Joseph Krist

Publisher

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ISSUE OF THE WEEK

$652,855,000

Black Belt Energy Gas District (AL) Gas Prepay Revenue Bonds (Project No. 3), Series 2018

Moody’s: A3

In the last decade while natural gas prices were fluctuating, prepaid natural gas purchase transactions financed through the issuance of municipal bonds were a popular financing technique. The benefit to the issuers was simple. a supply of gas was secured at a fixed and acceptable to the issuer price. These transactions, complex by their nature due to the number of various participants in the transactions, often benefitted from the credit rating of the guarantor of the payments due under the Prepaid Natural Gas h natural gas markets primarily as commodity traders and suppliers.

As the economics of the natural gas market changed and the financial crisis negatively impacted the credit ratings of the financial institution participants weakened, the attractiveness of the transactions diminished. The declines in ratings impacted ongoing market values of the bonds, raised concerns among investors about their credit worthiness, and in some cases led to defaults and restructurings. Overall, the technique lost favor.

In the current environment, with ratings more stable and more favorable natural gas economics these transactions are making a comeback. This week’s highlighted issue is one such transaction.

Moody’s assigned an A3 rating to this issue. The list of participants explains the level of complexity in the deal. The rating reflects (i) the credit quality of Goldman Sachs Group, Inc. (Goldman) (A3 stable) as guarantor for payments due under the Prepaid Natural Gas Sales Agreement (GPA), the back-end commodity swap and the Receivables Purchase Agreement (RPA); (ii) the credit quality of City of Tallahassee electric enterprise (Aa3 stable), Greenville Utilities Commission, NC (Aa2 stable), Omaha Metropolitan Utilities District, NE gas enterprise (Aa2 stable), and Okaloosa Gas District, FL (A1 stable) (collectively, the Municipal Participants); (iii) the credit quality of the providers of the guaranteed investment contracts (GICs) provided for the debt service account, debt service reserve account and the working capital account; and (iv) the structure and mechanics of the transaction which provide for the payment of debt service consistent with the rating assigned to the Bonds.

How does the transaction work? Bond proceeds will be used by the Issuer to prepay J. Aron (the Gas Supplier) for the delivery of a specified quantity of natural gas to be delivered on a daily basis over a 30 year period. The Issuer will sell gas acquired under the GPA to the Municipal Participants listed above as well as to Clarke-Mobile Counties Gas District, AL (Clarke-Mobile), pursuant to Gas Supply Agreements. Pursuant to the GPA between the Gas Supplier and the Issuer, the Gas Supplier agrees to deliver to the Issuer natural gas in quantities specified in the agreement. The Issuer will in turn sell daily quantities, billed on a monthly basis, of delivered natural gas to the Municipal Participants and Clarke-Mobile pursuant to Gas Supply Agreements. The Contract Price which the Municipal Participants and Clarke-Mobile pay will be based upon a first-of-the-month index price per MMBtu (the Index Price), less a specified discount. Payments for gas delivered will be due on the 22nd of each month. The payments to be received from the Municipal Participants and Clarke-Mobile, plus or minus net payments made or received by the Issuer on the commodity swap described below, combined with interest earned on the debt service account will be sufficient to make the fixed payments owed to Bondholders.

Should any of the Municipal Participants and/ or Clarke-Mobile fail to make a payment for delivered gas, the Trustee will (i) draw on the working capital account in order to make payments to the Commodity Swap Counterparty and (ii) if necessary, draw on the DSRA if there is a deficiency in the debt service account. Risk of non-payment by a Municipal Participant is reflected in their ratings which are incorporated into the rating of the Bonds. In the event of a nonpayment by Clarke-Mobile, if the trustee determines that the balance in the DSRA and/or the balance in the working capital account is less than the minimum requirement and sufficient funds will not be available to pay P&I on the Bonds immediately prior to the final maturity date or a mandatory redemption date, the trustee shall deliver a put option notice under the RPA . Upon receipt of such notice, J. Aron shall purchase such receivables. Therefore, risk of non-payment by Clarke-Mobile is covered by Goldman as guarantor under the RPA.

Since the revenue received from gas sales to the Municipal Participants and Clarke-Mobile is variable and the payment owed to Bondholders is fixed, the Issuer will enter into a commodity swap (the Commodity Swap) with Royal Bank of Canada Europe Limited (the Commodity Swap Counterparty), which will result in the Issuer receiving fixed payments while paying the Index Price to the Commodity Swap Counterparty, on a net basis. In order to address the risk that a nonpayment by the Commodity Swap Counterparty under the Commodity Swap could lead to an insufficiency in the payment due to the Bondholders or result in an early termination event under the GPA and a redemption of the Bonds, all payments to be made by J. Aron under the Back-End Commodity Swap are deposited monthly with a custodian under a custodial agreement. If the Commodity Swap Counterparty fails to make a required payment under the Commodity Swap, the custodian is required under the terms of the custodial agreement to deliver to the Trustee the funds provided by J. Aron on the Back-End Commodity Swap, which funds will be applied by the Trustee in the same manner as payments made by the Commodity Swap Counterparty. In addition, should any termination of the Back-End Commodity Swap occur, J. Aron will continue to make payments to the custodian until the earlier of (i) termination of the GPA and (ii) replacement of both the Commodity Swap and the Back-End Commodity Swap.

If we haven’t lost you by now, it is pretty clear that these bonds are very difficult for the average individual investor to track and value. It has long been our view that these bonds are fraught with risk for an individual investor and that this point was clearly made during the financial crisis. Although those events were hopefully unique and of much lower probability, we still believe that bond issues with this many moving parts and sources of risk are not appropriate for individuals.

