The Risk of Fiscal Contagion

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eBlog, 4/19/16

In this morning’s eBlog, we continue to follow the unprecedented leadership efforts of House Speaker Paul Ryan and House Natural Resources Committee Chair Rob Bishop, who are working with U.S. Treasury officials to address the nearing insolvency in Puerto Rico—where the Speaker confronts misinformation and a heavy lobbying campaign intended to mislead and prevent any Congressional action to avert the U.S. territory’s looming insolvency. The misinformation spread by opponents could have broader, adverse consequences for states and local governments. Speaker and Minority Leader Nancy Pelosi are meeting with their respective caucuses in hopes of moving the proposed legislation to the full House by next week. We continue to follow the comparable timeline—and governance dysfunction—in New Jersey, where Atlantic City is on a timeline to insolvency not very different than Puerto Rico, but where little consensus appears with regard to the most effective resolution—and where state dysfunction could have broader fiscal risks for cities throughout the state. Then we become electronically musical and listen to the noted electric rhythm guitarist, retired U.S. Bankruptcy Judge Steven Rhodes, as he works to avert insolvency and turn around the Detroit Public Schools. Finally, we hope that last night’s confirmation of a new Finance Director in San Bernardino will provide the key leadership stability critical to paving the way for the city to successfully emerge from the longest municipal bankruptcy in American history.

Puerto Rico & Congressional Leadership: Paul Ryan (R-Wis.) and House Natural Resources Committee Chair Rob Bishop (R-Utah) were forced to cancel a committee vote on a bill to avert Puerto Rican insolvency at the last-minute last week: they blamed the delay on Democrats and the Obama administration, who, they said, had requested more time to negotiate; however, the real stumbling block appears to have been their own members—who somehow seem to believe the proposed legislation, the PROMESA or Puerto Rico Financial Stability and Debt Restructuring Choice Act, which key sponsor Rep. Sean Duffy (R-Wis.) described as legislation which would “empower the Government of Puerto Rico with the choice to partner with the Federal Government and put the island on a path towards balanced budgets and a return to fiscal security. If Congress does not act, it would have a devastating effect on the people of Puerto Rico and countless Americans throughout the states who stand to lose billions in the bond markets.”

Nevertheless, in the wake of a closed-door GOP conference last Friday, it became clear the legislation lacked sufficient support: too many Members remain confused and believe the proposed bill would amount to a federal bailout of the commonwealth—a misperception galvanized and inflamed by hedge funds and other groups allied with Puerto Rico’s creditors who have sought to denounce the House Leadership effort as a federal bailout, notwithstanding the proposed bill does not provide for any direct federal assistance.

Nevertheless, the delay does not appear to have deterred either House Speaker Paul Ryan, or House Natural Resource Committee Chairman Ron Bishop (R-Utah); rather, if anything, it seems to have increased their commitment to achieve passage of a bipartisan bill—albeit against a tighter and tighter deadline, because the U.S. territory reports its economy will soon deteriorate further, because it can no longer afford to pay some of its $72 billion in debt.

Rep. Duffy’s bill would create a federal board to provide fiscal oversight, give the island a temporary legal stay against lawsuits from creditors, and create a mechanism for the island to restructure its debts. The legislation and unique Treasury—House Leadership partnership matters, because Puerto Rico sits in a governance twilight zone: it is neither a state, nor a municipality. Moreover, Puerto Rico currently has nearly a dozen different classes of debt, each with different security pledges—pledges which make some classes more senior than others—and it has a significantly underfunded pension system—and is soon to be the first part of the U.S. to experience the devastating Zika virus. The Treasury Department has been pressing—and working with House Speaker Ryan—on legislation to make it easier for Puerto Rico to restructure its debt in recognition that only Congress can create an orderly framework to resolve debt. Treasury officials have also expressed apprehension that the pending bill has technical provisions which could hamper recovery, because they could allow the island’s creditors to string along the restructuring process.

Ironically, some bondholders have been working closely with the Republican Study Committee, to steer the bill away from enabling broad restructuring authority: they oppose any federal legislation which might allow the voiding or restructuring of Puerto Rico’s debts or contracts. They have not offered any constructive alternative. Among the leaders of the opposing groups are some familiar ones: Franklin Advisers and bond insurers Assured Guaranty and Ambac Financial Group, names we have seen previously opposing and challenging Stockton’s plan of debt adjustment using similar arguments. They are pressing for legislation to make it virtually impossible for Puerto Rico to restructure its debts or void contracts—effectively, ironically, pressing for a Congressional position which would lead to the very federal bailout they claim to oppose.

In contrast, as Rep. Raul Labrador (R., Idaho) notes: “You’ve got all these ads saying this is a bailout. There’s no taxpayer money going to it…My fear, and I think it’s a pretty well-founded fear, is that if we don’t give them the tools, there will be a bailout request because they’re going to go under.” Now Chairman Bishop estimates that modifications to the pending bill will not be completed until the end of the week; nevertheless, with a major bond payment looming in two weeks, the Chairman is pressing for a bill “as soon as humanly possible…If we all can’t get together by May 1 and there is [a default] and all of a sudden creditors start suing again, maybe this will reinforce that this is a serious issue.”

Our friends at Municipal Market Analytics continue to believe the fiscal reverberations from the Puerto Rico trials and tribulations will have limited impact on state and local debt issuances, albeit they warn there could be 1)greater municipal bond investor hesitancy to lend to (or purchase the bonds of) already distressed state or municipalities, for fear of redistributive-oriented, ad hoc restructuring efforts by local, state, or federal politicians; 2) an accelerated erosion of non-managed retail ownership in municipal bonds generally once Puerto Rico related investor lawsuits commence against their broker dealers; and 3) the potential for brief systemic price weakness, in particular in the high yield subsector, if the two remaining municipal mutual fund investors in Puerto Rico are faced with major outflows.

