Joseph Krist

Municipal Credit Consultant

CHICAGO TAKES ANOTHER CREDIT HIT

Already facing a short term pension crisis, the City of Chicago suffered a severe body blow today when the Illinois  found unconstitutional a law that sought to cut benefits and require employees to pay more toward their retirement. The state’s high court agreed with a Cook County judge who found that the state law that Mayor Rahm Emanuel pushed through in 2014 violated a clause in the Illinois Constitution that states pension benefits once granted “shall not be diminished or impaired.” “These modifications to pension benefits unquestionably diminish the value of the retirement annuities the members of (the city workers and laborers funds) were promised when they joined the pension system. Accordingly, based on the plain language of the act, these annuity reducing provisions contravene the pension protection clause’s absolute prohibition against diminishment of pension benefits, and exceed the General Assembly’s authority,” the justices wrote in their opinion.

Losing the case frees up some money in the short term because the Emanuel administration won’t have to pay as much money into the two pension funds for non-uniformed municipal workers and laborers. But for the police and firemen’s funds a looming year-end budget shortfall has forced Mayor Rahm Emanuel’s administration to borrow $220 million in yet another sign of the city’s precarious pension funding status. The city drew the money down from its $900 million line of short-term credit, which carries an interest rate of about 3 percent. The money is not due to police and fire pension funds until the end of the year. But the city had to borrow the money to meet a March 1 deadline for having the cash in its treasury. State law requires that the city deposit the money with the treasurer to demonstrate it has the money available if it’s needed. The city doesn’t expect to raise enough from property taxes so, it must deposit the anticipated shortfall by March 1.

The City Council voted in October to increase property taxes by $543 million annually in phases over four years, with nearly all of the money dedicated to police and fire pension fund contributions. But that budget still depended on Gov. Bruce Rauner to sign a bill that would stretch out the payments and reduce this year’s cost by $219 million. Although the state House and Senate, both controlled by Democrats, approved the bill, they have not sent it to the governor for fear he’ll veto it if they don’t sign on to his pro-business, union-weakening agenda. The governor’s spokesman has said Rauner would sign the bill only “as part of a larger package of structural reform bills.”

That argument has been keeping the state from approving a budget for more than eight months now. And there’s no end in sight to that stalemate, given that last week’s primary elections did not change the state’s partisan political landscape despite the record amounts of money spent on some General Assembly contests. If the governor signs the bill, the city will return the $220 million to its line of credit. If not, it goes to the police and fire pension funds at the end of the year. If the bill isn’t signed, the city will have to pay off the $220 million loan. That could mean service cuts, further tax increases or both. Some political observers believe the Springfield logjam could break after the November general election. But if the Chicago police and fire pension bill is not signed by Rauner, the city could end up more than $1.2 billion short over the next five years.

An additional negative concern is that leaders of one pension fund think the city has to pay up well before the end of the year. The Firemen’s Annuity and Benefit Fund of Chicago board last week voted to notify city Treasurer Kurt Summers that it expects the city to remit $47 million — its share of the $220 million — to the pension fund within 31 days of depositing the borrowed cash. The police and fire retirement fund shortfalls aren’t the city’s only pension concerns. If the court upholds the trial court determination that the law is unconstitutional, the city would no longer be obligated to make the increased contributions, but the shortfall would continue to grow — meaning the city would have to pay more over the long haul. That could ultimately mean even higher property taxes.

PR SHOWS ITS HAND

Seven-members of the Supreme Court (Justice Samuel Alito recused himself from the case because of a financial conflict and no one has yet replaced the late Justice Antonio Scalia) heard arguments urging them to overturn a ruling last year by the U.S. Court of Appeals for the First Circuit in Boston, that concluded the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (DERA) is illegal. The appeals court sided with funds that hold over $2 billion of bonds by the Puerto Rico Electric Power Authority and concluded that DERA violates a section of the U.S. Bankruptcy Code that prohibits states from passing laws allowing their authorities to restructure debt without the approval of those entities’ creditors. The  high court is expected to rule on the case by June.

But even if four of the seven Justices rule in favor of Puerto Rico and overturn DERA, several of them seemed to be concerned that DERA might violate the contract clause of the U. S. Constitution, which prohibits states from impairing private contracts. The lawyer for the Commonwealth told judges the contract clause issue could be argued if the case is remanded back to the appeals court, but it is not an issue before the high court.

Congress could eventually pass legislation that either gives, or refuses to give, Puerto Rico or its authorities bankruptcy protection under Chapter 9 and that measure would supersede any ruling by the Supreme Court.

During oral arguments the lawyer representing hedge fund BlueMountain Capital Management as well as Franklin and Oppenheimer funds was asked, “Why would Congress put Puerto Rico in this never-never land, that is, it can’t use Chapter 9 and it can’t use a Puerto Rico substitute for Chapter 9?” Puerto Rico “is locked out … It has to take the bitter but it doesn’t get any benefit at all,” she said. Justice Sonia Sotomayer, said, “It is inherent in state sovereignty that states have to have some method, their own method, of controlling their municipalities.”

The Commonwealth’s attorney argued that two sections of Chapter 1 of the bankruptcy code serve as a “gateway” that keeps Puerto Rico out of Chapter 9 altogether, including Section 903(1) which says state law cannot prescribe “a composition of indebtedness” that bind creditors without their consent. Section 101(52) of the code says in part that the definition of state “includes the District of Columbia and Puerto Rico” except for the purposes of defining who may be a debtor under Chapter 9.”

Section 109(c)(2) of the code says an entity is only a debtor under Chapter 9 if it “is specifically authorized, in its capacity as a municipality or by name, to be a debtor under such chapter by State law, or by a governmental officer or organization empowered by State law to authorize such entity to be a debtor under such chapter.” The Commonwealth feels that section means Puerto Rico is categorically precluded from authorizing its municipalities to enter Chapter 9 and that it is simply not part of Chapter 9.

The justices noted that the bankruptcy code does not mention Guam or the Virgin Islands and wondered if Congress intended to treat the territories differently. (The Menendez legislation does.) Roberts asked why it doesn’t make sense to think Congress wanted to keep Chapter 9 for the states and make the territory come to it for help. In response to the argument that it would be very anomalous [for] Puerto Rico [to be] in a worse position, let’s say, than Guam and the Virgin Islands, Roberts asked why did Congress lump Puerto Rico with the District of Columbia in saying in the bankruptcy code that there were not states except for the purpose of defining who would be a debtor under Chapter 9.

Ginsburg also asked the hedge funds’ lawyer, “What explains Congress wanting to put Puerto Rico in this anomalous position of not being able to restructure its debts?” His answer was that Congress has always micro-managed Puerto Rico’s debt, citing a change to the Jones Act aid that limited the amount of debt it could take on. Second, he said, Puerto Rico debt is triple tax-free and therefore is held by bondholders all over the U.S. Finally, he noted, when Congress amended the bankruptcy code in 1984 to say Puerto Rico is a state except for defining who a debtor is under Chapter 9, it was concerned about the amount of indebtedness of both Puerto Rico and D.C.

The real strategy of the current PR administration was reinforced after the hearing. Resident Commissioner Pedro Pierluisi said “it continues to be my view that the most responsible course of action is not to wait for the Court to rule, but rather for Congress to swiftly enact legislation that, on the one hand, authorizes Puerto Rico to restructure a meaningful portion of its debt and, on the other hand, establishes a temporary and independent board that enables the Puerto Rico government to engage in more disciplined fiscal policymaking, to publish transparent and timely financial information, and to regain access to the credit markets on reasonable terms. The board can also between debt-issuing entities and their creditors and serving as a gatekeeper before any debt-issuing entity can ask a federal judge to make a restructuring agreement  binding on all creditors.”

FERTILIZER PLANT FAILS TO YIELD A GOOD CREDIT

Back in 2012, over $1 billion bonds were issued by the Iowa Finance Authority under its Midwestern Disaster Area Revenue Bond program on behalf of the Iowa Fertilizer Company. Iowa Fertilizer was a subsidiary of an Egyptian based production company. At the time, the issue generated much controversy due to the foreign ownership of the Company and its use of materials that were considered to be useful to terrorists. The plant was also being built shortly after a massive explosion at a Texas fertilizer production facility had occurred. Many questions were raised as to the appropriateness of the use of tax exempt financing in such a large amount for such a foreign owned project.

That facility is back in the news for more traditional high yield market reasons. The company behind a $1.9 billion fertilizer plant under construction in southeast Iowa stopped making payments and held on to tools of one of the project’s contractors, according to a lawsuit filed in U.S. District Court. In the lawsuit, the contractor claims Orascom E&C USA hired the company to work as a subcontractor on the fertilizer plant. The company claims Orascom E&C paid it for its work up until September 2015.

According to the suit, after that date Orascom E&C stopped making payments. Maintenance Enterprises says Orascom E&C has made no payments regarding certain work since Oct. 29, 2015. Overall, Maintenance claims Orascom E&C owes it more than $53.4 million. Maintenance also claims Orascom E&C “physically barred” the company from removing small tools, protection equipment and other property Maintenance says it purchased for use on the plant. Maintenance has filed a mechanic’s lien with the Iowa Secretary of State’s office against the Iowa Fertilizer property for more than $50 million. It is not the only company to issue a mechanic’s lien on the property.  Other liens include one for more than $119 million filed by Texas-based RW Constructors. Liens for millions of dollars each have also been filed by companies based in Iowa, Illinois and Washington.

Now the bond trustee has informed holders of the bonds that the commissioning of the plant has been delayed due to construction delays. The EPC Contractor is revising the Mechanical Completion and Provisional Acceptance dates. This has resulted in the Company incurring additional administrative costs during the delay period. In order to complete the project, the Company will need to rely on funds outside of the Committed Funds, as defined in the Collateral Agency Agreement, such as profits from production earned prior to Provisional Acceptance, cash deposits by customers on fall prepay sales customary for the Midwest fertilizer market, and potentially support from its parent. OCI N.V., the ultimate parent of the Company remains committed to completing the project.

The Company is required to provide notice within ten business days that it filed a Requisition with the Collateral Agent in accordance with the Collateral Agency Agreement. The Company filed such a Requisition on February 22, 2016, which will be disbursed from the Equity Construction Account in accordance with the provisions of the Collateral Agency Agreement. The Company did not satisfy the requirement of the Collateral Agency Agreement, providing for a certification by the Company on each requisition that Provisional Acceptance  can be achieved by the Scheduled Provisional Acceptance Date. The Company did not satisfy the requirement of the Collateral Agency Agreement, providing for a certification by the Company on each requisition that Other Project Costs are not reasonably expected to exceed amounts budgeted therefore in the aggregate in the Other Project Costs Budget.

The Company also did not satisfy the requirement the Collateral Agency Agreement, providing for a certification by the Company on each requisition that the Committed Funds are reasonably expected to be sufficient to complete the Project according to the terms of the EPC Contract and the Other Project Costs Budget. The Collateral Agency Agreement provides that, due to the omission in Requisition 38 of the certifications, any subsequent requisition submitted by the Company that omit any required certification shall not be funded by the Trustee and Collateral Agent if the beneficial owners of at least a majority of the aggregate principal amount of the outstanding Series 2013 Bonds direct the Trustee and Collateral Agent not to fund the requisition. After the payment of Requisition 38, the remaining amounts on deposit with the Trustee and Collateral Agent for Project costs are $41,038,647 in the Equity Construction Account of the Company Construction Fund, $0 in the Equity Contingency Account of the Company Construction Fund and $0 in the Indenture Construction Account.

This all matters because if the plant can’t be completed and operated hence the bondholders will have to rely on debt service reserves and the willingness of the foreign owner to provide additional funds for debt service. If the market is concerned it isn’t showing up in prices with bonds trading through the coupon below 5%. One has to ask if that is enough to compensate for the risk.

ATLANTIC CITY BRINKMANSHIP CONTINUES

The mayor of this New Jersey resort city said on Monday that dismal finances would force a three week long shutdown of all nonessential government services starting early next month if the city does not get state aid. Mayor Donald Guardian, a Republican, said the shutdown would start on April 8 and was likely to last until at least May 2, when quarterly tax revenue is set to arrive. Police, fire and sanitation workers would perform their jobs without pay but would be paid when the tax money came in. Mr. Guardian said the city could be in a similar situation in a couple of months, especially if the state withheld aid. The city’s tax base has contracted since four of its 12 casinos closed. State lawmakers are debating a financial takeover plan that Mr. Guardian said goes  too far in wresting control from city officials. The comments reflect the conflict between the City and Governor Christie who in his usual low key way said that he would not sign the legislation if “one word” in it was changed.

MUNIS REMAIN AT THE FOREFRONT ON NEW NUCLEAR DEVELOPMENTS

From 2029 to 2035, three dozen of the nation’s 99 reactors, representing more than a third of the industry’s generating capacity, will face closure as their operating licenses expire. Nuclear energy, which provides 19 percent of the nation’s electricity but has struggled in recent years to compete against subsidized solar and wind power and plants that burn low-priced natural gas. Industry advocates say that by removing sources of clean electricity — a nuclear reaction produces no carbon dioxide or other greenhouse gases — the closings could affect the government’s ability to fulfill its pledge, made at the Paris climate talks last year, to reduce emissions.

