MuniLand

Late in 2012, New York State Comptroller Thomas DiNapoli launched the Fiscal Stress Monitoring System, an early warning system for municipal entities in the state that were suffering financial stress. The program’s purpose was described this way in a webinar:

To identify both local governments and school districts that are in fiscal stress, as well as those nearing fiscal stress.

To identify for local officials the need to take actions in a timely manner that change their financial trends for the better.

This has the potential to be a great system for New York’s fiscally weak cities. Having closely followed several municipal bankruptcies in California, I know that public accounting systems are often weak and public officials are unaware of the extent of their fiscal stress until there is no money to make upcoming payroll or debt service payments. At that point there is no space to take corrective action – The Titanic has already hit the iceberg.

Moody’s downgrades to Baa2 from A2 for the City of Poughkeepsie’s (NY) General Obligation debt; outlook remains… bit.ly/141pKy4

Moody’s released it’s long awaited opinion of Assured Guaranty’s creditworthiness on January 17th. Moody’s analysts were not feeling good about the subsidiary that insures the bonds of municipalities. They pushed the rating down three notches from Aa3 to A2. The Bond Buyer noted that “fundamental challenges inherent in the business model make a return to the Aa rating level unlikely.” Zap and you are dead.

In the municipal bond insurance space, firms make money by insuring (or wrapping) bonds of communities or public entities that have lower credit ratings. This saves money for the entity issuing the bonds because it has a lower cost of borrowing and the insurer is guaranteeing that they will repay investors if the bonds default. It also benefits the investors who know that they will be made whole if the issuer cannot make payments on their bonds.

However, when a bond insurer’s rating is lowered, that means the pool of bonds it can insure shrinks because many new bonds have higher credit ratings. Assured now has a lower credit rating than most bonds being brought to market.

President Obama and others have called to create a “national infrastructure bank” that would leverage the credit backing of the U.S. to fund more privatization of public assets – also known as public-private partnerships. In other words, a federal bank to fund the selling off public assets with loans or guarantees provided at low interest rates. But is control of public assets a successful business model for the investors? Actually, it seems to be a disaster. Let’s look back at private toll roads over the years.

An academic paper “Is there ‘value for money’ in transportation PPP’s?” looked at the efforts of the Australia infrastructure firm, Macquarie, in building private toll roads in the United States. The paper, published in 2007, included this table of Macquarie’s U.S. projects. The record for these projects is abysmal.

Two of the projects declared bankruptcy. The assets of one, Pocahontas, were written down to zero by its new owner, and two were bought by the government jurisdictions where they were located. Another is in negotiations to be bought by the state of Virginia. None of these projects fulfilled their initial plans to operate successfully as profitable, private companies. Macquarie’s most substantial U.S. project, the Indiana Toll Road project, is near insolvency and attempting to restructure its loans.

Pennsylvania may have suffered more damage from municipalities using interest rate swaps than any other state in America. Many cities and school districts were sold these “hedging” instruments after former governor Ed Rendell pushed legislation allowing their use in 2003. The fallout for the state has been devastating.

Small communities, large cities and school districts have suffered substantial losses from their use. Bloomberg reported in March 2008 how a school district suffered deep losses:

James Barker saw no way out. In September 2003, the superintendent of the Erie City School District in Pennsylvania watched helplessly as his buildings began to crumble. The 81-year-old Roosevelt Middle School was on the verge of being condemned. The district was running out of money to buy new textbooks. And the school board had determined that the 100,000-resident community 125 miles north of Pittsburgh couldn’t afford a tax increase. Then JPMorgan Chase & Co., the third-largest bank in the U.S., made Barker an offer that seemed too good to be true.

I blogged recently in support of Columbia Law professor John Coffee’s proposal for the SEC to hire outside expert attorneys to prosecute complex cases. He called the performance of the current SEC enforcement division lackluster, and wrote that it is “an overworked, underfunded agency that is subject to severe resource constraints.”

The soon to retire head of the SEC’s enforcement division, Robert Khuzami, blasted Professor Coffee’s idea in the National Law Journal last week with a piece titled “Unfair claims, untenable solution.” The New York Post nicknamed Khuzami the “master blaster” with a “poison pen” for going after Coffee.

