Joseph Krist

Publisher

________________________________________________________________

ISSUE OF THE WEEK

$652,855,000

Black Belt Energy Gas District (AL) Gas Prepay Revenue Bonds (Project No. 3), Series 2018

Moody’s: A3

In the last decade while natural gas prices were fluctuating, prepaid natural gas purchase transactions financed through the issuance of municipal bonds were a popular financing technique. The benefit to the issuers was simple. a supply of gas was secured at a fixed and acceptable to the issuer price. These transactions, complex by their nature due to the number of various participants in the transactions, often benefitted from the credit rating of the guarantor of the payments due under the Prepaid Natural Gas h natural gas markets primarily as commodity traders and suppliers.

As the economics of the natural gas market changed and the financial crisis negatively impacted the credit ratings of the financial institution participants weakened, the attractiveness of the transactions diminished. The declines in ratings impacted ongoing market values of the bonds, raised concerns among investors about their credit worthiness, and in some cases led to defaults and restructurings. Overall, the technique lost favor.

In the current environment, with ratings more stable and more favorable natural gas economics these transactions are making a comeback. This week’s highlighted issue is one such transaction.

Moody’s assigned an A3 rating to this issue. The list of participants explains the level of complexity in the deal. The rating reflects (i) the credit quality of Goldman Sachs Group, Inc. (Goldman) (A3 stable) as guarantor for payments due under the Prepaid Natural Gas Sales Agreement (GPA), the back-end commodity swap and the Receivables Purchase Agreement (RPA); (ii) the credit quality of City of Tallahassee electric enterprise (Aa3 stable), Greenville Utilities Commission, NC (Aa2 stable), Omaha Metropolitan Utilities District, NE gas enterprise (Aa2 stable), and Okaloosa Gas District, FL (A1 stable) (collectively, the Municipal Participants); (iii) the credit quality of the providers of the guaranteed investment contracts (GICs) provided for the debt service account, debt service reserve account and the working capital account; and (iv) the structure and mechanics of the transaction which provide for the payment of debt service consistent with the rating assigned to the Bonds.

How does the transaction work? Bond proceeds will be used by the Issuer to prepay J. Aron (the Gas Supplier) for the delivery of a specified quantity of natural gas to be delivered on a daily basis over a 30 year period. The Issuer will sell gas acquired under the GPA to the Municipal Participants listed above as well as to Clarke-Mobile Counties Gas District, AL (Clarke-Mobile), pursuant to Gas Supply Agreements. Pursuant to the GPA between the Gas Supplier and the Issuer, the Gas Supplier agrees to deliver to the Issuer natural gas in quantities specified in the agreement. The Issuer will in turn sell daily quantities, billed on a monthly basis, of delivered natural gas to the Municipal Participants and Clarke-Mobile pursuant to Gas Supply Agreements. The Contract Price which the Municipal Participants and Clarke-Mobile pay will be based upon a first-of-the-month index price per MMBtu (the Index Price), less a specified discount. Payments for gas delivered will be due on the 22nd of each month. The payments to be received from the Municipal Participants and Clarke-Mobile, plus or minus net payments made or received by the Issuer on the commodity swap described below, combined with interest earned on the debt service account will be sufficient to make the fixed payments owed to Bondholders.

Should any of the Municipal Participants and/ or Clarke-Mobile fail to make a payment for delivered gas, the Trustee will (i) draw on the working capital account in order to make payments to the Commodity Swap Counterparty and (ii) if necessary, draw on the DSRA if there is a deficiency in the debt service account. Risk of non-payment by a Municipal Participant is reflected in their ratings which are incorporated into the rating of the Bonds. In the event of a nonpayment by Clarke-Mobile, if the trustee determines that the balance in the DSRA and/or the balance in the working capital account is less than the minimum requirement and sufficient funds will not be available to pay P&I on the Bonds immediately prior to the final maturity date or a mandatory redemption date, the trustee shall deliver a put option notice under the RPA . Upon receipt of such notice, J. Aron shall purchase such receivables. Therefore, risk of non-payment by Clarke-Mobile is covered by Goldman as guarantor under the RPA.

