Joseph Krist

Publisher

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ISSUE OF THE WEEK

$1,390,240,000*

Commonwealth Financing Authority

Tobacco Master Settlement Payment Revenue Bonds

Moody’s: “A1” (stable outlook)  S&P: “A” (stable outlook)
Fitch: “A+” (negative outlook)

The bonds are secured by a continuing appropriation of annual payments due to the commonwealth pursuant to the 1998 tobacco Master Settlement Agreement. In addition, like CFA’s $2.3 billion of outstanding debt, the bonds benefit from a continuing appropriation of the Commonwealth of Pennsylvania’s “Article II” revenues, composed of the state’s 6% sales and its 6% hotel occupancy tax. To the extent that the tobacco settlement revenue bonds would need to access the Article II revenues, their priority of payment claim on them is technically subordinate in timing to the outstanding CFA bonds.

Proceeds of the bonds will be deposited in the commonwealth’s general fund to close the $1.5 billion deficit it accumulated in its fiscal 2017 budget year (which ended June 30, 2017). That use of proceeds is the real credit issue here as it relates to the Commonwealth’s overall credit position. The risks of tobacco bonds as a credit are well known. the availability of additional tax revenue sources dilutes the reliance of the tobacco revenues alone thereby generating a stronger credit for these bonds. The use of proceeds is effectively the use of long term debt to finance current deficits which is a significant negative factor in the Commonwealth’s credit.

Pennsylvania historically relied on annual financing to fund operating deficits until the market began to significantly penalize the Commonwealth’s borrowing costs. The Commonwealth worked hard over a period of many years to end this reliance and only use financing for short-term purposes reflecting timing differences between the receipt and expenditure of revenues. This allowed the Commonwealth restore its ratings to the AA level so it is disappointing to see the politics of the legislative process result in backsliding on maintenance of a strong credit profile. The bonds will not address the Commonwealth’s refusal to effectively tax its natural gas extraction industry or its continuing need to find revenues to fund its growing pension obligations.

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PREPA PRIVATIZATION

A major change in philosophy towards the provision of basic services began to shape last week. in a televised address, the governor of Puerto Rico, Ricardo Rosselló, announced in a televised address that his administration is preparing to initiate the privatization of the utility’s power generation.. “The Puerto Rico Electric Power Authority [PREPA] will cease to exist as it deficiently operates today.” The sale of the public corporation’s assets to companies “will transform the generation system into a modern, efficient, and less expensive one for the people,” the governor said. He said ” One of the great impediments that has stopped our opportunities for economic development is the deficient and obsolete system of generation and distribution of energy on our Island. The Puerto Rico Electric Power Authority (PREPA) has become a heavy burden on our people, who are now hostage to its poor service and high cost. What we know today as the Puerto Rico Electric Power Authority does not work and cannot continue to operate like this.

The governor said the privatization process that “is about to begin” would last 18 months. It is proposed to consist of three phases, the first of which would be defining the legal framework through legislation, to then issue a request for proposals. The second is to evaluate the “technical, economic, and financial” merits of the submitted proposals. Finally, the terms and conditions for contracting the companies that have complied with the requirements would be negotiated.

The governor’s proposal includes a defined concession term for the distribution and transmission of energy to “end the monopoly of the production and sale of energy on the island and promote investment and competition for the benefit of customers as occurs in other jurisdictions in the United States.” The governor did not mention how the model affects the utility’s ongoing bankruptcy-like process under Title III of the Promesa federal law. However, the island’s fiscal oversight board had expressed being in favor of the public corporation’s privatization in August, which bodes well for the move to be presented in court.

We believe that given  PREPA’s unique market, its geographic limitations, and its probable lack of access to capital on its own for an extended period it makes sense for PREPA to consider its effective liquidation to a private entity which would provide better expertise as well as access to more reasonably priced capital. Effectively, the Commonwealth should take advantage of the unique situation that has resulted from hurricane Maria to take steps which have been historically untenable politically. PREPA can no longer be a prop to support employment and incomes. It must become the most efficient provider of its service possible. This includes not only basic service but also regulatory and environmental issues. The current conditions therefore present an “opportunity” that might not otherwise be exploitable.

It is not clear how much the Commonwealth could fetch in the market for these assets given the issues we discussed. Therefore, it is not possible to estimate what the monetary impact on the Title III proceedings would be or the potential return available to investors. Nonetheless, we see the effort to privatize as extremely positive for Puerto Rico’s long term economic viability. The utility would be much better positioned to be a support for economic recovery and development. Not only will it be better positioned from the standpoint of efficiency and cost, but also for an enhanced ability to access capital and employ the use of more modern renewable technologies. The positive impact of a privatization cannot be understated.

 THE INFRASTRUCTURE LEAK – SOMETHING ELSE WHICH NEEDS REHABILITATION

A leaked copy of the outline of the Trump Administration’s infrastructure plan retains the administration’s bias toward the private sector as the chief provider and/or beneficiary financially of infrastructure funding. Portions of the program will be overseen by the Department of Commerce. It’s various provisions in terms of project selection and provision clearly weigh the criteria in favor of private entities. Of course this is no surprise.

The ways in which it seeks to achieve that goal however, were surprising. To facilitate the attempt to employ private entities in traditionally governmental projects constraints on the use of municipal bonds to finance private activities would be loosened. These include categories of public purpose infrastructure, including reconstruction projects, to take advantage of PABs would encourage more private investment in projects to benefit the public. Notable is a proposed elimination of the AMT provision and the advanced refunding prohibition on PABs — this after the new tax law eliminated advanced refundings for all munis. The plan also calls for elimination of the transportation volume caps on PABs and expands eligibility to ports and airports, removal of state volume cap on PABs, provision for change-of-use provisions to preserve the tax exempt status of governmental bonds, and provision of change-of-use cures for private leasing of projects to ensure preservation of tax-exemption for core infrastructure bonds.

Incentives for states to spend will be established under formulae weighted toward projects with private participation and there are limits on the percentage of federal funding. The end result is a program which generates benefits for the private sector while shifting much of the cost of these projects to the states and localities. It seeks to loosen environmental reviews and encourages usage charges (tolls) to provide revenues for local shares.

The plan can be seen as constructive for bonds from the view of the financing side of the market but credit negative for the credit side of the market through its cost shift to the states. States and localities are encouraged to come up with more funds of their own while the tax code changes just enacted make it less attractive for taxpayers to support that choice. The debate has to start somewhere however, so now we at least have a starting point. The draft builds on support for relaxed PAB provisions as evidenced by the recent Warner-Cornyn bipartisan proposal just introduced. Their bill, the Building United States Infrastructure and Leveraging Development (BUILD) Act, they say would lead to additional investment in infrastructure projects by allowing state and local governments to enter into additional public-private partnerships to finance surface transportation projects.

Whether the proposal when it is formally released can garner enough support is not clear. Rural areas will want greater support for things like broadband provision and expansion above the proportions envisioned in the draft. States will be disappointed that traditional cost sharing ratios will be less favorably. The prime example of this would be the much discussed Gateway Tunnel. The proposed funding ratios in the draft plan would shift even more of the cost of this clearly necessary project onto the taxpayers and fare paying public in New York and New Jersey even though the trains using it serve a much wider area.

MEDICAID WORK REQUIREMENTS WHILE CHIP GETS FUNDING

The latest assault on Medicaid expenditures has begun.  The Centers for Medicare and Medicaid Services (CMS) announced that it had released landmark guidance aimed at allowing states to impose work requirements for Medicaid beneficiaries. Previously, no state has ever been able to get federal approval to impose work requirements on Medicaid beneficiaries. Kentucky became the first to receive approval from the Trump administration to impose work requirements as part of a broader overhaul of the state’s Medicaid program.

