Joseph Krist

Municipal Credit Consultant

ARGUMENTS BEGIN IN ILLINOIS PENSION CASE

Initial oral arguments were presented to the Illinois Supreme Court last week. Solicitor General Carolyn Shapiro offered the initial argument and cited Illinois’ need to protect the public welfare in the face of a fiscal emergency as a basis for cutting pension benefits despite their state constitutional protections. The court’s seven justices will decide the fate of legislation approved in December 2013 that reduced benefits with the goal of stabilizing a system facing $111 billion in unfunded obligations that has dragged down the state’s bond ratings and threatened its fiscal solvency.

A circuit court judge last November found that the legislation violated the pension clause adopted in a 1970 constitutional convention that gave contractual status to pensions and protects them from impairment or diminishment.

In the state’s view, the justices must decide whether the state is correct in its position that “the pension clause provides the same robust but not absolute constitutional protections provided to all contracts”. Or it can side with unions and the plan participants who are challenging the changes and find that it is instead a “categorical and absolute ban on any reductions to pensions even under extraordinary circumstances,” said the Solicitor General.

She also said that “Plaintiffs position is remarkable”. “If the state’s bond rating collapsed rendering borrowing prohibitively expensive, pensions would be entirely off limits regardless of the essential state services that might have to be eliminated.” If a natural disaster struck, pensions could not be even temporarily reduced, she added.

Shapiro acknowledged that such scenarios were extreme. But that is what plaintiffs are asking for,” Shapiro went further. “It is the state’s solemn responsibility to protect the public interest, the public health, safety and welfare in extreme situations but the necessary consequence of what plaintiffs are demanding and circuit agreed would tie the state’s hands when its need to act is most pressing.”

The State seeks to portray the diminished and impaired language as a reference to the enforceable contract status afforded to pensions, not to the pension benefits themselves and argued that past contract law precedent over the last 150 years allow the state to modify a contract under some circumstances. The State argues that there is little debate that the state is not facing a fiscal crisis given its budget deficit, massive unpaid bill backlog between $5 billion to $6 billion, and a credit rating that is the weakest among states.

The state further argued that “Like all contracts, they can be altered…they are not absolute” and argued that if the protections are absolute the clause does not legally meet the definition of a contract as the state constitution allows for contract modifications.

The attorney representing the union plaintiffs asked the court to look at both the plain language of the pension clause and the intent of the delegates to the 1970 constitutional convention that established the pension clause. It is “explicit, clear and unambiguous” and “is subject to no stated exception,” and the language is so “simple and plain” that the voters’ guide on the constitutional changes simply said “this section is new and self-explanatory.” The unions contend that the drafters anticipated the very situation that the court is now reviewing by which a General Assembly would act during a time of fiscal distress to “invalidate a constitutional protection” and so created “a binding contractual relationship for public employees” .

The state contends the U.S. Supreme Court has long held that a state can’t enter into binding contracts that would preclude it from exercising its police power in the future to protect the public welfare while the unions accuse the state of wrongly applying federal law. Justices pressed the state’s lawyers on whether a ruling in its favor would give it too much power, potentially unleashing future attacks on statutory and constitutional provisions. Justice Robert R. Thomas asked whether granting the use of police powers would give the state too great a “license” to modify its contractual obligations.

Shapiro stressed that the state constitution provides only a few exceptions for such modifications. She further argued that if the justices agree that the pension benefits are subject to police powers, a check on its power lay in future arguments that would be made at the circuit court level.

“The lower court will conclude whether the circumstances justify the state’s actions,” she said. Justices also questioned how the state’s pension funds sunk so low, suggesting it was a mess of the state’s own making. The state pinned the blame on the recession and economic conditions with inflationary levels driving big cost-of-living adjustments and stressed that the pension cuts don’t put the tab for past underfunding on employees but only the costs going forward.

One justice questioned whether the state faces what it considers a dire budget situation due to the state General Assembly’s failure to extend the 2011 income tax hike. The higher rates partially expired and lawmakers have not acted to make up the lost revenue.  Justices questioned why the state –if it in the midst of fiscal emergency – has asked the court to decide only whether the pension contract is subject to modification under state police powers and to then send the case back to the lower court for review. Justices said the case only would land back before them delaying legislative action possibly on new reforms. The state said it believed there would be sufficient time for lawmakers to act.

PA PENSION BONDS

Citing “a difficult second half of the year,” the underfunded, $27 billion-asset Pennsylvania State Employees’ Retirement System says its investments returned only 6.4 percent last year, below the system’s annual target of 7.5 percent, according to a report by Chief Investment Officer Tom Brier.

SERS’s stocks, bonds, real estate and hedge funds all posted returns below the fund target. Only one category, “alternative investments,” posted higher returns than the benchmark, thanks in part to soaring private equity valuations attributable to the strong U.S. stock market of the past few years. But even alternative investment returns lagged, posting a loss of 0.3 percent, during the fourth quarter of last year as stocks turned down.

New Pennsylvania Gov. Tom Wolf in his recent budget address called for SERS and the teachers’ pension system PSERS to reduce their reliance on high-fee private managers, and put more in indexed investments. A majority of the SERS board seats are held by legislators and appointees who in the past supported buying a wide range of investments from private managers. The results were announced as debate heats up over the Governor’s inclusion of a $3 billion pension issuance as a part of his budget plans for FY 2016. Bonds to fund pension funding have been long championed by Democratic legislators in the Commonwealth but did not have gubernatorial support. The election of Gov. Wolf is seen by pension bond supporters as creating a more favorable environment for consideration of such a debt issue.

We do not look favorably on the issuance of pension bonds for funding purposes. we equate the issuance of debt for what are arguably current expenses as bad policy and a negative ratings impact.

PUERTO RICO

Gov. Alejandro García Padilla worked to boost support for his tax-reform plan to a skeptical public earlier this week through a taped, prerecorded address Monday evening, March 9. The governor backed his reform as the best way to fix a broken system, and said nobody could defend Puerto Rico’s current “unjust” tax system. García Padilla announced no changes to his tax-reform plan, despite strong opposition from nearly every sector of society, as well as nearly daily protests in the past week. “I am going to the finish line to do what is right,” he said. “Puerto Rico’s tax system is unjust. I didn’t come here to put a patch, but to fix it.”

The heated rhetoric that has accompanied support for the plan continued in the Governor’s speech. The governor said the Treasury Department “confiscates” taxes before salaried workers get their pay, while nonsalaried professionals report an average $16,500 annually in earnings. Moreover, he said 82% of all taxpayers in Puerto Rico are either poor or middle class. García Padilla sought to reassure consumers, saying that the new 16% value-added tax (VAT, or IVA by its Spanish acronym) that is at the heart of his reform wouldn’t apply to the “immense majority of what you buy,” citing exemptions to non-processed food, automobiles, education, prescription drugs and most medical services.

“We live in an unjust system and have to make it just. It’s like a salary increase. You, not Treasury, will decide what you will pay in taxes,” the governor said. He criticized economists who have criticized implementing the reform at a time of economic crisis, saying the 160 countries that have a VAT implemented the tax system in similar situations.

While the governor redoubling his efforts on behalf of the reform in his message, some legislative leaders such as House Finance Committee Chairman Rafael “Tatito” Hernández and Senate Finance Committee Chairman José Nadal Power said changes would be needed to win sufficient support for passage in the Legislature. One possibility is that a substitute measure would either increase the 7% sales & use tax (IVU by its Spanish acronym)to 10%, or have a VAT of 12%. Along with tax reform there is support for the executive branch to reduce spending by $250 million to $500 million annually, about half the amount initially proposed by Senate President Eduardo Bhatia.

Meanwhile, technical amendments to a bill boosting the petroleum-products tax are still necessary for Puerto Rico to undertake a bond issue of nearly $3 billion, which it needs to shore up the Government Development Bank’s liquidity, refinance existing loans and keep the government afloat for the next two years. Lawmakers had previously approved the petroleum-products tax hike that will support the issue, but further amendments were needed to make the bond transaction viable. This month, the excise tax on a barrel of crude oil will be increased to $15.50 from $9.25.

Lawmakers already amended the legislation once to clarify language regarding when the petroleum-products tax hike takes effect and other related issues. Both the House and Senate approved amended legislation to take away the limit placed on the discount they could offer investors, but that isn’t sufficient to get a $2.95 billion deal done.

Another factor is the oil-tax hike escalator. Without it, the government can only borrow $2 billion, and hedge-fund investors don’t want to participate unless it is a $2.95 billion deal. They want to ensure the government stays out of the market for the next two years to protect the value of the bonds they will buy. Bond issuers will also likely participate in the deal if the escalator is in place, which will also work to make the deal more attractive.

Another important provision is the underlying security of pledged revenue, and language protecting it from being clawed back. Lawmakers have already agreed to extend a general-obligation constitutional guarantee for the deal, as well as giving investors the right to sue in New York City courts to resolve any claims arising from the deal. Investors are also pressing to have Puerto Rico commit to revenue and spending cut targets, with penalties for missed targets.

The Senate approved a bill last week with stronger “anti-clawback provisions” and an adjustment clause to ensure the tax would raise sufficient revenue to pay for the bond issue in the future. However, by this week’s deadline, the House hasn’t acted, although sources said the bill “was being prepared for the governor’s signature.”

FED FLOW OF FUNDS REPORT

The total amount of outstanding municipal securities and loans in the market rose 0.6% to $3.65 trillion in the fourth quarter of last year. Bank holdings increased 2.5% and mutual fund holdings rose to a record high of $658 billion.

The Federal Reserve Board released the data this week in its quarterly Flow of Funds report. The total size of the market was up from $3.63 trillion in the third quarter of 2014, but still experienced an overall year-over year decline from $3.67 trillion at the end of 2013. The size of the market has generally been declining for the past several years.

Bank holdings have risen sharply in recent years, totaling $452 billion at the end of 2014 compared to $419 billion the previous year and only $255 billion in 2010. Money market mutual fund muni holdings were up 1.1% to $281.7 billion in the fourth quarter, the only quarterly increase of the year. The category has dropped sharply since it was $386.7 billion at the end of 2010 and $509.5 billion at the end of 2008.  Dealers held $18.9 billion of munis at the end of 2014, a $2.7 billion increase over the previous quarter but a steep decline from the $40 billion dealers accounted for in 2010.

State and local governments accounted for $2.9 trillion of muni debt, with nonprofit organizations and industrial revenue bonds making up the balance. $2.87 trillion of those munis are long-term obligations, the Fed data shows.

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

TRYING AGAIN ON DISCLOSURE

The issue of municipal issuers’ disclosures of financial and operating data is back in the spotlight. Speaking at the National Municipal Bond Summit last week, Municipal Securities Rulemaking Board executive director Lynnette Kelly said there was a 40% increase in the financial and operating documents issuers filed to EMMA between June 2013 and June 2014. That is greater than the 7% increase the MSRB normally sees year over year, she said. At the same disclosures of bank loans have been disappointing.

Ms. Kelly attributed some of this increase to the Securities and Exchange Commission’s Municipalities Continuing Disclosure Cooperation initiative. The MCDC, announced last March, allowed both issuers and underwriters to voluntarily report, for any bonds issued in the last five years, any time they misled investors about their compliance with their continuing disclosure obligations. Underwriters had to report by Sept. 10 and issuers by Dec. 1 last year.