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EARLY RESULTS FOR VIRGINIA TOLLING PROJECT

A recent state study shows that Interstate 66 tolls for solo drivers in Virginia and expanded HOV hours have not slowed traffic on most major parallel routes during the morning rush hour. Whenever a toll facility opens, there is concern that drivers seeking to avoid the higher cost may switch to nearby free alternative routes resulting in higher volumes on those secondary routes and new bottlenecks replacing the old ones.

The analysis — which found the average daily toll paid in January was $12.37 — also showed that even an increased number of cars on some roads like U.S. Route 50 did not significantly change travel times in January, compared with the same time a year earlier. Speeds on parallel routes, such as U.S. 50, U.S. Route 29 and Virginia Route 7, are largely unchanged from a year ago.

The occasional spikes in tolls to high levels have created eye catching headlines and photos around the country. The State’s spin on the occasional very high toll ($40+) is that “what it’s really telling you is don’t get on, because it means the road is getting congested, this is not where you want to go.” A trip on the George Washington Parkway at 6 a.m. takes largely the same amount of time as the ride on I-66 at that time before tolling began because the highway would become clogged with drivers trying to get to work before the HOV restrictions began at 6:30 a.m.

Some 13,000 drivers are using the road eastbound each morning, and more than 15,000 drivers are using the road westbound each afternoon. Forty-three percent of the trips were vehicles with an E-ZPass Flex switched to HOV mode to indicate that they have at least one other person in the car. Forty-four percent of drivers paid the toll with an E-ZPass. The average morning toll paid in January was $8.07, while the average afternoon toll paid was $4.30. When analyzing only those drivers who paid to use the entire corridor from the Beltway to Rosslyn each way, the average round trip price was $18.06.

As for the extreme toll levels occasionally experienced, In January, 461 drivers paid $40 or more.

CALPERS ADJUSTS DISCOUNT RATE

After much criticism of its investment discount assumptions, CALPERS has decided to lower its assumed annual rate of return on its investment portfolio from 7.5% to 7%. The impact of this decision is to raise the level of contribution expected from the municipalities and their employees to fund their share of the costs of municipal employee pensions. This will increase the expense pressures facing cities across the Golden State.

The long awaited change will generate more conversation about the funding of pensions in the state and give more momentum to efforts to litigate, negotiate, and vote changes in the pension benefits available to current and future municipal employees.

CALPERS cited a number of benefits associated with reducing the discount rate. They  include: strengthening long-term sustainability of the fund; reducing negative cash flows; the fact that additional contributions will help to offset the cost to pay pensions; a reduction in the long-term probability of funded ratios falling below undesirable levels; an improved likelihood of CalPERS investments earning its assumed rate of return; and a reduction in the risk of contribution increases in the future from volatile investment.

CALPERS provided a hypothetical example of the impact on a municipality. A miscellaneous plan with a current normal cost of 15% of payroll can expect an increase to 15.25 % to 15.75 percent of payroll in the first year (Fiscal Year 2018-19), and 16 % to 18 % in the fifth year (Fiscal Year 2022-23). For the UAL payment, a plan with a projected payment of $500,000 in Fiscal Year 2018-19 and $600,000 in Fiscal Year 2022-23 can expect the revised payment to be $510,000 – $515,000 ($500,000×2.00%/$500,000×3.00%) for Fiscal Year 2018-19, and $720,000 – $750,000 ($600,000×20%/$600,000×25%) for Fiscal Year 2022-23. These estimated increases incorporate both the impact of the discount rate change and the ramp up.

Obviously, each city will experience different impacts based on the level of benefits promised and the salaries they provide. This is especially true where municipalities have made significant expense increases related to public safety. In California, there has been somewhat of an arms race among cities seeking to generate economic development through a concerted effort to reduce crime. At the same time demographic trends have been unfavorable. According to CalPERS, there were two active workers for every retiree in its system in 2001. Today, there are 1.3 workers for each retiree. In the next 10 or 20 years, there will be as few as 0.6 workers for each retiree collecting a pension.

In addition to lowering its discount rate, CALPERS also has decided to shorten the amortization period to 20 from 30 years for all investment gains and losses. This will lead to a rise in contribution requirements from participating municipalities. Some cities support the change because they believe it is prudent to shore up the fund and pay down the unfunded accrued liability faster instead of pushing the financial burden to future employees, employers and taxpayers. Other more economically challenged cities are worried that that reducing the amortization schedule will increase their employer contribution rates even beyond what they can afford.

In response, multiple pieces of state legislation have been proposed. Senate Bill 1031 would allow public employers to freeze cost of living adjustments for retirees if the pension fund isn’t 80% funded. SB 1032 would make it easier for local governments to exit CalPERS without paying termination fees. These fees have been cited as a significant hurdle to those cities which would prefer (wisely or not) to manage their own plans. SB 1033, would shift the burden of increased pension costs to the last city that hired an employee.

This would primarily effect cities which like to hire trained police officers from larger municipalities in lieu of financing the cost of training themselves. This is a phenomenon seen often in suburbs across the country which run their own local forces but do not have or wish to expend local resources on training. They tend to offer higher salaries since they have not had to absorb training costs.

How big is the problem? The California League of Cities released a study in January that looked at the situation. It confirmed much of what CALPERS has told its member cities. It found that rising pension costs will require cities over the next seven years to nearly double the percentage of their General Fund dollars they pay to CalPERS. Between FY 2018–19 and FY 2024–25, cities’ dollar contributions will increase by more than 50 percent. For example, if a city is required to pay $5 million in FY 2018–19, the League expects that it will pay more than $7.5 million in FY 2024–25. In FY 2024–25, half of cities are anticipated to pay over 30.8 percent of their payroll towards miscellaneous employee pension costs, with 25 percent of cities anticipated to pay over 37.7 percent of payroll. This means that for every $100 in pensionable wages (generally base salary), the majority of cities would pay an additional $31 or more to CalPERS for pensions alone.

