Joseph Krist

Municipal Credit Consultant

ADMINISTRATION OFFERS A PLAN FOR PUERTO RICO

After advising and standing back from direct involvement, the Obama administration has finally offered a plan for consideration by Congress to address Puerto Rico’s debt disaster. The plan would create new territorial bankruptcy rights and impose new fiscal oversight on Puerto Rico. But it requires cooperation from a Republican-led Congress bent on imposing spending restraint. Given the current state of Republican dysfunction in Congress, the likelihood of adoption is not high.

In describing the package, administration officials emphasized that they had exhausted the limits of their own authority to help Puerto Rico, and needed action by Congress to avoid a catastrophe. “Administrative actions cannot solve the crisis,” Jacob J. Lew, the Treasury secretary, said in a joint statement with Jeffrey D. Zients, the National Economic Council director, and Sylvia Mathews Burwell, the health and human services secretary. “Only Congress has the authority to provide Puerto Rico with the necessary tools to address its near-term challenges and promote long- growth”.

The administration is attempting to jumpstart consideration of the plan by calling Puerto Rico’s situation a humanitarian crisis. One senior administration official said the situation in Puerto Rico “risks turning into a humanitarian crisis as early as this winter”. That official was quoted anonymously in the press as saying that the Puerto Rican government has already “done a lot” to restore fiscal order but “Puerto Rico cannot do it on its own, and the United States government has a responsibility to 3.5 million Americans living in Puerto Rico” to step in with additional help.

Whether that is the case is open to debate. At the same time its administration allies were making the humanitarian case, the Government Development Bank said it had ended weeks of negotiations with certain creditors, aimed at persuading them to voluntarily accept lower bond payments. The bank has a bond payment of about $300 million coming due on Dec. 1.

It is our cynical view that the GDB never expected the negotiations to produce a settlement. The view that Puerto Rico has done all that it can is not shared here or by many others. For example, even the front man for PR’s efforts in Congress –  territorial  representative Pedro Pierluisi –  told Congress last week “the Puerto Rico government must break its entrenched spending habits, which have not adjusted to changing economic and demographic realities. Our government must be a better steward of funds received from taxpayers and lenders, accounting for every dollar it spends. The local tax system requires reform, because it is complicated and unfair. Some taxpayers owe too little, while others owe too much. And the government does a poor job of collecting what it levies.”

We think that real financial disclosure and a viable structure for accounting for and collecting revenues are the bare minimum required for debt holders to make any concessions let alone any of significance. Even Bernie Sanders called for more disclosure and transparency in a letter last week that effectively criticized debt holders as vultures seeking to starve children.

CHICAGO APPROVES TAX INCREASE…

Chicago’s City Council approved a budget Wednesday that includes a massive property tax hike and other fees to help close a shortfall and improve the city’s underfunded pension system. The  $543 million property tax increase was for police and fire pensions, along with a separate $45 million property tax hike for school construction, a $9.50 monthly household garbage pickup charge and other fees. The property tax will be phased in over four years, with the largest chunk — $318 million — added to property tax bills payable in August 2016. That increase will be followed by successive increases of $109 million payable in 2017, $53 million payable in 2018 and $63 million added to the property tax bill due in 2019.

The proposal has state legislative approval but Republican Gov. Bruce Rauner has not been supportive of a tax increase. For the plan to be implemented, Gov. Bruce Rauner must sign the legislation that would give Chicago 15 more years to ramp up to 90 percent funding level for the pension funds. Business groups and a renters’ association have testified at the Capitol against the exemption, saying the property tax hike would get passed on to consumers and renters. One of Chicago’s difficulties in addressing its budget and pension problems has been the need for legislative approval. The legislatures unwillingness to approve actions taken by the City is just another indication of its lack of courage in dealing with the State’s problems.

For the owner of a home worth $250,000, the annual property tax bill will be roughly $550 more. Over four years, a homeowner’s property tax bill could rise 13% more. This is only the second increase in property tax rates in the City since 1987. The garbage collection fee, common in the suburbs, is a first for Chicago. It will be added to water bills that arrive in mailboxes every other month.

…AND REDUCES ITS RATE EXPOSURE

While the City of Chicago has been constructing a budget, it has also been taking advantage of the current interest rate environment to fix the cost of its debt. As of this month, the City has now converted to a fixed interest rate 100% of its GO, sales tax, and wastewater debt. We have seen other troubled credits with weak fundamentals also be saddled with variable rate interest exposure. The removal of this risk allows at least that one aspect of the City’s debt burden to be a lessened source of pressure on the City’s ratings. If the tax increase is finally implemented, the downward momentum impacting the City’s credit would be slowed.

