The Seemingly Irreconcilable Challenge between Addressing Debt & Investing in the Future

September 11, 2015

Investing in Kids? S&P has lowered its ratings on the Michigan Finance Authority’s series 2011 revenue bonds to A from A-plus and series 2012 revenues bonds to A-minus from A-plus with a negative outlook—bonds issued by the MFA for the Detroit Public Schools, with S&P analyst John Sauter writing: “The district’s continued overall financial and liquidity deterioration is another contributing factor.” The bonds, which are payable from the repayment of loans made by the MFA to the Motor City’s school district—loans secured by all appropriated annual state aid to be received by the school district—which has irrevocably assigned 100% of its pledged state aid to the loans (and thereby to the authority’s bonds). The district’s 2011 obligation holds a first-lien pledge of state aid, and the 2012 obligation a second lien. The district’s limited-tax general obligation (GO) pledge also secures both obligations. The ratings reflect the strength and structural features of the district’s state aid pledge to its obligations. Mr. Sauter noted: “The downgrade is based on severe declines in the district’s enrollment, and subsequently, pledged state aid available to pay debt service.” DPS’ credit downward trajectory appears to reflect continued fiscal stress as indicated by significant growth in DPS’ accumulated operating fund balance deficit from FY2014 and ongoing declines in enrollment—declines which pressure operating revenue, as well as the perception that DPS lacks the capacity to reverse the negative operating trend. But the rating also takes into consideration the weak economic profile of the City of Detroit (B3 stable), DPS’ substantial debt burden, and an operating budget constrained by high fixed costs. Absent enrollment and revenue growth, fixed costs will comprise a growing share of DPS’s annual financial resources and potentially stress the sufficiency of year-round cash flow. The unholy combination of falling revenue, rising costs, and credit downgrades can raise the cost of borrowing money—creating a vicious cycle that erodes the fiscal capacity to invest in Detroit’s future taxpayers. Michigan law prohibits its school districts from raising property taxes for operating funds over 18 mills on non-homestead properties; thus, many districts have cut spending, laid off teachers and other staff and eliminated some school programs. DPS has been under the auspices of a state emergency manager for several years and has about $483 million in debt. The district’s enrollment was once well above 100,000 students, but now is about 47,000. Former state superintendent of Public Instruction Mike Flanagan wrote earlier this year in a report to education appropriation subcommittees as he was leaving his post that cash needs could force Detroit Schools to refinance even more debt. The downgrade affects both costs and reputation: for Detroit, its ability to leverage families to move into the city is inherently dependent upon the reputation of its public school system.

Planning Debt Adjustment. When a municipality is in bankruptcy, it is forced to juggle thousands upon thousands of issues relating to constructing a plan of debt adjustment with its creditors that will secure the federal court’s approval—a process made ever more difficult with the approach of elections. This adds stress—and confusion—as could be observed in San Bernardino in the wake of a brief welter of confusion yesterday when a tentative contract agreement already reported to U.S. Bankruptcy Judge Meredith Jury was abruptly pulled off the City Council agenda—a contract with the city’s general unit, which represents some 357 employees who are not in another union, such as police or management. Nevertheless, the contract is now set for the Council to review in closed session at the city council’s meeting scheduled for a week from Monday—in this instance, a contract with regard to leave policy for the city’s employees, who have been working under a contract which expired June 30th as they negotiated with the city for a new contract. The need for a revision arose in the wake of the city’s implementation of one part of its 2012 bankruptcy plan — freezing leave which had accrued before August 2012, when the city filed for bankruptcy protection. That meant that by this year, many employees wound up with negative leave balances—a situation which a city official described to the Council as “very detrimental to the employees.”

