NEW YORK, Jun 17, 2014 (BUSINESS WIRE) — The development of a tender option bond (TOB) structure that complies with the Volcker rule paves the way for tax-exempt money market funds to remain a buyer of municipal bonds. However, this structure does not provide a clear means for bringing outstanding TOBs into compliance. The Securities Industry and Financial Markets Association estimated the TOB market at $80 billion. Fitch rated a new Volcker-compliant TOB structure brought to market by Merrill Lynch, Pierce, Fenner & Smith last week.

We expect other banks that participate in the tender-option bond market to utilize similar structures for new TOBs in the second half of the year. For existing TOB trusts, banks may unwind the trusts and create new joint venture trusts or may potentially use a third-party non-banking entity as a sponsor to make those structures compliant.

In a typical TOB structure, the sponsor will deposit a fixed-rate bond or note into a trust that then issues one floating rate certificate (with a tender option) and one residual certificate. Tax-exempt money market funds may buy TOBs as the floating rate certificate’s tender option is often issued by the sponsor, shortening the maturity of the deposited bond.

The Volcker rule, which is expected to be fully implemented by July of 2015, prohibits banks from sponsoring the trust and providing any liquidity, credit, or remarketing services for the floating and residual certificates issued by traditionally structured TOBs.

The new structure establishes a joint venture trust that the liquidity provider, the floating interest holders, and the residual interest holders join. Each joint venture must have 10 or fewer parties. Joint ventures of this size were exempted from the Volcker Rule.

Additional information is available on www.fitchratings.com .

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com . All opinions expressed are those of Fitch Ratings.

WASHINGTON — The market for variable rate demand obligations has contracted five of the last six years, the Municipal Securities Rulemaking Board said in a report released Wednesday.

VRDOs are long-term securities with short-term interest rates. Interest rates are reset periodically by remarketing agents on behalf of the issuers. The obligations have a tender feature that allows them to be sold at par. After VRDO issuance peaked at almost $120 billion in 2008, it declined in 2009, 2010, 2011, and 2013, the report shows. New issuance of VRDOs in 2013 fell to $13.2 billion, compared to $15.2 billion the previous year. During the first quarter of 2014, issuance totaled $1.49 billion, about 3% less than the amount in the first quarter of 2013.

While new issuance has stabilized in the area of $14 billion annually since 2011, the MSRB said, the overall size of the VRDO market has also shrunk considerably in recent years. It contracted 22% to $222 billion between April 2012 and March 2014, the report showed. VRDO par volume dipped 7% in 2013 from the previous year, while the number of trades declined by 9%.

Matt Fabian, a managing director at Municipal Market Advisors, said the continuous shrinking of the VRDO market is the result of a variety of factors. Investor demand for VRDOs remains very strong, Fabian said, but there isn’t enough supply to go around.

“It is entirely a supply issue,” he said.

VRDO issuers traditionally relied on bond insurance, Fabian said, but the decline of the bond insurance industry led many banks who provided letters of credit for VRDOs to stop doing so. Also, a large number of VRDO issuers were in the healthcare sector, Fabian added, and the uncertainty surrounding that sector generally has led those issuers to reduce the size of their VRDO programs.

Michael Decker, co-head of municipal securities at the Securities Industry and Financial Markets Association, said many issuers are going away from VRDOs because of the “costs and complexities” involved in them, such as needing letters of credit and remarketing agents.

“Some issuers might like to find a more simple solution,” Decker said.

Bank direct purchases have largely stepped up to replace VRDOs, but Fabian said that the money market mutual funds that were major investors in VRDOs will continue to need floating-rate options, making the successful emergence of a Volcker Rule-compliant tender option bond structure extremely important. The first such TOB deal was completed late last week.

The MSRB report also details a decline in the market for auction rate securities, which were long-term securities that have variable interest rates that are reset on a short-term basis. No new ARS have been issued since 2008, and the size of the ARS market decreased 31% to $27 billion from April 2012 and March 2014.

The Securities and Exchange Commission and state regulators sued many broker-dealers for misleading investors about the liquidity risks associated with ARS. The ARS market collapsed on a widespread basis in early 2008 after firms that historically supported the auctions but were under no contractual obligation to do so, stopped propping them up. Most of the cases were settled.

BY KYLE GLAZIER
JUN 18, 2014 11:55am ET

Bond buyers are betting more than ever on the mercy of Mother Nature as they seek to boost yields being suppressed by central banks.

Demand for notes linked to insurance against hurricanes and other natural disasters is prompting investors to accept the lowest relative yields in almost a decade for this time of the year, when the Atlantic storm season gets underway. Buyers are speculating that the $22 billion market can continue its streak without an annual loss even as Warren Buffett said last week that Berkshire Hathaway Inc. is avoiding writing hurricane insurance in Florida because premiums have been pushed too low.

Investors who have snapped up $5.76 billion of new catastrophe bonds this year, the fastest pace of issuance ever as measured by data provider Artemis, are being emboldened by weather forecasts and average annual returns of 8.5 percent since 2002. Offerings this year include a record $1.5 billion transaction linked to potential hurricane damage in Florida.

“Wind season looks to be slightly below average in terms of the hurricane outlook and that’s attractive,” John Brynjolfsson, chief investment officer at Irvine, California-based hedge fund Armored Wolf LLC, which oversees about $700 million including the disaster-linked notes, referred to as cat bonds. “Although cat bonds are relatively tight, on a comparative basis they look attractive to capital markets investors.”

Spreads Narrow

Cat bond yields have dropped to about 4.7 percentage points more than benchmark interest rates, the lowest second-quarter level since 2005 and down from 6.57 percentage points a year ago, according to John Seo, managing principal at Fermat Capital Management LLC. The Westport, Connecticut-based firm oversees $4.5 billion, more than 90 percent of which is invested in cat bonds.

“The hurricane does not know the rate that was charged for the hurricane policy, so it’s not going to respond to how much you charge,” Buffett said at the Edison Electric Institute’s annual convention in Las Vegas on June 9. “And if you charge an inadequate premium, you will get creamed over time.”

The National Oceanic and Atmospheric Administration predicts only one to two storms will escalate to major hurricanes during this year’s season, which lasts from June through November, compared to a historic average of three major storms. A measure of loss probabilities for cat bonds issued this year averages 1.32 percent, down from an average 1.95 percent for securities sold in 2013, according to Steve Evans, Artemis’s founder.

Reinforcing Models

Catastrophe bonds in the U.S. have returned 22 percent the past two years, about the same gains delivered by junk-rated corporate notes, during a period that included the damage caused by superstorm Sandy that tore through the northeastern U.S. in October 2012.

“Some of the events that kind of captured headlines, such as superstorm Sandy, as devastating and headline-grabbing as they were, did not trigger any losses of note,” Brynjolfsson said. That has helped to “reinforce the integrity of the modeling firms,” he said.

Insurance companies and reinsurers typically sell cat bonds to help cover their most extreme risks, with the proceeds of the issues set aside and paid out in the event of a qualifying disaster. Buyers get a relatively high interest margin for holding the notes and risk forfeiting their entire investment if the securities are triggered before they mature.

Japan Losses

Catastrophe-bond investors haven’t experience major losses on bonds since 2011, when damage caused by the earthquake in Japan that March caused $300 million of losses for securities issued by Muteki Ltd. that helped cover earthquake risks taken on by German reinsurer Munich Re.

The market’s track record through the 2008 financial crisis and natural disasters of recent years is “especially important for the key investors in the sector, which are pension funds, endowments and sovereign wealth funds,” said Michael Millette, global head of structure finance at New York-based Goldman Sachs Group Inc.

Demand has “grown steadily over the past four years,” with most funds typically allocating less than 1 percent of their assets to cat bonds, he said in a telephone interview.

Investors are willing to accept lower yields because they provide returns that aren’t correlated with other asset classes such as equities.

Florida Bonds

“When you factor in that you can’t find anything else that is non-correlating with a decent return, it’s easy to see that cat bonds are still very attractive,” Artemis’s Evans said in a telephone interview from London.

In Florida, where state-run Citizens Property Insurance Corp. issued a record $1.5 billion sale in April, Chief Risk Officer John Rollins said the insurer is seeing an increasingly diverse pool of investors.

The three year floating-rate notes, with a spread of 750 basis points more than borrowing benchmarks was originally marketed for $400 million, and attracted investors including “a pension fund for Scottish miners, a mutual fund backed by Japanese middle class savers, a fund dedicated to managing royal assets,” Rollins said in a telephone interview from Tallahassee.

‘More Mainstream’

Rollins said he saw no indication of “limited demand” even as new issuers are debuting on the market.

The Texas Windstorm Insurance Association announced an offering this month after contemplating the securities for three years, according to General Manager John Polak.

Three years ago, “the terms and conditions associated with cat bonds weren’t quite as attractive and competitive as they are today,” he said in a telephone interview from Austin. Now, cat bonds are “more mainstream” and “most importantly, pricing is at a point where it’s a realistic consideration” for the association.

The offering is expected to grow from the initially marketed $300 million to $400 million, according to Polak.

Italian insurer Assicurazioni Generali SpA (G), based in Trieste, also issued its first cat bond this year, 190 million euros ($256 million) in floating rate notes at a spread of 225 basis point more than the London interbank offered rate, Bloomberg data show. The notes, which mature in 2017, cover damages from European windstorms.

“I think there’s kind a tipping point that has been passed,” Citizens’ Rollins said. “If we have significant weather activity, if we have some bond get triggered, I think there will be recalibration mostly in the area of price, but not in the unwinding of structures. I don’t anticipate that a test of these structures will not be passed.”

By Caroline Chen Jun 17, 2014 9:05 AM PT

To contact the reporter on this story: Caroline Chen in New York at [email protected]

To contact the editors responsible for this story: Shannon D. Harrington at [email protected] Dan Kraut

A central Florida facility that would convert sewage into fertilizer is the latest project to tap relentless demand for the riskiest municipal bonds.

The Orange County Industrial Development Authority plans to offer $62 million of unrated debt next week on behalf of a unit of VitAG Corp., which plans facilities that combine biosolids with sulfuric acid and ammonia to produce fertilizer. The federally tax-free securities will finance a plant on a site in Zellwood, Florida, near tourist center Orlando.

The malodorous initiative may still come up roses for high-yield investors who have been inundated with cash for 23 straight weeks, Lipper US Fund Flows data show. The wave has buoyed bonds for industrial-development projects. They’re the riskiest subset of junk-rated munis, accounting for the most defaults in part because of the dependence on a single project.

“This is like the worst of the worst,” yet investors will probably buy it, said Tom Metzold, co-director of munis in Boston at Eaton Vance Management, which oversees about $24 billion in local debt. “When too much money chases too few bonds, deals come to market that have no right coming to market. The risk-reward profile is so out of balance, it’s nuts.”

Outsize Return

Local agencies can issue debt in the $3.7 trillion municipal market on behalf of private companies, whose credit backs the securities.

Speculative-grade industrial-development debt has gained about 14 percent this year, more than double the return for all munis, Barclays Plc data show. The bonds, which carry an average tax-free yield of 6.4 percent, are luring investors as interest rates remain near generational lows.

“We’re aware that municipal-bond investors are looking for yield and the high-yield market has performed well,” said Ed Zughaft, senior vice president of finance for VitAG, which is based in Beech Island, South Carolina. “We’re hopeful that we can take advantage of the timing here. We’ve already received a lot of interest from investors.”

Biosolids, organic materials derived from treating sewage sludge, contain nitrogen nutrients, which are used in fertilizer to replenish soil. The company would follow other commodity-based ventures that have turned to the tax-exempt market in the past 14 months for financing.

Private Equity

The Iowa Finance Authority sold $1.2 billion of junk-rated debt in April 2013 to fund the building of a nitrogen fertilizer plant by Egypt’s Orascom Construction Industries. At the time, it was a record speculative muni offering. In November, a Louisiana public authority issued $140 million of unrated bonds for a German wood-pellet producer. The deal’s tax-exempt portion yielded 10.5 percent.

Private-equity firm KKR & Co. (KKR:US) bought $95 million of taxable debt in the wood-pellet offer. In this month’s Orange County deal, an affiliate of TPG Capital, a Fort Worth, Texas-based private-equity firm with $54.5 billion in assets, will contribute at least $20 million in equity, according to offering documents.

An affiliate of Denham Capital Management LP, a $7.3 billion U.S. private-equity fund focused on energy and mining, will get $1 million from the financing proceeds, offering documents show. Denham owned part of VitAG until last year.

7.5% Yield

Bond documents cited an estimated annual interest rate of 7.5 percent on the debt, which has portions due in 2024 and 2036. For top earners, that equals a 12.4 percent rate on taxable securities. Benchmark 10-year Treasuries yield about 2.6 percent.

“There are some big investors in it,” said Justin Land, who helps manage $3 billion of munis at Naples, Florida-based Wasmer, Schroeder & Co. The company will look at the deal for its high-yield fund. “It can work, though like anything else in project finance, there are a lot of ways it can fail.”

Projects funded with unrated bonds are ramping up to meet the demand for speculative securities, which have grades at least 10 steps below AAA. Unrated bonds fall into the high-yield camp.

Investors next week can also buy debt for a senior-living facility called Rose Villa near Portland, Oregon, Bloomberg data show. The securities don’t have a rating.

By Brian Chappatta and Toluse Olorunnipa June 17, 2014

Tax increment financing (TIF) can be a powerful economic development tool. Under the right circumstances, TIF can generate enough funding to make a real difference. And with the right safeguards in place, TIF encourages government and the private sector to form a partnership based on each other’s strengths.

“Without TIF or other government programs, the only redevelopment will be for the rich, by the rich,” says Stephen B.Friedman, a consultant with decades of TIF experience in Illinois and Wisconsin and a member of ULI’s Public/Private Partnership Council. For neighborhoods in need, he continues, “TIF works because government looks the private sector in the eye and puts the public money where the private sector is also willing to put the private money. You have to have a meeting of the minds about what works for the community and for the developers.”

Built on a foundation of growing tax revenues, TIF is vulnerable to both national and local economic downturns. Indeed, as the Great Recession spread throughout the United States, TIF districts became weak at just the time they were needed most. Moreover, as local governments cut budgets to the bone, the revenue generated in TIF districts came under close examination. In states where both TIF and education spending depend heavily on revenue from property taxes, TIF’s impact on education became a frequent flashpoint for controversy.

“The recession caused the whole development finance industry to take a hard look at what they are doing,” says Toby Rittner, chief executive officer of the Council for Development Finance Agencies (CDFA). At one extreme,

California Governor Jerry Brown in 2011 ended TIF for redevelopment and ordered the special authorities that managed TIF revenues to close. But most cities and states shared the view of TIF held by Minnesota’s legislature, which expanded a diminished TIF program as part of a 2010 jobs bill.

The hard look produced changes. “We discovered that TIF has a lot of depth,” says Rittner. “Coupled with a comprehensive approach to economic development, it can be used for more than just infrastructure and traditional redevelopment activities, and it can leverage other financing tools.”

TIF originated in an act of policy creativity in California in 1952: federal dollars flowing to remedy what was then called urban blight required a local match. In the subsequent decades, every state in the United States except Arizona has experimented with TIF in one form or another—and then in another and another. As the federal dollars dried up in the 1970s and 1980s, TIF nourished redevelopment. TIF has been exported: pilot projects are underway in Scotland and ­England, with versions tailored to their tax regimes.

From the developer’s perspective, TIF is just one of many ways to partner with government to share the costs of development. From the government’s perspective, TIF’s distinctive feature is that it provides a means to access new tax revenues to support the creation of these same new revenues, and more. Public investment increases private property values, which increases property tax revenues. Those new revenues can be leveraged to pay for the improvements that attract the private investment, setting up a virtuous cycle of increasing development that pays for itself and increases the tax base.

In the United States, TIF is governed by state law, but implemented by municipal governments. Although this discussion refers to cities, TIF can also be implemented by county governments, economic development authorities, or other municipal governments.

The following hypothetical example illustrates the components of TIF.

River City’s economic development plan aims to transform the city’s vacant industrial waterfront into a mixed-use district of offices, retail space, and housing lining a linear waterfront park. River City designates a TIF district on the waterfront, with a duration of no more than 15 years. The property tax revenue generated by the district at the time of designation becomes the frozen base revenue. The base revenue continues to flow to government coffers as usual.

The “increment” is any property tax revenue generated above the frozen base. Provided there is a spark to stimulate it, the increment grows over time, generating funding to pay—directly or through borrowing—for public investments in the district. River City can create a spark by working with a private developer on a development proposal. The city issues bonds secured by the forecast increment—the increase in property tax revenue expected from the developer’s proposal—to pay for upfront development costs, whether borne by the developer, the government, or both. At the end of 15 years, the TIF district is dissolved and the increment returns to general tax revenues.

Diversity and Complexity

TIF interacts with tax regimes that differ by state. For revenue generation, TIF is most powerful in places with high property taxes. Because states with high property taxes often dedicate those revenues to education, TIF laws that allow access to the school district’s portion of the property tax increment can produce significant revenue. Although many states allow TIF to access retail sales taxes at a district level, sales taxes are relatively weak revenue generators.

Either the public or private sector can take the first step in initiating a TIF district. A community-driven TIF district “means the city is taking a proactive role and making policy decisions about priorities,” says Amanda Rhein, senior director for transit-oriented development at the Metropolitan Atlanta Rapid Transit Authority and a member of ULI’s Public/Private Partnership Council. A developer-driven TIF district, however, relieves the city of the need to court developers with an untested plan. A city’s policy culture may favor one approach, but many cities do both. Developers should expect development negotiations to be more intense if they are the ones initiating TIF discussions.

Today, depending on the state, TIF supports everything from expanding affordable housing to attracting manufacturers to industrial zones, including provisions for job training. In some states, TIF must be used solely for public projects, such as infrastructure; other states allow, and even encourage, TIF in support of private development costs, such as those for rehabilitating existing buildings or subsidizing the interest on loans for new construction.

TIF laws include what is known as a “but for” clause—a way of saying that private sector projects that would happen anyway, without support from the increment, are ineligible for the financing. Though a too-literal interpretation of the “but for” clause can unnecessarily restrict TIF’s economic development uses, “there has to be some way of assuring the public that the city is not just giving money away,” says Rachel Weber, TIF expert and associate professor of urban planning and policy at the University of Illinois at Chicago. “A city should be able to distinguish between ‘what is needed’ versus ‘what would be nice’ to fulfill its economic development goals.”

Cities have options on bearing investment risk. They may use the increment to secure bonds—especially useful for large, upfront development costs. They may also use what is called “pay-as-you-go” financing and expect the developer to secure the credit: the city participates by promising the developer a portion of the increment. Cities may also choose to fund, rather than finance, the endeavor, spending the accrued increment directly on the project.

Developers should not expect 100 percent of the increment to be available. Rittner advises cities to reserve some of the increment to pay administration expenses. Moreover, the amount of need—the financing gap for each project—typically dictates the portion of the increment awarded. In times of scarce private financing, the financing gap may be bigger than the city is able or willing to fill with TIF. Indeed, Rhein notes, “developers often cannot depend on TIF alone; they need to be creative about layering public sector programs—drawing on TIF, but also other tax credit and grant programs.”

Chicago

Shortly after Chicago Mayor Rahm Emanuel took office in 2011, he fulfilled a campaign promise by convening a TIF Reform Task Force. Advising on a program generating $500 million a year from 163 TIF districts comprising about 10 percent of the city’s property tax base and covering 30 percent of its land area, the task force focused on increasing transparency and accountability. Under Illinois law, over the 23-year life of a TIF district, as long as money is flowing into a district, the city can continue to initiate new projects, increasing the importance of an ongoing process for accountability. In addition to recommending aligning TIF with a multiyear economic development plan and capital budget, the task force advocated establishing metrics to monitor performance of the city’s TIF program.

Among the reforms, the city has inaugurated strategic reviews every five years and in July 2013 unveiled the public TIF Portal, a web mapping tool linked to each district and its associated projects. “The city is becoming smarter in how they give their money away and stricter in terms of financial audits and holding recipients accountable to their promises,” says Weber, a member of the task force. “The city has taken more of an investment mind-set to ensure they are not providing a huge windfall to the developer at the public’s expense.”

Political debate continues in Chicago, especially regarding education spending and whether TIF is still appropriate in the city’s central area, now in its second decade of strong development. “The city is a lot more reticent to do downtown projects,” Friedman observes. “The focus now is on the outer neighborhoods.” In addition, Emanuel in November 2013 issued an executive order requiring annual calculation of the “TIF surplus” that can be returned to the original taxing bodies, including Chicago Public Schools.

Atlanta

Atlanta’s TIF program, known as TAD (for tax allocation district) and run by Invest Atlanta, the city’s economic development authority, has also undergone changes. “The lull during the recession allowed us to reevaluate our program, use it to create jobs, and better align it with citywide economic development efforts,” says Rhein, who participated in Invest Atlanta’s strategic review in 2011.

Historically, Atlanta used TAD for gap financing, funding developers through grants that covered 5 to 15 percent of project costs via bonds backed by the increment. After the strategic review, Invest Atlanta expanded its project evaluation criteria to include job creation and business attraction. New types of projects include building retrofits, facade improvements, and streetscape enhancements. An energy efficiency grant program rewards participants in the federal government’s Better Buildings Challenge.

In Georgia, school districts and county governments join a city TAD at their discretion. School districts have opted to join half of Atlanta’s ten TADs. When school districts join, Rhein explains, “they negotiate something such as payments in lieu of taxes or a lump sum out of the bond issuance.”

In recent years, Atlanta has also begun using TAD funding for major infrastructure projects, such as the Atlanta BeltLine transit and economic development plan, and a downtown streetcar.

California

By terminating redevelopment authorities and their TIF powers, Brown sent a signal that the goal of compact, walkable development at infill locations—and needs such as affordable housing—will have to be met in new ways. Ongoing discussions throughout the state focus on how to replace what was lost with a comprehensive tool kit. ULI’s five district councils in California worked together on potential next steps, and in November 2013 released the report After Redevelopment: New Tools and Strategies to Promote Economic Development and Build Sustainable Communities.

“If California is going to continue to lead on sustainable development and meet the state’s growing needs for affordable housing and infrastructure investment, cities and counties require the authority, legal powers, and financing tools to encourage infill development,” explains Libby Seifel, head of the Seifel Consulting and a member of the ULI report’s working group. Although the governor recently announced support for expanding eligible projects in infrastructure financing districts (IFDs), which can use TIF, Seifel fears “that IFDs alone are too narrow and will not generate enough public investment unless leveraged with other funds. As the ULI report states, California needs a comprehensive set of tools to achieve the state’s environmental, housing, and economic goals.”

Best Practices

To get started on considering TIF, developers should learn the state’s TIF law and the city’s policy culture, and “understand the terms of the city’s boilerplate development agreement before initiating a request for participation,” advises Rhein.

Friedman advises developers to remember, as negotiations proceed, that TIF is “not an entitlement, it’s a gap filler. Be prepared for a complex set of negotiations, the expectation that you will open your business practices to scrutiny, and that a variety of public goals and values will be injected into your project.”

Because to foster a true public/private partnership, the CDFA recommends that the best practices of accountability, transparency, and due diligence apply equally to both partners. This is the best way to guarantee that TIF’s virtuous cycle is optimally achieved.

Sarah Jo Peterson is senior director, policy, at ULI.
Urban Land Magazine | Jun. 13, 2014

Fears that a $75 billion corner of the municipal bond market for Tender Option Bonds would be closed down by the Volcker Rule may have been squashed with a new deal from Bank of America Merrill Lynch. The tiny $8.545 million deal has been structured to comply with Volcker Rule restrictions by using two loopholes in the Investment Company Act of 1940.

BofA’s new Tender Option Bonds (TOB) creation has received Moody’s Aaa/VMIG imprimatur. If regulators approve the new structure, it could be a template to restart the dormant TOB market.

Here is an example of a general TOB structure from Nuveen. The Volcker Rule does not apply to Nuveen, but the TOB structure is roughly equivalent to all muniland issuers.

Bank of America and its investment arm Merrill Lynch have altered the way the TOB trust (green box in the chart above) is organized to satisfy Volcker Rule restrictions on a bank owning hedge funds or trusts.

Rather than being separate parties in a TOB, Merrill Lynch combined all the deal participants into a joint venture trust between BofA and the investors in the trust. This structure takes advantage of the joint venture exception in the 40 Act. Moody’s says:

Merrill Lynch’s transaction relies on the joint venture exemption from 40 Act registration. Unlike a typical TOB where Merrill Lynch would have acted as the issuer of the TOB trust, in the new structure, Merrill Lynch sold the bonds via a sale agreement to a joint venture trust. The joint venture agreement is between Bank of America, N.A. (A2/ P-1) as trustor and liquidity provider and the floating and inverse floating rate investors (the parties purchasing the interests in the joint venture).

BofA established the joint venture trust and Merrill Lynch sold the underlying bonds (State of Maryland General Obligation Bonds, State and Local Facilities Loan of 2013, First Series B Tax-Exempt Bonds due August 1, 2019 and the Cusip for the TOB is 46641N) into the trust.

The other parties in the joint venture trust will be money market and closed-end funds that buy the cash flow portions of the deal. The new structure limits the number of these outside parties in the trust to take advantage of another 40 Act registration exemption related to the number of parties in a trust (or hedge fund). Moody’s again:

The agreement limits participation to 10 parties. Joint ventures among 10 or fewer participants are exempt from registration under the 40 Act. TOBs structured as joint ventures do not fit the definition of hedge funds included in the Volcker Rule, making it possible for banks to sponsor and invest in them.

Here are the parties in the deal, according to Moody’s:

Liquidity provider and Trustor – Bank of America NA

Trustee – US Bank Trust NA

Venturers (that’s what they call it instead of “investors”) – to be determined but limited to 10

Remarketing agent – Merrill Lynch

This is muniland structured finance at its best. There are many other nuances to the deal that you can find in the Moody’s rating announcement. Stay tuned for reactions from regulators. Moody’s foresees current TOBs possibly altering its legal structure if the new BofA trust structure meets regulator approval.

By Cate Long JUNE 13, 2014

DETROIT—The city of Detroit has reached new agreements with its largest municipal union and a separate settlement with a group of bondholders, likely reducing the number of creditors to oppose the city’s bankruptcy plan at a trial scheduled for this summer.

Terms of the settlements weren’t immediately released.

The tentative labor agreements between the city and the American Federation of State, County and Municipal Employees Council 25 build on earlier agreements and cover almost all employees represented by the union. But the pacts still need to be ratified by the union’s membership by June 30, according to a statement from federal mediators Friday.

The union also agreed to support a larger debt-cutting plan by the city to make cuts to pension benefits as part of its plan to exit municipal bankruptcy. Those pension cuts, however, will be softened if the pension holders approve a complex plan relying on more than $800 million in outside funding from donors, foundations and the state of Michigan.

Pension holders “simply cannot risk the further serious reduction in pension, pay and job security if the Plan, and our collective bargaining agreements, are not approved,” AFSCME Council 25 President Al Garrett said in a statement, calling on his members to vote for the city’s bankruptcy plan.

The separate bondholders deal was worked out between Detroit’s emergency manager and two principals that either hold or insure the majority of limited-tax general obligation bonds issued by the city, according to a statement on Friday from the federal mediators in the bankruptcy case.

“The settlement recognizes the unique status and niche of LTGOs in the municipal finance market,” the mediators said. “The insurer of the LTGOs has made clear it will honor its insurance commitments on the existing policies.”

Several bondholder groups declined to comment. But one confirmed a deal had been reached.

“Given Detroit’s unique circumstances, Ambac has accepted a settlement with the City for the limited tax general obligation bonds,” the company said Friday. “Ambac’s net par exposure related to Detroit’s limited tax general obligation bonds was $92.7 million as of March 31, 2014. We expect to continue to pay claims of scheduled principal and interest on the bonds insured by Ambac.”

According to the latest version of the city’s debt-cutting plan filed in April, the city of Detroit owed about $547 million in principal and interest on these LTGO bonds.

Compared with unlimited-tax general obligations bonds, these limited-tax bonds aren’t usually backed by a specific tax-revenue stream, prompting the city to argue that it could offer a much lower payout for those bondholders in bankruptcy. But bondholders opposed the cut as unfair, warning it could roil the municipal-bond market in Michigan and potentially drive up borrowing costs for municipalities.

Detroit’s plan to exit bankruptcy—the nation’s largest Chapter 9 case with an estimated $18 billion in long-term obligations—originally called for a different treatment for the city’s bondholders. Unlimited-tax general obligation bondholders who reached an agreement with the city in April are to receive about 74 cents on the dollar in recovery on their claim under the plan. But limited tax general obligation bondholders who were still at odds with the city would only get between 10 to 13 cents on the dollar.

It was unclear on Friday whether the agreement would boost the recovery for these bondholders and by how much.

The mediation team, led by U.S. District Judge Gerald Rosen, added that “with this settlement, only a few remaining, albeit significant, disputes remain” between the city and its creditors. A trial has been scheduled for mid-August on the merits of the city’s debt-cutting plan.

A spokesman for Detroit Emergency Manager Kevyn Orr said he didn’t have an immediate comment about the deal, which mediators said was still being completed.

By MATTHEW DOLAN
Updated June 13, 2014 6:29 p.m. ET

Write to Matthew Dolan at [email protected]

President Obama recently signed into law the Water Resources and Reform Development Act of 2014 (WRRDA). The statute begins to address ways to fund the billions of dollars necessary to update the country’s drinking water systems, dam infrastructure, levees, solid waste, wastewater, inland waterways, and ports. The legislation could lead to more widespread financing of water infrastructure projects through P3s.

Continue Reading.

June 13, 2014

by Brian Walsh, William C. Rhodes, Lee A. Storey, Steve T. Park, and Christopher R. Sullivan

Read the Brief.

East Dundee appealed its dismissed lawsuit against Carpentersville and Wal-Mart to the Illinois Supreme Court this week. The retailer has announced plans to close its East Dundee store, above, and build a supercenter in neighboring Carpentersville.

East Dundee didn’t waste time taking legal action against Carpentersville to stop Wal-Mart’s pending move to the neighboring village.

East Dundee appealed its dismissed case versus the village and Wal-Mart to the Illinois Supreme Court, less than 24 hours after Carpentersville officials reviewed Wal-Mart’s draft application for financial assistance.

Wal-Mart, slated to build a supercenter at Lake Marian Road and Route 25, seeks $4.3 million from a tax increment finance district that encompasses its future location in Carpentersville. If Carpentersville doesn’t come through with the money, Wal-Mart won’t build there, according to the draft application.

East Dundee argues the retailer should not receive funding from a TIF district because the new site is three miles from the East Dundee store, which is also in a TIF district. State law mandates a distance of at least 10 miles to stop communities from poaching businesses from each other.

While the Carpentersville village board isn’t due to vote on Wal-Mart’s redevelopment agreement until late summer, East Dundee would rather strike now, Village President Lael Miller said.

“They may actually start doing some work prior to (Carpentersville’s vote), we don’t know.” Miller said. “We anticipate we’ll move forward with this and we’ll take our chances.”

History isn’t on East Dundee’s side, and the latest appeal marks the village’s fourth attempt at blocking Wal-Mart from leaving.

In February 2013 a judge denied East Dundee’s move for a temporary restraining order and threw out a lawsuit aimed at preventing Wal-Mart from receiving funding from the Carpentersville TIF district.

Six months later, Kane County Judge David Akemann dismissed the lawsuit against the world’s largest retailer and Carpentersville, saying East Dundee had no standing in the case because TIF money had not yet changed hands.

East Dundee appealed that decision in April and the Illinois Appellate Court Second District sided with Akemann when it dismissed the case.

Carpentersville Village President Ed Ritter isn’t concerned about East Dundee’s latest filing and expects Wal-Mart to go on as scheduled.

“We’re very confident that Wal-Mart will be open in Carpentersville before the end of 2016,” Ritter said.

In 2012, Wal-Mart announced it would close its 23-year-old store in East Dundee to build in Carpentersville.

The departure means East Dundee would lose about $850,000 in annual revenues from Wal-Mart. Miller estimates the village has spent about $83,000 in legal fees since the litigation began 17 months ago.

But it made more than $1.2 million from Wal-Mart in the same time frame, he said.

“Yes we did spend money but obviously we made more money in the meantime as well,” Miller said.

By Lenore T. Adkins

An Atlanta bond issue to help finance a new stadium for the National Football League’s Falcons is being challenged before the Georgia Supreme Court over claims it violates the state’s constitution.

Home Depot Inc. co-founder Arthur Blank, who owns the Falcons, is getting help from the city to build a $1.2 billion football stadium to replace the Georgia Dome, which opened in 1992. The new site’s neighbors, who failed to persuade a state judge to invalidate the city bond issue of as much as $278 million, have appealed that decision to the state’s top court. They argue the city hotel tax to pay for the bonds is unconstitutional.

Superior Court Judge Ural Glanville in Atlanta last month validated the bonds and overruled all objections. Glanville found that the security for the bonds was “sound, feasible and reasonable,” and the stadium project met public purposes guidelines.

The neighbors’ appeal filed June 5, “delays the issuance of the bonds until final resolution” by the Georgia Supreme Court, John Woodham, the objectors’ attorney, said in an e-mail today. This would delay the city of Atlanta’s “public financing component” of the stadium project during that time, he said.

Construction of the stadium will proceed, Douglass Selby, an attorney for the city, said yesterday in a phone interview. While the bonds won’t be issued until the appeal is resolved, the city sought validation of the bonds early to accommodate any objections or appeals, he said.

Although the stadium will be state-owned through the Georgia World Congress Center Authority, the Falcons will operate it and keep stadium revenue under a licensing agreement. Jennifer LeMaster, a spokeswoman for the World Congress Center Authority, didn’t immediately return a call after regular business hours yesterday seeking comment on the case.

The Atlanta Falcons won’t comment on the bond issue because the team isn’t a party to the proceedings, Kim Shreckengost, a spokeswoman for AMB Group LLC, the Falcons’ parent company, said yesterday in an e-mail.

“We do have full confidence that our partners at the city, Invest Atlanta and the GWCCA will appropriately handle these challenges,” she said. “Construction of the new stadium has been under way for several months and we will continue to move forward.”

Neighborhoods Burdened

Neighborhood critics say the city-adopted plan unfairly burdens residents of two predominantly black neighborhoods. A group of community leaders, including three activists and a retired Baptist minister, won a court ruling in February allowing them to intervene in the city’s bond process.

The residents’ legal argument hinged on the claim that extending the city’s hotel tax to repay the bonds unconstitutionally turns a general law, applicable statewide, into one governing a single project. The city said in court filings that the bonds are authorized by state law and the plan’s use of 39 percent of the hotel tax is appropriate.

Glanville found no merit in the objectors’ arguments. Georgia law requires court approval before government general-obligation revenue bonds can be issued.

The case is Georgia v. Atlanta Development Authority, 2014-cv-242035, Superior Court, Fulton County (Atlanta).

By Margaret Cronin Fisk June 11, 2014

To contact the reporter on this story: Margaret Cronin Fisk in Detroit at [email protected]

To contact the editors responsible for this story: Michael Hytha at [email protected] Joe Schneider

The Kentucky Retirement System is appealing a judge’s decision that allowed one of the employers in its membership to abandon the underfunded system as part of its bankruptcy restructuring.

A federal judge ruled on May 30 that Seven Counties Services, a health services provider, could leave the pension system because it qualified as a nonprofit corporation rather than a government entity.

