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.

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