The SEC was focused on issuers who maintained in offering documents that they were fully in compliance with their self-imposed obligations to file annual financial and operating information by certain dates, when they had actually filed the documents late or not at all. SEC offered lenient settlement terms in exchange for the voluntary reporting under the MCDC program.

The MSRB began urging muni bond issuers to voluntarily post information about their bank loans on EMMA in 2012. Since then it has only received 88 such filings. Kelly said,  “That is far too low.” Concerns regarding such loans have grown as issuers have increasingly turned to bank loans to meeting their financing needs, typically because of lower interest and transaction costs, a simpler execution process, the lack of need for a rating, greater structuring flexibility, or the desire to deal to interact with a bank rather than multiple bondholders. Bank loans is a term used broadly to mean a bank’s direct loan to an issuer or the private placement of an issuer’s bonds to a bank. But there are no requirements that these be disclosed.

The MSRB, rating agencies, and some market groups have all said it’s important for issuers to disclose such loans, because they could affect an issuer’s financial condition, its credit or liquidity profile, as well as its outstanding bonds and the holders of those bonds. Ms. Kelly’s comments coincided with the National Federation of Municipal Analysts release of a paper detailing what disclosure practices it thinks should be adopted for bank loans.

In January, the MSRB made its most recent call for disclosure of bank loans well as other alternative debt such as direct loans from hedge fund investors. “Where we’ve not seen an increase in disclosures and would like to is … bank loans,” Kelly said. Kelly told those attending the conference that the MSRB has urged the SEC to revisit its Rule 15c2-12 on disclosure and that bank loan disclosure is one of the areas the MSRB wants the SEC to address.

HOSPITAL MERGERS CONTINUE

University Hospitals in Cleveland and Ashland’s Samaritan Regional Health System (SRHS), a small system anchored by a 55-bed hospital in Ashland OH, last week signed a letter of intent to merge. Should the merger close, SRHS will become part of the UH system like Parma Community General Hospital and Elyria’s EMH Healthcare did in 2013. Samaritan, which employs 35 physicians, would be UH’s southernmost outpost in the state. This is yet another sign of the changes wrought by the ACA. Those changes reward efficiency and scale, two things which are not characteristic of smaller stand alone facilities. UH has been pursuing other mergers with smaller institutions with various degrees of success. We expect that the trend of mergers in the industry will be long-term regardless of the outcome of current legal challenges to the ACA.

CONNECTICUT BUDGET

Connecticut’s governor released his proposal for a budget for the biennium beginning in July. The budget reflects General Fund expenditures of $18.0 billion for FY 2016, cutting $590 million from current law spending levels.  In addition, it cuts more than $753 million in FY 2017. The budget is $6.3 million below the spending cap for FY 2016 and $135.8 million below for FY 2017.  Payments on the state’s long term obligations and debt service will not be deferred, whether contributions to the state’s pension system or paying off Economic Recovery Notes.  The budget includes a proposal to lower the state sales tax rate albeit by widening the base.

The budget maintains funding for statutory formula grants at the FY 2015 level, including Education Cost Sharing (ECS) and Payment in Lieu of Taxes (PILOT).  Additionally, funding is increased for Municipal Projects by $3.6 million per year to provide $60 million annually to support local infrastructure. It establishes a new $20 million grant for green infrastructure, level funds Small Town Economic Assistance Program (STEAP) and the Local Capital Improvement Program (LoCIP), and maintains funding of $60 million annually for Town Aid Road (TAR). It maintains support for education, by keeping the commitment to local school construction (with nearly $600 million pledged annually) and continues funding for the teachers retirement system.

Health costs are a prime target for spending reductions. The majority of the reductions in DSS impact reimbursements to Medicaid providers.  The state’s share of Medicaid expenditures is reduced by: $43.0 million in FY 2016 and $47.0 million in FY 2017 by reducing provider rates ($107.5 million in FY 2016 and $117.5 million in FY 2017 after factoring in the federal share of Medicaid expenditures); $10.0 million in each year of the biennium by restructuring rates to achieve the savings assumed in the enacted budget for medication administration ($20.0 million in each year of the biennium after factoring in the federal share); $6.2 million in FY 2016 and $6.8 million in FY 2017 from changes to the pharmacy dispensing fee and reimbursement for brand name drugs ($18.9 million in FY 2016 and $20.6 million in FY 2017 after factoring in the federal share); $5.1 million in each year of the biennium from the elimination of the supplemental pool for low‐cost hospitals ($15.1 million in each year of the biennium after factoring in the federal share); $4.3 million in FY 2016 and $5.1 million in FY 2017 from ensuring that ambulance providers do not receive a combined Medicare and Medicaid payment that is higher than the maximum allowable under the Medicaid fee schedule ($8.6 million in FY 2016 and $10.2 million in FY 2017 after factoring in the federal share).

The budget also devotes significant resources to highways and mass transit, particularly the state’s commuter railroads. Known as  Let’s Go CT!  the plan will include expanded rail service on existing Metro‐North and Shore Line East lines, and expanded service on the New Haven‐Hartford‐Springfield line.  Additional station construction will also be complemented by Transit‐Oriented Development (TOD) and responsible growth programs which will enable the impacted communities to add more economic and housing options for their residents and visitors, while preventing sprawl. An additional $2.78 billion in transportation bond authorizations is recommended over the next five years to begin to implement Let’s Go CT!

WILL STATES LEARN ON PENSION FUNDING?

Last week in Kansas, the state Senate passed a bill, by a vote of 21-17, that would authorize the sale of $1 billion in POBs, the proceeds of which would be provided to the Kansas Public Employees’ Retirement System pension fund, which is roughly 60 percent funded, with a projected $9.8 billion shortfall. The $1 billion in new bonds is less than the $1.5 billion that Republican Gov. Sam Brownback’s administration had lobbied for.

Proponents are relying on a study by KPERS in which its actuaries concluded the House bill would save the state $2.8 billion in contribution obligations to the plan. Gov. Brownback has already reduced the state’s statutory contribution rate for fiscal year 2015. Supporters argue that the current historically low level of interest rates means that POBs are a relatively safe bet for state taxpayers. The cash raised would return a higher rate than the cost to service the debt, so long as the pension investments return their historical averages over the term of the bond, which can be as long as 30 years. Servicing the bonds is expected to cost Kansas $90.3 million annually, according to a blog post by Republican state Rep. Troy Waymaster.

The bill will now move to the Kansas House, where, last week, the Pensions and Benefits House committee passed its own version of the bill, authorizing $1.5 billion in POB sales, and capping the maximum interest rate on the notes at 5 percent.

An opposite approach is being taken in Kentucky. After that state’s House voted to authorize $3.3 billion in POBs for the state’s stressed teachers’ pension, the Senate strongly rejected the proposal, killing it by a 28-8 margin. The Kentucky Teachers Retirement System is funded at just over 50 percent, with nearly $14 billion in unfunded liabilities. Republican Robert Stivers, the Kentucky Senate president, said the POBs would create debt obligations that would tie up future governors and legislatures in issuing debt for other necessary projects.

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 ANNOUNCES UPDATE ON ITS RESTRUCTURING

Once again the market finds itself disappointed by the lack of timely follow through by the government of PR. The pattern of failed promises and lack of decisive timely action has become more than tiresome but unfortunately it is the basic m.o. in regard to its ongoing debt crisis. The latest example is the announcement on February 27 that PREPA continues in talks with creditors on the possibility of extending leniency agreements, which expire by its mandate on March 31, 2015.

PREPA said the Authority continues in productive talks with creditors on extending existing forbearance agreements,” through Lisa Donahue who leads the  official restructuring of the public corporation. “We have been working diligently with the Authority and all stakeholders in the operational transformation of the company.   To date, we have progressed significantly, but much remains to be done and as a result, we have not finalized the plan to present to creditors. Some time ago, we informed creditors would not reach the agreed date. Creditors are aware of the situation and have not taken any adverse action, “said Donahue.

“While most of the media coverage has focused on restructuring the debt of the Authority and talks with creditors, it is important that all employees, suppliers and customers understand that the restructuring of the Authority includes an operational transformation complete to ensure the reliability of service. We continue to work on efforts to create the infrastructure and financial resources needed to overcome the energy challenges of Puerto Rico and transform the Authority in a self-sustaining corporation, “said John F. Alicea Flores, executive director of the public corporation.

At some point the government of PR must realize that the juxtaposition of events such as that which occurred last week – the House hearings on Chapter 9 authorization followed by the PREPA announcement the next day – simply reinforce the image of disarray and frankly ineptitude in the handling of the restructuring needed for much if not all of Puerto Rico’s debt. The longer it takes the government to act decisively and competently, the more difficult it will be for the island to recover and move on. The trail of broken promises and deadlines must come to an end.

ISSUANCE CONTINUES ITS STRONG PACE

Favorable relative trends in yield movements benefitted issuance last month. Long-term municipal bond issuance in February increased 78.5% to $29.46 billion from a year earlier, the seventh monthly gain in a row, as refundings more than doubled to $14.53 billion from $5.11 billion in February of 2014, according to Thomson Reuters. Advanced refundings were the catalyst for issuance as long and intermediate tax exempt yields declined whie shorter dated treasury yields increased. AA 10 year yields are about 50 basis points lower this year relative to last year, while the 30 year yields are about 90 basis points lower in yield from this time last year.

Some estimate that if volume continues at the pace through February, yearly issuance could total $440 billion. Volume for the two months adds up to $56.54 billion, the most since 2010’s $59.714. January volume alone annualized to $450 billion.  New-money issuance increased 8.7% to $10.48 billion from $9.64 billion in February 2014. Negotiated issues rose to $21.85 billion (635 deals) from $10.82 billion (423 deals) for February of last year. Competitive deals increased to $7.46 billion (357 deals) from $3.78 billion (237 deals) while private placements dropped to $151.6 million from $1.90 billion.

Education, utilities and general purpose led the way. Education rose to $11.80 billion (501 deals) from $5.57 billion (257 deals), while general purpose rose to $6.78 billion (258 deals) from $3.77 billion (148 deals) in February 2014. State agencies increased issuance to $6.81 billion from $2.69 billion. Cities and towns lifted issuance to $3.60 billion from $2.06 billion while district bond sales rose to $8.63 billion from $4.37 billion. Bond insurers increased their footprint increasing par value insured to $1.93 billion in 166 deals compared to $1.16 billion in 93 deals in 2014.

The top five state issuers this past month were Texas, California, New York, Pennsylvania and Washington. Texas remained first, with $6.65 billion, up from $5.54 billion. California and New York switched positions, with California in second, at $5.43 billion from $3.84 billion. New York was third, at $4.15 billion versus $4.50 billion in 2014. Pennsylvania was fourth up from 12th, rising to $3.66 billion from $903.6 million. Washington state was fifth at $3.16 billion, up from $1.06 billion in 2014.

