Joseph Krist

Municipal Credit Consultant

The first week of January usually is the start of the upcoming fiscal year budget cycle. The most visible sign is the release of the Governor’s preliminary budget proposal in California. This year is a bit different as two of the largest states – Pennsylvania and Illinois – have yet to complete the enactment of budgets for the current fiscal year ending July 1, 2016.

PENNSYLVANIA

The adoption of a partial budget in Pennsylvania has reduced some of the cash flow pressure on the Commonwealth’s school districts. The action has shifted attention to the Commonwealth’s own cash position. In a move that only the very weak state credits employ, the Commonwealth has announced a plan for the General Fund to borrow from other state funds to finance a potential negative balance of $922 million after the governor’s line-item veto of a budget plan allowed its expenditure.

The Treasury has announced the creation of a $2 billion line of credit to cover expenses of the Commonwealth’s General Fund. The $2 billion credit line is the largest ever extended by the Treasury to cover General Fund expenses, exceeding the second-largest credit line of $1.5 billion extended in September 2014. The announcement Particularly noted the public school subsidy being withheld during the Commonwealth’s ongoing budget impasse until the partial budget plan was signed last week, the Treasury noted the General Fund’s balance was artificially inflated and, without the loan, would have fallen into a likely negative balance until the tax revenue collection spike in the spring.

As of last week, the Wolf administration has borrowed $1 billion of the available funds to cover expenses. The funds were borrowed from Treasury’s cash investment “Trust 99” fund and any borrowed funds will carry a 0.6 percent interest rate, which is lower than the Commonwealth could have obtained in the private sector while also allowing Treasury to make a positive gain for taxpayers when the loan is paid back.

The credit line also had to be approved by Auditor General Eugene DePasquale, who noted the credit line is necessary due to the Commonwealth’s structural deficit. “This is the second consecutive year the state hit a cash flow problem and needs to borrow money halfway through the fiscal year. As I said 16 months ago, the need to borrow money this early in the fiscal year is a strong indicator that the commonwealth’s unsustainable structural budget deficit continues to grow,” he said. “The long-term structural budget deficit and this year’s budget impasse should be a wake-up call to everyone involved that it is time to come to a resolution on these critical issues.”

The Commonwealth will have to repay the loan by June 30, 2016.

LOUISIANA BUDGET WOES

With so much attention devoted to Puerto Rico’s default and budget standoffs in Illinois and Pennsylvania, it is easy for some more familiar weak fiscal performers to get lost in the noise. One of those is perennial credit laggard Louisiana. Louisiana’s budget woes are even worse than the incoming administration of Governor-elect John Bel Edwards had anticipated. The shortfall for the fiscal year ending in June 2016 is estimated at $750 million. The chief fiscal adviser to the Governor said that the administration has not settled on a plan for fixing the problems with the current fiscal year’s $25 billion budget, but it has not ruled out tax increases, which would need legislative approval.

New revenue estimates showed a continuing drop in oil prices and a slump in collections from corporate income taxes and sales taxes. He said a $1.9 billion shortfall is estimated for the next fiscal year, which starts in July. The departing governor, Bobby Jindal, a Republican who mounted a failed presidential bid, refused to support anything he considered a net tax increase and leaned on short-term budget fixes.

LITIGATION BEGINS OVER THE CLAWBACK

As we have predicted in earlier discussions of the Puerto Rico credit situation, litigation has been filed to test the validity of the “clawback” provisions supporting general obligation debt of the Commonwealth. Two insurers of Puerto Rican bonds that are now in default sued the governor and other senior officials on Thursday, saying they had illegally diverted money from some creditors so they could pay other creditors in full. Assured Guaranty Corporation and the Ambac Assurance Corporation said in their complaint that Puerto Rico had diverted at least $163 million that had been pledged to pay debts they had insured. Those debts were in the form of municipal bonds issued by three governmental authorities on the island.

The governor responded that the litigation was a sign that a dreaded “race to the courthouse” had begun, leading to “litigation pandemonium” as different creditors sought to enforce their claims on the island’s resources. He called on Congress to enact legislation that would give Puerto Rico the ability to take shelter in bankruptcy, where such creditor litigation would be automatically stayed. “With no legal framework to handle this impending litigation crisis, both the Commonwealth and its creditors will soon face the opposite of due process and rule of law,” Mr. García Padilla warned.

Last week, the governor confirmed the use of at least $163 million — slightly less than the earlier reported $174 million — to help make a large payment due Jan. 1 to investors who hold Puerto Rico’s general obligation bonds. That type of bond is given the highest payment priority by the Puerto Rican constitution. Mr. García Padilla diverted the money by issuing an executive order on Nov. 30, starting what is called a “clawback” of funds from lower-priority bondholders.

Assured Guaranty and Ambac contend that the clawback was unconstitutional, because it “substantially and unjustifiably” impaired their contract rights under the United States Constitution. They also said they had constitutionally protected property interests in the money, because they held liens on the pledged funds. They acknowledged that their liens were subject to being paid after the general obligation bonds, but said the use of the clawback was still unlawful under the circumstances, “namely, where other available resources exist from which the public debt could be paid.”

The two insurers asked the court to declare the clawback unconstitutional and bar the Puerto Rican government from diverting any more pledged money. Their suit was filed in United States District Court in San Juan. The three public authorities whose bonds have been affected by the clawback are the Highways and Transportation Authority, the Convention Center District Authority and the Infrastructure Financing Authority. Holders of those bonds received some of the principal and interest payments due Jan. 1, from debt service reserves, which is considered a technical default. The Infrastructure Financing Authority did not have reserves in place to make the payment, and Ambac stepped in and provided $10.3 million.

LOMBARD HOTEL

The troubles of Puerto Rico and Detroit have overshadowed the more traditional sectors prone to default in our market. In a more typical situation, the village of Lombard, a Chicago suburb, wants bondholders to agree to a proposed restructuring of its $190 million of hotel/conference center debt. The village has since January 2014 not paid on its pledge to cover revenue shortfalls needed to avoid defaults on a portion of the bonds issued to finance construction of the Westin hotel. The restructuring proposal was made to bondholders in October but disclosed publicly only in December. It would cancel $29 million of unsecured C series 2005 bonds.

A exchange has been offered to holders of $64 million A-1 series, $54 million A-2 series, and $43 million B series, each of which carries different security.

The restructuring was initiated by ACA Financial Guaranty Corp. — which backstops $19 million of the $54 million series — and Lombard officials. If they can convince bondholders to agree to the new capital structure, it could lead to a resolution through a consensual bankruptcy filing by debt issuer Lombard Public Facilities Corp., according to documents and city officials. Under the restructuring proposal, the Lombard Public Facilities Corp. would retain ownership of the project. Without a restructuring, the Series A and B bondholders have a mortgage claim if the project were to declare bankruptcy.

Like other suburban hotel credits relying on corporate conference events in various sections of the country, the property has long failed to generate the revenue needed to support its debt. It includes a 500-room hotel, two restaurants, 39,000 square feet of meeting and convention space, a 25-meter indoor swimming pool and fitness center, and a 675-car, four-story parking deck. Village officials are promoting the plan as a means to align hotel revenues with debt repayment while also preserving the hotel’s business prospects. The hotel is operated by Westin Hotels & Resorts, part of Starwood Hotels & Resorts.

“Given market conditions, the hotel’s operational and financial performance and its inability to service the existing capital structure, a comprehensive restructuring is needed to preserve asset value and maximize bondholders’ return,” the plan reads. “If a restructuring plan is not undertaken to solve the default, the asset’s value may further deteriorate, including the potential loss of the Westin brand.” The hotel’s capital needs are increasing with few resources to cover upgrades because its revenues now go primarily to repay the bonds.

As part of the restructuring, the village would contribute $2.5 million for capital work at the hotel and be freed of further obligations on the debt. Lombard has seen its bond rating negatively impacted as the otherwise affluent village saw S&P lower Lombard’s credit rating six notches to a speculative-grade B from BBB in February 2014. Lombard’s previous refusal to make up shortfalls came ahead of a July debt service payment when it declined to cover a $2.6 million gap. The trustees have long taken the position that the village is not legally obligated to burden its taxpayers. The Lombard Public Facilities Corp. drained reserves to cover the Jan. 1, 2015 payment on the A series which carries an indirect appropriation pledge.

Like many project refinancings, coupon rates and maturities would be adjusted to better match operating realities. In this case, the A-1 bonds would be broken into a “hard” and “subordinate” series with $32.7 million paying an interest rate of 5.25% and carrying a 30-year term and a $32.7 million subordinate series also paying 5.25%, but with a maximum term of 55 years. The A-2 series would be similarly divided, with $27.3 million paying 5.25% and a 30-year term, and a subordinate $27.4 million piece paying a rate of 5.25% with a maximum term of 55 years. The B series would be divided into an $18.5 million tax revenue bond series with an interest rate of 3% and a 30-year term and a subordinate $28.1 million series paying 3% with a maximum 55-year term.

The A-1 bonds paid initial yields of between 6% and 7% on term bonds due in 2015 and 2036. The A-2 bonds paid yields between 4.11% and 4.8% with the final maturity in 2036. The B bonds paid initial yields between 4.125% and 4.59% on the final maturity in 2036. The plan argues that additional benefits of the new structure include the maintenance of bondholder claims and of the bonds’ tax-exemption, and the creation of marketable and tradable securities.

The July 1 default marked the fourth default on the $43 million B series that carries the village’s appropriation pledge. No payments have been made on $29 million of C series bonds. The January 2014 default marked the first actual payment default and it gave bondholders of the A and B bonds the right to accelerate repayment but they have not done so.

Originally, the village pledged — subject to appropriation — to cover debt-service shortfalls on the Series A bonds before reserves are tapped. The backstop was first triggered in 2012. The B series carried a more direct appropriation pledge but reserves were tapped first before the village was asked to cover shortfalls. The village in 2013 tried to issue a $10 million new-money issue of certificates but investors showed no interest in a non-general obligation debt that would have been secured by any legally available and appropriated funds. Property tax caps limit the non-home rule village’s ability to use a GO pledge. Lombard has no near-term borrowing needs for capital expenses.

The restructuring marks the second attempt by the village to get bondholders to agree to a plan that giving the project more breathing room. A proposed tender of the Series A and C bonds that asked holders to take a loss in 2011 failed due to bondholders’ competing interests.

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

THE BALL DROPS ON PUERTO RICO’S CREDIT

Puerto Rico made $594 million in bond payments due this week but still defaulted on $37 million in interest. The Governor at the same time said that there is no money available for future payments, including $400 million due in May in bonds issued by the Government Development Bank. The Governor reiterated that Puerto Rico needs Congress to give the territory access to debt reorganization under federal bankruptcy laws. “I’m not asking for a bailout,” he said. “I’m asking for the tools to address the problem.”

He said the government would default on $35.9 million in Puerto Rico Infrastructure Financing Authority bonds and $1.4 million of Public Finance Corporation bonds. This is the second time that Puerto Rico has defaulted on Public Finance Corporation bonds. The government missed a $58 million bond payment in August.

The U.S. Treasury said in a statement that the default demonstrates the gravity of the island’s situation and the need for Congress to act. “Puerto Rico is at a dead end, shifting funds from one creditor to pay another and diverting money from already-depleted pension funds to pay both current bills and debt service,” it said. The government has already increased taxes, closed schools, withheld tax returns and taken other numerous measures to cut costs and generate more revenue amid a worsening economic crisis. The Governor said government officials will start meeting with creditors in early January to discuss debt restructuring.

