Avoiding Municipal Insolvency, Except as a Last Resort

October 20, 2015. Share on Twitter

Avoiding Municipal Insolvency, Except as a Last Resort. Gov. Rick Snyder yesterday outlined a $715 million plan to split the Detroit Public School System (DPS) into two separate districts: a plan to both help improve academic performance, but also pay down more than a half billion dollars in DPS’s operating debt, marking the second time in six months that the governor has detailed plans to overhaul education in Detroit. Detroit Public Schools has lost close to 100,000 students over the past 10 years, according to Gov. Snyder’s office. The district has not yet released enrollment numbers for this school year, which were taken during a recent student count day, but it had about 47,000 students last year. Gov. Snyder would not say outright whether the alternative is taking DPS into bankruptcy, given the amount of state liability vested in the existing district. Rather, he said, this plan would avert the need for bankruptcy. Should the district default on its debt, Gov. Snyder said the cost to the state could soar beyond the $715 million expected over 10 years as the current school system pays back its debt: “I don’t use the bankruptcy word except as a very, very last resort…It is very reasonable and fair to say that compared to this solution, that solution could be much more expensive.”

Pensionary Complications. Gov. Snyder is seeking legislative action by the end of this year to create a $715 million, debt-free school district in the Motor City over the next decade, meaning the current district would exist only to pay off the debt, noting in his presentation: “This package provides an answer that’s rational, that’s comprehensive, that is lower cost and much less chaotic than the other alternatives.” A key issue confronting the school system is its nearly $100 million liability to Michigan’s school employee pension system—a debt of such proportions that a judge could be petitioned to order DPS or the state to pay up—an order, were it to be issued, which could trigger higher property taxes for the city of Detroit or an emergency bailout by the Legislature. Gov. Snyder warned the state could be on the hook for DPS’ $1.5 billion unfunded pension liability if lawmakers are unable to stabilize the district’s finances by assuming a projected $515 million in operating debt payments that were mostly racked up by state-appointed emergency managers, noting: “That’s an unfunded liability that would get spread to the other districts if DPS wasn’t making payments…There’s a lot of extra money that would have to go out if this doesn’t get done.” Gov. Snyder’s dire warning came in anticipation of the long-expected introduction of legislation to create new layers of oversight of DPS in exchange for the state assuming the seemingly relentless growth in the system’s operating debt amassed by emergency managers in recent years—a debt the cost of which to pay off has now reached the equivalent of an annual cost of $50 for every child in Michigan. The accumulated operating debt of DPS is expected to top $515 million by June 2016. In his remarks, Gov. Snyder noted Michigan’s School Aid Fund can handle the roughly $70 million annual payment for the next decade without taking money away from other schools districts—that is, under his proposal, helping DPS would not have to come at the expense of other Michigan public school districts—a claim that might be semantical—as the ever insightful Citizens Research Council notes: “Clearly you’re taking money that would be available to other school districts to help a single school district.”

