Posts Tagged ‘Chapter 9’

The Grand Jury of San Diego issued a report of this title yesterday.  Also, at yesterday’s GFOA (Government Finance Officers Association) business meeting, the group voted  that the Government Accounting Standards Board should stay away from the topic of sustainability.  The only conclusion one can draw from the Grand Jury report is: the city of San Diego’s current trajectory is UNSUSTAINABLE.  Here, are a few choice passages (please read as if these too, were fully capitalized):

The City has yet to articulate structural solution to close the multi-million dollar budget deficit in fiscal year 2010.  More than 50% of this gap in financing was filled by using one-time solutions, such as skipping reserve payments and deferring projects.

In summary, this investigation is presented to the City and its citizens because the status quo is not going to resolve the crisis of financial instability, unbalanced budgets and reduction of the city’s obligations, liabilities and debts.

One of the underlying causes of the current structural budget imbalance is the underfunding of the City’s pension obligation by previous City administrations.

Ok, we know this.  This is true among states and municipalities across the country.  But what to do?  In some (not all) places the pitch of the problem has reached a scream – CONTINUING GOVERNMENT OPERATIONS ARE UNSUSTAINABLE.  Amazingly, the choice to cut critical services has become the lesser of two evils – the other being pension and benefit reform.  Elected officials, charged with managing cities like San Diego would rather have fewer cops, less trash pick-up, deteriorating infrastructure and higher taxes, than deal with runaway benefit spending.  Even if you believe that the benefits are deserved, earned and righteous, the city simply does not have the resources to pay these costs and also maintain a livable city.  So what’s the decision?  Give up the livable city?  The City’s Independent Budget Analyst stated:

Structural deficits require structural solutions.

The report suggests using the federal bankruptcy courts to determine what can and cannot be restructured.  Investors, along with public employee unions (strange bedfellows) hate this solution and prefer to stay in one-shot-land, or stand by while the deterioration mounts (see stories on Vallejo’s increasing crime.)  The courts could also decide to trim back debt obligations in the same restructuring process.  This has happened in Vallejo, where there is a moratorium on debt service payments (at least with the current intent of re-paying in full at the end of the moratorium period).  Vallejo’s bankruptcy tackled the city’s ability to reject union contracts, a key step, but they did not touch the pension issue.  The San Diego Grand Jury suggests a bankruptcy court could help sort out this benefits conundrum.

Finding 26: A proactive dialogue as to the efficacy of a Chapter 9 reorganization cannot be removed from any discourse as to the City’s financial health

Finding 27:  A Chapter 9 filing would result in a federal determination of which fringe benefits and collective bargaining agreements could be restructured.  The fringe benefit total is $423.7 million, according to the FY 2011 Proposed Budget.

RECOMMENDATION

The 2009/2010 San Diego County Grand Jury recommends that the Mayor of the City of San Diego and the San Diego City Council:Convene a panel of bankruptcy experts to discuss the legal and financial ramifications of a Chapter 9 declaration of bankruptcy, in the context of a publicly noticed City Council or Council Committee meeting. 

In this context, the municipal credit analyst, the investor and the taxpayer, need a new tack on fiscal review.  Unfunded pension liabilities must be included as a long term debt in debt ratios.  The rating agencies discuss these burdens but they are not included in the numbers. Medians that include all long term and contractually obligated costs should be developed to correctly compare cities and identify outliers like San Diego Vallejo.  The long term cost of these obligations should clearly be disclosed so that ratios may be calculated.  For example, red flags of fiscal trouble are waving fervently in San Diego’s case and the Grand Jury mentions Vallejo as well:

In 1994, the city’s budget for pension expense was 6% of payroll cost.  Today, sixteen years later, the cost is 28% of payroll, and growing.

For FY2009, the City’s fringe benefits rate was 52.5% of budgeted salaries of $728 million (IBA Report #09-10 issued February 24, 2009, p.2).  On average, privately operated companies spend 35% of budgeted salaries on fringe benefits. 

Some 76% of Vallejo’s operating budget went to salaries and benefits.  The norm is 50%.  Pensions were not an immediate issue since Vallejo had funded its pension obligation.  Vallejo’s most significant liability was $135 million of unfunded health care.  Vallejo officials brought the unions back to the bargaining table after the federal bankruptcy judge ruled collective bargaining agreements can be voided. 

