Joseph Krist

Municipal Credit Consultant

PR

After months of lobbying, politicking, strongarming, and hyperbole the Senate, eager to follow the House out of town for the Fourth of July weekend, voted 68 to 30 for the Promesa  on Wednesday evening.  President Obama is expected to sign the measure, about which his Treasury secretary, Jacob J. Lew, said “I could write a bill that I think would be a better bill, but I don’t know that anyone could write a better bill that would pass the Congress that also solves the problem.” The Promesa legislation will not prevent Puerto Rico from missing the payment due on Friday on a $2 billion debt. That was made clear by PR’s governor on Wednesday morning.

In an editorial released through CNBC yesterday the Governor said “Puerto Rico does not have the ability to repay the $70 billion debt that was generated by past administrations and their creditors. The debt must be restructured fairly and equitably to both the people of Puerto Rico and the bondholders.

A fair solution to the problem is critical in order to bring progress back to the island. The case of Puerto Rico is similar to New York City’s and Detroit’s, except they had the tools to restructure their debt, and Puerto Rico does not.

My administration has acted swiftly. Puerto Rico adopted the most stringent austerity measures. The Island’s budget has been cut by billions during my term. The payroll has been reduced dramatically. We have deferred other obligations. We have withheld tax refunds.

Payables to suppliers have reached more than $2 billion. The inability to pay our suppliers has resulted in the loss of commercial credit and many services must now be paid on delivery. Without supplier credit, medicines and supplies for public hospitals and air-ambulance service to trauma centers are now in jeopardy.

The emergency measures we have taken are unsustainable, harm our economy, reduce revenues and diminish our capacity to repay our debts. Puerto Rico cannot endure any more austerity.

In order to yield a permanent fix to the debt crisis, lacking the mechanisms that New York and Detroit had, we introduced our own restructuring statute; but the federal courts closed that door. We have tried to negotiate a settlement with the creditors to no avail. This is why we sought the support of Congress. Their response was PROMESA, the Puerto Rico Oversight, Management and Economic Stability Act.

PROMESA is a mixed bag. On the one hand, it provides the tools needed to protect the people of Puerto Rico from disorderly actions taken by the creditors. The immediate stay granted by the bill on all litigation is of the utmost importance in this moment. Most importantly, the authority to adjust our debt stock provides the legal tools to complete a broad restructuring and route Puerto Rico’s revitalization.

On the other hand, PROMESA has its downsides. It creates an oversight board that unnecessarily undercuts the democratic institution of the Commonwealth of Puerto Rico. But facing the upsides and downsides of the bill, it gives Puerto Rico no true choice at this point in time.

On July 1, 2016, Puerto Rico will default on more than $1 billion in general obligation bonds, the island’s senior credits protected by a constitutional lien on revenues. Creditors and bond insurers have initiated multiple lawsuits and last week, hedge funds filed an injunction before the Southern District of New York claiming the “absolute highest priority” over government resources, including those needed for essential public services. That complaint minces no words and states that, in “times of scarcity,” bondholders should be paid before essential services.

No amount of contingency planning can shield us from the fallout of the defaults in the coming days; no amount of contingency planning will replace the necessity of a debt restructuring regime. We have suffered a decade of economic contraction. We are facing a government less capable of providing the services which the public needs.

As governor, I will use my remaining time in office to benefit from the tools provided by PROMESA and develop a fiscal plan that is faithful to the best interests of the people of Puerto Rico.”

The most important provision of the bill for the Commonwealth stays any litigation against the Commonwealth related to the default. Now the Commonwealth will feel free to move the political fight to focus on the makeup of the oversight board. We see that as a crucial piece in assessing the long-term likelihood of success of any restructuring agreement. Without strong and binding oversight, we can easily see the Commonwealth slipping back into its old ways of lax fiscal policies and poor disclosure. The pressure to do so will be immense. That would be a formula for disaster.

ILLINOIS

As we go to press, the Illinois legislature and the Governor were still negotiating over a budget plan that would at least allow the state government to continue to operate. The process continues to be conducted in a highly contentious and partisan manner. While there are signs of progress, enactment is far from certain. There are two basic proposals in play currently.

Senate democrats propose a full-year school funding plan increases state aid for elementary and secondary education by about $760 million, with no district losing money. CPS, would receive $287 million more in general state aid – a 30 percent increase over the current year. About three dozen of Illinois’ roughly 800 school districts receive a larger percentage increase. The plan would provides $112 million to help cover the employer contribution for Chicago teacher pensions. It authorizes more than $680 million for state operations, such as overdue utility bills . A measure in the House is expected to provide money for road construction and local governments’ share of gas tax revenues.

The Republicans countered with a full-year education plan which increases funding for schools by more than $240 million, with no district losing money but does not include money for Chicago teacher pensions or an increase in state aid for CPS. It does provide $729 million for state agencies to cover the cost of operating prisons, veterans’ homes and other facilities and to pay for road maintenance and repair, and gas and repairs for Illinois State Police vehicles. Additionally, it allocates $650 million for human services, including mental health care and autism programs. They would authorize spending for road and school construction, and provide money for local governments. Tellingly, it would not include any of the pro-business legislation Gov. Rauner has been holding out for, such as curbs to labor unions’ collective bargaining rights or term limits for lawmakers.

At this point, the process has entered the theater of the absurd. Universities are facing huge cuts and even closing, social service and health providers which are the main mechanisms in Illinois to provide such services are facing suspension or closure. One non-profit suing the Governor over lack of payment from the state is chaired by the Governor’s wife. Failure to resolve the budget should mark the end of Illinois’ status as an investment grade credit.

We will next publish on July 7. Celebrate the 240th anniversary of our country’s independence safely!

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

DOES NEW NUCLEAR MAKE SENSE FOR MUNIS?

The pending sale of debt by the South Carolina Public Service Authority presents us with an opportunity to update the market for nuclear power in the U.S. SCPSA and MEAG are the two municipal utilities with ownership interests in new nuclear generation facilities under construction.

Questions arise as the result of recent news regarding the early closure of operating nuclear facilities due to the unprofitable operating results they generate. Much of the unfavorable cost comparisons are the result of the shale revolution in the US. With natural gas prices so low and supplies so abundant, nuclear just does not compare favorably on a cost basis with natural gas.

In late May it was announced that Exelon’s Quad Cities and Three Mile Island nuclear plants have failed to clear the PJM capacity auction for the 2019–2020 planning year and would not receive capacity revenue for the period. That announcement followed Exelon’s announcement that it would retire its Quad Cities and Clinton nuclear plants if wide-ranging energy legislation to save the two plants and boost solar development was not passed during the spring Illinois legislative session that was scheduled to end on May 31. The legislation failed. The company has said that both the Quad Cities and Clinton plants have lost a combined $800 million over the past seven years, even though they are two of Exelon’s highest-performing plants.

Entergy plans to close its 852-MW FitzPatrick reactor in New York state in January 2017. Exelon last year announced it would shutter its Oyster Creek plant in New Jersey in 2019, about 10 years before its current operating license ends, to avoid costs associated with the Environmental Protection Agency’s cooling water rule. Entergy’s 677-MW Pilgrim reactor in Massachusetts will also be closed in 2019, owing to market conditions. Omaha Public Power District voted unanimously on June 16 to close Fort Calhoun Station, the smallest nuclear power plant in the U.S. OPPD is a municipal utility and municipals at one time owned pieces of FitzPatrick and Pilgrim.  Diablo Canyon, the two-reactor nuclear power plant on the central California coastline, will be permanently shuttered by 2025 under a renewables-boosting initiative announced this week by its owner, Pacific Gas and Electric (PG&E).

