Restructuring Municipal Debt: Is there a Lesson to be Learned from China?

May 14, 2015
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Getting Ready to Rumble. San Bernardino will release a proposed, sweeping plan of municipal debt adjustment this afternoon for the Mayor and Council to vote upon on Monday—a plan expected to propose sweeping changes which will affect the city’s businesses and residents, employees, and creditors for years to come—albeit, those changes, which will affect not just the different classes of the city’s creditors, but also its citizens, will not all be the same. City Attorney Gary Saenz yesterday noted: “It treats our citizens much better than our municipal bondholders…We expect our plan is going to provide for a substantial impairment of those (outside-the-city) groups, all for the purposes of increasing our service levels for our citizens. For each dollar we don’t pay our pension obligation bondholders, we will have a dollar to provide services.” Mr. Saenz, emphasized that the city had already made clear its intent to fully meet its public pension obligations to the California Public Employees’ Retirement System―in order, he noted, to retain employees―bit which, he noted, had already led to litigation against the city from its pension obligation bondholders. Without directly addressing the specific changes to cuts in basic city services, Mr. Saenz did state there would be “increased efficiencies” in municipal services, as well as other, unspecified “tough choices,” adding: “We are committed to it as a city…If we fail to implement in a significant way… Judge Jury (U.S. Bankruptcy Judge Meredith Jury) will have jurisdiction to call the city on that and require that we implement.” Dissimilar to the processes of finalizing plans of debt adjustment in Central Falls, Rhode Island and in Detroit; San Bernardino’s plan has been put together after seeking considerable citizen and business impute, strategic planning sessions by its elected leadership—or, as Mr. Saenz put it yesterday: “It was very much our intention, through the strategic plan and otherwise, to get input from the entire community — both the business community, the education community, and of course the everyday citizens — with regard to the city they want in the future…It was our intention to incorporate that into the Plan of Adjustment. We believe we have been successful in doing that, and we believe that the core team will concur that to the degree that we could, that we have been successful in doing that.” In fact, the city’s “core team” of 17 community representatives, as well as any other interested community members, will meet Saturday morning for a lengthy session to discuss the proposed plan of adjustment and other aspects of the city’s long-term future—a key session in advance of Monday’s vote. With Mr. Saenz warning, in advance, that the plan will involve some pain for many groups: “I believe that one of the primary purposes of Chapter 9 bankruptcy law is that a city that needs the protecting and the assistance of the bankruptcy court to readjust itself in order to continue providing services is going to need to do a number of things…That includes, unfortunately, impairment not only of a number of our creditors but of employee groups as well, and even to some extent impairment of our citizens who are going to have reduced service levels.” Nevertheless, he added, like castor oil, such a plan could be a keystone to a better and more sustainable fiscal future: “That’s the essence of it, a plan that essentially incorporates what the council will adopt as our recovery plan,” he said. “And that, of course, is going to describe for the court and all our creditors and, most importantly, for our citizens, how our city is going to recover and how we’re going to reestablish service solvency — which in my mind is the most important objective.”

An Ill Fiscal Wind. Citing the unremitting burden of debt from the Illinois Supreme Court’s recent decision finding the state’s proposed public changes unconstitutional, Moody’s has reduced the City of Chicago’s debt rating to junk with a negative outlook, writing that the city’s options for reducing the growth of its public pension liabilities “have narrowed considerably.” The rating agency dropped the Windy City’s $8.9 billion of general obligation, sales tax, and motor fuel bonds to a speculative grade Ba1—an action which will exacerbate Chicago’s borrowing costs when it reoffers floating-rate debt in fixed-rate mode later this month, and which could trigger a series of fiscal tribulations relating to bank support on its short-term borrowing program and other credit contracts: “Based on the Illinois Supreme Court’s May 8 overturning of the statute that governs the State of Illinois’ pensions, we believe that the city’s options for curbing growth in its own unfunded pension liabilities have narrowed considerably…Whether or not the current statutes that govern Chicago’s pension plans stand, we expect the costs of servicing Chicago’s unfunded liabilities will grow, placing significant strain on the city’s financial operations absent commensurate growth in revenue and/or reductions in other expenditures…The magnitude of the budget adjustments that will be required of the city are significant. In response, Chicago described Moody’s action as not only premature, but also irresponsible—an action which the city decried as playing politics with Chicago’s financial future by pushing the city to increase taxes on its residents without reform. Chicago’s four pension plans, collectively, have more than $20 billion in unfunded liabilities—leaving the city as much as about half the assets necessary to meet its promises. In response, Mayor Rahm Emanuel said: “While Chicago’s financial crisis is very real and at our doorsteps, today’s irresponsible decision by Moody’s to downgrade the City’s credit by two steps goes far beyond that reality,” adding that the agency both failed to acknowledge the city’s growing economy or its progress in addressing its fiscal challenges. Though the Illinois Supreme Court decision does not directly implicate Chicago’s pensions, it raises the risk that the city’s own proposed pension reforms will be similarly held unconstitutional—leading Mayor Emanuel to call the rating agency “irresponsible” to base its decision on the overturning of a state pension bill that did not include the city’s changes. In its action, Moody’s also dropped its ratings on the city’s senior and second lien water bonds, dropping them to Baa1 and Baa2 from A2 and A3, respectively; Moody’s also downgraded senior and second lien sewer bonds to Baa2 and Baa3 from A3 and Baa1, respectively, affecting $3.8 billion of revenue debt. The outlook remains negative.

