Posts Tagged ‘fiscal emergency’

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 this post on Reuters for discussion about Antioch, latest city in California to talk bankruptcy.  There is a bill, sponsored by state senator Mendoza, AB155, that would require cities to go through the state (via the California Debt and Investment Advisory Commission, CDIAC).  The bill was referred last week by the Senate appropriations committee — but now appears there will be some further review.  The pros and cons line up as follows;  cities strongly against state involvement in order to preserve local autonomy; unions and bondholders in favor in order to prevent reduction of obligations, whether they are union contracts or debt obligations.  Interesting line-up.  Many states have had oversight programs for their distressed communities for years.  Distressed designation may trigger  grants or aid to distressed municipalities that would not be present in a federal bankruptcy.  Some states map out a “receivership” process that gives the state certain intervention rights to reorganize the municipal government and bring finances back into balance.  Cities oppose any additional intervention by the state that encroaches on their powers.  Pro-union forces in the legislature want to prevent the cities from filing bankruptcy since it may result in reduction of  contract provisions (which was determined to be possible in the Vallejo case).  So far the pension albatross has yet to be tested.  According to Antioch’s 2009 audit the city is obligor on about $27 million certificates of participation, paid through lease agreements, current underlying ratings are Standard and Poor’s “A” and there is MBIA insurance on at least some (maybe all, we didn’t check each series) of the certificates.

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

The Illinois Comptroller’s April report  is scary reading.  The state is $4.5 billion in arrears on payments to vendors and others (like school districts and service providers) with no end in sight.  The Comptroller expects 2011 to be worse.  The following chart from the report looks to me like a deteriorating structural imbalance moving towards a delicate liquidity position.   

click for larger image

As long as markets are willing to provide liquidity, the state will be able to continue on this trajectory.  As we learned from the New York City fiscal crisis in the mid 1970’s, not to mention the banking liquidity issues beginning August 2007 and later, those institutions that depend on short term market access for viability will freeze up (seize up?) when the markets don’t cooperate.  

The Civic Federation prepared a detailed analysis  and critique of the proposed 2011 budget.  In the report they graphically present the state’s roll-over of short term debt from 2009 to 2010.   In 2011 the state expects to issue $4.7 billion notes for “voucher payments.”  Where will the re-payments come from?  

So here’s some simple math.  The state’s debt service payments for 2011 jump from $1.6 billion to $2.8 billion.  Short term debt will be $4.7 billion.  The budget assumes $27.4 billion General Fund revenues in 2011, so it looks to me like debt service consumes a hefty 27.4% of that total.  Red flag.  Maybe there will be some roll-overs, some additional budget cuts, maybe some tax increases, maybe the economy will be good to the state and they will make it into 2012.  But the long-term problem here is huge.  

 Bondholders are feeling sanguine since, like California, payments go to debt service before other services.  As tax increases loom on the horizon, investors want that tax exempt paper.  As the Civic Federation described:  

As the State continues to issue more G.O. debt than it retires on an annual basis, the amount of General Funds committed to debt service payments will continue to rise. To make these payments the State pledges its full faith and credit to its bondholders and legally commits itself to transfer the debt service payment into the General Obligation Bond Retirement and Interest Fund (GOBRI) prior to paying any other bills or transferring funds for any other appropriations.

  

  

 

  
 
 

 

I’m putting on my public policy hat now (as opposed to financial analyst).  There’s no mechanism for bankruptcy or receivership at the state level in the U.S. which may be comforting from an investor’s perspective, but lousy public policy.   There’s no IMF and no process at the federal level to re-structure state finances other than handing out bailout grants or loans — which usually require increased borrowing or matching spending.   There’s no Board of Directors as in the private sector whose charge is to protect shareholders (substitute “taxpayers” for shareholders) even when painful actions are necessary.   So we are left with random taxpayer uprisings and the occasional vote for elected officials and the analysis of think tanks.  Maybe there will be a lawsuit by vendors or school districts to get the state to meet its obligations.  Maybe vendors and residents will vote with their feet.   The preferred approach would be an objective mechanism with authority and mettle to resolve the fiscal mess.   Someone please tell me that I am wrong …

