Joseph Krist

Publisher

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The turn of the leaves lets us know that we are about to enter a potentially difficult phase of the pandemic. Lacking a vaccine, the potential for a “second wave” overhangs the economy. In the meantime, there has been much focus on the failing stimulus process. The individual impacts on individual states and cities are already coming into focus. With the close of the fiscal first quarter for many governments, revenue realities will begin to take shape.

The crush on revenues is creating newly favorable environments for policy and fiscal changes. In New Jersey we see the “millionaire’s tax” about to make it into law. In Pennsylvania, the issue of legalized recreational marijuana is up for debate legislatively. It’s an issue we focus on in more detail below. On the revenue side, the news continues to be negative. The NYS Comptroller reports that Local government sales tax revenue declined by 7.8 % in August compared to the same period last year. This drop in revenue is similar to the decline in July of 8.2 %. New York City had a 7.1 % decline, a $43.9 million reduction in revenues, which was comparable to the 7.3 % ($44.6 million) decrease seen in July.

A lack of congressional action and a continuation of trends continue to weaken credit. So risk increases. At the same time, all indications are that rates will be held low for an extended period making getting compensated for risk that much  harder. Stay awake!

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CANNABIS

A petition in Montana to legalize recreational marijuana for adults 21 and older has qualified for the state ballot in November. Initiative 190 and Constitutional Initiative 118 will be eligible for state residents to vote on. It is impressive that the ballot items qualified given the limitations of the pandemic. The initiative reportedly required 25,000 verified signatures to qualify, while the constitutional amendment needed around 50,000.

The initiative would legalize the sale and possession of limited marijuana quantities while adding a 20 percent tax on the sale of non-medicinal pot products in the state. Supporting organizations estimate that sales would generate $48 million in tax revenue for the state by 2025.

In South Dakota, Amendment A would legalize the recreational use of marijuana for individuals 21 years old and older. Individuals would be allowed to possess or distribute up to one ounce of marijuana. The amendment would require the South Dakota State Legislature to pass laws providing for a program for medical marijuana and the sale of hemp by April 1, 2022. Mississippi voters will decide whether to legalize medical marijuana. 

Arizona voters will be able to vote on Prop 207. If it passes, Arizona lawmakers would have to establish regulations for the Arizona recreational marijuana industry by April 5, 2021. The proposition purports to cover the whole range of concerns with legalization. Adults 21 and older would be able to possess 1 ounce of marijuana and the law limits home cultivation to 6 plants at an individual’s primary residence and 12 plants at a residence where two or more individuals who are at least 21 years old reside at one time.

A 16% excise tax (the same as cigarettes and alcohol) would be placed on recreational marijuana products. Money from the excise tax would fund various state agencies and be dispersed between community college districts, police and fire departments, and the Highway User fund. Marijuana use would remain illegal in public places and no marijuana products could be sold that imitate brands marketed to children or look like humans, animals, insects, fruits, toys or cartoons.

The governor of Pennsylvania has proposed legalization as a revenue source. This comes as New Jersey voters will consider Question 1. It would amend the state constitution to legalize the recreational use of  cannabis, for persons age 21 and older and legalizes the cultivation, processing, and sale of retail marijuana. The constitutional amendment would take effect on January 1, 2021. There would still be a significant legislative hurdle to overcome as the amendment would only be enabling the legislature and CRC to enact additional laws and regulations.

Much as was the case when Prohibition was ended in the midst of the Great Depression, initial moral objections to the legalization of alcohol were overcome by the need for state revenues during a time of economic distress. Current state and local government fiscal conditions are creating a similarly based source of support for legalization of marijuana.

APPROPRIATION DEBT

The long running dispute between Platte County, MO and holders of 2007 Platte County Industrial Development Authority bonds issued to finance parking facilities at a shopping mall is destined for the Missouri Supreme Court. In 2018, the County decided not to appropriate some $765,000 to cover shortfalls in revenue available for debt service on the bonds. The County had pledged to make up such shortfalls but the payment of those monies was dependent upon annual appropriations by the County legislature.

Such language is not unusual in financings of this type and while uncommon, other jurisdictions have taken similar actions when revenues which came up shirt were generated from private facilities. Other such non-appropriations have involved hotels and ice skating facilities.

The trustee for the bonds had threatened to pursue litigation from the start of the dispute in 2018 so the County sued to have its agreement validated and has won two prior rounds in the Missouri courts. The trustee unsuccessfully argued the financing agreement supporting the bond issue represented a legally enforceable promise to pay, even in the face of clear language in the bond documents that any payments under the County pledge were subject to appropriation. The Missouri Court of Appeals for the Western District opined that the plain language of the Financing Agreement does not contain a promise by the County to pay for the shortfalls for the Zona Rosa Bonds. 

The continued litigation comes as the new developer for Zona Rosa has announced major changes to the development. Plans include the demolition of retail space and the increase in open green space. It comes as the new developer hopes to develop multi-family housing and hotels at the development. Zona Rosa has been struggling since the Great Recession and more than 50 of its storefronts are closed. The mall hopes to continue to diversify its real estate with more office and residential uses. No details have emerged so it does not appear that there will be any quick fix for the defaulted bonds.