A few other red flags that can be identified with a bit of extra work:

Is the municipality/state postponing annually required benefit contributions?  Is the government making its “annually required contribution” or ARC?  If not, this will catch up quickly as evidenced in San Diego (see separate post on the state of Illinois)

Are judgments and claims high and increasing?  This points to the government’s poor risk management practices and sloppiness.  This is a low-hanging fruit that cities should tackle with gusto.  The Grand Jury found in San Diego’s case:

Funding of the City’s (self-insured) public liability fund against lawsuits that could drain the General Fund for years to come.  As of June 30, 2009, the City faces $129 million in claims.

Funding the city (self-insured) worker’s compensation fund against outstanding claims, currently estimated at $161 million.

As the press and blogosphere keep telling us, there will be more municipal defaults and bankruptcies.  But there is a difference between painting all securities with the same brush and rigorous analysis.  We believe the flags are identifiable. 

We are coming out of a period when investors bought municipal bonds with their eyes closed.  The mantra that municipals don’t default and the once widespread presence of bond insurance convinced the investing community that analysis was irrelevant.  No more.  On the other hand, Congress has pressured newly contrite rating agencies to upgrade municipals at perhaps the worst time in history. 

San Diego’s GO ratings?  Moody’s: Aa3; Fitch: AA- and Standard and Poor’s: A 

There is a table at the end of the Grand Jury report with a September 6, 2010 deadline for city officials to respond to the specific recommendations.  The Mayor, the City Council, the Retirement System’s administration, the Audit Committee and Independent Auditor are required under the state of California Penal Code to do so. Looks like a busy summer.

See today’s op ed by Dan Miller, Harrisburg’s controller.

An article about upstate New York town of Kingston and their discussion of fiscal stress, union contracts and the debate over Chapter 9 bankruptcy.

Here is an interesting clip from MLive about the debate over Flint’s dire finances.   Michigan has a receivership program that has been used a number of times so municipalities cannot just file bankruptcy in federal court without going through the state.  The article poses the sensible, if painful and difficult, questions of concessions on salaries and benefits compared with outright layoffs (in a city with 25% private sector unemployment) as well as collaboration with other municipalities on providing services (we applaud that approach).   We also note the exaggeration of county Commissioner Curtis, who said “cities across the country are going into Chapter 9 and getting relief from the contracts…”  Of the 89,000 municipalities in the U.S. there’s Vallejo, California and Prichard, Alabama.  Las Vegas monorail mentioned in the Wall Street Journal article last week  (you may need a subscription to access this) is in Chapter 11 which is the part of the bankruptcy code for corporate filings.  There have been a number of Chapter 9 filings by hospital districts, as well as numerous, small land-development-based special districts.  Then there’s Connector 2000 in South Carolina.  Harrisburg, PA has been discussed and of course, Jefferson County, Alabama sewer system,  but there has been more chatter on the wires since the Journal.  Connector 2000, the Harrisburg incinerator and the monorail have each been problem credits for some time, apart from the recession and credit market meltdown.

Looks like the city is making its best effort to try to resolve budget imbalance.  Ohio is one of the states that has a strong oversight/receivership program and municipalities may not file bankruptcy without approval of the state.  Local governments there do rely on income taxes, which is tough in the current economy, especially in auto and manufacturing which dominates the landscape.

Here’s a clip from the California League of Cities concerning AB 155.  AB155 (and its parallel, SB88) briefly, would prevent California cities from filing bankruptcy without going through the state — California Debt Investment Advisory Commission (CDIAC).  Numerous other states have adopted similar provisions, which puts the state in the middle of helping with a workout and prevents a municipality from directly filing for bankruptcy with the federal courts (the government level where bankruptcy is handled).  The bill has been around but appears to be picking up momentum.  The League opposes this bill.

Harrisburg, Pennsylvania can’t really afford to pay for the Resource Recovery bonds that it guaranteed.  Their recently adopted 2010 budget does not include debt service for this guarantee (see prior post with link).  It is accepted practice for rating agencies to rate municipally (or state) guaranteed debt off the credit of the guarantor.  Unlike bond insurance or any insurance for that matter there are no capital set-asides for guarantees by municipal governments.  Market analysts assume that the city or county would raise its taxes to the point of covering the debt.  Harrisburg is now testing that assumption. 