Previously, PREPA officials said that two bond insurers had agreed to take part in a five-year restructuring plan for the Authority. The insurers’ involvement signaled that PREPA had found a way to satisfy its bondholders, who expected to be paid about $177 million on Jan. 1, without having to part with that much cash itself. On Jan. 1, the two participating bond insurers, Assured Guaranty and National Public Finance Guarantee purchased $50 million of new revenue bonds from PREPA; a creditors’ committee known as the Ad Hoc Group will purchase an additional $65 million worth of bonds. Those purchases will give PREPA $115 million of fresh cash, which it can use to honor a large part of its scheduled bond payment due that day. PREPA was to make the rest of the payment out of its own resources.

The restructuring plan resembles terms that were made public earlier this year. They called for giving PREPA five years’ worth of interest-rate relief, which would save the utility more than $700 million. In addition, the creditors have agreed to permanently reduce PREPA’s outstanding bond principal by more than $600 million, according to a summary provided by the utility. This would be accomplished through a debt exchange, in which the holders of PREPA’s current, junk-rated bonds could turn them in and receive new investment-grade bonds. This was facilitated when  the two bond insurers agreed to backstop with a surety. The idea is to induce  investors to exchange their old bonds for the new ones, despite the lower face value, by making the new bonds a better credit risk.

The debt exchange is not expected to take place until next summer, and, until then, the negotiators must clear a number of obstacles. The first is Jan. 23 — a deadline for the Puerto Rican legislature to pass enabling legislation for the deal. Legislators have so far shown little appetite, because they would also have to request a rate increase for PREPA. In addition, a large number of PREPA’s bondholders continue to stay aloof from the restructuring talks, perhaps hoping an even better deal might appear later.

The creditors on board so far represent about 70 percent of PREPA’s $9 billion debt; they include the Puerto Rico Government Development Bank, mutual funds, hedge funds, and banks that finance PREPA’s fuel purchases. The holders of the remaining 30 percent of the debt have not yet signed onto the deal, and it is not clear whether enough of them ever will, at least under the incentives proposed by the current deal. But one more factor is expected to come into play in the first half of 2016: the hope by some investors  that Congress is preparing to make some form of bankruptcy protection available to Puerto Rico.

“While the entry into these agreements is another important milestone in PREPA’s transformation, the transaction is subject to a number of conditions and contingencies,” said Lisa Donahue, PREPA chief restructuring officer. “Chief among them are the enactment of the necessary legislation, the approval by the [Puerto Rico] Energy Commission of PREPA’s rate structure and the securitization charges, execution of a successful exchange offer, and the achievement of an investment grade rating for the securitization bonds, the last of which will of course depend on a number of factors, including the overall situation at the commonwealth.”

Effectively  the bond insurers have put up some money, in particular for the surety bonds, as their contribution for the deal, whereas the bond holders are accepting delays in principal payments and cuts in the interest rates, as their contribution for the deal. The lines of credit holders and the Government Development Bank for Puerto Rico have agreed to accept either an extended payment schedule plus lowered interest rates or to convert to bonds and accept the bond holder deal.

Officials continue to publicly hope that the PREPA agreement may serve as a template for similar agreements between creditors and Puerto Rico’s other debt-issuing entities. Whether  the collateralized debt concepts may be applicable to the ‘super bond’ structure being considered for the rest of Puerto Rico’s debt  is an open question. The statutory and constitutional issues underpinning the security for the outstanding general obligation debt create legal and political issues and involve many constituencies with clearly conflicting goals.

The commonwealth, however, still  has over $2 billion in payments due from February until July 2015. These payments are approximately as follows: $402 million in February; $ 29.3 million in March; $40.9 million in April; $469.4 million in May; $ 71.3 million in June and $1.9 billion in July 2016. In July, specifically, the government must pay $779 million in general obligations. COFINA has a $318.3 million payment due in February. The Puerto Rico Electric Power Authority must pay $423.8 million this year; the Aqueduct and Sewer Authority $147.5 million; the Public Buildings Authority $177.2 million and the Highway and Transportation Authority $232.5 million.

ALASKA

With oil prices down along with oil production, the state is facing a huge shortfall. Two-thirds of the revenue needed to cover this year’s $5.2 billion state budget cannot be collected. The governor  has proposed the imposition of a personal income tax for the first time in 35 years.  Many Alaskans are not old enough to remember a time when oil did not provide for state expenses. Oil royalties and energy taxes once paid for 90 percent of state functions. Residents received annual dividend checks from a state savings fund that could total more than $8,000 for a family of four .

Gov. Bill Walker, an independent, is proposing to scale back those dividends as he seeks to get Alaska back on a stable financial footing with less dependence on oil. The Permanent Fund has paid dividends to residents every year since 1982, from $300 to $500 a person in the early years to more than $2,000 this year, based on the fund’s investments.

The income tax would be 6 percent of the amount an Alaskan currently pays in federal taxes, so a person who owed $10,000 to the Internal Revenue Service would also need to write a $600 check to Alaska. Dividend payments would be tied directly to royalties that decrease or increase with oil production. Because oil production is down, next year’s payout would be cut by roughly half under the proposal, to about $1,000 a person. The governor would also raise taxes on alcohol and tobacco and would collect new taxes from the fishing, mining, energy and tourism industries.

Legislative leaders said the governor’s plans would be given fair consideration. The speaker of the House has conceded that some new revenue stream is probably unavoidable. In a deep first wave of budget cuts this year, Alaska eliminated almost all capital spending. The president of the State Senate, who is also an employee of the oil giant ConocoPhillips, said that he thought deeper budget cuts were still necessary and that residents would accept new taxes only when they were convinced that the old pattern of state spending — wasteful and inefficient, in his view — had been permanently changed.

Opponents argue that the governor’s plan would disproportionally hit working-class Alaskans. Which sectors of the state are hurt, or spared, will also be on the table when the Legislature returns to Juneau in January. The income tax plan, for example, would primarily hit urban Alaska, where most jobs are. A sales tax, by contrast, which some lawmakers favor, is seen as hurting rural residents more.

PENNSYLVANIA GETS A HALF A BUDGET LOAF…

Gov. Tom Wolf used line-item vetoes to allow some spending called for in a $30.3 billion budget lawmakers sent him. The vetoes strike $6.3 billion from the plan, leaving $23.4 billion in spending. The idea is funding will be restored if Wolf and lawmakers can negotiate a final plan. Wolf didn’t support lawmakers’ plan and wants one that includes an education funding boost and new tax revenue to close the recurring budget deficit.

Public schools will receive part of their basic education subsidy, but the vetoes withhold about $3 billion. Most other programs remain intact. The vetoes flat fund community colleges and state-system schools (including Kutztown University), cutting a combined $31.3 million proposed increase. Most funding is provided for student loans and grants, but $59 million is cut. A combined $521 million in proposed aid to state-related universities — Penn State, the University of Pittsburgh, Lincoln and Temple — is not included. But that’s because that funding has not been approved, not because of a veto.

The vetoes withhold the lion’s share of funding for agriculture programs, cutting $68.8 million from areas like dairy and livestock shows and agriculture research. State prisons will receive partial funding, but about $939 million is withheld. Medical assistance will be partially funded with $2 billion withheld. The vetoes cut $9.7 million of what was proposed for health items such as newborn screenings, poison control centers and programs targeting specific diseases.

Wolf flat funded the Legislature and commissions and offices that support it, vetoing a combined $64.7 million proposed increase.

… HELPING SCRANTON SCHOOLS AVOID DEFAULT

The Scranton PA School District officially secured a $40 million bond, avoiding default on tax anticipation notes due last week. The bond has a 4 percent interest rate for 2016. Earlier in 2015, the district received a note of $18.5 million and secured another note for $14.3 million in November to make payroll through the end of the year.

Directors passed a $146.5 million budget for 2016 on Dec. 21 that increases property taxes 2.8 percent and borrows millions, delays debt payments and uses money set aside for large health care claims. The district will again use procedures delaying paying nearly $10 million in debt and pushing payments into the future. Once the state passes a budget and the district begins to receive state funding again, the district hopes to pay off the loan. Scranton has 10 years to pay back the $40 million per a court order they sought in early December and a state statute.

Without state funding, the district had been unable to repay the two tax anticipation notes taken out earlier this year. After Standard & Poor’s withdrew the district’s credit rating earlier this month because of the state budget impasse, it had been much harder for the district to secure a bond. The bond has to be outstanding for one year. So if the district receives its state funding within the first half of the year, they have to wait until Dec. 1, 2016 to pay off the bond. The 4 percent interest rate is set for one year only. Rates can change through the life of the bond or the district can seek to refinance, he said. It was structured that way to allow the district to pay back as much as possible once state funding comes through. Extra money left over after the TANs are paid off will go toward paying the district’s everyday operations and payrolls, among other expenses.

HAWAII RAISES SMOKING AGE

Hawaii became the first state to raise the smoking age to 21. There will be a $10 fine the first time anyone under 21 is caught smoking and a $50 fine for every offense after that. Store owners will face a $500 penalty if caught selling to a person under the age limit. The rising popularity of electronic cigarettes led to passage of the new legislation. Officials cited a University of Hawaii study that found e-cigarette usage among Hawaiian teens is triple the national average. Twenty eight per cent of revenues received by the State under the MSA are statutorily pledged to support debt service on revenue bonds issued on behalf of the University of Hawaii. None of the revenues have been directly securitized.

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 OUTLINES STRUCTURE OF EXPECTED DEFAULT

PR has finally admitted that it will default on January 1 when the Puertto Rico Infrastructure Finance Authority”s (Prifa) $35.9 million debt-service payment is not made. There are no reserves to cover the payment due to the clawback of the authority’s pledged revenue stream — the rum tax proceeds received from the federal government — to help the commonwealth meet the $331.6 million GO payment due at the same time. There is also  $115 million due Jan. 1 to cover Highways & Transportation Authority (HTA) debt, as well as a $9.5 million payment corresponding to the Convention Center District, but their trustees hold enough reserves to cover both payments.

Despite the clawbacks undertaken, there is not enough to cover the full amount due on the general obligations. The governor has been lobbying Congress to include a bailout in the omnibus budget bill before Congress. this has been ruled out by House leadership. The governor is resorting to threats of a humanitarian crisis and invocation of Puerto Rico’s historic wartime activities in an attempt to shame the Congress into action.

House Speaker Paul Ryan, R-Wis., said on Wednesday that the House will work with Puerto Rico to come up with “a responsible solution” for the island’s debt problems next Unfortunately, the governor has been most closely aligning himself with some of the least mainstream and influential House members. Help will be best earned on the merits, not the emotions.

SPEAKING OF THE MERITS

Recent comments by Antonio Weiss, counselor to Treasury Secretary Jack Lew  may be seen as encouraging those who seek to achieve Puerto Rico’s goal of reducing its debts through the political process rather than through good faith efforts. Last week, Mr. Weiss gave a speech that was seen as endorsing Puerto Rico’s view that the Commonwealth itself –  not just its corporations and municipalities – be given the right to declare Chapter 9 bankruptcy. They were also viewed by some as trying to undermine ongoing negotiations to restructure PREPA’s debt. Weiss used creditor negotiations with the Puerto Rico Electric Power Authority, which have gone on for about 18 months, as a “cautionary tale” in his speech and a reason why the commonwealth needs access to a bankruptcy regime to bring creditors to the table. He is said to have called the need for audited financials before helping a “myth” and said “even without fiscal year 2014 audited financials, the magnitude of Puerto Rico’s problems, and the need for action, are clear.”

We find those remarks to be disturbing at best. The ignorance of the need for such data, if it represents Treasury’s view, is stunning given the precedents established during the New York City crisis. We view any effort to grant the Commonwealth directly the ability to declare Chapter 9 as being detrimental not only to holders of Puerto Rico debt but to the municipal market as a whole.  We agree that the portion of the Treasury plan that calls for a federal restructuring regime through Chapter 9 is advocating for a retroactive change in law that would be unfair to investors.

