Muni Credit News January 3, 2017

Joseph Krist

Municipal Credit Consultant

Happy New Year to our readers! We begin the year with a view of what we think are the issues which investors should give primary attention to on their municipal credit radar screens.

THE HEADLINES…

PENSIONS WILL REMAIN FRONT AND CENTER

TECHNOLOGY WILL CREATE CREDIT RISK

HEALTHCARE UNCERTAINTY

WILL CHANGES IN ENERGY POLICIES HELP OR HURT?

WHAT WILL INFRASTRUCTURE ACTUALLY MEAN UNDER TRUMP?

P3 WILL BE THE BUZZWORD OF THE YEAR

CONNECTICUT, ILLINOIS, AND NEW JERSEY

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PENSIONS WILL REMAIN FRONT AND CENTER

Chicago, IL, San Jose, CA, Miami, FL, Baltimore, MD, Portland, OR. These five cities have the highest annual pension expenditure requirements as a percentage of revenues. Chicago’s is over 30%. Chicago, IL, Detroit, MI, Houston, TX, Portland, OR, Dallas, TX. These five cities pay the lowest proportion of required pension costs as a percentage of total  revenues. It is not an accident that Chicago (MCN 12/1/16) is the “leader” in both categories. It is merely a data based affirmation of what most investors already believe. It is why we believe that any upgrades of ratings or outlooks for the city are or will be premature.

Dallas (MCN 10/11/16) and Houston(9/29/16) will continue to be in the news for their pension problems. Benefit levels are a problem as are investment management deficiencies in both jurisdictions. What makes these situations interesting is that both cities ultimately have sufficient resources to finance these and capital needs. What is limited is their ability to access those resources without relaxing taxing limits established under the State Constitution. As is the case in other jurisdictions, they serve as an example of the reliance on state legislative action in order for localities to effect necessary financial changes.

And investors will have to increase scrutiny of the pension funding levels of other sorts of entities. The pension problems of Chicago’s water and sewer utilities have been well documented. Information released in the fall of 2016 shows that Boston’s transit system,  the MBTA, faces increasing investment difficulties as the result of poor overall performance and some very poor individual investment choices. All of these situations will pressure revenues at a time of increased resistance to fare box increases. No entity is immune to these issues.

TECHNOLOGY WILL CREATE CREDIT RISK

Allegheny County, PA as we have previously discussed was the victim of a hack for ransom that resulted in a $1400 payment.

Los Angeles County acknowledged that confidential health data or personal information of more than 750,000 people may have been accessed in a cyber attack on Los Angeles County employees in May that led to charges this week against a Nigerian national. The May 13 attack targeted 1,000 county employees from several departments with a phishing email. The message tricked 108 employees into providing usernames and passwords to their accounts, some of which contained confidential patient or client information, officials said.

Most of the 756,000 people whose information may have been accessed had contact with the Department of Health Services, according to the county. A smaller amount of confidential information from more than a dozen other county departments also was compromised. Among the data potentially accessed were names, addresses, dates of birth, Social Security numbers, financial information and medical records — including diagnoses and treatment history — of clients, patients or others who received services from county departments.

Recent press reports have documented a raft of problems with software used since August 2016 by the Alameda County criminal justice system. The resulting ” glitches” have resulted in a number of false arrests stemming from poor case status management, erroneous documentation, and other issues which potentially could lead to civil liability on behalf of impacted defendants. Depending on the scale of the problem, there could be significant liability for the County.

Each of these situations highlight an ongoing and increasing potential liability facing municipal credits stemming from technology. Tech is not an area which has traditionally received a high priority as a spending item for municipalities, especially smaller ones. We think that this is one area which needs additional attention going forward.

HEALTHCARE UNCERTAINTY

We believe that healthcare will be the greatest source of uncertainty in 2017. The Trump administration has signaled significant changes in Medicaid through its appointment of a conservative ideologue in the field to head the CMS, The Centers for Medicare & Medicaid Services. CMS administers Medicare, Medicaid, the Children’s Health Insurance Program (CHIP), and the Health Insurance Marketplace. She has worked with Vice President Pence in Indiana to impose payment requirements for recipients and stringent regulations which tend to reduce enrollment. Similar programs in other states have been abandoned due to what has been viewed as a poor cost/benefit result but it is likely that she will support this general policy direction.

