The Peril of Twin Defaults

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eBlog, 5/02/16

In this morning’s eBlog, we consider the twin defaults in Puerto Rico and Atlantic City—as well as the ongoing precipitous challenge to the Detroit Public Schools—schools which will be closed today in the midst of its announced inability to meet payroll—potentially with signal longer term fiscal implications for the ongoing fiscal recovery of Detroit from the largest municipal bankruptcy in U.S. history. Because the quality of schools can have such profound implications for assessed property values—all eyes are on the blackboards in Michigan’s legislature as it tries to do the arithmetic so critical to Detroit’s ongoing recovery. The situation, moreover, is complicated—politically, physically, and fiscally because public school strikes are illegal in Michigan: ergo state lawmakers in Lansing have taken into consideration—in the wake of previous Detroit teacher sickout—consideration the tightening of the current legal definition in the state of what constitutes a strike.

No School Today, But What about Tomorrow? In the wake of Detroit Public Schools Emergency Manager Steven Rhodes’ notice over last weekend that DPS would be unable to make payroll on its $48.7 million in emergency state aid after Michigan state aid to the system runs out at the end of next month, DPS closed 93 of its 97 schools today in response to Detroit teachers’ union call for a district-wide sickout. Ivy Bailey, president of the 2,600-member Detroit Federation of Teachers stated: “No person should be asked to work without pay…This is the final straw.” The walkout occurred even as Judge Rhodes had warned that such a walkout risked his efforts in Lansing to convince the Michigan Legislature to approve a $715 million plan to rescue the 46,000-student DPS school district from financial collapse, stating: “A district-wide sickout will be counterproductive and detrimental to the efforts of everyone working to help the district.” The retired U.S. Bankruptcy Judge has repeatedly said he would not ask DPS employees to continue working without pay if the district became insolvent—making clear he was confident that the “Michigan Legislature understands the urgency of this situation and will act in a timely manner to ensure that operations of the school district continue uninterrupted.” But for teachers in the system, who met yesterday afternoon to mull over options, the non-payment would mean that some teachers who elect to have their checks spread out over the entire year would not be paid for work they have already done, according to Ms. Bailey, who noted to the Detroit News: “Detroit’s teachers deserve to be paid fairly for their work like every other working person…But Detroit Public Schools has just informed us that it cannot guarantee to pay these dedicated men and women for their work. This isn’t right. It isn’t fair,” comparing forcing employees to work without pay to a lockout. Asked if teachers would strike if no resolution were reached, Ms. Bailey made clear that all options were “on the table.”

New questions about district’s management under Judge Rhodes’ predecessors came to light recently when the school district disclosed to state officials that up to $30 million in federal aid earmarked for employee pensions was never sent to the state pension fund. Unpaid pension bills account for a projected $157 million of the $515 million in operating debt which Judge Rhodes is seeking to eliminate by means of his proposed financial rescue plan; start-up funds of $200 million would go toward a new debt-free Detroit school district.

For his part, Judge Rhodes is apprehensive that absent comprehensive action by the legislature, such as the comprehensive $715 million education reform package now under consideration by the Michigan House of Representatives, “there will be no funds available to pay any of our employees — those teachers on a 26-pay cycle included…There also will be no funds available for the district to conduct Summer School or provide the year-round special education services that a number of our students rely on.” Judge Rhodes added: “I urge our legislators to act thoughtfully, but with the urgency that this situation demands.”

Day I. Puerto Rico’s first significant step towards insolvency commences today when the Puerto Rico Government Development Bank (GDB), which provides liquidity to Puerto Rico’s government agencies, intends not to make most of a $422 million debt payment due today: last night Gov. Alejandro Garcia Padilla stated that, “Faced with the inability to meet the demands of our creditors and the needs of our people, I had to make a choice.” His choice, he said, would be against diverting funds critical for crucial health and public-safety services—thus triggering today a steep downhill fiscal path towards July 1—when the U.S. Territory’s major debt payment of nearly $2 billion in general obligation debt is due. Nevertheless, with Congress in recess this week, today’s non-payment sets in motion a significant increase in the island’s fiscal crisis. It comes in the wake of last month’s action by the legislature empowering the Governor to suspend debt payments to pay for essential public services pending some action by the U.S. Congress—e.g. marking the Territory’s first legislative step towards a likely default—as may be noted by the Puerto Rican government’s report that the GDB had $562 million available for paying debt as of April 1. Some expect this morning’s default to trigger creditor lawsuits—especially in the wake of last month’s filing in federal court by a group of hedge funds which own GDB bonds asking that the GDB be barred from allowing the withdrawal of funds. The see-saw battle between critical public services versus investors is imbalanced—with the Territory currently in debt to investors by about $70 billion. The GDB had reached an agreement late on the 29th with Puerto Rico’s state-chartered credit unions to exchange $33 million worth of debt due today for $33 million of debt due a year from now, but that left other $389 million still due this morning. In a speech last night, Gov. Padilla urged action by the absent Congress, noting: “Only a Congressionally approved restructuring process can provide a comprehensive solution.”

Twin Defaults. Almost like a parallel comet in the sky, Atlantic City Mayor Don Guardian is expected to announce as early as this morning whether his city will default on a $1.8 million municipal bond payment—should the city follow the path of Puerto Rico’s GDB decision, the city will become the first New Jersey municipality to default on its debt in some 78 years. The payment, technically, as in Puerto Rico, was supposed to be made yesterday, but the city, unlike Puerto Rico, gets an extra day since the payment date fell on a weekend; moreover, Atlantic City expects to receive its next tax payments today; however, the Mayor reports it is uncertain whether those payments will be sufficient to cover the bond payment.

The fateful day falls with another similarity: just as Puerto Rico was forced to act last night in the wake of inaction by Congress, so too Atlantic City has no choice but to act today as New Jersey’s Governor and legislature have been unable to reach agreement on any resolution. Should Atlantic City default today, it would become the first New Jersey municipality to do so since Fort Lee in 1938—a year before that municipality went into chapter 9 municipal bankruptcy. Indeed, as Standard & Poor’s Rating Services had noted at the beginning of this year: it seemed “inevitable” this day would come—absent either major improvements or a comprehensive state fiscal package. Or, as the Wall Street Journal notes: “Atlantic City’s credit rating has sunk so low that city officials and bankers say investors would likely reject any offers to buy new debt or refinance.” The brutal combination of seeming state dysfunction and high levels of per capita debt appear to have fiscally condemned Atlantic City—whose direct debt per capita in the wake of the collapse of its casino industry is nearly double that of Detroit: Atlantic City’s direct debt per capita is $6,867, versus $3,969 for Detroit. Median household incomes of the two cities are comparable—at just under $27,000, according to Merritt Research. Indeed, Atlantic City has fallen into a rare category of U.S. municipalities—well below 1%–which have credit have municipal credit ratings of BB-plus or below, according to Merritt Research. Moreover, the combination of the state’s apparent inability to fashion a rescue package and the increased discussion of default is scaring municipal bond investors whose holdings have traded for as little as 66 cents on the dollar in recent weeks, according to the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access (EMMA) website—a precipitous drop from close to 100 cents on the dollar early last year.

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