For “mature cities” with larger numbers of retirees, the percentages are even higher. Half of those cities are anticipated to pay 37.9 percent or more of payroll and 25 percent are anticipated to pay 42.9 percent or more of payroll. These findings are not specific to one region of the state. The data shows that cities throughout California are dealing with these challenges. Contributions are projected to be much higher for cities that employ safety personnel (police officers and firefighters). By FY 2024–25, a majority of these cities are anticipated to pay 54 % or more of payroll, with 25 % of cities anticipated to pay over 63.8 % of payroll. In other words, for every $100 in salary, the majority of cities would pay an additional $54 or more to CalPERS for pensions alone. For FY 2024–25, the average projected contribution rate as a percentage of payroll is 34.6 percent for miscellaneous employees and 60.2 percent for safety employees. For cities with a large percentage of retirees, the averages are 39.4 percent and 67.5 percent.

The California pension problem reflects not just its size and scale but also the State’s legal requirements governing spending. Under the California Constitution, a city’s options for revenue raising are strictly limited. Any increase in local taxes requires voter approval and voter tolerance for tax increases is waning. Much of a city’s budget is dedicated to employee salaries and benefits to provide fire protection, law enforcement, parks services and other municipal services. If new revenues are unavailable, as contributions rise, local agencies are forced to significantly reduce or eliminate critical programs. Pressure will continue to impact local California credits.

ANOTHER HEALTH SYSTEM MERGER

Bon Secours Health System (A2/A), an East Coast based Catholic health system and Mercy Health, a Catholic health ministry serving Ohio and Kentucky, announced their intent to merge, creating one of the largest health systems in the country spanning seven states in the eastern half of the U.S.  The merger creates the fifth largest Catholic health system in the country.

The merged entity creates one of the top 20 health systems in the nation and the fifth largest Catholic health system with $8 billion in Net Operating Revenue and $293 million in operating income. Together they employ 57,000 associates and more than 2,100 employed physicians and advanced practice clinicians. Mercy Health provided care for patients more than 6.8 million times in 2017. The system included assets of $6.8 billion and nearly 500 care facilities including 23 hospitals and 26 post-acute care facilities including senior living communities, hospice programs and home health agencies. Bon Secours owns, manages, or joint ventures 20 hospitals and 27 post-acute care facilities or agencies including skilled nursing facilities, home care and hospice services, and assisted living facilities.

Bon Secours has debt outstanding of $818.1 million. Mercy Health had total debt of $1.5 billion.

NYC COMPTROLLER REVIEWS FISCAL 2019 BUDGET PROPOSAL

New York City Comptroller Scott M. Stringer presented his analysis of the Mayor’s fiscal year (FY) 2019 Preliminary Budget and Financial Plan. Highlights include spending grows a modest 1.4% in FY 2019; spending is projected to accelerate to an average annual rate of 2.6% over the entire Plan period, fiscal years 2018 to 2022; revenues are projected to grow at an average 2.2% each year until FY 2022, resulting in budget gaps of $2.2 billion in FY 2020, $1.5 billion in FY 2021, and $1.7 billion in FY 2022; and the February Plan shows a $2.6 billion budget surplus in FY 2018, down nearly $1.6 billion from the $4.2 billion budget surplus of FY 2017.

The theme is not that the City’s finances are in current trouble. Rather, the Comptroller is concerned that any short-run stimulus effects of federal tax cuts and spending are likely to wear off quickly as the Federal Reserve and markets react to rising federal deficits and inflationary expectations. In addition, job growth in the City is expected to decelerate from an average of nearly 90,000 new jobs per year since the end of the Great Recession in 2010, to 22,700 in 2020, 15,900 in 2021, and 16,300 in 2022. He is concerned that spending trends under the deBlasio administration have reduced the City’s cushion against an economic downturn. he cites the City’s declining cash balances as an early warning signal, as they currently sit more than $2 billion below last year’s level, after falling to a low in December of $1 billion – the lowest point since 2010.

A number of spending categories are increasing not as the result of policy but of need especially in the area of housing and homelessness. The increased costs of housing across all income ranges continues to be a significant problem in the City. As a result, Citywide spending on homelessness across all agencies has more than doubled from $1.1 billion in FY 2013 to a projected $2.6 billion in FY 2019 and spending on shelters alone has nearly doubled since FY 2013 – from just over $1 billion to $1.9 billion dollars in FY 2019. In spite of claims by the administration that expanded low income housing is available, the number of individuals residing in shelters has steadily increased from 49,673 in 2013 to 61,029 as of February 2, 2018. One other expense area cited relates to the City’s well documented issues with its jail system. The average daily inmate population has declined by over 30 percent, from 13,850 in 2008 to 9,500 in 2017 but, over the same period, the average annual cost of housing an inmate on Rikers has more than doubled, from about $117,000 in 2008 to over $270,000 in 2017.

According to the Comptroller, the City’s reserves are currently insufficient, at just 9% of adjusted FY 2019 spending. The Comptroller says that the optimal range for the City’s reserve cushion is between 12% and 18% of spending. At the start of the last recession in 2009, the City’s budget cushion was equivalent to more than 17% of spending. The City’s accumulated FY 2018 surplus is over $1.5 billion less than at the start of the year.

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

LOS ANGELES UNIFIED SCHOOL DISTRICT

(County of Los Angeles, California)

$1,350,000,000

General Obligation Bonds,

(Dedicated Unlimited Ad Valorem

Property Tax Bonds)

Moody’s Aa2

The LAUSD is the nation’s second largest public school district. It has an an estimated enrollment for fiscal 2018 equal to 613,274, inclusive of 112,492 students enrolled in independent charter schools. It includes virtually all of the City of Los Angeles and all or significant portions of the cities of Bell, Carson, Cudahy, Gardena, Huntington Park, Lomita, Maywood, San Fernando, South Gate, Vernon, and West Hollywood, among other cities, in addition to considerable unincorporated territories devoted to both residential development and industry.