Add Xenia Rural Water District’s to the short but growing list of over-leveraged municipal borrowers.  With $143 million in debt and about 9,000 customers, the unfolding socio-gram includes bondholders, bond insurers CIFG and Assured Guaranty, the US Department of Agriculture, Bank of America, and last, but not least, the ratepayers.  A $5.2 million note to Bank of America comes due June 1 and the district is already in arrears to the USDA.  The BofA notes were sold on the assumption they would be taken out with permanent financing from the USDA.  Will that happen?  USDA has called in its auditors and expects to complete a financial review during May.  Having the federal lender as a creditor on this workout should make things interesting. The State of Iowa is also auditing, with results for 2009 to come out in a month.   As of the district’s 2008 audit there was 64% coverage of debt service from available revenues. 

The district had great dreams of expansion, aggressive you might say.  One of the problem projects was a 16 mile pipeline designed to reach about 20-30 homes, according to the Ames Tribune.  The former Executive Director Dan Miller (separated at birth from Harrisburg, PA’s comptroller, Dan Miller?) had a penchant for expansions, even when they no longer made sense.  The district expected to double the number of connections and revenues by 2011 when maximum debt payments kick in according to a read of the official statement.  For a rural, agricultural region, even in the best of times, this is ambitious.

Then there were the line extensions to several ethanol projects within the district.  According to the Guthrie Center Times, at least one of these projects

may have contributed to Xenia’s dire situation.. The company extended a pipeline from Clive to the western edge of Waukee and from DeSoto to Menlo at a cost of $15 million to provide water to the Hawkeye Renewables ethanol plant at Menlo.  The work was done by Xenia’s construction crew and the cost overrun of $3.5 million had to be born by the company.  Xenia charged Hawkeye Renewables $1 million for the connection fee to the pipeline.

The district has been in discussions to have Des Moines Water Works acquire Xenia.  They’ve raised rates by 22% and are asking forgiveness of $45 million of debt. 

The plot thickens.  CIFG, the now defunct bond insurer, guaranteed the $83.6 million 2006 bonds when they were issued (and when they were rated “AAA”).  The underlying rating on the bonds was then “BBB” by Standard and Poor’s, lowered to “BB” in August, 2009 following disclosure of the district’s difficulties.  CIFG is now in runoff and as part of the bond insurer’s workout, Assured Guaranty entered into a reinsurance agreement for the troubled company’s $13 billion municipal portfolio.  Assured Guaranty, as agent for CIFG said “no” to the district’s workout plan.  They would like to see rates go up enough to cover their obligations, without debt forgiveness.

BTW, Iowa is one of those states that do not permit municipalities to file bankruptcy.  So what happens now? 

For bondholders to claim an Assured Guaranty payment on default, the reinsured CIFG bonds have to be “novated” which is an insurance term for extinguishing the original CIFG policy and issuing a new Assured Guaranty policy. 

The process began on an optimistic note.  Assured Ltd’s president and CEO, Dominic Federico said in October 2008, announcing the deal:

Public finance investors will benefit from an upgrade of the rating on their investment if they agree to the novation of their current policy with CIFG NA, and we look forward to helping them make the novation process as quick and efficient as possible. 

Three months later, Assured sounded a far less confident and far more measured:

The novation process for each covered policy will be determined in conjunction with representatives for each underlying insured credit based on the applicable legal requirements and the particular facts and circumstances of each such insured credit.  There can be no assurance as to the timing of the novation process or whether an insured credit will be successfully novated. 