PENNSYLVANIA BUDGET IMPASSE WILL HAVE TO WAIT

The Commonwealth of Pennsylvania will likely enter its fifth month without a resolution of its budget impasse. In spite of rising difficulties for localities, school districts, and social service providers, the Pennsylvania Senate adjourned for two weeks as of yesterday. While negotiations will likely continue at the staff level and the Senate could be recalled to approve legislation in the event of an agreement, the decision to adjourn is telling. State Auditor Eugene DePasquale warned that the state’s schools were approaching a half-billion dollars in borrowed money simply to stay open. Those costs, he said, could double if there’s not a budget by Thanksgiving. The Philadelphia School District has already borrowed $275 million for cash flow.
Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

ILLINOIS

The Illinois legislature reconvened this week in another effort to craft a FY 2016 budget. The ongoing linkage between the Governor’s desire for policy changes in the management of the state labor force and a resolution of the state budget stalemate has come into clearer focus. As much as old-time politics has influenced the legislative side of the budget equation, Governor Rauner’s stubbornness in holding out for politically charged changes in union bargaining rights and work rule issues have come to be viewed as serious obstacles to resolution of the stalemate.

The fact that 90% of state spending is mandated statutorily or by the courts (including debt service payment) is unfortunately contributing to the entrenched stances of both sides. There are items that are not being paid. State Comptroller Leslie Munger said  Illinois will have to delay a $560 million November payment to its pension funds, and may also delay or reduce a similar payment in December. This reflects reduced cash flow associated with the lack of a budget. State pension funds will be paid in full by the time fiscal 2016 ends on June 30 using money from higher cash flow months in the spring. Illinois’ debt service payments on bonds total $3.4 billion in fiscal 2016, while payments to its five retirement systems total $6.8 billion.

So it comes as no surprise that Fitch Ratings downgraded Illinois one notch to BBB-plus.

PUERTO RICO

Puerto Rico found out how low the level of trust on the part of creditors is when they reacted to the latest proposal for an oversight board. The generally negative reaction followed the announcement that Governor Alejandro Garcia Padilla has presented to the legislature the Puerto Rico Fiscal Responsibility and Economic Revitalization Act (the “Act”), which will establish the Puerto Rico Fiscal Oversight and Economic Recovery Board (the “Board”). According to the announcement, the Board will be comprised of five members appointed by the Governor and approved by the Senate. The members will select a chairperson from among themselves. It is the lack of outside participation in the process of picking members of the Board which causes concern.

The announcement comes amidst a swirl of rumors over a potential plan by which the U.S. Treasury would assist the commonwealth government in issuing a large bond deal —a “superbond”—with the federal agency in charge of administering some of the island’s tax revenue to repay holders of the new bonds. The hope is that this would lead to Commonwealth revenues at some level going through a “lockbox” to ensure payment on the so-called “superbond”.

At the same time, Resident Commissioner Pedro Pierluisi recently presented a bill in the U.S. Congress that seeks to authorize Treasury to guarantee repayment of principal and interest on future bonds issued in by the commonwealth. The Treasury-secured bonds under Pierluisi’s bill would only be used for urgent short-term financing needs, capital expenditure projects that promote long-term economic development or to refinance existing debt at lower interest rates. Treasury would also determine and notify Congress that Puerto Rico “has demonstrated meaningful improvement in managing its public finances.”

The current unwillingness of the island to accept meaningful outside oversight in order to assuage investors concerns should create a serious roadblock to successful resolution of efforts to negotiate a debt restructuring. Currently, under a proposed debt exchange PRIFA notes would be secured with the proceeds of a rise in oil taxes adopted earlier this year. It is estimated that the PRIFA notes would have had an 8.5% coupon and a 10% yield to maturity.

The existing note holders ultimately rejected this plan, in which the holders would have exchanged their notes for PRIFA notes at 130% of their market value. In addition, there were preliminary plans to have PRIFA bonds mature from 2020 to 2037, which would have extended the maturities held by investors on some and perhaps all of their securities. The bonds would have been callable probably from 2018 onwards at a price assuring a 12% yield-to-call.

If a court impaired the effectiveness of the guarantee of the PRIFA notes, which were supposed to be senior to other PRIFA debt, then the note holders could have exchanged the PRIFA notes for the old GDB notes. If the commonwealth were not to make timely payments on its general obligation bonds or if the commonwealth were to seek bankruptcy for the PRIFA bonds, these events would be considered a default on the PRIFA bonds.

The GDB said it was disappointed that it was unable to reach a constructive and mutually beneficial agreement with the Ad Hoc Group of GDB creditors. According to the GDB, it and the Working Group for the Fiscal and Economic Recovery of Puerto Rico continue to make progress towards a comprehensive voluntary exchange offer that addresses the commonwealth’s indebtedness in a holistic manner and through which creditors across the commonwealth will agree to amended payment terms through consensual negotiations.”

Apparently, Puerto Rico has not earned the market’s trust yet.

TEXAS METHANOL PROJECT FINANCING

In 2013, a $1.8 billion financing for a fertilizer production facility sponsored by an Egyptian company spurred controversy when it came to market. There were concerns about the roots of the foreign ownership, potential dangers from the production process, and the attendant financial risk that bondholders might be assuming that could result from these factors. That financing was successfully accomplished and that project in Iowa is on track for completion by the end of this year.