Since the revenue received from gas sales to the Municipal Participants and Clarke-Mobile is variable and the payment owed to Bondholders is fixed, the Issuer will enter into a commodity swap (the Commodity Swap) with Royal Bank of Canada Europe Limited (the Commodity Swap Counterparty), which will result in the Issuer receiving fixed payments while paying the Index Price to the Commodity Swap Counterparty, on a net basis. In order to address the risk that a nonpayment by the Commodity Swap Counterparty under the Commodity Swap could lead to an insufficiency in the payment due to the Bondholders or result in an early termination event under the GPA and a redemption of the Bonds, all payments to be made by J. Aron under the Back-End Commodity Swap are deposited monthly with a custodian under a custodial agreement. If the Commodity Swap Counterparty fails to make a required payment under the Commodity Swap, the custodian is required under the terms of the custodial agreement to deliver to the Trustee the funds provided by J. Aron on the Back-End Commodity Swap, which funds will be applied by the Trustee in the same manner as payments made by the Commodity Swap Counterparty. In addition, should any termination of the Back-End Commodity Swap occur, J. Aron will continue to make payments to the custodian until the earlier of (i) termination of the GPA and (ii) replacement of both the Commodity Swap and the Back-End Commodity Swap.

If we haven’t lost you by now, it is pretty clear that these bonds are very difficult for the average individual investor to track and value. It has long been our view that these bonds are fraught with risk for an individual investor and that this point was clearly made during the financial crisis. Although those events were hopefully unique and of much lower probability, we still believe that bond issues with this many moving parts and sources of risk are not appropriate for individuals.

_________________________________

EARLY RESULTS FOR VIRGINIA TOLLING PROJECT

A recent state study shows that Interstate 66 tolls for solo drivers in Virginia and expanded HOV hours have not slowed traffic on most major parallel routes during the morning rush hour. Whenever a toll facility opens, there is concern that drivers seeking to avoid the higher cost may switch to nearby free alternative routes resulting in higher volumes on those secondary routes and new bottlenecks replacing the old ones.

The analysis — which found the average daily toll paid in January was $12.37 — also showed that even an increased number of cars on some roads like U.S. Route 50 did not significantly change travel times in January, compared with the same time a year earlier. Speeds on parallel routes, such as U.S. 50, U.S. Route 29 and Virginia Route 7, are largely unchanged from a year ago.

The occasional spikes in tolls to high levels have created eye catching headlines and photos around the country. The State’s spin on the occasional very high toll ($40+) is that “what it’s really telling you is don’t get on, because it means the road is getting congested, this is not where you want to go.” A trip on the George Washington Parkway at 6 a.m. takes largely the same amount of time as the ride on I-66 at that time before tolling began because the highway would become clogged with drivers trying to get to work before the HOV restrictions began at 6:30 a.m.

Some 13,000 drivers are using the road eastbound each morning, and more than 15,000 drivers are using the road westbound each afternoon. Forty-three percent of the trips were vehicles with an E-ZPass Flex switched to HOV mode to indicate that they have at least one other person in the car. Forty-four percent of drivers paid the toll with an E-ZPass. The average morning toll paid in January was $8.07, while the average afternoon toll paid was $4.30. When analyzing only those drivers who paid to use the entire corridor from the Beltway to Rosslyn each way, the average round trip price was $18.06.

As for the extreme toll levels occasionally experienced, In January, 461 drivers paid $40 or more.

CALPERS ADJUSTS DISCOUNT RATE

After much criticism of its investment discount assumptions, CALPERS has decided to lower its assumed annual rate of return on its investment portfolio from 7.5% to 7%. The impact of this decision is to raise the level of contribution expected from the municipalities and their employees to fund their share of the costs of municipal employee pensions. This will increase the expense pressures facing cities across the Golden State.

The long awaited change will generate more conversation about the funding of pensions in the state and give more momentum to efforts to litigate, negotiate, and vote changes in the pension benefits available to current and future municipal employees.

CALPERS cited a number of benefits associated with reducing the discount rate. They  include: strengthening long-term sustainability of the fund; reducing negative cash flows; the fact that additional contributions will help to offset the cost to pay pensions; a reduction in the long-term probability of funded ratios falling below undesirable levels; an improved likelihood of CalPERS investments earning its assumed rate of return; and a reduction in the risk of contribution increases in the future from volatile investment.

