Joseph Krist

Municipal Credit Consultant

Our usual Thursday posting time has been moved up this week to accommodate Thanksgiving. Enjoy the holiday and we will return to our regular schedule next week.

PREPA

It came as no surprise when the Friday, Nov. 20, deadline on a restructuring deal struck two weeks ago for PREPA came and went. The tone of the debate over legislation necessary to implement a restructuring agreement for PREPA showed that not enough of the political establishment currently had the will to meet all of its requirements. The effort to achieve a relatively pain free result (pain free for both politicians and customers) continues. Fortunately, the cash-strapped Authority secured from its creditors an additional extension to the agreement’s drop-dead date, until Dec. 10, to get its monoline insurers on board.

Press accounts attributed to Chief Restructuring Officer Lisa Donahue said PREPA insurers were on the verge of joining an agreement. The creditors are said to have granted an extension until at least Dec. 4 and no later than Dec. 10 to grant adequate time to secure passage of the bill and to seal final details with the remaining monoline bond insurers. According to the RSA, if PREPA fails to reach an agreement with monolines that is acceptable to all parties, the implementation of a recovery plan for the utility would be worked “through a mechanism to be agreed among the Parties that may include, without limitation, a judicial process (including an enforcement proceeding under applicable law).”

PR Senate President Eduardo Bhatia has previously said majority lawmakers would seek to safeguard the interests of the commission, ensure that the proposed changes to the governance are in line with what they want and that payment to creditors is guaranteed. PREPA  has warned about introducing changes to the legislation that could jeopardize the restructuring agreement. Among the RSA’s requirements that must be met for the accord to hold, PREPA must also submit a rate-review proposal at the Puerto Rico Energy Commission (PREC) by Dec. 15. The commission also has its own set of deadlines it must meet in order to maintain full authority over the rate-review process. Failure to meet the RSA’s timetable could force the utility back to the negotiating table.

AND ON THE TAX BACKED SIDE OF THINGS

On the general obligation front, the government presented representatives of the island’s largest debt holders with a proposal for a comprehensive restructuring structure — a “superbond” — that would consolidate the commonwealth’s different credits, Government Development Bank (GDB) President & Chairwoman Melba Acosta is said to have described the meetings with creditors’ advisers as “very positive and productive,” while stressing that no negotiations were conducted at this time, as it was only an “informative meeting.” She acknowledged that the administration is seeking to finish restructuring talks by summertime. Friday’s meetings in New York included representatives of different creditor groups, along with the Sales Tax Financing Corp. (COFINA), GDB and general obligations (GOs). Advisers representing mutual funds and cooperatives holding Puerto Rico debt also took part in the presentations. Commonwealth bond insurers didn’t participate in the meetings, according to Acosta.

She was quoted as saying “If we have different credits that have different repayment sources, and we would have single structure, then there will most probably be a consolidation of repayment sources,” she acknowledged, while adding that more details on the commonwealth’s proposal will be released later. Other reports indicate that as part of that new bond, general obligation holders would have the first claim on government revenues, giving them the highest priority in the superbond structure. Holders of other forms of the government’s debt would have lower priority. It is not clear whether bondholders, in return, would be asked to buy the superbond at a discount, resulting in a haircut on their current holdings.

When asked if a forbearance agreement similar to what was negotiated with PREPA was sought, Acosta said that hadn’t been discussed yet, but could be as the commonwealth moves forward with its debt-restructuring efforts. Friday’s meetings in New York included representatives of different creditor groups, including Sales Tax Financing Corp., GDB and general obligations (GOs). Advisers representing mutual funds and cooperatives holding Puerto Rico debt also took part in the presentations. Commonwealth bond insurers didn’t participate in the meetings, according to Acosta. The hedge funds hope that Washington will avoid taking any measures that might undermine that process.

On Dec. 1, the  Government Development Bank must make a $354 million debt payment. Moody’s has predicted that the government would skip some of those payments because of the worsening liquidity situation. Officials have stayed publicly vague about whether they intend to make the Dec. 1 payment. Ms. Acosta, the president of the Government Development Bank, said the government had yet to make up its mind on whether to make the debt payment next month or another large payment coming due in January.

Those pushing for Gov. Alejandro García Padilla to default to force the creditors, including the hedge funds, to the negotiating table argue that it might also prompt Congress to act faster to give Puerto Rico access to Chapter 9 — something many creditors want to avoid.

We advise investors to take the various published comments and press commentaries with some perspective. The idea of a universal settlement has great appeal to the Commonwealth but whether such an arrangement is appropriate for the many different classes of investors is another thing. The monolines have the capacity to absorb some level of loss but their interests are more akin to those of the individual par buyer. The deep discount hedge fund investors with a shorter time horizon have a much different set of ideas as to what is an acceptable outcome. Full repayment may never have been their actual goal. Many holders of COFINA sales tax debt will be greatly disappointed to be treated as general creditors after the Commonwealth went to such pains to market the bonds as such a distinct credit. Investors in all classes will likely never achieve certainty about the actual validity and value of the Commonwealth’s long standing ‘constitutional pledge” supporting GO debt and its ability to “clawback” taxes pledged to other debt for repayment.  It will probably be an unsatisfactory outcome for many which means it’s likely to be viewed in the long run as a good deal for the Commonwealth.