  • Costs. Under the Governor’s proposal, the new Detroit Community School District would need $200 million to cover $100 million in startup costs and initial capital improvements of facilities and $100 million to account for continued declining enrollment in the city. The new District would not be barred from seeking voter-approved millages for capital improvements unless and until the old district’s operating debt was paid off, and, according to John Walsh, Gov. Snyder’s strategy director, it is possible the $715 million figure could be reduced if Detroit’s economy continues to rebound, businesses relocate to the city, and property tax collections continue to increase, adding; “With property values going up, it could take less time to pay off.” Michigan’s contribution to Detroit’s federally approved plan of debt adjustment amounted to $350 million spread over 20 years—a state contribution which Mr. Walsh led, at the time, as a key leader in the Michigan House—leadership which will be critical for what is anticipated to be a “tough sell in the Legislature.” Moreover, such a new Detroit school district would still be liable for paying down the $1.5 billion in the system’s unfunded pension liabilities—with Gov. Snyder resisting the Coalition for the Future of Detroit Schoolchildren’s call for DPS to be exempted from continuing to pay its share of pension costs for current and former employees. As of last week, DPS was $99.5 million behind in public pension payments to the Michigan Public School Employee Retirement System—a debt exacerbated by $100,000 in monthly late fees and $12,000 in daily in interest penalties, according to state’s Office of Retirement Services.
  • Governance. Originally, the governor had proposed the creation of a new financial review commission to have oversight and veto power over spending decisions of the new school district in Detroit. In his revised plan, he is proposing to utilize the existing Financial Review Commission, which was created as part of the Detroit plan of debt adjustment, so that there would be long-term state oversight of Detroit’s finances. The Governor’s plan also retains another layer of oversight of all city schools in a Detroit Education Commission: it would entail hiring a chief education officer with the power to open and close academically failing schools run by DPS, charter schools, and the Education Achievement Authority. The commission’s membership would include three gubernatorial appointees and two mayoral appointees: it would be charged with streamlining some services for all schools, such as enrollment. But in the governor’s revised plan, he makes a common enrollment system voluntary. Gov. Snyder said he and Mayor Duggan are still discussing the mayor’s role in school reform in Detroit: Mayor Duggan has expressed a desire for more local control of Detroit schools, or, as Gov. Snyder put it: “The mayor sees the value in this, but there is a difference in governance: The mayor’s office still has issues they want to talk about, and I feel it’s important to get this dialogue going. We’ve taken a lot of input from the mayor. We have a supportive, positive relationship. No, we don’t agree on every issue.” Earlier this month, Mayor Duggan reiterated that he is advocating for local control, including an elected school board for Detroit to run its 100 public schools. He further proposed that an election be held next spring. Mayor Duggan has said the city needs an education commission with membership that he appoints, as recommended by the education coalition. The commission, he said, would level the playing field between public schools and charters and help to set standards for where they are needed and can locate.
  • Oversight. Gov. Snyder’s announcement follows news of an FBI corruption investigation involving DPS and the Governor’s K-12 reform district, the Education Achievement Authority, leading the Gov. to note: “I think it’s fair to say it complicates it.” Under his revised proposal, a new seven-member school board would be created to govern the new Detroit school district. The governor would appoint four board members, and Mayor Mike Duggan would appoint three board members. Mayor Duggan has resisted appointing school board members and has called for the return of an elected board. Detroit’s elected school board has been without policy decision-making powers for six years, during which time the district has been under the control of four state-appointed emergency managers. Gov. Snyder indicated he was open to changes in the legislative process. “Let’s get the legislative process going and let’s work through that…Not everyone is going to like every piece of this.” Members of the House Detroit Democratic caucus said they were ready to work with Gov. Snyder on a reform plan — as long as it includes local control of schools. “The state has controlled DPS for many years, and it has been a failure,” said Rep. Brian Banks, caucus chairman. “We have to find a better way, and we believe that way lies through local control. We look forward to working with all stakeholders to address all of the issues surrounding DPS.”
  • Partners. Gov. Snyder took care not to alienate the Coalition for the Future of Detroit Schoolchildren, which offered a reform plan in late March. One of the major differences between the coalition’s plan and the Governor’s is his recommendation for a voluntary enrollment system, as opposed to the mandatory system the coalition recommended. “We looked at the best practices around the country and they were all voluntary, and we felt that was the best way to go for parents, to give them more choice…We encourage charters to join the voluntary system in terms of making their school decisions.” Gov. Snyder also said the coalition presented far more recommendations than he used. “It’s not that we don’t agree,” he said. “It’s just that they (many of the recommendations from the coalition) didn’t appear to be prudent for state legislation.”
  • The forthcoming bills are expected to include:

• The Detroit Public Schools would be phased out completely once DPS pays down roughly $515 million in outstanding operating debt. It also collects a $70 million millage from city taxpayers. The city’s Financial Review Commission would oversee the old district while the debt is repaid.
• An additional $200 million would go to the new Detroit Community School District in startup funding and to cover anticipated operating losses due to potential declining enrollment. The new district also would be responsible for about $1.5 billion in pension obligations.
• A new seven-member board would be created to govern the Detroit Community School District. Its members initially would be appointed by Snyder and Detroit Mayor Mike Duggan, with elections phased in beginning in 2017. The board makeup would be majority-elected by 2019 and fully elected by 2021.
• A new Detroit Education Commission would be created, with oversight of the new Detroit school district, the Education Achievement Authority and charter public schools. Its members would be appointed by Snyder and Duggan and would be charged with hiring a chief education officer. The chief education officer would be in charge of academics, including having authority to close low-performing schools.
• A standard enrollment system would be introduced, with common forms and enrollment periods for all participating schools to help parents review options for their children. The common enrollment would be voluntary for schools, although all schools would be required to report academic and other performance standards for transparency.

