Joseph Krist

Municipal Credit Consultant

We took a couple of weeks off to rest and recharge but it was amazing to see that when we came back the budget lunacy surrounding some of the larger states had continued unabated.

PRASA TESTS THE MARKET

As we go to press, the PR Aqueduct and Sewer Authority will attempt to sell $750 of revenue bonds in the public markets. The bonds have been rated Caa3/CCC-/CC by the three major rating agencies. PRASA has $5.4 billion of debt already outstanding and there are questions about its ability to service its current level of indebtedness. It intends to use the new funding to finance a portion of its capital improvement program through June 30, 2019, reimburse itself for certain capital costs incurred during fiscal years 2013, 2014 and 2015, and repay or refinance certain outstanding credit facilities provided by local banks and the Government Development Bank (GDB).

The fears over the ability to cover debt service and act on a transparent basis will not be eased by the language added to the official statement regarding  future financial disclosure. The Authority says that it intends to provide quarterly reports but that it is not required to. The Bonds will be secured under a gross revenue pledge which is supported by a 2.5 times rate covenant. There is no provision for funding or maintenance of a debt service reserve fund.

Capital requirements will continue to be significant. PRASA currently operates under three existing consent decrees with the US EPA and faces a proposed fourth such decree. PRASA estimates that $1.7 billion of additional capital would be required to meet the terms of the consent decrees.

Another major concern is whether or not PRASA can continue to be seen as insulated from the overall financing and operating difficulties of the Common wealth as a whole. Each of the rating agencies expressed concern regarding this aspect of the PRASA credit. As for the central governments difficulties, the Governor’s office has said that the central government’s cash flow would only generate enough money to operate until November absent any additional deal that brings $400 million to $500 million in much-needed liquidity to the government.

“November continues to be the month when we would go under if we don’t take further actions,” according to the Governor’s chief of staff . He added that the government would take a determination at “some point in September” on whether to move forward with an initiative that seeks to provide the commonwealth with the needed short-term liquidity. “The one being more actively worked on is the exchange of notes at the GDB.”

MET PIER DOWNGRADE

The circus that is the budget dispute in Illinois has claimed yet another credit scalp. S&P lowered its rating on the Metropolitan Pier & Exposition Authority after the Illinois Legislature did not appropriate the sales tax revenue that is intended to support a monthly payment for debt service. S&P said ” although the statutory construct and bond document provisions historically have insulated these monthly payments — and ultimately debt service payments — from the budget and liquidity pressures occurring at the state level, we now believe this structure is vulnerable to those pressures as they play out in the state budget and appropriations process. The rating action reflects our view that the bonds are, in fact, appropriation obligations of the state, rather than special tax bonds, and are now one notch below our current A minus/Watch Neg general obligation rating on Illinois.”

The action is a blow to bondholders who had traditionally taken comfort from their belief that their bonds were protected from that fiscal machinations of the political process. The long term damage to the state’s credibility is incalculable and should be costly to it going forward.

Ninety percent of what the state usually spends has been authorized despite having no approved budget as of mid-August. according to an  analysis by Senate Democrats. That study shows that if spending continues at this rate, Illinois is on track to spend about $38 billion this year, leading to a $5 billion deficit.

The House revenue committee is holding hearings to try to determine how much the state is spending — something all involved acknowledge is a mystery. Estimates range from $32 billion to $38 billion rate over the current fiscal year. While the failure to enact a full budget has dragged on, dozens of consent decrees issued by federal courts kicked in, mandating Illinois continue to spend money on services like the Department of Children and Family Services and Medicaid. Payments to pension funds, state debt service and tax refunds also are automatically authorized by law. A court order requires the state to continue to pay its employees at their normal salaries.

When and if the two sides do reach a budget deal, they will have to raise taxes, cut spending retroactively or make 12 months’ worth of changes in a condensed time period — making any action more painful and politically difficult.

KANSAS PENSION BONDS

The jury may still be out on whether the Kansas experiment with tax cutting has been a success but one answer may lie in the authorization of $1 billion of bonds to fund payments to the state’s pension funds. It is somewhat amazing that in light of the historically bad experiences of pension bond issuers (New Jersey and Detroit are prime examples) that support for the concept still exists. The well-documented ideological approach to budgeting under taken by the Brownback administration has led the legislature to take the easy way out in its approach to historic pension underfunding in the state. There are enough other issues pressuring the state – especially in the area of education that punting on the pension issue made sense to the legislature.

PENNSYLVANIA BUDGET

There may be a way to resolve the Commonwealth’s budget impasse as Gov. Tom Wolf is said to be open to consideration of a new type of pension benefits plan for future state and public school employees. Called a “stacked hybrid,” the new Wolf plan would maintain the current pension formula – based on a years’  of service and career-ending salary – as a foundation benefit for all employees. But once a person’s income has crossed a certain threshold – Wolf has proposed $100,000, for starters – that plan would max out. Any benefits on income over the cap would be based on a 401(k)-type plan.

It also would expose current state and school employees to higher payroll contribution rates into the retirement systems if the funds’ internal investment targets aren’t met over an extended period of time. The governor also continues to support a $3 billion pension bond issue. Wolf claims annual debt service can be covered by increased profits from Pennsylvania’s state-held liquor monopoly, based on longer operating hours, more Sunday openings and greater price flexibility.

BUILD AMERICA BOND SUBSIDIES CUT

Under the requirements of the Balanced Budget and Emergency Deficit Control Act of 1985, payments to certain state and local government filers applicable to certain qualified bonds are subject to sequestration. This means that refund payments processed on or after October 1, 2015 and on or before September 30, 2016 will be reduced by the fiscal year 2016 sequestration rate of 6.8 percent. The sequestration reduction rate will be applied unless and until a law is enacted that cancels or otherwise impacts the sequester, at which time the sequestration reduction rate is subject to change. These reductions apply to Build America Bonds, Qualified School Construction Bonds, Qualified Zone Academy Bonds, New Clean Renewable Energy Bonds, and Qualified Energy Conservation Bonds. In plain English, the level of subsidies made to each issuer of BABs will be cut 6.8%. Prior cuts have not resulted in any reductions in payments or defaults and we anticipate that will continue to be the case. The irony is that many in Congress support some form of this type of bond support for infrastructure but the ongoing gridlock in Congress over real budget reform is catching the actual level of support for a successful existing program within the confines of its rather wide net.

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

Joseph Krist

Municipal Credit Consultant

PREPA RESTRUCTURING PLAN

PREPA disclosed that it is seeking to push debt maturities on its $8.1 billion of bonds back by five years, during which time no principal would be paid and interest would be cut to 1%, unless the authority’s cash position warrants it. Those features contrast the more common approach of simply cutting principal and interest payments. Under PREPA’s plan the debt of the forbearing bondholders and the debt of those non-forbearing bondholders who elected for this plan would be subject to what the Commonwealth is calling a moratorium. Non-forbearing bondholders would also have the right to elect to take immediate payments with haircuts from 30 to 35%.

In PREPA’s plan, insured debt would be excluded from these treatments.

The president of the House of Representatives Jaime Perelló said, “We are going to start a dialogue case by case concerning our (the Commonwealth’s direct) debts to see if we can extend their payment by five years,” the same period found in PREPA’s proposal. PREPA made its proposal to its bondholders on June 25, though it was not made public until after Perelló’s comment.

Perelló is one of five members of Puerto Rico’s government sitting on the Working Group for Economic Recovery for Puerto Rico, which is assigned to come up with proposals for restructuring the commonwealth government’s debt by Sept. 1.

One has to turn on the old way back machine to find an example of the kind of fiscal semantics being attempted by PR officials. The last time that this stunt was attempted was by New York in 1975 when it enacted a ‘debt moratorium’. This was seen for the semantic game it was and fooled no one while NY claimed that it had not actually ‘defaulted’ on the debt, they just postponed repayment.

PREPA is the logical candidate for a restructuring as a revenue backed enterprise with a discrete source of revenues for operations and debt service. There could be many reasons for creditors in this scenario to go along with a restructuring of that kind of enterprise. In the case of tax-backed debt like GO’s, the issue is much more difficult as the creditors will potentially viewed as being in direct competition with the provision of essential services.

 COMMONWEALTH CREDITOR DIVIDE

The dimensions of the fault line between creditors and the current administration become clearer this week. Centennial Group Latin America, a consulting firm, based in Washington, was hired several months ago by the group of hedge funds and other investment firms to analyze Puerto Rico’s economy and finances. It produced a study for that group, the Ad Hoc Group, which includes Fir Tree Partners, Brigade Capital Management, Monarch Alternative Capital and Davidson Kempner.

The Ad Hoc Group owns about $5.2 billion of debt, mostly general-obligation bonds and other bonds that are guaranteed by the central government. Economists working for that group say that the government could solve its debt crisis largely by improving tax collections and obtaining additional financing over the next two years. The message of sustainability is in real contrast with the recent announcement by Puerto Rico’s governor, Alejandro García Padilla, that the commonwealth’s debt is “unpayable.”

“There may be an issue of liquidity in the short term,” in Puerto Rico, “but the debt itself, in global terms, is sustainable,” according to the hedge funds’ consultants.  They estimate that Puerto Rico would need short-term financing of about $2.5 billion to get through 2016 safely. That would cover current overdue bills to vendors, scheduled payments on existing debt and finance a budget deficit projected to be less than $500 million.

The economists said they were not suggesting that Puerto Rico ought to impose any more tax increases on residents who were already paying the taxes they owe. The report shows the commonwealth collects far less of the taxes due than the 50 states, and that it would not have to increase tax rates at all if it could capture what residents are now supposed to be paying. The advisers also argued that Puerto Rico could improve its finances by privatizing the operation of its public works. The commonwealth had already contracted with a Mexican firm to operate its largest airport, and privatized of its toll highways.

Some of the hedge fund holders also offered earlier this year to loan Puerto Rico about $2 billion, to help get the commonwealth through another year of its perennial budget shortfalls. But the government declined those offers, saying the terms were too onerous. Víctor Suárez, chief of staff to Gov. García Padilla said, “The simple fact remains that extreme austerity placed on Puerto Ricans with less than a comprehensive effort from all stakeholders is not a viable solution for an economy already on its knees.”

On the funding side, a $2.95 billion bond issue through the Puerto Rico Infrastructure Financing Authority (AFI by its Spanish acronym) will not be pursued at this time, as “there is no market for it,” Suárez said Monday. The deal was intended to repay a $2.2 billion loan that the Government Development Bank (GDB) provided to the Highways & Transportation Authority (HTA), after transferring the loan to AFI. Recent hikes to the petroleum-products tax were legislated to serve as repayment source for the transaction and would have also provided cash for HTA operations.

“We are trying to achieve a smaller transaction, with reasonable terms, of some $400 [million] to $500 million,” according to Suarez. Meanwhile, Puerto Rico is seeking to finalize before mid-August a $400 million TRANs deal from three public corporations in a bid to ease the commonwealth’s current cash crunch. The commonwealth faces a $59.7 million payment on Public Finance Corp. bonds on August 1. We have discussed previously that Puerto Rico would be unable to meet with the current government’s liquidity. The government has reiterated that the priority will always be to provide essential services to citizens, such as security, health and education.