Now as that plant nears completion and operation, another large financing for a methanol production plant in Texas is being readied for the market. That plant is sponsored by the same Egyptian company and its successors. The largest use of methanol by far is in making other chemicals. About 40% of methanol is converted to formaldehyde, and from there into products as diverse as plastics, plywood paints, explosives, and permanent press textiles. In the US in 2011, the Open_Fuel_Standard_Act_of_2011″ was introduced in the US Congress to encourage car manufacturers to warrant their cars to burn methanol as a fuel in addition to gasoline and ethanol. The bill is being championed by the Open_Fuel_Standard_Coalition”.

Currently, domestic production accounts for one-third of methanol production while some 20% is imported from politically unstable Venezuela. The shale gas boom and lower domestic energy prices have boosted the perceived economics of the project. The combination of supporting domestic production and the seemingly reduced role of a middle Eastern based sponsor (after the pending merger is closed) are seen as factors reducing potential controversy around the deal. The location of the plant amidst a cluster of other petrochemical production facilities reduces concerns about dangers from the process or terrorism.

Once again, the municipal market is seen as a receptive vehicle for yield hungry investors seeking credit diversification and large block size in transactions that are really venture capital financings. This deal, like so many others, presents a complex series of agreements including fuel sourcing and transportation, production, transportation and distribution agreements, and a variety of commodity price based risks. These are all in addition to basic construction and operating risks and the resulting financial risks. All in all, a deal typical of what we see in the municipal market at the end of a low interest rate cycle and a red flag to savvy municipal investors.

CALIFORNIA

State revenues fell short of Department of Finance projections by 2.6 percent in September, but are still ahead of estimates for the first quarter of the 2015-16 fiscal year. In September, two of the state’s three top revenue sources were lower than projections. Retail sales and use tax revenues of $1.7 billion were $392.5 million, or 18.8 percent, less than estimates. Corporation tax revenues of $836.6 million came up $135.2 million short of projections, or 13.9 percent. Only the personal income tax beat Department of Finance expectations. Revenues of $6.7 billion were $447.0 million (or 7.2 percent) greater than anticipated in the budget.

When all taxes and revenues are included, the state in September brought in $9.6 billion, or $252.2 million less than projected in July. Compared to a year ago, September revenues came up short by 1.8 percent. However, for the first quarter as a whole, revenues exceeded last year’s by $1.6 billion, or 7.5 percent. The state ended September with $26.9 billion in unused borrowable resources—$3.8 billion, or 16.7 percent, more than expected.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

ARIZONA WASTE DEFAULT

The waste to energy sector of the municipal market has long been plagued with financial difficulties due to political, economic, and/or operating failures. The municipal landscape is littered with failed projects and interrupted or failed payment streams.

The latest example is a financing under taken through the Industrial Development Authority of the City of Phoenix, Solid Waste Disposal Facilities Revenue Bonds (Vieste SPE, LLC – Glendale, Arizona Project). The original project, which was negotiated in 2012, was a two-phase relationship between Vieste and the City of Glendale with phase 1 being the construction of the waste facilities to sort recyclable materials from a stream of acceptable waste to be supplied by the city. Phase 2 of the project would have built an energy facility for the conversion of solid waste into renewable energy.

Phase 1 was completed in 2014 and opened Feb. 20. Immediately, the operator – Vieste SPE – contended that the project was not required to accept yard waste and the issue was submitted to arbitration. An arbitrator’s ruling dated March 31 ruled against the city, stating, “the arbitrator finds that yard waste is not an acceptable waste type under the waste supply agreement before the date on which the phase 2 energy facilities are commissioned.” Due to the disputes with the City of Glendale, the Solid Waste Disposal Facility is not operating and is not generating any revenue to make any payments on the bonds.

In the interim, the Debt Service Reserve for the Bonds has been depleted and the limited funds remaining in the Debt Service Reserve Fund are insufficient to make payments to bondholders. Further, as a practical matter, the Vieste SPE, LLC acknowledges its obligations, but it has no ability to make payment. No further payments will be made to bondholders until a resolution of litigation can be achieved, or circumstances otherwise change.

The issue in question would seem to be one of a somewhat cut and dried nature. That will apparently be determined through an arbitration and litigation process as Vieste LLC has filed a notice of claim against the City of Glendale for $200 million for breach of contract. Vieste claims that it is willing to begin construction on phase two, which would separate all the trash, including yard waste, if the city would accept less payout per year to cover the cost of the construction. The reduced payout would finance a portion of construction costs. The City position is that the project should result in no cost to the City.

This is not the first contract to be subject to dispute as the result of upheaval in the Glendale government resulting in part from questions over the terms of contracts negotiated by previous local administrations. The much better known dispute between the City and the NHL Arizona Coyotes is the most prominent example.

