The Hard Choices Forced by State or Local Fiscal Distress


August 28, 2015

The Distressing Costs of Municipal Debt Adjustment. For a municipality, state, or—in this case, U.S. territory in serious fiscal distress, without access to bankruptcy so that the options for ensuring sufficient cash to provide essential services are at risk, just the costs of structuring a plan to return to a fiscally sustainable future can be daunting. Indeed, early reports indicate Puerto Rico has already spent as much as $60 million over the last two years as it nears its deadline for proposing a quasi-plan of debt adjustment in this twilight zone where there is neither a U.S. bankruptcy court nor any other official arbiter to adjudicate whatever proposals Governor Padilla ends up proposing next week to address Puerto Rico’s unpayable $72 billion in accumulated debts. Moreover, of course, the meter is still running—each day consuming more legal and consulting fees that leave less and less for upset creditors, public services, and the island’s bondholders in every state of the U.S. Fabulous Matt Fabian of Municipal Market Analytics tersely sums up the dilemma: “It’s an incredibly complex restructuring, with a lot of different investor groups, a lot of different securities and moving parts.” Puerto Rico’s public power utility and its creditors face a Tuesday deadline on a restructuring plan for its $9 billion of debt or an agreement that keeps discussions out of court will expire. Nevertheless, as the nation’s preeminent municipal bankruptcy wizard Jim Spiotto noted, the investment in these outside professionals could be critical to providing a way out for the commonwealth that will improve the economy and make its debt sustainable: “The analysis part is important in addressing it in an effective way, so that the money you spend is well spent, because you’re going to need a recovery plan that is going improve the situation, grow the commonwealth, and, thereby, improve the situation for everyone.”

What Options Does Congress Have? Even as Puerto Rican leaders are perusing options to sort out its overwhelming debt, the Congressional Research Service has offered Members of Congress options, “Puerto Rico’s Current Fiscal Challenges,” it could act upon in response to Puerto Rico’s fiscal crisis ranging from backstopping its debt to authorizing the U.S. territory access to municipal bankruptcy. The report notes that the U.S. government “has generally been reluctant to offer direct financial assistance to individual states in fiscal distress, although Congress at times has adjusted technical parameters of federal programs to provide direct or indirect support for states…The independence of state governments to set their own fiscal paths has been linked to an expectation that those governments take responsibility for the consequences of their fiscal decisions.” Under the dual sovereignty of our form of government there are constitutional limitations on any federal authority.  Arkansas, Illinois, Indiana, Louisiana, Maryland, Michigan, Mississippi, and the former Territory of Florida all recorded bankruptcies in the period running up to and through the great Panic of 1837. By 1841, 19 of the then 26 states, as well as two of the three U.S. territories had issued municipal bonds and incurred state debt—debt on which these aforementioned states and Florida defaulted. Ironically, the majority of state debt was owed to parties outside the U.S., primarily Europe. Nevertheless, the state debts were largely paid off in full by the late 1840s, notwithstanding that no direct sanctions were enacted to force repayment.

In this new report to Congress, the CRS author noted that Congress could:

• amend the current Chapter 9 bankruptcy law to allow access to Puerto Rico’s public corporations and municipalities; or,
• backstop Puerto Rico’s debt, which would help reduce its borrowing costs (noting that this has been done in the U.S. and elsewhere, usually contingent on budgetary or structural reform requirements.)

CRS also reported that the U.S. government guaranteed Mexico’s government debt in 1994-1995, as well as provided indirect credit support to some states in the 1930’s through 1950’s via the Reconstruction Finance Corp., noting, for example, the RFC “acted as an intermediary in helping to roll over $136 billion in debt for the State of Arkansas” after Arkansas had defaulted on its debt in 1933. The report also suggested Congress could waive the Jones Act for Puerto Rico—a significant unfunded federal mandate which requires ships operating between U.S. ports to be owned by U.S. citizens or companies, to have been constructed in the U.S., and to be operated by U.S. citizens. The CRS report also noted that Congress, as it did for the District of Columbia in 1995, could call for a financial control board. Finally, the CRS report notes that whilst Congress has traditionally been reluctant to provide assistance to states overwhelmed by fiscal storms, it has not been reluctant after natural storms—mayhap timely given yesterday’s memories of the federal assistance granted to Louisiana in the wake of Hurricane Katrina—and, Congress provided both direct and indirect support for New York City in the wake of its fiscal crisis in 1975.

First Chapter 9 since Detroit. Hillview, Kentucky City Attorney Tammy Baker has described the small city’s filing for federal bankruptcy protection as “a very difficult decision” for the city’s elected leaders, but, because of the mounting interest costs from a court judgment against the city, costing it more than $3,700 a day, she notes: “The city really ended up with no choice…With the interest accruing at that rate, it’s just really going to be impossible for the city to pay that judgment.” Counselor Baker has advised the Bond Buyer that the Kentucky municipality, which has filed for municipal bankruptcy, does not intend to restructure its municipal bond debt as part of its plan of debt adjustment. Hillview, the first municipality to file for bankruptcy since Detroit, filed its petition in order to halt payments it owes of thousands of dollars in accruing interest in the wake of an $11.4 million judgment against it—or, as Counselor Baker described it: “What the [municipal] bankruptcy has allowed is breathing room for the city…The interest has been stopped.” The effective halt on the interest payments offers breathing room for the small municipality to develop a plan to address the breach of contract judgment it lost to Truck America Training LLC. Its plan of debt adjustment will have to address some $1.39 million in debt it owes on outstanding general obligation municipal bonds Hillview issued in 2010, and $1.78 million as part of a 2010 pool bond issued on its behalf by the Kentucky Bond Corp. However, in her email to the Bond Buyer, Counselor Baker wrote: “The city does not intend to restructure any bonds through the filing…In fact, we are of the belief that such a restructuring could not be done.” In describing why the city filed its abrupt municipal bankruptcy last week, Ms. Baker noted: “The main reason the city filed for bankruptcy is to halt the crushing interest [of] $3,759 daily from accruing while we develop a plan.” While the filing might provide some instant r-o-l-a-i-d-s for the small municipality, it comes not only with the kinds of costs Puerto Rico is experiencing, but also in terms of borrowing costs: S&P last Friday dropped the municipality’s credit rating five notches to B-minus from BB-plus, and placed the lower rating on CreditWatch with negative implications pending a determination by the federal bankruptcy court on the city’s petition—the lower rating appears to have already translated into at least a ten percent increase to the cost of capital borrowing for Hillview—which, in its petition to the federal bankruptcy court, estimated its liabilities as high as $100 million versus assets of $10 million.

Schooling in Municipal Bankruptcy


August 27, 2015

Schooling in Muni Bankruptcy. Paul Vallas, CEO of the Chicago Public Schools (CPS) from 1995 to 2001, this week warned that were CPS to file for municipal bankruptcy—should the legislature authorize municipal bankruptcy in Illinois as proposed by Governor Bruce Rauner—that could devolve CPS, whose credit rating has been reduced to junk status by Fitch, into a financial “death spiral.” Mr. Vallas warned that such a filing would lead to an exodus of students from the system, which, in turn, would trigger a decline in state aid—in effect triggering a vicious fiscal cycle. Gov. Rauner, in proposing authorization of chapter 9 for Illinois municipalities has said CPS would be a good candidate for such a filing. The warning came as Mayor Rahm Emanuel’s CPS school board yesterday unanimously approved CPS’s budget, relying heavily on borrowed money and the hope of a nearly $500 million bailout from the legislature—a legislature which appears to be in a semi-permanent stalemate. Absent the assumed state aid, CPS will have few options but to make searing cuts in January. The $5.7 billion spending plan contains another property tax hike — an estimated $19-a-year increase for the owner of a $250,000 home — as well as teacher and staff layoffs. The CPS budget action came as the Chicago Board of Education also prepared to issue $1 billion in municipal bonds and agreed to spend $475,000 so an accounting firm can monitor a cash flow problem so acute that CPS considered skipping a massive teacher pension payment at the end of June. Mayor Emanuel’s new choice for board president, former ComEd executive Frank Clark, summed up the financial peril: “This is much like, in your personal lives, if you begin to have revenue shortfalls…you start living off your credit cards…And you can do it short-term, but sooner or later, those credit cards max out and you’ve got yourself in a very serious situation. That’s where CPS finds itself today: It is a budget that keeps us going today. It is not a sustainable approach long-term.” Indeed, the more than 8 percent hole in the adopted budget leaves little option but for Mayor Emanuel and new CPS Chief Forrest Claypool to try to get Gov. Rauner and the legislature to enact changes to CPS’ teacher pension obligations. On the reality front, CEO Vallas asked: “Who wants to send their kids to a bankrupt school district?” He warned that litigation and potential teacher strikes could “totally destabilize the system which means people would flock away from the system which means you would put the system in a financial death spiral,” adding: “At the end of the day bankruptcy is literally the kiss of death…that would decimate the finances so it’s simply not an option.” Chicago Civic Federation President Laurence Msall described the proposed CPS budget as “[Y]et another financially risky, short-sighted proposal and [one which] fails to provide any reassurance that Chicago Public Schools has a plan for emerging from its perpetual financial crisis…If stakeholders do not come together now to develop a multi-year plan, the Federation is deeply concerned that CPS could fail, with devastating consequences for the future of Chicago and Illinois.”

