Muni Credit News September 10, 2015

Joseph Krist

Municipal Credit Consultant


An independent financial control board will be tasked with ensuring that the recently released Fiscal & Economic Growth Plan (FEGP), once approved, is followed. It would comprise “experienced individuals from inside and outside the commonwealth,” according to an executive summary of the FEGP, with most of its members selected from a list that will not be determined by the government. It assumes that it would have the necessary powers to ensure compliance, particularly if subsequent administrations decide to do away with the final plan. The board would have the authority to approve the plan, as well as the power to force budgetary cuts, among other corrective actions that will be part of draft legislation submitted to allow for its establishment. It has yet to be revealed when the Economic Recovery Working Group will deliver its proposed legislation to Puerto Rico lawmakers for their necessary approval.

The board will oversee new budgetary regulations and practices, pursuant to a proposed law that would be known as the Fiscal Responsibility & Economic Revitalization Act. Constitutional questions have surrounded this topic since the group first began its work back in July. Legislation to this effect would have to be thoroughly analyzed to ensure it doesn’t infringe on the commonwealth’s Constitution and the delegation of powers.

Puerto Rico’s government will also need to get help from Washington, D.C., with many of the plan’s critical aspects depending heavily on federal action, as the commonwealth attempts to achieve economic growth and solve its fiscal woes. The plan again highlights the commonwealth’s lack of an orderly procedure to restructure its liabilities.

To control healthcare costs, the plan urges for parity in Medicare and Medicaid funding from the federal government. The FEGP recommends a long list of initiatives that would provide the commonwealth with equal treatment under both federal programs, allowing the local government to control healthcare costs.

Commonwealth efforts to achieve budget balance include extension until FY 2021 the Act 66 of2014’s freeze of new hires, formula-based appropriations, service costs, increase in salaries and collective bargaining agreements although the impact does not include the negative effect on Additional Uniform Contribution to the public pension systems. To reduce payroll costs the Commonwealth would implement a 2% annual attrition target. To achieve the attrition target, the Office of Management and Budget (“OMB”) may offer early retirement window to selected public sector employees. The Commonwealth may use a portion of the proceeds of P3 initiatives to incentivize voluntary retirement.

The FEGP calls for legislation to, beginning FY 2018, gradually adjust subsidies provided to municipalities by the central government, while empowering municipalities with the proper legal, administrative and operational tools for them to offset such decrease. The Commonwealth proposes significant changes to the funding scheme for the University of Puerto Rico in order to reduce the general fund subsidy requirement.

Much has been made of the demands from certain creditor groups to reduce education spending. This reflects the facts that since 1980, enrollment at public schools has declined 41% and, due to demographic trends, it is expected to fall an additional 25% (317,000 students) by 2020. This decline has led to a reduction in school utilization and a decrease in the student to teacher ratio to 12:1 (US average is 16:1). The Commonwealth proposes reduction of the  PRDE payroll through 2% attrition.

Other Commonwealth actions include proposals to concession remaining toll roads, including PR-20, PR-52 and PR-66 as well as maritime transport and bus system operations. These include 5-year minimum concession agreement for the operation and maintenance of the public maritime transportation services.

Several efforts will be made  to encourage Congress to provide Puerto Rico with tax treatment that encourages US investment on the island, such as the amendment of the US Internal Revenue Code to add new Section 933A to permit US-owned businesses in Puerto Rico to elect to be treated as US domestic corporations; enactment of  an economic activity tax credit for US investment in Puerto Rico designed as a targeted, cost-efficient version of former Section 936 of the US Internal Revenue Code; and in the event the US moves towards a territorial taxation system, exempt Puerto Rico from base erosion and/or minimum tax measures.

Other Federal action that could provide short-term impact include financing from the Department of Energy for the Aguirre Offshore GasPort project and finalizing its federal permit process; Federal Aviation Administration approval for airport consolidations; and technical assistance from the Bureau of Economic Analysis, Census Bureau, National Agricultural Statistical Service and Build America Transportation Investment Center.

The plan will also need an extension of the ruling that allows manufacturing companies that pay the Act 154 excise tax to deduct it against federal taxes. Successfully achieving an extension will allow the Puerto Rico government to extend the 4% tax until December 2017, after which it would be replaced by a “modified source income rule tax.” The large share of the island’s General Fund revenue comes from the levy, accounting for about 20%.

The plan’s base-case scenario assumes approximately -1% real growth in GNP while the high-growth scenario assumes structural reforms lead to GNP growth of 2% by 2020 (2% inflation is assumed in both cases). In the end however, the plan comes up short in terms of providing for sustainable budgetary balance. The government estimates a $ 27.8 billion cumulative financing gap over five years but 27.8 billion cumulative financing gap even after full implementation of the plan the proposed initiatives, together with economic growth, are expected to reduce the five-year financing gap by only about $13.8 billion, when taking into account $2.5 billion in incremental costs of the measures.

