Joseph Krist

Publisher

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ISSUE OF THE WEEK

LOS ANGELES UNIFIED SCHOOL DISTRICT

(County of Los Angeles, California)

$1,350,000,000

General Obligation Bonds,

(Dedicated Unlimited Ad Valorem

Property Tax Bonds)

Moody’s Aa2

The LAUSD is the nation’s second largest public school district. It has an an estimated enrollment for fiscal 2018 equal to 613,274, inclusive of 112,492 students enrolled in independent charter schools. It includes virtually all of the City of Los Angeles and all or significant portions of the cities of Bell, Carson, Cudahy, Gardena, Huntington Park, Lomita, Maywood, San Fernando, South Gate, Vernon, and West Hollywood, among other cities, in addition to considerable unincorporated territories devoted to both residential development and industry.

The general obligation bonds of the District are secured by an unlimited property tax pledge of all taxable property within the district boundaries. Debt service on the rated debt is secured by the district’s voter-approved unlimited property tax pledge. The county rather than the district will levy, collect, and disburse the district’s property taxes, including the portion constitutionally restricted to pay debt service on general obligation bonds.

Like many other older established urban districts, enrollment continues to decline. Nonetheless, the district faces significant capital needs if only to reduce overcrowding, eliminate multi-track calendars and reduce the number of portable classrooms from 10,000 to approximately 8,000. Going forward, capital projects will focus on modernization and repairs of aging schools coupled with addressing future needs for classroom capacity to support the district’s commitment to maintaining traditional school calendars and reducing the number of portable classrooms.

The district’s Aa2 rating is based on the perceived strength of district management and their demonstrated ability to guide the district’s finances through periods of revenue uncertainty, severe state budget challenges, and erosion in enrollment figures. While management has successfully addressed long-term fiscal challenges in the past, identified outyear budget gaps will require permanent, structural cost reductions to address budgetary imbalances and maintain current credit quality. The district has an exceptionally large and diverse tax base with steady growth expected over the medium term, but also must contend with the fact that its residents have a below-average socioeconomic profile. Improved state funding, including one-time revenues, has supported increases in the district’s general fund reserves and liquidity.

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TRUMP ENDORSES GAS TAX INCREASE

In a closed-door meeting on infrastructure with members of both parties, Trump pitched the idea of a 25-cent increase in the gas tax and dedicating that money to improve our roads, highways and bridges. The tax on diesel would be increased likewise.

Republican congressional leadership opposes such an increase while groups like the US Chamber of Commerce endorses it. An increase would be useful and would bolster efforts to reinfuse the depleted federal Highway trust Fund. At the same time, a real plan would provide some provisions for alternative funding to gas taxes in light of impending technological changes to the auto industry.

The U.S. Chamber says the proposal would raise $394 billion, more than enough to pay for Trump’s $200 billion infrastructure plan and possibly even expand it further. The idea however, highlights the hurdles facing any effort at raising revenues for infrastructure just on one side of the partisan equation. The oil funded Koch network, adamantly opposes any increase in the gas tax.

BANK LOAN DISCLOSURE MUST IMPROVE

Over the last decade, municipalities have increasingly turned to direct loan from banks as an alternative to the issuance of debt in the public markets. The municipal market has been debating for some time how much disclosure about the provisions included in bank loans should be required. he issues surrounding the loans include the potential adjustability of the interest rates and terms of the loans and the resulting impact on the respective positions of holders of existing bonded debt. these holders can, in the absence of disclosure about the loans, find themselves either in junior lien positions relative to the bank lenders or with much larger parity claims than they were led to believe existed.

The various players in the discussion have taken expected positions. Investors want more disclosure, issuers cite the costs of disclosing, and lenders seem to be opposed primarily for competitive reasons. The arguments have become tiresomely predictable. This discussion is being revisited and amplified with the news that many bank loan agreement “gross up” provisions are being triggered as the result of the recent changes in the tax laws.

