CDFA Spotlight: Moral Obligation Bonds By Stan Provus

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This article examines moral obligation secured bonds.

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This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel.

The use of the moral obligation pledge has changed since its first use by New York state in the early 1970’s to support debt of its housing finance agency. Where a moral obligation pledge once was used primarily by states to support housing agency debt, increasingly states and localities are using a moral obligation pledge to reduce capital costs for a variety of purposes, including economic development, environmental remediation, and social service delivery.

Moral obligation bonds do not carry the full faith and credit pledge of the obligor (i.e. state or locality). Rather, the moral obligation requires the issuer to maintain a debt service reserve fund at a specified reserve requirement, typically maximum annual debt service, and report any deficiencies that arise to an appropriate official of state or local government. The official then is required to request an appropriation from the legislative body to make up any shortfall. Since there is no legal requirement to make the appropriation, timely payment depends on the obligor’s willingness to support the debt.

Standard and Poor’s recognizes the security of this moral obligation pledge, but the lack of a legal obligation to appropriate results in these bonds being rated one full category below the obligor’s general obligation bond rating. For example, if a state’s general obligation rating is “AA”, a moral obligation securing bonds would typically be rated “A.”

Moral obligation bonds are then another type of credit enhancement used on both taxable and tax-exempt municipal bonds. In addition, the Finance Authority of Maine (FAME) uses the moral obligation pledge for commercial loan insurance/guaranty programs.
FAME has $90 million of full faith and credit authority and $150 million of moral obligation authority. These credit enhancement/guarantee resources totaling $240 million are used for the SMART (taxable bonds) and SMART-E (qualified small issues for manufacturers) bond programs as well as the Authority’s Commercial and Small Business loan guaranty programs with bankers.

In 1994, the FAME was authorized a separate $330 million of moral obligation authority for the Electric Rate Stabilization Program (ERSB). In 2003, $115.6 million was outstanding on these bonds. In addition, FAME was allocated a separate $120 million allocation of Moral Obligation bonding authority for the Major Business Expansion Program in 1995.

Description of FAME Moral Obligation Programs

SMART Bond Program

This program provides taxable long-term bond financing on loans of up to $7 million for real estate, machinery, and equipment acquisitions. Bonds are placed with the State’s pension system at market interest rates. FAME charges a 1% commitment fee, an annual credit enhancement fee of up to 2% based on risk, and $5,000 legal fee.

SMART-E Bond Program

This program, like the SMART bond program, was established in 1986. In the past it has been used to provide tax-exempt bond financing for both composite and stand-alone issues. Tax Code restrictions now limit project eligibility to manufacturing facilities—Qualified Small Issue bonds. The program can provide up to 90% financing generally in the range of $2,000,000-$7,000,000. FAME charges a 1% commitment fee and annual credit enhancement fee not to exceed 2% based on the risk of a project.

Major Business Expansion Program (MBE)

This Moral Obligation secured bond program was established in 1995. This program provides long-term credit enhanced financing up to $25,000,000 at taxable bond rates for businesses creating or retaining 50 jobs and long-term, tax-exempt bond financing of up to $10 million for Qualified Small Issue bonds for manufacturers. This program is intended for very established companies. FAME charges a .5% commitment fee on the first $10 million of bonds and $50,000 plus .15% of the amount between $10-$25 million. Annual credit enhancement fees range from .25% to 1% based on risk as determined by FAME.

Electric Rate Stabilization Program (ERSB)

This program was created in 1994. FAME issued nearly $330 million of taxable bonds for the state’s electric utility companies. The purpose of the program was to provide financing to electric utilities to enable them to buyout high electric rate contracts with electricity suppliers, particularly alternative energy projects constructed in the 1970’s and 1980s.

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.