Joseph Krist

Publisher

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ISSUE OF THE WEEK

$920,190,000

STATE OF ILLINOIS

General Obligation Refunding Bonds

Moody’s: “Baa3” (Stable Outlook)
S&P: “BBB-” (Stable Outlook)
Fitch: “BBB” (Negative Outlook)

The refinancing of state debt at more favorable terms is always a positive. That is not what we see as the important part of this effort to come to market. In this case, the focal point should be the nature of the disclosure included in the offering documents as it pertains to the State’s budget outlook.

From that perspective, the statement that the State has a structural budget deficit of $1.2 billion is important. While the State did enact a “balanced budget”, the level of the ongoing hurdles to be overcome to generate truly positive momentum for the State’s credit is important. The number indicates that regardless of the outcome of this November’s gubernatorial ballot, the next Governor and the Legislature have a significant road to hoe.

The structural deficit accompanies an ongoing backlog of unpaid bills estimated at $7.4 billion. So long as the State is unable to address its structural deficit the backlog will continue to serve as a significant drag on the State’s credit and ratings. In addition, the prospectus reminds investors once again of the magnitude of the State’s unfunded pension liabilities which plague not only the State but also its underlying municipalities and subdivisions. Overall the State’s unfunded liability position remains significant with an actuarial liability of $128.9 billion and a funding ration of 39.9%.

While the language dealing with factors which could potentially impact the State’s budget, we note that there is particular attention drawn in the document to the negative effects of US trade policy. Illinois, in addition to being significantly exposed to agricultural tariffs, is also impacted by tariffs on steel and aluminum which are significant manufacturing inputs to businesses in the State. In addition to raising costs of production and final products for domestic consumption, the trade war will negatively impact the State’s manufacturing sector. We take this view notwithstanding some isolated examples of manufacturing capacity being restarted in certain industries.

All of these factors place the enacted budget at significant risk of negative variance.

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GAS TAXES AND ELECTIONS

Ninety-six percent of state lawmakers who voted in favor of a gas tax increase and faced reelection in 2018 primaries will advance to the Nov. 6 general election, according to new data from the American Road & Transportation Builders Association’s Transportation Investment Advocacy Center. The 2018 primaries saw 802 legislators who voted on gas tax increase legislation from 12 states – California, Iowa, Indiana, Montana, Nebraska, Oregon, South Carolina, Utah, Oklahoma, Tennessee, Michigan and Washington – run for reelection. Of those lawmakers, 558 voted in favor of a gas tax increase and ran for reelection, with 538—or 96 percent—advancing to November’s general election.

The numbers include 97 percent of the 263 Democratic lawmakers, and 96 percent of 295 Republican lawmakers. Of the 222 legislators who voted against a gas tax increase and ran for reelection, 216—or 97 percent—will move on to November’s general election. This includes 96 percent of 52 Democratic lawmakers, and 97 percent of 170 Republican lawmakers. An additional 22 lawmakers did not cast a vote on a gas tax increase measure and ran for reelection.

Earlier findings from the advocacy group showed voting for a gas tax increase does not affect a lawmaker’s chance of reelection. In the 16 states that increased their gas tax rates or equivalent measures between 2013 and 2016, nearly all (92 percent) of the 1,354 state legislators who voted for a gas tax increase and stood for reelection between 2013 and 2017 were sent back to the state house by voters. Of the 712 elected officials who voted against a gas tax increase, 93 percent were also given another term.

The stats seem to show that excuses for not raising gas taxes over time have been just that – excuses. With a 90% success rate for advancement in the primaries occurring regardless of one’s voting record on gas taxes, it seems somewhat obvious that gas taxes just aren’t an issue. We suspect that gas tax levels matter far less than healthcare, education, and whether or not one has a job. Gerald Ford once said that the inflation rate doesn’t matter if you don’t have an income.

SEQUESTRATION TO IMPACT DIRECT PAY BONDS

Pursuant to the requirements of the Balanced Budget and Emergency Deficit Control Act of 1985, as amended, refund payments issued to and refund offset transactions for certain state and local government filers claiming refundable credits under section 6431 of the Internal Revenue Code applicable to certain qualified bonds are subject to sequestration.

This means that refund payments and refund offset transactions processed on or after October 1, 2018, and on or before September 30, 2019, will be reduced by the fiscal year 2019 6.2 percent sequestration rate. The sequestration reduction rate will be applied unless and until a law is enacted that cancels or otherwise affects the sequester, at which time the sequestration reduction rate is subject to change.

These reductions apply to Build America Bonds, Qualified School Construction Bonds, Qualified Zone Academy Bonds, New Clean Renewable Energy Bonds, and Qualified Energy Conservation Bonds for which the issuer elected to receive a direct credit subsidy pursuant to section 6431.

PREPA SETTLEMENT ONLY ONE STEP

It is hard to be optimistic about the long term financial outlook for Puerto Rico. In the case of PREPA, the electric utility, a proposed settlement with debt holders generates some encouragement but reality has a way of rearing its head at inopportune times.

The latest evidence of that is The Puerto Rico Comptroller’s Office finding evidence of irregularities in the electric power company’s fuel purchasing and payments for professional service. The report establishes that in eight contracts and an amendment for the purchase of $4.6 billion worth of fuel between 2008 and 2012, the Puerto Rico Electric Power Authority (PREPA) did not include in the contracts a clause to charge interest for delays. Despite the absence of this clause in the contracts, the utility disbursed $3.3 million to the suppliers. The audit of three findings indicates that $2.3 billion in payments were made to a company that had pleaded guilty to fraud in 2006.