Are There Alternates to Municipal Bankruptcy? In the absence of access to municipal bankruptcy because of Congressional reluctance, the U.S. Treasury, in discussions with Puerto Rico, has proposed consideration of the creation of a new municipal bond security—one which would be senior to Puerto Rico’s general obligation or GO bonds—and which could act as an exchange vehicle in a sweeping debt restructuring. Reportedly, the proposal would shift collection of all or some of Puerto Rico’s income, sales and use, and other tax revenues to the Internal Revenue Service or the Bureau of Fiscal Service in the U.S. Treasury: such tax receipts would pass through a quasi-lockbox before such revenues would then be effectively returned to the U.S. commonwealth—effectively creating a new governmental entity to securitize these new lockbox revenues. Because the potential governing and taxing structure would, effectively, bypass the existing constitutional revenue structure for the island and its constitution, the proposal appears to be a means under which Puerto Rico’s many, many municipal bondholders would be incentivized to exchange their newly-subordinated Puerto Rico municipal bonds at a discount for certificates of the new U.S. quasi-municipal security. The plan—in part based on a recognition that Congress appears almost certain not to act—nevertheless confronts signal hurdles and skepticism—or as our admired friends at Municipal Market Analytics put it: “[O]n its own, this debt strategy has little chance of success: without a meaningful, definitive, and well-supported program to restructure Puerto Rico’s revenue mix and operational spending, bondholders cannot judge the long-term effectiveness of any proposed debt haircut or the value in any exchange security, regardless of how structurally-insulated from PR’s economy and finances it appears to be….” Adding: “[T]here are massive execution risks in this plan, not the least of which is a (likely) need for Congressional approval. The US Treasury has been convincing that, beyond operational assistance, this plan intends no injection of Federal cash to PR and no other characteristics of a bailout. Yet, seeing as how Republicans oppose the extension of chapter 9 to Puerto Rico on the grounds that it would somehow be a bailout implies an extremely low hurdle for debt holders to successfully lobby their opposition to this plan.” In addition, of course, is the tricky issue of federalism: can you imagine any governor or state legislature which would willingly relinquish control of its income, sales and use, or other taxes to the federal government? MMA slyly adds that even were the Puerto Rican legislature to buy into such a proposal, there would be comparable doubt as to whether current Puerto Rico municipal bondholders scattered across the continental U.S. would be standing in long lines to exchange their current general obligation bonds for an untested new model. Moreover, as MMA masterfully writes:

“Finally, the island’s liquidity issues are on a much tighter schedule than a plan of this magnitude could hope to be. With the real possibility of a PR government shutdown and additional bond defaults before year end, this plan, if it happens at all, would most likely be a means for PR to cure, and not avoid, payment defaults. This is an important distinction, because ‘cure’ strategies have, by definition, a higher standard for long-term benefit, further complicating the plan’s implementation prospects. While this plan will help PR collect the taxes it is supposed to collect, any increase in taxes—even on “underground” economic activity—effectively relocates capital from PR citizens to the government, worsening the local economy and out-migration trends. So while the exchange security may get a first crack at all revenues—just as PR’s GO security is purported to do—it is unreasonable to expect that those revenues will move anywhere but downward over time, creating incremental pressure on now less-flexible PR finances. Any post-default implementation of this plan would need to consider these secondary effects and ensure that the new financing will not cripple PR in the future.”

