Joseph Krist

Publisher

________________________________________________________________

__________________________________

WHAT DOES A RATING REALLY SAY?

One of the characteristics of credit analysis in the municipal space is its willingness to divorce operational from financial issues. In the transportation sector this is especially true. Whether through the use of pledged revenues derived from non-transit sources (like sales taxes) or legal structures creating gross liens on revenues, the linkage between operational issues and credit perceptions remains weak.

We mention this in connection with ratings actions taken this week by Moody’s regarding debt issued by the Washington Metropolitan Transit Authority (WMATA). WMATA has been best known for its service difficulties, declining ridership, and significant capital needs. So it was a little surprising that WMATA revenue bonds had been the subject of an upgrade at this time.

Nonetheless, Moody’s Investors Service has upgraded to Aa3 from A2 the rating on gross transit revenue bonds of the Washington Metropolitan Area Transit Authority, DC (WMATA). The outlook on the rating is revised to stable from positive. Clearly the role of Virginia and Maryland in providing operating subsidies is the overriding factor in this move. “The upgrade to Aa3 incorporates the strong operating environment of the authority, which itself is grounded in continued commitments from the District of Columbia (Aaa stable) and the states of Maryland (Aaa stable) and Virginia (Aaa stable) to financially support the transit enterprise. Subsidies from these governments now cover more than half of WMATA’s annual operating costs.

We have seen though, that support for subsidizing the system has been known to waver. It is hard to see how a system like this with as many management, organizational, and political hurdles to overcome while relying so heavily on outside revenues. As operational issues arise as they did in recent years, they are a source of tension which lead to uncertainties about ongoing subsidy levels.

In making the case for the upgrade, Moody’s cited “improved internal liquidity, continued bank support through lines of credit, and greater certainty with regard to federal grant funding following the FTA’s approval of the Washington Metrorail Safety Commission’s Safety Oversight Program. ” At the same time, the announcement highlights “weak coverage of debt service by net operating revenue, though this is also mitigated by the role played by the state and local government subsidies. A key challenge factored into the rating is WMATA’s heavy post-employment benefits burden. Unfunded pension and OPEB liabilities are high relative to the authority’s revenue and will likely remain a source of rising expenses for years to come.”

It all adds up to quite a mixed bag of factors to evaluate. Our view is that these are enough to hold the rating at its previous level, hence our surprise at this point in time. It’s only been three years since the Authority’s debt was downgraded. It seems like a pretty quick turnaround from here.

LAUSD ELECTIONS HAVE CONSEQUENCES

The recent failure at the ballot box of a proposal to increase property taxes has rightly been seen as a blow to the District’s credit outlook. When the District reach an agreement with its teachers to raise wages and increase resources to the schools, it was widely assumed that support for the teachers goals would translate into support for increased funding from the taxpayers.

That turned out to be a significant miscalculation when voters rejected a proposal for a parcel tax to fund the increased costs of the settlement. The defeat has forced the District to scramble to find ways  keep its budget balanced without the increased revenue to fund a higher cost base. One had to wonder when these events would manifest themselves in the District’s ratings.

It did not take long to see action. Last week, Moody’s Investors Service has downgraded Los Angeles Unified School District, CA’s outstanding general obligation (GO) bonds to Aa3 from Aa2 affecting approximately $10.2 billion in outstanding debt. Specifically it said that “the rating downgrades reflect the district’s structural budgetary challenges and limited financial flexibility stemming from rising fixed costs and recent concessions with the teachers’ union for higher salaries and increased resources. The district faces revenue constraints arising from declining enrollment, increasing dependence on state aid growth that’s slowing and voter rejection of a recent parcel tax measure. As a result, the district is facing a $500 million budget gap.”

The nation’s second largest public school district and the largest one which issues its own debt clearly faces daunting challenges. One thing everyone agreed on at the end of the January teachers’ strike was that the funds to pay for it were not there. So let’s hope that Moody’s note that “management that has a record of outperforming budgeted projections and built up sound reserve levels that buy it time in responding to these challenges before they would cause financial strain” proves out.

PUERTO RICO

It is impossible to comment on events in the municipal space without doing so in regards to the latest efforts by Puerto Rico to evade its legal and moral responsibilities. Previously, I described the efforts to expunge debt while minimizing the pain inflicted on the electorate as being on a par with a drive by shooting. You may get your target but lots of innocent people can get hurt in the process.