YEAR END MARKET TRENDS

As we enter the final month of the year, a few trends are emerging reflecting the uncertainty around the economy and timing of an interest rate increase. These are having a direct impact on the market, the profitability of market makers, the appetite for bonds, and the ability to transact high yield credits in the new issue market.  Prominent among these is the decline in trading activity and its implicit impact on liquidity. Municipal bond trading declined in every month through September and even with a slight increase in October remained some 17% below average monthly volume. For the year, monthly trading declined 34% from January to October.

The decline in activity has obviously made it more difficult for the more marginal players and those without robust investment banking capabilities. Retail oriented shops are having a much more difficult time. Concurrently, the reduced number of outlets overall has made it harder for portfolio managers to transact and to make room for new issues. This has reduced the overall appetite for bonds and made it harder for large year-end high yield issue to be absorbed resulting in some cancellations of sales.

What does this all imply for credit? Investors must be much more selective in their choice of higher yielding bonds. It will be harder going forward to manage this risk, especially in the more speculative segments of the credit spectrum. At the same time, the results of the Puerto Rico debt restructuring could still have an impact on spreads as the market values the results and then weighs relative risks of different credit classes accordingly. None of these issues are likely to increase liquidity thus exacerbating the existing inertia in the market. It continues to be a time for caution with rates at absolute lows and spreads remaining tight.

PENNSYLVANIA BUDGET PLAN GOES OFF THE RAILS

In an unexpected development, a plan to cut property taxes statewide moved near collapse this past weekend, imperiling with it the tentative budget deal struck this month by Gov. Wolf and leaders of the Republican-led legislature. Without the property-tax reduction – a key feature of the $30 billion state spending plan – “the whole agreement fails,” said one high-ranking Democratic official, speaking on the condition of anonymity.

The budget plan presented by Gov. Wolf and GOP leaders in the legislature had called for a rise in the state sales tax from 6 percent to 7.25 percent. The $2 billion it was projected to generate was expected to increase school funding and offset a reduction in property taxes – the primary funding source for local school districts. But neither side has detailed how the education funds will be distributed, the form of property-tax relief or other key concepts in their deal – reform of the state’s pension system and state sales of wine and liquor.

In a letter to his Democratic caucus Saturday, House Minority Leader Frank Dermody (D., Allegheny) said Republican leaders told Wolf late in the week that they could not muster the votes among their members to pass the property-tax plan. “By failing to deliver the votes for the framework they agreed to, the Republican leaders would effectively kill the property-tax relief envisioned as part of the framework,” the letter said. Republicans acknowledged the new hurdle but strove to paint less of a doomsday scenario. “We are going to continue to work on the other segments of the agreement and hopefully bring it to closure,” said Drew Crompton, the Senate’s top Republican lawyer.

Five months into the impasse that has left schools, nonprofits, and other agencies turning to loans and credit to stay afloat, the two parties hailed what they said would be a historic agreement to help fund schools and shift away from the long-term reliance on the property-tax burden. The plan might have lowered property taxes a minimum of 20 percent and a maximum of 40 percent from current rates.

Strains in the agreement became evident  – and may have been worsened – last week, when the Senate unexpectedly let it be known that it intended to vote on a bill that would eliminate property taxes altogether. Its sponsor predicted it would pass. Members of the GOP House caucus were always skeptical of the so-called framework, but said that skepticism turned into opposition for some when it became apparent that the Senate was on the verge of passing a bill to eliminate property taxes altogether. On Monday night, the Senate took up a proposal designed to eliminate school district property taxes by raising the sales and personal income taxes, a plan Mr. Wolf cited as one that he opposed. Members tied 24-24 on a preliminary vote on the proposal, and Lt. Gov. Mike Stack broke the tie by voting no. A similar measure has failed in the House in the past.

New proposals being considered include expanding the list of items that would be subject to the sales tax. As it stands now, there are dozens of exemptions to the sales tax. Whether the Governor would agree is questionable – he campaigned last year on a pledge to provide significant property-tax relief. A new tax on natural gas drilling remains off limits in the negotiations.
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

PUERTO RICO

U.S. Senate Judiciary Committee Chairman Chuck Grassley said that he will convene a hearing on Puerto Rico’s fiscal situation on Tuesday, Dec. 1, at 10 a.m. Grassley said his goal is to help committee members and the public identify and gain a better understanding of the root cause of Puerto Rico’s fiscal problems, discuss what’s currently being done, and consider what options are available that could help Puerto Rico get itself out of the present situation.

The Judiciary Committee has jurisdiction over bankruptcy policy, which the commonwealth has implemented efforts to be included in, but Grassley has reiterated that restructuring debt and throwing taxpayer money at the island, without ensuring the creation and implementation of structural and fiscal reform, fails to resolve the underlying problems in Puerto Rico required to create economic growth. Witnesses for the hearing will be announced at a later date.