Assured Guaranty recently expressed such a view very well when it said that “Had Puerto Rico been eligible to file under Chapter 9 at the time these bonds were issued, investors would have priced that risk into the bonds, and Puerto Rico would have had to pay higher interest rates,” he said. “There is no justification for initiatives that would retroactively undermine the Puerto Rican constitution and the legal right and remedies that were the basis on which bondholders agreed to provide financing for the island’s development.”

We do not believe that it is extreme to believe that should Puerto Rico be successful in its quest to obtain the right for the Commonwealth to go the Chapter 9 route, that some states would want the same ability. Chapter 9 would provide a politically expedient route for irresponsible legislators to avoid making good on years of pledges to their employees.

This belief is based on the political trends which have become clear in the four decades since the New York City crisis. These reflect the increased partisanship of legislatures across the country buttressed by the highly ideological views of Republican legislators across the country. The resulting inflexibility in the face of increasing costs, especially for pensions, seems to be a perfect storm of conditions for those who would seek to reduce payments to all creditors including general obligation debt holders.

We hope that the sanctity of contracts and constitutional pledges was behind the U.S. Supreme Court’s decision last month to review a local law that would give the island’s public authorities access to bankruptcy-like restructuring capabilities. Two lower courts ruled the law is pre-empted by federal bankruptcy law but Puerto Rico appealed to the high court. The commonwealth, whose public authorities are not granted Chapter 9 protections under federal law, is arguing that it should not be left out of the federal law but also have the same federal law prevent it from trying to fix the exemption.

ST. LOUIS THROWS A HAIL MARY STADIUM PASS

It is hard to discern what actually went on in St. Louis last week when it approved a municipal financing plan that may be as ugly as the uniforms worn by the Rams in their game last Thursday night. Under the terms, the city would finance $150 million of the overall $1.1 billion project. The rest of the funding would come from the state, the NFL and the team owner. The NFL contribution is pegged at $300 million.

Two problems: the Rams owner is busy pursuing a plan to build a stadium in Los Angeles to return the Rams there and the NFL reiterated its position that the premise of the bill approved on Friday that the league has committed $300 million to the Mississippi River stadium proposal “is fundamentally inconsistent with the NFL’s program of stadium financing.”

The comments of various St. Louis aldermen express the “untidyness” of the plan best. Alderman Antonio French, once a critic of the project, turned into a supporter after amendments were added  to the bill to include minimum  requirements for ethnic and gender based owned contractors to be hired to build the stadium. French said he doubts the stadium will be built. But he said he hoped St. Louis’ action would show a “good-faith effort to hopefully sway a few votes to prevent Kroenke(the owner) from moving to Los Angeles”. Alderman Megan Green, labeled the process of generating  help from construction unions as well as minimum minority inclusion component “legalized bribery.”  But the best comment may have been from Alderman Sharon Tyus who said “we’re like at the strip club…and the stripper is throwing the money back at  us.”

The plan is being driven primarily at the State level through a task force created by the governor. It is of interest that St. Louis County has withdrawn from any plan to finance a stadium even though it is in a much better financial position than is the City. The result is an excellent reflection of the wide disagreement over the wisdom of public stadium finance that makes these financings among the most contentious in the public finance industry. The league is expected to decide in January whether or not it views the total package as viable or whether to support Rams’ ownerships desire to relocate to the L.A. market.

The Rams are in competition to relocate to that market with the San Diego Chargers and the Oakland Raiders. It is unlikely that the league would place three teams in that market. Complicating the process is the fact that interests with the Chargers and the task force supporting keeping the Rams in St. Louis are represented by the same investment banker. The whole situation is almost as ugly as those uniforms.

CHICAGO HOSPITAL MERGER UNDER FEDERAL CHALLENGE

With the enactment of the Affordable Care Act and its emphasis on cost saving, many have felt that consolidation was the way to achieve the operating efficiencies necessary to constrain costs to health consumers. To that end, significant mergers have occurred between numerous large health systems. Not all mergers have been seen by federal regulators to be in the public interest. Such is the case in Chicago where a proposed merger of Advocate Health Care, the state’s largest health system, and NorthShore University HealthSystem, (both mid AA rated systems) would create a 16-hospital system that would dominate the North Shore area of Chicago.

The Federal Trade Commission said on Friday that it planned to block the combination saying “this merger is likely to significantly increase the combined system’s bargaining power with health plans, which in turn will harm consumers by bringing about higher prices and lower quality.” “Competition between Advocate and NorthShore results in lower prices, higher quality and greater service offerings,” the F.T.C. argues in the complaint filed in the Eastern Division of the U.S. District Court for the Northern District of Illinois. The F.T.C. took similar action to halt the merger of two hospitals in West Virginia in November and, earlier this month, teamed up with Pennsylvania authorities to try to stop a deal between Penn State Hershey Medical Center and PinnacleHealth System.

Advocate argues that because the hospitals’ market was dominated by a major insurer (Blue Cross Blue Shield), the systems were “price takers, not price setters.” The hospital groups say the merger would shift health care from the traditional fee-for-service model of providing high volumes of care for high payments to one focused on a streamlined system aimed at achieving lower costs.

The hospitals believe that the federal government is subjecting mergers of providers to more scrutiny than it does to mergers of insurers to the detriment of providers.

Merry Christmas!! Our next publication date is January 7. Happy New Year!!

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

Joseph Krist

Municipal Credit Consultant

CHICAGO PUBLIC SCHOOL CREDIT UNDER MORE PRESSURE

After a series of downgrades this summer including two to below investment grade, the Chicago Public Schools credit is under pressure again. The Chicago Teachers Union has voted overwhelmingly to authorize their leaders to call a strike. The announcement was accompanied by the usual strong rhetoric from the union which only served to highlight the trouble that holds the credit down and sets the stage for another downgrade.

The union said in a statement,  “Do not cut our schools, do not lay off educators or balance the budget on our backs.” The teachers’ contract expired in June.  School administrators have threatened widespread layoffs as they deal with a half-billion dollar budget shortfall. The union, which represents close to 27,000 teachers and staff members, has said that the city is demanding changes that would result in a 12 percent cut to their compensation in the next three years.

The potential strike accompanies events in October when the former chief executive of the school system, Barbara Byrd-Bennett, pleaded guilty to accepting hundreds of thousands of dollars in bribes and kickbacks in exchange for steering $23 million in contracts to her former employer. The system has been notorious for both its contentious labor relations and managerial incompetence and corruption over the years.

Union and city officials would first have to go through mediation before a strike could take place. Under state law, at least 75 percent of union membership must approve a strike before it can be called.

PENNSYLVANIA BUDGET STANDOFF IMPACT ON SCHOOL DEBT

Standard & Poor’s says it has withdrawn its ratings on a state government program that helps school districts borrow by giving a guarantee to repay bondholders.

In a Friday note, Standard & Poor’s says Pennsylvania can’t ensure the timely payment of debt service because of the ongoing state budget stalemate. Many districts use the program to lower their debt costs but mostly poorer districts essentially rely on the state intercept program for market access because their own stand alone ratings are often too low for them to borrow at rates they feel they can afford.

Districts in this position are often the victims of long term economic deterioration that has negatively impacted their ability to raise revenues locally . These include big city as well as small rural districts. The larger districts serve huge pools of economically disadvantaged children through large and aging facilities that require capital to be maintained. The smaller districts have less diverse tax bases and/or aging populations that provide little, if any support for property tax increases to fund borrowings.

School funding has been at the center of the current budget dispute which has entered its six month without a resolution. The state auditor general’s office has tallied about $900 million in borrowing by Pennsylvania school districts to pay bills during the impasse.

NUCLEAR DEVELOPMENTS IN SC

South Carolina Public Service Authority (Santee Cooper) is one of two municipal joint action agencies undertaking financial participations in the development of new nuclear generation sources. Over the next three years, SC projects financing requirements of $2.1 billion for its 45% ownership interest in two new units at the existing Sumner Nuclear plant. Nuclear is a resource that many are looking to in order to address carbon emission issues that have been the subject of international negotiations this week.

The obstacles to nuclear power outside of the obvious post – safety issues have centered on the cost and financial risk associated with the construction of new capacity. The municipal market had much experience with these risks in the 1980’s when credit weakness and default plagued several joint action agencies involved in some well known nuclear construction projects. While much has been done in the area of design to address the safety and direct construction issues, there still  remains significant cost risk associated with financial participation.

SC is a good example. Work began on the Sumner expansion in 2008. By 2012, license and design related delays had resulted in increased costs of $113 million and construction delays of 11 and 8 months. One year later, additional delays of one year were announced. In 2014, additional delays were identified such that the units will not be completed until  mid 2019 and mid 2020. This will produce another $270 million of costs to the Authority. These could be offset by the payment of liquidated damages by the construction consortium but these damages are now capped b y agreement. This year the project costs were capped at $2.73 billion for the Authority reflecting its now 40% ownership interest in the project.

This history is instructive to other utilities considering additional nuclear capacity. Even with a streamlined approval and licensing process, along with use of a standardized design, the project will have taken 12 years to design and complete. The “smoother” licensing process still did not allow for limitations in cost and have not provided financial certainty for owners and operators. This despite the fact that SC is one of the financially stronger and well managed municipal utilities. It also has substantial nuclear experience.

WATER IN CALIFORNIA BACK IN THE NEWS

One of the ways in which water consumers in drought ravaged California have been coping with less water is to tap underground sources. Now that strategy is exposing a downside. Uranium increasingly is showing in drinking water systems in major farming regions of the U.S. West, including the major farming areas of California. The Associated Press has found that nearly 2 million people in California’s Central Valley and in the U.S. Midwest live within a half-mile of groundwater containing uranium over the safety standards.

Uranium is a naturally occurring but unexpected byproduct of irrigation, of drought, and of the overpumping of natural underground water reserves. In California, as in the Rockies, mountain snowmelt washes uranium-laden sediment to the flatlands, where groundwater is used to irrigate crops. Irrigation allows year-round farming, and the irrigated plants naturally create a weak acid that leeches increasing amounts of uranium from sediment at the bottom of aquifers.

The USGS calculates that the average level of uranium in public-supply wells of the eastern San Joaquin Valley increased 17 percent from 1990 to the mid-2000s. The number of public-supply wells with unsafe levels of uranium, meantime, climbed from 7 percent to 10 percent over the same period. USGS researchers recently sampled 170 domestic water wells in the San Joaquin Valley, and found 20 to 25 percent bore uranium at levels that broke federal and state limits.

It is difficult to assess the potential financial risk to water utilities throughout the state as there is limited data to rely on. One way of dealing with the issue has taken place in Modesto where the city of one half-million residents, recently spent more than $500,000 to start blending water from one contaminated well to dilute the uranium to safe levels. The city also retired a half-dozen other wells with excess levels of uranium. In California, changes in water standards  in place only since the late 2000s have mandated testing for uranium in public water systems.

WILL RATE HIKES OFFSET VOLUME DECREASES?

Municipal bond volume declined for the third consecutive month in November with refundings down over than one-third from the same month last year. They dropped 39.5% to $7.42 billion in 319 deals in November from $12.26 billion in 444 deals a year earlier. Long-term issuance dropped 21.6% to $23.19 billion in 834 issues from $29.56 billion in 995 issues in the prior year period, according to Thomson Reuters. This is the lowest November lower volume since 2000, when the monthly issuance $19.80 billion.