LOUISIANA BUDGET

Gov. Bobby Jindal of Louisiana introduced an FY 2016 budget proposal last Friday with deep cuts designed  to deal with a $1.6 billion shortfall and an entrenched structural deficit. The proposed cuts are substantial, even after years of moderate and severe reductions. They would potentially result in the closures of community health care clinics and historic sites. Hospitals partly privatized by Mr. Jindal would get $142 million less than they had sought. Spending on higher education would be lower by $141 million, a further 6 percent reduction after years of cuts.

The plan attempts to avoid some of the worst-case situations by reworking certain tax credits ways that would make an additional $526 million available to meet current expenses. Previously, Gov. Jindal has been firm in his opposition to new taxes. Even the renewal of existing taxes has been off limits. Officials insisted that the proposed changes did not constitute a tax increase, because they would simply take some refundable tax credits and turn them into nonrefundable tax credits. The change would not raise taxes as far as the state is concerned but, it could result in a net higher tax burden for businesses when certain local taxes are included. The plan also includes a complicated arrangement to raise cigarette taxes to pay for a tax credit that families could use to offset a new cost, called “an excellence fee” for students attending colleges and universities.

A fight is expected in the Louisiana Legislature as many believe that greater changes are needed in the state’s generous and expensive distribution of tax credits and exemptions. At the same time, significant pressure is expected from business groups against the proposed tax credit changes. The president and chancellor of Louisiana State University  called the current proposal “a bad budget for higher education,” but also said the situation would be devastating if the Legislature were to turn down the tax credit changes and fix the deficit on cuts alone. In that case, Mr. Alexander said, thousands of classes would have to be canceled, the state’s sole dentistry school and as many as half of the agriculture centers would have to close.

PENNSYLVANIA BUDGET

Gov. Tom Wolf issued his first budget proposal as the new chief executive. The budget reduces the Corporate Net Income Tax (CNIT) from 9.99 percent to 5.99 percent – improving the commonwealth’s ranking from second highest to fourteenth-lowest and bringing Pennsylvania’s tax rate below the national average and below all of its neighboring states. It ends the often delayed phase out of the Capital Stock and Franchise Tax by eliminating it effective January 1, 2016. The personal income tax would rise to 3.7 percent – the third lowest of all states with an income tax and significantly lower than all of Pennsylvania’s surrounding states. In addition, a family of four earning up to 150 percent of the poverty level (approximately $36,000) would pay no state income taxes.

Funds reserved for property tax and rent relief will be transferred from personal income tax revenues into a restricted account. Beginning in October 2016, $3.6 billion will be transferred to the Property Tax Relief Fund and distributed to homeowners and renters. The sales tax is proposed to be expanded to be more consistent with the modern economy and the rest of the nation. The sales tax rate would increase by 0.6 percentage points, and exemptions for food, clothing and prescription drugs would remain in place. Over the next two years, the budget provides an $80.9 million increase to Penn State University, the University of Pittsburgh, Temple University and Lincoln University.

Holders of local school district credits will look favorably on proposed increases in education funding. Proposed is a $400 million (7.0 percent) increase in the Basic Education Subsidy. This increase – the largest in Pennsylvania history – will fully restore the Accountability Block Grant and Educational Assistance Program funds that were previously cut. In addition, as part of the Basic Education Subsidy, school districts will receive a reimbursement for approximately 10 percent of their mandatory charter school tuition payments. This would have a positive impact on the Philadelphia School District. Additional resources will be provided to help close the funding gap based on Basic Education Subsidy cuts instituted since the 2010-11 school year.

A $100 million (9.6 percent) increase in the Special Education Subsidy is also proposed by the Governor. This increase will continue Pennsylvania’s transition to the formula enacted in 2014 reflecting the work of the bipartisan legislative Special Education Funding Commission. The budget incorporates that formula as a permanent component of the state’s education law, known as the Public School Code. Another item is a $120 million (87.9 percent) increase in high-quality early childhood education to enroll more than 14,000 additional children in Pennsylvania Pre-K Counts and the Head Start Supplemental Assistance Program.

We expect that the final budget will be substantially different. There is however, support for local property tax relief and the expansion of the sales tax base as well as increased education  funding.

COLLEGE CLOSING

Sweet Briar College, a 700 student women’s school in VA announced that it would close at the end of the 2014-2015 school year. Continuing declines in demand created operating pressures including tuition and fees covering less than  one-third of expenses. A 10% operating loss and a 10% spend rate on its endowment reflected unsustainable trends. The school’s $25mm of debt outstanding (B- by S&P) can be paid off from remaining endowment funds which will also be applied to severance costs and the cost of assistance to students who need to transfer. The demand for single sex, rural liberal arts colleges has continued to decline and one should not be surprised to see additional instances where institutions close when they can no longer effectively compete in a changing marketplace.

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 BANKRUPTCY BILL REINTRODUCED AGAIN

The U.S. House Judiciary Committee’s subcommittee on regulatory reform, commercial and antitrust law, which has jurisdiction over bankruptcy law, will hold a hearing as we go to press on legislation that would allow Puerto Rico government-owned corporations to restructure their debts under Chapter 9 of the federal Bankruptcy Code. The bill, the Puerto Rico Chapter 9 Uniformity Act of 2015, is sponsored by Democrat Pedro Pierluisi, Puerto Rico’s non-voting representative to the House. Pierluisi introduced the bill last session, but it failed to move.

Puerto Rico is looking for alternatives to restructure its debts after a federal court in Puerto Rico struck down the Puerto Rico Debt Enforcement and Recovery Act on February 9. That law was enacted last year to give the island’s public corporations a process to restructure their debts. Pierluisi did not support that law, and has said repeatedly that Chapter 9 would be a better approach.

Pierluisi said “it is my hope and expectation that the hearing will be productive,” “Many stakeholders support this bill, and this hearing will provide them with the opportunity to memorialize and explain their support.  Although no objections to the bill have been registered with me up until now, if there are any concerns about the legislation, those concerns can be raised and addressed at the hearing.  The point of the hearing is to create a comprehensive record that will help the committee’s leadership determine whether to take the next step in the legislative process, which would be to hold a vote on the bill.”

Investors have concerns about the proposed bill as it could be key for those holding the bonds of financially distressed government corporations on the island. The Puerto Rico Electric Power Authority had to draw on its debt service reserves to make a July 1 interest payment. PREPA, which has more than $8 billion of bonds outstanding, is now in discussions with its creditors, and there had been speculation that it might ultimately use the Recovery Act. The Puerto Rican government has said that it supports amending Chapter 9.

STOCKTON BANKRUPTCY ENDS

It began with a bang and ends with an effective whimper but the City of Stockton emerged from bankruptcy this week. The well documented fiscal difficulties of the City led to the elimination of OPEB benefits for its retired employees and defaults on a number of lease revenue obligations. But most importantly, the City’s pensioners survived the process with those benefits intact. This creates one more brick in the emerging structure around municipal bankruptcy whereby pension obligations are assuming a superior position to debt obligations in the restructuring of liabilities through Chapter 9.

TRANSPORTATION FUNDING DEBATE

Since the advent of the automobile as the nation’s primary source of transport , the gasoline tax has provided the financial foundation for the nation’s roads. For each gallon pumped, motorists have paid several additional cents in taxes to their state and federal governments. So long as vehicle ownership grew and driving remained increasingly popular, this model worked. But as vehicles have become more fuel-efficient and younger people are less eager to obtain drivers licenses, gas tax revenue has flattened.

Generally decreased support for tax increases over time has impacted the federal gas tax such that it has lost more than one-third of its value to inflation since it was last raised to 18.4 cents a gallon in 1993. This has altered the debate over long-term transportation funding, especially for highways. As a result, state and federal officials are more willing to look at  alternatives to help pay for repairs and upgrades to highways. Those alternatives are briefly summarized.

In lieu of the traditional model of taxing retail sales of gasoline –  taxing each gallon of gas pumped, some states have begun levying a tax on the wholesale price. Virginia in 2013 repealed its 17.5-cents-a-gallon gas tax and replaced it with a 3.5 percent wholesale tax on gasoline. Minnesota Gov. Mark Dayton has proposed a wholesale tax that would be added to the state’s current per-gallon tax. Because of price swings, wholesale tax revenue can be volatile from year to year. Advocates believe it could provide more revenue growth than a flat, per-gallon tax over the long term.

Some states have begun funding highway projects by taxing all retail sales. Arkansas voters in 2012 approved a half cent sales tax increase with that portion dedicated to highways. The Michigan electorate will decide in May whether to impose a 1-cent sales tax for transportation. Because they are broad-based, retail sales taxes can generate large sums for highways. Opponents most commonly object that sales taxes tend to have a larger proportional effect on lower-income residents. That helped Missouri voters last August to defeat a proposed sales tax increase for transportation.

One new concept is the idea of a tax on the number of miles traveled. It is one of the most commonly discussed alternatives to direct fuel taxes but has not been widely implemented. Oregon plans to test the concept this July with 5,000 volunteers, who will be charged 1.5 cents for each mile they drive while getting a refund on their gas taxes. The vehicle mileage tax also has been studied in California, Minnesota and Nevada. One major obstacle has been privacy concerns from people reluctant to have their vehicles tracked with GPS devices.

Toll roads have existed in some form since the earliest eras in the country’s history and are receiving renewed interest in some places. Delaware raised tolls last year after legislators rejected the governor’s proposed gasoline tax increase. Governors in Connecticut and Missouri also recently referenced the potential for tolls. Opponents cite the relatively high levels of toll which might be required to pay for major projects.  One study found that covering the cost of rebuilding a 200-mile stretch of Interstate 70 in Missouri could mean tolls as high as $30 per car and $90 for heavy trucks.

Public private partnerships continue to be considered and tried although they have had very mixed operating results. In December, Virginia opened a 29-miles stretch of express toll lanes on Interstate 95 outside Washington, D.C. The state funded less than 10 percent of the cost for the $925 million project. Private entities invested their own money, secured a federal loan and made use of tax-exempt bonds. In exchange, Virginia gave them the right to manage the road and collect tolls for the next 73 years. A number of private toll facilities have failed to live up to operating results. The most glaring failure has been the Indiana Toll Road which is in the midst of Chapter 11 proceedings after it failed to achieve projected revenue levels.

One other alternative to increasing existing or establishing new taxes is for states to redirect existing revenue to roads. Idaho last year shifted part of its cigarette tax revenue to highways. Texas voters in November approved the transfer of a portion of oil and gas severance taxes from the state’s rainy day fund to roads. Some states have increased vehicle registration fees. Washington has imposed fees on owners of electric vehicles, and Gov. Jay Inslee recently proposed a carbon-emissions tax on the state’s largest polluters that would help finance transportation projects. He describes it as “transportation pollution paying for transportation solutions.”

The area of most uncertainty has been the issue of the establishment of a consistent funding plan for the federal Highway Trust fund. After years of relative consensus on the issue and regular approval of five year funding programs, the issue has become caught up in annual political wrangles.  Currently, various proposals from President Barack Obama and U.S. Senate and House members would help finance the federal Highway Trust Fund with taxes on the foreign-earned profits of U.S. corporations. Some proposals also would create a $50 billion infrastructure fund, to be financed by selling bonds to private companies or by taxes on foreign profits. Such a fund could be used to make equity investments and loans for state and local infrastructure projects.