Citing the 1963 federal Community Health Act, which was designed to begin the privatization of mental health services, the opinion said that Seven Counties was a result of the “metamorphosis from state-run mental health services to a community-based, private non-profit structure.” The ruling could clear the way for other similarly financially strapped institutions across the state to do the same. The state has a total of 13 community mental health centers that could qualify as nonprofits and opt to leave the system.

The retirement system’s board of trustees voted 12-0 on June 11 in a closed-door meeting to appeal the ruling. State lawmakers and Gov. Steve Beshear had publicly urged the board to do so in the weeks before the meeting.

Kentucky has the worst-funded retirement system in the country, holding roughly 23 percent of the money it has promised to pay its current workers and retirees in retirement benefits. That means the state system, not including police and fire employees and teachers, has roughly $8.7 billion in unfunded liabilities, according to the most recent actuarial report. About $91 million of that is attributed to Seven Counties and the retirement system would have to cover that cost if the agency is actually allowed to exit.

Some have said covering that $8.7 billion would drive up what state government employers across the state would have to put in annually to the pension fund to keep it solvent. By some estimates, governments would collectively spend more than 38 percent of their payroll costs next year on retiree payments alone. That’s up from 5.9 percent in 2006.

Jim Carroll, co-founder of the 3,600-member Facebook group Kentucky Government Retirees, said his group is “gratified” that the retirement board has voted to appeal the Seven Counties Services bankruptcy ruling. “As stakeholders, we are pleased that the board had moved to protect the long-term viability of the financially troubled [retirement] fund,” he said in an emailed statement.

But others are more skeptical, saying the state retirement system was already in a “death spiral” before the bankruptcy ruling. Chris Tobe, a Louisville-area pension investment consultant, noted that state employer contributions into the pension fund this year have collectively been only about half of what is actuarially recommended. That means the 23 percent funded ratio will likely sink lower after this year.

“The appeal is a desperate measure to try to prevent any of the other 12 mental health agencies from jumping ship,” Tobe said.

BY LIZ FARMER | JUNE 12, 2014

A new brief from the University of Washington’s Center for Education Data & Research analyses the state’s teacher pension system, which has offered new enrollees a choice between a traditional plan or a hybrid plan since 1996. As other states consider similar changes to traditional pension plans, the paper notes that Washington provides a look into what could happen.

The paper finds that the “state’s financial exposure is significantly lower under the hybrid plan” as its per-teacher pension liability is approximately half as large as under the traditional plan. Interestingly, when given a choice, at least six in 10 teachers (statistics vary by year) choose the hybrid plan, the paper says. This runs counter to claims by traditional pension supporters that the defined benefit plans are more attractive and therefore better for recruiting talent.

Additionally, teachers may obtain more money under the state’s hybrid-plan. “In calculating potential retirement wealth accumulations under [the hybrid plans],” the authors note,”we find that teachers enrolled in Washington’s hybrid plan are likely to have a level of retirement security that is comparable or greater than that provided by the traditional plan.” The paper concludes that Washington State’s experience “suggests that teacher pension systems can be reformed in a way that is attractive to both teachers and states and ensures that significant resources are being set aside for teacher retirements.”

The fiscal rebound of Pittsburgh, the former steel-city capital that shed a Rust-Belt fate by rebuilding its economy around universities and hospitals, has struck an obstacle that’s bedeviling municipalities nationwide.

Pennsylvania’s second-most-populous city faces an operating deficit next year for the first time since 2005, partly because of higher pension contributions after officials lowered assumptions for the retirement system’s investment returns.

Pittsburgh faces a month-end deadline to approve a plan to plug the shortfall, illustrating how even municipalities that have dodged bankruptcy struggle with pension burdens. The city, which teetered on the brink of insolvency a decade ago, earned its highest rating ever from Standard & Poor’s in February.

“We’ve come a long way; we see the light at the end of the tunnel,” said Michael Lamb, the city’s controller. “We have put more money in pensions than we’re required to, but we’re still not doing enough.”

Lower Target

In December, Pittsburgh decided to lower its pension-return target — adding $8 million to annual costs — to fall in line with national trends, according to consultants hired by the state to oversee the city’s recovery. The average assumed return rate last year for 150 U.S. public plans was 7.66 percent, compared with 8.08 percent in 2001, according to the Center for Retirement Research at Boston College.

More municipalities will lower targets as rating companies factor retirement liabilities into credit assessments, said Howard Cure, head of municipal research in New York at Evercore Wealth Management LLC, which oversees about $5.2 billion.

Pittsburgh has evolved from its industrial past, when plants producing coke used in steel-making would shower parked cars with ash. As manufacturing dwindled amid global competition, residents left. About 306,000 people live in the city at the confluence of the Ohio, Allegheny and Monongahela rivers, compared with about 604,000 in 1960.

By 2003, Pittsburgh was in crisis. It cut about 13 percent of its workforce that year, firing 446 employees, including almost 100 police officers. It also earned the dubious distinction of having the lowest credit rating of any major U.S. city. Pennsylvania officials placed it in the Act 47 program for distressed communities in December 2003, giving the state oversight over its finances and requiring recovery plans.

Turnaround Time

Since then, city officials have turned around Pittsburgh’s finances through steps such as taxing companies’ payrolls and temporarily freezing wages, said Dean Kaplan, a managing director at Public Financial Management Inc., one of the state-appointed consultants.

In a sign of the diversifying economy, U.S. Steel Corp. (X), which has been based in Pittsburgh since 1937, no longer ranks among the top 10 employers. The biggest is the University of Pittsburgh Medical Center, and the city is also home to companies such as PNC Financial Services Group (PNC) and H.J. Heinz Co.

In November 2012, the state’s consultants said Pittsburgh was ready to exit the distressed program. Revenue had exceeded operating expenses every year since 2005, although transfers to pay debt and pensions in 2008 and 2010 generated shortfalls approved by the city’s fiscal overseers. State officials rejected the consultants’ recommendation in March, saying legacy costs such as pensions jeopardize the budget.

Deficit Ahead

That caution was borne out in the recovery plan consultants released last month in response to the state’s denial. The city faces a projected $14 million operating deficit in the year beginning in January and may use up its reserves by 2018, the report said.

The city’s change in how it levies real estate taxes curbed revenue, Kaplan said. At the same time, minimum pension contributions will jump to $43 million next year, or 8.6 percent of the general-fund budget, from $31 million, or 6.5 percent of this year’s plan. The swelling costs resulted from adjusting actuarial assumptions to reflect recipients’ longer life expectancy, and from lowering the target investment return on pension assets to 7.5 percent from 8 percent, Kaplan said.

Pay Up

The state’s consultants said the city should pay even more than required amounts over the next five years to sustain its pension system, which serves about 7,500 people and is about 58 percent funded. The average state and local plan had about 72 percent of the money needed to meet retirement obligations last year, the Center for Retirement Research said. In 2010, the city avoided a state takeover of its pensions by dedicating parking revenue through 2041 to the system.

The five-year road map recommends raising real-estate taxes and parking rates. Mayor Bill Peduto, a Democrat, wants to avoid the increases, and to do so, “all options are on the table,” said a spokesman, Tim McNulty, who declined to offer specifics. Officials have planned a public hearing on the consultants’ proposal for June 16, he said.

Kaplan said the city, which last sold municipal bonds in 2012, must also invest in roads and bridges. The consultants’ blueprint calls for selling $50 million of bonds in 2015 and again in 2017 for infrastructure.

Officials “are not going to have a hard time placing it” because of the city’s progress during the past decade, said Dennis Derby, who helps manage munis, including Pittsburgh debt, at Wells Capital Management in Menomonee Falls, Wisconsin.

S&P raised Pittsburgh’s rating in February to A+, its fifth-highest level, citing its diverse economy.

Pittsburgh general-obligation bonds maturing in September 2021 traded June 6 at an average yield of 2.4 percent, the lowest in 14 months and 0.52 percentage point above benchmark munis, data compiled by Bloomberg show.

By Romy Varghese Jun 12, 2014

To contact the reporter on this story: Romy Varghese in Philadelphia at [email protected]

To contact the editors responsible for this story: Stephen Merelman at [email protected] Mark Tannenbaum, Alan Goldstein

(Reuters) – A scarcity of new paper in the U.S. municipal bond market helped New York City borrow more at lower rates on Wednesday, in its first bond deal since Mayor Bill de Blasio’s multibillion-dollar accord with labor unions in May.

Critics said they expected investors to shy away from the city’s debt because of the new mayor’s liberal, big-ticket policies. But the city suffered no blowback in this sale, at least in part because of technical market factors, including low yields and tight supply.

New York increased the size of the deal to $1.02 billion from a planned $850 million offering of general obligation refunding bonds.

In the longest maturity, 2034, the city was able to borrow at a yield of 3.87 percent – 30 basis points lower than it did in March, when the same maturity sold with a 4.17 percent yield, according to the Mayor’s Office of Management and Budget.

Morgan Stanley was the senior manager on the negotiated deal, which had a two-day retail order period beginning on Monday resulting in about $203 million of retail orders.

The deal priced for institutional investors on Wednesday, when the size of the offering was increased, the OMB said.

Some analysts sounded a note of alarm on the city’s finances and creditworthiness after de Blasio reached an agreement with teachers, who had gone for years without a contract under former Mayor Michael Bloomberg.

De Blasio’s labor deal could cost the city close to $20 billion through 2021, not including healthcare savings, when applied to all city workers. It has helped create budget gaps of $2.2 billion to $3.2 billion from 2016 to 2018, according to the city’s estimates.

(Reporting by Hilary Russ; Editing by Jonathan Oatis)

For the first five months of 2014, Standard & Poor’s Ratings Services rated $3.365 billion of catastrophe bonds (cat bonds). Included in this total is the largest cat bond issued to date, from Everglades Re (please see Everglades Re Ltd., published May 2, 2014, on RatingsDirect). Since 1999, we have rated more than $53 billion of cat bonds. Cat bonds have and continue to attract capital from new investors. Risk spreads continue to decrease as capital inflows increase. U.S. hurricanes remain the dominant exposure as all but $300 million of 2014’s rated issuance covers losses from this peril. For the first time, we rated a cat bond providing indemnified coverage for losses from typhoons in Japan (see Aozora Re Ltd., published May 30, 2014).

Frequently Asked Questions

Which office will rate a transaction and how does that affect the rating?

We have seven analysts in the U.S and U.K. that can be the lead analyst on a cat bond issuance. Typically, the office that rates a transaction will be the same as the office of the insurance company analyst. For example, Swiss Reinsurance Co. has global exposure, but because Swiss Re’s lead company analyst is located in the U.K., a cat bond it sponsored would be rated by a Standard & Poor’s U.K. analyst. This is irrespective of the covered peril. A U.K. or U.S. analyst can rate a bond covering losses from hurricanes in the U.S., earthquakes in Japan, or windstorms in Europe. For bonds sponsored by companies where the company analyst is not located in the U.K. or U.S., the analyst of a cat bond could be in either the U.S. or U.K., depending on availability.

The applicable criteria for this asset class does not differ between offices. In almost all cases, analysts from the U.S. and U.K. will participate in a rating committee for a cat bond. Our goal is to apply the criteria consistently regardless of the office or analyst, achieving a similar outcome in every case.

How long does the rating process take?

The time it takes to rate a cat bond generally ranges from three to five weeks, and much of this time overlaps the marketing period of a transaction. The periods are general ranges but the time frame can be shortened if the issuing parties are familiar with the process. We have had a couple of transactions that needed to be completed in a limited period where the 17g5 website was set up in two or three days, the requisite information was promptly posted, and we were able to complete our review and assign a final rating within two weeks.

The ratings on cat bonds are subject to SEC regulation 17g5. Before we begin the analytical process, an engagement letter must be in place between Standard & Poor’s and the arranger, following which a secure website must be set up to allow for controlled and confidential sharing of documentation between the deal counterparties and the designated rating agency. Only when a sufficient level of documentation is uploaded to the secure website can ratings analysis commence. This process to establish a secure website and have sufficient levels of documentation made available typically takes between two and three weeks. As issuers have become familiarized with the process, the time it takes to establish the website has been decreasing.

The typical process is for the underwriters to announce and market a transaction with a preliminary rating and we will assign a final rating by the closing date.

Once we begin the analytical review, we can typically assign a preliminary rating within two to three weeks. The preliminary rating typically involves review of the insurance risk being transferred via the cat bond. If the cat bond has a unique feature (e.g., the attachment point is based on indemnified losses versus previous issues, has a parametric trigger, or the attachment point was based on industry losses or covers a new peril such as flood), it could take more time for us to assign a preliminary rating.

Because cat bonds are subject to 17g5, all information needs to be posted to the transaction’s website. We will post any queries to the website as well. If there is a delay in posting information or a response, the time it takes to assign a rating could increase.

The review of the transaction documents takes a similar amount of time (two to three weeks), assuming receipt of blacklined (versus a transaction rated by Standard & Poor’s) documents and opinions. The document review is completed with the assistance of Structured Finance analysts to determine if our criteria related to special-purpose vehicles has been met.

Much of the information posted to the 17g5 website for our review is the same as that posted to the investor website.

Please note that all timings are indicative and the actual timing could vary depending on the specific characteristics of each transaction.

What information do you require to rate a natural peril catastrophe bond?

We usually request the following information:

• The risk analysis results from the modeling company including the full aggregate exceedance probability or occurrence exceedance probability curves–whichever is applicable for a given transaction;
• The Offering Circular and the Offering Circular Supplement, if applicable;
• The Risk Analysis prepared by the risk modeling firm to the extent it is not included in the Offering Circular (or supplement);
• All underlying transaction documents (e.g., indenture, series supplement, deed of charge, trust agreement, servicer agreements);
• Legal opinions.

For indemnity deals, we request:

• Information about the underwriting process, the loss-estimation procedures, and the claims settlement processes;
• Information about the data used to generate the modeled results (both in terms of quality and completeness).
• Depending on the specific characteristic of the transaction we might request further information.

What criteria do you use to rate catastrophe bonds?

The applicable criteria is Rating Natural Peril Catastrophe Bonds: Methodology And Assumptions, which was published Dec. 18, 2013, on RatingsDirect. The article sets forth the analytical process of rating cat bonds. The following is a brief synopsis of the process.

For bonds that have a robust legal structure, our rating is the weak-link (lowest) of three factors (see Assessing Credit Quality By The Weakest Link, published Feb. 13, 2012) subject to ratings caps.

These factors are:

• Our estimate, expressed in symbols from ‘aaa’ to ‘cc’, of the likelihood of either a reduction in the bond’s principal amount or a reduction in the bond’s coupon due to the occurrence of a covered event or events;
• Our rating on the ceding company;
• The collateral risk, based on how the proceeds from the issuance are invested.

Will Standard & Poor’s rate a deal in which a company uses its own model?

As set forth in our criteria, we would likely not rate a natural catastrophe bond that used a model generated by a ceding company. However, it is possible for us to rate a transaction where the ceding company did its own modeling using a model from either Risk Management Solutions Inc., EQECAT Inc., or AIR Worldwide Corp. However, this would increase the length of our review because we would have to review each adjustment and assumption made by the ceding company that differed from those that would have been used by the modeling firm, and be comfortable that they have the requisite experience to run the model and complete tasks typically performed by the modeling firm.

How does Standard & Poor’s incorporate property catastrophe risk and cat bonds quantitatively in its credit analysis?

Our capital model uses a company’s catastrophe-modeled exposures–the exceedance probability curve. We incorporate a tax-adjusted aggregate one-in-250-year property-line-only probable maximum loss (PML) catastrophe capital charge, net of reinsurance and other forms of mitigants (e.g., catastrophe bonds), and net of reinstatement premiums. The PML should also capture the impact of investments in catastrophe bonds. Unless a rating committee believes there is basis risk inherent in the cat bond, the company will typically receive full credit for reinsurance when determining its one-in-250-year property-line-only PML.

There are two premium adjustments. First, we remove risk charges related to catastrophe premiums (or the catastrophe load) to prevent double-counting catastrophe risk. In the absence of catastrophe loading provided by the (re)insurer, we assume a reduction in premium risk charges based on the company’s risk profile. The second adjustment is to reduce the net aggregate one-in-250-year modeled loss by 70% of the associated net property catastrophe premiums written (to account for a 30% expense ratio). We make this adjustment because the catastrophe losses would typically relate to current premium writings that reduce the impact of the loss.

This charge is also net of any applicable tax relief because tax-paying (re)insurers receive an income tax benefit from catastrophe losses that mitigates the potential capital impact. To tax-adjust the output, we use the company’s effective tax rate. We use the one-in-250-year charge across all rating levels in our capital analysis. In other words, the charge is not scaled for various rating levels. Furthermore, we apply the net aggregate PML property catastrophe charge-based one-in-250-year return period to all rated insurers and reinsurers globally.

Does Standard & Poor’s have to maintain an interactive rating on a cedant?

No. Paragraphs 64-68 of the criteria address this question. Examples of cat bonds we’ve rated but do not have an interactive rating on the cedant are Metrocat Re (Metropolitan Transportation Authority), Embarcadero Re (California Earthquake Authority), and Tar Heel Re (North Carolina Joint Underwriting Association & North Carolina Insurance Underwriting Association).

When does Standard & Poor’s publish its ratings?

We publish a presale article for the preliminary rating and a closing article for the final rating. We publish a presale after a transaction is announced, and publish a closing article after the transaction closes. A rating letter is issued only for a final rating.

Under Standard & Poor’s policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

Primary Credit Analyst: Gary Martucci, New York (1) 212-438-7217;
[email protected]
Secondary Contact: Maren Josefs, London (44) 20-7176-7050;
[email protected]

The New York offices of BlackRock, the giant fund manager, crackle with the energy of money. BlackRock is the largest fund complex in muniland, with over $100 billion in municipal fund assets along with undisclosed amounts of separately-managed accounts that hold municipal bonds.

Peter Hayes leads the BlackRock Municipal Bonds Group. He is also a member of the Americas Fixed Income Executive Team and BlackRock’s Global Operating Committee. Hayes is muniland’s biggest kahuna. When he and his team talk, people listen.

Hayes, BlackRock’s head of municipal credit research Jim Schwartz and head muni strategist Sean Carney hosted reporters for a discussion last week.

Hayes said that muniland was oversold at the end of 2013. Now he is seeing a bigger crossover presence chasing yield. Crossover refers to non-traditional buyers who don’t use the municipal tax exemption.

Tax hikes on high income earners have helped produce steady muni fund inflows since January 15, according to Hayes. BlackRock has also had good growth in separately managed accounts (SMA). Muniland issuance is down 25 percent in 2014. Relative value is lower than the pre-crisis level, and Hayes says we may be in this environment for the duration of 2014. It is the strongest technical environment in some time, says Hayes.

Before its downgrade to junk status, Puerto Rico was 10 percent of high-yield indices. Now it is about 22 percent, says Carney. There is a significant amount of zero coupon bonds that skew the indices. Hayes says that Puerto Rico bought about a year’s liquidity with the March $3.5 general obligation (GOs) offering. If there is a debt moratorium, it will ripple through all the Puerto Rico credits.

All three are uniform in their concerns about state tax revenues. Schwartz is closely watching Puerto Rico, Detroit, the Illinois budget negotiations and Connecticut, which has high debt. Overall in the U.S., state sales tax revenues were up only 1 percent year over year. Personal income taxes were down 0.5 percent, which was anticipated after personal gains were loaded in 2013 due to federal tax changes.

Schwartz believes that Detroit could have mediated COPs outside of bankruptcy and saved $100 million of legal fees. There has been no definitive legal decision on GOs in Detroit. He said the Illinois legislature had some fictitious budget numbers and that the state’s payables would go up from $5 to $10 billion again as a way to manage revenue shortfalls.

Schwartz echoed a statement made by Hayes about Puerto Rico buying time, but not fixing its problems. Puerto Rico now provides too much information and needs to be better organized. PREPA, the electricity monopoly, is the first issue that needs to be addressed. My sense is that Blackrock is keenly interested in buying Puerto Rico bonds when the situation stabilizes, but there are too many unknowns to do so now.

Small rural hospital issuers may have a rough year, says Schwartz. The new healthcare act is drawing revenues away from them. Nevertheless, demand for new bonds is so strong that a recent $60 million Texas hospital deal has $1 billion of orders.

Chapter 9 cases are another variable in muniland that have left a lot of uncertainty about general obligation bonds. You don’t know where you stand until you get in front of a specific judge, says Schwartz. Dealing with different underlying state laws and constitutions makes these situations more complex.

Hayes mentioned taking a recent driving tour of New York City and was astonished at how much residential building was happening and how helpful that will be for the city’s tax base.

Overall, the duration of muniland is down to 15.3 years from 16.3 years in 2013. This is due to shrinking issuance.

BlackRock has been buying MCDX municipal credit default indexes to hedge portfolio risk, but very few single names (credit default swaps that insure against default for a single entity like California or New York City). The MCDX indices have been more liquid since Puerto Rico brought its March GO deal because hedge funds have been more active players in muni credit default swaps.

BlackRock has also been buying in the secondary market where possible. The company changed the mandate of its intermediate municipal mutual fund to allow the purchase of taxable (corporate) bonds. The fund now has about 3 percent corporate bonds.

Hayes said that it is hard to see outflows beginning again unless interest rates go up or investors start taking gains. Muniland has gotten so rich, it is hard to sustain these high-fund inflow levels.

By Cate Long

JUNE 9, 2014

Two recent important developments in Congress illustrate the opportunities, and limits, in financing infrastructure projects in today’s Washington. First, the House of Representatives and the Senate, by overwhelming margins, agreed to a conference report ironing out the differences on H.R. 3080, the Water Resources Reform and Development Act of 2014 (“WRRDA”), which pays for navigation, dredging, and flood protection projects throughout the country. The legislation heads to the President’s desk for his expected signature. Second, the Senate Environment and Public Works Committee unanimously approved legislation reauthorizing the nation’s surface transportation program S. 2322, the MAP-21 Reauthorization Act. However, the circumstances behind each bill are not the same: the Harbor Maintenance Trust Fund (“HMTF”), which funds water projects, has a surplus of more than $8 billion. Meanwhile, the Highway Trust Fund (“HTF”), which funds highway and mass transit projects, is almost insolvent. The funding disparities between the two indicate the challenges in providing infrastructure funding in today’s Washington.

$5.4 billion to pay for 34 water projects through Fiscal Year 2019.

According to the Congressional Budget Office, WRRDA authorizes $5.4 billion for water projects, which includes 34 projects, through Fiscal Year 2019. The key, in this era of no congressional earmarking, is that funds must go to water infrastructure projects that have (1) a completed report by the Army Corps that indicates that the project is in the federal interest, and (2) a completed environmental impact statement (section 1005(a)). As we noted previously, the HMTF is supported entirely by user-fees, yet sees half of its revenue diverted from port projects to support the federal government’s activities. Section 2101(b) of WRRDA addresses this by requiring all trust funds to be used for water projects by Fiscal Year 2025, leading to a large supply of funds for water projects.

But what about highways and mass transit?

Compare the relatively easy passage of WRRDA with the reauthorization of the nation’s transportation infrastructure program. Bridge, highway and mass transit projects are financed federally by the HTF, which itself is funded primarily by the 18 cent gasoline tax. Unfortunately, the Department of Transportation estimates the HTF will face a shortfall before the end of this fiscal year: gas tax revenue has fallen, requiring transfers from the general fund (i.e., the United States taxpayer), with the latest being a $9.7 billion transfer shortly after the start of FY 2014. However, the balance has continued to drop. The DOT notes “as of April 25, 2014, the Highway Account cash balance was $8.7 billion,” which will likely require another cash infusion before September 30. The MAP-21 Reauthorization Act would reauthorize surface transportation projects for six years at the baseline level established by the CBO, which is equal to current funding plus inflation. Even that amount is unsustainable, without new funding to the HTF. Nor is it enough to address the nation’s infrastructure deficit, as noted by the American Society of Civil Engineers and others. Before the MAP-21 Reauthorization Act can become law, Congress will have decide whether additional transfers from the general fund are required or whether a long-term funding mechanism is possible.

The likelihood of Congress making any decision on raising revenue seems unlikely, given the pending midterm elections. What is more likely is that Congress, failing to pass any legislation on transportation funding, waits until the 114th Congress convenes in 2014 to start anew.

Last Updated: May 29 2014
Article by Christopher L. Rissetto and Robert Helland
Reed Smith

(Reuters) – The amount of outstanding U.S. municipal bonds continued shrinking in the first quarter to $3.661 trillion from $3.671 trillion in the final quarter of 2013, Federal Reserve data released on Thursday showed.

Households, the backbone of the market, held $1.604 trillion bonds in the first quarter, compared to $1.626 trillion the quarter before and $1.676 trillion in the first quarter of 2013.

The Federal Reserve does not seasonally adjust the levels of outstanding debt, but does seasonally adjust the flow of the funds data. That data shows households shed $110.9 billion bonds in the first quarter. Banks, however, acquired $36.2 billion and mutual funds $28.8 billion in the quarter.

(Reporting By Lisa Lambert; Editing by Meredith Mazzilli)

U.S. housing finance agencies (HFAs) have filled a role as financiers of affordable single-family homeownership since the early 1970s. Traditionally, they did this by purchasing loans from lenders using proceeds from tax-exempt municipal bonds they issued. Because the interest rate on the bonds was typically lower than that on taxable debt, HFAs held an advantage over other loan financiers as long as the loan was for a first-time homebuyer and conformed to other qualifications regarding the borrower and the property.

The benefit of tax-exempt financing has disappeared since the financial crisis, to which the Federal Reserve responded in part by keeping market mortgage rates low. Standard & Poor’s Ratings Services surveyed 32 HFAs in September 2013 about their experience with and thoughts on low interest rates. At the time, the rate on a 30-year fixed rate mortgage was 4.57%, according to Freddie Mac. Eighty-one percent of the HFAs responded that higher mortgage rates would be a benefit, but rates have fallen even lower, to 4.14% currently.

(Watch the related CreditMatters TV segment title, “Innovative Single-Family Home Financing And Stable Loan Performance Continue To Shape U.S. Housing Finance Agencies,” dated June 6, 2014.)

HFAs Respond With Various Ways Of Financing Loans

HFAs have adjusted to the new normal of low mortgage rates by financing loans without issuing bonds. Our survey, answered by 33 HFAs, shows that HFAs financed 89% of the dollar amount of loans ($8.1 billion total) that they did in 2008 ($9.2 billion total) despite issuing 61% fewer mortgage revenue bonds (MRBs) in 2013 than in 2008. So, while lower interest rates have hindered HFAs’ ability to meet their objective, the impact hasn’t been as great as one might expect. On the debt side, HFAs financed only $3.3 billion of loans with bonds in 2013 compared with $8.4 billion in 2008.

HFAs filled the gap with various financing techniques, primarily the sale of mortgage-backed securities (MBS) with backing from Ginnie Mae or Fannie Mae. HFAs originate the loans in an MBS sale, but instead of warehousing them for a bond program, they package the loans into MBS and sell them on the “to-be-announced” (TBA) market, which is not limited to tax-exempt investors and avoids the problem of issuing bonds with the possibility of declining mortgage rates before the loans are purchased. The sale price typically includes a premium from buyers looking for a security that provides moderate yield with high credit quality. TBA sales surpassed MRB financing in 2012 and remain the most prevalent form of loan origination, with $3.6 billion in 2013, up from just $214 million in 2008. In six years, MBS sales went from the least-used loan origination method to the most common, increasing by 1,695% in par amount. Other loan-origination techniques that have supplanted MRBs are sales of non-MBS loans, which rose to about $800 million in 2013 compared with $235 million in 2008, and direct purchase loan participations, which increased to more than $400 million in 2013 from $300 million in 2008 but have slipped to fourth position in 2013 compared with second place in 2008.

These trends are in step with the responses from our 2013 survey. Forty-four percent of HFAs reported that they had sold MBS on the TBA market by 2013, and 22% had sold whole loans. Another 16% said they were considering entering the TBA market, and 3% said they might begin to sell whole loans.

MBS sales, in particular, seem to have found a permanent position in HFA loan financing. Once considered a method of last resort, HFAs now see MBS sales as a desirable way to diversify their revenue. Since the sale price comes with a premium paid at purchase, the HFAs receive the benefit of the transaction immediately. This contrasts with bond programs, which provide a steady stream of revenue over many years.

Balance Sheets Have Shrunk, But Equity Has Grown

Alternate loan origination methods have enabled HFAs to recover most of their lost loan production, but because the loans do not remain with the HFAs, the amounts of the individual loans are becoming smaller. Excluding the New York City Housing Development Commission, which does not have a significant single-family program, the average HFA had $3.4 billion in assets and $2.5 billion in loans in 2008. By 2013, HFA assets had decreased to $3 billion and loans had fallen to $2.1 billion; at the same time, HFA equity has increased. The equity-to-asset ratio reached 20.42% in 2012, up significantly from 16.39% in 2008. With the increase in equity, HFA ratings have generally crept upward with 11 upgrades and five downgrades since 2008.

HFAs have proven to be resilient and innovative in addressing affordable housing needs despite an environment that many consider suboptimal for affordable housing lending. Perhaps loan production would be stronger with higher interest rates, but the persistently low rates have caused HFAs to use different methods to stay on course with their mission. The new lending strategies have had the unintended effect of improving HFA credit quality despite their reduced balance sheets. Since Standard and Poor’s projects that interest rates will average less than 5% through 2015, we believe that HFAs will continue to originate loans outside of MRBs. Should prepayments continue on existing loans, causing further redemption of debt, equity ratios will likely strengthen, further supporting a climate that has allowed for the recent positive rating actions on housing finance agencies.

Related Criteria And Research

Related Research

A Survey Of U.S. Housing Finance Agencies Finds Many Would Welcome Higher Interest Rates, Sept. 3, 2013

WASHINGTON — The total amount of outstanding municipal securities and loans in the market dropped .28% to $3.66 trillion in the first quarter this year from the fourth quarter of last year, as bank holdings rose 1.43% and money market fund holdings plummeted 3.86%.

These are the highlights from the Federal Reserve Board’s Flow of Funds report for the first quarter of this year, which was released Thursday.

Outstanding munis in the first quarter of this year decreased to $3.66 trillion from $3.67 trillion at the end of last year and were down 1.9% over a 12 month period.

The decline in outstanding munis has been a trend since the end of 2010, said Michael Decker, managing director and co-head of municipal securities for the Securities Industry and Financial Markets Association.

In the fourth quarter of 2008, outstanding munis peaked at about $3.77 trillion, but have dropped 2.9% through the first quarter of this year.

“The market is shrinking, even if a bit more slowly,” said Matt Fabian, a managing director at Municipal Market Advisors. “It makes it less comfortable for buyers because there is more competition.”

As for the reasons why, Decker said, “I think many issuers are still wrestling with a kind of anemic recovery and are fiscally not were they were before the financial crisis began. They’re de-leveraging,” reducing their amount of debt to shore up their finances.

While gross muni bond issuance was strong for part of the period since 2010, that was mostly due to refundings done to take advantage of low interest rates. But new money issuance hasn’t kept pace with redemptions and calls, Decker said.

Fabian agreed and said he has determined that 3.4% or about $105 billion of the current outstanding munis will mature before the end of the year and that new issuance won’t make up for that.

The drop in money market fund holdings and the increase in bank holdings also are trends.

Money market funds fell 3.86% to $296.4 billion in first quarter of this year from $308.3 billion at the end of last year and were down 5.15% from $312.5 billion in the first quarter of 2013.

Decker said there has been a 42% drop in money market fund muni holdings since the end of 2008 when they were $509.5 billion.

“That trend is likely to continue,” he said, adding, “It’s a trend directly related to the rise in bank holdings.”

“Many issuers have shifted at least part of their variable rate and short-term debt from public market products like variable rate demand notes to bank products like floating rate notes or loans with floating rate components,” he said.

VRDNs have liquidity features and can be put back to banks. During the financial crisis, liquidity banks’ ratings were downgraded, many below investment-grade, which caused investors to put bonds back to banks and that triggered penalty rates on the VRDNs for issuers. Also letters of credit and other liquidity products became hard to get and expensive.

While that situation has abated somewhat, issuers have found that issuing floating rate notes or taking floating rate loans from banks can be more cost-effective because they don’t to pay for remarketing agents or liquidity providers, Decker said.

Fabian added, “Low rates are wearing away many investors” from MMFs.

As money market fund muni holdings have plummeted, bank muni holdings have showed gains. Bank holdings rose 1.43% to $433.1 million in the first quarter of this year from $427.0 million at the end of last year. They have jumped 12.73% from $384.2 billion in the first quarter of 2013.

“This is also a very significant trend,” said Decker. “Banks have been getting involved in the municipal market in different ways.”

Not only are they providing fixed rate products to state and local governments, but Decker says he has heard anecdotally that some banks are buying fixed-rate muni bonds with maturities as far as 15 years out.

“It’s an attractive product for them,” he said. Munis have relatively low credit risk and general obligation bonds are particularly attractive under the capital requirements of bank regulators.

Also banks have faced fewer commercial lending opportunities during the recovery because the business sector has not be expanding and, as a result, banks have money to spend, he said.

But Fabian said the increase in bank holdings is the slowest since the first quarter of 2011. “They are not a limitless source of demand,” he said of banks.

BY LYNN HUME
JUN 5, 2014

WASHINGTON — The Municipal Securities Rulemaking Board plans to soon unveil a new price discovery tool on EMMA that will allow investors to compare the prices and yields of municipal securities that share the same characteristics.

The tool is designed to improve price transparency for retail investors and others in the municipal market, something regulators have called for.

In its Report on the Municipal Securities Market that was issued in July, 2012, the SEC recommended that the MSRB “promptly pursue enhancements to its EMMA website so that retail investors have better access to pricing and other municipal securities information.”

With the new tool, investors will be able to enter the nine-digit Cusip of any municipal security on the MSRB’s EMMA website and find other munis that have the same maturity dates, interest rates and other features.

Investors will be able to select up to five securities from those results and do a side-by-side comparison of prices and yields. They will also be able to graph up to five securities for a visual representation of trading trends that show the daily high and low prices over a period of time.

In addition, EMMA will show a graphical summary of the daily high and low price for every municipal security on EMMA, with a scatter plot of trade prices over time. The grid display of trade data for individual securities will provide a daily summary of trade prices, yields, principal amounts and other trade information.

These enhancements will be second set of EMMA changes the MSRB has announced this year.

In February, the board unveiled an updated look to the EMMA website, with a focus on improving ease of navigation for investors and other users.

A “pilot” feature was added to the site allowing users to search all state, city, county and other municipal securities issues in a particular site. This “issuer home page” is prominently presented via a map on the site’s landing page. A daily recap feature highlights the most actively-traded securities each day, and provides links to marketwide data.

The board has invited reporters to join a webinar scheduled for June 5 at 1:00 p.m. for a demonstration of the new price discovery tool.

BY LYNN HUME
JUN 3, 2014

Read the Brief.

With more than $16.6 billion issued worldwide this year, 2014 is on track to surpass $40 billion in green bonds as more companies issue the debt to finance clean energy projects, according to a report by Bloomberg New Energy Finance.

That’s only about 1 percent of the total $1.4 trillion U.S. corporate bond market, as asset-backed securities and self-labeled corporate bonds surge, the London-based research company said in a report yesterday.

