THE 2010 FINANCIAL ADVISORY COMMITTEE REPORT ON

REVIEW OF THE COLUMBIA ASSOCIATION'S FISCAL TARGETS

COMMITTEE MEMBERSChair: James P. Howard, II, Long Reach

Vice-Chair: Alan Romack, Owen BrownEd Coleman, Long ReachRoger Hultgren, Harper's ChoiceRyan McCarthy, Wilde LakeDan Woodruff, Dorsey's Search

COLUMBIA, MARYLANDFEBRUARY 22, 2010

The 2010 Financial Advisory Committee

Cynthia CoyleChair, Planning and Strategy CommitteeColumbia Association, Inc.10221 Wincopin CircleColumbia, Maryland 21044

February 22, 2010

Dear Ms. Coyle:

Please accept the attached report from the 2010 Financial Advisory Committee on “Review ofthe Columbia Association's Fiscal Targets.”

As always, members of the Financial Advisory Committee are available for future consultation regarding this report or other matters the Board of Directors or the Planning and Strategy Committee require. The other committee members and I sincerely appreciate the opportunity to have served the Columbia Association and residents as members of the Financial Advisory Committee and on their behalf, I remain,

Respectfully,

James P. Howard, IIChair, Financial Advisory Committee

Review of the Columbia Association's Fiscal Targets 1

ChargeTo develop a successor to the current Financial Management Program. The current Financial Management Program is a ratio-based tool that is intended to analyze fiscal health. It has been used for the past 5 years and is up for review. The PSC is asking that the FAC benchmark best practices to create a successor program which may include these ratios, but which will not be limited to them.

RecommendationThe Financial Advisory Committee recommends the Columbia Association adopt the Low Range as specified as targets for financial health for the coming decade. These targets have been met mostly under the current financial management plan and could be completely attainable with a measure of fiscal discipline. Meeting these targets will help satisfy investor concern over the long-term viability of CA's debt and encourage bond ratings agencies to continue classifying CA debt at the upper range of investment grade.

Review of the Columbia Association's Fiscal Targets 2

IntroductionThe Financial Management Program (FMP) is a plan developed by the Columbia Association (CA) to provide targets for financial health of the organization. The previous FMP will soon be expiring and the charge asks the Financial Advisory Committee (FAC) to provide a new program consisting of targets for several financial measurement ratios. These ratios are used to measure the debt of the CA and provide insight into its long-term capacity to repay its obligations.

The CA uses debt financing to pay for new and existing programs and has done so since its inception. In general, while the CA does separate its capital and operating expenditures for budgetary purposes, the CA does not tie specific debts to specific programs nor physical plant. The CA has pledged the income from its assessment lien income against the senior secured bonds issued over the previous decades. The CA also maintains revolving credit which is available to finance continuing activities. As a result, the CA's debt is similar to general obligation debt in the parlance of municipal finance.

Much of the CA's debt is issued through the municipal bond market. The CA maintains a revolving line of credit of $20 million and taps that credit line on an as-needed basis to fund current activities. When that revolving line of credit is exhausted, the CA is able to issue marketable securities and uses the proceeds of that sale to extinguish the line of credit and the cycle begins anew. This can happen every two to four years depending upon the specific financial needs of the CA. Additionally, market conditions, including prevailing interest rates, may make it prudent to shorten or lengthen the cycle.

Using debt to fund CA operating and capital has both advantages and disadvantages. On the positive side, the costs of facilities that are used for years or decades can be spread across the entire time period for which the facility is in use, reducing the up front cost of a facility. Negatives, however, are the increased cost due to interest payments and the questionable logic of spreading the cost of operating expenses over a period of years. The core issue at hand, however, is the inherent risk associated with debt management. By incurring long-term liabilities, the CA and residents assume the risk that the CA might default and not meet its obligations.

