Muni Credit News August 23, 2016

Joseph Krist

Municipal Credit Consultant


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With the start of the school year looming just around the corner, education facilities come to mind. The low rate environment and the steady demand for higher yielding issues has led to a steady stream of charter school financings. For investors new to the sector, here’s a little primer.

The first law allowing the establishment of charter schools was passed in Minnesota in 1991. There are approximately 6,700 charter schools now. The basic criteria for these offerings are based in demand for seats, the supply of seats in a given area, the quality of the management of the school from both a financial and educational standpoint, the nature of the assets pledged, and the security for those assets in favor of the bondholder. More subjective criteria include the sponsorship of the particular school, their level of participation and oversight, and their record of academic results both at the individual school securing the bonds and at other schools they own or sponsor.

What nearly all of these credits have in common is the reliance on state per capita aid payments which are based on statutorily established formulas. Usually, a minimum  percentage of the student enrollment must regularly attend a school and an amount of aid for each of those pupils is appropriated by the state and delivered by the state to the school. These monies are the predominant source of revenues pledged to the bondholders.

So what are the risks to this revenue stream?  There are several. The state aid payments may be diminished if a school does not maintain attendance at the proscribed levels. The aid payments may be diminished if, for a variety of reasons, the state does not make the required annual appropriation of these monies. They can be diminished by formula changes enacted by the legislature or other changes to state per capita aid payments enacted for reasons having nothing to do with an individual school. Perhaps the biggest risk for bondholders is the possibility that a school’s charter may fail to be renewed or revoked in the event of academic or financial management deficiencies.

The risk of closure due to academic non-performance is real. One example is Michigan. Michigan was an early and enthusiastic participant in the charter school movement. The program in that state has existed since 1993. Currently, there are 302 charter schools in the State. Since the inception of the program in 1993 however, the charters of 108 such schools have been revoked by the State.

Charters are issued to each school by oversight entities established under state law. They are issued for varying amounts of time usually three, five, or ten years. What is important to bondholders is the fact that the charter usually is shorter than the maturity of the bonds. This exposes the bondholder to all of the financial risk associated with a school which loses its charter or other accreditation. It is the responsibility of the sponsor of each school to meet the criteria for charter renewal and to take the necessary remedial steps to address changes in charter status.

Should a school be unable to operate or operate in a financially deficient manner, the facilities are usually pledged to the bondholders under a first mortgage in their favor. This is a remedy which comes with some practical limitations. Often the building housing the school is on land  which is not part of the pledged assets, and some facilities are limited as to what purposes the facilities may be used. There can be zoning or other restrictions which limit the use of the facilities. This often limits the marketability of pledged property in the event of a liquidation. These are important factors in determining the actual value of a pledged asset.

For all of these reasons, many of these credits are rated below investment grade and are marketed to only qualified institutional investors. Hence the presence of these credits in so many high yield mutual fund portfolios. For the individual investor, these credits do provide additional income but they require a good deal of research and monitoring to avoid the kind of workout situation for which individual investors are generally unsuited.


Eight months after downgrading it to Baa1, Moody’s has upgraded Pennsylvania’s school district pre-default enhancement program to A2 from Baa1. It also raised the maximum rating on school district bonds enhanced under Pennsylvania’s post-default intercept to A3 from Baa1. The upgrades incorporate a law Pennsylvania passed on July 13 that would provide for state funds to be intercepted and diverted to bondholders in the event of a default even without appropriations due to school districts.

The law eliminates the doubts about the program’s swiftness and effectiveness that arose during the commonwealth’s fiscal 2016 budget impasse, during which school districts operated for months without any appropriations due to them, and therefore no funds available to be intercepted to prevent or cure a default. With the new law in place, funds will always be available to prevent or cure defaults, regardless of whether the commonwealth has passed a budget.

This upgrade is more justified than was the recent credit upgrade for the state. The law on which this upgrade is based is clearly an identifiable structural change. It does not reflect any perception that financially the credit is any stronger. (See the 8/9/2016 MCN for our views on the Commonwealth’s financial outlook) The move is a benefit for the school districts which depend on the program, especially a credit challenged one like Philadelphia.


One of the expected results from the pressure to reduce costs on providers under the Affordable Care Act was a wave of consolidation in the industry. One example of that trend is the merger of two major West Coast health systems. Providence St. Joseph Heath  is a multistate, not-for-profit healthcare system formed on July 1, 2016, and comprised of Providence Health System and St. Joseph Health System. The organization is headquartered in Renton, Washington (the corporate headquarters of PHS) and has a second base of operations in Orange County (the corporate headquarters for SJHS). PSJH is co-sponsored by Providence Ministries and St. Joseph Health Ministry, and is active in Alaska, Washington, Oregon, Montana, California, and Texas. Pro forma annual revenues is approximately $21 billion. Altogether, Providence St. Joseph Health will have $6.4 billion total debt outstanding after closing on a pending bond issue.

The combination results in a  large, mostly contiguous, service area covering much of the western United States; a large consolidated pro forma revenue base of over $20 billion; a leading market share in most of its markets; an integrated care delivery platform which includes significant inpatient and outpatient services, employed physicians, and various health plan products; and an experienced, capable, management team with significant experience executing large and complicated affiliations.