New Jersey & Fiscal Contagion Risk. The political stalemate in Trenton over the looming Atlantic City insolvency and potential municipal bankruptcy is increasing apprehension across the state that there could be lasting fiscal damage and risk throughout the state if the state were to impose a state takeover. That growing risk recognition might have both forced recognition—at least in the legislature, if not the Governor’s office, that some sort of compromise is ever more urgent—and that, perhaps, the agreement by state Senate President Stephen Sweeney to modify his plan for an immediate state takeover—and instead offer Atlantic City one last opportunity to structure its own recovery path with the benefit of a four-month extension—and the imposition of strict state fiscal benchmarks—might be critical to preventing spreading municipal fiscal risk. Ergo, state legislators now appear to be leaning towards granting the city a grace period of 130 days before a state takeover would be triggered. The emerging consensus marks a victory for Assembly Speaker Vincent Prieto, but, at the same time, puts increased pressure on both the Speaker and Mayor Don Guardian—especially with Sen. Sweeney’s proposed plan to mandate waves of layoffs and the sale of key parts of Atlantic City’s assets—such as its water utility—and a mandate to cut its municipal budget by nearly 50 percent. For a city which has already experienced a loss of more than 10,000 jobs and has experienced a loss of more than two-thirds of its tax base, the proposed state medicine might seem more like poison. Nevertheless, the toxic state-proposed medicine would still leave the city with a per capita budget greater than that of Newark, Trenton, and Camden. The other outstanding issue—as we saw in Detroit, Stockton, and San Bernardino—relates to bargaining agreements: to date, no meaningful reductions in force or benefits in the city have been negotiated—all key issues which became fulcrums to the plans of debt adjustment in Detroit and Stockton. Failure by Speaker Prieto—or too much delay in securing a House bill—will force the House to work with the Senate-passed bill which would authorize a quasi-state takeover by New Jersey’s Local Finance Board, which would be authorized to renegotiate outstanding debt and municipal contracts for as long as five years.

Grading Detroit’s Public Schools. Detroit Public Schools (DPS) transition manager, retired U.S. Bankruptcy Judge Steven Rhodes, yesterday reported he is not proposing to close any buildings in the next academic year, notwithstanding reports of the significant physical overcapacity (enough to support 40,000 more students than it currently enrolls). In his new 45-Day Financial and Operating Plan required under the 2012 Michigan state law that creates emergency managers for financially distressed schools and local communities, Judge Rhodes noted that the state’s largest school district “can look forward to enrollment stability” in the future and that decisions about right-sizing the district’s footprint to match falling enrollment are best left to an elected school board—one which could be elected or appointed later this year. Judge Rhodes added that the school system’s operating expenses are not sinking the district–nor are teacher salaries, “which,” he noted, “are significantly below suburban teacher salaries…Rather, the cause is DPS’ debt service. That debt service, $63,849,494, is sucking revenues away from our classrooms at the rate of approximately $1,394 per student.” As Judge Rhodes did the math, he said: “DPS simply cannot pay that debt while attempting to provide a quality education for its students.” Under a state restructuring proposal which would divide DPS into two entities and provide about $200 million for future operating costs, he estimated as much as $500 million in school debt could be retired. The Michigan House is currently considering two sets of bills that would reorganize the district after Judge Rhodes completes and submits his final report and recommendations next month.

The Coalition for the Future of Detroit Schoolchildren and others have previously contended DPS has capacity to seat 85,000 students in the buildings it continues to operate; but Judge Rhodes in the report notes that DPS operates 97 school buildings at about 78 percent capacity. Thus, while closing buildings would save on operating costs, such closings could risk creating further per-pupil state funding challenges, because officials have estimated about 30 percent of students in each closed building go elsewhere or do not remain enrolled in the traditional school district—or, as Judge Rhodes wrote: “I determined not to pursue any school closings for the 2016-17 school year…(T)his difficult and sensitive question is best left to the school board that will be appointed or elected later this year if the reform legislation is adopted returning the district to local control…DPS currently has 13 buildings that it is not using and does not maintain. We hope to negotiate an agreement to transfer these properties to the city of Detroit in the near future.”

Thinking about Tomorrow. San Bernardino, the city in municipal bankruptcy longer than any other in U.S. history, has chosen a new finance director, Brent Mason, who served as Riverside’s finance director until the beginning of this month. The City Council last night voted unanimously on his selection to head the critical department and increased the position’s compensation more than 10 percent. Mr. Mason, who will begin today in what is mayhap the most critical position—a position notably vacant now for more than a year—will start with a salary of $188,580 and benefits worth $61,587 per year—a significant step over the previous maximum compensation under the former salary range, which was based on a study done in 2007—so that, according to the report submitted to the elected leaders, the cost will be “absorbed” through savings because of other vacant positions in the department. It is hoped the appointment to the quasi-quarterback slot will provide some critical stability in a vital position which has experienced significant turmoil and turnover: three finance directors have left the city in the past three years: not exactly a good prescription for a municipality in bankruptcy. Reestablishing experience and stability in a municipality which has experienced high turnover in many departments since filing for municipal bankruptcy protection four years ago—especially in the Finance Department, could be vital to the city’s ability not only to gain U.S. Bankruptcy Judge Meredith Jury’s approval of its proposed plan of debt adjustment, but also to gaining some stability in the key city office, which will now be under its fourth finance director in three years.

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