The Southern Co. with whom the Municipal Electric Authority of Georgia participates in nuclear generation, announced in January that it would receive up to $40 million from the Department of Energy to develop an advanced reactor that uses molten salt as a coolant instead of water, which all current designs use. The process is being developed by a company called NuScale. It’s design has been under development since 2000. It has lined up a potential first customer, Utah Associated Municipal Power Systems, or UAMPS, which operates in the Intermountain West, and hopes to have 12 of the small reactors operating at a site in Idaho by the mid-2020s. NuScale has been testing its design for 13 years, using a nonnuclear prototype. Later this year, it plans to submit an 11,000-page application to the N.R.C. to have its design certified. The commission then has up to 40 months to review the application.

The certification process, and a later application by UAMPS for a construction and operating license, could be delayed if the N.R.C. asks for more information. But even if all goes smoothly, the plant will produce only about half the electricity of many existing reactors. About 50 of these 12-reactor plants would be needed to replace the generating capacity that could be lost by 2035. Many hope that extending the licenses of existing reactors will forestall at least some closings. Nuclear plants were originally licensed for 40 years, but almost all have sought and received 20-year extensions.

The regulatory commission has begun researching what would be required to extend a plant’s life to 80 years. “We’re asking very basic questions, like how long can a reactor vessel remain acceptable since it’s being bombarded by neutrons,” said a spokesman. “The information we have at this point is that those are issues that are not showstoppers.” So far one operator has announced plans to seek such an extension, for two reactors set to close in the early 2030s, but an application and possible approval are still years away. Duke Energy, owner of the Robinson plant in South Carolina, said it was evaluating whether to pursue an extension.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

LOWER LAND DEAL DEFAULTS ARE NO SURPRISE

Recently it was observed that land development defaults are slowing. Well to followers of recent data that should not have come as a surprise. For example, the California Association of Realtors (CAR) has released their report on California existing home sales and median prices in January. The statewide median price rose over the year in January by 9.2% to $468,330. The year-to-year price gain was the largest since May 2014 and reflects the shift in sales activity toward higher-priced properties.

Sales of single-family homes increased by 8.8% over the year in January to 383,670 units sold (annualized rate, adjusted for seasonality). This was the highest sales level for a January since 2013. Year-over-year increases were recorded in all three of the state’s major regions: Southern California (6.5%), San Francisco Bay Area (6.8%), and the Central Valley (11.8%). Over the month, sales declined by 5.4%.

Mortgage interest rates edged down in January, with the 30-year, fixed-mortgage interest rate averaging 3.87%, down from 3.96% in December, but up from 3.67% in January 2015. In Los Angeles County unit sales rose by 5.2% over the year in January, while the median price rose by 8.9% to $480,950. In Orange County sales shot up by 15.2% and the median price increased by 4.5% to $704,950. In Riverside County sales of existing homes rose by 7.7% while the median price moved higher by 8.9% to $333,370. In San Bernardino County sales increased by 5.7% in January; the median price jumped by 13.5% to $234,460. San Diego County saw unit sales inch up by 2.9% and the median price increased by 9.2% to $542,150. In Ventura County sales were up by 3.7% over the year while the median price rose by 9.6% to $638,590.

PROPOSED SPECIAL DISTRICT RULES DRAW MARKET IRE

The IRS has proposed regulations requiring that a political subdivision serve a governmental purpose and must be governmentally controlled. They define control to mean ongoing rights or powers to direct significant actions of the entity. Rights or powers to direct the entity’s actions only at a particular point in time are not ongoing and, therefore, do not constitute control. For example, the right to approve an entity’s plan of operation as a condition of the entity’s formation is not an ongoing right. The proposed regulations provide three non-exclusive benchmarks of rights or powers that constitute control: (1) The right or power both to approve and to remove a majority of an entity’s governing body; (2) the right or power to elect a majority of the governing body of the entity in periodic elections of reasonable frequency; or (3) the right or power to approve or direct the significant uses of funds or assets of the entity in advance of that use. Control by a small faction of private individuals, business corporations, trusts, partnerships, or other persons is fundamentally not governmental control.

The proposal generally requires that control be vested in either a general purpose State or local governmental unit or in an electorate established under an applicable State or local law of general application. If, however, a small faction of private persons controls an electorate, that electorate’s control of the entity does not constitute governmental control of the entity. Accordingly, an entity controlled by an electorate would not be seen to be governmentally controlled when the outcome of the exercise of control is determined solely by the votes of an unreasonably small number of private persons.

The proposed regulations rely on certain assumptions. The number of private persons controlling an electorate is always unreasonably small if the combined votes of the three voters with the largest shares of votes in the electorate will determine the outcome of the relevant election, regardless of how the other voters vote. The number of private persons controlling an electorate is never unreasonably small if determining the outcome of the relevant election requires the combined votes of more voters than the 10 voters with the largest shares of votes in the electorate. For example, control can always be vested in any electorate comprised of 20 or more voters that each have the right to cast one vote in the relevant election without giving rise to a private faction. For purposes of applying these measures of concentration in voting power, related parties are treated as a single voter and the votes of the related parties are aggregated.

Well that would certainly seem to drive a stake through the heart of many special district creations. Just look at the formation of special districts like California CFDs, Florida CDDs, and many other assessment driven districts that have issued bonds in the tax exempt market. It is easy to see why the proposed regulations would worry bond counsel, financial advisors, management companies, underwriters and the many other market participants who make a living from these financings. The potentially higher cost of development driven infrastructure could be the margin of difference for many developments.

The Treasury Department and IRS are driven by the potential for excessive private control by individual developers, the excessive issuance of tax exempt bonds, and inappropriate private benefits from this Federal subsidy. The Treasury Department and IRS seek public comment on whether it is necessary or appropriate to permit such districts to be political subdivisions during an initial development period; how such relief might be structured; what specific safeguards might be included in the recommended relief to protect against potential abuse.

AMICUS BRIEFS FILED IN PR SUPREME COURT CASE

Scotiabank de Puerto Rico, the Association of Financial Guaranty Insurers and the U.S. Chamber of Commerce are urging the U.S. Supreme Court in legal briefs to uphold the illegality of the Puerto Rico Debt Enforcement & Recovery Act. , a local statute that allows for the debt restructuring of the island’s public corporations that was found to be unconstitutional at the federal district and appellate levels. The local government contends that because Puerto Rico’s public corporations cannot file under federal bankruptcy law, it can enact its own bankruptcy law to fill in the gap.

Scotiabank, in an amicus brief filed after reaching joining in a restructuring agreement with the Puerto Rico Electric Power Authority (PREPA), says local banks that comprise the fuel-line syndicate, which pays for the utility’s oil, play a vital role in the island’s economy and support initiatives to address its fiscal problems. “But the Recovery Act, moreover, is so unfavorable to creditors—and so much less protective of creditors’ rights than the federal Bankruptcy Code—that it will inevitably affect the financing available to Puerto Rico”. “Although PREPA asserts in its amicus brief that the Recovery Act spurred negotiations on a consensual restructuring, the opposite is true. The Recovery Act reduced PREPA’s incentive to negotiate, and little progress was made before the district court struck down the Act on February 6, 2015. Only after that decision—on June 1, 2015—did PREPA deliver a proposed recovery plan to creditors, as required by its forbearance agreements. And only then could PREPA and its creditors begin to negotiate in earnest on a consensual restructuring,” the bank says.

The Association of Financial Guaranty Insurers (“AFGI”), the national trade association of the leading insurers and reinsurers of municipal bonds and asset-backed securities, says its interest in the outcome of this case extends well beyond the debt issued by Puerto Rico and its public corporations. “The prospect of States or territories enacting their own municipal bankruptcy laws would have grave consequences on the monoline insurance industry, as well as on the municipal bond market as a whole. Upholding the  contractual terms with municipalities could be altered in unpredictable, inconsistent and self-serving ways. This would create a chilling effect on credit markets and increase the cost of financing to municipal borrowers (and, therefore, to taxpayers),” the organization argues.

“This false portrayal of the potential impact of applying existing federal and Commonwealth law to the bond contracts at issue is an attempt to shift focus from the ‘straightforward’ issue of federal preemption here and from the dramatic negative effects that permitting laws like the Recovery Act would have on the nationwide municipal securities market,” the group adds. The U.S. Chamber of Commerce says there can be no bankruptcy uniformity if states and territories could break contracts for the special benefit of distressed municipalities. The result would be a municipal bond market with reduced access to the low-cost capital the investor class has always supplied.

MENENDEZ OFFERS PR RELIEF LEGISLATION

While the legal arguments are made, the legislative process continues to unfold. ‘‘The Puerto Rico Stability Act 5 of 2016’’. to be proposed by Senator Bob Menendez (NJ) provides for the establishment of a fiscal oversight board. Its creation would automatically stay any legal proceedings against the Commonwealth, provide for the Commonwealth to propose a plan of adjustment for its debts, and most importantly establish a first priority ” senior secured statutory lien on Commonwealth revenues in favor of its pension obligations. The Senator summarized the legislation of the floor of the Senate. It comes directly from the current Puerto Rico administrations playbook.

His comments were as follows. “That’s why the first and most important step we must take is to give Puerto Rico the ability to restructure its debts in an orderly fashion.  Our legislation would do just that, providing a fair and reasonable way for Puerto Rico to restructure all of its debts while avoiding a race to the courthouse that would result in years of costly litigation.

“But before Puerto Rico can even access this authority, it needs to affirmatively opt-in and accept the establishment of an independent ‘Fiscal Stability and Reform Board’ and Chief Financial Officer.  This both ensures that any restructuring plan is based on objective and independent analysis of the island’s situation and provides assurances to creditors that future governments will adhere to a prudent long-term fiscal plan, while affirming and respecting Puerto Rico’s sovereignty.

“Once Puerto Rico opts in, it receives an automatic 12-month stay to give government officials the necessary breathing room to organize their finances and develop a sustainable five-year fiscal plan upon which annual budgets and their restructuring proposal will be based.

“Once the Governor submits a restructuring proposal, a judge selected by the First Circuit Court of Appeals would have to confirm it complies with the Fiscal Plan, protects the rights of pensioners, and if feasible, does not unduly impair general obligation bonds.  Our process follows precedent by giving creditors a voice and the ability to object in court, and ultimately gives an independent judge the authority to ensure any plan is fair and reasonable.

“And in order to ensure the long-term fiscal plan is followed not just now, but in the future, our legislation gives the independent Board the power to review annual budgets, future debt issuances, and exercise strong oversight and transparency powers. “If future budgets do not comply with the fiscal plan, the Board has the authority to issue a vote of ‘no confidence’, which will send a strong and unequivocal message to the legislature, capital markets, and Puerto Rican people…”

“The Board will consist of 9 members chosen by the Puerto Rico Governor, Legislature, Supreme Court, and President of the United States.  At least six of the Board members must be full-time residents of Puerto Rico, at least six must have knowledge of Puerto Rico’s history, culture, and socioeconomics, and all members must have financial and management expertise. This proposal wouldn’t cost the U.S. treasury a penny and because it is limited to the territories, wouldn’t have a contagion effect on the broader municipal market.”

“Currently, Puerto Rico’s Medicaid program, rather than being reimbursed for necessary costs, is capped and set to hit a funding ‘cliff’ as soon as mid-2017.  When its Medicaid costs, a burden no state could handle. “There are several policies in Medicare that treat the island differently than the rest of the nation, leaving providers and seniors to face unfair penalties and lower reimbursements.  This bill eliminates many of these discrepancies to more accurately align Medicare policies in Puerto Rico with the rest of the country. “As citizens of the United States, it’s only fair that Puerto Ricans be afforded the same access to care, coverage and health benefits as everyone else.

“Finally, our legislation would incentivize Puerto Rican workers to enter the formal economy and give families the help they need to raise their children by providing parity to the island for the Earned Income Tax Credit and Child Tax Credit.

We think that the reordering of obligations in favor of pensioners would indeed have a contagion impact on the market. The fact that the legislation includes all US territories builds that in. Keep in mind that Senator Menendez’s home state of New Jersey is one of the leading pension underfunding offenders. As for funding and tax credits there has to be some consequence for being a Commonwealth resident and not paying personal income taxes. Years and generations of cultural resistance to the formal economy cannot be overturned simply by enacting this law.

WESTLANDS WATER SACTIONED BY THE SEC

The Securities and Exchange Commission charged California’s largest agricultural water district with misleading investors about its financial condition as it issued a $77 million bond offering.  According to the SEC, Westlands agreed in prior bond offerings to maintain a 1.25 debt service coverage ratio. Westlands learned in 2010 that drought conditions and reduced water supply would prevent the water district from generating enough revenue to maintain a 1.25 ratio. In order to meet the 1.25 ratio without raising rates on water customers, Westlands used extraordinary accounting transactions that reclassified funds from reserve accounts to record additional revenue. Not only did Westlands fail to disclose that wouldn’t have been possible without the extraordinary 2010 accounting transactions, but also omitted separate accounting adjustments made in 2012 that would have negatively affected the ratio had they been done in 2010.