CHICAGO PENSION DECISION

Cook County Judge Rita Novak threw out the pension changes adopted earlier this year by the City of Chicago on Friday. Her decision was based on an earlier Illinois Supreme Court ruling that said similar changes to state pension funds violated the state constitution. The decision was not unanticipated.

The overhaul sought to eliminate a $9.4 billion unfunded pension liability by cutting benefits and increasing contributions. Workers, retirees and labor unions sued, saying the constitution prohibits reducing pension benefits. In a statement Friday, Chicago corporation counsel Stephen Patton says the city is disappointed in the decision. He says the city looks forward to having its arguments heard by the Illinois Supreme Court.

Those arguments include the City’s contention that the City’s changes preserved and protected the funds from the depletion of their assets. It further legally binds the city to actuarially based contributions to fully fund the system, and obligates the city on pension annuities, which the city argued prior statutes did not. The judge said that this argument was “wholly inconsistent with constitutional teachings” saying “it disregards the settled distinction between pension benefits, which are constitutionally protected, and funding choices, which are not.”

Another argument was that the new provisions afforded fund members provide consideration for the cuts, a legal theory in contract law that allows for detrimental changes to be made in exchange for some perk if parties agree. The city notes that 28 of 31 impacted unions signed off on the plan. The judge said that the city failed to show it had authority for such an expansive interpretation of a “bargained-for exchange.” She further found that argument fails in ignoring the individual rights of fund members who are not in the unions that were party to the negotiations.

CA MELLO ROOS DEBT

This month an Orange County Grand Jury released a report that helps investors to understand what analysts face in trying to obtain and follow important credit-related data supporting this important class of largely non-rated debt. Much of this debt is held by individuals and their mutual fund proxies. The review covered only community facilities district debt issued within Orange County. Its findings, however have broad implications for the sector statewide.

The Grand Jury found that there is a significant lack of transparency regarding CFDs. Information pertaining to a CFD that is provided to the homeowner often does not include the intended purposes of the special tax. Administrative costs and servicing costs of the bond are often not openly revealed. It has been suggested to the Grand Jury that the only way to get good information is for the homeowner to request detailed accounting records (internal financial statements) of the CFD-T under the Freedom of Information Act. There is a lack of transparency to homeowners relative to how CFD funds are being used.

The Grand Jury discovered that the State does not require a complete accounting of the use of CFDs. The only information required by the State CDIAC is the original amount of bond funding, bond balance, taxes outstanding to be collected, and the end date of the bonds. There does not seem to be appropriate oversight and auditing of CFDs and special tax expenditures within the County of Orange. While the assumption is that the CFD debt would be repaid in a finite period of time, there is a mechanism available to controlling entities to extend debt obligations and thereby extend the CFD special tax in perpetuity.

The Grand Jury recommended that each local agency that established a CFD should create an oversight committee and an audit committee to provide for an independent, transparent view of the manner in which CFD funds are being expended. Audit report information, as delineated in California Government Code, 1982 § 53343.1, should be made available to the CFD taxpayers on a website after each fiscal year for each CFD number.

TIME FOR VACATION

It’s time to rest and recharge so we will not be publishing in the first two weeks in August.

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 ANNUAL APPROPRIATION DEFAULT

The Puerto Rico Public Finance Corporation  failed to make a $93.7 million debt-service payment last Wednesday. The corporation’s bonds are backed by a pledge that the Puerto Rican legislature will appropriate the cash needed to pay them down. But lawmakers did not appropriate the funds as promised. “In accordance with the terms of these bonds, the transfer was not made due to the non-appropriation of funds,” said the Government Development Bank. So far Puerto Rico has been making its scheduled payments on its $13 billion of general-obligation bonds. The move follows by only two days a presentation to investors in which the Commonwealth gave no indication of an impending failure to pay.

It is not a surprise that the Commonwealth would make such a move but it does further diminish the Commonwealth’s credibility in terms of the representations it makes and has made to investors over time. The upcoming debt restructuring negotiations will require mutual good faith to succeed but the Commonwealth seems to be willing to diminish that asset rather quickly. We believe that this move will simply strengthen the demands of investors for strong, binding, outside oversight and that those investors already inclined towards litigation will continue to pursue it.

While technically, the failure to transfer the funds was attributed to the failure by the legislature to appropriate the funds, the government admitted this week that regardless of the legislative action needed to enable the allocation, cash flow is not sufficient today to meet the Aug. 1 payment.

July is an important month for the commonwealth, as an estimated $1.92 billion in payments are due, according to data from the GDB and the Financial Times. These include payments of $630 million in general-obligation (GO) debt service; $415 million from the Puerto Rico Electric Power Authority for debt service; $390 million for other GO credits; and $300 million and accrued interest in tax revenue anticipation notes. On July 31, a payment of $92 million for a general fund debt is due.

ORRIN HATCH’S PRIMER ON PR

A letter from Sen. Orrin Hatch of Utah to the U.S. Treasury Secretary included a variety of questions which serve as a good basic primer for individuals interested in the PR debt situation. We offer excerpts from the letter including the questions that the Senator has for the Secretary.

What is the administration’s position on stand-alone proposals to allow Puerto Rico’s government to be treated as a state under chapter 9, including retroactive application to already outstanding indebtedness?

Has the administration given consideration to appointing a special mediator or arbitrator to work with Puerto Rico and its creditors to establish an orderly resolution of a Puerto Rican default?

What is the administration’s position on exempting Puerto Rico from the Jones Act, as recommended in the so-called “Krueger report?”

What is the administration’s position on exempting Puerto Rico from federal minimum wage law, or reducing the level of the federally-imposed minimum wage as President Obama has done in other instances (e.g., delays of scheduled minimum wage increases for American Samoa and for the Northern Mariana Islands), where the President acknowledges that a one-size-fits-all federal minimum wage can be costly to residents in areas where productivity and living costs are well below the national averages?

The government reportedly is “consulting with a group of bankers from Citigroup who advised Detroit on a $1.5 billion debt exchange with certain creditors” and “United States Treasury officials…have been advising the island’s government in recent months amid the worsening fiscal situation.” What advice have Treasury officials been offering to Puerto Rico? Have Treasury officials pledged any federal resources to Puerto Rico in conjunction with the advice, including expediting fund flows from the General Fund of the U.S. Treasury to Puerto Rico?

What actions are officials from Treasury’s recently formed Office of State and Local Finance taking with respect to Puerto Rico’s assertion that its debts are not payable? What “potential federal policy responses” have the Office of State and Local Finance at Treasury developed?

Does the administration intend to appoint an official to manage any federal aid packages to Puerto Rico, as was the case when former administration official Don Graves was appointed to manage aid given to Detroit following its filing for bankruptcy?

Do you, as Chair of the Financial Stability Oversight Council (FSOC), still agree with the assessment in FSOC’s latest annual report that “Despite problems exhibited by Puerto Rico, there has been little spillover thus far to the broader municipal bond market.”? Do you also still agree with the FSOC annual report that notable municipal defaults in recent years, though “severe events,” “appear to be idiosyncratic and not representative of a broader trend in municipal credit?”

Are there any anticipated executive actions under discussion among administration officials with respect to any changes in Treasury rules or regulations that may affect how the federal tax system impacts residents and businesses in Puerto Rico or the flow of transfers from the General Fund of the Treasury to Puerto Rico?

Does the administration intend for its proposed 19 percent minimum tax on foreign income to be applied to Controlled Foreign Corporation (CFC) operating in Puerto Rico in the same way it would apply to CFCs operating elsewhere?

For over four years, pursuant to Treasury Notice 2011-2, a Puerto Rican excise tax has received treatment from the Internal Revenue Service (IRS) as though it was eligible for the Foreign Tax Credit. The Notice stated that the excise tax presents new concerns and that “determination of the creditability of the Excise Tax requires the resolution of a number of legal and factual issues.” Until such a resolution, the IRS has not and is not challenging claims as to the creditability of the excise tax. Furthermore, the Notice states that if the IRS eventually decides that the excise tax is not creditable, such a lack of creditability will only apply on a forward-going basis.

1. When will Treasury finish its review to determine the creditability of the excise tax?
2. Are there other examples of Treasury, currently or in the past, allowing a tax to be eligible for Foreign Tax Credit treatment while the tax is under examination?
3. Has Treasury ever announced that, if a tax was determined to not be eligible for the Foreign Tax credit, such a lack of eligibility would apply on a prospective basis?

Many of these items fit the desires of the current administration in PR. At the same time, regardless of the Administration’s position on any or all of these topics, it is not clear that a political consensus exists in Congress to resolve all of these issues in Puerto Rico’s favor.

In the meantime, the Congressional Joint Committee on Taxation approved an  extenders bill which would extend through the end of 2016 two Puerto Rico-related tax provisions. One provision would temporarily increase the limit on the amount of excise taxes on rum that are distributed to Puerto Rico and the U.S. Virgin Islands. Under the bill, the territories would be able to receive $13.25 rather than $10.50 per proof gallon. The JCT estimated that extending this provision would lead to federal outlays of $336 million over ten years. The other provision would allow a domestic production activities deduction to be applied to activities in Puerto Rico. Under current law, special domestic production activities rules for the commonwealth apply for the first nine years of a taxpayer beginning after Dec. 31, 2005 and before Jan. 1, 2015. Under the bill, the rules would apply for the first eleven years of a taxpayer beginning after Dec. 31, 2005 and before Jan. 1, 2017.

CA BANKRUPTCY LAW

California Gov. Jerry Brown has signed a new law securing revenues for general obligation bonds issued by local governments — a law intended to protect bondholders in a bankruptcy proceeding. The law – SB 222 – is designed to preserve bondholder rights to the tax revenues used to back bonds, which are received by a municipality after it enters bankruptcy proceedings. The bankruptcy code defines statutory liens like those mandated under SB 222 as created by force of law, as opposed to consensual liens that are created by an agreement. “Secured” creditors of a bankrupt municipality are supposed to be first in line to recover their money, but California law was previously silent on whether local GOs were “secured” for that purpose. The new law addresses that ambiguity.

The need for the law would seem to pose somewhat of a dilemma for those who had previously expressed certainty that the statutory lien for voted GO debt had already been established. The attorney who drafted the law said “many have argued that the taxes levied to pay California GO bonds are ‘special revenues’ under the bankruptcy code, but this analysis has never been certain. This is the first time we have been able to say that GO bondholders are secured creditors in a municipal bankruptcy. Being a secured creditor in bankruptcy dramatically decreases the risk of nonpayment. This newfound certainty should permit investors and rating agencies to focus more narrowly on the tax-base as the credit for California GO bonds, and less heavily on issuers’ general funds.”

The new law, which becomes effective on Jan. 1, is very similar to legislation enacted in Rhode Island in 2011 after Central Falls filed for Chapter 9 protection.