Puerto Rico justifies its actions towards debt holders by invoking the specter of the evil hedge fund debt holders. Whatever anyone think of that particular investor class, it can’t be seen as a positive that issuers can decide which group of investors is worthy of fair and legal treatment. And it makes no sense to treat parties like the bond insurers in the same manner just because they are larger corporate entities.

So, it is from that perspective that we view the announcement by the Puerto Rico’s Financial Oversight and Management Board of its plan to restructure $35 billion in debt and non-debt claims of commonwealth and Public Buildings Authority creditors. The plan is to sharply reduce what is available for investors while essentially exempting the Commonwealth’s pensioners from any real pain. The 2012/2014 holders have the option to litigate for equal recovery with pre-2012 bonds, called vintage, or settle at certain levels. The 2012 GOs, which total $2.7 billion, can settle at 45% or be litigated for pari vintage recovery. The 2014 GO bondholders, which have a claim of some $3.6 billion, can settle at 35% or litigate for pari-vintage recovery. Holders of some $700 million in 2012 PBA bonds settle at 23% with net GO claim treated as 2012 GO. Vintage PBA bonds, which total about $3.9 billion can settle at 73% of the recovery.

The government was clear in expressing its position that the government will not support any proposed plan support agreement (PSA) that is based on the recently enacted fiscal plan, which calls for pension cuts. So there it is. All holders must be large holders, all of them were vultures, all of them are an excuse to walk away from responsibility. And all of this represents a corporate mentality whereby the rules of risk taking markets are applied to a risk averse market.

That’s great until one realizes that this is not the corporate market. Now Puerto Rico must face a future where its entree back into the municipal market is not clear. And if it does regain access, will it not need credit support? If it does, will the bond insurance industry be as open to exposure to the credit that treated them so poorly before? The idea that the bond insurer should be treated in the same way as a distressed buyer ignores one little point – the insurers effectively bought at par while many of the current creditors had an effective entry price into the credit of substantially less. So the bond insurers dismay is more than understandable.

It is ironic that for over 40 years potential individual investors would ask what if there’s an insurrection? The fear was of debt repudiation. Now the insurrection against debt repayment  is being generated not as much from below as it is being generated by a political establishment seeking to come out the other side of this debacle with their access to their power and relative privilege intact. They still do not appear to understand that audits and accountability matter. Just this past week, the Financial Oversight and Management Board said the commonwealth government failed to comply with the Puerto Rico Oversight, Management, and Economic Stability Act of 2016 (Promesa) because it has yet to submit certain financial and budget reports. 

The government did not submit, when due April 15, budget-to-actual reports for the University of Puerto Rico (UPR) and the Highway and Transportation Authority (HTA) for the third quarter of fiscal year 2019, as required by Section 203(a) of Promesa. The government did not submit budget-to-actual reports for PREPA, HTA and UPR for fiscal year 2018 and asked these be submitted by the new June 30 deadline. From now on, the board said, the government will also be required to publish public quarterly Section 203(a) reports one month after they are submitted to the board.

The question is will we make them pay a price?

SURPRISE MEDICAL BILLS – SIZE WILL AGAIN MATTER?

With bills under serious consideration in Congress to limit what are known as surprise medical bills, the healthcare industry has reacted with alarm. Clearly, the practice of accepting insurance and hen trying to claw additional revenues from patients usually not in a position to m informed decisions fails many tests of equity and fairness. Surprise bills usually arise from emergency services provided to patients insured patients who inadvertently receive care from providers outside of their insurance networks.

A number of solutions are on offer. Legislative solutions include capping out-of-network charges for emergency medical services at in-network levels; or setting up an arbitration process to resolve out-of-network charges. Other legislation would require a single, “bundled bill” for all care received in an emergency room or have hospitals guarantee that all of their affiliated doctors and service providers are in-network. As usual, change presents challenges and those entities with access to more resources will be best positioned to handle them. Smaller providers are likely to have high out-of-network exposures because they are challenged to negotiate favorable in-network rates from insurers. The largest providers have significant negotiating leverage with insurers, making them likely to already be in-network.