Had the 2010 reclassifications and the effect of the 2012 adjustments been disclosed, Westlands’ coverage ratio for 2010 would have been only 0.11 instead of the 1.25 reported to investors. Westland’s general manager Thomas Birmingham referred to these transactions as “a little Enron accounting” when describing them to the board of directors.   Birmingham and former assistant general manager Louie David Ciapponi improperly certified the accuracy of the bond offering documents.

The SEC’s order finds that Westlands, Birmingham and Ciapponi violated Section 17(a)(2) of the Securities Act of 1933 and must cease and desist from future violations. They neither admitted nor denied the findings. Westlands agreed to pay $125,000 to settle the charges, making it only the second municipal issuer to pay a financial penalty in an SEC enforcement action.  Birmingham and Ciapponi agreed to pay penalties of $50,000 and $20,000 respectively to settle the charges against them. Andrew J. Ceresney, Director of the SEC Enforcement Division said,  “issuers must be truthful with investors and we will seek to deter such misconduct through sanctions, including penalties against municipal issuers in appropriate circumstances.”

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

BUT IT WAS RATED – ANOTHER P3 TOLLROAD CRASHES

Regular readers will remember that we view privately operated toll roads with at best a great deal of skepticism. That position was reinforced with the news last week that the private company that operates part of the Texas toll road with the highest speed limit in the country filed for bankruptcy, fewer than three years after the section of the road it oversees first opened.

The SH 130 Concession Company, a partnership between Spain-based Cintra and San Antonio-based Zachry American infrastructure, opened the 41-mile-long southern portion of the State Highway 130 toll road, from north of Mustang Ridge to Seguin, in October, 2013. The company had signed an unprecedented deal with the state to build and operate its section of the road for 50 years in exchange for a portion of the toll revenue. Lower-than-expected traffic has led to shortfalls in revenue. A year after the road opened, the lack of traffic prompted Moody’s to severely downgrade the company’s debt. Moody’s released a report eight months later warning that the company was dangerously close to defaulting. Now those ratings have been withdrawn.

SH 130, which runs a total of 91 miles from north of Austin to Seguin, was designed as a way to alleviate gridlock on Interstate 35 through the capital city. The southern section is the only part operated by the Concession Company; the rest is run by the state department of transportation. SH 130 Concession Company CEO Alfonso Orol said in a statement that the road will continue to operate while it goes through Chapter 11 bankruptcy proceedings. The company said that, while its current debt payment schedule is “unsustainable,” it hopes to announce a resolution to its financial troubles in the coming months and points to gradual traffic increases as reason for confidence moving forward.

“We believe that this trend will continue and that the road will become an increasingly popular alternative to I-35 and a valuable asset for the Central Texas region in the years to come as connectivity improves and the area’s economy and population continues to grow,” Orol said. When the southern section of SH 130 was first unveiled, then-Gov. Rick Perry hailed the project as a significant achievement for the state, after he had pushed for private toll leases despite skepticism around the Capitol. The Texas Department of Transportation, said that the company’s bankruptcy filing should have no impact on state taxpayers. “No state money was used to build the portion from SH 45SE south to Seguin operated by the SH 130 Concession Company, and the state is not liable for any of its outstanding debt. SH 130 continues to be a viable alternative for drivers who want to bypass Austin and avoid congestion on Interstate 35.”

BUT IT WAS RATED – THE IMPORTANCE OF PROJECT VIABILITY

Recent times have shown yield investors the importance of underlying project viability even in those transactions supported by an implicit or direct guarantee of debt service by an issuing municipality. Recent refusals of communities in Missouri, Illinois and Minnesota have highlighted the issue. Another example is emerging in Florida. In 2010, the City of Port St. Lucie, Florida issued bonds for the benefit of Oregon Health and Science University Vaccine and Gene Therapy Institute Florida Corp., now known as Vaccine and Gene Therapy Institute of Florida Corporation (“VGTI”).

In October, 2015 the City paid the Trustee the amount of VGTI’s loan payment of $1,506,306 which The Trustee applied to the interest payment due on the Bonds on November 1, 2015. As of February 23, 2016, the Debt Service Reserve Requirement of $4,146,212.50 was deficient in the amount of $872,254.58. VGTI made two monthly payments of $218,175 on June 16, 2015 and July 15, 2015 to replenish the Debt Service Reserve Requirement. The City made six additional monthly payments of $218,175 and has committed to make the remaining four monthly payments so that the Debt Service Reserve Requirement will be fully funded by June 15, 2016.

In September 2, 2015 the City requested the appointment of a receiver over the corporate entity VGTI, as well as its real and personal property. Appointment of a receiver would facilitate an investigation of any improper action VGTI may have taken which dissipated the collateral that secures the payment of the Bonds and recovery of any additional revenues to which the Trust Estate may be entitled. While VGTI was generally cooperative in respect to the appointment of a receiver over the property, VGTI aggressively opposed the City’s and the Trustee’s efforts to obtain the appointment of a receiver over VGTI. The Trustee joined with the City in working with VGTI and the State of Florida Department of Economic Opportunity (“DEO”) to draft an agreed upon order for the Court to enter appointing a receiver over the property.

During the course of its remedial efforts, the City obtained from VGTI a draft appraisal of the Bond-financed real property that indicates the project value is less than half of the aggregate principal amount of Bonds outstanding. The Trustee cannot verify the reasonableness of this draft appraisal. The Bond-financed building is a very expensive facility to maintain, even in “cold storage.” The cost to maintain the building by a knowledgeable manager and pay the necessary utilities aggregates approximately $150,000 per month. The payment of these monthly expenses (and other payments made by VGTI) has essentially dissipated the cash balance that VGTI has previously held. The Trustee believes that the City has agreed to pay (within limits) the cost of the receiver and the monthly maintenance costs for the building.

Thus far VGTI and the City have been unwilling to pay the Trustee’s default administration expenses, including the fees and expenses of its counsel. As of January 31, 2016, those counsel fees and expenses aggregated in excess of $350,000. Pursuant to the court’s February 2, 2016 Order, VGTI’s remaining cash of approximately $144,000 was transferred to a default administration account established and maintained by the Trustee. While funds in this account were used to pay the Trustee’s outstanding attorneys’ fees and expenses, the account did not have sufficient funds to reimburse the Trustee for all of its fees and expenses. On January 6, 2016 and February 23, 2016, the Trustee requested indemnification from the City pursuant to the Trust Indenture.

On February 24, 2016, the City contacted the Trustee and stated that it would indemnify the Trustee. Later that same day, the City paid the Trustee $213,549.29 – the amount requested in the Trustee’s February 23, 2016 demand – to reimburse the Trustee for its attorneys’ fees and costs incurred through January 31, 2016. After that payment was received, however, the City’s outside counsel stated that the payment had been initiated “by mistake.” It therefore remains unclear whether the City intends to indemnify the Trustee as required under the Indenture. If the City ultimately refuses to pay those fees and expenses, the Trustee may seek indemnity from the bondholders as is permitted by the Indenture.

VGTI had offered to deed the property to the City in lieu of foreclosure but, the City did not accept. Under the Mortgage, it is the Trustee that holds the mortgage lien. The Trustee did not think it prudent for the Trustee to accept a deed in lieu of foreclosure from VGTI because taking title to the property in the name of the Trustee or a special purpose entity established by the Trustee could adversely affect the exemption from federal income taxation of interest on the Bonds. The Trustee expects to oppose a sale or lease of the building to any entity that is not a governmental body or a 501(c)(3) organization because it believes doing so could adversely affect the exemption from federal income taxation of interest on the Bonds.

Now the bondholders are looking at a situation where they thought that they were  protected to some degree from project economics but in reality were dependant on long-term viability to insure repayment. They are exposed to the declined value of the real estate and a highly uncertain source of funding for the costs of obtaining ultimate recovery of principal.  The continued payment of debt service on the Bonds through the final maturity of May 1, 2042 will then depend upon the City’s willingness to honor its covenant to budget and appropriate and deposit funds into the Debt Service Reserve Fund to cure any deficiency therein.

AND SO WAS THIS

The Rhode Island Economic Development Corporation (RIEDC, now called the Rhode Island Commerce Corporation) issued $75 million in bonds for the 38 Studios project as part of a state government program intended to spur economic development and increase employment opportunities by loaning bond proceeds to private companies. The Securities and Exchange Commission on Monday charged a Rhode Island agency and its bond underwriter with defrauding investors in the bond offering to finance startup video game company 38 Studios.

The RIEDC loaned $50 million in bond proceeds to 38 Studios. The loan and, in turn, bond investors would be repaid from revenues generated by video games that 38 Studios planned to develop. The bond offering document failed to disclose to investors that 38 Studios had conveyed it needed at least $75 million in funding to produce a particular video game. When 38 Studios was later unable to obtain additional financing, the video game didn’t materialize and the company defaulted on the loan. The SEC alleges that the issuer and underwriter knew that 38 Studios needed an additional $25 million to fund the project yet failed to pass that material information along to bond investors, who were denied a complete financial picture.

Investors weren’t informed that the underwriter had a side deal with 38 Studios that enabled the firm to receive nearly double the amount of compensation disclosed in offering documents. This additional compensation, totaling $400,000 and paid from bond proceeds, created a conflict of interest that Wells Fargo should have disclosed to bond investors. Now the State of Rhode Island is on the hook for the debt service on the bonds.

Rep. Karen MacBeth, who chairs the Rhode Island House Oversight Committee, has been arguing for years that tax-payers shouldn’t be the ones paying the $75 million price tag for the failed video game deal. After Monday’s announcement, MacBeth believes there’s even more reason to not pay back the bond. She is planning to introduce legislation that would ban the state from making any further payments to bond holders. MacBeth does not believe withholding funds would hurt the state’s bond rating. “How can we be knocked down in our bond rating with something that’s fraudulent?” MacBeth said.

CHICAGO PUBLIC SCHOOLS ANNOUNCES FURLOUGH PLAN

CPS canceled classes on March 25, Good Friday, as one of three planned furlough days designed to save $30 million. The announcement immediately prompted a renewed strike threat from the teachers union on April 1. The other two furlough days for teachers and school-based workers are set for June 22 and 23, which were to have been professional development days after the end of the regular school year when students would not be in the classroom.

Chicago Teachers Union officials said the furloughs will result in a 1.6 percent salary reduction for its members. “The mayor is already seeking a 7 percent pay cut, and today’s directive adds another reduction in salary and benefits.”  The district’s top labor lawyer said an April 1 walkout would violate state law and promised that CPS would take the issue to court. CPS said “as many as 8,000 staff members” were planning to take Good Friday off, about four times the daily average. CPS said administrative staff will take forced furloughs April 21 and 22, when the district is on spring break.

The district began its fiscal year with a $480 million budget hole that it hoped to cover with help from the state. That assistance has not arrived as the state budget standoff has continued. CPS has managed its cash flow through the year by laying off employees and borrowing.

The furloughs were announced after CPS and the union spent the day negotiating a new contract, and they follow the district’s decision to eliminate its long-standing practice of picking up seven percentage points of a 9 percent salary contribution teachers make toward their pensions. The “pick up” has long been a major issue of contention between CPS and its teachers. The district has said that eliminating the pension pickup for teachers would cut $65 million in spending this year, more than a third of $182 million in planned cuts this budget year. The district has not said when it will stop making the payments, but CTU officials believe the payments could be cut off next month and threatened earlier this week to strike as soon as April 1. That would be well before teachers are allowed to strike under a state-mandated process that is now in its final phase and wouldn’t play out until the end of May.

The union has not officially committed to a strike date. Such an action depends on whether the district follows through on its plans to end the pension pickup. CTU attorney Robert Bloch said that despite the state law, the union can strike under the authority of a 1956 U.S. Supreme Court decision. “The union’s view is that if it’s not striking over the contract, but is instead striking over an unfair labor practice under that Supreme Court decision, it need not fulfill all those statutory requirements for a strike before engaging in an unfair labor practice strike,” Bloch said. “We believe there is a right to engage in a strike without concluding the contractual impasse procedures, because we’re not striking over a contract,” he said.

The district’s top labor attorney, who helped write the state law that strengthened the steps that must be taken before the city’s teachers can strike. The district’s view is that the 1956 Supreme Court case deals with the National Labor Relations Act, which “has absolutely no applicability to the Chicago Public Schools system or to the Illinois Educational Labor Relations Act.” “Strikes are illegal, they’re prohibited except under very specific circumstances,” Franczek said. “The only way you can strike at CPS is if you comply with that (state) statute.” Also at issue is a provision in the union’s contract that states that the pension pickup ends with the contract — which expired June 30. Nonetheless, the union is arguing that the district should continue making the pension contributions throughout negotiations.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

TREASURY DROPS PENSION BOMB ON BONDHOLDERS …

A draft, obtained by The New York Times, indicates that the Treasury Department is putting forth a plan to address Puerto Rico’s financial crisis which would put pension payments to retirees ahead of payments to bondholders. This would be a huge change for our market. The establishment of such a move which would be highly detrimental to bondholders has long been sought by public employees and their advocates. It would also seem to override prime provisions of the Puerto Rico Constitution which have long been relied upon to offset the irresponsibility of the Puerto Rico political establishment.