To Be or Not to Be. With Gov. Alejandro García Padilla theoretically set to release a fiscal stability and economic development plan for Puerto Rico’s future next Monday, there has been increased discussion of the cancellation of the Puerto Rico Aqueduct and Sewer Authority’s (PRASA) bond offering, apparently out of apprehension with regard to global market conditions and an apparent lack of investor appetite for the municipal bonds—but without any official statement released on a change to the status of the sale, either from PRASA officials or from the Commonwealth. In addition, the U.S. territory has asked the U.S. Supreme Court for a ruling to overturn a ban which prevents Puerto Rico public agencies from restructuring, seeking permission for the right to restructure its debt — which has reached $72 billion — under its own quasi-bankruptcy law. The uncertainty came as Nuveen yesterday noted: “The Government Development Bank reports liquidity sufficient to operate until November…In addition, the Department of Justice has designated Puerto Rico a ‘high risk grantee,’ requiring Puerto Rico to account for how it spends federal funds going forward.” Yesterday, in addition, Moody’s added: The PRASA postponement of a $750 million bond offering after repeated delays “shows the difficult obstacles blocking Puerto Rico’s capital market access…Investor sentiment has deteriorated sharply since the commonwealth’s last public offering almost a year and a half ago. If underwriters can eventually complete the PRASA sale, it may signal a return to some degree of market access that would help maintain liquidity.” If anything, with Puerto Rico impinging on its self-set August 31st deadline to reveal its plan to restructure its staggering $72 billion debt, the island likely is opting not to move ahead with its controversial proposal to borrow an additional $750 million to pay for PRASA improvements—likely out of at least some apprehension it could not borrow the money — by issuing bonds — at an affordable interest rate. Adding to the messy situation, a working group, appointed by Gov. Garcia Padilla, has been trying to put a proposal together for several months; however, Puerto Rico’s main opposition party has dropped out of the group—raising grave doubts about any consensus. The PRASA debt issuance cancellation is more worrisome—as the utility provides essential services and is authorized to increase rates, within reason. Moreover, the utility’s bondholders have a first claim on its revenues: they are authorized to bring in a receiver to enforce collections.

A Post Muni Bankruptcy High? Recovering from municipal bankruptcy is like recovering from surgery. There are scars, but lessons learned. Thus, as post-bankrupt Stockton continues its comeback, City Attorney John Luebberke notes: “The City Council’s goal is to pursue the betterment of the community…Now that we’re out of bankruptcy, we can pursue some of these opportunities. Even in an era of constrained resources, we’re going to do what we can to improve the community.” One action, in which Mr. Luebberke is taking a lead role, is to enforce the city’s medical marijuana ordinance. Thus, post municipal bankruptcy Stockton last week filed two lawsuits last week aimed at preventing a pair of medical-marijuana dispensaries from operating in Stockton in violation of a city ordinance. While one has closed, the other—Collective 1950—will remain open while the city’s lawsuit is being adjudicated, with court dates not scheduled until mid-January. Mr. Luebberke said it is uncertain whether Stockton initially will seek a temporary injunction to immediately close Collective 1950 or choose to gain permanent injunctions from the court against Collective 1950 and Elevate Wellness. For Stockton, the issue of municipal enforcement of Stockton’s medical-marijuana ordinance is complicated by California’s “Compassionate Use Act,” which allows for marijuana use and possession for medical reasons—whilst Stockton’s ordinance is focused on preventing unregulated dispensaries from selling to minors and seeks to reduce the potential for “nuisances” and crimes associated with the presence of the facilities, according to Mr. Luebberke. According to Stockton’s lawsuits, the city can enforce its municipal code by “public nuisance abatement,” “civil injunction,” and “civil penalties of up to $1,000 per day of violation.”

First Chapter 9 since Detroit. Some of the first transatlantic passengers to come to America on the Arbella—passengers who left England in 1630 with their new charter–had a great vision. They were to be an example for the rest of the world in rightful living, or as then Gov. John Winthrop put it: “We shall be as a city upon a hill, the eyes of all people are upon us.” But there is a different perspective from Hillview, the small Kentucky municipality which last week filed for chapter 9 municipal bankruptcy in the first municipal bankruptcy since Detroit, with Rick Cohen noting: “With its Chapter 9 filing, Hillview may have liabilities of around $100 million, against assets potentially only as much as $10 million…There may be a reason that Hillview found bankruptcy preferable to paying out, even at a lower rate than the court ordered, to the trucking company.” His thesis, referring to Moody’s report this month: “Municipal Bankruptcy Still Rare, but No Longer Taboo,” notes that Moody’s Senior VP Al Medioli appears to find that recent chapter 9 decisions have treated public pensioners “as a group above other creditors, and that further places pensions on a higher plane above all other liabilities, regardless of bond security or legal revenue pledge.” He notes that Kentucky confronts an unfunded pension liability of over $9 billion, making it the nation’s least well-funded state pension system, albeit he confesses there is insufficient information with regard to Hillview’s pension obligations that might have been affected by the municipality’s bankruptcy filing and potential proposed plan of debt adjustment.

Stately Oversight. In a brief released yesterday by Pew, the organization determined that New Jersey’s long track record of “strong state oversight” has, at least to date, been a key factor in fiscally protecting Atlantic City from being forced into municipal bankruptcy. Noting that the Garden State established its first fiscal oversight program in 1931, the report finds that the state has taken an active role to prevent municipal defaults and bankruptcies: Camden, before the state intervened with additional funds to help the city meet its obligations, came close in 1999 to becoming the first New Jersey municipality to file for Chapter 9 since Fort Lee in 1938, noting that New Jersey’s “tradition of intervention” is a stark contrast to other states such as California and Alabama which leave it up to local governments to resolve their own fiscal challenges, noting: “Most states tend to react to distress when it’s too late and not be proactive and that is not the case with New Jersey.” The report adds that Atlantic City also has benefited this year from New Jersey’s Municipal Qualified Bond Act, which allowed it to issue $43 million in general obligation bonds to cover repayment of a state loan for refinancing $12.8 million in bond anticipation notes. Atlantic City also received a $10 million increase in state funds this year under the state’s transitional aid program designed to assist distressed local governments. Pew cautioned, however, that while New Jersey has a strong record of avoiding municipal bankruptcies, no municipality in modern times has experienced close to the city’s 64 percent tax base decline, driven largely by casino closures from increased regional gambling competition, noting that the state still might be forced to “bail the city out” if it is to avoid filing for municipal bankruptcy—adding that such a rescue could be manageable given Atlantic City’s relatively small size.

The Teeter Totter between Voters & Municipal Fiscal Sustainability


August 25, 2015

Averting Bankruptcy Dismissal. The San Bernardino City Council yesterday voted 4-3 to move ahead in transferring responsibility for fire and emergency protection to the San Bernardino County Fire Department—an action that automatically triggered a new, $142-per-year tax on every parcel in the city—with the Council’s vote corresponding to the bankrupt city’s plan of debt adjustment pending before U.S. Bankruptcy Judge Meredith Jury. Unsurprisingly, there has been strong citizen opposition to contracting out for fire services—and this is an election year. Nevertheless, city leaders made clear they believe San Bernardino’s credibility in the federal bankruptcy court, and its ability to obtain approval for its proposed plan of debt adjustment required it to be consistent—as well as referencing that between the reduced costs from contracting out and new tax revenues, the city would realize as much as $11-15 million in annual savings. In addition, City Attorney Paul Glassman had warned the Mayor and Council that if the city failed to meet the terms of its own proposed plan of debt adjustment, San Bernardino would risk having its bankruptcy dismissed by Judge Jury—a dismissal that would almost immediately jeopardize the city’s ability to continue to provide essential public services—or, as Mr. Glassman told the Council: “This would have a catastrophic effect on the city such that it could not go on as an ongoing entity.” Nevertheless, the close vote reflected apprehension from Councilmembers who expressed apprehension that the proposed changes might not only jeopardize public safety, but also hurt the city’s already suffering economy. Councilman John Valdivia, speaking against the measure, told his colleagues that his constituents were strongly opposed to the new tax, adding: “We’re not here to bail the city out, one more dime.” Councilman Henry Nickel, who together with Councilmember Valdivia and Councilman Benito Barrios, opposing the proposal, after the meeting warned that San Bernardino was losing what little goodwill it had from citizens who will be asked to approve other taxes as part of the recovery plan.

The bare majority gave the green light to authorize San Bernardino city staff to begin negotiating with San Bernardino County and the County Fire District over the terms of the annexation—at the end of which another City Council vote will follow—a process that City Manager Allen Parker told the elected leaders could take 60 days. Even if the proposal gets to the Local Agency Formation Commission (LAFCO) in 60 days, there would still be no guarantee it will be approved by July 2016, possibly meaning it might not receive formal approval until FY2017: the Commission will have to study the proposal, hold public meetings, and make decisions on it. So even though it will not be subject to a citizen vote in the county, it is not clear what citizens’ reactions and pressure on San Bernardino County elected officials might be. In addition, if 50 percent of registered voters in San Bernardino protest, the proposal would fail. Protests from 25 to 50 percent of voters (or at least 25 percent of the landowners, who also own at least 25 percent of the assessed land value within the city) would trigger an election, according to LAFCO annexation rules.

The Sharing Economy? As state and local leaders know, the art of legislating is not unlike making spaghetti, and so it is that state leaders in Lansing—as part of an effort to help finance Michigan’s transportation infrastructure—have been considering a proposal to help make whole Detroit’s single most important source of municipal revenue: its income taxes—taxes which in 2012 made up about 21 percent of the city’s total revenue. That requires addressing a persistent gap in the law which does not provide authority to require suburban employers of Detroit residents to collect and remit the city’s income taxes. According to the Citizen’s Research Council, in 2011, 38 percent of Detroit residents worked in the city, while 62 percent of city residents were employed in the suburbs. With the House considering surface transportation legislation the Michigan Senate approved last month—a major road funding proposal that could double fuel taxes over four years and eventually raise up to $1.7 billion a year in new revenue for infrastructure—the House has been considering, as part of such a measure—amending the legislation to include a provision to provide authority for new state legislation designed to help Detroit collect city income taxes from residents who commute to the suburbs—but only for Detroit: not for the other 21 municipalities which also rely on municipal income taxes: Albion, Battle Creek, Big Rapids, Detroit, Flint, Grand Rapids, Grayling, Hamtramck, Highland Park, Hudson, Ionia, Jackson, Lansing, Lapeer, Muskegon, Muskegon Heights, Pontiac, Port Huron, Portland, Saginaw, Springfield, and Walker. Under the pending proposal, on behalf of which Detroit Mayor Mike Duggan testified, suburban employers would be required to withhold Motor City income taxes from paychecks of Detroit residents—except for businesses with fewer than 10 employees and less than $500,000 in wages. An alternative would authorize the state to use audit and penalty procedures when it takes over Detroit’s income tax collection in 2016. The Republican-led House Tax Policy Committee has approved legislation which would require suburban employers to withhold Detroit city income taxes from residents’ paychecks, but the outcome will have to await full legislative consideration: The Senate was in session last week, but did not take attendance, votes or introduce bills. Neither the Senate nor the House is expected back in Lansing until after Labor Day.

