Joseph Krist

Publisher

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The year begins with efforts to subvert the November 2020 election. That effort comes after numerous incidents of intimidation and violence against elected officials. I publish this from Sullivan County, NY in a hamlet of 750 people. And yet in neighboring municipalities of similar size in the county we have seen resignations of officials in the face of physical threats. The point is that even the most local political processes have become unable to avoid the vicious display in Washington as we go to press.

Governments at all levels face a populist wave of anger reaching historic levels.  That creates an atmosphere where decisions are made in reflexive response to short term pressures. Those circumstances often lead to decisions with negative long term implications.  An example of this is in our first item this week. Nonetheless, populist anger rules the day at present so we may see more actions taken along  those lines.

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APPROPRIATION DEBT – IT IS WHAT IT IS

In the Show Me State, the trustees for a defaulted issue of bonds ultimately secured by funding from a County which was subject to annual appropriation are not going to be given the opportunity to show their case to the Missouri Supreme Court. To refresh, the case was rooted in a decision in 2018 not to appropriate County funds to cover shortfalls in revenues supporting debt related to a retail development located in Platte County, MO. 

In an effort to preempt legal moves by the trustee for the bonds, the county filed a lawsuit against  the bond trustee in November 2018 seeking court affirmation that it was not obligated to cover shortfalls.  A Platte County Circuit Court judge agreed with the county in a May, 2019 ruling. The trustee appealed and an appellate court panel on Aug. 25, 2020 upheld the lower court decision that the county bears no legal obligation. The trustee in September sought a rehearing that was rejected and it then asked the Missouri Supreme Court to take the case. 

We always were of the view that the effort to force the County to pay would fail. The legal details do not lie. The County was not absolutely obligated to appropriate.   The reality of 21st century municipal finance is that the failure to fund in situations where the requirement to do so is not clearly established in the transaction is no longer the crippling financial stain that it has oft been portrayed as. It helps if you are a smaller and infrequent issuer.

In the case of the bonds in question, interest is being paid but the existing principal amortization is not occurring on a timely basis. The decision by the Court should serve as a basis for more serious negotiations of a restructuring of the debt. It will occur in a changed significantly over time. Zona Rosa is an approximately 500,000 square feet, mixed-use lifestyle center located in Kansas City, Platte County, Missouri. The project opened in 2004 and was expanded by an additional 500,000 square feet starting in 2008. That facilitated a large department store’s relocation.

Ironically, while the litigation played out, the developers announced a plan demolish some storefronts to make way for a new outdoor green space as the first part of a major redevelopment effort. The mall, currently has dozens of vacancies and that is reflected in the financial underperformance of the parking facilities expected to generate revenues for the defaulted bonds. Over time, Zona Rosa hopes to add new multifamily residential development, hotel, office and restaurant space.

We have no quarrel with the idea that an effort to simply walk away from the project and its role as a participant in the financing is troubling. It should be disqualifying as a borrower in the public markets. The reality is that memory fades. If you do this long enough, you see too many examples of defaulting borrowers not only being able to reenter the market but to do so with ratings. But like most any other transactions secured by obligations, there are responsibilities on the investor’s part as well. It reported that this is the ninth transaction involving annual appropriation debt in Missouri to suffer some form of impairment since 2009. So it should not have been a shock.

That goes to reinforce one of our basic tenets of investing and credit risk management. That is the idea that a project should be economically sound and if there is a question about that, then the investors should demand significant financial compensation for that risk. Reliance on legal support as a primary replacement for economic viability simply does not work. Lease rental and other forms of appropriation backed debt are always in a more vulnerable position in bankruptcy. This trend has been reinforced in the restructuring of debt in Detroit and Puerto Rico. Like it or not, the risk of non-appropriation is the new reality.

OHIO NUCLEAR

The Ohio Supreme Court has issued an order stopping utilities from collecting a monthly fee to subsidize two nuclear power plants, part of the state’s scandal-scarred nuclear plant bailout law approved in 2019. A Franklin County judge last week issued a preliminary injunction to stop collection of the subsidies.  The Cities of Columbus and Cincinnati sued to block the law from taking effect January 1st.  That law, and the lobbying process which led to its enactment, were the subject of federal investigations leading to the indictment and resignation of the Speaker of the Ohio House. It is alleged that $60 million changed hands during the legislative process between and among the accused.

The law, HB 6, entitles the plant’s new owner, Energy Harbor, to receive as much as $150 million a year and nearly $1 billion in total. Another $20 million a year from the fees are earmarked for five large solar projects, none of which are operational. Ownership was transferred from First Energy to the Energy Harbor entity as part of its restructuring from bankruptcy. First Energy is at the center of the legal scandal.

