Muni Credit News March 19, 2015

Joseph Krist

Municipal Credit Consultant


Initial oral arguments were presented to the Illinois Supreme Court last week. Solicitor General Carolyn Shapiro offered the initial argument and cited Illinois’ need to protect the public welfare in the face of a fiscal emergency as a basis for cutting pension benefits despite their state constitutional protections. The court’s seven justices will decide the fate of legislation approved in December 2013 that reduced benefits with the goal of stabilizing a system facing $111 billion in unfunded obligations that has dragged down the state’s bond ratings and threatened its fiscal solvency.

A circuit court judge last November found that the legislation violated the pension clause adopted in a 1970 constitutional convention that gave contractual status to pensions and protects them from impairment or diminishment.

In the state’s view, the justices must decide whether the state is correct in its position that “the pension clause provides the same robust but not absolute constitutional protections provided to all contracts”. Or it can side with unions and the plan participants who are challenging the changes and find that it is instead a “categorical and absolute ban on any reductions to pensions even under extraordinary circumstances,” said the Solicitor General.

She also said that “Plaintiffs position is remarkable”. “If the state’s bond rating collapsed rendering borrowing prohibitively expensive, pensions would be entirely off limits regardless of the essential state services that might have to be eliminated.” If a natural disaster struck, pensions could not be even temporarily reduced, she added.

Shapiro acknowledged that such scenarios were extreme. But that is what plaintiffs are asking for,” Shapiro went further. “It is the state’s solemn responsibility to protect the public interest, the public health, safety and welfare in extreme situations but the necessary consequence of what plaintiffs are demanding and circuit agreed would tie the state’s hands when its need to act is most pressing.”

The State seeks to portray the diminished and impaired language as a reference to the enforceable contract status afforded to pensions, not to the pension benefits themselves and argued that past contract law precedent over the last 150 years allow the state to modify a contract under some circumstances. The State argues that there is little debate that the state is not facing a fiscal crisis given its budget deficit, massive unpaid bill backlog between $5 billion to $6 billion, and a credit rating that is the weakest among states.

The state further argued that “Like all contracts, they can be altered…they are not absolute” and argued that if the protections are absolute the clause does not legally meet the definition of a contract as the state constitution allows for contract modifications.

The attorney representing the union plaintiffs asked the court to look at both the plain language of the pension clause and the intent of the delegates to the 1970 constitutional convention that established the pension clause. It is “explicit, clear and unambiguous” and “is subject to no stated exception,” and the language is so “simple and plain” that the voters’ guide on the constitutional changes simply said “this section is new and self-explanatory.” The unions contend that the drafters anticipated the very situation that the court is now reviewing by which a General Assembly would act during a time of fiscal distress to “invalidate a constitutional protection” and so created “a binding contractual relationship for public employees” .

The state contends the U.S. Supreme Court has long held that a state can’t enter into binding contracts that would preclude it from exercising its police power in the future to protect the public welfare while the unions accuse the state of wrongly applying federal law. Justices pressed the state’s lawyers on whether a ruling in its favor would give it too much power, potentially unleashing future attacks on statutory and constitutional provisions. Justice Robert R. Thomas asked whether granting the use of police powers would give the state too great a “license” to modify its contractual obligations.

Shapiro stressed that the state constitution provides only a few exceptions for such modifications. She further argued that if the justices agree that the pension benefits are subject to police powers, a check on its power lay in future arguments that would be made at the circuit court level.

“The lower court will conclude whether the circumstances justify the state’s actions,” she said. Justices also questioned how the state’s pension funds sunk so low, suggesting it was a mess of the state’s own making. The state pinned the blame on the recession and economic conditions with inflationary levels driving big cost-of-living adjustments and stressed that the pension cuts don’t put the tab for past underfunding on employees but only the costs going forward.

One justice questioned whether the state faces what it considers a dire budget situation due to the state General Assembly’s failure to extend the 2011 income tax hike. The higher rates partially expired and lawmakers have not acted to make up the lost revenue.  Justices questioned why the state –if it in the midst of fiscal emergency – has asked the court to decide only whether the pension contract is subject to modification under state police powers and to then send the case back to the lower court for review. Justices said the case only would land back before them delaying legislative action possibly on new reforms. The state said it believed there would be sufficient time for lawmakers to act.


Citing “a difficult second half of the year,” the underfunded, $27 billion-asset Pennsylvania State Employees’ Retirement System says its investments returned only 6.4 percent last year, below the system’s annual target of 7.5 percent, according to a report by Chief Investment Officer Tom Brier.

SERS’s stocks, bonds, real estate and hedge funds all posted returns below the fund target. Only one category, “alternative investments,” posted higher returns than the benchmark, thanks in part to soaring private equity valuations attributable to the strong U.S. stock market of the past few years. But even alternative investment returns lagged, posting a loss of 0.3 percent, during the fourth quarter of last year as stocks turned down.

New Pennsylvania Gov. Tom Wolf in his recent budget address called for SERS and the teachers’ pension system PSERS to reduce their reliance on high-fee private managers, and put more in indexed investments. A majority of the SERS board seats are held by legislators and appointees who in the past supported buying a wide range of investments from private managers. The results were announced as debate heats up over the Governor’s inclusion of a $3 billion pension issuance as a part of his budget plans for FY 2016. Bonds to fund pension funding have been long championed by Democratic legislators in the Commonwealth but did not have gubernatorial support. The election of Gov. Wolf is seen by pension bond supporters as creating a more favorable environment for consideration of such a debt issue.