Because the lien against homeowners is structurally similar to an ad valorem property tax and the CA is a unique organization, the models of credit measurement available to cities and small governments provide the best lens with which to view the CA. The FAC and its predecessors have historically used the model of municipal debt when evaluating the CA's debt management and believes this approach is also used by credit ratings agencies.

This model does have shortcomings, however, as it is predicated on the ability of a jurisdiction to institute a tax on personal income. While many local governments engage in some enterprise activities, unlike many cities, the CA receives approximately half of its income from enterprise activities. As a result, the CA is subject to both cyclical and counter-cyclical market forces. If the organization is fiscally prudent, under these circumstances, it can effectively hedge against the broader market, providing significant protection to its credit standing, without regard to the macroeconomic climate.

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The Financial Model of the Columbia AssociationBecause the CA is effectively modeled as a municipality, and there is evidence to suggest this is the model used by the the credit ratings agencies,1 this is the approach the Financial Advisory Committee will take. Though this model suffers from drawbacks previously mentioned, it effectively relates the ability of the CA to repay its obligations based on its assessment income through the analogy to ad valorem taxes. In this regard, the CA is likened to a small city, with approximately 100,000 residents, in a generally prosperous region. The FAC has historically used this approach to understanding the CA's financial health.

The financial health ratios are important to the CA because some ratios are important for maintaining the CA's debt rating, ensuring cost effective debt placements. Creditors look for guidance from credit ratings agencies and if a ratings agency should consider the CA to be higher risk than a similar sized city, the CA would be forced to pay a higher rate of interest for its debt.

Additionally, some ratios, CA2 and CA3, must be maintained at specified levels by the current bond trust agreement. Failure to maintain those ratios can constitute technical default allowing the bondholders to seize CA assets. The FAC has noted previously that a default by the CA is not similar to a default by a local government given that a local government would likely survive bankruptcy proceedings and bondholders would be disadvantaged in such a proceeding compared to a private organization.

As CA income from both assessments and enterprise activities changes, along with expenses and debt, the financial ratios can vary. For instance, an increase in expenses will cause the ratio of income to expenses to decrease and may signal a potential problem. It is best to consider the set of ratios holistically and not focus on individual measures.

The FAC recommends using the four ratios recommended for observation by the Municipal Bond Association,2 according to their designations by the Budget Committee in 2007:3

R1=total debt /assessed value

R2=total debt / population

R3= per capita debt / per capita income

CA1=debt service / revenues

For reference, the Budget Committee also considered two other ratios, but because these are required by the bond trust agreement, the FAC will not recommend targets for those ratios:

1. Columbia Association Budget Committee, “Measuring the Financial Health of the Columbia Association,” (Columbia, MD: Columbia Association: 2007).

2. Judy Wesalow Temel, The Fundamentals of Municipal Bonds, (New York: John Wiley & Sons, 2001): 176.

3. See note 1.

Review of the Columbia Association's Fiscal Targets 4

CA2=debt service /annual charge revenue

CA3=operating expenses /revenues

The required target for CA2 is 67% and for CA3 is between 65% and 70%.4 The current FMP also includes references to other ratios that the FAC believes should no longer be considered.

Criteria for Policy EvaluationIn evaluating a potential change in ratio targets, this Committee will consider four questions:

1. Bond Rating–How does this affect the bond rating? Will changing a given target alter how credit ratings organizations view the Columbia Association?

2. Solvency–How does this affect the solvency of the corporation? This is closely related the first question, but is subtly different in extremity.

3. Cash Flow–How does this affect the cash flow? Will a specified target impact cash flow positively or negatively?

4. Assessment–How would this affect the assessment lien? Some changes may be best implemented by changing the assessment lien rate.