Any final legislative action by the legislature next month could also face concerns by municipal leaders from the other 21 municipalities which levy personal income taxes—indeed, Grand Rapids Mayor George Heartwell last week made clear he was “flummoxed” that Grand Rapids and 20 other communities were omitted from the legislation, noting he was “caught off guard,” adding he thought “We (referring to all 22 cities) were all on the same page about this,” noting he had met with Detroit Mayor Mike Duggan and several of the other communities that charge an income tax about ways to make collection a requirement for suburban employers. Grand Rapids is one of the exceptions in Michigan in that it collects income tax at a rate of 1.5 percent for residents and 0.75 percent for nonresidents who work in the city. The majority of the 22 cities impose an income tax of 1 percent on residents and 0.5 percent on nonresidents. Detroit has the highest rate with its residents who live and work in the city paying 2.4 percent; nonresidents who work in the city pay 1.2 percent. Eric Lupher, President of the Citizens Research Council of Michigan, said his organization supports equality for all, suggesting that every one of the state’s 276 cities should require employers to withhold city income taxes from employees: “The solution to the problem at hand is if you live or work in a city, then employers need to withhold tax from you…It shouldn’t apply only to cities with populations of 600,000 or more (such as Detroit)…The other thing is we don’t want to create disincentives to living in the cities…Most of the Michigan cities are down-and-up cities. They all are trying to revitalize themselves and be attractive in getting people to move there.”

Holy Cosmos! Fitch became the second credit-rating agency this week to upgrade Wayne County, removing the County’s negative rating watch from some Wayne County municipal bonds and terming Wayne County’s rating outlook “stable,” adding that the County’s approval of a consent agreement with the state to address its financial emergency was a step not only towards improving the county’s credit, but also to improving Wayne County’s fiscal outlook. Under the terms of the agreement, Wayne County Executive Warren Evans is granted the powers of an emergency manager in contract talks with the county’s unions—and, should the two sides be unable to achieve a consensus in good-faith negotiations 30 days after the consent agreement went into effect, he is authorized to impose terms such as lower wages, pension cuts, and employee contribution increases—all as part of a state-local effort to address a $52 million structural deficit—a deficit triggered by a $100 million drop in annual property tax revenue since 2008. Adding to the deficit, the county still has to contend with a significantly underfunded public pension system—as much as $910.5 million, according to the latest actuarial reports.

First Chapter 9 since Detroit. Hillview, a small (pop. just over 8,000) home rule-class city in Bullitt County, Kentucky, about 17 miles south of Louisville, has filed for chapter 9 municipal bankruptcy in the first chapter 9 filing by a municipality since Detroit’s filing more than two years’ ago—making the small city the 65th to file for bankruptcy in more than six decades. The city in Bullitt County about 17 miles south of Louisville listed assets of under $10 million and liabilities between $50 million and $100 million in its bankruptcy petition. Kentucky is one of 12 states which conditionally authorize municipal bankruptcy; however, Kentucky counties are not authorized to file for municipal bankruptcy protection unless the state local debt officer and state local finance officer have first approved said county’s plan of debt adjustment. The legal action was triggered by an $11.4 million judgment against the city for breach of contract after years of protracted litigation over a land sale—and after the municipality had been unable to reach any settlement agreement. Truck America Training LLC prevailed (see City of Hillview v. Truck America Training, No. 2012-CA-001910-MR.) Court of Appeals, Kentucky, March 7, 2014.), gaining an $11.4 million judgment for breach of contract against the city over a land sale. The judgment became final last March, after the Kentucky Supreme Court declined to review the case. Hillview, in its bankruptcy filing, listed assets of under $10 million versus liabilities between $50 million and $100 million. The city’s unsecured claims include $1.39 million of outstanding general obligation bonds issued in 2010, and $1.78 million of debt which is part of a pool bond issued by the Kentucky Bond Corp. in 2010 and operated by the Kentucky League of Cities. The decision to opt for municipal bankruptcy came in the wake of the city’s decision not to accept Truck America’s most recent settlement offer of approximately 40 cents on the dollar. To put those numbers in context, Hillview had total revenues of $2.7 million in FY2014, and a fund balance of $659,723 at the end of the year, according to its 2014 audit. Moreover, in addition to the judgment accumulating interest at 12% per year, the audit determined that Hillview had no insurance coverage available for the breach of contract litigation. S&P, last February, had downgraded Hillview’s full faith and credit GO bonds four notches to BB-plus, citing the judgment, as well as fiscal apprehensions with regard to the municipality’s FY2014 audit. In its analysis, S&P had included an examination of whether the Hillview could issue municipal bonds to pay the Truck America judgment, noting: “We believe the city has legally available options apart from [municipal] bankruptcy.”

The Difficult Road to Fiscal Sustainability


August 20, 2015

The Hard Road to Recovery in Detroit could be paved by state legislative deal-making over the legislature’s efforts to agree on a highway infrastructure financing plan by freeing up state legislation designed to help Detroit collect city income taxes from residents who commute to the suburbs. Mayor Mike Duggan testified yesterday in Lansing in support of legislation to require employers to withhold city income taxes from paychecks of Detroit residents. Businesses with fewer than 10 employees and less than $500,000 in wages would be exempt. An alternative would authorize the state to use audit and penalty procedures when it takes over Detroit’s income tax collection in 2016. The Motor City’s income taxes constitute the city’s largest single source, contributing about 21 percent of total revenue in 2012. The legislature is back in session for a three-day session, with House members debating a still-emerging bill to provide some $600 million a year in additional fuel and vehicles taxes and set aside $600 million in general funds for deteriorating roads and bridges — a compromise between legislation approved by the House and Senate in recent months (indicating that state legislatures—unlike the federal legislature—are actually able to function). In May, voters defeated a sales tax increase that would have triggered more money for roads, education, and municipalities. If the House votes this week, the bills would go to the GOP-led Senate and then Gov. Rick Snyder for his signature. Each penny increase in the state’s current 19 cents per gallon in gas and diesel taxes would raise about $50 million more annually—the un-wooden nickel increase under consideration would generate roughly $300 million. No longer letting registration fees drop in the three years after the purchase of a new car — a component of the failed ballot proposal — and increasing truck fees would pump $100 million more a year into road upkeep within three fiscal years.

To Market, To Market to Finance a Recovery…Detroit’s post-municipal bankruptcy debut in the U.S. municipal bond market yesterday resulted in costly yields for $245 million of bonds, perhaps indicating investors are still leery about prospects for Detroit’s longer term road to fiscal sustainability. Even though the 4.5% rate was lower than anticipated on the city’s bonds maturing in 2029, the rate was significantly higher than for other cities and counties. The city also marketed nearly $110.3 million of taxable bonds maturing in 2022, which were priced at par with a 4.60 percent coupon – a 300-basis-point spread over comparable U.S. Treasuries, according to the deal’s pricing scale. John Naglick, Detroit’s finance director, said the pricing resulted in an overall interest rate of 4.44 percent, which is lower than the 5.75 percent rate assumed in the city’s court-approved plan of debt adjustment—achieving $2.2 million in average annual interest cost savings. Clearly one’s perspective matters—as the sale of the city’s debt was “substantially” oversubscribed, thereby permitting the city to reduce the interest it had initially priced—even though Detroit will have to pay approximately 100 basis points over similarly situated cities—a price some dubbed a “bankruptcy premium.” S&P had given the Motor City’s bonds an investment-grade A rating, in no small part due to the state’s statutory lien on the city’s income tax revenues pledged to pay off the debt, even as it retained Detroit’s underlying credit rating at a B, deep in the junk category, citing Detroit’s “very weak” economy, management, and budgetary flexibility, as well as its previous bond defaults. In the sale, the city including a warning to potential investors: “[T]here can be no assurance the city of Detroit will not file another bankruptcy petition in the future.” Proceeds from the initial $275 million of bonds, which were privately placed with Barclays Capital, were earmarked for retiring a prior $120 million Barclays loan to the city, to pay certain creditor claims from the bankruptcy and to finance city improvements. Detroit has said it was able to reduce the size of the upcoming borrowing by $30 million to $245 million after the city’s bankruptcy consultants reduced their fees.

Gambling on Property Taxes. The Atlantic City Metropolitan area continues to lead the nation in foreclosure activity, with a rate four times the national average, according to RealtyTrac—a serious issue for a city whose property tax base has declined by nearly two-thirds since 2010. According to the new report, however, one in every 258 housing units had a foreclosure filing in July, the worst showing of any statistical area with a population of 200,000 or more. Nationally, new foreclosure starts are down to their lowest level since 2005, even though overall foreclosure activity was up 7 percent from the previous month and 14 percent from last July; Atlantic County starts were up almost 72 percent from last July, even as RealtyTrac noted that “Atlantic City is in for a tougher and longer haul back to a healthy housing market,” adding that it was impossible to predict when the market might return to normal in Atlantic County, noting: “We believe some of the repossessions are still tied to the last crisis, while starts are more likely tied to recent economic problems,” adding that Stockton and Phoenix were both leading the nation’s foreclosure rates about five years ago, but that their respective markets have turned around in both regions—and that they now have foreclosure rates lower than the national average. It is not just Atlantic City, moreover: New Jersey’s statewide foreclosure starts are up 129 percent over last July, with the state posting the third-highest overall foreclosure rate for states, behind just Florida and Maryland.

Arriba! Víctor Suárez Meléndez, Chief of Staff for Puerto Rico Governor Alejandro García Padilla, yesterday said that the exchange of Government Development Bank notes is the most likely approach to Puerto Rico’s liquidity crunch. The issue is apprehension that the government could run out of operating funds prior to the end of its fiscal year: it needs an additional $400 million to $500 million beyond the funds it currently has on hand or anticipates—adding that without additional fiscal measures, Puerto Rico anticipated running out of money in November. Mr. Suárez Meléndez said Puerto Rico is exploring other options besides the notes exchange—options that would not require restructuring of debt. He added that the Government Development Bank’s net liquidity had risen in recent weeks: as of May 31st the GDB had a net liquidity of $778 million.