The decision is expected to be challenged through litigation. Under federal law, the Centers for Medicare and Medicaid Services needs to consider if a waiver is “likely to assist in promoting the objectives” of Medicaid. CMS officials emphasized that the work requirements would only apply to “able-bodied” adults, coming with exemptions for children, the elderly, pregnant women and people with disabilities.

Kentucky’s program also exempts “medically frail” individuals, such as people with cancer, blood-clotting disorders, or alcohol or substance abuse disorders. It will apply to the newly eligible Medicaid enrollees, who gained coverage only after the state’s previous Democratic governor expanded Medicaid. Kentucky would require able-bodied adults to complete 80 hours a month of community engagement to qualify for coverage. The engagement could include work, education, community service or job training. The new guidance from CMS, however, says many Medicaid beneficiaries should be exempt from work requirements: children, people with disabilities and people in treatment for substance abuse disorders. And the definition of “work,” according to CMS, should include job training, volunteering or caring for a relative.

In Kentucky, officials estimated up to 95,000 people would no longer have Medicaid at the end of the five-year demonstration. They attribute the low enrollment projections to those who would transition off of Medicaid because they enter the workforce, get a better job and higher wages and gain access to employer-sponsored insurance or other private insurance.

Nine states – Arizona, Arkansas, Indiana, Kansas, Maine, New Hampshire, North Carolina, Utah and Wisconsin – have applied for Medicaid waivers that include work requirements. Each applying state will have variations in the specifics of its plans. Kentucky will also freeze people’s coverage if they fail to report any changes in their employment or income – a problem for those employed in industries where variable hours are the norm. In Indiana, where similarly restrictive requirements exist it has been found that they tend to lead to a decrease in Medicaid participation and increased numbers of the uninsured. The head of CMS held a similar position with the State of Indiana under then Governor Mike Pence.

Arizona and Maine both requested five-year time limits on how long people could stay on Medicaid, and Wisconsin wants to drug test applicants. One item that is prohibited under Federal law is asset testing.  Maine would determine a person’s eligibility for Medicaid based on their property value and savings — not just their income.

The effort appears to be a part of an overall strategy that would be credit negative for states and counties. Every individual who falls off the Medicaid rolls becomes an increased share of the charity care burden that eventually costs states through subsidies to healthcare providers.

At the same time, there was one “silver lining” to the shutdown. As part of the agreement to approve a continuing resolution, the CHIP program was funded for the next six years. The program which insures the children of families with incomes of 200% or below the federal poverty line had broad bipartisan support but was caught up in the larger partisan budget battle for the current fiscal year. Every state has some form of the federally supported program and some 9 million children are estimated to be covered. In the grand scheme of things, the $14 billion total federal expenditure is not a real credit influence one way or another for the states. It is however, one positive action that moves in the opposite direction from the trend of diminished support for state funding responsibilities.

NEW JERSEY TRANSIT UNDER THE MICROSCOPE

Nearly half a million commuters who live and work in New Jersey rely on the New Jersey Transit Corporation (“NJ Transit”) for transportation to and from their jobs every day. The State’s operating subsidy in support of NJ Transit has decreased drastically over the last eight years, having dwindled from $348 million in Fiscal Year 2009 to $141 million in the current budget, and hitting a low of $33 million in Fiscal Year 2016. NJ Transit has correspondingly increased commuter fares, raising its fares an average of 36 percent since 2009, including a 25 percent increase in 2010 that was the largest in NJ Transit history. NJ Transit also has transferred over $7 billion from its capital budget to support operations since 1990, with $3.4 billion of such transfers occurring in the past eight years.

NJ Transit experienced the most accidents last year of any of the ten largest U.S. commuter railroads from 2011 to 2016. Some of these accidents have resulted in injuries and deaths, including the crash at Hoboken Terminal on September 29, 2016 and  NJ Transit also led the nation in mechanical breakdowns in 2015, with over 50 percent more breakdowns than the second-highest ranking railroad; and  NJ Transit is subject to a federally-mandated December 31, 2018 deadline for installing Positive Train Control technology.

As of the end of September 2017, NJ Transit had reportedly equipped less than 6 percent of its trains with the necessary technology, and had yet to operate the technology on any mile of track on any of its lines. Significant track repairs at Penn Station led to what was widely called the “summer of Hell” for commuters, where riders of the Morris-Essex line were diverted to Hoboken and faced with significantly longer commutes. Eeven after the summer of Hell ended, morning peak trains to Penn Station were on time only about three-quarters of the time in the month of September.

Clearly, New Jersey Transit is a troubled agency. Now, the new governor has ordered The Commissioner of Transportation, who also serves as Chair of the NJ Transit Board, to engage and direct one or more independent consultants to conduct a comprehensive strategic, financial and operational assessment of NJ Transit that will review NJ Transit’s current sources of funding, and an evaluation of whether the sources are adequate to meet both NJ Transit’s current operating needs and necessary capital upgrades. It will review the leadership structure at NJ Transit, including whether changes should be made to the board, the executive staff, and the line divisions to improve the decision-making process and establish best practices for corporate governance.  It  will review personnel hiring and protocols.

A proactive approach will improve the environment for debate and funding for what is clearly a crucial asset for the State economy. Reform and rationalization of the department is seen as a credit positive for the State.

FLINT OVERSIGHT BY THE STATE RELAXED

State Treasurer Nick Khouri announced changes for the city of Flint that grant the mayor and city council more governance authority and diminishes state oversight through the Flint Receivership Transition Advisory Board (RTAB). Effective immediately, the final emergency manager order outlining many of the responsibilities of elected officials and their cooperation with the RTAB has been repealed. The mayor and city council now have the ability to conduct most city business as outlined under the City Charter without state oversight.

The state Treasury Department’s actions follow a recommendation by the Flint RTAB to further move the city out of receivership and to continue the process of transitioning to full, local control. The Flint RTAB will still meet as needed to review proposed and amended budgets, requests to issue debt and proposed collective bargaining agreements. In November 2011, a Financial Review Team concluded a financial emergency existed in the city and there was no satisfactory plan in place to address the city’s fiscal problems.

An emergency manager was present from November 2011 to April 2015, when the financial emergency was resolved and the Flint RTAB was appointed to oversee the city’s transition back to local control.

Regardless of the future results for the City’s finances, the oversight by the State will always be remembered for the unfortunate decision to replace the City of Detroit’s water system as the source of drinking water for the residents of Flint. The decision resulted in the City’s water supplies being compromised to the point where they had to be replaced by bottled water. The incident was characterized by an arguably negligent response by the State’s environmental oversight apparatus which has led to litigation and the filing of criminal charges against individual state officials.

It also supported a level of mistrust on the part of citizens in the system of state oversight in the case of local financial distress. For the citizens of Flint, the path to relaxed state oversight has been far too long.

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

Publisher

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ISSUE OF THE WEEK

We focus on multiple issues this week as names which have been in the news as the result of negative credit factors seek to issue debt in the municipal market this week. That is not to say that the issues come necessarily with lower ratings but they do provide an occasion to shine a spotlight on their underlying stories.

