Who’s at Risk of Defaulting?

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eBlog, 12/16/16

Good Morning! In this a.m.’s eBlog, we consider the challenge to state and local leaders arising from both the Federal Reserve’s decision to increase interest rates, apprehensions about growing state budget gaps—and the respective implications for city and county credit ratings—as well, of course, to the incoming Trump administration and next Congress’ proposals on federal tax reform where—as under former President Ronald Reagan, the authority of state and local governments to issue tax exempt municipal bonds is expected to come under challenge—as is the deductibility of state and local taxes. Moreover, with the Federal Reserve’s decision to raise interest rates, those increases could boost mortgage rates—adversely impacting assessed property values—putting cities, counties, and school districts into distinctly uncomfortable territory. Then we turn to the frigid weather in East Cleveland, where the city’s insolvency has let to increasing service insolvency and an inability to clear the city’s roads—threatening the capacity and ability to provide emergency public services. Then we follow the nation’s frigid weather east to Shenandoah, where the fiscally beset municipality of Petersburg, Virginia was hit yesterday by a 4th U.S. Circuit decision, even as S&P Credit granted it a small Yuletide respite. Finally, we venture back west to Chicago, where Municipal Market Analytics helps us to try to untangle the fiscal arithmetic so burdening the Chicago Public Schools.

Nota bene: We wish all readers a well-deserved holiday to you and your loved ones; we will resume the week after next.

Who’s at Risk of Default? Municipal Market Analytics this week, drawing from compiled data, noted that the trend of annually declining defaults is over—breaking a six-year trend—and warning that it “expects that issuer-credit quality has begun to erode,” describing the ominous trend as not only a factor of more “aggressive/permissive” underwriting standards, but also the risk created by growing state budget gaps—gaps which are likely to result in a double fiscal whammy for municipalities, counties, and school districts of reduced local aid—as well as less state public infrastructure investment. MMA suggests “municipal default activity will increase in 2017.”

Brrr! Municipal insolvency, as we have previously noted, often involves service insolvency. Thus it is that many side streets in the insolvent municipality of East Cleveland are complete sheets of ice—and have been so for an entire week, because the city does not have any working snow plows, leading one constituent to liken living in the city to being in the “Ice Age.” With bitter cold from the lake snow, which has been falling in heavy bands, neither of the municipality’s two salt trucks are working, leading some city officials to opine that the money spent on the recent special recall election could have been better used to fix the salt trucks. With one resident noting that “It is very precarious until you get into Cleveland or until you get into Cleveland Heights,” residents can easily make out the boundary where East Cleveland ends and Cleveland Heights begins: on the latter side, the streets are totally cleared. Ice free and this is all “full of ice.” One beleaguered resident noted: “I really hope that we can one day join with Cleveland…That is the only answer.”

Teeter Tottering in Petersburg. The fiscally struggling, historic Virginia municipality of Petersburg was on a teeter totter yesterday, after the 4th U.S. Circuit Court of Appeals yesterday ruled that the city’s police department’s policy barring its employees from criticizing the department on social media was unconstitutional (for further details, please see this morning’s Little Legalities in the eGnus), because its social media policy constituted a “virtual blanket prohibition” on all speech critical of the department and was “unconstitutionally overbroad,” but as the city was removed by S&P Global Ratings from Credit Watch.  In its decision, the court acknowledged a city’s need for discipline, but found that the policy and the disciplinary actions taken pursuant to it would, if upheld, lead to an utter lack of transparency in law enforcement operations that the First Amendment cannot countenance. (The suit had been filed after two of the city’s officers were placed on probation for discussing on Facebook their concerns about inexperienced officers being promoted and leading the department’s training programs: the department’s policy prohibited employees from posting anything that would “tend to discredit or reflect unfavorably” upon the agency—something the court held the police cannot be allowed to do.) In its ratings change, S&P, nevertheless, maintained its junk BB ratings on Petersburg’s general obligation bonds: the city has just over $55 million general obligation, full faith and credit bonds and Qualified Zone Academy bonds outstanding. S&P analyst Timothy Little wrote: “We removed the rating from CreditWatch due to the city securing $6.5 million in cash-flow notes…The negative outlook reflects the extreme uncertainty regarding the city’s ability to return to structural balance and what will likely be persistently very weak liquidity in a difficult budgetary environment,” adding that: “In our opinion, the interest rate is high compared to other non-distressed entities that annually place TANs, further underscoring the fiscal distress of the city.” The continued fiscal distress hinged on the city’s ongoing inability to balance its budget, in the main part because municipal property and other taxes have been less than projected, while expenditures for public safety and health and welfare have exceeded the city’s budget by $2.5 million, according to S&P. (A Virginia technical assistance team reported that general fund expenditures exceeded revenue by at least $5.3 million in FY 2016, and identified a structural imbalance with Petersburg’s FY2017 budget—leading to a state estimate that the city has $18.8 million in unpaid obligations to external entities and internal loans, including repayment of the TANs. S&P further noted that even though the city’s economy is diverse, its 27.5% poverty rate is more than double the statewide level—meaning it bears disproportionate fiscal challenges.

Pixie Dust? Municipal Market Analytics this week inquired into the harsh realities of determining interest rates with regard to municipalities in fiscal straits seeking to go to market (not to buy a fat pig!), focusing on the Chicago Public Schools—suggesting that investors in the school district’s new capital improvement tax bonds should seriously consider the bond-holder settlements in Detroit—and the ongoing legal battles in Puerto Rico—in trying to determine what interest rate would constitute sufficient compensation for the legal and credit uncertainties present in a muni transaction, suggesting: “Basically, rather than use its traditional alternative revenue bond security (which entails a pledge of state aid backstopped by an unlimited property tax), CPS is directly pledging its new limited property tax levy solely for the benefit of bondholders.” Theoretically, MMA notes, the new municipal security (rated A by Fitch and BBB by Kroll) insulates municipal bondholders from CPS’s not very investor friendly credit rating and profile—especially its very high unfunded public pension liability, but then wrote: “However, the real perceived strength here is the durability of the structure, or persistence of regular debt service payments, in a hypothetical (and currently not-permitted) municipal bankruptcy. This durability relies upon legal opinions that conclude that the new bond obligations would be considered backed by special revenues and therefore bond-holders would not see their lien impaired.” However, MMA noted, such reliance might not be something upon which to hang one’s Santa stocking, writing: “The aspiration of the structure is to insulate the bondholders from the fiscal troubles of the district, although the repayment schedule suggests that the district may have taken a more short-term view of the soundness of the transaction given the back-loaded principal. The main trouble with the transaction lies not with the documents but with the assumption—generally implicit, yet quite explicit in the opinions—that the fiscally distressed district will unconditionally continue to abide by, and not challenge the provisions of the indentures or ‘use or claim the right to use’ the capital improvement tax revenues. In other words, to rely on the willingness of CPS not to act exactly like every recent distressed city (and territory) in invading, capturing, and re-purposing every bondholder asset within and beyond easy reach. Even constitutional bond protections have fallen victim to debtor challenges during government disruption. So for this security to function fully as described, CPS would need to experience a Goldilocks bankruptcy the likes of which the municipal market has not seen in decades.” Thus, MMA, in a Yule gifted insight, strongly encourages potential muni investors to carefully unwrap the seasonal gift to determine whether it is really of better credit quality than CPS’ alternative revenue bonds, and “to be avoided by accounts who consider a CPS municipal bankruptcy to be likely or even unavoidable.”

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