As has been the case for the decade since the enactment of the Affordable Care Act, large providers with diverse sources of reimbursement will be best positioned to withstand changes in insurance reimbursement. The legislation is considered likely to impact hospitals, physician staffing companies, laboratories, radiology and other ancillary provider companies. There are also several proposals that would impact air ambulance providers. Overall, it will be better to be bigger going forward in the healthcare sector.

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

________________________________________________________________

ISSUE OF THE WEEK

$315,065,000*

LANSING BOARD OF WATER AND LIGHT

CITY OF LANSING, MICHIGAN

UTILITY SYSTEM REVENUE BONDS

Moody’s : Aa3  SP: AA-

Our interest in the deal is less with the creditworthiness of the issuer but more with the use of proceeds. in this case, the utility is financing the construction of a 250 MW combined cycle natural gas fueled generation plant. The project is designed to achieve the goals of a plan authored in 2015 to, among other things meet environmental goals. The new gas plant will allow Lansing to shut down five coal fired generating units at two sites, one at the end of 2020 and o at the end of 2025.

The city, which is also the state capital, has a goal of generating 30% of its energy from renewables and 40% by 2030. This is another case where economics supported by popular demand for greener power is driving local utility decisions in the face of the federal government abandonment of its environmental responsibilities. As recently as 2010, the utility owned 14 coal fired facilities.

The plan to construct the gas unit comes as the utility is also in the process of acquiring interests in wind and solar projects so that it can be generating 20% of its power needs from renewables by 2020.

The utility is also approaching cybersecurity issues in its disclosure. The electric system was the victim of a ransomware hack in 2016. This event is acknowledged in the documents and includes a broad discussion of its efforts to combat any future attacks. It may not be as robust as one might like but the acknowledgement of the subject is a positive.

__________________________________

WE’RE NOT IN KANSAS ANYMORE

When former Governor Sam Brownback took office he launched the state on a great experiment with Arthur Laffer-style government finance theories. This in spite of the fact that the State and a group of plaintiffs we involved in litigation over the state’s local school aid formulas. The uproar surrounding the state’s collapsing financial position often stole some attention from the issue of education funding. Well, the results of the supply side experiment are in. The state took downgrades, Governor Brownback retired to be representative to world religious groups, and Mr.Laffer  just was awarded the Medal of freedom by President Trump.

In the meantime, the dispute and debate over school funding in Kansas continued. Now, the Kansas State Supreme Court issued a unanimous decision signing off on a law enacted in April that boosts the state’s education funding by roughly $90 million a year. It was the high court’s seventh ruling in less than six years in a lawsuit over spending, which was filed by four school districts in 2010.

Kansas now spends more than $4 billion a year on its public schools — some $1 billion more than it did during the 2013-14 school year — as the result of the court’s decisions. Increases are promised through the 2022-23 school year, and the April law was designed to raise spending to account for inflation, something the court ruled last year was necessary.

The state will still be subject to review by the Court to insure that the State continues to comply with the Court’s orders. The result keeps pressure n the State to keep up its funding promises. For individual school districts, the resolution of the funding issue removes a source of negative credit pressure.

MANUFACTURING

It’s been difficult to assess whether the economic policies currently ascendant in Washington  truly have achieved their job retention and repatriation goals. That reflects the fact t the signals currently out there to evaluate e quite mixed. So says a report from the Economic Innovation Group. They reviewed data on manufacturing employment

Pennsylvania’s manufacturing base, for example, now employs only two-thirds the number of people it did in 2000. The state would have to keep adding the same number of manufacturing jobs it did over the past two years—5,570 jobs annually—for another 35 years to get back to where it was 18 years ago.

Only five western states—Nevada, Alaska, North Dakota, South Dakota, and Utah—contained more manufacturing jobs at the end of 2018 than they did in 2000.  Those numbers may confirm or undermine some of your suppositions about these places. So we want to look a little deeper at the data.

Those numbers actually highlight some anomalies. Nevada did indeed have the highest rate of gain in that period. Are all the theories about cost, weather, taxes true? It’s hard to tell because the growth is in one place. A Tesla battery factory in Storrey County is the change. So, Nevada’s number isn’t quite so impressive.