The Hard Road to Fiscal Recovery

July 7, 2015

The Steep Road to Recovery. Because almost every state which authorizes municipalities to file for municipal bankruptcy imposes different requirements/mandates—including, in the case of Michigan, suspension or preemption of authority of a municipality’s elected leaders, the process of reverting to municipal authority for Detroit came with strings attached—there was no stomach in Lansing to see a substantial state investment in Detroit’s recovery fail; nor, as retired U.S. Bankruptcy Judge Steven Rhodes noted, did he ever want to be known as the first U.S. Bankruptcy Judge to have to preside over a second or repeat municipal bankruptcy. Therefore, when Judge Rhodes approved Detroit’s plan of debt adjustment, clearing the way for the state-appointed emergency manager Kevyn Orr to leave and Mayor Mike Duggan and the City Council to resume governance authority, that authority became subject to nearly a decade of state oversight by means of a nine-member Financial Review Commission, created as a key provision in Detroit’s plan of debt adjustment last November as part of the “Grand Bargain,” that is the agreement which involved both state fiscal assistance and a significant contribution from non-profits to ensure the Detroit Institute of Art remained in the city. The agreement created a mechanism to ensure the City of Detroit is meeting statutory requirements. Statutorily required members of the body include Michigan Treasurer Nick A. Khouri, who serves as chairman; State Budget Director John Roberts serves as the designee of the director of the state Department of Technology, Management and Budget. The oversight board also includes, by statute, Detroit Mayor Mike Duggan and City Council President Brenda Jones, or their designees, as well as five gubernatorial appointees. The Commission is charged with reviewing and approving Detroit’s four-year financial plan, and establishing programs and requirements for prudent fiscal management, among other roles and responsibilities. Detroit is operating under the oversight of a Financial Review Commission and must maintain a balanced budget for three consecutive years, among other requirements, to emerge from oversight in 2018. The commission is scheduled to meet on July 27th, when it will likely review the City Council’s decision to reject a hike in water rates–unless, in the nonce, the Mayor and Council reverse their position.

Under the new law, one of strict requirements is that the Mayor and Council may not enact a budget with a deficit. Thus, in a letter last Thursday to the Mayor and Council, State Treasurer Khouri raised apprehensions over the Council’s vote not to increase water rates, writing that if the vote is not reversed, the Detroit Water and Sewer District’s Enterprise Fund will be in deficit—ergo requesting that Detroit’s elected leaders either provide the Commission with information to demonstrate the city’s plan to comply with the approved budget for the current fiscal year, or the basis upon which it will seek a budget amendment. In addition, Treasurer Khouri wrote that he was seeking details with regard to whether Detroit could — without the rate increase — meet its obligation to provide quarterly certifications to the commission that it can meet debt service requirements though the end of the fiscal year. Unsurprisingly, the City Council is expected to reconsider its decision to reject proposed water and sewer rate increases for city residents as early as today, with President Pro Tem George Cushingberry, Jr. expected to offer a motion asking the Council to revisit its June 30th vote on the rates recommended for the new fiscal year, which began July 1st. In its earlier vote, the Council voted 6-2 against the hikes proposed by the Detroit Water and Sewerage Department, with some members expressing apprehension with regard to how residents already having trouble paying their bills would be affected. Under the rejected and to be reconsidered proposal, DWSD’s average Detroit customer would pay about $64 more a year for service—in contrast, under the Council’s rejection of the proposed increase last week, an estimated $27 million leak was created in the city’s budget, triggering the state apprehension and response—with Detroit’s Chief Operating Officer Gary Brown noting last week that he has been educating Council members on the “unintended consequences” of the decision, reminding them that the no vote went against the Council’s unanimous support in March of the city’s fiscal year budget—a budget which, he noted, included revenue for the water department.

As the very fine editorial writer Daniel Howes of the Detroit News this morning notes: “Detroit’s bankruptcy would be an enormous waste of time, money and unparalleled cooperation between the public and private sectors, foundations and state legislators, unions, retirees and pension funds, if the city’s leaders choose grandstanding over financial discipline…Detroit collapsed into the largest municipal bankruptcy in American history in large part because its elected officials refused to do what they agreed to do. If their successors repeat the mistake, the result is likely to be less forgiving.”

