Joseph Krist

Publisher

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ISSUE OF THE WEEK

$206,710,000*

NORTH CAROLINA MEDICAL CARE COMMISSION

Health Care Facilities Revenue Bonds

(Wake Forest Baptist Obligated Group)

Moody’s: A2  S&P: A

WFB is the largest academic medical center in its region but that has not relieved pressure on the ratings. The Moody’s rating carries a negative outlook. The concerns driving the outlook include WFB’s the fact that operating cash flow margins, which were already moderate in fiscal 2017, fell lower in fiscal 2018 and will likely remain modest in fiscal 2019. The system is absorbing its acquisition of High Point Regional. That merger is leading to higher expenses associated with HPR and unfavorable payor mix shifts. These expenses are negatively impacting cash balances while the balance sheet was increasingly leveraged due to the acquisition. Another source of uncertainty is the potential financial impact of the State’s plan to convert its Medicaid population to a managed care model.

Wake Forest Baptist (WFB) consists of Wake Forest University Baptist Medical Center (WFBMC), North Carolina Baptist Hospital (NCBH), Wake Forest University Health Sciences (WFUHS), and their respective affiliates. WFBMC was created in 1975 and houses the senior management team and many of the centralized functions of three organizations: WFUHS, NCBH, and WFBMC. WFUHS includes the faculty practice plan, the School of Medicine and Wake Forest Innovations (formerly the Piedmont Triad Research Park). NCBH (885 beds) is WFB’s flagship tertiary and quaternary academic medical center. WFB also owns four smaller hospitals: Lexington Medical Center (94 beds located 26 miles south of NCBH), Davie Medical Center (81 beds located 12 miles southwest of NCBH), Wilkes Medical Center (130 bed located 56 miles west NCBH), and High Point Regional Medical Center (351 beds located 20 miles southeast of NCBH).

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BAD MONTH FOR TAX INCENTIVES

The Amazon debacle will be chewed over for some time and a variety of reasons will be offered. None of them individually will account for the company’s decision to take their project and go home. There are however, a few items which stand out that do not require a lot of analysis.

Amazon showed no ability to navigate anything other extremely calm political waters. The company has faced almost no opposition in any of its other locations whether they be headquarters or warehouses. They have been able to steamroll the political structures in so many locations. They got the City Council to reverse itself on housing finance matters merely by threatening not to expand. So they came into the most political jurisdiction in the nation unprepared to work with it.

They failed to appreciate that an anti-union position in New York will galvanize a critical mass of opposition to any entity espousing such a view. They were apparently unaware of the City’s history of successful skepticism of projects of this scale (Westway anyone?). And they apparently did not have the stomach for any real confrontation. That may have been the real miscalculation.

These sorts of machinations are not the prime concern of individual investors who hold municipal bonds. But they are interesting in that the experience does provide certain clues as to how governments and companies will balance their view of local needs versus the views of the general public. One issue that is becoming clearer is the level of public opposition to “tax incentives” and other funding transfers at a time of underinvestment in infrastructure. It was hard to explain in simple terms why the state and city would give up $3 billion at a time when two major agencies (excluding Gateway tunnel costs) need some $60-70 billion of capital funding.

And there was this view – “Google and Apple just expanded their offices,” he said. “And they did it quietly, without any handouts. It just seems that, also, Amazon wanted a bit more than their fair share when everybody else was still doing it the old-fashioned way.” “There should be a more altruistic concept of these companies like Amazon joining the community and earning loyalty rather than, ‘Punch my meal ticket,’” Both of those tech giants have landed in NY and expanded and Google is a significant employer now and going forward. Apple’s stores are fairly ubiquitous throughout Manhattan. So while not a sophisticated expression, the quote speaks volumes. Those interests which tend to speculate in these situations – real estate and retail – did exactly that and are being reminded of the fact that sometimes speculators lose.

It also bears mention that the Amazon project would have been developed within an Opportunity Zone. Ironically, opportunity zones were championed by tech funded interests. The people who invest in Opportunity Funds are able to minimize their tax burden through preferential treatment of capital gains. The people who invest in Opportunity Funds are able to minimize their tax burden through preferential treatment of capital gains. An investor who retains an investment for seven years will pay only 85 percent of the capital gains taxes that would have been due on the original investment. If the investment is held beyond 10 years, the investor permanently avoids capital gains taxes on any proceeds from the Opportunity Fund investment.

The point of the bill was to stimulate investment especially in smaller (less than 1 million) communities. It was not designed to support projects like Amazon’s in Long Island City (LIC). Gentrification was already a well established fact in the surrounding neighborhoods. Some investment in development was already happening with some developers repurposing projects in development in response to the planned Amazon campus. Would it have accelerated existing developments and attracted some newer ones? Of course. That will still happen at a slower and likely more diverse pace.

The public is catching on to these sorts of major revenue concessions to attract development. This is the second prominent such transaction to unfold somewhat differently than contemplated as it follows the reconfiguration of the Foxconn deal in Wisconsin. In both cases, the deals were likely not going to deliver promised job booms for the non-college manufacturing cohort. The continuing efforts by corporations to tie taxes to development run counter to the current political winds. It will be important to see how government tailors its policies to reflect these trends.