Regardless of the result, the sector should set off alarm bells when these sorts of public/private projects come to the municipal market for financing. It is clear that unless the investor has a high level of knowledge and confidence in  the details and strength of the underlying contracts and operation agreements, than these sorts of issues might be best left to the high yield professionals or speculative investors.

FLORIDA BOND VALIDATION RULING

An October 1 ruling validating $700 million of clean energy bonds by the Florida Supreme Court overturned 60 years of case law and made it harder to challenge future bond validations. The Florida justices overturned a 1955 precedent set in the case Meyers v. City of St. Cloud. The Meyers case held that a party that does not appear in a bond validation proceeding in circuit court, where the cases are initiated, still had the right to appeal from the trial court’s decision directly to the state Supreme Court. From now on, litigants must appear in the initial circuit court validation case to preserve their right to appeal.

Since Meyers, the court had stated on three other occasions that citizens and taxpayers who failed to appear in the circuit court bond validation proceeding nevertheless had standing to appeal the final judgment. In this case, the Court relied upon the plain terms of the statute, which specify that “any person wishing to participate in bond validation proceedings must appear in the circuit court.  In connection with the filing of a bond validation complaint, section 75.05(1), Florida Statutes, requires that “[t]he court shall issue an order directed against the state and the several property owners, taxpayers, citizens and others having or claiming any right, title or interest in property to be affected by the issuance of bonds or certificates, or to be affected thereby, requiring all persons, in general terms and without naming them and the state through its state attorney or attorneys of the circuits where the county, municipality or district lies, to appear at a designated time and place within the circuit where the complaint is filed and show why the complaint should not be granted and the proceedings and bonds or certificates validated.” Section 75.07, Florida Statutes, goes on to provide that “[a]ny property owner, taxpayer, citizen or person interested may become a party to the action by moving against or pleading to the complaint at or before the time set for hearing.”

Under these provisions, full party status is granted only to those who appear and plead in the circuit court proceedings.

LIPA TO RESTRUCTURE MORE DEBT

This week the Long Island Power Authority (LIPA) could see a second tranche of securitized debt issued that would be applied to the early retirement of some $1 billion of its outstanding debt. The issue comes after amended legislation permitting the securitization which would add to some $2 billion of similar debt authorized by the State in 2013. Proceeds would be applied to the purchase, maturity, or redemption of some of LIPA’s outstanding revenue bond debt. The securitization would be secured by a discrete charge on customer bills which are required to be segregated for the benefit of the securitized bondholders.

This refinancing method creates a more highly rated and lower cost financing vehicle for restructuring the LIPA debt and takes advantage of the current low interest rate environment. The impact of the scheme is a net credit positive for the LIPA revenue bond credit.

MIXED SIGNALS FROM DeBLASIO ON CITY FINANCES

The announcement over the weekend that New York City and the Metropolitan Transportation Authority had reached an agreement on the MTA’s capital funding plan raises some interesting questions about the City’s fiscal policies under the DeBlasio administration. The agreement settles, for the meantime a dispute over what the appropriate level of funding on the part of the City should be for this state agency’s capital needs. Under the agreement, the state pledged $8.3 billion in state funds to the authority, while the city would contribute $2.5 billion. The city had initially agreed to provide $657 million. Where the additional City money will come from is not specified.

The dispute is long running. A recent report by the City’s Independent budget Office reviewed the history of City funding over the period since 1982. The city makes an annual payment to the Metropolitan Transportation Authority (MTA) to support the authority’s capital program. According to the IBO, if the City contribution had remained constant in inflation-adjusted terms since the 1982-1986 Plan, Annual Aid would have exceeded $360 Million in 2014. The city’s contribution to the MTA’s first five-year capital plan (1982-1986) averaged $136 million a year. In nominal terms, the city’s contribution was highest during the 1987-1991 and 1992-1999 plans and has remained fairly constant at around $100 million per year since 2000. The city’s contribution to the MTA’s 1982-1986 capital plan averaged 1.2 percent of total city-funded expenses over the five-year period. Over time the city’s contribution as a share of total city-funded expenses has declined dramatically. The city’s contribution to the MTA capital plan in 2010-2014 averaged just 0.2 percent of total city-funded expenses a year.

$1.9 billion of its funding will come from the city budget and $600 million will come from alternative revenue sources that were still being negotiated with the authority. City officials said one option being considered was a method called value capture, which pays for upgrades by collecting taxes and fees from new development spurred by transit access.

The agreement continues a worrying pattern of inconsistency on the part of the DeBlasio administration. At first, the City takes a position that its finances are stretched and that further increases would damage fiscal stability. This tactic has been used in its general labor negotiations, police staff level debates, and in the ongoing MTA funding dispute. Each time, the issues have been resolved with the City eventually agreeing to higher funding levels than it says it can afford or, in the case of police force staffing, an agreement to a level in excess of that requested. This sends an extremely foggy message about the true state of the City’s budget as well as the outlook for the years ahead.