As of April 20, the city was carrying about $589 million on its short-term borrowing program that includes lines of credit and a commercial paper program with a total capacity of $900 million. A speculative grade rating triggers an event of default on the city’s banking agreements that support the short term program. All of the liquidity contracts expire over the next year. The city has reported ongoing negotiations with liquidity providers to extend the dates. Moody’s action appears in stark contrast with other rating agencies: S&P recently affirmed Chicago’s A-plus rating and negative outlook, and Kroll Bond Rating Agency affirmed its A-minus rating and stable outlook. Fitch Ratings rates the city A-minus with a negative outlook. The change makes Chicago the only major city, other than Detroit, to carry a junk bond rating from Moody’s. Howard Cure, director of municipal research at Evercore Wealth Management in New York, said his firm has been avoiding Chicago general-obligation bonds “for a while;” nevertheless, he said he was surprised Moody’s cut the city’s rating low enough to place it in junk territory. “It’s not as if the city’s economy is doing badly,” Mr. Cure said. “They’re actually gaining population and having growth downtown. They have some big-city problems, but it’s not a Detroit situation.”

Taxing Times. With a growing sense that Congress will not act to provide Puerto Rico with the authority that every state has to offer access to municipal bankruptcy for its 78 municipalities, Gov. Alejandro García Padilla is seeking to go back to the legislature with a revised tax and spending proposal to try to address the U.S. Territory’s looming insolvency. In the Gov. Padilla’s latest proposal, he proposes a 13.25% value added tax (VAT), which would replace Puerto Rico’s current 7% sales and use tax. The VAT would consist of 11.75% for the commonwealth government and 1.5% for the municipalities—instead of the current 7% sales and use tax, divvied up so that 5.5% goes to the commonwealth and 1% to the municipalities. The remainder 0.5% also is collected by COFINA until late in the year, after which those revenues, too, are directed to municipalities. Under Gov. Padilla’s new revenue proposal, of the 1.5% portion, a 1% sliver would go directly to the municipalities and 0.5% would go to a Corporation for Municipal Finance (COFIM), which would hold money for bonds for the municipalities. Governor Padilla and Puerto Rico Senate President Eduardo Bhatia apparently have also reached consensus that the tax increase would be combined with a $500 million cut in government spending. This week, Gov. Padilla met with Sen. President Bhatia and House of Representatives President Jaime Perelló to discuss the proposal, before the Governor presented it to members of his Popular Democratic Party in the Puerto Rico House and Senate. This new taxing effort comes in the wake of the legislature’s rejection, in April, of Gov. Padilla’s tax reform proposal to reduce income taxes and increase consumption taxes―he had proposed a value added tax or VAT tax of 16%–which, after it aroused a beehive of anger—he modified to 14%–still not enough for the legislature: the House voted 28-22 to reject the modified tax changes. The Governor is scheduled to meet with party leaders this morning in an effort to try to reach a consensus solution for the commonwealth’s fiscal year 2016 budget. The budget for the current fiscal year is for $9.56 billion in spending. The government has indicated that it needs to come up with more than $1 billion in spending cuts and/or revenue increases to achieve a balanced budget in fiscal year 2016.

Saving Motor City Homes. Detroit, before going into municipal bankruptcy, had 78,000 vacant structures and 60,000 vacant land parcels—vacancies which presented an ongoing public safety and public health concern, forcing the city, despite the signal loss of population, to provide and maintain services over its 139 square miles—and to be vulnerable to its 66,000 blighted and vacant lots which encouraged arson and other crimes. The vacancies did—and do—not stop at the city’s boundaries, but also crossed into adjacent and surrounding Wayne County, where, this week, County Treasurer Raymond Wojtowicz extended this week’s deadline for homeowners in the Detroit metropolitan area to make payment arrangements on overdue taxes to June 8th—marking the second extension of the previous March 31 deadline. The notice came in a year when foreclosure proceedings have been started on about 75,000 properties―most in Detroit. Taxpayers remitted their taxes on nearly 20,000; 24,000 others are on payment plans. Slightly over one third of the 30,000 properties still facing foreclosure are occupied. Detroit Mayor Mike Duggan called Mr. Wojtowicz’s efforts “vital to the stabilization and rebirth” of Detroit neighborhoods. Gov. Rick Snyder signed a bill this year that allows homeowners facing financial hardship to use a payment plan to pay off debts and avoid foreclosure.

Restructuring Municipal Debt. Even as Congress has now voted expressly not to help municipalities at risk of insolvency in the U.S., China is launching a broad stimulus to help its municipalities restructure trillions of dollars’ worth of municipal debts by means of a debt-for-bond swap program under which the People’s Bank of China’s plan will allow commercial banks to purchase local government bailout bonds which could then be used as collateral for low-cost loans from the bank. The new stimulus effort comes as China’s cities, which have $1.1 trillion renminbi in outstanding municipal bonds, are confronted with unsupportable levels of municipal debt—even as their borrowing costs remain high. China’s State Council has recently instructed the country’s top economic agencies, including its Finance Ministry, central bank, and the China Banking Regulatory Commission to put together a plan to help the nation’s local governments address their mounting debts.

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