Muni Credit News March 17, 2016

Joseph Krist

Municipal Credit Consultant


Recently it was observed that land development defaults are slowing. Well to followers of recent data that should not have come as a surprise. For example, the California Association of Realtors (CAR) has released their report on California existing home sales and median prices in January. The statewide median price rose over the year in January by 9.2% to $468,330. The year-to-year price gain was the largest since May 2014 and reflects the shift in sales activity toward higher-priced properties.

Sales of single-family homes increased by 8.8% over the year in January to 383,670 units sold (annualized rate, adjusted for seasonality). This was the highest sales level for a January since 2013. Year-over-year increases were recorded in all three of the state’s major regions: Southern California (6.5%), San Francisco Bay Area (6.8%), and the Central Valley (11.8%). Over the month, sales declined by 5.4%.

Mortgage interest rates edged down in January, with the 30-year, fixed-mortgage interest rate averaging 3.87%, down from 3.96% in December, but up from 3.67% in January 2015. In Los Angeles County unit sales rose by 5.2% over the year in January, while the median price rose by 8.9% to $480,950. In Orange County sales shot up by 15.2% and the median price increased by 4.5% to $704,950. In Riverside County sales of existing homes rose by 7.7% while the median price moved higher by 8.9% to $333,370. In San Bernardino County sales increased by 5.7% in January; the median price jumped by 13.5% to $234,460. San Diego County saw unit sales inch up by 2.9% and the median price increased by 9.2% to $542,150. In Ventura County sales were up by 3.7% over the year while the median price rose by 9.6% to $638,590.


The IRS has proposed regulations requiring that a political subdivision serve a governmental purpose and must be governmentally controlled. They define control to mean ongoing rights or powers to direct significant actions of the entity. Rights or powers to direct the entity’s actions only at a particular point in time are not ongoing and, therefore, do not constitute control. For example, the right to approve an entity’s plan of operation as a condition of the entity’s formation is not an ongoing right. The proposed regulations provide three non-exclusive benchmarks of rights or powers that constitute control: (1) The right or power both to approve and to remove a majority of an entity’s governing body; (2) the right or power to elect a majority of the governing body of the entity in periodic elections of reasonable frequency; or (3) the right or power to approve or direct the significant uses of funds or assets of the entity in advance of that use. Control by a small faction of private individuals, business corporations, trusts, partnerships, or other persons is fundamentally not governmental control.

The proposal generally requires that control be vested in either a general purpose State or local governmental unit or in an electorate established under an applicable State or local law of general application. If, however, a small faction of private persons controls an electorate, that electorate’s control of the entity does not constitute governmental control of the entity. Accordingly, an entity controlled by an electorate would not be seen to be governmentally controlled when the outcome of the exercise of control is determined solely by the votes of an unreasonably small number of private persons.

The proposed regulations rely on certain assumptions. The number of private persons controlling an electorate is always unreasonably small if the combined votes of the three voters with the largest shares of votes in the electorate will determine the outcome of the relevant election, regardless of how the other voters vote. The number of private persons controlling an electorate is never unreasonably small if determining the outcome of the relevant election requires the combined votes of more voters than the 10 voters with the largest shares of votes in the electorate. For example, control can always be vested in any electorate comprised of 20 or more voters that each have the right to cast one vote in the relevant election without giving rise to a private faction. For purposes of applying these measures of concentration in voting power, related parties are treated as a single voter and the votes of the related parties are aggregated.

Well that would certainly seem to drive a stake through the heart of many special district creations. Just look at the formation of special districts like California CFDs, Florida CDDs, and many other assessment driven districts that have issued bonds in the tax exempt market. It is easy to see why the proposed regulations would worry bond counsel, financial advisors, management companies, underwriters and the many other market participants who make a living from these financings. The potentially higher cost of development driven infrastructure could be the margin of difference for many developments.

The Treasury Department and IRS are driven by the potential for excessive private control by individual developers, the excessive issuance of tax exempt bonds, and inappropriate private benefits from this Federal subsidy. The Treasury Department and IRS seek public comment on whether it is necessary or appropriate to permit such districts to be political subdivisions during an initial development period; how such relief might be structured; what specific safeguards might be included in the recommended relief to protect against potential abuse.


