Managing debt capacity: taking a policy-based approach to protecting long-term fiscal health.

• Author: Statler, Bill

A former city manager for the City of San Luis Obispo, California, said, 'Any idiot can borrow money The genius part is being able to pay it back" The Great Recession has certainly underscored the truth of this observation and reminded everyone that a policy-based approach to debt affordability provides an essential foundation for the "genius" part of debt management: paying it back.

LAYING THE FOUNDATION FOR FISCAL HEALTH

Many factors determine a jurisdiction's long-term fiscal health, but the single most important ingredient is developing and articulating clear fiscal policies before financial crises hit. They will help avoid fiscal crisis to begin with; and they will help the organization respond in a prudent manner during times of financial stress.

Local governments exist to make our communities better places to live, work, and play; fiscal health is not their reason for existence. But to achieve its goals, a community needs the fiscal capacity to link those goals with the necessary resources. And this is rarely a matter of luck. A strong local economy makes a difference, of course, but financial management is the most critical factor. Look at the $1 billion Orange County bankruptcy. It did not occur because of an underlying weakness in the local economy but because the county didn't have appropriate investment policies (or didn't follow them).

Any debt issuance should be preceded by longer-term financial and capital improvement plans that address these fundamental questions:

* What does the jurisdiction plan to do, and why?

* How does the jurisdiction plan to pay for it?

* What's the "right" combination of pay-as-you-go versus debt financing?

Plans change over time as actual results replace assumptions, but policies don't. Policies serve as a guidepost that jurisdictions can look at when making plans, making tough decisions easier by laying out the organization's values before they are placed under stress by adverse circumstances. Even if you choose not to follow the policy, at least it provides a good place to start.

THE CITY OF SAN LUIS OBISPO'S EXPERIENCE

In 1996, the San Luis Obispo City Council asked staff to prepare a summary of the city's finances, compared with the six other cities in the county. Along with a number of other financial measures such as revenues and expenditures per capita, San Luis Obispo asked the other cities if they had formal minimum general fund reserve policies, and if so, what they were, and how their actual results compared with their policies.

As Exhibit 1 shows, not all cities with policies had the same ones, or had fully achieved them. However, those cities with articulated policies were clearly in better financial condition than those without them. Exhibit 2 shows the results of a follow-up survey ten years later, when all of these cities in the county had adopted minimum reserve policies and were closely following them.

San Luis Obispo has used formal policies as an integral part of its financial planning and budgeting process for more than 20 years, which has served the city well in both good times and bad. (The fact is that for most governments, the roots of fiscal adversity take hold in the good times, when they make commitments that are not sustainable.) As shown in Exhibit 3, the city's budget and fiscal polices, which are included in its budget document, cover a broad range of areas. (The document is available for download on the city's Web site at www.slocity.org/finance/policies.asp.) Of these, the debt management policies have played an especially important role in preserving the city's long-term fiscal health.

PREPARING DEBT MANAGEMENT POLICIES

There are no right answers in preparing debt management policies, only right questions. These include:

* Who prepares them?

* Who approves them?

* Who sees them?

* Who is the audience?

* How detailed should they be?

* How often are they reviewed and updated?

The importance of effective debt management policies is reflected Exhibits 4 and 5, which summarize the role fiscal polices play in the formal assessment process of two major credit ratings agencies, Standard & Poor's and...