Connecticut will issue $800 million of its special tax revenue bonds to fund transportation infrastructure in the State. Bonds are secured by a first lien on Pledged Revenues deposited into the State’s Special Transportation Fund (STF). The Second Lien Bonds are secured by Pledged Revenues on a subordinate basis to the Senior Bonds. Pursuant to Public Act 84-254 of 1984 (Act), both Senior and Second Lien Bonds are payable prior to use of pledged revenues for operations of the STF. Pursuant to the Act, all amounts necessary to pay debt service on both Senior and Second Lien Bonds are deemed appropriated from pledged revenues and no further approval of the General Assembly is required.

Both the Senior and Second Lien Bonds are also secured by debt service reserve funds funded to combined maximum annual debt service. Pledged revenues consist of taxes, fees and charges and other receipts credited to the STF. These revenues include motor fuel taxes, oil company taxes, a portion of the State’s general retail sales taxes, motor vehicles receipts, motor vehicle related licenses, permits and fees, sales taxes imposed on casual sales of motor vehicles, certain federal transportation related revenues (including federal subsidy payments relating to Build America Bonds (BABs) and interest income. The pledged revenues become subject to lien for payment of debt service when received by the State.

Burke County, Georgia will issue just under $400 million of pollution control bonds on behalf of the Oglethorpe Power Company. Oglethorpe is one of the co-owners (30%) of the Votgle Nuclear Plants. As a result, they are one of three entities along with MEAG and Georgia Power that is on the hook for the sunken costs of the troubled Units 3 and 4 which have been under construction. The future of the plants has been uncertain since last year’s bankruptcy of Westinghouse, the original primary contractor for construction of the facilities.

For weeks, the commission has gone back and forth with Georgia Power over a reasonable standard for costs. The owners of the plant have received some $3 billion of payment from Westinghouse’s parent company, Toshiba. But that still leaves almost $2 billion of sunk cost to be recovered and some estimate that additional investment of $8 billion is required to complete. On December 21, 2017, Georgia Power filed with the PSC for approval of its plan to go forward with completion of Votgle 3 and 4. The Owners have approved, a 29-month extension to the currently approved schedule for Votgle 3 & 4 as the most reasonable schedule for the Project. GPC estimates that $7 billion will be required for completion. The PSC is expected to decide on a course of action in February. Under the new project management structure, Georgia Power, along with Southern Nuclear Operating Company (“SNC” or “Southern Nuclear’) acting as the project manager, will manage the Project on behalf of the Owners pursuant to a revised Ownership Participation Agreement. Bechtel Corporation (“Bechtel”)  will serve as the prime construction contractor.

The effort to continue the plant is controversial to say the least. There is substantial support from the business community to complete the plant. There is also substantial customer opposition to any rate increase. It into this credit environment that Oglethorpe seeks to refinance debt dating back to 2008. The statutory deadline for a PSC decision is February 27, 2018.

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SIFMA 2018 ISSUANCE SURVEY

SIFMA released its survey of projected issuance activity for the municipal bond market in 2018. “Respondents to the 2018 SIFMA Municipal Issuance Survey1 expect total long term municipal issuance to reach $322.5 billion in 2018, down from the $407.8 billion issuance in 2017.2 Short-term issuance is expected to decline in 2018, with $40.0 billion in short-term notes expected to be financed compared to $46.7 billion in 2017. Including short-term issuance, total municipal issuance is expected to fall to $362.5 billion, down from $454.6 billion expected in 2017.

Respondents were generally unanimous that general purpose and education would be the two largest sectors for 2018, followed by utilities and transportation. In prior years, the general purpose sector has traditionally been the largest issuing sector by gross amount. Respondents expected approximately 50 issuers to default in 2018 for a par value of $2 billion, defined for the purpose of the survey as the occurrence of a missed interest or principal payment or a bankruptcy filing.”

MINNESOTA LOOKS TO FUND INFRASTRUCTURE AHEAD OF FEDERAL PLAN

Gov. Mark Dayton on Tuesday proposed a $1.5 billion public works bonding bill that prioritizes upkeep projects on college campuses but would also spread resources to improving other state buildings, constructing affordable housing and repairing clean water infrastructure.

“Now is the time to make substantial investments in our state’s future,” Dayton said in a statement, citing the state’s Triple-A bond rating and what he called an “enormous need for infrastructure improvements across Minnesota.” The governor’s plan includes $30 million for a revitalization project at Fort Snelling, $12 million for renovations at the Stone Arch Bridge in downtown Minneapolis, $100 million for affordable housing statewide, and $50 million for development of an express bus program in Hennepin County.

This will likely lead to opposition in the Legislature which has responded to previous proposals with less expansive plans. The matter is also complicated by the fact that Minnesota communities submitted proposals for projects, including trails, interchanges and water system improvements. Their requests for state money totaled $857 million. Dayton chose not to include the projects in his plan.  Dayton wanted to focus on preserving state assets and getting some long-needed maintenance work done. The governor’s plan includes $998 million for maintaining and improving state infrastructure. Of that, $167 million is dedicated to local water infrastructure projects and $115 million would go to housing projects.

 SOME PROGRESS IN THE US VIRGIN ISLANDS

While overall disaster aid is caught up in the ongoing Congressional budget standoff, there is some small progress to be reported for the US Virgin Islands. The U.S. Department of Transportation’s Federal Highway Administration (FHWA) announced the immediate availability of $6.5 million in “quick release” Emergency Relief (ER) funds for further repairs to roads and bridges throughout the U.S. Virgin Islands. The additional funding supplements $8 million in ER funds previously made available to the U.S. Virgin Islands for Hurricanes Maria and Irma damage, bringing the total amount to $14.5 million for emergency work.  The bulk of the funds provided today will be used to restore traffic signal service on the islands of St. Thomas and St. Croix and make repairs to damaged intersections critical to highway safety.

The FHWA’s ER program provides funding for highways and bridges damaged by natural disasters or catastrophic events. The “quick release” payments to U.S. Virgin Islands are considered as initial installments of funds used to restore essential traffic and limit further highway damage, which can help long-term repair work begin more quickly.

THE OTHER FERTILIZER DEAL SEEKS TO RESTRUCTURE

Iowa Fertilizer Company LLC IS soliciting the Holders of the 2019 Bonds and the 2022 Bonds to tender in exchange for their choice of an equal principal amount of Midwestern Disaster Area Revenue Refunding Bonds (Iowa Fertilizer Company Project), Series 2017 due December 1, 2050, with a final mandatory tender on December 1, 2033 (the “Series 2017A Bonds”), or with a final mandatory tender on December 1, 2037, and a coupon of 5.00% priced at par. The Exchange will (a) permit the Company to credit the tendered and accepted (i) 2019 Bonds to all of the June 1, 2018, and December 1, 2018 Sinking Fund Installments, a portion of the June 1, 2019, Sinking Fund Installment of the 2019 Bonds, and a portion of the principal payment at final maturity of the 2019 Bonds on December 1, 2019, and (ii) 2022 Bonds to a portion of the June 1, 2020, December 1, 2020, June 1, 2021, December 1, 2021, and June 1, 2022 Sinking Fund Installments of the 2022 Bonds and a portion of the principal payment at final maturity of the 2022 Bonds on December 1, 2022, (b) reduce on a dollar-for-dollar basis the mandatory Sinking Fund Installments of the 2019 Bonds and a portion of the Sinking Fund Installments of the 2022 Bonds on such dates, and (c) constitute a refunding of 2019 Bonds and 2022 Bonds for an equivalent principal amount of the corresponding Series 2017 Bonds.

