MuniLand

#PuertoRico‘s projected structural deficit for FY ’13 is $2.15B, higher than what was originally informed to credit agencies, Moody’s, S&P.

— News is my Business™ (@biznewspr) March 14, 2013

Dark clouds are hanging over Puerto Rico. Its projected 2013 deficit follows a likely 2012 deficit and twelve preceding deficits stretching back to 2000. The economy has not been generating sufficient tax revenue to support the services that the government has been providing to citizens. The difference has been made up by borrowing in the bond market and loans from the Puerto Rico Government Development Bank.

Now the bond market gatekeepers, – credit ratings agencies – are waving the red flag. Yesterday Standard & Poor’s downgraded the Commonwealth of Puerto Rico to BBB- (one tiny step before junk status) and followed this downgrade with one of the island’s Government Development Bank to BBB-. This is ominous. The GDB is the heart of Puerto Rico’s borrowing system.

Breckenridge Capital described the role and importance of the GDB in a March 2012 report:

However, Puerto Rico is unique in its extensive use of public corporations to deliver public services. It directly and indirectly manages 48 public benefit corporations. This governance structure has tended to limit transparency and fiscal accountability in its public sector…

One of the best muniland research teams, Blackrock, is out with its State of the States and Local Governments report. If you have time to read the 12-page report, you will get a very balanced roadmap of the challenges that municipal governments are facing.

The one area where I felt that the report broke new ground was its emphasis on the uncertainty that state and local fiscal processes face, thanks to the federal government. Here is what the report says (emphasis Blackrock):

Ironically, the greatest threats to state fiscal integrity are not primarily endemic fiscal matters or economic conditions, but rather, the effects of federal policies. First, capping tax exemption is a potential problem for the entire municipal asset class, although offsetting factors would certainly alleviate the impact. For states, as well as local governments, a tax cap could mean higher borrowing costs. Still, as has been the case recently, increased borrowing costs would likely translate into program reductions or cost-shifting to local governments. As stated earlier, we believe passage of the cap will be difficult in the current political environment and is unlikely in 2013.

A well known political maxim is that politicians remain in office when they bring home benefits for their constituents. Nothing proves this point more than how the sequester process protects the senior citizen entitlement programs – Medicare and Social Security – while cutting federal spending for the most economically disadvantaged Americans. One of the nation’s most prominent sell-side analysts, Natalie Cohen of Wells Fargo, thinks the effects of these cuts have big consequences, and  eventually could even be socially destabilizing. From Cohen’s recent report:

Medicare is lightly touched (2 percent) and Social Security not at all. We see Congress protecting the programs that matter most to retirees while traditional anti-poverty programs, largely managed by state and local governments, are being rolled back.  In all, we see a more disturbing longer-term trend away from a vision of government that assures opportunity for all citizens while protecting the poor. Over the longer term, we believe this new approach will deepen the divide between ‘haves’ and ‘have not’s’ both generationally and racially, a trend that could lead to unrest, in our view.

Last December over 2,700 institutional investors voted Cohen the first place sell-side research director and generalist analyst in Smith’s Gradings municipal analyst poll. She is considered one of the leading thinkers in muniland.

Numerous public pension plans across America are in horrendous shape. The employee plan of the Commonwealth of Puerto Rico, funded at an alleged 7 percent of assets, is functionally broke. Other public plans, like that of Charleston, West Virginia, have 24 percent of the assets needed to meet future promises to retirees.

There is little to no regulatory oversight of public pensions. And what little there is comes in a roundabout way. For example, the sanction that the Securities and Exchange Commission administered to the state of Illinois for not adequately disclosing to bond investors that it was not properly funding its system.

The core of the SEC complaint says:

The state omitted to disclose in preliminary and final official statements material information regarding the structural underfunding of its pension systems and the resulting risks to the state’s financial condition.

Want to take a 30,000-foot flyover of municipal market trading? The Municipal Securities Rulemaking Board has published its 2012 Fact Book. Let’s have a look at some of the highlights.

By every metric, municipal bond trading has been declining since the first quarter of 2008:

In the meantime, yields on municipal bonds, in lockstep with U.S. Treasury yields, have been declining since the end of 2008. Note also the separation between the customer-bought trades  (blue line) and customer-sold trades (black line). This is the difference (or spread), and it equals the revenue earned by dealers on transactions. This spread has widened since 2011.