NEW JERSEY PENSIONS DECISION; GOVERNOR CHRISTIE’S BUDGET PRESENTATION

New Jersey Superior Court Judge Mary Jacobson ruled Monday that the state’s failure to make a full pension payment is “substantial impairment” of the contractual rights of the police, firefighters, teachers and office workers who sued. “Because the state will now make nearly 70 percent less than the statutorily required $2.25 billion payment,” the expectations of workers have been “substantially impaired,” the judge ruled. “In short, the aim of the legislation is not being met.”

The decision is a change in course from last year for the same judge. Jacobson’s ruling contrasts with her decision days before the last fiscal year ended June 30, when Christie said he faced a fiscal emergency. Workers sued then as well, and the judge said Christie acted reasonably in paying $696 million to the pension system to cover current employees while deferring $887 million to help close the gap left by previous governors.

Jacobson’s ruling contrasts with her decision days before the last fiscal year ended June 30, when Christie said he faced a fiscal emergency. Workers sued then as well, and the judge said Christie acted reasonably in paying $696 million to the pension system to cover current employees while deferring $887 million to help close the gap left by previous governors.  The legislative and executive branches “have now had almost 10 months to find a solution to the pensions crisis for FY 2015,” Jacobson said in the latest ruling.  “Time is of the essence for the legislative and executive branches to work together to come up with a solution to the pension crisis,” Jacobson said, adding that there’s no evidence of “any serious efforts to find a solution since the revenue shortfall accrued.”

A  spokesman for the Governor blamed “liberal judicial activism” for the decision. Democrats faulted Christie for refusing to adopt their proposed balanced budget that fully funded the state’s pension obligation. “This ruling is the predictable and unfortunate result of the governor’s fiscally irresponsible decision,” Assembly Speaker Vincent Prieto, Majority Leader Lou Greenwald and Budget Chairman Gary Schaer said in a statement.

In his FY 2016 budget presentation, Mr. Christie called for a freeze of the existing state-run pension system and proposed that public workers be shifted into a different type of retirement plan, one that would not force state taxpayers to make what the Governor deems to be open-ended contributions. Both the existing plan and the new follow-on plan would be placed within a new legal entity – a trust –  over which public worker unions would have oversight. The freeze would not eliminate the underfunding in the existing pension system. Mr. Christie called for paying it down over 40 years proposing a constitutional amendment making the payments necessary to do so mandatory.

One major problem emerged immediately. Mr. Christie declared in the address that he had an agreement with the state’s largest teachers’ union to solve the pension problem, but the union countered that it had agreed only to a framework, and to keep talking. He offered no details as to how he would meet the obligations the judge said had to be made — to pay the full pension payments that were due this year under the legislation he signed in 2011. The governor fell short of that amount by about $1.57 billion. For next year, the governor proposed making another partial payment — $1.3 billion instead of the $2.9 billion called for in the 2011 legislation.

Another Christie proposal would require local government, including school districts, to finance their employees’ pensions, rather than leaving the state to do so as it currently does. It is unclear where that money would come from, as state law caps property tax increases at 2 percent and the Governor did not specify how localities were to develop the funding necessary to cover the new expense.

The governor’s proposal was although noteworthy in that it excluded any proposal for new or increased taxes as a potential source of revenue to finance pension and health benefit costs associated with the need to make up the State’s long existing pension shortfall. It does include a $1.3 billion payment for pensions but this appears to be below the required level of funding required by legislation enacted in 2011. There was no mention of the State’s Transportation Trust Fund difficulties. Should the proposals be adopted intact – something we see as unlikely – there would appear to be little prospect of relief on the horizon for the State’s beleaguered bond ratings based on this presentation. All in all a negative day for New Jersey bond holders.

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 DOWNGRADED AGAIN

Just after we went to press last week, S&P announced a downgrade of Puerto Rico’s  general obligation (GO) bonds and Puerto Rico Tax Financing Corp. (Cofina) bonds to B. Also downgraded was debt of the Puerto Rico Municipal Finance Agency, the Puerto Rico Employees Retirement System’s, the Puerto Rico Infrastructure Financing Authority’s (rum tax) and the Puerto Rico Convention Center District Authority. The outlook on all ratings is negative.

In particularly strong language S&P warned that “Puerto Rico’s focus more recently has turned to new rounds of financing to simply maintain critical levels of operating cash, while paying a high price for new financing. All of this poses a threat, in our view, to the commonwealth’s ability to continue providing basic governmental services. We have observed in other jurisdictions that such an environment can easily give way to political and policy instability,” the report stated. “The government’s response to the situation has vacillated between rounds of spending austerity and tax cuts, or increased taxes and limited layoffs, but in either case it has relied on debt issuance to cover operating deficits.,”

PR does not like to see its situation compared to that of sovereign debtors like Greece. It’s responses to events like this however are not helpful. As has often been the case, government spokespersons used somewhat emotional language to respond. “The continued push by this firm to provoke abrupt measures like the mass firing of public employees is not in line with the public policy of this administration,” said a government public affairs official. “We will continue taking necessary measures to straighten out public finances in a responsible way without firing employees. Government Development Bank for Puerto Rico (GDB) President Melba Acosta said “While we are disappointed with Standard & Poor’s decision, we remain committed to the implementation of our fiscal and economic development plans, and to addressing both near- and long-term challenges.”

The market continues to look for tangible evidence that the government not only has a plan but also is in a position to implement it. The concerns about its ability to successfully implement a value added tax and for the tax to achieve the projected collection levels are real. A well executed implementation would do more for the credit than the continued rhetoric of an aggrieved party.

The need for economic improvement was highlighted when it was announced that Puerto Rico government revenue missed estimates again in January by $18.8 million, increasing the revenue shortfall so far during fiscal year 2015 to $115.2 million. $699.5 million was collected in January, up $20 million from the previous year, but the $4.455 billion in net revenue through the first seven months of the fiscal year is still $183 million below what was collected during the same period last year. Corporate revenue of $54.1 million was $36.1 million below estimates and $39..8 million below last January, sales & use tax (IVU by its Spanish acronym) revenue of $91.4 million missed targets by $55.1 million and below the previous January by $500,000, and Act 154 revenue of $81.9 million was $54.1 million below revenue and $59.7 million off last January.

Individual income taxes rose by $47 million and nonresident withholdings were up by $109 million. An additional $62 million in revenue was collected in January as a result of the enactment of Act 238 of 2014, which extended the due date to make pre-payments at preferential rates on certain transactions, such as Individual Retirement Accounts (IRAs), retirement plans and other capital assets. Following the enactment of this law, taxpayers who were previously unable to make these pre-payments were able to take advantage of the law during the month of January.

Excise tax collection changes versus last year showed alcoholic beverage revenue was up by $8 million, tobacco products were down by $11 million and motor vehicles by $10 million. The Treasury secretary said he is preparing a new revenue estimate for the remainder of the fiscal year based on year-to-date collections and prevailing economic conditions. In order to close the $115 million gap, the secretary announced that as a preamble to the tax system overhaul, a bill (H.R. 2316) was introduced allowing the pre-payment of a special tax on certain transactions including taxes on corporate dividends for future distributions of accrued benefits and profits. It also allows for prepayments to  IRAs and Educational Contribution Accounts until March 31.

NEXT ACT IN ILLINOIS FISCAL DRAMA

It hasn’t taken long for the Illinois fiscal drama to develop. Just days after it was issued the state comptroller, Leslie Munger, said Friday she would not follow an executive order by Gov. Bruce Rauner to hold up so-called fair-share union dues from nonunion workers. Ms. Munger, a Republican as is the Governor, said she would follow the guidance of Attorney General Lisa Madigan, a Democrat, who said that the fees are part of union contracts and that executive orders do not apply to offices outside the governor’s. Mr. Rauner, who appointed Ms. Munger, issued the decree on Monday explaining that it was unfair for 6,500 nonunion workers to pay dues to unions that engage in political activities — although the law already prohibits using fair-share dues on politics. He ordered the money taken from their paychecks to be held in escrow until a federal lawsuit he filed this week is settled. Union leaders contend that the fees are reasonable contributions from workers who, while choosing not to be union members, still benefit from collective bargaining agreements.

It was in front of this backdrop that the Governor made his budget proposal for FY 2016. In regards to pensions, the State currently offers two levels of pension benefits – one plan for those first hired before 2011 and another, more affordable plan for more recent hires. The Governor proposes legislation to put in a “freeze” on the level of benefits that employees hired before 2011 have earned as of July 1, 2015. For work after July 1, 2015, these employees’ newly earned benefits will be based on the plan that now applies to employees and officials first hired or elected after 2010. The key change in newly earned benefits will be moving to a lower cost-of-living adjustment (COLA). COLAs on benefits earned before July 1, 2015 would continue to be paid in retirement at 3 percent a year compounded. COLAs on newly earned benefits would be the lesser of 3 percent or half of inflation, non-compounding, and would begin later. The governor’s proposed reforms are projected  by him to reduce the state’s general-funds payments in the next budget year by $2.2 billion.

The Governor proposes to reduce the projected FY 2016 budget gap through employee benefit reform ($2.9B), reduced subsidies to other governments ($1.3B), medical provider rate reductions ($1.2B), reduced services ($0.8B), “operational efficiencies” ($0.2B), earmark eliminations ($0.1B), and moving citizens to health exchanges ($0.1B).  Tax increases not part of the formula. The proposals will be controversial. They include significant service reductions in Medicaid and payments to hospitals. Proposed employee benefit reductions  require legislation and survival of legal challenges in order to implement them.

We expect that the plan will run into significant political opposition from the full spectrum of interest groups both individual and governmental. We believe that it is unrealistic to expect that all of the proposed savings will be achieved and that the decline in the state’s relative creditworthiness will continue.

MEDICAID

Medicaid is front and center in many budget debates across the country.  In Pennsylvania new Gov. Tom Wolf said that he would pursue a straightforward expansion of the Commonwealth’s Medicaid program for the poor, no longer charging premiums or limiting benefits for some enrollees. In Tennessee and Wyoming  bills to extend Medicaid to far more low-income residents under the law were defeated by Republican legislators, despite having the support of the states’ Republican governors. Expansion opponents do not believe the federal government would keep its promise of paying at least 90 percent of the cost of expanding the program. It currently pays the full cost, but the law reduces the federal share to 90 percent — a permanent obligation, it says — by 2020.

In Utah, Gov. Gary R. Herbert has negotiated a tentative deal with the Obama administration for an alternative Medicaid expansion but it is meeting with resistance in the state’s Republican-controlled Legislature. So far, 28 states have taken advantage of the federal funds offered through the health care law to sharply increase the number of adults eligible for Medicaid. Ten had Republican governors when they decided to expand the program, and supporters of the law hoped that the most recent, Indiana, would influence other holdouts to follow. Indiana’s governor, Mike Pence, is one of the most conservative yet he decided that accepting the federal Medicaid expansion funds — albeit with concessions from the Obama administration, like requiring many beneficiaries to pay something toward their coverage or be locked out of it for six months — was good policy.

Just after Indiana’s move, a similar plan from Gov. Bill Haslam of Tennessee went down to swift defeat by the vote of a State Senate committee. The Governor had called a special session for the Legislature to consider his plan, which he had spent months working out with the Obama administration. He had traveled the state to promote it — and persuade people that it was not part and parcel of the Affordable Care Act, partly because the Tennessee Hospital Association had agreed to pay any expansion costs beyond what the federal government covered.