The plan reflects the disappointing operating results of the facility versus projections since it began operations in the Spring of 2017. Declines in the price of various feed stocks for the plant which produces nitrogen based fertilizer have not been sufficient to offset the market clearing price for nitrogen based fertilizers. The restructuring would relieve near term debt service pressures over the next five years and allow time for the market to rebalance.  The bonds were originally rated BB-minus by Fitch and S&P Global Ratings but have since been downgraded. S&P affirmed its B rating in May, while shifting its outlook to stable from positive. Fitch in May removed the credit from negative watch but assigned a negative outlook.

PENNSYLVANIA TOBACCO DEBT GETS S&P RATING

The Commonwealth of Pennsylvania has historically used its share of tobacco Master Settlement Agreement payments to fund specific programs. Now the Commonwealth is turning to those revenues purely to balance its General Fund. It will issue debt backed by a pledge of those revenues with the proceeds to be deposited into the commonwealth’s general fund. The annual effort to balance the Commonwealth’s budget has become increasingly political and contentious over the last four years. The legislature has steadfastly refused any real effort to impose a severance tax on gas production. At the same time, it has significantly misjudged annual operating results such that missed revenue estimates of $1.1 billion and cost overruns of $400 million led to a $2 billion budget gap for this year. Pennsylvania ended fiscal 2017 with a negative $1.539 billion general fund balance on a budgetary basis. Constitutionally, it is required to adopt a balanced budget, and legislators approved the series 2018 bonds as a source of revenue to close the commonwealth’s $2.2 billion budget gap.

Total interest projections on 20-year bonds equate to 2.9% of budgeted fiscal 2018 expenditures. In addition, the Commonwealth will have to find resources to cover programmatic costs formerly funded with the tobacco payments. No matter how one tries to frame the planned issuance, the bond issue constitutes deficit financing. Pennsylvania at one time relied on annual access to the note market which held down its long term ratings. The Commonwealth worked hard over a period of years to wean itself off the need to annually borrow for deficit financing. It is quite disappointing to see the Commonwealth seem to fall back into its old discredited ways.

S&P rates the bonds at A, equivalent to the Commonwealth’s appropriated debt rating. This reflects the fact that although the commonwealth intends to pay the debt service on the bonds with tobacco master settlement payments, debt service payments are subject to appropriation. The commonwealth’s general appropriation pledge further secures the bonds.

NEW JERSEY REVENUES ARE STRONG BUT EXPENSE PRESSURE IS STRONGER

The new administration in Trenton received mixed news as the State announced a nearly 12% increase in fiscal year-to-date gross income tax collections because of strong growth in December collections. At the same time, a sales tax rate cut took effect on 1 January. All in all, it may not ease the future budget outlook as the fiscal 2019 pension contribution will increase $235 million more than previously expected owing to a recent reduction in the state’s assumed rate of return to 7.0% from 7.65%. The combined pension contribution from the general fund and lottery funds will increase to $3.4 billion (60% of the statutory annual required contribution based on the 7% return assumption) from $2.5 billion (50% of the annual required contribution, based on the 7.65% return assumption).

The December revenue increase is not considered to be indicative of a trend. Income tax growth was particularly strong in December 2017 at 30.5% from a year earlier. The state Office of Legislative Services suggests this growth was the result of two onetime events and therefore is unlikely to continue: a 2008 federal tax law requiring hedge fund managers to repatriate accumulated offshore gains by 31 December 2017 and taxpayers accelerating tax payments into 2017 to avoid the recent federal tax law changes. To the extent that the gain came from the latter, there will be an offsetting decline in April 2018 tax payments. Year to date, revenue remains 0.5% below budget when excluding lottery revenue and constitutionally restricted gas taxes.

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

Publisher

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ISSUE OF THE WEEK

$898,070,000

Sales Tax Securitization Corporation

Sales Tax Securitization Bonds, Series 2018A

S&P: “AA-Stable”     Fitch: “AAA-Stable”

It may be a holiday shortened week but that does not mean it lacks for interesting deals. In this case it is the issue from Illinois’ Sales Tax Securitization Corporation which has attracted significant analytical interest. At a time when the City of Chicago continues to face rating pressure primarily due to its ongoing pension funding issues, efforts to access the capital markets for the City’s financing needs have become paramount.

The bonds being sold are secured by revenues derived under a first lien on the state-collected portion of the city’s home rule sales and use taxes and the local share of the state-wide sales and use taxes, net of an administrative fee imposed by the state.  Pledged revenues include the portions of the city’s home rule sales taxes that are collected by the state as well as its local share of state sales taxes, some of which are subject to state appropriation. The pledged home rule sales and use taxes comprise three separate taxes: a 1.25% Home Rule Municipal Retailers’ Occupation Tax on most non-titled tangible personal property, a 1.25% Home Rule Municipal Service Occupation Tax on tangible personal property purchased from a service provider, and a 1.25% Home Rule Municipal Use Tax on Titled Personal Property. There is no legal limit to the rate the city may impose for these. Some of the pledged revenues collected by the state are net of a 2% administrative fee imposed by the state.

The details of the taxes are the Illinois Retailers’ Occupation Tax (city portion is currently equivalent to 1% of sales within the city), Illinois Service Occupation Tax (city portion is currently equivalent to 1% of sales within the city), Illinois Use Tax (city receives 4% of net receipts of a 6.25% tax on most non-titled personal property purchased outside of the state and 20% of a state-wide 1% tax on grocery food, drugs and medical appliances purchased out of state), and the Illinois Service Use Tax (city receives 4% of net receipts of a state-wide 6.25% tax on most tangible personal property purchased from a service provider and 20% of a state-wide 1% tax on grocery food, drugs and medical appliances purchased from a service provider).

In the end the ratings, substantially better than that of the City’s general obligation debt, are based on the legal structure. The sale of the revenues by the City to the Corporation is characterized as a “true sale”. This is key to the rating. It complements the bankruptcy-remote, statutorily defined nature of the issuer and a bond structure involving a perfected first lien security interest in the sales tax revenues. The authorizing act assures that the state “will not limit or alter the basis on which transferred receipts are to be paid to the issuing entity as provided in this Article, or the use of such funds,
so as to impair the terms of any such contract.” The importance of the existence of state authorizing legislation is a key consideration.

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CA REVENUES THROUGH DECEMBER

California’s total revenues of $16.25 billion for December were $2.79 billion above June’s budget expectations. Personal income taxes (PIT) and corporation taxes, two of the “big three” sources of General Fund dollars, exceeded projections for the month. All three, including retail sales and use taxes, are ahead of fiscal year-to-date estimates. For the first half of the 2017-18 fiscal year, total revenues of $57.21 billion are higher than budget projections by 7.1 percent and 10.6 percent higher than the same period in 2016-17.  For December, PIT receipts, the state’s largest revenue source, were $11.50 billion, or 25.0 percent above projections. While a portion of the variance may be due to taxpayer behavior, it is likely to be offset by reductions in future months’ receipts.

For the fiscal year, PIT receipts of $39.10 billion are higher than budget estimates by $2.28 billion or 6.2 percent. Corporation taxes for December of $2.47 billion were $699.0 million or 39.6 percent higher than expected. For the fiscal year to date, total corporation tax receipts of $4.26 billion are $932.2 million, 28.0 percent, above assumptions in the 2017-18 Budget Act. Sales tax receipts of $1.86 billion for December were $272.4 million lower than anticipated in the budget. However, for the fiscal year, sales tax receipts of $12.03 billion are $461.0 million or 4.0 percent above budget estimates.

Unused borrowable resources through December exceeded projections by $6.88 billion, or 33.9 percent. Outstanding loans of $16.11 billion at the end of December were $2.45 billion less than 2017‑18 Budget Act estimates.