In reality, the picture is mixed. Manufacturing has no doubt recorded positive job growth. As the report indicates, the employment surge was broadly felt but still uneven. A majority of counties (57%) saw their manufacturing growth rates improve, with either growth accelerating or decline slowing, over the first two years of the Trump administration relative to the last four years of the Obama administration.

Manufacturing’s expansion was broad-based across regions, but on average counties in western states saw the highest annual growth rates from December 2016 to December 2018. The South created the largest sheer number of new manufacturing jobs over the past two years: 173,900.

Here comes the old water. The jobs are often in sectors like food and beverages which are now considered manufacturing. It added 84,400 jobs to the economy from December 2016 to December 2018. The apparel and print-related industries combined were responsible for a loss of 28,700 jobs. Income data helps to account for why there is so much attention on wealth disparity. Manufacturing’s share of U.S. GDP has grown steadily since 2008, from 12% to 16%—increasing by a quarter. Manufacturing now contributes more to U.S. economic output than it did 10 years ago. However, manufacturing employment has been far surpassed by that of the professional services sector.

It also makes it harder to estimate revenues since service employment has often been harder to account for and tax than has been the case with income earned by employees  from traditional industrial employers. It also increases risk in that the merging tech based economy will by its very nature be much more mobile. The fact that one’s living will likely be less dependent upon being attached to one place or physical facility introduces a complication  the process of estimating, planning, and collecting revenues.

NYC JUST KEEPS SPENDING

The City of New York announced agreement on its budget for fiscal 2020. That’s the good news. It’s all downhill from here.  The budget, including capital spending, comes in at $92.6 billion. That means that NYC spending has increased some 23% above the level included in the Mayor’s first budget only five years ago. It is something t think about when the city complains when it is asked to pay for things like NYCHA and the MTA.

 It reflects a continuing trend of increases in soft spending – things like social workers in schools, quieter fire truck sirens. They reflect the priorities of the mayor who has never seen a program he does not want to spend on. In his view, “the things that we are investing in either, in some cases, are sheer need, things we must address for a variety of reasons or things that we think are the kinds of investments that make sense for this city and are manageable and affordable.”

The Mayor also contends that the city has accumulated reserves in amounts sufficient to support the spending through any downturn. Some might beg to differ. For example, the nonpartisan  Citizens Budget Commission estimates that a recession would reduce revenues by as much as $20 billion over three years, a number that dwarfs the city’s reserves.

The rate of growth in the level of spending by the City has been an issue of concern to us for some time. The Mayor has been extremely fortunate to have been in office during one of the longest periods of economic expansion in US history. The good economy has allowed increases in spending but has also created a sense of security about the City’s finances which we view as unwarranted.

The City’s personal income tax revenues remain concentrated among higher income residents. While the City has seen the economy reduce its dependence of the health of the financial markets, Given the sources of that income, the City remains vulnerable to financial market downturns . The declines in incomes would naturally hit the City’s real estate and service industries which could force the City to have to cut back spending (usually with a meat ax rather than a scalpel) quickly to avoid rapid draw downs of reserves.

One also has to account for the facts that term limits  have resulted in an inexperienced City Council when it comes to managing in a downturn. From a financial standpoint there will be plenty to cut in a downturn but, politically it will be much harder so much of the increased spending is in the area of social service which can be considered as “nice to haves” but not necessities. That lack of experience in a downturn would make managing such a period extremely difficult.

MEASURING THE IMPACT OF EXPANDED MEDICAID

A recent study in the journal of the American Medical Association (JAMA) asked “Has the expansion of Medicaid eligibility under the Affordable Care Act been associated with any differences in cardiovascular mortality rates?” It found that states that expanded eligibility for Medicaid had a significantly smaller increase in rates of cardiovascular mortality for middle-aged adults after expansion than states that did not expand Medicaid.

So amidst all of the debate which occurred in several legislatures around the country at least some facts were established. the study showed that “Medicaid expansion was associated with lower cardiovascular mortality and may be an important consideration for states debating expansion of Medicaid eligibility.” Other studies show that for  patients with end-stage renal disease, Medicaid expansion was associated with lower all-cause mortality.

This is one piece of non-political data which helps to explain the support for Medicaid expansion and the position of healthcare as one of, if not the leading, issue in recent polling. As a leading source of spending for states after education, trends in this area hold important clues as to the ability of states to keep budgets balanced in the face of rising healthcare demands.