At the same time, new money issuance declined 1.7% to $11.93 billion in 449 transactions from $12.13 billion in 473 transactions a year earlier. Revenue bonds fell 17.1% to $14.22 billion, while general obligation bond sales dropped 27.7% to $8.97 billion. Negotiated deals were down 15.3% to $17.43 billion and competitive sales were lower by 26.8% to $5.62 billion.

Taxable volume was down 22.7% to $1.69 billion from $2.19 billion, while tax-exempt issuance declined by 24% to $20.42 billion. Minimum tax bonds more than doubled to $1.08 billion from $508 million. Bond insurance broke its trend of decreases, as the par amount of insured issues rose 16.8% to $2.09 billion in 121 deals from $1.79 billion in 147 deals in November 2014. Cities and towns saw an increase of 49.4% increase to $4.37 billion in 224 transactions from $2.92 billion in 254 transactions, while state governments, state agencies, counties and parishes, districts, local authorities, colleges and universities and direct issuers all saw large declines.

Swimming against the tide were sectors like the housing and public facilities sectors saw gains despite having a lower number of transactions, compared with November 2014. Housing transactions increased 23.7% to $1.19 billion in 35 deals from $967 million in 44 deals while public facilities issuance jumped up 46% to $1.65 billion in 49 deals from $1.13 billion in 57 deals. Housing and public facilities sectors increased in spite of their being a lower number of transactions, versus November 2014. Housing transactions increased 23.7% to $1.19 billion in 35 deals from $967 million in 44 deals while public facilities issuance jumped up 46% to $1.65 billion in 49 deals from $1.13 billion in 57 deals.

Our view is that initial fed moves to raise rates will be mitigated by a continued demand for tax exempt income by investors who are seeing bonds called at a faster rate than they can be replaced in the new issue market.

PUERTO RICO REVENUE SHORT AGAIN

Puerto Rico’s General Fund net revenue for November totaled $488.6 million. This is $15.4 million, or 3.2%, less than estimated for the month in the original budget for fiscal 2016. This is the third consecutive month that revenues have missed estimates. Fiscal year-to-date (July-November) revenues total $3.051 billion, an increase of approximately $149.5 million year-over-year, but $23.9 million below estimates for the same period during fiscal 2016.

Individual income taxes showed a $31.3 million decrease compared with November 2014. In fiscal 2015, the Treasury Department received $29.4 million in nonrecurring revenues associated with Act 77 of 2014, which granted a temporary period during which certain transactions, such as those involving individual retirement accounts (IRAs), retirement plans and other capital assets, could be prepaid at preferential rates.

VAT collections for November were $191.5 million, some $74.9 million more than in November 2014, the result of the increase in the VAT rate to 10.5% from 6%. VAT revenues were divided: $109.3 million, corresponding to the 6% rate, was allocated to the Sales Tax Financing Corp. (Cofina by its Spanish acronym) and other $82.2 million, corresponding to the 4.5% rate, was allocated to the General Fund.

Corporate income tax revenues registered an $8.2 million decrease. Non-resident withholdings, which include royalties from the use of manufacturing patents, registered a $21.9 million decrease. Actual revenues were $25 million below estimates. Foreign excise tax collections increased by $10 million year-over-year.

For excise taxes, alcohol taxes rose $4.9 million with motor vehicle excise taxes up by $7.6 million. This is the first year-over-year increase in motor vehicle excise taxes for a month in fiscal 2016. Year-to-date motor vehicle revenues decreased $31.9 million.

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

Senior Municipal Credit Consultant

PUERTO RICO TROUBLES CONTINUE

Just as the storm surrounding the credit woes of Puerto Rico intensifies, the worst suspicions of the most cynical investors and observers are confirmed. U.S. Attorney Rosa Emilia Rodríguez-Vélez of the District of Puerto Rico announced that 10 Puerto Rico businessmen and government officials have been indicted for their alleged participation in several schemes to corruptly give things of value to public officials within the government of the Commonwealth of Puerto Rico in exchange for favorable treatment and awarding of government contracts to various corporations. The 25-count indictment includes charges of conspiracy to commit federal programs bribery and honest services wire fraud, wire fraud, federal program bribery, extortion through fear of economic harm, money laundering, false declarations before a grand jury, and obstruction of justice.

Among the indictees are the Purchasing Director of the Puerto Rico Aqueduct and Sewer Authority and the Administrator and Special Assistant for Administration at the House of Representatives of Puerto Rico.

Just when it needs to show that it is serious about tackling its problems, Gov. Alejandro García Padilla signed into law the commonwealth’s self-imposed fiscal oversight board. Several amendments watered down the original version including provisions that the five-member board will only certify or endorse, rather than control, the commonwealth’s fiscal practices, while investigative, approving and budgetary-control powers also remained toned-down. The board will certify if each monitored entity is undertaking sustainable fiscal practices and complying with the five-year fiscal and economic plan. Such entities may request the board to be excluded from its scope if certain criteria are met, including long-term fiscal health and not running counter to the FEGP. The legislative and judicial branches, PREPA and PRASA, and the University of Puerto Rico are not considered monitored entities, so they do not fall under the board’s review powers.

SUPREME COURT ACCEPTS PR RECOVERY ACT FOR REVIEW

The Supreme Court on Friday agreed to decide whether Puerto Rico, which is in the midst of a financial crisis, may allow public utilities there to restructure $20 billion in debt. Puerto Rico’s lawyers had urged the court to take immediate action in light of the overall magnitude of the commonwealth’s debts, around $72 billion, which it says it cannot pay. “Anyone who has even glanced at the headlines in recent months knows that the commonwealth is in the midst of a financial meltdown that threatens the island’s future,” the lawyers wrote in their petition seeking review of an appeals court decision that struck down a 2014 Puerto Rico law allowing the restructurings.“Because that decision leaves Puerto Rico’s public utilities, and the 3.5 million American citizens who depend on them, at the mercy of their creditors,” the commonwealth’s lawyers wrote, “this court’s review is warranted — and soon.”

The United States Court of Appeals for the First Circuit, in Boston, said the 2014 law, the Recovery Act, was at odds with the federal Bankruptcy Code, which bars states and lower units of government from enacting their own versions of bankruptcy law. Puerto Rican officials countered that the Recovery Act addressed a gap in the way its debts are treated. Chapter 9 excludes all branches of Puerto Rico’s government, including its public utilities. The Recovery Act, Puerto Rican officials said, merely filled the gap in the overall legal structure.

Creditors of the utilities sued, arguing that the Bankruptcy Code displaced, or pre-empted, the local law. So far, the courts have agreed. The decision to accept the case for review seems to have reinforced the government’s strategy of appearing to put all of its eggs in the bankruptcy basket so to speak. PR lawmakers were informed Saturday, Dec. 5, that the Governor  won’t be calling a special session to consider the Puerto Rico Electric Power Authority (PREPA) Revitalization Act bill, after all.

CONGRESSIONAL PROPOSAL ON PR

Senate Republicans introduced a bill Wednesday to include up to $3 billion in cash relief, a payroll tax break for residents of the island and a new independent authority that could borrow for Puerto Rico — but with no taxpayer guarantee. “Consistent with the views of Congress and the administration that there will be no ‘bailout’” of Puerto Rico, said a bill summary, “the full faith and credit of the United States is not pledged for the payment of debt obligations issued by the Authority.” “Consistent with the views of Congress and the administration that there will be no ‘bailout’” of Puerto Rico, said a bill summary, “the full faith and credit of the United States is not pledged for the payment of debt obligations issued by the Authority.” The legislation also included a provision to require Puerto Rico — and all the states — to disclose, for the first time, the true financial condition of their pension systems for government workers.

The bill provides for tapping a $12 billion public-health fund created under the Affordable Care Act, for research and preventive medicine programs nationwide. The bill summary said the money was as yet “unobligated,” and could be “repurposed” with federal supervision to help Puerto Rico through an expected cash squeeze this winter. The legislation was introduced by the Republican chairmen of three Senate committees with jurisdiction over Puerto Rico’s: Senator Hatch of Utah, whose Finance Committee has jurisdiction over tax policy; Senator Grassley of Iowa, whose Judiciary Committee is responsible for bankruptcy law; and Senator Murkowski of Alaska, whose Committee on Energy and Natural Resources has jurisdiction over matters involving America’s territories.

The bill would designate a “chief financial officer” for Puerto Rico to advise the island’s governor on drafting and sticking to an annual budget. The designee would remain in place even if the government changes hands in next year’s election, giving Puerto Rico a better chance of seeing through its five-year economic recovery plan no matter who is elected. The bill proposes only further study of  how to revive Puerto Rico’s failing pension system, or changing the way doctors on the island are paid by federal programs like Medicare.

By waiting until the end of the current Congressional session, the bill’s sponsors implicitly indicate that the measure is at best a band aid to fund the upcoming January 1 general obligation bond payment and provide more time for a more serious and comprehensive plan in 2016.

PA MOVES TOWARDS A BUDGET

The Pennsylvania state Senate passed a public pension reform plan Monday by a 38-12 bipartisan vote. Monday’s vote sends the bill  to the House for further action. For school teachers hired after July 1, 2017 and state workers hired after Jan. 1 2018, the bill creates a new, two-track pension plan that combines a reduced guaranteed benefit based on years of service and final salary at retirement with a separate 401(k)-style component. It also will change some rules pertaining to current employees, though the basic form of their pension plan would not change.

Pennsylvania union leaders immediately blasted the bill as unfair to future workers, and noted that it may have passed improperly without a required independent actuarial note from the state’s Public Employee Retirement Commission. Unsurprisingly, the leader of the largest state employees’ union, vowed to continue to fight against the bill in the House, and also promised a certain court challenge if passed because of the changes for current employees.

The  director of the Pew Charitable Trusts States’ Public Sector Retirement Systems project has said that his reviews showed that while retirement benefits for a career worker hired under the new bill’s terms would be reduced about 10 to 15 percent from present, with Social Security that worker could still expect to receive an average of about 90 percent of their take-home pay through the course of their retirement.

The new benefit would cut the current “defined benefit” pension formula in place for workers hired since 2011 in half, essentially guaranteeing new hires 1 percent of their final salary for each year served as opposed to the 2 percent multiplier in place now. That would be paired with a mandatory 401(k)-style piece, into which the state would contribute the equivalent of 2.5 percent of an employees’ salary to their personal retirement account. Between the two components, school district employees hired under the new plan would contribute 7.5 percent of their salaries to their retirement. Affected state workers would contribute 6.25 percent.

There is a carve-out for “hazardous-duty” workers, including state police, corrections officers, game wardens and park rangers, for whom the current defined-benefit plans would continue. Current state and school district employees would see changes including changes to rules regarding lump-sum withdrawal of individual pension contributions for any payments made into the system, starting Jan. 1 for state workers and July 1 for school employees. Also included were resets to the final salary calculation to the higher of average salary over the last three years of employment, excluding overtime; or the average of the last five years’, overtime included.

The bill includes an adjustment up to workers’  payroll contributions by 0.5 percent if, over the prior 10-year period, the state’s two major retirement funds have missed their investment return targets by a full percentage point. On the other hand, contributions would be cut by a half-percent if investment gains beat targets by 1 percent. The review would be applied once every three years. Actual savings from the reform bill are small: the Senate released an analysis Monday putting the number at $2.6 billion over the next 20 years, against a cumulative cost of over $200 billion. As a result, other budget issues will have to be relied upon to stabilize the Commonwealth’s finances and ratings.

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

Debt service may have been paid but the Puerto Rico debt crisis entered a new phase. The government of Puerto Rico was able to meet in full a $354.7 million payment on outstanding Government Development Bank (GDB) notes due Tuesday, Dec. 1, the governor’s fiscal team announced that certain revenues pledged to pay debt held by five public entities will be “clawed back” due to the severe cash crunch affecting the commonwealth.