Fort Calhoun becomes the twelfth U.S. nuclear unit to close or announce plans to close since October 2012. Many of the plants have been small, single-unit facilities facing economic difficulties similar to Fort Calhoun. But the Quad Cities station, an 1,871-MW dual-unit facility in Illinois, demonstrates that current market prices—driven low by the abundance of natural gas in the U.S.—can affect any size nuclear plant. Electricity supplied by the Fort Calhoun plant cost more than $71/MWh in 2015. The cost is substantially higher than the roughly $20/MWh that OPPD can buy and sell power for on the open market.

So in this environment it is fair to question why the two Southeastern utilities are investing in new nuclear. With so many renewable choices and the regulatory tide steadily tilting away from large scale thermal generation, are these two agencies spitting into the wind? For SCPSA, the issue is complicated by construction delays until the 2019-2020 timeframe (two to three years of delay) and its associated costs. Construction is taking place during a period of declining revenue for the Authority which actually exceeds the decline in its operating expenses. That trend continues through the first quarter of 2016.

All of this suggests a credit on the decline. The downward slope is not steep but it does seem to be increasingly steady. Should we ever get back to a market where rates are higher and spread matters more, we think that the Authority’s debt will likely be an underperforming investment. Nuclear isn’t about politics anymore like it was in the late 20th century, it’s about markets and competitiveness now.

KANSAS SCHOOL FINANCE PLAN MOVES FORWARD

Many have commented on the usefulness of deadlines as a way to focus attention and force solutions. One example of that phenomenon occurred when a special session of the Kansas Legislature ended Friday night with lawmakers passing a school finance bill to avoid a shutdown of the state’s schools next week. The Senate voted 38-1 to approve the bill with only 15 minutes of debate following the House’s passage of the bill, 116-6.

Kansas is in the middle of a process of responding to a lawsuit filed by four school districts, and legislators were fashioning a one-year funding fix ahead of a potentially more contentious legal and political battle over schools next year. The immediate issue was complying with the Supreme Court’s mandate to make the distribution of state aid fairer to poor school districts.

The vote followed action against an earlier school finance plan in favor of another proposal that won’t cut money from every school district in the state. The plan boosts aid to poor school districts by $38 million, just as a previous plan from Republican leaders did. It redistributes some funds from wealthier districts to meet a Kansas Supreme Court mandate to make the education funding system fairer to poor districts. For example, The Kansas City, Kan., school district would end up gaining about $2.6 million in funding, while the three large suburban Johnson County school districts would still lose money, but less than the previous plan.

It does not rely as heavily on reshuffling of existing education dollars as prior plans, however the bill does take money from the planned sale of assets of the Kansas Bioscience Authority to cover $13 million of the aid to poor schools. The authority was set up a decade ago to nurture bioscience businesses. If the sale doesn’t cover that cost, money will be taken from the state’s K-12 extraordinary needs fund. The bill also  uses  motor vehicle fees and a portion of  the state’s share of the national legal settlement with tobacco companies in the 1990s.

The lawyer for the districts whose lawsuit led to the Supreme Court order, said he supported the new legislation. The plaintiff districts will now submit a brief to the court, saying they consider the equity portion of the lawsuit satisfied with this bill. That would effectively guarantee that schools will stay open in August. The Court had suggested in its recent ruling that schools might not be able to reopen after June 30 if lawmakers didn’t make further changes. Many have programs, serve meals to poor children and provide services to special education students during the summer.

The court is considering separately whether Kansas spends enough overall on its schools — and could rule by early next year. Meanwhile senators debated a constitutional amendment to keep the state’s Supreme Court from putting them in this position again. The amendment failed by one vote.

LOUISIANA

A three week second special legislative session of 2016 closed after three weeks with lawmakers raising only $263 million during the special session  less than half of what the governor sought. They set aside no money for a projected $200 million budget deficit in the 2016 fiscal year that ends Thursday. That shortfall was caused by a drop in corporate tax collections due either to the economy being in recession, to an excessive number of corporate tax giveaways, or both. State officials must eliminate any deficit in the upcoming fiscal year, which begins July 1. The second special session was the longest stretch in the history of the Louisiana Legislature.

Lawmakers — reflecting the rigid ideology of House Republicans — also delayed to next year a total overhaul of the tax system by rejecting interim tax reform measures backed by independent economists on a special task force studying the state’s tax and spending policies. State finances are challenged due to temporary taxes imposed by lawmakers in 2015 and earlier this year that will fall off in 2018. Those revenues total $1.1 billion, according to the state Division of Administration.

There is a significant block of  anti-tax lawmakers who will be asked to support a proposed reform that likely would eliminate tax loopholes, lower tax rates and raise enough money to end the chronic budget shortfalls that Louisiana has experienced since early in former Gov. Jindal’s administration. The governor’s position is that he inherited a $900 million shortfall that had to be plugged immediately, as well as a billion-dollar shortfall for the upcoming fiscal year that he also had to fill.

The recent process included an effort to raise $88 million more by ending the provision that allows taxpayers to deduct their previous year’s state and local tax payments on the  middle-income taxpayers, although studies show that taxpayers who earn over $100,000 would shoulder 75 percent of the cost.

One expected area of contention is the Taylor Opportunity Program for Students scholarships. Because of the overall funding shortfall, parents will now have to pick up 30 percent of the cost of tuition for students receiving the scholarships. That means the average student will have to pay $1,500 in tuition to make up the difference.

EDGING TOWARDS THE CLIFF

Sen. Robert Menendez (D-N.J.), one of the leading opponents of Promesa as passed by the U.S. House critics, has prepared amendments that he says he will try to attach even if it means passing the debt-relief package after July 1, when the commonwealth faces a $2 billion debt payment. Amending the bill would require sending it back to the House of Representatives for approval, yet the House is adjourned until July 5.Though Menendez is a member of the minority party, he could place a hold on the bill, which the Senate leadership would need 60 votes to break. He declined to say whether he would use that parliamentary maneuver, though he didn’t rule it out.

He will propose that the island’s government and agencies be able to restructure their debt without a supermajority vote of approval by a federally appointed oversight board that the legislation will set up. He also wants to add two seats to the board to be nominated and approved by Puerto Rico’s governor and senate. And he or another Democrat will propose eliminating overtime and minimum wage provisions.

Menendez has been at the leading edge of efforts to weaken the board and eliminate the minimum wage and overtime portions of the bill. Delaying passage of the bill past July 1 may play into the hands of some creditors, who could file an emergency injunction to prevent Puerto Rico from spending money on anything other than its debt if no stay is passed before then. That fear has been expressed by the U.S. Treasury. Parliamentary maneuvers could force cloture, or a limit to debate, which could force a vote in the Senate by Thursday. The House is out of session until July 5, so the Senate will have to pass the House bill unchanged for it to head to the president’s desk for his signature before the Friday deadline.

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

SOME THINGS NEVER CHANGE

Here we are at a point in the cycle where rates are at a cyclical if not an historic low. There is a mixture of opinion about the pace and direction of rates, the sustainability of current economic conditions, and the potential impact of changes in those variables. The municipal market is seeing consistently strong cash flows and yield oriented investors seem to be willing to stretch in terms of both duration and credit. So it is a perfect time for the market to accept a credit with significant downside.

It is in that context that we review an offering from the Port of Greater Cincinnati Development Authority of taxable securities to finance the construction of a suburban hotel. The list of stand alone, hotel revenue based financing disappointments is fairly extensive with many high yield funds. They have failed to meet revenue projections in suburbs throughout the country including some of the largest metropolitan areas.

The first red flag is the issues status as a Rule 144A offering made only to “qualified institutional investors”. The transfer of the bonds is also restricted. This could create problems for holders seeking to liquidate holdings in the event of any adverse credit changes.

