Joseph Krist

Publisher

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ISSUE OF THE WEEK

$1,390,240,000*

Commonwealth Financing Authority

Tobacco Master Settlement Payment Revenue Bonds

Moody’s: “A1” (stable outlook)  S&P: “A” (stable outlook)
Fitch: “A+” (negative outlook)

The bonds are secured by a continuing appropriation of annual payments due to the commonwealth pursuant to the 1998 tobacco Master Settlement Agreement. In addition, like CFA’s $2.3 billion of outstanding debt, the bonds benefit from a continuing appropriation of the Commonwealth of Pennsylvania’s “Article II” revenues, composed of the state’s 6% sales and its 6% hotel occupancy tax. To the extent that the tobacco settlement revenue bonds would need to access the Article II revenues, their priority of payment claim on them is technically subordinate in timing to the outstanding CFA bonds.

Proceeds of the bonds will be deposited in the commonwealth’s general fund to close the $1.5 billion deficit it accumulated in its fiscal 2017 budget year (which ended June 30, 2017). That use of proceeds is the real credit issue here as it relates to the Commonwealth’s overall credit position. The risks of tobacco bonds as a credit are well known. the availability of additional tax revenue sources dilutes the reliance of the tobacco revenues alone thereby generating a stronger credit for these bonds. The use of proceeds is effectively the use of long term debt to finance current deficits which is a significant negative factor in the Commonwealth’s credit.

Pennsylvania historically relied on annual financing to fund operating deficits until the market began to significantly penalize the Commonwealth’s borrowing costs. The Commonwealth worked hard over a period of many years to end this reliance and only use financing for short-term purposes reflecting timing differences between the receipt and expenditure of revenues. This allowed the Commonwealth restore its ratings to the AA level so it is disappointing to see the politics of the legislative process result in backsliding on maintenance of a strong credit profile. The bonds will not address the Commonwealth’s refusal to effectively tax its natural gas extraction industry or its continuing need to find revenues to fund its growing pension obligations.

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PREPA PRIVATIZATION

A major change in philosophy towards the provision of basic services began to shape last week. in a televised address, the governor of Puerto Rico, Ricardo Rosselló, announced in a televised address that his administration is preparing to initiate the privatization of the utility’s power generation.. “The Puerto Rico Electric Power Authority [PREPA] will cease to exist as it deficiently operates today.” The sale of the public corporation’s assets to companies “will transform the generation system into a modern, efficient, and less expensive one for the people,” the governor said. He said ” One of the great impediments that has stopped our opportunities for economic development is the deficient and obsolete system of generation and distribution of energy on our Island. The Puerto Rico Electric Power Authority (PREPA) has become a heavy burden on our people, who are now hostage to its poor service and high cost. What we know today as the Puerto Rico Electric Power Authority does not work and cannot continue to operate like this.

The governor said the privatization process that “is about to begin” would last 18 months. It is proposed to consist of three phases, the first of which would be defining the legal framework through legislation, to then issue a request for proposals. The second is to evaluate the “technical, economic, and financial” merits of the submitted proposals. Finally, the terms and conditions for contracting the companies that have complied with the requirements would be negotiated.

The governor’s proposal includes a defined concession term for the distribution and transmission of energy to “end the monopoly of the production and sale of energy on the island and promote investment and competition for the benefit of customers as occurs in other jurisdictions in the United States.” The governor did not mention how the model affects the utility’s ongoing bankruptcy-like process under Title III of the Promesa federal law. However, the island’s fiscal oversight board had expressed being in favor of the public corporation’s privatization in August, which bodes well for the move to be presented in court.

We believe that given  PREPA’s unique market, its geographic limitations, and its probable lack of access to capital on its own for an extended period it makes sense for PREPA to consider its effective liquidation to a private entity which would provide better expertise as well as access to more reasonably priced capital. Effectively, the Commonwealth should take advantage of the unique situation that has resulted from hurricane Maria to take steps which have been historically untenable politically. PREPA can no longer be a prop to support employment and incomes. It must become the most efficient provider of its service possible. This includes not only basic service but also regulatory and environmental issues. The current conditions therefore present an “opportunity” that might not otherwise be exploitable.

It is not clear how much the Commonwealth could fetch in the market for these assets given the issues we discussed. Therefore, it is not possible to estimate what the monetary impact on the Title III proceedings would be or the potential return available to investors. Nonetheless, we see the effort to privatize as extremely positive for Puerto Rico’s long term economic viability. The utility would be much better positioned to be a support for economic recovery and development. Not only will it be better positioned from the standpoint of efficiency and cost, but also for an enhanced ability to access capital and employ the use of more modern renewable technologies. The positive impact of a privatization cannot be understated.

