Joseph Krist

Publisher

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CITY REVENUE OUTLOOK

The National League of Cities has released the results of its annual survey of City Fiscal Conditions. This year’s City Fiscal Conditions research looked at the fiscal conditions and factors across 500+ U.S. cities. It found that almost two in three finance officers in large cities are predicting a recession as soon as 2020. Cities’ revenue growth stalled in the 2018 fiscal year, but this year’s continued drop indicates mounting pressures on city budgets. The Midwest is bearing the brunt of declining conditions, the report found. Overall general fund revenues in Midwestern cities dipped by 4.4% in fiscal year 2018.

In fiscal year 2018, total constant-dollar general fund revenue growth slowed to 0.6 percent. Income tax and property tax revenues slowed, while sales tax revenue growth was unchanged from the prior year. Property tax revenues grew by 1.8 percent, compared to 2.6 % in FY 2017. Sales tax revenues grew by 1.9 %, compared to 1.8 % in FY 2017. Income tax revenues grew by 0.6 percent, compared to 1.3 percent in FY 2017. expenditures are climbing, increasing by 1.8 percent in fiscal year 2018. While that’s a growth rate is slightly lower than the prior three years, officials also expect it to climb again to 2.3 percent for fiscal year 2019. Infrastructure needs, public safety spending and pension costs are among the most significant expenditures.

The data shows the impact of the continuing decline in manufacturing and the impacts of tax and trade policies and their very detrimental effect on the Midwest. Overall, revenues in Midwestern cities declined 4.4%. Much of that appears to be driven by  large revenue drops   in big cities. Chicago, Illinois, recorded an 11.7 percent revenue decline in fiscal year 2018 while Minneapolis, Minnesota, dropped by 9.6 percent. According to the NLC survey, finance officers from large (63%) and larger mid-sized cities (49%) are more likely than finance officers from smaller mid-sized cities (38%) and small cities (35%) to predict that the next recession will occur in the next one to two years.

The NLC attributes the difference in outlook to a couple of factors. large cities are experiencing a bigger gap between revenue growth and spending growth than their smaller counterparts. Housing market growth is also reaching its peak in large cities and is already slumping in some large West Coast cities such as Seattle, Washington, and San Francisco, California. June home prices for  major West Coast cities fell for the first time since 2012, declining by 1.7 percent. Business investment in 2019 is also on the decline, a metric which tends to hit larger cities first.

The report reiterates the leading pressures on local budgets. Infrastructure needs, public safety needs and pensions were reported as the top three burdens on city budgets in 2019. At the same time, the survey revealed several trends on the revenue side of the credit equation that should give one pause. Sales and income tax growth rates peaked in 2015 and growth rates for property taxes peaked a year later. Another source of concern is the growth of state level preemptions which limit local powers to tax and regulate. For example, this year the Texas state legislature signed into law a bill to cap local property tax revenue growth at 3.5%. In addition to preemptions that have been in place for years in states like Michigan and Colorado, new legislation was passed this year to cap local spending in Iowa, to require elections for tax increases in Texas, and to prevent cities from imposing their own commercial activity taxes in Oregon.

Put all of this together and one begins to ask, at current market conditions do I get paid for the risk I’m taking? It’s not so much a question of whether the market is most effectively pricing municipal debt relative to different asset classes but rather a question of whether current absolute rates generate a sufficient reward for the risk potentially being assumed. It’s clear that the best days for revenue growth have passed while the same pressures  plaguing local budgets have not subsided and in many cases have increased. We don’t propose the end of the world as we know it but we do wonder when the market will wise up and asked to be paid for the risk they take.

NEW YORK MAKES ITS CHOICES

The war on mass transit continues in New York City. The MTA continues to scramble to find funding for projects expanding access in poor neighborhoods (the Second Avenue subway extension to 125th Street), improving accessibility for the disabled and the aging, and maintaining its capital plant in general. The affordable housing crisis continues with the revelation that there are some 110,000 homeless students enrolled in the City’s public schools ( that’s a lot more than the City’s regularly peddled number that there are 60,000 homeless overall in the City). Not to say that the NYCHA is in a bit of a funding pickle for capital themselves.

So what has the City government agreed on for $1.5 billion in spending over a ten year period? 250 miles of protected bike lanes. Lanes by the way which are paid for by some sort of user fee, right? Some form of safety regulation (helmets) or insurance requirement? Some form of revenue generated from the user base (even the farebox covers a much higher % of operating costs than most other US transit systems)? No. None of that. Instead, the City will spend this money which intentionally or not really covers a very specific cohort (white males under say 45) at the expense of other more diverse population cohorts.

In the end, it’s up to the City to do what it wants but it is fair to question the capital priorities especially when there is no connection between use and funding of an asset. It’s one side of the dilemma posed by the advances of various modes of micromobility. Until the issues of funding relative to utilization are more clearly established, issues not directly related to transportation will continue to intrude on the debate over the future of transportation.

