By Dan Linehan
---- — The city of Madelia has little debt, and pays what it has quickly. Its conservative budgets create annual surpluses in both utility and general government accounts. And it has plenty of money saved up.
Moody’s Investors Services, a firm that examines how well governments and companies are able to pay their debts, heaped praise on the city during a recent credit rating change. The only surprise was the direction of the change — Moody’s lowered the city’s credit rating.
The agency cited residents’ relatively low incomes and steep declines in the city’s tax base.
Madelia is not alone. About 40 Minnesota cities, including six in south- central Minnesota, have seen their credit ratings lowered in the past 18 months, almost all by Moody’s. There was only one downgrade in 2011.
One area city, Le Center, dropped seven notches in a so-called “super downgrade,” in 2012, causing the city to lose its “investment grade” status. It was downgraded two notches further, to B1, earlier this year.
The trend, first reported by Watchdog.org, has some cities and analysts wondering if Moody’s is accurately gauging these cities’ financial health. Declines in tax base are cited as a reason for the downgrade in nearly every case, though most of the downgraded cities have other problems as well. Many or most Minnesota cities lost some tax base in the recession as home prices fell, but a steeper decline took effect in 2012 after the Legislature changed how taxable value is calculated.
To give lower-valued homes a tax break, the Legislature decided to exempt part of their value from taxes. This shifted the tax burden to more- expensive houses and businesses, but it did not, by itself, affect the amount of taxes cities collected. There was still a tax consequence, though, as cities were forced to raise their tax rates to compensate for the reduction in tax base.
The result, especially in rural cities with older houses, was that the tax base fell dramatically. Madelia’s market value dropped by 23 percent in 2012, to $62.8 million. Of that decline, about 84 percent was due to the tax change, said Gary Carlson, government affairs director for the League of Minnesota Cities.
Dan Madsen, city administrator of Madelia, called the Moody’s downgrade “misguided” because the legislative change didn’t make the city any poorer.
“ To be downgraded for something out of our locus of control is a bit frustrating,” he said.
Other cities, too, are asking these questions. The downgrades will have the consequence of raising interest rates for cities to borrow money.
“ The conversation among local governments is: Is Moody’s correctly interpreting what is changed here?” said David MacGillivray, a principal with Springsted, a St. Paul-based public sector advisory firm.
In a statement, Moody’s said it is aware of the legislative changes to taxable values brought on by the market value exclusion.
“ While this had a one-time negative impact on the assessed and full market taxable values of certain homesteads, we have seen a multi-year trend of steep declines in valuations prior to the legislative change, which is an indication of economic challenges,” the statement said.
The statement noted that while cities can still increase their levies, “political unwillingness to do so in some cases has led to fiscal pressure.”
Moody’s cited North Mankato as an example: “ The city has also not raised its property tax levy to increase revenue although it has the ability to do so.”
A declining tax base is the most common problem cited by Moody’s, but it is not the only one. In other words, some cities have more to worry about than a falling tax base.
Le Center has been downgraded twice in the past 18 months and ended up with a B1 rating earlier this year. It was one of two cities, the other being Vadnais Heights, that recently lost “investment grade” status as a result of the recent downgrades.
Some banks don’t lend to below investment grade cities, so the market for creditors shrinks, said Lisa Washburn, author of a report for Municipal Market Advisors, a public finance research and advisory firm, on the Minnesota downgrades. She called them “alarming” but added that cities will still probably be able to make their debt payments.
Le Center deals with debt
Le Center City Administrator Christopher Collins said the city of 2,506 people has about $15 million in debt, or about $5,985 per person, mostly from loans to fund street projects. Statewide, Minnesota’s small cities have $3,027 in debt per person.
“ We just decided to bite the bullet and take on the debt,” he said.
But it turned out the city bit off more than it could chew.
The city has loan payments due Feb. 1 and Aug. 1, but like all Minnesota cities doesn’t get its first property tax payment until May or its first state aid payment until July.
For the last several years, Le Center has not been able to make its February loan payments. So it’s been forced to take out short-term loans to pay back its long-term loans.
After state aid and property taxes come in, the city can pay off both loans. It’s still a problem, though.
“I’m not saying that it’s all a timing issue,” Collins said. “ We should have more in that fund.”
The council certainly has not been shy about raising the levy. From 2009 to 2012, the city raised the levy by 95 percent. There was a smaller increase for this year, 5.25 percent, to give taxpayers a break.
Collins said Le Center is going in the right direction. Though the city ended 2011 with a negative general fund balance of $52,000, it ended last year with a positive $75,000, he said. And they’ve paid $18,000 to a financial adviser to come up with a plan to help the city, which is still facing a negative outlook from Moody’s.
“It doesn’t matter how painful it is. It’s something we have to do,” he said.
Other cities have their own problems that contributed to credit downgrades. North Mankato, as previously reported, is dealing with about $3.75 million in deferred or delinquent assessments. Le Sueur’s sewer fund isn’t generating enough revenue to pay back loans to the state.
But questions remain about what appears to be the link among these downgrades: falling tax base caused by the Legislature’s change to taxable values. Other credit rating agencies are only responsible for three city downgrades over the past 18 months, according to the Municipal Market Advisors report.
This is likely in part because Moody’s rates credit worthiness for most Minnesota cities, but it may also reflect different analyses by the two other major credit rating agencies.
“I still don’t believe that Moody’s is really assessing the impact appropriately,” said Carlson with the League of Minnesota Cities. The legislative change mostly hit Greater Minnesota cities, as did the credit downgrades, because the change reduced taxable value only for lower- and middle-priced homes.
“ We actually saw some cities that lost roughly 30 percent of their value and we honestly have cities in the metro area that lost one-tenth of 1 percent of their value,” Carlson said. There is an effort on to persuade Moody’s to take another look at its credit rating changes.
Madsen, the Madelia adminis-trator, emailed a Moody’s analyst for weeks but didn’t get far.
“They said, at times we agree with your position, but it doesn’t create a material change,” he said.
In its statement, Moody’s said it downgraded 23 local governments in 2012 and 14 in the first quarter of 2013. Moody's rates 379 local governments and school districts in Minnesota, the company noted.
“Moody’s has had a negative outlook on all U.S. local governments since 2008, and downgrades have outpaced upgrades during that time,” the statement reads.
MacGillivray, the Springsted principal, said it’s extremely rare for rating agencies to admit they made a mistake and reverse their position. He’s not sure that’s the case, to be clear.
“I want to phrase this carefully,” he said. “I don’t know if they’re right or wrong.”
Cities pay more to borrow
The effect of rising interest payments on taxpayers is impossible to estimate in advance. Though interest rates depend on several factors, including how the municipal loan market is performing overall, a lower credit rating will generally drive an interest rate higher.
For example, the average interest rate of Mankato’s three most recent loans is 1.91 percent. That low figure is thanks in part to the city’s strong AA2 credit rating.
Le Center’s interest costs run closer to 3.5 percent, or higher.
If both cities borrowed $1 million using those rates and paid back the loan over 10 years, Mankato would pay about $210,000 in interest. Le Center would pay about $415,000.
Except for its short-term loans, Le Center can avoid paying those higher interest costs if it doesn’t undertake any costly road repairs.
That’s Collins’ plan.
“I’ve been preaching to the council to not do any street projects or any bonding until after 2015,” he said, by which time the city will have made progress on paying back old loans.
“Until we want to go bond again, it doesn’t hurt us,” he said.
This article was edited to correct an error. Le Sueur lost its investment grade status as a result of a seven-notch downgrade, in 2012, not a three-notch downgrade.