Like many of these hotel projects, the planned facility will count on significant corporate related demand not only for rooms but for meeting, function, and dining facilities. many of the hotel projects which counted on this sector of the hospitality market have experienced shortfalls in demand. This reflects the high elasticity of demand for these facilities and the vulnerability of that demand to rapid changes in corporate spending as the events they are designed to serve are often among the first corporate expense categories to be reduced during times of economic downturns.

The project bears an number of other risks. The financing is essentially secured by a single asset owned by an entity controlled by one individual. There will not be a corporate “deep pocket” available to bail out the project. That heightens the risks associated with siting and location of the facility which has access to but is not directly adjacent to the nearest interstate highway. The site itself has its issues as it is located on a remediated former manufacturing site.

All of these risks are to be mitigated by a security pledge of “Gross Hotel Operating Revenues”. While it is true that these monies do go through a “lockbox” mechanism, operating expenses of the facility will be paid out prior to the provision of funds for debt at the project rather than just an assumed level of demand. There is projected to be additional revenue generated from the lease of office space at the site. Hotel revenues are projected to provide 1.20 times coverage. Office revenues are projected to increase this cushion to 1.7 to 1.8 times over most years of the deal.

So this is all well and good but why should an individual care? It is only being sold to “qualified institutional investors” after all.  Well if you own a high yield mutual fund or ETF, you could very well own a piece of this deal that will contribute to your income but become a drag on the net asset value of your fund or of the value of your share of an ETF. So I argue that most of it does wind up being owned by individuals albeit by proxy. So that’s why you should care.

POLITICS AND CREDIT

Excuse us for the New York-centric nature of this comment but we see before us one example of political risk in municipals. This time it involves the venerable NYC Water and Sewer Finance Authority Credit and Mayor Bill DeBlasio who is facing an election for a second term in 2017. The mayor’s political troubles are well documented. He is apparently concerned about his perception among “outer borough” homeowners who have been a source of difficulty for incumbent mayors. Trying to seriously reform the property tax system is fraught with political complications the resolution of which create many competing winners and losers. So he decided to throw them a bone that he could effectively take credit for.

Mayor Bill de Blasio proposed a $183 summer credit on the water and sewer bills of over 664,000 homeowners, representing almost 80 percent of all customers. The one-time credit would  have come from the Administration’s decision to no longer request a rental payment from the NYC Water Board, saving $244 million in FY17 and $268 million in FY18. The Mayor has the authority to request or decline to request the rental payment. The decision to not take a rental payment is the first time this has occurred since the City originally leased the water and sewer systems to the Board in 1985.

The politics of the decision were easy. One to three-family households would have received the $183 automatic credit in their bills this summer. It would represent a nearly 17 percent savings on the annual water and sewer bills for a typical single-family homeowner. For approximately 150,000 homeowners, many of whom are seniors, who use less than 95 gallons of water per day and pay the minimum charge, the credit represents a nearly 40 percent savings on their annual water and sewer bills.

Alas, three Brooklyn real estate companies and the Rent Stabilization Association, a landlord group, filed a petition in court to stop the city’s proposal, which also included a rate increase of 2.1 percent and was set to go into effect on July 1. The rate increases would have affected landlords across the city, most of whom would not receive the credit, and by extension their renters. The administration argued that the credit, which was to apply only to one- to three-family homes, was made possible by the city’s decision to no longer request a “rental payment” from the water board, an independent public benefit corporation, leaving it with a surplus.

This week, State Supreme Court in Manhattan ruled that the actions of the water board in authorizing the one-time payment along with a general rate increase was “an abuse of discretion” and exceeded the board’s authority.  Because the city “failed to demonstrate” that it had the authority to approve the rate increase and the bill credit, “the resolutions were arbitrary, capricious and unreasonable, as a matter of law.”

Fortunately, the Mayor’s politics have not negatively impacted the Authority’s credit and have not seriously harmed holders of one of the New York market’s more widely held credits, institutionally and on a retail basis. It is disturbing nonetheless to see the Authority’s credit involved at all in the Mayor’s political activities.

MORE PR LITIGATION

A hedge fund group sued the Commonwealth of Puerto Rico; Alejandro García Padilla, in his official capacity as governor; Treasury Secretary Juan Zaragoza; and other officials after restructuring negotiations broke down Tuesday. Plaintiffs’ counsel, said: “Governor Alejandro García Padilla has willfully violated the first priority guaranteed to general obligation bonds by Puerto Rico’s Constitution and has flouted centuries-old federal constitutional protections for contract and property rights.  The Moratorium Act is transparently unlawful.”

After the talks broke down, the GDB released details of the heretofore confidential negotiations. These details will undoubtedly make some investors unhappy with decisions they made without the benefit of this information. The Commonwealth was  prepared to provide approximately $15.0 billion of incremental debt service to the GO and Commonwealth Guaranteed (“CW-Guaranteed,” and together with the GO, the “GO Holders”), COFINA Senior and COFINA Subordinated creditors via a revised proposal (the “Revised Proposal”), which contemplated GO Holders, COFINA Senior and COFINA Subordinated creditors receiving new debt implying a recovery of approximately 81%, 80%, and 60% of par plus estimated accrued interest  as of July 1, 2016, an additional $1.0 billion of cash interest over the first four years, provided through both the increase in the face amount of cash pay debt and an increase in the cash interest  rates, PIK interest for the differential between 5% and the cash interest rate paid during the first four years, for a total of 5% yield through the life of the bond, the removal of the CAB feature, and consequently, and an improvement in final maturity for the majority of the GO and COFINA creditors.

Debt service on GO and guaranteed debt would have increased gradually over the next 15 years and then leveled at $878 million annually through 2060 with final payment the next year. Senior COFINA debt service would have followed a similar pattern leveling at $389 million annually through the same final payment schedule. Subordinate COFINA debt service would have reached an annual level of $310 million  in five years with balloon payments in 2062 through final maturity in 2066. Combined debt service would be $1.8-1.9 billion through 2039 and $2 billion through 2070.

The GO creditors countered at an 11% haircut and a stepped bond structure that would have included no principal repayment for five years. The plan would have restricted issuance of additional debt and forced any future litigation into New York based courts. COFINA bondholders proposed maintenance of the  COFINA structure and first lien on all COFINA revenues and assets, a smoothing of pledged sales and use tax base amount (“PSTBA”) in order to grant the Commonwealth interim liquidity relief, subject to agreement on sufficient collateral cushion and mechanism, an amortization schedule, including 5-year principal holiday and maturity extensions, and partial PIK interest for the first 4 years, as had been proposed by the Commonwealth. COFINA senior creditors asked for a base bond equal to 95% of the principal amount of bonds outstanding (accreted amount for CABs) at the time of the exchange, a 5.17% coupon for tax-exempt bonds, ratcheting down to 5% upon BBB+ rating, and that sub debt not begin amortizing until after full payment to seniors.

So that is what was on the table when talks broke off. The governor said the counter proposals offered only limited short-term liquidity and basically expected Puerto Rico “to roll the dice on future growth while locking into a debt burden that no other U.S. state faces.” Now it’s off to the courts absent further discussions. And a full default is but 8 days away. The pressure now shifts to the U.S. Congress to try and fashion a plan for Puerto Rico to find a way out of this mess.

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 sale of $550 million of general obligation debt last week by the State of Illinois managed to reflect much of the frustration that many long term observers feel towards the municipal market and its ability to use market forces to discipline irresponsible credits. An analysis published by the University of Illinois Institute of Government and Public Affairs noted that “due to a decline in overall market interest rates and favorable conditions in the municipal market at the time of the bond sale, the state realized a historically low overall borrowing cost…from an absolute interest rate level perspective.”