As for the MTA, any agreement that increases intergovernmental funding should be viewed as a positive for the credit to the extent it slows the growth in its massive current and future debt burden. The agreement as proposed still leaves the Authority some $700 million short of its own estimate of its needs. This in a system that is becoming increasingly expensive for its working class riders while retaining a seemingly insatiable appetite for capital. This in an environment that sees increasing regional competition for potential additional funding sources throughout the region.

NASSAU COUNTY DREAMS ON

One example of regional competition for revenues is Nassau County, NY. The financially troubled and management challenged county, recently released  a 2016-2019 Multi Year Financial Plan. The plan relies on several heroic assumptions. The redevelopment of Nassau Veterans Memorial Coliseum is projected to generate a minimum of $334 million in rental income over 49 years  to the County, or a minimum of 8% of gross income, whichever is greater. Additional revenues are expected to be derived from projected sales and related economic activity including entertainment, sales and hotel taxes, parking, arena revenues (ticket fees, merchandising, rental/leasing, concessions), and plaza rental revenues.

The MYP reflects the possible sales tax shortfall of $37 million for 2015 and has budgeted 2% growth in 2016 from this reduced base. As the economy expands, sales tax is projected to grow by 2.5% in 2017, 3.0% in 2018, and 3.0% in 2019. The sales tax is where regional competition comes in. The MTA would love additional sales tax revenues to reduce pressure on fares and to derive it from a regional base. At the same time, Nassau County proposes that if the New York State Legislature would allow for the regionalization of the downstate sales tax rate the affected counties would receive significant recurring revenues. Currently, the New York City sales tax rate is 8⅞%, whereas the Nassau and Suffolk sales tax rate is 8⅝%.

At the same time, the County will seek State approval to amend current State law that requires the County to contribute annually to the cost of MTA-LIRR station maintenance. The County is seeking for the State to take over the cost of station maintenance or allow County personnel to perform the maintenance at lower cost. The result would be to potentially reduce revenue to the MTA while increasing Authority expenses.

We see this as the sort of thinking that has continually hindered resolution of the County’s financial decline. Along with this kind of thought, the County continues to place great faith in privatization – the County is currently exploring a potential public-private partnership that could result in the sale, lease, or private operation of the County’s district energy facility. The plant consists of a combined heat and power facility and central utility plant that provides thermal and electrical energy to the marketplace. A request for proposals is expected to be issued by end of 2015. Also to be revived is a plan advisor to explore a P3 to improve sewer service to County residents and strengthen its infrastructure assets. This follows on a previously failed effort to accomplish the same goal.

Overall we see questions about the long-term for New York City, continuation of the constant grind for funding by the MTA in the face of greater limitations, and a continued long unrealistic path to recovery for Nassau County.

 

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

HOUSTON – DO YOU HAVE A PROBLEM ?

In 2004, the issue of pension reform for municipal government really came to the forefront through a study done by University of Chicago professor Joshua Rauh. In brief, it created a concern that consistent underfunding and underperformance of investments was creating a crisis that could potentially bankrupt many American cities. Among the potential hot spots were cities including Chicago, Houston, Philadelphia, San Diego and Milwaukee. Since that time we have seen the issue of pensions play a prominent role in the financial difficulties of cities including Detroit, Stockton, and San Bernardino which have all declared bankruptcy.

Prominent in  the news now are pension issues confronting the Commonwealth of Pennsylvania, the States of Illinois and New Jersey, and the City of Chicago. But a recent report from the Laura and John Arnold Foundation has returned the pension spotlight to Houston. According to the Arnold Foundation report, Chicago was in roughly the same position 10 years ago that Houston is in today. the city’s strong economic position has helped to cushion the impact of poor pension funding decisions thus far, but conditions are changing. The drop in the oil markets along with the property tax revenue cap could quickly magnify the city’s pension problems and result in a crisis much like the one in Chicago.

The Foundation suggests that Houston should obtain local control over the city’s pension systems in order to negotiate changes directly with workers and enact those changes locally. In addition, they posit that the City must fully fund the pension systems; paying off the unfunded liability in 20 years or less. In 2001, the City’s unfunded liability was $300 million. In 2014, it had grown to $3.1 billion. The funding gap is due in large part to the fact that the city hasn’t been paying enough into the pension fund on an annual basis. Houston’s Annual Required Contribution has more than doubled since 2003 and is now equal to nearly one-fifth of the total general fund revenue. Yet, Houston has only paid a portion of the amount each year since 2006, despite the fact that it has increased the amount of money dedicated to pensions from about $150 million to nearly $300 million.