In Florida, business leaders and hospital executives are pressuring conservative legislative leaders to consider alternative expansion plans in the session that starts next month. In Alaska, the new governor, Bill Walker, an independent, will try to convince state lawmakers to agree to expand Medicaid by the start of the new fiscal year on July 1. In Idaho, an alternative Medicaid expansion plan, put forth by a task force appointed by Gov. C. L. Otter may go before the Legislature in the next few months.

KANSAS BUDGET TROUBLES

In November, shortly after Gov. Sam Brownback won re-election, some observers forecast that the state would bring in $1 billion less than expected over the next two years. His response was to cut state agency budgets and propose transferring of funds among various state accounts including moving funds intended for the state highway system to the general fund. In December came news of lower than expected revenue, some $15.1 million below estimates. Mr. Brownback proposed increasing taxes on liquor and cigarettes, slowed reductions in the income tax and changed the way money was distributed to public schools.

Revenue continues to disappoint: January receipts fell $47.2 million short of predictions, and Mr. Brownback has responded by cutting funding for public schools and higher education by a combined $44.5 million. The move has upset education officials across the state.  In one example, the Kansas City Public School District has received $45 million less in state revenue since 2009. A cut of 1.5 percent to public school funding statewide would amount to a loss of $1.3 million according to the District. The state has not paid the district $3 million for capital expenses required under a formula intended to help poor districts. Mr. Brownback has asked legislators to change that formula. The cuts come amidst a larger budget picture in which the governor has been forced to fill a $344 million budget gap for the fiscal year ending in June; a shortfall of nearly $600 million has been forecast for the fiscal year starting July 1. Many blame the state’s budget situation on the income tax cuts that the governor has ushered into law in recent years.

The governor has asked lawmakers to rewrite the formula used to provide aid to the neediest school districts. If the Legislature saves money by doing so, the governor says that it could restore the $28 million in cuts to K-12 public schools that he called for this month. The governor has also requested that lawmakers overhaul the means for financing schools in general. In the meantime, the state courts are addressing a lawsuit brought by a group of school districts and parents which asserts that the state has violated the Constitution by not providing adequate funding for education. In December, a state district court handed down a decision which said that Kansas schools were not adequately financed. That  decision was appealed before the state Supreme Court. If the court orders the state to increase spending, it could conflict with the cuts that the governor has ordered.

DETROIT ANNOUNCES WATER RATE INCREASES

The first round of post-bankruptcy water rate changes for area municipal providers of water have been proposed. The Detroit Water Department is changing its billing practices to shift more of the cost of service to the fixed monthly fee. The new system will rely less on payments based on water use, which is subject to considerable variance. The wholesale rate increase will average 11.3% while Detroiters will pay about 3.4% more under the proposal. The potential for much larger increases for out of City customers was one of the factors that complicated negotiations over the proposed creation of a new regional water entity to finance the water system’s extensive maintenance-related capital needs going forward. According to data provided by the Detroit Free Press, most communities will see decreases in the cost of 1000 cubic feet of water but some will see increases of up to 14%.

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 RESTRUCTURING LEGISLATION REJECTED IN FEDERAL COURT

Investors in billions of dollars of Puerto Rico bonds scored an initial major legal victory when a federal judge ruled that the commonwealth’s recently enacted debt-restructuring law was unconstitutional. Judge Francisco A. Besosa of the United States District Court in Puerto Rico said on Friday that the Puerto Rico Public Corporations Debt Enforcement and Recovery Act was void and enjoined commonwealth officials from enforcing it.

The act as passed enables the commonwealth to restructure its debts (other than Commonwealth G.O. bonds) and labor contracts of the island’s public corporations, including the Puerto Rico Electric Power Authority (PREPA). Puerto Rico cannot seek protection from creditors under federal bankruptcy law, so it has fewer options to restructure the finances of its troubled agencies.  A group of PREPA bond holders, including BlueMountain Capital and OppenheimerFunds, that own about $2 billion of the power’s authority’s debt sued the commonwealth in federal court, arguing that the recovery act violated their contractual rights.

The passage of the recovery act in June disappointed investors, particularly hedge funds, which had been active buyers of bonds issued by PREPA and other Puerto Rico entities at distressed prices. Investors perceived that the new law showed how the government of Puerto Rico was unwilling to pay, a keystone of municipal finance. Enactment led to a series of downgrades by Moody’s, which had already rated the commonwealth’s debt as junk.

The decision said that the legislation was pre-empted by federal bankruptcy law. “The commonwealth defendants, and their successors in office, are permanently enjoined from enforcing the recovery act,” according to the 75-page decision. A spokesman for the Government Development Bank said: “We will be reviewing all the aspects of the ruling rendered by Judge Francisco Besosa. In due time and after careful examination, we will decide on a course of action.” The ruling is a significant setback for the Puerto Rico government, as it tries to restructure the debts of its public corporations while still maintaining the confidence of the municipal bond market. Due time was not much time as  the government announced that it will seek to appeal the ruling.

We see the situation less positively. The reality is that Puerto Rico still needs to restructure its debt in the face of a persistently underperforming economy. Any celebration would be clearly premature.

FIRST SHOT FIRED IN ILLINOIS PUBLIC SECTOR BATTLE

Newly elected Gov. Bruce Rauner took his first step toward curbing the power of public sector unions this week by issuing an executive order that would bar unions from requiring all state workers to pay the equivalent of dues. Mr. Rauner said. “An employee who is forced to pay unfair share dues is being forced to fund political activity with which they disagree. That is a clear violation of First Amendment rights — and something that, as governor, I am duty bound to correct.”

The action follows that of other Republican governors in the Midwest who have aggressively taken on public sector unions in recent years. It started with Mitch Daniels of Indiana, who ended collective bargaining by state workers by executive order; Scott Walker of Wisconsin, led efforts to cut collective bargaining rights for most public employees; and Rick Snyder of Michigan, signed legislation ending the requirement that all workers in unionized workplaces pay union dues.

The  executive order affects about 6,500 of the state employees who are not in unions but currently pay fees in lieu of union dues. The American Federation of State, County and Municipal Employees said that about 42,000 state employees are represented by unions. Union leaders have described the fees, often called “fair share” payments, as reasonable contributions from workers who, while choosing not to be union members, still benefit from collective bargaining agreements.

The order does not affect private sector unions or state employees who choose to be in unions. A spokesman for the governor said that the executive order would take effect immediately but that the money from the union fees would be placed in escrow in case the order was challenged in the courts. In his recent State of the State address, Mr. Rauner called for a ban on political contributions by public employee unions to “the public officials they are lobbying, and sitting across the bargaining table” from, as well as allow local governments to enact “right to work” laws. Those laws typically abolish the practice of making both union membership and dues-paying automatic in unionized workplaces leading to declines in union ranks.

AFSCME, which is set to negotiate a contract with the state this year, is one of many unions that backed Mr. Rauner’s Democratic opponent in last year’s election. A spokesman for the National Right to Work Committee, said the action could be seen as a natural progression from recent victories in nearby states. “There will inevitably be a union battle on this,” he said, “but we’re excited this is bringing this issue to the forefront.”  “We’d like to see Illinois become a right-to-work state,” he said. “Obviously, you need more than just the governor to get that done.”

The move has some aspects of kabuki theatre to it in that it follows a pattern of regional governors taking the executive order route rather than offer a legislative proposal. In Illinois, the state’s legislature is controlled by Democrats, many of whom have received union support over the years. On Monday evening, the reaction from legislative leaders was strategically muted.

“Our legal staff is reviewing the governor’s executive order regarding fair share,” said the Senate president, John Cullerton, a Democrat. “At the same time, I look forward to hearing the governor’s budget as we search for common ground to address our fiscal challenges.” Bob Bruno, director of the labor education program at the University of Illinois at Urbana-Champaign, said “in principle, it’s a pretty serious assault. In terms of impact, it remains to be seen because it’s a relatively small percentage of the population that’s chosen fair share,” Mr. Bruno said. “This is an assault on the institutional existence of the union in the public sector, and these sorts of fights are historic fights and have big impact.”

AFTER DETROIT IS WAYNE COUNTY NEXT?

Municipal investors continue to chew over the implications of the Detroit bankruptcy. The result there and its negative impact on debt holders versus other creditors has led to concern that Michigan issuers may consider similar moves to be available tools to deal with other entities in financial trouble. Hence, the importance of comments made by Wayne County Executive Warren Evans last week about a financial mess that could see the county’s general fund revenue depleted as early as May 2016.

A financial review from auditing firm Ernst & Young, along with research from a group put together during Evans’ transition into office, developed a forecast of general fund results going forward. The county currently has a $70-million deficit, and pension funds are funded at 45%, down from 95% just 10 years ago. “We understand the fiscal illness,” Evans said. “We’re working to make sure the illness isn’t terminal.”  He was quick to dismiss concerns on whether state oversight — or a potential bankruptcy – were looming. He characterized the problem as one which was solvable in-house. He implied that this would lessen the likelihood of outside oversight.

Evans said solutions have not been devised at this point as his administration has been working to find out “exactly how deep the hole was.” “Everything is on the table,” he said about the potential for cuts. “We’re working on solutions. And those need to be worked on by the stakeholders.” The county’s director for budget and planning attributed most of the shortfall to the economic downturn beginning around 2008, when the county began facing massive losses from property tax revenues. In the meantime, the county’s responsibility for legacy costs — employee healthcare and pension contributions — increased about $50 million annually.

According to the former county executive Robert Ficano, losses from property-tax revenue due to the economic downturn had left the county with more than $200 million in debt, unable to keep up with employee pension liabilities and increasing health care costs. For the 2012-13 fiscal year, with a budget of $2.34 billion, the county reported a deficit of about $30 million. The 2014-15 budget is for $1.68 billion.

In response to the comments, Moody’s downgraded to Ba3 from Baa3 the rating on the general obligation limited tax (GOLT) debt of the County. The county has a total of $695 million of long-term GOLT debt outstanding. Moody’s adjusted the outlook to negative to reflect its expectation that the county faces hurdles in implementing significant cost reductions. Failure to reach structural balance in the near term is seen as degrading available liquidity and could raise the probability of state intervention and increase the risk of the county seeking to restructure its debt and other obligations.

COLORADO POT TAXES – NOT QUITE THE HIGH EXPECTED

Colorado released data on tax revenue collections from recreational marijuana in the first year of sales, and they were below estimates — about $44 million. The release of December sales tax data was for its first full calendar year of the taxes from recreational pot sales, which began Jan. 1, 2014. Colorado was the first government anywhere in the world to regulate marijuana production and sale, so the data was widely anticipated. In Washington, where legal pot sales began in July, the state had received about $16.4 million in marijuana excise taxes by the end of the year; through November, it brought in an additional $6.3 million in state and local sales and business taxes.

Colorado’s total receipts related to marijuana for 2014 was about $76 million. That includes fees on the industry, plus pre-existing sales taxes on medical marijuana products. The $44 million represents only new taxes on recreational pot and  were initially forecast to bring in about $70 million. By all accounts, that estimate was a guess. Colorado has already adjusted downward spending of the taxes, on everything from substance-abuse treatment to additional training for police officers.