As more data like this is developed and made available, pressure will increase to expand Medicaid access. This may be enough to put most of the remaining holdout states to the point where expansion makes sense.

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.

__________________________________

STATE FINANCIAL TRENDS

The Pew Charitable Trusts recently released t results of its survey of rends in state spending since the Great Recession. What initially caught our eye is the data on spending on education. We can’t help but note the correlation between decreased spending on public higher education and the rise of the cost of a college education and the concern about student loan indebtedness. It helps to explain the political pressure to increase spending to support institutions directly or to do it by providing tuition free access to the public higher education system.

Despite nearly 10 years of national economic growth—in what would be the longest U.S. expansion on record by the end of June 2019—states haven’t fully erased the effects of the recession. States still have not fully restored cuts in funding for infrastructure, public schools and universities, the number of state workers, and support for local governments. Nearly a fifth of states collect less revenue than before the downturn, more than a third have smaller rainy day funds, and almost half spend less from their general fund budgets than a decade earlier. Meanwhile, fixed costs—for Medicaid and underfunded public pension systems—are higher in almost every state.

The recession undercut states’ largest source of revenue: tax dollars. States missed out on an estimated $283 billion when collections fell and remained below 2008’s level until 2013 after adjusting for inflation.  Even though total state tax collections in late 2018 were 13.4 % higher than a decade ago, based on quarterly tax revenue collections adjusted for inflation, nine states still were taking in fewer tax dollars than at their peak before receipts fell in the 2007-09 downturn.

Spending from states’ general funds—the largest source of state expenditures—has surpassed pre-recession levels by 4.3 % after adjusting for inflation. In fiscal year 2018, 23 states still spent less in inflation-adjusted terms than in fiscal 2008. Spending in nine states in fiscal 2018 was more than 10 % below fiscal 2008 levels. Nowhere was spending down more than in Alaska—by nearly a third compared with a decade ago. Still, 14 states were spending at least 10 % more than at the start of the recession, led by North Dakota’s 53 % jump since fiscal 2008.

State financial support for higher education—the third-biggest slice of state budgets—was still 13 percent below its high before the downturn on a per-student basis after adjusting for inflation. States now rely primarily on tuition revenue from students and their families, rather than state support, to fund public higher education. Nationally, tuition dollars collected by public universities jumped 43 % per student from 2008 to 2018 after adjusting for inflation.

State financial support peaked at $9,248 per full-time-equivalent student in fiscal 2008 and fell by about a quarter to its lowest level of $6,888 in fiscal 2012. State support has partially recovered but still remained 13 % below fiscal 2008 levels in 2018, at $8,073 per student. In total dollar terms, this meant states spent $88.2 billion in 2018, 7 % less than in 2008 after adjusting for inflation. Preliminary data show that total nominal state support for higher education increased in 2019 for the seventh year in a row, though support is expected to remain highly sensitive to economic slowdowns.15

Seven years after the recession ended, state funding per pupil for public elementary and secondary schools—the largest area of states’ general fund budgets—stood at $6,745 nationally, below 2008 levels by about 1.7 %, or nearly $120 per pupil, after adjusting for inflation. State support per pupil was lower in a majority of states—29—in academic year 2016 compared with 2008, according to the most recent available data, and was down at least 10 % in nine of those states. Initial data for 2017 and 2018 show that more than 20 states continued to provide less per-pupil funding than at the start of the recession.

Primary and secondary schools receive roughly 45 % of their funding from the state, with a nearly equal share from local governments. The mix varies widely, so both funding streams are important in gauging the recession’s full effect on education. After the downturn, both state and local funding fell on a per-pupil basis when faced with declining tax revenue. Although the 50-state total for this combined funding has surpassed 2008 levels, schools in 20 states still received fewer dollars per pupil from state and local funds in 2016.

Wrapped up in school funding are teacher salaries, which on average were still below pre-recession levels in 2016 in real dollars. But how much teachers earn and who funds their salaries differ significantly by state. Even an increase in per-pupil spending doesn’t necessarily mean more dollars for salaries and classrooms. For example, an increase also could reflect rising pension contributions.

