Puerto Rico’s moral hazard

Puerto Rico’s short term funding needs are sending out warning bells. The Padilla Administration has been pushing the Commonwealth Legislative Assembly to agree to an increase in the Sales Use Tax to 3.5 percent from 2.75 percent. With this diverted revenue, the government could issue a third series of Cofina bonds for approximately $2 billion. This third tranche would be subordinate to the first two series of Cofina bonds, but have higher ratings than PR general obligations bonds and other public authority debt. The additional Cofina debt may be needed for short-term borrowing done through private placements.

El Neuvodia reports on the action in the Legislative Assembly (translated from Spanish):

Although they stressed there is ‘no rush’ to go to the markets, the principal officers of the prosecution team of Alejandro García Padilla administration today defended the move in a joint public hearing of Finance committees in the House and Senate.

‘We need to refinance this debt,’ said Interim President of GDB, José V.Pagan, referring to $1.223 million that would have been used to cover the daily expenses of the government.

Meanwhile, Debtwire ran an unsourced story that said U.S. government officials would consider backstopping a new issue of Puerto Rico bonds:

The ‘unintended consequences’ of flood insurance reform

Hurricanes Katrina and Sandy left about $220 billion in total property damages in their wake. Katrina caused approximately $16 billion in flood damages and required the flood insurance program overseer, FEMA, to borrow from the U.S. Treasury to cover insured losses. Losses from Sandy could push FEMA borrowing from the U.S. Treasury to $28 billion when all claims are paid.

Congress acted in July, 2012 to restore the program to solvency with the passage of the Biggert-Waters Act. Now, as the new flood insurance premiums take effect, an outcry against FEMA and Congress has grown in force.

The new rates are tightly targeted. According to data from FEMA, approximately 250,000 households out of over 5 million households in the program will see substantial premium increases. Insurance Journal drills down more deeply:

Will Stockton go the way of Vallejo?

Late Friday, the City of Stockton, California released its “Plan of Adjustment” for how it intends to treat its creditors in bankruptcy. The plan has been in the works since the city filed for protection under chapter 9 of the United States Bankruptcy Code on June 28, 2012. Stockton’s City Council will vote on the plan this week, on October 3rd.

On inspection, the plan looks a lot like the failed adjustment for formerly bankrupt Vallejo, California, which continues to suffer massive operating deficits. The lead bankruptcy attorney for both Stockton and Vallejo is Sacramento-based lawyer Marc Levinson, who seems to be failing both cities by not using bankruptcy to create a stable fiscal base. If it is approved by Federal Bankruptcy Judge Christopher Klein, the plan will keep Stockton perennially saddled with massive pension liabilities. I wrote in May about Vallejo:

The structural fiscal problems, which [Vallejo] could have addressed through the bankruptcy process and chose not to, remain. Even after spending an estimated $12 million on bankruptcy and legal fees, the city has fiscal problems. Standard & Poor’s Gabriel Petek led a cost benefit analysis on Vallejo’s bankruptcy and determined (emphasis mine):

In a budget crunch, calling in the volunteers

Fiscally stricken Woonsocket, Rhode Island recently informed its firefighters union that it would be replacing 15 vacancies in the fire department with volunteer firefighters. The Woonsocket Call reported:

The Woonsocket Fire Department would become the only urban fire district in the state to employ on-call volunteers under a cost-cutting edict issued this week by the Budget Commission – under the threat of a lawsuit from the firefighters union.

The firefighters won’t allow this to happen if they can help it. It is common for small communities of less than 10,000 people to use volunteer fire fighters. I have never heard of a mixed department, though some might exist. Maybe this precedent should be established as debt-burdened cities struggle to provide essential services.

Emanuel should fix Chicago’s pensions now

According to Moody’s latest report on local government pensions, Chicago’s adjusted pension and debt burden (relative to its tax base) is the largest in the nation. The city is now putting about 8 percent of its revenues toward its pension funds. But the pensions are so underfunded that if the city made the full annual pension payment it would amount to 28 percent of revenues. The city has seriously neglected funding its pension plans.

The problem is complicated by the fact that Chicago must work through the Illinois General Assembly to enact changes to pension contributions and benefits. There is little discretion at the local level on these issues. Chicago Mayor Rahm Emanuel should go to Springfield and twist arms in the General Assembly before credit rating agencies whack the city with more downgrades. Instead, Emanuel intends to push the issue off for several years and do nothing. The Chicago Tribune reports:

Faced with the prospect of a major tax hike or severe service cuts just as he stands for re-election a year from now, Mayor Rahm Emanuel told the Tribune Wednesday that his formula for fixing the financially out-of-whack government worker pension system requires ‘reform, revenue and time.’

What’s with Puerto Rico GDB bonds?


The bonds of Puerto Rico’s fiscal agent, the Government Development Bank, are inexplicably blowing up today. After a trader alerted me to the sell-off I haven’t been able to find any public information that would explain why.