Green bonds offer a simple method for investors to tap into fixed income markets and finance clean energy, including energy efficiency and sustainable business practices, and have already exceeded the $14 billion issued last year.

A coalition of banks, including Bank of America, JPMorgan Chase & Co., Credit Agricole SA (ACA) and others created a common set of criteria for green bonds in January to act as a catalyst for the development of the market.

By Ehren Goossens Jun 3, 2014

To contact the reporter on this story: Ehren Goossens in New York at [email protected]

To contact the editors responsible for this story: Reed Landberg at [email protected] Will Wade, Robin Saponar

There’s no sure-fire way to get fiscal policy right. But there are a few simple ways to get it disastrously wrong.

This is part of the ongoing Finance 101 series that breaks down the basics of public finance for public officials.

The temptation of the quick fiscal fix has seduced just about every lawmaker at one time or another. Scraping pennies together to balance the budget? Perhaps skipping a contribution to the public employee pension plan is the best way to get through the year. Can’t afford to pay for building maintenance? Push some of it off into the following year’s liabilities. Governments have been using these and other money-shuffling tricks since balanced budgets and municipal financing were invented. But in the aftermath of the Great Recession, short-sighted gimmicks like these became more common as governments looked for any solution to combat dwindling revenues. Revenue is back up now in most places, but some of the fiscal trickery has hardened into common practice.

“If it happens for a year or two in a down economy, that’s understandable,” says Tom Kozlik, an analyst with the finance firm Janney Montgomery Scott. “In 2009 and 2010, you didn’t want that to be the time you raise taxes. But, as an analyst, if I’m looking at a situation where the same things are happening pre- and post-recession, then it’s a significant problem.”

What follows is Governing’s list of the most tempting financial schemes that can severely weaken a government’s fiscal future when practiced as a matter of course. Although the consequences aren’t necessarily lethal, those that make heavy use of these 7 Sins of Public Finance find that they only succeed in digging deeper financial holes.

1. Balancing the Budget with One-Time Fixes

States and many cities have a legal obligation to balance their budgets each year. But there are all sorts of tricky maneuvers that can place a government in technical compliance with that rule. Shifting payments into the next fiscal year, for example, can instantly take the problem off the current books. But it serves only to make the following year’s budgeting that much more difficult. Borrowing money for operating costs, another common tactic, may be even more dangerous. It adds to the public’s long-term debt without creating any related future public benefit.

Bad Choice
One of the most perilous quick fixes is the practice of taking costs out of one fund and transferring them to another. New York did that in 1992, when it balanced its general fund budget by taking the state’s historic canal system and moving it to the Thruway Authority. The canal system, which includes the Erie Canal, has traditionally been a financial albatross — it costs up to $90 million to run each year but generates only a few million dollars in revenue. The deficiencies are highlighted every time the Thruway raises its tolls, particularly during a stretch in the 2000s when it raised tolls four out of five years to cover the canal system. The problem is that New York never solved the real issue — the canals are simply draining a different fund. “You’re creating the illusion that things are in balance but you haven’t actually changed any of the financial facts,” says Peter Hutchinson, a state and local government consultant for Accenture. “In the case of the Thruway Authority, the issues with the Erie Canal didn’t go away.”

Better Choice
DeKalb County, Ga., was downgraded by rating agencies in 2012 after years of transferring money from one fund to bail out another in an effort to meet operating costs. The result was an overall deficit that never seemed to go away. Finally officials in DeKalb took a painful but responsible step. They raised taxes, cut expenses (including a reduction in staff) and added to cash reserves. The county also imposed new controls on fund transfers. By the 2014 fiscal year, DeKalb had stopped cash-flow borrowing and its credit outlook was raised to positive.

2. Ignoring the Long-Term Consequences of a Deal

Few governments have a long-term financial plan and even fewer have multiyear budgets. Many don’t even require a fiscal analysis of proposed legislation. That’s made it possible for some, facing immediate demands for wage increases, to buy off public employee constituencies by increasing retirement benefits at an unsustainable long-term cost. Other governments have been wooed by the prospect of privatizing assets as a way to get quick cash, a move that some have called the governmental version of an unwise payday loan.

Bad Choice
In 2008, Chicago accepted a one-time fee of a little more than $1 billion in exchange for giving up control of its 36,000 parking meters for 75 years. The public outcry started almost immediately as the new private owners pushed through a substantial increase in parking rates. A report by an inspector general brought in to assess the consequences estimated that the process used to award the deal cost the city $974 million, and that the amount charged to the private purchaser should have been much higher.

Better Choice
Chicago learned a lesson. Five years later, Mayor Rahm Emanuel, elected in 2011, halted a possible deal to privatize Chicago’s Midway International Airport. Citing the problems with the city’s parking deal, he insisted that an airport privatization arrangement share revenue with the city and demanded a Travelers’ Bill of Rights to cap parking costs and food prices. The demands were enough to scare off the potential investors, almost certainly a benefit to the city in the long run.

3. Taking on Too Much

One of the reasons privatizing assets has become alluring to governments is because many of them have been burned by taking on more public investments than they could handle. This frequently involves development projects funded by municipal bonds. If a project’s tax revenues don’t deliver, governments have to pay the difference to bondholders out of their general fund budgets — a promise that becomes an embarrassing burden for some that can ill afford the actual risk. “It’s a question of scale,” says Julie Beglin, vice president of Moody’s Investors Service local government team. “Is the scale affordable for the government if the project doesn’t go well?”

Bad Choice
In 1996, Hamilton County, Ohio, got voters to approve a sales tax increase to help pay for two new Cincinnati sports stadiums by offering them a property tax break. But the stadiums, which cost more than $1 billion, never generated the downtown business that local officials had hoped to see. As the county found the stadium debt financing eating up an increasing share of its budget, it repealed the property tax break, then raised taxes. It sold off a hospital and refinanced the stadium debt. But the annual stadium costs — $30 million in 2008 — keep rising. In 2014, the county is projected to put as much as $50 million toward its two stadiums.

Better Choice
By contrast, the development of a downtown sports arena in Washington, D.C., in the mid-1990s has been heralded as the starting point of a hugely successful revitalization of the center of that city. The arena was privately developed; the city provided the land and infrastructure in what was then a barren and oft-times dangerous part of town. Now the area is home to retail, restaurants and hotels that churn out millions in annual tax revenue. The city is attempting to apply the same concept today with a major league soccer stadium after local officials refused to take on the main responsibility for developing the project.

4. Misapplying a Temporary Windfall

This is the sin that many governments commit when it seems like the good times will never end. Every economic boom is followed by a bust, but elected officials are often tempted to spend money as if that weren’t true, using one-time surpluses in especially good years to cover recurring expenses that they will have to meet in the bad years. When the downturn comes, the money to meet these expenses isn’t there. “State and local officials get into this over and over again,” says Steve Dahl, a consultant for Deloitte. “They make very generous decisions at the top of a bull market run instead of recognizing where they are in the economic cycle.”

Bad Choice
In the early 2000s, California reacted to its booming economy by granting pay raises and increased benefits to public employees, including some benefits that were awarded retroactively. Thanks to that decision and to the stock market crash later in the decade, the state and its localities have seen their entitlement bills multiply. In the first 10 years of this century, the state’s pension contribution mushroomed from $611 million to $3.5 billion. Had pensions been left alone, today’s bills would not be nearly as high.

Better Choice
Meanwhile, in Southern California’s Riverside County, the Eastern Municipal Water District was using its skyrocketing revenues from connection fees during the boom to pay only for one-time expenses. It expanded wastewater treatment plants and water storage facilities, and improved its recycled water program. “So, when everything went bust, their expenses were very affordable as they hadn’t incurred debt,” notes Suzanne Finnegan, chief credit officer of Build America Mutual. “It’s ironic sometimes that when you really need the discipline is when things are going well.”

5. Shortchanging Pension Obligations

The most serious threat to some government pension plans has been a chronic unwillingness by lawmakers to contribute what is necessary to keep the plans fully funded. To be sure, many governments skipped or pared down payments into pension plans during the recession. But some places did that for years prior to the downturn and continue to do it today. The longer they delay, the larger the long-term liability becomes.

Bad Choice
Over the last decade, New Jersey’s public employee pension system has gone from a fully funded enterprise to a roughly $56 billion unfunded liability. The financial crisis certainly played a part. But the situation in New Jersey is worse than in most other places mainly because the state wasn’t making its full pension payments even before the crisis began. In 2011, lawmakers passed a new pension law that legally spared the state a portion of its annual payments into the fund. It also gave New Jersey seven years before it had to start making its full contributions. “In other words,” says Howard Cure, director of bond credit research at Evercore Wealth Management, “rather than continue to fully fund the pension, they used it as an excuse. Now they’re back to the same hole.” This year, in response to that hole, Gov. Chris Christie retroactively changed the pension funding formula to allow the state to contribute $94 million less in order to help balance the 2014 budget. Now, thanks to the formula change, the state is slated to put a total of $900 million less into the fund by the time it’s required to start making its full payments. The likely outcome is that the unfunded liability will continue to grow.

Better Choice
Lexington, Ky., had a similar problem with habitually shortchanging its pension plan. But in 2012, it put together a pension task force made up of city officials and public employee union representatives, guided by an outside financial consulting firm. The result was a new agreement that guarantees Lexington will increase its annual contribution to the pension fund to $20 million from $11 million. In return, employees agreed to an older retirement age and increased paycheck deductions.

6. Making Unrealistic Projections About Rate of Return

Every budget or financial planning document has to start with some assumptions about the rate of interest that will be earned on an invested portfolio. It’s tempting — too tempting sometimes — to stretch those assumptions beyond what sensible economics can justify. Some pension funds still base their total liabilities owed on an expected annual investment return of more than 8 percent, a figure that affects the formula used in figuring out how much governments should contribute each year. “That means they’re targeting a pension funding level that’s lower than what most people might consider prudent,” says Donald Fuerst, a senior pension fellow at the American Academy of Actuaries. Similarly, a budget that expects too much from a volatile revenue stream like the sales tax can be burned in any given year if the economy hits the skids.

Bad Choice
In 2012, Rockland County, N.Y., faced a $40 million budget deficit and was hit with a credit rating downgrade to one step above junk status. In its downgrade action, Standard & Poor’s cited the county’s “vulnerable” management practices based on overly optimistic budgeting. The following year, the county based one-fifth of its revenue returns on sales tax receipts — and expected a 4 percent increase in those returns when consumer spending growth had been far slower. The financial practices prompted the state to step in, demanding that county officials scale back their estimates and develop a realistic financial plan to escape Rockland’s deficit woes, which had mounted to $125 million by 2014.

Better Choice
Many states that assumed at least an 8 percent return on investment from their pension funds have since reduced their expectations. New York state’s public pension funds, for example, lowered their target return rate to 7.5 percent from 8 percent in 2010 (in addition to other changes in actuarial assumptions concerning career duration, salaries and life expectancy). This had the effect of increasing the unfunded liability (and thus, the state’s required contribution) but it was more in line with the fund’s financial realities. Starting this year, pension funds throughout the country will have to follow new accounting rules that include a lower assumed rate of return on their unfunded liabilities.

7. Ignoring Financial Checks and Balances

Don’t lose track of the money you have. It seems like the most obvious advice in the world. But in government finance and fund accounting, where there are many different ways to count the same revenue, weak financial controls can lead to serious dollar losses. Governments can lose track of how much money they actually owe one of their special funds. Or lax internal monitoring can result in poor financial choices not getting flagged until it’s far too late.

Bad Choice
Earlier this year, a legislative audit criticized Idaho Treasurer Ron Crane for acting on investments without the guidance of others. At issue were $31 million worth of mortgage-backed securities that Crane transferred from the Local Government Investment Pool to the state’s Idle Pool in order to protect the credit rating of the local pool. (Both pools are vehicles for storing government cash that isn’t needed immediately.) Later, Crane took $31 million in cash from the Idle Pool and put it back in the local one. The problem cited by the audit was that while the securities had a face value of $31 million, their market value was only $19 million as the move was made during the depths of the recession. The audit concluded that the treasurer’s office overrode internal controls meant to contain financial risks, resulting in inappropriate transfers that cost at least $10 million in “a disproportionate share of investment losses.”

Better Choice
A number of organizations have published best practice guides that help governments limit their vulnerability to financial reporting problems. The Government Finance Officers Association recommends that reporting systems incorporate an antifraud program and that financial managers periodically evaluate internal control procedures to ensure they are still working as envisioned. The Association of Local Government Auditors recommends that, at a minimum, governments have an ethics policy, established performance measures and an audit committee. State governments also cite best practices for their local governments to follow. Vermont, for example, has fact sheets available to localities offering advice on financial management of fixed assets, cash receipts and accounts receivable.

BY LIZ FARMER | JUNE 2014

The U.S. municipal-bond market is performing a vanishing act.

While businesses and consumers are borrowing more as the economy revives and the Federal Reserve holds its benchmark interest rate near zero, America’s local governments are doing the opposite. States, cities and public agencies have reduced their debt load by $111 billion since 2010, the biggest decline peak to trough since records began in 1945, according to Fed data released yesterday.

The $3.66 trillion market is on pace to contract for an unprecedented fourth straight year. Localities recovering from the recession that ended five years ago are paying down debt instead of pumping money into aging roads and bridges. The scarcity of bonds has helped fuel the longest rally in munis since 1991.

“There is a retrenchment going on, and I think that’s going to continue,” said Tom Kozlik, director of municipal credit analysis at Philadelphia-based brokerage Janney Montgomery Scott LLC. “One of the last things that an issuer wants to do, if it doesn’t have to, is add fixed costs in terms of debt.”

Municipalities have sold about $106 billion of long-term, fixed-rated bonds this year, a 25 percent decline from the corresponding period of 2013, data compiled by Bloomberg show.

Surprising BlackRock

“The low absolute level of gross issuance has caught the market, including ourselves, a little by surprise,” said Sean Carney, a muni strategist at New York-based BlackRock Inc., which manages $108 billion of local debt.

Issuers from California, the most-populous state, have offered 47 percent fewer bonds this year. The nation’s most-indebted state has focused on spending money raised in previous sales instead of borrowing more, said Tom Dresslar, spokesman for Treasurer Bill Lockyer.

Another reason for the borrowing dip: The state has fewer bonds to refinance after a wave of such deals last year. California has refunded $800 million of debt in 2014, down 72 percent from a year earlier, according to Dresslar. Meanwhile, sales of bonds for new projects have dropped 24 percent.

“We have taken a somewhat more conservative approach for the last couple of years or so,” Dresslar said.

1991 Redux

Even as the menu of muni offerings has diminished, individuals have been chasing the rally in tax-free bonds. Investors added $2.9 billion to muni mutual funds in May, Chris Mauro, a strategist at RBC Capital Markets in New York, wrote in a June 4 research note.

Munis have gained each month this year, the first time that’s occurred since 1991, according to Bank of America Merrill Lynch indexes. The market has earned 6.2 percent in 2014, compared with 5.1 percent for corporate bonds.

The performance is more a sign of dropping supply than surging interest in tax-exempt securities, said Chris Mier, chief muni strategist at Loop Capital Markets in Chicago. The market is dominated by individual investors, who own more than half of local-government debt.

“It’s not that the demand is inordinately high, it’s just that the supply impact is stronger,” said Mier.

2010 Peak

The market began to shrink after the end of the Build America Bonds program, an economic-stimulus measure that began in 2009 and subsidized interest costs of debt that localities sold for infrastructure projects. Issuance under the program tallied $188 billion by the time it lapsed at the end of 2010. Municipal issuance that year totaled $408 billion, the most since at least 2002, Bloomberg data show.

Borrowing has also waned as a result of a political shift among officials forced to cut budgets when tax revenue faltered during the recession that ended in June 2009.

“It is understandable given the pull-forward that had taken place in past years, coupled with post-crisis management styles and general aversion to adding new debt,” BlackRock’s Carney said.

California Governor Jerry Brown, a Democrat, has pledged to chip away at debt used to pay for prior shortfalls, and has moved to save surplus tax money. In Florida, Republican Governor Rick Scott has boasted of cutting $3.6 billion of debt.

Mier, the Loop analyst, said the aversion to borrowing will ebb as municipalities’ finances recover. It wasn’t until a year ago that state tax collections recovered to their 2008 peak, adjusted for inflation, according to the Nelson A. Rockefeller Institute of Government in Albany, New York.

Officials have a ready list of projects to tackle. Areas such as schools, roads, transit and water need about $3.6 trillion of investment by 2020, according to a report last year from the American Society of Civil Engineers.

“The political sentiment will move back in the other direction and you will see more debt issuance again,” Mier said.

By William Selway Jun 5, 2014

To contact the reporter on this story: William Selway in Washington at [email protected]

To contact the editors responsible for this story: Stephen Merelman at [email protected] Mark Tannenbaum, Alan Goldstein

Fitch Ratings-New York-02 June 2014: The recently passed Water Resources Reform and Development Act of 2014 (WRRDA) is an important step toward strengthening U.S. water infrastructure. Public sector and private sector participation are important to completing the $630 billion in water and sewer infrastructure needs projected over the long term. However, the ban on the use of tax-exempt bond proceeds for projects receiving Water Infrastructure Finance and Innovation Act (WIFIA) support will limit the reach of the program, Fitch Ratings says. Access to the full spectrum of funding options would improve project economics and could enlarge the number of projects under consideration within the WIFIA program.

WRRDA establishes a public-private partnership (PPP) that promotes private investment in much-needed water and wastewater infrastructure. WIFIA, modeled on the successful Transportation Infrastructure Finance and Innovation Act (TIFIA) program for surface transportation, provides low-cost loans capped at 49% of a project’s cost. However, TIFIA doesn’t exclude the use of tax-exempt financing.

PPPs provide a useful alternative to advance project delivery for public service needs. Tax-exempt financing enables PPPs to lower the marginal cost of project development. Allowing tax-exempt private activity bonds and other financing tools to be used with WIFIA support would maximize access to diverse funding sources for critical infrastructure development and invite worthy proposals that might not apply for WIFIA under the current prohibition.

For example, the San Diego County Water Authority recently began a desalination project that leans heavily on tax-exempt bond proceeds. The Carlsbad Desalination Plant improves the water authority’s source diversification and drought tolerance. Proceeds for the plant are funded by the California Pollution Control Financing Authority (CPCFA) through a nearly $800 million bond issue of plant and pipeline bonds. Fitch rated the CPCFA’s bond issue ‘BBB-‘ with a Stable Outlook. This important project would not be eligible for WIFIA support due to its use of a tax-exempt financing option.

Contact:

Yvette Dennis
Senior Director
Global Infrastructure and Project Finance Group
+1 212 908-0668
33 Whitehall Street
New York, NY

Cherian George
Managing Director
Global Infrastructure and Project Finance Group
+1 212 908-0519

Rob Rowan
Senior Director
Fitch Wire
+1 212 908-9159

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Internet-Information Revamp Could Help Retail Investors Navigate the Muni-Bond Market

The Internet storehouse of free municipal-bond data and documents is getting a makeover, adding tools and information for retail investors in a market critiqued for years as opaque and unwieldy.

The website revamp could help retail investors navigate the $3.7 trillion municipal-bond market. Individuals own about 72% of the debt issued by cities, states and other municipalities, either directly or through mutual funds, according to the Securities and Exchange Commission. Many buy the bonds for tax-free income as a way to help fund their retirements. Individual ownership of municipal debt exceeds that of any other financial asset class except for the U.S. stock market, where trades are made mostly on exchanges and where prices are freely available and constantly updated.

One new tool coming this month to the Electronic Municipal Market Access site, known as EMMA, allows investors to compare the trade histories of bonds with similar characteristics, helping to establish comparable prices for securities that don’t change hands often. New features also let users graphically display what others are paying for a security on any given day.

“All of this is part of a long-range plan to bring greater transparency to the market,” said Daniel Heimowitz, chairman of the Municipal Securities Rulemaking Board.

In 2012, the MSRB released a plan for improving transparency in the municipal-bond market, which included additions to the EMMA site, which gets about 90,000 unique visitors a month. The site, launched in 2008, stores municipal issuers’ disclosures, documents, trade data and other information.

For the past few years, the SEC has been pressing for the muni-bond market to improve and make it easier for individual buyers to assess their investments.

SEC Commissioner Daniel M. Gallagher praised the EMMA site in a speech last week at the MSRB’s Municipal Securities Regulator Summit in Washington before adding that retail investors still need more help.

“Despite these advances in post-trade price transparency, retail investors continue to face headwinds in the bond markets,” Mr. Gallagher said, adding that “the opacity of the markets, especially given the lack of a centralized collection and continuous dissemination of bid/ask quotes—that is, pretrade price transparency—makes it difficult for retail investors to feel confident that they received the best execution.”

The site will help investors who want some basic information about a bond and what it should cost, said Ron Valinoti, operating manager of Municipal Bond Information Services LLC, a consortium of 11 companies formed to improve municipal-bond valuations and price monitoring. “The little guy doesn’t always know how the muni market works, and the website is set up to help them learn,” Mr. Valinoti said.

Users of the new price-discovery tool can enter the nine-digit alphanumeric code that identifies a given bond and search for securities with recent trades that share its characteristics, such as maturity date, the bond’s source of repayment and interest rate.

Lynnette Kelly, executive director of the MSRB, said those new functions will help widen the view into the market that the website already provides.

By AARON KURILOFF
June 2, 2014 5:50 p.m. ET

Write to Aaron Kuriloff at [email protected]

USAA, the US insurer, has sold $130m of catastrophe bonds that allow investors to collect yields of 15 per cent or more by betting on the chances of a meteor strike or volcanic eruption.

The bonds are the first to cater to these two types of natural disasters, but investors nevertheless clamoured to buy the new debt. The size of the deal was increased from a planned $100m, underscoring strong appetite for insurance-linked catastrophe bonds, sales of which are on course to reach record levels this year.

The USAA cat bonds, known as Residential Reinsurance 2014 Ltd Series 2014-I, met “robust” demand from investors, according to people close to the sale.
In addition to providing coverage for a meteor strike and the standalone risk of a volcanic eruption – two firsts for the insurance-linked industry – the USAA bonds also cover so-called “unmodelled” risks of wildfires, severe thunderstorms and blizzards in US states where such disasters are not typically assessed.

“They [USAA] have a number of larger cat bond deals still in effect,” said Steve Evans, owner of Artemis.bm, which collects data on insurance-linked debt. “What they tend to do is use these smaller issues in order to test the market a little bit. Last year they issued some of the riskiest notes ever, this year they’ve chosen to test by including meteor and volcanic eruption risk.”

The USAA sale comes on the back of continued strong demand for cat bonds, which offer investors higher yields as well as returns that are uncorrelated to other types of securities.

Such bonds allow insurers to transfer some of the risk that they will have to pay out billions of dollars in the event of a major natural disaster. While the debt offers juicy returns, investors are at risk of losing their principal if catastrophes such as earthquakes or hurricanes do occur.

The amount of cat bonds and insurance-linked debt sold so far this year has reached $5.5bn, according to Artemis.bm, taking the amount of the debt sold over the past 12 months to a record $9.2bn.

“In recent cat bond deals the majority have priced at the mid or upper-end of pricing guidance, which shows investors have reached a place where they feel they can’t go down any more on pricing,” said Mr Evans.

USAA’s debt deal was divided into two classes of bonds. The size of the riskiest class of the bonds, where investors receive a coupon of 15 per cent in exchange for an expected loss rate of about 11 per cent, was increased from $50m to $80m.

A third of these riskier bonds went to hedge funds while another third went to cat bond funds that specialise in investing in insurance-linked debt, said people familiar with the deal.

Almost two thirds of the $50m second class of the bonds, with a coupon of 3.5 per cent for an expected loss rate of less than 1 per cent, were sold to pension funds and money managers.

USAA declined to comm­ent on the sale, which was run by Goldman Sachs and Swiss Re Capital Markets.

By Tracy Alloway in New York

(Reuters) – U.S. cities and states are leery of borrowing more money despite near-record low interest rates, forcing bond funds to scour for investments and boosting returns on existing debt.

The drought in issuance is also slowing city and state capital projects and threatens to disrupt the summer high season for bond buying.

So far this year, sales are running 25.4 percent below the same period in 2013, according to preliminary Thomson Reuters data. May’s issuance, $22.41 billion of bonds sold in 907 deals, was the lowest for the month in three years and the smallest since January, when only $18.17 billion in bonds came to market.

The paltry pace of issuance has investors competing to get a slice of new deals and in many cases forcing them to bid on lower-quality credits than they would like.

“Many of the new issues that are coming to market are eight to 10 times oversubscribed. So it’s difficult getting bonds,” said Burton Mulford, portfolio manager at Eagle Asset Management, which emphasizes high-grade debt.

Eagle has begun buying more single-A credits, the mid-to-low end of the investment-grade scale. Instead of focusing on deals of at least $75 million, it has been looking at some $35 million and $40 million deals, Mulford said.

Cities and states’ refinancing binge, which was fueled by low interest rates, ended in 2013 as rates rose and retail buyers avoided the municipal market, spooked by bad financial news from Detroit and Puerto Rico. Issuance started falling.

As 2014 dawned, many expected bond sales to drop further, given that governments’ financial managers are gun-shy about taking out debt after the budget crises resulting from the 2007-09 recession. Political leaders facing elections in November, too, may want to appear conservative about borrowing.

Last year’s 0.4 percent growth in municipal bond sales was the smallest in 20 years, and the trend is set to continue “because of the slow and uneven pace of revenue recovery,” according to Moody’s Investors Service.

Most states are not fully utilizing their borrowing capacity and are spending less on infrastructure, which is primarily financed by bonds, the National Association of State Budget Officers said in a report released on Thursday. The growth in debt for infrastructure in almost all states has been “very minor or flat” despite the era of low interest rates, the group found.

Spending austerity and political attitudes, along with lack of federal policy supporting infrastructure spending and higher interest rates, will keep the year’s total bond sales between $250 billion and $275 billion, Janney Capital Markets estimated. Last year’s sales totaled $311.8 billion.

“It’s helping drive prices up and yields down, but demand is pretty strong as well,” J.R. Rieger, head of fixed income at S&P Dow Jones Indices said of the supply shortage. “The muni market started the year relatively cheap compared to Treasuries and corporates… I think investors recognized it.”

The S&P Municipal Bond Index has had a year-to-date return of 6.09 percent. The high-yield index has returned 9.65 percent, more than double its counterpart for U.S. corporate junk bonds.

Yields started 2014 fairly high but have recently fallen. Those on top-rated 10-year bonds began 2014 at 2.79 percent and on highly rated 30-year debt at 4.20 percent on Municipal Market Data’s benchmark scale. By the end of last week, 10-year bonds were at 2.16 percent and 30-years at 3.26 percent.

Meanwhile, yields on A-rated, 10-year bonds were 2.77 percent and on A-rated, 30-year issues were 3.89 percent on Thursday, according to MMD, a Thomson Reuters company.

With $8.6 billion in deals expected to come to market this week, the supply shortage could ease during the summer. Still, investors might be caught scrambling to find places for the cash they receive from bond redemption and coupon payments during the summer “reinvestment season.”

Loop Capital Markets expects the amount of cash coming available in June, July and August to total $151.53 billion, down slightly from $160.74 billion last year.

Loop has revised its forecast for 2014 issuance to $275 billion from the $300 billion it estimated in December. But Loop Managing Director Christopher Mier said the combination of large amounts of cash with short bond supply may not have a predictable impact on the market.

“You can’t just assume this money is coming back, and there’s a particular reason you don’t want to make that assumption this year: there’s been a significant decline in yields and a significant outperformance,” he said. Mier added that investors may opt to buy equities instead.

BY LISA LAMBERT
WASHINGTON Mon Jun 2, 2014 7:04am EDT

In 2008, Florida’s government-run property insurer paid Warren Buffett $224 million to agree to buy its debt if a major storm struck. Six hurricane-free years later, the state is turning investors away.

With hurricane season set to start June 1, municipal securities sold by Florida’s taxpayer-owned property insurers are rallying, and the state boosted a catastrophe-bond sale last month by almost four times, to $1.5 billion.

Florida, typically the nation’s most hurricane-prone state, is benefiting from a thirst for yield as investors seek higher returns with municipal interest rates close to generational lows. The demand is bolstering state-run Citizens Property Insurance Corp. and the Florida Hurricane Catastrophe Fund Finance Corp., which have record cash reserves.

“We haven’t had a hurricane make landfall in eight years,” said Jack Nicholson, who runs the catastrophe fund from Tallahassee. The taxpayer-owned entity provides backup coverage for insurance companies. “I’d rather be lucky than smart any day.”

The last hurricane to strike Florida was Wilma in 2005. If the streak ends this year, the fourth-most-populous state may need to sell bonds for recovery costs. Dwindling issuance in the $3.7 trillion municipal market and investors’ search for yield bodes well for the catastrophe fund, according to Bank of America Corp., JPMorgan Chase & Co. and Wells Fargo & Co.

Andrew’s Legacy

The banks, which underwrite the reinsurer’s bonds, estimated on average that the fund would be able to sell $8.3 billion of debt within a year to meet its obligations after a hurricane. That’s more than twice what the fund would need to borrow if it runs out of cash.

The catastrophe fund was created by the state in 1993, a year after Hurricane Andrew ravaged Miami. The fund, which has about $11 billion in cash, is obligated to pay out as much as $17 billion for this hurricane season.

In 2008, it had $3.6 billion in cash to cover $29 billion in potential liabilities. The U.S. was in the first year of the longest recession since the 1930s and Nicholson wasn’t sure if investors would be willing to finance the gap after a major storm.

Buffett Deal

Florida cut a deal with Buffett’s Berkshire Hathaway Inc., paying the Omaha, Nebraska-based company in exchange for a guarantee that it would buy the state’s bonds if a storm caused more than $16 billion in losses.

Buffett, 83, whose $65.3 billion net worth makes him the world’s third-richest person, didn’t respond to a request for comment sent to an assistant.

The state of about 19.6 million people won’t need special deals to attract investors this year because of pent-up demand for higher-yields, said Michael Schroeder, chief investment officer at Naples, Florida-based Wasmer, Schroeder & Co.

If the catastrophe fund were to issue federally taxable 30- year bonds this year, they’d probably carry interest rates about 2.50 percentage points more than benchmark Treasuries, Bank of America estimated in a May 1 letter. Benchmark Treasuries maturing in 2044 yield about 3.3 percent.

The fund’s bonds, which are exempt from state taxes, are rated Aa3 by Moody’s Investors Service, fourth-highest.

Interest Abounds

“If they had to do a deal today, it would not be a problem,” said Schroeder, whose firm manages about $3.5 billion in munis, including Florida hurricane bonds. “You’d have a significant number of players that would be interested.”

Texas, North Carolina and Louisiana also have systems to provide insurance in high-risk areas. California offers state- run earthquake insurance.

Citizens Property, which offers Florida homeowners direct coverage, is also benefiting from investors’ willingness to take on hurricane-linked risk. The insurer increased the size of its catastrophe bond offering to a record $1.5 billion last month, after initially marketing $400 million, said Jennifer Montero, its chief financial officer in Tallahassee.

“We were oversubscribed,” she said. “There’s so much money that investors don’t know where to put it.”

The taxable three-year bonds priced to yield 7.5 percent, she said.

Risk Appetite

Catastrophe bonds offer higher returns in exchange for risking the loss of principal. If hurricanes or other disasters cause a specified amount of damage, insurers can use the principal to cover recovery expenses. Holders of the Florida bonds face a 1.7 percent chance of losing their entire principal, according to Citizens.

More buyers are willing to take that risk, said Caleb Wong, who helps oversee catastrophe bonds at New York-based OppenheimerFunds Inc., which manages $237 billion.

“The fact that there has been no sizable event in Florida recently, I think that has had some impact in drawing some investors,” he said.

The catastrophe bonds helped Citizens’ balance sheet, which also includes a record $7.6 billion in cash and proceeds of $1.5 billion in munis issued in 2012. Fitch Ratings gave the Citizens debt its fifth-highest grade, pointing in part to the cash stockpile. Citizens, which was created in 2002, is the state’s largest property insurer, with 940,000 policies.

“They’re at the point that they could deal with what they estimate to be a once-in-100-year storm without having to go to the market,” said Karen Krop, a Fitch analyst.

Bond Backing

The catastrophe fund and Citizens repay bonds by levying assessments on owners of homes and cars.

Citizens last sold tax-exempt municipal bonds in June 2012. The catastrophe fund last sold debt in April 2013, raising $2 billion.

Federally taxable bonds issued by the catastrophe fund that mature in July 2020 traded this week with an average yield of 2.66 percent, matching the lowest since their issue last year, data compiled by Bloomberg show. The yield was about 0.9 percentage point above Treasuries, down from about 1.8 percentage points at issue.

Both the fund and Citizens have amassed record cash reserves during the eight-year span without hurricanes. Combined, they have more than $18.5 billion available to pay claims.

1992 Reminder

That may not be enough, as a direct hit to a population center like Miami could cause more than $80 billion of damage, according to state estimates. Andrew in 1992 caused more than $45 billion of damage in the Miami area, adjusting for 2010 prices, National Weather Service records show.

Three to six hurricanes will probably form in the Atlantic this year, the National Oceanic and Atmospheric Administration predicted May 22. One or two may qualify as major, with winds of 111 miles (179 kilometers) per hour or more. The Atlantic season runs through November.

Florida’s streak of seasons with no hurricanes is a record, according to data from the National Hurricane Center. From 1851 to 2004, 273 hurricanes struck the U.S. mainland, according to the center. Florida was hit more often than any other state, with 110 hurricanes making landfall.

The unpredictability of hurricanes can be a draw, as weather isn’t correlated with financial risks such as recessions, said Schroeder. And with municipal issuance dwindling, buyers may pounce on bonds issued to pay for a destructive hurricane.

Schroeder doesn’t count himself among investors eager for that opportunity, he said from his office along the west coast of Florida.

“It would do a lot of damage,” he said.

By Toluse Olorunnipa | May 30, 2014

–With assistance from Noah Buhayar in New York.

Localities in the $3.7 trillion municipal market are planning the largest wave of debt sales in almost three months, bucking a trend of diminished borrowing that’s pushed yields to the lowest since June.

States and cities have set $8.6 billion of bond sales over the next 30 days, according to data compiled by Bloomberg. That’s 35 percent above this year’s average, and close to the highest since March, when Puerto Rico issued $3.5 billion of general obligations in the largest muni deal of 2014.

At 2.26 percent, benchmark 10-year muni yields are sinking as demand for tax-exempt securities outpaces the slowest period for bond sales since 2011. Investors have added $2.9 billion to muni mutual funds in the past four weeks, the most in 16 months, Lipper US Fund Flows data show. A wave of maturing and refinanced debt in coming months is poised to add to demand.

“We’re coming into the reinvestment season and there seems to be cash on the sidelines,” said Ken Kollar, a trader with Arbor Research & Trading Inc. in New York. “Supply will be easily absorbed.”

Next week, Phoenix, the Miami-Dade County Expressway Authority, the Chicago Park District and Portland, Oregon, join issuers offering $5.9 billion in debt, compared with almost $5 billion in this holiday-shortened week. Miami-Dade will borrow to upgrade highways and Portland’s debt will help finance a bridge.

Phoenix and the Chicago Park District are refinancing debt. Muni bondholders are set to receive $92 billion from maturing and refunded bonds in the three months through August, Citigroup Inc. estimates. That may exceed issuance by $20 billion.

