Ethics & Their Role in Municipal Fiscal Distress

October 15, 2015. Share on Twitter

Unravelling SWAPs & Paying the Windy City’s Pipers. In a new report, the Chicago Civic Federation rendered its support for Mayor Rahm Emanuel’s City of Chicago proposed FY2016 budget of $7.8 billion—applauding the Mayor’s proposals to take on the Windy City’s public safety pension funding crisis, but expressing apprehension that perhaps the largest municipal property tax increase in U.S. history, by itself, might be insufficient to stabilize Chicago finances, especially given continued legal uncertainty with regard to the city’s public pension and retiree health care reforms. The big kahuna in the Mayor’s proposed FY2016 budget is a $1.26 billion property tax levy, an increase of more than 33% from the originally adopted FY2015 budget, rising in subsequent years to $544.2 million between FY2015 (payable in 2016) and FY2018 (payable in 2019) with those proceeds dedicated entirely to fund the city’s Police and Fire pension funds, with the always insightful federation leader Laurence Msall noting: “Mayor Emanuel and his team deserve credit for transparently outlining a plan to address one of the City’s most urgent financial crises,” adding, however, that “[G]reater sacrifice will be needed to address the pension funding crises for non-public safety funds, the liquidity crises at Chicago Public Schools (please see below for the criminal, ethical, and fiscal challenges to CPS), and Chicago’s ongoing structural deficit, urging the city to consider greater cost savings and efficiencies, “especially in public safety operations that have largely avoided budgetary scrutiny in recent years.” Mr. Msall noted that the Mayor’s FY’2016 budget reduces Chicago’s reliance on what the Federation terms “scoop and toss,” or what he notes is “an expensive practice which extends the life of existing [municipal] bonds and dramatically increases the cost of providing government services—” a practice Mayor Emanuel pledged to the Association he would phase out by FY2019, beginning with a $100 million reduction in FY2016. {Please note next item, “Gambling,” with regard to this prohibitive municipal finance process.] Nevertheless, Mr. Msall expressed apprehension with regard to the as yet unreleased portion of the city’s proposed budget on its plans for how to fund two significant potential expenses in its upcoming fiscal year: an additional $220 million pension contribution and an increase in retiree health care costs. In its proposal, the city’s budget assumes the state will act to adopt the Mayor’s proposed changes to the City’s pension funding schedule. Indeed, such legislation has passed both houses of the Illinois legislature; however, the bill has not been released for Governor Rauner’s signature, nor has Gov. Rauner indicated that he will sign it: without such a signature Chicago will be required to contribute an additional $220 million to its pension funds in the new fiscal year. Moreover, the city still faces uncertainty with regard to the ongoing litigation over its proposed phase-out of its retiree health care benefits—where an adverse court ruling could significantly increase retiree health care costs.