Executive Order 2015-46, signed Monday by Gov. Alejandro García Padilla, allows the central government to use revenues that cover debt service of certain public corporations — the Highways & Transportation (HTA), Infrastructure Financing (AFI), Metropolitan Bus (AMA), Integrated Transportation and Convention Center District authorities — to pay debt carrying the commonwealth’s guarantee. In all, the government would claw back about $329 million in such revenues for the payment of commonwealth-guaranteed debt and would allow to maintain essential government services, officials say.

This opens the door to potential litigation by creditors of the impacted agencies that would test the validity of the “claw back” now that it has been used for the first time.  GDB President & Chairwoman Melba Acosta said the Dec. 1 payment was met using the bank’s funds and is intended to show its creditors Puerto Rico’s willingness to honor its obligations as it continues to seek a consensual debt-restructuring deal. Puerto Rico’s liquidity position continues to be “severely constrained” despite the extraordinary measures.

At the same time, revenue estimates for the current fiscal year have been further adjusted, about $508 million less than originally projected in the commonwealth’s budget for fiscal year 2016, from $9.8 billion to $9.3 billion. In a government quarterly financial report released Nov. 6, the administration had already hinted at the possibility of the “claw back” through which it could tap these revenues to pay debt guaranteed by the commonwealth. Citing the Puerto Rico Constitution, the government could do so “if there is an insufficiency of available resources to meet debt service on general obligation debt.”

“In the case of the contracts where a clawback could be carried out, they provide that if there is a need of cash flow to pay debt with more legal protection and government services, a clawback can be executed,” Secretary of State Víctor Suárez said.

Meeting the Dec. 1 GDB payment proved to be a challenge for the government, with several payments looming , and as soon as Jan. 1, the administration would have to come up with more than $600 million if it is to meet all its debt obligations that come due on New Year’s Day. Primary among those Jan. 1 payments, the government faces $331.6 million due on general obligation (GO) debt. There is also some $115 million due on HTA debt, about $36 million due on Infrastructure Financing Authority (AFI) and $9.5 million corresponding to the Convention Center District Authority.

The GDB said that despite the  decision to claw back revenues pledged to the public corporations, they would still have enough resources to meet their debt-service schedule. “What we are doing is clawing back on the money that goes to the trustee. Most of these agencies have sufficient reserves to pay their scheduled debt service payments. Not sending the money [to the trustee] doesn’t necessarily mean that we are not going to pay that debt. Each entity is different. The executive order was signed yesterday, and the first clawback was yesterday, of some $22 million that was going from HTA to its trustee,” Acosta said.

The action was concurrent with a U.S. Senate hearing on Puerto Rico’s problems. According to the testimony submitted by Governor García Padilla for the  hearing over the Puerto Rico fiscal crisis, the governor stated that “in simple terms, we have begun to default on our debt,” as a result of his decision to sign the order that allows for the clawback. Other spokesmen for the Government were more equivocal saying, “According to each contract, there are different definitions on what a default would be. From a technical default, to a default or a breach of contract, there are different definitions”.

The  Justice Secretary César Miranda said the administration’s decision to use these pledged revenues to pay other public debt “could be interpreted as a technical default, in the way that we are retaining money that would have been used to eventually pay a debt when it’s due. Certainly, the debt hasn’t matured. When it is due and not paid, then there could be an absolute default. Someone may interpret that retaining the money that would have been used to pay certain debt could constitute a default. It is questionable legally, and would depend on what is stated under each particular contract.”

ILLINOIS FINDS SOME CASH

The other large troubled credit made some level of progress this week. Gov. Bruce Rauner and House Democrats on Wednesday came to a rare compromise to release more than $3.1 billion to pay Illinois Lottery winners and help cities and towns operate 911 centers, plow roads and train firefighters. Normally, municipalities receive a share of gas tax, 911 surcharge and gambling revenue to finance up day-to-day operations.  Those dollars have been on hold due to the state budget impasse. Legislation passed 107-1 by the House would free those funds. Of the total, $1 billion would be for the lottery which had stopped making large payouts because the state hasn’t had a budget since July 1.

The bulk of the $3.1 billion in new spending is money set aside in accounts earmarked for specialized purposes, though lawmakers also signed off on $28 million in spending from the state’s main checking account. About $18 million of that will go to domestic violence shelters and another $10 million was set aside for the Secretary of State’s office, which stopped mailing yearly reminders for drivers to renew their vehicle registrations.

By year’s end, Comptroller Leslie Munger projects the backlog of delayed bill payments could reach $8.5 billion. Areas that remain unfunded include colleges and universities, scholarship programs for low-income students and various programs for victims of sexual assault and those with developmental disabilities.

Rauner said he would support the bill if it also included more money for things like debt payments and salting and plowing of roads.  He billed the move as a compromise, although it also provided him political cover as some House Republicans were willing to vote for the plan in the face of pressure from suburban mayors to free up the money. Following Wednesday’s House vote, Rauner said there were some things in the bill he liked and some things he didn’t, but “what we did is we compromised.”

The Senate is scheduled to return to the Capitol on Monday of next week to vote on the legislation. Rauner and Democrats also were able to find common ground on a bill that could make workers ineligible for unemployment benefits if they do things like drink on the job, lie on an employment application or refuse to follow an employer’s instructions.

It says a lot that those last items represent a real achievement in Illinois budget politics.

MEDICAL FINANCING POLITICS

If there is one industry that has faced more challenges to its at ability to plan financially over the last two decades it has to be the healthcare industry. This week will present yet another example. It is likely that as we go to press that the U.S. senate will use the reconciliation process to approve a repeal of Obamacare. It would represent the first  time in the six year history of the ACA that both houses approve such legislation. It will have no practical impact as all involved agree that the bill will be vetoed and that the votes to override such a veto are not to be had. It will however thicken the cloud that hangs over the law and add to the uncertainty about exactly what pool of revenues will be available to hospitals and other providers going forward over the long term.

The other headwinds are pretty well established and have been highlighted during the current enrollment period for coverage for 2016. Between stories about higher premiums, fewer insurer participants, and the possibility of changes under a new administration in Kentucky the stream of news about the ACA has not been positive. Of course this excludes the fact that millions of Americans have gotten health insurance and that the % of Americans uninsured is at a multi-decade low.

All of these factors conspire to make the job of hospital CFO more unenviable by the day. Our view is that they combine to continue the support for scale on the part of providers although scale without efficient use of technology, especially in billing is not a sufficient panacea. In fact, technology at any facility whether it be large or small, urban or rural, is a key issue. Having said that, smaller and stand alone facilities will remain the most vulnerable to the uncertainties inherent in the battle over the ACA. we believe that investors should keep that in mind as they continue or consider their investments in credits in this sector.

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

Joseph Krist

Municipal Credit Consultant

Our usual Thursday posting time has been moved up this week to accommodate Thanksgiving. Enjoy the holiday and we will return to our regular schedule next week.

PREPA

It came as no surprise when the Friday, Nov. 20, deadline on a restructuring deal struck two weeks ago for PREPA came and went. The tone of the debate over legislation necessary to implement a restructuring agreement for PREPA showed that not enough of the political establishment currently had the will to meet all of its requirements. The effort to achieve a relatively pain free result (pain free for both politicians and customers) continues. Fortunately, the cash-strapped Authority secured from its creditors an additional extension to the agreement’s drop-dead date, until Dec. 10, to get its monoline insurers on board.

Press accounts attributed to Chief Restructuring Officer Lisa Donahue said PREPA insurers were on the verge of joining an agreement. The creditors are said to have granted an extension until at least Dec. 4 and no later than Dec. 10 to grant adequate time to secure passage of the bill and to seal final details with the remaining monoline bond insurers. According to the RSA, if PREPA fails to reach an agreement with monolines that is acceptable to all parties, the implementation of a recovery plan for the utility would be worked “through a mechanism to be agreed among the Parties that may include, without limitation, a judicial process (including an enforcement proceeding under applicable law).”

PR Senate President Eduardo Bhatia has previously said majority lawmakers would seek to safeguard the interests of the commission, ensure that the proposed changes to the governance are in line with what they want and that payment to creditors is guaranteed. PREPA  has warned about introducing changes to the legislation that could jeopardize the restructuring agreement. Among the RSA’s requirements that must be met for the accord to hold, PREPA must also submit a rate-review proposal at the Puerto Rico Energy Commission (PREC) by Dec. 15. The commission also has its own set of deadlines it must meet in order to maintain full authority over the rate-review process. Failure to meet the RSA’s timetable could force the utility back to the negotiating table.

AND ON THE TAX BACKED SIDE OF THINGS

On the general obligation front, the government presented representatives of the island’s largest debt holders with a proposal for a comprehensive restructuring structure — a “superbond” — that would consolidate the commonwealth’s different credits, Government Development Bank (GDB) President & Chairwoman Melba Acosta is said to have described the meetings with creditors’ advisers as “very positive and productive,” while stressing that no negotiations were conducted at this time, as it was only an “informative meeting.” She acknowledged that the administration is seeking to finish restructuring talks by summertime. Friday’s meetings in New York included representatives of different creditor groups, along with the Sales Tax Financing Corp. (COFINA), GDB and general obligations (GOs). Advisers representing mutual funds and cooperatives holding Puerto Rico debt also took part in the presentations. Commonwealth bond insurers didn’t participate in the meetings, according to Acosta.

She was quoted as saying “If we have different credits that have different repayment sources, and we would have single structure, then there will most probably be a consolidation of repayment sources,” she acknowledged, while adding that more details on the commonwealth’s proposal will be released later. Other reports indicate that as part of that new bond, general obligation holders would have the first claim on government revenues, giving them the highest priority in the superbond structure. Holders of other forms of the government’s debt would have lower priority. It is not clear whether bondholders, in return, would be asked to buy the superbond at a discount, resulting in a haircut on their current holdings.

When asked if a forbearance agreement similar to what was negotiated with PREPA was sought, Acosta said that hadn’t been discussed yet, but could be as the commonwealth moves forward with its debt-restructuring efforts. Friday’s meetings in New York included representatives of different creditor groups, including Sales Tax Financing Corp., GDB and general obligations (GOs). Advisers representing mutual funds and cooperatives holding Puerto Rico debt also took part in the presentations. Commonwealth bond insurers didn’t participate in the meetings, according to Acosta. The hedge funds hope that Washington will avoid taking any measures that might undermine that process.

On Dec. 1, the  Government Development Bank must make a $354 million debt payment. Moody’s has predicted that the government would skip some of those payments because of the worsening liquidity situation. Officials have stayed publicly vague about whether they intend to make the Dec. 1 payment. Ms. Acosta, the president of the Government Development Bank, said the government had yet to make up its mind on whether to make the debt payment next month or another large payment coming due in January.

Those pushing for Gov. Alejandro García Padilla to default to force the creditors, including the hedge funds, to the negotiating table argue that it might also prompt Congress to act faster to give Puerto Rico access to Chapter 9 — something many creditors want to avoid.

We advise investors to take the various published comments and press commentaries with some perspective. The idea of a universal settlement has great appeal to the Commonwealth but whether such an arrangement is appropriate for the many different classes of investors is another thing. The monolines have the capacity to absorb some level of loss but their interests are more akin to those of the individual par buyer. The deep discount hedge fund investors with a shorter time horizon have a much different set of ideas as to what is an acceptable outcome. Full repayment may never have been their actual goal. Many holders of COFINA sales tax debt will be greatly disappointed to be treated as general creditors after the Commonwealth went to such pains to market the bonds as such a distinct credit. Investors in all classes will likely never achieve certainty about the actual validity and value of the Commonwealth’s long standing ‘constitutional pledge” supporting GO debt and its ability to “clawback” taxes pledged to other debt for repayment.  It will probably be an unsatisfactory outcome for many which means it’s likely to be viewed in the long run as a good deal for the Commonwealth.