Moody’s Investors Service said “Generally speaking, the security for California local government GO bonds is a dedicated, unlimited, voter-approved property tax levy, the proceeds of which cannot be used for any purpose other than the bonds authorized by voters. The California Constitution makes the debt service levy separate from the property tax levied for operating purposes. State statute is nonetheless silent on whether GO investors would be secured in the event of a local government’s bankruptcy filing, and case law on this matter is also very limited. The new law is positive for GO investors because it clearly establishes their secured status.” However, it said it would not likely have a “material effect” on the ratings of California local GOs.

Fitch Ratings took a different view saying “revenues supported by a statutory lien are not free from the automatic stay of a municipality’s general revenues once bankruptcy proceedings begin.  Rather, the statutory lien prevents the municipality in a bankruptcy from generally diverting the revenues subject to the statutory lien. The statutory lien does not prevent use of the revenues in the bankruptcy process as long as adequate protection for recovery is offered to bondholders benefiting from the statutory lien. These protections will not guarantee full or timely repayment, only potentially higher recovery.”

PROVIDENCE CONSIDERS OUTDOOR SMOKING BAN

Rhode Island’s capital city is considering a law to prohibit smoking throughout the downtown, a ban that an advocacy group says is the most wide-reaching one it’s seen. The ban would improve the quality of life for residents and visitors, according to proponents, but some business owners are concerned it could actually drive away customers. The state was one of the early issuers of tobacco securitization debt.

The proposed law would cover non-enclosed sidewalks and other pedestrian areas, including alleys, that are accessible to the public anywhere in downtown Providence. Smoking would only be allowed in private residences and vehicles. Smokers who break the law could be fined up to $250. The city banned smoking indoors in businesses including bars and restaurants in 2005. The Providence smoking ban would cover more area and prohibit smoking in all of downtown, an area that is defined by the city as about one square mile. Public hearings could begin in September.

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

Puerto Rico Gov. Alejandro García Padilla signed legislation allowing the government to suspend general obligation bond set-asides early in the fiscal year and requiring the government to address deficits as they develop. A 1976 law required the government to set aside a proportionate amount of upcoming interest and principal coming due. The bill signed Friday overturns this law. The bill also will allow the government to borrow about $400 million from three commonwealth-run insurance funds. The State Insurance Fund, the Administration for Compensating for Automobile Accidents, and the Insurance Fund for Temporary Non-occupational Incapacity will lend the money.

Most of Puerto Rico’s revenues come in late in the fiscal year, which has required the government to issue short-term debt at the start of the fiscal year and pay it off near the end of the year.

The legislation would seem to conflict with the Puerto Rico Constitution. Article VI, section 8 of the Puerto Rico constitution reads, “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.” The Governor’s office however took the stance that “the suspension of these deposits does not imply a breach with the bondholders on the date of payment,”.

Puerto Rico House of Representatives Treasury and Budget Committee Chairman Rafael Hernández Montañez contends that the government will only stop the set-asides if it cannot borrow the $1.2 billion in intra-year funding or the Puerto Rico Infrastructure and Finance Authority cannot sell a $2.9 billion gas-tax supported bond which seems to be the current case.

The new law also requires the government use its normal reserves and set up a separate budget reserve at the GDB. In this way the amount in reserve can be more easily monitored. The law requires that if the reserve is drawn on, steps be taken to replenish it.

The Commonwealth followed up the legislative action with an investor meeting at the beginning of this week. It was, in many ways, the opening act in a long but predictable play. As is often the case, the presentation was obvious and unfulfilling in that it really was just a presentation of known facts rather than a framework for action. In many ways it continues a tradition of uninformative presentations which have become an unfortunate hallmark of the Commonwealth’s management of its credit relations. Nevertheless, it did serve to reiterate some things which have been clear for some time.

On the positive side, the Commonwealth denies that it is looking for direct Federal monetary aid. That would at least show a degree of realism about the appetite in Washington for direct fiscal aid. It wasn’t available for Detroit so there is no reason to suspect that it would be there for Puerto Rico. The need to get its own fiscal house in order as well as the need for some level of investor-accepted oversight was acknowledged. In addition, it was clear that the need for structural economic reform in the form of a more productive and legitimate economic structure was emphasized.

On the negative side, it appears that the Commonwealth is looking for debt relief over an extended period – at this point some 8 years. In addition, it is obvious that the Commonwealth ties serious reforms of the government employment and compensation structure to a haircut for creditors. While it seemed to acknowledge the contradiction between not meeting its constitutional and contractual commitments and market access, the Commonwealth gave no indication that it had managed to reconcile these opposing interests.

On the subject of restructuring, the Commonwealth tried to emphasize the voluntary nature of restructuring but also reiterated support for H.R. 870 authorizing Puerto Rico municipalities to declare bankruptcy under Chapter 9. Sens. Chuck Schumer, D-N.Y., and Richard Blumenthal, D-Conn. introduced companion legislation to H.R. 870 as we go to press. The emphasis on partnership, transparency, and all of the other current terms of art as well as references to Greece were not reassuring. The Commonwealth did all it could to encourage a quick resolution (obviously) and positioned itself to blame creditors if a protracted negotiation impeded economic recovery.

The reliance on economic recovery as a source of resources for repayment of debt going forward is no surprise. At the same time, the Kruger Report does lay out how many competitive forces work against Puerto Rico. The emphasis on lower wage costs to attract business could be argued to be a race to the bottom as many lower wage base competitors exist in the Caribbean. Some are better located relative to end markets. And left unsaid in any of the discussions are potential long-term competition from Cuba – effectively an 800 pound gorilla in the room.

We see restructuring and relief as the answers for the Commonwealth rather than reliance on stronger revenues. That implies a protracted negotiation over the terms of debt relief and we believe that there are sufficient differences between the needs of the different creditor groups to indicate a longer rather than shorter process. We also believe that the current stance of the Commonwealth may drive some creditors to legally test the constitutional and contractual supports for the various types of Commonwealth debt. We believe that those tests will occur in or out of bankruptcy.

PREPA, which is already underway with its restructuring, has been trying to achieve it for a year now. As for PRASA, the Commonwealth expressed belief that a rate increase would allow its current debt structure to be supported. That may not be realistic in terms of historic resistance to increases and the drought conditions which are impacting current usage. For 160,000 residents and businesses on the island, currently water is turned off for 48 hours and then back on for 24 hours, sending people into a frenzy of water collection. Another 185,000 are going without water in 24-hour cycles, and 10,000 are on a 12-hour rationing plan. 340,000 households and businesses — about 28 percent of the island’s total — in 13 municipalities are at times going without water.

PENSIONS

The Pew Charitable Trusts have released their latest view of the nation’s pension crisis. According to Pew, the nation’s state-run retirement systems had a $968 billion shortfall in 2013 between pension benefits that governments have promised to their workers and the funding available to meet those obligations—a $54 billion increase from the previous year. In 2013, state pension contributions totaled $74 billion—$18 billion short of what was needed to meet the ARC—with only 24 states setting aside at least 95 percent of the ARC they determined for themselves. Illinois continues to have the lowest funding ratio followed by Kentucky and Connecticut at under 50%. Other laggards below 60% include Alaska, Rhode Island, Louisiana, Mississippi, and New Hampshire. New Jersey, a well known pension defunder has seen its funding ratio drop from 68% to 63% in the last two years.

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 PENSION BATTLE EXTENDS INTO NEW FY

The most recent analysis of a scaled-back, Republican-authored public employee pension reform bill reduces the projected long-term savings from $18.3 billion back to $11.1 billion. None of those savings would show up for state government or Pennsylvania’s school districts in the 2015-16 fiscal year. The analysis done for the Public Employee Retirement Commission said the adjustment rests on House actions to delete a provision to try to unwind 2001 retirement benefit increases.

That clause – sure to invite a court challenge from public sector employee unions – was the biggest single cost-saver in the original bill. It would have required current employees to pay more to keep the higher benefits granted in 2001. New Gov. Tom Wolf opposes increased payroll deductions for existing employees. The remaining reforms include the shift of most future state employees and school teachers into a something more like the 401(k)-style plans now prevalent in the private sector.

In 2001, Pennsylvania’s lawmakers granted pension benefit increases to themselves, plus all public school employees and state workers. They then delayed payments on the resulting higher cost structure in order to avoid tax increases and keep funding available for other state needs. Since then, taxpayer-funded “employer contributions” have grown from under $1 billion in 2010 to more than $4 billion in the fiscal year 2015, and are projected to reach $5.9 billion by fiscal 2016-17.

If  not for the 2001 revisions, the current requirement would about 40 percent of what it is today – or less than $2 billion. The Legislature believes reform requires converting the state’s two major pension plans – at least for future employees – to a 401(k)-style. The Governor, with the support of public sector unions, contends that reforms approved in 2010 for workers hired after that date are working as intended and that funding is the issue. The Governor supports the issuance of $3 billion in bonds secured by increased profits from an enhanced state liquor store system.

The legislature wants employees to contribute 6 percent of their salary for retirement, half in the defined contribution plan matched by 2.59 percent of pay for teachers and 4 percent for state employees. The other three percent of salary would go into a cash balance plan with no additional employer contribution, earning interest tied to yields on 30-year U.S. Treasury bonds, capped at 4 percent. Retirement system gains in excess of that guarantee would be retained by the funds, and go toward paying off their liabilities, a provision union leaders have derided as “inter-generational theft” as new hires see investments on their contributions used to pick up the tab for the changes in 2001.

About 20 percent of the state’s current workforce, mostly law enforcement staff like state troopers and corrections officers, would remain in the current defined-benefit plan, under the House amendment.

The debate is over whether the proposed changes are enough. According to an analysis by the Pew Charitable Trusts’, the biggest discrepancies come for those who work to full retirement, or 35 years, in the public sector. Under the defined contribution plan set out in Senate Bill 1, Pew says a 35-year state worker qualifying for the maximum annuity at age 62 would see their pension drop from 67.6 percent of salary now, to 39.5 percent (assuming annual investment returns of 7.5 percent.)

Assume an average annual return on those 401-(k) investments to 5 percent, and the prospective new worker’s pension would be just 28.6 percent of final salary – an income cut of 58 percent from someone hired today. If the system provides retiree health care benefits, as the State Employees Retirement System does now, proponents argue that the new system – because of an enhanced ability to take funds with them if workers switched jobs – would actually outperform the current defined benefit system for people who leave the public sector before retirement for other careers.

The Pennsylvania State Education Association notes that their members don’t get free health care in retirement, and none of the state or school retirees get an inflation adjustment on their pensions. The PSEA worries that by definition, workers’ benefits will be less certain in the proposed plan because of the built-in risk of depending on future investment returns, as opposed to the current defined benefit plan.

Coloring the debate is the perception that the proposed bill doesn’t appear to generate a lot of savings. For example, the defined contribution portion of SB 1 only generates, according to the PERC report, a long-term savings of about $6.6 billion between both systems. The current PSERS bill through 2035, when pension costs are finally expected to crest, is $109.7 billion. Under the new bill, the cost is pegged at $105.2 billion, or a cut of little more than 4 percent. That is because the biggest savings source –  the piece that tells current workers to pay a higher contribution for the benefit they won in 2001 no longer exists.