In the meantime, PREPA announced that it has executed an amendment to its previously announced restructuring support agreement (“RSA”) with the Ad Hoc Group of PREPA bondholders, comprising traditional municipal bond investors and hedge funds, its fuel line lenders and the Government Development Bank for Puerto Rico. The amendment extends the deadline for PREPA to reach an agreement with the monoline bond insurers on a consensual recovery plan to November 20, 2015. PREPA will use the extension to continue discussions with its monoline bond insurers, while the legislative process to approve the PREPA Revitalization Act continues.

Puerto Rico Senate President Eduardo Bhatia Gautier said it will be hard to pass the energy bill presented on Nov. 4 to restructure the island’s energy sector by the current deadline of the end of Thursday. If it is not approved by then, the governor will ask for an extraordinary legislative session to handle the matter, he said. The extraordinary session could be either in November or in December.

Gov. Alejandro García Padilla said if bondholders don’t agree to new terms on their debt, he will choose to pay for the needs of the people before paying the commonwealth’s creditors. The governor said that he has called for negotiations with bondholders, proposed a five year plan, and is working to assure future responsible Puerto Rico policies, according to a government transcript. Referring to the bondholders, he said, “If you don’t negotiate and I am obligated to choose between the creditors and the Puerto Rican people, I’m going to pay the Puerto Ricans.”

The government has said it is running low on money. There have been locally-based news stories about talk of a partial government closure or a cut of Christmas bonuses for government workers to deal with the financial crisis. “We are evaluating all of the mechanisms, like we said before, to avoid reducing the workday, government shutdown or stopping payments on the debt,” García Padilla said, according to the government. “What [Government Development Bank for Puerto Rico President] Melba Acosta, [Secretary of the Treasury Juan] Zaragoza, and [Office of Management and Budget Director] Luis Cruz all said is what the numbers say. If we don’t come up with extraordinary mechanisms, uncommon and abnormal in the government, those things, like partial shutdown, workday reduction, etcetera can happen.”

If the governor chose to allow a default and use government’s revenues for other purposes, it may put him at odds with Section 8 of Puerto Rico’s constitution, which states: “In case the available revenues including surplus for any fiscal year are insufficient to meet the appropriations made for that year, interest on the public debt and amortization thereof shall first be paid, and other disbursements shall thereafter be made in accordance with the order of priorities established by law.”

Acosta seemed to present a different approach to the government’s impending debt payments. In testimony to a joint hearing of two Puerto Rico House of Representatives committees, she said the payment of debts on Dec. 1 and Jan. 1 have the highest priority for payment, according to the El Nuevo Día news web site. Puerto Rico’s GDB owes $354 million in debt on Dec. 1. According to Moody’s, $273 million of this sum has a constitutional guarantee and $81 million does not. Puerto Rico also owes $330 million in general obligation debt Jan. 1.

Acosta told the legislators that the government is likely to make the Dec. 1 payment, according to El Nuevo Día. The debt is insured, she said. She said that the government was in talks to make the payment but did not further explain the talks. Moody’s however released a short report saying it thought a default on at least some of the Dec. 1 debt service was likely.

At the hearing House President Jaime Perelló Borrás said that the government should prioritize remaining fully open and paying Christmas bonuses and delayed tax refunds and supplier bills before the bond debt. Perelló Borras is in the same party as the governor, the Popular Democratic Party. Not making the December and January bond payments would lead to further major complications, Acosta said, according to El Nuevo Día. Acosta also said the government would present a proposal for restructuring the debt to the bondholders as we go to press.

ILLINOIS WORK AROUND PROPOSED

The Illinois Finance Authority passed a resolution to ask its Board to provide the Executive Director, and 23 relevant staff with Authority, to use the State Procurement Code to explore the market to see if there will be any lenders that will, in essence, loan the Illinois Finance Authority money so that it may be of assistance, in connection with paying state bills, in connection with the state budget  impasse. Illinois Finance Authority was among a large number of state agencies that were asked to explore options. The resolution points to three statutory powers that the General Assembly  has provided to IFA: Statutory lien, statutory  non-impairment, and the statutory authority to provide up to around $100,000,000 in moral  obligation debt, which was a  form of statutory taxpayer guarantee.

The resolution would authorize an emergency purchase under the procurement code to competitively select and enter into contracts with necessary parties, including but not limited to lenders, underwriters, trustees or paying agents, servicers, printers, road show providers, and/or rating agencies, to finance one or more projects authorized under the Illinois Finance Authority act, including public purpose projects, the proceeds of which will be used to address one or more of the following in the absence of an enacted appropriation for fiscal year 2016, a court order or a consent decree: (i) threat(s) to public health or public safety, (ii) if immediate expenditure is necessary for repairs to state property in order to protect against further loss or damage to state property, (iii) to prevent or minimize serious disruption of critical state services that affect health, safety, or collection of substantial state revenues, or (iv) to ensure the integrity of state records; and other matters related thereto adopted.

In plain English, the Authority would borrow money to pay state bills which could not otherwise be paid without adoption of a state budget. It is yet another sign of the dire straits in which Illinois finds its credit position.