CHICAGO BLUES

This is shaping up to be a tough budget season for the City of Chicago. The Mayor’s budget proposal is receiving lukewarm support from a variety of constituencies. Many are expressing concern about the need for the state to take actions in order to allow the City to address its revenue and pension problems. And the teachers strike against the Chicago Public Schools continues. The longer it goes the more vicious the cycle gets as more people will look for permanent alternatives to CPS schools. With each passing day, the district doesn’t get aid based on average daily attendance.

It can be hard to see through the rhetoric of this strike. The union is taking on a variety of issues outside of traditional workplace issues. They are attempting to direct funds from tax increment districts. According to the Chicago Tribune, TIFs now cover about one fourth of the city’s real estate, including some areas downtown. The city can redirect money from TIF districts that isn’t committed to specific projects through a process called declaring a surplus. Mayor Lightfoot has proposed declaring a record $300.2 million TIF surplus in 2020. That’s up from the $175.7 million this year that Emanuel included in his final budget. As the biggest taxing body, CPS stands to collect $163.1 million of the proposed $300.2 million surplus.

We do not take the view that the City is in danger of default. What we do however believe is that investors need to be compensated for the risks they are taking in connection with the direct debt of the City or the schools district. These entities are fortunate that absolute market levels provide reasonable borrowing costs for both new money and refunding purposes. In a market where rates rise and are expected to continue to do so, credits like the City of Chicago and the CPS are in a position to get hammered in terms of spread.

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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MAJOR SYSTEM SETTLES ANTI TRUST CHALLENGES

Sutter Health, a large Northern California nonprofit health care system with 24 hospitals, 34 surgery centers and 5,500 physicians, has announced a preliminary settlement agreement in an antitrust case brought originally by private interests but joined by California’s Office of the Attorney General. Sutter stood accused of violating California’s antitrust laws by using its market power to illegally drive up prices.

The case shone a light on many of the aspects of the issue of healthcare costs – what drives them and how they can be controlled. As systems grow and consolidation continues, many of the same issues raised in this case appear in the evaluation of other mergers. They involve a number of significant interests – the hospitals, insurers, state and federal government – all of whom are positioned to advance their particular interests.

Some aspects of the Northern California marketplace made Sutter a convenient target. The chain of health care facilities had $13 billion in operating revenue in 2018. A University of California, Berkeley study from 2018 found that health care costs in Northern California, where Sutter is dominant, are 20% to 30% higher than in Southern California, even after adjusting for cost of living.

The settlement is expected to address the issue of negotiations between providers and insurers. Sutter is known as an aggressive bargainer but that is true of other large systems across the country. Merger opponents seize on these negotiations as a source of price inflation. In terms of the immediate impact on the Sutter credit, that likely will not be publicly revealed until 1Q 2020. There were estimates that Sutter could have had monetary exposure of up to $2.7 billion according to press reports.

PROVIDENCE SCHOOLS FACE STATE CONTROL

It was recently announced that the State of Rhode Island would take over the operation of the Providence Public School System. The action comes after the release of an outside report produced by Johns Hopkins University (Aa2 stable that highlighted the system’s  significant academic and administrative deficiencies., The state’s takeover, prompted by poor academic outcomes rather than financial difficulty, takes effect November 1 and will continue for at least five years. The school system is a unit of the city, which is responsible for its debt.

Schools are the largest single source of expenditure for the City. It is important to note that this action was not driven by finances. The state education department has sweeping powers to assume budgetary, governance, programmatic and personnel control of chronically underperforming school districts. The state education commissioner is crafting a turnaround plan for the Providence schools and the state is expected  appoint a turnaround superintendent in the coming weeks. PPSD’s board comprises nine members appointed by the Providence mayor and approved by the City Council.

So this is not a credit event for the schools but it could have some benefit for the City’s overall financial position. In fiscal 2018 (ended 30 June 2018), 58% of PPSD revenue was from the state, 31% from local sources and 11% from federal funding. The state presence likely reduces the need for the city to increase its own funding of the school system, including the growing cost of educating English-language learners, which is considerable given the city’s diverse population. The action comes at a time when the City’s finances are still considered to be vulnerable. Moody’s correctly points out that a weak educational system generally has adverse social effects, making a city a less desirable place to live and less attractive to businesses. If the Providence takeover leads to material improvement in school quality, the city’s socioeconomic profile will improve.

The state has controlled the Central Falls School District (CFSD) since 1993, when CFSD was unable to meet financial obligations absent increased state funding.  