The political and financial dysfunction of Illinois saw the state pay the highest yield penalty over the triple-A curve imposed on a sovereign state Thursday. The deal’s 10-year maturity priced at a yield of 3.32%, 185 basis points over the Municipal Market Data top-rated benchmark and 111 basis points over the BBB benchmark, up from its last sale in January. The true interest cost of 3.7425% reflecting the widening spreads benefitted from lower overall yields in a market that has seen record lows across scales, disguising the true cost of the state’s fiscal deterioration.

The cost of the issue allowed Governor Bruce Rauner to say with a straight face “Given the decade of fiscal mismanagement at the hands of the Democrats, we are pleased with the record-low interest rate on the bond sale.” A spokesperson later added “It’s clear from today’s bond sale that investors realize Illinois now has a governor that is trying to turn the state around and right its fiscal ship.

The UI study estimated that the issue cost the state $12 million on Thursday’s $550 million bond pricing compared to its previous sale in January. The relative penalty rises to $70 million when the new sale’s results are held up against a decade-old sale that benefitted from double-A level ratings. Since the state’s sale in January, Moody’s and S&P both dropped the state one notch, to Baa2 and BBB-plus, respectively, and Fitch has put the state’s BBB-plus rating on negative watch. The legislature just adjourned without adopting a budget.

The Civic Federation of Chicago, a local government research organization, earlier this year estimated the state paid an additional $43 million over what other single-A credits paid to borrow on the January sale. The 185 basis point spread on the state’s 10-year bond in the recent issue marked a 30 basis point jump just since January.

Once again, the market finds itself at the end of an interest rate cycle with lots of cash becoming more narrow, the pressure to invest at anything that looks like relative value than becomes its own worst enemy in disciplining wayward issuers. This deal is a prime example of that failure.

This trend continues one that was evident in 2015. SIFMA has just released research on state by state issuance in 2015. It shows that Illinois issuers sold some $14.760 billion of municipal bonds in 2015. Some 35% of that debt was issued by the City of Chicago and the Chicago Board of Education. These two troubled credits faced significant pension liability funding issues, declining ratings, and were hamstrung by inaction at the state level to address their problems. Yet both were able to achieve access to the market, albeit at some yield penalty.

PENNSYLVANIA ALSO BENEFITS FROM EASY ACCESS

The same SIFMA survey also showed Pennsylvania in a similar light. Issuers in the Commonwealth, buffeted by State budget inaction and reduced aid from the state managed to sell some $18.272 billion of municipals. The Commonwealth and its agencies accounted for 19% of the total even without a budget being adopted 9 months into fiscal 2016. Its largest City, Philadelphia which faces its own set of daunting pension issues managed to sell $1107.5 billion or 6% of debt sold in the Commonwealth. Like the Illinois issuers, the sales came at some penalty but access was never the issue.

You can view the entire data set at https://states.sifma.org/#state.

TOBACCO FACES INCREASED SALES RESTRICTIONS

With California’s recently approved increase in the age at which tobacco may be legally purchased from 18 to 21, another brick in the wall supporting tobacco securitization debt has been removed. California is by far the largest jurisdiction to make such a change joining Hawaii as the second state to do so. Similar legislation has passed the Senate in New Jersey and Vermont. Since 2013, when Hawaii and New York City increased the minimum age, 100 communities in Massachusetts, Kansas City, Cleveland, Boston and San Francisco joined the list of big cities to adopt an increase. As of June, 2016, 159 municipalities in 12 states, and the entire states of Hawaii and California, have taken this step, covering over 58.5 million people.

The tobacco industry strongly resists such efforts. Its own work has found that “raising the legal minimum age for cigarette purchase to 21 could gut our key young adult market (17-20) where we sell about 25 billion cigarettes and enjoy a 70 percent market share.”

DISCLOSURE LEGISLATION MOVING FORWARD IN CALIFORNIA

The California Senate unanimously passed a bill which would require state and local government debt issuers to report to  the California Debt and Investment Advisory Commission (CDIAC) specified information  about proposed and outstanding debt. Among other things the bill would require all local governments issuing Mello-Roos Community  Facilities  District  bonds to provide a fiscal status report containing specified information to CDIAC by October 30 of every  year until  the  bonds have been retired. All joint powers authorities issuing bonds pursuant to the Marks-Roos Bond Pooling Act must provide a fiscal status report containing specified information  to CDIAC by October 30 of every  year until  the  final  maturity of the bonds.

Issuers would be required to report the use of proceeds of issued debt during the reporting period, which must include: debt proceeds available  at the  beginning  of the  reporting period, proceeds spent during the reporting period and the purposes for which it was spent, and debt proceeds remaining  at  the end  of the reporting period.

In January, 2015, news reports revealed that millions of dollars in  bond proceeds held by the Association for Bay Area Governments’ Finance Authority were missing. A former employee of the authority subsequently admitted to taking the missing proceeds. In response to these disclosures, State Treasurer John Chiang created the Task Force on Bond Accountability.  The Treasurer’s task force worked to develop best practice guidelines for how bond proceeds should be managed to reduce the risk of fraud, waste, and abuse and to identify strategies to increase transparency and  oversight  of the use of bond funds.

Our view is that anything that increases transparency, especially in the murky world of land based financings (a favorite of individual high yield investors and high yield funds) is a positive thing.

PRASA LEGISLATION

Days after the PR legislature appeared to approve it, the PRASA Revitalization Act, or House Bill 2786 is being called back by the PR Senate to address “certain discrepancies”.   The legislation would prevent PRASA from implementing water-rate hikes to its clients within the next three years, while allowing the utility to issue as much as $900 million in debt.

PRASA’S bill calls for a securitization mechanism, whereby a new corporation is created with the sole purpose of issuing new debt for the utility. This new debt would be backed by a portion of water bills PRASA’s clients receive each month. The bill would also allow PRASA to restructure its roughly $4 billion in debt, although the utility would be required to meet a range of conditions in doing so. Moreover, H.B. 2786 calls on PRASA to reduce its water loss by 5%, a goal that must be reached by 2019.

The legislation would give PRASA the opportunity to pay its contractors, who are owed roughly $150 million, and resume its capital improvement program. PRASA estimates it needs about $375 million to resume capital investment. It is estimated that can take up to four months to establish the mechanism following the bill’s enactment into law.

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

PR LITIGATION WAS INEVITABLE

National Public Finance Guarantee Corporation filed a Complaint in Federal District Court in Puerto Rico as we went to press seeking a declaration from the court that the Puerto Rico Moratorium Act is preempted by Federal bankruptcy law and violates the U.S. Constitution in several respects. Similar to the Puerto Rico Public Corporation Debt Enforcement and Recovery Act that was adopted by Puerto Rico and found to be invalid by the United States Supreme Court, National believes that the Moratorium Act is likewise invalid.

With this action, National is seeking to protect the right to priority of payments established under the Puerto Rico Constitution on the General Obligation bonds that it insures, and the liens on properties that secure other National-insured bonds, which the Commonwealth has already invaded under claimed authority of the Moratorium Act. While National it is supportive of the efforts by the U.S. Congress to pass legislation to address Puerto Rico’s financial difficulties, the current draft of the PROMESA legislation approved by the House of Representatives, in its opinion, does not foreclose continued reliance on the unconstitutional Moratorium Act.

The passage of the Moratorium Act while Puerto Rico was in the middle of trying to negotiate a restructuring of its debt made the filing of litigation inevitable. In our view it was an act of bad faith towards its creditors and another in a string of poor decisions by the current Commonwealth government.

ALL ABOARD FLORIDA TRAIN MOVES TO NEXT STOP

A Leon County, Florida Circuit Judge has denied Indian River County’s writ of certiorari that was sought in an effort to block a state-created conduit issuer from selling $1.75 billion of tax-exempt bonds for a private passenger rail project. The project, owned by Fortress Investment Group, has constructed stations and upgraded infrastructure with equity,  spending a total of $787 million since January. Of the total amount spent to date, approximately $594 million corresponds to Phase I (the Miami to West Palm Beach segment), and approximately $193 million relates to Phase II (the West Palm Beach to Orlando segment).