In the wake of the recession, state governments reduced investing in infrastructure. As a share of the economy, state spending on fixed assets—such as highways, sidewalks, airfields, electronics, or software—has been falling since 2009.20

In real dollars, state governments’ investments in infrastructure dropped by 3.2 % from 2007 to 2017, with ups and downs along the way. But infrastructure spending relative to gross domestic product (GDP) dropped almost every year between a 2009 peak and 2017, following more than two decades of stability. In fact, 2017 marked the lowest level of funding as a share of the economy in more than half a century. States’ declining infrastructure investment relative to GDP is a sign that spending on fixed assets has not kept pace with economic growth.

Because state-level data on infrastructure investment by category are unavailable, a look into combined investments by states and localities shows that infrastructure types were affected differently. For example, transportation structures—such as air transportation and mass transit systems—seem to have been prioritized, with a nearly 30 % increase in spending. Funding for highways and streets, which generally receive the most state and local infrastructure investment, dropped 6 % between 2007 and 2017, while spending on the second-largest recipient—educational structures such as schools—fell 14 % after accounting for inflation.

In the recession’s wake, many local governments had to manage with less money from their states. Total state aid to localities was down by 5.3 % at its post-recession low point in fiscal 2013 and was still slightly lower—by just 0.8 %—at the end of fiscal 2016 than before the recession after adjusting for inflation. But local governments in 26 states received less state aid in fiscal 2016 than in fiscal 2008, the last year before tumbling tax revenue led to budget cuts and forced states to cut spending. The decline in state aid to local governments ranged from less than 0.5 % in Pennsylvania to 22.8 % in Arizona compared with fiscal 2008. 

Cutbacks in state aid put a strain on local budgets and exposed cities and other localities to greater risk of financial problems. For local governments together, state aid is the second-largest source of revenue after tax dollars, and significant cuts can lead to difficult decisions about raising other revenue or cutting spending.

One way for states to cut spending during downturns is to reduce their payroll. Whether through early retirements, buyouts, or layoffs, state agencies can cut spending by shrinking their workforce. The 2007-09 recession was no different. Total state employment, excluding teachers and other public school staff, peaked at slightly above 2.8 million public employees in 2008 as states had not yet borne the brunt of the recession. After shedding almost 170,000 jobs and reaching its lowest point in 2013, the state workforce nationwide started to grow slightly. However, in 2018, more than a decade after the recession began, state governments across the U.S. still had fewer employees, having lost 4.7 %, or more than 132,000 jobs, from the peak.

With fewer workers on government payrolls, lawmakers’ options for reducing spending in a future recession are reduced. In addition to pent-up demand to restore spending cuts from the recession, states face the challenge of rebuilding rainy day funds to prepare for the next economic downturn.

At the end of fiscal 2018, these funds held more money than in any year on record. But at least 19 states still had smaller rainy day funds as a share of general fund operating costs than in fiscal 2007—the last full budget year before the recession hit. For many states, though, even pre-recession levels were inadequate to plug huge budget gaps caused by the last recession.

Seven states had less than a week’s worth of operating costs in rainy day funds in fiscal 2018, including Wisconsin (6.8 days), Kentucky (3.0 days), Illinois (0.1 day), and Pennsylvania (less than 0.1 day). Three had nothing: Kansas, Montana, and New Jersey. Although there is no one-size-fits-all rule for how much states should save, the clock is ticking on their chances to use the economic expansion to rebuild reserves.

Medicaid costs borne by the states surged following the recession after the phaseout of a one-time infusion of federal economic recovery dollars. The extra federal aid helped states deal with a spike in enrollment in the health insurance program for low-income Americans after people lost jobs and income during the downturn. Even after the economy improved, Medicaid continued to consume a greater share of state revenue than before the recession.

Nationwide, Medicaid expenses accounted for 17.1 cents of every state-generated dollar in 2016, compared with 14.3 cents in 2007, just before the recession. Although the federal government covers at least half of the total costs of insuring Medicaid recipients, the portion shouldered by states is their second-biggest expense after K-12 education. Higher Medicaid costs can limit what states have left to fund other priorities, such as schools, transportation, and public safety.