YEAR END MARKET TRENDS

As we enter the final month of the year, a few trends are emerging reflecting the uncertainty around the economy and timing of an interest rate increase. These are having a direct impact on the market, the profitability of market makers, the appetite for bonds, and the ability to transact high yield credits in the new issue market.  Prominent among these is the decline in trading activity and its implicit impact on liquidity. Municipal bond trading declined in every month through September and even with a slight increase in October remained some 17% below average monthly volume. For the year, monthly trading declined 34% from January to October.

The decline in activity has obviously made it more difficult for the more marginal players and those without robust investment banking capabilities. Retail oriented shops are having a much more difficult time. Concurrently, the reduced number of outlets overall has made it harder for portfolio managers to transact and to make room for new issues. This has reduced the overall appetite for bonds and made it harder for large year-end high yield issue to be absorbed resulting in some cancellations of sales.

What does this all imply for credit? Investors must be much more selective in their choice of higher yielding bonds. It will be harder going forward to manage this risk, especially in the more speculative segments of the credit spectrum. At the same time, the results of the Puerto Rico debt restructuring could still have an impact on spreads as the market values the results and then weighs relative risks of different credit classes accordingly. None of these issues are likely to increase liquidity thus exacerbating the existing inertia in the market. It continues to be a time for caution with rates at absolute lows and spreads remaining tight.

PENNSYLVANIA BUDGET PLAN GOES OFF THE RAILS

In an unexpected development, a plan to cut property taxes statewide moved near collapse this past weekend, imperiling with it the tentative budget deal struck this month by Gov. Wolf and leaders of the Republican-led legislature. Without the property-tax reduction – a key feature of the $30 billion state spending plan – “the whole agreement fails,” said one high-ranking Democratic official, speaking on the condition of anonymity.

The budget plan presented by Gov. Wolf and GOP leaders in the legislature had called for a rise in the state sales tax from 6 percent to 7.25 percent. The $2 billion it was projected to generate was expected to increase school funding and offset a reduction in property taxes – the primary funding source for local school districts. But neither side has detailed how the education funds will be distributed, the form of property-tax relief or other key concepts in their deal – reform of the state’s pension system and state sales of wine and liquor.

In a letter to his Democratic caucus Saturday, House Minority Leader Frank Dermody (D., Allegheny) said Republican leaders told Wolf late in the week that they could not muster the votes among their members to pass the property-tax plan. “By failing to deliver the votes for the framework they agreed to, the Republican leaders would effectively kill the property-tax relief envisioned as part of the framework,” the letter said. Republicans acknowledged the new hurdle but strove to paint less of a doomsday scenario. “We are going to continue to work on the other segments of the agreement and hopefully bring it to closure,” said Drew Crompton, the Senate’s top Republican lawyer.

Five months into the impasse that has left schools, nonprofits, and other agencies turning to loans and credit to stay afloat, the two parties hailed what they said would be a historic agreement to help fund schools and shift away from the long-term reliance on the property-tax burden. The plan might have lowered property taxes a minimum of 20 percent and a maximum of 40 percent from current rates.

Strains in the agreement became evident  – and may have been worsened – last week, when the Senate unexpectedly let it be known that it intended to vote on a bill that would eliminate property taxes altogether. Its sponsor predicted it would pass. Members of the GOP House caucus were always skeptical of the so-called framework, but said that skepticism turned into opposition for some when it became apparent that the Senate was on the verge of passing a bill to eliminate property taxes altogether. On Monday night, the Senate took up a proposal designed to eliminate school district property taxes by raising the sales and personal income taxes, a plan Mr. Wolf cited as one that he opposed. Members tied 24-24 on a preliminary vote on the proposal, and Lt. Gov. Mike Stack broke the tie by voting no. A similar measure has failed in the House in the past.

New proposals being considered include expanding the list of items that would be subject to the sales tax. As it stands now, there are dozens of exemptions to the sales tax. Whether the Governor would agree is questionable – he campaigned last year on a pledge to provide significant property-tax relief. A new tax on natural gas drilling remains off limits in the 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

PUERTO RICO

U.S. Senate Judiciary Committee Chairman Chuck Grassley said that he will convene a hearing on Puerto Rico’s fiscal situation on Tuesday, Dec. 1, at 10 a.m. Grassley said his goal is to help committee members and the public identify and gain a better understanding of the root cause of Puerto Rico’s fiscal problems, discuss what’s currently being done, and consider what options are available that could help Puerto Rico get itself out of the present situation.

The Judiciary Committee has jurisdiction over bankruptcy policy, which the commonwealth has implemented efforts to be included in, but Grassley has reiterated that restructuring debt and throwing taxpayer money at the island, without ensuring the creation and implementation of structural and fiscal reform, fails to resolve the underlying problems in Puerto Rico required to create economic growth. Witnesses for the hearing will be announced at a later date.

In the meantime, PREPA announced that it has executed an amendment to its previously announced restructuring support agreement (“RSA”) with the Ad Hoc Group of PREPA bondholders, comprising traditional municipal bond investors and hedge funds, its fuel line lenders and the Government Development Bank for Puerto Rico. The amendment extends the deadline for PREPA to reach an agreement with the monoline bond insurers on a consensual recovery plan to November 20, 2015. PREPA will use the extension to continue discussions with its monoline bond insurers, while the legislative process to approve the PREPA Revitalization Act continues.

Puerto Rico Senate President Eduardo Bhatia Gautier said it will be hard to pass the energy bill presented on Nov. 4 to restructure the island’s energy sector by the current deadline of the end of Thursday. If it is not approved by then, the governor will ask for an extraordinary legislative session to handle the matter, he said. The extraordinary session could be either in November or in December.

Gov. Alejandro García Padilla said if bondholders don’t agree to new terms on their debt, he will choose to pay for the needs of the people before paying the commonwealth’s creditors. The governor said that he has called for negotiations with bondholders, proposed a five year plan, and is working to assure future responsible Puerto Rico policies, according to a government transcript. Referring to the bondholders, he said, “If you don’t negotiate and I am obligated to choose between the creditors and the Puerto Rican people, I’m going to pay the Puerto Ricans.”

The government has said it is running low on money. There have been locally-based news stories about talk of a partial government closure or a cut of Christmas bonuses for government workers to deal with the financial crisis. “We are evaluating all of the mechanisms, like we said before, to avoid reducing the workday, government shutdown or stopping payments on the debt,” García Padilla said, according to the government. “What [Government Development Bank for Puerto Rico President] Melba Acosta, [Secretary of the Treasury Juan] Zaragoza, and [Office of Management and Budget Director] Luis Cruz all said is what the numbers say. If we don’t come up with extraordinary mechanisms, uncommon and abnormal in the government, those things, like partial shutdown, workday reduction, etcetera can happen.”

If the governor chose to allow a default and use government’s revenues for other purposes, it may put him at odds with Section 8 of Puerto Rico’s constitution, which states: “In case the available revenues including surplus for any fiscal year are insufficient to meet the appropriations made for that year, interest on the public debt and amortization thereof shall first be paid, and other disbursements shall thereafter be made in accordance with the order of priorities established by law.”

Acosta seemed to present a different approach to the government’s impending debt payments. In testimony to a joint hearing of two Puerto Rico House of Representatives committees, she said the payment of debts on Dec. 1 and Jan. 1 have the highest priority for payment, according to the El Nuevo Día news web site. Puerto Rico’s GDB owes $354 million in debt on Dec. 1. According to Moody’s, $273 million of this sum has a constitutional guarantee and $81 million does not. Puerto Rico also owes $330 million in general obligation debt Jan. 1.

Acosta told the legislators that the government is likely to make the Dec. 1 payment, according to El Nuevo Día. The debt is insured, she said. She said that the government was in talks to make the payment but did not further explain the talks. Moody’s however released a short report saying it thought a default on at least some of the Dec. 1 debt service was likely.

At the hearing House President Jaime Perelló Borrás said that the government should prioritize remaining fully open and paying Christmas bonuses and delayed tax refunds and supplier bills before the bond debt. Perelló Borras is in the same party as the governor, the Popular Democratic Party. Not making the December and January bond payments would lead to further major complications, Acosta said, according to El Nuevo Día. Acosta also said the government would present a proposal for restructuring the debt to the bondholders as we go to press.

ILLINOIS WORK AROUND PROPOSED

The Illinois Finance Authority passed a resolution to ask its Board to provide the Executive Director, and 23 relevant staff with Authority, to use the State Procurement Code to explore the market to see if there will be any lenders that will, in essence, loan the Illinois Finance Authority money so that it may be of assistance, in connection with paying state bills, in connection with the state budget  impasse. Illinois Finance Authority was among a large number of state agencies that were asked to explore options. The resolution points to three statutory powers that the General Assembly  has provided to IFA: Statutory lien, statutory  non-impairment, and the statutory authority to provide up to around $100,000,000 in moral  obligation debt, which was a  form of statutory taxpayer guarantee.

The resolution would authorize an emergency purchase under the procurement code to competitively select and enter into contracts with necessary parties, including but not limited to lenders, underwriters, trustees or paying agents, servicers, printers, road show providers, and/or rating agencies, to finance one or more projects authorized under the Illinois Finance Authority act, including public purpose projects, the proceeds of which will be used to address one or more of the following in the absence of an enacted appropriation for fiscal year 2016, a court order or a consent decree: (i) threat(s) to public health or public safety, (ii) if immediate expenditure is necessary for repairs to state property in order to protect against further loss or damage to state property, (iii) to prevent or minimize serious disruption of critical state services that affect health, safety, or collection of substantial state revenues, or (iv) to ensure the integrity of state records; and other matters related thereto adopted.

In plain English, the Authority would borrow money to pay state bills which could not otherwise be paid without adoption of a state budget. It is yet another sign of the dire straits in which Illinois finds its credit position.

CHICAGO PENSIONS UPDATE

On November 10, 2015, Moody’s released a scenario analysis of the City of Chicago’s (Ba1 negative) possible pension funding paths. The scenarios incorporate the city’s recently adopted property tax increase as well as the outcomes of two key decisions pending with the State of Illinois and the Illinois Supreme Court. The analysis indicates that, despite significantly increasing its contributions to its pension plans, Chicago’s unfunded pension liabilities could grow, at a minimum, for another ten years.

“Chicago’s statutory pension contributions will remain insufficient to arrest growth in unfunded pension liabilities for many years under each scenario,” Moody’s says in the new report.” The scenario that Moody’s views as having the most positive credit impact for Chicago consists of a favorable Illinois Supreme Court decision, as the city’s budget assumes, but state legislative action that does not conform to the city’s adopted plan. Senate Bill 777 has been passed by the Illinois General Assembly, but requires the governor’s approval to become law. The bill lowers Chicago’s current statutory public safety pension contributions relative to existing statute, granting the city more time to meet statutory funding targets. Without Senate Bill 777, the city’s 2016 statutory pension contribution will be much higher than the city has budgeted.

“This scenario is the most credit positive over the long term. Although it would require larger pension contributions than currently budgeted, the higher payments would achieve the slowest and least extensive growth in unfunded liabilities among the four scenarios,” Moody’s says.

The city’s adopted budget assumes the governor signs Senate Bill 777 and the Illinois Supreme Court reinstates PA 98-0641, the latter of which would preserve benefit reform of Municipal and Laborer pensions and reduce the plans’ risk of insolvency. While the adopted budget notably increases the city’s pension contributions relative to prior years, the amounts contributed under these assumptions could enable unfunded pension liabilities to grow for up to 20 years.