PUERTO RICO

Puerto Rico filed a supplement to its May 7 quarterly report that updates the financial state of the commonwealth to reflect recent developments. It states, “if no significant measures are implemented to increase the government’s cash flow, absent new financing from GDB or third parties, during the first quarter of fiscal year 2016 the government may not be able to continue funding all governmental programs and services while continuing to meet all of its debt service obligations in a timely manner.”

The Government Development Bank (GDB) states that the most recent projections point to a fiscal year 2015 budget deficit of $705 million to $740 million, after previously estimating to close this fiscal year with a deficit amounting to about $191 million. That figure does not include nearly $291 million in pending tax refunds. It is also not a figure based on GAAP.

For fiscal 2016, “the Commonwealth faces set aside payments to the Redemption Fund for the Commonwealth’s general obligation bonds of approximately $276 million during the first three months of the fiscal year (approximately of $92 million per month), $93.7 million in appropriations which are due on July 15, 2015 to the Puerto Rico Public Finance Corporation for the payment of debt service, and $300 million in TRANs issued by the GDB plus accrued interest that mature on July 10, 2015, (which the Commonwealth expects to offset during July 2015 with a new $300 million TRANs to be issued by GDB).”

To finance cash needs, the government will delay the payment of income tax refunds by the Treasury and issue about $400 million in TRANs to certain public corporations. GDB President Melba Acosta said that the government was moving forward with various efforts aimed at securing the remaining $800 million needed to operate the government during the beginning of the fiscal year, including a potential deal with private banks that amounts to $400 million.

Legislation also allows the Treasury Secretary to “suspend, totally or partially,” monthly deposits made to cover principal and interest payments on GO debt if it fails to either secure $1.2 billion in TRANs or at least $2 billion in a bond deal backed by the latest petroleum-products tax increase. The supplement also showed a liquidity position at the Treasury Department, with a book overdraft on its cash balance expected to exceed the $271 million figure at the end of May.

Meanwhile PREPA avoided a payment default on July 1 by borrowing from its bond insurers and drawing down its reserves. It’s day of reckoning is now postponed until December.

Supporters of bankruptcy for the Commonwealth may have gotten a boost from a U.S. appeals court affirmation of a lower court decision to strike down Puerto Rican legislation aimed at granting local municipalities the right to enter bankruptcy, but said excluding the U.S. territory’s public entities from federal bankruptcy law was unconstitutional. In the decision, the Court seems to support the idea by saying that “besides being irrational and arbitrary, the exclusion of Puerto Rico’s power to authorize its municipalities to request federal bankruptcy relief should be re-examined in light of more recent rational-basis review case law,”.

Thus the 75-page ruling ostensibly vindicates the suing bondholders’ position, while also making a case that Puerto Rico should be given access to Chapter 9 of the U.S. bankruptcy code, which deals with municipal bankruptcies. Bondholders have consistently opposed this view. The detailed ruling, citing much legislative history, appears to strengthen the case for Congress to act on a bill, currently before a House committee, that seeks to change Chapter 9 to allow Puerto Rico to file for bankruptcy.

VA P3 ROAD SAGA COMES TO ITS TERMINUS

Under a settlement announced by Gov. Terry McAuliffe  the Commonwealth of Virginia  will recover $46 million already paid to US 460 Mobility Partners and avoid paying $103 million in additional claims submitted by the developer for the U.S. 460 project. The road  was a four-lane, 75-mph toll expressway between Suffolk and Petersburg which never was able to receive U.S. Army Corps of Engineers approval to destroy wetlands in its planned route. A total of $260 million had been spent the before the project had the permit from the Corps in hand. The project did result in a new state law new law which creates a committee that will include General Assembly representation to ensure that proposed deals under the Public-Private Transportation Act serve the public interest; require the mitigation of potential risks such as federal permitting; and force the secretary of transportation to attest in writing that a project delivers what was promised before a final agreement is signed.

In prior discussions, we had pointed out that the Corps often becomes an effective vehicle for environmental opposition to road development  involving wetlands. It was a surprise that investors did not apparently give this risk the weight it deserved when the bonds initially came to market. While the investors will ultimately recover their principal through a state financed redemption, the intervening threat to principal value and opportunity cost of investing in the project should give pause to those evaluating future projects.

LEGAL POT IN WA. STATE GENERATES HIGHER TAX BUZZ

Reports out of the State of Washington show an estimated $250 million in marijuana sales in the past year , generating $62 million in marijuana excise taxes. The state’s original forecast was $36 million. When state and local sales and other taxes are included, the tax take for the state and local governments tops $70 million. One year after legalization, the state has about 160 shops open, sales top $1.4 million per day.

This month, two new laws take effect, one to regulate and tax medical marijuana, and one to cut Washington’s three-level excise tax on pot to a single, 37-percent tax. In Washington, marijuana is taxed at 25 percent each time it moves from the growers to the processors to the retailers. That’s been especially tough on retailers, who must pay federal income tax on the marijuana tax they turn over to the state. The new tax rate should help. The law makes clear that the 37 percent tax is the responsibility of the customer — not the retailer. That means stores won’t have to claim that money as income on their federal filings.

The numbers reflect that few growers were harvesting by the time the first stores opened, with the average price of a gram of legal marijuana rising to nearly $30 last summer — about three times the cost in medical marijuana shops. But prices have been dropping with larger harvests and Washington has harvested 13.5 tons of marijuana flower intended to be sold as bud, but stores have only sold about 10 tons. Some of the excess can be turned into marijuana extracts, such as oil, but the harvest has helped drive down the prices to an average of about $11.50 per gram.

The Washington Liquor Control Board is soon to be renamed the Liquor and Cannabis Board. It regulates the business  by adopting background checks and financial investigations of pot-license applicants, and capping the total amount of production to try to keep it in line with in-state demand. The state required strict packaging and labeling requirements to keep children from buying and products that appeal to them.

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 PEERS INTO THE ABYSS

Puerto Rico Gov. Alejandro García Padilla has announced a working group to achieve a negotiated moratorium with bondholders. He issued an executive order creating the Work Group for the Economic Recovery of Puerto Rico. The group will be led by La Fortaleza Chief of Staff Víctor Suárez; Government Development Bank (GDB) President Melba Acosta; Justice Secretary César Miranda; and the presidents of the Senate and House, Eduardo Bhatia and Jaime Perelló. According to the Governor, “the goal will be to reach a negotiated moratorium with bondholders to postpone debt payments for a number of years so that this money is invested here in Puerto Rico.”

The group will have until Aug. 30 to develop a plan aimed at boosting economic and fiscal reforms so it can be considered and approved in the legislative session that begins in mid-August. According to the Governor, “It is the first time that this kind of comprehensive analysis of the fiscal situation over 10 years, considering the entire government and not only the general fund. This type of analysis has never been done.” That analysis is contained in a study by former officials at the International Monetary Fund and the World Bank which he commissioned. Concluding that the debt load is unsustainable, the “Krueger Report,” as it is known, suggests a bond exchange, with the new bonds carrying “a longer/lower debt service profile,”.

For bondholders, many of the findings reflect long term concerns. As the governor said the report “reveals outdated accounting methods, public corporations without revenue sources, lack of fiscal controls, unreliable statistics and other factors that conspire against the goodwill of many public servants, and which produced the situation we face.” He admitted what many have known – the economy does not generate enough revenue to repay the undertaken obligations.”

Whether his administration is completely willing to deal with al of Puerto Rico’s realities is yet to be seen. For example, his comment that “I will not consider, for example, education as an expense, rather as an investment, nor will I promote lowering the minimum wage for workers, among others. Furthermore, I will defend jobs as the main objective in this process.” He contended that “All the measures we took in the past two years demonstrate our willingness to pay, and had we not taken them, we would not be in a position today to ask for a restructuring. We have done everything in our power but, as the report shows, the next step must be to get more-favorable terms for the payment of our debt”.

The governor described a plan that would establish the parameters for a five-year fiscal adjustment plan, propose further spending cuts, including cuts in some services (“this way we can insist in avoiding tax increases”) and increase revenue based on an operational restructuring of Treasury. He also proposed to promote partnerships with the private sector for the provision of certain services currently provided by the public sector.

That is an idea that has been promoted by many outside observers who have watched agencies like PREPA and PRASA operate inefficiently and uneconomically for many years. As for federal help he asked for changes to Chapter 9 and Medicare. Puerto Rico, like the states, does not have the option of bankruptcy under the federal bankruptcy statutes. A default on its debts will create a state of legal and financial limbo that will take years to undo. It has wide implications for every market participant. Much of Puerto Rico’s debt is widely held by individual investors on the United States mainland, in mutual funds or other investment accounts, and they may not be aware of the extent of that exposure. The monoline insurers have a significant multi-billion dollar exposure to the island’s debt.

The response from Washington was along partisan lines. “Bondholders purchased Puerto Rican bonds at a time when Chapter 9 was not an option,” said Representative Bob Goodlatte, the Virginia Republican who is the full Judiciary Committee chairman. “Proposals to retroactively impact investors’ rights should be reviewed with care and caution.” Democrats said it appeared that Puerto Rico had been denied access to bankruptcy inadvertently, when the most recent amendments to the code were drafted. If Puerto Rico was excluded on purpose, they said, the reason was not clear. The White House press secretary Josh Earnest said on Monday “Detroit did not receive anything you could say was like a federal bailout. “It did receive significant advice. And that did have a measurable impact on their ability to turn their problems around.”

A broad restructuring by Puerto Rico would be unprecedented by a state or near-state equivalent.  It comes on the heels of municipal bankruptcies in Detroit and  Stockton, CA.  It further undermines the assumption that state governments in the United States would always pay back their debt. The governor’s comments were ominous. He said creditors must now “share the sacrifices” that he has imposed on the island’s residents. “If they don’t come to the table, it will be bad for them. They will be shooting themselves in the foot.”

The restructuring process is arguably already underway. Puerto Rico officials and creditors of the island’s electric power authority were said to be close to a deal that would avoid a default on a $416 million payment due on July 1. The government essentially needs to set aside some $93 million each month to pay its general obligation bonds —its constitution requires such bonds to be paid before any other expense. No American state has restructured its general obligation debt in living memory.

The government’s Public Finance Corporation, which has issued bonds to finance budget deficits in the past, owes $94 million on July 15. The Government Development Bank — the commonwealth’s fiscal agent — must repay $140 million of bond principal by Aug. 1. The proposed debt restructuring marks a major departure for Gov. García Padilla, (Popular Democrat) who was elected in 2012. His party favors maintaining the island’s legal status as a commonwealth. Only a few months ago, his administration was considering borrowing as much as an additional $2.9 billion, which would be paid for by a fuel tax.

But the actions to be proposed reflect the results of a study by former officials at the International Monetary Fund and the World Bank which he commissioned. Concluding that the debt load is unsustainable, the “Krueger Report,” as it is known, suggests a bond exchange, with the new bonds carrying “a longer/lower debt service profile”. In June, Puerto Rico hired Steven W. Rhodes, the retired federal judge who oversaw Detroit’s bankruptcy case, as an adviser.  Mr. Rhodes said in a recent interview, “They need Chapter 9 for the whole commonwealth.” The government is also being advised by  Citigroup who advised Detroit on a $1.5 billion debt exchange with certain creditors.