We do not look favorably on the issuance of pension bonds for funding purposes. we equate the issuance of debt for what are arguably current expenses as bad policy and a negative ratings impact.


Gov. Alejandro García Padilla worked to boost support for his tax-reform plan to a skeptical public earlier this week through a taped, prerecorded address Monday evening, March 9. The governor backed his reform as the best way to fix a broken system, and said nobody could defend Puerto Rico’s current “unjust” tax system. García Padilla announced no changes to his tax-reform plan, despite strong opposition from nearly every sector of society, as well as nearly daily protests in the past week. “I am going to the finish line to do what is right,” he said. “Puerto Rico’s tax system is unjust. I didn’t come here to put a patch, but to fix it.”

The heated rhetoric that has accompanied support for the plan continued in the Governor’s speech. The governor said the Treasury Department “confiscates” taxes before salaried workers get their pay, while nonsalaried professionals report an average $16,500 annually in earnings. Moreover, he said 82% of all taxpayers in Puerto Rico are either poor or middle class. García Padilla sought to reassure consumers, saying that the new 16% value-added tax (VAT, or IVA by its Spanish acronym) that is at the heart of his reform wouldn’t apply to the “immense majority of what you buy,” citing exemptions to non-processed food, automobiles, education, prescription drugs and most medical services.

“We live in an unjust system and have to make it just. It’s like a salary increase. You, not Treasury, will decide what you will pay in taxes,” the governor said. He criticized economists who have criticized implementing the reform at a time of economic crisis, saying the 160 countries that have a VAT implemented the tax system in similar situations.

While the governor redoubling his efforts on behalf of the reform in his message, some legislative leaders such as House Finance Committee Chairman Rafael “Tatito” Hernández and Senate Finance Committee Chairman José Nadal Power said changes would be needed to win sufficient support for passage in the Legislature. One possibility is that a substitute measure would either increase the 7% sales & use tax (IVU by its Spanish acronym)to 10%, or have a VAT of 12%. Along with tax reform there is support for the executive branch to reduce spending by $250 million to $500 million annually, about half the amount initially proposed by Senate President Eduardo Bhatia.

Meanwhile, technical amendments to a bill boosting the petroleum-products tax are still necessary for Puerto Rico to undertake a bond issue of nearly $3 billion, which it needs to shore up the Government Development Bank’s liquidity, refinance existing loans and keep the government afloat for the next two years. Lawmakers had previously approved the petroleum-products tax hike that will support the issue, but further amendments were needed to make the bond transaction viable. This month, the excise tax on a barrel of crude oil will be increased to $15.50 from $9.25.

Lawmakers already amended the legislation once to clarify language regarding when the petroleum-products tax hike takes effect and other related issues. Both the House and Senate approved amended legislation to take away the limit placed on the discount they could offer investors, but that isn’t sufficient to get a $2.95 billion deal done.

Another factor is the oil-tax hike escalator. Without it, the government can only borrow $2 billion, and hedge-fund investors don’t want to participate unless it is a $2.95 billion deal. They want to ensure the government stays out of the market for the next two years to protect the value of the bonds they will buy. Bond issuers will also likely participate in the deal if the escalator is in place, which will also work to make the deal more attractive.

Another important provision is the underlying security of pledged revenue, and language protecting it from being clawed back. Lawmakers have already agreed to extend a general-obligation constitutional guarantee for the deal, as well as giving investors the right to sue in New York City courts to resolve any claims arising from the deal. Investors are also pressing to have Puerto Rico commit to revenue and spending cut targets, with penalties for missed targets.

The Senate approved a bill last week with stronger “anti-clawback provisions” and an adjustment clause to ensure the tax would raise sufficient revenue to pay for the bond issue in the future. However, by this week’s deadline, the House hasn’t acted, although sources said the bill “was being prepared for the governor’s signature.”


The total amount of outstanding municipal securities and loans in the market rose 0.6% to $3.65 trillion in the fourth quarter of last year. Bank holdings increased 2.5% and mutual fund holdings rose to a record high of $658 billion.

The Federal Reserve Board released the data this week in its quarterly Flow of Funds report. The total size of the market was up from $3.63 trillion in the third quarter of 2014, but still experienced an overall year-over year decline from $3.67 trillion at the end of 2013. The size of the market has generally been declining for the past several years.

Bank holdings have risen sharply in recent years, totaling $452 billion at the end of 2014 compared to $419 billion the previous year and only $255 billion in 2010. Money market mutual fund muni holdings were up 1.1% to $281.7 billion in the fourth quarter, the only quarterly increase of the year. The category has dropped sharply since it was $386.7 billion at the end of 2010 and $509.5 billion at the end of 2008.  Dealers held $18.9 billion of munis at the end of 2014, a $2.7 billion increase over the previous quarter but a steep decline from the $40 billion dealers accounted for in 2010.

State and local governments accounted for $2.9 trillion of muni debt, with nonprofit organizations and industrial revenue bonds making up the balance. $2.87 trillion of those munis are long-term obligations, the Fed data shows.

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