TEXAS REVENUE TRENDS POST HARVEY

We have always maintained that natural disasters are not usually a harbinger of credit disasters let alone significant credit damage. Recent news from Texas provides quantitative evidence to support that view. The Texas Comptroller announced that state sales tax collections, the state’s largest general operating revenue, had increased 12.3% in December over the prior year and are up 10.2% cumulatively for the first four months of fiscal 2018, which ends 31 August 2018. Post-storm sales taxes surged as insurance proceeds and federal aid spurred rebuilding and replacement of lost property.

The energy sector is also contributing. According to the Railroad Commission of Texas (which regulates the energy industry in the state), new well permits issued in 2017 were 55% greater than the prior year. The sales tax, however, comprises 62% and is applied to a broad base of most tangible personal property and some services, including equipment used in the energy industry. This has generated an increase in taxable purchasing to supply the activity associated with increased well operation. West Texas Intermediate prices averaged nearly $51 per barrel in 2017 after falling to a low of $43 per barrel a year earlier, according to the US Energy Information Administration (EIA). Texas produces more crude oil than any other US state and accounts for 30% of all US petroleum refining, according to the EIA.

TOLLS ARE EXPANDING

Florida will open two new toll roads in the Jacksonville area: express lanes along I-295, and State Road 23, known as the First Coast Expressway, which will extend south from Jacksonville into suburban Clay County. In Texas, the North Texas Tollway Authority in the Dallas region will begin operation of the 360 Tollway, a 9.7-mile toll road. It will have four lanes, two in each direction.

In Seattle, tolls on the State Highway 99 tunnel under its downtown are scheduled to go into effect this year, but a long ramp-up period is expected once the state transportation commission settles on the fees. Proposals include tolls that would vary during the day, from $1 overnight to a top rate of $2.50 for an afternoon trip.

New Hampshire has begun a process to increase tolls on the major state highways. The cash toll rate on I-93 in Hooksett would go from $1.00 to $1.50. On the Spaulding Turnpike, the Dover and Rochester tolls would rise to $1.00 from $0.75. In Hampton, the Interstate 95 toll would increase from $2.00 to $2.50. EZ Pass users would still enjoy a 30-percent discount. The plan would also give a discount to in-state commuters, who would receive 10 free rides after passing through the tollbooths 40 times during a calendar month.

CONNECTICUT CONSIDERS PRIVATE OPERATORS FOR AIRPORTS

The tide of privatization continues to roll with the Nutmeg State looking at private operators for airports. The Connecticut Airport Authority is considering outsourcing operations of three of its five general aviation airports in an attempt to save money and narrow multimillion-dollar losses on the facilities. The Authority has announced its negotiation with Dulles, Va.-based AFCO AvPORTS Management LLC involves Hartford-Brainard, Waterbury-Oxford and Groton-New London airports and could include a phased-in operations contract. The proposal also does not include Hartford’s Bradley International Airport.

The five general aviation airports reported cumulative operating losses, excluding depreciation, of about $3 million in fiscal 2016 and $2.7 million in fiscal 2017. AvPORTS manages commercial airports that include Albany (N.Y.) International, Newark (N.J.) Liberty International, Stewart International (New Windsor, N.Y.) and Westchester County (N.Y.). On the general aviation side, it lists Gary/Chicago International, Republic (Farmingdale, N.Y.), Rhode Island Airport Corp. (for five general aviation airports in the state) and Teterboro (N.J.).

SANTA ROSA BAY BRIDGE BAILOUT UNDER CONSIDERATION

Bondholders may finally see some resolution to the six year long default on bonds issued by The Santa Rosa Bay Bridge Authority for the Garcon Point Bridge. The Authority issued approximately $95.0 million of revenue bonds in 1996 and the actual toll revenues generated by the Bridge have been significantly lower than projected since opening in 1999. As a result, the Bridge almost immediately faced financial difficulties, and by Fiscal Year 2002 the Authority was forced to begin using bond reserves to make debt service payments. The bond reserves were fully depleted in Fiscal Year 2011, and the Authority defaulted on the July 1, 2011 debt service payment.

The revenues from toll collections continue to fall short of required debt service payments and so the aggregate amount owed on the Bonds continues to increase. The amount owed on the Bonds is currently $135.2 million as of June 30, 2017. The trustee for the Bondholders has declared the Bonds to be in default which accelerates all amounts payable on the Bonds including all principal and unpaid interest. Interest continues to accrue on the outstanding bonds at rates ranging between 6.25% and 6.80%.

So now the Florida Legislature is being called upon again to consider what if any involvement the State of Florida should have in rescuing the investors in the bonds. A feasibility study was commissioned and has been completed in support of those efforts. It suggests acquisition of the bridge via one of two options. A restructuring of the debt on the Bridge could be effectuated in two ways, both of which would require legislative action. The first alternative would be for the Turnpike to issue bonds that would replace the Authority’s bonds in exchange for transfer of the Bridge directly to the Turnpike. The second alternative would be for the Turnpike to acquire the Bridge by purchasing the outstanding Authority bonds in the open market at a discount or via a tender offer.

The acquisition through the Turnpike is suggested to be structured in a way that gives the Legislature cover against charges of a bailout. according to the study, the acquisition of the Bridge by Turnpike at a price calculated by reference to toll collections would not be a “bailout” because the price paid would be no more than the amount that the existing Bondholders are currently legally entitled to receive based on the actual revenues of the Bridge. The Bondholders would receive no guarantee that they would recoup their entire investment in the Authority’s Bonds.

The State Legislature would need to adopt legislation authorizing the acquisition. After being authorized by the Legislature, DBF and FDOT would enter into negotiations with the Trustee or existing Bondholders regarding the price and terms of the acquisition. Finally, if negotiations were successful, the Turnpike would issue bonds to pay the agreed upon price to existing Bondholders and take full control of the Bridge.

So the stage has been set for the bailout which was never supposed to happen. Regardless of which method is chosen, residents and users of transportation facilities throughout Florida will wind up paying for a supposedly public/private project that in reality was built to fulfill a private developers dream. Another example of the fallibility of public/private financings.

KANSAS FINANCES ALMOST AN AFTERTHOUGHT FOR DEPARTING? GOVERNOR

To the surprise of many, Sam Brownback was still around to deliver this year’s State of the State Address. He was supposed to off to a diplomatic job with the federal government but a delayed confirmation has delayed his resignation. So this ultimate lame duck delivered a minimal discussion of the State’s budget and school financing outlook. “So, let me address the biggest issue of the session, school finance. We have received the decree of the Kansas Supreme Court and are putting forth a proposal to comply, as we have done with the prior decisions. My budget recommendation includes an additional six-hundred million dollars in funding over the next five years.  This multi-year approach will provide the time necessary for school districts to plan and spend this additional money more effectively. My proposal does not include a tax increase.”

So that’s it. No funding source, no suggestions for one, just a hope. And a recommendation that the legislature to put a Constitutional amendment on the ballot this year  addressing our school finance system. Some would call this a punt. We think it is more like a drop kick. And it does nothing to improve our long time negative on the State’s finances and credit ratings. Hopefully, a more detailed and thoughtful budget proposal will follow.