“The Report states that a fuel supplier that filed and paid their Monthly Tax Return to the Department of the Treasury more than two years after the term established by the Law was identified,” the comptroller said.

Puerto Rico’s electric power restoration after Hurricane María mangled the island’s grid entailed an estimated $2.5 billion. The utility is now entering a phase that consists of improving the temporary work done to put the lights back on as quickly as possible, which means outages are imminent during the coming six months. “There will be one or more blackouts in one sector or another because we have to remove [utility] poles that aren’t installed in the best way. We’re going to be notifying people in time so they know when there’ll be some [work done] to be able to change their poles to firmer ones and do a job well done.”

THUMB ON THE BRIGHTLINE SCALE?

We are more than interested in the news that current Governor and Senate candidate Rick Scott and his wife invested at least $3 million in a credit fund for All Aboard Florida’s parent company, Fortress Investment Group, according to recently disclosed financial documents. One has to wonder what impact this decision, which generates the Governor some $150,000 in annual investment income has sweetened the environment for All Aboard Florida’s plan to expand service from Orlando to Tampa.

In 2011, Gov. Rick Scott canceled a $2.4 billion federally funded and shovel-ready bullet train from Orlando to Tampa because it carried “an extremely high risk of overspending taxpayer dollars with no guarantee of economic growth.’’ Now he thinks that such a venture is “a good idea”.  The Governor’s  investments are in a blind trust but most of his and his wife investments are held in her name limiting the disclosure requirements about his investments.

This is exactly the kind of thing that clouds the municipal finance universe. It’s not the first ethically challenged investment activity for the Governor. When he ran HCA, that for  profit hospital chain paid fines in excess of $1 billion to the federal government. While all parties deny that the Scott’s investments directly benefit from the ultimate success or failure of the Brightline, it creates an unsightly perception that moves the project from the realm of sound economic development to that of politicized investing.

It all harkens back to earlier times in the US where infrastructure development was influenced by the role of various private participants and investors. One could hope that those days were behind us but in the instance that does not appear to be the case. It is no surprise that privatization and public private partnerships are viewed through a skeptical prism by so many.

SEC ENFORCEMENT CONTINUES

The ongoing efforts by the Securities and Exchange Commission (SEC) to police the municipal bond market continue. The latest charges two firms and 18 individuals in a scheme to improperly divert new issue municipal bonds to broker-dealers at the expense of retail investors.  According to the SEC’s complaint, the defendants – known in the industry as “flippers” – purchased new issue municipal bonds, often by posing as retail investors to gain priority in bond allocations. The defendants then “flipped” the bonds to broker-dealers for a fee. The SEC also charged a municipal underwriter for accepting kickbacks from one of the flippers.

Many issuers require underwriters to give retail investor orders the highest priority when allocating new issue bonds, particularly retail investors within the municipal issuer’s jurisdiction. According to the SEC’s complaint, these defendants used fictitious business names, falsely linked their orders to ZIP codes within the issuer’s jurisdiction, and split orders among dozens of accounts. After acquiring the bonds, the SEC alleges that the defendants quickly resold them to broker-dealers, typically for a fixed, pre-arranged commission, and often sought to hide the flipping activity from issuers and underwriters by manipulating sales tickets.

Fifteen individuals charged settled the SEC’s charges without admitting or denying the allegations, agreeing to injunctions, to return allegedly ill-gotten gains with interest, pay civil penalties, be subject to industry bars or suspensions, and to cooperate with the SEC’s ongoing investigation. Three individuals face criminal proceedings.

The continued vigilance of the agency under the current administration is an overall positive for the market. With infrastructure demands increasing almost daily it is important that the municipal market be able to appeal to the widest range of investors. These efforts will help to increase the long-term attractiveness of the market to potential investors whether they be individuals seeking tax sheltered income or to non-traditional institutional investors looking to enter the market for the first time.

SOUTH CAROLINA PUBLIC SERVICE AUTHORITY DOWNGRADE FINALLY COMES

Moody’s Investors Service has downgraded the rating on the South Carolina Public Service Authority (Santee Cooper) revenue bonds to A2 from A1. The rating action is based on  consideration of the continued unstable governance with uncertainty about future rate setting as Santee Cooper operates without a board chairman. The downgrade also reflects the very high leverage that will persist for many years owing to the termination of the Summer Nuclear project which has introduced cost recovery challenges to Santee Cooper, particularly in the near-to-medium term. Another consideration in the downgrade is the continued uncertainty about the ultimate outcome of the litigation brought by Central Power Electric Cooperative (Central), Santee Cooper’s major wholesale customer that provides more than 60% of its revenues.

No legislative action was enacted in the 2018 session which curtails the Santee Cooper board’s unregulated authority to establish rates and charges to meet bond covenants in a timely manner. An existing state statute prohibits the state from doing anything including enacting new laws that would impact bond covenant compliance. An additional factor in favor of the rating is the fact that Santee Cooper does not have to immediately replace the planned Summer addition with a new generation. This would lead the fact that Santee Cooper does not have to immediately replace the planned Summer addition with a new generation. This would lead to an even more unfavorable debt profile which would further increase downward pressure on the rating.

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