The Commonwealth has been pushing for a federal bill that would allow the island’s public corporations, like its electrical power authority and water agency, to declare bankruptcy. Of Puerto Rico’s $72 billion in bonds, some $25 billion were issued by the public corporations. Some say Congress needs to go further and permit Puerto Rico’s central government to file for bankruptcy.

Hedge funds holding billions of dollars of the island’s bonds at steep discounts are frustrated that the government has not seemed willing to reach a deal to borrow more money from them. In a letter last week, a group of investment firms, including Centerbridge Partners and Monarch Alternative Capital, wrote “we want to be a part of the solution to the commonwealth’s fiscal challenges,” but the Commonwealth has decided that the hedge funds’ debt proposal was too onerous.

A review of the Krueger Report provides a summary of what is so maddening about how P.R. got to this point. The issues of lack of economic development, poor fiscal practices, overstaffing, and inefficiencies are all issues which the investment community has repeatedly brought to the Commonwealth’s attention. They are issues which the investment community has repeatedly cited the necessity of dealing with while the Commonwealth has consistently failed to follow through with concrete actions. There has been no political will exhibited by governments of both major parties. Instead there has been consistent delay and lack of response, albeit a trend facilitated by large investors and financial intermediaries.

For long time analysts of Puerto Rico’s credit, the report merely serves as confirmation. That is not to say that it is not of value. Like many of these sort of reports, it is an important part of any like process in that it provides an objective reference point and initial framework for resolution. The somewhat stark nature of the presentation and its willingness to frame the island’s problems simply and directly create a good starting point for reform.

CHICAGO SCHOOLS PENSION QUAGMIRE

The Illinois House last week defeated Chicago Mayor Rahm Emanuel’s plan to delay a massive Chicago Public Schools(CPS) pension payment due at months’ end, a result of years of deeply rooted partisan mistrust surfacing in a new era of divided state government. The legislation which would have delayed the CPS pension payment due at the end of the month until Aug. 10. That is when general state aid payments are to be made to school districts — provided a state budget agreement is reached.

The House vote was 53-46. 71 were needed for passage. Democrats have 71 members in the House, but only 37 voted for the measure. The remaining 16 votes in favor of the bill came from among the 47 Republicans. Members who voted against the bill or did not take part in the vote, included five from Chicago. One problem was a lack of detail on how the pension payment eventually would be paid. Many members fearing being targeted in the 2016 election for supporting a bill that could lead to a property tax increase. A series of internal reports indicated that even if CPS emptied its checking account and used all of its cash set aside for other debts, it still would not be able to make the pension payment, cover payroll and pay other bills.

The action comes as the Chicago Board of Education is expected to authorize two borrowing packages totaling more than $1.1 billion to fund district operations through the year. Those loans would be paid off with future property tax collections. Additional property taxes are expected to start flowing to CPS on July 6 and total $816 million by Aug. 10, but that money along with revenue from the state and other sources still would not cover the bills, according to documents that have been presented in recent weeks to union officials and state legislators. Those documents show a negative cash balance of $102 million on Aug. 10.

Legislative leaders promised another vote. In a surprising announcement, House Speaker Michael Madigan said Tuesday afternoon a Chicago schools pension delay bill was moot, since “reliable sources” told him a bill due Tuesday would be paid in full by day’s end. “I’ve been advised by reliable sources they have cash on hand and they’ll be in the position to make the payment before the end of the business day today. The full payment,” Madigan said. When pressed on who told him, Madigan said: “It wasn’t Rahm.”

The consequences to the Chicago Public Schools and its students were far from clear Tuesday. Mayor Emanuel at an news conference earlier in the day refused to say where CPS would get the money or what cuts would take place in classrooms to make the payment.

The Chicago schools pension issue is but one more part of the ongoing partisan battle between the Governor and the House Speaker . Democrats under House Speaker Michael Madigan blamed the Governor for failing to provide enough Republican votes to secure passage. In response, the Governor accused the Speaker of double-dealing, contending that Madigan failed to deliver votes because the speaker was not part of the original negotiations.

The vote also reflects dissatisfaction between Chicago-based legislators and the Mayor over his recent school closings and other efforts to strengthen the finances of the CPS. Some have contended Emanuel was disproportionately targeting the African- American community by closing dozens of schools affecting black children.

A failure to act on pensions could negatively impact ongoing talks on a new contract for teachers further pressuring the CPS finances. The Board’s debt ratings have already been under pressure, especially at Moody’s (Ba3) vs. A- at S&P. The split has already complicated valuations. In its most recent financing, the Board chose not to come with a Moody’s rating. Moody’s has been criticized for having an overly negative view of many Chicagoland credits.

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

WHY YOU NEED US

Thirty six municipal bond underwriters operating in the $3.7 trillion muni market will collectively pay about $9 million to settle civil charges over fraudulent offerings, as part of the first settlement of its kind with the U.S. Securities and Exchange Commission. The SEC said that the charges stemmed from a March 2014 invitation to brokers and bond issuers to voluntarily report disclosure violations in offering documents, such as material misstatements and omissions.

The firms represented about 70 percent of the dollar value of all municipal bonds issued in the United States during the four years ended on Sept. 30. The settlement requires each firm to pay civil penalties based on the number and size of the fraudulent offering. The maximum penalty is $500,000 for large firms and $100,000 for smaller ones. The firms also must hire independent consultants to review their policies and procedures.

PUERTO RICO UPDATE

With PR fast approaching its July 1 fiscal cliff, Governor Alejandro García Padilla confirmed that his administration recently pursued a proposal to request that the U.S. Congress allow the Puerto Rico government to declare bankruptcy. García Padilla said he has since rejected the proposal in favor of a current effort to get rules that would allow only Puerto Rico’s public agencies to file for bankruptcy under Chapter 9.  A U.S. House committee is studying the issue amid growing concerns about the government’s ability to repay its debt and is holding hearings this week.

Pedro Pierluisi, Puerto Rico’s representative in Congress, criticized García Padilla for pursuing such a proposal privately. The Government Development Bank has warned that the government could have to shut down in the coming months if new measures to generate revenue are not enacted. García Padilla recently signed a bill to increase the sales and use tax (IVU by its Spanish acronym) from 7% to 11.5% and to create a new 4% tax on professional services. The sales tax increase goes into effect July 1 and the new services tax on Oct. 1, with a transition to a value-added tax by April 1.

Legislators are now debating a proposed $9.8 billion budget which includes $674 million in cuts and sets aside $1.5 billion to help pay off Puerto Rico’s debt. The budget has to be approved by June 30. In the meantime, Senate Bill 1350, which aims to enhance oversight powers and immunity protections for Government Development Bank (GDB) officials now moves to the governor’s desk after a conference committee version was approved by the Legislature.

The bill keeps immunity language, which stipulates that GDB directors, officers and employees “shall be indemnified by the bank and shall not have any personal civil liability to any entity for actions taken or not taken in good faith in their capacity and authority, absent clear and convincing proof or gross negligence comprising reckless disregard of, and failure to perform, applicable duties”. The bill also calls for the Senate’s approval of GDB directors appointed by the executive branch, beginning in January 2018.

It keeps provisions for the creation of the Audit and Risk Management committees, and places lending restrictions on loans provided by the GDB. The bank would be empowered to require from public corporations and instrumentalities access to any financial information and related documents it deems necessary, with sanctions established for noncompliance. The GDB would also be allowed to pass judgment on the “reasonability” of the government revenue estimates for each fiscal year.

The bill includes provisions requiring the bank’s president to submit a monthly report on new loans to the legislature, as well as amendments to existing ones approved by the bank’s board; appear once a year at both chambers to present the bank’s annual report on public debt; and submit both the Commonwealth’s Financial Information & Operating Data Report and Quarterly Reports within five days of publishing them. The bill also creates a Commission for the Integral Audit of Public Credit with broad powers to analyze and audit everything related to Puerto Rico’s public debt. It would act autonomously, and would comprise members from both public and private sectors, as well as academia.

Many of S.B. 1350’s original provisions, including those allowing for the appointment of emergency managers for troubled public corporations and instrumentalities, and the transfer of deposits from municipalities and the University of Puerto Rico (UPR) to the GDB were eliminated in order to secure the necessary votes for passage in both chambers.

To address the Government Development Bank’s liquidity,  a bill that seeks to raise short-term debt from some public corporations, as well as requiring reserves to cover general-obligation (GO) debt, was approved late Tuesday by the House. House Bill 2542 now moves to the Senate, which would have to consider it before Thursday, the last day for both chambers to approve measures during this session, while bills at conference committees have until June 30.

Amendments to the measure include provisions allowing the Treasury Secretary to “suspend, totally or partially” monthly deposits made to cover principal and interest payments on GO debt, if it fails to either secure $1.2 billion in tax & revenue anticipation notes (TRANs), or at least $2 billion in a bond deal backed by the latest hike to the petroleum-products tax.  The House-approved bill also requires the Office of Management & Budget (OMB) to reserve $250 million in the proposed fiscal 2016 budget, which would bring it down to $9.55 billion from the initially projected $9.8 billion, he indicated.

The bill would allow use of about $400 million for TRANs from investment funds of the Automobile Accidents Compensation Administration (ACAA), Temporary Nonoccupational Incapacity Insurance (Sinot) and State Insurance Fund (SIF). While Sinot and ACAA would provide $15 million and $50 million, respectively, SIF’s share stands to total about $335 million. The bill adds that these investments would still be carried out, regardless of the credit rating of the instrument or any restriction placed by the public corporations’ investment policies or contractual obligations.

During the House debate, the minority leader declared ominously, “we are telling bondholders that if you want certainty, invest first in Puerto Rico,” adding, “We will pay the GOs, but we have to restructure the rest of the debt.”

Under a scenario in which the government can’t accomplish any of two financing plans, the minority leader stated that with the “combination of the $400 million from the public corporations, the additional 4.5% to the sales tax, and not doing the monthly reserves for GOs, we would keep the government operating.”

Government officials have previously said that absent TRANs or short-term financing at the beginning of the fiscal year, Treasury could potentially run out of cash during the first quarter, which would affect government operations and services, as well as exacerbate the island’s economic and fiscal crisis. Several options are under consideration—including the exchange of short-term notes worth as much as $4 billion—as it pursues a parallel initiative with the U.S. Treasury Department. The GDB’s net liquidity position was $778 million, as of May 31.  It has been reported  that Puerto Rico’s government has lobbied the U.S. Treasury to purchase GDB notes in a last-resort effort to increase much-needed liquidity.

Meanwhile, as a significant July 1 principal payment looms, Puerto Rico Electric Power Authority (PREPA) and its creditors entered into yet another forbearance agreement extension, until June 30, while they continue to negotiate a restructuring plan for the financially troubled utility that prevent a potential default and court-mandated receivership. Bond insurers would have to cover much of the July 1 payment, if PREPA were to miss it. In a recent filing, U.S. Bank N.A. PREPA’s trustee, indicates that it doesn’t hold sufficient funds or investments to cover the July 1 payment, adding that no deposits have been made by PREPA to the trustee since March 31.