The Florida Development Finance Corp. voted unanimously on last Aug. 5 to allow the corporation to serve as the conduit issuer for All Aboard Florida’s $1.75 billion in private activity bonds for the project. The project is expected to cost $3.5 billion.

The judge ruled that the county failed to establish that it had standing to challenge the federally approved private activity bonds to be issued for All Aboard Florida. He further ruled that even if Indian River County had standing to challenge FDFC’s vote, the county failed to establish that certiorari jurisdiction was appropriate because the corporation’s decision was “quasi-legislative as opposed to quasi-judicial.” The FDFC was created by the Florida Legislature. Its board members are appointed by the governor and confirmed by the state Senate.

All Aboard Florida has already changed its name to Brightline and expects next year to begin daily service on the 70-mile-segment from Miami to West Palm Beach, with a stop in Fort Lauderdale. Initially it will operate over existing Florida East Coast freight rail right-of-way and is building stations in Miami, Ft. Lauderdale, and West Palm Beach. Upon completion, the full 235-mile system will extend to Orlando International Airport following construction of a new, 40-mile spur between Orlando and existing rail line on the Atlantic Coast. All Aboard eventually plans to run 32 passenger trains a day between Miami and Orlando.

The passenger trains will pass through Indian River and Martin counties on the existing Florida East Coast freight railroad line with no passenger stops planned in the two counties. They have filed three different petitions in various state courts seeking reviews of FDFC’s vote. None have been successful.

Both counties also filed separate federal lawsuits— the first ever to contest a USDOT bond allocation for private activity bonds – for the project. The federal suits — the first ever to contest a USDOT bond allocation — are pending in the U.S. District Court for the District of Columbia. A hearing is scheduled June 30 on motions by USDOT and All Aboard Florida to dismiss the cases. A hearing is scheduled for June 30.

The counties contend that the bond allocation was approved in violation of the National Environmental Policy Act, and that the federal approval process failed to consider adverse impacts on traffic and public safety. The suits have stymied more than one attempt by All Aboard Florida to sell its $1.75 billion of unrated bonds to qualified institutional buyers and accredited investors several times. AAF claims that market conditions relative to bond financing began to improve earlier this year and are continuing to improve.

Permits are yet to be approved for proposed safety improvements for the roughly 170 grade crossings and monitoring of archaeological and historical items. Permit risk is always something that savvy bondholders should not accept.

COOK COUNTY

With so much attention focused on Chicago’s pension problems, there has not been as much light shed on the pension situation for the city’s slightly bigger cousin, Cook County. The official statement supporting the County’s pending general obligation bond issue does just that. The O.S. states that the County’s unfunded pension liability grew from $6.5 billion at the end of 2014 to $7.2 billion at the end of 2015. Lower numbers of employees paying into the system combined with lower investment results resulted in the County’s already low funding rate to decline to 55.4%.

The County acknowledges that the statutory formula which establishes annual funding levels from the employees and the County do not meet its actuarially required annual contribution level. In addition, the State of Illinois Pension Code does not provide for any mechanism to account for changes in demographics, assets, or benefits. Any changes for those factors must be remedied by State legislative action.

Here is where the ongoing budget and ideological stalemate between the Governor and the legislature hurts the County. Even if it wanted to address those factors on its own, those actions could be legally challenged. So the County and its ratings are between a rock and a hard place. And the prospect for a quick resolution of the stalemate in Springfield does not look good.

Our view is that the County’s credit will continue to weaken and that the relative value of its bonds should decline. We would expect further downgrades of its credit.

WAYNE COUNTY, MICHIGAN

Wayne County is another troubled borrower whose major city has garnered most of the attention of the market. As Detroit was emerging from its bankruptcy, it appeared  that the County might be headed off a fiscal cliff of its own. Fortunately, a combination of state intervention and strong expense control forestalled the worst for the County’s  grade.

Like Cook County, Wayne County faces substantial demands on its finances to fund pension obligations. In the official statement released in support of its pending tax anticipation borrowing, Wayne County reports a pension liability funding ratio of 46.8%. Such a funding level is unacceptably low however the County does deserve some credit for meeting its actuarially required annual funding level each year since 2011. In the last three years, the County’s contribution has exceeded the requirement rising to 120% in fiscal 2015.

So unlike its larger counterpart, Wayne County’s credit remains on an upward trajectory.

BOND INSURANCE MISCONCEPTIONS

One would think that after the meltdown of bond insurer ratings due to the financial crisis of the last decade, issuers would understand how the product works. It is still amazing to see how some issuers still believe that in a default, they somehow do not have an obligation to repay the insurer. We have another reminder of that misconception this week with a small Virginia issuer.

Buena Vista, VA is a community of 6000 located in the scenic hill country in the State’s south. It is not too far  from the Virginia Military Institute and Washington and Lee University. In 2005, the City issued some $9 million of lease revenue bonds backed by an annual appropriation pledge. The bonds financed a golf course which was supposed to stimulate land values and development in the City. As security for its obligation to bondholders (and ACA the insurer), the City pledged the golf course and land on which its City Hall and other city offices were located.

Like so many other golf course projects financed through munis, this one failed to meet financial projections and did not generate sufficient funds to pay off the Bonds. So the City had to choose to either default on the lease or appropriate other monies in the City’s budget to pay off the bonds. In 2011 ACA agreed to work with the City by allowing it to make reduced payments to reimburse ACA for paying debt service on time and in full to bondholders. In 2015, it chose not to make the appropriations and has continued to fail to do so. Also, the City failed to prepare and Make Public or cause to be Made Public by the Dissemination Agent, with a copy to the Bond Insurer, Annual Financial Information with respect to Fiscal Year 2015 not later than 180 days after the end of such Fiscal Year.

So it is with some amusement that the City seems surprised that ACA is seeking legal remedies to compel payment. ACA is seeking to act on its right to take possession of the pledged assets securing the obligation which means it could theoretically lose title to the golf course and land on which its City Hall and other city offices were located. “All bond holders have been paid in full because the city purchased payment insurance from ACA,” according “All bond holders have been paid in full because the city purchased payment insurance from ACA,” to the City Attorney. But that doesn’t make the problem go away. So far the City is acting like they can do just that.

 SEC INVESTIGATING MORE MUNICIPAL BONDS

The latest SEC municipal bond investigation would seem to have been brought upon the issuer themselves. In April of this year, Community High School District Number 210, Will and Cook Counties, Illinois received reports regarding certain District revenues derived from three bond issues totaling $225,000,000 for capital improvements, including the construction and equipping of two new high schools and the improvement and equipping of the District’s then-existing high schools. An outside auditor has determined that certain bond issue proceeds and  interest  earnings on those proceeds  were,  in  fact, transferred  between  District  funds  or otherwise accounted for in a manner not in accordance with best practices and without, in some instances, adequate evidence of Board approval.

Despite the direction of the Board in the 2009 Bond Resolution and without any Board direction to the contrary, the District’s records of accounts currently indicate that the proceeds of the 2009 Project Bonds were accounted for in operating funds. a significant portion ($18,000,000) of the misdirected  proceeds and an interest  transfer  was  used  to fund expenditures other than for capital improvements. Those interest earnings were not needed for capital projects, and federal  law might render the tax-exempt bonds taxable should such sum be transferred back to a capital fund. The Board determined that it could use the interest earnings for operating purposes.

The SEC will look at all of this to determine if the District was truthful with investors when it issued official statements for the three bond issues. If it was not, the District could be charged with securities fraud. The Commission has clearly become more vigilant in regard to disclosure included in official statements. our view is that any such activity by the Commission is welcome in support of the investor community’s efforts to improve disclosure in the municipal bond market.