As for the Commonwealth’s debts, here is what the report concludes. “As difficult as debt restructuring is likely to be, the Working Group has instructed its advisors to begin working on a voluntary exchange offer to be made to its creditors as part of the implementation of the Fiscal and Economic Growth Plan  In the design of the voluntary exchange offer, the Working Group has directed its advisors to take into account the priority accorded to various debt instruments across the Puerto Rico debt complex, including its GO debt, while recognizing that, even assuming the clawback of revenues supporting certain Commonwealth tax-supported debt, available resources may be insufficient to service all principal and interest on debt that has a constitutional priority  Therefore, a consensual compromise of the creditors’ competing claims to the Commonwealth’s revenues to support debt service will be required in order to avoid a destabilizing default on the Commonwealth’s debt and to avoid a legal morass that will further destabilize the Commonwealth’s economy and finances  Accordingly, the Working Group has directed its advisors to meet with the creditor groups that have already been organized (and those that may be formed hereafter) to explain the Fiscal and Economic Growth Plan and to begin negotiation of the terms of a voluntary exchange offer that can garner widespread creditor acceptance  It is the Working Group’s belief that a voluntary adjustment of the terms of the Commonwealth’s debt that allows the measures contained in the FEGP to be implemented is the best way to maximize all creditor recoveries.”

Undermining the statements about voluntary exchanges is the Commonwealth’s announcement on Wednesday of its long-awaited debt restructuring proposal. The plan does not include the debt payments of its electric utility and its water and sewer authority which are being handled separately. Nor did they include debts structured without any payments due in the next five years. That leaves DEBT with a face value of some $47 billion. Five years’ worth of interest and principal payments on them is estimated at $18 billion. These include Puerto Rico’s general obligation bonds, which were sold to investors with an explicit constitutional promise that timely repayment would take priority over all other expenditures on the island.

The restructuring would provide $13 billion to finish paying for government services over the coming five years, which would leave just $5 billion for the bondholders over that period. It was not detailed how they thought this might be divided among the different classes of debt. Creditors are expected to get a more detailed set of cash-flow projections from the working group and form negotiating groups of their own over the next few weeks, according to the types of debt they hold. Then the negotiations over altering the repayment are expected to begin.

One way or another, it is clear that the Commonwealth is likely relying on both a reduction and an extension of its debt repayment schedule to finance itself. We continue to believe that this will lead to a protracted and uncertain process which can and should hamper the Commonwealth’s ability to access needed capital financing in the public debt markets.


Standard & Poor’s downgraded Kentucky’s debt and credit rating last Thursday, citing the enormous and growing unfunded liabilities of its public pensions plans, as well as the lack of commitment by the state’s elected officials to do anything about it. The rating was lowered from AA- to A+. S&P said, “the downgrade reflects our view of Kentucky’s substantially underfunded pension liabilities that are the result of chronic underfunding and that we view as placing long-term pressures on the state’s finances. Despite pension reform efforts that began in 2008, Kentucky lawmakers have yet to make meaningful progress in reducing its long-term pension liability, especially as it relates to Kentucky Teachers’ Retirement System (KTRS). Although pension reform was discussed in the 2015 legislative session, the session ended without a resolution on how to address  KTRS’ large unfunded liability.”

The estimated combined $48 billion of unfunded liabilities for both pension systems is the equivalent of $12,000 for every man, woman and child in the state.


In communities with large numbers of charter schools, legacy school districts struggle with declining enrollments that can lead to school closings and leave the remaining schools with students who often are the most difficult to educate. One such example is the Detroit Public Schools. Population declines and the availability of charter schools have reduced revenues distributed to it on a per pupil basis. This has made it more difficult for the DPS to balance its operations and reduced available funds for debt service.

As a result, Standard & Poor’s Rating Service announced its downgrade of two series of long-term bonds issued by the Michigan Finance Authority for DPS. S&P lowered the rating on 2011 revenue bonds to “A” from “A+” while 2012 revenue bonds dropped to “A-” from “A+.” This even though the bonds are pledged to be repaid from state aid to the schools, with the money passing each month directly from the state to a trustee charged with making the bond payments.


Washington State’s highest court declared last week that much of the law underpinning new charter schools around the state was unconstitutional. The court set a 20-day clock, at which time the charter system could be dismantled — a step that legal experts said no other state court had ever taken. The failure to enact school funding reform was already a huge budget and political issue. The panel that struck down the charter law, last month began assessing $100,000 a day in fines on the state until the Legislature comes up with a plan to better fund the K-12 system as a whole. Some teachers unions, including Seattle’s — the state’s biggest system — have been threatening to strike over issues of pay and staffing. Classes are scheduled to start on Wednesday in Seattle.

The court ruled that under the state Constitution, charter schools had to be run by a locally elected school board because they are operated with public money. The Washington court defined public schools in a unique way — the court cited in particular a 1909 legal precedent requiring that schools be governed by locally elected school boards —other states.

In the initial schools case, McCleary et al v. Washington, which led to the order last month on fines, the court said years of underfunding had created a patchwork of rich and poor, with some districts better able to raise taxes and money for their schools than others. The court said it would put the $700,000 a week in contempt-order fines assessed on the state into an education fund and keep collecting the money until a new plan was approved.

In its new ruling on the second case, League of Women Voters of Washington et al v. State of Washington et al, the court said that public funding and local control were intertwined and enshrined in Washington law and that privately run charter school boards did not constitute that elected control. “The fiscal impact of the initiative was merely to shift existing school funding from existing (common) schools to charter schools,” the court said.

One option under consideration if the State Legislature does not address the issue soon, is to treat the charter schools as extensions of home school, allowing students to continue in their current schedules and classes while issues of money were sorted out.


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