Muni Credit News January 12, 2017

Joseph Krist

Municipal Credit Consultant

THE HEADLINES…

MOODY’S MOVES AGAINST RECALCITRANT ISSUERS

CALIFORNIA BUDGET PROCESS BEGINS

PENNSYLVANIA BUDGET BACK IN THE NEWS

PORT AUTHORITY FACES DISCLOSURE CHARGES 

INFRASTRUCTURE WILL BE A MESS

ILLINOIS PENSION NEWS

HIGH YIELD LOOKS AT SUBORDINATE TOBACCO DEBT

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MOODY’S MOVES AGAINST RECALCITRANT ISSUERS

Moody’s Investors Service has placed the ratings of 8 local government obligors on review with direction uncertain, affecting approximately $382.3 million of outstanding debt. In addition, the City of Ithaca, NY’s MIG 1 BAN rating has been placed on review for possible downgrade. The review is prompted by the lack of sufficient, current financial information. If the information is not received over the next 30 days, Moody’s will take appropriate rating action which could include the withdrawal or lowering of the ratings.

The action reflects a continuing crackdown by Moody’s against issuers who are unable or unwilling to provide complete, accurate, and timely financial information to support their ratings.  These actions have been welcomed by the investment community and ratings, especially those of smaller and infrequent issuers.

This round includes the following credits: Hampton (Town of) NH, Blooming Grove (Town of) NY, Bridgehampton Fire District, NY, Ithaca (City of) NY, Montebello (Village of) NY, Ramapo (Town of) NY, St. Lawrence (County of) NY, Northampton (Borough of) PA. The Town of Ramapo has a developing outlook reflecting uncertainty around the eventual outcome of the federal charges, including the possibility that the town’s financial position could be materially different than what was presented in previous audited financial statements.

CALIFORNIA BUDGET PROCESS BEGINS

Governor Edmund G. Brown Jr. today proposed a balanced state budget that eliminates a projected $2 billion deficit and bolsters the state’s Rainy Day Fund while continuing to invest in education, health care expansion and other core programs. In a letter to the Legislature, the Governor explained that while this year’s budget “protects our most important achievements,” it is also “the most difficult that we have faced since 2012” and “uncertainty about the future makes acting responsibly now even more important.”

Significant details of the Governor’s 2017-18 State Budget include: Without corrective action, this year’s budget would face a deficit of $1.6 billion, or 1.3 percent of annual spending. Without action, the state would face annual deficits into the future of about $1 to $2 billion. The two main factors causing this deficit are a revenue forecast that is $5.8 billion lower than expected and a current year shortfall in the Medi‑Cal program. The deficit would be billions worse if not for the passage of a number of ballot measures at the November election, including Proposition 52 (hospital fee), Proposition 56 (tobacco tax), and Proposition 57 (prison reform). Proposition 55’s extension of temporary income tax rates on the wealthiest Californians will begin to help balance the budget in 2018‑19.

As the economy and revenues were surging in recent years, budgets consistently upgraded revenue forecasts from the prior year. Yet, now, the January Budget is the second straight downgrade of revenue expectations over the past 12 months. The Budget reflects a revised revenue forecast that is $5.8 billion lower for 2015‑16 through 2017‑18. This represents a modest adjustment to expectations compared to the 2016 Budget Act—1.6 percent lower over the three years of revenues. Across the board, each of the state’s “big three” revenues — the income, sales, and corporation taxes — are showing weakness.

The budget proposes $3.2 billion in solutions to ensure a balanced budget. By tempering spending growth rather than cutting existing program levels, these actions minimize the negative effects on Californians. The solutions include adjusting Proposition 98 spending, recapturing unspent allocations from 2016 and constraining some projected spending growth. In total, General Fund spending remains flat compared to 2016-17.

Proposition 2 establishes a constitutional goal of having 10 percent of tax revenues in the state’s Rainy Day Fund. With a $1.15 billion deposit in the budget, the Rainy Day Fund will total $7.9 billion by the end of 2017-18, 63 percent of the constitutional target. While a full Rainy Day Fund might not eliminate the need for further spending reductions in case of a recession or major federal policy changes, saving now would allow the state to soften the magnitude and length of necessary cuts.

K-14 funding is expected to grow to $73.5 billion in 2017-18, up 55 percent – or $26.2 billion – from 2011-12. For K-12 schools, funding levels will increase by about $3,900 per student in 2017-18, over 2011-12 levels. Under the optional expansion provisions of the federal Affordable Care Act, the budget increases enrollment of this Medi-Cal population to 4.1 million Californians, with the state’s General Fund share of cost increasing from $888 million to nearly $1.6 billion.
Annual maintenance and repairs of California’s highways, roads and bridges are billions of dollars more than can be funded annually within existing revenues. The budget reflects the Governor’s transportation package, first proposed in September 2015, which would provide $4.2 billion annually to improve the maintenance of highways and local roads, expand public transit and strengthen critical trade routes.