 THE INFRASTRUCTURE LEAK – SOMETHING ELSE WHICH NEEDS REHABILITATION

A leaked copy of the outline of the Trump Administration’s infrastructure plan retains the administration’s bias toward the private sector as the chief provider and/or beneficiary financially of infrastructure funding. Portions of the program will be overseen by the Department of Commerce. It’s various provisions in terms of project selection and provision clearly weigh the criteria in favor of private entities. Of course this is no surprise.

The ways in which it seeks to achieve that goal however, were surprising. To facilitate the attempt to employ private entities in traditionally governmental projects constraints on the use of municipal bonds to finance private activities would be loosened. These include categories of public purpose infrastructure, including reconstruction projects, to take advantage of PABs would encourage more private investment in projects to benefit the public. Notable is a proposed elimination of the AMT provision and the advanced refunding prohibition on PABs — this after the new tax law eliminated advanced refundings for all munis. The plan also calls for elimination of the transportation volume caps on PABs and expands eligibility to ports and airports, removal of state volume cap on PABs, provision for change-of-use provisions to preserve the tax exempt status of governmental bonds, and provision of change-of-use cures for private leasing of projects to ensure preservation of tax-exemption for core infrastructure bonds.

Incentives for states to spend will be established under formulae weighted toward projects with private participation and there are limits on the percentage of federal funding. The end result is a program which generates benefits for the private sector while shifting much of the cost of these projects to the states and localities. It seeks to loosen environmental reviews and encourages usage charges (tolls) to provide revenues for local shares.

The plan can be seen as constructive for bonds from the view of the financing side of the market but credit negative for the credit side of the market through its cost shift to the states. States and localities are encouraged to come up with more funds of their own while the tax code changes just enacted make it less attractive for taxpayers to support that choice. The debate has to start somewhere however, so now we at least have a starting point. The draft builds on support for relaxed PAB provisions as evidenced by the recent Warner-Cornyn bipartisan proposal just introduced. Their bill, the Building United States Infrastructure and Leveraging Development (BUILD) Act, they say would lead to additional investment in infrastructure projects by allowing state and local governments to enter into additional public-private partnerships to finance surface transportation projects.

Whether the proposal when it is formally released can garner enough support is not clear. Rural areas will want greater support for things like broadband provision and expansion above the proportions envisioned in the draft. States will be disappointed that traditional cost sharing ratios will be less favorably. The prime example of this would be the much discussed Gateway Tunnel. The proposed funding ratios in the draft plan would shift even more of the cost of this clearly necessary project onto the taxpayers and fare paying public in New York and New Jersey even though the trains using it serve a much wider area.

MEDICAID WORK REQUIREMENTS WHILE CHIP GETS FUNDING

The latest assault on Medicaid expenditures has begun.  The Centers for Medicare and Medicaid Services (CMS) announced that it had released landmark guidance aimed at allowing states to impose work requirements for Medicaid beneficiaries. Previously, no state has ever been able to get federal approval to impose work requirements on Medicaid beneficiaries. Kentucky became the first to receive approval from the Trump administration to impose work requirements as part of a broader overhaul of the state’s Medicaid program.

The decision is expected to be challenged through litigation. Under federal law, the Centers for Medicare and Medicaid Services needs to consider if a waiver is “likely to assist in promoting the objectives” of Medicaid. CMS officials emphasized that the work requirements would only apply to “able-bodied” adults, coming with exemptions for children, the elderly, pregnant women and people with disabilities.

Kentucky’s program also exempts “medically frail” individuals, such as people with cancer, blood-clotting disorders, or alcohol or substance abuse disorders. It will apply to the newly eligible Medicaid enrollees, who gained coverage only after the state’s previous Democratic governor expanded Medicaid. Kentucky would require able-bodied adults to complete 80 hours a month of community engagement to qualify for coverage. The engagement could include work, education, community service or job training. The new guidance from CMS, however, says many Medicaid beneficiaries should be exempt from work requirements: children, people with disabilities and people in treatment for substance abuse disorders. And the definition of “work,” according to CMS, should include job training, volunteering or caring for a relative.

In Kentucky, officials estimated up to 95,000 people would no longer have Medicaid at the end of the five-year demonstration. They attribute the low enrollment projections to those who would transition off of Medicaid because they enter the workforce, get a better job and higher wages and gain access to employer-sponsored insurance or other private insurance.

Nine states – Arizona, Arkansas, Indiana, Kansas, Maine, New Hampshire, North Carolina, Utah and Wisconsin – have applied for Medicaid waivers that include work requirements. Each applying state will have variations in the specifics of its plans. Kentucky will also freeze people’s coverage if they fail to report any changes in their employment or income – a problem for those employed in industries where variable hours are the norm. In Indiana, where similarly restrictive requirements exist it has been found that they tend to lead to a decrease in Medicaid participation and increased numbers of the uninsured. The head of CMS held a similar position with the State of Indiana under then Governor Mike Pence.

Arizona and Maine both requested five-year time limits on how long people could stay on Medicaid, and Wisconsin wants to drug test applicants. One item that is prohibited under Federal law is asset testing.  Maine would determine a person’s eligibility for Medicaid based on their property value and savings — not just their income.