It said that “in advance of the July 1, 2015, bond payment date, the trustee may be required to liquidate investment obligations held in the reserve account, including substantial long-term government obligations.” Failure to extend the forbearance protection before agreeing on a restructuring deal would virtually allow creditors to ask the court to oversee the utility’s overhaul by placing a receiver in charge of the process if PREPA were to default on any of its debt obligations. Under that scenario, a default notice would be issued by the trustee, which would give PREPA 30 days to address the issue. Failure to do so would result in an event of default, allowing creditors to take the matters to court.

The net take-away is that PR well deserves a mid or lower range CCC rating. Only Moody’s has gone down that far. We think that the B and CCC+ ratings from Fitch and S&P are still too generous.

SWEET BRIAR COLLEGE REVERSES CLOSING

Sweet Briar College, the women’s liberal arts college in rural Virginia that announced it would close in August — setting off protests and lawsuits from students, faculty and alumnae — will remain open for at least one more academic year under an agreement announced Saturday by the attorney general of Virginia. The AG said the agreement, which includes plans for electing a new president and board, and calls for an alumnae group to donate $12 million for Sweet Briar’s continuing operations. The agreement also calls for the easing of restrictions on $16 million from the college’s $85 million endowment — money that, combined with the $12 million from alumnae, will help keep the school open. The alumnae group has agreed to deliver the first $2.5 million of its donation by July 2.

A judge in Amherst County, Va., whose county attorney sued to keep Sweet Briar open, approved the settlement on Monday. Away from the obvious issues – the conversion of pledged donations to hard cash, recruitment of a freshman class mid-summer, and an effort to repatriate students, faculty and employees who had  been told to leave, many of whom have already made plans to attend other schools – the decision raises real questions for debt holders. The closure plan provided for the full redemption of the school’s outstanding bonds. While the call could be seen as premature, redemption would have provided full payment and relieved the bondholders of the principal risk associated with a weak credit. Now there has been no call, and without a long-term plan, bondholders remain in limbo with potentially $16 million less in endowment assets available.

Under the memorandum of understanding released by the attorney general, 13 of Sweet Briar’s 23 board members will be replaced by at least 18 new elected members. The new board, the memorandum said, is expected to appoint Phillip C. Stone, a former president of Bridgewater College, a small private college in Virginia, to serve as the new president of Sweet Briar. The agreement also calls for the attorney general to ease restrictions on $16 million from the college’s $85 million endowment — money that, combined with the $12 million from alumnae, would finance operations.

Sweet Briar was founded in 1901 by a wealthy Virginia landowner, who bequeathed her entire estate — a former plantation — for the express purpose of educating young women. How much demand there is for a school best known for its equestrian programs is unknown. Enrollment has been in decline for some time. Fifty years ago, there were 230 women’s colleges in the United States; last year there were 46.

The fact that the school will remain open does nothing to improve the credit from a rating standpoint. The existing S&P CCC is well deserved.

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

ARENA DRAMA IN ARIZONA TAKES ANOTHER TURN

The  season on ice may have finally ended this week, but the action continues off it foe NHL fans. The Arizona Coyotes’ tortured relationship with the city of Glendale took a negative turn last week when the City Council voted to terminate its lease agreement with the team at Gila River Arena. In 2013, the city agreed to pay IceArizona, the team’s ownership group, $15 million a year for 15 years to run the building in return for a share of the naming rights and other revenue.

Bond investors care because there is some $230 million of outstanding debt issued to finance the arena. Action by the Council to void its operating agreement could put into doubt the continued viability of the debt financing. Here is some background.

At the time of the lease agreement, the mayor and some council members opposed it before it was signed, and new council members have since been elected. The city has not released the results of an annual audit of the arena for the 2013-14 fiscal year. It has been reported in the local press that the city’s assistant auditor resigned in April because some of her findings were changed.

The council voted, 4-3, last week to end the agreement citing a state statute that allows an agency to cancel a contract if an employee directly involved with the agreement becomes an employee or agent to the other party. The Coyotes hired the former city attorney as general counsel in 2013.  In November 2013, an ethics complaint with the State Bar of Arizona that the attorney went to work for the Coyotes in 2013 while still being paid a severance by Glendale.

Before the meeting, the City Council announced that the city would consider amending the deal if it “provides certainty and fairness to both parties, especially the taxpayers.” IceArizona responded that the meeting was a “blatant attempt to renege on a valid contract that was negotiated fairly and in good faith.” After the council voted to dissolve the deal the team’s chief executive and president, said the city had violated its obligations under the agreement. The N.H.L. said before the meeting that it was “extremely disappointing that the city of Glendale would do anything that might damage the club.” The league said it expected the Coyotes to continue playing at Gila River Arena.

In 2009, the prior owner of the team put the franchise into bankruptcy. The league took over the team for several years before finding new owners. The Coyotes average of 13,345 fans a game is the third-lowest in the N.H.L. The agenda posted for the Council meeting cited a state statute that allows government entities to end a contract within three years of being signed if a person involved in negotiating the contract for the city is, in effect, an employee or agent of the other party to the contract. The attorney relinquished his duties with the city when his separation agreement went into effect April 1, 2013, three months before the City Council approved a 15-year agreement with the Coyotes. He was paid his full salary through September 2013.

Glendale has still not released its audit of the Coyotes 2013-14 season a year after it notified the team that it would exercise its option to evaluate the team’s financial results. The Coyotes blamed a delay in providing information to the city on the ownership change at the end of 2014, when Barroway became the majority owner. Glendale’s losses for hockey and concerts at Gila River Arena through April were $6.3 million, or nearly 14 percent from a year earlier.

After the announcement, a Maricopa County Superior Court judge granted the team’s request for a temporary injunction to keep Glendale from killing their arena deal. Attorneys for the Coyotes filed legal claims against Glendale over the team’s lease agreement for Gila River Arena, and lawyers appeared in court Friday afternoon for a hearing about a temporary restraining order. Superior Court Judge Dawn Bergin granted the motion for a temporary injunction and set another hearing on the dispute for June 29. The next move will be when the Glendale City Council meets in executive session and decides whether to send the team a letter confirming its vote to sever the agreement.

IDEOLOGY WINS AND LOSES IN BUDGET OUTCOMES

Tax ideology has had a big influence on state budget policies in recent years. The drive to limit revenues stemming from supporters of the ideology that the only way to control government is to “starve the beast” has had great currency in recent years. This year however, the ability of that ideology to stand the pressure of service demands from constituents has tested the staying power of that ideology. The recent outcomes of budget battles in two states provided two different answers to that test.

In Kansas, it took 113 days to complete this year’s budget session, the longest ever, and more than three weeks longer than the mandated 90 days. Much of the delay was due to debate over taxes after lawmakers passed about $3.8 billion worth of tax cuts in 2012 and 2013. Democrats and moderate Republicans have cited the cuts for the budget shortfalls that have since arisen, while conservatives cite unforeseen cost drivers out of their control like Medicaid growth.

Many acknowledged that the only way to close the gap now was through tax increases. Eventually, they voted to slow the pace of income tax decreases, raised sales taxes and increased the cigarette tax by 50 cents a pack, among other measures. But overcoming the gridlock to reach that deal required long legislative sessions stretching into the early morning. Thursday morning the House failed to pass a Senate plan that leaders were optimistic would pass. Legislative leaders and Gov. Brownback issued several threats about what could happen if a tax bill was not passed — for instance, cutting all state funding for public universities and colleges.

Eventually,  a tax plan was spread over two bills and the first passed at 1:51 a.m. Friday with exactly the 63 votes needed to pass. The second vote opened at 2:24. On that item the initial count was only 59 yes votes. After two hours of effort the necessary votes in the House were obtained. Later Friday, the Senate got exactly the 21 votes it needed to send the bill to the governor’s desk.

In Louisiana, the result was much less straightforward. The $24.5 billion budget passed last week contains so many short-term fixes that next year’s governor and Legislature will inherit a budget deficit of an estimated $1 billion, documents show, and the size of the deficit is only projected to grow in the following years. All four candidates for governor — U.S. Sen. David Vitter, Lt. Gov. Jay Dardenne, Public Service Commissioner Scott Angelle and state Rep. John Bel Edwards, the only Democrat — have said that if elected, they would hold a special legislative session shortly after taking in office in January devoted to finding a long-term solution to the budget problems that Jindal and the outgoing Legislature are leaving behind.

They balanced revenue with spending during the current budget year by continuing to raid the state’s trust funds and resorting to what most analysts would consider to be  gimmicks, including a tax amnesty program that provided only a short-term windfall. In all, the budget passed by legislators in 2014 and signed into law by Jindal contained a record $1.2 billion in one-time money, that is, money that wouldn’t be available in 2015.

After oil prices dropped late last year, legislators and Gov. Jindal had to close a $1.6 billion budget deficit when this year’s session began April 13. After seven years of cutting taxes, Jindal and the Legislature moved in the opposite direction in 2015 and sought to raise new revenue. Legislators chose instead to shave 25 percent of the rebates that companies get from the state when they pay inventory taxes to local governments, increased the cigarette tax by 50 cents to a new rate of 86 cents per pack, limited a number of business breaks and the amount of subsidies for the solar energy and film and television industries.

Adding in a $50 increase in the vehicle title fee to $68.50, the state will raise about $750 million in new money next year. The Governor, in keeping with his presidential ambitions, is claiming it is not a net tax increase following passage of the SAVE fund. Under this measure, no students will pay a higher fee, no one will pay lower taxes and higher education institutions will get no extra money.

But the tax credit included in the plan allows the Governor to claim that it offsets all of the new tax revenue, under rules promulgated by Americans for Tax Reform, a national anti-tax organization headed by the noted anti-tax activist Grover Norquist. A June 9 report by the Legislative Fiscal Office several days before the budget was approved said that it  included $509 million in one-time money — by drawing down more money from trust funds, from the final year of the tax amnesty program and through a one-year plan to reimpose a one-cent sales tax on businesses’ utility bills. Legislators got $7 million for next year only by suspending the program that allows filmmakers to sell their tax credits back to the state for 85 cents on the dollar.

The Legislature found another $73 million in trust funds for the budget. Of that amount, $20 million would come from unclaimed lottery winnings and another $25 million from the state’s Medicaid Assistance Trust Fund. The problem is that the fund has a $1.3 million balance, according to the state treasury’s office, and it last had at least $25 million three years ago. The Department of Health and Hospitals plans to replenish the fund in the upcoming fiscal year through provider fees to make the $25 million available for spending.

The net result is no real improvement in  the state’s already weak budget outlook. This in turn maintains downward pressure on Louisiana’s already weak general obligation debt ratings.

GREAT LAKES WATER AUTHORITY MOVES AHEAD

Last week, the new Great Lakes Water Authority signed a lease for Detroit’s water and sewer system, two days before a deadline. This is the first in a number of steps that the Authority must take by Jan. 1, 2016, or the leases terminate and the authority could be dissolved. These steps include getting  customer communities to agree to assign their Detroit Water and Sewerage Department contracts to the authority. It also must reach an agreement with the city and Detroit General Retirement System to manage its pension obligations to the retirement system, which is now frozen.