By Elizabeth Campbell and Brian Chappatta

To contact the reporters on this story: Elizabeth Campbell in New York at [email protected]; Brian Chappatta in New York at [email protected]

To contact the editors responsible for this story: Stephen Merelman at [email protected] Mark Tannenbaum, Alan Goldstein

New York, May 22, 2014 — The rate of growth in the outstanding debt issued by the US states in 2013 slowed for a fourth consecutive year and was also the slowest growth in debt for the last 20 years, says Moody’s Investors Service in “2014 State Debt Medians: Appetite for Borrowing Remains Weak.” Moody’s expects state debt levels to continue to show only modest growth in 2014.

“The continued slowdown in the growth of net tax-supported debt primarily reflects a new conservative attitude toward debt among the states,” says Kimberly Lyons, a Moody’s Assistant Vice President and Analyst. “Growing spending pressures coupled with inconsistent revenue growth and uncertainty over future revenue trends have forced states to take a cautious approach when considering the addition of new debt service costs to their budgets.”

The combined 2013 total net-tax support debt (NTSD) for all 50 states increased to $518 billion from $516 billion in 2012, according to Moody’s. Approximately half of all states saw a decline in their NTSD, including some historically large debt issuers such as California.

Total NTSD growth slowed to 0.4%, slightly less than the 1.4% growth rate in 2012. The modest growth rate is well below the 10-year average of 6% growth and considerably lower than the high growth rates of some recent years such as the 9% rate in 2009 and 17% rate in 2004.

The lower borrowing also led to a decline in the median leverage ratios for the states, with NTSD per capita declining to $1,054 from $1,074 in 2012. Additionally, NTSD as a percentage of personal income declined to 2.6% from 2.8%, and NTSD as a percentage of gross state product also fell to 2.4% from 2.5%.

Debt service costs increased by 8% in 2013, up from the 3% increase in 2012. Growth in debt service costs reflects a return to normal debt service schedules after years of artificially low debt service, a result of higher than normal debt refunding for savings in a low interest rate environment, says Moody’s.

Moody’s also found very low levels in variable rate demand debt and privately placed bank loans among states. Variable rate demand debt comprises just $21.6 billion of outstanding state debt (4% of total) and private bank loans just $3.5 billion (0.01%). Moody’s said its review of the private agreements finds similar credit terms to those contained in bank-supported financings for state borrowers in the public market.

Moody’s 2014 state debt medians are based on the rating agency’s analysis of calendar year 2013 debt issuance and fiscal year 2013 debt service. For more information, Moody’s research subscribers can access the report at

https://www.moodys.com/viewresearchdoc.aspx?docid=PBM_PBM170895.

Global Credit Research – 22 May 2014

***

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Municipal bonds are not highly liquid. To some, that’s stating the obvious, but if US regulators write it into their version of Basel III’s liquidity coverage ratio, state and city treasurers say their financing costs will rise.

It may seem unlikely, but if the residents of Cary in North Carolina notice public verges becoming unkempt, or pilots using Boston’s Logan International Airport start seeing potholes, there could be a single cause – a rule drawn up in Switzerland and implemented by the US Federal Reserve Board.

This rule is the liquidity coverage ratio (LCR). If last October’s Fed draft version is introduced unchanged, bonds issued by US states, cities and towns will not count towards the new liquidity buffers that banks are required to hold. This will reduce the value of the bonds and demand for them will drop, the argument goes. With banks currently holding around 10% of the stock of municipal debt, issuers fear they will have no choice but to pay higher coupons.

“As a muni issuer, we are concerned that if our bonds are not included it will reduce the market for them, increasing the interest we will have to pay, and increasing costs to our citizens and rate payers,” says Town of Cary’s finance director, Karen Mills. “We have service levels in Cary, such as how often we should sweep the streets or mow the medians, and it is a balancing act. If we have higher interest rates then we can’t spend as much on other things.”

We have service levels in Cary – such as how often we should sweep the streets or mow the medians – and it is a balancing act

The LCR is supposed to ensure banks can survive a short-term liquidity squeeze. It forces institutions to hold enough high-quality liquid assets (HQLA) to cover their liabilities over a 30-day period of stress. For an individual bank, the ratio is calculated as its total HQLA divided by the estimated net cash outflows – based on the run-off rates set by regulators. The Fed has proposed banks will need to have an LCR of 80% by the start of 2015, rising by an additional 10% each year until the minimum becomes 100% in 2017.

HQLAs are split into three categories, as in the international version of the LCR, finalised by the Basel Committee on Banking Supervision in January 2013 (Risk February 2013). Level 1 assets, such as US Treasury debt and other government agency debt that is unconditionally guaranteed by the US government, can be held without limit and not receive a haircut. Level 2a assets, including debt issued by Fannie Mae and Freddie Mac, receive a 15% haircut. Level 2b assets, which include investment-grade corporate bonds and stocks in the S&P 500 index, get a 50% haircut (Risk July 2011). Taken together, Level 2 assets can be no more than 40% of the buffer, with 2b assets alone capped at 15% of the total.

“The proposed rule likely would not permit covered bonds and securities issued by public sector entities, such as a state, local authority or other government subdivision below the level of a sovereign (including US states and municipalities), to qualify as HQLA at this time,” the rules say. The Fed argues municipal bonds are not “liquid and readily marketable”, citing low daily trading volumes as one justification.

Critics would like to see more of the Fed’s reasoning. “There was not much in the proposed rule that justified throwing out municipal bonds from the definition of HQLA. There were maybe two sentences and we were hoping they would show more careful consideration,” says Susan Collet, vice-president of government relations at Bond Dealers of America, a trade association representing bond brokers.

So, what was the Fed looking for? In short, assets that can be liquidated quickly in large volumes with little impact on prices. The rules say HQLAs must have a high potential to generate liquidity through sale or secured borrowing in a stressed environment. They also “exhibit low risk and limited price volatility, are traded in high-volume, deep markets with transparent pricing, and are eligible to be pledged at a central bank”, according to the draft US rules. Defenders of municipal bonds argue the market satisfies much of this. On one point there is no debate: research by Citi points out that all US municipal bonds are accepted as collateral by the Fed at a 2–5% haircut, depending on maturity – the same applies to US agency securities. By comparison, the Fed accepts US AAA corporate bonds at a 3–6% haircut and all other investment-grade corporate bonds at 5–8%.

The other points are debatable. On the subject of price volatility, Citi’s research claims that in 2008/2009, only Freddie Mac mortgage loans were subject to less depreciation – about 0.4% – over a 30-day period than AA-rated municipal obligations. This is because the sector, by and large, has robust ratings, its supporters say.

“Our rating has been pretty steady. We had one blip during 9/11, but other than that it has been AA-credit quality, even through the crisis,” says John Pranckevicius, chief financial officer at the Massachusetts Port Authority (Massport).

For the sector as a whole, research from Moody’s Investors Service shows the average rating for investment-grade munis between 1970 and 2012 was AA3. The average rating for investment-grade corporates was roughly Baa1. Municipalities that commented on the proposed LCR tended to be highly rated (see box, Corporates fear jump in commercial paper costs).

“The history of default is so vastly less than on the corporate side,” says George Friedlander, a municipal bond strategist at Citi and author of the bank’s recent research on this issue. “During a financial crisis credit spreads widen out. Sectors with a history of default widen out more. That is a measure of liquidity – it is what spreads try to reflect. On that basis, the fact so many muni credits are vastly higher in average rating and lower in average default experience makes a case for them to be included as a stronger sector.”

The two other main HQLA criteria are trading volume and depth of market. “As a purchaser, we manage a $400 million portfolio, and we try to purchase other North Carolina municipal bonds and have a hard time finding them,” says Town of Cary’s Mills.

This might suggest the secondary market for municipal bonds is illiquid, trading infrequently, and the head of one small private investment firm, says that was certainly the case following the collapse of Lehman Brothes in 2008, when investors had to sell at a discount to exit their positions.

But according to data from the Securities Industry and Financial Markets Association (Sifma), which is quoted in numerous municipalities’ comment letters to the Fed, 0.27% of the municipal market’s outstanding par value is turned over every day on average, which is the same as federal agency debt and higher than the 0.19% seen for corporate bonds.

“I think there are US credits in the muni market that are high quality and have high liquidity, and have as much liquidity as some of the other assets the Federal Reserve says it would be acceptable to be holding,” says Richard Ellis, state treasurer for Utah and chairman of the National Association of State Treasurers.

The argument matters because banks are becoming increasingly important as investors. As of September 2013, they held $413 billion of municipal securities and loans, according to the Fed’s flow of funds report – a year-on-year increase of 15.7% and a jump of more than 60% since the end of 2010. In total, roughly 11% of the market is held by banks.

“We have a lot of bonds outstanding, so a lot of folks have them, from big banks to regional players. All we are saying is if we’re not included as HQLAs, then possibly – we don’t know for sure – they could choose different assets to our bonds,” says a debt manager at another small municipality in North Carolina.

Some banks are already threatening to pull back, say state treasurers. Utah’s Ellis says he has spoken to financial advisers at Salt Lake City-headquartered Zions Bank who raised the possibility that the institution may have to cut its holdings. According to the bank’s most recent annual filing, it holds $558 million in held-to-maturity municipal securities with a further $66 million in the available-for-sale category. “Zions has a lot of local debt, with much of it coming from small issuers – some with only a hundred thousand dollars outstanding – and now the bank is asking, ‘What do we do? We have to unload these.’ These are issuers without good market access, so their borrowing costs would be significantly higher,” says Ellis. “Until now, the bank has bought some of these less-liquid bonds into its portfolio because they are assets it is happy to hold and it is supporting the local economy. Now there’s a disincentive for the bank to do that.”

One of those financial advisers is Jon Bronson, managing director at Zions Bank Public Finance, who confirms that if municipal bonds are not HQLAs then the bank will have less reason to hold them. This could affect other local investors, he adds. Bronson helps the bank to sell municipal bonds into the portfolios of several local community banks and sits on the board of one. “Every bank’s response will be different,” he says. “I’m on the board of a bank that buys munis in the secondary market and knowing the Basel III rules are coming – and those assets are currently not deemed HQLA – that little bank’s appetite for munis will probably change.”

There are other impacts too. Municipal debt can no longer be used to offset the potential cash outflows from municipal deposits, and Town of Cary’s Mills says North Carolina-headquartered BB&T declined to bid when the town was renewing a certificate of deposit.

One capital markets vice-president at a large regional bank confirms the new rules are having an impact: “On the periphery, yes, it certainly could have an impact. As far as our firm’s outlook goes, they have asked us to step back.”

State treasurers and municipal issuers worry where this will end up – if banks pull back, the market for municipal debt will shrink, increasing their financing costs. “If interest rates are higher, we will have less capital to maintain assets,” says Massport’s Pranckevicius

Massport maintains runways, terminals, parking garages, hangars, piers and cranes, he adds, and those facilities employ more than 20,000 people.

“We create jobs through our capital programme. With higher interest rates, our costs would be higher, resulting in less dollars around to do the work that needs to get done on our capital assets. It becomes a spiral. You don’t repair assets because costs have increased, so your assets deteriorate. If you could put money to work, and people to work, it would create jobs, and that has a spillover effect into the construction industry. That’s our concern,” he says

Some are less sympathetic, saying municipal issuers are confused about what the LCR is supposed to do. One regulatory specialist at a North American bank points to the default of Detroit last year, and other municipalities shortly before. The municipal market has also been historically reliant on monoline insurance to guarantee its bonds – an issue at the centre of a court battle involving Detroit’s outstanding swaps contracts – suggesting investors are not assured of their credit on its own terms (Risk September 2013).

“The LCR is not about yield or community reinvestment, or getting money to worthy borrowers. It is supposed to be about keeping cash in reserve, or other marketable securities that are high quality and liquid,” he says.

Treasurers reject any comparison to Detroit. “We have a triple-A bond rating from all agencies. To compare us to Detroit is a non-comparison,” says the second North Carolina municipality’s debt manager. In addition, those hoping to change the existing definition are not expecting the blanket inclusion of municipal debt as a Level 1 asset, says Citi’s Friedlander: “The proportion of muni assets that are below-investment grade is very small but no-one is asking that they are included.”

While the fight goes on, municipalities say they are not reflecting the rule’s potential impact in their funding forecasts. Instead, they are hoping amendments will make it into the final version of the LCR, which is expected within weeks.

“These bonds need to be included at Level 2a. Level 2b is already overcrowded with other assets and the restrictions are too tight. But there is a reasonable chance of getting that outcome,” says Friedlander. “The case for this is excellent. I am encouraged because it is so strong.”

Author: Joe Rennison
Source: Risk magazine | 28 May 2014

Muni Debt Prices Storm Back After Last Year’s Rout

Municipal-bond prices have come roaring back, reversing last year’s rout despite enduring financial challenges facing U.S. cities and states.

The resurgence in the $3.7 trillion market comes as bond buyers attempt to find higher investment returns amid a tumble in U.S. interest rates.

Long coveted by mom-and-pop investors for their tax benefits and relative stability, municipal bonds – debt sold by cities, states and local government-related entities – are benefiting from a broad bond-market rally and a decline in new debt being issued by municipalities that are still trying to tighten their belts.

The municipal-bond market posted its worst year in 2013 in almost two decades, registering losses in the wake of Detroit’s record municipal bankruptcy-protection filing, concerns over hefty pension costs in Illinois and economic worries in Puerto Rico.

Investors have poured $3.1 billion into municipal-bond mutual funds this year, compared with $2.96 billion over the same period in 2013, according to data from Lipper as of Wednesday. The gains mark a shift after investors pulled $39.9 billion from the funds in the last 31 weeks of 2013, the data show.

Yields on municipal debt fell to 2.325% on Wednesday, according to Barclays PLC, their lowest in almost a year. Yields fall when prices rise.

The gains have made the debt a star performer for investors this year, in a twist few predicted. Municipal bonds have returned 5.869% in 2014, reflecting interest payments and price appreciation. That compares with total returns of 5.769% on highly rated corporate bonds, 3.3% for the S&P 500 and 2.982% on U.S. Treasury debt, according to Barclays data.

“I don’t think the need for tax-exempt income ever went away, and there appears to be pent-up demand,” said John Miller, co-head of fixed income at Nuveen Asset Management LLC, which oversees about $90 billion in municipal bonds.

Cities and states aren’t borrowing enough to meet the demand from investors, said Vikram Rai, a fixed-income strategist at Citigroup Inc., which forecasts issuance will fall to $280 billion this year, from $334 billion in 2013. “The primary market supply is very anemic and that’s really driving down yields,” he said.

Many municipal bonds are still considered nearly as safe as Treasurys, because they are backed by the taxing authority of various governments. Their prices typically move in tandem with the U.S. government-debt market, and this year, Treasury bond prices have staged a surprising rally.

The riskiest municipal bonds are rallying the most, though many brokers and investment advisers still are steering retirees and other individual investors away from junk-rated municipal bonds, as their clients are looking for stable income and savings.

These buyers generally “are looking for the safety that muni bonds have and shy away from those municipalities that have lower credit ratings or are in trouble,” said Benjamin Chuckrow, a senior vice president with Wells Fargo Advisors in Saratoga Springs, N.Y.

He warns clients interested in municipal debt that there are two types of risks to consider: whether the issuer is in good financial health and what may happen to the bond’s value between now and when it matures. If interest rates rise before the bond matures, investors who want to sell beforehand could get lower prices.

To be sure, some state and local governments are struggling to mend their finances amid anemic U.S. economic growth. Many have cut their budgets and plugged pension gaps.

Puerto Rico is attempting to recover after its debt was downgraded to junk in February, but the bonds’ prices have risen since the U.S. territory sold $3.5 billion of debt in March. One Puerto Rico general obligation bond traded at 71.5 cents to the dollar this week, up from 63.75 in December. The S&P Municipal Bond Puerto Rico Index has returned 10.6% this year through Wednesday.

In comparison, high-yield municipal bonds have returned 9.33% this year, Barclays said.

Illinois, which has struggled to address its underfunded pension, in February sold $1 billion in general obligation bonds, paying less to borrow than the state did eight months earlier. The new deal came as lawmakers reached an agreement that would close the pension gap by about $100 billion.

“State and local governments were in a severe squeeze following the housing downturn and the deep recession,” said Dean Maki, chief U.S. economist at Barclays. “Now, that is stabilizing.”

Rising federal tax rates also have brought investors back to tax-exempt municipal debt, said George Rusnak, managing director of global fixed income at Wells Fargo Private Bank. “You’re seeing individuals have stronger demand for tax-free income,” he said.

By AARON KURILOFF
Updated May 29, 2014 8:12 p.m. ET

The Clean Energy + Bond Finance Initiative created this recommended financing model factsheet for clean energy development. The Qualified 501(c)(3) model achieves low-cost capital for renewable energy installations at nonprofit facilities.

WASHINGTON – Qualified 501(c)(3) bonds are a financing tool that can be used to increase nonprofits’ clean-energy infrastructure and reduce their energy expenditures, the Clean Energy and Bond Finance Initiative said in a recently released paper.

The initiative, known as CE+BFI, was formed by the Council of Development Finance Agencies and the Clean Energy Group.

Qualified 501(c)(3) bonds can finance energy-efficiency or renewable-energy installations for nonprofit facilities. They are issued by state and local government entities, and their proceeds are loaned to nonprofit borrowers. The bonds are repaid by revenues of the nonprofits, and in some cases some of the debt service can be paid from the money the nonprofits save on their utility bills as a result of the clean-energy improvements, according to the paper.

At a webinar Thursday, Jason Rittenberg, CDFA director of research and advisory services, said that his group felt it was important to discuss 501(c)(3) bonds because a lot of the types of clean-energy projects that have been done by state and local governments through bond financing can similarly be done by nonprofits through 501(c)(3) bond financings. He noted there are fewer restrictions for 501(c)(3) bonds than other types of private-activity bonds, and data recently provided to Congress shows that most PABs are 501(c)(3) bonds.

“The flexibility and established investment reputation of this financing tool will encourage the spread of retrofits, installation of renewable energy infrastructure, reduce energy expenditures among donation-dependent nonprofits, and contribute to state and nonprofit clean energy goals,” CE+BFI said in the paper.

Nonprofits who have used 501(c)(3) bonds to finance clean-energy projects include Loyola University in Chicago, which used the bonds to finance facilities with energy saving features and Elmhurst College in Illinois, which used bonds to finance a student housing facility that achieved Leadership in Energy & Environment Design silver certification and a green surface parking lot. World Wildlife Fund also used the bonds to finance construction of its ‘green headquarters’ in Washington D.C.

One benefit to using these bonds for clean-energy projects is that they make marginal projects financially feasible, since bonds offer borrowers low interest rates over long periods of time. Another benefit is that investors are already familiar with 501(c)(3) bonds, so there would be a market for bonds of good quality. And 501(c)(3) bonds are repaid by revenues of the borrower, rather than by public funds as is the case with general obligation bonds, the paper pointed out.

“Bond financing can allow an organization to complete an eligible project sooner, at a larger scale, and with more favorable terms than would be feasible through capital fundraising efforts or other financing tools,” CE+BFI said. “Financing large projects through 501(c)(3) bonds also frees up cash flow in the short term to serve other purposes, providing the borrower greater flexibility in financing its operations.”

There are many potential projects that could be financed with 501(c)(3) bonds, because nonprofit facilities are common across the county and both new and older buildings could benefit from improvements that reduce monthly energy expenditures. Additionally, a single issuance could finance improvements for multiple facilities or nonprofit organizations.

“Whether combining multiple improvements to a single, large facility or pooling retrofit projects among several nonprofit owned facilities, 501(c)(3) bonds can scale clean energy investments to a considerable degree,” CE+BFI said.

The paper notes there are some limitations to using this type of financing. One limitation is that qualified 501(c)(3) bonds offer little cost benefit to smaller projects as a result of the administrative costs of structuring transactions, according to the paper.

Also, nonprofits have to demonstrate that they will be able to use future revenue to pay debt service, the paper said. Private, detailed assessments would need to be conducted to make sure the projects would produce enough cost savings to support repaying the bonds.

Further research should be done to determine whether energy cost savings equal to or greater than monthly debt service would serve as an acceptable credit enhancement, and what the potential is for issuers to collaborate to finance large-scale projects across a wide geographical area, CE+BFI said.

by Naomi Jagoda MAY 29, 2014 4:08pm ET

The GASB recently voted unanimously to approve two Exposure Drafts proposing significant improvements to financial reporting by state and local governments of other postemployment benefits (OPEB), such as retiree health insurance. The GASB also approved a third Exposure Draft that would establish requirements for pensions and pension plans that are outside the scope of the pension standards the GASB released in 2012.

The most significant effect of the OPEB Exposure Drafts would be to require governments to recognize their net OPEB liabilities on the face of their financial statements – providing all financial statement users with a more comprehensive understanding of these significant OPEB promises than is currently available.

The Exposure Drafts, including instructions on how to submit written comments, are each expected to be available in mid-June on the GASB website.

May 29, 2014

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China has just taken another step down the long road to a domestic municipal bond market. On May 19, 2014, the Ministry of Finance (MOF) expanded a trial that allows selected local and regional governments (LRGs) to tap the bond market. Standard & Poor’s Ratings Services views this as an important step toward establishing a transparent LRG bond market. Such a market is vital to reducing the risks to China’s sovereign creditworthiness stemming from local governments’ use of off-balance-sheet debt. But a municipal bond market similar to those in developed economies and containing the risks of local government financing will need many more important changes, in our view. These include changes to the legal framework and greater restrictions on LRG off-balance-sheet borrowing.

• The latest LRG bond market trial shows increased emphasis on transparency.
• Despite the latest changes, the central government retains significant control over LRG bond issuances.
• Developing the municipal bond market requires careful management on various fronts such as ensuring fiscal stability and improving information disclosure.

A New Year, Another Municipal Bond Trial

The MOF’s latest move granted increased debt-issuing responsibilities to more LRGs than it did in 2013. In addition to organizing the process of bond issuance, the selected LRGs also take on the responsibility of making interest and principal payments to bondholders. The 2014 trial is extended to the Beijing municipality, Jiangxi province, Ningxia province, and Qingdao City. The LRGs of the six regions included in both the 2013 and 2014 trials are Shanghai municipality, Zhejiang province, Guangdong province, Shenzhen City, Jiangsu province, and Shandong province.

The latest LRG bond trial shows increased emphasis on transparency. A new requirement in the 2014 trial is the need for greater disclosure. The MOF requires the LRGs involved in the trial to publish news relevant to the bond issues–including the government debt situation as well as economic and fiscal developments–on a timely basis. The announcement on the trial also warned against inaccurate or misleading submissions as well as material omissions of information; this could be a reflection of the public’s doubt on the reliability of LRG data.

Still No Full Freedom To Borrow

Despite the latest change, the selected LRGs are still some way from having full freedom to sell bonds. The central government continues to control the LRG bond issuance process in a few ways. Most importantly, the amount of bonds LRGs are allowed to issue are subject to annual quotas assigned by the State Council (the Chinese cabinet). The LRGs are also only allowed to issue fixed-rate bonds with maturities of five, seven, and 10 years in the proportion 4:3:3.

Some investors could inevitably read the significant influence of the central government over this process as implying sovereign support for the LRG bonds. Bonds issued by local governments in the past few years were priced close to central government bonds. Secondary market activities also show LRG bonds trading at lower yields than the highest rated nongovernment bonds. The effort to develop the Chinese municipal bond market can only be considered a success if investors price debts of different LRGs according to their individual credit characteristics rather than the perception that the bonds have central government support.

More Changes Needed To Further Develop Municipal Bond Market

Getting investors to price bonds based on the LRGs’ differentiated credit metrics isn’t easy. Not least because it is difficult for the central government to absolve responsibility if an LRG defaults on its debt in a unitary state. A default by an LRG could also hurt confidence across the sector and affect the financing of other LRGs. Therefore investors will expect the central government to come to the rescue if an LRG comes close to defaulting.

Also, from the experience of other more developed bond markets, our view is new indirect restrictions to ensure fiscal stability may have to be in place before removing direct controls such as annual bond issuance quotas. Otherwise, there is the risk of a sudden uncontrolled growth in LRG debt. Measures to achieve this in other countries include public finance laws or rules that limit annual net bond issuances to a proportion of capital spending and prescribed ceilings on total LRG debt levels. These measures are effective if the government regularly publishes regional economic and fiscal indicators that are generally regarded as reasonably accurate. Changes to laws or rules governing government public finance may have to happen before the municipal bond market in China develops further.

Even a well-developed municipal bond market does not ensure fiscal stability. This objective is likely to be the main impetus for the MOF’s efforts but it requires off-balance-sheet LRG borrowing to be insignificant. Otherwise, allowing LRGs significantly more freedom to sell bonds will simply add to their borrowing capacity. Consequently, it is also likely that the municipal bond market development will not move far ahead unless the MOF is able to reduce LRGs’ access to off-balance-sheet financing.

Under Standard & Poor’s policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

Read the full report.

The U.S. infrastructure spending gap stands at a whopping $200 billion per year. Traditional funding sources, such as state and local governments, are no longer in a position to help. But Standard & Poor’s believes insurance company pension funds and private sector investment could spur significant funding capacity. In this CreditMatters TV segment, Senior Managing Director Jay Dhru discusses the possibilities.

Watch the video.

Investors’ ravenous demand for high-yield municipal bonds has created an optimal environment for lower-rated issuers, analysts say.

High-yield fund flows totaled $408.1 million for the week ending May 22, and have remained positive for all but one week this year, according to Lipper FMI data. High-yield funds reported outflows 69.2% of the time in 2013.

“It’s a good time for high-yield issuers, BBB category all the way down to nonrated,” Adam Buchanan, vice president of institutional sales and trading at Ziegler Capital Markets, said in an interview. “Due to this market environment, we’re telling issuers bring transactions to market.”

Investor’s desire for high-yield bonds increased this year because of the limited amount of deals coming to market. Volume as of April 30 totaled $89.34 billion, compared to $122.72 billion for the same period in 2013, according to The Bond Buyer’s and Ipreo’s data.

The lack of supply has allowed underwriters to price the few bonds that do come to market at relatively low yields.

“Issuers should look at this market and say yields are being driven lower by demand,” Jim Colby, chief municipal strategist at Van Eck Global, said in an interview. “There is an appetite for high-yield it’s a good time to bring deals to market.”

He said that Van Eck is proof of investors’ appetite for high-yield to a certain extent, since it’s attracted flows into its high-yield fund.

Buchanan also pointed to this year’s tightening credit spreads as another example for why it’s an ideal time to bring high-yield issuances to market.

“There has been a lot of chatter about recent yield transactions and how much their spreads have tighten[ed],” Buchanan said. “Higher-rated yield sector borrowers’ spreads have also come in, for example spreads on AA rated healthcare bonds have tightened 20-30 basis points since December of last year.”

Credit spreads between the Municipal Market Data’s benchmark AAA 10-year GO and its 10-year Baa GO has tightened by 29 basis points to 122 basis points from Jan. 2, 2013, to market close on Friday.

“The spread tightening in yield is from a supply and demand imbalance,” Buchanan said. “High-yield supply is down 50%-plus year-over-year, while the overall market supply is down 30%. Additionally, tax-exempt fund inflows are being driven by high yield funds. The supply/demand imbalance is geared towards the high yield sector and it’s creating an excellent environment for yield sector borrowers.”

Despite these favorable market conditions, analysts are not seeing a large or varied amount of high-yield issuers come to market.

“High-yield is now the domain of many Puerto Rico, many securitized tobacco, and many airports,” Colby said. “It’s a real opportunity for other types of issuers.”

Colby said investors want to see as many different types of investors as are able to come to market.

“I think if you’re building a portfolio and the mantra is diversification,” Colby said. “If you’re not forgetting you need to hedge your bet in some intelligent manner, you want [different high-yield] in your portfolio. What you want is broad diversification and in this kind of an asset class where you really need to pay attention to credit, a broad diversification of issuers is something to be desired.”

Michael Schroeder, president and chief investment officer at Wasmer, Schroeder & Co., said in an interview that this is an environment more high-yield issuers should take advantage of.

“A lot of BBB hospitals have not been issuing much in the high-yield department, and we are not seeing that they will be anytime soon,” he said. “Maybe that will change. It is a good time for issuers to be borrowing, people want high-yield.”

Colby said that in addition to hospitals, charter schools and transportation issuers should be borrowing more.

For the buyside there are credit dangers associated with high-yield bonds, analysts warn. High-yield issuers often have low ratings and therefore a greater chance of defaulting than issuers with investment-grade ratings.

Buchanan acknowledged that while high-yield credit conditions have improved, it is still the risk sector of the marketplace.

“Its credit by credit when you get to the high-yield sector, there are certainly well positioned good nonrated credits out there though, there’s no doubt about that,” he said.

Both Buchanan and Colby said that much of the risk associated with high-yield bonds can be avoided if investors do a credit analysis.

“The dangers are always there if you don’t do your credit work, you don’t do your homework,” Colby said. “[Many investors] just react to the apparent opportunity, which is a yield comparison. But investors, whether they are individual or ETF investors have to make sure your deals are properly protective of bondholder rights, and assert the responsibility of issuer to follow through on their commitments.”

Schroeder noted the inherent risks in high-yield sector, and said investors should be careful, especially in the current rich market.

Buchanan does not see anything that will change market conditions to make them less appealing for high-yield issuers in the immediate future.

“There continue to be dovish comments from [Federal Reserve chair Janet Yellen] and uneven economic data, which has given a bid to treasuries,” he said. “Couple that with low supply and fund flows, this is a unique combination.”

The Federal Open Markets Committee Meeting minutes released on Wednesday re-affirmed the Federal Reserve’s stance that it will not look to raise interest rates until housing data and the inflation rate are stronger.

He does acknowledge though that headline risk could disrupt the high-yield rally, and described it as the “one thing” market participants have to watch.

By HILLARY FLYNN
MAY 27, 2014

DALLAS – Water groups and state and local officials are already urging members of Congress to amend a new federal loan program for infrastructure projects to allow tax-exempt bonds to be used in conjunction with the financial assistance.

The Water Infrastructure Finance and Innovation Act, included in the Water Resources Reform and Development Act Congress passed that President Obama is expected to sign this week, provides $350 million of low-cost loans and credit enhancement for ports, inland waterways, and water supply and treatment infrastructure projects in a five-year pilot program.

The bill limits WIFIA’s contribution to no more than 49% of a project’s cost and caps the overall federal share at 80%. Proceeds from tax-exempt municipal and private activity bonds cannot be used, directly or indirectly, for a project receiving WIFIA support.

Proponents of the WIFIA program hail it as an important new finance tool for funding large projects, while opponents say the prohibition of tax-free debt is a fundamental flaw that will lead to increased privatization of public infrastructure.

Conversations have begun with lawmakers on Capitol Hill in an attempt to amend the water bill in the remainder of this session of Congress or in 2015, said Tommy Holmes, legislative director at the American Water Works Association.

“We’ve already starting talking to Congress,” Holmes said. “We’d like to get that 49% cap raised and be able to use tax-exempt bonds as part of the financing.

“It’s going to be very difficult to get that bill amended this quickly, but it is not impossible,” Holmes said. “If we can’t, we’ll take it up again when the new Congress comes in next year.”

The ban on tax-exempt bond financing was part of the WIFIA proposal in the original Senate bill, and was included by the conference committee that reconciled the differences between Senate and House water bills that passed in 2013, Holmes said. The House bill did not contain any WIFIA program.

“It was a budget decision,” he said. “They wanted to avoid a hit on the U.S. Treasury from reduced revenue due additional tax-exempt debt.”

The National League of Cities, also said it was concerned about the ban on using tax-exempt bonds in conjunction with WIFIA assistance. “We vow to continue to work with Congress to improve this important provision in order to maximize its effectiveness for communities, NLC executive director Clarence Anthony said in a release.

The water bill, H.R. 3080, was approved by large margins in both chambers of Congress last week. The new WIFIA program is a significant breakthrough in confronting the water infrastructure, said David LaFrance, chief executive officer at AWWA. A 2012 report from association put the price tag for maintaining and expanding drinking water systems at $1 trillion over the next 25 years, with a similar amount for waste water systems.

“WIFIA will reduce the financing costs of critical infrastructure projects, allowing communities to fix and expand water systems at a lower cost to their customers,” LaFrance said.

However, the 49% limit and the ban on tax-exempt financing are mistakes that lawmakers should correct, LaFrance said.

“WIFIA will be most effective when communities can fund 100% of project costs, and any non-WIFIA share should be allowed to be financed with tax-exempt debt,” LaFrance said.

Saving just two percentage points on a 30-year loan can result in a savings of 25% of total borrowing costs, LaFrance said, which on a large project can amount to millions of dollars that would otherwise be absorbed through customer bills over many years.

Many utilities and communities won’t be able to take advantage of the low-interest WIFIA loans because of the ban on tax-exempt bonds as a funding method, said Diane VanDeHei, executive director of the Association of Metropolitan Water Agencies.

Utilities will have to issue taxable debt that carry higher interest rates than could be achieved with conventional government bonds or attract private investments to complete WIFIA projects, she said.

“The tax-exempt financing restriction was not conceived as a matter of policy, but was necessary to achieve a clean budget score,” VanDeHei said. “AMWA is confident that lawmakers who have consistently supported WIFIA will continue working with us to do so in the months ahead.”

The ban on tax-exempt debt for WIFIA projects is a “raw deal” and “a wolf in sheep’s clothing” for municipal water systems, said Wenonah Hauter, executive director of Food & Water Watch.

“WIFIA is anything but innovative,” she said.

“WIFIA will give low-interest loans primarily to private water corporations, compete with the state revolving funds for federal resources, and place inappropriate pressure on local governments to privatize their drinking water and wastewater systems,” Hauter said.

Water utilities have financed $1.7 trillion of water infrastructure needs over the last decade with tax-exempt bonds, she said.

“Cities and towns will not be able to use tax-exempt bonds to cover the portion of an infrastructure project that WIFIA doesn’t fund,” Hauter said. “This effectively makes WIFIA useless for most municipalities.”

Strengthening federal support of state water revolving loan programs would be more effective than the enacted WIFIA legislation, she said.

Federal funding for local water and sewer systems has dropped 80%, adjusted for inflation, since 1980, Hauter said. The Environmental Protection Agency has estimated that $384 billion is needed over 20 years to maintain deteriorating water systems, she said, but federal assistance over the last 16 years totals only $15 billion.

The ban on tax-exempt bonds for WIFIA opens the door to more public-private partnerships in water projects and more privatization of water suppliers, said Erin Diaz of watchdog group Corporate Accountability International.

“The privatization of water systems around the globe has often resulted in devastating results for the economy and people

Summary

Citi says the municipal-bond market looks rich and that it doesn’t see good things ahead for munis for the remainder of this year, with possibly one exception: the toll road sector. Citi’s muni strategy troika of Vikram Rai, Mikhail Foux and George Friedlander foresee a time soon, likely next year, “when the need for infrastructure investment overwhelms fiscal restraint,” and they expect a slew of new bond issuance to support municipal infrastructure needs. Citi says new projects in the toll-road sector already seem to be picking up, and sees investor opportunities ahead. From Citi today:

Toll road projects serving large metropolitan areas with high wealth levels and a diverse geographic and economic base (for instance, projects in the New York tri-state area and San Francisco Bay area) are typically blessed with relatively strong inelastic demand for their services and also possess strong independent rate setting ability. Thus, these highly rated issues have traded more like essential service revenue bonds and have richened fairly drastically with the rest of the high grade municipal sector. While there is no doubt that these bonds aren’t exactly suitable for investors looking for yield pick-up, we still consider them cheap vs. high grade bonds in essential service categories such as gas, power and electric utilities. These bonds also offer strong defensive play against a darkening of the municipal credit landscape.