For the pending bond issue, PSJH was assigned a Aa3 rating by Moody’s which is consistent with Providence’s pre-merger rating. St. Joseph was rated A1 pre-merger.


On July 1, 2016, a merger between two major providers in New Jersey closed. System are now Hackensack Meridian Health Network. HMHN is now one of the largest systems in the state. Hackensack is the largest provider in Bergen County, and Meridian Health System, is a sizable $1.9 billion integrated multi-hospital system in Monmouth and Ocean counties. The combination results in a $3.5 billion entity. The expectation is that synergies that will be realized over time will outpace the costs to capture such efficiencies.

This positions the ultimate credit –  the debt obligations of each system remain separately secured at this time – to ultimately be positioned for another upgrade. For now, Hackensack University Medical Center is upgraded to A2 from A3. This in spite of Hackensack’s historically high operating lease exposure declined following the debt-financed acquisition of a clinical plaza and parking garage which will reduce future lease expenses. While Hackensack has taken several steps to mitigate its growing pension liabilities and low investment returns, weakening the absolute measure of total debt relative to unrestricted cash.

One other major difference is that while HMHN is now bigger and more diverse, it still is exposed to potentials for change in state funding for Medicaid by having all of its facilities in the one state. The multi-state nature of Provident St. Joseph diversifies that risk.


The issues of rising tuition and student debt were front and center during the national political conventions. Proposals for student debt forgiveness and free tuition at public colleges were bandied about. Interestingly, it was the managements of small private colleges who were the most vocal in their concern about the possible negative impact of free tuition on the demand for small private colleges. In the last two years, the closings of Sweet Briar and Dowling Colleges made news in the municipal bond market.

Last week, Bard College, a well known small private college in New York saw its rating continue its three year plunge below investment grade. Moody’s lowered the rating on Bard’s $131 million of debt from Ba3 to B1. The downgrade comes on the heels of ongoing declines in total cash and investments decreasing spendable cash and investments further and an increase in debt, including amounts outstanding under lines of credit and lender financing incurred for the purchase of an historic site adjacent to the Annandale-on-Hudson (NY) campus. Bard is increasingly dependent on operating lines of credit, even as it expects to have violated financial covenants in the bank agreements again for FY 2016.

The ongoing depletion of liquidity and increased exposure to bank agreements heightens the prospects for a liquidity crisis in the absence of extraordinary donor support. With a cash flow from operations insufficient to cover debt service, prospects for a material increase in liquidity apart from collecting pledges receivable or benefiting from additional gifts remain slim. A settlement with the US Department of Justice for $4 million in FY 2016, is likely to result in more weak operating performance. One positive element is that the Bard Graduate Center benefits from an external trust that held $111 million in investments as of June 30, 2016.


Localities which have looked to private prisons as a source of revenues and/or jobs got a jolt last week when the U.S. Justice Department announced plans to end its use of private prisons.  A DOJ memo instructs officials to either decline to renew the contracts for private prison operators when they expire or “substantially reduce” the contracts’ scope. The goal is “reducing — and ultimately ending — our use of privately operated prisons.”

Officials concluded the facilities are both less safe and less effective at providing correctional services than those run by the government. “They simply do not provide the same level of correctional services, programs, and resources; they do not save substantially on costs; and as noted in a recent report by the Department’s Office of Inspector General, they do not maintain the same level of safety and security.”

There are 13 privately run privately run facilities in the Bureau of Prisons system, and they will not close overnight. The Justice Department will not terminate existing contracts but instead review those that come up for renewal. All the contracts would come up for renewal over the next five years.

The Justice Department’s inspector general recently released a report concluding that privately operated facilities incurred more safety and security incidents than those run by the federal Bureau of Prisons. The private facilities, for example, had higher rates of assaults — both by inmates on other inmates and by inmates on staff — and had eight times as many contraband cell phones confiscated each year on average, according to the report.

Private operators have said that comparing Bureau of Prisons facilities to privately operated ones was “comparing apples and oranges.” They generally dispute the inspector general’s report.

Three weeks ago the bureau declined to renew a contract for 1,200 beds at the Cibola County Correctional Center in New Mexico. Plans would allow the Bureau of Prisons over the next year to discontinue housing inmates in at least three private prisons, and by May 1, 2017, the total private prison population would stand at less than 14,200 inmates. According to the inspector general’s report, private prisons housed approximately 22,660 federal inmates as of December 2015. That represents about 12 percent of the Bureau of Prisons total inmate population, according to the report. By 2013, the private prison population was 32,000 but it began to decline because of efforts to adjust sentencing guidelines and to change the way low-level drug offenders are charged. DOJ said the drop in federal inmates gave officials the opportunity to reevaluate the use of private prisons.

The real threat will come if the Bureau of Immigration, Customs, and Enforcement follow the Justice Department’s lead. There are many rural jurisdictions which built facilities “on spec” to house illegal immigrants under occupancy based contracts with that agency. Many of the outstanding bonds were issued under those circumstances. Bonds secured by those payments would be immediately at risk if those contracts were not to be renewed. So, if you own bonds backed by payments from the federal government for prisons financed with local certificates of participation be very alert to any moves by ICE to follow the DOJ lead.

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.

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