Municipal Bankruptcy & The Role of Intergovernmental Relations

August 18, 2015

Municipal Bankruptcy, Intergovernmental Relations, & Democracy. The San Bernardino City Council voted 4-2 late Monday to appropriate over half a million dollars to fund a new community center on the bankrupt city’s Westside—notwithstanding apprehensions the city might not be allowed to use the modular that will now be used for that purpose, much less concerns about how it might affect the city’s already difficult relations with the state. The center, once constructed, is intended to provide classes on aerobics, Zumba, nutrition, mental health, and English as a second language, in addition to partnering on other services. The financing is not to come from the bankrupt city’s general fund, but rather from the city’s CDBG grants. But it was only after a citizen at the session raised a question—after the first of the two votes needed to approve the center—that there appeared to be some recognition of a problem. The citizen asked how it was that that since the state had taken control of redevelopment how it was the Council could “wonder why the state is mad at you, you wonder why the state doesn’t want to help you? Maybe listen to yourselves, and wonder, ‘What am I doing?’” Indeed, City Manager Allen Parker responded to a follow-up question to staff that last year, when the city had requested the California Department of Finance to transfer redevelopment assets — items such as desks, computers, and this $158,000 modular, which the city-controlled agency had used until the statewide shut-down — to San Bernardino so the city could control them: the request had been rejected. The response triggered two Councilmembers to change their votes from aye to nay, with Councilmember Henry Nickel noting: “We have some very delicate negotiations going on with the state right now…The last thing I want to do is upset them. I want to be very clear on the legal ramifications of taking a $150,000-plus asset and using that for city use.” Notwithstanding, the rest kept their votes unchanged, demonstrating one of the many intergovernmental challenges that confront the city as it seeks to put together a plan of debt adjustment for the U.S. bankruptcy court’s approval, even as—in an election year—it must continue to govern the municipality. Indeed, community members have been asking for the community center since the city promised it before the state’s dissolution of the redevelopment agency.

As we have previously noted, the uneasy relationship between California cities and the state has played an important role in San Bernardino’s municipal bankruptcy, whether it be the suit filed by the state’s California retirement agency (CalPERS) for non-payment of the city’s prescribed contribution to the state’s public retirement system for its employees, or the—to this point—takeover and dissolution of local redevelopment agencies in 2012, a takeover at least in some part triggered by disagreement as to whether cities were consistently using the revenues from these redevelopment agencies as originally intended. More broadly, of course, the withdrawal of most California state direct financial aid to cities, which commenced some three decades ago in the wake of Proposition 13, has not only negatively impacted most cities in the state, but especially poorer cities such as San Bernardino—with fiscal insult added to injury via California’s redirection of some non-state revenues to specific programs including education and public safety, thereby shifting the expenditure burden from the state to its cities. State aid constitutes a very small percentage of revenue for cities in California—2% in the case of San Bernardino. This minute amount does little to even out disparities in fiscal capacity and need for cities such as San Bernardino. State actions in recent years—including changes in the motor vehicle license taxes and redevelopment agencies— have only served to exacerbate, rather than ameliorate San Bernardino’s fiscal problems.

The Painful Cost of Recovery. Notwithstanding some of the unique and fiscally creative partnerships engineered as part of the resolution of the Motor City’s record municipal bankruptcy recovery, Detroit will find that getting back on its four wheels will come at a high price: the city is expected to have to pay interest rates close to 5 percent in its maiden return to the municipal bond market on its sale set for tomorrow of some $245 million in bonds—the city’s first sale since emerging from municipal bankruptcy. The sale, which will be done through the Michigan Finance Authority, will provide that bondholders will have the first claim on Detroit’s income tax revenues, so as to ensure investors in the recovering city are repaid. Ergo, the 14-year bonds are being marketed at an initial yield of 4.75 percent, according to persons familiar with the sale, some 2.1 percentage points more than top-rated municipal securities. The high cost to Detroit’s taxpayers and the city’s budget is a reflection of the significant cuts the city’s g.o. bondholders received as part of the court-approved plan of debt adjustment, nearly a 60 percent reduction. Nevertheless, for the city—in stark contrast to virtual bankruptcy in state-local fiscal relations in California (please see above)—this is a key factor in the likely successful sale tomorrow: Michigan Gov. Rick Snyder, together the bipartisan leadership of the state leadership, enacted legislation to provide prospective Detroit municipal bondholders first claim to the Motor City’s income taxes—an innovative step to help in the city’s recovery—and one which earned an A rating for tomorrow’s sale from S&P–nine levels higher than its grade on Detroit’s general obligations. Moody’s, in mayhap a surprisingly upbeat mode, noted that Detroit’s employment has risen 3 percent over the past four years; more generously, the rating agency wrote that the Motor City’s income tax revenue rose 18 percent from 2010 to 2015. The proceeds from this week’s sale are intended to be devoted to repayment of a loan from Barclays plc that was a key to the city’s emergence from bankruptcy, as well as to help finance city projects, including upgrades for the fire department’s fleet. S&P wrote that Detroit’s income tax collections are strong enough to cover the bonds.

Arriba! The Puerto Rico Treasury Department reports that last month’s General Fund tax revenues for the U.S. territory of Puerto Rico came in 3.5% higher than budgeted, with sales and use tax collections coming in at a rate more than ten times (35.7%) greater than those for a year ago. The increased revenues included $21.1 million more than projected for the island’s General Fund. But the most significant increase came from individual income taxes: some $7.2 million more than projected, as well as foreign corporation excise taxes ($4.6 million ahead), and alcoholic beverage taxes ($4.5 million above projections). The biggest shortfall was for motor vehicle taxes, at $2.7 million. No doubt, the increase in the territory’s sales and use tax revenues was due in no small part to the rate rise from 7 to 11.5% which went into effect last July 1st; nevertheless, the Treasury reported the increased rate only contributed about $8 million directly to the sales and use tax revenue increase of $40.6 million in July compared to one year earlier—moreover, as Puerto Rico Treasury Secretary Juan Zaragoza Gómez noted, the sales and use tax realized revenue increases might have been spurred by a rush-to-beat-the rate increase which went into effect July 1st. But Sec. Zaragoza Gómez also noted that Puerto Rico’s completion last May of the last phase of an Integrated Merchant Portal collection of sales and use taxes at ports also likely contributed to the improvement in these tax collections. Finally, the Secretary also noted the government had reached settlements for back sales and use taxes owed with several large retailers last month—adding: “These collection efforts will continue during the coming months.” The rising revenues from traditional tax sources came as a Puerto Rican study group has recommended going ahead with converting Puerto Rico’s sales and use tax to a value added tax effective April Fools’ Day next year.

Failing Grade. S&P downgraded the Windy City’s Chicago Public Schools three notches, finding that its proposed budget would do little to address either its structural or liquidity woes. The rating agency also removed the credit from CreditWatch with negative implications and assigned a negative outlook, with analyst Jennifer Boyd scholastically writing: “The rating action reflects our view of the proposed fiscal 2016 budget, which includes what we view as the [school] Board’s continued structural imbalance and low liquidity with a reliance on external borrowing for cash flow needs.” The poor grades appear to reflect the system’s increased reliance in its proposed $6.4 billion FY2016 budget on more than $300 million from one-time revenues, not to mention an almost mythical assumption that the stalemated Governor and state legislature will provide CPS with $480 million in public pension funding assistance this year to close a $1.1 billion deficit—or, as CEO Forrest Claypool put it: “This budget reflects the reality of where we are today — facing a squeeze from both ends — in which CPS is receiving less state funding to pay our bills even as our pension obligations swell to nearly $700 million this year.” The hopes from CPS come as the stalemate in Springfield over passage of the state’s FY2016 budget has shown little to no progress—even as Chicago’s kids are already, no doubt, dreading the September 2nd return to the classrooms. CPS’s proposed budget assumes Illinois will help assume almost $200 million in CPS pension contributions—not unreasonable, as that would be in line with what the state contributes on behalf of other districts. The package could also be made up by shifting $170 million of the teachers’ contribution now paid by the district over to teachers, extending a payment amortization period, and possibly higher property taxes. Further, CPS last month announced some $200 million in cuts in the wake, last month, of its failed efforts to delay its FY2015 pension payment. The budget also relies on $250 million of debt relief primarily from $200 million in so-called scoop and toss refunding in which principal payments coming due are pushed off. CPS is proposing to draw down $75 million from reserves. Unsurprisingly, S&P does its math differently than CPS: the rating agency questions the school system’s arithmetic, wondering how it all adds up, especially because of CPS’ reliance on $480 million in, to date, unsecured state assistance for debt restructuring and reserves, both non-recurring revenue sources, adding: “The rating is also based on our view of the challenges the board faces in attempting to secure a sustainable long-term solution to its financial pressures, given the state’s own financial problems reflected in the current budget stalemate, and the board’s fiscal 2016 budget proposal that shows the continuation of a structural imbalance even if the board gets the assistance from the state.” The challenged fiscal math has already exacted a cost: CPS is paying a premium to borrow: its most recent issuance came at a yield of 5.63 percent on 25-year bonds—and that even with not only the system’s full faith and credit pledge, but also security via an alternate revenue pledge of state aid. The convoluted math, S&P totes up, is further jeopardized by next year’s expiration of the district’s teachers’ contract.