The company and its predecessors have been long time guarantors of tax exempt pollution control revenue bonds. So what happens to their successors and the management and operation of the legacy projects can have implications for other investor owned utilities who support municipal bond debt. We also take it as a sign that the utilities know what is economically viable and what is not. As far as we are concerned – message received.

PURPLE LINE MOVES FORWARD

Among the nation’s prominent P3 arrangements, the Purple Line in Maryland has stood out for its delays related to opposition and resistance which led to crippling litigation. Ultimately, the construction member of the partnership pulled out citing unacceptable losses stemming from delays. It is one of the messiest P3 breakups we have seen. It came after the failed P3 renovation project at the Denver Airport. So the P3 concept was under a bit of pressure as we approached year end.

So it was good news to see that the Maryland’s Board of Public Works approved a $250 million legal settlement which requires the State to pay the companies managing the construction to resolve delay-related contract disputes dating to 2017.  The initial ask from the State by the departing partner was $800 million.  So the project has reduced one major cost and source of litigation while providing a basis for moving forward.

Purple Line Transit Partners, now consists of infrastructure investors Meridiam and Star America.  Meridiam and Star America agreed to spend up to an additional $50 million to keep construction moving until a new contractor is on board.  That process has a one year deadline and the hope is that a new contractor will be hired much sooner so that construction can resume. In the interim in the absence of a construction manager,  the Maryland Transit Administration is managing some work, including moving utilities, completing the design and obtaining environmental permits.

NOW THAT THE BALL HAS DROPPED

The New Year will provide some early indicators of the sorts of hurdles and uncertainties states will face as they begin the annual budget cycle. Three large states – New York, California, and Pennsylvania – will each have specific budget issues to deal with. They reflect the general pressures faced by all states but they also reflect issues peculiar to each one.

As the initial epicenter of the pandemic, New York was bound to be in the unenviable position of having to break trail for the others. While a bit of pressure has been taken off the MTA, there remain numerous sources of pressure. The NYC economy is and will remain under extreme duress. The ultimate level of outside funding remains highly uncertain. And the state continues to try to balance the interests on both sides of the landlord/tenant relationship. The current eviction ban will run until the end of February.

California has actually seen substantial revenue growth for the State’s General Fund. For FY 2021 through November, GF revenues were 20% higher than estimated. It was personal income and retail sales taxes driving those gains. Here the State’s income tax structure which had traditionally been a source of volatility actually caused revenues to over perform. Because so much of the State’s income tax revenues come from the highest bracket taxpayers, historic economic slowdowns which impacted that group severely curtailed revenues. In the case of the pandemic, that cohort was least impacted in terms of their ability to generate income by restrictions on the economy resulting from the pandemic.

That does not ensure easy budget sledding for the State. The recent reimposition of lockdowns will serve as an additional pressure on revenues especially as they were imposed through the holidays. The process will be important to watch.

Pennsylvania decided to delay a potentially contentious funding debate which emerged at the end of the last legislative session until this month. Just as a compromise budget for the Commonwealth was about to pass, the state transportation agency (PennDOT) asked for funding to cover a $600 million revenue shortfall related to the pandemic. The debate will come in the wake of the effort to involve the Legislature in the attempt to invalidate the results of the election. And then, they can move on to the FY 2022 budget.

The results of the budget processes in these three states will be good indicators of what the overall budget environment is like.  

TAX CHALLENGE AT THE SUPREME COURT

New Jersey, Connecticut, Hawaii and Iowa have filed an amicus brief in a Supreme Court case that challenges the ability to tax nonresidents’ income while they’ve been working remotely. Arkansas, Connecticut, Delaware, Massachusetts, Nebraska, New York and Pennsylvania rely on the “convenience rule which allows states to tax income earned in the state by non-residents. The case in question was filed by New Hampshire against Massachusetts in October after Massachusetts enacted a temporary tax based on the rule.

Historically, the issues regarding potential double taxation have been resolved through agreements between states. It is a real issue even if an aggressive stand is more a reflection of the fact that 2021 is an election year. It is not a clear cut argument. If one state’s residents are prohibited by a shelter in place order from working in another state, what is the appropriate remedy?

The exact impact of a decision in favor of New Hampshire is unclear as estimates of the ultimate liability range depending upon the states involved. Should it be decided in favor of New Hampshire, it would force the states to attempt to recalibrate their tax relations with other states. We have seen estimates ranging from $1.2 to $3.5 billion in the case of New Jersey taking money back from New York. These are unprecedented times so we are not surprised to see actions taken which reflect the short term conditions imposed by the pandemic.