PUBLIC POWER IN CALIFORNIA

The role of private utility generation and transmission assets as sources of wildfire risk has focused enormous attention on California’s investor owned utilities. This week, tens of thousands of Californians could be without power again this week as two major utility companies consider shutting off electricity to large swaths of the state amid heightened concerns that hot weather and strong winds could lead to wildfires. PG&E may shut off power in 17 California counties as dangerous winds return. More than 17,000 Southern California Edison customers in five counties — Los Angeles, San Bernardino, Orange, Santa Barbara and Ventura — are also under consideration for power outages in coming days.

One of the city’s without its own integrated public power system is San Jose. In San Jose, somewhere around 60,000 residents went without power for a couple days in the last series of rolling blackouts.  This is motivating support for investigating alternatives to reliance on PG&E in the City. The mayor has announced that he is directing staff to study the feasibility of creating a municipal utility. That would potentially require the city to purchase power lines off of PG&E and to finance construction of microgrids and energy storage systems.

San Jose already buys energy outside of PG&E through its own provider, San Jose Clean Energy. But PG&E controls energy transmission. The mayor is trying to shift the city into increased reliance on solar even though the city also ranks third in the nation for solar power generation per capita. 

The city of Santa Clara has run its own electrical utility for more than a century, offering lower rates and higher ratios of clean energy than PG&E.  San Jose officials plan to poll residents in the fall to gauge public interest in having the city acquire PG&E’s distribution lines and invest in microgrids. If voters say they don’t want San Jose to buy PG&E infrastructure,  the city will push forward on its efforts to develop microgrids.

SF HOUSING BOND

The median home sales price in San Francisco is $1.35 million. The median rent of a one bedroom apartment is $3,700 per month. The City’s affordable housing woes are well documented. The City has previously sought approval for bonding authority to address the crisis as recently as 2015. Now, the City seeks additional authority on the November 5 ballot.

If Proposition A passes, the city would borrow $600 million dollars to construct 2,800 new affordable housing units. Part of the money would go toward repairing existing public housing developments that have become dilapidated. Other parts would finance the building or buying of low income housing. The bonds would be paid from the proceeds of a tax on homeowners in San Francisco at nearly two cents for every hundred dollars in assessed property value. So if your house is worth that median $1.35 million, you’d pay about $256 in additional property taxes a year.

The proceeds would be spent as follows: $150 million for public housing, $220 million for low-income housing, $60 million for middle-income housing and preservation, $150 million for senior housing, and $20 million for educator housing. Another proposition, Prop. E would allow 100 percent affordable and educator housing to be built on public land.

Teacher unions have offered data which shows that 64 percent of its teachers pay more than 30 percent of their income on housing, making them officially rent-burdened, and almost 15 percent spend more than half.  It is a phenomenon which is being replicated in cities across the country, impacting not only but teachers but the vast majority of municipal employees.

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

Publisher’s Note: We took an unanticipated hiatus to deal with some medical issues. We should be back to our weekly publishing schedule. We appreciate your indulgence.

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NEWARK WATER

It did not seem to get as much publicity as one might expect given that it is the state’s largest city but the lead pipe contamination situation facing Newark, NJ is moving towards a resolution. There was rightfully much concern about the potential costs of a remediation for a city which has long faced financial difficulties. It was clear that the cost of remediation would be substantial and that the City would need some outside financial assistance to address the water problem.

So it was very positive to see the news that federal legislation was signed that allows the State of New Jersey  to provide financial assistance to Newark  that would help the city remediate lead in its drinking water, a credit positive. State assistance, combined with $155 million Newark will receive from a settlement with the Port Authority of New York and New Jersey , would be used to service $120 million in debt the city plans to issue for the lead remediation.  The Port Authority settlement will generate $5 million upfront and $5 million per annum for 30 years.

The legislation permits the state to transfer certain federal funds to its drinking water revolving fund to be used for lead remediation. The state has not yet allocated or promised any of these monies to Newark. The $120 million debt issuance will increase Newark’s leverage, though the degree is limited. Debt will increase to 4.8% of fiscal 2019 equalized value or 1.06x 2017 current fund revenue, up from 4% and 0.88x.

The situation has shown that when governments get together to address situations like these, a resolution is possible. The Port Authority’s participation is key. So too is the fact that Essex County, where Newark is located, will be guaranteeing the city’s debt issuance. Because Essex has much stronger credit quality than Newark, the guarantee will help the city cut borrowing costs, which the city and county estimate could save Newark as much as $15 million over the life of the bond.

The situation in Newark has highlighted the significant use of lead piping especially to convey water to individual residences. The Governor has announced a plan to issue $500 million of bonds to pay for some of the costs of removal and replacement of existing lead piping. A proposal for a bond authorization would appear on the November 2020 ballot if such a plan is approved by the Legislature.