Scotiabank de Puerto Rico, the Association of Financial Guaranty Insurers and the U.S. Chamber of Commerce are urging the U.S. Supreme Court in legal briefs to uphold the illegality of the Puerto Rico Debt Enforcement & Recovery Act. , a local statute that allows for the debt restructuring of the island’s public corporations that was found to be unconstitutional at the federal district and appellate levels. The local government contends that because Puerto Rico’s public corporations cannot file under federal bankruptcy law, it can enact its own bankruptcy law to fill in the gap.

Scotiabank, in an amicus brief filed after reaching joining in a restructuring agreement with the Puerto Rico Electric Power Authority (PREPA), says local banks that comprise the fuel-line syndicate, which pays for the utility’s oil, play a vital role in the island’s economy and support initiatives to address its fiscal problems. “But the Recovery Act, moreover, is so unfavorable to creditors—and so much less protective of creditors’ rights than the federal Bankruptcy Code—that it will inevitably affect the financing available to Puerto Rico”. “Although PREPA asserts in its amicus brief that the Recovery Act spurred negotiations on a consensual restructuring, the opposite is true. The Recovery Act reduced PREPA’s incentive to negotiate, and little progress was made before the district court struck down the Act on February 6, 2015. Only after that decision—on June 1, 2015—did PREPA deliver a proposed recovery plan to creditors, as required by its forbearance agreements. And only then could PREPA and its creditors begin to negotiate in earnest on a consensual restructuring,” the bank says.

The Association of Financial Guaranty Insurers (“AFGI”), the national trade association of the leading insurers and reinsurers of municipal bonds and asset-backed securities, says its interest in the outcome of this case extends well beyond the debt issued by Puerto Rico and its public corporations. “The prospect of States or territories enacting their own municipal bankruptcy laws would have grave consequences on the monoline insurance industry, as well as on the municipal bond market as a whole. Upholding the  contractual terms with municipalities could be altered in unpredictable, inconsistent and self-serving ways. This would create a chilling effect on credit markets and increase the cost of financing to municipal borrowers (and, therefore, to taxpayers),” the organization argues.

“This false portrayal of the potential impact of applying existing federal and Commonwealth law to the bond contracts at issue is an attempt to shift focus from the ‘straightforward’ issue of federal preemption here and from the dramatic negative effects that permitting laws like the Recovery Act would have on the nationwide municipal securities market,” the group adds. The U.S. Chamber of Commerce says there can be no bankruptcy uniformity if states and territories could break contracts for the special benefit of distressed municipalities. The result would be a municipal bond market with reduced access to the low-cost capital the investor class has always supplied.


While the legal arguments are made, the legislative process continues to unfold. ‘‘The Puerto Rico Stability Act 5 of 2016’’. to be proposed by Senator Bob Menendez (NJ) provides for the establishment of a fiscal oversight board. Its creation would automatically stay any legal proceedings against the Commonwealth, provide for the Commonwealth to propose a plan of adjustment for its debts, and most importantly establish a first priority ” senior secured statutory lien on Commonwealth revenues in favor of its pension obligations. The Senator summarized the legislation of the floor of the Senate. It comes directly from the current Puerto Rico administrations playbook.

His comments were as follows. “That’s why the first and most important step we must take is to give Puerto Rico the ability to restructure its debts in an orderly fashion.  Our legislation would do just that, providing a fair and reasonable way for Puerto Rico to restructure all of its debts while avoiding a race to the courthouse that would result in years of costly litigation.

“But before Puerto Rico can even access this authority, it needs to affirmatively opt-in and accept the establishment of an independent ‘Fiscal Stability and Reform Board’ and Chief Financial Officer.  This both ensures that any restructuring plan is based on objective and independent analysis of the island’s situation and provides assurances to creditors that future governments will adhere to a prudent long-term fiscal plan, while affirming and respecting Puerto Rico’s sovereignty.

“Once Puerto Rico opts in, it receives an automatic 12-month stay to give government officials the necessary breathing room to organize their finances and develop a sustainable five-year fiscal plan upon which annual budgets and their restructuring proposal will be based.