CALIFORNIA JANUARY REVENUE

State Controller Betty T. Yee reported California’s total revenues of $18.79 billion in January were lower than estimates in the governor’s 2019-20 fiscal year budget proposal by $1.81 billion, or 8.8%, but higher than projections in the FY 2018-19 Budget Act by $1.21 billion, or 6.9%. Total revenues of $74.42 billion for the first seven months of FY 2018-19 were lower than expected in the proposed and enacted budgets by $2.87 billion and $1.32 billion, respectively. In the fiscal year to date, state revenues are just 0.2% lower than the same time last year.

Sales tax and corporation tax –– two of the state’s “big three” revenue sources –– came in higher than assumed in last month’s proposed budget. For January, personal income tax (PIT) receipts of $16.36 billion were $2.53 billion, or 13.4%, less than the Department of Finance forecasted last month but $403.6 million, or 2.5%, higher than assumed in the budget enacted last June. PIT revenue was still 4.8% higher than in January 2018. Sales tax receipts of $1.59 billion for January were $602.8 million higher than anticipated in the proposed FY 2019-20 budget and $647.4 million higher than in the FY 2018-19 Budget Act. Last month’s $579.2 million in corporation taxes were 9.0% higher than estimates in the FY 2019-20 budget proposal and 12.0% higher than in the enacted FY 2018-19 budget.

ILLINOIS PENSIONS

The new administration in Illinois is attempting to undertake an overall program of asset sales and the use of pension obligation bonds in an effort to improve the State’s woefully underfunded pension plans. Our view of pension bonds has been and continues to be negative. Away from the obvious risk of investment underperformance, we are philosophically opposed to the bonds in that they are always a mechanism to relieve the current pain associated with a current problem. They are a political answer rather than a sound financial answer.

That view is supported by Deputy Gov. Dan Hynes who suggested the key to the plan is to extend the period of time the state has to reach full funding of its pension plays by seven years, to 2052. “Full funding” currently is defined has having 90% of the assets needed to pay promised benefits. He acknowledges that current budget relief is a goal. Extending the full-payment ramp to 2052 will reduce the amount the state has to contribute next year by about $800 million. In fairness, the administration is also suggesting that it will provide a guaranteed annual share of revenues from the graduated income tax Gov. Pritzker hopes to enact into law after voters consider a constitutional amendment in 2020. 

The Governor also supports a plan to consolidate hundreds of smaller pension funds, mostly downstate plans covering police and fire workers, to allow them to cut resources and get better returns on investment. These funds have been a source of contention leading to court actions seeking to segregate operating funds and requiring them to be applied to pension funding. This has significantly reduced the operating flexibility of the smaller communities often exacerbating already weakening financial positions.

TEXAS DEVELOPMENT FINANCING

One of the tried and true methods of financing infrastructure in unincorporated areas of the Lone Star State is the use of municipal utility districts (MUD). MUDs are created under Texas law and are managed by a board of directors often consisting of developer representatives. The construction of the infrastructure is undertaken to support development against which taxes are levied  for the monies needed to pay off the MUD debt. In reality, the hope for a MUD is that the larger municipality next to which many MUDs are located will annex the land in the MUD. The MUD debt is then refinanced with debt secured by the much larger revenue base of the annexing entity. MUDs are regulated by the state, require a local election to issue bonds, and exist separately and out of the control of a city or county government.

That structure raises issues of control and management for the municipalities which are expected to absorb the debt acquired through annexation. One solution to those control issues is the use of public improvement districts (PID).  PIDs issue debt backed by special assessments which are fixed for the life of the issue. PID are created within existing municipalities. PID bonds are issued by cities or counties but, they are clearly only repaid from assessments and not by the local government’s general obligations. They carry separate ratings from the government’s credit.

PID debt much more closely resemble assessment backed debt issued by jurisdictions in  Florida and California. This will introduce an increased level of risk from exposure to the willingness and ability of developers to pay the assessments through the build out phases of these developments. While a newer risk for Texas investors, the use of PID debt is much more familiar to the high yield municipal investors across the market. With PIDs effectively restricted to larger minimum denominations ($100,000) yields tend to be higher reflecting the developer risk . Significant increases in the issuance of this debt (MUDs outstanding exceed PIDs outstanding by a factor of 10) will provide a new sector for institutional high yield investment.

One characteristic of Texas MUD debt is that it is highly concentrated around the Houston area. Historically, this was seen as a positive. Recent attention focused on the chronic flood problem facing Houston and surrounding Harris County has raised some concerns about the potential for flooding to alter or limit development. The Dallas Fed has raised the issue as it surveys the outlook for economic growth in the Houston region. ” The high concentration of MUDs in the Houston area may expose this financing model to new risks — those associated with more frequent and catastrophic flooding events. While MUDs will likely remain a vital part of the developer’s toolkit, this type of debt could become costlier and raise home prices in residential developments. And rising costs for homeownership might diminish one of the Houston area’s traditional selling points: affordability.”

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.