JEA PRIVATIZATION

Jacksonville Florida has taken the next step in its effort to divest itself of its integrated utility system. The City received 16 bids from a variety of private utility interests. Information about who the bidders are is not coming from the City which has adopted a somewhat opaque approach to the whole process. The bids were presented in sets of boxes which the City made a show of opening but concealing any details. JEA is using an unusual “invitation to negotiate” process that keeps information under wraps during the evaluation and negotiation stages. After JEA staff announces an intent to award all the records and tape-recordings of the meetings will become public record.

Nonetheless, some of the bidders disclosed their participation in the bidding. NextEra Energy, the parent company of Florida Power & Light, Duke Energy, and Emera, which owns Tampa Electric and Peoples Gas have disclosed that they have bid.  JEA will need to cover costs of eliminating several billion dollars of debt, $400 million in one-time customer rebates, $132 million in pension benefits for employees, $165 million in retention bonuses for JEA workers and a cash payment of at least $3 billion to City Hall. Estimates are that To purchase the entirety of JEA’s electric and water operations, a bidder would need to be able to pay at least in the range of $6.8 billion to $7.3 billion. 

There are arguments on both sides of the issue of the process being used by city officials. The opacity of the process is probably more comfortable for the private entities in the negotiation but it does raise issues of perception. This might raise some unnecessary barriers in the approval process. If the JEA board agrees to do a deal, it would go to the City Council for it to decide if the deal makes sense for city government and the community. The City Council can either approve or reject a deal. Approval would send the terms and conditions to Duval County voters for final say in a voter referendum.

The potential for unnecessary perception issues to arise has not gone unrecognized. The city Inspector General and Ethics Director have expressed their intention to sit in on the negotiations. The city is contacting inspector general offices throughout the country to see what “best practices” they use for such closed-door negotiations.  The Authority intends to decide over the next two weeks which respondents will move to the next stage of entering negotiations with JEA.

CALIFORNIA UPGRADE

Moody’s Investors Service has upgraded to Aa2 from Aa3 the rating on the State of California’s outstanding general obligation (GO) bonds. Here’s their rationale. ” The upgrade of California’s GO bonds to Aa2 incorporates continued expansion of the state’s massive, diverse and dynamic economy and corresponding growth in revenue. The action also recognizes the state government’s disciplined approach to managing revenue growth indicated by its use of surplus funds to build reserves and pay down long-term liabilities. At the upgraded rating, these strengths balance several challenges that will persist. The most significant challenges include high revenue volatility given the state’s heavy reliance on income taxes, lower flexibility to adjust spending and raise revenue compared to other states, and above average leverage and fixed cost burdens. The upgraded rating still reflects certain social challenges relative to other US states. These include a high rate of poverty when accounting for the state’s elevated cost of living, and very expansive public support of the lower income population that would present the state with difficult spending and policy decisions in the event of reduced financial support from the US government.”

Well now we have until the next recession to see if the California credit has become any less exposed to its historic level of volatility, reflecting its income tax dependence on a relatively small percentage of taxpayers at the high end of the income scale. The State still faces awesome capital needs and its increasingly difficult housing market is becoming problematic for the economy. The state also faces issues from federal immigration policies which contribute to reductions in population in certain primarily urban areas. Historically in many cities, immigrants make up for the well documented phenomenon of population movements in search of more affordable housing costs. These, along with pension and climate related costs, weigh on a potentially higher rating.

PR CREDITORS HAVE THEIR DAY AT THE SUPREME COURT

The Supreme Court heard arguments in the challenge to the authority of the PROMESA financial control board. The creditors in this case contend that the board was appointed in violation of the US Constitution. The dispute is over whether the oversight board supervising Puerto Rico’s finances is actually a federal agency whose members must be presidential nominees confirmed by the Senate, or an entity structured by Congress under its authority to administer the U.S. territories. To date, it has operated as a Congressionally structured entity.

Aurelius has a heavyweight counsel representing them before the Court, Ted Olson. That didn’t prevent the justices from challenging the Aurelius arguments. Aurelius has historically taken aggressive stands in other sovereign debt cases. This time, Justice Brett Kavanaugh suggested that if the creditors’ definition of a federal officer requiring Senate confirmation was correct, it could put territorial self-government in jeopardy.

The Board argues that Congress specifically invoked its territorial powers in creating the board, directed it to work in Puerto Rico’s interest and insulated its members from political interference by giving them three-year terms during which they could be removed only for cause. This led to Justice Sotomayor to ask “How you can label this a territorial officer as opposed to a federal officer…when none of the people of Puerto Rico have voted?”

When the federal appeals court in Boston ruled in February that the board’s members were federal officers requiring Senate confirmation. At the same time, it suggested a remedy – the Senate could vote to confirm the members—President Obama’s appointees who, as a backstop, subsequently were nominated by President Trump. That was noted by the Justices who suggested that this could be accomplished quickly, obviating the need to dismantle the board and throw a huge delay into the debt restructuring process.

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.