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

NJ COURTS RULE AGAINST PENSION COLAS

The state Supreme Court on Thursday upheld a landmark 2011 law freezing cost-of-living adjustments for retired government workers. The 6-1 ruling is a victory for Gov. Chris Christie. The lawsuit was filed by a group of retired prosecutors and hinged on whether the legal promise not to reduce workers’ pensions includes cost-of-living adjustments. Christie and state lawmakers suspended the regular increases in 2011 as part of an overhaul of employee benefits that also raised the retirement age and required workers to pay more for their pensions and health care.

Public workers sued, arguing before the court in March that their cost-of-living adjustments have the same protections as the pensions themselves and cannot be reduced, while a lawyer for the state said COLAs fall outside that “non-forfeitable,” or absolute, right. Assistant Deputy Attorney General Jean P. Reilly argued if there was any ambiguity in the language of the 1997 law, which granted a non-forfeitable right to the “benefits program,” it should be interpreted narrowly and in the state’s favor.

Writing for the majority, Justice Jaynee Lavecchia agreed, finding “In this instance, proof of unequivocal intent to create a non-forfeitable right to yet-unreceived COLAs is lacking. Although both plaintiff retirees and the state advance plausible arguments on that question, the lack of such unmistakable legislative intent dooms the plaintiffs’ position.”

The COLA suspension was part of a broader law requiring public employees and the state to pay more into the pension system. The legislation was enacted to reduce the state’s massive pension debt by $140 billion over 30 years and preserve the fund. Freezing cost-of-living adjustments was projected to save more than $70 billion of that total.

With this ruling, it could be decades before many public workers’ COLAs can be restored. Under the law, they won’t receive increases until the individual pension plans that make up the pension fund are much healthier, which the statute defines as at least 80 percent funded.

In his dissent, Justice Barry Albin, wrote that in drafting the law the Legislature could have, but didn’t explicitly exclude COLAs from the contractual right. “Many public employees may not have retired or may have deferred their retirement had COLAs not been guaranteed as part of their pension benefits program,” he said. “Although the Legislature had the right to suspend COLAs for those public employees whose pension benefits had not vested and who had yet to retire, it did not have the right to do so for those public employees who retired expecting that the state would keep its word.”

The full contribution recommended by actuaries — well above what the state actually pays — for this year would immediately jump from $4.4 billion to $5.7 billion. And for the governor to stick to his current payment schedule next year he would need to kick in $400 million more than planned and $1 billion more than the state is to pay in this year.

Thursday’s ruling was the second major state Supreme Court decision on the 2011 pension reform law in favor of the State in as many years. In June 2015, the high court ruled a piece of the law requiring Christie to gradually increase annual payments into the system couldn’t be enforced.

In both cases, the court invalidated what public workers believed to be contractual obligations binding the state to make annual contributions or pay out COLAs. The decisions re only partial victories for bondholders in that they do not force the State to adequately fund the remaining legal pension obligations. While theoretically reducing the ultimate total liability, the State’s credit does not significantly benefit from maintenance of the status quo. We find this development to be credit neutral at best.

PR VOTE

The House on Thursday overwhelmingly passed a rescue package for Puerto Rico, clearing a major hurdle in the ongoing effort to bring relief to the U.S. territory. The bipartisan vote was 297-127 for the legislation that had the strong support of President Barack Obama, House Speaker Paul Ryan, R-Wis., and Minority Leader Nancy Pelosi, D-Calif.  Despite leadership support, the measure faced opposition from some in the ranks of both parties, as some bondholders, unions and Puerto Rican officials have lobbied against it. Some conservatives said it would cheat bondholders, while some Democrats argued the control board has colonial overtones.

In spite of an impassioned appeal from the Speaker, Republican support was mixed. While the vote met the “Hastert Rule”, the fact is that 103 out of 240 Republicans voted against the bill. Despite some outspoken opposition from Democrats before the vote, only 24 of them voted against the bill. Hours before the vote, the White House strongly endorsed the bill, saying that failing to act could result in an “economic and humanitarian crisis” in the U.S. territory beyond what the island is already facing. In a push to get the bill passed, Obama summoned House Democrats with ties to Puerto Rico to a meeting in the Oval Office on Wednesday, including supporters and opponents of the measure.

Democrats and labor unions opposed a provision in the bill that would allow the Puerto Rican government to temporarily lower the minimum wage for some younger workers. A Democratic amendment that would have deleted that provision was rejected, 225-196.

On the same day the U.S. House approved Promesa, Sen. Bernie Sanders (I-Vt.) filed a measure that seeks another alternative to the island’s fiscal and economic woes. Sanders’ Puerto Rico Humanitarian Relief Act would recognize the Federal Reserve’s authority to provide emergency financing to the commonwealth. His bill would grant the island’s public corporations with access to Chapter 9 bankruptcy protections, on a prospective basis.

The bill would create the Reconstruction Finance Corp. of Puerto Rico — an entity to be run by a seven-member board and designed to assist in the commonwealth’s debt-restructuring efforts. It calls for ensuring that the Puerto Rico Commission for the Comprehensive Audit of the Public Credit continues its work and allow Puerto Rico not to pay any debt issued against the island’s Constitution. Holders of affected bonds would be prompted to “seek redress from the investment banks that helped market and sell these unconstitutional instruments,” according the a copy of the bill obtained by press sources.

Sanders’ measure would also seek to improve federal healthcare funding, and calls for providing $10.8 billion over the next five years to modernize Puerto Rico’s infrastructure, an initiative that would create 140,000 jobs, according to a summary of the bill. It would also grant Puerto Rico with access to the federal earned income and child tax credits. A process would be established to allow Puerto Rico and municipal governments to file for insolvency with the proposed public corporation, which would also be allowed to lend money to the commonwealth and its instrumentalities. It would be capitalized through the U.S. Treasury’s Exchange Stabilization Fund.

Upon an insolvency filing, a legal stay and a moratorium on debt payments would be imposed, and affected bonds “would be written down to whatever the current owner paid for [it],” reads a summary of the bill. The new entity would then buy those bonds at said price, resetting their par value.

“This section makes clear that the pensions of ordinary investors should be protected, and that Wall Street speculators should not be able to profit from the misfortune of [Puerto Rico’s people],” the document further states.

The entity’s board members would need to be all Puerto Rico residents, to be chosen by the island’s governor (2), Legislature (4) and the U.S. President (1). The bill also calls for “a vote or a series of votes” in which Puerto Rico’s people can decide whether to become a state, an independent country or be allowed “to reform the current commonwealth” status. The federal government would be required to “respect and honor the will of the people of Puerto Rico,” and votes would need to take place by January 31, 2018, with a transition process be put into place by January 31, 2022.

The bill’s healthcare provisions seek “to ensure Puerto Rico receives payments under Medicare and Medicaid that are at least equal to payments received by all states,” by increasing Medicare payments to healthcare providers, removing caps on Medicaid funds and fully applying the federal poverty level limitation.

Our view is that the Sanders legislation has little prospect of passage. Getting Promesa enacted will be hard enough.

SUPREME COURT DEALS PR ANOTHER BLOW

The U.S. Supreme Court followed up its ruling in the Sanchez case dealing with Puerto Rico’s sovereignty by ruling 5-2 against the Debt Enforcement and Recovery Act of 2014 in Puerto Rico v. Franklin California Tax-Free Trust, No. 15-233. Puerto Rico argued that it could enact its own measures since the island is precluded from using bankruptcy law. But lower courts struck down the law. Writing for the court, Justice Clarence Thomas said the plain text of the law bars Puerto Rico from enacting its own municipal bankruptcy schemes. He said Congress “would have said so” if it didn’t want the exclusion to apply to the island.

