quoted by the Richmond Times-Dispatch. Referring to the three bond-rating agencies that grade government debt, he added, “Virginia has been a Triple-triple A bond rated state for as long as bond rating agencies have conferred the rating, a distinction held only by a handful of states.”

The AAA bond rating is a red line that both Virginia Republicans and Democrats agree must not be breached — a rare example of bipartisan consensus. By itself, a downgrade to AA would not be the end of the world. AA is still investment grade, and Virginia still could issue bonds relatively cheaply. But allowing the rating to slip is like an alcoholic thinking, what the heck, it’s just one little drink, what could go wrong?

Over a couple of decades, AA degrades to A, and then to BBB. Next thing you know, you’re Illinois with billions in unpaid bills and a massive pension liability. And then you’re Puerto Rico, too fiscally feeble to respond effectively to a natural disaster.

At some point, whether ten years in the future or twenty, the federal government will face a fiscal crisis. The national debt exceeds $20 trillion, deficit spending soon will be adding another $1 trillion a year, interest rates on that debt are rising, and Washington, D.C., is neither interested in reforming the entitlement state nor in scaling back America’s global military commitments. Meanwhile, the Medicare Trust Fund for hospital expenses will run out in eleven years and the Social Security Trust Fund will run out in 16 years. And that’s the favorable scenario because it assumes no recessions between now and then.

When Washington plunges into crisis and chaos, we Virginians will be glad we have a federal form of government. And we’ll be glad the state has a AAA bond rating. While Illinois and New Jersey collapse into fiscal insolvency, the Commonwealth will be able to preserve essential functions of government. Virginia’s ability to maintain an orderly government and society is literally what’s at stake. That dystopian future is still a decade or two down the road, so prophesies of calamity seem like scare mongering. But absent a sea change in public and political sentiment that seems nowhere in evidence, that is where we’re heading, and that is why there can be no compromise on the AAA rating.

Just a Reminder…

The national debt has passed the $21 trillion mark. It took only six months to get there from $20 trillion. Unlike the last time the U.S. racked up debt this rapidly, the economy is growing, not in a recession. Blame whomever you want — Boomergeddon is coming. It’s just a matter of time.

The New Normal: Rising Interest Rates

U.S. Treasury Department

The United States enjoyed a three-decade decline in interest rates, beginning with the early-1980s quashing of inflation by Federal Reserve Board Chairman Paul Volker and culminating with Ben Bernanke’s Quantitative Easing in the mid-2010s. Lower interest rates, which made equities look more favorable by comparison, helped drive stock market indices like the Dow Jones Industrial Average and the S&P 500 to record highs.

Now the age of declining interest rates is over. Dead. Pound the nail in the coffin. Dig the grave.

The implications of this seismic shift are dire for the world’s largest debtor, the U.S. federal government. But state and local governments have cause for concern, too.

The manic bull market for stocks took its first big drubbing earlier this week when U.S. Treasury yields took an unexpected uptick. It is finally dawning on financial markets that as good as the Trump tax cuts may prove to be for the economy, they will increase federal budget deficits and borrowing, which will pressure interest rates higher. Even accounting for a stronger economy that pumps up tax revenues, nonpartisan groups say the tax law could add $1 trillion to deficits over the next 10 years.

Meanwhile, the Treasury Borrowing Advisory Committee has estimated that the Treasury will need to borrow a net $955 billion in the fiscal year ending Sept. 30, 2018, up from $519 billion the previous year. Borrowing will increase further to $1,083 billion next year and $1,128 billion the following year. That’s with a strong economy, not a recession.

The Treasury borrowed even larger sums back in 2009 and 2010 as the U.S. economy struggled to pull out of the global recession. But the economic picture looked very different back then, allowing the U.S. to finance $1.6 trillion annual deficits without driving interest rates higher. As the Wall Street Journal explains:

Back then, global demand for safe assets was high and investors gobbled up U.S. Treasury issues, pushing up Treasury prices and down their yields. The Federal Reserve had also cut short-term interest rates to near zero and was beginning a series of programs to buy government debt itself, putting further upward pressure on Treasure prices and downward pressure on interest rates. …

Treasury’s increased borrowing now comes against a much different economic and financial backdrop. The economy is strong and inflation is expected to rise gradually in the months ahead. In response, the Fed is pushing short-term interest rates higher and allowing its portfolio of Treasury and mortgage debt to shrink as bonds mature.

Another factor, I might add, is the weakness of the dollar, which also discourages foreign purchases of U.S. debt and adds to inflationary pressure.

Why am I writing about the end of the era of low interest rates in a blog dedicated to Virginia public policy? Because state and local governments, colleges, universities, economic development authorities, and public service entities are big borrowers, too. Higher interest rates makes life harder for all of them.

To draw from the latest headlines, Mayor Levar Stoney wants to increase the City of Richmond meals tax to fund school building improvements because the city has maxed out its debt capacity and can borrow no more without undermining its AA bond rating. Likewise the Commonwealth of Virginia has borrowed close to its cap, constraining the state’s ability to issue new debt.

Virginia policy limits annual service on its long-term debt to 5% of General Fund revenues. Debt service can be broken into two main parts: the principal borrowed and the interest paid. It is axiomatic: If interest rates increase, so does the annual debt service…. Which means the state can borrow less.

Most important of all, Virginia has a massive unfunded pension liability. That liability, about $20 billion now, has shrunk modestly in the past couple of years thanks to the strong performance of the Virginia Retirement System (VRS) equities portfolio. The next VRS report, reflecting results from the astonishing Trump-era bull market, likely will be positive. Virginia, it will appear, is making continual progress in whittling down its liabilities. No one will be concerned.