Colorado will also likely have to return to voters to ask to keep the pot tax money due to a 1992 amendment to the state constitution that restricts government spending. The amendment requires new voter-approved taxes, such as the pot taxes, to be refunded if overall state tax collections rise faster than permitted. Lawmakers from both parties are expected to vote this spring on a proposed ballot measure asking Coloradans to let the state keep pot taxes.

The results underscore a big conflict facing public officials considering marijuana legalization. Taxes should be kept low if the goal is to eliminate pot’s black market. But the allure of a potential weed windfall is a powerful argument for voters, most of whom don’t use pot. So far, the Colorado experiment shows the tax revenue isn’t trivial but it has also shown that pot-smokers don’t necessarily want to leave the tax-free black market and pay taxes. If medical pot is untaxed, or if pot can be grown at home and given away as in Colorado, the black market persists.

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

OBAMA BUDGET PROPOSAL

The $4 trillion fiscal 2016 budget request unveiled by President Obama on Monday includes several proposals for the municipal market to chew over. They include: a six-year, $478 billion transportation infrastructure plan; the creation of tax-exempt qualified public infrastructure bonds; America Fast Forward direct-pay bonds; and an increase in the annual issuer bond limit for bank-qualified bonds.

On the negative side, the idea to limit the value tax-exempt bond interest to 28% of a taxpayer’s income was again included. A new proposal to eliminate the use of tax-exempt bonds to help finance professional sports stadiums was also included.  As expected, the budget proposes the creation of tax-exempt QPIBs, which would not be subject to volume caps or the alternative minimum tax. They would however, have to comply with other private-activity bonds requirements, such as having to obtain public approval.

QPIBs could be issued beginning in 2016 for airports, docks and wharves, mass commuting facilities, water furnishing and sewage facilities, solid waste disposal projects, and qualified highway or surface freight transfer facilities. Projects financed by QPIBs would have to be owned by a state or local governmental unit and would have to serve a public use or be available on a regular basis for general public use. QPIBs could replace certain PAB categories or could be issued in addition to them. The revenue loss associated with the new bonds would increase the deficit by $4.83 billion from 2016 through 2025, according to the budget.

As anticipated, the budget would increase the issuer annual cap to $30 million from $10 million for bank-qualified bonds. Banks could buy the tax-exempt bonds of issuers who reasonably expected to issue less than $30 million of munis during the year. Also proposed was a change to the 2% de minimis rule for financial institutions to include banks. That provision would allow banks to deduct 80% of the cost of buying and carrying tax-exempt bonds, to the extent that their tax-exempt holdings do not exceed 2% of their assets. Banks currently are only able to take advantage of that 80% write-off when purchasing bank-qualified bonds.

The president proposed expanding a little-known program called Qualified Public Education Facility Bonds. First authorized in 2001, issuance is currently capped at the greater of $5 million or $10.00 per capita. The program has not been used much, if at all, because of its problematic requirement that an educational facility be both part of a public elementary or secondary school and owned by a private, for-profit corporation engaged in a public-private partnership with a state or local government. The proposal would eliminate the private corporation ownership requirement and subject QPEFs to state PAB volume caps. Once more the administration renewed its idea for a 28% cap on the value of tax-exempt bond interest, including for bonds already issued, beginning in 2016. Dealer groups complain this would be a tax on municipals.

Obama’s proposed fee of seven basis points for banks, broker-dealers and other financial institutions with worldwide assets of more than $50 billion was also criticized.

The budget once again calls for the creation of a permanent, taxable direct-pay America Fast Forward bond program, with Treasury making subsidy payments to issuers equal to 28% of their interest costs. AFF bonds could be used to finance projects that could be financed with PABs or QPIBs as well as governmental capital projects or current refundings of bonds associated with such projects. They could also be used for working capital financings and projects for 501(c)(3) nonprofit entities.

FEDERAL BUDGET IMPACT ON PUERTO RICO

The President’s budget proposal for FY 16 included provisions that would cause manufacturers based in the states to no longer be able to avoid Federal taxation of income through U.S. territories and foreign countries. Currently, companies can avoid the taxation by establishing subsidiaries in territories and other nations. The 35% corporate income tax is not due unless the parent company receives the earnings from the subsidiary.

Under the provision known as repatriation, the President calls for  taxing the income at a 19% rate. Also proposed  is a one-time rate of 14% for earnings that have been kept out of the United States for past years through the first year of the new taxation. The President, additionally, also proposed lowering the rate on corporate income from the States to 28%. The 19% rate would be reduced for taxes paid locally and investments in operations such as manufacturing facilities.

The tax avoidance strategy is used by most of the companies based in the States that have manufacturing operations in Puerto Rico. Puerto Rico could theoretically be the beneficiary of most of the 19% rate under the Obama proposal but the commonwealth government has entered into contracts with manufacturing operations that lower its taxation of their income to a few percent at most. Because the contracts prevent the Commonwealth from increasing the tax, it has also imposed a four percent excise tax on parent company purchases of the products of their subsidiaries. The combined taxation, however, is still far short of the 19%.

The tax proposal was the only real change in the direct federal impact on Puerto Rico in the Obama budget. An annual list of State, territory, and freely associated state shares of selected programs estimated that Puerto Rico would receive $4.02 billion in Federal Fiscal Year 2016 vs. $3.93 billion this fiscal year. The increase is smaller than the increase for all jurisdictions but in line with the Commonwealth government’s usual share. That share for Federal Fiscal Year 2016 is .71% of the programs. The share is small compared with what it would be if Puerto Rico were a State and treated equally with the other States in all programs. The territory about 1.1% of the nation’s population.

OHIO BUDGET CONTINUES TAX REFORMS

In his Executive Budget for the FY 2016-FY 2017 biennium, Governor Kasich recommends GRF appropriations of $35.3 billion in FY 2016 (a 12.5% increase over estimated FY 2015 spending) and $37.0 billion in FY 2017 (a 4.8% increase over FY 2016). The Governor’s recommendations for all funds total $68.5 billion in FY 2016 (a 2.0% increase over estimated FY 2015 spending) and $70.2 billion in FY 2017 (a 2.5% increase over FY 2016). Medicaid is the single-largest program in the state budget, with recommended GRF appropriations in FY 2016 of $18.5 billion (21.4% above FY 2015 estimated spending levels) and $19.6 billion in FY 2017 (6.2% above FY 2016 spending levels). These appropriations include the federal share of the program, which makes up approximately 68% of the total. State share appropriations total $6.0 billion in FY 2016 (4.4% above FY 2015 estimate) and $6.3 billion in FY 2017 (6.1% above FY 2016).

The centerpiece of the budget plan is tax reform. The Governor’s tax reform proposal, would reduce state revenues by $367 million in FY 2016 and $443 million in FY 2017. The proposal would cut all marginal income tax rates by 23% and create a new small business deduction. To help pay for these significant cuts, offsetting revenues would be generated by increasing the state sales tax rate from 5.75% to 6.25%, subjecting a subset of services to the sales tax, reducing the motor vehicle trade-in allowance, increasing the commercial activity tax (CAT) rate, and increasing tax rates on cigarettes and other tobacco products (OTP). Also, a small set of income tax deductions and credits would be eliminated for taxpayers with incomes in excess of $100,000. Finally, the Administration is proposing a severance tax on oil, natural gas, and other hydrocarbons extracted from shale wells at tax rates from 4.5% to 6.5%.

Of interest to tobacco securitization bond holders is the Administration proposal to raise the cigarette tax rate by $1.00 per pack to $2.25 per pack. Research shows that increasing cigarette tax rates can accomplish the twin goals of raising revenue and reducing cigarette consumption. The reform proposal also increases the tax rate on the wholesale value of OTP (such as cigars, snuff, etc.) from 17% to 60%, to equalize the OTP tax rate with the estimated average cigarette tax burden as a percent of price. Finally, the proposal would introduce a new “vapor products tax” on so-called e-cigarettes, also at 60% of value. These changes are estimated to increase revenues by $528 million in FY 2016 and $463 million in FY 2017.

CA DROUGHT UPDATE

December’s rains enabled Californians to finally meet Gov. Jerry Brown’s call for a 20 percent reduction in monthly water consumption, but more restrictions loom as the state adapts to a drought. A survey released Tuesday that showed an unusually rainy month helped residents cut water use by 22 percent statewide from December 2013 levels. This welcome news was offset by the fact that the Sierra Nevada snowpack, which supplies a third of California’s water, is 75 percent below its historical average. Regular readers will recall a photo we published of San Francisco’s Hetch Hetchy Reservoir and its lower water levels. For the first time in recorded history, there was no measurable rainfall in downtown San Francisco in January, when winter rains usually come. The governor called on Californians to use 20 percent less water last year when he declared a drought emergency. The closest they previously came to reaching that goal was in August, when water use dropped 11.6 percent. The state has authorized cities to fine people $500 a day for violating restrictions on lawn watering and washing cars.

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

HIGHER ED SECTOR DODGES A BULLET

This week, the Obama Administration announced that it was dropping its proposal  to change the 529 college savings plans held by millions of families. In his State of the Union address, the change was proposed as part of the President’s plan to simplify the tax code and help the middle class. The change would have eliminated  one of the 529 plan’s most attractive benefits: Money could no longer be withdrawn tax-free. (The new rules would have applied only to new contributions.) The money can continue to be withdrawn without payment of capital gains taxes as long as the proceeds are used for education expenses. Many states provide state income tax deductions for contributions as well.

Some say 529 plans disproportionately benefit the most affluent families, which can afford to save. More than 12 million accounts are in circulation, according to Strategic Insight, an investment consultant that tracks the industry. The Federal Reserve’s Survey of Consumer Finances, said that more than 70 percent of the account balances for 529 plans and another option known as Coverdell Education Savings Accounts are held by families with incomes over $200,000. (Those figures also include health savings accounts, but still provide a reasonable best estimate, the administration said.) A report from the Government Accountability Office found that a small percentage of families use 529 plans and Coverdell accounts and that their median income is three times the median income of families without the accounts.

The proposed changes — which were widely opposed in a Republican-controlled Congress — would have discouraged savers from using the accounts because the withdrawals would be taxed as ordinary income. As ordinary income it is also likely to reduce how much they may receive in federal financial aid. The average value of a 529 account is $19,774, according to Strategic Insight, while it estimates the average contribution to accounts that receive regular electronic contributions is about $175 a month.

A partial offset to expand and make permanent the American Opportunity Tax Credit, a credit for qualified education expenses for the first four years of higher education will still be pursued by the Administration. The maximum credit is $2,500, and phases out for married people filing joint returns who earn $160,000 to $180,000 and for single people earning $80,000 to $90,000. Forty percent of the credit is refundable, with a maximum of $1,000, which means that those who have no federal tax liability will still receive money back. The Obama plan would increase the refundable portion to a flat $1,500 and make it available for up to five years, as well as extend part of the break to part-time students.