Policy AlternativesThe Committee will consider four potential targets for financial planning. The first option is to maintain the current situation and keep the existing targets. The first alternative is an array of low-range targets, exemplified by low debt and a push for expenses drawing from current income. The second alternative is an array of mid-range targets, showing a middle-ground approach. The third alternative is an array of high range targets, exemplified by higher debt. There are infinite possibilities within the spectrum of options. However, the Committee believes these four options present a simple but broad picture of the effects of the entire spectrum. The target ranges are:

Alternative R1 R2 R3 CA1

Current FMP N/A N/A N/A 25.00%

Low Range 1.00% $750 1.00% 5.00%

Middle Range 2.00% $1,300 3.00% 10.00%

High Range 3.00% $2,000 5.00% 15.00%

The CA currently only has targets for the final metric, CA1.

4. Columbia Association Budget Committee, Report on the FY2006 Budget, (Columbia, Maryland: Columbia Association, Inc., January 27, 2005).

Review of the Columbia Association's Fiscal Targets 5

Comparison of Alternatives by CriteriaThe comparison matrix for the effect of each alternative on each criterion the Financial Advisory Committee deemed important is as follows:

Alternative Bond Rating Solvency Cash Flow Assessment

Current FMP Neutral Neutral Neutral Neutral

Low Range Positive Positive Positive Negative

Middle Range Negative Neutral Neutral Neutral

High Range Negative Neutral Negative Positive

This analysis is subjective and can be interpreted in a variety of ways. It is the FAC's best guess as to how altering the targets would affect the CA's financial condition. However, the FAC is comfortable making this judgement due to its current and past analyses of the CA's and local governments' financial conditions.

RecommendationThe Financial Advisory Committee recommends the Columbia Association adopt the Low Range as specified as targets for financial health for the coming decade. These targets have been met mostly under the current financial management plan and could be completely attainable with a measure of fiscal discipline. Meeting these targets will help satisfy investor concern over the long-term viability of CA's debt and encourage bond ratings agencies to continue classifying CA debt at the upper range of investment grade.

Review of the Columbia Association's Fiscal Targets 6

Appendix 1: Ratio Comparison for Selected Cities NationwideBeaverton, OR Boulder, CO Fargo, ND Kenosha, WI Las Cruces, NM

FY 2008 Figures

Founded 1893 1859 1871 1835.00 1907

General Obligation Debt $14,190,063 $60,120,000 $174,922,478 $8,236,434 $173,357,114

Debt Service $2,299,897 $12,883,000 $10,087,666 $7,499,567 $262,549

Assessed Value $7,000,000,000 $2,416,542,000 $3,201,497,937 $6,341,813,300 -

Revenue $60,605,037 $174,794,000 $108,246,514 $71,561,315 $84,539,359

Property Tax $28,131,042 $21,865,000 $17,269,481 $42,822,076 $7,777,195

Operating Expenses 58,252,893 $154,896,000 $97,307,824 $64,061,748 $70,995,143

Population 85,560 94,171 93,531 96,950 89,722

Per Capita Income - $28,976 $37,553 $27,237 24293

Key Ratios

CA1—debt service / revenues 3.79% 7.37% 9.32% 10.48% 0.31%

CA2—debt service / annual charge rev. 8.18% 58.92% 58.41% 17.51% 3.38%

CA3—operating expenses / revenue 96.12% 88.62% 89.89% 89.52% 83.98%

R1—total debt / assessed value 0.20% 2.49% 0.05 0.13% -

R2—total debt / population $166 $2,075 $4,658 $302 $1,932

R3—per capita debt / per capita income - 7.16% 12.40% 1.11% 0.08

Source: Committee Compilation

Review of the Columbia Association's Fiscal Targets 7

Appendix 1: Ratio Comparison for Selected Cities Nationwide (continued)Livonia, MI Macon, GA Roanoke, VA Sandy, UT Waukegan, IL Wilmington, NC

FY 2008 Figures

Founded 1950 1823 1882 1893 1859 1739

General Obligation Debt $63,070,804 $67,452,000 $275,531,207 $2,425,000 $94,565,307 $29,655,000

Debt Service $2,818,271 $4,963,690 $31,165,398 $1,779,700 $8,306,966 $7,388,341

Assessed Value $5,209,000,000 $1,895,364,925 $7,407,774,726 $8,834,376,909 - $13,643,490,563