“The major problem is, the entire pension system is close to being depleted,” said Antonio Weiss, counselor to Jacob J. Lew, the Treasury secretary. “But 330,000 people depend on it. It’s unfunded, and they have to be protected.” Weiss has previously been the Treasury’s point man for advocating positions negative to bondholders. Shielding retirees from pension cuts, the thinking goes, would not only protect thousands of older residents on the island, but it might also encourage younger retirees to stay there, rather than move to the United States mainland in search of new jobs and incomes.

Out-migration is considered a prime cause of Puerto Rico’s financial decline, because it shrinks the island’s economy, leaving fewer people and fewer dollars to support debt. That out migration has been seen greatly among those population cohorts which are best positioned to support an economy over the long term. These are non-public employees or those (like nurses and doctors and financial professionals) for whom private opportunities on the U.S. mainland will continue to be better than what is available on the island.

But deciding that pensioners’ interests should be put above those of bondholders — if a choice must be made — is not without certain risks. If Puerto Rico can renege on promises to pay debts to investors, while sparing retirees, other municipalities might try to do the same. While it would be “special treatment” for Puerto Rico there huge contagion risk to the entire  municipal market.   Issuers where pensioners have constitutional protection, as is the case in Illinois, would likely cite such a resolution as a way out of their own similar pension funding problems. The Treasury contends that such concerns are unfounded. The framework they are proposing would be designed only for distressed United States territories, like Puerto Rico, and could not be used by states or municipalities on the mainland.

The problem is that once established, it would be hard to limit the precedent set. We disagree with the notion that most institutional investors understand Puerto Rico’s unique situation and the coming debt restructuring will not create widespread credit implications. Moving public pensions to the top of the flow of funds would greatly upset bondholders — especially those who paid close to face value for their bonds years ago, when they were still rated investment grade, and who had expected to hold them to maturity and get all their principal back.

Although the Puerto Rico government has sought to portray the bondholders as deep-pocketed vultures since Puerto Rico’s debt crisis began, many of them are small investors, themselves trying to save for a comfortable retirement. Many are over 65, and they mostly have incomes of less than $100,000 a year. They are not vulture funds. They are regular individuals. This reflects the above average yields and interest that was exempt from federal, state and local taxes, no matter where the buyer lived.

A version of Treasury’s plan was outlined in a draft bill presented to a Senate committee; it has not been voted on. The draft document also is said to call for a five-member “fiscal reform assistance council” appointed by the president to hold the island to meaningful budgeting, disclosure and fiscal reform practices. The board would have the power to make across-the-board budget cuts if necessary.

Currently, Puerto Rico’s laws and Constitution give top priority to general-obligation bonds — the type backed by the government’s “good faith, credit and taxing power.” In general, its bonds can be ranked in a hierarchy of eight levels, with general-obligation bonds at the top. The ranking is described in according to an analysis of the debt by the Center for a New Economy, a nonpartisan research group in San Juan. Public workers’ pensions, the center found, fall on a second hierarchy altogether, which sets priorities for the government’s operational disbursements. Here again, however, payments due on general-obligation bonds come first, followed by payments due on legally binding contracts. Outlays for pensions come third.

The Treasury’s proposed restructuring framework would change that. It would require that the restructuring plan “not unduly impair the claims of any class of pensioners.” General-obligation bondholders, on the other hand, would get such protection only “if feasible,” according to the draft that outlined the plan.

… WHILE PR GOVERNMENT FOLLOWS UP

Puerto Rico will run out of cash to meet the more than $2.5 billion in debt-service payments it owes this summer, beginning with $422 million due May 2 by the cash-strapped GDB. After putting forth earlier this year a voluntary debt-restructuring offer to creditors, the administration is already “working to develop a counterproposal that is responsive to all of the creditor feedback but falls within the parameters of the commonwealth’s ability to pay,” according to a presentation made this week to investors. The exchange offer targets about $49 billion in “tax-supported debt,” including general obligations (GOs), Sales Tax Financing Corp. and various other public entities.

According to the  presentation given Tuesday by Puerto Rico officials during an investor event in Miami, Chapter 9 is now insufficient to tackle its problems. Among the reasons Chapter 9 won’t be enough for Puerto Rico, the officials mentioned it would fail to cover such credits as GOs, Cofina and pension systems. Commonwealth officials believe an effective process to restructure Puerto Rico’s tax-supported debt should be comprehensive enough to cover GOs, Cofina and pensions, while everything is done under one coordinated proceeding. It should provide for bringing holdouts onboard any deal potentially reached with a majority of creditors, while establishing access to interim funding through a process known as “debtor in possession” (DIP) financing, as well as a temporary stay on litigation. A fiscal oversight council — a commonwealth entity authorized and designed by federal statute — should also be established.

PR believes the plan should comprise an out-of-court process, whereby an overseeing federal court would first appoint a mediator in the restructuring talks between Puerto Rico and its creditors, amid a short-term litigation stay and DIP financing to finance government operations. If an acceptable deal is reached by the majority, the court would then make it binding on all creditors. If no accord is struck, an in-court proceeding similar to Chapter 9 would follow, although with the broadest definition of instrumentality and streamlined standards for eligibility.

DETROIT PENSIONS BACK IN THE NEWS

For an example of why settlement of the Puerto Rico situation matters to others, one only has to look at Detroit just two years after its bankruptcy. Mayor Mike Duggan, heading into his 2016-17 budget presentation before the City Council last week, said that he’s concerned about the long-term impact of a $491-million pension shortfall that threatens to balloon payments to the city’s two pension funds in 2024.Duggan said there’s no question that extra tens of millions of dollars a year the city will have to pay to the pension funds could cut into reinvestment efforts aimed at improving critical city services such as public safety and blight removal.

The city is running ahead of budget for the year — with a projected $34- million surplus — that gives the city a cushion. Duggan planned to propose to the council that the city make an additional $10-million pension payment this year in 2016 to begin paying down the extra pension costs, which the city blames on mistaken actuarial assumptions used by consultants in Detroit’s landmark Chapter 9 bankruptcy. Detroit’s population decline is slowing, people are moving back into the city, and property values are rising significantly in a majority of Detroit’s neighborhoods. If that trend continues it will generate enough revenue in property taxes so that the city can pay to upgrade public services and meet its pension obligations.

The bankruptcy was supposed to have settled the city’s shortfalls in paying into the Police and Fire Retirement System and the General Retirement System, but an actuarial consultant for the pension plans now estimates the funds will be $491 million short, leading to higher payments than expected beginning in 2024. The consultant, Gabriel, Roeder, Smith, said bankruptcy consultants used outdated life expectancy tables — estimates on how long retirees will live to collect their pensions — in projecting the city’s total pension obligation.

Duggan said the city plans to manage the problem now with additional payments instead of dealing with a crisis in 2024. Detroit is now looking to hire a consultant to verify the pension plan shortfall and determine the best way to pay for it. The city ultimately may end up making even larger payments to cover the shortfall in 2017 and subsequent years, or continuing payments in years where the city’s long-term budget calls for lowering them.

“We’re just really disappointed  that we came out of bankruptcy having been told — and everybody was told in the grand bargain — the pension shortfall was solved, and now it appears it was not,” Duggan said. The grand bargain was the deal in which the State of Michigan, charitable foundations and the Detroit Institute of Arts pledged the equivalent of $816 million to reduce cuts to city pensioners in exchange for sparing the museum from having to sell art in Detroit’s bankruptcy.

NEW JERSEY WINS PENSION DISPUTE

The U.S. Supreme Court has declined to rule on a major case involving payments to New Jersey’s pension system for public employees. The case – Burgos v. State of New Jersey – concerned Governor Christie’s decision to cut billions of dollars in payments he had once promised for the retirement system. As a part of his plan to address New Jersey’s negative financial outlook, Governor Chris Christie signed legislation that was described as requiring the State to make increased annual payments to shore up the State’s woefully unfunded pension systems. As time went on and the State’s economic recovery lagged national trends, the State finances continued to be strained and its credit continued to be downgraded.  In order to balance the State’s budget in 2014, Christie began to cut those payments despite having signed those laws in his first term that pledged more than $16 billion over seven years for the troubled retirement system.

Public worker unions then sued, arguing that Christie and the state Legislature could not skip the higher payments. The New Jersey Supreme Court disagreed, ruling 5-2 that the seven-year plan was not legally binding. In an order issued Monday, the U.S. Supreme Court declined to review that decision. As is their custom, the justices did not give reasons for declining to hear the case. It is likely that they did not see a federal constitutional issue in the case which required their review. This means that the ruling by the New Jersey Supreme Court stands as the law.

DETROIT SCHOOL FINANCES

Retired bankruptcy judge Steven Rhodes been named by Gov. Rick Snyder as the new transition leader for the district the district as it addresses the debt crisis in Detroit Public Schools. The District will need financial help from state lawmakers to provide the additional cash the district needs to reorganize and pay its debts — a necessity given the district is expected to run out of money this spring.

Snyder has backed legislation that calls on lawmakers to approve an additional $715 million in state funding to pay off the district’s $515-million operating deficit and fund the creation of a new debt-free district to educate Detroit children. But getting legislation through could be a difficult task. Lawmakers in the House and the Senate have introduced two very different packages of bills aimed at trying to fix the district.

Rhodes said his first priority will be to obtain accurate and complete, detailed cash-flow projections of what revenue and expenses will be, what they are projected to be through the end of the year. He said he plans to make that information available to the public. It  is troubling that once again a major municipal issuer is in financial trouble and that the information about its finances is not clear and available for a resolution to be quickly implemented.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

HEALTH CREDIT IN THE ERA OF OBAMACARE

The current presidential campaign has highlighted healthcare  as a major issue. Candidates have proposed various schemes ranging from single government payer to completely private schemes. while this all plays out, providers are grappling with how to plan under the existing scheme. Intermountain Healthcare, a nonprofit health system in Salt Lake City, is a major issuer of tax exempt debt. Operating 22 hospitals throughout the American West, it is a major provider in that region. As such, it is at the forefront of many of the current trends in healthcare finance. So it is with interest that we look at IHC’s answer.

It has a new health plan, SelectHealth Share, which guarantees to hold yearly rate increases to one-third to one-half less than what many employers across the country typically face. To help keep the rate increases roughly in line with changes in consumer prices, Intermountain says it will produce savings of $2 billion over the next five years. IHC believes it has established itself as a leading health system by tracking and analyzing costs and the quality of patient care, allowing it to improve treatments and reduce unnecessary expenses.

Intermountain has already saved money by renegotiating the cost of surgical staplers, pitting a cheaper manufacturer against another and saving $235,000 a year. It saved $639,000 a year by ensuring that heart attack patients get into the catheterization lab within 90 minutes of emergency room contact, thereby helping patients recover faster.

Intermountain’s Share program sets the increase at approximately 4 percent — which is seen as particularly attractive to employers because coverage then becomes a predictable expense. IHC said its new effort was not a marketing gimmick. But there are risks for its Aa1/AA+ credit as it experiments. Intermountain, for example, could incur significant losses if it wound up having to spend a lot on caring for patients, which is why few, if any, systems — or insurers — make similar guarantees.

Intermountain is concentrating on its most costly patients, most of whom have complicated chronic conditions like diabetes that also might be accompanied by depression or other problems.  There have been growing pains. A two-year-old clinic created to deal with these sick patients was expected to manage about 1,000 patients, but so far only about 140 are enrolled, many of whom need a daily check-in. Patients are also staying longer — while the ultimate goal is to send someone back to a primary care doctor once stable. Only 19 patients to date have graduated from the clinic and can now see a regular doctor.

Intermountain says it will not have information it can share publicly until this summer. In 2016, the system expects to achieve savings approximately equal to 8 percent of its volume, or about $500 million. It decided it would not keep the savings or wrangle with outside insurers about who gets to pocket the money.“What we’ve decided to do is to give it back to the community in terms of lower rates,” said Dr. Brent James, the executive director for Intermountain’s Institute for Health Care Delivery Research.

Intermountain is taking a somewhat different tact in that it has agreed to care for about a third of its patients for a fixed amount. That puts the risk on IHC if its health care costs rise too much because it did not do enough to keep people healthy or because its treatments were too expensive. It is among the minority of systems ready to do so.

Doctors who are not affiliated with Intermountain who care for patients under the plan must agree to changes like using an electronic medical record and sharing information about their outcomes. Employers must agree to offer coverage that their workers can afford by paying for at least 70 percent of average premiums and funding a savings account with a sizable contribution. Businesses must also choose SelectHealth as their and doctors to take care of patients without worrying about whether they will switch if their health plan changes or skip a needed doctor’s visit because of a high deductible.

PREPAID NATURAL GAS DEALS RETURN

Before the financial crisis in the last decade in the era of high energy prices, many smaller municipal utility consumers of natural gas looked for ways to stabilize their future supplies and prices through transactions with financial institutions and gas suppliers. These transactions effectively allowed the utilities to pre-pay for long term supplies of gas under long-term supply contracts. These complex transactions involved bond issuances, gas supply contracts, interest rate swaps, investment agreements all supplied by a variety of financial intermediaries. When the creditworthiness of some of the financial institutions providing the necessary products declined or even resulted in their financial failure, investors in these transactions saw significant declines in market value of their bonds and even some risk to principal repayment. Hence, they went out of fashion.