CALPERS provided a hypothetical example of the impact on a municipality. A miscellaneous plan with a current normal cost of 15% of payroll can expect an increase to 15.25 % to 15.75 percent of payroll in the first year (Fiscal Year 2018-19), and 16 % to 18 % in the fifth year (Fiscal Year 2022-23). For the UAL payment, a plan with a projected payment of $500,000 in Fiscal Year 2018-19 and $600,000 in Fiscal Year 2022-23 can expect the revised payment to be $510,000 – $515,000 ($500,000×2.00%/$500,000×3.00%) for Fiscal Year 2018-19, and $720,000 – $750,000 ($600,000×20%/$600,000×25%) for Fiscal Year 2022-23. These estimated increases incorporate both the impact of the discount rate change and the ramp up.

Obviously, each city will experience different impacts based on the level of benefits promised and the salaries they provide. This is especially true where municipalities have made significant expense increases related to public safety. In California, there has been somewhat of an arms race among cities seeking to generate economic development through a concerted effort to reduce crime. At the same time demographic trends have been unfavorable. According to CalPERS, there were two active workers for every retiree in its system in 2001. Today, there are 1.3 workers for each retiree. In the next 10 or 20 years, there will be as few as 0.6 workers for each retiree collecting a pension.

In addition to lowering its discount rate, CALPERS also has decided to shorten the amortization period to 20 from 30 years for all investment gains and losses. This will lead to a rise in contribution requirements from participating municipalities. Some cities support the change because they believe it is prudent to shore up the fund and pay down the unfunded accrued liability faster instead of pushing the financial burden to future employees, employers and taxpayers. Other more economically challenged cities are worried that that reducing the amortization schedule will increase their employer contribution rates even beyond what they can afford.

In response, multiple pieces of state legislation have been proposed. Senate Bill 1031 would allow public employers to freeze cost of living adjustments for retirees if the pension fund isn’t 80% funded. SB 1032 would make it easier for local governments to exit CalPERS without paying termination fees. These fees have been cited as a significant hurdle to those cities which would prefer (wisely or not) to manage their own plans. SB 1033, would shift the burden of increased pension costs to the last city that hired an employee.

This would primarily effect cities which like to hire trained police officers from larger municipalities in lieu of financing the cost of training themselves. This is a phenomenon seen often in suburbs across the country which run their own local forces but do not have or wish to expend local resources on training. They tend to offer higher salaries since they have not had to absorb training costs.

How big is the problem? The California League of Cities released a study in January that looked at the situation. It confirmed much of what CALPERS has told its member cities. It found that rising pension costs will require cities over the next seven years to nearly double the percentage of their General Fund dollars they pay to CalPERS. Between FY 2018–19 and FY 2024–25, cities’ dollar contributions will increase by more than 50 percent. For example, if a city is required to pay $5 million in FY 2018–19, the League expects that it will pay more than $7.5 million in FY 2024–25. In FY 2024–25, half of cities are anticipated to pay over 30.8 percent of their payroll towards miscellaneous employee pension costs, with 25 percent of cities anticipated to pay over 37.7 percent of payroll. This means that for every $100 in pensionable wages (generally base salary), the majority of cities would pay an additional $31 or more to CalPERS for pensions alone.

For “mature cities” with larger numbers of retirees, the percentages are even higher. Half of those cities are anticipated to pay 37.9 percent or more of payroll and 25 percent are anticipated to pay 42.9 percent or more of payroll. These findings are not specific to one region of the state. The data shows that cities throughout California are dealing with these challenges. Contributions are projected to be much higher for cities that employ safety personnel (police officers and firefighters). By FY 2024–25, a majority of these cities are anticipated to pay 54 % or more of payroll, with 25 % of cities anticipated to pay over 63.8 % of payroll. In other words, for every $100 in salary, the majority of cities would pay an additional $54 or more to CalPERS for pensions alone. For FY 2024–25, the average projected contribution rate as a percentage of payroll is 34.6 percent for miscellaneous employees and 60.2 percent for safety employees. For cities with a large percentage of retirees, the averages are 39.4 percent and 67.5 percent.

