Joseph Krist

Municipal Credit Consultant

MSRB DISAPPOINTS ON BANK LOAN DISCLOSURE

Participants in the municipal bond market have been fighting the glacial pace of disclosure reform for as long as I can remember. The latest development in this effort is in the realm of disclosure of credit exposure by municipal issuers through direct lending by banks. In an effort to avoid the time, cost, and financial disclosure requirements associated with a public debt offering, smaller municipalities have increasing turning to commercial banks as a source of financing. While there have been some benefits for issuers, this lending has raised a number of credit issues for analysts and investors attempting to ascertain the actual level of risk associated with investment in a given issuers bonds.

One of the big concerns associated with this kind of borrowing is the lack of disclosure available to debt investors surrounding the exact security provisions for these loans. While the loans themselves are usually secured on a subordinate basis to outstanding debt, that can change in the event of a default on a loan. Often, in the event of default, the lending bank can demand that the borrower issue actual bonds which are secured on a parity with previously issued debt. holders of those bonds can suddenly find themselves with a significantly larger amount of debt secured on a parity with theirs. This complicates the analysis of potential recovery in the event of a default and/or bankruptcy and makes valuation of the total amount of outstanding debt much more problematic.

So it was with some disappointment that we see that the Municipal Securities Rulemaking Board (MSRB) announced this week that the U.S. muni market’s self-regulating group would not pursue “at this time” a rule to facilitate disclosure of bank loans taken out by states, cities, schools and other bond issuers. The board, which regulates muni dealers, bond underwriters and financial advisors, but not state and local government issuers, has been trying to devise a way to boost disclosure of such private loans for the reasons we have discussed.

The MSRB’s decision likely means that most investors will not be able to get this information. This despite the fact that the regulator itself acknowledged in March that only a small number of issuers had disclosed the loans “The board continues to believe that disclosure of alternative financings is important for assessing a municipal entity’s creditworthiness.” She said the board would instead continue to push for voluntary c”We preserve our ability in the future to do rule-making, but we wanted to give it a little more time,” Kelly said.

Our view continues to be that the industry needs to err on the side of more rather than less disclosure. As the old saying goes “sunlight is the best disinfectant”. With more municipalities using this technique and bankruptcy becoming more prevalent, this is an increasing concern for investors.

CHICAGO MAKES ITS CASE TO INVESTORS

This week the City of Chicago held its annual investor presentation. Given the daunting challenges the city faces, the update is timely. The City’s total revenues for 2016 are projected to end on target, although certain revenues are projected to end substantially under budget due to factors unrelated to Chicago’s economy. These revenues include utility taxes and the personal property replacement tax (PPRT). Utility tax revenues are expected to come in 2.6 percent or $11 million below budgeted amounts. The decline is driven by continuing low prices for natural gas, the mild winter, and the cooler than normal spring and early summer. Electricity tax, cable television tax, and telecommunication tax revenues are projected to end even with the 2016 budgeted amounts.

In addition to the decline in utility tax revenue, the City estimates that it will receive $40 million less in PPRT revenue in 2016 than budgeted. This reduction is due primarily to a misclassification of income taxes by the State of Illinois in 2014 and 2015 that resulted in the overpayment of PPRT revenues to local governments. The State adjusted downward its PPRT payments to local government earlier this year to reflect amounts that are owed. Local governments will be required to reimburse the State beginning in 2017.

Personal property lease tax revenues are expected to end 16.8 percent, or $29.8 million, above budget due to greater than previously anticipated compliance by the technology industry. The City lowered the personal property lease tax rate and waived taxes penalties and interest for years prior to 2015 for certain cloud software and infrastructure. Transportation-related taxes, including the garage tax and ground transportation tax, are anticipated to finish 2016 near budget at $238 million.

Corporate fund expenditures are currently expected to end the year at $3,548.7 million, or 1.0 percent, below the budgeted level of $3,570.8 million. These estimates are based on year-to-date spending, incorporating payroll trends, market pricing for relevant commodities, and any known changes or events that have or are anticipated to occur during the remainder of 2016. Based on current revenue and expenditure projections, the City estimates a 2017 corporate fund gap of $137.6 million.

The $137.6 million gap for 2017 is the lowest projected gap since 2007, and is substantially smaller than was projected for 2017 in the 2014 and 2015 Annual Financial Analysis. For the first time since 2011, the gap for the coming year is put forward without separate consideration of the City’s pension funds.

Corporate fund resources are projected to decrease from 2016 year-end estimates, and 2016 budget, by 1.6 percent or $58 million to $3,513 million in 2017, largely due to further expected declines in PPRT revenue. The 2017 PPRT estimates are anticipated to decline an additional $34.6 million, making these revenues 27 percent below the 2016 year-end expectations, as the State further decreases PPRT payments to recoup overpayments in previous years.

Economically sensitive tax revenues are anticipated to increase in 2017 above the 2016 level. Sales tax revenues are expected to grow at a rate of almost 3.0 percent through 2017 as consumer confidence figures continue to improve. Compliance levels for the personal property lease tax are projected to remain high, causing revenues to grow 4.5 percent on top of the growth in 2016 revenues. Utility tax revenues are expected to return to levels consistent with the 2016 budget on the expectation 2017 will bring more typical winter weather and natural gas tax revenue will increase over 2016 revenues. Other utility taxes are projected to remain flat or experience small fluctuations. Even though real property transfer tax revenues are projected to decrease by nearly 12 percent in 2017 compared to 2016 year-end, they are expected to grow over the 2016 budget by almost 4 percent. The decline from year-end is due to one-time increases from the transfer of ownership interests in the Skyway and Millennium Park garages in 2016.

The 2017 expenditures are forecasted to grow by approximately $80 million over the 2016 budget to $3,650.6 million. The majority of the projected expense increases for 2017 are personnel costs, primarily wages. The 2017 projection for these expenses assumes the same number of employees as 2016 with wages growing based on required contractual wage and prevailing rate due to the final phase-out of retiree health care and other initiatives designed to reduce growth in the cost of the City’s health care plan.

And of course no discussion is complete without news on pensions. As of July 29, 2016, the City has identified a permanent, reoccurring source to fund three of its four pension funds. In the fall of 2015, the City adopted a four-year property tax increase that provides funding for the City’s pension contributions to the Police and Fire pension funds through 2018. A small additional payment is needed in 2019 which is incorporated in the 2019 projections. Increases in pension contributions necessary to stabilize the Municipal pension fund are not included in the 2017 budget shortfall, as any increase in contribution will be coupled with a dedicated revenue source. Prior to the adoption of the 2017 budget, the City anticipates reaching a funding plan and reform agreement with the Municipal pension fund following the same framework as was achieved with the Laborers’ pension fund.

These projections assume status quo in terms of state action regarding pension reform. They also assume a successful outcome to ongoing litigation over the City’s obligation to fund healthcare benefits for retirees. The next step in that litigation is August 11.

The City’s presentation is consistent with our view that the Emmanuel administration is trying to do the right thing within the constraints of a challenged local political environment and an unsupportive state political environment. The disparate views represented on a 50+ member City Council and a dysfunctional state government severely handcuff anyone trying to enact broad reforms in Chicago’s long term credit trajectory. To the extent that management can influence a rating, this administration has to be viewed as a net positive factor.

BRAVES STADIUM HAS A POLITICAL COST

It won’t reduce the $400 million contribution from the County’s revenue base, but the voters of Cobb County, GA have exacted some political price for the County’s funding of part of the new stadium for the Atlanta Braves under construction for the 2017 season. The project has been controversial for a number of reasons unrelated to its cost and financing. Their current facility, Turner Field in central Atlanta, is only twenty years old. Nevertheless, the publicly financed facility has been declared outmoded after less than 20 seasons of use by the Braves.

Sun Trust Park will be supported by $397 million of bonds to be issued by the Cobb-Marietta Coliseum & Exhibit Hall Authority. The stadium will supposedly be more convenient to the majority of the Braves’ fan base but for many fans the real issue may be that this will result in a less “urban” tilt to the fan base. Ironically, it has not been the cost or the public financing of that cost that has raised the ire of Cobb county’s residents.

It has been reported that the Cobb County Commission—the five-person local governing body – that approved the Braves’ plan without public debate by standing in hallways to get around open-meetings laws — has determined that if county residents want to get the $40 million in new parks they voted for way back in 2008, they’ll have to raise taxes, because that money has now been siphoned off for the new baseball facility. The park bonds were never issued, then when the property tax hike funding them was set to run out, the commission decided to renew it for the stadium instead of spending it on what voters had intended it for.