But, for investors looking for yield pick-up while willing to slide down the credit spectrum, we would encourage exploring newly issued BBB/BB rated toll road bonds. While evaluating these new issues, we prefer projects which offer essentiality i.e. there is no threat from other toll free options which could force new toll roads to compete for business based on toll charges.

May 27, 2014, 12:01 P.M. ET
By Michael Aneiro

Pay for Success is an approach to funding social service programs designed to improve outcomes and ultimately reduce the costs of addressing these issues. In a Pay for Success contract, private investors provide funding for preventative or interventional services up-front, and government reimburses these investors with a return on their investment, only if results are achieved.

In doing so, private investors take on the initial risk, governments pay based on outcomes, and cost-saving programs with demonstrated effectiveness gain access to new and additional funding sources. Pay for Success projects are underway in several states in the U.S., including California.

The Housing California conference, an annual conference held in April with more than 1,000 participants involved in housing, included an informative session on the outlook on Pay for Success, or Social Impact Bonds, with LeSar Development Consultants, Corporation for Supportive Housing, Third Sector Capital Partners, Santa Clara County, and California State Assemblymember Toni Atkins’ office.

The audience, a mix of affordable housing developers, local government staff, and lenders, were receptive to Pay for Success, interested in learning how it could be applied to their programs, particularly around affordable housing.

Some of the key highlights of the panel looking at the outlook for Pay for Success included:

Change the Nomenclature to Gain More Understanding and Support – move away from the misnomer “social impact bond” to nomenclature that more accurately describes the tool –“Pay for Success” or “Pay for Performance”. Santa Clara County’s COO Gary Graves shared that upon hearing about “Social Impact Bonds”, he was skeptical, as the notion of floating a bond was unappealing. Once understanding that Pay for Success actually does not involve bond financing, but rather contracts that are paid upon outcomes being reached, and learning more, Mr. Graves became a proponent of the idea and Santa Clara County has a Pay for Success program under development.

Counties Are Key Partners, Along with Cross-Sector Community Partners – Pay for Success programs that are currently emerging in California have Counties serving as the public agencies that pay upon successful outcomes being reached, and a broad cross-sector of the community collaborating. In Santa Clara County, the County was spurred to action by the community, who advocated for the County to adopt a Pay for Success program. Community partners and the County worked in collaboration to complete a landscape analysis process to determine which services could fit into a Pay for Success model. Now, the County is issuing a Request for Proposals to select a lead agency for the program.

Homelessness, Workforce Development, Recidivism, Frequent Health Users, Supportive Housing, and Child Welfare are emerging areas where Pay for Success programs are being developed. Santa Clara County’s landscape analysis identified homelessness and acute mental health treatment as two areas where services could fit into a Pay for Success model. One success outcome measure will be keeping a homeless family housed for at least a year.

In Minnesota and Massachusetts, PFS projects are focused on supportive housing. Minnesota also has a workforce development PFS program underway. In Los Angeles, the PFS model is used by Just In Reach provides housing, workforce, and substance abuse services to homeless inmates to reduce recidivism. Success outcome measures include reducing bed days in incarceration.

Challenges remain for this burgeoning field. Some of the most significant challenges are:

• High Transaction Costs, resulting in a need for scalability
• Credible Outcome Measurement
• Limited Government Capacity
• Limited Provider Capacity
• Difficulty in “Accessing” Government Cost Savings

Some of these challenges are being overcome by communities and local government seeing the benefits of a Pay for Success model and forging ahead despite the drawback. In Santa Clara County’s case, the County had difficulty identifying cashable savings from their acute mental health treatment Pay for Success program, because while they anticipated wait times at local emergency rooms would decrease, they did not anticipate it would equate to cash savings. Despite this, strong community support of paying for verifiable outcomes convinced County Supervisors and the County to move forward with the program. Another obstacle Santa Clara County is facing is a lack of provider capacity, so they have agreed to invest $1,000,000 upfront toward capacity-building for homeless providers and community-based organizations in preparation for program ramp-up, all with the goal of bolstering homeless health care. With community and political will, the Pay for Success challenges are being overcome.

For more information about Pay For Success, read the Federal Reserve Bank of San Francisco’s Community Development Investment Review – Pay For Success Financing (Volume 9, Issue 1, 2013).

MAY 23, 2014
By Leilani Barnett.

Leilani Barnett is Regional Manager of Community Development with the Federal Reserve Bank of San Francisco, covering California’s Central Valley.

The US Department of Transportation’s TIFIA (Transportation Finance & Innovation Act) credit support program is by far the most successful federal program providing financial support for surface transportation public-private partnerships (P3). Few major P3 transportation projects in recent years would have been possible, and few P3s in the pipeline will go forward, without TIFIA assistance. Now, Congress has set out to try to repeat the success of TIFIA with a similar program—just substituting a “W” for the “T” in the acronym—to support major water infrastructure projects.

The new WIFIA (Water Infrastructure Finance and Innovation Act) program is part of the Water Resources Reform and Development Act (WRRDA) that passed the House on May 21 and the Senate on May 22, and is expected to be signed by the President shortly.

WRRDA authorizes funding for the construction and repair of waterway and port projects across the United States. It also allows Congress to authorize the Army Corps of Engineers to spearhead the development, maintenance and support of vital US port and waterways infrastructure, as well as supporting targeted flood protection and environmental restoration needs.

Consciously building on the increased use of public-private partnerships for the financing, construction and operation of major surface transportation infrastructure, WRRDA encourages P3s for development of major water infrastructure projects. Specifically, the legislation establishes WIFIA in order to provide credit assistance for drinking water, wastewater and water resources infrastructure projects. WIFIA is designed to leverage federal funds by attracting substantial private or other non-federal investments to promote increased development of critical water infrastructure and to help speed construction of local projects.

WIFIA is very closely modeled on the USDOT TIFIA program and has many similar elements, including interest rate (tied to long-term Treasury rates) and maximum maturity (35 years); maximum percentage of eligible project cost that can be financed (generally 49 percent, although in contrast in TIFIA program, WIFIA legislation provides that up to 25 percent of each year’s financing assistance can be made be available for loans exceeding 49 percent of project cost); deferral of loan repayment for up to five years after substantial completion; credit rating requirements; and non-subordination/ “springing parity lien” in the event of bankruptcy.

Also consistent with the initial authorization of TIFIA program, WIFIA is established as a five-year “pilot” program, with the Comptroller General directed to report to Congress prior to the end of this period on status of program implementation and with recommendations for improvements, continuation authorization or termination.

The most significant difference between TIFIA and WIFIA is in the level of authorized spending. Authorized spending for the WIFIA program starts at $20 million in the first year and increases to $50 million in the fifth year. If “scored” for federal budget purposes similar to the scoring for the TIFIA program, this would provide for approximately $200 million in financing in the first year, increasing to approximately $500 million in the fifth year. That compares to TIFIA’s current funding level under MAP-21 legislation of $1 billion (which allows credit support of for loans of approximately $10 billion). By way of further comparison, the first year (1999) appropriation for the TIFIA program was $80 million. Given that the nation’s water infrastructure needs are, by most estimates, even larger in total than its transportation needs, this is clearly a “pilot” program—with a very small “p.”

WRRDA directs the Army Corps of Engineers and the Environmental Protection Agency to implement and manage the WIFIA program. The Army Corps of Engineers is authorized to carry out projects for flood damage reduction, environmental restoration, coastal or inland harbor navigation improvement, and inland and intracoastal waterways navigation improvement. The Environmental Protection Agency is authorized to carry out projects that are eligible for assistance under the Federal Water Pollution Control Act or the Safe Drinking Water Act in addition to projects that enhance energy efficiency or that repair, rehabilitate or replace public water systems or publicly owned treatment works. Amounts appropriated for WIFIA financing assistance are allocated jointly to the Corps of Engineers and the EPA, possibly with subsequent implementing regulations to clarify the specific amounts to be made available to each agency.

Given USDOT’s successful implementation and management of the TIFIA program, supporters of P3 can hope the Corps of Engineers and EPA learn from USDOT’s experience with the TIFIA program and build on established and now well-understood policies and program guidelines.

WRRDA has one other notable provision supporting the use of P3 approaches to water infrastructure projects. It establishes a Water Infrastructure Public-Private Partnership Program, authorizing the Corps of Engineers to enter into agreements with state and local governments and private entities to finance construction of at least 15 water resources development projects, including coastal harbor improvement, channel improvement, inland navigation, flood damage reduction, aquatic ecosystem restoration and hurricane and storm damage reduction.

To identify these projects, the Corps of Engineers must consider the extent to which the project is significant to the US economy, leverages federal investment by encouraging non-federal contributions to the project, employs innovative project delivery and cost-savings methods, has received federal funds in the past and experienced delays or missed scheduled deadlines, has unobligated Corps of Engineers funding balances and has not received federal funding for recapitalization and modernization since the project was authorized. The Corps of Engineers must then, in consultation with the non-federal applicant, develop a detailed project management plan.

To qualify for participation in the Water Infrastructure Public-Private Partnership Program, each project must also have specific Congressional authorization provided by subsequently enacted legislation. Projects qualifying for the Public-Private Partnership Program will benefit from potential waiver from or modification of applicable federal regulations as well as technical assistance from the Corps of Engineers.

As an initial project that might be implemented under this new Public-Private Partnership Program, Alaska Congressman Don Young is expected shortly to introduce House Resolution 4668 designed to promote a P3 framework for the privately financed development of a major new port facility in Alaska’s Seward Peninsula.

The final version of WRRDA does not change the existing requirements for issuance of private activity bonds (PABS) for water infrastructure projects. During the multi-year consideration of this legislation, various stakeholder groups advocated in particular for eliminating the state volume cap on water and wastewater infrastructure PABS and instead providing that they be treated in the same manner as PABS for airports, ports and certain solid waste disposal projects. This change would have allowed local communities to more effectively leverage the municipal capital markets and, in combination with other finance mechanisms, was estimated would have leveraged an additional $2 billion to $6 billion annually in private investment in water infrastructure projects.

WRRDA is further evidence of the strong and bipartisan support in Congress for the use of P3 structures for major US infrastructure projects. The next question will be how far and how fast states and localities, and the federal government itself, will partner with the private sector to take advantage of these new incentives.

Originally published on 22 May 2014

Last Updated: May 23 2014
Article by John R. Schmidt, David Narefsky, Joseph Seliga, George K. Miller and Natalie Veltman
Mayer Brown

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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

Municipal financing differs in a number of significant ways from traditional commercial financing. Therefore, while chapter 9 of title 11 of the United States Code (the “Bankruptcy Code”) incorporates many provisions applicable in cases under chapter 11 of the Bankruptcy Code, including section 1129(b), a/k/a the “cram down” section, it also contains its own provisions with respect to the confirmation of a plan of adjustment – i.e., sections 943 and 944 of the Bankruptcy Code. See 11 U.S.C. § 901(a) (incorporating sections of the Bankruptcy Code). When considering the differences between cram down scenarios in cases under chapter 11 of the Bankruptcy Code and cases under chapter 9 of the Bankruptcy Code, one must consider the prevalence of special revenue financing by municipal debtors and the protections that are built into chapter 9 of the Bankruptcy Code.

I. CAN SPECIAL REVENUE DEBT BE IMPAIRED?

A. Special Revenue Financing

Our system of federalism grants state governments the independence and the freedom (with the consent of their citizens) to authorize local governmental bodies to finance various governmental functions and necessary improvements through the issuance of municipal bonds. Municipalities issue their own debt obligations either based on their full faith and credit (general obligation bonds) or based upon the revenues to be collected by the municipality from the financed improvement (revenue bonds). Local government borrowing differs in a fundamental way from either individual or corporate borrowing. The municipal borrower is an entity having special characteristics that differ from those of private actors. See Joel A. Mintz et al., Fundamentals of Municipal Finance 45 (2010). The local government exists solely to provide governmental services; it does not exist for profit-making purposes. Id. Due to the public benefit of financed projects, like water and sewer systems, municipalities are limited in the actions they can take with these assets, including certain restrictions on the right to mortgage or transfer the property, or to allow foreclosure or possession of the property by a secured creditor in the event of default.1 Further, limitations exist due to the state’s interest in protecting the credit of the state and insuring that municipalities do not harm the state’s credit by undertaking obligations which cannot be repaid.

As municipalities have grown, so has their need for financing. Protecting the integrity of municipal financing is essential to the continued confidence of the municipal bond markets. Thus, municipalities have traditionally made every effort to honor their public debt obligations.

i. Protections for Special Revenue Creditors

Unlike general obligation bonds, which are backed by the full faith and credit of the issuer and, therefore, rely on the assessment and collection of taxes for repayment, revenue bonds do not increase the tax burden of the citizens. They are non-recourse obligations repaid solely from the revenues (and other specified pledged funds) generated by the project that is being financed, such as a sewer or water system, toll road, toll bridge, tunnel, or the like. Consequently, in many jurisdictions, revenue bonds may be issued without voter approval or other procedures often required for the issuance of general obligation bonds. See Fundamentals of Municipal Finance, at 3-4.

To entice the public to purchase revenue bonds in particular, states have enacted statutory provisions designed to promote this type of financing. Since repayment of the revenue bonds are limited to the stream of income from the financed public projects, states authorize the issuing municipality to irrevocably pledge (or set aside) the revenue stream (or net revenue stream) for the benefit of the revenue bondholders. Typically, the pledge includes the creation of a first lien on the revenue stream. Some states even provide that the pledged revenue streams are held in trust for the benefit of the special revenue creditors. For example, Alabama recognizes that pledged revenues “shall constitute a trust fund or funds which shall be impressed with a lien in favor of holders of the warrants to the payment of which such pledged funds are pledged” and that the pledged revenues are “irrevocably pledged for the payment of the principal and interest on such warrants as provided in Section 11-28-3.” Ala. Code §§ 11-28-2, 11-28-3.

Other protections that are authorized by state law and that are often contained in revenue bond documents are covenants in which the issuer pledges: (a) to issue all bonds necessary to finance the project; (b) to complete project construction expeditiously; (c) to maintain specified amounts of reserve funds; (d) to fix, establish, and collect appropriate fees, rates, tolls, or user charges; and (e) to restrict the investment of bond proceeds. Fundamentals of Municipal Finance, at 3-4. In addition, where revenue bonds are issued to finance a series of projects undertaken by the same issuer, the municipality that issued them will usually pledge not to issue any additional bonds that are secured by the same revenue stream, unless current revenues are sufficient to cover a specified percentage of both current and future debt service on both outstanding bonds and the new bonds. Id. Once entered into, the revenue bond covenants may not be modified or abandoned by the municipality. Id.2

Since bondholders are unable to take ownership of certain public assets, municipalities will often transfer certain control rights to bondholders to provide the holders with a meaningful remedy in the event of nonpayment. One such remedy is the right to the appointment of a receiver to oversee the particular project in question, and, if appropriate, raise rates sufficient to pay the special revenue debt issued to finance the project.

The states and their municipalities have designed these financing structures to guaranty that the revenue stream relied upon by special revenue bondholders will be protected and not impaired. These statutory provisions protect not only bondholders but also protect the overall credit of the state and all of its municipalities. See Fundamentals of Municipal Finance, at 4. As will be discussed in more detail below, given the prevalence of this type of financing, and with it being particular to municipal debtors, Congress, in amending chapter 9 of the Bankruptcy Code in 1988, intended to protect and preserve the bargain made between the municipal debtors, as issuers, and the holders of special revenue debt.

B. Chapter 9 And A Brief History Of Municipal Bankruptcy Legislation3

Chapter 9 of the Bankruptcy Code is the sole chapter under which a municipality may seek bankruptcy relief. Chapter 9 has evolved since it was first enacted in 1934. Prior to 1988, chapter 9 lumped all of a municipality’s debt into one pot and did not distinguish between general obligation bonds and special revenue bonds. In 1988, Congress approved a series of amendments (the “1988 Amendments”) aimed at distinguishing between the two types of bonds. The intent of Congress in enacting the 1988 Amendments was to ensure that state laws protecting special revenue financing were honored in a chapter 9 proceeding and the rights of special revenue creditors would receive additional protections not granted prior to the 1988 Amendments. See S. Rep. No. 100-506, at 13 (1988) (the “Senate Report”). Specifically, the 1988 Amendments sought to ensure that special revenue bondholders would have unimpaired rights to the project revenues pledged to them.

The ultimate intent of Congress in enacting the 1988 Amendments was to provide assurances to the capital markets that special revenues essential to municipal financing remain unimpaired in the event of a Chapter 9 filing. The Senate Report for the 1988 Amendments noted that “[r]easonable assurance of timely payment is essential to the orderly marketing of municipal bonds and notes and continued municipal financing.” Id. at 21. The Senate Report further noted that:

To eliminate the confusion and to confirm various state laws and constitutional provisions regarding the rights of bondholders to receive the revenues pledged to them in payment of debt obligations of a municipality, a new section is provided in the amendment to ensure that revenue bondholders receive the benefit of their bargain with the municipal issuer and that they will have unimpaired rights to the project revenues pledged to them. . . .

Id. at 12 (emphasis added). For example, prior to the 1988 Amendments, special revenue bondholders were at risk that section 552(a) of the Bankruptcy Code would strip them of their liens on post-petition revenues. The Senate Report addressed that issue:

In the municipal context, therefore, the simple answer to the Section 552 problem is that Section 904 and the tenth amendment should prohibit the interpretation that pledges of revenue granted pursuant to state statutory or constitutional provisions to bondholders can be terminated by the filing of a chapter 9 case. Likewise, under the contract clause of the constitution (article I, section 10), a municipality cannot claim that a contractual pledge of revenue can be terminated by the filing of a chapter 9 proceeding.

Id. at 6 (emphasis added). The risk posed by section 552(a) was eliminated by the 1988 Amendments. See In re Cnty. of Orange, 179 B.R. 185, 191-92 (Bankr. C.D. Cal. 1995).

While protecting the integrity of special revenue bonds in chapter 9, Congress was also determined to protect the integrity of the state laws that authorize special revenue municipal financing. With revenue bonds, “the general taxpayers are usually not committed to repaying the bonds or funding operational deficits through general tax revenues . . . [and] it would be quite problematic and contrary to state law if a bankruptcy filing resulted in revenue bonds being converted into general obligation bonds.” Senate Report, at 5. With regard to the 1988 Amendments, one court has noted:

The 1988 Amendments to the Bankruptcy Code added the definition of “special revenues” in § 902(2). The 1988 Amendments were intended to preserve a dichotomy between general obligation and special revenue bonds for the collective benefit of bondholders (to secure the benefit of their bargain), municipalities (to maintain the effectiveness of the revenue financing vehicle) and taxpayers (to ensure that revenue obligations were not transformed into general obligations).

In re Heffernan Mem’l Hosp., 202 B.R. 147, 148 (Bankr. S.D. Cal. 1996).

C. Sections 927, 928(a) And 1111(b) Protect Special Revenue Debt From Impairment During the Case and From a Cram Down.

The confluence of sections 927, 928(a) and 1111(b) of the Bankruptcy Code demonstrate Congress’ intent to protect the benefit of the bargain made by a municipal debtor, as issuer, and the holders of special revenue debt obligations under chapter 9 of the Bankruptcy Code both during the case and at confirmation.

i. Congress preserved the extent, validity and priority of liens on special revenues post-petition.

Through section 928(a) of the Bankruptcy Code, Congress preserved the extent of the creditors’ liens on special revenues of a municipal debtor. Section 902 defines special revenues as:

(A) receipts derived from the ownership, operation, or disposition of projects or systems of the debtor that are primarily used or intended to be used primarily to provide transportation, utility, or other services, including the proceeds of borrowings to finance the projects or systems; (B) special excise taxes imposed on particular activities or transactions; (C) incremental tax receipts from the benefited area in the case of tax-increment financing; (D) other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions; or (E) taxes specifically levied to finance one or more projects or systems, excluding receipts from general property, sales, or income taxes (other than taxincrement financing) levied to finance the general purposes of the debtor[.]

11 U.S.C. § 902(2). In turn, section 928(a) of the Bankruptcy Code preserves the extent of a creditor’s lien on special revenues by granting such creditor a continuing post-petition lien on special revenues to the same extent as existed prepetition. Specifically, section 928(a) of the Bankruptcy Code provides:

Notwithstanding section 552(a) of this title and subject to subsection (b) of this section, special revenues acquired by the debtor after the commencement of the case shall remain subject to any lien resulting from any security agreement entered into by the debtor before the commencement of the case.

11 U.S.C. § 928(a). Whereas, in a chapter 11 case a secured creditor with a consensual lien will not maintain its liens on collateral of the same type generated post-petition, in a chapter 9 case a consensual lien secured by special revenues continues to attach to post petition revenues to the same extent it existed prepetition.

ii. Congress similarly preserved the value of liens on special revenues.

Through the combination of sections 1111(b) and 927 of the Bankruptcy Code, Congress also preserved the value of liens against special revenues. Section 1111(b) of the Bankruptcy Code provides:

(1)(A) A claim secured by a lien on property of the estate shall be allowed or disallowed under section 502 of this title the same as if the holder of such claim had recourse against the debtor on account of such claim, whether or not such holder has such recourse, unless – (i) the class of which such claim is a part elects, by at least two-thirds in amount and more than half in number of allowed claims of such class, application of paragraph (2) of this subsection; or (ii) such holder does not have such recourse and such property is sold under section 363 of this title or is to be sold under the plan.

(2) If such an election is made, then notwithstanding section 506(a) of this title, such claim is a secured claim to the extent that such claim is allowed.

11 U.S.C. § 1111(b). Congress enacted Section 1111(b) in an attempt to prevent the harsh results faced by non-recourse lenders in a cram-down scenario. See, e.g., Great Nat’l Life Ins. Co. v. Pine Gate Assocs., Ltd., 2 B.C.D. 1478 (Bankr. N.D. Ga. 1976). In Pine Gate, the court exercised its cram-down powers under Chapter XII to cash out a nonrecourse undersecured mortgagee at the appraised value of the property, rather than the amount of debt, at a time of depressed prices. In opposition to the debtor’s proposed plan, the lenders argued that their negotiated “benefit of the bargain” under the non-recourse financing arrangement was either (i) full payment or (ii) the right to foreclose on the property, and that their interests would not be adequately protected unless they were paid in full or allowed to foreclose. The Pine Gate court disagreed, holding that the proposed treatment of the secured claim through a cash payment equal to the appraised value of the collateral was sufficient. In reaching its decision, the court relied upon authority for the proposition that a secured creditor was entitled to receive no more than the appraised value of secured property as just compensation for the loss of the property and satisfaction of its security interest.” Pine Gate, 2 B.C.D. at 1478. Accordingly, while the debtor retained ownership of the property, the mortgagee was not paid in full, did not retain its lien, and was deprived of its right to sue for a deficiency. See In re S. Vill., Inc., 25 B.R. 987 (Bankr. D. Utah 1982) (discussing the Pine Gate decision).

As a result of Pine Gate, it became clear that a debtor could seek relief through bankruptcy during a period when property values were depressed, propose to repay secured indebtedness only to the extent of the then-appraised value, cram-down a non-recourse secured lender, and preserve all potential future appreciation for the debtor alone.” See In re DRW Prop. Co., 57 B.R. 987, 990 (Bankr. N.D. Tex. 1986). In addition, “[t]he undersecured nonrecourse lender would not be entitled to vote in the unsecured class, thereby making confirmation of the plan much easier.” Id. (citing In re S. Vill., 25 B.R. 987 (Bankr. D. Utah 1982); Jeffrey A. Stein, Section 1111(b): Providing the Undersecured Creditors with Post-Confirmation Appreciation in the Value of the Collateral, 56 Am. Bankr. L.J. 195 (1982)). Secured creditors were shocked by this result and sought relief from Congress when the Bankruptcy Code was proposed and debated. See Richard F. Broude, Cramdown and Chapter 11 of the Bankruptcy Code: The Settlement Prerogative, 39 Bus. Lawyer 441 (1984).

As a result of the concern communicated to Congress, the final version of the Bankruptcy Code included section 1111(b) for purposes of alleviating the problem recognized under Pine Gate and restoring the “benefit of the bargain” expected by nonrecourse lenders. Kenneth N. Klee, All you Ever Wanted to Know About Cram Down Under the New Bankruptcy Code, 53 Am. Bankr. L.J. 133 (1979); Michael J. Kaplan, Nonrecourse Undersecured Creditors Under New Chapter 11 – The Section 1111(b) Election: Already a Need for Change, 53 Am. Bankr. L.J. 269 (1979). Accordingly, as codified in the Bankruptcy Code, section 1111(b) now represents Congress’ attempt “to create a balance between the debtor’s need for protection and a creditor’s right to receive equitable treatment.” See In re Trenton Ridge Investors, LLC, 461 B.R. 440, 505 (Bankr. S.D. Ohio 2011) (quoting In re Union Meeting Partners, 160 B.R. 757, 769 (Bankr. E.D. Pa. 1993)).

Section 1111(b) balances those interests in two ways. First, if a nonrecourse mortgagee is substantially undersecured, the mortgagee may retain the recourse status conferred by section 1111(b)(1)(A) and cause that class of claims to vote to reject the plan. Id. In such a circumstance, the undersecured creditor can make it impossible to confirm a plan absent a cramdown in accordance with section 1129(b)(2)(B), which would require that the unsecured claims be paid in full or that junior interests receive nothing under the plan. Id. In this way, the undersecured creditor can force the debtor into a situation where the debtor must propose a plan satisfying the unsecured debt or eliminate the debtor’s interest in the property. Id. (citations omitted).

Second, a secured creditor is permitted to make an election pursuant to section 1111(b)(2). Upon making such an election, the secured creditor forfeits its right to recourse against the debtor (i.e., the right to pursue an unsecured claim), but is instead granted an allowed secured claim in the amount of the debt rather than in a judicially determined amount. Id. Hence, the creditor may benefit from any future increase in the value of the property. Id.; see also Tuma v. Firstmark Leasing Corp., 916 F.2d 488 (9th Cir. 1990) (with section 1111(b), Congress sought to give creditors the opportunity to capture future appreciation in the value of their collateral); In re Bloomingdale Partners, 155 B.R. 961, 974 n.7 (Bankr. N.D. Ill. 1993) (“Congress [arguably] enacted section 1111(b) to prohibit debtors from cashing-out creditors at judicially determined values.”); In re Weinstein, 227 B.R. 284, 295 n.12 (B.A.P. 9th Cir. 1998) (“The real benefit of the [section 1111(b)] election is that it protects the creditor against a quick sale of its collateral. . . . By making the election, the creditor guards against an opportunistic sale . . . .”).

In 1988, Congress amended chapter 9 of the Bankruptcy Code, proposing “to clarify the provisions of the Bankruptcy Code applicable to municipalities and to correct unintended conflicts that currently may exist between municipal law and bankruptcy law.” Senate Report, at 1. Congress approved the 1988 Amendments to chapter 9 because it wanted to ensure that the market for municipal debts remained stable. Id. at 21 (Senate Judiciary Committee recognizing that “[r]easonable assurance of timely payment is essential to the orderly marketing of municipal bonds and notes and continued municipal financing.”). In approving the 1988 Amendments, Congress recognized that the pledges common to municipal finance must not be adversely affected, even where a bankruptcy filing has occurred, in order to ensure stability in the special revenue financing market. Id. at 3. Congress also recognized that there were restraints on the treatment of special revenue financing imposed by state constitutions. Accordingly, Congress included limitations on both the: (i) conversion of non-recourse obligations into recourse obligations; and (ii) the ability to impair the holders of special revenue debt obligations.

As part of the amendments in 1988, Congress addressed the non-recourse nature of special revenue financing. One of the main concerns that the 1988 Amendments sought to address was that “[s]ection 1111(b) provides that in some circumstances non-recourse debt may be treated as recourse debt.” Senate Report, at 22. The problem presented was that “[m]any municipal obligations are, by reason of constitutional, statutory, or charter provisions, payable solely from special revenues and not the full faith and credit of the municipality.” Id. Thus, to resolve this problem, the 1988 Amendments adopted section 927, prohibiting conversion of revenue bonds into general obligation bonds in a chapter 9 case. “[The 1988 Amendments] [therefore] avoid[] the potential conversion of revenue bonds into General Obligation bonds under Section 1111(b).” Senate Report, at 2; see also H.R. Rep. No. 100-1011 (1988), at 7 (new section 927 to be added to ensure that non-recourse revenue bonds cannot be converted under section 1111(b) into recourse, or general obligation, debt because allowing such may violate some state constitutions and statutes). The reasoning behind Section 927 has been summarized as follows:

The amendments protect the future effectiveness of revenue bond financing against the possibility of an adverse judicial determination in connection with a municipal bankruptcy. Specifically, the amendments insure that in the event of a municipal bankruptcy, taxpayers will not be required to pay bondholders for bankrupt municipal projects that were intended to be funded exclusively through project revenues. The amendments insure that state constitutional and statutory debt limits will not be preempted by the application of bankruptcy laws. Finally, the amendments insure that revenue bondholders receive the benefit of their bargain with the municipal issuer, namely, they will have unimpaired rights to the project revenues pledged to them.

Senate Report, at 12-13 (emphasis added).

Section 927 of the Bankruptcy Code reads as follows:

The holder of a claim payable solely from special revenues of the debtor under applicable nonbankruptcy law shall not be treated as having recourse against the debtor on account of such claim pursuant to section 1111(b) of this title.

11 U.S.C. § 927. While adding section 927 to chapter 9, Congress could also have elected to remove the incorporation of section 1111(b) into chapter 9. However, pursuant to section 901, Congress incorporated section 1111(b), but chose merely to limit it. Section 1111(b), subject to the limitations imposed by section 927, still stands. Thus, in the context of special revenue bonds, the section 1111(b) election is automatic, not requiring any affirmative act by the secured creditor. The ability to elect full recourse treatment for non-recourse debt has been statutorily removed by section 927.

Although Congress recognized that the existing chapter 11 choice for full recourse treatment of non-recourse debt would be unavailable to chapter 9 creditors due to state constitutional limitations on recourse financing, it did not intend for the result to be the continued impairment of special revenue financing by results such as that reached in Pine Gate. Indeed, the existing structure of the Bankruptcy Code prevents such an impairment. By incorporating section 1111(b) into chapter 9, but also limiting the conversion of nonrecourse debt to recourse debt, Congress made the section 1111(b)(2) election automatic, providing that the debtor must pay the full value of the claim. Any other reading would render the incorporation of section 1111(b) and the limitation set forth in section 927 superfluous. Further, it makes no sense to read chapter 9 as taking both the recourse protection as well as the section 1111(b)(2) protection away from secured lenders when Congress could have achieved such a result by simply not including section 1111(b) in section 901. Accordingly, in a case under chapter 9, a special revenue finance creditor must be treated as having an allowed secured claim in the full amount of the outstanding debt.

D. In Addition To The Foregoing Provisions Of The Bankruptcy Code, Municipal Debtors Face Additional Constitutional Limitations.

In addition to Congress’s intent to protect the bargains made with respect to special revenue financing, municipal debtors, as governmental units, are also subject to certain limitations imposed by the United States Constitution (the “Constitution”) and the municipality’s applicable state constitution.

Limitations set forth in the Fifth Amendment to the Constitution may impose obstacles or otherwise prohibit a cramdown with respect to a creditor whose claim is secured by special revenues. The Fifth Amendment provides:

No person shall be held to answer for a capital, or otherwise infamous crime, unless on a presentment or indictment of a grand jury, except in cases arising in the land or naval forces, or in the militia, when in actual service in time of war or public danger; nor shall any person be subject for the same offense to be twice put in jeopardy of life or limb; nor shall be compelled in any criminal case to be a witness against himself, nor be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.

U.S. Const. amend. V. (emphasis added). The limitations of the Fifth Amendment also apply, through the Due Process Clause of the Fourteenth Amendment, to takings by state governments and their subdivisions. See, e.g., Lucas v. S.C. Coastal Council, 505 U.S. 1003 (1992). As a result, the Fifth Amendment is applicable to municipal debtors, and a municipal debtor may not take property without just compensation.

The protections afforded by the Fifth Amendment are not abrogated by the Bankruptcy Code. The legislative history of the Bankruptcy Code indicates that the drafters of the Bankruptcy Code considered the Fifth Amendment to be a limitation upon the impairment of property rights in bankruptcy, and current bankruptcy law gives great deference to property rights. Julia Patterson Forrester, Bankruptcy Takings, 51 Fla. L. Rev. 851, 863 (Dec. 1999). The Supreme Court of the United States has addressed the takings issue in the context of bankruptcy on several occasions, holding each time that the bankruptcy power is limited by the Fifth Amendment. See United States v. Security Indus. Bank, 459 U.S. 70, 75, 78 (1982); Wright v. Vinton Branch of Mtn. Trust Bank, 300 U.S. 440, 456-58 (1937); Louisville Joint Stock Land Bank v. Radford, 295 U.S. 555, 589 (1935); see also Continental Ill. Nat’l Bank & Trust Co. v. Chicago, Rock Island, & Pac. Ry., 294 U.S. 648, 669 (1935) (stating that the bankruptcy power is not unlimited); Holt v. Henley, 232 U.S. 637, 639 (1914) (holding that an amendment to bankruptcy law must be applied prospectively to avoid affecting existing property rights). In the context of a chapter 9 case, it is important to determine the scope of the property rights held by a creditor where the debt at issue is secured by special revenues, and the impact that may have on the debtor’s ability to effect a cramdown.

While most people think of property as a thing that is owned by someone, bankruptcy specialists understand property as a collection of rights with respect to things. Stephen J. Ware, Security Interests, Repossessed Collateral, and Turnover of Property to the Bankruptcy Estate, 2002 Utah L. Rev. 775, 776 (2002). A sophisticated understanding of property dissolves the unitary conception of ownership into a metaphorical “bundle” of rights reflecting the fact that more than one person can have rights with respect to a particular thing. Id. Consistent with this understanding, courts have held that contractual rights are cognizable property interests protected under the Takings Clause of the Fifth Amendment. Century Exploration New Orleans, Inc. v. United States, 103 Fed. Cl. 70, 76 (Fed. Cl. 2012) (citing Lynch v. United States, 292 U.S. 571, 579 (1934) (stating that valid contracts are property protected by the Fifth Amendment); Lion Raisins, Inc. v. United States, 416 F.3d 1356, 1370 (Fed. Cir. 2005)). Even further, courts have generally classified as property, or rights to property, transferable interests generating pecuniary value. 21 West Lancaster Corp. v. Main Line Restaurant, Inc., 790 F.2d 354, 357 (3d Cir. 1986) (citing United States v. Bess, 357 U.S. 51, 55 (1958) (for tax lien purposes, life insurance policies are property to the extent of their cash surrender value, since policy holder could compel payment of that amount); Note, Property Subject to the Federal Tax Lien, 77 Harv. L. Rev. 1485, 1486–87 (1964) (federal classifications have focused on transferability and leviability of interest)). In the words of one court, the question to be asked is, “[is] the interest . . . bargainable, [is] it transferable, [does] it have value?” Randall v. Nakashima & Co., Ltd., 542 F.2d 270, 278 (5th Cir. 1976). Based upon the foregoing, the question then becomes, “Which parts of the contract – of the bargain – constitute property subject to the protections afforded by the Fifth Amendment?”

