Muni Credit News March 28, 2017

Joseph Krist

joseph.krist@municreditnews.com

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THE HEADLINES…

FOCUS SHIFTS FROM ACA TO TAX REFORM

RAUNER VETO FOR CHICAGO PENSION FUNDING

KENTUCKY PENSION PROBLEMS LINGER DESPITE ATTENTION

PREPA NEGOTIATION TWISTS AND TURNS

NIH CUTS – UNIVERSITIES AND HOSPITALS

ANOTHER INFRASTRUCTURE PLAN PROPOSED

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FOCUS SHIFTS FROM ACA TO TAX REFORM

The failure to repeal and replace the ACA is, in the short run, it’s good news for states especially those who expanded Medicaid and for New York State in particular. The failed effort takes some of the short-term heat off of state budget making efforts in this cycle. But along with this turn of events comes a change in focus to tax reform. And like any good sentry we know that the elimination of one source of incoming fire does not mean that the threat is over.

If the focus does indeed turn to tax reform, then threats remain for state and local government. They come from a number of directions. Will tax reform mean elimination of the tax exemption and a rising cost of capital for municipal borrowers? Will tax reform mean the elimination of the deduction for state and local income taxes? Would tax reform include elimination of the mortgage interest deduction leading to uncertainties in the housing market which could impact taxable valuations? The possibilities are myriad. None of them can be spun as particularly positive for municipal credit.

Tax reform on the scope of what has been suggested would severely impact the federal budget deficit. It can only be addressed through the types of spending cuts which were briefly outlined in the “skinny budget” recently released. We have already indicated our concerns with those proposals from a municipal credit perspective and reiterate those concerns here.

The one source of temperance regarding those concerns is that the scenario whereby the budget and policy hawks in the Freedom Caucus torpedoed ACA repeal might be repeated in the tax reform process. Will their insistence on deficit reduction not just neutrality be enough to torpedo efforts to make significant changes in tax policy (as opposed to just changes in rates) and thereby prevent significant change to the tax code to be enacted? That will have to play itself out as the process unfolds.

RAUNER VETO FOR CHICAGO PENSION FUNDING

Gov. Bruce Rauner on Friday vetoed legislation designed to shore up the pension funds for city of Chicago laborers and other city workers. “While I appreciate the effort to address the insolvency of certain pension funds for Chicago’s public employees, the legislation will create another pension-funding cliff that the city does not have the ability to pay,” Rainer said in a statement Friday. “This legislation will result in increased taxes on Chicago residents.”

Senate Bill 2437 would have put more money into retirement systems covering some 88,000 city workers, excluding police officers and firefighters, who are covered by separate pension funds. The Illinois House passed the bill in December and it was unanimously approved by the Senate in January. Instead the Governor’s ideological battle continues as Rainer had previously said he wouldn’t support the bill without more systemic wide-reaching government pension reforms. He also questioned the use of revenue in the bill, which would resort to the city using property-tax money to fund pensions after it runs out of funds from a new tax on city water and sewer service.

The veto comes despite workers’ concessions calling for employees hired after Jan. 1 to become eligible for retirement at age 65 in exchange for an 11.5 percent pension contribution. That’s 3 percentage points higher than employees pay now. Veteran employees hired after Jan. 1, 2011, get to choose between contributing 11.5 percent for the right to retire at 65 or continuing to pay 8.5 percent and waiting until 67 to retire.

It is this sort of move that belies the Governor’s efforts to portray the current financial disaster that is the State of Illinois as being solely based on legislative intransigence. He seems hell bent on getting the State and its largest city downgraded again rather than working for a solution.

KENTUCKY PENSION PROBLEMS LINGER DESPITE ATTENTION

There has been much focus on the public pension systems sponsored by the Commonwealth of Kentucky as they have served as a sort of poster child for the problem of chronic underfunding of state pensions. So it was with some interest that we examined the latest disclosure from the Commonwealth in support of its planned issue of state appropriation bonds.

That disclosure focused on the Teachers Retirement Fund and the funds covering the Commonwealth’s non-pedagogical employees. The Teachers Fund has seen its unfunded accrued actuarial liability grow in four of the last five years. As of June 30, 2016, the UAAL totaled $14,551,333,000. That results in a funding ratio of 54.6%. That ratio actually declined from the prior year’s 55.6%.

The funds covering the state’s other employees are in substantially worse shape. The UAAL has increased in each of the last five years. At the same time the funding ratio has substantially declined from an already unacceptable 30.2% to an incredibly low 19.5% in 2016. The funds had been using an assumed investment rate of 7.75%. As pension fund managers have discovered across the country, this assumed rate has been unrealistically high. Two of the general employee funds have reduced this assumed rate of return to 6.75%. The Teachers Fund and two other general employee funds slightly lowered their annual return assumptions to 7.5%.