There has been some disagreement on the underwriting floors (at least in bond insurance, if not at the rating agencies) whether one should take into account the credit quality of the project being financed or simply “look through” to the guarantor’s quality.  I suggest a middle ground.  Assume that the Resource Recovery project was rated on its own merits as a project finance — what category would that be?  Then assume a contingent liability on the balance sheet of the guarantor of that lower credit quality.  If it is clear that the guarantor cannot afford the contingency the rating should embed this risk.  This thinking extends to “moral obligation” bonds whose ratings are automatically notched down from the state (or infrequently, local) rating.  Should a “white elephant” project backed by a moral obligation bear the same rating as one that is performing and essential?  (We don’t think so)   Affordability of obligations (add pensions, opeb, debt service to the list) is going to become an increasingly important risk factor as government wrestles with raising taxes, reducing expenditures and satisfying multiple constituencies — unions, taxpayers, retirees and service beneficiaries.

This is a follow-up to the earlier post on October 14 about Prichard, Alabama when the city failed to make the October payment to their retirees.  According to the Press-Register city leaders do not expect to pay November either.  To protect themselves from the lawsuit that ensued they filed Chapter 9 (municipal) bankruptcy yesterday.  (Note to the municipal bond analysts reading this, Prichard does not have general obligation bonds outstanding at this time, although they do have water and sewer bonds, guaranteed by Assured Guaranty, which should not be affected by the bankruptcy filing).  See link to al.com below:

http://www.al.com/news/press-register/metro.ssf?/base/news/1256721412135050.xml&coll=3

The check is not in the mail.  Prichard, Alabama, came out of Chapter 9 bankruptcy in 2002 and promised to make deposits into its public pension fund.  They didn’t and now they are simply out of money.  Retirees did not get their October 1 payment.    What’s next?  The retirees are suing.  The city is looking for investors in a bingo operation as a last ditch effort to raise cash.  The bankruptcy word is being raised again.  (see our post from June 20)

The city does not have general obligation bonds outstanding at this time but some are eyeing the cash in the water and sewer system. That system, which refinanced its bonds in May (insured by AGO) has had its disputes as well.  They were under a consent decree to clean up their system.  The Mobile Area Water and Sewer System (MAWSS) was willing to take them over, but the city refused.  The city purchases water from MAWSS and handles its own treatment, distribution, billing and collection services.  Standard and Poor’s rated the system BBB- in 2005 but rates the 2009 bonds A-.  Coverage has improved, disclosure of the multiple lawsuits that were in the 2005 official statement have been dropped from the current disclosure and the refunding will save the water and sewer Board a significant amount of money.    After the May 2009 issue, the Board signed a 10 year public-private-partnership contract for $78 million with Severn Trent to operate the system (the amount is according to WKRG).  The amount seems high for a 2008 budget of about $7.4 million (excluding depreciation and amortization) that also includes about $1.0 million fixed cost for water purchase from MAWSS. 

Is the city’s dilemma symbolic of a pattern across the U.S.?  We think so.  Small municipalities that manage their own pension and retiree benefit programs, poor fiscal management and maybe an external shock such as loss of a major employer or reduced tax revenues are symptoms of trouble.  Vallejo, California fits this pattern as does the Sierra Kings Health Care District, California that just filed Chapter 9 last week.  While the common belief in the market is that municipalities don’t default, we see trouble among these smaller, vulnerable communities.  Watch the balance sheet for these factors before you pass “go”.

At this point in the meltdown timeline, municipal bond defaults have not yet occurred in the traditional sectors we think about such as cities, towns, states, utility systems and school districts.  The few notable exceptions include Vallejo, California, currently working through a Chapter 9 bankruptcy and Jefferson County, Alabama sewer system, which is a heavily leveraged enterprise working through its reserves and under its sixth? tenth? forebearance agreement with a number of swap providers, so according to some balance sheets not yet really in default.  Which brings me to this blog topic: what, after all, is a default?

The SEC currently requires disclosure of a list of material events, so some default reports include a draw on cash reserves along with payment defaults in the same statistics.  The typical understanding of default is a non-payment to the investor or bondholder.  When a security is spiraling downhill fast, a cash draw frequently ripens into a payment default.  Both will be noted in the material event filings.  The numbers will also include multiple filings for different series of bonds for the same issuer, or for two missed payments in the same year, or for multiple missed payments on a monthly basis.

When an investor or portfolio manager, or bond insurer or rating agency makes a decision about the quality of a security, they are usually thinking about the credit, meaning the borrower, or in some cases the obligor if it’s different than the borrower – that is, which entity has to pay back the obligation.  So if you don’t like an obligor, you are not going to like Series 2006A from that obligor as well as not liking Series 2007B.

To clear this up, we parsed the default filings for 2008 and the first half of 2009 for reserve draws, payment defaults and unique obligors vs. actual filings.  If you click on the attached chart, you can enlarge it.  We will be updating this information for third quarter in the near future, so stay tuned….

default table

Click twice to enlarge