Tax lien securitization: putting nonperforming assets to work.

• Author: Tigue, Patricia
• Position: Innovations in Debt Financing

Uncollected tax receivables impose a burden on the finances of local governments. Local governments rely on tax receivables to pay for municipal services, including police, fire, transportation, and park services. Delinquent tax revenues detract from the ability of governments to fund these essential public services. To the extent that these amounts represent a significant portion of a jurisdiction's budget, higher tax rates may be needed to ensure that planned service levels can be maintained, penalizing citizens who do pay taxes.

Several local governments have taken advantage of financing approaches to convert tax receivables into up-front cash payments. A number of states permit local governments to liquidate property tax receivables by selling tax liens attached to properties for nonpayment of property taxes or other assessments. When a tax lien is created, the unpaid taxes accrue at high interest rates until they are paid. Penalties also may be imposed. Tax liens are removed when all unpaid taxes, accrued interest, and penalties have been paid.

The sale of tax liens has proven beneficial for governments that are able to use this approach. Rather than wait until the taxpayer makes up delinquent payments, governments authorized to sell tax liens are able to covert these receivables into up-front cash payments. Some governments find the sale of tax liens is preferable to foreclosure on properties on which taxes are due. These jurisdictions may not be able to afford the legal fees associated with foreclosure or may be unwilling to expose the government to negative political fallout which may accompany this action. Additionally, with the foreclosure option, governments end up with a portfolio of properties that do not generate taxes, impose added liabilities for the government, and must be disposed of at some point.

Securitization of Tax Liens

In recent years, the practice of selling tax liens has been done on a larger scale. In 1993, the City of Jersey City, New Jersey, became the first local government to securitize its tax liens. Tax lien securitization is accomplished through the creation of a trust which purchases outstanding liens of one or more jurisdictions. The trust then issues bonds that are purchased by investors. A portion of the proceeds is used to pay the jurisdiction for the sale of the tax liens. In a typical securitized lien transaction, the amount of bonds issued is less than the par amount of the liens (e.g., 70 percent). This over collateralization provides comfort to investors but with little or no cost to the government.

In addition to an up-front payment, the jurisdiction selling the liens also receives a subordinate position with respect to the balance of the value of the liens (e.g., 30 percent). The effect of the subordinate position is to give bondholders first priority in receiving delinquent taxes as they are collected. Any collections in excess of the principal and interest amounts to be paid to bondholders would then revert to the jurisdiction. Since tax liens are usually a relatively small percentage of the value of the property (5 to 20 percent), property owners or banks holding the mortgage will generally want to extinguish the tax lien rather than risk foreclosure on the property. Redemption rates of tax liens that have been sold to investors have historically been in excess of 90 percent.

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