CHICAGO PENSIONS UPDATE

On November 10, 2015, Moody’s released a scenario analysis of the City of Chicago’s (Ba1 negative) possible pension funding paths. The scenarios incorporate the city’s recently adopted property tax increase as well as the outcomes of two key decisions pending with the State of Illinois and the Illinois Supreme Court. The analysis indicates that, despite significantly increasing its contributions to its pension plans, Chicago’s unfunded pension liabilities could grow, at a minimum, for another ten years.

“Chicago’s statutory pension contributions will remain insufficient to arrest growth in unfunded pension liabilities for many years under each scenario,” Moody’s says in the new report.” The scenario that Moody’s views as having the most positive credit impact for Chicago consists of a favorable Illinois Supreme Court decision, as the city’s budget assumes, but state legislative action that does not conform to the city’s adopted plan. Senate Bill 777 has been passed by the Illinois General Assembly, but requires the governor’s approval to become law. The bill lowers Chicago’s current statutory public safety pension contributions relative to existing statute, granting the city more time to meet statutory funding targets. Without Senate Bill 777, the city’s 2016 statutory pension contribution will be much higher than the city has budgeted.

“This scenario is the most credit positive over the long term. Although it would require larger pension contributions than currently budgeted, the higher payments would achieve the slowest and least extensive growth in unfunded liabilities among the four scenarios,” Moody’s says.

The city’s adopted budget assumes the governor signs Senate Bill 777 and the Illinois Supreme Court reinstates PA 98-0641, the latter of which would preserve benefit reform of Municipal and Laborer pensions and reduce the plans’ risk of insolvency. While the adopted budget notably increases the city’s pension contributions relative to prior years, the amounts contributed under these assumptions could enable unfunded pension liabilities to grow for up to 20 years.

Two other scenarios assume an unfavorable ruling from the Illinois Supreme Court, which would raise the possibility of substantial cost growth for the city over the next decade, with or without Senate Bill 777. “This would exert additional negative credit pressure on Chicago’s credit quality because it would likely remove all flexibility to reduce unfunded liabilities through benefit reform and raise the probability of plan insolvency,” says Moody’s.

NYC 40 YEARS LATER

With the debt crisis in Puerto Rico about to come to a head, many references are made to the NYC financial crisis which this month marks its 40th anniversary. A seminal event in the history of the municipal bond market, it opened an era of regulation, disclosure, and reform that continues to this day. It can be said to have led to improved (not perfect) financial disclosures and practices and spawned a generation of municipal analysts who expected and demanded a more transparent credit environment on behalf of all segments of the market. It is easy to forget how bad the situation was and how much was accomplished over the following four decades.

New York City faced a significant fiscal crisis and effectively defaulted in 1975 because it had literally run out of money and could not pay for normal operating expenses. Timely state and federal action saved the city from defaulting on its obligations and possible bankruptcy. At the time, New York City and its subdivisions had $14 billion of debt outstanding of which almost $6 billion was short-term. The city admitted to an operating deficit of at least $600 million, although modern  accounting methods would have produced a deficit of something along the lines of $2.2 billion. The city was effectively shut out from credit markets.

The city had used obsolete and confusing budgeting and accounting gimmicks for over a decade including: overly optimistic forecasts of revenues, reliance on revenue anticipation notes, including notes for revenues that did not materialize, underfunding of pensions, use of funds raised for capital expenditures for operating costs, and the appropriation of illusory fund balances, meaning that special fund revenues were overestimated and used to balance the budget. Finally in February 1975 a sale of tax anticipation notes was canceled when the underwriter backed out. In the meantime, banks began selling their own holdings of city securities.

In March of 1975, underwriters were growing more and more resistant to working with the city on any more debt issuance.  Bond counsel would not issue a clean opinion on a sale, which was necessary for reselling the notes and bonds  and doubts had arisen that bondholders could exercise their first lien on city revenues. Then, the New York State Urban Development Corporation defaulted on some bond anticipation notes. Although the corporation was separate from the city, the projects of the corporation were in the city. Investor concerns grew when the legislature made sure that the suppliers and contractors were paid but not the bondholders (the infamous moratorium).

The city attempted to move debt off its own balance sheet and stretch out their maturity through a separate corporation, the Stabilization Reserve Corporation, to hold the city’s debt. This move was challenged as an unconstitutional attempt to get around the City’s statutory debt limit. The city was forced to drop the plan. By April 1975, the city was out of money. After lengthy negotiations, underwriters agreed to underwrite more securities provided that the city adopted sound accounting principles, admitted that it had large operating deficits, and ended its budget ploys, including the practice of phony forecasts of revenues. But the City resisted.

The Municipal Assistance Corporation (MAC) was an independent corporation authorized to sell bonds to meet the borrowing needs of the city. MAC was a creation and entity of the state. The majority of appointees on the Corporation’s Board were made by the Governor. As part of the creation of MAC, the state passed legislation that converted the city’s sales and stock transfer taxes into state taxes. These taxes were then used as security for the MAC bonds without ever passing through to the city. Besides creating the MAC, the state also advanced additional funds. The state prepaid state aid that the city was scheduled to get during the fiscal year, in an attempt to keep the city afloat. The MAC demanded that the city institute a wage freeze, lay off employees, increase subway fares, and begin charging tuition at city universities. Despite a summer of labor unrest, these measures stuck and MAC was able to refinance some city debt.