Specifically, many of the underlying loan agreements between bank lenders and municipalities contain provisions which provide for increases to the interest rate on loans in the event of legal changes which are determined to have reduced the value of the loans. The corporate tax cuts are one such item. After the tax law lowered the rate on taxable income, the relative value of loans to municipalities was adversely impacted. In that event, the banks are entitled to raise the rates to “gross up” the total value of the loan asset. Many municipal borrowers are being informed of the new higher rates and are calculating the new higher cost of debt service on the borrowings from banks.

To the detriment of bond investments, there is no current requirement that municipal borrowers disclose the details of these loan documents or disclose the amount of increase in their associated debt service requirements. depending on the size of the loan, these increases may be substantial. Should they be disclosed, investors could make their own determination as to the resulting impact on an individual municipality’s ability to pay and on its projected budget results. this would enable the investor to make a more informed determination as to the market value of the bonds they own. Instead the details of the loans remain shrouded in mystery, leaving investors in the dark about debt service costs, lien positions, and other repayment terms competing with their interests as creditors.

So what can be done about this? As has been the case throughout the last four decades of municipal finance, the issue is unlikely to change until investors – especially those purchasing new issues in size – demand full disclosure of this information as a condition of purchase. Insist that this become a documented disclosure issue in official statements, bond reporting covenants, and reports issued to and posted on the NRMSRs. Until such pressure is applied on a consistent basis, the market will remain inefficient and slanted against the interests of investors.

GOVERNOR PROPOSES ILLINOIS BUDGET

As required under the Illinois Constitution, the Governor has submitted a state budget to the General Assembly for the upcoming fiscal year. The budget proposes reforms to save $1.6 billion to balance the fiscal year. An important assumption is that economic growth will foster revenue growth. The recommended budget, including all proposed structural reforms, achieves a surplus for fiscal year 2019. After two fiscal years without an enacted budget, fiscal year 2018 was marked by the General Assembly’s enactment of a full budget. The legislature overrode the Governor’s objection that their budget was built on the back of a $4.5 billion income tax increase, $6 billion in long-term debt, and a continuing backlog of unpaid bills expected to be $7.5 billion at the end of the fiscal year.

The Governor proposes that the General Assembly consider two positive options – apply the surplus towards the bill backlog to pay down current operating obligations or rollback 0.25 percent of the income tax rate for Illinois taxpayers starting in fiscal year 2019. By implementing the consideration model, Illinois could realize immediate relief in the form of a tax cut.

The Governor’s priorities are clear. Fiscal year 2019 marks a record level of funding for K-12 education and includes $6.834 million for the second year of evidence-based funding. It increases early childhood education funding 55 percent from 2015 levels, continues Monetary Award Program (MAP) grants for college students, and provides new capital funding for deferred maintenance and repair of university and community college facilities. There are increases in funding for police, corrections, and criminal justice. At the same time it leaves flat spending for children’s and family services, food for the elderly, and Medicaid.

So education, public safety, and tax reductions are the main priorities. Given the State’s difficulties in recent years in generating sufficient revenues, these priorities may be a loggerheads with each other. The budget also reflects the Governor’s generally antagonistic stance towards the state’s workforce.

On the capital side, the plan provides $2.2 billion in pay-as-you-go (non-bonded) funding for the Department of Transportation’s annual capital road program. On the labor and pension sides, the Governor proposes group health insurance program changes allowing employees options for different health insurance packages with varying levels of benefits and premium costs, reintroduces the Governor’s proposal for a consideration model that offers benefit options to retirement system participants of the State Employees’ Retirement System, the Teachers’ Retirement System and the State Universities Retirement System as a means to contain long-term pension costs, and begins the incremental shift of payment responsibility for the normal costs of pensions to the school districts and institutions that employ the participants in the Teachers’ Retirement System and the State Universities Retirement System.

The impact of these changes would be to shift insurance and pension costs from the state to employees and to lower levels of government and state institutions. In fiscal year 2019, universities, community colleges and school districts would begin to pick up 25 percent of the normal pension cost for their employees who participate in SURS and TRS. Then, over the next three fiscal years, they would pick up an additional 25 percent each fiscal year until they become fully responsible for the normal pension costs related to their employees. The total cost realignment in fiscal year 2019 would be $363 million. Currently, the state pays the retiree health insurance costs for all retirees of TRS and SURS. The fiscal year 2019 budget proposes no direct state funding for retiree health benefits for retirees of TRS and SURS.