The general obligation bonds of the District are secured by an unlimited property tax pledge of all taxable property within the district boundaries. Debt service on the rated debt is secured by the district’s voter-approved unlimited property tax pledge. The county rather than the district will levy, collect, and disburse the district’s property taxes, including the portion constitutionally restricted to pay debt service on general obligation bonds.

Like many other older established urban districts, enrollment continues to decline. Nonetheless, the district faces significant capital needs if only to reduce overcrowding, eliminate multi-track calendars and reduce the number of portable classrooms from 10,000 to approximately 8,000. Going forward, capital projects will focus on modernization and repairs of aging schools coupled with addressing future needs for classroom capacity to support the district’s commitment to maintaining traditional school calendars and reducing the number of portable classrooms.

The district’s Aa2 rating is based on the perceived strength of district management and their demonstrated ability to guide the district’s finances through periods of revenue uncertainty, severe state budget challenges, and erosion in enrollment figures. While management has successfully addressed long-term fiscal challenges in the past, identified outyear budget gaps will require permanent, structural cost reductions to address budgetary imbalances and maintain current credit quality. The district has an exceptionally large and diverse tax base with steady growth expected over the medium term, but also must contend with the fact that its residents have a below-average socioeconomic profile. Improved state funding, including one-time revenues, has supported increases in the district’s general fund reserves and liquidity.

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TRUMP ENDORSES GAS TAX INCREASE

In a closed-door meeting on infrastructure with members of both parties, Trump pitched the idea of a 25-cent increase in the gas tax and dedicating that money to improve our roads, highways and bridges. The tax on diesel would be increased likewise.

Republican congressional leadership opposes such an increase while groups like the US Chamber of Commerce endorses it. An increase would be useful and would bolster efforts to reinfuse the depleted federal Highway trust Fund. At the same time, a real plan would provide some provisions for alternative funding to gas taxes in light of impending technological changes to the auto industry.

The U.S. Chamber says the proposal would raise $394 billion, more than enough to pay for Trump’s $200 billion infrastructure plan and possibly even expand it further. The idea however, highlights the hurdles facing any effort at raising revenues for infrastructure just on one side of the partisan equation. The oil funded Koch network, adamantly opposes any increase in the gas tax.

BANK LOAN DISCLOSURE MUST IMPROVE

Over the last decade, municipalities have increasingly turned to direct loan from banks as an alternative to the issuance of debt in the public markets. The municipal market has been debating for some time how much disclosure about the provisions included in bank loans should be required. he issues surrounding the loans include the potential adjustability of the interest rates and terms of the loans and the resulting impact on the respective positions of holders of existing bonded debt. these holders can, in the absence of disclosure about the loans, find themselves either in junior lien positions relative to the bank lenders or with much larger parity claims than they were led to believe existed.

The various players in the discussion have taken expected positions. Investors want more disclosure, issuers cite the costs of disclosing, and lenders seem to be opposed primarily for competitive reasons. The arguments have become tiresomely predictable. This discussion is being revisited and amplified with the news that many bank loan agreement “gross up” provisions are being triggered as the result of the recent changes in the tax laws.

Specifically, many of the underlying loan agreements between bank lenders and municipalities contain provisions which provide for increases to the interest rate on loans in the event of legal changes which are determined to have reduced the value of the loans. The corporate tax cuts are one such item. After the tax law lowered the rate on taxable income, the relative value of loans to municipalities was adversely impacted. In that event, the banks are entitled to raise the rates to “gross up” the total value of the loan asset. Many municipal borrowers are being informed of the new higher rates and are calculating the new higher cost of debt service on the borrowings from banks.

To the detriment of bond investments, there is no current requirement that municipal borrowers disclose the details of these loan documents or disclose the amount of increase in their associated debt service requirements. depending on the size of the loan, these increases may be substantial. Should they be disclosed, investors could make their own determination as to the resulting impact on an individual municipality’s ability to pay and on its projected budget results. this would enable the investor to make a more informed determination as to the market value of the bonds they own. Instead the details of the loans remain shrouded in mystery, leaving investors in the dark about debt service costs, lien positions, and other repayment terms competing with their interests as creditors.

So what can be done about this? As has been the case throughout the last four decades of municipal finance, the issue is unlikely to change until investors – especially those purchasing new issues in size – demand full disclosure of this information as a condition of purchase. Insist that this become a documented disclosure issue in official statements, bond reporting covenants, and reports issued to and posted on the NRMSRs. Until such pressure is applied on a consistent basis, the market will remain inefficient and slanted against the interests of investors.

GOVERNOR PROPOSES ILLINOIS BUDGET

As required under the Illinois Constitution, the Governor has submitted a state budget to the General Assembly for the upcoming fiscal year. The budget proposes reforms to save $1.6 billion to balance the fiscal year. An important assumption is that economic growth will foster revenue growth. The recommended budget, including all proposed structural reforms, achieves a surplus for fiscal year 2019. After two fiscal years without an enacted budget, fiscal year 2018 was marked by the General Assembly’s enactment of a full budget. The legislature overrode the Governor’s objection that their budget was built on the back of a $4.5 billion income tax increase, $6 billion in long-term debt, and a continuing backlog of unpaid bills expected to be $7.5 billion at the end of the fiscal year.

The Governor proposes that the General Assembly consider two positive options – apply the surplus towards the bill backlog to pay down current operating obligations or rollback 0.25 percent of the income tax rate for Illinois taxpayers starting in fiscal year 2019. By implementing the consideration model, Illinois could realize immediate relief in the form of a tax cut.