The dispute gives us an opportunity to reinforce our long held belief that investors who rely on legal provisions over and above economic fundamentals are making a serious mistake. If a project is not economically viable on its own, legal provisions can only help so much. They guaranty a place on line at bankruptcy court and not much else. Threats against market access for issuers who do not meet “moral obligation” payment requirements have proven largely empty.

As litigation has increasingly become a favored tactic of investors, the increasing reliance on litigation simply reinforces the details of the legal agreements underlying bond issues. “Moral obligation” security pledges are not legally enforceable payment requirements. The litigation in this case will likely result in affirmation of that concept.

As always, it is up to the investor to do their due diligence and to understand exactly what the legal provisions are and to understand what they do and what they do not do.

GOING TO SCHOOL ON THE MLF

If you have been doing this as long as I have, the continued inability of Congress to get its arms around the municipal bond market is a source of unending frustration. The latest evidence is that Congress is planning to hold hearings on the Municipal Lending Facility. The MLF is a borrowing program which allows the Federal reserve to provide liquidity funding to state and local governments which cannot be addressed through the marketplace.

The MLF provides funding at relatively expensive rates. The Fed initially charged issuers a premium for using the program at a baseline of 150 basis points for triple-A to 590 basis points for below investment-grade-rated issuers. Last month, the Fed reduced those prices by 50 basis points in each credit category. That still does not provide cheap money. As a result, potential borrowers seem to be waiting out the process currently underway in Congress to develop one more stimulus package.

This has caused some consternation among some in Congress who apparently expected strapped municipalities to embrace short term borrowings in a rapid manner. They are shocked that only two borrowers have accessed the funding. That concern reveals a failure to grasp what the facility was intended for – a lender of last resort who could provide financing at a market clearing rate. By that measure, the lack of utilization is almost predictable. In addition, the program was designed with a major flaw in that the minimum population requirements for borrowers – 500,000 – excluded huge swaths of the issuer community to be denied access to the program. There are e tire counties at the forefront of the excess expenditure pressures facing governments who are not able to access the funding.

Those are the obvious places to start. Municipalities have been clamoring for a reduction in the population threshold with numerous bills being offered to do so. That would be a start. A further reduction in borrowing rates would make sense. The problem is that Congress has limited time to act unless one believes that action could be taken during a lame duck session. It is likely that some borrowers are waiting until after the election to see what the expected makeup of Congress is to determine the likelihood of a better deal emerging from a different political atmosphere after January.

MTA DOWNGRADE

The most predictable downgrade of the year finally happened when Moody’s lowered its rating on NY MTA transit revenue bonds from A2 to A3. The Authority’s precarious financial position is well known. The highly uncertain outlook for additional aid from the federal government helps to drive the timing of the downgrade as well as the maintenance of a negative outlook.

This is a very difficult period for the agency. The corporate sector in NYC is working to return its workers to office locations which would hopefully increase utilization of public transit and generate revenues. Some companies are considering rotation plans which would effectively turn many office jobs into a form of shift work. This would enable them to meet pandemic limits on occupancy to enforce social distancing.

A return to the status quo is likely the best long term remedy for the revenue woes of a system which derives a far greater proportion of its total revenues from fares than do most transit systems in the US. More clarity around timelines for an increase in demand would enable the Authority to be more precise in estimating its revenue needs going forward. The problem is that there remains great resistance to the idea of a return to status quo as well as the likelihood of extended economic disruption.  

WATER WARS

When I write about disputes over water, those stories usually come out of the American West. While the extended drought which has plagued the West is rightly now in the spotlight, the first Supreme Court case to resolve a dispute over groundwater that crosses state lines will unfold over the session beginning October 1. That case is a dispute over the use of a fresh water aquifer which provides very clean fresh water to businesses and residents of a three state region.

Mississippi v. Tennessee has been dismissed and rejected  multiple times since Mississippi originally filed the suit against the City of Memphis and its utility company Memphis Light, Gas, and Water in 2005. In 2014 the State of Mississippi revived its suit and added the State of Tennessee to the list of defendants.  The interstate nature of the dispute enabled the Supreme Court to accept the case.

The appeals continued in spite of a significant trail of case law that supports water having a special status as an asset in terms of ownership. Individuals and entities can often have rights to the use of water accessed through their property but ownership of the water itself as part of the real estate has been negatively viewed by courts for nearly 200 years.

It is an argument about where each party gets to place its “straw” into the aquifer in question. Some of the argument ironically around increased use of what has become a  scarce and declining asset – the water. One of the factors driving the search for a final judgment is that the water’s purity makes it a source of inexpensive and non-filtered water. That is a significant cost to avoid. As is the claim by Mississippi for some $615 million. It is also been driven by evidence of subsidence in the area which indicates that the aquifer is effectively running low.

SEC ENFORCEMENT

Yet another municipal bond issuer has run afoul of the securities and exchange commission (SEC). In the latest example, charged Park View School, Inc., a state-funded, nonprofit charter school operator based in Prescott Valley, Arizona, and its former President with misleading investors in an April 2016 municipal bond offering.