Gambling on a City’s Future. At the exceptional conference, Bankruptcy and Beyond, hosted by Professor Juliet Moringiello of the Widener Law School in Harrisburg, Pennsylvania last year, there was substantive focus on the dangers of municipal involvement with so-called swaps—or municipal instruments packaged by Wall Street to make bets on interest rates—bets which Bloomberg this week insightfully noted are “costing [Chicago] taxpayers at least $270 million since Moody’s Investors Service cut its rating to junk in May,” noting that while traditionally, the exchange of one kind of municipal security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed has been a more or less regular practice—one which has left all too many municipalities susceptible to significant fees and risk; more recently, so-called swaps have expanded to include currency and interest rate swaps—all leading to increased payouts to Wall Street banks, but coming, as noted above, as the Windy City considers a record tax increase to cover its public pension liabilities—swap costs in this case that are more than the city spends annually for the collection of garbage at 613,000 homes, or the equivalent of hiring more than 2,000 police officers. And that is before the city is forced to pay the piper to unwind municipal derivatives as it considers still another round of municipal debt restructuring—a round which could cost the debt-stressed city $110 million to unwind derivatives on its water debt—or, as the ever prescient Richard Ciccarone, the CEO of Merritt Research Services: “I don’t think the public should be gambling with its funds…Save the speculation for people who risk their own money, not for taxpayers.” Indeed, as can be seen from Bloomberg’s chart, Chicago confronts enormous debts to banks—not to teach in its troubled schools or to protect it citizens, but almost as a penalty for failing for too many years to address its rising pensions and borrowings to cover debt service. Instead of such critical investments, the city—and other cities and counties, as Bloomberg noted, “and other municipal borrowers in the past decade made bets on the future direction of interest rates through agreements with banks to swap interest payments. But when rates fell under the Federal Reserve’s attempt to stimulate the economy after the financial crisis, many issuers ended up on the wrong side of the bets. Since then [municipal] issuers have paid at least $5 billion to unwind the agreements.” Indeed, the city was scheduled to sell $439 million worth of municipal of bonds yesterday—with nearly 20 percent set aside to cover some $70.2 million to end an interest-rate swap tied to variable-rate debt for the city’s sewer system—and that, as Bloomberg adds, is “on top of $185 million paid to unwind swaps on general-obligation and sales tax debt since May.”The estimated $270 million total also includes the cost to banks and other professionals to restructure, according to data Bloomberg compiled from city documents. Chicago owed as much as $396 million to banks in March, before the city started terminating the swap agreements, according to market values at the time. Saqib Bhatti, a Chicago-based fellow at the Roosevelt Institute, told Bloomberg: “We’re paying these fees at the same time the city is looking at the biggest tax increase in its history,” adding that he has been recommending that governments with swaps should push to cut the fees rather than pay Wall Street banks: “Working residents of the city are going to have to sacrifice for the city to pay these fees to the banks.”

Aiding & Abetting Municipal Fiscal Distress. While they might teach math in Michigan’s schools, it might be that ethics ought also to be mandatory there and in Chicago—both places of exceptional fiscal challenges, but with, seemingly, one common denominator: unethical behavior from the top with abhorrent fiscal consequences. Thus it was Tuesday that former Chicago Public Schools (CPS) head Barbara Byrd-Bennett pled guilty to her role in a scheme to steer $23 million in no-bid contracts to education firms for $2.3 million in bribes and kickbacks. As part of her agreement, prosecutors recommended that Ms. Byrd-Bennett serve 7.5 years in prison for one count of fraud—an agreement under which prosecutors said in return they would drop the 19 other fraud counts, each of which carried a maximum 20-year term. The disservice by which Ms. Byrd-Bennett harmed Chicago’s fiscal sustainability and its children’s future came from her own past disservice to Detroit, where, as the former Detroit Public Schools chief academic officer, she had stepped down in the wake of a federal investigation into a contract between the district and SUPES Academy, a training academy where she once worked.—an investigation in which prosecutors allege the scheme started in 2012 — the year Mayor Rahm Emanuel hired her to become Chicago’s school district CEO. The indictment alleged that the owners of the two education service and training firms offered her a job and a hefty one-time payment, a payment purported to be a lucrative signing bonus — once she left CPS. The indictment alleges Ms. Byrd-Bennett expected to receive kickbacks worth 10 percent of the value of the contracts, or close to $2.3 million—or enough as Ms. Byrd-Bennett emailed to executives more than three years’ ago so that she could make money, writing: “I have tuition to pay and casinos to visit.” Her untimely departure comes in the wake of leaving the Detroit Public Schools system with what, today, is $327 million in debt with no visible means of repayment, and contemplating municipal bankruptcy, even as its debt insurer, Assured Guaranty Ltd., is pressing the Michigan legislature to bar the system from such a filing. Without the agreement, the insurer has threatened to accelerate long-term debt payments, raising the annual payment amount from $21 million to $45 million. In some sense, Ms. Byrd-Bennett brought her unethical and criminal fiscal legacy with her: SUPES Academy and Synesi Associates LLC owners Gary Soloman and Thomas Vranas have been accused of offering Ms. Byrd-Bennett money, along with sporting-event tickets and other kickbacks, in exchange for the contracts. Synesi Associates, which trains principals and school administrators—one shudders to imagine what kind of training they offer, was awarded contracts with Detroit Public Schools under Ms. Byrd-Bennett’s tenure, according to records posted on DPS’ website.