The Emergency Financial Control Board (EFCB) was created in September during a special legislative session. It was analogous to putting the city into receivership. The EFCB had authority over the finances of the city. It could control the city’s bank accounts, issue orders to city officials, remove them from office, and press charges against city officials. The Governor made the majority of appointments to the Board. The state law creating the EFCB required the city to balance its budget within three years, change its accounting, and submit a three-year financial plan. The Board had the power to review and reject the city’s financial plan, operating and capital budgets, contracts negotiated with the public employees unions, and all municipal borrowing. Besides creation of the control board,  a deputy state comptroller was appointed to audit city books. The Mayor’s Management Advisory Board California Research Bureau, was created and staffed by business representatives to advise the mayor on management practices. The temporary Commission on City Finances was established to analyze, criticize, and recommend changes in the city’s long-range taxation and expenditures policies.

Only after all of this did the City receive assistance from the Federal Government. In November of 1975. Federal legislation extending up to $2.3 billion of short-term loans to the city was passed. The House of Representatives passed the aid package by a 10 vote margin. The city was forced to hike fees for services, especially for the city university and the subway. Other services were cut. The city’s work force was trimmed and a wage increase was rescinded. Up to 40 percent of the assets of the city pension fund were invested in MAC securities. The state pension fund also invested in MAC securities. A total of $2.7 billion of city debt was bought by the pension funds.

The banks who had served as the underwriters for New York’s securities agreed to purchase additional securities and/or lengthen the maturity or lower the interest rate on the securities that they held. Other holders of securities had to exchange them for ten-year MAC securities or face a three-year moratorium on the repayment of principal on the notes. The banks turned in $819 million in notes for MAC debt and restructured the interest and maturities of the other debt they held. The budget had to be balanced using generally accepted accounting principles. Most notable of these were the elimination of financing operations from capital funds and a requirement that the city fully fund its pension plans. The First Deputy Mayor, Deputy Mayor for Finance, and the budget director all had to resign so that trustworthy staff could be appointed. The federal loans were made at 1 percentage point over the cost of funds to the federal government.

The city kept its part of the bargain in dealing with public employees. City employment fell by 20 percent and work rules were loosened. Wages were reduced and eventual raises were held below the level of inflation. By 1977-78, the city had no short-term debt. As part of its obligation imposed by the federal government, the state assumed the full cost of financing the city university system (leading to the imposition of tuition) and a portion of welfare and court systems. The state also tightened controls over Medicaid reimbursements to health care providers.

This history is something to keep in mind as the market deals with Puerto Rico. These steps outlined above were painful for the City and its residents over a long time period. Puerto Rico would be wise to understand this history as its continues to demand a relatively pain-free exit from its own legacy of irresponsibility and mismanagement. Talk of prioritizing things like Christmas bonuses ahead of debt service shows a fundamental lack of maturity and seriousness on the part of the Commonwealth’s political leadership. The use of inflammatory rhetoric like that of the Commonwealth’s representative to Congress this week in which he likens the requirement for a federal control board to colonialism would be laughable if it were not so sad. If Puerto Rico does not want to be treated as the equivalent of a financial child, it needs to grow up an act like a financial adult.

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

PENNSYLVANIA IMPASSE IMPACTS LOCAL SCHOOL DISTRICTS

Moody’s Investors Service has downgraded the Commonwealth of Pennsylvania’s (Aa3 negative) pre-default intercept programs for school districts to A3 from A2. As a result of the downgrade of the programs, 13 pre-default intercept ratings on Pennsylvania school districts were lowered to A3 from A2 and the ratings put under review for further downgrade. This action affects the State Public School Building Authority Lease Revenue Intercept Program (Sec. 785) and the Pennsylvania School District Fiscal Agent Agreement Intercept Program (Sec. 633).

The downgrade of the Commonwealth of Pennsylvania’s pre-default school district intercept program, and 13 ratings under the program, is a consequence of the commonwealth’s chronically late budgets and the lack of clarity surrounding the intercept program’s mechanical feasibility in the absence of an approved and implemented budget. While the commonwealth is expected to cover any missed debt service payments on enhanced bonds, the current lengthy budget impasse has heightened risks to bondholders, and raises doubt about whether the pre-default mechanisms will work effectively every time without funds appropriated to districts.

The confirmed cap of A3 on school district bonds enhanced on a post-default basis (Pennsylvania Act 150 School District Intercept Program) also reflects the increased risks to bondholders given state budget delays, as well as competing claims for state aid from pre-default obligations, pensions, and charter school tuition. The downgrade of 11 post default ratings reflects revising the potential uplift from a district’s underlying rating to one notch from the previous two notches. The decision to limit the uplift to at most one notch is based on Moody’s post-default scoring method, which considers such factors as the timing of and trends in state aid distributions, and the mechanics of the program. More specifically, this change reflects a lack of funding and an increasing uncertainty surrounding program mechanics in the absence of a state budget.