All of this assumes that federal actions in terms of potential tax reform, healthcare changes, and other policy changes do not negatively impact the state. The reality that they most likely will. As such, the May revision to the budget will likely represent a substantial change from this blueprint and the final budget actually adopted could easily change again. It has been estimated that up to one-third of California’s budget is exposed to substantial potential impact from possible federal actions under a Trump administration and the new Congress.

PENNSYLVANIA BUDGET BACK IN THE NEWS

It will be nearly one month until Gov. Tom Wolf will formally present his proposed executive budget for fiscal 2018 but he did recently offer extensive comments to the press on his views of the environment for that budget in an interview with the Scranton Times Tribune which we summarize and excerpt.

Pennsylvania’s distressed cities can be helped by a three-pronged approach of providing school property tax relief, targeting state economic aid and easing municipal pension debt, Gov. Tom Wolf said.  He said there’s real interest in Harrisburg in achieving property tax relief and the key to success is getting a bill in the right form. It would help cities like Scranton by cutting the biggest tax bill that residents pay. “Places like Scranton would see a big drop in the tax bill and a big increase in property values,” said Mr. Wolf.

The House passed a bill last session to replace nearly $5 billion worth of property taxes with higher state income and sales taxes while the Senate narrowly rejected a bill to mostly eliminate property taxes with that same combination of higher state taxes. As examples of how state government can target aid to cities, Mr. Wolf cited recent grants of $2.5 million for a medical complex corridor in West Scranton, $2 million for the Innovation Squared program in downtown Wilkes-Barre and $3 million for the “Cornerstone Commons” project at Lackawanna College in Scranton through the Redevelopment Assistance Capital Program.

He said the state needs to be a partner in helping cities like Scranton escape from municipal pension debt. Bills to increase state oversight of troubled municipal pension systems didn’t advance beyond the committee level last session.

The governor said he has been able to work with GOP lawmakers in recent months on education funding and tackling the opioid abuse epidemic. Of note is the fact that Mr. Wolf said he won’t call for hikes in broad-based state taxes for the fiscal 2017-18 budget, thereby removing a major sticking point with GOP lawmakers that fueled a lengthy budget stalemate in his first year in office.

Mr. Wolf also discussed with the newspaper his stance on school aid, a severance tax and health care. State education spending has been restored to the level of fiscal 2011-12, before a wave of cuts, but he said that more needs to be done to help public schools, early education programs and community colleges and career programs. Having a state severance tax on natural gas production would help gas drillers win acceptance from residents living in regions of Pennsylvania that don’t have drilling yet face pipeline development. The MCN has discussed the peculiarity of the Commonwealth’s lack of a severance tax given the role of the fracking industry in the Commonwealth (see December 8, 2016 MCN).

In the face of the upcoming Congressional debate over the ACA and its potential replacement, the governor said he will do his best to protect some 700,000 Pennsylvanians receiving health care through an expansion of federally funded Medicaid as a GOP-controlled Washington vows to scrap the federal Affordable Care Act. Readers are referred to our January 3, 2017 MCN where we highlighted Temple University Health System’s role as a huge Medicaid provider.

Mr. Wolf’s comments came on the opening day of the 2017-18 legislative session amid a backdrop of expanded Republican majorities in the House and Senate.

PORT AUTHORITY FACES DISCLOSURE CHARGES

In our last issue, we highlighted the Port Authority’s upcoming 10 year capital program. So it was disturbing that right after we went to press, the Securities and Exchange Commission announced that the Port Authority of New York and New Jersey has agreed to admit wrongdoing and pay a $400,000 penalty to settle charges that it was aware of risks to a series of New Jersey roadway projects but failed to inform investors purchasing the bonds that would fund them.

The SEC’s order finds that the Port Authority offered and sold $2.3 billion worth of bonds to investors despite internal discussions about whether certain projects outlined in offering documents, including the Pulaski Skyway, ventured outside its mandate and potentially weren’t legal to pursue.  One internal memo noted, “There is no clear path to legislative authority to undertake such projects.” Another memo explicitly identified “the risk of a successful challenge by the bondholders and investors” in connection with the funding of the roadway projects.  But the Port Authority omitted any mention in its offering documents about these risks surrounding its ability to fund the projects.  Its offering documents stated that it issued bonds “only for purposes for which the Port Authority is authorized by law to issue bonds.”

“The Port Authority represented to investors that it was authorized to issue bonds while not disclosing significant known risks that its actions were not legally permitted,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office.  “Municipal bond issuers must ensure that their disclosures are complete and accurate so that investors can make fully informed decisions about whether to invest.”

The Port Authority is the first municipal issuer to admit wrongdoing in an SEC enforcement action. The SEC’s order finds that the Port Authority violated Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933.  The SEC’s order acknowledges the Port Authority’s cooperation and prompt remedial acts.  The projects at issue have proceeded as planned.