Now we are in a new era in the energy and financial markets with restored financial institution balance sheets, a new understanding of the risks inherent in these transactions, and a new cost environment for supplies of natural gas. These factors have joined to renew interest in pre paid gas transactions to enable utilities to lock in lower prices and provide an outlet for potential oversupplies of gas stocks. this is evidenced by at least two transactions proposed for the first quarter in the municipal bond market.

The Lower Alabama Gas District hopes to sell up to $675,000,000 of bonds to finance the prepayment for a 30 year supply of natural gas for sale to municipal gas systems in Alabama and Louisiana. The transaction involves purchases of gas from the commodity trading subsidiary of Goldman Sachs who will guarantee that entity’s financial performance as well as act as underwriter for the District’s bonds. Goldman will also guaranty the performance of the provider of an Investment Agreement for the Debt Service Reserve Fund, the earnings on which along with net revenues from the purchasing utilities will pay off the bonds. The economics of the transaction will also involve commodity swap agreements with a Royal Bank of Canada subsidiary.

The second transaction is a $1,000,000,000 issue from the Black Belt Energy Gas  District to finance the prepayment of a 30 year supply of natural gas for sale to municipal gas systems in Alabama, Tennessee, and Georgia. In this deal, Royal Bank of Canada and its subsidiaries will act a gas supplier, interest rate swap counterparty, liquidity provider, and bond underwriter. The Bonds are paid from the net revenues of the ultimate gas supply customers.

Each of the states in which purchasers of the gas are located have had experience with these kinds of transactions and have been involved in essentially failed transactions. The major risk in these deals stems from their complexity and the multi-faceted roles of the primary financial institution providing the underlying financial performance guarantees of the various participants. A prime example of this is when Lehman Brothers collapsed thereby involving a number of gas prepayment transactions to experience payment interruptions and involvement in its bankruptcy and subsequent unwinding.

So in the end, investors are buying a municipal bond that is on a practical basis bank debt. It is important for individual investors to understand that this is likely where the primary risk is, not the ultimate gas utilities or their customers.  That is why the rating of the primary financial institution participant is the real basis for the rating on the bonds. There still are many moving parts which can result in deal restructuring or early termination so it remains difficult for the individual investor to understand what their bond is worth at any given point in time.

SIFMA RELEASES 2015 MARKET STATS

The following are excerpts from the 2015 SIFMA Municipal Market review. Long-term public municipal issuance volume totaled $76.4 billion in the fourth quarter of 2015, a decline of 11.3 % from the prior quarter ($86.1 billion) and a decline of 23.0 % year-over year (y-o-y) ($86.1 billion). Including private placements1 ($8.4 billion), long term municipal issuance for 4Q’15 was $84.7 billion. Despite the fourth quarter decline, full year issuance was $377.6 billion, an increase of 19.9 % from 2014 and just slightly above 10-year volume averages. According to the SIFMA Municipal Issuance Survey (“Survey”), respondents expect long-term municipal issuance in 2016 to decline slightly to $388.5 billion.

Tax-exempt issuance totaled $67.4 billion in 4Q’15, a decline of 11.2 % q o-q and 24.9 % y-o-y. For the full year, tax-exempt issuance was $338.4 billion, an increase of 19.7 % from the prior year; Survey respondents expect tax-exempt issuance to rise slightly to $347.5 billion. Taxable issuance totaled $5.2 billion in 4Q’15, a decline of 34.1 % q-o-q and 22.8 % y-o-y. For the full year, taxable issuance was $27.8 billion, an increase of 21.2 % from 2014; for 2016, Survey respondents expect taxable issuance to rise slightly to $30.5 billion. AMT issuance was $3.8 billion, an increase of 60.8 % q-o-q and 42.3 % y-o-y. For the full year, issuance was $11.3 billion, 24.0 % above 2014 volumes; Survey respondents expect 2016 volumes to be lower at $10.5 billion. By use of proceeds, general purpose led issuance totals in 4Q’15 ($15.7 billion), followed by primary & secondary education ($14.7 billion), and water & sewer ($8.4 billion).

For the full year, general purpose led issuance totals ($91.2 billion), followed by primary & secondary education ($82.5 billion), and higher education ($36.6 billion). Notable sectors that saw increased q-o-q issuance were solid waste ($152.3 million, an increase of 882.6 %and 468.3 % q-o-q and y-o-y, respectively), airports ($4.1 billion, an increase of 36.3 % and 232.4 % q-o-q and y-o-y respectively), and single-family housing ($2.4 billion, an increase of 3.2 % and 28.4 % q-o-q and y-o-y, respectively). Refunding volumes as a percentage of issuance declined slightly from the prior quarter, with 43.4 % of issuance attributable to refundings compared to 48.9 % in 3Q’15 and 53.1 % in 4Q’14.

According to the Investment Company Institute (ICI), fourth quarter net flow into long-term municipal funds was positive, with $10.8 billion of inflow in 4Q’15 compared to $2.5 billion of outflow from 3Q’15 and $9.6 billion of inflow y-o-y. For the full year, approximately $14.9 billion of inflow was recorded, down from the $28.0 billion of inflow from the prior year. According to Bank of America-Merrill Lynch indices, municipals returned 1.72 %in the fourth quarter of 2015 and 3.55 % in the full year.

FLINT REVERBERATES IN ATLANTIC CITY

Efforts to have the state intervene in a financial restructuring for Atlantic City, ran in to a near term hurdle when the City’s elected officials of this struggling gambling resort calling the state’s plan to take more control of the city fascist and hypocritical. Mayor Donald Guardian urged lawmakers to reject legislation introduced last week in the State Senate, saying it would hand too much power to the state. “We cannot stand here today and accept any bill with the broad, overreaching powers as the one presented to us last week contained,” Mr. Guardian, a Republican, said. “It is unacceptable. The civil rights of our citizens are being trampled on.”

The legislation was introduced by the Democratic president of the Senate and would give the state nearly complete control of Atlantic City’s finances and the power to renegotiate contracts with the police and fire departments. A similar bill was introduced in the Assembly on Monday. Atlantic City officials had drawn up different legislation that they hoped would be introduced soon, though he declined to say who might sponsor it. A key difference in this bill, he said, would be a provision for redirecting more of the taxes collected from casinos to the city.

State officials oppose allowing Atlantic City to make what would be the state’s first municipal bankruptcy filing since the Great Depression. The issue of racism as a factor in the dispute was introduced when the NAACP said the organization would file a civil-rights lawsuit against the state if the takeover proceeded. About 70 percent of Atlantic City residents are black or Hispanic.  The experience of Flint, MI. was cited by one local official as a reason to protest any attempt by state officials to take control of the provider of water in the city, the Municipal Utilities Authority. The authority is one of the few assets the city has to sell to pay off some of its debts, but residents fear that their water bills will rise and that the quality of the water could decline under private ownership.

A spokesman for the Democratic leadership of the Senate, said, “No one has been a better partner or a better advocate for Atlantic City than Senate President Sweeney, but the city has had more than two years to make the types of cutbacks and reforms needed to bring finances into line but has failed to do the job.”

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

PR FINALLY RELEASES DRAFT AUDIT FOR FY 14

The long-awaited release of a draft of the Commonwealth of PR’s FY 2014 financial statements has finally occurred. Before a recitation of the numbers, this language is important. “The Commonwealth is currently experiencing a severe fiscal and liquidity crisis. The Commonwealth and its instrumentalities face a number of fiscal and economic challenges that, either individually or in the aggregate, could adversely affect their ability to pay debt service and other obligations when due. The Commonwealth is currently considering a number of emergency measures that could affect the rights of creditors. Recipients of the Draft should be advised that to the extent that the Commonwealth or any entities related to the Commonwealth are unable to materially improve their financial position in the immediate future, such entities and/or the Commonwealth may need to seek relief under existing or potential future laws regarding receivership, insolvency, reorganization, moratorium and/or similar laws affecting creditors’ rights, to the extent available, and may resort to other emergency measures including nonpayment of debt obligations.”

Nothing new or unexpected in terms of the language or the numbers. The Commonwealth’s net deficit position increased $47.48 billion at June 30, 2013 to $50.06 billion at June 30, 2014, an increase of $2.58 billion. The increase is the result of higher operating expenses than operating revenues and an increase in the Commonwealth liabilities, such as bonds and notes, net pension obligations, legal claims and compensated absences, among others. Approximately 57.39% of Governmental Activities’ revenue (including transfers) came from taxes, while approximately 35.69% resulted from grants and contributions (primarily federal financial assistance). Charges for services represented approximately 3.62% of total revenue. The largest expenses were for general government, education, public housing and welfare, health and public safety. In fiscal year 2014, Governmental Activities’ expenses, which amounted to $20.70 billion were funded by $10.78 billion in general revenues, $7.12 billion in program revenues and transfers of $214 million from Business-Type Activities.

So there it is without a surprise in the lot.

PR STILL NOT SERIOUS ABOUT PREPA

When the PR restructuring saga began, it was clear that the path to resolution would be fraught with many artificial hurdles based on the island’s strained political environment. A tradition of populist policies that resulted in artificially low taxes and charges for services was clearly going to be the largest hurdle. We saw more evidence of that this week when the PR House passed the Puerto Rico Electric Power Authority Revitalization Bill (Senate Bill 1523 ) with 26 votes in favor and 22 against. The bill  must now return to the Senate so senators can concur with the House amendments to the legislation.

The process was as untidy as expected. Two members asked to abstain from the vote because they are PREPA employees. The NPP delegation announced it was going to submit a written explanation of its vote against the bill. Members of the Irrigation & Electrical Workers Union (Utier by its Spanish acronym) protested the bill. Some began to shout their discontent from the House galleys after the bill was passed. The bill does not guarantee workers rights.

The bill would create a separate corporation, the PREPA Revitalization Corp., that will issue new bonds that will be exchanged for the PREPA bonds that are currently on the market through a new securitization that will also be used to finance the $2.4 billion Aguirre liquefied gas facility. It will restructure PREPA’s board, create a new structure of contribution in lieu of taxes with cities and promote an increase in the utility rates through the Energy Commission. The restructuring will be financed through a so-called transition charge to consumers. As part of the deal, bondholders are expected to accept a 15% haircut on their investment.

PDP Rep. Javier Aponte Dalmau expressed misgivings about the bill and wanted the vote on the bill to be postponed, insisting that bondholders and PREPA should negotiate further cuts to the utility’s $9 billion debt. He believes that the 15% cut was insufficient. He said his vote on the bill was conditioned to the amendments introduced to the bill. “I am proposing language in the bill stating that the 15% cut is the minimum amount in the cut. I don’t want us to limit ourselves…. If that does not happen, then I have to see which amendments are introduced in the bill so I can determine how am I going to vote,” Aponte Dalmau said. The amendment Aponte Dalmau requested, however, was accepted by the majority late Monday and he announced he would vote in favor of the bill.

The action comes on the heels of a PR Senate investigation into irregularities in PREPA’s fuel purchases that officials say cost millions for customers. The legislation calls for a separate office to handle the purchases. For years, it is alleged that authority bought cheap, residual oil that failed to meet federal clean-air standards, and faked tests to make it look like it had passed. Ledgers were falsified too to make it appear as though the authority had actually bought the higher-grade oil, which cost more. The higher price was then passed on to consumers. In the 1990s, the Environmental Protection Agency found that the oil being burned did  contain unacceptable levels of sulfur. If true, the accusations would go beyond errors in judgment and amount to a decades-long fraud.

During her speech in the House opposing the bill, one House member complained that the restructuring support agreement between PREPA and the bondholders was not included in the bill that enables it. “If this bill validates the agreement, why it is not in the bill? She alerted the public to the fact that the wording in the restructuring support agreement (RSA) and the wording of the bill were not the same. The RSA, she said, put consumers on the hook if the corporation or PREPA failed to pay the debt. “It appears that the debt here is not divided among everyone but that the customers are responsible for it together with PREPA,” she said.

An amendment was introduced in the bill that made it clear that PREPA’s clients could not be held liable for the debt. Another amendment introduced by the House made it easier for consumers to challenge the amount in their utility bills. It was then asked of the bill’s sponsor, if the legislation was eliminating customers as “obligors” of the debt. He did not answer the question.

During his speech on the floor, Aponte Dalmau noted that two years ago he had proposed the creation of a separate corporation for PREPA but was called “crazy.” He was referring to a bill he introduced in 2013 that would have replaced PREPA with a new entity, end the utility’s monopoly in the area of power generation and create separate entities to purchase fuel and set consumer power rates. He did so at the time to help make the utility more efficient. The utility ended up paying Alix Partners nearly $30 million to come up with the idea of creating a separate corporation to handle the securitization of PREPA’s bonds. The new corporation will not be able to incur new debt. “This new corporation will securitize the debt but the only project it can finance is the Aguirre one,” he said.

