Joseph Krist

Municipal Credit Consultant

THE HEADLINES…

KANSAS REVENUE EXPERIMENT CONTINUES TO FAIL

MORE STATES SEE REVENUE SHORTFALLS

IS MIAMI GOING TO SETTLE WITH THE SEC?

EVEN GOOD CREDITS GOING COVENANT LITE

CAT BONDS IN THE SPOTLIGHT

DALLAS PENSION FUNDING

HARTFORD TAKEN BELOW INVESTMENT GRADE

MORAL OBLIGATION HOTEL DEAL IN CALIFORNIA

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KANSAS REVENUE EXPERIMENT CONTINUES TO FAIL

The experiment masterminded by the “mad scientist of the budget”, Governor Sam Brownback of Kansas, continues in the face of continued failed results. The State collected nearly $45 million less in taxes in September than expected and now faces a shortfall of over $60 million, just three months — or one quarter — into the fiscal year. Barring a dramatic turnaround, lawmakers and the governor will confront a bleak financial situation when the Legislature returns in January.

Some legislators believe that Brownback is required by law to make cuts himself because state finances are in the red. The governor’s office said the administration is not planning to make allotments. Month after month, with only a few exceptions, revenue been below projections. Sometimes the shortfall is small — $10.5 million in August. In other months, the numbers are staggering: May fell $76 million below expectations.

Individual income tax collections were down $14 million, or 6 percent. The Kansas Department of Revenue cited weaker than expected quarterly payments related to capital gains and the stock market in explaining the figures. Corporate income taxes were short by $17 million, or 21 percent. Retail sales tax collections fell short by $9 million, or about 5 percent.

The approximately $45 million monthly shortfall represents a miss of about 8 percent. So far during the fiscal year, which began in July, Kansas has collected $69 million less in taxes than projected.  The state began the fiscal year in July with an anticipated positive ending balance of only $5 million that was quickly wiped away by poor July and August tax collections. Continued monthly revenue shortfalls could realistically push the figure past $100 million. A twice-yearly revenue forecast will also be released in November, and that projection could send the figure even higher.

State budget director Shawn Sullivan asked agencies in August to provide budget scenarios featuring a 5 percent cut. Last week, he said Brownback’s budget proposal in January wouldn’t include across-the-board cuts, but acknowledged the current budget will have to be adjusted. The governor’s opponents have said taxes cannot be cut without also cutting spending. No significant spending reductions were made in 2012 when the Legislature passed and Brownback signed tax cuts into law.

Kansas has faced rounds of budget cuts over the past two years. And in 2015, during the longest legislative session in Kansas history, the Legislature passed and Brownback signed an increase in sales and cigarette taxes in an effort to raise revenues while the Governor’s response was to cut public university spending by 4 percent. He also imposed a 4 percent reimbursement cut to KanCare providers.

Looming over all of this is an upcoming ruling from The Kansas Supreme Court in a school finance lawsuit that could force millions in additional education spending. Estimates vary, but legislators may have to appropriate upwards of $900 million to comply with a ruling unfavorable to the state.

OTHER STATES ARE FALLING SHORT TOO

In a troubling sign a review of other state revenue reports shows that revenue shortfalls are not uncommon. West Virginia is reporting across the board shortfalls in nearly all of its general fund revenue sources through the end of the first quarter of FY 2017. Given the declining demand for coal this is not a complete surprise. With prices down and employment negatively impacted, it is not unexpected that economic activity would slow impacting both income and sales related taxes.

It is only one month of results but the State of Texas reports a 3% decline in year over year revenues for the month of September. Energy price declines are also playing a major role here as taxes from oil and gas production decline and the effect of those changes bleeds into the rate of growth of sales taxes, the State’s major non-energy revenue source.

IS MIAMI SETTLING WITH THE SEC?

Miami’s City Commission is set to consider paying a $1 million fine to settle securities fraud claims brought by the U.S. Securities and Exchange Commission, according to documents posted on the city’s website. The proposed settlement is said be the largest penalty the SEC has ever imposed on a municipal bond issuer. In a Sept. 22 court filing, the parties said they had reached a tentative settlement, though terms were not then disclosed. The deal must still be approved by the city commission, which will consider a resolution to approve it at an Oct. 13 meeting. The SEC has not confirmed this.