“Once the Governor submits a restructuring proposal, a judge selected by the First Circuit Court of Appeals would have to confirm it complies with the Fiscal Plan, protects the rights of pensioners, and if feasible, does not unduly impair general obligation bonds.  Our process follows precedent by giving creditors a voice and the ability to object in court, and ultimately gives an independent judge the authority to ensure any plan is fair and reasonable.

“And in order to ensure the long-term fiscal plan is followed not just now, but in the future, our legislation gives the independent Board the power to review annual budgets, future debt issuances, and exercise strong oversight and transparency powers. “If future budgets do not comply with the fiscal plan, the Board has the authority to issue a vote of ‘no confidence’, which will send a strong and unequivocal message to the legislature, capital markets, and Puerto Rican people…”

“The Board will consist of 9 members chosen by the Puerto Rico Governor, Legislature, Supreme Court, and President of the United States.  At least six of the Board members must be full-time residents of Puerto Rico, at least six must have knowledge of Puerto Rico’s history, culture, and socioeconomics, and all members must have financial and management expertise. This proposal wouldn’t cost the U.S. treasury a penny and because it is limited to the territories, wouldn’t have a contagion effect on the broader municipal market.”

“Currently, Puerto Rico’s Medicaid program, rather than being reimbursed for necessary costs, is capped and set to hit a funding ‘cliff’ as soon as mid-2017.  When its Medicaid costs, a burden no state could handle. “There are several policies in Medicare that treat the island differently than the rest of the nation, leaving providers and seniors to face unfair penalties and lower reimbursements.  This bill eliminates many of these discrepancies to more accurately align Medicare policies in Puerto Rico with the rest of the country. “As citizens of the United States, it’s only fair that Puerto Ricans be afforded the same access to care, coverage and health benefits as everyone else.

“Finally, our legislation would incentivize Puerto Rican workers to enter the formal economy and give families the help they need to raise their children by providing parity to the island for the Earned Income Tax Credit and Child Tax Credit.

We think that the reordering of obligations in favor of pensioners would indeed have a contagion impact on the market. The fact that the legislation includes all US territories builds that in. Keep in mind that Senator Menendez’s home state of New Jersey is one of the leading pension underfunding offenders. As for funding and tax credits there has to be some consequence for being a Commonwealth resident and not paying personal income taxes. Years and generations of cultural resistance to the formal economy cannot be overturned simply by enacting this law.


The Securities and Exchange Commission charged California’s largest agricultural water district with misleading investors about its financial condition as it issued a $77 million bond offering.  According to the SEC, Westlands agreed in prior bond offerings to maintain a 1.25 debt service coverage ratio. Westlands learned in 2010 that drought conditions and reduced water supply would prevent the water district from generating enough revenue to maintain a 1.25 ratio. In order to meet the 1.25 ratio without raising rates on water customers, Westlands used extraordinary accounting transactions that reclassified funds from reserve accounts to record additional revenue. Not only did Westlands fail to disclose that wouldn’t have been possible without the extraordinary 2010 accounting transactions, but also omitted separate accounting adjustments made in 2012 that would have negatively affected the ratio had they been done in 2010.

Had the 2010 reclassifications and the effect of the 2012 adjustments been disclosed, Westlands’ coverage ratio for 2010 would have been only 0.11 instead of the 1.25 reported to investors. Westland’s general manager Thomas Birmingham referred to these transactions as “a little Enron accounting” when describing them to the board of directors.   Birmingham and former assistant general manager Louie David Ciapponi improperly certified the accuracy of the bond offering documents.

The SEC’s order finds that Westlands, Birmingham and Ciapponi violated Section 17(a)(2) of the Securities Act of 1933 and must cease and desist from future violations. They neither admitted nor denied the findings. Westlands agreed to pay $125,000 to settle the charges, making it only the second municipal issuer to pay a financial penalty in an SEC enforcement action.  Birmingham and Ciapponi agreed to pay penalties of $50,000 and $20,000 respectively to settle the charges against them. Andrew J. Ceresney, Director of the SEC Enforcement Division said,  “issuers must be truthful with investors and we will seek to deter such misconduct through sanctions, including penalties against municipal issuers in appropriate circumstances.”


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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