Preliminary figures indicate that the dollars states spent on Medicaid also increased in 2017 and 2018, even though a leading cost driver—enrollment growth—began to slow. Some of the increase was due to states for the first time picking up a small share of the costs of insuring newly eligible low-income adults under the Affordable Care Act’s optional expansion of Medicaid coverage. Through 2016, the federal government covered 100 % of the costs of the expansion population. States began picking up 5 % of the costs for this population in 2017 and will gradually increase their share to 10 % by 2020.

The recession didn’t cause states’ pension funding problems, but it did compound them—first, by reducing investment returns on the assets that states had saved to fund their employees’ retirements, and second by squeezing state budgets and making it even more difficult to fully fund their annual pension payments. As a result, the gap grew between how much states had saved and how much they needed to cover the pension benefits promised to public workers. The greater the gap, the more a state would need to set aside annually simply to keep its pension debt from growing.

As of fiscal 2016, states had enough set aside to cover just 66 % of their total pension liabilities, the lowest level since fiscal 2003 (the earliest available data). The shortfall between pension assets and liabilities amounted to a collective debt of $1.35 trillion by fiscal 2016, taking into account new accounting standards that raised the 50-state total by roughly $100 billion.

Greater than expected investment returns on the back of a booming stock market in fiscal years 2017 and 2018 helped shrink the 50-state total unfunded pension liability, though estimates show that it remained near historic highs. However, market losses in the first half of fiscal 2019 threatened to reverse the progress states may have made in whittling down their pension debt.

So no, it’s not your imagination. The recovery of state fiscal positions during the 10 year recovery from the Great Recession has been slow and sporadic. The data shows that states are significantly under investing in forms of capital. The lowest infrastructure spending in half a century and significant declines in higher education spending represent serious disinvestment in those forms of capital most likely to generate the highest returns going forward in a more technologically and knowledge based economy. And it leaves many states badly positioned for the next recession.

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

__________________________________

ALTERNATIVE ENERGY GETS A BOOST

Revolution Wind is projected to be a wind powered energy generation project to be built off the coast of Martha’s Vineyard. Last week, Rhode Island state regulators approved a 20-year power purchase agreement (PPA) for the power delivered by an offshore wind joint venture of Ørsted and Eversource Energy. Ørsted operates America’s only operating offshore wind farm – the 30MW Block Island Wind Farm, developed by Deepwater Wind – in Rhode Island. The five-turbine offshore wind farm has been in operation since 2016.

Revolution Wind would include about 50 turbines located in federal waters between Montauk, New York, and Martha’s Vineyard, Massachusetts. The state of Connecticut has also selected about 300 MW from Revolution Wind in a PPA. The project backers claim that Revolution Wind can deliver a quarter of Rhode Island’s total electric load. Once permits are in-hand, local construction work on Revolution Wind will begin as early as 2020, with offshore installation starting in 2022 and the project in operation by 2023. Offshore oceanographic and geophysical survey work began in 2018.

BALTIMORE HACKING TWIST

During the month that the City of Baltimore has spent recovering from the early May ransomware attack a persistent concern has been the discovery that the software which facilitated attack may have been something originally created by the National Security Agency. A program known as EternalBlue and other N.S.A. tools were stolen and released on the internet in 2017. Those tools have been cited in other attacks on municipalities. The NSA used EternalBlue for such spying for at least five years before the hackers stole the tool.

What’s maddening is that Microsoft issued a patch to combat these programs  2017. Yet, Baltimore never installed the patch. Apologists for the city suggest that

“the reality is that patching can be hard and requires resources that many municipalities don’t have.” To some extent true, but this seems to be more of an execution issue rather than a pure financial issue.

Some have suggested that the federal government should provide funding to protect local government computer stems. It would be a surprise to see that happen. Just the other day, the President said that people can vote twice, once electronically and once on paper ballots as a way to deal with foreign election interference. No one wants to admit that this is not just about money. It is about the relatively weak position that technology managers are in today versus the position of private vendors. The fear is that not only in terms of cybersecurity but also in terms of technology generally, states and municipalities are showing up at the tech gunfight with pea shooters.

IT’S A MORAL RATHER THAN A LEGAL OBLIGATION

The term seems almost quaint now. In an age of hyperlegalization, it is surprising  that the concept of the “moral obligation” has lasted this long. There was always a basic legal fact about all such debt. The obligation to pay was dependent upon an affirmative legislative act each year in order for debt serve to be paid. It was always thought that the failure to pay on appropriation risk debt would be considered to be tantamount to effectively defaulting  all debt. This led to an era of high acceptance of the “moral obligation” concept.