The complaint charged that in the years and months leading up to the bond offering, Park View experienced significant operating losses and repeatedly made unauthorized withdrawals from two reserve accounts to cover routine operating expenses, to pay other debts, and to transfer money to affiliated entities. Park View allegedly defaulted one year later by reducing the interest payments that it made on the bonds. Park View allegedly provided investors an offering document that included misleading statements about profit and expense projections and showed that Park View would be profitable in the upcoming fiscal year and able to repay the bondholders.

According to the SEC, a 2016 official statement issued to support an offering of bonds included misleading statements about profit and expense projections and showed that Park View would be profitable in the upcoming fiscal year. In reality, it experienced significant operating losses and repeatedly made unauthorized withdrawals from two reserve accounts to cover routine operating expenses, to pay other debts, and to transfer money to affiliated entities.  

Park View and its President agreed to settle with the SEC and to be enjoined from future violations of the charged securities laws. The school President  further agreed to pay a $30,000 penalty and to be enjoined from participating in future municipal securities offerings. Investors seem to have overestimated the state’s role in chartering the school and assumed a level of veracity to be associated with a state chartered entity that simply was not there.

The irony is that the schools – a middle school and a senior high school-  Prescott, AZ – are not new to the municipal bond market. The sponsor has been chartered for 20 years and has had outstanding debt since at least 2011. So they knew what the rules of the road were when they brought this issue to market leaving them little excuse for misleading investors. The situation also highlights the role of conduit issuers and the lack of control or authority over the conduct of some of the borrowers they help.

THE FUTURE IS ALREADY HAPPENING

I continue to see article after article issuing “the answer” to a whole range of estimates of the ultimate impact of the pandemic in relation to the structure of work. Much is being made of the ongoing debate in cities like New York and other major economic hubs over how to reopen. The most intense debate in terms of public goods has been over education. A consensus formed around online learning except in NY. The issues in the private sector seem to revolve around when office staff can be asked, requested, or required to return. At the same time, the hospitality industry continues to be battered.

In the most  cautiously reopened major city, NY, major employers are quietly establishing schedules and procedures which would enable fairly significant numbers of their employees to return to office settings. It’s what is driving some of the clamor from major businesses in the city. New York office-based employers have been permitted to bring back workers at 50 percent capacity. As the pandemic drags on, the pressure will be there to repopulate existing office space which often exists under long term lease. The asset becomes a drag as the cost of rent is not offset by the existence of any economic activity on site.

Despite the benefits of working from home being apparent to many, there is also a significant share of the workforce that relishes a return to the office. Here is where the maintenance of existing space and the goals of a new workplace actually converge. Office capacity will have to be reduced to meet social distancing requirements so some work from home will likely continue on a rotational basis. Real estate interests are already talking about total workplace ecosystems and other concepts in support of the idea that office space and the demand for it will still be needed.

The timing and scale of the return to offices will be the key factor driving transit, development, and real estate trends longer term. It is hard to see in the midst of the event unfolding whether it be the pandemic, the fires, or the floods and storms that they have an eventual end. That is not the same as saying that it will just go away. We believe that cities are not dead and that ultimately employment will drive migration pretty much as it has always done.

NEW JERSEY MILLIONAIRE TAX

It has always been a policy goal of the Governor to raise marginal income tax rates at the high end off the income scale. Opponents have long believed that such a tax scheme would drive high income residents out of the state (to places like Florida where there is no income tax). It has taken the economic impact of the pandemic to make the concept acceptable politically. To that end, the Governor announced a budget agreement with the legislature whereby lawmakers agreed to raise the tax rate on income over $1 million to 10.75 %, up from 8.97 %. Individuals earning more than $5 million were already taxed at the higher rate.

The deal may not be as beneficial to the state as it also includes a recurring $500 rebate for families with at least one child and an annual income of less than $150,000 a year for couples and $75,000 for single parents. Estimates of the revenue impact of the new tax are $390 million in new revenues but this is offset by the cost of the rebates estimated at $340 million. So it is a tax shift rather than a real revenue producer.

The politics matter. More than 1.5 million NJ residents have filed for unemployment benefits since lockdowns were imposed. The Governor has a 71% approval rating. So the political stars aligned for the tax shift to be agreed to. Now we will see how realistic the threatened exodus from the state will be. An above average hurricane season and the current wildfire disaster are limiting the options for people looking to move. So the jury is out on the impact of the tax plan.

The next step is legislative approval of the full budget.  The pending nine-month, $32.4 billion spending plan will cover the remainder of fiscal 2021 beginning  Oct. 1. (The 2020 fiscal year was extended through September 30.)  The proposed budget Mr. Murphy released last month also includes about $1.2 billion in spending cuts and $4 billion in new bonding debt.

So, if adopted, New Jersey will be the crash test dummy for the raise taxes on the rich movement. If it succeeds, progressives will move onto other states with graduated income tax schemes (New York being the next likely battleground) and try to achieve the goal of taxing the rich there.  The debate will unfold as the home sale market in northern NJ has heated up as NYC residents seek homes with outdoor space within commuting distance. So it will be interesting if that dynamic is altered by the tax if enacted.

 
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.