The effort appears to be a part of an overall strategy that would be credit negative for states and counties. Every individual who falls off the Medicaid rolls becomes an increased share of the charity care burden that eventually costs states through subsidies to healthcare providers.

At the same time, there was one “silver lining” to the shutdown. As part of the agreement to approve a continuing resolution, the CHIP program was funded for the next six years. The program which insures the children of families with incomes of 200% or below the federal poverty line had broad bipartisan support but was caught up in the larger partisan budget battle for the current fiscal year. Every state has some form of the federally supported program and some 9 million children are estimated to be covered. In the grand scheme of things, the $14 billion total federal expenditure is not a real credit influence one way or another for the states. It is however, one positive action that moves in the opposite direction from the trend of diminished support for state funding responsibilities.

NEW JERSEY TRANSIT UNDER THE MICROSCOPE

Nearly half a million commuters who live and work in New Jersey rely on the New Jersey Transit Corporation (“NJ Transit”) for transportation to and from their jobs every day. The State’s operating subsidy in support of NJ Transit has decreased drastically over the last eight years, having dwindled from $348 million in Fiscal Year 2009 to $141 million in the current budget, and hitting a low of $33 million in Fiscal Year 2016. NJ Transit has correspondingly increased commuter fares, raising its fares an average of 36 percent since 2009, including a 25 percent increase in 2010 that was the largest in NJ Transit history. NJ Transit also has transferred over $7 billion from its capital budget to support operations since 1990, with $3.4 billion of such transfers occurring in the past eight years.

NJ Transit experienced the most accidents last year of any of the ten largest U.S. commuter railroads from 2011 to 2016. Some of these accidents have resulted in injuries and deaths, including the crash at Hoboken Terminal on September 29, 2016 and  NJ Transit also led the nation in mechanical breakdowns in 2015, with over 50 percent more breakdowns than the second-highest ranking railroad; and  NJ Transit is subject to a federally-mandated December 31, 2018 deadline for installing Positive Train Control technology.

As of the end of September 2017, NJ Transit had reportedly equipped less than 6 percent of its trains with the necessary technology, and had yet to operate the technology on any mile of track on any of its lines. Significant track repairs at Penn Station led to what was widely called the “summer of Hell” for commuters, where riders of the Morris-Essex line were diverted to Hoboken and faced with significantly longer commutes. Eeven after the summer of Hell ended, morning peak trains to Penn Station were on time only about three-quarters of the time in the month of September.

Clearly, New Jersey Transit is a troubled agency. Now, the new governor has ordered The Commissioner of Transportation, who also serves as Chair of the NJ Transit Board, to engage and direct one or more independent consultants to conduct a comprehensive strategic, financial and operational assessment of NJ Transit that will review NJ Transit’s current sources of funding, and an evaluation of whether the sources are adequate to meet both NJ Transit’s current operating needs and necessary capital upgrades. It will review the leadership structure at NJ Transit, including whether changes should be made to the board, the executive staff, and the line divisions to improve the decision-making process and establish best practices for corporate governance.  It  will review personnel hiring and protocols.

A proactive approach will improve the environment for debate and funding for what is clearly a crucial asset for the State economy. Reform and rationalization of the department is seen as a credit positive for the State.

FLINT OVERSIGHT BY THE STATE RELAXED

State Treasurer Nick Khouri announced changes for the city of Flint that grant the mayor and city council more governance authority and diminishes state oversight through the Flint Receivership Transition Advisory Board (RTAB). Effective immediately, the final emergency manager order outlining many of the responsibilities of elected officials and their cooperation with the RTAB has been repealed. The mayor and city council now have the ability to conduct most city business as outlined under the City Charter without state oversight.

The state Treasury Department’s actions follow a recommendation by the Flint RTAB to further move the city out of receivership and to continue the process of transitioning to full, local control. The Flint RTAB will still meet as needed to review proposed and amended budgets, requests to issue debt and proposed collective bargaining agreements. In November 2011, a Financial Review Team concluded a financial emergency existed in the city and there was no satisfactory plan in place to address the city’s fiscal problems.

An emergency manager was present from November 2011 to April 2015, when the financial emergency was resolved and the Flint RTAB was appointed to oversee the city’s transition back to local control.

Regardless of the future results for the City’s finances, the oversight by the State will always be remembered for the unfortunate decision to replace the City of Detroit’s water system as the source of drinking water for the residents of Flint. The decision resulted in the City’s water supplies being compromised to the point where they had to be replaced by bottled water. The incident was characterized by an arguably negligent response by the State’s environmental oversight apparatus which has led to litigation and the filing of criminal charges against individual state officials.

It also supported a level of mistrust on the part of citizens in the system of state oversight in the case of local financial distress. For the citizens of Flint, the path to relaxed state oversight has been far too long.

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.