MD TO TRY ANOTHER CONFERENCE CENTER/HOTEL DEAL

In spite of a very checkered history for such projects being successfully financed in  the muni market, a Maryland community wants to try to tax-exempt finance a conference center/hotel project. These projects are seen by many suburban entities as a way to jumpstart local downtown development. Yet suburbs in New Jersey, Illinois, and Maryland previously have previously seen those projects fail to pan out.

Frederick County, MD lawmakers hope to move through the state General Assembly session as a delegation divided — at least on two issues: a downtown hotel project and a hotel tax. A bill authorizing $19.8 million of Maryland Stadium Authority bond funding to help support a proposed downtown Frederick hotel and conference center project failed to get majority support from the County delegation. The bill was nonetheless introduced in the House of Delegates on Friday. It outlines how Maryland Stadium Authority funding will move forward, if approved by the General Assembly. The bond bill represents the largest piece of public funding for the conference center, which is now projected to cost about $69.8 million.

About $44 million of that cost will be paid by the hotel’s developer, Plamondon Hospitality Partners. The rest would be a combination of city, county and state funding. The budget includes $14.8 million in bond funding from the Stadium Authority, but the bill is written to include a figure the Maryland Stadium Authority believes could be paid back through revenue generated by the project. In July, a Stadium Authority report concluded that the state could leverage up to $17.8 million in bonds that would be paid off, including interest, through the project’s revenue in 20 years. This week, that number was increased to $19.8 million, the figure included in the filed bill.

The bill outlines what would happen if the project fails to be in line with the projected budget if there are cost overruns. Those would be assigned to the city, which intends to pass along such costs and responsibilities to the developer in separate legal agreements. If the project comes in under budget, rebates would be returned to the city and county. The city of Frederick will buy the land for the hotel and conference center, and the city and Stadium Authority would each own half of the leasehold interest for the property.

Income from an increase in the County hotel tax was included as part of a funding plan for the downtown hotel and conference center, but Republican members of the County delegation voted to introduce a bill to cap the tax at its current rate of 3 percent. Those members said it would be unfair to pass a tax on to customers of other hotels to help finance the construction of a competitor. County leaders said the bill interferes with local authority to set the rate, and other revenue increases from a proposed 5 percent rate would have helped fund other tourism programs. The county collected about $1.3 million in hotel taxes last year. An increase to a 5 percent rate would increase revenue to about $2 million.

The proposed hotel and conference center will continue to face obstacles, aside from the General Assembly bill. After the session, a financing plan must be approved by the state Board of Public Works before bonds can be issued, and other legal requirements, like approval from the city’s Historic Preservation Commission, must also be met. County Executive Jan Gardner said county government would also continue to support the project.

CBO ADVOCATES TOLLING MORE INTERSTATE HIGHWAYS

From time to time, advocates for direct user financing schemes for highway expansion and development bring up the idea of imposing tolls on many currently untolled sections of the Interstate Highway System. Recent experience has shown that the introduction of tolls on those roads as well as on existing toll roads can be a political minefield. The most recent effort was in Pennsylvania where the tolling of Interstate 80 was proposed. That effort was concurrent with the enactment of a plan to use higher Pennsylvania Turnpike tolls to generate revenues for statewide road expansion.

Now the Congressional Budget Office (CBO) has weighed in on the subject through a recently released report. The report states that ” more widespread charging for the use of roads could increase economic output by giving drivers a financial incentive to switch to other roads and discouraging some travel and reducing congestion. Highly valued freight would thus move more quickly and more reliably, reducing delivery costs for producers as well as inventory costs for retailers, thereby freeing up resources to accommodate additional demand by consumers or allow for additional investment by businesses.

Similarly, shorter commutes could translate to a boost in the supply of labor in the economy by allowing workers to spend more time on the job or encouraging some people to take a job at a more distant location. Charging for the use of roads could allow for more travel overall by reducing congestion, which occurs in many urban areas during peak periods. That counterintuitive effect occurs because user fees, by diverting even a relatively small number of users to other roads or to another time of day on the same road, can cause speeds to rise sharply, increasing the total number of vehicles that can pass through a bottleneck during peak periods.1 In addition, charging drivers would raise revenues, which could be used to make repairs, expand capacity, substantially renovate the Interstate System, or pursue other purposes.”

While they make an excellent argument, it goes awry with the last three words of the excerpt from the report – pursue other purposes. This is where toll proposals go off the rails. Look at the bad reaction to a similar scheme for the PA Turnpike whereby toll revenues for that road were to be raised for other highway purposes throughout the state. It lead to lower usage, more frequent toll increases, higher bond and debt service requirements and an overall degradation of the credit. That is just one example for  tolling opponents to point to.

2015 RATINGS TRENDS

Standard & Poor’s made nearly twice the number of upgrades as downgrades in United States Public Finance in 2015, the fourth consecutive year and the 13th consecutive quarter that S&P’s upgrades outnumbered its downgrades in the sector. Every subsector except higher education and charter schools saw more upgrades than downgrades. S&P downgraded 69 higher education ratings and upgraded 29 in that group. It downgraded 25 and upgraded nine charter school ratings.

Unsurprisingly, Puerto Rico and other organizations in the commonwealth accounted for more downgrades – 115, including four defaults – and more multiple notch downgrades than any other entity. These were 7% of all of S&P’s U.S. public finance rating changes in the year. The upgrade of California to AA-minus from A-plus in July affected 97 ratings. Improved issuer finances were the primary reason for upgrades outnumbering downgrades. At the same time, S&P’s rated issuers had 12 defaults in 2015, the third highest since 1986.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

WHAT’S UP AT WMATA?

Nearly one year ago, Moody’s downgraded debt of the Washington Metropolitan Area Transit Authority to A1 as the result of the Authority’s use of short-term debt as a tool to bridge restrictions on its receipt of federal funds. These restrictions were the result of findings from a Federal Transit Administration (FTA) audit of the Authority’s grant’s management process. The slow receipt of grants through the FTA has constrained WMATA’s liquidity and led it to draw fully on its lines of credit and enter into private financings to maintain capital spending. WMATA’s short-term debt is now in excess of its low level of long-term debt.

Since the downgrade, the Authority has continued to face declining farebox revenue coupled along with increased maintenance and upgrade expenses. While the downgrade has caused some bondholder concerns, a more recent move by the operator of the capital city’s Metrorail and Metrobus systems, along with MetroAccess paratransit has raised some more serious red flags. It has come to light that WMATA has hired leading bankruptcy lawyer Kevyn D. Orr to advise the agency on getting its finances in order. Mr. Orr comes to the Authority after stints managing Detroit’s bankruptcy and advising Atlantic City as it considered bankruptcy.

Among the options Orr could advise WMATA taking are to restructure its debt, not agree to any wage or benefit increases in this year’s contract negotiations with its labor unions, and try to get more money out of its member jurisdictions. Unlike most U.S. transit systems that enjoy dedicated funding from the Highway Trust Fund’s Mass Transit Account, WMATA relies on annual appropriations from Congress and its member jurisdictions: the District of Columbia, State of Maryland, Commonwealth of Virginia and the Maryland and Virginia counties it serves.

As muni participants who went through the Detroit bankruptcy saga know, Orr is the partner in charge of the Jones Day law firm’s Washington office. Under a contract worth up-to-$1.74 million, he will serve as “part-time strategic executive adviser” to WMATA’s newly-installed General Manager, Paul J. Wiedefeld, according to WMATA officials cited by The Washington Post.

WMATA’s major problem is reflected in its budget for fiscal year 2017 (starting July 1, 2016). Its operating budget is $1.7 billion, $1.2 billion of which is employee pay and benefits. Contracts with each of three unions expire June 30, and negotiations are expected to begin soon. WMATA officials say that management has little latitude to implement financial reforms. So it hopes to use Orr in a role of talking to officials and organizations that interact with the commuter system.

Bondholders should be concerned that the system plans to spend $1.3 billion on capital improvements in fiscal 2017, for which it is relying heavily on federal grants — money that may not be coming after an audit report revealed the agency’s extensive mishandling of such funds for years.

As an offset for delays in federal grants, WMATA has relied on short-term borrowing, amassing a debt of around $500 million with costly interest payments. Officials hope Orr will convince the jurisdictions served by WMATA to increase their funding levels. Orr was said to be on a “short list” to be WMATA’s General Manager after the January 2014 retirement of Richard Sarles, but said he was more interested in practicing law.

Metrorail ridership has been trending downward since 2010 since reductions in federal employees’ transit benefits (federal workers make up an overwhelming portion of Metro’s weekday riders), while its member jurisdictions are reluctant to increase their contributions in light of several highly publicized incidents and safety lapses in the subway system.

CONGRESS TRIES AGAIN ON INFORMATION FROM PR

The chair of the U.S. Senate Finance Committee, Sen. Orrin Hatch (R., Utah), sent on Wednesday a letter to Gov. Alejandro García Padilla, asking for a host of information to be delivered no later than March 1. Se. Hatch  is seeking information that would “prove useful” in how Congress would deal with the Puerto Rico issue. “Unfortunately, it has been challenging to acquire recent verifiable financial information about Puerto Rico’s financial condition,” Hatch wrote.

As a result, the senator is calling for the delivery of the commonwealth’s audited financial statements for fiscal year 2014, which were due last May but have yet to be delivered by the García Padilla administration. Officials have pointed to a number of reasons for the delay, and a draft of the statements is expected to be made public this week.

During a hearing to discuss the federal budget on Wednesday, featuring U.S. Treasury Secretary Jacob Lew as witness, Hatch suggested that GOP members in the Senate have already worked on legislation for the commonwealth that could be introduced as soon as March. Along with two other Republican senators, Hatch presented last year a bill that sought to implement a federal fiscal control board on the island, although without access to a debt-restructuring or funds to provide short-term liquidity assistance to Puerto Rico.

Meanwhile, in his letter to the governor, Hatch also requests detailed information on Puerto Rico’s debt and wants to know García Padilla’s position on whether general obligations (GOs) have repayment priority according to the commonwealth’s Constitution. Hatch is particularly interested in the island’s severely underfunded main pension systems.

Hatch is also questioning the expenditure side of the island’s fiscal equation. Specifically, he asks about the spending-control measures that have been implemented, and how much the Puerto Rico government has paid during the past five years in such areas as healthcare, public housing, welfare and education. Hatch is also following up on the U.S. Treasury’s technical assistance and how exactly it has been provided.

At some point Puerto Rico will realize that financial disclosure must occur. The inability or, in our view, unwillingness to provide decent ongoing financial data would be comical were it not for the overwhelming need for the data. We look forward to next week’s draft financial report.

PREPA LEGISLATION MOVES FORWARD

Puerto Rico’s Senate approved legislation that would enable the island’s main electricity provider to restructure almost $9 billion of debt. The upper chamber passed the bill in a 16 to 10 vote. The measure now moves to the House. The debt reduction agreement between the Puerto Rico Electric Power Authority and its creditors is due to expire Feb. 16 unless lawmakers pass the legislation. Two deadlines have already been missed.

DETROIT WATER RATINGS SURFACE

With so much negative attention being focused on the City of Flint’s water catastrophe, it has been easy to lose sight of the improvement in its new old water supplier, the Detroit regional water utility. That improvement was highlighted this week when Moody’s upgraded the rating of the new Great Lakes Water Authority (GLWA). The upgrade of the senior lien and second lien water revenue ratings to Baa1 and Baa2, respectively, reflects the GLWA’s assumption, in full, of all debt previously secured by net revenue of the DWSD. While DWSD retains ownership of both the City of Detroit (local) and suburban (regional) water system, it has executed a lease agreement with the GLWA whereby the GLWA will assume full responsibility of regional system operations. The GLWA is also granted sole ownership interest in revenue generated by the combined regional and local system.

This is seen as significantly limiting the risk that a future bankruptcy filing by the City of Detroit or intensified fiscal pressure on the city in general would contribute to bondholder impairment with respect to the water revenue debt. The across the board investment grade ratings vindicate the view of this newsletter that holders of Detroit Water and Sewer debt would be well served through the bankruptcy process by holding on to their debt.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

PUERTO RICO PROPOSES RESTRUCTURING

The Working Group for the Fiscal and Economic Recovery of Puerto Rico released details of a comprehensive voluntary exchange proposal presented to advisors to the Commonwealth’s creditors last week. The proposal seeks to reduce the Commonwealth’s mandatorily payable tax-supported debt and near term debt payments. The implementation of the expense and revenue measures in the FEGP – totaling approximately $20.6 billion in revenue increases and $13.8 billion in expenditure reductions over the next ten years – are projected to reduce the Commonwealth’s projected cumulative fiscal deficit for the next decade to approximately $34.0 billion.

A voluntary exchange offer is intended to restructure more than $33 billion of payments due over the next ten years on its tax supported debt to allow the Commonwealth make its tax-supported debt sustainable. The plan provides for the Commonwealth to institute a fiscal control board to provide necessary oversight and ensure the Commonwealth complies with the FEGP and the terms of the exchange offer.