EMERGENCY MANAGER FOR ATLANTIC CITY

Gov. Chris Christie signed an executive order appointing Kevin Lavin as emergency manager for Atlantic City. He also appointed Kevyn Orr, most recently the emergency manager of Detroit as a special adviser to the emergency manager. According to the Governor’s announcement of the executive order, Mr. Lavin has extensive credentials in restructuring both private and public underperforming entities, most recently as the leader of FTI Consulting’s Global Restructuring business unit. Mr. Lavin has played a key role in the turnaround or restructuring of over 150 companies around the globe and across a broad range of industries and has served in interim management roles as CEO, COO and CFO.

The Executive Order was in response to a recommendation of the Governor’s Advisory Commission on New Jersey Gaming, Sports and Entertainment that an “Emergency Manager” should be appointed immediately with extraordinary supervisory powers under the Local Government Supervision Act (legislative action may be required to augment the existing Statute). Initial recommendations of the Commission include: (i) tax reform; (ii) school reform; (iii) pension reform; (iv) regionalization or privatization / reduction of certain public services; and, (v) redirecting Atlantic City Alliance funding.

The City faces a number of hurdles. Total Atlantic City gaming resort revenues have fallen by a CAGR of -7.5% since 2006. Four properties (Atlantic Club, Showboat, Revel, Trump Plaza) closed in 2014. Property taxes represent over 81% of Atlantic City revenues in FY 2014, the Municipal tax rate is 1.75%, over 100 bps higher than the statewide average, and Total Property Assessment could be as low as $6.5 billion according to data from recent tax appeal rulings. Concurrently, Atlantic City municipal appropriations, less grants and the dedicated library tax levy, grew by a CAGR of 4.3% from 2006 – 2014. Departmental Appropriations (Police, Fire, Health and Human Services) grew by a CAGR of 0.8%, while non-departmental (pension, healthcare, debt service, bulk purchases, etc.) appropriations grew by a staggering 7.9% CAGR over this period.

The Commission also recommended that Atlantic City has upcoming pension payments of $22.8M in 2014, $23.2M in 2015 and $25.1M in 2016 and that the State should defer these payments for a period of up to three years to help balance the budget in the short term while other recommendations are being implemented.

While the City’s problems may be obvious, the solutions are not nor is the support for the proposed intervention at either the local or state levels. Many argue that additional legislative action is needed to enable the emergency manager to function as fully as the Governor envisions.

CUOMO PROPOSES FY 2016 BUDGET

New York Governor Andrew Cuomo proposed a $141.6 billion budget that would provide tax breaks for middle-class property owners and small businesses, and boost spending on rail and road projects. The fiscal 2016 spending plan was announced during Cuomo’s fifth State of the State address. It would raise spending by 2.8 percent according to documents provided by his office. The governor also seeks to set aside an $850 million share of a $5 billion surplus from legal settlements with banks for a reserve fund. New York is projected to end the current fiscal year on March 31 with a $525 million operating surplus.

Cuomo also wants to increase the number of charter schools allowed under state law to 560 from 460. He also wants to extend mayoral control of New York City’s schools beyond its 2015 expiration while allowing other cities to apply for the same power. Other proposals include raising the minimum wage to $10.50 an hour ($11.50 in New York City) from $8.75 and spending $450 million to build a train to LaGuardia Airport.

The budget would use a record $5 billion surplus from legal settlements with banks on a $1.5 billion economic development competition for seven upstate regions, $1.3 billion on the Thruway Authority and the Tappan Zee Bridge, and $500 million to bring high-speed Internet to rural areas. An additional $250 million from the surplus would be spent to help extend a Metro North commuter rail line to Manhattan’s Penn Station and provide $400 million to support debt restructuring and projects at rural hospitals, according to the documents. Also proposed was a $1.7 billion property-tax break for middle-class New Yorkers and a plan to lower the net income tax rate for 42,000 business to 2.5 percent from 6.5 percent by 2018, the lowest since 1917.

NASCAR DEAL CRASHES

Last week’s announcement that The Charlotte City Council in North Carolina has voted for an agreement to forgive more than $22 million in debt from the NASCAR Hall of Fame was not a surprise to high yield credit analysts. The bond issue is but one more example of a credit based on specialty facility admission charges that failed due to attendance shortfalls.

As has been the case with so many other museum and “amusement” type credits, attendance and revenues fell short of projections. In the case of this facility, attendance has been far less than expected. The hall was expected to attract about 400,000 visitors each year. Last year attendance was about 170,000.

All of the major stakeholders in the project lost. It is reported that Charlotte will pay Bank of America and Wells Fargo $5 million. They will write off nearly $18 million in debt. NASCAR will give up more than $3 million in royalties that it has been owed since the hall opened in 2010. The hall of fame has not been able to pay the royalties because it has lost more than $1 million each year.

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

Joseph Krist

Municipal Credit Consultant

VI CONTRASTS WITH PR

While it is widely expected that Puerto Rico’s electric utility will soon default, Standard & Poor’s revised its outlook on Virgin Islands Water & Power Authority’s (WAPA) electric system revenue bonds to stable from negative. At the same time, S&P affirmed its BBB- senior-lien rating and its BB+ subordinate debt ratings on the bonds. S&P said that “the outlook revision reflects our view of the improved competitive position from recent rate cuts and the progress that the authority has made in diversifying its outlook for energy costs.”

WAPA has reduced oil dependence in its generating fleet by converting two plants to burn propane, improved efficiency at its plants and in its distribution network, and adding renewable energy sources, such as solar power. Fuel accounted for 72% of fiscal 2014 operating expenditures which is actually slightly lower than in recent years. Generally high oil prices have stressed the authority’s financial performance, due to the lag in recovering fuel costs quickly from electric customers. Failure to recover fully and timely fuel costs affected debt service coverage. The recent decline in oil prices has improved WAPA’s cost profile.

The stable outlook is based on a view that while rates remain high, the recent drop-off in levelized energy adjustment clause rates and improved competitive position will be favorable for collections and electricity demand. Given the decline in oil prices and the expected drop in the authority’s exposure to oil price swings, near-term financial pressures are set to moderate. However, if the economic or oil price situations weaken, there could be downward pressure on the rating or outlook. Because of the system’s high debt burden, rates, and receivable balances, it is not expected that the rating will be upgraded in the next year.

PUERTO RICO UPDATE

Amendments to legislation increasing the petroleum-products tax, known locally as la crudita, which would authorize a bond deal of nearly $3 billion and passage of a sweeping tax reform, are at the top of the agenda for Puerto Rico. Officials and legislative leaders have dampened expectations of swift passage of both measures, with Gov. Alejandro García Padilla saying tax reform would be introduced by mid-February, with an eye to passage by March 31, and Senate President Eduardo Bhatia insisted that the upper chamber wouldn’t rush its consideration of sweeping tax reform.

The legislation raising the petroleum-tax hike and authorizing a $2.95 billion bond issue was approved in a special session in December. However, to win enough support, the final version of the legislation “imposed conditions that will delay and may even prevent the [bond] issuance,” said Moody’s at the time of passage. Those include making the petroleum-tax increase contingent on implementation of a broad tax overhaul. Another condition nixed a provision for annual inflation adjustments to the tax, while a third limits borrowing costs on bonds backed by the new tax revenue, capping the coupon at 8.5% and requiring a minimum issue price of 93 cents on the dollar.

Government estimates of how much the petroleum tax raised in fiscal 2014, which ended June 30, have fluctuated greatly from $255.5 million to $661.9 million, according to an NCM Noticias report. These estimates were made after the administration tripled the petroleum tax from $3 a barrel to $9.25 a barrel. In terms of revenue collected, the peak was in 1999 when $406 million was collected from the petroleum tax, with the low point dropping to $264 million in fiscal 2013.

The legislation was approved by only a single vote in both the House and Senate and changing the language could alienate swing votes. Many analysts still expect the measure to pass, given its importance in shoring up Government Development Bank (GDB) finances. The bond issue would repay $2.2 billion of principal and interest on loans the GDB provided to the Puerto Rico Highways & Transportation Authority (HTA). The legislation would transfer the GDB’s $2.2 billion loan to the HTA to the Puerto Rico Infrastructure Financing Authority (AFI by its Spanish acronym), along with the means to pay for it through revenue produced by increases in the petroleum tax. The bill also provides extra funding to cover operational budget gaps at the HTA, including its mass-transit assets that are being spun off into a new public corporation.

On paper, Puerto Rico has enough money to make it through the end of fiscal 2015, which ends June 30, but officials say boosting GDB liquidity is essential so that Puerto Rico can use the extra cash to plug any fiscal holes in this year’s budget and cover other emergency situations. If not amended, some think that the GDB could be forced to write off more than $2 billion of HTA loans, risking the possibility that the GDB’s auditors could determine the bank insolvent. More importantly, the GDB would be unable to cover potential central government and public corporation deficits, triggering a potential cash-flow crisis.

While the tax-reform proposal details are being kept under wraps, it is rumored  to exempt from income taxes those earning $35,000 a year or less, while making up for the lost revenue with a value-added tax (VAT) of about 15%, which would be levied on food, medicine and other items currently exempt from the 7% sales & use tax. Tax reform is also expected to overturn the gross receipts tax and increase property taxes.

There are significant risks entailed with the implementation of a VAT, which would be the only such tax in the U.S. The transition to such a tax would be challenging in the best of times. PR has a mixed record of implementing tax changes and there is a culture of evasion on the island.

IS KANSAS MOVING AWAY FROM TAX OZ?

Gov. Sam Brownback, who made cutting taxes and shrinking government the centerpieces of his government, proposed last week to close a huge projected shortfall in the state budget by increasing some sales taxes and sharply slowing his plan to gradually reduce the state income tax. The move marks a significant turn for Mr. Brownback, who has tried to make his state a national model for conservative governance and who criticized calls from his opponent in last year’s campaign to scale back his income tax cut.

“I’d rather speed it up,” he said of his income tax cut. “But what we’re trying to do is balance the obligations we have as a state.” Mr. Brownback’s allies said the budget proposal represented necessary modifications that would keep alive the goal of someday eliminating the income tax, but opponents painted the plan as tacit acknowledgment of their longstanding argument that his policies were damaging the state’s finances.

Even some lawmakers who generally align philosophically with Mr. Brownback, who started his second term this month, seemed wary of parts of his proposal. Republicans control the Legislature. “He’s proposed some revenue enhancements that I think the Legislature will have a great difficulty passing,” said Senator Susan Wagle, the chamber’s Republican president. “That’s tax increase.” In 2012 and 2013, the governor championed and the Legislature passed the largest tax cuts in state history, eliminating taxes on non-wage earnings for nearly 200,000 small businesses and starting to phase in a series of cuts on individual income taxes.

The enacted income tax cut dropped rates this year to 4.6 percent on the top end and 2.7 percent on the low end. The lower rate was set to drop to 2.4 percent next year, but under the new budget proposal, it would fall only to 2.66 percent, while the higher rate would remain at 4.6 percent. By 2018, the higher rate was supposed to dip to 3.9 percent, and the lower to 2.3 percent. But under the governor’s new proposal, the rates would remain at 2.66 percent and 4.6 percent. The governor’s plan includes a mechanism for continuing the income tax decreases if revenue rises.

