Joseph Krist

Publisher

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ISSUE OF THE WEEK

What caught my eye this week was not the underlying credit stories behind some of the deals but the number of sizable in the water sector.  The condition of older water systems and threats to local supplies as the result of infrastructure deterioration will likely drive more rather than less difficulty with issue surrounding the state of repair of the infrastructure. This week Los Angeles, Philadelphia, and the New York State Revolving Fund all provide examples of the service needs of varying types of systems.

Los Angeles which is dealing with long term supply concerns, the impact of droughts (climate change), and a continued growth in population reflect those issues. Philadelphia must deal with the constant need for upkeep of physical plant to insure delivery reliability and water quality. The NYS revolving fund program allows smaller often rural systems a source of financing for their water infrastructure needs. A small NY community was in the news in recent months over contamination issues with the community’s drinking water supply.

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S&P EXPLAINS ITS RECENT CHICAGO RATING ACTIONS

It is understandable that a criteria change at a rating agency which results in a significant downward adjustment in ratings is frustrating to issuers and bond holders alike. The latest instance in which such an action has occurred is in S&P’s treatment of the sales tax revenue bonds. Late last month, S&P lowered the rating of Illinois’ Build Illinois senior- and junior-lien sales tax bonds to ‘BBB’ from ‘AA-‘.

When the Build Illinois bonds were first issued they were hailed as a way to provide a secure and lower cost credit that would be somewhat insulated from changes in the general credit standing of the State of Illinois. As the state’s overall credit fundamentals of the State deteriorated over time, Build Illinois bonds provided a bit of a safe haven for investors. With this criteria change and its attendant negative impact on ratings, this is no longer the case.

So what has changed? The criteria change reflects a view that deterioration in an issuer’s general creditworthiness can reflect a diminished capacity to make all payments, including debt statutory or contractual claim on revenues with a higher priority than competing claims. Priority lien ratings factor in the fundamental credit quality of the obligor, not solely the revenue stream pledged to the bonds. Under the new criteria, a priority lien rating is limited to a maximum of four notches above the obligor’s creditworthiness (captured in an issuer’s general obligation [GO] rating), and four notches can only be attained in limited circumstances.

S&P cites the fact that the issuing entity collects its own priority-lien revenue and the revenue is used for general operating purposes (i.e., there is no lockbox arrangement). Second, after the priority-lien obligations are satisfied, there is no meaningful limitation on the use of the revenues. S&P takes the view that the State’s funding of pensions was a violation of state law which raises concerns about willingness to pay, despite legal structures supporting payment of the Build Illinois bonds. S&P notes that Illinois would first look to local share sales tax revenue reductions or violations of state law in times of liquidity distress.

Nonetheless, despite the level of coverage (1.82x) and favorable history of funding debt service the rating on the Build Illinois bonds is now tied directly to that of the State. The rating on the bonds now will move in tandem with the State’s GO ratings. So much for the insulation from the State’s problems which the credit was designed to address.

As for the Chicago the Sales Tax Securitization Corporation (STSC), Ill.’s outstanding sales tax securitization bonds issued for the city of Chicago, a different view prevails. S&P cites the Illinois Public Act 100-0023 authorization for home rule municipalities to sell their interest in revenues or taxes received from the state of Illinois to special purpose entities. This is meant to insulate bond holders from operational risk associated with Chicago.

Illinois Public Act 100-0023 authorizes home rule municipalities to sell their interest in revenues or taxes received from the state of Illinois to special purpose entities. The Illinois Department of Revenue collects revenues and then passes them directly to the corporation or its bond trustee. There is a legal opinion that  once sales taxes are sold, they are no longer property of the city and would not be treated as such in a bankruptcy case.

PENSION CHANGES IN ARIZONA

In 2017, the state enacted legislation which made numerous changes to benefits offered under the Corrections Officer Retirement Plan (CORP). Many participating employees in the CORP hired after 1 July 2018 no longer receive defined benefit pensions, which will gradually reduce pension risks, for the state and other sponsoring governments, associated with investment performance and employee longevity.

In aggregate, participating employers in CORP must currently contribute 29% of payroll to the pension system, 21% of which is to amortize past unfunded liabilities. In comparison, employer contributions to the defined contribution plan are only 5% of payroll, with no risk of future unfunded liabilities developing. New cost-of-living adjustment (COLA) formulas will apply prospectively to current employees and retirees.