Additional education funding is provided in fiscal year 2019 to help defray these realigned costs. This is meant to offset the increased costs to local school districts. In many districts the increased aid is less than the increase in costs. These would have negative impacts on the credits supported by taxes and revenues generated by those governments and institutions. In other words, tax increases and tuition rises.

At the same time, the state credit would continue to be impacted by the fact that the unfunded pension liability has reached $129 billion, and the annual pension contributions for fiscal year 2019 from general revenue will be $7.9 billion unless changes are enacted. The bill backlog hovers around $8.5 billion—down from $16.5 billion in November 2017, when the state borrowed $6 billion to pay it down. In the 20 years from 1996 to 2016, annual contributions to the five state pension funds grew more than ten-fold, from $614 million to $7.6 billion. While pension and health benefits constituted just 7.5 percent of the budget in 2000, they now take up 25 percent of the budget.

Enrollment in Medicaid increased by 1.8 million—a 130 percent increase—between fiscal year 2000 and fiscal year 2016. Illinois now has nearly one-quarter of its population—more than 3.1 million people— enrolled in Medicaid. The growth trend in enrollment has reversed somewhat in recent years as the ACA has taken effect. Federal financial support for the expansion of Medicaid under the ACA will drop from 94 percent of costs in fiscal year 2018 to 93 percent in fiscal year 2019 to only 90 percent in fiscal year 2020 and thereafter.  the fiscal year 2019 budget includes a 4 percent reduction in current rates paid to providers, excluding prescriptions and community health centers. The budget also utilizes managed care.

One time items are also included in the budget balancing scheme. The divestment of the James R. Thompson Center (JRTC) is projected to  achieve net proceeds of $240 million in fiscal year 2019 and avoid deferred maintenance expenses estimated in the hundreds of millions of dollars over the next 10 years.

On what are revenue projections based? Fiscal year 2018 are projected to be $36,783 million, an increase of $6,450 million, or 21.3 percent from actual fiscal year 2017 revenues. This increase primarily reflects an increase of $4,501 million in individual income tax and corporate income tax revenues due to the increases in the individual income tax rate from 3.75 percent to 4.95 percent and the corporate income tax rate from 5.25 percent to 7.0 percent, effective July 1, 2017. Individual income taxes deposited into the general funds are estimated to total $17,610 million, while corporate income taxes are estimated to total $1,884 million for fiscal year 2018. These estimates include an estimated $1,217 million to be deposited into the Commitment to Human Services Fund and the Fund for the Advancement of Education. These numbers also reflect the impact of the direct deposit of income tax revenue sharing with local governments, estimated to reduce income tax deposits to the general funds by $1,140 million in fiscal year 2018.

Net sales tax revenue deposits into the general funds are estimated to total $7,951 million, reflecting the impact of the deposit of $448 million directly into local transit funds instead of being deposited into the general funds first. Revenues from other state sources, including Public Utility Taxes, are expected to total $3,328 million. Federal sources are projected to increase to $3,418 million in fiscal year 2018 from the fiscal year 2017 total of $2,483 million. Use of the proceeds from the November 2017 backlog borrowing to pay down prior year Medicaid liabilities is expected to add an additional $1,206 million to fiscal year 2018 totals. This additional amount is not included in the base resources for fiscal year 2018 as it is attributable to the payment of prior year liabilities. Transfers in, not including amounts from fund reallocations or interfund borrowing authorized in PA 100-23, are projected to increase to $1,718 million in fiscal year 2018 from fiscal year 2017 results of $1,542 million.

It would not be a surprise to see a most contentious budget adoption process. The state’s politics – always complicated – will be more so this year with the Democratic primary guaranteed to yield a wounded yet well funded candidate. How much leverage the traditional budget adversaries will have this year is not clear. The lack of clarity will make the process that much more difficult to favorably resolved. We believe then that the risk to the State’s credit remains weighted to the down side regardless of the perceived improvement in the State’s credit due to its recent year end bond sale.

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.