Debt Restructuring Outside of Bankruptcy. If you can imagine an NFL football game without any referees or under-inflated footballs, you can begin to imagine the chaos triggered by the release in Puerto Rico this week of its quasi plan of debt adjustment—a plan which, unsurprisingly, calls for its municipal bondholders in each of the nation’s 50 states to accept less than they are owed. The U.S. territory has $13 billion less than it needs to cover its debt payments over the next five years—and that is even after taking into account the proposed spending cuts and measures to raise revenue in the newly proposed plan. Puerto Rico officials estimate that the island will have only $5 billion of available funds to repay $18 billion of debt service on $47 billion of debt, excluding obligations of its electric and water utilities. The projected debt-funding shortfall is after anticipated savings from the consolidation of 135 public schools, reductions in health-care spending, additional subsidy cuts and reductions in payroll expenses. So now, in an unrefereed, unprecedented fiscal process, Puerto Rico’s fiscal team plans to present its investors with a debt-exchange offer in the next few weeks. It also intends to seek a moratorium on principal payments. And it will not have long: the whistle will blow by the end of the year, leaving the unenviable challenge and task of seeking to get all the creditors on the field quickly: Puerto Rico is on course to run out of cash by the end of this calendar year unless it can refinance its debt—or as non-football BlackRock analyst Peter Hayes yesterday put it: “They have a real solvency issue…They have a liquidity crisis on their hands that grows very dire by the end of the year.” And the fiscal threat and challenge was exacerbated by S&P’s dropping of Puerto Rico’s tax-backed debt to CC from CCC-, and removal of the U.S. territory’s ratings from CreditWatch, where they had been placed with negative implications July 20. The outlook is negative. With the near certainty of a default or restructuring—or fiscal event, there is an increased likelihood of either a missed debt service payment or a distressed exchange which would resemble a default. Gov. Alejandro Garcia Padilla stated that if Puerto Rico’s creditors are unwilling to partake in restructuring negotiations, Puerto Rico would have no alternative but to proceed without them even if it involved “years of litigation and defaults.”

Herding Angry Sheep. In a television address, Gov. Padilla yesterday announced the appointment of a team of debt restructuring experts to negotiate with Puerto Rico’s creditors—a process which would be unprecedented as those creditors run from some of the world’s most sophisticated to tens of thousands of individual municipal bondholders in each of the nation’s 50 states—and a process which, absent action by Congress, might more resemble gladiators in a coliseum than the kinds of overseen negotiations which took place under the aegis of U.S. Bankruptcy Judge Steven Rhodes in Detroit. Adding to the uncertainty, the report on which such negotiations is premised is technically only a recommendation. Try and imagine a football game not only without referees or under inflated balls, but also without agreed upon rules. That report projects Puerto Rico’s treasury will exhaust its liquidity by November—and only until then if Puerto Rico takes extraordinary measures to preserve cash. Unlike a non-governmental corporation—Puerto Rico has no ability to act unilaterally: actions require legislative and gubernatorial action and concurrence. Moreover, it is not just Puerto Rico, but also the Puerto Rico Government Development Bank (GDB)–which is projected to exhaust its liquidity before the end of calendar 2015. And there are dozens and dozens of municipalities at growing fiscal risk (Puerto Rico’s municipalities cannot file for Chapter 9 bankruptcy protection, and a local debt-restructuring law enacted in June 2014 was thrown out by a federal judge in San Juan.). But, like in football game, there is a clock: and it is already running: we know that Puerto Rico will not have fully sufficient fiscal resources in FY2016 to make payment on its scheduled tax-supported debt, including its General Obligation (GO) debt, so that for creditors, it is almost as if the music for a game of musical chairs has already started. The report released this week forecasts a total central government deficit as a whole, including the general fund, GDB net revenue, COFINA, federal programs, and Puerto Rico Highways & Transportation Authority (HTA) net revenue, in fiscal 2016 of $3.2 billion, or about 16 percent of expenditures, including payment of debt service; it projects only a $924 million surplus available before payment of debt service. That is, it appears, as in musical chairs, that there simply will be insufficient fiscal capacity to meet the obligations to pay $1.8 billion of GO and GO-guaranteed debt service (GO debt service alone is $1.2 billion), much less total central government debt service, including GO debt, of $4.1 billion. Or, as Mr. Hayes wrote: “We rate all Puerto Rico tax-backed debt at the same ‘CC’ level, except for Puerto Rico Public Finance Corp. (PFC) debt, which is currently in default and rated ‘D,’ reflecting the report’s projection of limited liquidity to meet all debt service before the end of calendar 2015, including GO debt service, and the report’s recommendation to enter restructuring discussions with all tax-backed debt holders.”

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