 

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

Publisher

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ISSUE OF THE WEEK

$413,000,000

Commonwealth Financing Authority (PA)

Revenue Bonds

The bonds are special obligations of the CFA, which was created in 2004. Debt service is now derived first from a statutory continuing appropriation of Article II revenues (the statewide 6% sales tax and 6% hotel tax) to a restricted account within the commonwealth’s general fund. This account can only be applied toward payments of CFA debt service. The monthly Article II transfers by the state treasurer are made pursuant to a letter agreement with the treasurer and equal one-sixth of biannual interest payments and 1/12th of annual principal payments. Under the agreement, the payments are timed to be fully accumulated 30 days prior to debt service due dates. Article II revenues provide ample coverage of the monthly transfers.
In the event the Article II transfers are insufficient, the bonds are also secured by payments from the commonwealth to the CFA under multiple service agreements, subject to annual legislative appropriation.

Pennsylvania continues to struggle to balance its budget. A contentious political climate and significant pension obligations have combined to make the annual budget process difficult at best. Negotiations have taken to dragging on until well after the traditional July 1 deadline with significant negative impacts on the Commonwealth’s underlying municipalities and the many non-profit service providers on which the commonwealth relies. The pending gubernatorial election in November will only complicate the process for FY 2019.

The outlook for the Commonwealth’s ratings is negative and this should only be exacerbated by these factors.

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US AUTO SALES DECLINE FOR FIRST TIME SINCE FINANCIAL CRISIS

For the first time since the financial crisis, US auto sales declined on an annual basis. Though sales dropped 1.8% from the last year to 17.2 million vehicles, 2017 still marks the fourth-best sales year in U.S. history. This is because this is the first time that the industry has cleared the 17-million mark for three consecutive years.

Of the six major American and Japanese automakers, Fiat Chrysler posted the biggest sales decline of 8.2%, followed by modest declines of 1.3% for General Motors, 1.1% for Ford Motor, and 0.6% for Toyota. Nissan Motor  and Honda sales were up 1.9% and 0.2%, respectively. Should negative trends continue the finances of auto and parts manufacturing states could be negatively impacted.

BRANSON AIRPORT PROPOSES SETTLEMENT

Near the end of the last tidal wave of junk bond issuance in the municipal bond market, one of the more conspicuous deals was one for the construction of an airport at Branson, Missouri. The airport was the vision of a group of local developers – Branson Airport, LLC – who hoped to transform the essentially regional entertainment mecca, reliant on an auto oriented market, into a national destination. For those of us who were skeptical as to the viability of this concept, the ensuing history of operations was somewhat vindicating.

Financial distress has prevented the Company from paying scheduled debt service to Bondholders since 2011. Bondholders have in that time received a single interim payment in 2016 from extraordinary proceeds the Company received. The Airport has during this same period reported a single calendar year where operating income exceeded operating expenses (2013). When total expenses are included, the Company has reported an overall net loss every year since the Airport opened in 2009. Multiple prior notices reflect multiple efforts by the Company to attract sustained air service to the Airport from legacy carriers, low cost carriers, and scheduled charter carriers.

The Company retained ICF SH&E as financial adviser in the spring of 2017, and the Company’s financial adviser prepared an assessment of the Company’s prospects, including its go-forward business plan. Branson Airport, LLC is proposing a global settlement with its bondholders which ostensibly has the support of a majority of those holders which would allow the airport to continue to operate free of the constraints of its currently outstanding debt.

The proposal includes a mix of new debt and equity in the operating entity. Specifically, each Bondholder would receive a pro rata share of new “Series A Bonds”, in the principal amount of $32.5 million, and a pro rata share of 65 percent of the equity of the Company and its affiliates BKG Branson Airport, LLC, Branson JetCenter, LLC, FlyBranson Travel, LLC and Branson Land, LLC. They would also be given “opportunities to invest in $3 million of new “Series B Bonds” and a pro rata share of an additional 23 percent of the equity of the Airport Parties to provide the Company working capital. The Series B Bonds would have a liquidation preference over the Series A Bonds if the Company is liquidated while principal, interest or other fees or charges remain outstanding on the Series B Bonds.

12 percent of the equity of the Airport Parties which may take the form of warrants will be allocated to management and sub debt holders. And so it goes for yet another deal that never made sense to begin with which could only really be done in the municipal bond market.

ALASKA MUNICIPAL UTILITY PROPOSES SALE TO MUNICIPAL CO-OP

The City of Anchorage AK has announced a proposed sale of its municipal light and power utility to the Chugach Electric Association , a neighboring rural electric cooperative. Chugach currently serves the area around Anchorage in an area extending from Anchorage to the northern Kenai Peninsula, and from Whittier on Prince William Sound to Tyonek on the west side of Cook Inlet.

The proposed sale, valued at $1 billion, must be approved by both voters and the Regulatory Commission of Alaska (RCA) to proceed. The sale is expected to close no later than fall 2019, if approved by voters and the RCA. The sale would likely result in the full funding of the City of Anchorage’s outstanding 4325 million of revenue bonds backed by municipal light and power revenues.

The municipality expects to dedicate a significant amount of transaction proceeds to its permanent trust fund, which would boost ongoing interest income and could ease near-term budget pressures.

NEW YORK’S GOVERNOR LAYS OUT AMBITIOUS CAPITAL PLANS

This year’s State of the State Address by Governor Andrew Cuomo laid out an ambitious capital facilities wish list for consideration. The transportation sector was the area of concentration with updates and expansions of a variety of facilities suggested. They include improving transportation access to the Red Hook area of Brooklyn and surrounding communities, including the potential extension of subway service from lower Manhattan to a new station in Red Hook through an underwater tunnel.  This would involve the MTA.

On the highway front, the Governor plans to implement cashless tolling technology on all toll collection points along the Thruway. The project will utilize Design-Build construction to reduce costs and accelerate the construction schedule. Cashless tolling throughout the Thruway system will be operational in 2020. The Governor urged the Port Authority of New York and New Jersey to study the possibility of installing cashless toll collection on all PANYNJ operated Bridges and Tunnels. These follow the successful P3 replacement of the Tappan Zee, Kosciusko, and Goethals Bridges.

He also discussed the renovation of JFK Airport which would also include associated mass transit and highway access expansion. The plans follow on from the expansion of Newark Liberty Airport and the ongoing P3 project to renovate and expand LaGuardia Airport.

CAN A MUNICIPAL CHARITABLE TRUST WORK AROUND THE SALT LIMIT?

Paramus, Park Ridge and Fair Lawn, N.J. announced that they will start charitable trusts to work around the loss of the SALT deduction. A taxpayer who pays $20,000 in annual property taxes would contribute that exact amount to the charitable trust. The charitable trust would then allocate the $20,000 to various entities — the schools, the police department and other agencies — as though the donation were a tax payment. The town would then credit the taxpayer for 90 to 95 percent of the donation, making it nearly entirely deductible. (The town could factor in administrative costs to lessen a donation’s value.) Such a plan would require approval by each town’s local governing body.

There are other hurdles as explained by the Tax Foundation. To be deductible, charitable contributions must have a genuinely charitable aspect, and cannot primarily benefit the contributor or involve a quid pro quo. Payments which function as taxes may be classified as taxes even if states choose to call them something else. While governmental entities are qualifying organizations for purposes of claiming the charitable deduction, expressly delineated at IRC § 170, contributions are only deductible if, per IRS guidance, the contribution “is solely for public purposes (for example, a gift to reduce the public debt or maintain a public park).”