The report says that the pension systems for Houston’s firefighters and municipal employees use the highest investment return assumption for any major plan in the United States—8.5 percent. Meanwhile, the pension system for Houston’s police officers uses an investment return assumption of 8 percent, a number that is still higher than the national average. Under an assumed rate of return of 7.5 percent, the plans’ funded ratio, when considering the market value of assets, would fall from 75 percent to 67 percent and the debt would jump to approximately $5 billion. When assumptions are lowered to 7 percent—which is considered to be a reasonable expectation for future returns—   the funding level falls to just 63 percent.

Houston also was one of the cities that in prior years – Philadelphia, San Diego and Milwaukee which used DROP, or deferred retirement option programs. The basic concept works as follows: When an employee becomes eligible to retire, he instead opens an escrow account, and then keeps on working at normal pay. His pension benefit stops growing, just as if he had retired. The pension fund starts sending monthly checks to his escrow account. The escrow money earns interest, and when the employee finally does retire, he gets a lump sum. He also starts receiving his monthly pension checks, which are based on his benefits before the escrow accounts were created.

TAX EXEMPTION COULD BE UNDER ATTACK AGAIN

A lengthy tax relief and job creation bill recently introduced in the House has once again raised concerns that the tax exemption on municipal bonds could be revisited again. The 299-page bill, H.R. 3555 called “Jobs! Jobs! Jobs! Act of 2015,” was introduced by Rep. Frederica Wilson, D-Fla., and has more than 30 Democrats as co-sponsors.

It provides an exemption for private-activity bonds issued from 2015 through 2018 from the alternative minimum tax, repeal sequestration, and creates an infrastructure bank. The bill includes a number of provisions aimed at tax relief for workers and businesses, putting workers back on the job while rebuilding and modernizing the country and providing pathways for job-seeking Americans to get back to work through infrastructure projects.

It would however, cap the value of the municipal bond tax exemption at 28%. The measure also would repeal federal spending cuts known as sequestration which have included reductions in the subsidy payments issuers receive from the Treasury Department for their direct-pay bonds, such as Build America Bonds. One of the offsets for the bill would be the limit on certain deductions and exclusions, including the exclusion for tax-exempt interest. Other offsets include taxing carried interest in investment partnerships as ordinary income, closing the loophole for corporate jet depreciation and repealing oil subsidies.

The bill would exempt PABs issued from 2015 through 2018 from the AMT. Generally, these types of bonds are subject to the AMT, increasing their yields, but PABs issued in 2009 and 2010 were exempt from AMT under the terms of the American Recovery and Reinvestment Act. By exempting PABs from the AMT, but subjecting all bonds to the 28% cap, PAB issuers may not be better off than they are under current law, and issuers of other types of bonds would be worse off by some estimates.

Under current conditions in Congress, most particularly the House, we view the chances of enactment of serious and/or comprehensive tax reform to be effectively nil. What we do take note of is the fact that the idea of capping the value of the municipal bond tax exemption is being forwarded from the legislative side. It had previously been floated primarily by the Administration.

PUERTO RICO WILL LEAVE SOME DEBT AS IS

Try as one might to go a week without a story on the Commonwealth, it is well nigh impossible. At least the news is somewhat better this week. The GDB announced that debt  from the Municipal Finance Agency (MFA), Children’s Trust and Housing Finance Authority (HFA) are not currently expected to be restructured as part of the ongoing effort to manage the Commonwealth’s debt. Who would have thought that under any scenario, that tobacco bonds would look better than a general obligation with a constitutional revenue pledge?  That is because, according to the GDB, MFA is backed by municipal property taxes and  the Children’s Trust is a dedicated source. [What is going to be restructured] is everything else that is part of the government’s cash flow.

The Puerto Rico government intends to begin debt-restructuring talks with its creditors by mid-October. To that end, six groups have already signed confidentiality agreements as part of the overall debt-restructuring process, while other creditor groups are amending nondisclosure agreements that were previously signed for other transactions. While it faces a severe cash crunch that is expected to worsen by November if no additional liquidity measures are taken, the commonwealth faces two debt-service payments on Dec. 1, of $354.7 million, and Jan. 1, of $331.6 million, corresponding to GDB and general obligation (GO) debts.

Meanwhile the PREPA negotiations lurch along. PREPA announced Thursday that the Ad Hoc Group and fuel-line creditors have agreed to extend their forbearance agreements until Oct. 15. Talks with the monoline insurers hit another snag when the Puerto Rico Energy Commission (PREC) rejected Wednesday a petition filed Sept. 17 by National in which it sought a rate revision and hike of 4.2 cents per kilowatt-hour. PREC denied the petition alleging National didn’t meet requirements to prompt a rate revision procedure, nor provided enough evidence.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

IS A P3 PUBLIC OR PRIVATE?

A recent letter from a local tax entity in Texas has raised an interesting issue with regard to the tax exempt status of student housing projects operated as public private (P3) partnerships on public lands. Brazos Central Appraisal District (“BCAD”) has requested seek an  Attorney General opinion to assist BCAD and its chief appraiser in  determining  whether  certain properties and improvements located in Brazos County, Texas are exempt  from  taxation. This request concerns two student housing  projects  on  property  owned  by  the  Texas A&M University System (“TAMUS”) in College Station, Texas. The first project described below is under  construction,  and  the  second  project  described  below  is  completed and occupied.