This will occur with the uncertainty associated with the likely repeal of the Affordable Care Act as backdrop. There has been so much speculation about the timing and form of replacement, if any, that we would only be pretending to know what will result. Imagine how the CEO and CFO of any size hospital must be thinking. We can say that stand alone, small rural, and big city (Temple 10/25/16) Medicaid providers face the greatest uncertainty. “We were finally in a situation where for most of our patients there was a coverage option,” said Temple’s director of patient financial services, already speaking about the health law in the past tense. “Now there’s just a total unknown about what will be left.”

Diversely funded, geographically diverse providers would still be the credits to own as the process plays out. Cash on the balance sheet will continue to be the best cushion against such an uncertain outlook.

WILL CHANGES IN ENERGY POLICIES HELP OR HURT?

The U.S. Department of Energy has projected energy prices for 2017. While prices are projected to be higher across the board, they are nowhere near the levels of the halcyon days of just three years ago. This would bode poorly for the energy dependent states which have continued to experience lower production related revenues as well as lower general revenues as a result of decreased overall economic activities.

2014 2015 2016 2017
WTI Crude Oil
dollars per barrel
93.17 48.67 43.07 50.66
Brent Crude Oil
dollars per barrel
98.89 52.32 43.46 51.66
Gasoline
dollars per gallon
3.36 2.43 2.14 2.30
Diesel
dollars per gallon
3.83 2.71 2.31 2.70
Heating Oil
dollars per gallon
3.71 2.65 2.12 2.62
Natural Gas
dollars per thousand cubic feet
10.94 10.36 10.24 11.02
Electricity
cents per kilowatt-hour
12.52 12.65 12.53 12.87

North Dakota is a state were growth rates were in excess of 2% for four consecutive years. The 2014 prices of oil coincide with North Dakota registering the highest growth rate in the country in  2014-15.  In 2015-16 however, North Dakota’s growth fell to 0.15 percent, ranking 37th among states.

WHAT WILL INFRASTRUCTURE ACTUALLY MEAN UNDER TRUMP?

We believe that infrastructure will obviously be a major topic in 2017 but, we are concerned that there will remain a huge disconnect between Washington and the local level as to what their priorities should be under any infrastructure “program”. Recently, Politico conducted a discussion among a number of Rust Belt politicians and policymakers regarding what their concerns were as to what the most important infrastructure projects should be. We found their comments interesting in that they reflected projects on which economic growth could be supported and developed versus projects which might generate profits for their providers. Their unattributed comments as presented by Politico are in italics.

One good example cited was the challenge of updating 19th Century sewers that handle both waste and storm water. A mandate from the EPA to upgrade sewers without accompanying federal funds is creating a major challenge for cities and property owners who cannot afford the costs of replacement. The costs are holding back economic development. Participants suggested that sewer repairs should be combined with street projects as part of a national infrastructure push.

“Sewers are a major issue for all Midwestern cities and the EPA is killing us with costs and regulations. If I were running the federal government, my number one thing I’d do by far is pay all these unfunded sewer mandates, which are by far the largest capital expense in many of these cities.” “It’s a huge deterrent to businesses and residents—sewers. And it’s being funded by low income, regressive taxes.” “The EPA’s speed at which they expect us to fix it, to bring it up to clean air and clean water standards, is terrible, because it requires these massive local tax increases—rate increases for sewers that compound the cost of living.”

Local officials complained about by free-riding suburban residents who pay no taxes in the cities they commute to every day. Free riders have long been an issue in the provision of public goods.

There was disagreement among participants over the value of investing in large rail projects which can be costly to build and maintain, but there was broad support for expanded bus systems. “Cities depend on a robust public transit system. And in the Midwest, I think that’s primarily bus transit, and I think that needs to be dramatically expanded.” “I think these speculative rail transit investments are really not going to deliver the results … I think the back bone of these highly dispersed, sprawling Midwest cities has to be bus—plain old bus service in select areas.” “Is there an argument to be made to give us the money for the regional transportation system that is going to preserve the rural communities, and enhance the industrial manufacturing capacity, jobs creating capacity, of this city, so that people do not have to move away?”

Several participants suggested that transportation infrastructure should combine public transit, bike lanes, and access to ride sharing services such as Uber and Lyft. Many policy makers are concerned that for-profit transit providers will be a substitute for cost of service mass transit. There are potential issues of income based tiers of levels of service if Uber and Lyft is used to replace mass transit, specifically buses, as we know them. Leaders of smaller cities seem to lean in that direction. “So it’s a mix of fixing up 50 and 60-year-old transit systems like they have in Chicago, like we have here [in Washington, DC]. Fixing up roads and bridges, but adding to those alternative forms of transportation. Bus rapid transit means you buy new buses.