While it is clear that the Fifth Amendment provides certain protection, there is no set formula for determining when justice and fairness require that economic injuries caused by public action be compensated by the government, rather than remain disproportionately concentrated on a few persons. Penn Central Transp. Co. v. City of N.Y., 438 U.S. 104, 124 (1978). Rather, a takings analysis depends on the facts of each case, as the Supreme Court of the United States has explained:

[T]he Court’s decisions have identified several factors that have particular significance. The economic impact of the regulation on the claimant, and, particularly, the extent to which the regulation has interfered with distinct investment-backed expectations are, of course, relevant considerations. . . . So, too, is the character of the governmental action. A “taking” may more readily be found when the interference with property can be characterized as a physical invasion by government . . . than when interference arises from some public program adjusting the benefits and burdens of economic life to promote the public good.

Id. (citations omitted). Consistent with the Penn Central opinion, the Supreme Court of the United States has further explained that, when considering whether an impermissible taking has occurred, courts should consider: (i) the economic impact of the action; (ii) its interference with reasonable investment-backed expectations, and (iii) the character of the governmental action. Kaiser Aetna v. United States, 444 U.S. 164, 175 (1979).

Based upon the foregoing, many questions arise in the context of a chapter 9 debtor seeking to cramdown the holders of debt, particularly special revenue debt. Can a municipal debtor impair covenants, such as the covenant to control the value of the stream of special revenues – i.e., covenants with respect to controlling the proverbial spigot – without violating the Fifth Amendment? Is a municipal debtor entitled to divert special revenues to pay additional obligations for the good of the municipality? To the extent certain provisions of the contractual relationship between a municipal debtor and a creditor secured by special revenues are deemed property, the Fifth Amendment arguably prohibits such actions or, at least, imposes obstacles to the debtor’s ability to do so.

E. State Trust Law May Remove Special Revenues From A Municipal Debtor’s Control and Its Ability to Impair in a Case Under Chapter 9.

As mentioned above, some state laws provide that special revenues pledged to the repayment of special revenue obligations are pledged and held in trust. For example, the Supreme Court of Alabama has stressed, a pledge “means set apart, appropriated, or charged with the payment of a specific obligation authorized by law. . . . That the pledge may, by appropriate remedy, require such revenues conserved and applied to the secured demand . . . needs no citation of authority.” Heustess v. Hearin, 104 So. 273, 274 (Ala. 1925). See also Sylvan G. Feldstein, et al., The Handbook of Municipal Bonds 1295 (John Wiley & Sons, Inc. eds., 2008) (defining “pledged revenues” as “revenues legally pledged to the repayment” of the warrants).

It is fundamental that a debtor can only restructure “claims” against it in accordance with the requirements of the Bankruptcy Code. “[A] debtor owes a ‘debt’ to [a] creditor, who has a ‘claim’ against the debtor.” In re Threatt, No. 04-82082C-13D, 2004 WL 2905344, at *2 (Bankr. M.D.N.C. Dec. 13, 2004) (quoting 8 Collier on Bankruptcy ¶ 1300.12[5] (15th ed. 2d. rev. 2004)). “Claims against a debtor” are defined as including “claims against the property of the debtor.” 11 U.S.C. § 102(2) (emphasis added).4 These fundamental principles of bankruptcy law were incorporated into chapter 9. When special revenues are by state law transferred to be held in trust for the benefit of the holders of the debt secured by the special revenues, the municipal debtor may not be able to impair the creditors’ property interests in the revenues.

A bankruptcy court must look to state law to determine the debtor’s interest in a particular piece of property. Under settled principles of state trust law, property held in trust by one for the benefit of another is deemed to be property belonging to the beneficiary, not the trustee. Because, under state law, trust assets belong to the beneficiaries, the trust assets are not debtor’s property or property of the debtor’s estate, and shall not be distributed to any other creditors or sold unless all trust beneficiaries have been paid. See, e.g., In re Monterey House, Inc., 71 B.R. 244 (Bankr. S.D. Tex. 1986) (“That the corpus of a trust is not property of the estate is so widely accepted as to be beyond dispute.”); Matter of Vacuum Corp., 215 B.R. 277, 280 (Bankr. N.D. Ga. 1997) (“Because the debtor does not own an equitable interest in property he holds in trust for another, that interest is not ‘property of the estate’ and is also not ‘property of the debtor’ for purposes of § 547(b).”); Matter of Quality Holstein Leasing, 752 F.2d 1009 (5th Cir. 1985) (“Congress did not mean to authorize a bankruptcy estate to benefit from property that the debtor did not own.”); United States v. Whiting Pools, Inc., 462 U.S. 198, 205 n. 10 (1983) (“Congress plainly excluded property of others held by the debtor in trust at the time of the filing of the petition.”); Pearlman v. Reliance Ins. Co., 371 U.S. 132, 135-36 (1962) (“[Bankruptcy law] simply does not authorize a trustee to distribute other people’s property among a bankrupt’s creditors.”).5

Courts have treated numerous types of municipal debtors as “trustees” of funds held on behalf of municipal bondholders. See, e.g., State ex rel. Central Auxiliary Corp. v. Rorabeck, 108 P.2d 601, 603 (Mont. 1941) (officers of irrigation district responsible for levy and collection of tax sufficient to pay principal and interest on bonds of the district, as well as county treasurer who is custodian of those funds, are trustees for district bondholders); Blackford v. City of Libby, 62 P.2d 216, 217-18 (Mont. 1936) (city becomes trustee on behalf of warrantholders of special improvement district); Fidelity Trust Co. v. Vill. of Stickney, 129 F.2d 506 (7th Cir. 1942) (holding the money which municipality collects in payment of special assessments is trust fund). In those cases, the courts held that the municipality merely served as a custodian of the funds held for the bondholders, and could not apply the funds toward other purposes. See, e.g., In re City of Columbia Falls, Mont., 143 B.R. 750, 762 (D. Mont. 1992) (“A fund that is derived from a special levy or one created for a specific purpose is in the hands of municipal officials in trust. The municipality is merely a custodian, and its duties relative to such funds are purely ministerial. . . .”; holding funds held in trust may not be applied to purchase of other property). In addition, courts have found a fiduciary relationship exists between the municipality and the bondholders. See, e.g., Vill. of Brookfield v. Prentis, 101 F.2d 516 (7th Cir. 1939) (municipality issuing special assessment bonds for local improvement is a trustee of the special assessment funds charged with all duties of such a fiduciary, including the obligation to spread the assessment, collect it, and make disbursement thereof in conformity with the statutory provisions to those holding bonds payable out of the assessments); Sampson v. Vill. of Stickney, 173 N.E.2d 557 (Ill. App. 1961) (holding special assessments bondholder entitled to accounting from municipality who acted as trustee; “[t]he rule is that when a municipality issues special assessment bonds it becomes a trustee of the funds resulting from the collection under the special assessments, and is charged with all attending fiduciary duties.”).

Based upon the foregoing, a bankruptcy court could find that, because the holders of debt secured by special revenues hold an ownership interest solely in the special revenues, and because the special revenues are held in trust and are not property of the debtor, such holders do not have a claim against the debtor or the debtor’s property. See, e.g., Ni-Fuel Co. v. Jackson, 257 B.R. 600, 619 (N.D. Okla. 2000) (remanding to state court those claims which are not “property of the estate,” and involved “no claims” against the bankrupt debtors); In re Threatt, 2004 WL 2905344, at *2 (holding the movant has “no claim” against the debtor or against any property of the debtor; hence, there is no debt owed to movant and movant is not a creditor in the case). Without a claim against the debtor or the property of the debtor, the holder of debt secured by special revenues is arguably not subject to the cram-down provisions contained in the Bankruptcy Code.

To read this article in full, please click here.

Footnotes

1 U.S. Secs. & Exch. Comm’n, Field Hearing on the State of the Municipal Securities Market, Distressed Communities, Remarks of James E. Spiotto, July 29, 2011, at 36 (generally, foreclosure is not permitted for essential governmental property as it would be against public policy). http://www.sec.gov/spotlight/municipalsecurities/statements072911/spiotto.pdf (the “Spiotto Statements”).

2 See also Spiotto Statements.

3 For an excellent discussion of the history or chapter 9 and the 1988 Amendments, see Spiotto Statements.

4 11 U.S.C. § 101 also defines the term “claim” to mean—(A) right to payment, whether or not such right is reduced to judgment, liquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.”

5 Further, the Senate Report on the 1978 Bankruptcy Act and statements of the floor managers of the Act in both the House and Senate demonstrate that the Bankruptcy Act “will not affect various statutory provisions . . . that create a trust fund for the benefit of a creditor of the debtor.” See S. Rep. No. 989 at 82, 95th Cong., 2d Sess. (1978). U.S. Code Cong. & Admin. News 1978, pp. 5787 at 5868; 124 Cong. Rec. S17.413 (daily ed. Oct. 6, 1978) (remarks of Sen. DeConconcini); 129 Cong. Rec. H11.096 (daily ed. Sept. 28, 1978) (remarks of Rep. Edwards).

Last Updated: April 28 2014
Article by David Lemke, Blake D. Roth and Courtney Rogers
Waller Lansden Dortch & Davis

For further information visit Waller

Something big is cooking in Puerto Rico, and it demands our immediate investment attention.

For the last seven years, the beleaguered Puerto Rican economy has been mired in the muck, enduring GDP contraction in five of those seven years.

To keep the commonwealth afloat, policymakers have suffered through innumerable debt offerings, which now tally roughly $73 billion, according to bond documents.

But did Puerto Rico just hit rock bottom in February?

Likely so.

In February, the three largest rating firms slashed Puerto Rico’s credit below investment grade, citing “liquidity problems” as the culprit.

Since then, however, the commonwealth has been getting tons of “big money” attention.

Puerto Rico’s mid-March bond issue (valued at $3.5 billion) is now the largest U.S. municipal junk bond sale in history.

Trading of the bonds has been fast and furious, with demand outstripping supply by a huge margin.

Orders totaled more than $16 billion from 270 different accounts.

The second-most-popular bond in the first quarter had orders totaling only $131 million.

Yields on the bonds have spiked as high as 9.425%.

But here’s where the story really gets juicy . . .

Hedge funds accounted for roughly 70% of the Puerto Rican bond issue.

Why is that significant? Because hedge funds rarely dip their toes into the municipal bond pool.

Och-Ziff Capital Management, Paulson & Co, Fir Tree Partners, Perry Capital LLC and Brigade Capital Management each bought more than $100 million of the bonds.

Billionaire hedge fund manager, John Paulson, is among the believers, saying that “Puerto Rico will become the Singapore of the Caribbean.”

Paulson has municipal debt interests in Puerto Rican hotels and continues to strategically add to his Puerto Rican portfolio. In fact, he’s on pace to invest $1 billion in the territory over the next two years, mostly through real estate.

The fact that Puerto Rico’s governor just announced that it will balance the budget without selling debt – for the first time in 20 years – only adds to the investment appeal.

One particular stock now stands ready to explode as a result of the situation.

Onward and Upward,

Robert Williams

Founder, Wall Street Daily

Since 2005, the percentage of municipal bonds that are insured has plummeted. But, it’s recently started to rise.

After a long dry spell, we are starting to see renewed interest and growth in the insured municipal bond market. For investors, the promising outlook may be due to the recent outperformance of insured bonds relative to uninsured bonds. For financially troubled municipal issuers, the recent credit-rating upgrades by Standard & Poor’s (S&P) of two large bond insurers has aided the growth of the insured municipal bond market.

Signs of growth in the market

In 2005, the percentage of municipal bonds that were insured was 57%; in 2012, it was 3.5%. Why the dramatic fall? Bond insurers were obligated to pay for underperforming or defaulted structured-finance instruments (i.e., mortgage-backed securities) that they insured during the financial crisis in 2008, which weakened the financial condition of the insurers.

Today, insured municipal bonds are showing strong signs of a recovery. The percentage of municipal bonds that were insured in 2013 increased to 3.9% (the first annual increase since 2005.), and the rise has continued this year, hitting 4.3% as of April 30, 2014. Bond insurers expect the insured market to increase to 7.0% to 8.0% of issuance later in 2014.

At the same time, the rating agencies are more bullish on the companies that insure municipal bonds. S&P upgraded two of them in March: Assured Guaranty (AA/stable) and National Public Finance (MBIA) (AA-/stable). The upgrades were supported by the insurers’ strong capital levels, good operating performance, a decline in their legacy structured-finance portfolios and their payment of claims for recent high-profile municipal bankruptcies. Higher credit ratings will help support the insured municipal market by increasing the value of bond insurance and will also make bond insurance more attractive to issuers by lowering borrowing costs.

Why consider insured municipal bonds?

Municipal bond insurance does not cover market risk due to interest rate movements, but it can help investors reduce credit risk in an overall portfolio. Based on current pricing of selected Detroit and Puerto Rico credits, investors can see the value of municipal bond insurance. The table below shows that credits wrapped with insurance from Assured Guaranty performed 20+ points better than the same uninsured bonds following Detroit’s bankruptcy and the selloff of Puerto Rico bonds over their financial concerns.

Conclusion

After experiencing years of decline, we believe the insured portion of the municipal bond market is staging a comeback. Suitable investors in higher tax brackets may wish to talk to their advisors about adding insured municipal bonds to their long-term fixed income allocations.

Sources

The Bond Buyer, “Bond Insurance: Then & Now: The Revival of an Industry,” April 30, 2014
Citi, “U.S. Municipal Strategy Special Focus: The Return of Monolines,” March 28, 2014
Bank of America Merrill Lynch, “Municipal Weekly,” May 2, 2014
Standard & Poor’s, “U.S. Bond Insurance and the Financial Guarantee Sector Stand at a Crossroads”
Important information

Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/ or interest.

NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE
All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is a U.S. distributor for retail mutual funds, exchange-traded funds, institutional money market funds and unit investment trusts.

Invesco unit investment trusts are distributed by the sponsor, Invesco Capital Markets, Inc. and broker dealers including Invesco Distributors, Inc. These Invesco entities are indirect, wholly owned subsidiaries of Invesco Ltd.

By Tim O’Reilly and Greg Rawls

©2014 Invesco Ltd. All rights reserved.

blog.invesco.us.com

Weather-related events place local governments, which are generally the first responders to disaster, on the front lines of caring for their citizens. They must also manage budget volatility following such events, as well as repair and adapt their infrastructure to prepare for changing risks. In Standard & Poor’s Ratings Services’ experience, U.S. municipal and state governments have historically been able to manage the risk of natural disasters without diminishing their credit quality. The credit impact of most natural disasters has been limited. There are some exceptions, however: Hurricane Katrina, which hit an underprepared Gulf Coast at a time when the federal government was ill-equipped to respond, led to a number of negative credit actions on local communities and Louisiana, and Hurricane Ike led to a downgrade of Galveston, Texas’ general obligation and water and sewer ratings. To some extent, our ratings on local governments and states incorporate the potential for disasters in high-risk areas, such as the Gulf Coast and the earthquake-prone West, by considering financial flexibility and liquidity in the context of potential losses from a major storm or quake. However, the potential for increasingly frequent climate-related disasters makes the issue more relevant for local governments all across the U.S.

While the timing and severity of weather events remain unpredictable, the increasing uncertainty arising from changing climate patterns represents a difficult-to-quantify risk for local governments. This risk could result in more credit pressure for local governments if the federal government were to not provide timely and sufficient financial support for relief, or if the local government’s ability to prepare for disasters — for example through improvements that reduce the impact on infrastructure of extreme weather, transportation adaptation, or flood control measures — comes at the cost of financial flexibility and increased leverage.

Overview

In our 2011 article on natural disasters and credit quality (see “Ready for the Big One? How Natural Disasters Can Affect U.S. Local Governments’ Credit Quality,” on Ratings Direct), we noted that Standard & Poor’s evaluates the impact of natural disasters in light of key credit factors — both quantitative (such as the government’s financial position and the tax base’s relative strength and diversity) and qualitative (including management’s emergency preparedness and the adequacy of its response).

The Effects Of Weather Events On U.S. Municipal Governments

The immediate effects of extreme weather on local governments may include volatile fiscal performance, strained liquidity, increasing debt burdens, and economic loss during periods of extended extreme weather or disaster recovery. While federal disaster relief is available, increased recovery costs for local governments could result if future federal government austerity affects reimbursement levels. Even when federal relief is available, it might not completely cover the loss of taxing and revenue capacity for entities that rely on property taxes and retail sales, and distribution of federal funds can take several years. Municipalities, therefore, may be tasked with managing the immediate disaster costs — for emergency response costs, debris removal, and restoration of services — using immediately available liquid resources at a time when revenue streams, such as sales taxes and development-related fees, may temporarily decline. If future federal budgets were to limit disaster relief (from the Federal Emergency Management Agency, for instance), an increase in the magnitude and frequency of weather-related events could exacerbate this dynamic over time, forcing local governments to assume more of the recovery costs.

Perhaps most difficult to measure are the long-run economic consequences of a failure to prepare for climate change. In the past two years alone, major weather events have been severe enough to put a dent in national GDP growth for a short time. By some estimates, the deep freeze that gripped the eastern U.S. in early 2014 crimped national first quarter 2014 GDP growth by one- to two-tenths of a percentage point, and Superstorm Sandy lowered growth during the fourth quarter of 2012 although the recovery effort quickly boosted output once again. At the local and regional level, short-run economic effects may be more pronounced and are sometimes accompanied by lost taxing capacity when a portion of the property tax base is damaged. The interdependence of urban infrastructure, such as water and wastewater, power, transportation, and communications systems can magnify the downside risk, as we saw from the damage to the entire New York metropolitan region and the New Jersey coast following Superstorm Sandy.

These short-term losses may be followed by a rebound in GDP as construction and rebuilding activity ramp up following a disaster. Over the long run, however, taxing capacity at the local level may suffer if, for example, there are significant out-migrations as occurred following Hurricane Katrina, or if reconstruction and development are prohibited in high-risk areas following a disaster, as has occurred in many communities in the Gulf Coast. In other cases, such as in California’s Sacramento Valley, we have observed the dampening effect of weather-related risk on private development activity in high-risk areas as insurers tighten their underwriting standards for disaster coverage, and governments place constraints on new development. This limits the tax base growth that many municipal issuers rely on to fund their recurring and disaster-related expenditures.

Responding To Climate-Change Risk: Local Strategies And Their Credit Effects

State and local governments are key stakeholders in national climate change-related efforts. States create policies and programs that encourage or discourage adaptation and mitigation at all levels of government through regulation, funding, and public adoption of “clean” technologies. Currently, many state and local governments’ efforts to address climate change have focused on land-use planning and incremental improvements to public facilities and infrastructure. Some state and local efforts to reduce carbon emissions have also been undertaken: most notably, in 2012, California became the first state to implement a cap-and-trade program to reduce greenhouse gas emissions, which generates a relatively small amount of revenue for the state, but which we believe has had little effect on the state’s credit quality.

A growing number of state and local governments are also making adaptive improvements to reduce the effects of weather events on critical infrastructure. These include flood control improvements and water storage and delivery system upgrades, as well as storm-preparedness improvements by utility and transit providers to increase infrastructure resistance to severe storms.

In California’s Sacramento Valley, for instance, joint federal and local efforts are currently underway to finance levee improvements designed to achieve 200-year flood protection, according to FEMA’s most recent standards, which have become stricter in the wake of Hurricane Katrina and subsequent storms. These types of financing projects increase debt burdens and cost-sharing with federal and state agencies. If shared revenues and tax-supported debt together are not sufficient to cover costs, these projects may have the potential to erode credit quality by placing strain on resources available for capital spending.

New York State’s Sea Level Rise Task Force is one example of a nonfederal effort to identify and address climate change. The 2010 task force report identifies the risks associated with climate change — particularly rising sea levels — to communities and infrastructure. It also recommends actions for state and local governments to undertake to address these risks, including studying the impact of sea-level change on communities, making regulatory changes to address sea level change, implementing funding mechanisms, and seeking federal aid for adaptation and disaster-prevention measures. However, the recommendations are short on cost details.

In our view, New York’s task force and the California investment highlight some of the efforts underway to understand and mitigate weather-related vulnerability. We expect continued focus on this area given the pattern of natural disaster activity over the past decade. The pace and progress of actual investments will likely be slow due to funding constraints at all levels of government.

What’s Costlier, Preparing Or Doing Nothing?

Ultimately, the risk for U.S. public finance issuers of a changing climate emanate from the impact of unpredictable weather patterns on infrastructure and economic growth. While we continue to believe that local governments — in collaboration with regional, state, and federal entities -– can withstand the effects of extreme weather with limited impact on credit quality, only time will tell whether an increase in the unpredictability of climate-related events will make ratings more volatile. But as evidence of climate change and related risks mounts, the costs associated with not preparing for them may continue to grow.

20-May-2014

ay 22, 2014

MUNICIPAL BOND MARKET MONTHLY – JANNEY FIXED INCOME STRATEGY – May 22, 2014

Municipal Issuer Brief – May 19, 2014

In October 2012, Superstorm Sandy knocked out electric service to 1.4 million of New York’s Consolidated Edison Inc.’s approximately 3.3 million electric customers and about 920,000 of Long Island Power Authority’s (LIPA) approximately 1.1. million customers. The lights also went out for about 1.7 million of New Jersey’s Public Service Electric & Gas Co.’s (PSE&G) 2.2 million electric customers. For many, the outages lasted weeks, resulting in strong economic impacts that reverberated through the region as businesses closed and gasoline sales ground to a halt. Because the repercussions of the storm-related power outages were so wide, utility and government officials realized they needed strong utility responses to prevent this from happening again. Specifically, the utilities clearly needed to pursue investments in what the industry calls “storm hardening.”

Although these utilities’ solutions and their costs share common elements, the funding sources available reflect varying views among government officials as to where the financial responsibility for funding these investments lies. The availability of federal aid is also an important element of the funding solutions. Standard & Poor’s believes that the means for funding and cost recovery can be important factors in determining credit quality.

Overview

The Storm-Hardening Programs’ Common Attributes

Given the breadth of these utilities’ service areas and their extensive coastal exposures, storm hardening costs will be substantial — about $1 billion per utility. Common elements of their storm hardening programs include raising key structures, such as substations, to heights that are better able to withstand storm surges. The utilities will also replace existing poles with stronger poles in those areas at risk for storm surges and they will step up activities to reduce the potential for trees and branches knocking down power lines.

FEMA Comes To LIPA’s Aid

The long outages that LIPA’s customers experienced triggered considerable ire among customers and politicians, leading to state legislation that imposed greater regulatory oversight. It whittled LIPA’s capacity to set rates on its own, subjecting rate adjustments to hearings if rate increase proposals exceed prescribed thresholds. In addition, the legislation transformed the utility’s operations by transferring day-to-day operations to an affiliate of one of the region’s investor-owned utilities and sets three days as the baseline for restoring service following a major power failure. If LIPA does not meet this target, the system operator must provide New York’s Department of Public Service with an assessment of the utility’s pre-event preparedness and post-event restoration efforts. The state also asked LIPA to freeze its base rates for at least one year, which it did, and the state is seeking a second year on that freeze. We believe these actions could reduce the utility’s financial flexibility. We consider financial flexibility to be critical to responding to potentially volatile costs and preserving credit quality. Our negative outlook on LIPA reflects the constraints these conditions could impose on financial performance.

Against the backdrop of the state’s response to the storm outages, the utility found a financing lifeline in the Federal Emergency Management Agency (FEMA). FEMA reimbursed LIPA for about 90% of its storm restoration costs. The agency reimburses these types of costs for not-for-profit utilities because they cannot take advantage of the federal tax benefits that investor-owned utilities can. Moreover, in an unusual move, the agency also agreed to finance much of LIPA’s prospective storm hardening activities. This decision provides the utility with the capacity to buttress its system without incurring substantial infrastructure investment financing needs while its base rates remain frozen. The FEMA reimbursement plan helps shore up credit quality while enabling LIPA to invest in reliability as it faces ratemaking constraints.

Limits On Consolidated Edison’s Options

Unlike LIPA, New York’s Consolidated Edison, an investor-owned utility, will not have the benefit of FEMA resources to strengthen its system’s storm resiliency. It also funded its storm recovery and restoration costs differently from LIPA, by capitalizing portions of its $363 million of spending. It recorded the uncapitalized balance as a regulatory asset for deferred recovery. In 2012, the company had no current federal income tax liability as a result of, among other things, deduction of costs incurred in connection with Sandy.

Consolidated Edison asked the state’s rate regulator for cost recovery for about $1 billion of prospective storm hardening projects. The regulator approved the projects, albeit within a framework of stable rates. We believe that the company will need to effectively control costs and avoid cost overruns in its sizable capital program to mitigate the rate freeze’s impact. The costs of storm hardening also need to be considered within the context of the recent East Harlem natural gas explosion. Although the explosion’s cause has yet to be determined, and we believe Consolidated Edison carries insurance that should cover a portion of potential costs if it is found liable, it is our view that such a finding could lead to penalties and higher compliance costs for the utility’s aging gas distribution system. Our outlook on the company is stable, but possible penalties and additional capital investment needs could harm its financial condition and might lead to modestly lower ratings.

PSE&G Benefits From Supportive State Regulation

By comparison, neighboring PSE&G appears to operate under more beneficial state regulation. On May 1, the New Jersey Board of Public Utilities’ staff recommended that the regulator allow the utility to recover from customers $1.2 billion of the $2.6 billion of the multiyear storm hardening investments it had proposed. PSE&G ultimately plans to align its storm hardening spending with the amounts the regulator approves. Staff’s recommendation includes a 9.75% return on equity on the first $1 billion of investment and a rate of return on the balance that this utility’s next rate case will determine.

Vehicles For Recovering Investments Can Influence Credit Quality

Although very different avenues for funding storm hardening investments are available to these utilities, and some of the investments might weigh negatively on credit quality, the utilities and their regulators nevertheless are consistent in recognizing that investments that will help these systems better withstand storms are critical to enhancing operational predictability and improving customer satisfaction. Although we believe that these investments can contribute to greater operating stability and benefit utilities’ enterprise and financial risk profiles, cost recovery — whether from customers or government reimbursements — remains an overarching consideration for credit quality.

Public elementary and secondary schools saw annual revenue decline $5 billion in 2012, the first drop since 1977, according to a U.S. Census Bureau report.

The Governmental Accounting Standards Board (GASB) is currently conducting pre-agenda research to inform its assessment of the effectiveness of Statement No. 34, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments, and related standards. The objective of this research is to gather feedback on these broad questions:

• What concerns exist regarding the application of the standards?
• How do the costs of applying the standards compare with the perceptions of the benefits of the resulting information?
• What financial reporting model requirements are effective or ineffective in providing information that is essential for decision-making and that enhances the ability to assess a government’s accountability?

The GASB has developed an online survey to gather feedback from preparers of governmental financial statements. The GASB would greatly appreciate you taking the time to complete the preparer survey, which can be accessed by following this link http://www.gasb.org/GASB-reexam-survey.

It is anticipated that the survey will take longer than a typical GASB survey, given the magnitude of the requirements in Statement 34. You can, however, download a copy of the survey in its entirety to consider before entering your responses into the online version. The deadline for completing the survey is Friday, June 6, 2014.

Your input is vital to the GASB’s standards-setting process. If you have any questions, please feel free to contact Roberta Reese ([email protected]) or Lisa Parker ([email protected]).

Washington, DC, May 21, 2014 – SIFMA today issued the following statement from Kenneth E. Bentsen, Jr., SIFMA president and CEO, after the House Committee on Appropriations voted to adopt a legislative provision (Section 233) which, if signed into law, would effectively eliminate the threat that eminent domain could be used to seize mortgages, a serious concern of housing market participants for over two years:

“SIFMA commends the members of the House Committee on Appropriations for adopting a provision which would  prevent the Federal Housing Administration (FHA) from using taxpayer monies to facilitate a scheme by which eminent domain would be used to seize mortgage loans from Main Street investors.  Should FHA allow this scheme to move forward, investors in pension plans, 401Ks, mutual funds and other savings and retirement accounts will suffer the losses.  Today’s action is an important development in the fight to remove a cloud hanging over our housing markets.”

We’ve come a long way from the abacus.

The online world is not flat, which continues to increase the power of the Internet.  Certainly, we can access vast amounts of information online.  We can also, in a growing number of examples,interact with that information, through tools or calculators that allow us to change variables and see the impact of those changes.

At what rate are these calculators cropping up and changing the online experience?  Well, we don’t have a calculator for that.  (Not yet, at least.)  But we can point you to five powerful online tools that can help with your municipal-related research.

Continue reading.

In a filing in the U.S. Court of Appeals in San Francisco, lawyers for mortgage-bond trustees moved to end appeals in two related cases.

The move was made because the plan, based on a legal process called eminent domain to seize private property for a public purpose, had not materialized, said John Ertman, partner at law firm Ropes & Gray, which representing mortgage trustees Wells Fargo and Deutsche Bank.

But the lawsuit would be “immediately re-filed” if the city of Richmond, California, took steps toward adopting the plan, he said.

The trustees sued Richmond last year over the plan aimed at keeping local residents who owed more than their properties were worth in their homes.

The other trustees are Bank of New York Mellon, U.S. Bank, and Wilmington Trust.

U.S. District Judge Charles Breyer ruled last September that the original case was premature, and that ruling was appealed roughly a month later. Friday’s withdrawal was filed in the U.S. Court of Appeals for the Ninth Circuit in San Francisco.

“We continue to believe that using eminent domain to seize mortgage loans is unconstitutional, and harmful to homeowners and ordinary savers with a pension, 401(k) or IRA,” Ertman said.

He said the trustees were dismissing the appeal since Richmond had not progressed toward seizing loans since Judge Breyer’s ruling and the filing of their appeal seven months ago.

San Francisco-based private investment firm Mortgage Resolution Partners (MRP) crafted the eminent domain plan for Richmond. The investor group had said that if the city of Richmond was allowed to go ahead with its plan, it may result in steeper down payment requirements and higher interest rates. (Reporting by Sam Forgione; Editing by Andrew Hay)

BY SAM FORGIONE

The Wall Street watchdog that culls bond-trade data is honing in on limits for acceptable commissions that are lower than their stated guidelines.

Larry Morrissey is mayor of the old industrial hub of Rockford, Illinois, and he says that if bankruptcy revived the U.S. auto industry, it might save his city of 151,000 from “the slow death” of pension costs.

Project Description:

The objective of this project would be to consider developing disclosure guidance for governments that have granted tax abatements. For purposes of this project, tax abatements are a reduction of or exemption from taxes, offered by a government to a specific taxpayer, typically for the purpose of spurring economic development. The project would not consider guidance for programs that reduce the tax liabilities of broad classes of taxpayers, such as senior citizen or veterans, and which are not the product of individual agreements with each taxpayer. The project also would not consider issues related to recognition.
Status: Added to Current Agenda: December 2013

• Project Plan
• Recent Minutes
• Tentative Board Decisions to Date 
• Project staff:
  • Lisa Parker
  • Dean Mead
  • Ken Schermann
    Mitchell Harrison
    Jay Fountain (Consultant)

TAX ABATEMENT DISCLOSURES—PROJECT PLAN

Background: Tax abatement programs are highly prevalent in the U.S.—governmental entities in 44 states currently have them. The results of external research conducted under a Gil Crain Memorial Research Grant from the GASB suggest that tax abatements are an issue of concern among citizen groups, county board members, and municipal bond analysts, and that each group desires to receive information about the level of abatement activity and the results of the abatement programs. However, the researchers found relatively few states (six) with statutes requiring any level of external reporting after tax abatements are granted. These findings indicate that there is an important information need that is largely unmet.

Tax abatement programs are widespreadand the dollar amounts and number of governmental entities involved can be substantial. For example, 40 percent of localities in Michigan granted at least one tax abatement between 1980 and 2001 under a statewide industrial development abatement program that abated local government taxes by an estimated $1 billion annually.¹ That is the equivalent of approximately 4.2 percent of all sub-state tax revenue in Michigan.²

Further, the academics awarded the Gil Crain grant for 2010 found that 44 states have statutes regarding programs in line with the definition of a stand-alone property tax abatement program. (This is consistent with a 2007 study that concluded governments in 42 states are allowed by their states to offer tax abatements.³). However, they identified just six states with statutes addressing reporting requirements. Fourteen states addressed accountability for abatement programs in their statutes by including provisions for benefit recovery (clawbacks) in instances of nonperformance by the recipient of the abatement. It may be possible that more states require reporting or impose consequences for nonperformance in policies and procedures outside their statutes.

Their review of websites involved 36 counties (across 14 states) which had been identified through a Lexis-Nexis search as having tax abatement programs. The review turned up only one of the 36 county websites with any reporting on tax abatements after they were granted.

The academics concluded, “While other county websites included information about tax abatements in general or about the granting of a particular abatement, none provided information that would be useful in monitoring abatements currently in effect. Finding even limited information on these websites required much effort and diligence. Certainly, the average citizen could not be considered to have reasonable access to tax abatement information from any of these counties’ websites.”

Constituents have periodically raised the possibility of a pronouncement requiring governments to disclose additional information about tax abatements. At present, generally accepted accounting principles do not require state and local governments to disclose information related to tax abatements.

In September 2013 the project staff conducted interviews and received feedback from 78 individuals responsible for keeping records on tax abatements within governments that had been identified as authorizing stand-alone tax abatements. This research indicates that governments generally do keep records on the type of information identified by users as being necessary for their decision-making and assessment of a government’s accountability of stand-alone tax abatements that have been authorized.

Finally, some tax abatements, depending on how they are structured (for example, refunds, rebates. or credit), do involve cash inflows and cash outflows. In these instances, the taxpayer first pays the taxes and the government refunds, rebates, or credits the appropriate amount back to them once they have fulfilled their obligations associated with receiving the tax abatement. In other tax abatements, there is no flow of resources but rather a foregone cash inflow and associated cash outflow. In these instances, the taxpayer pays a tax amount that is net of the tax abatement authorized. However, this foregone flow of resources has affected the government’s net position. Users also have expressed a need for this information to make assessments of how other taxpayers have subsidized the taxes that have been abated to other taxpayers.

User needs. The survey of users was conducted by the academics awarded the Gil Crain grant was administered to staff and members of citizen groups, municipal bond analysts, and county board members. Responses were received from 38 citizen group staff and members (response rate of 26.4 percent), 68 county board members (8.8 percent), and 114 bond analysts (10.3 percent). The overall response rate of 10.9 percent is low but in line with typical responses to targeted email surveys (10–15 percent) and characteristic for these populations.

One portion of the survey offered statements about tax abatement programs drawn from the literature and asked respondents to rate their agreement or disagreement with the statement on a five-point scale (1 = strongly disagree, 5 = strongly agree). The statements specifically relevant to financial reporting were:

1. Governments should report annually on tax abatement agreements outstanding.
2. Legislators (for example, county commissioners or county board members) involved in granting tax abatements should receive timely reports comparing expected performance to actual performance.
3. Citizens and other interested parties should have access to annual reports comparing expected performance to actual performance for all tax abatement agreements outstanding.
4. Information about taxes recovered through recapture provisions should be reported to legislators who grant tax abatements.
5. Information about taxes recovered through recapture provisions should be accessible to citizens and other interested parties on an annual basis.