The key to these changes is their prospective nature. Making changes going forward typically gets around statutory and constitutional issues which speak to the diminishment of benefits for retirees. There usually is no prohibition against changes made on a going forward basis. So when we look at the debate around public employee pensions, we wonder why so many jurisdictions spend their time spinning their wheels trying to diminish vested benefits when they could take the immediate step of closing existing schemes and imposing new terms for new employees while adjusting benefits on a going forward basis.

Had these types of steps had been taken there would still be a significant problem requiring substantial resources in the future. The scale of the problem would not be as severe as it is. Jurisdictions which have taken the approach of tiered benefits schedules are better off than those which have not. Even a union friendly state like New York has successfully implemented tiered approaches to pensions without producing the adversarial approach which so many states and municipalities currently face.

WHEN LOSERS ARE WINNERS

In the aftermath of the apparent decision by Amazon to build new headquarters facilities in northern VA and in New York City, the notion of whether or not those cities which did not make the cut actually win in the long run has taken hold. Those who believe that the Amazon facilities would be at best a mixed blessing are noting that both markets are already facing significant negative impacts in the form of increased demand on already overburdened housing stocks and mass transit systems.

Both proposed sites have much in common in terms of location near major centers of finance and politics. They both have significant cohorts of educated and younger workers. The areas both have significant rapid transit infrastructure. Both of those transit systems are however, better known for their poor service and deteriorated infrastructure. The adjacent airports are both slot limited and, while the closet to their respective downtowns are also limited as to their scope of service due to their small size relative to current airport designs.

Only time will tell if the way to win this competition was to lose competitively. It will be interesting to watch.

“Health care was on the ballot, and health care won.”

This is true from just about any perspective. Medicaid expansion won in the three states with initiatives designed to accomplish the task. It also won in terms of the election of governors in states like Maine where outgoing governor Paul Le Page has fought requirements to expand Medicaid pursuant to a 2016 initiative. Kansas elected a Democratic governor who supports the expansion of Medicaid. While the Trump Administration will continue its assault on the Affordable Care Act, we believe that the ballot box will out.

So who benefits? The provider system which will always be better off if everyone has insurance. Any reduction in the reliance on the emergency room as the primary patient entry point to healthcare system is a credit positive. The hospital sector will step back on stage and allow the pharmaceutical industry to occupy center stage in the effort to control healthcare costs. With the Administration and Congress in broad agreement on the need to lower prescription drug costs, we would expect to see a legislative effort in that direction.

When hospitals return to center stage, issues like the restoration of disproportionate share (DSH) payments for rural and safety net providers. Small rural hospitals can hope to get some relief through state expansion of Medicaid and restored DSH payments. There is a real crisis in the rural healthcare space which is now a significant source of default in the healthcare sector.

CALIFORNIA REVENUES

State Controller Betty T. Yee reported the state received $6.57 billion in revenue in October, falling short of assumptions in the 2018-19 fiscal year budget by 5.9 percent, or $412.2 million. This month, sales tax was the only major revenue source to come in higher than projected in the enacted budget. Personal income tax (PIT) and corporation tax –– the two other revenue sources in the “big three” –– were lower than assumed in the enacted budget.

Four months into FY 2018-19, revenues of $35.28 billion are 3.0 percent ($1.02 billion) higher than projected in the budget enacted at the end of June. Total revenues for FY 2018-19 thus far are 8.1 percent ($2.63 billion) higher than through the first four months of FY 2017-18. Sales tax receipts of $1.03 billion for October were 8.2 percent ($77.9 million) more than anticipated in the FY 2018-19 budget.

For October, PIT receipts of $5.13 billion were 8.4 percent ($472.0 million) less than expected in the FY 2018-19 Budget Act. October corporation taxes of $254.8 million were 10.9 percent ($31.1 million) below FY 2018-19 Budget Act estimates.

CHARTER SCHOOLS FACE HEADWINDS

One under the radar issue is the potential impact on the charter school movement and industry in light of the revised post-election map. The turnover of seven governorship and an increase in Democratic Party control would seem to result in a slowing of momentum for the industry. In some states, the issue was a significant one in the governor races.

Wisconsin’s rejection of Gov. Scott Walker replaces him with a much more union and public education friendly governor. Illinois Governor elect Pritzker is in favor of slower creation of charter schools and the incoming governor in Michigan has explicitly opposed the policies (pro charter) of Michigan resident and education secretary Betsy deVos.

For charter school operators the potential for more regulation and transparency in terms of their results and finances is seen by some as an unwelcome burden. That is the most likely significant result of “regime change” at the state level. The new regulations could include more stringent requirement and supervision of the provision of facilities to accommodate the disabled.

 

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