The Governor’s priorities are clear. Fiscal year 2019 marks a record level of funding for K-12 education and includes $6.834 million for the second year of evidence-based funding. It increases early childhood education funding 55 percent from 2015 levels, continues Monetary Award Program (MAP) grants for college students, and provides new capital funding for deferred maintenance and repair of university and community college facilities. There are increases in funding for police, corrections, and criminal justice. At the same time it leaves flat spending for children’s and family services, food for the elderly, and Medicaid.

So education, public safety, and tax reductions are the main priorities. Given the State’s difficulties in recent years in generating sufficient revenues, these priorities may be a loggerheads with each other. The budget also reflects the Governor’s generally antagonistic stance towards the state’s workforce.

On the capital side, the plan provides $2.2 billion in pay-as-you-go (non-bonded) funding for the Department of Transportation’s annual capital road program. On the labor and pension sides, the Governor proposes group health insurance program changes allowing employees options for different health insurance packages with varying levels of benefits and premium costs, reintroduces the Governor’s proposal for a consideration model that offers benefit options to retirement system participants of the State Employees’ Retirement System, the Teachers’ Retirement System and the State Universities Retirement System as a means to contain long-term pension costs, and begins the incremental shift of payment responsibility for the normal costs of pensions to the school districts and institutions that employ the participants in the Teachers’ Retirement System and the State Universities Retirement System.

The impact of these changes would be to shift insurance and pension costs from the state to employees and to lower levels of government and state institutions. In fiscal year 2019, universities, community colleges and school districts would begin to pick up 25 percent of the normal pension cost for their employees who participate in SURS and TRS. Then, over the next three fiscal years, they would pick up an additional 25 percent each fiscal year until they become fully responsible for the normal pension costs related to their employees. The total cost realignment in fiscal year 2019 would be $363 million. Currently, the state pays the retiree health insurance costs for all retirees of TRS and SURS. The fiscal year 2019 budget proposes no direct state funding for retiree health benefits for retirees of TRS and SURS.

Additional education funding is provided in fiscal year 2019 to help defray these realigned costs. This is meant to offset the increased costs to local school districts. In many districts the increased aid is less than the increase in costs. These would have negative impacts on the credits supported by taxes and revenues generated by those governments and institutions. In other words, tax increases and tuition rises.

At the same time, the state credit would continue to be impacted by the fact that the unfunded pension liability has reached $129 billion, and the annual pension contributions for fiscal year 2019 from general revenue will be $7.9 billion unless changes are enacted. The bill backlog hovers around $8.5 billion—down from $16.5 billion in November 2017, when the state borrowed $6 billion to pay it down. In the 20 years from 1996 to 2016, annual contributions to the five state pension funds grew more than ten-fold, from $614 million to $7.6 billion. While pension and health benefits constituted just 7.5 percent of the budget in 2000, they now take up 25 percent of the budget.

Enrollment in Medicaid increased by 1.8 million—a 130 percent increase—between fiscal year 2000 and fiscal year 2016. Illinois now has nearly one-quarter of its population—more than 3.1 million people— enrolled in Medicaid. The growth trend in enrollment has reversed somewhat in recent years as the ACA has taken effect. Federal financial support for the expansion of Medicaid under the ACA will drop from 94 percent of costs in fiscal year 2018 to 93 percent in fiscal year 2019 to only 90 percent in fiscal year 2020 and thereafter.  the fiscal year 2019 budget includes a 4 percent reduction in current rates paid to providers, excluding prescriptions and community health centers. The budget also utilizes managed care.

One time items are also included in the budget balancing scheme. The divestment of the James R. Thompson Center (JRTC) is projected to  achieve net proceeds of $240 million in fiscal year 2019 and avoid deferred maintenance expenses estimated in the hundreds of millions of dollars over the next 10 years.

On what are revenue projections based? Fiscal year 2018 are projected to be $36,783 million, an increase of $6,450 million, or 21.3 percent from actual fiscal year 2017 revenues. This increase primarily reflects an increase of $4,501 million in individual income tax and corporate income tax revenues due to the increases in the individual income tax rate from 3.75 percent to 4.95 percent and the corporate income tax rate from 5.25 percent to 7.0 percent, effective July 1, 2017. Individual income taxes deposited into the general funds are estimated to total $17,610 million, while corporate income taxes are estimated to total $1,884 million for fiscal year 2018. These estimates include an estimated $1,217 million to be deposited into the Commitment to Human Services Fund and the Fund for the Advancement of Education. These numbers also reflect the impact of the direct deposit of income tax revenue sharing with local governments, estimated to reduce income tax deposits to the general funds by $1,140 million in fiscal year 2018.

Net sales tax revenue deposits into the general funds are estimated to total $7,951 million, reflecting the impact of the deposit of $448 million directly into local transit funds instead of being deposited into the general funds first. Revenues from other state sources, including Public Utility Taxes, are expected to total $3,328 million. Federal sources are projected to increase to $3,418 million in fiscal year 2018 from the fiscal year 2017 total of $2,483 million. Use of the proceeds from the November 2017 backlog borrowing to pay down prior year Medicaid liabilities is expected to add an additional $1,206 million to fiscal year 2018 totals. This additional amount is not included in the base resources for fiscal year 2018 as it is attributable to the payment of prior year liabilities. Transfers in, not including amounts from fund reallocations or interfund borrowing authorized in PA 100-23, are projected to increase to $1,718 million in fiscal year 2018 from fiscal year 2017 results of $1,542 million.

It would not be a surprise to see a most contentious budget adoption process. The state’s politics – always complicated – will be more so this year with the Democratic primary guaranteed to yield a wounded yet well funded candidate. How much leverage the traditional budget adversaries will have this year is not clear. The lack of clarity will make the process that much more difficult to favorably resolved. We believe then that the risk to the State’s credit remains weighted to the down side regardless of the perceived improvement in the State’s credit due to its recent year end bond sale.