Internal Revenue Service Publication 526 outlines what qualifies as a deductible charitable contribution, specifically excluding contributions from which one benefits, to the extent of that benefit. For instance, if one purchases a $250 ticket to a benefit dinner, and the fair market value of the dinner is $50, then $200 can be deducted—not $250. Arguably, the benefit of, say, a $20,000 “contribution” to one’s state which yields a $20,000 credit against state tax liability is, in fact, $20,000, completely wiping out deductibility. The contributor actually receives two benefits: one, the benefit of government services, and two, the benefit of a reduction in overall tax liability.

Kevin de León, president pro tempore of the California Senate is offering a bill in the state Senate to let Golden State residents make charitable donations to a state fund and receive a dollar-for-dollar tax credit for the donations. The proposal rests on the fact that the California legislature in 2014 passed a measure that gives people a tax credit for donations to a state higher education grant program. That program does not establish a direct benefit to the contributor or involve a quid pro quo.

OR PAYROLL TAXES VERSUS INCOME TAXES

Eliminating the state income tax on wages would put more money in worker paychecks and mitigate the loss of full deductibility of such taxes on the federal level. That revenue would instead be raised by a statewide payroll tax, paid by employers, and still legally deductible on their federal taxes. The state would then make employers whole through a tax credit or some other mechanism. Another alternative would be for the state to keep its income tax but also implement an additional payroll tax, the revenue from which would be funneled back to taxpayers as a credit or wage supplement.

In either the case of charitable trusts or payroll taxes, we expect significant legal pushback from the federal government. The level of economic growth required to make the tax reform plans numbers work remains substantial with little room for error. So the viability of all of the enacted “pay fors” remains crucial. If we had to hazard a guess, the payroll tax idea is likely the more viable of the two.

MIDWEST FERTILIZER DEBT IS TAXABLE

Indiana’s troubles with private entities and municipal bonds continued with the announcement by the IRS of a Notice of Proposed Adverse Determination regarding some $1.2 billion of economic development bonds issued to finance the construction of an nitrogen based fertilizer plant in Posey County. The IRS determined after an audit that the bonds did not meet the criteria for qualified Midwest Disaster Area Recovery Bonds.

The plant and the financing for it have had a checkered history. In October of 2008, Congress passed the Heartland Disaster Tax Relief Act (the “Disaster Act”) in response to severe storms, tornadoes and flooding throughout the Midwest. The Disaster Act created a new category of federally tax-exempt bonds called Midwestern Disaster Area Bonds (“Disaster Bonds”) which are designed to finance capital expenditures for business that suffered a loss caused by these disasters or are designated by the Governor as a business that is carrying on a trade or business that could have suffered a loss caused by these disasters. The original bonds were issued by the Indiana Finance Authority in late December of 2012 to beat the December 31, 2012 deadline for issuance under the Disaster Act.

In a May 17, 2013 letter addressed to Fatima Group, an investor in the Company, the Indiana Economic Development Corporation (the “IEDC”) announced that it was withdrawing its offer of incentives, as initially conveyed to and accepted by the Company on November 30, 2012. On the same date, Governor Mike Pence announced that the State of Indiana was withdrawing its offer of economic incentives for the Project. This led Posey County to step in and offer to use its bond issuance authority to finance the plant. It did so through the issuance of $1,259,000,000 Posey County, Indiana Economic Development Revenue Bonds, Refunding Series 2013A in May, 2013. This was after the deadline for Disaster Act bonds. Proceeds were applied to the refunding of the IFA debt.

The project is described as one of the largest fertilizer manufacturing investments in the U.S. in more than 20 years. According to economic impact calculations by the Indiana Economic Development Corporation (IEDC), the construction of Midwest Fertilizer’s plant alone is expected to have an economic impact of $425 million and, at full employment, the company’s operations are expected to have a total economic impact of $138.6 million annually on state and local GDP.

When finished, Midwest Fertilizer says up to 185 permanent jobs will be created. In addition to the bonds, the state has agreed to kick in nearly $3 million in tax credits, and $400,000 in training grants. The Indiana Economic Development Corporation also offered up to $300,000 in conditional incentives from the Hoosier Business Investment (HBI) tax credit based on the company’s planned investment. This project will create 2,500 construction jobs over the next three years and is expected to open in 2022.

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

Publisher

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ISSUE OF THE WEEK

$385,000,000

New Jersey Economic Development Authority

State Lease Revenue Bonds

Fitch: A

It will only be the first week of a new administration in Trenton after the end of the Chris Christie era but the State will see its first test of investor perceptions of its credit outlook through this issue of state lease revenue bonds. The bonds are secured by the authority’s payments is derived from separate lease-sublease arrangements for each project under each series of bonds between NJEDA and the Department of the Treasury’s Division of Property Management and Construction (DPMC). A trustee has been assigned all of NJEDA’s rights to receive DPMC’s rental payments, funded via annual legislative appropriation, under the subleases related to these bonds for the benefit of bondholders.

New Jersey uses annual appropriation debt to finance over 95% of its direct capital needs as the result of a cumbersome electoral approval requirement for the issuance of general obligation debt. The State has a very mixed history of success in seeking voter approval. This builds in a pretty strong incentive for the state legislature to annually appropriate monies for its lease revenue debt. Unsurprisingly, a lawsuit has been filed challenging the legality of this bond issue under the debt limitation clause of the state constitution; however, bond counsel strongly believes NJEDA’s ability to issue debt authorized by its enabling act is not subject to the limitations of the clause. Bond counsel will render a clean legal opinion concurrent with the sale of the bonds.

The change in administrations has not changed the basic challenges facing the state. Pension contributions of $1.9 billion approximated 5.4% of fiscal 2017 adjusted appropriations, but were only four-tenths of the $4.7 billion actuarially-determined contribution (ADC). A contribution at the ADC would have resulted in pensions consuming 13.5% of fiscal 2017 adjusted appropriations. The state has appropriated $2.5 billion for its fiscal 2018 contribution, 50% of the ADC, consistent with its stated plan to incrementally add one-tenth each year until full funding of the ADC is reached, in fiscal 2023. Under the 2017 Lottery Enterprise Contribution Act (LECA) the state’s payment is offset by anticipated net lottery receipts, resulting in a net $1.5 billion payment from operating funds.  Pressure to aid education to limit growth in local taxes continues as does the need to fund health expenses. Like any state with significant health expenses, it would be vulnerable to decrease which the Congress will likely try to impose on Medicaid funding and possible other healthcare funding.

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ISSUES TO WATCH FOR IN 2018

TOLL ROADS

Pennsylvania will see a tenth consecutive annual rise in tolls on its Pennsylvania Turnpike. The toll hike will raise the most common toll, a trip between two interchanges, from $1.95 to $2.10 for cash customers, about 7.7 percent, and the E-Z Pass toll from $1.23 to $1.30, about 5.7 percent. Tolls have been rising annually ever since the Commonwealth enacted its now infamous plan to use turnpike revenues to fund non-Turnpike transit projects throughout the State.  The associated state transportation law that requires turning over $450 million of turnpike revenues to regular state coffers for mass transit through fiscal year 2022. After that, the law says the amount drops to $50 million.

By Ii2nmd at English Wikipedia, CC BY-SA 4.0, https://commons.wikimedia.org/w/index.php?curid=61002291

Originally the plan was to be part of an overall scheme in 2007 that included tolling Interstate 80. I-80 tolls would have ended the turnpike payment. When the federal government rejected tolling I-80, the state’s main east-west highway, the turnpike had to keep paying $800 million a year to the state for mass transit and non-turnpike road and bridge improvements. Since 2007, the turnpike has turned over about $5.65 billion — about $2.25 billion to the state motor license fund for road and bridge projects and $3.4 billion to the public transportation trust fund for mass transit systems. The turnpike has generally met projections of 4 percent annual growth in costs set out in a 2007 management plan while also selling $1 billion in bonds annually to pay for turnpike repairs and upgrades.