The District makes the case that these projects will be in competition with private  housing projects that do not enjoy tax exempt  status, and when those private projects  compete against tax exempt projects they are at a competitive disadvantage. The projects in question comprise a 3,400-bed complex with rooms ranging from studio apartments to three-bedroom,  garden-style units built on 48 acres of A&M land.

According to the District, there does not appear to be any definite restriction on the right to lease to persons other than faculty, staff and students of TAMUS or Blinn College. The lease contemplates that the facilities will be subleased to students, faculty and staff of Texas A&M, and also to students, faculty and staff of Blinn College, but it appears to permit subleases to persons who are not faculty, staff or students  of  Texas A&M or Blinn College. A&M’s agreement with the developer says that during the term of the land lease, all improvements will be owned by the developer and therefore the developer will have the legal title to those improvements.

A&M is relying on existing case law, including a 1992 case in which the court held that improvements to state land were exempt from taxation, despite the fact that the legal title to the improvements was not owned by the state. A&M maintains that “the new projects clearly serve a public purpose directly related to the University’s mission, providing housing for our students. “The concerns of local officials and local apartment owners are misplaced. The new projects are exempt from property taxes because they serve a public purpose, like the Corps of Cadets dorms and other dorms on the University campus.”

We suspect that the projects will be found to be exempt from local property taxes but the question raised is interesting and has implications for other P3 projects as well as possible challenges to property tax exemptions for other “not for profit” entities.

PUERTO RICO

On Monday, the trustee of the Puerto Rico Electric Power Authority (PREPA) filed a notice in which it warns the utility about the end, since Sept. 15, of a period in which the trustee had limited power to take such actions as sending default cure notices and impose other enforcement measures, as a result of the forbearance agreements that were in place with PREPA’s main creditor constituencies — the Ad Hoc Group of bondholders, fuel-line lenders and monoline insurers.

The trustee, U.S. Bank National Association, stated that as a result of the Sept. 15 deadline expiration, its power to send cure, or need for corrective action notices and take enforcement actions with respect to defaults is no longer limited by a requirement that called for a written request from a majority of principal holders for the trustee to act. Moreover, a temporary relief that allowed PREPA to not fulfill its obligation to transfer money “from the General Fund to the Revenue Fund has also ended.”

“The Trustee continues at this time to monitor and assess the negotiation process, and reserves all rights and remedies under the Trust Agreement, including, without limitation, the right to send cure notices and the right to pursue enforcement actions following an event of default,” the filing states.

As first reported by CARIBBEAN BUSINESS, PREPA reached an agreement with its fuel-line lenders last week to restructure about $700 million in debt held by the group of banks, which also agreed to further extend their forbearance agreement from Sept. 25 to Oct. 1. Meanwhile, the utility reached a restructuring agreement at the beginning of the month with the Ad Hoc Group that calls for an exchange of unwrapped, or uninsured, bonds for new, securitized paper; a 15% haircut, or debt reduction, on principal; and a moratorium on principal payments for the next five years, among other items. PREPA also secured an additional extension on its forbearance agreements with the Ad Hoc Group, through Oct. 1.

However, PREPA hit a snag with its other main creditor constituency, monoline insurers, when they failed to reach an agreement before negotiations hit the Sept. 25 deadline. In addition, while bond insurers Syncora and Assured Guaranty first agreed to extend their forbearance agreement with the utility from Sept. 18 until Sept. 25, MBIA Inc.’s National Public Finance Guarantee did not consent to it. National filed a petition Sept. 17 at the Puerto Rico Energy Commission (PREC), seeking a rate revision and hike of 4.2 cents per kilowatt-hour, which should take place within four months. The insurer is expecting a response from PREPA by Oct. 1, according to the document filed by the insurer at PREC.

The utility remains deadlocked with its monoline insurers, with all three currently out of their forbearance agreements with PREPA. “We continue to negotiate with our bond insurers in an effort to reach an agreement that will allow the authority to further progress in its transformation,” PREPA Chief Restructuring Officer Lisa Donahue stated after reaching the preliminary deal with fuel-line lenders. Insurers are now technically allowed to notify the trustee of a default event, putting the utility on a 30-day clock to address the issue after a notice is sent by the trustee requiring corrective action, or potentially face litigation..

The PREPA negotiations have been a litmus test of sorts, separate from the García Padilla administration’s recent announcement that it intends to restructure some $47 billion — not including PREPA and the Puerto Rico Aqueduct & Sewer Authority — of the commonwealth’s $72 billion debt. The commonwealth was hopeful that the financially troubled public corporation, with its outsized debt towering at $9.4 billion, could represent an example for creditors of the shape of restructuring to come.