The issue before the high court was how to interpret a 1984 amendment to the nation’s federal bankruptcy laws. The law allows states to let their cities and utilities seek bankruptcy relief, but it specifically excludes Puerto Rico – a territory – from doing so. Now Puerto Rico’s best hope would seem to rest with the enactment of Promesa including its provisions for oversight.

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

PR INVESTORS MEET…

The magnitude of the gap between the various interests involved in the process of dealing with Puerto Rico’s impending default were presented in stark relief this week at a conference for institutional investors held in NY this week. Representatives of investors, bond insurers, and one gubernatorial candidate attended as did the head of the GDB.

The lack of information transparency was noted by several, especially the continued lack of audited fiscal 2014 audited financials. The head of Assured Guaranty expressed sentiments which have bothered us for some time. “You have a government that seems to ignore every law…. How can we do anything if they don’t follow the law. When do we get to choose which law or constitutional provision is enforced?” he said.

The comments of various participants shed a light on the continuing schisms between the various investors classes. Representatives from the credit-union group, believe an entity-by-entity approach should be quickly adopted and that the commonwealth’s negotiation strategy “has been divided among creditor groups.” Individual investors representatives explained how the group representing their interests formed precisely out of local bondholders’ frustration from not being part of the negotiations. The director of the GDB said the superbond would help the commonwealth manage its debt more efficiently, but conceded the structure is not set in stone.

Many views on Promesa were expressed. Gubernatorial candidate Rosselló was quick to point out his opposition to Promesa, and proposes a joint commission, “which essentially is a fiscal control board, but specifically for managing the debt restructuring,” he said. He still believes federal government involvement is important moving forward, providing assistance in such areas as tax-revenue collection. He explained his plans to reduce the government’s size and spending, and how his plans are more suitable to solve the island’s problems.

AMBAC’s representative expressed support for Promesa and its debt-restructuring components, includingTitle VI, which provides for collective action as did institutional investor reps. Assured’s chairman would rather see a voluntary process under Title VI, instead of following the path of Title III, where both Puerto Rico and the market could lose. Title III would allow for a court-ordered debt-restructuring process if the fiscal oversight board approves it.

Meanwhile,  P.R. House Treasury Committee Chairman Rafael “Tatito” Hernández is cancelling, through the 2017 fiscal budget, the contracts extended to Millstein & Co. as restructuring. Hernández said that instead of getting paid from the general fund, the advisers should be paid at the closing of the transaction as it was done in the case of AlixPartners and Chief Restructuring Officer Lisa Donahue, who handled the Puerto Rico Electric Power Authority’s $9 billion debt restructuring. Cleary Gottlieb’s Richard Cooper and Millstein & Co.’s founder, Jim Millstein, were hired by the Government Development Bank as restructuring advisers, and they have been paid more than $65 million. The cancellation will take place starting in July with the new fiscal year.

…AND A LEGAL SHOE DROPS…

The U.S. Supreme Court ruled in the case of COMMONWEALTH OF PUERTO RICO v. SANCHEZ VALLE ET AL. The case involved an issue of double jeopardy in a criminal matter but the decision reached would be based on the Court’s interpretation of Puerto Rico’s status as a commonwealth. Prosecutors argued that Puerto Rico and the United States are separate sovereigns for double jeopardy purposes and so could bring successive prosecutions against each defendant. The Puerto Rico Court of Appeals consolidated the cases and reversed. The Supreme Court of Puerto Rico granted review and held, in line with the trial court, that Puerto Rico’s gun sale prosecutions violated the Double Jeopardy Clause.

The justices’ 6-2 ruling on the Puerto Rico v. Sánchez Valle case says Congress is the ultimate source of the island’s legal power even though Puerto Rico has its own constitution. Opponents of a fiscal control board being imposed on PR through Congressional action had pinned their hopes on a ruling in favor of the Commonwealth. The court had to decide what is “the ultimate source” of the commonwealth’s authority to prosecute. If the local and federal courts derive their prosecutorial power from the same ultimate source, they are not separate sovereigns.

Those in favor of a Congressionally imposed solution process for Puerto Rico’s debt problems will be heartened by the decision. Our view is that Puerto Rico has been trying to have things both ways in its approach to investors, justifying many of its requests on its status as part of the U.S. while invoking sovereignty when it came to matters of oversight, fairness, and transparency.

The ruling would seem to limit the potential scope of legal challenges to Promesa should it ultimately be adopted by the Congress.

…WHILE A FY 2017 BUDGET IS CONSIDERED

It is proposed that in the next fiscal year, the Puerto Rico government would have to pay $1.78 billion in total debt service payments, an amount that is around 19.5% of the service is 12% of the budget of $9.5 billion. In 2013, debt service was 6% of the $9 billion budget. In 2012, the debt was 7% of the $9.2 billion budget.

The budget package is comprised of 11 measures. One of the most controversial would amend the 2006 Fiscal Reform Act to require that all monetary earmarks given to entities will be fixed according to the fiscal state of the government and not as established by special laws. “There will be no debt or obligation resulting from any difference between the amount that has to be provided and what is provided,” the bill states. For example, if the government were required by a special law to earmark $5 million to a program in the Family Department, it would be able to allocate a lower amount under the proposed legislation.

Another measure, House Bill 2962, would suspend all monthly payments to the Amortization and Redemption Fund for General Obligation (GO) bond payments. The government has been since 1976 setting aside GO payments in the fund. The government would stop all deposits to the fund unless it is able to obtain $1.2 billion in tax-revenue anticipation notes. The government owes $1.78 billion in total debt payments that include $24 million owed by the Treasury Department, $21.4 million by the Land Authority, $408 million by the Aqueduct and Sewer Authority, $322 million in public debt, $64.4 million by the University of Puerto Rico, $10 million by the courts, $545 million by the Electric Power Authority, $1.4 million by the Infrastructure Financing Authority, $20.8 million by the Puerto Rico Industrial Development Company, $17.6 million by the Public Housing Administration, $31.2 million by the Housing Financing Authority, $283.4 million by the Public Buildings Authority, $3.8 million by the Infrastructure Financing Authority and $30 million by the Convention Center District Authority.

STADIUM FINANCE SEASON IN FULL SWING

Maybe municipalities are learning something about stadium finance and its risks. Manchester, NH has seen the downside of government funding for sports facilities with its negative experience with its indoor arena. That facility was financed with entertainment tax debt through the State of NH. Ultimately those revenues were insufficient and the local American Hockey League franchise was moved to California. Now the city’s Board of Mayor and Aldermen voted unanimously to approve an agreement with the minor league baseball New Hampshire Fisher Cats that commits city funds to pay for stadium improvements at a ten year old facility.

This agreement contains a concession from team ownership regarding collateral if they attempt to move out of Manchester before 2028. In exchange for the city funding $948,000 in repairs to Northeast Delta Dental Stadium, the contract contains language that pledges that the ownership team (NH Triple Play) will pay $9 million of principal balance on the city’s stadium bonds if there is an attempt to move the team out of the city prior to 2028.

According to an amortization schedule provided by the city, approximately $18 million of principal balance remains on the city’s bond for the stadium project. According to the agreement, half of the principal balance will be paid from NH Triple Play’s annual payments to the city. Under the new agreement proposed Tuesday, ownership agrees to secure the remaining $9 million of bond payments by providing the city with a security agreement, secured by its financial interest in the team.

The original request made last year was for the city to pay for about $1 million in improvements at Northeast Delta Dental Stadium, including putting in a new fire suppression system and replacing the playing field at the ballpark. The city’s deal with the stadium ends when the stadium bonds are fully paid off, projected to be in 2028. The team currently pays a $730,000 rent-like payment plus another $167,627 a year to cover stadium building costs it agreed to pay beyond the $25 million stadium project.