The restructuring proposal contemplates that creditors will exchange their existing securities for two new securities: a “Base Bond,” with a fixed rate of interest and amortization schedule, and a “Growth Bond,” which is payable only if the Commonwealth’s revenues exceed certain levels. The new securities would also provide creditors with enhanced credit protections, such as a Commonwealth Guarantee and statutory liens and pledges with respect to certain revenues. Enhanced credit support would include a statutory lien on and pledge of the 4.5% sales and use tax (“SUT”) and up to approximately $325 million annually of petroleum products tax revenues.

Under this proposal, the $49.2 billion of tax-supported debt would be exchanged into $26.5 billion of newly issued mandatorily payable Base Bonds (a 46% haircut) and $22.7 billion of newly issued Growth Bonds. Interest payments on the Base Bonds would begin in January 2018, scaling up to 5% per annum by FY 2021, when principal payments would begin.

The Growth Bonds would be payable only to the extent the Commonwealth’s revenues exceed its current baseline projections as a result of real economic growth on the Island. The first such payments, if any, would be made beginning in the tenth year after the close of the exchange offer. In any given year in which the Growth Bond would be payable, creditors would receive payment of up to 25% of such revenues. The proposal also seeks to lower the Commonwealth’s debt service-to-revenue on tax-supported debt to approximately 15%, a level consistent with the debt limit contemplated by the Commonwealth constitution. At 15%, Puerto Rico would still remain at levels exceeding the most heavily indebted of the U.S. states. Debt service on the Base Bonds has been structured to give the Commonwealth the opportunity to further reduce that ratio as a result of economic growth and develop into a stronger credit over time. A successful exchange offer, along with the implementation of the measures recommended in the FEGP, should improve the Commonwealth’s credit-worthiness, and, if the Commonwealth’s economy is able to grow in line with the growth assumed for the United States, investors will be able to recover the full principal amount of their investments through payments on the Growth Bonds.

The exchange offer is predicated upon a number of key assumptions, including very high participation levels from the creditor groups as well as the U.S. Federal Government maintaining at least its current percentage levels of programmatic support for the Commonwealth. If very high participation levels cannot be achieved or the U.S. Federal Government allows the level of programmatic support for Puerto Rico to materially decline, then the terms of the exchange offer will have to be revisited and creditor recoveries adjusted accordingly.

A serious proposal would accept the need for outside oversight. It can be argued that the Commonwealth has forfeited the trust of its various stakeholders to oversee its own recovery. The continuing lack of audits, reliable ongoing revenue collection reporting, and the lack of urgency with which these matters have been addressed all convey a serious lack of purpose. The risks to bondholders are basic and clear. Primary among them is that the plan assumes that the Commonwealth can reverse years of negative economic growth in the face of steady declines in population especially among the more educated and skilled segments of the population.

The effective five year moratorium in principal repayment is in line with the Commonwealth’s attempt to pose the situation as an us vs. them (as in the hedge fund investors) situation which has always been a convenient oversimplification of the situation. The size of the proposed haircut and the economic risk sharing aspects of the proposal are in line with an effort to align the various interest groups behind a Congressional bailout.

The plan continues the strategy of delay which the Commonwealth has been employing as it seeks a federal solution. It comes on the heels of a failure by island politicians to approve a PREPA restructuring which might require power users to actually pay for power. At the same time, the proposed interest rates contemplated in the tax-backed restructuring seem quite unrealistic in the face of the yields being demanded by the market for the Chicago Public Schools deal postponed from last week. Hence our view that this current proposal is preliminary at best and a mere stalling tactic for the Commonwealth.

CONGRESSIONAL ALLIES MAKE MOVES ON PUERTO RICO

At the same time Puerto Rico is offering its debt restructuring proposal, Sen. Elizabeth Warren, D-Mass., filed an amendment to an energy bill pending before the Senate to include a provision that would temporarily halt litigation over Puerto Rico debt until April 1. If the amendment is passed as part of the energy bill, it would put a stay on any creditor litigation filed on or after Dec. 18. Warren’s effort to include the amendment has support from Sens. Blumenthal, Schumer, and Menendez, co-sponsors of the legislation, as well as Sens. Kirsten Gillibrand, D-N.Y., Chris Murphy, D-Conn., and Bill Nelson, D-Fla.

The amendment asserts that as Puerto Rico continues to deal with roughly $70 billion in debt, “a temporary stay on litigation is essential to facilitate an orderly process for stabilizing, evaluating, and comprehensively resolving the commonwealth’s fiscal crisis.” A stay would avoid a disorderly race to the courthouse, benefitting creditors and other stakeholders, and will only be temporary, according to the proposal.

The April 1 deadline for the stay happens to line up with a late December directive House Speaker Paul Ryan, R-Wis., gave to House committees with jurisdiction over Puerto Rico to create a “responsible solution” for the commonwealth by the end of March. Assured Guaranty Ltd., Ambac Financial Group Inc., and Financial Guaranty Insurance Co. have all filed lawsuits in January, during the time period that would be covered by the moratorium. A judge has consolidated the insurers’ cases in the U.S. District Court for the District of Puerto Rico.

The House Natural Resources Committee held a hearing this week that may lead to legislation designed to aid Puerto Rico. Pedro Pierluisi, Puerto Rico’s sole representative in Congress and a member of the committee said he supports creating an independent board to approve things like Puerto Rico’s long-term financial plan, annual budgets, and effort to publish accurate and timely financial information. But he warned that “if the forthcoming bill seeks to extinguish rather than enhance” Puerto Rico’s democracy at the local level, he “will do everything in [his] power to defeat it.”

The question of extending Chapter 9 protections to the commonwealth’s public authorities has even less of a consensus. The argument against a Chapter 9 bankruptcy solution is that it would not force the commonwealth to take steps toward reforming its operating, accounting, and other financial reporting systems. Those who hold this view (such as we do) think that Puerto Rico should be allowed to restructure its debt only after it agrees to real lasting reforms of these practices and the assent of the majority of bondholders supporting the restructuring proposal.

In the meantime, PR House Bill 2786 would create a new, independent corporation whose only task would be to serve as a vehicle for PRASA to achieve financing at reasonable terms. It is based on the legislation that would provide for the restructuring of the Puerto Rico Electric Power Authority (PREPA), as agreed with a majority of its creditors. One difference is based in the fact that “PRASA has already a gross pledge whereby revenues go directly to the trustee, who pays first [PRASA] bondholders and then what is left is given to the utility. In this sense, PRASA does not have the same leverage to bring its bondholders to the table with the argument, ‘I won’t pay you.’” The head of PRASA has asserted that [PRASA has] repayment capacity for about $700 million, at a 10% [interest rate], but there is no access.”

Of continuing concern is the sentiment expressed against rate hikes. PRASA head Lázaro said that in the event of a rate hike, he explained the size would depend on the sacrifices the utility is willing to make when discussing the issue, but that it could be as much as $10 monthly. Lazaro said “I’m the last person who wants to increase the water rate. With House Bill 2786, “we are seeking to give certainty, mitigate the [financing] transaction’s risk and avoid a rate hike,” said Rep. Rafael Hernández, co-author of the measure and chair of the House Treasury Committee.

PRASA’s last water-rate hike back in 2013 was projected to cover all operational costs from its revenue, debt service until fiscal year 2018, and projected deficits during fiscal 2016 and 2017. But it also intended to pay for its capital improvement projects with external financing, and not with the utility’s revenues. What’s more, to pay roughly $90 million in short-term debt maturing on Feb. 29, PRASA would siphon its Rate Stabilization Fund — monies that were supposed to be used to cover projected deficits during fiscal 2016 and 2017.

CHICAGO PUBLIC SCHOOL ISSUE DELAYED AS INVESTORS RAISE QUESTIONS

The Chicago Public Schools yielded to investor uncertainty when it delayed its planned $875 million general obligation bond sale by moving it to the day-to-day calendar. The district’s finance officials said the decision was made to give investors more time to digest the deal and the underwriting syndicate time to make final structure revisions. The action followed  the General Assembly’s GOP minority leadership announcement of legislation backed by Gov. Bruce Rauner to put the district under state oversight and put it on a possible path to bankruptcy. The Board has obtained an opinion that its pledged revenues securing the planned bonds are special revenues for purposes of bankruptcy. We see that as being less than definitive.

The less than helpful comments from Springfield led to a pre-marketing wire offering spreads of more than 500 basis points to the Municipal Market Data’s top-rated benchmark. The 25-year and final 28-year maturities were offering a preliminary yield of 7.75%, 506 basis points and 502 basis points, respectively, over MMD’s AAA. Both were more than 400 basis points over a triple-B credit. The preliminary price on the taxable, 17-year maturity offered a yield of 9.75% with a coupon of 9.50%.

Chicago’s chief financial officer, Carole Brown, and CPS finance chief Ronald DeNard said that it had sufficient order interest to place with buyers at pre-marketing pricing levels distributed Tuesday. CPS bonds had been trading at a 350 to 375 basis point spread before the announcement. The district’s $300 million sale last spring saw a top yield of 5.63% on a 25-year maturity that was 285 basis points over top-rated MMD.

OLD HABITS DIE HARD

Two years ago, the use of Capital Appreciation Bonds by school districts in California for new construction led State lawmakers to pass AB 182 at the urging of then-State Treasurer Bill Lockyer after it came to light that many school districts had issued non-callable capital appreciation bonds with 40-year maturities and nominal interest-to-principal repayment ratios of 10-to-1 or even 20-to-1. The public relations poster child for the controversy was Poway Unified School District’s $105 million series, issued without a call option and requiring $1 billion of debt service through its 40-year maturity.

Initially the legislation and public uproar caused school CAB issuance to drop to $292 million of CABs in 2014. Once the concern died down, issuance of capital appreciation bonds by California school and community college districts more than tripled from 2014 to 2015. It was the highest level of school CAB issuance since 2009, according to CDIAC data. K-12 school districts conducted 46 CAB sales in 2015 totaling $691 million, compared to $250 million the prior year. The state’s community colleges executed eight CAB sales last year totaling $307 million, up from $42 million in 2014.

The legislation sought to limit CAB issuance by K-12 and community college districts, by requiring ratios of total debt service to principal for each series not exceed 4-to-1, and that bond issues include a 10-year call option. Permitted maximum interest rates were cut to 8% from 12%. Now that the negative uproar has subsided, K-12 school districts conducted 46 CAB sales in 2015 totaling $691 million, compared to $250 million the prior year. The state’s community colleges executed eight CAB sales last year totaling $307 million, up from $42 million in 2014. The increase occurred in the face of comments from some financial advisors and district officials, who have said that districts have been steering away from the structure after the wave of criticism that resulted in AB 182’s passage.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

PREPA TALKS CRASH

It was supposed to be a model for the overall restructuring of all of the Commonwealth of Puerto Rico’s debt. Whether that was actually going to be the case was the subject of debate. Right now, the model lies in pieces – crushed by the weight of pride, impracticality, intransigence, and irresponsible politics. So it seems as it was announced that negotiations to restructure roughly $9 billion of the debt of Puerto Rico’s power company collapsed late Friday, according to a statement from a group of creditors involved in the talks.

“Today the PREPA Bondholder Group put forward an offer to extend the RSA until February 12^th in order to give the Puerto Rican legislature more time to pass the PREPA Revitalization Act. Based on our direct and positive conversations with Puerto Rican lawmakers, we are optimistic that the bill will be passed and it was our desire to be as supportive of the legislative process as possible. In addition, we also offered to extend our Bond Purchase Agreement (“BPA”) with PREPA, under which RSA creditors would provide $115 million in additional financing once the energy commission approves the securitization charge, with a deadline of May 23^rd. This amendment to the BPA reflects a milestone that was previously agreed upon, and was included in order to help ensure the deal would get done – as the energy commission approval is a vital element of the agreement.

“Unfortunately, PREPA is choosing not to extend the RSA. Over the approximately 18 months that we have been negotiating this plan it has consistently been our desire to reach a fair, collaborative agreement that would benefit all stakeholders, including the people of Puerto Rico. The plan has been described as fair to all parties and beneficial to Puerto Rico – not only by key legislative leaders but by other decision-makers in the Commonwealth. This is why we were willing to offer these further concessions, recognizing the complexities of the legislative process. While it is extremely disappointing and perplexing that PREPA has chosen to take this stance, we continue to remain open to reaching a deal with PREPA and it is our sincere hope that they reconsider their position and assume postures beneficial to the people of Puerto Rico.”

The statement did not say whether the creditors would now declare PREPA in default. If they did so it would be by far the largest and most momentous default in Puerto Rico’s growing debt crisis. PREPA has a debt payment of about $400 million due to bondholders on July 1. It also owes about $700 million to two financial institutions that help to finance fuel purchases.

It is said that PREPA was still willing to keep the negotiations going and that the talks broke down because the creditors attempted to impose a new requirement in exchange for granting more time. Before the deal could proceed, the Puerto Rico legislature had to approve it, and some lawmakers argued that PREPA and its creditors were rushing to close the deal before the island’s new public utility commission had a chance to properly review it. This is the second “deadline” missed by the legislature. The creditors had expected the legislature to approve the deal in a special session in December. When that did not happen, they said they would wait until Jan. 22, and they offered $115 million to help finance PREPA while the legislature considered an enabling bill.