August 13, 2015

Municipal Bankruptcy & Public Safety. In California alone, 16 wildfires are burning 229,713 acres. So it is unsurprising that citizens and their elected leaders in San Bernardino have a significant stake in ensuring that any plan of debt adjustment approved by U.S. Bankruptcy Judge Meredith Jury ensures confidence, thereby guaranteeing there will be significant interest in the 28-page report ( by fire consultant Citygate Associated the city released last night—a report recommending that the city’s fire department be annexed into the San Bernardino County Fire District. The report is consistent with the proposal recommended by San Bernardino City Manager Allen Parker; it is contrary to the position of the San Bernardino Fire Management Association. For both the city’s residents—and Judge Jury—the issue in bankruptcy is how to ensure the continuity of essential public services.  In its report to the city, Citygate evaluated the ability of three bidders — county fire, city fire, and Florida-based private firm Centerra — to meet certain key staffing standards. The report recommends San Bernardino County take over, under a plan which would include keeping 10 current city fire stations open, closing two, and adding the use of one additional county fire station, noting: “The best cost-to-services choice is County Fire’s Option C for 14 units and 41 firefighters (per shift) at $26,307,731 which includes sharing the use of a nearby County Fire station and Battalion Chief that can assist with covering part of the western City.” While the mere suggestion of privatizing or turning over control of a municipality’s fire department to another jurisdiction has traditionally been a sure fire road to unelection, it has actually become more prevalent in other parts of San Bernardino County and other areas in California. Indeed, San Bernardino Councilman Henry Nickel compared the modest opposition by constituents to the proposal to the outpouring of opposition when a community sent a robocall asking citizens to oppose privatizing the Fire Department, noting to the San Bernardino Sun yesterday: “My phone was literally on fire for two days…My voice mail filled up within about an hour of that robo call going out, and it took me two or three days to catch up. But since this article came out (outlining the report), I’ve received one phone call today regarding the county versus city debate…I think it’s very clear that Centerra is not something the public by and large supports, but — I hate to use the word resignation, but I think much of the public understands that the county medicine is probably the one we’ll have to take…It’s not something we want to do, but it’s something we might have to do.” City spokeswoman Monica Lagos posted a summary of the report and the city’s next steps here ( A special meeting, including a presentation of the report and a chance for resident comment, is scheduled for a week from Monday.

The uncontrollable nature of wildfires adds a combustible to the already complex challenge of elected leaders of a municipality in bankruptcy—with elections pending in November—creating a difficult balancing set of public as compared to campaign responsibilities. Unlike Donald Trump, the decision to file for bankruptcy for the city’s elected leaders is something no elected leader ever wants to do. And then the responsibility to approve a plan of debt adjustment to the federal bankruptcy court—even while contemplating a re-election campaign amidst the combustion of wildfires and politics is evidence of the extraordinary challenges and decisions ahead which will affect so many citizens—and their safety—not to mention the future of a city.

Jailhouse Rock. Wayne County’s elected leaders are scheduled to consider the proposed fiscal consent agreement between Michigan and the County today—an agreement intended to offer ways to improve Wayne County’s cash position, reduce underfunding in its pension system, and eliminate the county’s$52 million structural deficit—and be a governing alternative starkly different than in neighboring Detroit where the state preempted local authority through the appointment of an emergency manager. The consent agreement allows for the commission and Chairman Evans to “retain their respective authority.” The document has a number of highlighted sections on issues such as employee relations and changes that can be made to expired contracts, state financial management and technical assistance, and a prohibition against new debt unless approved by the State Treasurer. It also specifically mentions pension obligations and other employee contract commitments as at least a factor in the county’s financial troubles. But the major point of the agreement that will likely gain close scrutiny by many who work for the county is the authority it grants Chairman Evans to act as the sole agent of the county in collective bargaining with employees or representatives and approve any contract or agreement. The agreement will also address—and affect—the county’s jails, whose conditions have already been the subject of a court order this year, as Wayne County—and jail host Detroit—consider the future of the unfinished facility. In its review of Wayne County’s finances, the state noted the county’s unfinished jail and its $4.5 billion in long-term obligations as problems that need to be addressed, and mandated Wayne County to put together a plan to “adequately meet the county’s needs for adult detention facilities…” The County’s elected leaders, who are scheduled to discuss the agreement tomorrow, have just over three weeks in which to approve the document—an agreement which Wayne County Chairman Warren Evans very much hopes will be the key to resolving the county’s structural debt and unsustainable fiscal future: the proposed recovery plan lays out $230 million in cuts over four years.

Whether and how the plan will get the County and Detroit out from behind the fiscal bars will be a subset—but one with critical implications for the future relationship of the two jurisdictions, as well as for the county’s fiscal sustainability. The jail—in downtown Detroit on which Wayne County broke ground for construction four years ago—is an exceptional fiscal millstone: some two years after construction was halted because of ballooning expenses, the failed Wayne County jail project is still costing taxpayers more than $1 million a month. The plan was to build a $300-million state-of-the-art jail in downtown Motown four years ago—a plan which today features a costly pile of steel and concrete — fenced and guarded — with construction costs of $151 million, and an ever growing fiscal tab for county taxpayers of an average of $1.2 million every month. Thus, not only is the jail a sticking point between the two jurisdictions, but also a severe fiscal drain—or as the County described the situation last May: “Due to the county’s financial state, anything done on the Gratiot jail will just add to the deficit. Once the deficit has been solved, the county can move forward with options on whether to finish the Gratiot site or renovate the three existing jails. As the county makes progress on its recovery plan, it will better be able to solve the jail issue.” Worse, it appears that much of the debt issued by Wayne County for the jail’s construction has been diverted for other purposes—meaning Wayne County is spending as much as $1.2 million each month from its general fund. According to County officials, only $49 million remains from the $200 million in bonds Wayne County sold to finance the unfinished jail—a borrowing forcing the county to make interest payments on of $1.1 million monthly—even as it is spending nearly $55,000 each month on unfinished jail-related costs, including: security ($10,849), sump pump maintenance ($12,852), and electricity to the site ($4,000).

Trying to Measure the Costs of Financing a Sustainable Fiscal Future

August 11, 2015

Fiery Issues. In California where, this summer, more than 1,000 homes have been evacuated in vast forest fires stretching across the state, the San Bernardino City Council will receive a report today recommending the city outsource fire services to the San Bernardino County Fire Department: the report and recommendation come as the Council is scheduled to select from among three options a week from Monday with regard to how to ensure this essential public service is available for its citizens—and at what cost to the bankrupt municipality. Under the staff preferred alternative, San Bernardino would realize some $7 million in savings—but experience increased fire and emergency response, according to City Manager Alan Parker: his recommended alternative would mean nearly $8 million in additional savings to San Bernardino’s general fund through a possible $139-per-parcel fee on the city’s residents, albeit the Manager reported his proposed plan would involve an annexation process, which the city must initiate with the Local Agency Formation Commission for San Bernardino County by the first week of September in order to ensure completion by 2016, advising the Mayor and Council: San Bernardino County would annex the city to a fire district: ergo, he noted, San Bernardino would no longer operate fire services. Nevertheless, he said, the proposal would not just ensure savings to the city, but also faster emergency response times: “We wouldn’t be going down this road if we didn’t think it would improve service…They would close one additional (fire) station, but they’d supplement that with one of theirs. The number, I think, would go from 38 to 41 (firefighters) on duty at a given time.” How the Mayor and Council will react, however, could itself be a fiery political issue: the manager, in putting together and recommending the proposal, broke his commitment to the seven top-ranked San Bernardino Fire Department employees, who form a union called the Fire Management Association, to seek their advice and input; yet, as San Bernardino Battalion Chief Michael Bilheimer wrote to Councilmembers: “Yet as of (Monday), we have been excluded from every step. It gravely concerns me that you have independently elected to draft a Request for Proposal, retained a consultant to review those proposals, barred us from reviewing the proposals, and are preparing to take action without ever having consulted with the leadership of the Fire Department.” In response, Mr. Parker promised he would meet with fire management this week, but only after the City Council had received a final copy of the report, admitting it was “probably” accurate he had made a commitment to involve the leadership. The failure to communicate has stirred up its own political fire, with Chief Bilheimer responding by emailing city community leaders a one-page “fact sheet” opposing outsourcing, pointing out that, under the pending plan, an extra $139 would be charged to the owners of each of San Bernardino’s 56,000 parcels, noting: “That’s a tax, even if they don’t call it a tax.” Bilheimer said, asking residents to call their City Council member to oppose the outsourcing move.

An Alternative to Municipal Bankruptcy. Wayne County, beset by a $52 million structural deficit, stemming from a $100 million drop in annual property tax revenue since 2008 and an underfunded pension system, yesterday completed a consent agreement with the Michigan Department of Treasury under which the County, under state oversight, hopes it will have the authority to achieve structural changes to the county’s fiscal approach to insolvency by reducing future pension obligations and retiree benefits, as well as obtaining authority to take other actions to eliminate Wayne County’s structural deficit. The County’s pension system is underfunded by $910.5 million, according to the latest actuarial reports. Under the proposed consent agreement, County Executive Warren Evans and the commission would retain their powers and responsibilities. Wayne County would be barred from selling assets worth more than $50,000 without the Michigan state treasurer’s permission, but County Executive Evans would receive “the powers prescribed for emergency managers…to act as the sole agent of the county in collective bargaining with employees or representatives and approve any contract or agreement.” The proposed agreement with the state—unlike the appointment by Governor Snyder of an emergency manager for Detroit—would ensure retention of local elected authority, if the Wayne County Commission opts to approve it at a special board meeting tomorrow: the 12-page agreement may not be implemented and enforced unless and until approved by the commission. A key issue will be what kinds of agreements County Executive Evans is able to work out with Wayne County’s unions—under the consent agreement, he has a significant advantage: should there be no agreement within 30 days, he is authorized to impose terms. Lawrence Verbiest, head of the Government Administrators Association, unsurprisingly, yesterday, expressed apprehension the agreement would enable Mr. Evans to drastically cut wages, pensions, and benefits, noting: “We know we have to do something to help the county solve its problem…But we’d rather the county tried to work it out than unilaterally and dictatorially impose contracts on us.”