Revenue $127,400,000 $104,892,000 $287,996,553 $70,491,195 $89,250,643 $80,730,676

Property Tax $58,381,619 $17,814,000 $98,714,420 $7,233,667 $17,356,638 $41,472,281

Operating Expenses $123,100,000 $93,964,000 $306,874,197 $65,334,719 $87,873,000 $69,638,456

Population 91,220 90623 93504 96660 89877 100192

Per Capita Income $27,923 32619.00 33358.00 49151.60 - 32800.91

Key Ratios

CA1—debt service / revenues 2.21% 4.73% 10.82% 2.52% 9.31% 9.15%

CA2—debt service / annual charge rev. 4.83% 27.86% 31.57% 24.60% 47.86% 17.82%

CA3—operating expenses / revenue 96.62% 89.58% 106.55% 92.68% 98.46% 86.26%

R1—total debt / assessed value 1.21% 3.56% 3.72% 0.03% - 0.22%

R2—total debt / population $691 $2,068 $2,947 $49 $1,052 $904

R3—per capita debt / per capita income 0.02 6.34% 8.83% 0.10% - 2.76%

Source: Committee Compilation

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Appendix 2: Historical Ratio Comparison for Selected Counties in MarylandAnne Arundel Baltimore Co. Howard Montgomery Columbia Assn.

FY 2006 FiguresFounded 1650 1659 1851 1776 1965General Obligation Debt $875,982,000 $752,245,000 $541,323,315 $1,493,888,054 $63,035,000Debt Service $104,580,589 $68,084,000 $67,132,766 $215,372,072 $12,703,000Assessed Value $43,802,722,000 $48,292,908,000 $29,852,994,080 $110,529,249,116 $8,034,858,000Revenue $1,047,237,963 $1,389,453,000 $996,345,521 $3,410,462,595 $52,923,000Property Tax $411,488,309 $588,640,000 $353,894,412 $1,073,936,688 $26,060,000Operating Expenses 924,028,630 $1,325,854,000 $931,195,501 $3,273,734,293 $30,775,000Population 511,549 786,650 276,287 953,000 98,383Per Capita Income $44,927 $39,478 $54,924 $61,805 $54,924

Key RatiosCA1—debt service / revenues 9.99% 4.90% 6.74% 6.32% 24.00%CA2—debt service / annual charge rev. 25.42% 11.57% 18.97% 20.05% 48.75%CA3—operating expenses / revenue 88.23% 95.42% 93.46% 95.99% 58.15%R1—total debt / assessed value 2.00% 1.56% 1.81% 1.35% 0.78%R2—total debt / population $1,712 $956 $1,959 $1,568 $641R3—per capita debt / per capita income 3.81% 2.42% 3.57% 2.54% 1.17%

Source: Committee Compilation

Review of the Columbia Association's Fiscal Targets 9

Addendum 1Per the request of the Columbia Association's Planning and Strategy Committee, the FAC provides a time table for reduction of CA1:

Fiscal Year CA1

2011 16%

2012 18%

2013 15%

2014 12%

2015 11%

2016 6%

2017 5%

2018 5%

2019 5%

2020 5%

The values for fiscal year 2011 through 2016 are based upon the existing and proposed debt as of April 30, 20125 and assumes a 3.0% increase in income from all sources for each year.

5. Columbia Association, Operating and Capital Budget (Draft), (Columbia, Maryland: Columbia, Association, Inc., December 17, 2009).

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Addendum 2The Columbia Association's Planning and Strategy Committee asked the FAC to consider the impact of a proposed new headquarters building on the targets recommended in this review. The FAC recognizes that a proposed building project will be expensive and impossible to fund from current revenues. Borrowing will be necessary. However, these recommendations are based on best practices and it is incumbent upon the Columbia Association's Board of Directors to balance the value of a new facility with the costs of building it.