Then New York State Insurance Commissioner Eric Dinallo was more upbeat.  He stated in January 2009:

We expect that the municipal bonds currently insured by CIFG will go from junk to the highest investment grade.  This will result because the bonds will be reinsured by and are intended to be novated to Assured Guaranty Corp, meaning that Assured will replace CIFG as the insurer…

But the novation process is taking far longer than expected.  According to last week’s Bond Buyer the “vast majority” of bonds have yet to be novated.   One has to assume the bondholders have every reason to be cooperative in this process.  As of this morning the Xenia bonds were still rated “BB” by Standard and Poor’s. S&P rates Assured “AAA” so these bonds have not been re-branded.  Maybe Assured has an out on the novation, given Xenia’s now non-investment grade rating. 

If the bonds are just reinsured and not novated, any payment that CIFG recoups from Assured via the reinsurance agreement could just go into the big, black CIFG pot and not to bondholders. 

Meanwhile, back on the farm, customers are none too happy with the prospect of 63% higher water rates.  Ratepayers, who include rural residents as well as numerous franchise communities, are busily looking into ways to get off the system. Heavy attrition would make achieving revenue targets only that much more difficult.

Tight financial margins are not kind to political squabbles.  In the last few weeks the city of Los Angeles has been engaged in a squabble with the city council and its utility, the Los Angeles Department of Water and Power (LADWP).  The city’s mayor wants the utility to implement green power, the utility asked for a rate increase to cover additional expenses, the council refused and the utility held hostage a transfer to the city of funds.

Each of these events has its own logic, but when the “b”-word (as in “bankruptcy”) got thrown around, the city’s rating was downgraded and put on negative watch. 

Looked at from a different perspective, when one body of government promotes green power or makes a regulatory change, utilities either get some kind of financial incentive or are simply required to comply.  They could file a rate increase request with their state Public Utilities Commission.  Or at the municipal level the utility would pass along the extra costs to the consumer – assuming the local council goes along.  The PUC could grant the increase (or not) and the utility would charge higher rates or alternatively eat the loss through lower profits (or maybe find savings!).

Transfers from municipally owned utilities are also common practice.  Think of them as “payments in lieu of taxes” (PILOT).  Most investor owned utilities (IOU’s) pay taxes to the local government.  The PILOT or tax covers the cost of the usual stuff – police, fire, sanitation, roads that benefit the utility, as well as an economic environment that allows the utility to grow or maintain its customer base.  In some parts of the country, where municipally owned utilities are more common, these transfers are made below the line – after all other expenses have been paid – so that the security covering utility bonds is not compromised.  For IOU’s, not paying the corporate taxes – is out of the question.  Non-payment could result in penalties or shut-off of power.

Not so in Los Angeles where all of this is up for negotiation.  In tight economic times, when reserves are thin and maintaining monthly cash flow is essential to the government function, a hold-up could spell disaster.  The LA city council opted to play a high stakes game and in the current environment, the mayor’s counter-offer of bankruptcy or shutting down city government added fuel to the fire.  Factors that are not up for negotiation elsewhere got caught in the political crossfire in Los Angeles.

I am posting Municipal Utility Transfers , an article I wrote  some time ago on this topic – covering Los Angeles under Mayor Riordan – that still has merit today. For municipal history buffs (a small and nerdy group), today bears a strong resemblance to the 1992 period: a run-up in asset values followed by a bubble-burst; taxpayer protests; downgrades and economic recession, particularly in southern California not to mention the Clinton mid-term elections.  Keep in mind that the city of Los Angeles and its utility are large, diverse and wealthy and will be able to manage through the storm.