So, when it came time for the primary election for the chairmanship of the Commission Incumbent Chairman Tim Lee lost his reelection bid . Some of the voters who voted against Lee said they were in favor of the Braves’ move to Cobb, but objected to the way the deal was negotiated in secret and committed some $400 million in public money to build and maintain a new stadium without a popular referendum. One said simply, “He should have asked.”

So the takeaway is not very straightforward. Voters seemed to be more concerned about the process than the result. A lot of the local opposition seemed to be development related rather than stadium related. This instance provides little clue as to whether politician’s usual fear of stadium referenda was validated. We see no applicability of this result to any possible result in November on a referendum in San Diego for a new Chargers stadium.

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

OUT IN THE TERRITORIES

With Puerto Rico sitting in a state of limbo as events under Promesa play  out, investors are looking at debt from other U.S. territories in a new light. So the recent downgrades of the debt issued for the Virgin Islands Water and Power Authority to below investment grade merited attention. The downgrades come on the heels of a Spring decision by the Public Services Commission to deny W.A.P.A. a requested electric rate increase and instead placed the petition under a 60-day review. W.A.P.A. said it needed the increase to help stabilize its finances, and to have, at minimum, 45 days cash on hand, which equates to roughly $34 million. It also said the rate increase would bolster the market’s confidence in the authority’s bonds. Moody’s calculates that W.A.P.A. has approximately $127 million in electric system revenue bonds outstanding and approximately $100 million in subordinated electric system revenue bonds.

In a press release, W.A.P.A. Interim C.E.O., Julio Rhymer Jr., said the downgrade was expected in wake of the P.S.C.’s decision, along with W.A.P.A.’s deteriorating financial condition. “In light of last week’s decision by the Public Services Commission to delay action on a requested emergency rate increase, resulting in W.A.P.A.’s inability to amass sufficient days of cash on hand, the rating downgrade, was largely anticipated”. The Moody’s downgrade of senior bonds from Baa3 to Ba2 and subordinate bonds from Ba3 to Ba1, follows previous pronouncements by not only Moody’s but by Fitch, another rating agency, and S&P which contend that W.A.P.A. is in a precarious financial position based largely on outstanding receivables, the lack of liquidity and a multi-million dollar lawsuit recently brought by a former fuel supplier.

Despite expected modestly improving operating cash flow generation owing to recent customer gains and access to a $13 million term loan from the Rural Utility Service (RUS), W.A.P.A.’s financial flexibility will remain tight. Bond debt service over the next 12 months is secured by a debt service and fully cash funded debt service reserve fund. The authority’s unrestricted cash position of around $13.7 million has been improved by the Virgin Islands government’s efforts since the beginning of this year to reduce outstanding electric receivables to an estimated $22 million from a peak of around $41 million at June 30, 2015.

For some time, the Authority’s credit has been characterized by a short-term approach towards liquidity and financial management as well as frequent late filing of audited financial statements. The territory’s hospitals, along with some of the semi-autonomous agencies of the government, continue to owe the authority millions of dollars for past electrical and potable water service. These agencies are not current and have sizeable outstanding balances. WAPA is effectively subsidizing their operations while its finances deteriorate.

A proposal to incorporate a permanent charge that recovers street lightning costs to help support has been made W.A.P.A., and the P.S.C.’s could go either way. However, actions are uncertain and unlikely to restore W.A.P.A.’s weak financial profile to levels commensurate with a higher rating in the short term.

ATLANTIC CITY AGREES TO LOAN TERMS; AVOIDS DEFAULT

A last minute agreement with the State of New Jersey allowed Atlantic City to avoid an August 1 default. City Council approved a loan agreement with the state during an emergency meeting Thursday night. The state asked for certain assets, including the dissolution of the city’s Municipal Utilities Authority. “I want it secured by every asset they have, so that if they don’t pay it, I get to take the assets, sell them and pay you (the taxpayer) back,” Gov. Christie said Thursday.

The council is set to start the process of dissolving the authority during its September meeting. Dissolving the authority requires two readings of the ordinance, and the council can pull the ordinance after funding has been secured. City officials contend the state has no need to worry about the repayment of the loan. The city plans on repaying the state with the two years of marketing funds that would have gone to the Atlantic City Alliance — totaling $60 million — and $18 million from the Investment Alternative Tax, as part of a rescue package signed in May.

Some Council contended that the agreement was rushed. The state countered that members were notified about the emergency meeting two hours before it was scheduled to start and that all members of council were notified of the meeting at the same time. The loan is being made pursuant to legislation the governor signed in May giving the city until Nov. 3 to draft a five-year fiscal plan that includes a balanced budget in 2017. If the city fails to submit a plan or the plan is deemed insufficient, the state can sell city assets, break union contracts and assume major decision-making powers from the city’s government for five years.

The Mayor of Atlantic City said that “a five-year projection for city budgets from 2017 through 2021 is currently being prepared under the terms of the recovery plan. The city plans to have a draft of the plan completed by late fall and the final document presented to the commissioner of the Department of Community Affairs prior to the deadline.”

PENNSYLVANIA TURNPIKE

While neighboring New Jersey battles it out over gasoline taxes, the Pennsylvania Turnpike Commission looks to market some $315 million of bonds backed by oil franchise taxes. This tax is levied at a rate of 208.5 mills per gallon of fuel sold at wholesale in the Commonwealth. In 1991, the distribution of a portion of this tax was enacted into law which dedicated 14% of the 55 mills of the tax to the Commission. The security for the bonds includes a determination that these revenues are deemed to be appropriated without additional legislative action.

This matters given the budget delays which have characterized the Commonwealth’s budget process in each of the last two years. Those delays would not have prevented the timely collection and distribution of the pledged revenues. The major risk associated with the credit is the potential for reductions in demand for fuels in the face of a decline in sales related to either the economy or to increased fuel efficiency. Those risks are common to any consumption driven tax revenue stream. Consumption has been steady to slightly declining since 2007 which is not surprising given the economy over that period as well as driving trends nationally.

NEW JERSEY

A revised plan for renewing New Jersey’s Transportation Trust fund was advanced by the State Assembly. It calls for a 23 cent per gallon increase on retail sales at the pump. and reductions in other taxes, including a phase out of the estate tax and larger tax exemptions on retirement income. The New Jersey Chamber of Commerce, the New Jersey Gasoline, Convenience Store, and Automotive Association and the New Jersey Sierra Club have come out in support of raising the gas tax to replenish the trust fund, but caution the hike proposed by lawmakers might not produce the level of revenue they expect.

The revenue concerns reflect worries that there is a good amount of the volume in the state of New Jersey that comes from New York and those people will have less reason to purchase gasoline in New Jersey anymore.

The Senate Budget Committee Chairman is trying to get a measure approved that would satisfy concerns about tax fairness. The impact on employment short term is a major political concern. The shutdown of transportation projects because of the funding stalemate has meant layoffs during what’s usually their busiest time of the year, he said.  Union supporters have said that the standoff will lead to its workers taking about a 20 percent cut in their income this year. “They’re not going to be able to make this up with overtime.”

Gov. Chris Christie has said he will veto the legislation, which he has described as an exercise in tax unfairness. Senate President Steve Sweeney said he is working to get a veto-proof majority of lawmakers before posting the bill for a Senate vote.

LIPA

The effort to lessen the rate burden on Long Island electricity users continues with a pending fourth phase of Utility Securitization Bonds. These taxable securities seek to take advantage of the current rate environment to refund outstanding tax exempt debt payable from general retail electric rates and replace it with debt secured by a standalone fixed charge designated for debt service on these bonds. The financing refunds a chunk of the Authority’s debt out of the electric system’s expense base which is used as a part of the ratemaking process.

The securitization plan was designed to lower and stabilize the Authority’s ratemaking in response to customer concerns. The Authority’s costs and overall management had become a significant political issue on the regional and state level. So in 2013, the NY state legislature enacted legislation restructuring the Authority’s management, putting its ratemaking under Public Service Commission review, and restructuring its debt. It also enacted a three year freeze on retail electric rates. Day to day operations at the Authority are managed by a subsidiary of PSEG expressly created for this purpose. These actions reduced the political heat on the Authority and stabilized its credit at investment grade.

The security for this debt is effectively independent from the operations of the Authority. The securitization charge appears as a distinct fixed line item on a customer’s bill. The idea is to lower the overall cost of power to consumers than would have been the case had the refunded debt remained outstanding.

ERIE COUNTY, NEW YORK

The Authority is making its first debt offering in nearly two years. These bonds are secured by County sales tax collections and State Aid payments made to the County. The sales tax revenues are collected for the County by the State and may only be applied to debt service payments on the bonds. Neither the state or county can appropriate the funds for any other purpose.

The Authority issues debt on behalf of the County in addition to its oversight responsibilities over the financial operations of Erie County. The economic difficulties of Western New York’s population center (anchored by Buffalo) are well documented. The County’s finances were historically impacted by those difficulties as well as its former responsibilities for a County hospital. These combined to damage the County’s bond ratings such that it had effectively lost access to the market. This led to the creation of the Authority.

The County faces some daunting challenges despite  significant redevelopment efforts undertaken in Buffalo and the direction of significant funds from state economic development resources to the region. Buffalo and the County continue to experience population declines and efforts to increase private employment have been mixed at best. Public entities still are five of the ten largest employment in the County.

CHICAGO PUBLIC SCHOOLS PLACE DEBT PRIVATELY

Chicago’s cash-strapped public school system sold $150 million worth of bonds to JPMorgan in a “private placement.” The bonds, to be paid off in 2046, were sold at yields of 7.25 percent. The deal worked out better for school officials than their last one — an open market sale in February — was for $725 million at yields of 8.5 percent. Those bonds are to be paid off in 2044.

The rates are significantly higher than they were for comparably structured CPS bond deals from last spring, when CPS sold bonds at yields of closer to 5.5 percent. A $300 million budget deficit, possible teachers’ strike and large looming pension payments have led to CPS’ bonds being rated by three ratings agencies at “junk” status.

The private placement reflects concerns about these credit issues in the face of inaction by the legislature and the Governor to negotiate a way to fund the state’s as well as the Chicagoland localities’ huge unfunded pension liabilities. It is yet another reinforcement of the overall negative credit trend for Chicago and its related credits.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this 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

CALIFORNIA PENSION RETURNS HAVE NEGATIVE LOCAL IMPLICATIONS

The California Public Employees’ Retirement System (CalPERS) reported a preliminary 0.61 percent net return on investments for the 12-month period that ended June 30, 2016. CalPERS assets at the end of the fiscal year stood at more than $295 billion. Fixed Income earned a 9.29 percent return, nearly matching its benchmark. Infrastructure delivered an 8.98 percent return, outperforming its benchmark by 4.02 percentage points, or 402 basis points. A basis point is one one-hundredth of a percentage point. The CalPERS Private Equity program also bested its benchmark by 253 basis points, earning 1.70 percent.

For the second year in a row, international markets weighed CalPERS’ Global Equity returns. However, the program still managed to outperform its benchmark by 58 basis points, earning negative 3.38 percent. The Real Estate program generated a 7.06 percent return, underperforming its benchmark by 557 basis points.

So we have a very mixed bag. The total absolute return is unacceptably low. Two of the discrete investment sectors reflected negative and/or below benchmark performance. Some positive performance still reflected poor performance relative to benchmarks.

CalPERS 2015-16 Fiscal Year investment performance will be calculated based on audited figures and will be reflected in contribution levels for the State of California and school districts in Fiscal Year 2017-18, and for contracting cities, counties, and special districts in Fiscal Year 2018-19. The ending value of the CalPERS fund is based on several factors and not investment performance alone. Contributions made to CalPERS from employers and employees, monthly payments made to retirees, and the performance of its investments, among other factors, all influence the ending total value of the Fund.

CalPERS has underperformed its targeted 7.5% return over the past 3, 5, 10 and 20 years. The low overall return means that there will be pressure on localities and their employees to increase their contributions for pensions. For localities, the lower investment performance is a credit negative as they face higher expenses not necessarily coincident with the state of the economy at the time of those requirements.

HAMILTON COUNTY REFUNDS STADIUM BONDS

Regular readers know by now of our ongoing interest in the issue of public financing for professional sports facilities. Hamilton County, OH has been undertaking a financing program for stadia for the NFL Cincinnati Bengals and the MLB Cincinnati Reds since 1998. The program has utilized sales tax revenue bonds with proceeds of those taxes dedicated to the repayment of those bonds. While there have been no issues in terms of the level of resources available for bond repayment, the program has been controversial as the County’s overall fiscal position has been tight and difficult choices have had to be made as to the priority of programs for funding.

The structure of a currently outstanding issue of these bonds and the continuation of a favorable low interest rate and high demand market has made possible the refunding of some $320 million of debt related to the stadium finance program. The refunding is designed to achieve ongoing actual savings on debt service but will also be used as an opportunity to adjust the security provisions supporting the bonds which will make more monies available to the County for current spending

Those changes include an increase in reserves held by the Trustee for the bondholders. Previously, the County had been required to hold funds equal to 10% of one half of 1% of sales tax collections. The County will now be able to take those $7.4 million of funds and use them for any County purpose. In exchange, the size of the trustee held reserve is changed to of average of annual debt service to the lesser of100% of those amounts. The debt service reserve requirement can be fulfilled through a Credit Support Instrument from Build America Mutual.

Clearly the County through the refunding and the use of a surety for the debt service reserve is trying to address the concerns from its citizenry about the level of County resources benefitting the two teams. It is another indication of public misgivings about the propriety of using public funds to support what are in the end facilities used to generate a high level of private profit.

NJ TRIES AGAIN ON TRANSIT FUNDING

With the Republican convention now concluded, NJ Governor Chris Christie can try again to reach an agreement with the NJ legislature over how to raise increased funds for the State Transportation Trust Fund. Under a plan released Friday by Democratic leaders in the Legislature, the state would spend $20 billion over the next 10 years on roads, rails, bridges and other transit projects, using new revenue from higher gas taxes and borrowing.

The proposal would raise the gas tax by 23 cents a gallon to be offset by a phase out of the estate tax over 3.5 years at an annual cost of $552 million. In addition, the plan would increase the earned income tax credit for the working poor – annual cost: $137 million; increase income tax exclusions for retirees over four years, to $100,000 for joint filers and $75,000 for individuals – annual cost: $164 million;  give a $500 income tax deduction to all motorists with incomes below $100,000 – annual cost: $20 million; and give a $3,000 income tax exemption for all military veterans – annual cost: $23 million. The total cost of the tax cuts and credits: $896 million.

The NJ debate is occurring within a context of changes in gas taxes nationwide. Six states have changes to their gas tax rates. California and North Carolina are decreasing their tax rates, while Washington State is instituting its second gas tax increase in less than a year. Three other states, Iowa, Maryland, and Nebraska, will see revisions via formula. All states are dealing with the phenomena of much better vehicle fuel efficiency and decreases in driving frequency by millennials.

KANSAS RATINGS PAY THE PRICE

S&P Global Ratings dropped its rating for Kansas to “AA-,” from AA, three months after putting the state on a negative credit watch. S&P earlier dropped the state’s credit rating in August 2014. The ratings agency cited the state’s lack of cash reserves, even after multiple rounds of budget adjustments during the past year. Budget director Shawn Sullivan said the S&P report criticizes the state’s ongoing diversion funds for highway projects to general government programs and says the state continues to underfund pensions for teachers and government workers.

The state says that it is unfair to see diverted highway dollars as a one-time source of funds to help balance the budget because the state has done it regularly for years. It also feels that criticism of Kansas for underfunding its public pension system, which includes delaying nearly $96 million in payments otherwise due under the current budget, is unfair.  The state wants more of the focus to be on the fact that with funding improvements mandated in 2012, the state is spending significantly more on pensions than it did in the past.

Our view is to wonder what has taken the rating agencies this long to recognize that the current administration is so ideologically driven as to effectively preclude a more positive reading of recent events.

RATINGS GO DOWN WITH THE TUBES

Somerset, Kentucky general obligation bonds were downgraded to Baa2 from Baa1 on Monday, because of park subsidies totaling $7.6 million since 2007, by Moody’s Investors Service. The financial support from the city’s general and sanitation funds was for SomerSplash Waterpark, which opened in 2006 with six water slides and other attractions, including a “lazy river” for tubing and a wave pool.

“The downgrade to Baa2 reflects the further deterioration of the city’s financial reserves and consecutive operating deficits that result, in part, from ongoing and substantial general fund subsidy of its water park,” said Moody’s.

Somerset operations are “unusual” because the city owns a 155-mile-long gas pipeline that connects eastern Kentucky gas fields to major interstate pipelines. The pipeline has historically provides “substantial” margins that have subsidized general operations of the city such that tax revenues cover only half of expenses. The Gas Department is an enterprise fund that is self-supporting, and does not receive revenues from the general fund, The Gas Department is an enterprise fund that is self-supporting, and does not receive revenues from the general fund, according to the city’s 2015 audit.

In fiscal 2015, the general fund received $2.7 million from the Gas Department and $3.1 million from the Water Department, representing 46.5% of general fund revenues. The outlook remains negative for this formerly A1 credit due uncertainty from the ongoing support of the water park as well as potential risks surrounding the operations of the Gas Department.

We believe that recreational facilities should only be financed on a standalone basis. This is just one more of the countless examples of small communities being forced to pressure their general fund revenue bases to support clearly non-essential activities.

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

PHILADELPHIA BUDGET STORY

Philadelphia will be getting lots of attention later this summer as the site of the Democratic National Convention. The City hopes that the event will draw positive attention to many aspects of local development which have occurred in the three decades since the City reached its nadir as a center of urban decline and mismanagement. In the interim before the convention, we get a chance to view the outlook for the City’s near term finances.

City Controller Alan Butkovitz this week recommended that the Pennsylvania Intergovernmental Cooperation Authority (PICA) accept the City’s FY2017-2021 Budget Plan. The budget submission highlighted areas of concern about the City’s financial future. One is the newly adopted Sugary Drink Tax, a contentious point of revenue development for the City.

The City estimates that $416 million will be collected over the five years, before additional costs for collection, advertising and auditing.  The City has indicated that the revenues from the Sugary Drink Tax will fund three major initiatives: expanded Pre-K, community schools, and debt service for Rebuilding Community Infrastructure program when those programs are fully funded.

At the same time, opposition to the tax from producers as well as consumers is expected to move from the political arena to the legal front. The Controller acknowledges that PICA must be mindful of any litigation that could occur from critics of the Sugary Drink Tax, who have vowed court challenges against the tax. “While no litigation has been initiated, the outcome of such litigation could significantly affect the forecasted revenues and obligation amounts over the life of the Plan,” admits the Controller.

The Plan also comes up short in the area of labor costs. The City Controller’s analysis also indicated that the Plan does not include any potential costs above $200 million in obligations for future labor agreements over the five years.  AFSCME DC 33 and DC 47 Local 810 Courts are currently in negotiations. “The City would be responsible for identifying additional funds to cover any costs above the budgeted amount,” said the Controller.

GREEN BONDS

As the municipal market continues to evolve, new classifications of bonds have been developing to meet the needs of specialized investors. The mutual fund industry has been familiar with primarily equity funds that advertise themselves as socially responsible investors. They allow individuals with strong political or ethical beliefs to participate in the investment markets without feeling as if they have compromised those values.

This trend has expanded into the municipal market. There are funds and fund sponsors who practice “green investing” through our market. in response, issuers are working to achieve that status for their issues. Green Bonds are so designated according to  generally accepted Green Bond Principals as promulgated by the International Capital Market Association. The purpose of the label is to allow for investors to evaluate the environmental merits and benefits of bonds so labeled.

The latest example of Green Bonds is an issue of $415 million scheduled for sale next week by the City of Aurora, CO. The City Utility Enterprise is offering water revenue  particular project was designed to increase the efficiency of its existing water system and expand water supplies without the acquisition of additional land for its water rights. This is consistent with the principals supporting a Green Bond designation.

A Green Bond  designation does not lead to any changes in the basic characteristics of the bonds in terms of security or structure. In the case of the Aurora issue, the bonds are traditional first lien net revenue bonds of the water system featuring a traditional serial/term maturity structure. The only thing different is the Green Bond designation. The benefit is that it helps to expand the market for the debt by supporting an expanded class of investors. It looks like a win/win for the overall municipal market.

PENNSYLVANIA FUNDS ITS BUDGET

Early in July, Governor Tom wolf signed a budget that was underfunded by over $1 billion. That led to general derision and threats of further downgrades. The reaction seems to have spurred the legislature and the Governor to get together on a revenue package to fund the shortfall. Perhaps now the Commonwealth can move forward with its recently postponed general obligation bond issue.

That final revenue package is expected to raise nearly $1.3 billion through a $1.00-per-pack tax increase on cigarettes, an expansion of gambling, liquor reforms and applying the personal income tax on Pennsylvania Lottery winnings. There is an increase tax on the expanded vaping industry but cigars will not see a tax increase. Other revenues under consideration include tuition at the 14 state universities rising by as much as 3 percent in the coming academic year to fill the anticipated budgetary shortfall that the State System of Higher Education is facing. Tuition  has increased 13 percent over the last five years. A rise of 3 percent would mean a $212 increase in the yearly tuition rate, bumping up the base rate to $7,272.

Among other  tax changes signed by Gov. Tom Wolf this week, the state’s 6 percent sales tax will be extended to the purchase of digital downloads including games and music. This tax expansion is expected to be worth about $47 million in 2016-17, according to Wolf Administration estimates.

Missing from all of the budget deliberations is any serious reform of the Commonwealth’s underfunded pension liability. The pension issue is the elephant in the room in terms of the Commonwealth’s long-term credit outlook. The short-term resolution of the FY 2017 budget could be enough to hold off a rating downgrade in the near term. Absent meaningful reform of the Commonwealth’s pension situation, we see the credit as a consistent underperformer.

TEXAS HIGH SPEED RAIL HITS SPEED BUMP

Texas Central Railroad and Infrastructure, Inc. and Texas Central Railroad, LLC, propose to build a 240-mile high speed rail line between Dallas and Houston, Tex. In April of this year,  Texas Central filed  a petition for an exemption from the state prior approval requirements due to oversight from the U.S. Surface Transportation Agency. Such oversight would ease the process of right of way development and acquisition. That process is being used by opponents of the route and the plan overall to delay and/or halt the project. this in turn, has complicated financing for the project. Texas Central anticipates beginning construction in 2017 and plans to initiate passenger service as early as late 2021. Texas Central estimates the cost of construction, which is being privately financed, to be over $10 billion.

Texas Central made its request for federal jurisdiction based on the claim that the Line is part of the interstate rail network, despite the absence of a physical connection with Amtrak. Texas Central compares itself to the state-owned Alaska Railroad, which is located entirely in the State of Alaska, does not physically connect at any location with the interstate rail network and relies on water carriers to interchange and connect with other United States railroads; yet, the railroad is part of the interstate rail network and subject to the Board’s jurisdiction. The Alaska Railroad and the water carriers that it uses to connect to the interstate rail network are part of the noncontiguous domestic trade statutorily subject to the Board’s jurisdiction.

The Surface Transportation Board declined the request to supervise the project. The proposed Line would have no direct connection with Amtrak, such as a shared station or a clearly defined arrangement to connect passengers using through ticketing. The Line and Amtrak need not share the same track, but with no direct connection to the interstate rail network the construction and operation of the proposed Line is not subject to the Board’s jurisdiction.

While the Texas project is entirely private, we are interested in it for its potential precedent setting impact for high speed rail projects which hope to rely in whole or in part on municipal bonds for their financing. Understanding the various obstacles which could impact construction planning and scheduling and their potential effects on financing viability will be important to the credit analysis by potential investors in these sort of projects.

PROMESA CHALLENGES CONSOLIDATED

A U.S. Federal Judge consolidated the various cases brought up by a hedge fund firm, an insurance firm and private investors to resolve the issue on whether the Puerto Rico Oversight Management and Economic Stability Act (Promesa) has stayed their lawsuits. The government recently had asked the court to stay the three lawsuits, contending that there is a disposition to that effect contained in Promesa, but the judge declined to do so.  Currently, there are six cases in the Federal District Court in Puerto Rico and one in New York related to bond defualts and fiscal matters.

A hedge fund recently sued to stop the Government Development Bank from transferring assets. National Public Finance Guarantee Corporation,  which insures approximately $3.84 billion of debt issued by the Commonwealth of Puerto Rico and related entities, and a group of bondholder plaintiffs want the Puerto Rico Emergency Moratorium and Financial Rehabilitation Act to be declared unconstitutional.

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

ALASKA BUDGET CRISIS REVISTED

Two years ago I had the good fortune to spend time in interior Alaska. The trip gave me an appreciation for its vast scale, unique attributes, and the role of nature and the State in the creation of a unique role for its State government. These are some of the reasons that back in the first quarter of this year we commented on the looming budget crisis facing the State of Alaska in the face of consistently lower oil prices. The state is facing huge ongoing deficits as oil prices remain stubbornly low. This is forcing the State to consider – given its history – radical approaches to manage the state fiscal position going forward in an era of diminished oil revenues.

The State Office of Management and Budget has just issued a report suggesting two potential remedies for consideration by the Legislature. One remedy proposed is the “No Action Plan” and requires a state budget of $1.5 billion revenue. This revenue level assumes an optimistic $55/bbl price of oil, increasing over time to offset production declines.  The other is the “SB128 but No Tax Plan” and assumes a budget of $3.4 billion, $1.5 billion current revenue at $55/bbl plus $1.9 billion, the amount expected if SB128 passes the legislature, but no other revenue measures. State budget reserves will be completely depleted in FY18 without new revenue measures. In FY19, Alaska could be facing these scenarios. 

The budget would be one-third of the current FY17 budget and only one-quarter of the FY15 budget. Most government agency operating budgets would be 10 to 20% of current levels, a level similar to state spending experienced in the late 1960’s. School funding would be reduced to 32% of the current $1.25 billion, dropping to $400 million. Local education employment would fall from the current 24,400 to an estimated 10,000 statewide. The Alaska Performance Scholarship and Power Cost Assistance would end in FY19.

Medicaid and other health formula funding would be reduced by 25% to maintain as much federal coverage as possible. All other health programs would be shut down, privatized, or significantly reduced. These include senior benefits, child care benefits, homeless assistance, victim’s assistance, housing programs, pioneer homes, health clinics, public health labs, etc. Fish and Game, Environmental Conservation, and Natural Resources combined would have $18 million in operating revenue compared to $134 million total in FY17. This represents less than 10% of the FY15 funding level.

Transportation’s operating budget would be less than $40 million compared to the $218 million. Road maintenance and ferry service would end for some segments and be significantly curtailed on others. Many of the 240 state maintained airports would be closed, and the rest would have reduced operations. The legislature would have a budget of $11.6 million compared to the current $64 million 15% of FY15. The current budget is just over $1M per legislator, it would drop to $193,000 per legislator. There would be no ‘on behalf’ retirement payments, no school debt reimbursement, and no community revenue sharing, shifting all those costs to local governments. There would be no rural school construction funding or rural school maintenance.

Most prisons would be closed, and prisoners either released early or send to out of state facilities as a result of funding at 25% of current level. Public safety would be 25% of current level, leaving most areas without trooper presence. The capital budget would be less than $20 million costing the state federal highway match funding. AVTEC and most University campuses would lose all state funding. Any remaining campuses would receive one-third or less of current revenue. Up to 50% of state and university facilities would need to be sold or shuttered. State Library and Museum facilities would operate only at the level that could be sustained by earned revenue and fund raising.

State employment would drop by an estimated 12,000 employees (25,000 total, ~13,000 UGF funded, cut 70% of UGF employees, and cut 25% of state employees on other fund sources due to lack of matching funds). The drop in state and education employment plus the reduction in Medicaid would precipitate significant reduction in health care spending compounding overall state job losses. The amount spent for the Permanent Fund Dividend would nearly match the total state budget.

If the Senate Bill 128 (the Permanent Fund Protection Act) is passed in its current form, state revenue will increase by ~$1.9 billion and provide total Unrestricted General Fund revenues of $3.4 billion. The budget would be 78% of the current FY17 budget and just over half, 56%, of the FY15 budget. Most government agency operating budgets would be cut an additional 25% from the current levels and operate at 40-60% of the FY15 level. School funding would be reduced to 80% of the current $1.25 billion, dropping to $1.0 billion. Local education employment would see 3,000 to 5,000 fewer employees from the current 24,400.

 Medicaid and other health formula funding would be reduced by 10% to protect federal coverage. All other health programs would see an additional 25% reduction, impacting senior benefits, child care benefits, homeless assistance, victim’s assistance, housing programs, pioneer homes, health clinics, public health labs, etc. Fish and Game, Environmental Conservation, and Natural Resources combined would have $100 million in operating revenue compared to $134 million total in FY17. This represents about 59% of the FY15 funding level. Higher fees for permitting and inspections would be expected.

The transportation operating budget would be $163 million compared to $218 million. Road maintenance and ferry service would be curtailed. Many of the 240 state maintained airports would be closed or have reduced operations. The legislature would have a budget of $48.5 million compared to the current $64 million over 60% of FY15. The current budget is just over $1 million per legislator, it would drop to $800,000 per legislator. There would be no ‘on behalf’ retirement payments, no school debt reimbursement, and no community revenue sharing shifting those costs to local governments.

The Alaska Performance Scholarship and Power Cost Assistance would be reduced and eliminated within 5 years. There would be no rural school construction funding and minimal rural school maintenance. Corrections would be reduced an additional 10%. Two or possibly three prisons would be closed and some prisoners would be housed out of state. Public safety would be reduced an additional 10% from the current level, leaving some areas without trooper presence. The capital budget will remain at the minimal level to meet federal highway and other match requirements at $100 million. University funding would be reduced another $80 million likely forcing campus closures and possible divestitures to communities. Some state and university facilities would need to be sold or shuttered. State employment would drop by another 2,000 employees on top of the 2,100 fewer expected by the end of FY17.

Clearly these are worst case scenarios designed to stimulate thought and debate. Many of the contemplated spending cuts would be self-defeating for the State and its economy. We do note that the document does not make any reference  to the State seeking to address its problems on the backs of its bondholders. Perhaps the harsh if beautiful environment and self-sufficient spirit of most Alaskans serve to better focus the mind on solutions in a way that warm tropical winds do not.

CHICAGO RELEASES FY 15 FINANCIAL REPORT

The City of Chicago released its Comprehensive Annual Financial Report for calendar 2015. It includes a huge reported increase($17 billion) in liabilities consisting almost entirely of unfunded liability in the city’s four employee pension funds, covering police, firefighters, laborers and white-collar workers. The increased figure reflects two changes in how the liability is reported. First, it had to report the true shortfall in assets for its pension funds, using real actuarial figures. And it had to reduce the assumed rate of return on pension assets from 7.5 percent to 5 percent, an action that pushed up the unfunded liability.

The number also reflects the impact of the recent Illinois Supreme Court decision overruling, on constitutional grounds, a prior city pension rescue plan that relied on a combination of tax hikes and benefit cuts. The court ruled out those cuts, saying full benefits amount to a contractual promise that cannot be infringed.

There is some good news in that the shortfall between what the city is now contributing and what it actuarially should be contributing is down to the lowest level since between 2006 and 2011, depending on which fund is examined. But the city still isn’t meeting its actuarially required contribution or ARC and won’t fully begin to do so until 2020-22, under the current plans. The funds now have just 20.3 percent to 33.6 percent of the assets needed to pay promised benefits.

On the positive side, the amount of unrestricted cash in the city’s operating fund has roughly doubled in the past year, to $93 million, and that the city spent $106 million less than budgeted in its operating fund. Also, the city has removed all variable-rate and swap debt, but total outstanding general obligation debt rose about $1 billion during the year, to $23 billion.

On balance, there are positive things that stand out. The adoption of more realistic earnings assumptions for the pension funds, the improved ARC shortfall ratio, the reduction of exposure to variable rate risk, and the restraint on City spending relative to budget must be noted. While Chicago has a plethora of problems, lack of understanding on the part of the mayor is not one of them.

PROPOSED TRADING TAX WOULD INCLUDE MUNICIPALS

Municipal bond investors always have to be on the lookout for innocent sounding legislative proposals that target something else but hurt municipal bonds. The latest example is from Rep. Peter DeFazio (D-OR). Last week, he introduced legislation that would levy a 0.03 percent tax on transactions of stocks, bonds and derivatives to discourage speculative financial trading. “The ‘Putting Main Street First Act’ is designed to stop the sorts of high-speed trading that adds volatility to the markets.

According to supporters, a “Wall Street speculation tax” would not only help move our financial markets away from dangerous high-frequency trading, but also raise significant revenue to address unmet needs.” Oh by the way, according to the Joint Committee for Taxation, the tax would raise $417 billion over ten years.

While well intentioned, the tax would, by including munis, be effectively throwing out the baby with the bathwater. “This tax is a great way to raise money for the federal government by making the financial sector more efficient,” said Dean Baker, Co-Director of the Center for Economic and Policy Research. “The cost of the tax will be fully covered by the savings from reduced trading. This means that the ordinary investor will be left unharmed by this tax. The only people who feel the impact will be the short-term traders and the financial intermediaries.” We could not disagree more as it pertains to municipal bonds. Fortunately, DeFazio admits that there is no chance of passage in the current Congress.

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

SAN DIEGO STADIUM PROCESS KICKS OFF

We have previously commented on efforts to get the City of San Diego to finance the bulk of the cost of a new stadium for the NFL’s San Diego Chargers. Those efforts took a major step forward when the San Diego City Clerk announced that the Chargers secured enough valid signatures for the team’s proposal to raise local hotel taxes for a downtown stadium and convention facility to appear on the November ballot.

The announcement will provide another opportunity for proponents and opponents to make their cases regarding this project. The project itself will consist of the football stadium and an adjoining convention center annex. The existing center’s exhibit floor spans more than 525,000 square feet. The Chargers are proposing a total of 260,000 square feet of new exhibit space, of which 100,000 square feet would be on the stadium floor adjoining the proposed convention center.

That is much more exhibit space than a previous city plan to enlarge the center on the waterfront, which has been supported by the mayor and hotel industry but has been blocked in court. The grouping of the convention center expansion with the stadium is a shrewd move by the Chargers given that it ties their stadium to revenues from the hotel industry which wants an expanded convention center on its own.

The Chargers would contribute $650 million for the stadium portion of the project, using $300 million from the NFL and $350 million from the team, licensing payments, sales of “stadium-builder” ticket options to fans, and other private sources. The city would raise $1.15 billion by selling bonds that would be paid back with the higher hotel tax revenues. That $1.15 billion would cover the city’s $350 million contribution to building the football stadium, $600 million to build the adjoining convention center annex, and $200 million for land.

The initiative would raise the city’s tax on hotel stays from 12.5 percent to 16.5 percent to finance a $1.8 billion stadium and convention center in downtown’s East Village, next to Petco Park (the stadium for MLB’s San Diego Padres). City Attorney Jan Goldsmith says the initiative would need approval from two-thirds of voters. But Goldsmith more recently indicated there was a chance that approval by somewhere between a simple majority and two-thirds would leave the fate of the initiative in limbo until a Supreme Court decision whether to uphold or overturn the lower court ruling, which said only simple majorities are required for tax increases by citizens’ initiative.

Opponents include politicians (mostly Republicans when it comes to the stadium portion), business organizations and neighborhood groups. Neighborhood and citizens groups have raised the issue that such a tax increase should contribute revenue for other priorities and that higher hotel taxes could damage local tourism. They would prefer to see higher taxes applied to basic services. They do support an expansion of the convention center on its own.  

The outlook for voter approval is uncertain, especially if a two thirds vote is required. Now that Cleveland has one the NBA championship, San Diego bears the dubious distinction of being the major league city with the longest “championship drought”. The performance of the Chargers on the field has not been particularly successful over the past two decades and the popularity of the Spanos family and its ownership has been uneven at best. These are the qualitative factors that make these deals so interesting and we will continue to monitor the situation through the fall. Quantitatively, The proposed 32 % tax rate increase would lift San Diego from 21st highest in the nation for hotel, or transient-occupancy, taxes, up into a tie for third. The new rate of 16.5 percent would be slightly above San Francisco at 16.25% and Los Angeles at 15.5%.

HARRISBURG BACK IN THE NEWS

The Harrisburg Parking Authority sent notices of default to the executive director of the Pennsylvania Economic Development Finance Agency asking for payments due totaling $1,468,732. The money comprises mostly unpaid payments from 2014 and 2105, when the system didn’t generate enough revenue. The EDFA floated the bonds for the long-term lease of the city’s parking assets as part of the overall restructuring of Harrisburg’s finances in 2013.

City council members agreed to “sell” city parking assets in late 2013 under a 40-year lease. Since then, parking revenues have not generated enough moneyto ma ke all the payments listed in the deal’s “waterfall of payments” after debt obligations and operating expenses. City officials believe they are still owed their full payments, as the city ranks first in the prioritized waterfall. But parking officials claim that the language in the asset transfer agreement is “ambiguous,” as to whether it must pay unpaid payments from prior years when revenue falls short.

The dispute could wind up in court to determine if the city is owed full payments from prior months and years when revenue lagged. The city was promised $3 million this year, for example, from so-called waterfall payments. But parking officials approved a parking budget in December that called for $2.1 million in payments this year, while still paying full payments for “performance fees” for parking managers.

Although overall revenue fell short of initial projections by about 12 percent, the system made money, ending the first six-months of this year with more than $800,000 in cash. Parking officials have previously said they would have to raise parking rates if the city insists on its full payments. But city officials have said that the system should instead defer on “performance fees” for parking managers and cut operating expenses. The parking system could draw funds from its capital reserve fund to pay the city.

In the meantime, the bonds that financed the long-term lease of the parking system in Harrisburg have been reduced to junk status, by S&P Global Ratings, downgraded two notches to BB+.  Parking officials in June started withholding some revenue payments from the city and plan to continue to hold that money in a separate account until “there is resolution on this matter,”. Meanwhile, the city will continue to get the $3 million in so-called waterfall payments it expected this year.

Parking officials released an unaudited financial report for 2015 at Monday’s meeting that showed overall revenues for the parking system fell $1.2 million short of expectations. The biggest disappointment came from enforcement revenue (-$1.6 million) while meter revenue exceeded expectations by $764,000.

The confrontation serves to show the limits of financial engineering in the face of daunting economic challenges. The City’s fiscal position may have been temporarily shored up but the underlying fundamentals remained essentially unchanged. It leads us to once again repeat or view of the need for strong economic fundamentals whether it be a tax backed or revenue backed, public or private.

PUERTO RICO WATER LEGISLATION

The PRASA Revitalization Act was signed into law this week. by amending the moratorium act, the law establishes a securitization mechanism, whereby the utility would pledge 20% of what it charges its clients, for new debt that could reach as much as $2 billion. It establishes a securitization mechanism, whereby the utility would pledge 20% of what it charges its clients, for new debt that could reach as much as $2 billion.

For now, the legislation establishes limits to ensure no more than $900 million is issued in new money—a key amendment from the Senate that helped in overcoming the deadlock with the House. The utility is called to use any new debt raised to pay its suppliers, who are owed about $150 million, as well as to restart its $400 million capital improvement program. The remaining capacity, which is estimated to be about $1.1

The legislation’s enactment is meant to facilitate the issuance of debt on an expedited basis. This could provide for issuance before the establishment of an operating oversight board included as a major part of the PROMESA by the U.S. Congress. We have concerns about the execution of such a large transaction outside of the terms of PROMESA. While it is understood that Puerto Rico is resistant to the oversight of the board, efforts to circumvent its oversight can only be interpreted as interference with that oversight. this would be against the interests of all of Puerto Rico’s stakeholders.

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

Joseph Krist

Municipal Credit Consultant

NJ TRANSPORTATION ROADBLOCK

Over the Christie years, budget battles have been a primary characteristic influencing New Jersey’s bond ratings. One of the factors which was seen as a positive was the New Jersey Transportation Trust Fund credit and the constitutional provisions securing debt issued by that credit. Our view of reliance on legal versus economic supports for credits were enunciated in connection with Puerto Rico in our last issue.

So it was with dismay that we view the events of this week in connection with efforts to fund the New Jersey Transportation Trust Fund. Gov. Christie , a Republican, reached a deal with the Democratic-led State Assembly to raise the gas tax by 23 cents per gallon and to lower the sales tax. But Democratic leaders in the State Senate said they could not support the legislation because it would harm the state budget. The issue was that the sales tax cut would have reduced state by over $1 billion.

In response Gov.Christie’s administration declared a state of emergency and said that nonessential transportation projects would be suspended to conserve the money left in the state’s depleted transportation trust fund. The governor had directed the state transportation commissioner and the executive director of New Jersey Transit to submit plans for an “immediate and orderly shutdown” of most state-funded work. Projects with other sources of funding or that were deemed critical to safety were not affected.

Gov. Christie’s administration released a list of projects that will be shut down, saying they would be postponed for at least seven days. The 50-page list of transportation projects that will be shut down includes work in every corner of the state, from Bergen County in the north to Cape May at the southern tip. The State Transportation Department’s projects totaled $775 million, and New Jersey Transit’s projects added up to $2.7 billion.

The governor’s decision to shut down projects was highly unexpected prompting concerns over workers losing their jobs. State lawmakers had seen an opportunity to raise the gas tax ( the second lowest in the country), at 14.5 cents per gallon. There have been many suggestions that the tax be raised not just because of its low rate but based on the belief that users should pay more of the cost of road construction.

The volatile reaction by Mr. Christie is consistent with his habit of lashing out at those with opposing views. It also raises suspicions that his actions are being influenced by his vetting as a possible running mate for Donald J. Trump. This yet another example of an issue we have recently commented on(June 23) , namely the issue of political ideology as a credit negative.

Legislative Democrats are said to be examining several options for a transportation funding deal such as legislation to phase out the estate tax in exchange for raising the gas tax, but Mr. Christie said he did not support the idea.