One time budget director Michael Boudreaux  however, has not reached a settlement with the SEC. The former budget director remains confident he will be fully exonerated. It is unusual for an enforcement action against a municipal issuer to go to trial and a rare instance of monetary penalties being sought against a municipality. The SEC has  The SEC has in recent years sought to be more aggressive in its regulation of the municipal bond market. Success in Miami will further embolden the agency’s efforts, although this marks the second time that the city has been cited for securities fraud.

SAN ANTONIO WATER TO COME WITHOUT RESERVE FUND

The City of San Antonio TX is planning a $300 million issue of new money and refunding bonds that seeks to take the fullest advantage of the current favorable environment for issuers. The bonds will be secured as junior lien revenue bonds but they are no secured by any sort of reserve fund. Certainly, not cash and not even a surety bond. It would appear that the “covenant lite” phenomenon getting so much press in the tax exempt environment is bleeding over into the tax exempt market, albeit with a high quality issuer.

The issue is refunding debt maturing from 3 to 23 years from now carrying coupons from 4% to 5.375% . As a solid double A credit their ability to effect a successful refunding is not questioned. But in addition to the expected cost savings, the City is structuring the deal to give it more flexibility in terms of the security, thereby increasing the amount of principal available for their refinancing and capital financing goals.

Effectively, the “no reserve” structure creates another lien of debt within the existing junior lien security waterfall. There are now two classes of junior lien water debt. Given the systems strong financial position and history, it may not make much of a difference That may not look so favorable under less favorable credit conditions and/or a higher rate environment in the future.

In the case of this credit, we do not see it as a reason not to buy it. We are interested in seeing over time if the market makes a measurable valuation differentiation going forward between reserve secured and no reserve debt from the same credit. At current  yield levels, we think that investors are already giving up enough and are dismayed to see the merger of more characteristics of the corporate market make their way into the municipal bond credit mainstream.

CAT BONDS

With all of the attention focus on Florida as the result of Hurricane Matthew and its aftermath,  it’s a good time to focus on the funding and status of the Florida Hurricane Catastrophe Fund (FHCF). The Fund reimburses insurers for losses caused by covered events within a given contract year. To fund itself, FCHF issue bonds backed by Reimbursement Premium s charged to participating insurers under contracts with the Fund and by Emergency Assessments of 6% of losses during any contract year and up to 10% of aggregate losses. Those funds are invested and the earnings on those investments along with the premium and assessment revenues are pledged to the repayment of its bonds.

The State of Florida has been fortunate in that a hurricane has not made landfall in Florida  in eleven years. This has provided an opportunity to accumulate revenues without offsetting expenditures and has provided a favorable environment for insurers to participate in. Over the last five years through FY 2015, annual premiums collected by the Fund have been at least $1.2 billion and have created a reported net position of $11.6 billion.

So the State is positioned well to deal with the effects of Hurricane Matthew. In the short run it provides ready funding to deal with immediate needs and in the long term it provides an incentive for insurance carriers to continue to do business in the State. It’s broad assessment base, established mechanism for collections of assessments, and credit. This allows it to reasonably achieve its financial goals while providing Florida  residents some assurance that insurance will be available in order to allow them to continue to maintain their homes, businesses, and the economy in the face of the

CHICAGO GETS G.O. OUTLOOK UPGRADE

S&P has maintained its BBB-plus rating for Chicago’s general obligation bonds. At the same time, it revised the outlook to stable from negative. It reflects the impact of the recent City Council action to approve tax increases to fund a portion of the City’s huge unfunded pension liabilities. The city’s action had previously led to an outlook revision to stable from negative in August from Fitch Ratings, which rates Chicago’s GO bonds BBB-minus. Moody’s Investors Service still rates the City’s debt below investment grade. It has a negative outlook on its Ba1 rating for Chicago.