We do note that, at least in the NY/NJ metro area, there was very extensive press coverage of the fact that Gov. Christie’s use of the Port Authority to fund the Pulaski Skyway project was highly controversial and possibly illegal as the sale process was unfolding. Institutional investors certainly were aware of the risk at the time of sale.

INFRASTRUCTURE WILL BE A MESS

Learning anything about a Trump administration’s plans for the future from the current Senate confirmation hearings has been well nigh impossible. In the case of infrastructure, it’s a real struggle if proposed Transportation Secretary Chao’s responses are any indication. We did not hear confirmation of whether she favors the private sector to deliver infrastructure projects. We also learned nothing about what the administration considers infrastructure to be.

We do know however, what some sense of the Senate is. Ted Cruz advocates that the apportionment formula be adjusted to benefit Texas. Sen. Cory Booker thinks that that the Hudson River Tunnels carried the entire population of South Dakota between New York and New Jersey every day when the actual levels are some 20% of that number. Alaska Sen. Dan Sullivan cited how few roads his state had—fewer miles than Texas and even Connecticut—despite its size. I’ve been to Alaska and there aren’t many people to drive there.

West Virginia Sen. Shelley Moore Capito expressed that she was “concerned about how we’re going to be able to incentivize the private dollars to go to the less populated, less economically developed areas of our country?” And weighing in for the aforementioned South Dakota was its Sen. Thune who said “the urban-rural thing is my version of bipartisanship.” For those of us interested in infrastructure and its implications for municipal credit, it was not a hopeful exercise.

ILLINOIS PENSION STANDOFF

As we go to press, Illinois Governor Bruce Rauner has signaled a likely veto of newly passed legislation to stave off possible insolvency for two of Chicago’s pension funds. This will simply increase the pressure on the city’s ratings should it come to pass and further poison the state’s already toxic budget environment.

By a 41-0 vote, the Illinois Senate approved the proposed rescue, which cleared the House overwhelming in December. The plan would authorize new city funding for Chicago’s municipal and laborers retirement systems. As we have noted on multiple occasions, the systems are projected to run out of money in the coming decade and were depending on legislative sign-off of the city’s enactment of a water and sewer usage tax and telephone surcharge designed to help get them 90 percent funded in 40 years. City officials have acknowledged that more money will be needed starting in 2023 when payments will reach actuarially required levels.

“The bill essentially authorizes another property tax hike on the people of Chicago and sets a funding cliff five years out without any assurances that the city can meet its obligations,” the Governor’s spokeswoman said in a statement. “The governor cannot support this bill without real pension reform that protects taxpayers.” It’s not clear that this is news to anyone who follows Chicago’s finances and it is less clear how this contributes to a resolution of the state’s many other problems given that it is the Chicago Board of Alderman who take the real political hit.

Meanwhile, a bipartisan, statewide fix to Illinois’ $129.8 pension crisis did not get called for a vote in the Illinois Senate as part of a legislative plan to end an 18-month budget stalemate, pass non-budgetary reforms sought by Rauner and expand casino gambling, among other things. On a separate budgetary track, the House approved a $657.3 million appropriation plan for universities and social service agencies that lost spending authority on Jan. 1. The House-passed legislation that would fund operations through June awaits Senate approval, but Rauner has expressed past reluctance to support new stopgap spending without other reforms. A veto on the Chicago plan will serve to nearly ensure that those reforms won’t happen.

HIGH YIELD LOOKS AT SUBORDINATE TOBACCO DEBT

The City of New York’s tobacco securitization entity, TSASC, is planning to issue $495 million of subordinate tobacco securitization bonds. The deal was originally expected to close in November, 2016 but a several factors outside of a rise in interest rates intervened to make a closing at that time less feasible. These most prominently include a proposal by BAT (British American Tobacco) to purchase all of the stock of Reynolds American not already owned by BAT. Reynolds was an original producing manufacturer (OPM) under the Master Settlement Agreement securing the revenues pledged as security by issuers of tobacco bonds. Reynolds rejected BAT’s initial offer but would consider a higher offer.

It matters because such a transaction would increase the concentration risk related to  the financial ability of fewer but larger contributors to the settlement payment requirements. We don’t view this as a significant increase in the overall risk profile of tobacco bonds but ones as to which investors should make their own judgment as to how much industry concentration with which they are comfortable.

The deal represents the first substantial tobacco offering in an environment in which investors have received positive high yield returns and the sector is seeing positive flows after an extended period of the reverse. The subordinated bonds in this issue are unrated. We have always taken the position that senior lien tobacco debt from any issuer represents a speculative investment and one subject to valuation volatility. We believe that unrated subordinated tobacco debt carries with it those characteristics at a much higher level. As such, these bonds remains best appropriate as an institutional trading vehicle rather than an attractive opportunity for individuals.

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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