It is rumored that the creditors were willing to wait until February, but the new public utility commission was more likely to need until May. The debt exchange would have required PREPA’S first increase in its base rate for power since 1989. The public utility commission is so new it has never been through a rate-setting process before. In the meantime, the Commonwealth clings to its strategy of running out the clock in the hope that the U.S. Congress can be persuaded to bail out the Commonwealth.

ATLANTIC CITY FACING TAKEOVER

The recent troubles of Flint, MI have cast a negative light on the concept of state “takeovers” of the financial operations of municipalities. The well known troubles in Flint resulted in the reinstatement of local control by the State. The usually poor reception given to outside managers has been a factor in the length of time given to Atlantic City, NJ to resolve its own deep financial troubles. As we have previously documented, a long term trend of decline and consolidation in the City’s economic engine – gambling – has resulted in a serious financial bind. The City has toyed with bankruptcy in an effort to undo contracts with Civil Service unions and to renegotiate tens of millions of dollars in tax refunds.

For the City’s creditors, the presidential race may have driven the State – or more precisely, Governor Chris Christie – to intervene in the City’s finances one week after Christie vetoed an aid package for the city, and his spokesman issued a statement denouncing local leaders for being fiscally irresponsible. “Atlantic City government has been given over five years and two city administrations to deal with its structural budget issues and excessive spending; it has not,” the statement said. “The governor is not going to ask the taxpayers to continue to be enablers in this waste and abuse.” The Council and the mayor had been scheduled to hold an emergency meeting this week to discuss a court filing under Chapter 9 of the federal bankruptcy code. In New Jersey, cities must seek approval from the state’s Local Finance Board to file for bankruptcy.

The reality is that with the Iowa caucus coming up next week, the city’s falling into bankruptcy would have proved deeply embarrassing for Mr. Christie who has sought to present himself in the race as a responsible executive, tested by crises and capable of extracting major compromises from Democratic adversaries. The timing of the announcement is reflected in the fact that the legislation still needs to be drafted and passed by the Legislature and signed by Mr. Christie. As planned , it would give the state the authority to act on the city’s behalf for five years, including the right to negotiate, amend and terminate all labor agreements for the city.

The City government, which opposes a state “takeover” faces daunting challenges. Casino revenue has fallen by half since 2006, to $2.56 billion last year from $5.2 billion. Thousands of jobs have been eliminated. And now there is the possibility that state lawmakers might end the city’s monopoly on gambling by allowing it in North Jersey. All of this combines to increase the difficulty the City faces in dealing with a declining taxable property base and more than $150 million in tax appeals from just one casino, the Borgata.

PENNSYLVANIA BUDGET MESS DRAGS ON

In two weeks, Gov. Tom Wolf is scheduled to deliver a budget proposal for the 2016-17 fiscal year, despite significant portions of the current 2015-16 fiscal year still unfinished. The Republican-controlled legislature reconvened this week amid a 7-month-old budget fight that has left billions in school aid in limbo, but lawmakers took no action on budget-related legislation. Prior to his formal proposal, the Governor made some extensive comments on the situation.

Wolf said lawmakers have not figured out how to pay for the spending in a plan they sent to him before Christmas. “If we don’t fix the budget deficit by 16-17, there are going to be huge cuts in education, and huge cuts in local services, so that local taxes are going to go up and services are going to decline”. “So we need a real balanced budget, we need some honesty, we need fiscal responsibility. It’s not just me saying that, it’s the rest of the world looking at Pennsylvania and they’re going to watch us and we’ve got to get it right.”

Wolf signed $23.4 billion of the main appropriations bill in a $30.3 billion budget package that had been written by House GOP majority leaders. He call it emergency funding to prevent schools from closing and social service agencies from laying off more workers. However, Wolf vetoed billions for public schools to keep pressure on the Republican-controlled House to pass the bipartisan deal. The action did keep some school districts from having to undertake short-term borrowings but was too late for others. Many social service providers are struggling to maintain their finances as the process drags on.

As is the case in Illinois, this situation is all about the politics. That is the one factor that separates municipal credit from all other fixed income credits. Until that changes, the concept of full equality of ratings across all classes of fixed income debt will be essentially impossible to achieve. We would not be surprised to see one more downgrade of the Commonwealth’s rating before the budget process is finally resolved.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Joseph Krist

Municipal Credit Consultant

GREAT LAKES WATER AUTHORITY BEGINS OPERATIONS

With so much attention being focused on the City of Flint, MI and its problems with a tainted public water supply, it would be easy to overlook a major development  for the primary supplier of water to the greater Detroit metropolitan area. January 1, 2016 marked the launch of a regional water authority in Southeast Michigan.  The City of Detroit, the counties of Macomb, Oakland, and Wayne, and the State of Michigan have officially united to form the Great Lakes Water Authority (GLWA).  The new Authority was formed as a part of the Grand Bargain resolving Detroit’s bankruptcy. The new structure gives suburban water and sewer customers a voice in the management and direction of one of largest water and wastewater utilities in the nation.

GLWA begins management and control of regional water and wastewater services, while Detroit, like suburban communities throughout the region,  will retain control of water and sewer services within the City limits.  The GLWA has signed a 40 year lease with Detroit for $50 million a year. Detroit will use these funds to overhaul its aging infrastructure.  The lease also provides for a $4.5 million Water Residential Assistance Program to help low-income customers of GLWA customer communities pay their water and sewer bills.

The GLWA is comprised of six board members: two from the City of Detroit, and one each from Wayne, Oakland and Macomb counties, plus one representing the State of Michigan. The Authority also has a new old customer. In order to address the City of Flint’s needs for potable drinking water in the face of its crisis, it will return to its former status as a customer of the City of Detroit’s water system. It was an effort to avoid feared increased costs from the resolution of Detroit’s bankruptcy that drove Flint officials to seek a different water supply leading to its current dire situation.

PUERTO RICO AUDIT MAY FINALLY BE MADE PUBLIC

Office of Management & Budget Director Luis Cruz told reporters that the commonwealth’s audited financial statements for fiscal year 2014, which ended June 30, 2014, could be finally released within the next few weeks, as the process being conducted by KPMG nears its end. “[The audited statements] should be ready by the end of this month; first week of February,” Cruz said. The commonwealth’s audited financial statements for fiscal year 2014 were due in May 2015, and the government has previously missed self-imposed deadlines to release it.

Meanwhile, the Puerto Rico government budget for fiscal year 2016, which ends June 30, has been adjusted, from $9.8 billion to $9.27 billion, mainly as a result of lower than expected revenue entering the commonwealth coffers, the revised budget translates into roughly $250 million in additional, across-the-board government spending cuts, including such areas as healthcare, security, social well being and education. The $250 million figure also includes a $119 million adjustment in debt service under the budget, mainly as a result of the default on certain Infrastructure Financing Authority (Prifa) bonds.

Cruz stressed the budgetary cuts are being made without affecting essential services to citizens, while ensuring government employees continue to receive their paychecks. “In a surgical manner, we are adjusting the budget…affecting in the least possible way and ensuring essential services to citizens. At the same time, we also want to ensure government payroll is met each pay period, as well as the least impact on the economy. Those are the judgment elements in making this decision,” Cruz explained.

Fiscal 2017 starts with more than $1.5 billion in payments due July 1. Since the release of the Fiscal and Economic Growth Plan (FEGP) in September, the fiscal crisis on the Island has worsened, and the Commonwealth is now facing even larger estimated financing gaps in both the near and long term. Specifically, the General Fund revenues included in the FEGP have decreased from a previous estimate of $9.46 billion for FY 2016 to $9.21 billion; the estimated five-year projected financing gaps increase from approximately $14 billion to $16.1 billion, even with the inclusion of economic growth and the implementation of all of the proposed measures in the FEGP; and the ten-year projections estimate a $23.9 billion aggregate financing gap.

Melba Acosta Febo, President of the Government Development Bank reiterated that it expects to sit with creditors shortly and put forth a comprehensive restructuring proposal. The proposal will  include a comprehensive adjustment of its debt that reflects the Commonwealth’s actual capacity to pay its creditors over the long term. It continues to characterize lobbying efforts as being of  those seeking to lock in speculative gains but hope that creditors will sit and work on a solution that will allow investment in Puerto Rico and repay its creditors through growth in the  economy over the long run.”

NASSAU COUNTY TESTING THE MARKETS

A pair of troubled credits have recently released preliminary official statements in connection with the hoped for sale of debt. We have taken the opportunity to review them for updates on their relative precarious financial positions. The first is A2 rated Nassau County, NY which operates under the oversight of a state financial control board. The County hopes to refund $273 million of outstanding GO bonds and issue $120.3 million of new bonds and $23 million of bond anticipation notes.

The County is currently projecting a $24.9 million deficit for fiscal 2015. According to the oversight board (NIFA), it ran a deficit of $190 million in fiscal 2014. The County budget and rejected by NIFA. After a period of changes and legislative actions, a revised budget was submitted to NIFA which approved the proposed debt issue. The $2.92 billion budget is considered to have some 480 million at risk in the form of unrealized revenues and/or expense savings.

The County is still undertaking to resolve long standing issues related to required substantial property tax refunds and the unwillingness of the County legislature to enact increased property taxes. So long as the refund issues require external borrowings to finance and structural budget balance remains unattained, the County’s credit will remain under pressure. Investors may take some comfort in the County’s lack of legal authorization under New York State law to resort to bankruptcy.

CHICAGO PUBLIC SCHOOLS

The Board of Education of the City of Chicago is a more troubled story. A long history of budget difficulties, turbulent labor relations, and dependence upon the increasingly troubled State of Illinois have combined to pressure the Board’s finances over an extended period. The tax base supporting the credit is also the same as that supporting the City of Chicago and other tax backed credits which all have increasing demands on that common revenue . Like the City, the Chicago Public Schools also have substantial unfunded pension obligations that require increased revenues.

In addition, CPS estimates that its system requires some $4 billion of capital to maintain an aging and outdated physical infrastructure. The ability to reduce those needs through closings and other consolidation initiatives is hamstrung by a very difficult and complex political environment reflecting the dire economic straits of a huge portion of the student population. Those issues have challenged multiple city administrations and board management over many years. The result has been a steady decline in the credit’s relative creditworthiness and the bonds are now rated below investment grade without any external credit support.

Concerns about the Board’s credit have been heightened due to the ongoing lack of an enacted budget by the State. This has raised questions about potential impacts on the Boards cash flow and ability to service its debt. The Board expects to receive 92% of the statutory State aid anticipated in its current budget. It also expects to receive $597 million in scheduled block grants from the State. The lack of a State budget has made the receipt of some $490 million of additional aid anticipated in the current FY budget highly uncertain.

This has required the Board to undertake and consider a range of expense cutting actions to offset the reduced funding. In addition, the cuts have influenced the negotiations being undertaken with the teachers union. These negotiations are ongoing and include the recent participation of a mediator as the teachers have reacted negatively to proposals that would reduce the Board’s pension contributions. The teachers have threatened to strike in an effort to influence negotiations. The primary impact of a strike would be to reduce state aid according to a formula penalizing CPS 1/176th for each day there is no class. Some 5 weeks’ worth of the school year could be lost in the event of a strike.

The ongoing uncertainty led S&P to lower its rating on the district’s $6 billion of general obligation bonds this past Friday to B-plus from BB and left it on CreditWatch with negative implications “while it continues to monitor the board’s efforts to maintain sufficient liquidity to meet its financial obligations.”

In the midst of this effort to complete the bond issue, Gov. Bruce Rauner and Republican legislative leaders on Wednesday proposed a state takeover of Chicago Public Schools and permitting the troubled district to declare bankruptcy to get its finances in order, billing the controversial ideas as a “lifeline” and not “a state bailout.” As described by the GOP leaders, the legislation would allow the Rauner-appointed State Board of Education to remove the current Chicago Board of Education and create an independent authority to run CPS until it is determined the district is no longer in financial difficulty. The leaders said the change would add CPS to a state financial oversight law that it is exempted from but that applies to all other Illinois school districts. Another measure would allow school districts like CPS to declare bankruptcy, which could allow it to void union contracts.

House Speaker Michael Madigan and Senate President John Cullerton made it clear the Republican takeover plan is dead on arrival at the Capitol.  Madigan said in a statement. “Republicans’ ultimate plans include allowing cities throughout the state to file for bankruptcy protection, which they admitted today would permit cities and school districts to end their contracts with teachers and workers — stripping thousands of their hard-earned retirement security and the middle-class living they have worked years to achieve. “When Detroit was granted bankruptcy protection, retirement security was slashed for employees and retirees. That is not the path we want to follow in Illinois.”

This type of political infighting has hampered serious reform of CPS operations. Investors should not be fooled now into thinking that the Governor and his allies are looking at the bondholders are a primary interest. The Governor’s anti-union agenda (whether you are for or against it) has been at the core of the budget impasse at the state level and is at the core of the Governor’s effort to jump into the middle of this dispute. Like Pennsylvania, the Illinois crisis is as much a creature of ideological political considerations as it is about economic or financial realities. All in all a toxic mix for current and potential investors.

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.