The timing of the changes to the City’s outlook is interesting in that that they precede the presentation of the fiscal 2017 budget plan next week by Mayor Rahm Emanuel. The achievement of budget balance on a year to year basis has been increasingly difficult. One would think that a view of that plan would provide a more sustainable view as to the City’s outlook.

MOODY’S TAKES HARTFORD BELOW INVESTMENT GRADE

Moody’s Investors Service has downgraded the City of Hartford, CT’s general obligation debt rating to Ba2 from Baa1. The par amount of debt affected totals approximately $550 million. The outlook remains negative. The downgrade to Ba2 reflects the challenges the city faces in achieving structurally balanced operations, closing its current year (fiscal 2017) budget gap and subsequent year projected shortfalls. The city has limited operating flexibility, exacerbated by weak and declining reserves and rising costs (including debt service and pension payments) over the next several years.

The action also factors in narrowing liquidity and expansion of the current year budget gap since its last review. The city’s options for addressing the growing revenue/expenditure mismatch and eliminating the structural imbalance are limited with property tax revenue constrained by an already high tax rate and prospects for additional state aid limited by the state’s own fiscal challenges. Further expenditure reductions will prove difficult after cuts in the current and prior fiscal years and extended negotiations with unions. Moody’s acknowledges that it is increasingly unlikely that the city will be able to address its financial challenges on its own and, external assistance, either from the state or region will be needed. The city’s position as the state capital and regional economic and employment center is a positive credit factor; however, those strengths are offset, to some extent, by depressed wealth and income levels, and high tax payer concentration.

The maintenance of the negative outlook reflects the expectation that the city will remain challenged to restore and maintain fiscal stability given the expected ramp up  revenue growth prospects. The outlook also incorporates the city’s significant reliance on state aid and the financial challenges that the state is facing which could adversely impact the city.

WHILE FITCH DOWNGRADES DALLAS TX ON PENSION FUNDING

Fitch announced that it had downgraded City of Dallas, Texas general obligation ratings to ‘AA’ from ‘AA+. The downgrade was based on Fitch’s heightened concern about the city’s unfunded pension liabilities given the reporting of updated plan valuations since the time of Fitch’s last review. Those results increased the total unfunded pension liability to the city’s general fund by about 40%. There are particular issues with the city’s DPFP (combined) plan reflecting persistent investment losses and risks highlighted by recent developments related to its deferred retirement option plan (DROP).

The city’s ‘AA’ rating continues to reflect strong operating performance enabled by robust economic and revenue growth prospects, strong control over revenues, conservative budgeting , solid reserve funding, and long-term liabilities that Fitch expects to remain a moderate burden on resources if current extensive pension reform efforts are successful.

CITY TO STAND BEHIND HOTEL DEBT

We have commented before on the intersection of the end of an interest rate cycle, risk, and the demand for diversified yield by investors. We present another example in the form of a financing for a 203 bed extended stay hotel in Montebello CA. In this case the security for the bonds is the revenue generated by the hotel. In the event that there is a revenue insufficiency, the City can be called upon to make appropriations sufficient to make up the shortfall.

The City expects to generate revenues from the collection of transient occupancy taxes collected from hotel guests as well as taxes from the operator of the property.  This does not limit the City’s exposure to the project to only those revenues. The City’s covenant to appropriate is from any available revenues. Demand for the facility is to be generated primarily from businesses and groups looking for conference facilities with access to golf. This hotel would be located within the City’s Montebello Golf Course.

We focus on this deal because it reminds us of a number of other deals like it. They share suburban locations, a business/conference orientation, and were financed at fairly similar points in the economic and interest rate cycles. Unfortunately, these facilities in New Brunswick, NJ, Lombard, IL, and Cambridge, MD all had something else in common – they did not work for their initial investors. Demand did not materialize, cash flows were not sufficient, and in Lombard, the City decided not to make good on its financial support pledges on which bondholders relied.

In this case, it would make for a truly awkward situation as the project has been sold by the City Council to its constituents as one that will generate $1 million annually to the City’s general fund. The deal has other “hair” on it in that there was only one contractor which bid on the project and it was connected by family ties to a member of the approving city council. Caveat emptor!!

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