Ownership offers to pay the city $500,000 a year in rent beginning from 2029 to 2035, if city officials will commit to earmark half that amount for a capital reserve fund to be used for stadium maintenance. if the stadium capital reserve fund doesn’t cover capital expenditure costs for any given year, the team will fund any additional money required. After five years, if capital reserve funds come up short for any year, the additional funding needed will be split 50-50 between the city and team “after both parties agree on the need.” The city will also prepare a city-owned parcel of land between the stadium and the railroad tracks for additional parking.

So the deal does force the team to provide more security, lessening the chance that the city will be left with stranded costs. In our view, it is good to see municipalities insisting on better protections for their own investment and some mitigation of the long run risk to taxpayers.

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

STATE FINANCIAL HEALTH RANKINGS

The Mercatus Center at George Mason University annually ranks each US state’s  financial health based on short- and long-term debt and other key fiscal obligations, such as unfunded pen­sions and healthcare benefits. This ranking of the 50 states and Puerto Rico is based on their fiscal solvency in five separate cate­gories: Cash solvency. Does a state have enough cash on hand to cover its short-term bills? Budget solvency. Can a state cover its fiscal year spending with current revenues, or does it have a budget shortfall? Long-run solvency. Can a state meet its long-term spending commitments? Will there be enough money to cushion it from economic shocks or other long-term fiscal risks? Service-level solvency. How much “fiscal slack” does a state have to increase spending if citizens demand more services? Trust fund solvency. How much debt does a state have? How large are its unfunded pension and healthcare liabilities?

Alaska, Nebraska, Wyoming, North Dakota, and South Dakota rank in the top five states. Kentucky, Illinois, New Jersey, Massachusetts, and Connecticut rank in the bottom five states, largely owing to the low amounts of cash they have on hand and their large debt obligations. There were big movers in each of the five categories that make up the overall ranking: Colorado, Delaware, New Mexico, and Iowa all moved down in the ranking of cash sol­vency, while Maine and Minnesota both improved.

While the methodology of the study is clear, its results show its limitations. The bottom five states would be likely to finish near the bottom of any such survey. At the same time, states like Kansas with limited direct debt issuance powers inflate their relative position. On the other hand, current oil/gas productions states like Alaska and North Dakota are clearly under current fiscal distress. Alaska is balancing its budget by running down reserves accumulated in prior years of higher oil prices. North Dakota and its municipalities, like Williston, are seeing significant revenue impacts. No one would call them financially strong on a current basis.

Our point is to help investors place surveys like this in context. Information without context is like trying to operate a new piece of electronics without reading the instructions.  It’s likely to go a lot better if you follow the guidance of the professionals. That is also true for municipal bond investing. It’s something to keep in mind when you try to interpret data and evaluate it in relation to your municipal bond portfolio.

FLORIDA CITY UNDER STATE REVIEW AGAIN

Just weeks after Miami-Dade County officials sent letters to the governor warning that the City of Opa-Laka could be shut down because of gaping budget shortfalls in the millions Governor Rick Scott issued an executive order declaring that it needs  state assistance to resolve the state of financial emergency that currently exists through the implementation of measures authorized  by Part  V, Chapter  218, Florida Statutes.

Under the Agreement, the City of Opa-locka shall obtain written approval of its proposed annual budgets, and any amendments to such budgets, from the Governor before final approval of the budget. A  financial  emergency board  shall be established  by the Governor to oversee the activities of the City of Opa-locka. The board members and chair of the financial emergency board shall be appointed by, and serve at the pleasure of, the Governor.

The financial emergency board shall adopt such rules as are necessary for conducting board business, and shall make  regular  reports to the Governor  of its findings, recommendations , and  actions. The City of Opa-locka is prohibited to issue bonds, notes, certificates of indebtedness, or any other form of debt without the prior written approval of the Governor. The City of Opa-locka shall make available for inspection and review all records, information, reports, and assets of the City at the request of the Governor.

For months, Miami-Dade County Mayor Carlos Gimenez had urged Scott to issue the order while the FBI was undertaking an investigation targeting city leaders, including the Mayor, the City Manager and a City Commissioner. Last week, one Commissioner took his own life by crashing his SUV into a tree two days before he was to turn himself in to Miami-Dade prosecutors in a state corruption case. The order follows by nine months the discovery of $8 million of previously undisclosed debts.

Publicly issued debt outstanding from the City is insured. It does not have an underlying rating. While the Governor’s order is in effect, the City does not control its fiscal affairs and cannot make any decisions of consequence without approval. The City of Opa-locka would have to obtain prior written approval from the Governor before it may seek application of the laws under the bankruptcy provisions of the United States Constitution and/or Federal Statutes.

ARE STATE CREDITS ABOUT TO WEAKEN AS A GROUP?

Some are concerned about “slowing” state revenues in the first quarter of 2016. A recent report from the Rockefeller Institute of Government is the latest source of concern. So what does it say?

It observes that personal income tax revenue growth slowed to 6.5 percent on a year-over year basis, down from 14.4 percent growth in the second quarter of 2015. Thirty-four states reported increases in personal income tax collections, while nine states reported declines. Second-quarter growth had been atypically high, likely reflecting the strong stock market of 2014 and taxpayer response to federal tax rate changes. Growth was also weak in all other major tax sources: corporate income taxes grew by 1.0 percent, sales taxes 3.2 percent, and motor fuels 5.3 percent.

The Institute also notes that states expect fiscal years 2016 and 2017 to be much weaker than fiscal year 2015. The median forecast of income tax growth in the thirty-six states for which it was able to gather recent forecasts is 4.6 percent for 2016 and 4.4 percent for 2017, compared to 7.8 percent actual growth reported for 2015. The median forecast of sales tax growth in the thirty-eight states for which we have data is 3.5 percent for 2016 and 3.9 percent for 2017, down from actual 2015 growth of 4.5 percent.

We think that it is important to note that what is being observed is slower rates of growth, not actual declines. We would also note that some of the prior rates of growth against which these rates are compared must be viewed in the context of the impact of the Great Recession on state revenues. Those impacts were unique in the post-war experience of our market and created a low base against which to measure growth. Before one panics, keep in mind that the data is available to budgeters early enough in this budget cycle for them to take into account when projecting budgets for the upcoming fiscal year.

Our view is that this data is important but we believe that political and ideological issues should be of more concern to bond investors than the absolute short term revenue trend data. We are not ready to panic yet.

PR PRIMARY RESULTS ARE ANTI PROMESA VOTE

Puerto Rico chose the son of former governor, Pedro Rosselló, who served from 1993 to 2001, and who opposes a U.S. House plan for fixing the island’s debt crisis, over their representative in Congress who supports it for the New Democratic spot in this year’s gubernatorial election. Ricardo Rosselló Nevares won 51.08 percent of the vote, while Resident Commissioner Pedro Pierluisi, Puerto Rico’s congressional representative, won 48.92 percent in the Sunday election.

Rosselló will contest the general election in November, with he and David Bernier, the pro-commonwealth Popular Democratic Party (PPD) candidate, considered the frontrunners. Bernier also opposes the bill – and has threatened to sue to block it – as do the other candidates on the ballot: María de Lourdes Santiago of the Puerto Rican Independence Party (PIP), Rafael Bernabe of the Puerto Rico Working People’s Party (PRTP) and independent candidates Alexandra Lúgaro and Manuel Cidre.

The vote shows the difficulty that is faced in determining how feasible any recovery program imposed by Congress will be. Between the high level of opposition on the island and efforts expected from the U.S. Senate against strong oversight, we think that approval and implementation of an effective restructuring and recovery program is far from a done deal.

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.