In his rebuttal to Coffee, Khuzami lauds the number of settlements the SEC has achieved under his tenure. But the number of settlements under Khuzami and former SEC Chairman Mary Shapiro has actually declined from post-Sarbox-era SEC Chairmen William Donaldson and Chris Cox. NERA Economic Consulting shows this in its recently released SEC Settlement Trends: 2H12 Update (page 19):

There have been hundreds of articles written about how a number of U.S. states have unfunded pension liabilities. These massive shortfalls have been researched by numerous groups, and although they differ on the size of the shortfalls, they all agree that pension liabilities are creating a troublesome drag on many state budgets. The Pew Center on the States is one of the first groups to dig down and analyze the condition of city pension funds and the promises made for retiree health benefits. Their new study, A Widening Gap in Cities, reports a mixed picture.

Cities such as Milwaukee, Wi. and Washington D.C. are prepared to meet their financial commitments to retirees (see above). Others, such as Chicago and Portland, Or. have seriously neglected their pension funds. Almost universally, cities have failed to pre-fund the commitments they have made for retiree health care. In total, cities have pre-funded only 6 percent of their healthcare promises, leaving a shortfall of $118 billion, according to Pew. In contrast, cities have funded 74 percent of pension liabilities, leaving an unpaid balance of $99 billion. In fact, 22 cities face larger unpaid bills for retiree health care than for pensions (page 16).

There are many approaches to increasing the funding for pension and retiree benefits. Pew discusses some of these approaches (page 22):

David Fillman, with union of #PALottery workers, says public mgmt could be more lucrative than private. “And we don’t have a profit motive.’

— Marywilson (@Marywilson) January 14, 2013

A big brawl is going on in Pennsylvania over the way that Republican Governor Tom Corbett has been maneuvering to privatize the state’s successful public lottery. The governor held negotiations in secret for months before announcing in November, 2012 that he had chosen a single bidder, the UK’s Camelot Global Services, to be awarded a 20-25 year contract to operate the lottery.

This announcement, made while the Pennsylvania legislature was in recess, was intended to move the governor’s process to conclusion before the legislature came back into session. Public outrage caused Corbett to initially delay the contract, but in a move that seemed to show contempt for the state’s legislators, his office gave Camelot a “Notice of Award” late last Friday; just before the Senate Finance Committee was to hold a hearing on the details of the contract.

The Golden State, under the leadership of Governor Jerry Brown, has done a remarkable job of managing its finances through the worst economic period since the Great Depression. Because the state was the epicenter of the housing bust, its fiscal meltdown was one of the most severe in the nation. Although three California cities have declared bankruptcy (with others to possibly come) the state deserves a lot of credit for getting through a very rough period.

The governor held a press conference touting the state’s recovery. However, fireworks and champagne to celebrate recovery would be a little premature. Adam Nagourney of the New York Times reported:

“The deficit is gone,” Mr. Brown proclaimed, standing in front of an array of that-was-then and this-is-now charts that illustrated what he said were dramatic changes in California’s fortunes.

Underfunded public pensions are an enormous problem that states, cities, school districts and other municipal entities will continue to wrestle with in 2013. Many public officials have already taken up the issue of reform, as their budgets are pressured by large required payments to public pension plans.

Nationally public pensions are funded at about 80 percent of their liabilities, but that masks the severe under-funding faced by some systems. For example, the Illinois state system only has about 43 percent of the assets needed to fund future pensions. States, cities, school districts and public employee unions have three options to address this problem – litigate, negotiate or go bankrupt. Here are examples of how this choice is playing out:

Litigate

A private group, the Arnold Foundation, has published a guide to pension litigation across the country. The guide lays out the changes enacted by state legislatures and city governments, and the litigation filed to overturn the changes (see the map above). From the 2013 guide:

Alarm bells are ringing across muniland because the discussion about capping the municipal bond tax exemption at 28 percent has surfaced again. Bloomberg reports:

“If and when there is a serious attempt to make substantial reforms to the tax code, I think that there’s a risk that the [municipal bond] tax exemption could be curtailed or eliminated,” said Decker, the co-head of SIFMA’s municipal securities activities.

The possibility of municipal-bond income losing its exemption from tax is as great as any time since 1986, when major tax reform was ushered into law during the Reagan administration, said George Friedlander, Citigroup Inc. senior municipal strategist.