Is Puerto Rico Being Held Up? Puerto Rico Gov. Alejandro García Padilla yesterday reported he had created a Working Group for the Economic Recovery of Puerto Rico. The effort, to be led by Chief of Staff Victor Suárez, Government Development Bank President Melba Acosta, Secretary of Justice César Miranda, and the Presidents of the Senate and House, Eduardo Bhatia and Jaime Perelló, is to focus on how to achieve a consensus on the restructuring of Puerto Rico’s public debt, or, as Gov. Padilla described it: “The ultimate goal is a negotiated moratorium with bondholders to postpone debt payments a number of years, so that the money can be invested here in Puerto Rico.” In a response, Senate Pres. Eduardo Bhatia said, “I have long anticipated this moment. Restructuring the debt has always been the right way, but it is not an easy road. I constantly referred to the 3 Rs: reducing costs, increasing revenues, and restructuring the debt.” Absent access to a federal bankruptcy court, where a timeout could be called by a federal judge and Puerto Rico could provide critical public services, even as it worked to put together a plan of adjustment in negotiation with all its creditors; the U.S. territory instead confronts an expensive challenge from one of its biggest bondholders as it seeks to reduce debt service payments for several years. OppenheimerFunds has announced it intends to defend the municipal bond promises to its clients—in effect following up on its successful legal challenge last summer to the Territory’s proposed bankruptcy measure for its public corporations. Puerto Rico has appealed this case to a higher court, where it is still being considered. The profound challenge for Puerto Rico is how it can adjust its debts in a manner to ensure the ongoing ability to provide essential public services, as well as to ensure economic growth: clearly, it has long since passed the time when it has the fiscal resources to pay each and every one of its creditors 100 cents on the dollar. Consequently, GDB President Acosta will be meeting with representatives of the island’s municipal bondholders and representatives of the muni bond industry in New York City and Washington, D.C. to discuss restructuring of the bonds: the stiff challenge: how to juggle about $72 billion of total outstanding Puerto Rico public sector debt outside of a public process or federal court supervision. Because it is appears clear that Puerto Rico cannot pay all of its debt–even if it took strong measures to cut spending and increase revenues—the issue is how, or is it even possible, to create a process outside of bankruptcy—to restructure? The ever effervescent Natalie Cohen, a managing guru at Wells Fargo Securities, yesterday put it—as she invariably does, succinctly: “I agree that Puerto Rico’s current trajectory is unsustainable and lack of immediate action will only make their situation more painful to resolve. I thought the [Puerto Rico — A Way Forward] report was balanced and shows that without action, there is a financing gap of $3.7 billion in 2016, growing substantially in future years as Affordable Care Act reductions and loss of Act 154 benefits disappear (about 20% of General Fund revenues).”

According to Gov. Padilla, a Working Group formed this week will create a long-term fiscal agenda by the end of next month focused on:
• “Establishing the parameters for a five-year fiscal plan; proposing additional cuts in spending — including cuts in some services — to avoid an increase in taxes;
• “restructuring the Department of Treasury to increase the efficiency of income gathering; promoting alliances with the private sector to provide some of the services which are today provided by the public sector, such as successful projects like the Moscoso Bridge, the airport, and the highway to Arecibo;
• “radically changing the way in which we work with government finances and economic statistics, to establish greater transparency and credibility; guaranteeing our citizens’ essential services and our pensioners a just income;
• “[and] creating a fiscal board which, outside political considerations, will guarantee the continuity and honor of the commitments agreed upon by us during the restructuring process.”
• Finally, Gov. Padilla said he would seek passage in Washington for Chapter 9 eligibility for Puerto Rico’s public corporations, a more equitable distribution of Medicare payments, and the end of the Jones Act, which increases costs of shipping to and from the island.

The ABC’s of a Sustainable Fiscal Future. Chicago Mayor Rahm Emanuel reports that the Chicago School District, the third largest of the country, will be eliminating 1,400 jobs, while at the same time increasing borrowing in response to the growing fiscal crisis facing both the State of Illinois and the Windy City, noting that the job cuts at the Chicago Public Schools, which largely shield teachers and include positions that are vacant, are part of a plan to cut annual spending by $200 million, or roughly 3.5%. The announcement came in the wake of a decision by Chicago officials to make a $634 million payment due to the teachers’ retirement system before a Tuesday night deadline, with Mayor Emanuel noting: “These payments do not come without a cost…There is a series of political compromises and patchwork over the years that can no longer continue.” The announcement comes in the wake of inaction by the Illinois legislature—in a state where state lawmakers have considerable control over education spending and the pension systems—but where, at least to date, no steps to assist the city school system—or, as Mayor Emanuel put it: “Your stalemate is having consequences.” In the immediate term—to ensure the city’s schools open on time and keep class sizes from rising, the district drew down on two credit lines to make the pension system payment due this week. Now it is seeking to put off for a year $500 million in pension payments due in the new fiscal year. For his part, Mayor Emanuel has proposed that teachers’ pension contributions and local property taxes would be increased if the state would make increased payments into Chicago’s teacher retirement system. But the prospects are most uncertain: the state government remains entrapped in its own budget Armageddon—at an impasse over this fiscal year’s state budget, which had yet to be approved nearly a week into the new fiscal year and now faced with a partial state government shutdown. Continue reading