Posts Tagged ‘municipal bankruptcy’

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.

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

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.

We have two opposing camps in the muni-market at the moment: those who say it is the next systemic shoe to drop and the rating agencies that are systemically raising ratings.

Which is right?

We have moved from a market that has had heavy intermediation from the bond insurance companies to one where investors are on their own. Bond insurers historically performed heavy analysis and monitoring of the credits they insure and actively affect the legal protections embedded in a security. Bank credit enhancers have done the same, although in some cases their agreements allow them out of the risk under certain circumstances. Rating agencies assign their rating on sale and their business model has never been designed to provide robust monitoring of issuers in the secondary market. The Moodys and other agency default studies covered this time period – a relatively prosperous period from 1970 – 2007 when pending defaults on the investment grade level were mostly managed by bond insurers. Further, the default studies did not include insured bonds.

Municipal bonds do default and have throughout this period –not at all in large numbers by any comparison to the corporate world. Knowledgeable high yield investors are aware the risks in hospital, senior care, land development, and corporate-style tax exempts such as industrial revenue bonds. Project finance, such as the Harrisburg incinerator, Las Vegas monorail and Connector 2000 also carry high risk. (I should add WPPSS and other nuclear power projects to this list.)  These should not be lumped together with the other 30,000 or so municipal bond issuers. Like the stock market, there are many, many nuances among borrowers. Only now the investor is left to grapple with his own resources – and the loss of granularity among this diverse and deep market from ratings “re-calibration”.

(Concerning re-calibration of ratings:  As I have said before, lowering corporate ratings to their appropriate probability of default relative to municipals – would achieve the same effect, and be truer to their own research. Instead, the agencies are compressing ratings into fewer categories and eliminating much granularity for investors. But of course the other approach would have been business suicide and harmed many corporate portfolios.)

Within this, market prophets are now generalizing greatly, mostly those who have not spent their careers in this non-standard, messy, sometimes corrupt and poorly understood state and local financial world.

This brings me to some comments on Rick Bookstaber’s recent post. Many of his points are strong and need to be actively debated, but others generalize to the detriment of this very varied marketplace.

Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.

Agreed. The Tower Amendment should be abolished and municipalities that want to participate in public capital markets and be rated like corporates should be held to the same reporting standard. Period. Would you buy a corporate bond whose disclosure was two years old?

The argument that it’s too expensive and too burdensome for smaller municipalities to achieve transparency can and must be resolved. Technology and know-how exist to achieve this in a cost effective manner. Those municipalities that cannot produce timely and accurate reporting – should borrow locally and not expect to participate in national markets. Or they should not be given (potentially misleading) ratings. Borrowing locally will likely end up costing more than paying the auditor to get the report done in a timely manner.  Hiding behind the “municipals don’t default, so what difference does it make?” argument is so yesterday.

The rating agencies still do not fully incorporate pension and other benefits into the debt statement that produces their debt ratios and medians. Taxpayers certainly do consider these factors. All obligations that are paid from the public purse should be clearly disclosed. Understandably, rating agencies argue that they serve investors not taxpayers. But political risk – unwillingness to pay – clearly reaches back into the investor’s pocket.

Size and potential systemic effects. That this is a big market in the credit space goes without saying.

This is a big market, but is not uniformly systemic like housing.

Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?

In some cases. Given our federal system, each state has its own set of rules for local municipal finance. For example financing infrastructure for housing and economic development is vastly different in structure and credit quality in California (Mello Roos for example) vs. Florida (community development districts) vs. Texas (municipal utility districts).

Bookstaber’s point does apply to the municipal market in several ways. Investment portfolios and cash management are prey to marketers of the security “du jour”. As one of his commenters suggests, Fannies and Freddies could put municipal investments systemically at risk of a federal policy change — affecting many municipal government investors at one time. I would add to this list: securities lending practices among pension plans and other large public funds  (which some practice but others do not).

Ratings triggers on counterparties that create terminations, unwinds and a change in interest rates, basically legal provisions that automatically change the terms of the deal — also create across the board risk for those borrowers involved. Examples include variable rate securities, swap transactions, LOCs and GICs. These structures effectively embed corporate and market risk into municipal credit.

At the traditional fixed income municipal debt level however, there is significant diversification among security types and legal structures – given the 10th amendment and individual state peculiarities.

Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky — the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.

Agreed. Analysts and investors should incorporate a haircut for unfunded pension and benefit liabilities that use overly ambitious earnings as a discount rate. The debate about “risk free” vs. a historical earnings rates is an important one. Stated another way, this debate points to the fact that public pensions (defined benefit) are irrevocable, guaranteed and must be paid.  How would you invest funds when you could not afford to lose a penny vs. money you are willing to take on more risk? Since pension obligations are long-lived, the counter-argument that earnings over time should be used has some merit as well.   But the inequities between public retirees and the rest have piqued the taxpayer whose 401K and life savings have been subject to market losses.  Also, the “defined benefit” retirees are facing off against the “defined contribution” beneficiaries.  Fairness is an important public good, as difficult as this debate may be.   

Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the underfunded portion of the portfolio.

Absolutely. Maybe they don’t have to do a site visit on each review, but they should disclose the date of their latest full review for each rating, no question. How many of the re-calibrated ratings have been freshly reviewed?

Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.

Disagree. See my comments above and other blog posts on this site. Municipalities do not behave the same as homeowners. Clearly there are scoundrels and irresponsible politicians who just want out of obligations they did not understand or were misled from the get-go.

Even with debt repudiation talk in the air, it is difficult to file bankruptcy in most states, and default is not a good option for a municipality that needs capital markets access. Plus, as covered elsewhere, given the 10th amendment, bankruptcy does not give the federal courts the same kinds of control over a municipality as a corporate entity.

Keep in mind that the majority of municipal borrowers (like the majority of homeowners) want to do the right thing.

Neither are taxpayers irrational. Protests are explainable. There are only certain states where initiatives and referenda are permissible (and this too has historical roots). There are correlations between rapid growth in taxable assets, public spending increases and taxpayer protest. (I have written about this on my blog and elsewhere.) 

Taxpayers are right to be angry at politicians who are spending their money mainly to buy votes and for poor policy reasons. We need to look at the spending patterns in government and have this debate. How many say, “It’s a pre-election year, of course nothing will get done.” In the private sector, someone with that approach would be fired.

Two important worries Bookstaber hasn’t addressed directly:

Liquidity: There are major liquidity issues at some of the states, quickly filtering down to the local level. At least three states have held back making payments to localities and vendors – California, New York and New Jersey. At some point liquidity markets may stop lending – or the cost will become prohibitive — which will have immediate impact on the economy in those states. Where enough taxes roll in the next month to cover payments, these states will limp along until they are able to cure their structural imbalance or they will hit the wall. While some look for a federal bailout in this situation, a failure to tackle the cure for structural deficits is bad policy. As we learned in recent banking crisis, institutions that require regular market funding for survival will fail in a liquidity freeze.

State solvency: tied to the first point, there is no mechanism in our society to address state insolvency. States, as sovereign entities, do not go bankrupt. There simply does not exist any legal or political institution with the authority to facilitate an orderly reorganization of state obligations. We need to think up objective, non-political structures that put the brakes on spending increases when times are good and that facilitate reorganization when times are bad.

I just came across this blog from John Moorlach, Orange County.  Scroll down for a “five year lookback” on the discussion about San Diego, thought you might find it of interest.

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 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.