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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Editor’s Note: The posting is late to reflect the issuance of the Trump infrastructure plan this past Monday.

ISSUE OF THE WEEK

Intermountain Power Agency (IPA)

$102.5 million Subordinated Power Supply Revenue Refunding Bonds, Series 2018A.

Moody’s: A1

Maybe you can teach an old dog new tricks. Conceived in the eighties as a way to site coal fired power plants to serve California without running afoul of the nation’s strictest state air pollution regulations, IPA seemed to check off all of the boxes for large scale base load power generation resource development. A couple of decades of climate change later, the coal orientation and desert location outside of California were not enough to offset the environmental regulatory demands of the California electric market.

So in March, 2016, IPA and its 35 participants executed a Second Amendatory Power Sales Contract under which IPA plans to repower its existing coal units into combined cycle natural gas units by July 1, 2025. IPA and its participants have agreed to extend the term of the existing power sales contracts that expire in 2027 by another 50 years through the Renewal Power Sales Contract (RPSC). The RPSC will provide energy generated by the natural gas units following the conversion from 2025 to 2077.

To recall, the primary purpose of IPA is the operation of the two-unit 1,800 MW Intermountain Power Project (IPP) coal-fired generation facility. IPP is located in Millard County, Utah and a significant portion of the energy is transmitted about 490 miles from the Intermountain Converter Station to the station at Adelanto, California via the Southern Transmission Line (STS). The STS line is owned by IPA with the improvements finance by the Southern California Public Power Authority (SCPPA). The generation and transmission facilities are operated by the LADWP.

Going forward, the primary risks to the credit are regulatory related cost risks. Increased regulatory pressure from Federal or California agencies on municipal electric utilities to reduce GHG emissions in the near-term. Main among these are Increased regulatory pressure from Federal or California agencies on municipal electric utilities to reduce GHG emissions in the near-term.

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INFRASTRUCTURE PLAN FALLS FLAT

After the long wait for the formal release of the trump Administration infrastructure plan, the resulting document is a huge disappointment. By emphasizing financing over funding, private over public, and uneven distribution of support relative to where the needs are, to plan comes up short effectively across the board.

The amount of spending – $1.5 trillion over ten years – was but a reinforcement of an effective 85% plus state/local share dampened state and local enthusiasm. Financing is not the issue for states and localities. They know how to finance these projects. The challenge is how to meet the need for funding. That is where the plan is likely to come up short. The draft does not comport with recent legislative realities. It envisions the use of tax-exempt private activity bonds (PAB) and advance refunding of tax-exempts. PABs withstood a significant assault before being retained under tax reform but advance refundings were eliminated.

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. It seeks to loosen environmental reviews and encourages usage charges (tolls) to provide revenues for local shares. 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.

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. While not explicitly referenced, asset recycling where the sale or lease of existing facilities to generate toll revenue for funding of additional projects and profits for the private asset purchasers is likely a philosophical centerpiece of any plan . These assets would likely include highways, airports, and rail facilities. In the area of federal assets, the draft suggests several electric utility assets owned by the Federal government as examples of potential asset sales.

On the funding side, the draft raised many concerns on the part of state and local governments who will see increased funding responsibilities under the anticipated state and local/federal shares of the proposed trillion dollar plan.  The allotted $200 billion comes from cuts to programs including the Transportation Investment Generating Economic Recovery (TIGER) grants and transit funds.

Whether the proposal when it is formally released can garner enough support is not clear. Upon release, the plan will face challenges. 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 favorable. Let’s look at three examples of major infrastructure programs requiring massive capital investment. 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.

High speed rail is another area of infrastructure with a fair measure of public support. In California, high speed rail has encountered opposition from some of the state’s congressional delegation who have strongly fought to obstruct any efforts at even indirect federal funding. Yet the only recent new high speed rail project to begin service (in Florida) fought long and hard for as much of a federal subsidy as it could get through the use of tax exempt municipal bonds. And finally, the Delta water tunnel project in California would provide water resources serving large swaths of the state and a variety of arguably national economic interests. High speed rail and projects like the Delta Tunnels do not seem to have an outlet in this program.

The Administration has made clear that the document is the mere starting point for negotiating legislation. In favor of passage is the fact that the concept of infrastructure does have bipartisan and widespread regional support. At the same time, the funding of the plan through the elimination of some popular existing mass transit funding sources will make it harder to drive a bargain. One thing we know is that the adopted plan will be far different than what we see in this effort.

ADVANCE REFUNDING LEGISLATION

U.S. Representative Randy Hultgren, an Illinois Republican, and U.S. Representative Dutch Ruppersberger, a Maryland Democrat announced that they are cosponsoring bill to restore the federal tax exemption for a type of debt refunding used by U.S. states, cities, schools and other issuers to lower borrowing costs . Advance refundings were eliminated in the sweeping tax bill signed into law by President Donald Trump in December.

Advance refunding bonds are used to refund outstanding debt beyond 90 days of its call date to take advantage of lower interest rates in the municipal market. Advance refunding bond issuance totaled $91 billion in 2017, accounting for 22.2 percent of supply last year, according to Thomson Reuters data. The termination of the tax break for interest earned on the debt is expected to generate $17.3 billion for the U.S. government between 2018 and 2027.

In addition to providing cost savings due to favorable turns in interest rate trends, the refundings are an important tool for the restructuring of debt especially in the case of distressed credits. The termination of the tax break for interest earned on the debt is expected to generate $17.3 billion for the U.S. government between 2018 and 2027.Given the size of the revenue loss associated with the overall tax cut, the negative policy implications for municipal credits just don’t seem worth the loss of refudning ability.