Overall, the level of agreement in each of the three groups of users was very high on all five of these statements (an average greater than 4.0). Citizen group members and staff particularly agreed with statements a (average ranking of 4.53), b (4.54), and c (4.62). The difference between the rankings by citizens and county board members was statistically significant for several of the statements, and the county board member rankings were lower across the board (though still above 4.0 on each statement). The highest level of agreement among county board members was with statement b (4.23). The rankings by municipal bond analysts fell in between those of citizens and county board members. Municipal bond analysts most strongly agreed with a (4.31), c (4.40), and d (4.33).

Bond analysts were asked to rate how often they consider five issues related to tax abatements when analyzing municipal securities on a five-point scale (1 = never, 5 = always):

1. Revenues forgone through property tax abatements
2. Expected and actual outcomes related to existing property tax abatements
3. Taxes recovered through recapture provisions when abatements recipients fail to meet conditions in the tax abatement agreements
4. The degree to which a government uses property tax abatements to attract new businesses or to retain and expand existing businesses
5. The degree to which a government uses tax incentives to encourage economic development.

Four of the five factors linked to tax abatements were identified by bond analyst respondents as being considered somewhat regularly (average mean of approximately 3.0—1, 2, 4, and 5).

The surveys of all three user groups asked them to rank the importance of seven items that could be reported by governments about tax abatements they have granted:

1. Name of recipient
2. Date abatement was granted
3. Amount of tax abatement in the current year
4. Length of tax abatement and projected abatement amounts in future years
5. Commitments made by the government (e.g., infrastructure improvements)
6. Contractual promises made by the recipient (if any)
7. Recipient’s compliance with contractual promises.

The survey again used a five-point scale (1 = not at all important, 5 = very important). All three groups rated the importance of items iii–vii highly (average of 4.0 or greater). Citizen respondents rated i and ii highly as well, and county board member respondents rated those items near 4.0 (3.97 and 4.02, respectively). Citizen respondents rated items iv–vii particularly highly (each over 4.5). Those items also were the most highly rated among county board member respondents. The highest-ranked items among bond analyst respondents were iii and iv.

The surveys concluded by asking the three groups of users their opinions about how, if at all, tax abatements should be reported in audited financial reports. The questions were posed to all municipal bond analysts and to citizens and board members who responded with a 2 or higher when asked to rate their familiarity with audited government financial reports (1 = not at all familiar, 5 = extremely familiar; the average citizen response was 3.42 and for board members 3.60). Respondents were asked to identify their preference among five reporting options:

The greatest support across the three groups was given to recognition as a reduction in revenues and disclosure only. In fact, recognized property tax revenues do not include abated taxes either because they were not levied on the abatement recipients or they were levied but are not expected to be collected. The academics acknowledge that a part of the explanation of the relative popularity of the reduction of revenues option may be the parenthetical specification of “total revenues – amount abated = net revenue.” Respondents may have been signaling a desire to know all three components of that equation; whereas the net revenue is an issue of recognition in the financial statements, the reporting of gross revenues and the amount abated may be more suitable to note disclosure.

Accounting and Financial Reporting Issues: The project will consider the following issues:

1. What information about tax abatements, if any, should be disclosed in the notes?
2. What tax abatement information do governments currently have available?
3. What costs, if any, might a government incur to collect information about tax abatements?

Project History: The GASAC considered this topic during its discussion of priorities at its March 2012 and 2013 meetings. The GASAC members have ranked the topic among the highest in priority of all research activities and potential projects in the GASB’s technical plan.

Work Plan:

TAX ABATEMENT DISCLOSURES—PROJECT PLAN

Minutes of Meetings, April 8-10, 2014

The Board began deliberations on the Tax Abatement Disclosures project, focusing on defining the scope of transactions that will be covered by this project and creating a tentative definition of the term tax abatement.

The Board discussed whether to include the following components in the definition of a tax abatement: (a) the mechanism for reducing taxes, (b) the purpose of the tax abatement, (c) the breadth and applicability of abatement programs, (d) the existence of an agreement, and (e) the type of revenue being abated.

The Board tentatively agreed to include the purpose of the tax abatement, the existence of an agreement, and the type of revenue being abated in the tentative definition of a tax abatement. The mechanism for reducing taxes and the breadth and applicability of abatement programs were tentatively excluded from the definition.

Based on these tentative decisions, the Board tentatively agreed to propose the following definition for a tax abatement, for the purposes of this project, subject to further revision after subsequent deliberations:

Further, the Board tentatively agreed that the scope of possible standards that it will consider for tax abatement disclosures should be limited to transactions that meet the proposed definition of a tax abatement.

Minutes of Meetings, March 3-5, 2014

The Board received and discussed the results of staff research on the key issues of the Tax Abatement Disclosures project. Preliminary research findings were presented covering the following areas: nature and extent of tax abatements; commitments made in tax abatement agreements; user needs; and the availability of information. No formal deliberations took place at this meeting.

TAX ABATEMENT DISCLOSURES—TENTATIVE BOARD DECISIONS

These tentative decisions have been made since the inclusion of the project as a part of the current technical agenda. The Board tentatively agreed to the following:

• The definition of tax abatement will include:
  • The purpose of abatements—specifically, for economic development and other purposes that benefit the government or it citizens
  • The existence of an agreement between one or more governments and the taxpayer
  • Only reductions in tax revenues.
• The definition of tax abatement will not address the mechanism for reducing taxes, nor will it refer to the breadth and applicability of tax abatement programs.
• The Board tentatively agreed on the following definition of a tax abatement for the purposes of this project, subject to futher revision as deliberations continue:
  • For financial reporting purposes, a tax abatement is a reduction in taxes that results from an agreement between one or more governmental entities and an individual taxpayer in which (a) one or more governmental entities forgo tax revenues that the taxpayer otherwise would have been obligated to pay and (b) the taxpayer promises to take a specific action that contributes to economic development or otherwise benefits the government(s) or its citizens.
• The Board tentatively agreed that the scope of possible standards that it will consider for tax abatement disclosures should be limited to transactions that meet the proposed definition of a tax abatement.

¹Sands, Gary and Laura A. Reese. Public Act 198 Industrial Facilities Tax Abatements: Current Practices and Policy Recommendations. (East Lansing, MI: Land Policy Institute, Michigan State University, October 2007).
²2007 Census of Governments, State and Local Government Finances, U.S. Bureau of the Census. Available at: http://www.census.gov/govs/www/estimate07.html.
³Wassmer, Robert W. “The Increasing Use of Property Tax Abatement as a Means of Promoting Sub-National Economic Activity in the United States” (December 12, 2007). Available at SSRN:http://ssrn.com/abstract=1088482.

Wassmer, Robert W. “The Increasing Use of Property Tax Abatement as a Means of Promoting Sub-National Economic Activity in the United States” (December 12, 2007). Available at SSRN:http://ssrn.com/abstract=1088482.

²Sands, Gary and Laura A. Reese. Public Act 198 Industrial Facilities Tax Abatements: Current Practices and Policy Recommendations. (East Lansing, MI: Land Policy Institute, Michigan State University, October 2007).

³2002 Census of Governments, State and Local Government Finances, U.S. Bureau of the Census. Available at: http://www.census.gov/govs/www/estimate02.html.

⁴Dalehite, Esteban G., John Mikesell, and Kurt C. Zorn. “Variation in Property Tax Abatement Programs Among States.” Economic Development Quarterly, 2005, pp. 157–173.

Project Description:

The objective of this project is to reexamine issues associated with lease accounting, considering improvements to existing guidance. This project will provide a basis for the Board to consider whether operating leases meet the definitions of assets or liabilities. Current guidance is provided by National Council on Governmental Accounting (NCGA) Statement 5, Accounting and Financial Reporting Principles for Lease Agreements of State and Local Governments, GASB Statement No. 13, Accounting for Operating Leases with Scheduled Rent Increases, GASB Statement No. 62, Codification of Accounting and Financial Reporting Guidance Contained in Pre-November 30, 1989 FASB and AICPA Pronouncements, and GASB Statement No. 65, Items Previously Reported as Assets and Liabilities. Statement 62 incorporates the provisions of FASB Statement No. 13,Accounting for Leases, as amended and interpreted, into the GASB’s authoritative literature.

Status:

Added to Current Agenda: April 2013
Added to Research Agenda: April 2011

• Project Plan
• Recent Minutes
• Tentative Board Decisions to Date
• Project staff:
  • Deborah Beams
  • Randy Finden
  • Ken Schermann
  • Jialan Su
  • Cody Domasky
  • Christopher Teats 

LEASE ACCOUNTING—PROJECT PLAN

Background: Governments routinely enter into leases. Under the current authoritative literature, many of these leases are reported as operating leases. Even though operating leases represent long-term commitments to make payments, no liabilities are reported, although there are disclosures. Likewise, no assets are reported when governments have long-term rights to receive operating lease payments. In Concepts Statement No. 4, Elements of Financial Statements, the Board established definitions of assets and liabilities. This project provides an opportunity for the Board to consider whether operating leases meet the definitions of assets or liabilities.

The FASB and the International Accounting Standards Board (IASB) have current projects that propose to replace private sector guidance. Because of the potentially significant changes of the FASB/IASB project, the staff has received technical inquiries regarding whether there are any plans for the GASB to update its leasing guidance.

This project undertaken by the GASB is being performed in concert with the similar FASB/IASB project to maximize efficiency and timeliness. A simultaneous lease accounting project on the GASB agenda provides the opportunity to follow the progress of the FASB/IASB leasing project to assess any proposed new or amended leasing guidance in the context of the state and local government environment on a contemporaneous basis. This allows the Board to consider and address amendments to FASB Statement 13 (GASB Statement 62) in a timely manner.

Finally, part of the GASB’s strategic plan is to evaluate the effectiveness and impact of existing standards that have been in effect for a sufficient length of time. NCGA Statement 5 was issued in 1982 and GASB Statement 13 in 1990. This project provides an opportunity for a fresh look at the existing guidance for any improvements not contemplated by the FASB/IASB project given the unique nature of governmental entities and the complexities of their leasing transactions.

Accounting and Financial Reporting Issues: The major topic being researched is the forms of financial reporting display and disclosure that would meet essential financial statement user needs. The project is considering the following issues:

1. What types of leases are entered into by state and local governments?
2. What specific user needs exist regarding governmental leases and what decision-useful or accountability information is needed to meet those needs?
3. Are current accounting and financial reporting standards appropriate to meet essential user needs?
4. Should there be a distinction between types of leases, such as operating and capital?
5. If current standards are not considered adequate, what additional potential requirements should be considered?

Project History: A proposal to add the project to the research agenda was discussed by the GASAC at its March 2011 meeting and the project was added to the research agenda in April 2011.

At its February 2013 meeting, the GASAC ranked the project fifth in priority among research and potential projects. The project was added to the current agenda in April 2013.

The project was added to the current agenda in April 2013. At the June 2013 meeting, the FASB staff presented an education session on the proposed revisions to lease accounting contained in its revised Exposure Draft that was issued in May 2013.

At its August 2013 meeting, the Board discussed the scope of the project, the definition of a lease, and related scope issues. The Board tentatively agreed with the timeline and scope of the project. The Board then discussed minor revisions to the definition of a lease. The Board tentatively decided to replace “agreement” with “contract” and replace “capital assets (land and/or depreciable assets)” with “an asset (the underlying asset). The Board also tentatively decided to add the phrase “in an exchange or exchange-like transaction” to the definition of a lease.

The Board then discussed the inclusions and exclusions to the scope of lease guidance.

The Board tentatively decided to continue to include contracts not identified as leases but that meet the definition of a lease. The Board tentatively decided to not provide an example of such a contract, and remove the example currently provided. The Board tentatively decided to continue to exclude the following from the scope of the guidance: agreements that are contracts for services that do not transfer the right to use capital assets from one contracting party to the other; leases to explore for or use of minerals, oil, natural gas, and similar nonregenerative resources; licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents, and copyrights; and agreements that meet the definition of a service concession arrangement (SCA). In addition, the Board tentatively decided that biological assets, including timber should be excluded from the scope of the lease guidance, while intangible assets other than licensing agreements would continue to be included in the scope.

Current Developments: At the September 2013 meeting, the Board discussed issues associated with lease classifications and lease terms that drive the accounting treatment of leases. After discussing characteristics of various types of leases, the Board considered alternate methods to classify leases for accounting purposes. The Board tentatively agreed that while there might be inherent differences in leases, a single accounting model could be developed in the interest of not creating unnecessary complexity, with potential exceptions for certain circumstances.

The Board then discussed elements relevant to the duration of a lease, including the definition of a lease term, how to account for fiscal funding clauses, and the reassessment of a lease’s term. The Board tentatively decided that the lease term should start with the noncancellable period. The Board also tentatively decided that the lease term should include the periods covered by renewal options (or exclude periods covered by termination options) that are probable of being exercised based on an assessment of qualitative factors. The Board tentatively agreed to include in the noncancellable period of the lease term periods covered by fiscal funding and cancellation clauses with a remote possibility of cancellation. Leases that contain a fiscal funding or cancellation clause with a more than remote possibility of cancellation should be treated as having a termination option. The Board also tentatively agreed the lease term should be reevaluated when there is a change in relevant factors that would result in a change in judgment as to the lessee’s likelihood to exercise or terminate the lease, or when the lessee actually exercises or terminates the lease opposite of what was previously expected. The Board tentatively decided the relevant factors used in the initial assessment also should be the factors that trigger a reassessment.

At the October 2013 meeting, the Board discussed lessee recognition and measurement, including the foundation for recognition and measurement, and lessee recognition of assets and liabilities. The Board also began discussions on the lessee initial measurement of liabilities. The Board tentatively decided that the notion of leases as financings be the foundation for the governmental leasing model.

The Board continued deliberations by discussing the recognition of assets and liabilities for lessees. The Board tentatively agreed that the right to use the underlying asset be recognized as an asset by the lessee and that the obligation to make lease payments be recognized as a liability by the lessee. Furthermore, the Board tentatively decided that the obligation to return the underlying asset at the end of the lease not be recognized as a liability by the lessees; it also should not be recognized as a deferred inflow of resources or an outflow of resources. The Board then discussed other rights and obligations that may arise from a lease. The Board tentatively agreed that other rights be considered part of the overall lease asset and that other obligations be evaluated on a case-by-case basis.

The Board then discussed potential exceptions to the overall lease model. The Board tentatively decided that exceptions be made for short-term leases, under which the lessee government is not required to recognize assets or liabilities. The Board tentatively decided that a short-term lease be defined as a lease that, at the beginning of the lease, has a maximum possible term under the contract, including any options to extend, of 12 months or less. The Board tentatively agreed that the presence of a purchase option not affect the definition of a short-term lease. However, the Board also tentatively decided that leases that transfer ownership not qualify for the short-term lease exception, even if those leases meet the other criteria.

The Board then discussed the overall approach to the measurement of lease assets and liabilities for lessees. The Board tentatively decided that the general approach to measuring lease assets and liabilities be to measure the liabilities first and base the assets on that amount. The Board also tentatively decided that the general measurement approach for a lease liability be based on the present value of future payments.

The Board discussed the lessee measurement of lease liabilities and the types of payments that should be included. The Board tentatively decided that the following types of lease payments be included in the measurement of the initial lease liability:

• Fixed payments for the lease term
• Variable payments based on an index or rate, using the rate in effect at that date
• Variable payments that are in-substance fixed.

The Board tentatively decided that lease payments that depend on a lessee’s performance or usage of an underlying asset not be a component of the initial lease liability. The Board also discussed residual value guarantees as a potential component of the lease liability as well, and requested additional staff research before making a tentative decision.

At the November 2013 teleconference, the Board discussed certain topics related to the initial measurement of assets that are created when entering into a lease. Specifically, the Board discussed prepayments, lease incentives, and initial direct costs. The Board tentatively agreed that prepayments (amounts paid for the lease prior to measuring the lease liability) should be included in the value of the reported lease asset. The Board also tentatively decided that lease incentives received should be reductions in the cost of lease assets. The Board tentatively decided that initial direct costs should be either capitalized (if they are ancillary charges to place the asset into use) or expensed (all other costs). The Board also discussed measurement in governmental funds and tentatively decided that lease liabilities should be measured consistent with the current measurement requirements for capital leases.

At the December 2013 meeting, the Board continued discussions on issues related to initial measurement of a lease liability and asset for lessees. The Board also discussed issues related to subsequent measurement of lease liabilities and assets, additional issues related to short-term leases, and issues related to leases with multiple components, noncore assets, and other expense topics.

Work Plan: In addition to the topics below that will be deliberated by the Board, the project staff will continue to monitor the progress of the FASB and IASB projects on leases.

Work Plan:

LEASE ACCOUNTING —RECENT MINUTES

Minutes of Meetings, April 8-10, 2014

The Board began deliberations by discussing potential note disclosure requirements for lessees in relation to the general description of leasing arrangements. The Board tentatively agreed to propose a requirement for lessees to disclose a general description of the lessee’s leasing arrangements, including the basis, and terms and conditions, on which variable lease payments are determined and the existence, and terms and conditions, of residual value guarantees provided by the lessee. The Board also tentatively decided not to propose a requirement for lessees to disclose the existence and terms of purchase options; the existence, and terms and conditions, of renewal and termination options; the restrictions or covenants imposed by leases; or information about significant assumptions and judgments made in accounting for leases.

The Board continued deliberations by discussing potential disclosure requirements for lessees related to assets and liabilities. The Board tentatively agreed to propose that lessees be required to disclose only the general reconciliations of the changes in the lease liability and of the changes in capital assets currently required by Statement No. 34, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments, and not to include a requirement for a more detailed reconciliation. Furthermore, the Board tentatively agreed to propose a requirement for the total amount of assets recorded under leases, and the related accumulated amortization, to be disclosed separately from owned assets. The Board also tentatively decided not to propose a requirement for lease assets to be disaggregated by major classes of underlying assets.

The Board then discussed potential disclosure requirements for lessees involving expenses related to leases. The Board tentatively decided not to propose that lessees separately disclose the amount of amortization expense recognized for lease assets. The Board also tentatively decided to propose a requirement for lessees to disclose the total variable lease payments actually incurred. Furthermore, the Board tentatively decided to propose that the due process document supersede any existing disclosures related to operating leases.

The Board continued deliberations by discussing potential disclosure requirements for lessees in relation to future lease obligations. The Board tentatively agreed to propose a requirement for lessees to disclose a maturity analysis of future minimum lease payments that shows the payments for each of the first five years and five-year increments thereafter, with the payments shown undiscounted and total interest summed for all years. The Board also tentatively decided not to propose that the lessee disclosure requirements include amounts of sublease rentals to be received. The Board agreed that this topic would be addressed in the lessor disclosure deliberations.

Furthermore, the Board tentatively decided to propose a requirement for lessees to disclose commitments relating to leases, other than short-term leases, for which the lease term has not begun with a conforming edit to NCGA Statement 1, Governmental Accounting and Financial Reporting Principles. The Board also tentatively decided not to propose a requirement for lessees to disclose a maturity analysis of the nonlease components of a contract.

The Board then discussed other considerations regarding lessee disclosures. The Board tentatively decided not to propose that the due process document refer to the noncash transaction disclosure requirement in Statement No. 9, Reporting Cash Flows of Proprietary and Nonexpendable Trust Funds and Governmental Entities That Use Proprietary Fund Accounting. The Board also tentatively agreed to replace the example in Statement 9 of “obtaining an asset by entering into a capital lease” with “obtaining a right-of-use asset by entering into a lease.” Furthermore, the Board tentatively decided not to propose that the due process document refer to the related party disclosures in Statement No. 62, Codification of Accounting and Financial Reporting Guidance Contained in pre-November 30, 1989 FASB and AICPA Pronouncements.

The Board continued deliberations by discussing other potential disclosure requirements. The Board tentatively decided not to propose a requirement for disclosure of the discount rate(s) used in measuring lease liabilities. The Board also tentatively decided to propose an amendment to Statement 62 to exempt lease liabilities from imputed interest guidance. Furthermore, the Board tentatively decided not to propose a requirement for lessees to disclose the fair value of the lease liability, the amount of initial direct costs capitalized as part of lease assets during the reporting period, and information about arrangements that upon transition no longer meet the definition of a lease. The Board also tentatively decided not to propose a requirement for lessees to disclose the amount of interest expense related to leases or a requirement for lessees to disclose together all lease-related expenses. In addition, the Board tentatively decided not to propose a requirement for lessees to disclose cash paid for principal and interest on leases.

The Board tentatively agreed to propose a requirement for disclosure of payments made in excess of contractual requirements, such as residual value guarantees or penalties. The Board also tentatively decided not to propose a requirement for lessees to disclose the actual lease terms for significant leases and the weighted-average lease term of all leases, as well as the categorization of renewal options by likelihood.

The Board tentatively agreed to propose that lessee disclosure requirements not include information about below-market leases. The Board tentatively decided not to propose a requirement for lessees to disclose information about a government’s decision-making. Furthermore, the Board tentatively agreed to propose an amendment to Statement 62 to exempt disclosure of the underlying asset as collateral. The Board also tentatively agreed to propose that lessee disclosure requirements include the components of a net impairment loss (that is, gross impairment loss and adjustment to the lease liability).

The Board continued deliberations by discussing short-term lease disclosures for lessees. The Board tentatively decided that the existing disclosure requirements for accounting policies are sufficient to cover disclosure of accounting treatment for short-term leases and that no additional guidance is necessary in the due process document. The Board also tentatively agreed to propose a requirement for lessees to disclose the amount of expense and expenditure recognized for the period related to short-term leases. The Board also tentatively decided not to propose a requirement for lessees to disclose commitments under short-term leases or qualitative information about circumstances when the next period’s short-term lease expense is expected to be significantly different than the current period’s expense.

Minutes of Meetings, March 3-5, 2014

The Board met in a joint session with the Federal Accounting Standards Advisory Board (FASAB). The Board and FASAB began by discussing the foundation of a new accounting model for lessors. The Board tentatively decided that a new accounting model for lessors should be considered and that symmetry between the lessee and lessor accounting models should be a key factor in development of the lessor model.

The Board and FASAB then discussed the tentative decisions the Board has made to date. No further tentative decisions were made by the Board.

Minutes of Meetings, February 13, 2014

The Board discussed topics related to impairment of a lease asset. The Board tentatively decided to propose that in circumstances in which an asset underlying a lease is damaged and requires restoration or replacement, the time period during which the underlying asset is not usable generally is the relevant factor in assessing whether the impairment test has been met. This amended the Board’s previous tentative decision that a lessor’s responsibility to repair or replace an impaired underlying asset may indicate that impairment of the lease asset (right to use) will be temporary.

The Board continued deliberations by discussing impairment indicators. The Board tentatively decided to propose that the following be included in the text of a proposed Leases standard:

a) Impairment indicators present with respect to the underlying asset may result in a change in the manner or duration of use of the lease asset
b) A change in the manner or duration of use of the lease asset may indicate impairment of that asset.

The Board then discussed whether a lessor’s responsibility to restore or replace the underlying asset may indicate that the magnitude of the decline in service utility of the lease asset is not significant. The Board tentatively decided not to include that statement in a potential Leases standard.

The Board continued deliberations by discussing how to measure and recognize the impairment of a lease asset. The Board tentatively decided to propose that the lease asset should be adjusted first by the same amount as any change in the related lease liability. If the carrying value of the lease asset is reduced to zero, any further adjustments should be recognized in the flows statement. The Board also tentatively decided to propose that an impaired lease asset first be adjusted by any change in the corresponding lease liability, with any remaining adjustment recognized as the impairment loss.

The Board continued its discussions by reviewing examples of different impairment scenarios presented by the project staff. The Board provided suggestions to staff for changes to the examples if they are to be included in a due process document or future implementation guidance.

Minutes of Meetings, January 27-29, 2014

The Board began deliberations by discussing a possible exception to the overall lease accounting model for noncore assets, which could be defined as assets that are not essential to a government’s operations. The Board tentatively decided to propose that there not be an exception made to the overall leases model for leases of noncore assets.

The Board continued deliberations by discussing topics on lease-related expenses. The Board tentatively decided to propose that the existing guidance related to the accounting treatment for operating leases with scheduled rent increases be superseded. The Board also tentatively decided to propose that lease payments for short-term leases that have a rent holiday or rent reduction provisions be recognized as expenses based on the terms of the contract. Furthermore, the Board tentatively decided to propose that lease payments not included in the liability measurement be recognized as expense in the accrual accounting-based flows statement in the period in which the obligation for those payments is incurred.

The Board then discussed recognition in governmental funds. The Board tentatively decided to propose conforming edits to the existing guidance on accounting for leases in governmental funds. Furthermore, the Board tentatively decided to propose that the general guidance for recognition of liabilities in governmental funds adequately addresses short-term leases, and only limited amendments to existing provisions are needed.

The Board then discussed issues relating to the lease asset. The Board tentatively decided to propose that the right-of-use asset in a lease is an intangible asset that should be accounted for in accordance with existing authoritative guidance for capital assets. The Board also tentatively decided to propose that the relationship between the underlying asset and the lease asset could mean that the lease asset is impaired if indicators of impairment are present with respect to the underlying asset. Furthermore, the Board tentatively decided to propose that a lessor’s responsibility to repair or replace an impaired underlying asset may indicate that an impairment of the lease asset (right to use) will be temporary. The Board discussed how a lessee would measure an impairment of the lease asset and requested that the staff develop example calculations.

The Board continued deliberations by discussing guidance on presentation of lease assets and liabilities. The Board tentatively decided to propose that existing guidance on presentation of capital assets would apply to the lease asset. The Board also tentatively decided to propose that existing guidance on presentation of general long-term liabilities apply to the lease liability and that it be referred to as a long-term liability in a proposed Statement. Additionally, the Board tentatively decided to propose that specific guidance on the presentation of lease activities in the statement of cash flows be provided through implementation guidance rather than in the proposed Leases standard as existing standards related to the statement of cash flows are sufficient.

Minutes of Meetings, December 10-12, 2013

The Board continued its discussion on the measurement of lease liabilities by a lessee and the types of payments that should be included. The Board tentatively decided to propose that the following types of lease payments be included in the measurement of the initial lease liability:

• The best estimate or minimum of range of residual value guarantees probable of being paid based on an assessment of qualitative factors
• Purchase options probable of being exercised based on an assessment of qualitative factors
• Termination penalties, if based on the determination of the lease term, the termination option is probable of being exercised.

The Board then discussed several alternatives with respect to the determination of the discount rate. The Board tentatively decided to propose that lease liability payments be discounted using the rate the lessor charges the lessee. However, if that rate cannot be readily determined, the lessee’s incremental borrowing rate should be used. The Board tentatively decided not to propose an exception to use a risk-free interest rate in certain situations. The Board also continued its discussion of the initial measurement of lease assets and tentatively decided to propose that the first component of the lease asset be the initial measurement of the lease liability.

The Board continued deliberations by discussing subsequent measurement of the lease asset and lease liability by a lessee during the term of the lease. The Board tentatively decided to propose that a lessee remeasure a lease liability by calculating the amortization of the discount on the lease liability and reducing the lease liability by the actual lease payment amount less the amortization of the discount. The Board tentatively decided to propose that lease assets be amortized using a systematic and rational basis. The Board also tentatively decided to propose that lease assets be amortized over the shorter of the useful life of the underlying asset or the lease term. However, the Board also tentatively decided to propose that the lessee amortize the right-of-use asset as if the lessee owns the underlying asset, using the lessee’s depreciation policy, if the lease transfers ownership or if by assessing qualitative factors, it is probable that a purchase option will be exercised. In those situations, if the underlying asset is a non-depreciable asset such as land, the lessee should not amortize the right-of-use asset. Furthermore, the Board tentatively decided that the proposed guidance on leases that transfer ownership be included in the text of a standard.

The Board then discussed classification in the accrual-basis flows statement and the Board tentatively decided to propose that the lessee report the amortization of the lease asset as amortization expense and the amortization of the discount on the lease liability as interest expense.

The Board then discussed the reassessment of lease liabilities for lessees. The Board tentatively decided to propose that there be a reassessment of a lease liability when there is a change in the likelihood (probable to not probable or vice versa) of a purchase option being exercised based on an assessment of qualitative factors. The Board also tentatively decided to propose that, based on an assessment of qualitative factors, there be a reassessment of the residual value guarantee component of a lease liability when there is either a change in the amounts expected to be payable or when there is a change in the likelihood (probable to not probable or vice versa) that a payment will be required. Furthermore, the Board tentatively decided to propose that there be a reassessment of a lease liability when the result of a change in an index or a rate used to determine lease payments during the reporting period may be significant.

The Board tentatively decided to propose that a reassessment of the discount rate be required in any of the following situations:

• The lease term is changed
• There is a change in the likelihood (probable to not probable or vice versa) that a purchase option will be exercised
• The result of a change in the reference rate used to determine a variable lease payment may be significant.

The Board also tentatively decided to propose that in the event of a reassessment the Board’s tentative decision regarding the initial selection of a discount rate also be the approach for selection of a discount rate.

The Board continued deliberations by discussing the recalculation of the lease liability and asset. The Board tentatively decided to propose that adjustments arising from remeasurements of lease liabilities also adjust the right-of-use asset. The exception is adjustments due to a change in the rate upon which a variable lease payment is based, which should be recognized as revenue or expense in the current period.

The Board then discussed whether a lease asset should be subject to existing guidance on impairment. The Board requested to defer a tentative decision on this question until it discusses classification of the lease asset. The Board then considered a situation in which a lease asset also meets the proposed definition of an investment. The Board tentatively decided to propose that the asset be measured in accordance with guidance for investments rather than leases.

The Board then continued discussions on short-term leases. The Board tentatively decided to propose that a short-term exception be an accounting requirement, rather than a policy election, for all leases that qualify. The Board also tentatively decided to propose that lessees not be required to recognize assets or liabilities associated with the right to use the underlying asset for short-term leases. Furthermore, the Board tentatively decided to propose that lease payments for short-term leases be recognized as expenses/expenditures based on the terms of the contract.

The Board also discussed cancellable leases and tentatively decided to propose that cancellable periods (those periods for which a lessee and lessor each have the right to cancel the lease) be excluded from the lease term. The Board also tentatively decided to propose that the maximum possible term for a cancellable lease be defined as any noncancellable period, including any notice periods.

The Board then discussed whether contracts with multiple components (lease and nonlease, or multiple leases) should be bifurcated for accounting purposes and, if so, how the consideration should be allocated to the different components. The Board tentatively decided to propose that governments separate contracts into lease and nonlease components, subject to a practicality exception related to measurement. The Board also tentatively decided to propose that governments separate lease contracts involving multiple assets into multiple lease components only if there are different lease terms, subject to a practicality exception related to measurement.

For allocation of consideration between multiple components, the Board tentatively decided to propose that lessees first use prices in the contract for individual components, if available, if those prices are reasonable based on other observable stand-alone prices. If individual prices are not included in the contract, or the prices are not reasonable, the Board also tentatively decided to propose that lessees allocate consideration based on relative observable stand-alone prices, if those prices are available for all components of the contract. If observable stand-alone prices are not available for all components, the Board tentatively decided to propose that lessees (1) allocate the stand-alone price to any components for which there are such prices and then (2) consider any remaining components to be a single unit of account and assign the remaining consideration to that unit.

The Board continued deliberations by discussing how to account for a contract if components are not separated and the idea of providing guidance for concurrent contracts. The Board tentatively decided to propose that guidance be provided when multiple lease components are considered one unit for accounting purposes. The Board also tentatively decided to propose that accounting for multiple lease components that are considered as one unit for accounting purposes be based on the primary component. Furthermore, the Board tentatively decided to propose that guidance be provided for treating separate contracts that were signed concurrently. The Board will consider issues associated with concurrently signed contracts at a later meeting.

Minutes of Meetings, October 29-31, 2013

The Board discussed lessee recognition and measurement, including the foundation for recognition and measurement, and lessee recognition of assets and liabilities. The Board also began discussions on the lessee initial measurement of liabilities. The Board tentatively agreed that the major criticisms of current lease accounting, opportunities for structuring around a bright-line classification test and omission of a perceived liability, are items that the Leases project should attempt to address. The Board also recognized that the proposed accounting model for leases may have differences from the private sector as a result of factors found in the state and local government environment. The Board tentatively decided that the model should attempt to measure resources available to provide services, and obligations to sacrifice such resources, with consideration given to the characterization of expenses. The Board also discussed whether leases are executory contracts but did not reach a tentative decision. The Board tentatively decided to propose that the notion of leases as financings be the foundation for the governmental leasing model.

The Board continued deliberations by discussing the recognition of assets and liabilities for lessees. The Board tentatively agreed to propose that the right to use the underlying asset be recognized as an asset by the lessee and that the obligation to make lease payments be recognized as a liability by the lessee. Furthermore, the Board tentatively decided to propose that the obligation to return the underlying asset at the end of the lease not be recognized as a liability by the lessees; it also should not be recognized as a deferred inflow of resources or an outflow of resources. The Board then discussed other rights and obligations that may arise from a lease. The Board tentatively agreed to propose that other rights be considered part of the overall lease asset and that other obligations be evaluated on a case-by-case basis.

The Board then discussed potential exceptions to the overall lease model. The Board tentatively decided to propose that exceptions be made for short-term leases, under which the lessee government is not required to recognize assets or liabilities. The Board tentatively decided to propose that a short-term lease be defined as a lease that, at the beginning of the lease, has a maximum possible term under the contract, including any options to extend, of 12 months or less. The Board tentatively agreed to propose that the presence of a purchase option not affect the definition of a short-term lease. However, the Board also tentatively decided to propose that leases that transfer ownership not qualify for the short-term lease exception, even if those leases meet the other criteria. Furthermore, the Board tentatively decided to propose that it not be necessary to make an exception for leases that transfer ownership of underlying assets.

The Board then discussed the overall approach to the measurement of lease assets and liabilities for lessees. The Board tentatively decided to propose that the general approach to measuring lease assets and liabilities be to measure the liabilities first and base the assets on that amount. The Board also tentatively decided to propose that the general measurement approach for a lease liability be based on the present value of future payments.

The Board discussed the lessee measurement of lease liabilities and the types of payments that should be included. The Board tentatively decided to propose that the following types of lease payments be included in the measurement of the initial lease liability:

• Fixed payments for the lease term
• Variable payments based on an index or rate, using the rate in effect at that date
• Variable payments that are in-substance fixed.

The Board tentatively decided to propose that lease payments that depend on a lessee’s performance or usage of an underlying asset not be a component of the initial lease liability. The Board also discussed residual value guarantees as a potential component of the lease liability as well, and requested additional staff research before making a tentative decision.

Minutes of Meetings, September 17-19, 2013

The Board discussed issues associated with lease classifications and lease terms that drive the accounting treatment of leases. After discussing characteristics of various types of leases, the Board considered alternate methods to classify leases for accounting purposes. The Board tentatively agreed that while there might be inherent differences in leases, a single accounting model could be developed in the interest of not creating unnecessary complexity, with potential exceptions for certain circumstances.