So it really should not come as any surprise that these actions have not yielded significant improvement in the funding position of the funds. In FY 2016, the Actuarially Determined Employer Contribution for the Commonwealth was $562.1 million which was fully funded but this did nothing to address the existing shortfalls. The biennial budget calls for $186 million in contributions above the ADEC requirement. Since 2014, new employees have joined a hybrid pension plan. Localities may opt out of the plans but must repay their full actuarial liability to the Commonwealth in order to do so. So that is not an option which is particularly attractive. There are provisions to dedicate 25% of state surplus to the pension funds but with four months remaining in the current FY, revenues are still some 4.4% short of estimates. So the odds of any real help from that source seem pretty low.

PREPA NEGOTIATION TWISTS AND TURNS

The Puerto Rico Fiscal Agency and Financial Advisory Authority (FAFAA) filed  proposed terms for a new restructuring support agreement (RSA) with Puerto Rico Electric Power Authority (PREPA) bondholders. However, PREPA’s Ad Hoc Group of Bondholders issued a statement rejecting it. The filing takes place amidst a U.S. congressional subcommittee holding a hearing on the RSA. One PREPA board member called the hearing is a pressure tactic to push the government into accepting the current RSA, which the government wishes to amend to obtain better terms.

Later, FAFAA issued a statement saying the discussions are ongoing and that the entity “remains committed to a good faith negotiation with PREPA’s creditors in order to consensually achieve important improvements to the RSA. In the hearing in Congress however, Governor Rosella expressed worries about the impact of the 3-cent transition charge on Puerto Rican ratepayers; the effect the transaction may have on the capital and liquidity available to PREPA to complete its operational transition; the failure of certain creditor groups, such as monoline bond insurers, to provide significant concessions; the reality that the RSA does not provide for sufficient capital to close the transaction; and that under the current conditions, the RSA would not be sustainable for bondholders.

The current RSA, which expires March 31, calls for a 15% haircut on the principal of the debt, which is around $9 billion. But the government is proposing a split between 80% in securitization bonds and 5% in new PREPA bonds to maintain 85% of the total debt. While the current RSA proposes a debt service reserve fund of 10%, the government is proposing a reserve fund ramp up to 3.5% by year five. The current RSA calls for a bond exchange in which current PREPA bonds will be exchanged with bonds from PREPA’s Revitalization Corp. Those new bonds are required to be of  investment-grade credit quality. The government now says these shouldn’t need to be an investment-grade requirement for securitization.

Under the current RSA, bondholders can elect between two types of bonds, whose terms were proposed to be amended to, among other things, extend their maturity to 2047. The Ad Hoc group issued a statement saying the proposal would not simply modify the existing RSA but “fundamentally change it and undermine the value and structural integrity of the new PREPA

PREPA has a major bond payment of roughly $455 million of combined principal and interest due July 1. “Without the cash flow relief provided by the terms of the RSA and without any other viable options for making such a payment afforded to the distressed utility, PREPA will once again default.

NIH CUTS – UNIVERSITIES AND HOSPITALS

The skinny budget issued by the Trump administration provides for an approximate 20% cut in funding for the National Institutes of Health (NIH). Trump’s $5.8 billion reduction is roughly equivalent to what NIH spent last year to reimburse universities for the so-called indirect costs of research, which include overhead items like utility bills and the staff needed to comply with federal research regulations. Some speculate that the White House wants to reduce those indirect payments in hopes of saving money without reducing the amount of research that NIH funds. But university officials have long maintained that they could not afford to accept NIH grants if the government didn’t also pay reasonable overhead costs.

In the absence of budget specifics, one is left to applying some rudimentary calculations to estimate where these potential cuts might impact. So we go to data supplied by NIH listing the largest university recipients of NIH grants and how much that represents.

ORGANIZATION CITY STATE COUNTRY AWARDS FUNDING
JOHNS HOPKINS UNIVERSITY BALTIMORE MD UNITED STATES 309 $141,961,360
UNIVERSITY OF MICHIGAN ANN ARBOR MI UNITED STATES 231 $105,176,124
UNIVERSITY OF CALIFORNIA, SAN FRANCISCO SAN FRANCISCO CA UNITED STATES 273 $105,139,483
UNIVERSITY OF PENNSYLVANIA PHILADELPHIA PA UNITED STATES 245 $99,741,661
WASHINGTON UNIVERSITY SAINT LOUIS MO UNITED STATES 213 $94,088,787
YALE UNIVERSITY NEW HAVEN CT UNITED STATES 242 $90,722,334
UNIVERSITY OF PITTSBURGH AT PITTSBURGH PITTSBURGH PA UNITED STATES 233 $86,522,236
STANFORD UNIVERSITY STANFORD CA UNITED STATES 216 $85,049,075
UNIVERSITY OF CALIFORNIA SAN DIEGO LA JOLLA CA UNITED STATES 205 $80,270,406
U.S. Department of Health and Human Services, NIH Awards by Location & Organization

These are clearly meaningful amounts of resources to these programs. Municipal bond investors should care because these funds often represent funds available for debt service in support of capital facilities in which research is physically carried out. Even if not directly pledged or otherwise dedicated to debt service, the lack of these resources would pressure already weakened resource bases for debt repayment by forcing the universities to make additional hard budget choices as they face diminishing state support and pressures on sources of full tuition paying students.