The “moral obligation” concept was born in a time when attitudes towards debts, defaults, and obligations were looked at much differently. In the ensuing 50 years, attitudes towards debt repayment, moral versus legal obligations, bankruptcy, and the like have all significantly changed. Increasingly, municipalities which helped to facilitate debt issuance, especially for private owned and operated projects, by putting their “moral obligation” pledge to make up revenue shortfalls at projects behind these deals. Investors historically looked at the practice as an extra source of security.

Now it is becoming clear that the “moral obligation” is not nearly as of much concern to borrowers as it once was. Penalties are hard to impose in this market as pools of investible cash wait n the sidelines and absolute l rate levels make the rate “penalty” much more manageable. So when faced with a choice between raising taxes, annoying constituents by cutting services, or sticking it to anonymous bondholders, the decision not to subsidize bad bond deals for private projects is not that hard a decision.

There are two ways for investors to react. They can scream and holler about a city’s willingness t meet a contingent liability. The second choice  to install some discipline into the investment process and buy deals that make economic sense. That decision does not need a court imprimatur, investors can do it themselves.

So against that backdrop, we view the announcement that a Missouri Circuit Court Judge issued a decision granting summary judgment in favor of Platte County in its declaratory judgment action against UMB Bank, N.A., the Trustee for bonds issued to finance a parking facility at a retail complex in the County. The bonds were secured by limited sales tax revenues and a “moral obligation” on the part of the County to appropriate funds to cover any debt service shortfalls. In the face of a budget shortfall away from this obligation and lacking political support for paying, the County has declined.

It is easy to lump this situation in with decisions in Detroit and Puerto Rico and see it as part of a trend. I see this as different from PR in that (not that it’s a better result for creditors) if the security requires regular appropriations for annual debt service then the County is likely within its rights to fail to appropriate. The retail facility is constantly offered for sale. There are relatively new current owners. The project defaulted on its mortgage. That’s not enough to trigger the “moral obligation” in the County’s view. Other smaller communities have done this and the predicted financial and market Armageddon hasn’t happened to them  at least from their point of view. The County budget is tight so they’ve decided it is worth this.

It’s not so much that courts are seemingly siding with bondholders. Populism is a real thing west of the Hudson, so the onus is on the investor to understand the legals. A moral obligation, like many other things is for better or worse not what it once was. It is also a trend. A hotel in Illinois, an ice rink in Minnesota, parking facilities all have been the subject of non-appropriation actions. This one won’t be the last.

ILLINOIS

As we post this week’s edition, the Governor was poised to sign several pieces of significant legislation to implement  several provisions of the budget. The Legislature took advantage of the ability to coordinate which resulted from the Governor’s decisive election margin in the Fall. The Governor had been upfront during the campaign about his priorities so the political atmosphere had changed significantly than was the case during the Rauner administration.

Two pieces have a direct credit impact The first is the approval of legislation to lay the groundwork for voters to vote on a constitutional amendment to convert the state’s income tax from a flat tax to a graduated rate schedule. The second piece included a vote to raise vehicle fees, double the gas tax to 38 cents per gallon, expand casino gambling in the state, and legalize recreational marijuana and sports betting.

The casino legislation will allow a casino to be opened in Chicago and established provisions for the distribution of revenues to among others the City of Chicago. The marijuana legislation provided a structure for revenue allocation and distribution of those revenue. Included among the revenue dedications, the law provides for 10% of marijuana derived revenue to be applied specifically to the State’s unpaid bill backlog. The new budget also includes an elimination of the state’s franchise tax, the reinstatement of a tax incentive to help manufacturers and a new tax incentive to support data centers in Illinois.

Clearly, the state is on a different track under the new Governor. At the same time, the State still faces significant problems. The largest of the festering problems is that of pensions. That is the one area that proved most difficult to address. The difference now is that the Legislature and the Governor are no longer locked into a ideological battle that yielded at best a stalemate while the State’s ratings were battered. Pension reform will be a long process given the need to amend the State Constitution to enable real change to occur.