As far as the system’s debt is concerned, the authority must get at least 51% of bondholders to agree to the transfer of the water system assets and bond obligations from DWSD to the new authority. In addition, it must persuade the bond rating agencies to confirm ratings on the bonds it is assuming from the Detroit Water and Sewerage Department that are at least as high as the current ratings. This anticipates the adoption of a bond ordinance that basically mirrors the current bond ordinance of DWSD and the receipt of  legal opinions on the validity and enforceability of the lease agreement as it relates to tax treatment of bonds.

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

NJ SUPREME COURT UPHOLDS SHORT FUNDING OF PENSIONS

New Jersey’s highest court ruled on Tuesday that Gov. Chris Christie could skip the pension payments he promised to make in 2011 in the signature law of his tenure. In the short term, it mitigates a huge fiscal crisis just weeks before the state closes its books for the year. In the long term, the 5-to-2 decision by the Supreme Court of New Jersey maintains the negative pressure on the state’s credit which has bedeviled the state’s bondholders throughout Mr. Christie’s tenure.

Christie has aggressively claimed to have fixed the state’s well known pension underfunding problem. He boasted in his keynote speech to the Republican National Convention in 2012 that he had “fixed” the problem of underfunded pensions. Unfortunately, the “Jersey Comeback” the governor regularly cites has seen the state economy lag behind his forecasts, and the nation. As a result Mr. Christie said the state could not afford to make the payments he had promised in the law.

Nine credit downgrades later, “The loss of public trust due to the broken promises” in the law, the court wrote in its decision Tuesday, “is staggering.” The court said that the governor and the Legislature violated the debt limitation clause in the State Constitution when they signed the law requiring the state to make large payments over a series of years. The court supported the view of most fiscal observers when it said  “That the state must get its financial house in order is plain,”. The decision added however, “the responsibility for the budget process remains squarely where the framers placed it: on the Legislature and executive, accountable to the voters through the electoral process. Ultimately, it is the people’s responsibility to hold the elective branches of government responsible for their judgment and for their exercise of constitutional powers. This is not an occasion for us to act on the other branches’ behalf.”

The dispute between the state’s employees and the governor stems from the implementation of the 2011 law and a companion law signed in 2010 requiring public employees to pay more toward their benefits, and in exchange, the state agreed to make the annual pension payments that several governors had ignored. Payments were made for two years, but beginning with the budget for 2014, the governor said he could not balance the budget if he made them. The payment in 2014 was $696 million instead of the $1.58 billion the law required; the 2015 payment was $681 million instead of the $2.25 billion owed.

The unions sued, and a trial court ruled in February that the law had given public employees a constitutionally protected right to those payments. That decision was reversed by the Supreme Court. Predictably, unions called the ruling “devastating” and “indefensible,” saying it was unfair that they had held up their end of the deal, while the Supreme Court allowed the governor to abandon his. In a dissent, it was pointed out that “The decision unfairly requires public workers to uphold their end of the law’s bargain — increased weekly deductions from their paychecks to fund their future pensions — while allowing the state to slip from its binding commitment to make commensurate contributions.”

The legislature is expected to send Mr. Christie a budget that makes the required pension payment in the next fiscal year, which begins in July. The governor however, is almost certain to strike the payment with his line-item veto. He has called on unions to give up more benefits. Unions and Democrats who lent him crucial support in 2011 said Mr. Christie had to guarantee that the state would finally make its payments.

JUSTICE DEPARTMENT RULING IMPACTS CCRC FACILITIES

Harbor’s Edge is an upscale continuing care retirement community in Norfolk, Va. It includes amenities, including River Terrace, a dining room with waterfront views originally open to all residents. That changed when management announced, in May 2011, that the River Terrace and certain activities like Fourth of July celebrations would be restricted to independent living residents and off-limits to everyone else. This sparked protests from residents who had lost access to that amenity.

Last month, the Department of Justice issued a complaint which charged that the facility had violated the federal Fair Housing Act by establishing policies that discriminated against people with disabilities and retaliating against those who complained. To settle the case, Harbor’s Edge admitted no wrongdoing, but will pay $350,000 to compensate those harmed, and a $40,000 civil penalty. The consent order also requires the facility to appoint a Fair Housing Act compliance officer, provide training for its staff and adopt a “reasonable accommodation” policy.

“This is a decision that’s going to put the rest of the industry on notice,” said a senior attorney for the AARP Foundation. While the settlement doesn’t create new law, “it’s a continual battle to get compliance” with the Fair Housing Act, according to Justice in Aging, an advocacy group. Such cases rarely generate the large damages that would encourage lawyers to file suits. Now, Mr. Carlson said, “if I’m running a long-term-care facility and I realize there are significant financial consequences, I think, I’d better change the way I do business.” Though complaints of discrimination or segregation more commonly crop up at communities whose residents have very different functional abilities, the Fair Housing Act applies to any senior housing or care facility — and the Justice Department clearly wants administrators to know it’s paying attention. “It’s not an isolated situation,” said Gregory Friel, deputy assistant attorney general for civil rights. “We’re looking into facilities with analogous practices.”

According to press accounts, the facility initially blamed overcrowding believed that allowing people of different disability levels to use the same facilities violated Virginia regulations. The Justice Department saw a simpler motive. “Harbor’s Edge adopted these policies because it wanted to market its facility as a place for ‘young seniors’ who wanted an active lifestyle,” its complaint said. The DOJ sent lawyers to Norfolk to interview Harbor’s Edge executives, residents and family members, and review thousands of pages of documents. Last summer, it notified the facility that it would bring suit, and executives agreed to begin negotiations.

The three-year DOJ order ensures that Harbor’s Edge can’t revert to discriminatory practices for its duration. Other facilities’ policies are also being reviewed such as the independent living section of Redstone Village in Huntsville, AL. The impact of the Norfolk settlement may be letting residents (and lawyers) around the country know that senior communities must make reasonable accommodations to enable them to use facilities. Segregating them in certain parts of their supposed homes because of their need for assistance is not reasonable. It’s illegal.

The existence of such regulations and the potential for financial penalties at already cash strapped facilities is another item of due diligence for investors in this already risky class of credits found in many high yield municipal funds.

RHODE ISLAND PENSION SETTLEMENT APPROVED

A proposed settlement to resolve years of legal uncertainty over a landmark public pension system overhaul was approved Tuesday by a judge who called it an imperfect but fair solution. The judge, Sarah Taft-Carter of Superior Court, overruled objections, putting an end to nearly all the lawsuits by public-sector unions and retirees against Rhode Island over the 2011 reform, which was designed to save $4 billion over 20 years. The deal would preserve about 90 percent of the savings. Lawmakers must also approve the settlement. Speaker Nicholas Mattiello of the House said the changes from the settlement would be incorporated into the budget, which lawmakers are considering. The settlement provides for cost-of-living increases and one-time stipends for retirees.

WHY WE DON’T LIKE PENSION BONDS

Recently, we reported that Pennsylvania Governor Tom Wolf was advancing the idea of issuance of $3 billion of pension debt to temporarily address funding shortfalls in the Commonwealth’s pension systems for teachers and other employees. We opined that this was a bad idea. We have always held to that view for a number of reasons. These mostly reflect our belief that the issuance of this debt is no different than the issuance of debt for any other operating expense. Such practices have always been indicators of fiscal irresponsibility and often strong indicators of fiscal difficulties.

A look at the history of such issuance is instructive. At the state level, major issuers of such debt include New Jersey (the first state to use the technique in 1997) and Illinois. Neither of these two states have managed to properly address their pension funding shortfalls even with the issuance. On the local level, pension funding shortfalls continued to bedevil a number of cities even after such issuance. In some cases, the overall fiscal position was made even worse as poor investment of the bond proceeds resulted in continuing shortfalls, no lessening of the current funding expense requirements, and the additional expense o f debt service associated with the issued debt.

Now, a series of decisions in recent municipal bankruptcy proceedings have increased concerns for investors in these bonds. These securities were generally issued with a security pledge that relied on annual appropriation actions by the legislatures of the issuing entities. They were effectively unsecured obligations of these issuers. As the municipalities involved in recent bankruptcies have sought to restructure their finances and associated obligations, they have sought to use this unsecured status as a basis for effectively repudiating the debt.

The successful effort by Detroit to avoid the repayment of much of the principal on its outstanding $1 billion plus of pension obligations is well documented. The most recent example is in San Bernardino where the city has contested its obligations to make payments to both CALPers and to holders of outstanding pension COPs. Last month, CALPers successfully challenged the city’s effort to avoid required contractual payments due to the pension fund. The City contends that it cannot afford both the payments to CALPers and repayment of debt service on its pension COPs. While not yet final, the city’s recovery plan is expected to include sharply reduced principal recoveries for holders of the COPs.

These efforts mirror the treatment of certificate of obligation debt by other issuers in bankruptcy or undertaking restructurings outside of bankruptcy. Given the rather thin case history that existed under Chapter 9 prior to the rash of filings over recent years, the resulting decisions upholding efforts to force debt holders to take significant haircuts has begun to establish a pattern of precedent which is highly unfavorable to bondholders.

We believe that these precedents have created a situation where pension obligation securities should not be a part of an individual’s portfolio at any price. The results of the recent restructurings have created a highly insecure obligation that provides a level of risk which is not offset by any available yield.

PENSION MANGEMENT TAKES A TURN

Over the years, the CA Public Employees Retirement System has been a leader in the management of state pension funds. Whether it be matters of investments, fund management, corporate governance activism, or non-traditional investing, CALPERS has been a leader. For years, the country’s biggest state pension fund, paid billions of dollars in fees to external managers to help finance the retirement plans of teachers, firefighters, police and other state employees.

Now Calpers, which has just more than $300 billion of assets under management, plans to cut back drastically on those fees by severing its ties with half of the external investment managers of its funds. Calpers will inform its investment board this month about its plans to reduce the number of external managers to 100 from 212. As part of the move, Calpers will reduce the number of private equity firms to 30 from 98, giving those remaining managers $30 billion to manage. Calpers invests in some of the biggest and best known private equity firms in the world, including Blackstone, TPG, Carlyle and Kohlberg Kravis Roberts.

The move follows on last year’s decision to liquidate $4 billion in hedge fund investments in an effort to simplify a portfolio that has become complex and expensive. This year, the fund will begin to make more payments to retirees than it receives from its investments. And by 2030, it could be left with a $10 billion shortfall between payments and the total amount of contributions from active workers and income from investments, Calpers said in a presentation in May.

Last year, it paid $1.6 billion in management fees, $400 million of which were a one-time payment for its real estate managers. Many other pensions funds have begun to focus on fees, too. Despite a bull market for the last several years, many state and municipal pension funds have not received large enough returns on their investments and are now faced with having too few assets to cover future costs. They now need to address issues of earning enough to make up for their failure to earn what they said they would earn in the past, and making enough in this environment to pay for new promises.