The ABC’s of Municipal Fiscal Challenges. The Holland, Michigan, School District, more than 100 years old—as may be observed from one of its oldest photos—is, like many Michigan school districts, confronting sharp and unexpected enrollment declines—declines adversely affecting their bottom lines; or, as Moody’s yesterday moodily opined, Holland illustrates not the place to skate all Winter, but rather the kinds of severe fiscal challenges of too many Michigan school districts—districts facing declining enrollments, stagnant state aid, and limited ability to raise additional revenues. Holland, a city of about 33,000 in the southwestern part of the lower peninsula, not unlike Detroit, is confronting a severe fiscal, as opposed to scholastic challenge in its K-12 system—or, as Moody’s this week reported, the A-1 credit-rated school district, has experienced a 174-student drop in enrollment—a drop nearly double what the district had anticipated and budgeted for in its current fiscal year—an enrollment drop which translates into a revenue loss of $591,000 in state aid, or, as Moody’s moodily explains: “The enrollment decline is not only credit negative for the district, but reflects the widespread credit challenges that continue to face Michigan school districts.” Moody analyst David Levett wrote: “Such pressures have led us to downgrade 44 Michigan school districts this year.” Holland’s six consecutive general fund operating deficits have been driven primarily by declining enrollment and the ensuing reduction in state aid under Michigan’s per-pupil funding system. As Mr. Levett notes: “Although officials are still analyzing this year’s enrollment figures, the district’s long-term trend of enrollment declines is attributable to significant competition from charter schools and an aging population,” effectively a fiscal one-two punch—two trends, however, which appear to be schooling Michigan’s elementary and secondary school fiscal sustainability, albeit with a potential steepening of the downward curve—or, as Mr. Levett added: “Even [school] districts that plan for declines may miss the mark on the magnitude of those declines.” Demographics are contributing to the fiscal python squeeze; the Census Bureau reports Michigan’s under-18 population is projected to decline an estimated 13% from 2000 to 2012, so that, as Mr. Levett further writes, “The state’s funding structure, demographic trends and liberal enrollment policies create an unpredictable and competitive environment for districts.” Indeed, close to 80 percent of Michigan’s school districts with more than $25 million in outstanding municipal debt experienced enrollment declines between 2009 and 2013—creating not just arithmetic opportunities for the system’s students, but math problems for the state’s school fiscal officers.

Restructuring Municipal Debt & Supermunis. Treasury Department and Puerto Rico officials are negotiating options for restructuring the U.S. commonwealth’s $72 billion in debts, especially with it becoming increasingly clear that the absentee U.S. Congress is unlikely to take any action to ensure Puerto Rico can avoid insolvency and be unable to provide essential public services. Under the evolving plan, the Treasury, or an agreed upon third party, would be in charge of an account which held a significant portion of Puerto Rico’s tax revenues—which would, effectively, be designated to pay holders of so -called super municipal bonds—municipal bonds, in this instance, held by bond owners in Puerto Rico and every state in the country who agreed to trade in their existing bonds for the new hybrid—albeit, a post “haircut” hybrid which, as in the case of a municipal bankruptcy, would be worth less than before the exchange, but which would be backed by employment and other taxes that the U.S. Treasury would collect for the territory, as well as possibly some of Puerto Rico’s own Treasury revenues. Under the evolving proposal, Treasury would act as a kind of intermediary; it would not be providing the territory with any kind of direct financial assistance or any guarantee; rather its role would be to serve as a quasi-trusted third party in a financial arrangement under which the new super municipal bonds would not only be backed by a much broader range of taxes than those that back the individual bonds of the territory and its authorities currently, but also indirectly through the unprecedented role of the U.S. Treasury—protecting and providing greater assurance to Puerto Rico’s bondholders of repayment. The discussions have not resolved whether any Congressional legislation would be needed, albeit, it is clear that the U.S. territory’s elected leaders would have to agree to potential debt exchange.

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