But the stock market cannot possibly extend the past decade’s performance into the future. While earnings may continue to improve, stock prices will be dampened by interest rates and shrinking price-earnings multiples. Do not be deceived. The turning point in the bond market does not augur well for either the United States with its $20 trillion national debt or Virginia with its more modest obligations.

Petersburg Now Has a Plan. Does It Have the Will?

Robert Bobb, of the Robert Bobb Group, outlines a five-year financial plan for Petersburg.

The Robert Bobb Group, a consulting firm hired to straighten out the city of Petersburg’s finances, has outlined a five-year plan to keep the city on the fiscal straight and narrow. Among the 15 recommendations is creation of a Financial Advisory Board tasked to make monthly reports on the budget and ensure that financial policies and procedures are being followed, reports the Progress-Index.

The board, comprised of individuals credentialed in finance and accounting, along with a newly created position of Internal Auditor, would give City Council independent insight into what’s happening in city government.

The Bobb Group report also recommended selling the city water system’s excess water capacity or privatizing the utility entirely, and disposing of parcels of city-owned real estate properties, including the Petersburg Hotel and the old Ramada Inn. Converting those properties to cash would help rebuild the city’s fund balance, which currently stands at negative $7.7 million.

The city, which experienced a $12 million budget gap last year and faced $19 million in unpaid bills, narrowly averted a default on its debt. The Bobb Group,  which assumed extraordinary budget powers in a $520,000 contract, rescued the city from insolvency. Among other contributions, the firm claims to have identified more than $10 million in savings and avoided costs. But its contract has expired, the consultants are leaving, and City Council and the apparatus of city government are on their own again.

In their parting report, the Bobb Group listed steps that Council “must take” to keep finances on track. The consultants’ report urged the city to “continue to develop solid financial and business policies, practices and procedures.”

Changing the culture of city government will be easier said than done. A recently released forensic audit of city finances found extensive evidence of abuse of city money and resources in the run-up to fiscal disaster. Reports the Progress-Index in a separate article: “Included in these allegations of misconduct are: misappropriations of fuel for city vehicles, falsification of overtime hours, vacation/sick leave abuse, use of city property for personal gain including lawn mowers and vehicles for travel, excessive or lavish gifts from vendors, and questionable hiring practices.”

“The perception that employees had was that the ethical tone had not been good for quite some time,” said chief auditor John Hanson. “The culture led employees to do things they might not otherwise do.”

Are Virginia Colleges Deferring Maintenance?

Source: State Council of Higher Education for Virginia

According to calculations of the State Council of Higher Education for Virginia (SCHEV), the replacement value of the buildings and grounds of Virginia’s public colleges and universities totals $12.2 billion. And according to the National Association of College and University Business Officers (NACUBO), institutions should plan for an annual reinvestment rate of between 1.5% and 3.5% of that replacement value to offset wear, tear and depreciation.

The Commonwealth established a maintenance reserve program in 1982 to provide funding for facility repairs that are not addressed in the institutions’ operating budgets and are too small to quality for bond financing. Examples might be roof repairs, boiler and chiller replacements, or major electric system upgrades.

Over the past 10 years, the Commonwealth has chipped in about $75 million per year to the maintenance reserve program, according to a report (page 212) submitted Monday to the SCHEV Resources and Planning Committee. That contribution has fallen consistently short of the 1% guideline ($120 million this year) that SCHEV recommends. As of 2011, the cumulative shortfall had grown to $501 million, and this year the state kicked in only l$63.2 million for higher-ed maintenance. 

Instead of funding the maintenance reserve out of operating revenue, the state addressed the condition of colleges’ buildings and grounds by making two state bond issues for new construction. Those outlays did improve the condition of college and university buildings and grounds. But the effect since FY 2009, states the SCEHV report, has been to change the funding source for the maintenance reserve program from the general fund to bond proceeds.  “As a result, the state bond funding for new construction, renovation and deferred maintenance is constrained by the annual debt capacity.”

As Finance Policy Director Dan Hix reminded SCHEV at its monthly board meeting today, the state has little capacity this year to issue new debt without jeopardizing its AAA bond rating. While some money may be available for higher-ed capital projects, he said, it won’t be much.

The practical consequence of state funding policy, Hix said, has been to compel colleges and universities either to generate their own maintenance funds by raising tuition or to simply put off maintenance projects. He offered no estimate of the size of the deferred maintenance liability.

Bacon’s bottom line: The Commonwealth of Virginia is constitutionally mandated to submit balanced budgets. But as I have blogged in the past, there are many forms of hidden deficit spending. One is unfunded pensions. Another is deferred maintenance. I was unaware before today that there was an issue with the condition of colleges’ buildings & grounds. But I’m not surprised. Deferring maintenance is one of the oldest fiscal tricks in the books — I lay odds that the practice dates back to Nebuchadnezzer and the Hanging Gardens of Babylon. Given the stress of higher-ed finances, no one would be surprised that it occurs here in Virginia as well.

While we have a sense of how much the state has short-changed its colleges and universities, we don’t know how many institutions sucked it up and found the money to conduct needed maintenance projects, and how many put off the spending for the next guy to worry about. Perhaps that’s an issue that boards of visitors could dig into. If not, maybe the bond rating agencies will find the practice of interest. One way or another, Virginia’s higher-ed system could be building up a big hidden liability.