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DEALS OF THE YEAR

Jersey City collects taxes via asset-backed structure;
How does a municipality on the verge of bankruptcy get $ 44.5 million of delinquent taxes?

Originally appeared in the Investment Dealers' Digest. on December 20, 1993
By Anne Schwimmer

Early this year, it looked like the State of New Jersey would have to take over the finances of troubled Jersey City.

At the time, Jersey City was collecting only 78% of the taxes due it. If collections dropped to 75%, the state would have taken over the finances of the municipality.

"It's the political equivalent of bankruptcy," says Mayor Bret Schundler, who entered office in November 1992 as the first Republican mayor of Jersey City in decades.

According to Schundler, "desperation" led him to the idea of securitizing the city's liens on properties with unpaid taxes by a structure mimicking that of a collateralized mortgage obligation. Indeed, he says he had to be desperate to step into a political dogfight like the one which then ensued.

"Politicians can be very weak vis a vis demanding payment," Schundler explains. "You have to have a mayor who is going to say: 'Listen, we have to require people to pay taxes.' Here in the city my predecessors like to say they were compassionate, because they weren't making people pay their taxes."

Schundler notes that it took a lot of work and debate at each stage of the process to get approval from the city council to do the deal.

Jersey City was struggling with a $ 40 million deficit, Schundler said, explaining that he did not want to try closing the gap by raising taxes -- a move which might lower the collection rate still more -- and could not close the gap through layoffs or other cost cutting measures.

Instead, the city chose to sell $ 44.5 million worth of tax liens on Jersey City properties in a securitized structure common in the asset-backed finance market, yet practically unknown in the public finance sector. According to the mayor, other major cities like Albany, Philadelphia and Chicago have shown an interest in adopting the technique.

In the transaction -- which closed in June -- Jersey City sold the $ 44.5 million in liens to a trust via First Boston Corp., the deal's underwriter. In the first step, First Boston bought the liens from Jersey City for $ 25.5 million in cash and $ 19 million in subordinated notes issued by the trust into which the liens were placed.

Then the investment bank sold a tranche of single A-rated senior notes backed by the overcollateralized pool of liens to institutional investors hungry for high-quality, high-yielding fixed-income investments -- including insurance companies, money managers and banks -- through a private placement.

The senior notes bear a coupon of 8 1/4% and have an average life of 1.5 years.

As with other similar asset-backed structures, any income exceeding the amount needed to fulfill the obligation to the senior note holders will be paid by the trust to the city, as holder of the subordinated tranche of the deal.

Exposure cut to $ 19 million

Through this structure, Jersey City shrank a $ 44 million exposure to unpaid property taxes down to just $ 19 million, and hopes to get even that $ 19 million back at the end of the day, according to Schundler, who cut his teeth on structured finance while an investment banker at Salomon Brothers.

Schundler says that if only some of the total $ 44 million is recouped, the city will garner at least $ 19 million, thanks to New Jersey's stringent 18% interest rate charged on unpaid taxes.

However, the bulk lien sales worked even better than expected, notes Michael Cook, the mayor's chief of staff, who also left the securities industry to join government. When the city announced its plans to sell off the tax liens, many people began voluntarily paying off their back taxes, says Cook, formerly of Chase Securities.

As a result, the $ 40 million needed to wipe out the deficit had already been collected before the lien sale had closed, according to Cook.

The CS First Boston banker who worked on the deal hopes it will be the first of many. Indeed, the State of New Jersey is moving to broaden the legislation which granted Jersey City permission to conduct this transaction. The new legislation, if passed, will extend the same ability to other municipalities in the state and will go a step further, allowing them to group their liens together in a joint lien sale through a state-wide conduit.

"We're excited about the idea because it has a very broad-based appeal, given the number of municipalities which are strapped for cash and the greater efficiency of privatizing the collection and foreclosure process, which for many cities and countries is a cumbersome and labor-intensive process," says Frederick Terrell, a managing director at CS First Boston who worked on the deal.

Other cities said to be eyeing the idea include: New York, St. Louis and New Haven, Conn. New York State is also said to be examining the idea, as is Allegheny County, Pennsylvania.

According to Joel Cooper, senior vice president of WR Lazard & Co., the financial adviser to Jersey City, the city's action has also had a revitalizing effect on the market for municipal tax liens in general. Prior to this groundbreaking deal, cities only sold off their tax liens individually, which allowed buyers to cherry pick.

"What people have been telling us in other municipalities is that more liens are being sold at public auction," Cooper says. "Now there's a feeling of: 'They're not going to sit around forever.' It's been a boost to the whole process."

DEAL AT A GLANCE
Seller: Jersey City, New Jersey
Transaction type: Bulk tax lien sale through an overcollateralized structure. Sold in the private placement market.
Issuers: FBTLC Trust I, FBTLC Trust II
Amount: $ 44.5 million; $ 25.5 million in A-rated 8 1/4% series A senior notes (sold by FBTLC II) and $ 19 million in 29% series B subordinated notes (held by the city and officially issued by FBTLC I).
Maturities: The senior notes mature in 7.5 years, with an average life of 1.5 years.
Fees: Placement fee
Underwriter: CS First Boston
Financial adviser to the city: WR Lazard & Co.


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