To Market, to Market, to Buy a…Detroit returns to the municipal market for its first issuance since its exit from the largest municipal bankruptcy in the nation’s history next week—with significant uncertainty how the state-crafted, first post-bankruptcy issuance will go. Under the plan, the Michigan Finance Authority expects to price $245 million of local government loan program revenue bonds on behalf of Detroit—with the allure to potential municipal bond purchasers coming from a statutory lien and intercept feature on Detroit’s income tax—an issuance which has secured an S&P A rating. Because the deal is premised on the city’s income tax (Detroit has one of the broadest tax bases of any city in the U.S.: Municipal income taxes constitute Detroit’s largest single source, contributing about 21 percent of total revenue in 2012, but receipts have been declining for years, reflecting both a rate reduction mandated by the state, the recession, and, of course, the municipal bankruptcy. The declining revenues also reflect not just the significant population decline, but also the make-up of the decline: the census reports that one-third of current residents are under the poverty line and that the composition of businesses—unlike any other major city in the nation—are primarily made up of public organizations.) Thus, the success of the first post-bankruptcy sale hinges upon the Motor City’s fragile recovery. The issuance is to raise the cash to repay Barclays for a $275 million loan—the loan which helped the city finance its exit from municipal bankruptcy—and the issuance benefits from reduced fees from municipal bond attorneys and consultants; it is divided into two series: $134.7 million of tax-exempt bonds with a 2029 final maturity and $110.3 million of federally taxable bonds with a 2022 maturity. Under the deal, potential bondholders would have a superior, statutory lien on Detroit’s income tax revenue under legislation Gov. Rick Snyder signed last April – a state statute which also exempts the revenue held in trust from being levied upon, sequestered, or applied toward any other debts—and which a legislative fiscal analysis projects could save Detroit and its taxpayers as much as $2 million to $3 million annually in interest. The ever prescient Lisa S. Washburn, a managing director at Municipal Market Analytics, noted: “Michigan did its best to provide some structural protections that insulate the debt from a future Chapter 9 for Detroit, but you just don’t know going into another bankruptcy if the structure would hold up…If there is another bankruptcy, it’s likely that the income tax revenues are suffering anyway.” Indeed, if, God forbid, there were another municipal bankruptcy for Detroit, the preliminary bond documents warn potential investors: “Should the city file for bankruptcy protection, the bankruptcy court’s decision regarding these matters would be based on its own analysis of the law and interpretation of the factual evidence before it…The bankruptcy court would not be bound by legal opinions other than binding precedent, and there currently is no binding precedent regarding these matters.” That is, Detroit—and Michigan—are entering uncharted municipal finance waters. The income tax pledge is also complicated by Detroit’s set aside of a portion of those revenues—some 8 percent—to finance the Motor City’s police operations: a pledge superior to the bondholders’ lien. Should Detroit realize a net outflow of taxpayers—a key factor in its municipal bankruptcy—that could precipitate a serious problem; however, the city anticipates rising income tax revenues: they have increased from $228.3 million in 2011 to $248 million in FY2013—and are projected to grow to $256.5 million for FY2015. Nevertheless, as guru Washburn warns, the difficult balance between critical investments in the future and added debt can be a challenge; she notes that while the city’s income tax is “arguably the strongest revenue stream they have and they’ve pledged that specifically to repay this debt…” that was “exactly what they were trying to get away from in municipal bankruptcy — they were trying to prioritize services and their citizens ahead of investors, and here it seems once again: they’ve prioritized creditors: [Debt payments] could be taking a bigger chunk of the revenue in the coming years, meaning less money go to the city, so there’s a lot at stake for the city to experience stability and growth in the next several years.”

Digging an Agujero, or hole (in Spanish) might be one way to think about last week’s payment default in Puerto Rico, because, as MMA insightfully notes: “it has made the goal of a voluntary, consensual debt restructuring more difficult to achieve and has thus raised the potential for disorder on the island…In effect, the potential for the worst possible outcome for Puerto Rico and its investors continues to grow at the expense of the best possible outcome.” Noting that Puerto Rico’s decision to suspend monthly deposits into its general obligation bond redemption fund greatly increases the odds of Puerto Rico defaulting next January, the suspension threatens to undercut the island’s negotiations with PREPA and other municipal bondholders. While the suspension appeared to be focused on enhancing Puerto Rico’s liquidity—and avoiding still more borrowing, MMA notes monthly liquidity is “likely worsening amid a general economic slowdown and reported difficulties in reining in expenditures.” Ergo, unless the island can find new cash or financing by December, Puerto Rico’s fiscal hole or agujero has grown so deep it will confront a new payment cliff for general obligation debt interest payments by January.

Truth or Consequences: Could Puerto Rico Be Contagious? While Puerto Rico is neither a state, nor a municipality—and while it is far from the mainland; nevertheless, its approaching default, coming amidst on and off again discussions in the House and Senate tax-writing committees, could have Bob Barker back on the screen. State and municipal debt—and the interest thereon with their exemptions from federal taxation—could become juicier targets, potentially strengthening the arguments of those who would prefer to use the federal “revenue loss” for other tax expenditures. The manner in which Puerto Rico has kept investors in its municipal bonds—investors scattered throughout each and every state—could also have ramifications: your closest friends at the SEC and IRS might have some suggestions with regard to new federal mandates with regard to acceptable disclosure.

Potty Costs. The Puerto Rico Aqueduct and Sewer Authority (PRASA) anticipates paying as much as a 10% interest or borrowing rate on municipal bond on a $750 million issuance later this month—giving a better idea of the rising cost of public debt as the U. S. territory nears insolvency—and yet prepares to mark the island’s first general obligation bond issuance of the year. PRASA hopes to raise $1.45 billion for its five-year capital plan, of which $790 million would come from borrowing, with some help from $350 million in federal funds. Government Development Bank for Puerto Rico President Melba Acosta Febo said PRASA’s plan to issue the new municipal debt–just when Puerto Rico hopes to complete a plan to restructure its debts by the end of the month, “reflects the individual financial circumstances of the various debt issuers across the commonwealth.” One may get a sense of the fiscal risks and challenges ahead, however, by noting that—especially for a public utility—the island’s population decline over recent years (more than 7% over the past 10 years and the decline in the average daily water demand—declines which have forced the utility to raise rates on a shrinking customer base. The public utility, which provides service to some 97 percent of the territory’s population, increased its water rates by 60 percent two years ago and reports it plans to raise rates further in FY2018 and 2019. The bond proceeds will be used to finance a portion of PRASA’s capital improvement program, and to repay a $90 million bank line of credit—with any disputes about the bonds governed by the laws of New York unless it involves the authorization and execution of a receivership, which would be governed by Puerto Rico’s laws.
Municipal Risk. As we observe, today, Detroit seeking to reenter the municipal market—even as its surrounding county prepares to seek approval of a debt consent agreement with the State of Michigan—there are some jitters with regard to non-general obligation, full faith and credit pledges by cities and counties. Indeed, unsurprisingly, Moody’s has moodily modified how it rates such so-called sub‐GO security pledges to more fully incorporate what it perceives as the risk inherent in a municipality’s appropriation, general fund, or lease‐backed debt. Ergo, even as our admired friends at Municipal Market Analytics note that current municipal default rates remain very low—and are even lower for state and local issuers; nevertheless, MMA remarks that “the resilience of security pledges—meaning strength of post-default recovery—is weaker than originally believed,” reporting that “virtually no municipal security pledge has gone unscathed,” with special apprehension reported with regard to the core weakness in the appropriation pledge, because the “repayment is subject to the willingness of the legislature of the borrower to appropriate the necessary funds.” Democracy, alas: or, as MMA persists: “When a government’s willingness to allocate its resources is compromised because the financed project has underperformed (e.g. Lombard, Ill. Vadnais Heights, Minn.; Buena Vista, Va, etc.), its finances have faltered (e.g. Puerto Rico), or politics has stymied the budget process (e.g. Illinois), the risk of nonpayment rises.” MMA appropriately notes that where there is a payment default, the bondholders’ remedies are often limited (they may take over leased facilities) or non‐existent, adding that the “general market perception—even if not the reality—of the strength of other municipal security pledges has also been weakened as a result of recent defaults and bankruptcies.

Can Default be Contagious?

August 7, 2015

Default & Its Consequences. Puerto Rico, in uncharted fiscal, and public health territory in the wake of its default and its current drought, confronts increased borrowing costs and greater public demands. The U.S. territory’s decision, last month, to cease setting aside funds to meet its general obligation bonds now raises constitutional and legal questions with regard to how and whether Puerto Rico will make payments to its general obligation bondholders next New Year’s Day, when a $375 million payment to GO bondholders is due. Because such obligations have a superior claim on revenues, that could force the government to syphon off fiscal resources from public services, including infrastructure, schools, health care, and other authorities in order to make the payment: that is, the Solomon’s Choice between essential public services and critical access to capital is looming. Article VI, §8 of the Puerto Rico constitution provides that “In case the available revenues including surplus for any fiscal year are insufficient to meet the appropriations made for that year, interest on the public debt and amortization thereof shall first be paid, and other disbursements shall thereafter be made in accordance with the order of priorities established by law.” Nevertheless, on Monday, Puerto Rico posted a statement on EMMA that it had “temporarily suspended” the set asides. Last month, Luis Cruz Batista, Puerto Rico’s Director of the Office of Management and Budget told El Vocero that the GO payment was not assured—an uncertainty confirmed this week by Government Development Bank President Melba Acosta Febo, who stated she could not guarantee the general obligation payment to bondholders would be made, albeit she made clear Puerto Rico working to improve the central government’s liquidity so that it would be able to make the payment, noting to El Vocero: “We recognize the GO’s priority over other debts and its difference from other debts, but we must also recognize that there is a duty of the state to maintain health services, education services, and some security to our people – we must look at those things.” Indeed, the island’s general obligation debt holds a superior claim to revenues compared with other government debts and claims, meaning that, for instance, motor vehicle fuel taxes, crude oil, and derivative products excise taxes, cigarette excise taxes and license fees allocated to the Puerto Rico Highways and Transportation Authority can be diverted to meet the island’s general obligation debt, at least according to the official statement for its March 2014 Puerto Rico GO bond sale. Moreover, there is authority to divert some rum tax payments allocated to the Puerto Rico Infrastructure and Finance Authority, as well as hotel occupancy tax revenues currently flowing to the Puerto Rico Convention Center District Authority in order to meet general obligation debt; however neither Puerto Rico’s constitution, nor its applicable laws specifically mandate funds to revert to the central government “even if other available resources of the commonwealth are insufficient for the payment of public debt.”