The change reflects the fact that taxpayers are increasingly being asked to pay for public pension shortfalls. Many feel that the more that is being paid to the asset managers, the less is available for public services. In Pennsylvania, where the state is looking at a $50 billion hole in its pension fund, Gov. Tom Wolf recently asked  “why are we paying Wall Street managers hundreds of millions of dollars?” In New York City, Comptroller Scott M. Stringer has noted that the city’s five pension funds have paid more than $2 billion in fees over the last decade, outpacing the returns during the same period. “Right now money managers are being paid exorbitant fees even when they fail to meet baseline targets,” Mr. Stringer said in April.

The move towards nontraditional investment strategies gained additional traction in response to the financial crisis, when the value of assets was decimated by losses. It led pension funds to shift more aggressively into private equity and hedge fund strategies. But returns after the fees — which typically follow a “2 and 20” model in which investors pay an annual management fee of 2 percent of assets under management and 20 percent of returns — have been disappointing in more recent years.

CALPERS will also use just 15 of the current 51 real estate managers to invest the fund’s $26 billion real estate portfolio. And Calpers will eliminate 24 managers from its general equities portfolio, leaving 20 firms to invest $24 billion.

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 POTENTIALLY GETS A BREAK ON PENSION FUNDING

Under a 2010 state law, the city’s contribution to its police and fire fighter funds next year increases by $550 million to about $839 million. A bill to restructure contributions in the near term won final legislative approval on Sunday from the Illinois Senate. The bill now awaits the Governor’s signature but earlier in May the Governor said  “For Chicago to get what it wants, Illinois must get what it needs.” As we go to press, the bill is unsigned.

The bill would reduce that amount by about $220 million, to $619 million. Chicago’s payments would increase every year between 2017 and 2020, but not as much as under the 2010 law. After 2020, the city’s contributions would be calculated at amounts that would enable the two pension systems to become 90 percent funded by 2055, which is 15 years longer than in the 2010 law.

If Chicago fails to make required pension payments, the bill allows for an intercept of state funds due the city and for the retirement funds to go to court to force payments. The bill also requires proceeds from a Chicago casino in the future to be allocated to the public safety retirement funds. Emanuel has been asking state lawmakers for a bill authorizing a city-owned casino, but that legislation did not advance.

We have previously documented the Governor’s demands for the enactment of a package of tax changes and regulatory changes considered to be “business friendly”. They are unrelated to the pension problems of either the State or to the City of Chicago. The debate over pensions and the budget have had a decidedly partisan edge with the Governor saying after the end of the legislative session he called “stunningly disappointing, “we’re going to have a rough summer.”

SPORTS FINANCING

The NBA Finals begin on June 4 and they will command the most attention from pro basketball fans. Many owners however, will also have an eye on developments surrounding the financing for a new arena in Milwaukee for the NBA Bucks. Gov. Scott Walker has finally taken a public stand in support for the major aspects of a plan to publicly fund such an arena.

As currently conceived, taxpayers would be responsible for half the initial cost of a new arena. The initial public investment would be $250 million, but taxes would ultimately pay for principal and interest on a bond issue for that amount, issued by the Wisconsin Center District. The rest of the arena — another $250 million — would be funded by the Bucks owners and former U.S. Sen. Herb Kohl, who used to own the team.

To support the planned municipal debt, lawmakers would have to change state law to extend taxes the district levies that are set to expire in coming years as it pays off the debt. It would extend for years taxes that are set to expire and could result in a boost in the tax on hotel rooms in Milwaukee County. Walker, who is preparing a run for the presidency, argued that potential hike would not be a tax increase because the Wisconsin Center Board already has the ability to raise it. “It’s already within their means, so that’s not a new tax,” Walker told reporters after a groundbreaking for a plant expansion in Portage.

The district operates the Wisconsin Center convention center, Milwaukee Theatre and UW-Milwaukee Panther Arena. In Milwaukee County, it levies three taxes: 3% on car rentals, 2.5% on hotel rooms, and 0.5% on restaurant food and beverage sales. Under current law, the district has the ability to raise the tax on hotel rooms to 3%. (The district also has the ability to raise the rental car tax to 4%, but only if it needs help from the state because its collections of that tax are falling short of the amount needed to pay its debt.)

Like the debate in many other venues over sports arena financing, this one has strong opinions on both sides. Walker claims that a deal for the Bucks is essential because the team will leave if it doesn’t have plans in place for a new arena by 2017. This would have a significant impact on the state budget. Backers hope to insert the plan into the state budget. The Joint Finance Committee is expected to complete its work on the budget by next week and forward it to the Assembly and Senate for final votes. Both houses are controlled by Republicans. Many conservative commentators object to the use of state money for such a project. Having the district raise the tax on hotel rooms to the maximum amount to help pay for a new arena would not constitute a new tax, Walker contended.

Under the plan, the state would be responsible for bonds worth more than $55 million. The state would commit $4 million a year over 20 years, or $80 million total, to cover its shares of principal and interest costs. The Wisconsin Center District would issue $93 million in zero-coupon bonds that could be paid off years from now. Officials have not detailed how much it would cost to pay back those bonds when accounting for interest.

The city would spend $35 million on a new 1,240-vehicle parking structure and provide $12 million in tax incremental financing. In the most unusual feature of the deal, Milwaukee County would “certify” tens of millions of dollars in uncollected county debt. The county, in effect, would then count on the state to recover at least $4 million of that debt a year for 20 years, a total of another $80 million that would then be funneled to the arena project. The state would also pay off the final $20 million owed on the Bradley Center, where the Bucks have played since 1989. That would bring the state’s total commitment to $100 million.

PRIVATE TOLL ROAD NEWS

IFM Investors has announced the completion of IFM Global Infrastructure Fund’s previously announced acquisition of 100 percent of the equity in the Indiana Toll Road Concession Company, LLC (ITRCC), which operates the Indiana Toll Road. The final purchase price for the ITRCC was US$5.725 billion, consistent with the purchase price and transaction structure outlined when the planned acquisition was announced.

The ITRCC is required to operate the toll road under a lease agreement that was executed in 2006, giving it the exclusive right to collect toll revenues through the term of the agreement, which has a remaining life of 66 years. The transaction is being financed using a capital structure that includes debt with maturities as long as forty years.

IFM inherits the remaining 66 years of a Concession Lease Agreement between ITRCC and the State of Indiana implemented in 2006 for a 75-year period. ITRCC on Sept. 22, 2014, announced that it had filed Chapter 11 bankruptcy. Nearly all of the $5.72 billion garnered in the toll road’s lease sale will be used to pay off bondholders who owned bonds backing up ITR Concession’s $6 billion debt. Financing for the acquisition came from some 70 U.S. pension funds and represents their first foray into the toll road market.

The jury is still out in terms of the viability of privately operated toll roads. There are numerous examples of such failed financings in the municipal market and many municipal investors remain wary of bonds in that space. A lot of the risk is based on the level of local opposition to these sorts of projects. In North Carolina, anti-toll group wants a judge to proceed with its lawsuit in an attempt to stop the state’s Interstate 77 toll project for which the P3 contract was finalized May 20. A state senator has developed a draft of a bill that would address opposition concerns. The long-shot bill would use money from an upcoming bond package to expand I-77 north of uptown without toll revenue, breaking a that contract between the N.C. Department of Transportation and a private developer to build express toll lanes.

In another sign of problems with P3 transportation projects, the VA DOT has determined in its discretion to terminate the Comprehensive Agreement with U.S. Mobility Partners, LLC (the “Design-Build Contractor”) for the construction of a 55 mile toll facility in southern VA. Boosters said it would spur development, connect military facilities, provide an alternative hurricane escape route and smooth freight shipments to and from the Port of Virginia. Instead, the project ran into environmental hurdles threatening to delay it and substantially raise its costs.

The termination of the Agreement subjects the Bonds to extraordinary redemption from funds derived from termination compensation amounts to be paid by VDOT.  VDOT will determine the portion of the termination compensation amount necessary to redeem the Bonds by or about the June 15, 2015, termination date and that the Bonds could be called for redemption as early as on or about August 1, 2015. There is no certainty that the Bonds will be called for redemption on such date and VDOT’s Notice of Termination could be rescinded, although the Corporation does not believe that rescission is likely based on discussions with VDOT and public statements made by Virginia’s Secretary of Transportation and representatives of the Governor’s Office. $114.87 million of current interest bonds and $116.73 million of capital appreciation bonds were issued for the project in 2012.

KANSAS REBOOT?

We’ve been following fiscal events for the State of Kansas for some time as the Governor undertakes a significant experiment with supply side economic theory, using the state budget as his test case. Legislation in 2012 and 2013 phased in rate reductions on personal income taxes — to 3.9 percent from 6.45 percent on the high end and 2.3 percent from 3.5 percent on the low end — by 2018. The reductions were expected to cost a total of about $7 billion through 2019. They were based on the premise that they would stimulate economic growth. But that growth did not appear, and after repeatedly trimming spending to close shortfalls, legislators find themselves facing a $400 million budget hole for the coming fiscal year.

The situation has become so serious that many of those legislators are considering whether to reverse field by raising taxes. Both houses of the Republican-controlled Legislature are proposing tax increases. The primary driver is negative public reaction to the idea of cutting more expenditures without significantly hurting popular programs, including education.

The debate  now focuses on which taxes to raise. Some believe that income taxes are off limits instead supporting a rise in sales taxes. Others advocate a mixed approach with income taxes on the table. Democrats argue that increasing sales taxes would be another blow to low-income Kansans to the benefit of the business class. Business owners were seen to be beneficiaries of the plan’s signature piece of the law passed in 2012: the elimination of taxes on certain types of small businesses.

To avoid repeal there is a proposal for removing the exemption on nonwage income for small businesses, instead giving them a 1 percent payroll tax credit. This would be accompanied by an increase in the sales tax to 6.5 percent from 6.15 percent on everything except food, which would be taxed at 6 percent. A competing plan would tax the nonwage income on small businesses at 2.7 percent and increase the sales tax to 6.45 percent, but reduce it to 5.9 percent for food.

The debate has been particularly prolonged. The legislative session reached  the 100-day mark over the weekend for just the sixth time in state history. (Sessions are typically limited to 90 days, and each additional day costs around $40,000.) Supporters of the tax cuts are not necessarily willing to concede that the cuts were the reason for the state’s fiscal problems. To meet revenue shortfalls, Gov. Sam Brownback and lawmakers have found themselves repeatedly tinkering with the budget to fill hundreds of millions of dollars in shortfalls. The governor has cut some state agency budgets by 4 percent, reduced contributions to the state pension system and shifted money between state accounts. Lawmakers have rolled back funding for poorer school districts and changed the way they allocate money to schools. They have slowed funding increases for entitlement programs.

One leading legislative proponent said “We hoped they would just be a magic lantern and everybody would react to it,” he said. “But, eh, it’s hard to get a company to uproot their business when they’re established and move to another place just because of this difference in tax policy.” He unwittingly articulated what many studies have shown. Namely that tax policy is but one of many factors that go into a relocation decision and that taxes are often not the major driver. Initial estimates were that the small business tax exemption would affect about 191,000 entities and cost about $160 million. Instead, for the 2013 tax year, 333,000 filers took advantage of the exemption at a cost of $206.8 million, according to the Revenue Department.

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