Two other scenarios assume an unfavorable ruling from the Illinois Supreme Court, which would raise the possibility of substantial cost growth for the city over the next decade, with or without Senate Bill 777. “This would exert additional negative credit pressure on Chicago’s credit quality because it would likely remove all flexibility to reduce unfunded liabilities through benefit reform and raise the probability of plan insolvency,” says Moody’s.

NYC 40 YEARS LATER

With the debt crisis in Puerto Rico about to come to a head, many references are made to the NYC financial crisis which this month marks its 40th anniversary. A seminal event in the history of the municipal bond market, it opened an era of regulation, disclosure, and reform that continues to this day. It can be said to have led to improved (not perfect) financial disclosures and practices and spawned a generation of municipal analysts who expected and demanded a more transparent credit environment on behalf of all segments of the market. It is easy to forget how bad the situation was and how much was accomplished over the following four decades.

New York City faced a significant fiscal crisis and effectively defaulted in 1975 because it had literally run out of money and could not pay for normal operating expenses. Timely state and federal action saved the city from defaulting on its obligations and possible bankruptcy. At the time, New York City and its subdivisions had $14 billion of debt outstanding of which almost $6 billion was short-term. The city admitted to an operating deficit of at least $600 million, although modern  accounting methods would have produced a deficit of something along the lines of $2.2 billion. The city was effectively shut out from credit markets.

The city had used obsolete and confusing budgeting and accounting gimmicks for over a decade including: overly optimistic forecasts of revenues, reliance on revenue anticipation notes, including notes for revenues that did not materialize, underfunding of pensions, use of funds raised for capital expenditures for operating costs, and the appropriation of illusory fund balances, meaning that special fund revenues were overestimated and used to balance the budget. Finally in February 1975 a sale of tax anticipation notes was canceled when the underwriter backed out. In the meantime, banks began selling their own holdings of city securities.

In March of 1975, underwriters were growing more and more resistant to working with the city on any more debt issuance.  Bond counsel would not issue a clean opinion on a sale, which was necessary for reselling the notes and bonds  and doubts had arisen that bondholders could exercise their first lien on city revenues. Then, the New York State Urban Development Corporation defaulted on some bond anticipation notes. Although the corporation was separate from the city, the projects of the corporation were in the city. Investor concerns grew when the legislature made sure that the suppliers and contractors were paid but not the bondholders (the infamous moratorium).

The city attempted to move debt off its own balance sheet and stretch out their maturity through a separate corporation, the Stabilization Reserve Corporation, to hold the city’s debt. This move was challenged as an unconstitutional attempt to get around the City’s statutory debt limit. The city was forced to drop the plan. By April 1975, the city was out of money. After lengthy negotiations, underwriters agreed to underwrite more securities provided that the city adopted sound accounting principles, admitted that it had large operating deficits, and ended its budget ploys, including the practice of phony forecasts of revenues. But the City resisted.

The Municipal Assistance Corporation (MAC) was an independent corporation authorized to sell bonds to meet the borrowing needs of the city. MAC was a creation and entity of the state. The majority of appointees on the Corporation’s Board were made by the Governor. As part of the creation of MAC, the state passed legislation that converted the city’s sales and stock transfer taxes into state taxes. These taxes were then used as security for the MAC bonds without ever passing through to the city. Besides creating the MAC, the state also advanced additional funds. The state prepaid state aid that the city was scheduled to get during the fiscal year, in an attempt to keep the city afloat. The MAC demanded that the city institute a wage freeze, lay off employees, increase subway fares, and begin charging tuition at city universities. Despite a summer of labor unrest, these measures stuck and MAC was able to refinance some city debt.

The Emergency Financial Control Board (EFCB) was created in September during a special legislative session. It was analogous to putting the city into receivership. The EFCB had authority over the finances of the city. It could control the city’s bank accounts, issue orders to city officials, remove them from office, and press charges against city officials. The Governor made the majority of appointments to the Board. The state law creating the EFCB required the city to balance its budget within three years, change its accounting, and submit a three-year financial plan. The Board had the power to review and reject the city’s financial plan, operating and capital budgets, contracts negotiated with the public employees unions, and all municipal borrowing. Besides creation of the control board,  a deputy state comptroller was appointed to audit city books. The Mayor’s Management Advisory Board California Research Bureau, was created and staffed by business representatives to advise the mayor on management practices. The temporary Commission on City Finances was established to analyze, criticize, and recommend changes in the city’s long-range taxation and expenditures policies.

Only after all of this did the City receive assistance from the Federal Government. In November of 1975. Federal legislation extending up to $2.3 billion of short-term loans to the city was passed. The House of Representatives passed the aid package by a 10 vote margin. The city was forced to hike fees for services, especially for the city university and the subway. Other services were cut. The city’s work force was trimmed and a wage increase was rescinded. Up to 40 percent of the assets of the city pension fund were invested in MAC securities. The state pension fund also invested in MAC securities. A total of $2.7 billion of city debt was bought by the pension funds.

The banks who had served as the underwriters for New York’s securities agreed to purchase additional securities and/or lengthen the maturity or lower the interest rate on the securities that they held. Other holders of securities had to exchange them for ten-year MAC securities or face a three-year moratorium on the repayment of principal on the notes. The banks turned in $819 million in notes for MAC debt and restructured the interest and maturities of the other debt they held. The budget had to be balanced using generally accepted accounting principles. Most notable of these were the elimination of financing operations from capital funds and a requirement that the city fully fund its pension plans. The First Deputy Mayor, Deputy Mayor for Finance, and the budget director all had to resign so that trustworthy staff could be appointed. The federal loans were made at 1 percentage point over the cost of funds to the federal government.

The city kept its part of the bargain in dealing with public employees. City employment fell by 20 percent and work rules were loosened. Wages were reduced and eventual raises were held below the level of inflation. By 1977-78, the city had no short-term debt. As part of its obligation imposed by the federal government, the state assumed the full cost of financing the city university system (leading to the imposition of tuition) and a portion of welfare and court systems. The state also tightened controls over Medicaid reimbursements to health care providers.

This history is something to keep in mind as the market deals with Puerto Rico. These steps outlined above were painful for the City and its residents over a long time period. Puerto Rico would be wise to understand this history as its continues to demand a relatively pain-free exit from its own legacy of irresponsibility and mismanagement. Talk of prioritizing things like Christmas bonuses ahead of debt service shows a fundamental lack of maturity and seriousness on the part of the Commonwealth’s political leadership. The use of inflammatory rhetoric like that of the Commonwealth’s representative to Congress this week in which he likens the requirement for a federal control board to colonialism would be laughable if it were not so sad. If Puerto Rico does not want to be treated as the equivalent of a financial child, it needs to grow up an act like a financial adult.

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

PENNSYLVANIA IMPASSE IMPACTS LOCAL SCHOOL DISTRICTS

Moody’s Investors Service has downgraded the Commonwealth of Pennsylvania’s (Aa3 negative) pre-default intercept programs for school districts to A3 from A2. As a result of the downgrade of the programs, 13 pre-default intercept ratings on Pennsylvania school districts were lowered to A3 from A2 and the ratings put under review for further downgrade. This action affects the State Public School Building Authority Lease Revenue Intercept Program (Sec. 785) and the Pennsylvania School District Fiscal Agent Agreement Intercept Program (Sec. 633).

The downgrade of the Commonwealth of Pennsylvania’s pre-default school district intercept program, and 13 ratings under the program, is a consequence of the commonwealth’s chronically late budgets and the lack of clarity surrounding the intercept program’s mechanical feasibility in the absence of an approved and implemented budget. While the commonwealth is expected to cover any missed debt service payments on enhanced bonds, the current lengthy budget impasse has heightened risks to bondholders, and raises doubt about whether the pre-default mechanisms will work effectively every time without funds appropriated to districts.

The confirmed cap of A3 on school district bonds enhanced on a post-default basis (Pennsylvania Act 150 School District Intercept Program) also reflects the increased risks to bondholders given state budget delays, as well as competing claims for state aid from pre-default obligations, pensions, and charter school tuition. The downgrade of 11 post default ratings reflects revising the potential uplift from a district’s underlying rating to one notch from the previous two notches. The decision to limit the uplift to at most one notch is based on Moody’s post-default scoring method, which considers such factors as the timing of and trends in state aid distributions, and the mechanics of the program. More specifically, this change reflects a lack of funding and an increasing uncertainty surrounding program mechanics in the absence of a state budget.

In the meantime, negotiations over a budget are heating up and details of some proposals have begun leaking out. The two major points are that production of natural gas will continue to escape taxation while more of the new revenue burden will be shifted to individuals through and increase in the retail sales tax rate from 6% to 7.25%. This would result in a total sales tax rate of 8.25% in Pittsburgh and 9% in Philadelphia. These changes are designed to support increased funding to school districts but it does not appear to tie in directly to local property tax relief to slow rapid increases in many districts. Should the budget be enacted along these lines it would be a clear win for business interests with at best, mixed results for individuals.

PREPA RESTRUCTURING ADVANCES

The Puerto Rico Electric Power Authority (PREPA) reached a restructuring support agreement (RSA) with the Ad Hoc Group of PREPA Bondholders last week, just after we went to press. The Ad Hoc Group’s financial adviser said legislation on the public utility’s revitalization must be approved “this month.” The government submitted the PREPA Revitalization Act to the Puerto Rico Legislature. However, the last day for the Legislature to pass bills during the present session is Nov. 12, giving lawmakers only one week to analyze and pass the measure.

The basic terms of the agreement include:

The Ad Hoc Group will exchange all of their debt for new securitization notes and receive 85% of their existing claims in new securitization bonds, which must receive an investment grade rating.

Bondholders will have the option to receive securitization bonds that will pay cash interest at a rate of 4.0% – 4.75% (depending on the rating obtained) (“Option A Bonds”) or convertible capital appreciation securitization bonds that will accrete interest at a rate of 4.5% – 5.5% for the first five years and pay current interest in cash thereafter (“Option B Bonds”).

Option A Bonds will pay interest only for the first five years, and Option B Bonds will accrete interest but not receive any cash interest during the first five years.

All uninsured bondholders will have an opportunity to participate in the exchange.

Ad Hoc Group will negotiate with PREPA in good faith to backstop a financing on terms to be mutually agreed that will allow for a cash tender for bonds held by non-forbearing creditors.

Fuel line lenders will have the option to convert existing credit agreements into term loans with a fixed interest rate of 5.75% per annum, to be repaid over 6 years in accordance with an agreed upon schedule or exchange all or part of principal due under the existing credit agreements for new securitization bonds to be issued on the same terms described above.

PREPA’s debts owed to the Government Development Bank for Puerto Rico will be treated in substantially the same manner as those owed to the fuel line lenders.

The PREPA Bondholder Group’s financial adviser said,  “We are pleased to be able to make official what we believe is a reasonable deal with substantial concessions from bondholders that will significantly benefit the people of Puerto Rico. It has not been easy to get to this point and meaningful sacrifices have been made on the part of bondholders. We hope that this agreement can be an example to others of the positive outcome that can be realized through committed negotiation – and that PREPA and its remaining creditor constituencies can now reach similarly fair and reasonable solutions.”

Bondholders are taking substantial risk by agreeing to set rates until the deal is implemented, the bondholder group said. The transaction outlined by the RSA must be executed by June 30, 2016, as further delay could materially change the economic terms agreed to by both sides. This deadline represents an extension of the initial timeline by the PREPA bondholder group. The transaction is also contingent on PREPA coming to an agreement with its bond insurer constituencies.