Before the 10-year streak of hikes, the turnpike only raise tolls five times since opening in 1940.

CONGESTION PRICING

Congestion pricing is likely to get its biggest test yet as it looks like New York City may get some form of it in 2018. A combination of available tested technology on other City roads, greater political support, and a recent study supporting the notion that vehicles for hire (Uber et al) are choking the City’s streets to the point of perpetual gridlock. So it is believed that at least a fee on user of vehicles will be proposed with the proceeds going to fund improvements to MTA systems – primarily the subway – in the City.

The well funded car services which the City estimates account for some 103,000 vehicles a day are expected to object vociferously with extensive media efforts. The situation is complicated by the Mayor’s opposition to congestion pricing which is seen by many as the result of pressure and financial support from the industry. A fee on vehicles for hire would address some of the long standing concerns that “outer borough” state legislators have used as a basis for refusing to support the needed state legislation enabling the City to impose such a plan.

The San Francisco County Transportation Authority is considering turning existing car pool lanes on Highway 101, as well as Interstate Highway 280 to toll lanes in an effort to ease congestion on those roads. The transportation authority must get approval from its board, which is made up of members of the Board of Supervisors, before any carpool or paid lanes are created. So far the Board has expressed skepticism about the plan citing increased costs for their constituents.

HEALTHCARE INNOVATION

The healthcare sector will continue to be challenged as the result of changes to the individual mandate and an expected campaign to significantly alter the federal Medicaid and even Medicare plans. The sector will continue to consolidate. In addition to the normal risks associated with implementation of a merger, the merging institutions will  often be expanding their footprint into what for them are non-traditional markets. They include essentially urban entities absorbing more rurally based facilities in an effort to expand their revenue base. These efforts carry with them however, the risks associated with poorer rural patient bases whose access to primary care may already be limited as well as their access to affordable insurance.

This will require these facilities, as well as those whose base is primarily the underinsured less economically well off inner city populations to be especially innovative as they meet the challenges of these poorer cohorts. This will require hospitals to use technology not only  not only in their medical procedures but also apply it to coordination of services in and out of their facilities. These efforts, which have been applied at some large urban facilities, have been shown to have a positive impact on cost trends as well as patient outcomes.

These steps will become more of a necessity as hospitals face an increasingly challenging funding environment as well as an evolving competitive landscape. While it has always been important factor for investors and analysts, a solid understanding of all of the market forces impacting a hospital credit will take on even greater importance in this rapidly changing industry.

STATE BUDGET CHALLENGES

             

Connecticut, Louisiana, and Oklahoma are already facing significant current year budget gaps. We expect contentious processes to resolve these issues to be front and center in 2018. We also expect that the overall state budget process will be more difficult than usual with much confusion emanating from  the extended rollout of IRS regulations resulting from the new tax laws. The lack of guidance as to details of the implementation of a law whose provisions go into effect January1. The timing of these events will complicate revenue estimates for the states, likely require changes to state tax procedures since so many are linked to federal policies, and will face pressures on both the expense and revenue sides due to the loss of the SALT deduction above $10,000 and expected expenditure requirements related to an infrastructure program.

SPEAKING OF THE SALT DEDUCTION

The IRS did finally provide some clarity to the effort on the part of many taxpayers to prepay 2018 local property taxes in an effort to fully deduct them under existing regulations which ended on December 31. Taxpayers will be able to take advantage of the maneuver — but only under limited circumstances. The IRS said that taxpayers can claim an additional property tax deduction when paying their 2017 taxes if they pay the tax in 2017 and if the local tax authority has notified homeowners prior to 2018 of how much they owe in property taxes, known as a tax assessment. State and local laws vary as to when this occurs.

COBB COUNTY STADIUM – DISAPPOINTMENT ON AND OFF THE FIELD

The Atlanta Braves were not the most successful franchise in Major League Baseball with the year ending in significant scandal involving the team’s front office. On top of this, it appears that the stadium is not turning into the economic windfall that was promised by government supporters of Cobb County’s role in financing the project. Those supporters had predicted positive revenue effects for the County from the County directly but also from its “halo effect” on economic activity indirectly linked with the project.

By Thomson200 – Own work, CC0, https://commons.wikimedia.org/w/index.php?curid=58721303

Former Cobb County Chairman Tim Lee predicted “a 60 percent annual return on investment from the SunTrust Park partnership. “In fact, it will be the first private public partnership of its kind to result in a return on investment to taxpayers in the very first year.”  The County then undertook an increase in spending including employee compensation increases. Now the new County Finance Director Bill Volckmann said even though income from the stadium is on track to meet or even exceed expectations, “It’s not going to be a windfall.”

As a result of the activity disappointment and increased spending, Cobb is facing a $30 to $55 million budget shortfall after raiding $21 million in rainy-day funds to plug a gaping hole in the 2018 budget. The public debt obligation on the stadium amounts to $16.4 million a year. Of that, $6.4 million is paid by Cobb residents out of the county’s general fund, while the remaining $10 million is funded through taxes and fees, including a countywide hotel/motel tax, a countywide rental car tax, a localized Cumberland hotel/motel tax, and localized Cumberland commercial property taxes. Cobb pays another $1.2 million for stadium operation and maintenance and about $1 million for police overtime and traffic management at games and events.

In total, Cobb County is paying a minimum of $8.6 million out of its general fund just for debt service, stadium operations and public safety. The Cumberland Community Improvement District is 50% developed and the commercial project around the stadium has generated about $460,000 in property taxes for the county’s general fund and $1.3 million for schools. The Braves pay $6.1 million toward the debt service.

PROGRESS ON CYBERSECURITY

While many have expounded on the potential for financially disruptive effects on municipal credit from technological change in the future – near and far -, a different threat emerged in the early summer of 2017. The threat involved the use of security software from a Russian vendor – Kaspersky Labs – whose ownership had links to the Kremlin. It was feared that the software might actually be making those systems which used the software more vulnerable to malevolent hackers and it was recommended by the Federal Government that that civilian agencies remove Kaspersky Lab software within 90 days. that civilian agencies remove Kaspersky Lab software within 90 days.

Investigative reporting by NBC News and the Washington Post revealed that the use of Kaspersky software was rather widespread among U.S. municipalities. After various hacking of operating systems at some municipal utilities and ransomware efforts to extort funds from some municipalities, pressure grew to force these entities to find some other source of security for their various computer systems.

Much of the resistance to changing to different software seemed to be based on the cost of replacements. After all, the success of the software was in many ways tied to its relatively inexpensive cost and widespread availability through distributors like Best Buy. A smaller municipality could literally walk into Best Buy and purchase the software and install it relatively cheaply so it was attractive to many.

Since that time, the publicity surrounding the background of Kaspersky’s ownership has led to public pressure to replace the software. Some municipalities admit that this rather than the occurrence of any actual hacking event led to changes. Now the effort has been reinforced by President Donald Trump signing into law legislation that bans the use of Kaspersky Lab within the U.S. government. This will likely embolden users as well as constituents in the effort to replace the software.

We view the action as positive as an increasing number of efforts to access and impede municipal operating systems increase. In addition to the risk to major utility and public safety entities, the potential for financial mischief and potential financial damages should create momentum to insure that security for municipal operating systems is subject to the fewest risks. This will mitigate any potential negative financial impacts resulting from technological change on municipal credit.

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