CHINATOWN REDUX

The Colorado River Compact was drafted in 1922. It allocates the river’s annual flow, dividing the water among seven states. The Colorado provides water to 40 million people and 5.5 million acres of farmland in Colorado, Wyoming, Utah, New Mexico, Nevada, Arizona and California as well as to 29 Native American tribes and the Mexican states of Sonora and Baja California. 

Colorado, Utah, New Mexico and Wyoming must deliver 7.5 million acre-feet a year to Lake Powell for use by the lower-basin states (Arizona, California and Nevada). If the upper basin doesn’t make this delivery, the lower basin can “call” for its water, triggering involuntary cutbacks in water use for the upper basin. The long term drought currently impacting the West has driven flows down 20% over the last 20 years. 

Now the seven states are conducting a new negotiation to manage the Colorado’s flows in the face of that reality. The reduced amount of water has brought renewed attention to one of the most enduring conflicts between agricultural interests and development interests. That conflict has renewed attention to the history of historical water disputes in the region. The easiest example is the dispute over water which pitted interests of farmers in California’s Owens Valley against those of real estate developers in Los Angeles in the 1920’s.

Now the negotiations over the Compact are complicated by the emergence of a significant bloc of private institutional investors. These investors are buying up the rights to water from farmers throughout the region. They won’t use it. Instead, they hope to turn water into a commodity, a basis for speculation tradable on futures markets. They do not seek water for agricultural use but rather as an asset which can be held and manipulated. 

The effort would raise the cost of water especially for users in metropolitan areas. It would not increase supplies. The investors seek to be able to create “accounts” for their water allocations within existing water supplies. Under their plan, an account could be created within one of the region’s federal reservoirs (Lake Powell for example). This would allow the private water owners to hold their water until demand drives the price up. In the case of Colorado, it could theoretically find the State in the position of having to buy back its own Colorado River water. In September, Nasdaq and CME Group, announced a plan to establish a futures market for California water.

Such an arrangement will put some large municipal water systems under pressure. The Metropolitan Water District of Southern California is the largest water utility in the U.S. It has a significant interest in the price of Colorado River water. Should there be a “call” of water, the agricultural water owners would be in a position to profit.

It comes after a year when water utility credits were among the most stable performers. So the introduction of private water markets is a concern and something to watch as the process of renegotiation unfolds over the next five years. It would be a shame to see this sector turned away from its long history of stable financial results and strong credit quality

MORE ANALYTICS FOR THE MUNI MARKET

As is the case with so many other things, in the age of data analytics have become king. Whether its sports, financial management or a variety of other sectors, the available data base and tools to utilize it continue to grow. The rating agencies are developing and acquiring data and using it to implement new ratings criteria. Moody’s explicitly cites environmental, governmental, and social issues when it announces rating changes.

Now there is another data contribution coming from the Federal Emergency Management Agency (FEMA). FEMA has calculated the risk for every county in America for 18 types of natural disasters, such as earthquakes, hurricanes, tornadoes, floods,  volcanoes and even tsunamis.  The risk equation behind the National Risk Index includes three components: a natural hazards component (Expected Annual Loss), a consequence enhancing component (Social Vulnerability), and a consequence reduction component (Community Resilience). 

Expected Annual Loss represents the dollar loss from building value, population and/or agriculture exposure each year due to natural hazards.  Social Vulnerability is the susceptibility of social groups to the adverse impacts of natural hazards, including disproportionate death, injury, loss, or disruption of livelihood.  Community resilience is the ability of a community to prepare for anticipated natural hazards, adapt to changing conditions, and withstand and recover rapidly from disruptions. 

FEMA’s index scores how often disasters strike, how many people and how much property are in harm’s way, how vulnerable the population is socially and how well the area is able to bounce back. That results in a high risk assessment for big cities with high proportions of poor residents and expensive property that are ill-prepared to be hit by once-in-a-generation disasters.

FEMA’s 10 riskiest counties list is led by Los Angeles, followed by the Bronx, New York County (Manhattan) and Kings County (Brooklyn), Miami, Philadelphia, Dallas, St. Louis, Riverside, and San Bernardino counties in California. The bias generated by property values is clearly reinforced in the individual disaster risk indexes.

One example is the fact that Oklahoma City gets a better tornado risk score than does New York City. This reflects the wide disparity in the value of potentially impacted property bases. It does not take into account historic frequencies of events.  It’s flaws are recognized even by FEMA who’s spokesman was quoted in the press as advising “that people shouldn’t move into or out of a county because of the risk rating.”

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.