The GDB bond in the graph above is Cusip 745177FN0 due 2019. It was issued in 2012 for $500 million. The bond is taxable and its yield is hovering around 13.2 percent on inter-dealer trades today (trades done between dealers are the sharpest prices in the market).

In contrast, Puerto Rico tax-exempt general obligation bonds of the same maturity are trading at around 6.74 percent, or 11.16 percent on a fully-taxable equivalent basis. Why did the GDB bond move out 2 percent on heavy trading?

Public pension assets reach highest-ever level

The pension doomsayers, who claim that pensions are direly underfunded and losing ground, may be surprised to hear that public pension assets grew to their highest-ever level for the last fiscal year (ending June 30). Strong equity market returns helped propel the national median investment return to 12.4 percent. The whiff of panic about public pensions should be subsiding, except for the ongoing hot spots like Puerto Rico, Illinois and Chicago. Overall, the winds have calmed.

Reuters’ Lisa Lambert reported:

Asset values at U.S. public pension funds rose 8.4 percent in the latest fiscal year to the highest level in more than 40 years, but their costs also rose, the U.S. Census reported on Monday.

Most retirement systems ended fiscal 2013 on June 30. In the final quarter of that fiscal year the cash and securities holdings of the 100 largest public-employee pensions were $2.944 trillion, up 8.4 percent from a year earlier and the highest level since the Census began collecting pension data in 1968.

Detroit’s contentious swaps

The proposed settlement between Detroit’s emergency manager Kevyn Orr and the city’s swaps counterparties, UBS and Merrill Lynch, is on the docket this week in federal bankruptcy court where the case is being heard. The Bond Buyer reported:

Key hearings on #detroit‘s swap settlement originally set for this week may be delayed … parties in mediation.

— Caitlin Devitt (@Devitt_BB) September 23, 2013

Mediation could be a good alternative for the parties because this is a complex element of Detroit’s bankruptcy. Circling around the perimeter of this bankruptcy litigation and mediation is the bond insurer Syncora, which insured both the underlying pension obligation bonds and the interest rate swaps that are part of the negotiations between Orr, UBS and Merrill Lynch. Orr has worked to force Syncora, the bond insurer, out of the picture and essentially leave it responsible to pay off the pension obligation bonds without access to Detroit’s casino tax revenues. Syncora believes that it is legally entitled to access the casino revenues because it insured the pension obligation bonds, which have a cross-default covenant with the swaps.

A pension system that swings with investment returns

Although the media is full of hair on fire stories about the level of funding in public pension funds some of the funds are in great shape. State run pension systems like the North Carolina Local Government, Wisconsin Retirement System and numerous Washington state funds have extremely high funding levels, near 100 percent in the latest figures from 2011. Each plan has different state funding requirements, retiree benefit schemes, asset mix and projected investment returns. But each plan has been prudently managed, and, most importantly, excessive benefits have not been promised to retirees.

Almost every public pension has a “defined benefit” structure, which means that the benefits promised to an employee upon retirement are a fixed amount and may also have mandated annual inflation increases. The pool of assets that these benefits are paid from fluctuates in value from year to year and state and local governments are responsible to make up any funding shortfall in the plan. This structure, where the government is responsible for all shortfalls, is what has caused large and accelerating government contributions to make up for investment losses from the 2001 and 2008 financial crises. And when governments have to unexpectedly increase pension contributions it crowds out funds that would have been used for education or other social services. Or taxes must be raised.

Unique among state pension funds, the Wisconsin Retirement System is structured as a “defined contribution” fund where everyone, taxpayers, employees and retirees share the risk that the fund will not achieve the returns necessary to fully fund pensions. Wisconsin is structured like a giant 401(k) for its members with steady contributions from the government and employees but the annual payout to retirees varies according to how well the fund is performing. Institutional Investor describes it:

How much profit can non-profit hospitals make and be tax exempt?

I’ve been involved in a local community effort to downsize a large proposed hospital expansion in my tiny historic village, Rhinebeck, New York (population 2,657). It’s been very interesting because it exposes many of the issues that I’ve long studied and thought about. There is the broad issue of what level of profitability hospitals can have while still being tax exempt from property and corporate income taxes. There are issues around the levels of executive compensation. And most interestingly is the question of non-profit hospital being used as shells for profit-making entities. And what does all this do to their status as tax-exempt institutions?

The Illinois General Assembly studied the issue of setting some standards to determine if hospitals were operating as non-profits, but their hospital lobbying group derailed the legislation. The practice of sheltering for-profit activity is beginning to be studied because it reduces state and federal corporate income and property tax collections. Local governments generally rely on property taxes for 50 percent or more of general fund revenues and exempting hospitals from property taxes can place an enormous burden on taxpayers.

The Internal Revenue Service has been grappling with the issue of profitability and tax exempt status for non-profit hospitals. In its most recent study, in March 2013, it surveyed 500 nonprofit hospitals nationally to analyze the ratio of revenues to expenses to get some sense of profitability. The numbers varied but the IRS determined that profit or median excess revenue (operating revenues minus operating expenses) for hospitals with total revenue below $250 million was 3.8 percent (page 27):

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