CA REVENUES REMAIN STRONG IN JANUARY

California’s total revenues of $17.35 billion for January beat the governor’s 2018-19 proposed budget estimates by $2.37 billion, or 15.8 percent, and outpaced 2017-18 Budget Act projections by $1.45 billion, or 9.1 percent, State Controller Betty T. Yee reported today.

Personal income taxes (PIT) and corporation taxes, two of the “big three” sources of General Fund dollars, exceeded estimates for the second consecutive month and are both surpassing assumptions for the fiscal year. For the first seven months of the 2017-18 fiscal year, total revenues of $74.56 billion are higher than expected in the January budget proposal by 4.0 percent, 7.5 percent above the enacted budget’s assumptions, and 11.7 percent higher than the same period in 2016-17.

For January, PIT receipts of $15.60 billion were $2.25 billion, or 16.9 percent, above the proposed budget’s projections and $1.33 billion ahead of 2017-18 Budget Act estimates. For the fiscal year, PIT receipts of $54.70 billion are higher than anticipated in last summer’s budget by $3.61 billion, or 7.1 percent.

Corporation taxes for January of $551.6 million were $211.3 million, or 62.1 percent, higher than expected in the proposed budget and $143.4 million above the enacted budget’s estimates. This variance is partially because refunds were approximately $38.0 million lower than anticipated. For the fiscal year to date, total corporation tax receipts of $4.81 billion are $1.08 billion, or 28.8 percent, above assumptions in the 2017-18 Budget Act.

Sales tax receipts of $1.01 billion for January were $138.0 million, or 12.0 percent, lower than anticipated in the governor’s budget proposal unveiled last month. Notably, for the fiscal year, sales tax receipts of $13.03 billion are $151.2 million lower than January’s assumptions but $396.6 million, or 3.1 percent, above the enacted budget’s expectations.

Unused borrowable resources through January exceeded revised projections by $7.83 billion, or 30.8 percent. Outstanding loans of $5.64 billion were $5.19 billion, or 47.9 percent, less than the 2018-19 proposed budget estimates and $5.02 billion, or 47.1 percent, less than the 2017-18 Budget Act assumed the state would need by the end of January. The loans were financed entirely by borrowing from internal state funds.

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

$600,000,000*

HARRIS COUNTY, TEXAS

TOLL ROAD SENIOR LIEN REVENUE AND REFUNDING BONDS,

SERIES 2018A

Moody’s: Aa2      Fitch: AA

It is a long established credit with a favorable historic track record so there should not be anything which makes this particularly interesting that meets the eye. It’s for precisely that reason that we feel the deal is worthy of comment. A traditional toll road may not the most likely candidate as a harbinger of what might best work down the road in this sector but ironically it may be.

Here we have a facility which fits the profile of a user fee financed road. The facility can generate revenue regardless of the type of vehicle using it. It has no dependence on fuel based taxes as a source of debt repayment. It has flexibility regarding of method of revenue collection.

The senior lien revenue bonds are special obligations of the county, secured by a first lien on the trust estate established under the revenue bond indenture, which includes a gross pledge of funds in the debt service and debt service reserve fund (DSRF) and all revenues of the toll road system. The rate covenant requires toll revenue collection sufficient to produce revenues that provide at least 1.25x aggregate debt-service coverage on toll road senior lien revenue bonds accruing in such fiscal year. The senior lien DSRF is to be funded at not less than average annual aggregate debt service and not more than maximum annual debt service.

That revenue pledge is supported by a system of roads which serves a growing and increasingly diverse area economy that is highly dependent on the roadway network for commuting and combines with annually indexed toll rate increases to provide a significant track record of strong revenue growth. The tollway is considered to be in good condition. The combination of these factors has produced revenues adequate for good operational performance and limited maintenance expenditures. In addition, other entities have benefitted  from the Authority’s legal ability to transfer funds either to a $120 million annual transfer to the county for mobility projects or major capital projects like the $962 million Ship Channel Bridge.

The point is that the financial structure seems to be well positioned to handle the potential financial risks which are seen as inherent in the rollout of transportation and mobility as a service.

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INDIANA GETS A MEDICAID WAIVER TO REQUIRE WORK

It comes as no surprise that the head of CMS who was formerly the head administrator for Indiana’s Medicaid Program under then Governor Mike Pence, has approved a waiver permitting a requirement that Medicaid recipients work. In order to qualify for coverage under the new plan, able-bodied individuals under 60 years old would need to work at least 20 hours a week on average, be enrolled in school, or participate in the state’s job training and search program. Those not meeting the standards will be suspended from the program until they can comply with the requirements for a full month. Indiana’s proposal offers exemptions from its work requirement, including if a beneficiary is pregnant, a primary caregiver, receiving substance use disorder treatment or identified as medically frail.

The newly confirmed head of HHS described the waiver provisions as things that can make Medicaid can become a pathway out of poverty. The thing is that Medicaid was never intended to be an employment program. The authorizing legislation always made clear it was an access to health program.

As for the concept that Medicaid is provided to a group of deadbeats sitting around, the Kaiser Family Foundation has data that puts paid to that idea. Data show that among the nearly 25 million non-SSI adults (ages 19-64) enrolled in Medicaid in 2016, 6 in 10 (60%) are working themselves. A larger share, nearly 8 in 10 (79%), are in families with at least one worker, with nearly two-thirds (64%) with a full-time worker and another 14% with a part-time worker; one of the adults in such families may not work, often due to care giving or other responsibilities. Adults who are younger, male, Hispanic or Asian were more likely to be working than those who are older, female, or White, Black, or American Indian, respectively. Those living in the South were less likely to work than those in other areas.

Most Medicaid enrollees who work are working full-time for the full year, but their annual incomes are still low enough to qualify for Medicaid.  So one has to ask, what is the real purpose of the waivers? Other than to achieve budget savings for states and the federal government, it is hard to see what the underlying basis for these waivers is. It seems more politically driven. More than four in ten adult Medicaid enrollees who work are employed by small firms with fewer than 50 employees that will not be subject to ACA penalties for not offering coverage. So it is hard to see exactly where all of these undeserving are.