TRYING TO HAVE IT BOTH WAYS

For many of us who have observed Puerto Rico’s unwillingness to honestly face its financial failings, Tuesday’s hearing before the Senate Finance Committee was yet another example of why it is hard to take the Puerto Rican government seriously. The officials sent by that government were told once again that the numbers they were using to make their case were too incomplete to persuade lawmakers that help was warranted — or that the money would be well spent. This reflects long-held views of the municipal bond analytical community.

Senator Orrin G. Hatch of Utah, chairman of the Senate Finance Committee, said that while he sympathized with the island’s plight, Congress needed to know more detail about the causes and structure of its debt, and whether help from Washington would benefit it in the long run. “We’d better get the right information, or nothing’s going to be done,” Senator Hatch warned.

The officials  came before the committee to argue for changes in various federal laws, which they said currently discriminate against Puerto Rico. It occurred in the face of large debt payments due in November and December, and warnings that it will not have enough cash to pay them while still providing an acceptable level of government services. None of the officials asked explicitly for a bailout, but they said the United States had a moral duty to help Puerto Rico, and identified a number of federal laws and programs that they said were discriminatory and ought to be changed.

“I want to help you,” Mr. Hatch told them. “I don’t think Puerto Rico is treated fairly. But we have to get really good information in order to help you.” Melba Acosta Febo, the head of the Government Development Bank, told Senator Hatch that the lack of financial data reflected Puerto Rico’s antiquated computer systems, which the government wanted to replace. She promised to gather as much information for the senators as possible. Given the need for such data, one would think that some of the island’s huge debt could have financed an updated system. But yet again, Puerto Rico failed to take responsibility for their own shortcomings.

These shortcomings have been well known for a long time but have continued to go unaddressed. They affect not only Puerto Rico’s ability to generate financials that can be audited but also casts doubt as to whether the island can actually account for ongoing cash flow and develop a base of economic data to support realistic planning and execution of economic development plans.

Instead, the Puerto Ricans relied on old complaints about federal laws they considered inequitable, particularly those that govern health care for the elderly and the poor, like Medicare and Medicaid. Yes, Puerto Rico’s population is older, and considerably poorer, than the rest of the United States. Ms. Acosta estimated that amending the relevant laws would be worth an additional $1.5 billion for Puerto Rico.

Sergio M. Marxuach, policy director for the Center for a New Economy, a nonpartisan research institute in San Juan, said that the best way Washington could reduce poverty and promote growth in Puerto Rico was to extend a version of the federal earned-income tax credit program to the island. The credit is for low- and moderate-income working individuals and couples — particularly those with children. He said this could be done even though residents of Puerto Rico do not now pay federal income tax — a questionable assumption. He also acknowledged that at some point Puerto Rico’s legal status as a territory would have to be changed. That message was mixed at best.

Pedro Pierluisi, Puerto Rico’s nonvoting member of Congress, chose to take a less diplomatic route. “We should treat Puerto Rico equally,” he said. “They are fellow American citizens. You shouldn’t be looking the other way. You shouldn’t be ignoring us. If you do so, you do so at your peril.”

Interestingly, the only witness who was not from Puerto Rico, Douglas Holtz-Eakin, the former head of the Congressional Budget Office, and now president of the American Action Forum expressed skepticism that giving Puerto Rico more federal health care money would bring about the structural economic changes the island needed. “You don’t generate long-term economic growth by increasing health care spending in Puerto Rico,” said Mr. Holtz-Eakin. “You might relieve some budget pressure, but so would a check for anything else.” “The primary emphasis should be on economic growth,” rather than simply finding new sources of money, he said. This supports arguments that many have made regarding the long-term outlook for Puerto Rico.

The hearing did produce some firm statements from the GDB which will only serve to steel the resolve of general obligation bondholders in any upcoming negotiation. Senator Hatch asked the witnesses about other types of debt that Puerto Rico owes, such as its pension obligations to retired government workers. He wanted to know which had priority in the hierarchy of creditors — Puerto Rico’s general obligation bondholders, or Puerto Rico’s pensioners. He elicited a response from Ms. Acosta that affirmed that general obligation bonds have an explicit constitutional guarantee and pensions did not. “It’s a very big problem,” she added. Further, she stated that the pension system will probably run out of cash in 2018. She said that at that point Puerto Rico would have to pay retirees directly from its general fund. “This is one of the reasons that we’re saying that we have to restructure the debt,”. “The idea is to use some of that money to put into the pension plans, because they badly need it.” As was the case in Detroit, this directly pits bondholders against pensioners.

From our standpoint, it was a very poor performance from the Puerto Rico officials both strategically and tactically. At this point, the Puerto Rican government appears to be clearly outmatched and its interests are not being best served by the current cast of characters. It also raises questions about the quality of the advice it is receiving. Sadly, this is not anything new. It points to our standing belief that the restructuring process will be long and messy and not be settled anytime soon.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.