If revenue grows to 103 percent of the previous year’s amount, the plan calls for placing the additional revenue into a fund that the Legislature could use to implement more income tax reductions. The plan also creates a budget stabilization fund that would use revenue growth to fill deficits. The Governor also has asked lawmakers to begin reducing itemized deductions this year — those reductions were supposed to start in 2017 — and to increase sales taxes on liquor and tobacco products. Those changes, along with a tax amnesty for delinquent payers, would increase revenue by more than $423 million over the next two fiscal years, according to the governor’s estimates.

The big expenses in the state’s budget of more than $6 billion are pensions, Medicaid and K-12 education. With the deficit estimated at $650 million for the fiscal year beginning in July, Gov. Brownback proposed overhauling how each of those areas was funded. He called on lawmakers to rewrite the school funding formula, which has been the subject of a hotly debated lawsuit that has bounced around the state’s court system. While lawmakers contemplate how to rewrite the formula, the governor has suggested funding the schools over the next two fiscal years with block grants rather than through the traditional method. This has raised concern among some school advocates about whether districts would be shortchanged.

WASHINGTON FACES COURT EDUCATION REQUIREMENTS

Gov. Jay Inslee, a Democrat, has called for the biggest increase in new tax dollars in state history. “The time of recession and hollowing out is behind us,” Mr. Inslee said in his State of the State address to lawmakers. “It is now time for reinvestment.” Mr. Inslee is seeking $1.4 billion in new revenue as part of a nearly $39 billion budget plan that includes a new capital gains tax on the wealthy and a cap-and-trade carbon tax system he said would also reduce climate-altering pollution.

The extra money, along with a projected $3 billion increase in revenue from existing taxes in a recovering economy, would be funneled heavily to one line item: education. This is in response to a decision of the Washington Supreme Court, which last fall found the state in contempt for failing to outline a schedule, in dates and dollar amounts, to remedy years of underfunding of schools. The justices issued a contempt order in September, after many failed promises by the Legislature, but held off enforcement until the end of the 2015 legislative session, which began last Monday and is to last for 105 days.

The imposition of a penalty, if it comes to that, could well be a first in American politics. Legal scholars could not cite another example of a state high court holding an equal branch of government in contempt. No one is certain what might happen. The court was vague about what it might do, leaving just about anything on the table, and there is no  relevant precedent. The court could, for example, order money deposited from state general funds into school accounts, legal scholars have said, or impose fines or do something else altogether.

Because the federal courts do not police disputes between branches of state government over the separation of powers, any challenge to the court’s action could be appealed to only the justices themselves, who would be asked to second-guess whether they had acted within constitutional bounds.  The Legislature is divided and less than 24 hours before the governor’s speech, the Senate changed its own rules to make any new tax harder to pass — requiring two-thirds approval of the chamber instead of a simple majority.

Gov. Inslee’s tax package would be the largest ever in dollar terms, but in terms of percentage increase, some tax hikes have been much bigger. Court orders on education are common in state politics. Particularly since the 1990s, lawsuits have focused on state constitutions, which vary greatly in their requirements for education. Sixteen states, for example, simply require a system of free public schools, according to the National Conference of State Legislatures. Washington’s constitution is one of the most stringent — one of only eight that call education a “fundamental,” “primary” or “paramount” state obligation. Some lawmakers say an increase in the range of $1 billion to $2 billion in the current budget would meet the court’s demands, while others cited higher or lower numbers.

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

Joseph Krist

Municipal Credit Consultant

THE GAMES BEGIN IN ILLINOIS

Before Gov. Bruce Rauner could even officially begin his term, the games have begun in Illinois. The Illinois General Assembly approved legislation last week establishing a special election in two years’ time for state comptroller in a move that clearly defies the wishes of the Gov.-elect. The Senate approved the measure by a 37-15 vote, with the House voting 66-40.  The move is the first indicator of the partisan divide that overhangs Illinois as it attempts to deal with its financial and pension predicament. Democrats said the legislation was in the spirit of democracy and good government, while Republicans called it a political power grab.

Rauner’s spokesman released a statement saying Democrats in the General Assembly “refused to take bipartisan steps” and “proceeded instead with a constitutionally dubious election bill.”  Outgoing Gov. Quinn had called a special session following Republican comptroller Judy Baar Topinka’s death in early December. Topinka was reelected to a second term in November, but died six weeks before taking the oath. A legal opinion from Attorney General Lisa Madigan determined that Quinn could appoint a replacement to serve until Jan. 12, when the current term expired, but that Rauner could name someone to serve the upcoming term.

In addition to the comptroller position, the bill also would apply to other vacancies that might occur in statewide constitutional offices going forward, except the governor’s office. Still, Republicans complained the move was designed to strip Rauner of his executive authority and an attempt to better place Democrats for the post in 2016. They also called it a purely partisan maneuver with one GOP state Sen. saying approval of the legislation “sets a new day in Springfield off on a disappointing foot. It poisons the well.”

GOV. BROWN PROPOSES FY 16 CA BUDGET

Governor Edmund G. Brown Jr.  proposed a budget last week that injects billions of dollars more into schools and health care coverage, holds college tuition steady and delivers on Propositions 1 and 2 by investing in long overdue water projects and saving money, while continuing to chip away at the state’s other long-term liabilities – debt, infrastructure, retiree health care and climate change.  “This carefully balanced budget builds for the future by saving money, paying down debt and investing in our state’s core needs,” said Governor Brown. “Our long-term fiscal health depends on the wise and prudent actions we take today.”

When Governor Brown took office in 2011, the state faced a $26.6 billion budget deficit and estimated annual shortfalls of roughly $20 billion. Since then, the state has eliminated these deficits with billions of dollars in cuts, an improving economy and new temporary revenue approved by California voters.

The Budget includes the first $532 million in expenditures from the Proposition 1 water bond to continue the implementation of the Water Action Plan, the administration’s five-year roadmap towards sustainable water management. Additionally, the Budget includes the last $1.1 billion in spending from the 2006 flood bond to bolster the state’s protection from floods. It also proposes $1 billion in cap-and-trade expenditures for the state’s continuing investments in low-carbon transportation, sustainable communities, energy efficiency, urban forests and high-speed rail.
Under the Budget, the state’s Rainy Day Fund plans for a total balance of $2.8 billion by the end of the fiscal year. The Budget spends an additional $1.2 billion from Proposition 2 funds on paying off loans from special funds and past liabilities from Proposition 98. In addition, the Budget repays the remaining $1 billion in deferrals to schools and community colleges, makes the last payment on the $15 billion in Economic Recovery Bonds that was borrowed to cover budget deficits from as far back as 2002 and repays local governments $533 million in mandate reimbursements.

In positive credit news for local school districts, K-12 school funding levels will increase by more than $2,600 per student in 2015-16 over 2011-12 levels. This reinvestment provides the opportunity to continue implementation of the Local Control Funding Formula. Rising state revenues mean that the state can continue implementing the formula well ahead of schedule. When the formula was adopted in 2013-14, funding was expected to be $47 billion in 2015-16. The Budget provides almost $4 billion more – with the formula instead allocating $50.7 billion this coming year.

University tuition almost doubled during the recession. The Budget commits $762 million to each of the university systems that is directly attributable to the passage of Proposition 30. This increased funding is provided contingent on tuition remaining flat. All cost containment strategies must be explored before asking for higher tuition.

Due principally to the implementation of federal health care reform, Medi-Cal caseload has increased from 7.9 million in 2012-13 to an estimated 12.2 million this coming year. The program now covers 32 percent of the state’s population. The state’s unfunded liability for retiree health care benefits is currently estimated at $72 billion. State health care benefits for retired employees remain one of the fastest growing areas of the state budget: in 2001, retiree health benefits made up 0.6 percent of the General Fund budget ($458 million) but today absorb 1.6 percent ($1.9 billion). Without action, the state’s unfunded liability will grow to $100 billion by 2020-21 and $300 billion by 2047-48. The Budget proposes a plan to make these benefits more affordable by adopting various measures to lower the growth in premium costs. The Budget calls for the state and its employees to share equally in the prefunding of retiree health benefits, to be phased in as labor contracts come up for renewal. Under this plan, investment returns will help pay for future benefits, just as with the state’s pension plans, to eventually eliminate the unfunded liability by 2044-45. Over the next 50 years, this approach is estimated to save nearly $200 billion.

DETROIT’S WAKE

Last week the Municipal Analyst Group of NY (MAGNY) held a discussion on the meaning and impacts of the Detroit bankruptcy now that the final opinions have been issued as of yearend. The panel assembled included advisors to the bankruptcy judge, a bond insurer, and holders of the City’s pension COPs. A few key takeaways from the meeting are as follows. The consensus is that the pace and results of the bankruptcy resulted from its relative speed. The pace seemed to be driven by politics – the politics of the 2014 gubernatorial election, a possible desire for higher office on the part of the Governor, and fears as to reliance upon the political infrastructure of the City.

The plan of adjustment that resulted – especially its reliance on the Grand Bargain for funding pensions – was cited as an outlier relative to other Chapter 9 proceedings. The fact that the City’s best asset in terms of monetary value – the art collection at the DIA – was effectively ring fenced throughout the negotiations between the City and its creditors contrasts with the actions of many other municipalities facing insolvency or bankruptcy. The sale of assets by Allentown and Harrisburg, PA were specifically noted as contrasting with the lack of asset sales by the City.

The result is that the plan of adjustment only had a real impact on the City’s balance sheet. It did not truly address the City’s operating culture or resources over the long term. This concerned many analysts as the process unfolded as it is clear that a mere reduction in the City’s debt payment obligations was insufficient to deal with its long term operating and economic issues. A good example is the City’s well documented problem with blighted properties.

With nearly 85,000 such properties, the City faces a herculean task to address these conditions and provide a more realistic footprint for the City. This will impact the scope of infrastructure restoration, the ability to develop new resources whether for economic or residential development, and has real impacts both current and long-term on the scope of the City’s operating demands and resources. As an example, over 50% of police and fire incidents responded to involve these properties. Current budgeted resources are clearly insufficient to address the current state of these parcels.

The net result is that on many levels, the bankruptcy has many negative implications for tax backed bondholders across the municipal market. The relative standing of pensioners relative to debt holders in favor of pensions was reinforced while the value of a voter approved debt issuance and tax pledge was effectively limited. In addition, the failure to meaningfully address long-term operations meant that bond holders will continue to be subject to many of the same risks that led to the bankruptcy in the first place. These include dysfunctional politics, inefficient operations, a weak economy, and a poor environment to support future economic growth. Each of these issues are strikes against the bondholder.

DETROIT SCHOOLS STILL FACE HUGE PROBLEMS

Gov. Rick Snyder of Michigan appointed a new emergency manager on Tuesday for the Detroit Public Schools, the fourth since 2009. About 47,000 students in kindergarten through high school attend Detroit’s 97 schools now, compared with 96,000 in existing schools in 2009.  In 2009, the school system had a $327 million deficit; this year the deficit was estimated at $169.5 million. The intent of Michigan’s emergency manager law has always been to quickly move cities and schools systems out of financial distress and back on their own, but Mr. Snyder said the problems in the school system were so great that an emergency manager must remain. The term of the current EM was due to run out so a replacement had to be named. He is was the emergency manager for the city of Flint, and he worked as Saginaw’s city manager before that. The Governor has ruled out bankruptcy for the Detroit Public Schools, a distinct legal and financial entity from the City of Detroit.

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