Emerging from Municipal Bankruptcy: a Rough Ride

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eBlog, 1/04/17

Good Morning! In this a.m.’s eBlog, we consider the ongoing challenges for the U.S. city emerging from the nation’s largest ever municipal bankruptcy, Detroit; then we veer into the warm Caribbean waters to observe the first days of the new administration of Gov. Ricardo Rosselló in Puerto Rico—where his new administration must adjust to coming to terms with its own PROMESA oversight board.

A New Detroit? The city emerging from the largest ever municipal bankruptcy is witnessing a string of major construction projects, from a massive hockey arena and street car line downtown to the resurrection of the Wayne County jail project: changes which will reshape the Motor City’s downtown in 2017—a level of activity and investment which seemed most improbable as the city shrunk and then dissolved into chapter 9 municipal bankruptcy. Today, the construction detours and closed sidewalks seem to offer a welcome sign of a new era for many who live and work near downtown. According to recent statistics, office vacancies in the downtown area are at their lowest point in a decade, and now the addition of the city’s new rail line could open demand in the New Center area, as well as increase demand for office space in neighborhoods near downtown such as Corktown and Eastern Market. Notwithstanding, the Detroit Financial Review Board, created as part of Detroit’s plan of debt adjustment to secure the U.S. bankruptcy court’s approval to exit bankruptcy, in its most recent oversight report, noted that the city continues to confront an unexpected gap in its public pension obligations and the absence of a long-term economic plan, reporting in its fourth annual report that could leave the city vulnerable to further fiscal challenges.(The next certification is due by October 1, 2017: under the plan of debt adjustment stipulations, the review board is charged with reviewing and approving annual four-year financial plans.) Both previous such plans have been approved. The most recent plan, submitted at the end of November, projects a general fund surplus of at least $41 million for FY2016, based on budget projections; Detroit expects to finish the current fiscal year with a general fund surplus of about $30 million. Nevertheless, the city faces a double-barreled fiscal challenge: its public pension liabilities and high costs of borrowing. Because its junk territory credit ratings from Moody’s and S&P, Detroit is forced it to pay disproportionately higher interest rates on its bonds.

With regard to its pension liabilities, where Detroit’s plan of debt adjustment approved by now retired U.S. Bankruptcy Judge Steven Rhodes left intact public safety monthly checks, but imposed a 4.5% cut on general employees—and reduced or eliminated post-retirement (OPEB) benefits, as part of a mechanism to address some $1.8 billion in post-retirement obligations, the approved plan nevertheless suspended the COLa’s only until 2024—so a longer term liability of what was originally projected to be $111 million pends. (Indeed, the city’s pension agreement withstood a challenge last Fall when a federal appeals court ruled in favor of Detroit in a lawsuit by city retirees whose pensions were cut as part of the city’s approved plan of debt adjustment, after some retirees had sued, claiming they deserved the pension which was promised before the city filed for bankruptcy in 2013, with U.S. Judge Alice Batchelder of the 6th Circuit Court of Appeals noting it was “not a close call.”)

But, as Shakespeare would put it: ‘There’s the rub.” Detroit’s actuaries, in their 2015 actuarial valuation reports, projected the liability in FY2024 and beyond to be nearly $200 million, based upon a thirty year amortization, with level principal payments and declining interest payments; however, as we have previously noted, those estimates were based upon optimistic estimates of assumed rates of return of 6.75 percent. In response, Detroit set aside $20 million from this year’s FY2016 fund balance, $10 million from its FY2016 budgeted contingency fund, and added an additional $10 million for each of the next three fiscal years—or, as Detroit Finance Director John Naglick told the Bond Buyer: “The city has six fiscal years to make an impact and close the gap on the [pension] underfunding. We don’t want to create such a cliff in 2024 where there is a big budget shock…The reality is to find those kind of monies over the next six fiscal years will cause some tradeoff in services.” Director Naglick added that last month Detroit completed an updated decade-long plan to update its approved plan of debt adjustment, adding: “The 10-year model will show the FRC that this incremental funding can be folded into the budget, but we aren’t naïve, it will also create some disruption in services to accommodate that…Think of it as a master plan on how we are going to make this stable.” Nevertheless, Mr. Naglick’s challenge will be hard: Moody’s last summer warned that the city’s “very weak economic profile” makes it susceptible to future downturns and population loss—threatening its ability “to meet its requirement to resume pension funding obligations in fiscal 2024.” Detroit’s next deadline looms: The City must submit its FY18-FY21 Four-Year Financial Plan to the Financial Review Commission by the statutory deadline of March 23rd.