The California pension problem reflects not just its size and scale but also the State’s legal requirements governing spending. Under the California Constitution, a city’s options for revenue raising are strictly limited. Any increase in local taxes requires voter approval and voter tolerance for tax increases is waning. Much of a city’s budget is dedicated to employee salaries and benefits to provide fire protection, law enforcement, parks services and other municipal services. If new revenues are unavailable, as contributions rise, local agencies are forced to significantly reduce or eliminate critical programs. Pressure will continue to impact local California credits.

ANOTHER HEALTH SYSTEM MERGER

Bon Secours Health System (A2/A), an East Coast based Catholic health system and Mercy Health, a Catholic health ministry serving Ohio and Kentucky, announced their intent to merge, creating one of the largest health systems in the country spanning seven states in the eastern half of the U.S.  The merger creates the fifth largest Catholic health system in the country.

The merged entity creates one of the top 20 health systems in the nation and the fifth largest Catholic health system with $8 billion in Net Operating Revenue and $293 million in operating income. Together they employ 57,000 associates and more than 2,100 employed physicians and advanced practice clinicians. Mercy Health provided care for patients more than 6.8 million times in 2017. The system included assets of $6.8 billion and nearly 500 care facilities including 23 hospitals and 26 post-acute care facilities including senior living communities, hospice programs and home health agencies. Bon Secours owns, manages, or joint ventures 20 hospitals and 27 post-acute care facilities or agencies including skilled nursing facilities, home care and hospice services, and assisted living facilities.

Bon Secours has debt outstanding of $818.1 million. Mercy Health had total debt of $1.5 billion.

NYC COMPTROLLER REVIEWS FISCAL 2019 BUDGET PROPOSAL

New York City Comptroller Scott M. Stringer presented his analysis of the Mayor’s fiscal year (FY) 2019 Preliminary Budget and Financial Plan. Highlights include spending grows a modest 1.4% in FY 2019; spending is projected to accelerate to an average annual rate of 2.6% over the entire Plan period, fiscal years 2018 to 2022; revenues are projected to grow at an average 2.2% each year until FY 2022, resulting in budget gaps of $2.2 billion in FY 2020, $1.5 billion in FY 2021, and $1.7 billion in FY 2022; and the February Plan shows a $2.6 billion budget surplus in FY 2018, down nearly $1.6 billion from the $4.2 billion budget surplus of FY 2017.

The theme is not that the City’s finances are in current trouble. Rather, the Comptroller is concerned that any short-run stimulus effects of federal tax cuts and spending are likely to wear off quickly as the Federal Reserve and markets react to rising federal deficits and inflationary expectations. In addition, job growth in the City is expected to decelerate from an average of nearly 90,000 new jobs per year since the end of the Great Recession in 2010, to 22,700 in 2020, 15,900 in 2021, and 16,300 in 2022. He is concerned that spending trends under the deBlasio administration have reduced the City’s cushion against an economic downturn. he cites the City’s declining cash balances as an early warning signal, as they currently sit more than $2 billion below last year’s level, after falling to a low in December of $1 billion – the lowest point since 2010.

A number of spending categories are increasing not as the result of policy but of need especially in the area of housing and homelessness. The increased costs of housing across all income ranges continues to be a significant problem in the City. As a result, Citywide spending on homelessness across all agencies has more than doubled from $1.1 billion in FY 2013 to a projected $2.6 billion in FY 2019 and spending on shelters alone has nearly doubled since FY 2013 – from just over $1 billion to $1.9 billion dollars in FY 2019. In spite of claims by the administration that expanded low income housing is available, the number of individuals residing in shelters has steadily increased from 49,673 in 2013 to 61,029 as of February 2, 2018. One other expense area cited relates to the City’s well documented issues with its jail system. The average daily inmate population has declined by over 30 percent, from 13,850 in 2008 to 9,500 in 2017 but, over the same period, the average annual cost of housing an inmate on Rikers has more than doubled, from about $117,000 in 2008 to over $270,000 in 2017.

According to the Comptroller, the City’s reserves are currently insufficient, at just 9% of adjusted FY 2019 spending. The Comptroller says that the optimal range for the City’s reserve cushion is between 12% and 18% of spending. At the start of the last recession in 2009, the City’s budget cushion was equivalent to more than 17% of spending. The City’s accumulated FY 2018 surplus is over $1.5 billion less than at the start of the year.

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.