In the meantime, negotiations over a budget are heating up and details of some proposals have begun leaking out. The two major points are that production of natural gas will continue to escape taxation while more of the new revenue burden will be shifted to individuals through and increase in the retail sales tax rate from 6% to 7.25%. This would result in a total sales tax rate of 8.25% in Pittsburgh and 9% in Philadelphia. These changes are designed to support increased funding to school districts but it does not appear to tie in directly to local property tax relief to slow rapid increases in many districts. Should the budget be enacted along these lines it would be a clear win for business interests with at best, mixed results for individuals.

PREPA RESTRUCTURING ADVANCES

The Puerto Rico Electric Power Authority (PREPA) reached a restructuring support agreement (RSA) with the Ad Hoc Group of PREPA Bondholders last week, just after we went to press. The Ad Hoc Group’s financial adviser said legislation on the public utility’s revitalization must be approved “this month.” The government submitted the PREPA Revitalization Act to the Puerto Rico Legislature. However, the last day for the Legislature to pass bills during the present session is Nov. 12, giving lawmakers only one week to analyze and pass the measure.

The basic terms of the agreement include:

The Ad Hoc Group will exchange all of their debt for new securitization notes and receive 85% of their existing claims in new securitization bonds, which must receive an investment grade rating.

Bondholders will have the option to receive securitization bonds that will pay cash interest at a rate of 4.0% – 4.75% (depending on the rating obtained) (“Option A Bonds”) or convertible capital appreciation securitization bonds that will accrete interest at a rate of 4.5% – 5.5% for the first five years and pay current interest in cash thereafter (“Option B Bonds”).

Option A Bonds will pay interest only for the first five years, and Option B Bonds will accrete interest but not receive any cash interest during the first five years.

All uninsured bondholders will have an opportunity to participate in the exchange.

Ad Hoc Group will negotiate with PREPA in good faith to backstop a financing on terms to be mutually agreed that will allow for a cash tender for bonds held by non-forbearing creditors.

Fuel line lenders will have the option to convert existing credit agreements into term loans with a fixed interest rate of 5.75% per annum, to be repaid over 6 years in accordance with an agreed upon schedule or exchange all or part of principal due under the existing credit agreements for new securitization bonds to be issued on the same terms described above.

PREPA’s debts owed to the Government Development Bank for Puerto Rico will be treated in substantially the same manner as those owed to the fuel line lenders.

The PREPA Bondholder Group’s financial adviser said,  “We are pleased to be able to make official what we believe is a reasonable deal with substantial concessions from bondholders that will significantly benefit the people of Puerto Rico. It has not been easy to get to this point and meaningful sacrifices have been made on the part of bondholders. We hope that this agreement can be an example to others of the positive outcome that can be realized through committed negotiation – and that PREPA and its remaining creditor constituencies can now reach similarly fair and reasonable solutions.”

Bondholders are taking substantial risk by agreeing to set rates until the deal is implemented, the bondholder group said. The transaction outlined by the RSA must be executed by June 30, 2016, as further delay could materially change the economic terms agreed to by both sides. This deadline represents an extension of the initial timeline by the PREPA bondholder group. The transaction is also contingent on PREPA coming to an agreement with its bond insurer constituencies.

The restructuring support agreement provides a structured framework to implement the previously announced economic agreements, and is designed to provide PREPA with five-year debt service relief of more than $700 million and a permanent reduction in PREPA’s principal debt burden of more than $600 million, according to a PREPA statement. The agreement also outlines other elements of PREPA’s recovery plan, including new governance standards, operational improvements, rate structure proposal and a capital plan.

KANSAS REVENUES SHORT AGAIN

As time goes on, the Brownback administration looks more and more like Ahab in pursuit of the whale in its pursuit of its tax based economic policy. The report for October for the State’s General Fund reports another shortfall in revenues versus expectations. The continued reductions in income taxes simply have not translated into the higher levels of jobs and economic activity that the administration premised its tax cut program on. While some of the shortfalls can be attributed to continued lower oil and gas prices in this natural gas state, the data shows that this is not the predominant factor.

Total tax revenues are 3.8% below estimates for the fiscal year through October 31. The largest proportion is the decline in the retail sales tax. This tax is historically an excellent indicator of current economic activity and these are running 4.2% below estimates. Now the economy in Kansas is showing positive activity relative to fiscal 2015 – tax revenues are up 2.8% year over year. But it is clear that the state’s ability to predict revenues has not improved leading to the need for mid-year budget adjustments usually in the form of cuts to local aid especially for schools.

So the song remains the same for Kansas. The great tax cut experiment continues, the State’s budget continues to be tight and under pressure, and local units especially school districts must try to plan with the constant threat of additional cuts hanging over them. All in all, this is not a formula for credit stability in the Sunflower State.

ALL ABOARD FLORIDA?