The restructuring support agreement provides a structured framework to implement the previously announced economic agreements, and is designed to provide PREPA with five-year debt service relief of more than $700 million and a permanent reduction in PREPA’s principal debt burden of more than $600 million, according to a PREPA statement. The agreement also outlines other elements of PREPA’s recovery plan, including new governance standards, operational improvements, rate structure proposal and a capital plan.

KANSAS REVENUES SHORT AGAIN

As time goes on, the Brownback administration looks more and more like Ahab in pursuit of the whale in its pursuit of its tax based economic policy. The report for October for the State’s General Fund reports another shortfall in revenues versus expectations. The continued reductions in income taxes simply have not translated into the higher levels of jobs and economic activity that the administration premised its tax cut program on. While some of the shortfalls can be attributed to continued lower oil and gas prices in this natural gas state, the data shows that this is not the predominant factor.

Total tax revenues are 3.8% below estimates for the fiscal year through October 31. The largest proportion is the decline in the retail sales tax. This tax is historically an excellent indicator of current economic activity and these are running 4.2% below estimates. Now the economy in Kansas is showing positive activity relative to fiscal 2015 – tax revenues are up 2.8% year over year. But it is clear that the state’s ability to predict revenues has not improved leading to the need for mid-year budget adjustments usually in the form of cuts to local aid especially for schools.

So the song remains the same for Kansas. The great tax cut experiment continues, the State’s budget continues to be tight and under pressure, and local units especially school districts must try to plan with the constant threat of additional cuts hanging over them. All in all, this is not a formula for credit stability in the Sunflower State.

ALL ABOARD FLORIDA?

The largest deal to hit the U.S. municipal market next week is $1.75 billion of private activity bonds to help fund All Aboard Florida, a 235-mile (378 km) passenger rail project that will connect Miami to Orlando. The bonds will be sold by the Florida Development Finance Corporation, a state authorized issuer of industrial revenue bonds, and the sale will be managed by Bank of America Merrill Lynch. All Aboard Florida is a privately owned, operated and maintained passenger rail system with stations planned in Miami to Fort Lauderdale, West Palm Beach and the Orlando International Airport. The express train is expected to take approximately three hours, move at speeds up to 125 mph, and be completed by early 2017.

The transaction has met a mixed reaction with potential investors. The market for high speed rail service in Florida is speculative (a nice word for untested). We have reviewed a summary of the feasibility study produced for the project and it raises a number of questions in our mind. Our experience tells that that demand studies for controversial projects (and this one is) often rely on small sample sizes relative to projected usage which often accounts for why actual usage on transportation projects often falls short of projections.

In this case, 1,800 stated-preference surveys and 10,800 origin and destination surveys were conducted to confirm travel behavior, preferences, and willingness to pay. This is out of a projected ridership of 5.7 million in the first year of stabilized operations in 2020. Revenues are projected to rise by 3.8% annually through 2030. All of this relies on projections that gas prices will remain at a steady $4 per gallon even though recent experience tells that gas prices are very volatile and that the current environment supports a price at only 50% of that level in many areas.

According to the study, introduction of a new mode of travel, particularly premium rail service which is more convenient and improves travel time, can often encourage travelers to make trips they may not have made in the absence of the new service. This is called induced ridership. Previous studies have found that the introduction of intercity rail service can result in levels of induced travel ranging from 5 percent to 30 percent. Most of this is attributed to longer trips such as from Miami to Orlando. In this project, that better be true as the bulk of revenues are projected to be derived from long distance trips.

The proposed timing of the deal reflects a number of factors which have often aligned ultimately against a successful outcome for bondholders. One is absolute market levels, relative credit spreads reflecting those absolute levels and the demand for high yield product, and the municipal market’s proclivity for underpricing credit risk during periods of low absolute yields and demand for product to supply the plethora of high yield funds out there.

Our view is that this transaction should be approached extremely cautiously and that potential buyers should hold out for the highest possible spread and be prepared to walk away if it’s not provided. In this case walking may be a better alternative than taking the train.

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

ARIZONA SCHOOL FINANCING MOVES FORWARD

The Arizona legislature approved a package of bills last week that could provide $3.5 billion to K-12 schools over 10 years to settle a five-year-old lawsuit that had been filed by several school districts after the state refused to make inflation-adjusted payments during the worst years of the recession. The package passed with limited support from Democrats. Only one part of the deal, which increases base-level funding per student by $173, was unanimously endorsed by both parties. Democratic lawmakers, as well as educators, argued that the package failed to address how, or if, the state will seek to add more funding to the schools later on. The bill was supported by direct lobbying by Republican Gov. Doug Ducey. “With this permanent infusion of dollars into our schools that schools can spend as they see fit on their needs, educators will finally have the resources they have been asking for and our students will have greater opportunities to succeed,” Mr. Ducey said.

Legislative passage is the first step – the bills will require voter approval in a special election, scheduled for May 17 in a state that has the lowest rate of spending per student in the country. An analysis by the Joint Legislative Budget Committee, released in August, showed the state’s current budget for K-12 schools at $3,437 per student — still 19.2 percent lower than it was in 2005, when adjusted for inflation. The plan to add the additional $3.5 billion relies on increasing the percentage of money taken from a trust fund that holds proceeds from the sale of state land. If voters approve the plan, the state’s 238 school districts will share in a $249 million payment by June 30, or an additional $226 per student — still not enough to lift Arizona from the bottom of rankings on student funding and teacher pay.

Despite recent infusions of cash, many school districts are still struggling to pay for their most basic needs, like new textbooks. Some schools also need additional teachers to handle a surge in enrollment driven primarily by a rise in the number of Latino students, who at 44 percent are already the largest ethnic group in the state’s public education system. The superintendent of the Peoria Unified School District, said the money “will not replace the $218 million we have reduced from our budget over the last nine years, but it is a welcome bandage to slow the hemorrhaging.” The timing of the bill’s passage is problematic for 50 of the state’s 238 school districts that are asking voters to approve property tax increases to provide additional money for local schools, a mechanism known here as overrides.

The upcoming vote will highlight a classic problem in terms of local school funding where there are high proportions of older residents. One example is Apache Junction Unified School District, 35 miles east of Phoenix, a lower-middle-class suburb filled with retirees and voters who have repeatedly rejected requests to increase property taxes to pay for local schools. Last year, 91 percent of all ballots were cast by voters at least 50 years old, and the district’s override request, its fifth in eight years, lost by 1,881 votes. The odds seemed stacked against it once again this year: More than 90 percent of voters who had mailed in early ballots by Oct. 23 were at least 50 years old, according to official statistics. Opposition is summed up by the reaction of one 85 year old resident who said “I voted no, hell no.”  The override would be in effect for seven years and, he said: “I don’t know how they can guarantee it’s not going to pad the superintendent’s salary. We’re all struggling. When is enough enough?”

HILLVIEW KY BANKRUPTCY

Another test of the use of Chapter 9 bankruptcy versus judgment bonds or other mechanisms will be given a hearing in December. The Sixth Circuit U.S. Bankruptcy Court held a preliminary hearing on October 6, 2015 on the Memorandum of Facts and Authorities in Support of Statement of Qualifications  filed by the City of Hillview and the Objection of Truck America Training, LLC to the Chapter 9 Petition Filed By the City of Hillview, Kentucky filed by Creditor, Truck America Training, LLC. It determined that an evidentiary hearing should be conducted at 9:00 a.m. on December 9, 2015 and at 9:00 a.m. on December 10, 2015 in the United States Bankruptcy Court, Louisville, Kentucky. The City filed after Truck America won a $14.5 million judgment against the City which has some $1 million of outstanding debt.

PUERTO RICO

The U.S. Supreme Court will decide by December whether it will take up the case of Puerto Rico’s local bankruptcy law, which federal district and appeals courts have overturned as unconstitutional. Puerto Rico enacted Act 71 of 2014, or the Puerto Rico Public Corporation Debt Compliance & Recovery Act, in the summer of 2014, which is applicable to some $20 billion of public corporation debt, to address the fact that P.R. is specifically barred from accessing U.S. municipal bankruptcy protection. Officials said they needed the law to bring Puerto Rico Electric Power Authority (PREPA) creditors to the table because the electric utility was running out of cash to keep operating.

Two of the largest PREPA investors immediately challenged the constitutionality of the law, and it was subsequently declared unconstitutional. Since then, the government has been waging additional court battles to try to enable the law to take effect while lobbying Congress to extend chapter 9 protections to its public corporations and municipalities. The Puerto Rico government appealed in July to the U.S. Supreme Court, arguing that it has the power to legislate on bankruptcy matters related to its public corporations after the U.S. Congress, for unclear reasons, excluded the island in 1984 from the protections afforded by Chapter 9 of the Federal Bankruptcy Code. Prior to that, Puerto Rico enjoyed access to Chapter 9 since 1938.

A three-judge panel of the First Circuit Court of Appeals in Boston in July upheld a ruling by a federal district court in which the recovery act was declared unconstitutional. Two PREPA bondholders, Blue Mountain and Franklin Advisors, filed opposition briefs to the petition last week. The companies reportedly allege that there are no debatable constitutional issues and that PREPA and its creditors are about to reach a deal to restructure the utility’s $9 billion debt. In fact, PREPA announced late Friday that the ad hoc group of bondholders and fuel line lenders have extended their forbearance agreements until Nov. 3.

PREPA will use the extension to finalize its agreements with the forbearing creditors and continue discussions with its monoline bond insurers. “As we continue our efforts to transform PREPA, this extension affords us additional time to continue constructive negotiations with our key creditors,” said Harry Rodríguez, chairman of PREPA’s governing board. “Working with our creditors to restructure PREPA’s debt is an important component of our comprehensive plan that shares the burden of addressing PREPA’s finances among all stakeholders. We look forward to continuing to make progress towards this transformation which will create a better future for PREPA and provide Puerto Ricans the economical, safe and reliable utility they are asking for.”

Some $128 million of short-term bridge bonds, which carry a yield-to-maturity rate of 12%, are scheduled to be paid in full by Dec. 15.

RURAL HOSPITAL MAKES MARKET COMEBACK

The changes in the healthcare landscape have brought additional pressure and scrutiny to certain hospital sectors. One of the most vulnerable is the facility serving a smaller rural population characterized by vulnerable and less stable underlying economics. One of those entities was the Sierra Kings Hospital District. California hospital districts have long been under pressure and several have availed themselves of Chapter 9 protection. In 2009, Sierra Kings was one of those. In the fourth quarter of 2011, it closed on the sale of its hospital which it had directly operated since 1965 to Adventist Health. As a part of the bankruptcy proceedings, the statutory lien of the District’s ad valorem taxes which are pledged to debt service was affirmed. All claims which were affirmed in the proceedings were finally paid in full by September 30 of this year.

Now that the bankruptcy has been fully dealt with and an operating track record under the new structure established, the District has obtained a newly upgraded investment grade rating from Moody’s and plans to return to the market. The upgrade reflects 100% repayment to its creditors as per its plan of adjustment and the relief of the district of any of the day to day responsibilities of managing the hospital or attendant employees. The District plans to issue $27,040,000 of general obligation bonds secured by a pledge of the statutorily secured tax revenues of the District. For the District, the timing is favorable with rates remaining low and new issue volume remaining constrained.

ILLINOIS BUDGET ILLS TRICKLE DOWN TO THE UNIVERSITIES

The continuing budget standoff has resulted in additional pressure on the ratings of the various units of the state’s public university system. While the ratings of the main campus in Champaign-Urbana and at Illinois State were maintained, the other five units saw their ratings downgraded by Moody’s. The reduced cash flow that results from the lack of a budget has kept the ratings of the universities on a negative outlook. For two campuses, the next move is to below investment grade. Unfortunately this negative trend has not induced the governor and the legislature to settle their differences.

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.