Promises, Promises…Could Puerto Rico Be Contagious? Just as Chicken Pox can be contagious, so too there can be apprehension that political promises to pay—when perceived to be welshed upon, can create contagion fears and higher costs to cities, counties, and states in other places—especially on state or local debt supported only by a legislature’s, county or city council’s promise to pay. Thus it is that S&P this week abruptly downgraded Chicago’s Metropolitan Pier and Exposition Authority’s rating from its stellar AAA status to near junk: why? Because Gov. Bruce Rauner and the Illinois legislature are in a stalemate: the state has yet to appropriate funds to meet its promises to pay the bondholders. It is unsurprising that state and local bondholders in other states, counties, and cities—observing an inability to make a promised payment—might insist upon a higher interest rate to reflect the political risk. Whereas a general obligation or revenue bond issued by a state, local government, or authority provides the municipal bondholders with claims to designated revenues, so-called appropriation bonds might be perceived to give bondholders claims only to promises to pay. Moody’s unmoodily this week illustrated the extreme distinctions: examining the Motor City’s municipal bankruptcy, the credit rating agency wrote that holders of Detroit’s certificates of participation, which had neither the city’s taxing power nor dedicated specific revenue streams, received only twelve percent of what they were owed—some 16 percent of what Detroit’s general obligation bond holders received under the city’s federally approved plan of debt adjustment. Under San Bernardino’s proposed plan of debt adjustment pending before U.S. Bankruptcy Judge Meredith Jury, the California municipality has proposed paying its pension-obligation bondholders only one cent on the dollar. Already the Puerto Rican contagion seems to be giving potential Jayhawk development finance authority bond investors the eeby-jeebies. With Kansas collecting $3.7 million less in taxes than anticipated this month, potential investors in the $1 billion of debt it is seeking to sell next week through its development finance authority to shore up its underfunded workers’ retirement system are almost certain to be affected—especially as the prospectus circulated to potential buyers warns that if Kansas does not allocate cash to pay investors, the agency “has no obligation to seek or obtain any source of moneys for deposit to the Revenue Account, other than State appropriations.”

Advice and Consent. The Wayne County Board yesterday voted 12-2 to enter into a consent agreement with the state to handle its financial emergency and avoid insolvency. The strong vote means Wayne County and Michigan Treasurer Nick Khouri have started the clock ticking over the next 30 days during which to negotiate a draft of an agreement—one which the County hopes would enhance its authority vis-à-vis labor contracts as well as allow the county to continue to maintain local control over its restructuring. Wayne County Executive Warren Evans noted: “Today Wayne County continues on its road to financial recovery…We have already made significant strides towards getting Wayne County back on the right fiscal path. The consent agreement will ensure our ability to fully implement our recovery plan and stabilize the county for the future.” The next steps are to negotiate with the state over the terms of a consent agreement, or, as Executive Evans noted: “As we finalize the terms of the consent agreement with the state Treasurer, we will continue in our commitment to negotiate in good faith with our unions…Although a consent agreement will eventually give the county the ability to set the terms of employment, our preference is to reach agreements at the bargaining table.” Any final consent decree will affect Detroit—the County seat in the middle of Wayne County—thus one might imagine a double helix with the city and county interlinked in their fiscal fates.

Heard It Through the Grapevine. First recorded 49 years ago in Detroit by producer Norman Whitfield with various Motown artists by the Miracles on August 6th, yesterday’s anniversary marked a miracle of a different kind: Detroit posted preliminary bond documents for what will be its first public sale of municipal bonds since its historic municipal bankruptcy: sale through the Michigan Finance Authority is tentatively set for a week from Wednesday, marking the city’s first public market access since it received the rhythm guitar playing U.S. Bankruptcy Judge Steven Rhodes’ approval of its plan of debt adjustment of the largest municipal bankruptcy in U.S. history last December. In contrast to the kinds of appropriation bonds which have both worried investors and driven up the cost of borrowing for states and local governments, this new issuance is expected to benefit from a remarkable state role through which Michigan makes use of a statutory lien on income-tax revenue and an intercept feature by means of which the income-tax revenue is first routed to a bond trustee before the rest is sent back to the city—meaning that S&P has already assigned an A rating to the deal. In addition to the relatively unique statutory lien and intercept feature, the sale also provides that about 8 percent of the income-tax revenue, will first be sent to the police budget, a pledge that is senior to bondholders’ under the deal. The Motor City is issuing the debt to repay Barclays for a $275 million loan, the proceeds of which the city used to help finance its exit from municipal bankruptcy. Notwithstanding the nice rating and excitement about the city’s return to the bond market, Detroit’s preliminary municipal bond documents hint at the uncertainty of how the liens might be interpreted in a U.S. bankruptcy court: “The bankruptcy court would not be bound by legal opinions other than binding precedent, and there currently is no binding precedent regarding these matters…Thus, the opinion of bond counsel to the city is not (and cannot be) a guaranty that the pledged income tax revenues would be treated as subject to a statutory trust or lien.” The documents note other potential risks, including the possibility of another bankruptcy filing; the uncertainty of future income tax revenue; limitation on rate of income tax; and Detroit’s economic and fiscal condition.

Yet, as Motown singer Ted Nugent, in his “Motor City Madhouse Lyrics” sings:

Who! Welcome to my town
High energy is all around tonight
Who! You best beware
Well, Detroit city, she’s the place to be.

Municipal Default & Consequences

August 6, 2015

Default & Its Consequences. Puerto Rico is in uncharted fiscal and physical territory in the wake of its default, and now faces a severe physical and fiscal drought. Lacking the protections to ensure the ability to provide essential public services under municipal bankruptcy, the drought threatens to syphon off already insufficient resources—almost certainly forcing further defaults—a fiscal situation which will make the island’s cost of borrowing increasingly prohibitive. Put another way, further credit downgrades could pose a serious challenge to Puerto Rico’s post-crisis recovery. With nearly 13 percent of the island under an extreme drought, the U.S. territory’s public utility will be providing water only every third day, raising the total facing 48-hour cuts in service to 400,000, as Puerto Rico’s main reservoirs continue to shrink, according to the island’s water and sewer company. Last month was the fourth-driest month on record in San Juan since 1898. Now the drought has forced some businesses in Puerto Rico to temporarily close—closures which will further erode critical tax revenues, including recently increased sales and use tax revenues. But the island’s travails will have widespread fiscal reverberations: if Puerto Rico fails to make interest payments on its $72 billion public debt, pension funds across the U.S. could find themselves unable to meet their own payment obligations. Thus, even as Congress has slipped out of town without any consideration of what threatens to become a much more national financial crisis, tens of thousands of Americans in Puerto Rico are facing an immediate issue—one with potential serious health and safety consequences—and one which even a simple debt restructuring, were Puerto Rico’s bondholders to agree to it — would not resolve the fiscal and increasingly physical challenge. Absent some intervention, the U.S. territory, with a population of 3.6 million, assumes that each and every person on the island would need to pay $1,400 a year — 9 percent of Puerto Rico’s per-capita income — just to cover this year’s $5 billion principal and interest payments on the debt.

Advice and Consent. Wayne County Executive Warren Evans told his fellow commissioners yesterday that agreeing to a consent agreement is Wayne County’s only option for resolving its financial emergency: “It’s the only rational option…It keeps power in the county’s hands.” Mr. Evans’ remarks came as he and his colleagues must opt for one of four options under Michigan law: a consent agreement, mediation, appointment of an emergency manager, or Chapter 9 municipal bankruptcy. Mr. Evans added, yesterday, that Michigan State Treasurer Nick Khouri had told him earlier in the day that the county could be released from a consent agreement as early as next April. Commissioner Burton Leland, D-Detroit, said the panel’s realistic choices are limited. “There are really only a couple of options,” he said. “Bankruptcy and emergency manager aren’t really options.” Commissioners have until 5 p.m. today to make their decision—with the most radical to, in effect, remove themselves and hand over power and governance authority to an unelected emergency manager. For his part, the County Executive made clear he would prefer a consent agreement: such an agreement, he said, would spell out specific budgetary reforms the county would have to meet, adding that power is only a tool—and one he would not necessarily need to use if cost-saving contracts with Wayne County’s labor unions could be negotiated, noting: “I would much rather negotiate contracts with our unions than impose them…Because I have the hammer doesn’t mean I drop it.” Leaders of Wayne County’s public unions asked commissioners to consider how their decision might impact workers before they vote, with Edward McNeil of AFSCME testifying: “You commissioners were asking (Executive Evans) if the consent agreement would take away your power…If you go with a consent agreement, you take away our power to sit down and negotiate (a contract) on equal footing.” The issue confronting the elected leaders is how they can address a $52 million annual structural deficit—a deficit caught between the Scylla of a $100 million drop in annual property tax revenue since 2008 and the Charybdis of the county’s desperately underfunded pension system: Wayne County’s primary pension plan is 45 percent funded and has a liability of $910.5 million, based on the latest actuarial valuation. Officials currently project Wayne County’s deficit could reach $171.4 million by FY2019 absent immediate fiscal steps.

Rolling the Fiscal Dice. Standard & Poor’s Monday cut Atlantic City’s general obligation credit rating three notches to BB, citing uncertainty over whether the fiscally stressed municipality can meet its fiscal obligations this year, with S&P analyst Timothy Little commenting that Atlantic City confronts short-term fiscal risks from the “lack of a clear plan” to plug an estimated 2015 deficit of $101 million, adopting a 2016 fiscal budget and achieving tax collection projections. Mr. Littler noted: “The downgrade reflects continued uncertainty regarding the long-term fiscal stability and recovery of the city as it responds to increasing liabilities from tax appeals and an eroding tax base… [it] reflects our view that the city is more vulnerable to nonpayment since our last review given that three months have passed without additional clarity on how the city will propose to resolve its long-term financial challenges.” The downgrade came as the city—rather than awaiting tonight’s GOP debate—instead is frustrated by the delay in action by Gov. Chris Christie. Atlantic City Revenue Director Michael Stinson made clear that Atlantic City not only has met its August debt payments, but also that he expects a balanced budget to be achieved in early September, provided Gov. Christie signs legislation to implement a state fiscal package which would provide the city with additional revenue. Mr. Stinson added that Atlantic City was successful in selling some $40.5 million in Municipal Qualified Bond Act (MQBA) bonds last May to pay off a state loan and that tourism has been up this summer, noting: “There has been nothing negative happening to the city since we issued those bonds in May…A downgrade at this point is unwarranted.” But S&P’s Little wrote that although Atlantic City was able to address immediate financial and liquidity pressures through the MQBA bonds, the future ability of Atlantic City to the municipal bond market remained more of a gamble, adding that since the release last March of a 60-day report from the city’s emergency manager Kevin Lavin, there has been no clarity on potential payment deferrals. Indeed, on July 1st, Mr. Lavin said that all options are on the table with a potential municipal bankruptcy filing not ruled out—in effect reemphasizing the confused governance situation with regard to his role and relationship with Mayor Don Guardian, leading Mr. Little to note: “The lack of clear and implementable reforms to restore fiscal solvency without payment deferrals or debt restructuring remains uncertain as the city continues to operate in a difficult fiscal environment.”

