Joseph Krist

Municipal Credit Consultant

ILLINOIS

The Illinois legislature reconvened this week in another effort to craft a FY 2016 budget. The ongoing linkage between the Governor’s desire for policy changes in the management of the state labor force and a resolution of the state budget stalemate has come into clearer focus. As much as old-time politics has influenced the legislative side of the budget equation, Governor Rauner’s stubbornness in holding out for politically charged changes in union bargaining rights and work rule issues have come to be viewed as serious obstacles to resolution of the stalemate.

The fact that 90% of state spending is mandated statutorily or by the courts (including debt service payment) is unfortunately contributing to the entrenched stances of both sides. There are items that are not being paid. State Comptroller Leslie Munger said  Illinois will have to delay a $560 million November payment to its pension funds, and may also delay or reduce a similar payment in December. This reflects reduced cash flow associated with the lack of a budget. State pension funds will be paid in full by the time fiscal 2016 ends on June 30 using money from higher cash flow months in the spring. Illinois’ debt service payments on bonds total $3.4 billion in fiscal 2016, while payments to its five retirement systems total $6.8 billion.

So it comes as no surprise that Fitch Ratings downgraded Illinois one notch to BBB-plus.

PUERTO RICO

Puerto Rico found out how low the level of trust on the part of creditors is when they reacted to the latest proposal for an oversight board. The generally negative reaction followed the announcement that Governor Alejandro Garcia Padilla has presented to the legislature the Puerto Rico Fiscal Responsibility and Economic Revitalization Act (the “Act”), which will establish the Puerto Rico Fiscal Oversight and Economic Recovery Board (the “Board”). According to the announcement, the Board will be comprised of five members appointed by the Governor and approved by the Senate. The members will select a chairperson from among themselves. It is the lack of outside participation in the process of picking members of the Board which causes concern.

The announcement comes amidst a swirl of rumors over a potential plan by which the U.S. Treasury would assist the commonwealth government in issuing a large bond deal —a “superbond”—with the federal agency in charge of administering some of the island’s tax revenue to repay holders of the new bonds. The hope is that this would lead to Commonwealth revenues at some level going through a “lockbox” to ensure payment on the so-called “superbond”.

At the same time, Resident Commissioner Pedro Pierluisi recently presented a bill in the U.S. Congress that seeks to authorize Treasury to guarantee repayment of principal and interest on future bonds issued in by the commonwealth. The Treasury-secured bonds under Pierluisi’s bill would only be used for urgent short-term financing needs, capital expenditure projects that promote long-term economic development or to refinance existing debt at lower interest rates. Treasury would also determine and notify Congress that Puerto Rico “has demonstrated meaningful improvement in managing its public finances.”

The current unwillingness of the island to accept meaningful outside oversight in order to assuage investors concerns should create a serious roadblock to successful resolution of efforts to negotiate a debt restructuring. Currently, under a proposed debt exchange PRIFA notes would be secured with the proceeds of a rise in oil taxes adopted earlier this year. It is estimated that the PRIFA notes would have had an 8.5% coupon and a 10% yield to maturity.

The existing note holders ultimately rejected this plan, in which the holders would have exchanged their notes for PRIFA notes at 130% of their market value. In addition, there were preliminary plans to have PRIFA bonds mature from 2020 to 2037, which would have extended the maturities held by investors on some and perhaps all of their securities. The bonds would have been callable probably from 2018 onwards at a price assuring a 12% yield-to-call.

If a court impaired the effectiveness of the guarantee of the PRIFA notes, which were supposed to be senior to other PRIFA debt, then the note holders could have exchanged the PRIFA notes for the old GDB notes. If the commonwealth were not to make timely payments on its general obligation bonds or if the commonwealth were to seek bankruptcy for the PRIFA bonds, these events would be considered a default on the PRIFA bonds.

The GDB said it was disappointed that it was unable to reach a constructive and mutually beneficial agreement with the Ad Hoc Group of GDB creditors. According to the GDB, it and the Working Group for the Fiscal and Economic Recovery of Puerto Rico continue to make progress towards a comprehensive voluntary exchange offer that addresses the commonwealth’s indebtedness in a holistic manner and through which creditors across the commonwealth will agree to amended payment terms through consensual negotiations.”

Apparently, Puerto Rico has not earned the market’s trust yet.

TEXAS METHANOL PROJECT FINANCING

In 2013, a $1.8 billion financing for a fertilizer production facility sponsored by an Egyptian company spurred controversy when it came to market. There were concerns about the roots of the foreign ownership, potential dangers from the production process, and the attendant financial risk that bondholders might be assuming that could result from these factors. That financing was successfully accomplished and that project in Iowa is on track for completion by the end of this year.

Now as that plant nears completion and operation, another large financing for a methanol production plant in Texas is being readied for the market. That plant is sponsored by the same Egyptian company and its successors. The largest use of methanol by far is in making other chemicals. About 40% of methanol is converted to formaldehyde, and from there into products as diverse as plastics, plywood paints, explosives, and permanent press textiles. In the US in 2011, the Open_Fuel_Standard_Act_of_2011″ was introduced in the US Congress to encourage car manufacturers to warrant their cars to burn methanol as a fuel in addition to gasoline and ethanol. The bill is being championed by the Open_Fuel_Standard_Coalition”.

Currently, domestic production accounts for one-third of methanol production while some 20% is imported from politically unstable Venezuela. The shale gas boom and lower domestic energy prices have boosted the perceived economics of the project. The combination of supporting domestic production and the seemingly reduced role of a middle Eastern based sponsor (after the pending merger is closed) are seen as factors reducing potential controversy around the deal. The location of the plant amidst a cluster of other petrochemical production facilities reduces concerns about dangers from the process or terrorism.

Once again, the municipal market is seen as a receptive vehicle for yield hungry investors seeking credit diversification and large block size in transactions that are really venture capital financings. This deal, like so many others, presents a complex series of agreements including fuel sourcing and transportation, production, transportation and distribution agreements, and a variety of commodity price based risks. These are all in addition to basic construction and operating risks and the resulting financial risks. All in all, a deal typical of what we see in the municipal market at the end of a low interest rate cycle and a red flag to savvy municipal investors.

CALIFORNIA

State revenues fell short of Department of Finance projections by 2.6 percent in September, but are still ahead of estimates for the first quarter of the 2015-16 fiscal year. In September, two of the state’s three top revenue sources were lower than projections. Retail sales and use tax revenues of $1.7 billion were $392.5 million, or 18.8 percent, less than estimates. Corporation tax revenues of $836.6 million came up $135.2 million short of projections, or 13.9 percent. Only the personal income tax beat Department of Finance expectations. Revenues of $6.7 billion were $447.0 million (or 7.2 percent) greater than anticipated in the budget.

When all taxes and revenues are included, the state in September brought in $9.6 billion, or $252.2 million less than projected in July. Compared to a year ago, September revenues came up short by 1.8 percent. However, for the first quarter as a whole, revenues exceeded last year’s by $1.6 billion, or 7.5 percent. The state ended September with $26.9 billion in unused borrowable resources—$3.8 billion, or 16.7 percent, more than expected.

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