There is data which shows what can happen when programs like welfare and Medicaid are tied to work requirements. The Center for Budgets and Priorities analyzed state-collected data on the employment and earnings of Kansas parents leaving TANF cash assistance between October 2011 and March 2015. Beginning in November 2011, Kansas Governor Sam Brownback and a Republican-controlled legislature enacted a series of punitive eligibility changes in the state’s Temporary Assistance for Needy Families (TANF) cash assistance program that made it harder for parents who lose their job or cannot work to receive the support needed to pay rent and utilities and afford basic goods.

The analysis indicates that the vast majority of these families worked before and after exiting TANF, but most found it difficult to find steady work and secure family-sustaining earnings. Most parents leaving TANF had jobs at some point, before and after leaving the program. Work was common but for most it was unsteady. Although some parents’ earnings rose after leaving TANF, the majority remained far below the federal poverty line.

According to the CBPP, Kansas’ TANF cash assistance caseload, hereafter referred to as families served, has fallen substantially since the state implemented its new work and time limit policies (see Figure 2). The number of families served has plummeted by more than half, from 13,014 in October 2011 to 5,231 in October 2016. Previously, that number ebbed and flowed as the economy and low-income programs changed. The steepest drop in families served occurred in the mid-to-late 1990s due to a strong economy, the 1996 welfare law, and other factors such as expansions in the Earned Income Tax Credit. Thereafter, the number rose in the early 2000s, fell in the mid-2000s, and increased again when the Great Recession caused poverty and joblessness to spike. With the recent changes, few families living in poverty now have access to benefits that help them meet their basic needs when work is not feasible or available. For every 100 Kansas families in poverty in 2015-16, only ten received cash assistance from TANF — down from 17 families in 2011-12 and 52 families in 1995-96.

NEW YORK SCHOOL DISTRICTS GET FAVORABLE TAX RULING

Beginning January 2012, New York State’s underlying levels of government became subject to a tax cap law. The law limits New York local governments from increasing the property tax levy above 2% or the rate of inflation, whichever is lower. The cap applies to school districts differently than other local governments. School districts need majority voter support to pass annual budgets, but require 60% voter approval for budgets that raise the levy beyond the limit. In mid-January, State Comptroller Thomas DiNapoli announced that allowable levy growth for school districts will increase to 2%, the current maximum allowable limit.

The increase in the levy cap is a credit positive for the state’s nearly 700 school districts because it makes it easier for them to increase property taxes. The allowable levy will be higher than in prior years. This will allow districts that have historically sought to override the levy cap to not have to do so in this budget round, thereby reducing political pressure. This will allow districts to include services and programs that were generally not covered under the old levy rate. This reverses a trend of extremely low caps on levy increases of 0.12% in fiscal 2017, which ended  June 30, 2017. The number of districts seeking overrides more than doubled to 36 in fiscal 2017 from 16 in fiscal 2016.

The change comes at a good time politically in New York which will see elections for Governor and the state Legislature in 2018. By reducing the pressure on local budgets, especially for schools, a major issue influencing state election politics will have been effectively taken off the table.

CONNECTICUT BUDGET FOR SECOND HALF OF 2019 BIENNIUM

The Governor has released his Fiscal Year 2019 budget adjustments. The proposal is designed to achieve a balanced budget in the current and future fiscal year. They include expenditure and revenue changes totaling more than $266.3 million. These changes are responsive to the underlying $165 million shortfall identified by the latest consensus revenue forecast, and an additional $100 million of changes to correct unrealistic spending assumptions in the adopted budget or for unrecognized needs.

It reduces projected out-year deficits by half; decreasing by $1.35 billion in FY20, $1.43 billion in FY21, and $1.49 billion in FY22, takes steps to ensure the long-term solvency of the Special Transportation Fund and restoration of billions of dollars in transportation projects currently deferred, pays the entire State Employees Retirement System (SERS) and Teachers Retirement System (TRS) state contribution and proposes changes to smooth the looming TRS payment spikes.

The plan leaves major tax rates are unchanged, but revenue changes include repeals of exemptions and credits or cessation of enacted rate changes. It also establishes a series of new steps to allow Connecticut’s citizens to receive more friendly tax treatment following the federal tax changes, including changes to pass-through entities, decoupling expensing and bonus depreciation, and allowing municipalities to create charitable organizations supporting local interests.

Proposed adjustments to the current two-year state budget also wipes out the $200 personal property tax exemption, creates a new 25-cent deposit on wine and spirit bottles and eliminates education cost sharing for the 33 wealthiest communities. On the transportation front, the budget eliminates threatened 10 percent Metro-North fare hikes on the New Haven Line while restoring Metro-North weekend branch line service. It would raise gas taxes by 7 cents per gallon over four years and would add a $3 charge on new tires.

PR BUDGET NEEDS MORE REVIEW

In a letter to Governor Ricardo Rossello, the PROMESA fiscal control board set a Feb. 12 deadline for the new draft, which will chart Puerto Rico’s plan to regain economic stability. The original draft turnaround plan, submitted on Jan. 24, projected a $3.4 billion budget gap that would bar the island from repaying any of its debt until 2022. The plan included subsidy cuts to cities and towns and the streamlining of public agencies but, the board, which must approve the plan, demanded more details in the letter.

The board wants more details on key structural reforms, notably labor. It suggested that Rossello make Puerto Rico an at-will employer and make severance and Christmas bonuses optional. The board wants an emergency reserve of $650 million in the next five years and $1.3 billion within 10 years, “based on best practices for states and territories regularly impacted by storms.”

 

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.