As far as investors are concerned Transportation Trust Fund bonds are secured by the state’s absolute, unconditional contract payments subject to annual legislative appropriation. The state makes contract payments to the authority from the Transportation Trust Fund (TTF) account of the general fund. The accounts are funded with certain statutorily- and constitutionally-dedicated revenues for Transportation System bonds and with only constitutionally-dedicated revenues for Transportation Program bonds.

Bondholders have no direct lien on any of the dedicated revenues, and the legislature has no legal obligation to appropriate funds to the authority. Importantly, approximately 84% of New Jersey’s net tax-supported debt is subject to appropriation. The importance of maintaining access to the capital markets provides strong incentive for the state to make these appropriations.

PROMESA TAKES ITS RATING TOLL ON OTHER TERRITORIES

Fitch announced negative outlooks for Guam and U.S. Virgin Islands credits following the enactment of S.2328, the ‘Puerto Rico Oversight, Management, and Economic Stability Act’ or ‘PROMESA’ on June 30, 2016. According to Fitch, PROMESA fundamentally alters the premises used to rate certain tax backed debt issued by territorial governments distinct from and above a territory’s highest ratings.

In Fitch’s view, the adoption of PROMESA demonstrates the capacity of the federal government to adopt legislation controlling territorial bankruptcy in much the same manner that a state might do to control the ability of municipalities to seek bankruptcy protection. Previously, territories were assumed to be like states which would not themselves be subject to insolvency proceedings. PROMESA creates a framework to allow an oversight board to initiate proceedings aimed at restructuring territorial tax backed debts as if the territory itself was a municipality.

This is along the lines of concerns that we expressed last week. The securities being placed on Rating Watch Negative have been higher than the general credit quality of the respective territories based on their legal security structures. While the PROMESA legislation seeks to preserve the relative rights of lien holders, provisions of Chapter 9 that would otherwise protect holders of specific tax backed liens from automatic stay provisions require further assessment according to Fitch in light of the new legislative scheme.

Fitch notes that although PROMESA does not establish an oversight board for territories other than Puerto Rico, our extension of the inherent logic of the act to the rating of the tax backed debt of other territories would be consistent with the approach taken when rating municipal debt in states where local governments are not currently authorized by state government to file proceedings under Chapter 9. Fitch notes that it makes no distinction between entities in states that allow for local government bankruptcies and those that do not based on Fitch’s belief that, if a state deemed an entity’s best option to be a filing, the state would make the legal provisions necessary for that entity to file. Fitch’s view is that the same approach should be taken with respect to the federal power to authorize territorial bankruptcy.

PENNSYLVANIA MISSES AGAIN

This year, the state legislature has sent a spending plan to the Governor for his signature not too many days past the deadline for enactment. The problem this time around is that they have not agreed on how to pay for it. If signed as is, the “budget” is short on the revenue side by over $1 billion. The legislators have yet to agree on new sources of funding. They are considering gambling revenues, a possible increase in the base for sales tax collections, or a cigarette tax increase (see May 31 and May 17 issues).

An increase in the sales tax base would likely include the retail sales of clothing. This would be unpopular on both sides of the transaction with obvious opposition from consumers but also from retailers and localities. Many border localities have been able to entice retailers to establish and even relocate from New York to Pennsylvania bringing jobs along with them. Any reduction in that competitive advantage would be viewed poorly by those localities.

The Governor has decided to sign the underfunded budget rather than risk an ongoing budget debacle while his state hosts his party’s National Convention. The recurring failure to adopt timely budgets along with the recurring failure address the Commonwealth’s structural budget issues (education, pensions, property tax relief) combine to sustain the Commonwealth’s downward rating trajectory. We view the Commonwealth’s credit as an underperformer for the foreseeable future.

CHICAGO OPEB DISPUTE MOVES NEXT PHASE

In 1987, litigation was filed by the City of Chicago to establish what its legal obligation to fund the healthcare costs of its retirees. In many ways it was a forward thinking step. Other post-employment benefits as a source of credit pressure have really come to the fore since the turn of the century. Prior to that time, they were not a prime consideration for most investors. This step by the City has not been the stabilizing factor it hoped it would be.

Since 1988 the City of Chicago and its four pension funds have been party to the settlement of City of Chicago v. Korshak regarding how much the City, the funds and annuitants pay for healthcare. Much has changed in the time since that settlement which expired on June 30, 2013. Over that time, the City’s fiscal position worsened, a new administration took over in the City, and the Affordable Care Act was enacted. These factors led the City to seek ways to try to eliminate City support for retiree healthcare benefits. The City had hoped to rely on the fact that beginning in 2014, under the ACA, non-Medicare eligible retirees would be able to access insurance through new regulated marketplaces, or exchanges. The ACA increases access for retirees not yet eligible for Medicare by outlawing practices that previously made finding healthcare coverage difficult.

The City has been reducing subsidies for retiree healthcare costs since 2013. The retirees are now challenging Chicago’s efforts to phase out most retiree healthcare subsidies – or other post-employment benefits — which had cost the city about $100 million annually. They argue the benefits are protected by the state constitution’s pension clause and that the city is seeking to breach its contract with retirees. That position is based on a 2014 decision from the Illinois Supreme Court (Kanerva v. Weems) in which the court did not rule on whether changes the state made to retiree premium subsidies actually impaired retiree benefits, just that they are protected under the state constitution pension clause which gives benefits contractual protections against being impaired or diminished.

The Cook County Circuit Court heard oral arguments on July 6. It is  expected to issue a ruling on the city and pension funds’ motion to dismiss in the next two weeks. This will not be the final step in the process as both sides are interested in a certain outcome. That will undoubtedly come through an appeal to the Illinois Supreme Court. There is much riding on the outcome for the City and its investors.

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

Joseph Krist

Municipal Credit Consultant

PR

And so it’s done. Puerto Rico covered only about $150 million of the $958 million in constitutionally guaranteed debt it owed Friday, according to the government. In all, it missed $911 million out of the $2 billion in debt-service payments due. “When I became governor, Puerto Rico was a colony of Wall Street,” Gov. Alejandro García Padilla told reporters in his typically theatrical style. “There should be no doubt today that I have chosen to protect the Puerto Rican people, and that we have been telling the truth all along”.

That statement reflected the fact that, at 3 a.m. Friday, the Puerto Rico government released its audited financial statements for fiscal year 2014. The Government reports a net deficit of $49.7 billion. The current FY 2014 operating deficit was $2.7 billion. The Government expressed concern over its ability to operate as a going concern. A 7% decrease in revenues was not met with anything close to cuts of that magnitude on the expense side. The report spends significant space on the difficulties facing the Commonwealth, PROMESA and its provisions. It projects the insolvency of its primary pension systems by 2018 and 2019 respectively.

Of the $958 million of bonds that carry the island’s full faith and credit, the government missed $780 million worth of general obligations (GOs), while paying about $150 million of the $178 million owed in Public Buildings Authority (PBA) bonds. Fiscal authorities stated that “over $800 million” in debt guaranteed by the commonwealth was still owed July 1 and the administration won’t use “clawed back” revenues to pay for this debt, and instead will leave the roughly $150 million on a separate account, while its final use has yet to be determined.

The rest of the payments due Friday, or about $1 billion corresponding to several public entities, were covered mostly by siphoning the entities’ debt-service reserves held by their trustees. As a result, the commonwealth defaulted on roughly half of the $1.9 billion due July 1, including the $780 million in GOs and $77 million tied to the Infrastructure Financing Authority.

On Thursday, the Governor signed executive orders authorizing the government to miss payments on its constitutionally guaranteed debt, while also declaring moratoriums on certain obligations of the Highways & Transportation Authority (HTA), Convention Center District Authority, the Public Employees Retirement System, the Industrial Development Co. (Pridco) and the University of Puerto Rico (UPR). Despite the executive orders, partial payments were still be made, although coming from debt-service funds already held by a trustee. In addition, the orders seek to preserve cash and protect against potential legal action by creditors.

At the same time Puerto Rico’s reported only about $200 million in cash in its operating account, according to the government’s statement. It warns it would need to continue taking emergency fiscal measures over the next six months to avoid depleting its liquidity.

We have many problems with the process that is included in Promesa that will likely allow Puerto Rico to evade its constitutional requirement to pay debt. We are not ignorant of the human and economic realities on the ground. However, the reasons notwithstanding, any precedent that allows constitutionally enshrined promises to be broken is troubling. We stand with those who fear the establishment of such a precedent. At the same time, it reinforces one of our basic tenets of credit. Namely, that one should always rely on economic viability rather than legal provisions to support investment in a credit.