Similar concerns logically apply to hospitals. So we applied the same observation to hospital grant data.

 

ORGANIZATION CITY STATE COUNTRY AWARDS FUNDING
BRIGHAM AND WOMEN’S HOSPITAL BOSTON MA UNITED STATES 133 $111,465,823
MASSACHUSETTS GENERAL HOSPITAL BOSTON MA UNITED STATES 188 $77,287,551
BOSTON CHILDREN’S HOSPITAL BOSTON MA UNITED STATES 96 $39,477,541
VANDERBILT UNIVERSITY MEDICAL CENTER NASHVILLE TN UNITED STATES 103 $36,379,660
CHILDREN’S HOSP OF PHILADELPHIA PHILADELPHIA PA UNITED STATES 43 $35,326,998
DANA-FARBER CANCER INST BOSTON MA UNITED STATES 42 $32,324,722
CINCINNATI CHILDRENS HOSP MED CTR CINCINNATI OH UNITED STATES 76 $31,054,789
ST. JUDE CHILDREN’S RESEARCH HOSPITAL MEMPHIS TN UNITED STATES 29 $20,306,129
BETH ISRAEL DEACONESS MEDICAL CENTER BOSTON MA UNITED STATES 47 $19,464,246
U.S. Department of Health and Human Services, NIH Awards by Location & Organization

We are not taking the view that any particular near-term credit issue will result if these proposals are adopted. We do however think that the phenomenon should be highlighted as an additional issue to be included in the credit evaluation and valuation process undertaken by investors.

MORE INFRASTRUCTURE PLANS PROPOSED

The Partnership to Build America Act would create a new American Infrastructure Fund to pay for state and local projects. Another bill is called the Infrastructure 2.0 Act. It includes the AIF and provides additional long-term revenues to stabilize and expand the Highway Trust Fund. The Partnership to Build America Act finances $750 billion dollar in infrastructure investment using no appropriated funds, According to its sponsor. The  Infrastructure 2.0 Act is designed to provide six years of funding for the Highway Trust Fund. The American Infrastructure Fund (AIF) which would provide loans or guarantees to state or local governments to finance qualified infrastructure projects. The states or local governments would be required to pay back the loan at a market rate determined by the AIF to ensure they have “skin in the game.”  In addition, the AIF would invest in equity securities for projects in partnership with states or local governments.

The AIF would be funded by the sale of $50 billion worth of Infrastructure Bonds which would have a 50 year term, pay a fixed interest rate of 1 percent, and would not be guaranteed by the U.S. government. U.S. corporations would be incentivized to purchase these new Infrastructure Bonds by allowing them to repatriate a certain amount of their overseas earnings tax free for every $1.00 they invest in the bonds.  This multiplier will be set by a “reverse Dutch auction” allowing the market to set the rate. The bill assumes a 1:4 ratio, meaning a company repatriates $4.00 tax-free for every $1.00 in Infrastructure Bonds purchased, a company’s effective tax rate to repatriate these earnings would be approximately 8 percent and the $4.00 could then be spent by the companies however they chose. The AIF would leverage the $50 billion of Infrastructure Bonds at a 15:1 ratio to provide up to $750 billion in loans or guarantees. At least 25 percent of the projects financed through the AIF must be Public-Private Partnerships for which at least 20 percent of a project’s financing comes from private capital using a public-private partnership model.

The bill reflects many of the problems that infrastructure finds itself in. Many of the ideas look for ways to avoid the use of current revenues for spending on infrastructure, try to force the issue of P3s, and get themselves entwined with other issues such as the effort to repatriate foreign derived corporate income. This kind of approach to funding unnecessarily complicates an already complex issues and raises the kind of issues which make it harder to find consensus. Repatriation, tax credits, low interest non-guaranteed debt financing in a time of rising interest rates are nor really beneficial to the municipalities. Neither is the lack of specificity as to what constitutes a “market rate” for repayment of loans made to states while at the same time benefitting corporations with equity infusions and tax credits. All will serve to delay the provision of meaningful infrastructure improvement.

At the same time, Rep. Peter DeFazio (D-Ore.), the ranking Democrat on the House Transportation and Infrastructure Committee, proposed a bill which  would raise the federal gas tax by approximately 1 cent per year, to generate about $500 billion for revitalizing U.S. roads, bridges and transit systems over the next 30 years.

As many have observed, the federal gasoline tax has not been increased over 20 years. The bill would index the gas and diesel tax to the cost of constructing transportation projects and to the reduction in motor-fuel usage, which would approximately translate into a 1-cent increase every year. The hike would be capped at 1.5 cents annually.

The Treasury Department would use that new revenue to issue and pay back 30-year “Invest in America Bonds,” and deposit the cash from those bond sales into the ailing Highway Trust Fund. The measure, which would lead to a 30% boost in infrastructure investment every year, would ensure that the money is invested proportionally among highway, transit and safety programs. Raising gas taxes at the state level has not been a political landmine. Seventeen states have raised their gas taxes since 2013, including nine red states. Those increases range from 1 cent to 27 cents.

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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