The largest deal to hit the U.S. municipal market next week is $1.75 billion of private activity bonds to help fund All Aboard Florida, a 235-mile (378 km) passenger rail project that will connect Miami to Orlando. The bonds will be sold by the Florida Development Finance Corporation, a state authorized issuer of industrial revenue bonds, and the sale will be managed by Bank of America Merrill Lynch. All Aboard Florida is a privately owned, operated and maintained passenger rail system with stations planned in Miami to Fort Lauderdale, West Palm Beach and the Orlando International Airport. The express train is expected to take approximately three hours, move at speeds up to 125 mph, and be completed by early 2017.

The transaction has met a mixed reaction with potential investors. The market for high speed rail service in Florida is speculative (a nice word for untested). We have reviewed a summary of the feasibility study produced for the project and it raises a number of questions in our mind. Our experience tells that that demand studies for controversial projects (and this one is) often rely on small sample sizes relative to projected usage which often accounts for why actual usage on transportation projects often falls short of projections.

In this case, 1,800 stated-preference surveys and 10,800 origin and destination surveys were conducted to confirm travel behavior, preferences, and willingness to pay. This is out of a projected ridership of 5.7 million in the first year of stabilized operations in 2020. Revenues are projected to rise by 3.8% annually through 2030. All of this relies on projections that gas prices will remain at a steady $4 per gallon even though recent experience tells that gas prices are very volatile and that the current environment supports a price at only 50% of that level in many areas.

According to the study, introduction of a new mode of travel, particularly premium rail service which is more convenient and improves travel time, can often encourage travelers to make trips they may not have made in the absence of the new service. This is called induced ridership. Previous studies have found that the introduction of intercity rail service can result in levels of induced travel ranging from 5 percent to 30 percent. Most of this is attributed to longer trips such as from Miami to Orlando. In this project, that better be true as the bulk of revenues are projected to be derived from long distance trips.

The proposed timing of the deal reflects a number of factors which have often aligned ultimately against a successful outcome for bondholders. One is absolute market levels, relative credit spreads reflecting those absolute levels and the demand for high yield product, and the municipal market’s proclivity for underpricing credit risk during periods of low absolute yields and demand for product to supply the plethora of high yield funds out there.

Our view is that this transaction should be approached extremely cautiously and that potential buyers should hold out for the highest possible spread and be prepared to walk away if it’s not provided. In this case walking may be a better alternative than taking the train.

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 SCHOOL FINANCING MOVES FORWARD

The Arizona legislature approved a package of bills last week that could provide $3.5 billion to K-12 schools over 10 years to settle a five-year-old lawsuit that had been filed by several school districts after the state refused to make inflation-adjusted payments during the worst years of the recession. The package passed with limited support from Democrats. Only one part of the deal, which increases base-level funding per student by $173, was unanimously endorsed by both parties. Democratic lawmakers, as well as educators, argued that the package failed to address how, or if, the state will seek to add more funding to the schools later on. The bill was supported by direct lobbying by Republican Gov. Doug Ducey. “With this permanent infusion of dollars into our schools that schools can spend as they see fit on their needs, educators will finally have the resources they have been asking for and our students will have greater opportunities to succeed,” Mr. Ducey said.

Legislative passage is the first step – the bills will require voter approval in a special election, scheduled for May 17 in a state that has the lowest rate of spending per student in the country. An analysis by the Joint Legislative Budget Committee, released in August, showed the state’s current budget for K-12 schools at $3,437 per student — still 19.2 percent lower than it was in 2005, when adjusted for inflation. The plan to add the additional $3.5 billion relies on increasing the percentage of money taken from a trust fund that holds proceeds from the sale of state land. If voters approve the plan, the state’s 238 school districts will share in a $249 million payment by June 30, or an additional $226 per student — still not enough to lift Arizona from the bottom of rankings on student funding and teacher pay.

Despite recent infusions of cash, many school districts are still struggling to pay for their most basic needs, like new textbooks. Some schools also need additional teachers to handle a surge in enrollment driven primarily by a rise in the number of Latino students, who at 44 percent are already the largest ethnic group in the state’s public education system. The superintendent of the Peoria Unified School District, said the money “will not replace the $218 million we have reduced from our budget over the last nine years, but it is a welcome bandage to slow the hemorrhaging.” The timing of the bill’s passage is problematic for 50 of the state’s 238 school districts that are asking voters to approve property tax increases to provide additional money for local schools, a mechanism known here as overrides.

The upcoming vote will highlight a classic problem in terms of local school funding where there are high proportions of older residents. One example is Apache Junction Unified School District, 35 miles east of Phoenix, a lower-middle-class suburb filled with retirees and voters who have repeatedly rejected requests to increase property taxes to pay for local schools. Last year, 91 percent of all ballots were cast by voters at least 50 years old, and the district’s override request, its fifth in eight years, lost by 1,881 votes. The odds seemed stacked against it once again this year: More than 90 percent of voters who had mailed in early ballots by Oct. 23 were at least 50 years old, according to official statistics. Opposition is summed up by the reaction of one 85 year old resident who said “I voted no, hell no.”  The override would be in effect for seven years and, he said: “I don’t know how they can guarantee it’s not going to pad the superintendent’s salary. We’re all struggling. When is enough enough?”