While student borrowing for college has expanded to record levels and 12 percent of student loans are delinquent, enrollment in U.S. public and private universities declined in 2012. The number of full-time students stood at 11.5 million last year, a 0.7 percent decline from 2011. Meanwhile, state and federal governments have been reducing funding to public universities. Schools themselves have increased their borrowing for capital improvements to compete for the best students. There are rough seas ahead for education; lower the sail and batten the hatches.

Moody’s Managing Director, John Nelson, explained in a recent report why Moody’s has switched to a negative view of the entire higher education sector. It is mainly a lack of preparation for the economic and institutional changes:

The new sector-wide negative outlook reflects mounting pressure on all key university revenue sources, requiring bolder actions by university leaders to reduce costs and increase operating efficiency. As the economic growth languishes below previous benchmarks and the federal government seeks to reduce spending in key areas, even market leading universities with diversified revenues are facing diminished prospects for revenue growth. Universities have been restraining costs in response to the weak economic conditions since the 2008-09 financial crisis, but they have only recently begun examining the cost structure of their traditional business model.

This chart from Moody’s provides a clear picture of the swings in revenue that states have experienced over the last 12 years. Even with big changes in revenues, states must end every year with a balanced budget. It’s truly a feat of magic given the spending demands of states with education, Medicaid and pension payments leading the priority list.

Although state revenues have increased since 2010, there are still warning signs sprouting here and there. Moody’s wrote in a recent report:

Moody’s Investors Service continues to have a negative outlook on the US states sector because of uneven employment and tax revenue growth and spending pressures from Medicaid and pensions, despite signs of economic stabilization across the country. Repercussions from possible reductions in the federal deficit, which could damage economic growth, are also a risk for states.

The debate surrounding the sacred cow of municipal bond tax exemption is reaching new heights. In a recent report from the National League of Cities, estimates by SIFMA (the dealer trade group) show that municipal governments would have paid an additional $173 billion in interest over 10 years with a 28 percent cap on municipal bond tax exemption. And if Congress had fully repealed the municipal bond tax exemption, municipal issuers would have paid an additional $495 billion in interest costs over the last 10 years. These amounts would be on top of the $1.09 trillion in interest paid on municipal bonds in the last 10 years under the current law.

SIFMA/NCL arrived at these projections using this method (page 6-7) emphasis mine:

The information in Chart C was determined by taking the amount of interest paid by each jurisdiction in the last fiscal year, with a median interest average of 4.69 percent over the past 15 years (Thomson Reuters), and applying a 70 BPS increase for what the interest costs would have been if the bonds were issued with a cap in place, and applying a 200 BPS increase for what the interest costs would have been if the bonds were issued without the exemption in place.

President Obama shut down his infamous “jobs council” at the end of January after very desultory efforts and no substantive outcomes. Reuters reports on what comes next:

In place of the jobs council, the administration said it will begin an expanded effort to work with the business community and other groups to boost economic growth, cut debt and fix a broken immigration system.

“It’s a broad engagement strategy to make sure the president’s message is getting out to the American people, because with their voices involved we think that we can still do big things,” Obama adviser Valerie Jarrett, his point person on working with business, told Reuters in a recent interview.

Last week media was in a frenzy about the effects that federal spending cuts would have on states and cities under sequestration. Last Monday morning, the White House put out information including the graphic above to highlight the implications of spending cuts for the most vulnerable Americans. These are tough numbers, but there is no context provided to understand the magnitude of spending reductions.

I spent all week on Twitter trying to point out that cuts to state and local governments from the sequester would sting, but they would not chop off limbs. Media were reporting that communities would be devastated. Reports highlighted personal stories from employees who were worried about their jobs or loss of services. But almost all the frantic coverage failed to put the funding reductions for state and local governments in context. None of the coverage focused on the possibility that state governments could, and most likely would, damper or avert these cuts by finding internal efficiencies and re-prioritizing their own budgets.

A broader view was provided by Standard & Poor’s via Governing.com:

In fact, states and municipalities may already be fairly well prepared to handle the effects of sequestration, thanks to cutbacks and other austerity measures they’ve already made in response to a weaker revenue environment. Standard & Poor’s Ratings Services said in a report Thursday that sequestration  “may have only minor negative credit consequences for state and local governments and their affiliated entities.”