Is Municipal Bankruptcy a Dirty Word? Moody’s, in a decidedly unmoody examination, today wrote that the nation’s city and county leaders no longer consider municipal bankruptcy to be taboo; rather, they said, fiscally distressed cities and counties in those states which authorize chapter 9 municipal bankruptcy are increasingly likely to consider it a viable option, based upon their examination of recent municipal bankruptcies, adding that “The number of general government bankruptcies following the recession remains low, but is still remarkable compared to the long-term experience of the U.S. municipal market since World War II.” They noted that four of the five largest municipal bankruptcy filings in U.S. history have been made in a little more than three years, a record they attributed to a slow recovery from the Great Recession, but also to changing attitudes about debt. But they also noted that the successful recovery from municipal bankruptcy by municipalities such as Central Falls, Jefferson County, and Detroit—in addition to the willingness of investors to come back to defaulting cities like Wenatchee, Washington could further help change municipal investors’ perceptions with regard to default and bankruptcy: “In the apparent absence of a severe or prolonged capital markets penalty, it is not surprising that various governors, mayors, and other local government officials have come to consider bankruptcy as a potentially realistic and effective option for restructuring liabilities.” The magnificent seven also noted that while these municipal bankruptcies have gained wider acceptance and appear—at least so far—to have worked; they have been less friendly to municipal bondholders, noting especially that pensions have been largely protected, whilst municipal bondholders have taken steep cuts, adding: “A more frequent use of bankruptcy by distressed credits does not in and of itself alter our overall stable outlooks for the state and local government sectors, but it does underscore how the recent recession has resulted in significant pockets of pressure, ongoing challenges of balancing rising fixed costs against anti-tax sentiment and a tighter budgetary ‘new normal’ that is less resistant to new shocks…We expect that bankruptcy and default will remain infrequent among rated local governments and consequently expect no change to our broad distribution of municipal ratings.”

What Are the Consequences of Default?

August 4, 2015

Default & Its Consequences. The Puerto Rico Public Finance Corp. (PRPFC) yesterday defaulted on 99% of its due payment of some $58 million, according to Government Development Bank for Puerto Rico president Melba Acosta Febo, with Mr. Acosta stating that the decision by the Puerto Rican government not to appropriate funds to pay the debt “reflects the serious concerns about the commonwealth’s liquidity in combination with the balance of obligations to our creditors and the equally important obligations to the people of Puerto Rico to ensure the essential services they deserve are maintained.” Puerto Rican officials have said that the PRPFC default does not constitute a Puerto Rican government default; nevertheless, the default marked the first default by the U.S. commonwealth and could open a Pandora’s Box as the U.S. territory now enters unknown territory in seeking to restructure about $72 billion in debt without access to a federal bankruptcy court. But like the first skittering of stones marking an avalanche, yesterday’s default appears likely to be the first in a broad series of defaults in coming days and months. The bank did pay about $628,000 remaining from prior funds.

The event came as the cost of debt for the island continued to escalate: Puerto Rico municipal bonds were trading at levels more than 30% below their issuance levels of just a year ago yesterday in the wake of the default. Because the defaulted bonds were so-called “appropriation bonds,” as opposed to full faith and credit general obligation or revenue bonds—that is, bonds backed by the legislature’s willingness to appropriate funds to pay the interest rate payments due to holders—the bonds (and bondholders) have far fewer protections than most municipal bonds issued by states and local governments. Indeed, the official statement for the 2011 series A PRPFC bonds states on its first page: “The 2011 series A bonds will not constitute an obligation of the commonwealth or any of its public instrumentalities (other than the corporation), and neither the commonwealth nor any of its political subdivisions or public instrumentalities (other than the corporation) will be liable thereon.” Nevertheless, Puerto Rico yesterday afternoon announced that it had “temporarily suspended” setting aside funds on a monthly basis for general obligation debt service payments, notwithstanding assurances by government officials that the commonwealth will nevertheless make the GO bond payments. Puerto Rico has said its debt includes about $18.6 billion of general-obligation bonds and government-guaranteed debt, $15.2 billion of sales-tax-backed bonds and $24.1 billion of bonds issued by government agencies, like the Puerto Rico Electric Power Authority, which is already negotiating a restructuring with creditors. Many investors in every state across the U.S. hold Puerto Rico’s municipal bonds across the different sectors, meaning they might which could recover different amounts in a restructuring. Fabulous Matt Fabian, a partner at Municipal Market Analytics, remarked that while worries about Puerto Rico have had little impact on the broader market for state and local capital debt, the deliberately skipped payment could spur new selling by investors of other Puerto Rico commonwealth debt. Moody’s Investors Service vice president Emily Raimes said, “Payment of debt service on these bonds is subject to appropriation, and the lack of appropriation means there is not a legal requirement to pay the debt, nor any legal recourse for bondholders. This event is consistent with our belief that Puerto Rico does not have the resources to make all of its forthcoming debt payments. This is a first in what we believe will be broad defaults on commonwealth debt.”

What’s Next? The default entered Puerto Rico in a place beyond San Bernardino, or Detroit, or Jefferson County, because the U.S. territory has no legal access to ensure protection for essential public services, much less a federal judge to preside over negotiations with the islands thousands and thousands of creditors. A group of Puerto Rico policy makers is working on a restructuring plan—such as a plan of adjustment negotiated by a city in municipal bankruptcy—but without those protections. The policy makers hope to present their findings at the end of August. Creditors, including mutual funds, hedge funds and other distressed-debt investors, have been splitting into committees based on which kinds of Puerto Rican municipal bonds they own—but it promises to be an unprecedented restructuring process unlike any that has ever occurred in U.S. history.

Caught between Governance, Democracy, and Municipal Bankruptcy

August 3, 2015

Aching for a Fiscally Sustainable Tomorrow. Saturday marked the third anniversary of San Bernardino’s municipal bankruptcy filing—making it not only the longest period of any city in such a transition, but also a time of considerable public disruption. Because, in California, unlike Michigan or in a number of other states which authorize municipal bankruptcy, municipal elected officials remain in charge; only in the case of San Bernardino, even there—unlike Jefferson County—there has been significant change—a new Mayor, City Council, and City Attorney. Now even more could well be on the way. Candidates for the Third, Fifth, Sixth, and Seventh Ward Council Member positions, as well as for City Attorney, City Treasurer, and City Clerk, must file for election or re-election next November by the end of this week. For the bankrupt city’s voters and taxpayers, moreover, there is a tenuous balance between local control and the federal court. Almost as if in a twilight zone in a most disinterested state, San Bernardino is suspended not just in a time warp, but also in uncertainty as to critical decisions which will emerge not from their own elected leaders, but also U.S. Bankruptcy Judge Meredith Jury. That is, the city’s elected officials (and prospective challengers) bear not only their responsibility to their constituents and taxpayers, but also to be responsive to the federal court. Unsurprisingly, what might satisfy the federal bankruptcy court is less than likely to meet with citizens’/taxpayers’ hopes. Mayor Carey Davis provided his perspective: “I think there’s a fair amount of frustration on the part of residents with the protracted nature of this, but (bankruptcy) is a long and expensive process to move through…A lot of residents, I find, are surprised, because they saw filing the Plan of Adjustment as a completion. It required a considerable amount of effort to put together that Plan of Adjustment, and so the implementation of that, I think, is going to take just as much work — and I think it will be the most difficult time of the bankruptcy.” One of the terrible ironies of municipal bankruptcy is that a municipality that cannot meet its fiscal obligations is, after all, beset with very significant costs in bankruptcy: as of last February, San Bernardino had already more than doubled its budgeted costs for the municipal bankruptcy process from $4.1 to $9.3 million.

Pop Goes the Weasel. Sort of like the musical chairs game we played as kids, where when the music stopped—and one chair had been removed—someone was out. What is different is that in the case of Puerto Rico, with default now happening, and Puerto Rico’s government having suspended setting aside funds to meet its general obligation debt, the issue is rather which creditors will not be paid—especially in the wake of the Puerto Rico’s Treasury announcing that the government was not making the set asides—or, as Puerto Rico Secretary of the Treasury Juan Zaragoza put it in an interview: “We aren’t making the monthly deposits. But that does not mean in any way that we won’t pay our GO obligations.” Of course, it does not mean Puerto Rico will. As of today, the U.S. territory has moved into a fiscal Twilight Zone. Under legislation Governor Alejandro García Padilla signed, Puerto Rico is authorized to suspend set asides as long as it finds itself unable to borrow some $1.2 billion in intra-year funding or the Puerto Rico Infrastructure and Finance Authority cannot sell a $2.9 billion gas-tax supported bond. So, now the island—and its creditors—find themselves in a brave new fiscal world where—outside of municipal bankruptcy—there are few prescribed rules; moreover, unable to access federal bankruptcy, there is no federal bankruptcy judge to either ensure the protection of essential public services, much less to act as a referee amongst the clamoring creditors. Puerto Rico’s constitution prioritizes the payment of its guaranteed debt over any other financial need. The approved fiscal year 2015-2016 General Fund budget allocated $1.011 billion for general obligation debt, and a Treasury spokeswoman on Friday confirmed that the Government Development Bank had transferred about $170 million to the bond trustee for payments of its debts today.