Puerto Rico: A New Chapter? The new Governor of Puerto Rico, Ricardo Rosselló, yesterday, in the wake of his swearing in, acted straightaway on his first day in office to cut government spending and revenues, amid greater urgency to take steps to avoid a massive out-migration and end ten years of economic recession, and increase efforts to stem vital population losses which in 2013 alone witnessed some 74,000 Puerto Ricans leave the island. The new governor has already signed five executive orders, cutting annual agency spending by 20 percent, encouraging asset privatization, and proposing a zero based budgeting standard. Efforts like these, if actually implemented (a crippling risk in the context of historical Puerto Rico governance), could represent strides towards achieving fiscal solvency and help lay the groundwork for economic recovery. Governor Rosselló directed his agency heads to implement zero-based budgeting, under which agency heads start with a $0 and only adds to it when they can provide a justification for particular programs. Gov. Rosselló also created a Federal Opportunity Center attached to the governor’s office. The center will provide technical and compliance assistance to the office to make programs eligible for federal funds. For the new Governor, the three keys to recovery appear to be: how to revive the economy, fix the territory’s fiscal situation, and address the public debt.

The key, many believe, would be to opt for Title VI of the new PROMESA law, the voluntary restructuring portion. A growing concern is to create job opportunities—with one leader noting: “Many will leave if they cannot find jobs to search off the island for a better quality of life: our cities have to be habitable and safe…it has to be a place where the world wants to come to live…” Governor Rosselló also signed six executive orders, directing his department heads to cut 10 percent in spending from the current budget and to reduce the allocations for professional services by a similar amount—with even deeper cuts in other hiring; he imposed a freeze on new hires, noting: “We do not come to merely administer an archaic and ineffective scaffolding: Ours will be a transformational government.” Nevertheless, his task could be frustrated by the Puerto Rico House, where, yesterday, El Vocero reported that Puerto Rico House of Representatives President Carlos Méndez Núñez had told the newspaper last weekend that the legislature would cut Puerto Rico’s sales and use tax rate and the oil tax rate, reversing steps by the prior governor and legislature over the last four years. Governor Rosselló also pledged to work with the PROMESA Oversight Board in a collaborative way, as he departed the island to meet with members of the new Congress in Washington, D.C., where he planned to lobby for statehood for the U.S. territory.

With new administrations in San Juan and Washington, Gov. Rosselló will also have to work out a relationship with the PROMESA board, as the absence of cash to pay debt service, combined with the current payment moratoriums and federal stay on bondholder litigation appear destined to be extended deep into the year, albeit some anticipate that under the incoming Trump administration, one which will have much closer ties to creditor groups than the outgoing Obama administration, could lead to efforts to restart formal bondholder negotiations—negotiations which could become a vehicle by means of which creditors would increase their investment in Puerto Rico risks, by means of new loans and/or partial restructuring of liabilities in ex-change for a settlement which would be intended to improve long term municipal bond-holder recoveries and, most critically, work to enhance the price evaluations of Puerto Rico’s general obligation municipal bonds. Nevertheless, the territory’s structural, long-term budget deficit of nearly $70 billion over the next decade risks crowding out any medium-term payment of debt service absent serious spending reform as well as public pension reform—especially because of the ongoing outflow of young persons seeking better economic opportunities on the mainland.

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