DETROIT PUBLIC SCHOOLS

The split of the existing Detroit Public School District into two distinct entities took effect on July 1. Immediately, Standard & Poor’s downgraded its credit rating for Detroit Public Schools bonds and said there is more than a 50% chance of additional downgrades in the coming months as those bonds will remain with the old district when the school system splits into two entities. Standard & Poor’s lowered the district’s bond ratings because of the risk for bondholders and uncertainty about the restructuring plan that places their debt into a non-operating district.

DPS is being split into two districts as part of a massive restructuring brought on by a recently passed $617-million state-aid package. The school district previously known as Detroit Public Schools becomes two entities — one that will provide education to its students and one that will exist solely to collect property taxes to pay down the district’s debt. Standard & Poor’s is concerned that bondholders face much higher risk of repayment for bonds that will stay with a district whose debt is no longer secured by the state.

S&P downgraded one set of the district’s bonds from A to BBB and another set of bonds from A- to BBB- and kept the bonds under “Creditwatch with negative implications”. Despite the state’s promises to meet its financial obligations, Standard & Poor’s said the complicated nature of the restructuring results “in a more than 50% chance we will lower the rating over the next three months, and could take more than one rating action during that time if warranted.” S&P even said the rating could sink to a ‘D’ rating, which is far below investment grade, or could be completely withdrawn.

Steven Rhoades, the former bankruptcy judge now leading the District, has sought board approval for a bond refinancing for $235million of debt but was turned down. This despite district officials saying in an e-mail to the Detroit Free Press that the bonds must be refinanced because they are no longer tied to a traditional school district. “The original bonds are secured by state aid,” the district said. “Since (the old district) will not have state aid funding … the bonds have to be refinanced to reflect that they will be secured by property tax.”

ILLINOIS

Illinois lawmakers overwhelmingly approved a spending plan that will allow K-12 schools to operate for another year and keep other essential state services operating for the next six months. But before one gets too excited heed the words of Gov. Rauner who said “It is not a budget. It is not a balanced budget.”

The budget compromise voted on boosts general state aid to schools by $331 million. It also provides $250 million more for schools that have high concentrations of low-income students. No school district will get less state aid than it did during the just-concluded school year. About $1 billion is going to higher education, including money for grants made under the Monetary Award Program.

The bill also provides $720 million for state operations, such as food for prisons and other state facilities, gasoline for state cars and medical care for prisoners or residents of state facilities. About $670 million will go toward human services, including autism programs, breast and cervical cancer screenings, funeral and burial services for the indigent and additional services for seniors and the homeless. Road construction projects will be able to continue, and the state will be allowed to spend federal money as it comes in.

All in all the deal simply puts off any serious budget reform until after the legislative elections in November and potentially sets up another fiscal cliff for the State and its universities in January. This continues to be a political problem. The danger for investors is that once the November elections come and go that the budget players shift their focus to the next gubernatorial vote in two years. That will merely serve to delay a serious long term fix to the State’s credit problems.

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

After months of lobbying, politicking, strongarming, and hyperbole the Senate, eager to follow the House out of town for the Fourth of July weekend, voted 68 to 30 for the Promesa  on Wednesday evening.  President Obama is expected to sign the measure, about which his Treasury secretary, Jacob J. Lew, said “I could write a bill that I think would be a better bill, but I don’t know that anyone could write a better bill that would pass the Congress that also solves the problem.” The Promesa legislation will not prevent Puerto Rico from missing the payment due on Friday on a $2 billion debt. That was made clear by PR’s governor on Wednesday morning.

In an editorial released through CNBC yesterday the Governor said “Puerto Rico does not have the ability to repay the $70 billion debt that was generated by past administrations and their creditors. The debt must be restructured fairly and equitably to both the people of Puerto Rico and the bondholders.

A fair solution to the problem is critical in order to bring progress back to the island. The case of Puerto Rico is similar to New York City’s and Detroit’s, except they had the tools to restructure their debt, and Puerto Rico does not.

My administration has acted swiftly. Puerto Rico adopted the most stringent austerity measures. The Island’s budget has been cut by billions during my term. The payroll has been reduced dramatically. We have deferred other obligations. We have withheld tax refunds.

Payables to suppliers have reached more than $2 billion. The inability to pay our suppliers has resulted in the loss of commercial credit and many services must now be paid on delivery. Without supplier credit, medicines and supplies for public hospitals and air-ambulance service to trauma centers are now in jeopardy.

The emergency measures we have taken are unsustainable, harm our economy, reduce revenues and diminish our capacity to repay our debts. Puerto Rico cannot endure any more austerity.

In order to yield a permanent fix to the debt crisis, lacking the mechanisms that New York and Detroit had, we introduced our own restructuring statute; but the federal courts closed that door. We have tried to negotiate a settlement with the creditors to no avail. This is why we sought the support of Congress. Their response was PROMESA, the Puerto Rico Oversight, Management and Economic Stability Act.

PROMESA is a mixed bag. On the one hand, it provides the tools needed to protect the people of Puerto Rico from disorderly actions taken by the creditors. The immediate stay granted by the bill on all litigation is of the utmost importance in this moment. Most importantly, the authority to adjust our debt stock provides the legal tools to complete a broad restructuring and route Puerto Rico’s revitalization.

On the other hand, PROMESA has its downsides. It creates an oversight board that unnecessarily undercuts the democratic institution of the Commonwealth of Puerto Rico. But facing the upsides and downsides of the bill, it gives Puerto Rico no true choice at this point in time.

On July 1, 2016, Puerto Rico will default on more than $1 billion in general obligation bonds, the island’s senior credits protected by a constitutional lien on revenues. Creditors and bond insurers have initiated multiple lawsuits and last week, hedge funds filed an injunction before the Southern District of New York claiming the “absolute highest priority” over government resources, including those needed for essential public services. That complaint minces no words and states that, in “times of scarcity,” bondholders should be paid before essential services.

No amount of contingency planning can shield us from the fallout of the defaults in the coming days; no amount of contingency planning will replace the necessity of a debt restructuring regime. We have suffered a decade of economic contraction. We are facing a government less capable of providing the services which the public needs.

As governor, I will use my remaining time in office to benefit from the tools provided by PROMESA and develop a fiscal plan that is faithful to the best interests of the people of Puerto Rico.”

The most important provision of the bill for the Commonwealth stays any litigation against the Commonwealth related to the default. Now the Commonwealth will feel free to move the political fight to focus on the makeup of the oversight board. We see that as a crucial piece in assessing the long-term likelihood of success of any restructuring agreement. Without strong and binding oversight, we can easily see the Commonwealth slipping back into its old ways of lax fiscal policies and poor disclosure. The pressure to do so will be immense. That would be a formula for disaster.

ILLINOIS

As we go to press, the Illinois legislature and the Governor were still negotiating over a budget plan that would at least allow the state government to continue to operate. The process continues to be conducted in a highly contentious and partisan manner. While there are signs of progress, enactment is far from certain. There are two basic proposals in play currently.

Senate democrats propose a full-year school funding plan increases state aid for elementary and secondary education by about $760 million, with no district losing money. CPS, would receive $287 million more in general state aid – a 30 percent increase over the current year. About three dozen of Illinois’ roughly 800 school districts receive a larger percentage increase. The plan would provides $112 million to help cover the employer contribution for Chicago teacher pensions. It authorizes more than $680 million for state operations, such as overdue utility bills . A measure in the House is expected to provide money for road construction and local governments’ share of gas tax revenues.

The Republicans countered with a full-year education plan which increases funding for schools by more than $240 million, with no district losing money but does not include money for Chicago teacher pensions or an increase in state aid for CPS. It does provide $729 million for state agencies to cover the cost of operating prisons, veterans’ homes and other facilities and to pay for road maintenance and repair, and gas and repairs for Illinois State Police vehicles. Additionally, it allocates $650 million for human services, including mental health care and autism programs. They would authorize spending for road and school construction, and provide money for local governments. Tellingly, it would not include any of the pro-business legislation Gov. Rauner has been holding out for, such as curbs to labor unions’ collective bargaining rights or term limits for lawmakers.

At this point, the process has entered the theater of the absurd. Universities are facing huge cuts and even closing, social service and health providers which are the main mechanisms in Illinois to provide such services are facing suspension or closure. One non-profit suing the Governor over lack of payment from the state is chaired by the Governor’s wife. Failure to resolve the budget should mark the end of Illinois’ status as an investment grade credit.

We will next publish on July 7. Celebrate the 240th anniversary of our country’s independence safely!

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.