HILLVIEW KY BANKRUPTCY

Another test of the use of Chapter 9 bankruptcy versus judgment bonds or other mechanisms will be given a hearing in December. The Sixth Circuit U.S. Bankruptcy Court held a preliminary hearing on October 6, 2015 on the Memorandum of Facts and Authorities in Support of Statement of Qualifications  filed by the City of Hillview and the Objection of Truck America Training, LLC to the Chapter 9 Petition Filed By the City of Hillview, Kentucky filed by Creditor, Truck America Training, LLC. It determined that an evidentiary hearing should be conducted at 9:00 a.m. on December 9, 2015 and at 9:00 a.m. on December 10, 2015 in the United States Bankruptcy Court, Louisville, Kentucky. The City filed after Truck America won a $14.5 million judgment against the City which has some $1 million of outstanding debt.

PUERTO RICO

The U.S. Supreme Court will decide by December whether it will take up the case of Puerto Rico’s local bankruptcy law, which federal district and appeals courts have overturned as unconstitutional. Puerto Rico enacted Act 71 of 2014, or the Puerto Rico Public Corporation Debt Compliance & Recovery Act, in the summer of 2014, which is applicable to some $20 billion of public corporation debt, to address the fact that P.R. is specifically barred from accessing U.S. municipal bankruptcy protection. Officials said they needed the law to bring Puerto Rico Electric Power Authority (PREPA) creditors to the table because the electric utility was running out of cash to keep operating.

Two of the largest PREPA investors immediately challenged the constitutionality of the law, and it was subsequently declared unconstitutional. Since then, the government has been waging additional court battles to try to enable the law to take effect while lobbying Congress to extend chapter 9 protections to its public corporations and municipalities. The Puerto Rico government appealed in July to the U.S. Supreme Court, arguing that it has the power to legislate on bankruptcy matters related to its public corporations after the U.S. Congress, for unclear reasons, excluded the island in 1984 from the protections afforded by Chapter 9 of the Federal Bankruptcy Code. Prior to that, Puerto Rico enjoyed access to Chapter 9 since 1938.

A three-judge panel of the First Circuit Court of Appeals in Boston in July upheld a ruling by a federal district court in which the recovery act was declared unconstitutional. Two PREPA bondholders, Blue Mountain and Franklin Advisors, filed opposition briefs to the petition last week. The companies reportedly allege that there are no debatable constitutional issues and that PREPA and its creditors are about to reach a deal to restructure the utility’s $9 billion debt. In fact, PREPA announced late Friday that the ad hoc group of bondholders and fuel line lenders have extended their forbearance agreements until Nov. 3.

PREPA will use the extension to finalize its agreements with the forbearing creditors and continue discussions with its monoline bond insurers. “As we continue our efforts to transform PREPA, this extension affords us additional time to continue constructive negotiations with our key creditors,” said Harry Rodríguez, chairman of PREPA’s governing board. “Working with our creditors to restructure PREPA’s debt is an important component of our comprehensive plan that shares the burden of addressing PREPA’s finances among all stakeholders. We look forward to continuing to make progress towards this transformation which will create a better future for PREPA and provide Puerto Ricans the economical, safe and reliable utility they are asking for.”

Some $128 million of short-term bridge bonds, which carry a yield-to-maturity rate of 12%, are scheduled to be paid in full by Dec. 15.

RURAL HOSPITAL MAKES MARKET COMEBACK

The changes in the healthcare landscape have brought additional pressure and scrutiny to certain hospital sectors. One of the most vulnerable is the facility serving a smaller rural population characterized by vulnerable and less stable underlying economics. One of those entities was the Sierra Kings Hospital District. California hospital districts have long been under pressure and several have availed themselves of Chapter 9 protection. In 2009, Sierra Kings was one of those. In the fourth quarter of 2011, it closed on the sale of its hospital which it had directly operated since 1965 to Adventist Health. As a part of the bankruptcy proceedings, the statutory lien of the District’s ad valorem taxes which are pledged to debt service was affirmed. All claims which were affirmed in the proceedings were finally paid in full by September 30 of this year.

Now that the bankruptcy has been fully dealt with and an operating track record under the new structure established, the District has obtained a newly upgraded investment grade rating from Moody’s and plans to return to the market. The upgrade reflects 100% repayment to its creditors as per its plan of adjustment and the relief of the district of any of the day to day responsibilities of managing the hospital or attendant employees. The District plans to issue $27,040,000 of general obligation bonds secured by a pledge of the statutorily secured tax revenues of the District. For the District, the timing is favorable with rates remaining low and new issue volume remaining constrained.

ILLINOIS BUDGET ILLS TRICKLE DOWN TO THE UNIVERSITIES

The continuing budget standoff has resulted in additional pressure on the ratings of the various units of the state’s public university system. While the ratings of the main campus in Champaign-Urbana and at Illinois State were maintained, the other five units saw their ratings downgraded by Moody’s. The reduced cash flow that results from the lack of a budget has kept the ratings of the universities on a negative outlook. For two campuses, the next move is to below investment grade. Unfortunately this negative trend has not induced the governor and the legislature to settle their differences.

 

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.