The Board then discussed elements relevant to the duration of a lease, including the definition of a lease term, how to account for fiscal funding clauses, and the reassessment of a lease’s term. The Board tentatively decided that the lease term should start with the noncancellable period. The Board also tentatively decided that the lease term should include the periods covered by renewal options (or exclude periods covered by termination options) that are probable of being exercised based on an assessment of qualitative factors. The Board tentatively agreed to include in the noncancellable period of the lease term periods covered by fiscal funding and cancellation clauses with a remote possibility of cancellation. Leases that contain a fiscal funding or cancellation clause with a more than remote possibility of cancellation should be treated as having a termination option. The Board also tentatively agreed the lease term should be reevaluated when there is a change in relevant factors that would result in a change in judgment as to the lessee’s likelihood to exercise or terminate the lease, or when the lessee actually exercises or terminates the lease opposite of what was previously expected. The Board tentatively decided the relevant factors used in the initial assessment also should be the factors that trigger a reassessment.

Minutes of Meetings, August 6-8, 2013

The Board began deliberations for the leases project by reviewing the history of leases and current literature, the tentative scope of the project, the definition of a lease, and related scope issues. The Board tentatively agreed with the timeline and scope of the project. The Board then discussed minor revisions to the definition of a lease. The Board tentatively decided to replace “agreement” with “contract,” and “capital assets (land and/or depreciable assets)” with “an asset (the underlying asset).” The Board also tentatively decided to add the phrase “in an exchange or exchange-like transaction” to the proposed definition of a lease.

The Board then discussed the inclusions and exclusions to the scope of lease guidance. The Board tentatively decided to propose including contracts not identified as leases but that meet the definition of a lease. The Board tentatively decided to not provide in the proposal an example of such a contract, and remove the example currently provided. The Board tentatively decided to propose continuing to exclude the following from the scope of the guidance: agreements that are contracts for services that do not transfer the right to use capital assets from one contracting party to the other; leases to explore for or use of minerals, oil, natural gas, and similar nonregenerative resources; licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents, and copyrights; and agreements that meet the definition of a service concession arrangement. In addition, the Board tentatively decided to propose that biological assets, including timber, be excluded from the scope of the lease guidance, while intangible assets other than licensing agreements would continue to be included in the scope of lease guidance.

Minutes of Meetings, June 25-27, 2013

The FASB project staff on leases provided the Board with background information on the provisions of the recently released revised Exposure Draft, Leases. The session was educational in nature. No deliberations were conducted and no decisions were reached.

LEASE ACCOUNTING—TENTATIVE BOARD DECISIONS TO DATE

The Board tentatively agreed to propose that:

• The definition of a lease be revised to be “a contract that conveys the right to use an asset (the underlying asset) for a period of time in an exchange or exchange-like transaction”
• The scope of the Leases guidance continue to include contracts not identified as leases but that meet the definition of a lease
• The scope of the Leases guidance continue to exclude:
  • Contracts for services that do not transfer the right to use assets from one contracting party to the other
  • Leases to explore for or use of minerals, oil, natural gas, and similar nonregenerative resources
  • Licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents, and copyrights
  • Service concession arrangements
• The scope of the Leases guidance also exclude biological assets, including timber
• A single accounting model be developed, potentially with exceptions for certain circumstances
• The lease term include:
  • The noncancellable period
  • Periods covered by renewal options (or exclude periods covered by termination options) that are probable of being exercised based on an assessment of qualitative factors
  • Periods covered by fiscal funding and cancellation clauses if the possibility of cancellation is remote (If the possibility of cancellation is more than remote, the period should be treated as any other termination option when determining the lease term.)
• Cancellable periods be excluded from the lease term
• The lease term be reevaluated when there is a change in relevant factors that would result in a change in judgment as to the lessee’s likelihood to exercise or terminate the lease, or when the lessee actually exercises or terminates the lease opposite of what was previously expected
• The relevant factors used in the initial assessment of the lease term also be the factors that result in a reassessment
• The underlying assumption that leases are financings be the foundation for the governmental leasing model
• The right to use the underlying asset be recognized as an asset by the lessee
• The general approach to measuring lease assets and liabilities be to measure the liabilities first and base the assets on that amount
• The general measurement approach for a lease liability be based on the present value of future payments
• The obligation to make lease payments be recognized as a liability by the lessee
  • The obligation to return the underlying asset at the end of the lease not be recognized as a liability by the lessee
• A practicality exception be made for short-term leases
  • A short-term lease be defined as a lease that, at the beginning of the lease, has maximum possible term under the contract, including any options to extend, of 12 months or less
  • The maximum possible term for a cancellable lease be defined as any noncancellable period, including any notice periods
  • The definition of a short-term lease not depend on the presence of a purchase option
  • A short-term exception be an accounting requirement for all leases that qualify
  • Lessees not be required to recognize assets or liabilities associated with the right to use the underlying asset for short-term leases
  • Lease payments be recognized as expenses/expenditures based on the terms of the contract
  • Lease payments for short-term leases rent holiday or rent reduction provisions be recognized as expenses in accrual accounting financial statements based on the terms of the contract
  • There not be a practicality exception made for leases of noncore assets
• The initial measurement of a lease liability for a lessee include:
  • Fixed payments to be made over the lease term
  • Variable payments based on an index or rate, using the rate in effect at that date
  • Variable payments that are in-substance fixed
  • Residual value guarantees probable of being required based on an assessment of qualitative factors
  • Purchase options probable of being exercised based on an assessment of qualitative factors
  • Termination penalties if based on the determination of the lease term, the termination option is probable of being exercised
• Lease payments that are dependent on a lessee’s performance or usage of an underlying asset not be included in the measurement of the lease liability
• Payments not included in the liability measurement be recognized as expense in the accrual accounting-based flows statement in the period in which the obligation for those payments is incurred
• Lease liability payments be discounted using the rate the lessor charges the lessee and if that rate cannot be readily determined, the lessee’s incremental borrowing rate should be used
• The initial measurement of a lease asset for a lessee include:
  • The value of the initial lease liability
  • Any prepayments (amounts paid for the lease prior to measuring the lease liability)
  • Initial direct costs if they are ancillary charges to place the leased asset into use
• Lease incentives received be reductions in the cost of lease assets
• Initial direct costs be expensed if they are costs other than ancillary charges to place the leased asset into use
• A lessee remeasure a lease liability by calculating the amortization of the discount on the lease liability and reducing the lease liability by the actual lease payment amount less the amortization of the discount
• Lease assets be amortized using a systematic and rational basis over the shorter of the useful life of the underlying asset or the lease term
• The lessee amortize the right-of-use asset as if the lessee owns the underlying asset, using the lessee’s depreciation policy, if the lease transfers ownership or if by assessing qualitative factors a purchase option is determined to be probable of being exercised. In those situations, if the underlying asset is a non-depreciable asset such as land, the lessee should not amortize the right-of-use asset
• The lessee classify the amortization of the lease asset as amortization expense and the amortization of the discount on the lease liability as interest expense in the flows statement
• The right-of-use asset in a lease is an intangible asset that should be accounted for in accordance with existing authoritative guidance for capital assets
  • The relationship between the underlying asset and the lease asset could mean that indicators of impairment present with respect to the underlying asset may result in a change in the manner or duration of use of the lease asset
  • A change in the manner or duration of use of the lease asset may indicate impairment of that asset
  • In circumstances in which an asset underlying a lease is damaged and requires restoration or replacement, the time period during which the underlying asset is not usable generally is the relevant factor in assessing whether the impairment test has been met.
  • An impaired lease asset first would be adjusted by any change in the corresponding lease liability, with any remaining adjustment recognized as the impairment loss
• A reassessment of a lease liability be required in any of the following situations:
  • When there is a change in the likelihood (probable to not probable or vice versa) of a purchase option being exercised based on an assessment of qualitative factors
  • A change in the amounts expected to be payable under a residual value guarantee or when there is a change in the likelihood (probable to not probable or vice versa) that a payment will be required based on an assessment of qualitative factors
  • Result of a change in an index or a rate used to determine lease payments during the reporting period may be significant
• A reassessment of the discount rate be required in any of the following situations:
  • Lease term is changed
  • A change in the likelihood (probable to not probable or vice versa) that a purchase option will be exercised based on an assessment of qualitative factors
  • Result of a change in the reference rate used to determine a variable lease payment may be significant
• Initial selection of a discount rate also be the approach for selection of a discount rate in the event of a reassessment
• Adjustments arising from remeasurements of lease liabilities also adjust the right-of-use asset by the same amount. The exception is adjustments due to a change in the rate upon which a variable lease payment is based, which are recognized as revenue or expense in the current period.
• If the adjustment to the lease liability is greater than the carrying value of the lease asset, the difference be recognized in the flows statement
• Contracts separated into lease and nonlease components or multiple lease components, subject to a practicality exception related to measurement
• Allocate consideration to multiple components, lessees:
  • First use prices in the contract for individual components, if available, and if those prices are reasonable based on other observable standalone prices
  • If individual prices are not available or not reasonable, allocate consideration based on relative observable standalone prices, if those prices are available for all components of the contract
  • If observable standalone prices are not available for all components,
    • Allocate the standalone price to any components for which there are such prices and then
    • Consider any remaining components to be a single unit of account and assign the remaining consideration to that unit
• Accounting for multiple lease components that are considered as one unit for accounting purposes be based on the primary component.
• The guidance in Statement 13 relating to the accounting treatment for operating leases with scheduled rent increases be superseded
• Lessees be required to disclose the following:
  • A general description of leasing arrangements, including the basis, and terms and conditions, on which variable lease payments are determined and the existence, and terms and conditions, of residual value guarantees provided by the lessee
  • Total amount of assets recorded under leases, and the related accumulated amortization, disclosed separately from owned assets
  • The total variable lease payments actually incurred during the reporting period
  • A maturity analysis of future minimum lease payments that shows payments for each of the first five years and five-year increments thereafter, with the payments shown undiscounted and total interest summed for all years
  • Lease commitments, other than short-term leases, for which the lease term has not begun
  • Payments made in excess of contractual requirements, such as residual value guarantees or penalties
  • Components of a net impairment loss
• Amount of expense and expenditure recognized for the period related to short-term leases
• A new lessor accounting model be considered with symmetry between lessee and lessor accounting as a key factor in its development.
• The Board issue a Preliminary Views document for the Leases project.

Fair Value Measurement and Application

Governments should continue gearing up to implement the GASB’s recent pension standards as planned in light of a recent Board decision not to delay the implementation date. The decision came after extensive Board discussion, research, and outreach in response to a request by certain stakeholders to delay implementation.

Read the Report.

The Department of Energy’s Loan Program Office (the “DOE”) announced on April 16, 2014, a new loan guarantee program for up to $4 billion under Section 1703 of Title XVII of the Energy Policy Act. The announcement coincides with the DOE’s release of a Draft Renewable Energy and Energy Efficiency Project Solicitation (the “Draft Solicitation”) for innovative renewable energy and efficient energy projects in the U.S. that reduce, avoid, or sequester greenhouse gases. The aim of the Draft Solicitation is to foster renewable energy and energy efficiency technologies that are “catalytic, replicable, and market ready.”

12-May-2014

In our annual update of the key statistics underlying our assessments of debt issues in the U.S. municipal water and sewer sector, we’re focusing on the medians and means of several widely used variables. As in previous reports, we present data for economic and financial measures to offer insight into correlations that exist between these measures and the ratings we’ve assigned to issuers in this sector.

When assigning a bond rating, Standard & Poor’s Ratings Services takes into account a variety of factors, both qualitative and quantitative. We believe a thorough examination of the quantitative information sheds light on the strengths and weaknesses of individual issuers relative to others. By providing this information, we hope to increase transparency and continue our open and accurate discussions about credit quality among all participants in the municipal water and sewer bond sector.

It is important to remember that the ratios and other measures we provide here are not the sole determinants of our rating assignments, nor can they serve as rating benchmarks because they do not account for the issuer’s complete financial, operating environment, or sector risk. Moreover, these means and medians reflect recent historical information, while we intend our credit ratings to be forward-looking. Also, because our long-term ratings are designed to hold up through business cycles, a particular issuer’s ratios may appear to be inconsistent with its assigned debt rating at a particular point within a cycle. We also exercise some degree of caution when making national comparisons of revenue bond issuers because the operating environments may differ from state to state. Issuers often face differences in regulations that determine their ability to raise rates and issue debt, what their required service provisions may be, and the regulatory environment in which they operate. However, these differences tend to be minor.

Rating Distributions Continue To Cluster In The ‘AA’ And ‘A’ Categories

Given the stability of the municipal water and sewer sector, a quick look at the overall rating distributions for municipal water and sewer bonds reveals two immediate conclusions: (1) the ratings are almost exclusively investment-grade, with only 0.3% of all bonds rated below ‘BBB-‘, and (2) nearly half of the ratings are now in the ‘AA’ category. In this year’s report, we focus on exclusively, or predominantly, retail systems and exclude ratings on larger wholesale systems. However, we do include data for the systems that determine a wholesaler rating. For example, we have excluded the ratings on certain debt issued by Trinity River Authority, Texas, but have added the data related to its principal wholesale customers. This explains some of the differences in ratings counts from last year’s report.

Of our total rated universe of more than 1,500 issuers, just over 90% fall in either the ‘AA’ or ‘A’ category. Approximately 47% of the ratings are in the ‘AA’ category, with 45% in the ‘A’ category. Currently, about 6% of the ratings in this report are ‘AAA’, with only 2% rated ‘BBB+’ or lower (see chart 1). While ratings cluster around the ‘AA’ and ‘A’ categories, with a median rating of ‘A+’, a self-selection bias admittedly affects the distributions. Many water and sewer systems of potentially poorer self-assessed credit quality may choose not to apply for a public Standard & Poor’s rating, or they may access capital though state revolving funds. The absence of those potentially lower-rated issuers may artificially elevate the rating distribution.

When we dive deeper into the rating distributions according to the systems’ service area population, some differences begin to emerge. As in previous years, for systems with populations of less than 20,000, the ratings are predominantly in the ‘A’ category (72%). The ‘BBB’ category is now home to less than 5% of systems with service areas with populations under 20,000, while 24% are rated ‘AA’ and less than 1% are ‘AAA’ (see chart 2).

For systems with populations between 20,000 and 150,000, the spread between those in the ‘AA’ category (57%) and those in the ‘A’ category (39%) has widened in recent years. Approximately 5% of those in this population range are rated ‘AAA’, while less than 1% are ‘BBB+’ or lower (see chart 3).

As population levels increase, so does the percentage of higher-rated issuers. For systems with a service area population ranging between 150,000 and 500,000, the majority of the ratings are in the ‘AA’ category (64%), while only about one-third are ‘A+’ or lower. In this range, about 25% are rated ‘AAA’ (see chart 4). Similarly, for very large systems with populations above 500,000, about 20% are ‘AAA’, 60% are ‘AA’, and about 20% are rated ‘A+’ or lower (see chart 5).

Summary Of Key Economic, Financial, And Debt Ratios

The ratios we provide below reflect three of the four main areas Standard & Poor’s evaluates when rating issuers: economic, financial, and debt factors. Measures for the fourth factor, administration and management, are generally more qualitative. The ratios include:

• Median household effective buying income: Commonly known as “disposable income,” or a household’s wages, salaries, dividends, and transfer payments, less all applicable taxes and withholdings.
• Customer concentration (top 10%): The percent of total operating revenues from the top 10 customers.
• Liquidity ratio (days’ cash on hand): Enterprise fund cash and cash equivalents, divided by annual enterprise fund expenses and multiplied by 365, expressed in the number of days of cash on hand. Standard & Poor’s excludes depreciation.
• Senior-lien debt service coverage (DSC): The total amount of senior-lien debt divided by the net revenues available to service the debt.
• All-in DSC: Total senior, junior, and self-supported debt, coupled with other obligations routinely covered by the enterprise fund, divided by the net revenues available for debt service. DSC ratios, however, are internally adjusted for utilities that are distribution-only and/or collection-only systems versus those that are vertically integrated. For utilities that are not vertically integrated, we impute a pro rata share of the wholesale provider’s fixed costs onto the utility. While it is probable that the wholesale provider may have once issued debt on the utility’s behalf, it also makes DSC comparisons more meaningful and allows better insight into the true financial capacity of all obligations.

Table 1  |  Download Table

Table 2  |  Download Table

Table 3  |  Download Table

The Relationships Between Our Ratings And Select Ratios

As in previous years, the data show correlations between several ratios-—including the issuer’s population, income levels, and liquidity—-and our ratings on these debt issues. This is not surprising because the economic base (i.e., the population and income levels) tends to provide the foundation for credit quality in general. What’s more, larger systems tend to enjoy the benefits of economies of scale because they can tap into a larger base to generate revenue, address system emergencies, and adapt to fluctuations in demand often more expeditiously and efficiently than smaller systems. Similar to population, a system’s total operating revenues correlate to rating level: Systems with larger budgets generally get rated higher.

Given the overwhelming majority of ratings are ‘A-‘ or higher, ratings below this level usually have a unique set of credit factors associated with them. This year, ratings at the ‘BBB’ level or lower include those on Detroit; Jefferson County, Ala.; Stockton, Calif.; New Orleans; and Atwater, Calif. Each of these issuers has experienced significant stress related to either their enterprise fund, general government operations, or both.

A direct correlation exists between our issue ratings and ratios such as median and mean population, days’ cash on hand, and coverage ratios. For several of the data points, we used the average of the previous three years for analysis. Although the sector is extremely stable and only minor deviations typically occur from year to year, using a three-year average tends to smooth any atypical year-over-year changes.

Across all rating categories, the range from the minimum value to the maximum value is, for almost every data point, extremely large. For example, days’ cash levels for ‘AAA’ issuers range from less than 100 days to more than 2,000 days. Given the size differences between the smallest issuers and the exceptionally large issuers, the means may be skewed but can nevertheless provide some insight.

Income levels, unemployment rates, and population

In general, better economic indicators correlate with higher ratings. From the ‘BBB’ category to the ‘AAA’ category, median household effective buying income increases to 120% of the national average from 83%, while the median unemployment rate declines to 6.1% from 7.8%. Additionally, the median population for ‘AAA’ rated issuers is significantly higher than those in any other rating category.

Liquidity ratios

The issuers’ days’ cash on hand, a measure of liquidity, are also stronger at the higher rating levels, although median liquidity levels remain healthy, in our view, for each category. However, for smaller systems, a high days’ cash number does not always equal a nominally high amount of cash. For example, a very small system with 180 days’ cash may have a nominally low amount of cash available to address any emergencies or wet weather conditions that cause a decline in demand.

The median days’ cash level is about 144 days for ‘BBB’ category issuers and rises to 283 for those in the ‘A’ category, 417 for those in the ‘AA’ category, and 472 for ‘AAA’ issuers. When aggregating by population, the correlations are not quite as strong, with median liquidity levels of the midsize issuers greater than those of the larger issuers. Again, liquidity measures are typically strong across all rating categories despite population levels.

Coverage ratios

As with days’ cash on hand, the coverage ratios also have strong correlations with credit quality because the higher-rated issuers tended to have better debt service coverage. Mean and median coverage levels improved noticeably between each rating category. The median senior-lien coverage ratio is 1.3x for ‘BBB’ credits and rises to 3.3x for ‘AAA’ credits. However, these correlations do not exist when taking population ranges into account because issuers in the 20,000 to 150,000 range had higher coverage means and medians than larger systems. These trends are consistent with previous years.

A closer look at the ‘AA’ category

While ‘A+’ remains the median rating level, a slightly greater percentage of ratings are in the ‘AA’ category versus the ‘A’ category. Within the ‘AA’ category, a slightly higher percentage of ratings are at ‘AA-‘ (20%) than ‘AA’ (17%), with about 8% at ‘AA+’. Some of the correlations that were evident from category to category are still evident within the ‘AA’ category itself. Specifically, median population levels and unemployment rates improve with rating quality. Financial indicators, such as days’ cash and debt service coverage, do not differ significantly from ‘AA-‘ to ‘AA+’, though the liquidity ratio rises slightly (see table 3).

As Always, Numbers Don’t Tell the Whole Story

While the ratios presented here may show particular trends from category to category, or even within certain categories, they are not the sole determinants for the assignment of a rating. Management policies and practices, coupled with the environment in which the utility operates, will often lead to higher coverage or liquidity ratios. Those governance factors may be the primary reason for a higher rating, with the operating performance a result of higher-quality management. While strong financial metrics can certainly lead to higher ratings, it is also the underlying management of the system, the resources available to staff and the ability to maintain those strong financial metrics that ultimately underpins the rating assignment.

15-Apr-2014

We present the medians by rating category and they apply to U.S. counties. These ratios exclude municipalities and special districts such as school districts. We are publishing a separate GO municipality median report concurrently with this article. We plan to continue updating this article quarterly as we move through the one-year implementation period.

We drew the medians from 325 county reviews completed through March 12, 2014, of the approximately 1,000 total ratings in our portfolio for counties that fall under the revised GO criteria. We have committed to reviewing all issuers that fall under the new GO criteria by September 2014.

We calculate the metrics, for which we provide the medians, based on raw, or in some cases, data that we have adjusted (for more information, see the related research article below), and they are only one component of the rating analysis. The metrics play a part in the quantitative analysis in five factors: economy, budgetary flexibility, budgetary performance, liquidity, and debt and contingent liabilities. Qualitative adjustments within each factor (which the medians do not reflect) also play an important part in the analysis.

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Median Definitions

• MVPC ($) (total market value per capita): Total value of taxable property within the jurisdiction divided by population.
• Proj PC EBI (%) (projected per capita effective buying income as a % of U.S. projected per capita EBI): Projection of per capita after-tax income measured as a percent of that of the U.S.
• FB/exp (%) (available fund balance as a % of expenditures): This ratio measures all funds available for operations as a percent of general fund expenditures.
• GF op res (%) (general fund net result): This ratio measures fiscal year-end general fund net operating results, as a percent of general fund expenditures.
• TGF op res (%) (total governmental funds net result): This ratio measures fiscal year-end total governmental funds net operating results, as a percent of total governmental funds expenditures.
• TG cash/exp (%) (total government available cash as % of total governmental funds expenditures): This ratio includes all available total government cash (in all funds) and measures it as a % of total governmental funds expenditures.
• TG cash/DS (%) (total government available cash as % of total governmental funds debt service): This ratio includes all available total government cash (in all funds) and measures it as a % of total governmental funds debt service.
• Net DD/rev (%) (net direct debt as % of total governmental funds revenue): This ratio measures the total debt burden on the government’s revenue position.
• TGF DS/exp (%) (total governmental funds debt service as a % of total governmental funds expenditures): This ratio measures the annual fixed-cost burden that debt places on a government.

Related Criteria And Research

Related Criteria

USPF Criteria: Local Government GO Ratings Methodology And Assumptions, Sept. 12, 2013

Related Research

S&P Public Finance Local GO Criteria: How We Adjust Data For Analytic Consistency, Sept. 12, 2013

15-Apr-2014

We present the medians by rating category, and they apply to U.S. municipalities covered under the GO criteria including cities, towns, townships, boroughs, and villages. They exclude special purpose districts such as school districts. We are publishing a separate county GO median report concurrently with this article. We plan to continue updating this article quarterly as we move through the one-year implementation period.

We draw the medians from 1,245 municipality reviews completed through March 12, 2014, of the approximately 3,000 in our portfolio of total ratings for municipalities that fall under the revised GO criteria. We have committed to reviewing all issuers that fall under the new criteria by September 2014.

We calculate the metrics, for which we provide the medians, based on raw data, or in some cases, data we have adjusted (for more information, see the related research articles), and they are only one component of our analysis. The metrics play a part in the quantitative analysis in five factors: economy, budgetary flexibility, budgetary performance, liquidity, and debt and contingent liabilities. Qualitative adjustments within each factor (which the medians do not reflect) also play an important part in the rating outcome.

Download Table

Median Definitions

• MVPC ($) (total market value per capita): Total value of taxable property within the jurisdiction divided by population.
• Proj PC EBI (%) (projected per capita effective buying income as a % of U.S. projected per capita EBI): Projection of per capita after-tax income measured as a percent of that of the U.S.
• FB/exp (%) (available fund balance as a % of expenditures): This ratio measures all funds available for operations as a percent of general fund expenditures.
• GF op res (%) (general fund net result): This ratio measures fiscal year-end general fund net operating results, as a percent of general fund expenditures.
• TGF op res (%) (total governmental funds net result): This ratio measures fiscal year-end total governmental funds net operating results, as a percent of total governmental funds expenditures.
• TG cash/exp (%) (total government available cash as % of total governmental funds expenditures): This ratio includes all available total government cash (in all funds) and measures it as a % of total governmental funds expenditures.
• TG cash/DS (%) (total government available cash as % of total governmental funds debt service): This ratio includes all available total government cash (in all funds) and measures it as a % of total governmental funds debt service.
• Net DD/rev (%) (net direct debt as % of total governmental funds revenue): This ratio measures the total debt burden on the government’s revenue position.
• TGF DS/exp (%) (total governmental funds debt service as a % of total governmental funds expenditures): This ratio measures the annual fixed-cost burden that debt places on a government.

Related Criteria And Research

Related Criteria

USPF Criteria: Local Government GO Ratings Methodology And Assumptions, Sept. 12, 2013

Related Research

S&P Public Finance Local GO Criteria: How We Adjust Data For Analytic Consistency, Sept. 12, 2013

Citigroup Inc. terminated a deal to purchase $265 million of revenue bonds from Anaheim, California, after opponents sued over plans to expand the city’s convention center, a city spokeswoman said.

Phoenix, facing pension costs that have doubled in six years, may become the largest U.S. city to put new workers in 401(k)-style plans if voters pass a ballot measure in November.

Fitch Ratings-San Francisco-08 May 2014: The California Supreme Court’s decision last week against reviewing a lower court’s decision on other post-employment benefit (OPEB) liabilities removed one legal challenge to public employers’ efforts to reduce obligations, Fitch Ratings says. However, many other hurdles remain. We generally view OPEBs as more flexible than pensions. This decision supports that view, as well as the view that local governments’ (in this case California’s) ability to make material adjustments to these benefits.

The April 30 denial by the California Supreme Court leaves standing a December 2013 opinion by the state’s Court of Appeals, which affirmed the city of San Diego’s ability to cap its contributions toward retiree health care benefits. The appeals court cited substantial legal precedent in concluding that San Diego’s OPEBs were an employment benefit rather than a vested contractual right and, unlike pension benefits, could be reduced for current employees and retirees.

California courts have looked closely at the circumstances under which OPEBs have addressed the validity of subsequent reductions. A series of decisions over the past several years by both the federal 9th Circuit Court and the state Supreme Court have held that OPEBs in general are not vested with contractual rights, but this status may be granted or implied through labor negotiations or other governing board actions. As a result, local governments’ legal authority to reduce OPEBs must be determined on a case-by-case basis, leading to repeated litigation of benefit cuts across multiple jurisdictions.

Fitch expects OPEB litigation to continue as public employers in California increasingly look for means to reduce long-term liabilities and growing expenses. Several cases arising from OPEB cuts made during the recent recession continue to wend their way through the state’s courts, and any new efforts to reduce benefits are likely to face legal challenges as well. Litigation is likely to slow the pace of OPEB reform in California and the prospect of litigation may also lead some employers to reconsider such efforts.

Contact:

Stephen Walsh
Director
U.S. Public Finance
+1 415 732-7573
650 California Street
San Francisco, CA

Rob Rowan
Senior Director
Fitch Wire
+1 212 908-9159
33 Whitehall Street
New York, NY

Norwalk, CT, May 15, 2014—The Governmental Accounting Standards Board (GASB) today issued for public comment a proposed Statement addressing accounting and financial reporting issues related to fair value measurements.

The Exposure Draft, Fair Value Measurement and Application, describes how fair value should be defined and measured, what assets and liabilities should be measured at fair value, and what information about fair value should be disclosed in the notes to the financial statements.

“The proposed changes to the GASB’s fair value standards are intended to increase clarity, consistency, and comparability in governments’ fair value measurements and their related disclosures,” said GASB Chairman David A. Vaudt. “The Board believes that fair value measurements enhance the relevance of reported financial information, particularly when accompanied by robust disclosures.”

The GASB is proposing that fair value be defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Exposure Draft also proposes that investments would generally be measured at fair value. Investments would be defined as a security or other asset that a government holds primarily for the purpose of income or profit and the present service capacity of which is based solely on its ability to generate cash or to be sold to generate cash.

Certain investments would continue to be excluded from measurement at fair value, such as investments in money market instruments with remaining maturities at time of purchase of one year or less.

Under current accounting standards, state and local governments are required to disclose how they arrived at their measures of fair value if they are not based on quoted market prices. In the Exposure Draft, the GASB is proposing to expand those disclosures to include the inputs a government uses to measure fair value and the judgments made to arrive at those inputs.

The Exposure Draft is available on the GASB website, www.gasb.org. Stakeholders are encouraged to review the proposals and provide comments by August 15, 2014.

The GASB will hold a live, one-hour, CPE webinar on the Exposure Draft at 1 p.m. EDT on Tuesday, July 15 aimed at auditors and preparers. On Thursday, July 17 at 1 p.m. EDT, the GASB will host a one-hour, non-CPE webinar for financial statement users. Registration for both events will be announced on the GASB website in the coming weeks.

 Recently, the White House announced that 8 million Americans have signed up for private health coverage under the Affordable Care Act. Approximately a third are younger than 35 years old, and the costs of the expansion are reportedly less than expected; for instance, the administration predicts that Medicare and Medicaid costs in 2020 will be $180 billion less than 2010 estimates. Many governments are looking for more information about complying with the act and making sure their health-care benefit is sustainable. Take a look at the GFOA’s best practices for ideas on implementation, as well as insurance and cost containment options.

New York, NY, May 13th 2014 – CUSIP Global Services (CGS) today announced the launch of its Municipal Pre-Refunded Linkage Service. Created to identify and link partially pre- refunded municipal bonds into one record, the new product will reduce clerical errors that could arise from the manual process typically followed in today’s market. The service will also aid in the risk management of partially pre-refunded bonds, which are frequently backed by U.S. Treasuries.

The new service assigns CUSIP numbers when a municipal bond is partially pre-refunded, a situation that occurs when a portion of the outstanding principal amount of an issue is pre- paid before the scheduled maturity date. The service contains over 59,000 linked issues which include reference data for the partially pre-funded parent, the newly issued pre- refunded bond and the newly issued bond for the un-refunded balance. The service is delivered daily via FTP in the form of an initial master file along with daily updates.

“We are constantly surveying our clients for ways we can offer solutions to help in their daily operations,” said Jim Taylor, Managing Director and Head of CGS. “This product underscores our commitment not only to the municipal market, but to all of those who are looking for easier ways to properly track municipal assets in their portfolio.”

About CUSIP Global Services

The financial services industry relies on our unrivaled experience in uniquely identifying instruments and entities to support efficient global capital markets.

Our extensive focus on standardization over the past 45 years has helped us earn the reputation for being the trusted originator of quality identifiers and descriptive data, ensuring that essential front- and back-office functions run smoothly.

CGS is managed on behalf of the American Bankers Association (ABA) by S&P Capital IQ, with a Board of Trustees that represents the voices of leading financial institutions For more information, visit www.cusip.com.

About The American Bankers Association

The American Bankers Association represents banks of all sizes and charters and is the voice for the nation’s $14 trillion banking industry and its two million employees. Learn more at www.aba.com.For More Information:

Michael Privitera S&P Capital IQ Communications [email protected] 212-438-6679

U.S. states and cities are selling bonds via competitive bidding at the fastest pace in more than a decade as officials strive to cut costs almost five years after the recession.

Fitch Ratings-New York-02 May 2014: Despite more stringent state laws, water and sewer utilities must comply with EPA water regulations and would bear much of the financial burden if hydrofracking (fracking) operations lead to contamination of a water supply, Fitch Ratings says. This week the state of Michigan joined a growing list of states that require disclosure of the chemicals injected into the ground during fracking processes.

State regulations require oil and gas companies to disclose the chemicals used for fracking. However the utilities are subject to federal disclosure laws that allow companies to claim trade-secrets exemption. Even if the chemicals used for fracking are disclosed, they may not be on the EPA’s list of regulated contaminants. As water utilities are ultimately responsible for complying with EPA regulations for monitoring, treating and delivering water that is safe for public consumption, they would bear much of the financial, operational and regulatory burden of safeguarding water that could potentially be contaminated by fracking operations.

In this scenario, Fitch would expect a serious blow to a utility’s revenues, with losses concurrent with other growing direct and indirect costs. This would lead to debt service coverage reductions, liquidity strains and possibly the need for additional leverage.

In the coming days we will release a report entitled “Fracking: Possible Implications to Water & Sewer Credits” that will provide more detail on this possible scenario and illuminate the risks for bondholders.

Contact:

Doug Scott
Managing Director
U.S. Public Finance
+1 512-215-3725
111 Congress Avenue
Austin, TX

Rob Rowan
Senior Director
Fitch Wire
+1 212 908-9159
33 Whitehall Street
New York, NY
Media Relations: Elizabeth Fogerty, New York, Tel: +1 (212) 908 0526, Email: [email protected].

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY’S PUBLIC WEBSITE ‘WWW.FITCHRATINGS.COM’. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH’S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE ‘CODE OF CONDUCT’ SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.

Testimony by Joseph Kile, Assistant Director for Microeconomic Studies, before the Committee on Finance, United State Senate

Offers Glimpse into “The Road Ahead” for the FAF, the FASB, and the GASB

Norwalk, CT, May 8, 2014—The Financial Accounting Foundation (FAF) today issued its 2013 Annual Report, available online at www.accountingfoundation.org.

Themed as “The Road Ahead,” the 2013 Annual Report outlines the future direction of the FAF and its standard-setting Boards, the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). As stated in the introduction:

The issues we face are varied and complex. How should we continue to work toward more comparable global accounting standards? To what degree should we provide accounting alternatives for private companies while preserving the strength and consistency of GAAP? How can we make the financial position of governments more transparent for taxpayers, bond buyers and other users of financial statements?

These questions are examined from the perspective of the leaders of all three organizations and in letters to stakeholders from FAF Board Chairman Jeffrey J. Diermeier, FAF President & Chief Executive Officer Teresa S. Polley, FASB Chairman Russell G. Golden, and GASB Chairman David A. Vaudt.

The report also provides illustrative, high-level overviews of the accomplishments of the FAF, the FASB, and the GASB, presented in a way that gives even the most time-pressed readers a comprehensive overview of the year’s highlights.

Other features in the 2013 Annual Report include:

• Full-color photos featuring both current and past FAF, FASB, and GASB leaders, staff, and other stakeholders
• Listings of all FAF, FASB, and GASB advisory groups, including the Private Company Council and the Emerging Issues Task Force, and
• Complete 2013 management’s discussion and analysis and audited financial statements.

Those interested in receiving a hard-copy version of the annual report may request one by e-mailing[email protected]. Hard copies will be distributed in late May.

For more information about the FAF, visit www.accountingfoundation.org.

About the Financial Accounting Foundation

The FAF is responsible for the oversight, administration, and finances of both the Financial Accounting Standards Board (FASB) and its counterpart for state and local government, the Governmental Accounting Standards Board (GASB). The Foundation is also responsible for selecting the members of both Boards and their respective Advisory Councils.

As demand for government services continues to grow across the United States, federal, state and local government agencies must identify innovative and cost effective methods to deliver essential social infrastructure. While many agencies are interested in pursuing innovative P3 delivery models to procure public buildings, they often lack the clear necessary legislation to authorize P3 deals.