Mayors expressed enthusiasm for the creation of a national infrastructure bank. “An infrastructure bank where cities can borrow money—patient money, to invest—to deal with industrial sites, old and abandoned industrial sites.” “Don’t put a lot of requirements in it; just make it straight. And part of the dilemma is the federal government, in the best of times, is difficult to deal with.” There was also support for increased funding for the Transportation Infrastructure Finance and Innovation Act (TIFIA) and the Transportation Investment Generating Economic Recovery Act (TIGER). TIFIA is the lone program that allows cities to come innovative, creative, take some private dollars, take some state dollars—boom. Build a new bridge, fix a bridge, fix a transit system, build a walking and biking path.”

One of our concerns is the willingness of Congress, especially the House, to fund  infrastructure spending. “The Trump people are talking a good game about infrastructure, but Obama proposed an infrastructure bank at $50 billion and the Republican Congress said no. Now, we still have a Republican Congress; we have a Republican president, so maybe now that it’s Trump’s idea, and it’s not Obama’s idea, they’ll like it.” “Whatever we do in America, we need a big pot of money.” Participants predicted that despite interest at the local level for a creative approach to infrastructure, a federal infrastructure effort would remain focused on building highways—and that’s not necessarily a good thing. “I think if there’s an infrastructure bill, 80 percent or 90 percent of it will go to highways, because that’s the powerful lobbies, and it will be 10 percent of it going to transit.”

P3 WILL BE THE BUZZWORD OF THE YEAR

No matter what sort of project is undertaken, the term P3 will likely be attached to it. What that means for individual projects will be different in every case. Will it be a privately financed and operated new or expanded road facility (new toll HOV lanes) ? Will it be the use of design/build contracting programs to produce traditional public facilities on a turnkey basis (the Goethals Bridge Replacement Project for the Port Authority of NY/NJ or the Tappan Zee bridge replacement)? Will it be some mix of design/build/operate for profit (LaGuardia Airport replacement)?

Many of the highest return infrastructure investments — such as improving roads, repairing 60,000 structurally deficient bridges, upgrading schools or modernizing the air traffic control system — do not generate a commercial return and so are excluded from his plan.  Nor can the non-taxable pension funds, endowments, and sovereign wealth funds that are the most promising sources of capital for infrastructure take advantage of the program. In many cases, the kind of improvements that people would choose would realistically turn currently free facilities into revenue generators – tolling many of the currently free interstate highways for example. I’m not sure that is what folks in the hinterlands were voting for.

Each has its own policy and credit implications and there is no correct answer for each undertaking. All of them have strengths and weaknesses in terms of which is most likely to generate the most positive result for investors. Investors will have to weigh all of the issues when evaluating P3 projects as they are developed.

CONNECTICUT, ILLINOIS, AND NEW JERSEY

The toxic mixture of pensions, taxes, and politics will be played out most prominently in these three states. Each of them have massive pension underfunding problems. Each of them has a highly tax averse voting base. Each of them has a highly unpopular governor. These form a tripod of likely inaction in each of these jurisdictions, at least over the next year.

In New Jersey, Gov. Chris Christie is term limited and his popularity ratings are one point above the historic low recorded for any New Jersey Governor in modern times. Lacking little if any political capital, the Governor is unlikely to be able to use his usual package of tactics in order to maneuver the legislature into any serious changes to pensions. We think that investors should be pleased if the State actually makes its four required payments as established under legislation recently signed by the Governor. We see no potential for credit improvement for the State in 2017.

In Illinois, Gov. Bruce Rauner’s first term may only be half over but he has already announced his intention to run for reelection and to heavily finance his own campaign. In response, we would expect a continuation of the political mud wrestling which has characterized the last two years. Investors will get a sense of which way things will go as the budget agreement reached for FY 2017 only covered its first half. The governor and legislature will need to reach a new agreement for the remainder of the FY immediately after the beginning of the New Year. We see a reversal of negative credit trends to be in the realm of the miraculous.

In Connecticut, Gov. Dannel Malloy faces a tax resistant electorate as well. Here the problem with pensions is at both the State and local level. While dealing with its own pension problem, localities will increasingly look to the State for additional aid. Coming  up with the funding for either is highly problematic. It may not be for two years but, if he runs for reelection, Malloy would be seeking a third term. His poll numbers are low, among the five worst in the country. That embattled status will make meaningful reform difficult and will continue to weigh negatively on the State’s ratings.

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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