The financial reform proposals, designed to eliminate systemic risk, could actually trigger another meltdown upon the bill’s passage.  This is due to the ratings notching approach that has given rating credit to government support since the meltdown.  A change in the expectation of support – both emergency and on-going would result in ratings downgrades for certain banks.  Standard and Poor’s for example, gives a three notch upgrade to the counterparty ratings of Bank of America Corp., Citigroup Inc and Morgan Stanley and two notches to Goldman Sachs and UBS AG.  Reverting to a lower stand alone rating could trigger collateral calls, terminations or other nasty events, not unlike what we have seen over the last three years.  My bank analyst colleagues are more sanguine about the likely outcome.  They suggest the banks would raise more capital, and by the time of passage, the underlying stand alone ratings could be improved.  But the House bill requires bondholders to take it on the chin before federal monies could be used.  And if the goal is to withdraw federal support, where would the capital come from?  While this issue may be better-understood by bank analysts I thought this should e brought to the attention of the municipal finance readership here.  Caveat counterparty.

Westfall Township, Pennsylvania filed a Chapter 9 bankruptcy petition in April, 2009 and the court confirmed a reorganization plan in March, 2010.  According to the law firm that handled the case:

Westfall Township, located in Pike County, PA, was saddled with a $20 million debt due to a prior government’s mistreatment of a developer.  Without the resources to pay anything close to the amount of that judgment, the township filed for Chapter 9 and was able to negotiate a settlement in the much more feasible amount of $6 million over 20 years without interest.

 “The Westfall Township case was a unique bankruptcy event because municipal reorganizations under the Bankruptcy Code are rarities in the U.S.,” said J. Gregg Miller, an attorney with Pepper Hamilton LLP.  “Filing for Chapter 9 in Pennsylvania requires cooperation between the federal bankruptcy court and the Pennsylvania governmental bureau in charge of financially distressed municipalities.

Pennsylvania is one of several states that have a distressed municipalities program.  Municipalities in these states are supposed to go to the state first, before they file in federal bankruptcy court. 

Why did the township file directly?  Act 47 as the Pennsylvania program is called, has two conditions that may allow a municipality to file bankruptcy directly.  First, the act of filing federal bankruptcy “shall be deemed to be a financially distressed municipality under the act.”  Hmmm. Sounds circular.  Second, if the municipality is in “imminent jeopardy of an action by a creditor, claimant or supplier of goods or services which is likely to substantially interrupt or restrict the continued ability of the municipality to provide health or safety services to its citizens.”  So there needs to be an imminent action against the municipality — not quite the Harrisburg situation at this point.

In the case of Westfall, there was a settlement with a developer a number of years ago that obligated the town to provide water and sewer services to the developer’s property.  The township never acted and the developer sued to get the town to act.  The court sided with the developer, and over time the obligation grew to $20 million. 

The state intervened in the case and the Department of Community and Economic Development appointed a coordinator to work with the township and the bankruptcy court to solve the problem.

Westfall doesn’t have bonds outstanding.  However, bank debt was modified by the bankruptcy court.  $2 million obligations to Dime Bank were suspended until April 10, 2010.  The loan term was extended for ten years at the same interest rate.  A note to Pennstar Bank for purchase of a truck was also extended for three years. 

Adverse settlements against small communities have led to Chapter 9 filings from time to time.  Looking through an official statement for outstanding litigation should be a basic part of an investor or analyst’s underwriting. 

By the way, Johnstown, Pennsylvania, which is under its fourth reorganization plan under Act 47 is considering a filing…see an interesting analysis of Johnstown and other Pennsylvania communities by the Allegeny Institute for Public Policy (conservative think tank) and their discussion of Chapter 9.

I am adding a link to this article that updates Toledo’s fiscal situation.  (See prior post.)  The city is wrestling with a budget gap and trying to negotiate with unions over compensation.  Ohio is a state that has a fiscal emergency program and municipalities may not file for bankruptcy without going through the state.  The state’s oversight of fiscal emergencies is useful but does not give the oversight panel the right to cancel contracts or replace management.  The biggest clout is the panel’s ability to prevent borrowing — a severe but important hammer for any city in fiscal emergency that may be facing a cash flow shortfall.

Here’s a good, local clip about the Harrisburg bond/incinerator problem: