A bill introduced in the House of Representatives last week would amend the IRS Code to exempt water and wastewater infrastructure projects from the Private Activity Bond volume cap. H.R. 4237, titled The Sustainable Water Infrastructure Act of 2014, was introduced on March 13, 2014, by Reps. John Duncan, Jr. (R-TN) and Bill Pascrell, Jr. (D-NJ) and referred to the House Committee on Ways and Means.

A press release issued by Rep. Duncan, Jr. states that “raising the PAB cap on water infrastructure projects would leverage $50 billion in private capital investment, create 1.4 million jobs, and add $101.5 billion in tax revenue to federal, state and local governments.” The legislation is supported by the National League of Cities, Sustainable Water Infrastructure Coalition, and other groups.

The text of the bill can be seen here.

Even though Obama proposes cuts, mayors are asking Congress not to touch Community Development Block Grant funding (which, unlike most federal funding, flows directly to cities).

When a Vietnam veteran took a fall that left him paralyzed, the city of Pembroke Pines, Fla., gave him money to help make his house wheelchair accessible. Akron, Ohio, used funds to demolish blighted homes abandoned during the Great Recession. And money also helped the township of Piscataway, N.J.,to rebuilt local parks damaged by Hurricane Irene in 2011 and Superstorm Sandy a year later.

The funding source for all these projects is the federal Community Development Block Grant (CDBG) program. Mayors gathered in Washington, D.C. this month to protest proposed spending cuts to the program proposed in next year’s federal budget.

Founded in 1974, CDBGs were aimed at lifting up the poor and restoring community to the nation’s inner cities. Proposed by President Richard Nixon’s administration, the program was aimed at reducing the bureaucracy of the social welfare program of the previous administration by giving money directly to the cities. Mayors are asking Congress to keep the current $3 billion funding level.

Cities love the program because it provides a rare, direct pipeline to federal government money, although some CDBG funding is directed to states to distribute. (A total of 1,209 local governments and states receive annual CDBG funding on a formula basis based on poverty and population, according to HUD.) Cities use the money for many things, most of them falling under the vast umbrella of economic development, housing or social services. “It’s one of the very few, federally direct funds that doesn’t go through the state house or the counties and they take the administrative costs off of us and we’re left with the crumbs,” said Piscataway Mayor Brian Wahler at a press conference hosted by the U.S. Conference of Mayors.

But critics of the program say its flexible structure makes it more vulnerable to misuse. Steven Malanga, a senior fellow at the conservative-leaning Manhattan Institute, noted the program was “almost immediately” abused by self-serving politicians – in the 1980s, a HUD investigation found that members of Congress were using the program to funnel money to qestionable projects.

“Often ignoring the most distressed communities, local pols channeled the grants into their pet projects, including tennis courts and parks in affluent areas, purchases of CB radios and other perks for senior-citizen centers, and new roads and other infrastructure improvements in thriving neighborhoods,” Malanga wrote in hiscritique, published in the City Journal. “Officials claimed that this spending would provide employment to the poor, though there was never any evidence of that.”

But the mayors this month said a few bad apples were spoiling the bunch – the vast majority of CDBG money is spent helping those who need it. Wahler said New Jersey communities devastated by the hurricanes in recent years have been able to rebuild some spaces quickly largely because CDBG funding is more accessible than the reimbursement program run by the Federal Emergency Management Agency (FEMA).

“To some extent, FEMA’s like a black hole sometimes,” he said. “I’m not knocking FEMA, but depending on who the case worker is in the area, what part of the country they’re coming from, everybody has a different spin on what FEMA can and can’t do. So this is program is the path of least resistance to accomplish something that had to get done anyway.”

Cities have already dealt with major cutbacks in CDBG funding. In the last decade, the total federal disbursement to cities and states has fallen 30 percent to $3.03 billion this year. Obama, who has said the funding should be more targeted so it is not as prone to misuse, is proposing cutting funding in fiscal year 2015 to $2.8 billion. In Akron, Mayor Don Plusquellic said CDBG funding has fallen by nearly half over the course of about 25 years from $11 million to $5.7 million. His staff estimates that, had funding stayed flat, it would be the equivalent of $20 million today, or roughly 10 percent of the city’s general fund budget.

“I’m going to take a shot at my own president – he is wrong,” Plusquellic said. “He is dead wrong to cut this program to try to appease the right wing who want to cut out all support and all partnership with local government.”

BY LIZ FARMER | MARCH 18, 2014

Liz Farmer  |

---

lfarmer@governing.com @LizFarmerTweets

That’s some fancy financing, Bob.

The latest municipal issuer brief from Municipal Market Advisors highlights a unique move by the state of Wisconsin designed to avoid the expected increase in interest rates in the coming year or so. Rather than waiting until next year to go to the municipal market and refinance a certain set of bonds, the state got a $278 million loan secured directly from a bank. In doing so, Wisconsin locks in today’s interest rates and can pay off bondholders next year with the proceeds.

MMA notes that this type of refinancing tool, called a delayed draw term loan, may be something more issuers do to take advantage of today’s rates before they rise. But, because of its complexity and disclosure requirements, this will likely only appeal to large municipalities or states that are very accustomed to issuing bonds.

The Boulder City Council voted 6-3 late Tuesday to authorize the city manager to use negotiated bond sales rather than competitive bond sales when the city next sells open space bonds.

Judicial Watch, a non-profit watchdog that promotes transparency, has sued the Arizona Public Safety Personnel Retirement System after the trust refused to release a copy of a federal grand-jury subpoena that is part of a criminal investigation into the pension system.

If all the parties approve it, a recent agreement will preserve most of the benefits of a sweeping reform law.

The practice of dealers showing clients different prices for the same securities on electronic bond-trading platforms is drawing the scrutiny of the U.S. Securities and Exchange Commission, which is concerned that smaller investors are being penalized.

California voters are approving tax increases and bond measures more frequently because of a lower bar for passage, rather than growing support for the issues, the state’s Legislative Analyst’s Office said.

Wisconsin may sell heating plants and land to pay down debt. Thirty-two North Carolina cities are deciding whether to unload stakes in power stations. Philadelphia wants to cash in on its gas works to bolster its pension fund.

Part of that world includes what the industry refers to as a markup. In the simplest terms, when brokers sell muni bonds to clients, they have the option of charging the client more than the original price. It’s the equivalent of buying at wholesale and selling at retail, and it’s not that much different from what you see when you walk into the grocery store. The problem is that it’s almost impossible to determine the markup, and it can vary from transaction to transaction.

The price you pay for the bond, including the markup, has a direct impact on the return you’ll earn as the owner of the bond. While markups are common, it isn’t always clear how much they tend to be. A recent Wall Street Journal story tried to shed some light on this and found that “individual investors trading $100,000 in bonds of a municipality, such as Washington State, in December paid brokers an average ‘spread’ [or markup] of 1.73 percent, or $1,730.” Given that these bonds don’t generate huge returns, the markup could potentially absorb an entire year’s interest.

I saw the sales process firsthand when I worked for a large brokerage firm in the mid-1990s. During training, I often asked grizzled veterans what advice they had for a rookie. I was particularly curious about how we were supposed to decide which bonds to buy for a client’s portfolio.

The answer I got more than once was something like, “Go to the list of bonds we keep in inventory and see which one pays you the most.” So instead of seeing which bond would be best for the client, I was supposed to figure out which one had the highest markup and would deliver the highest compensation for me and the firm. I could actually adjust my commission up or down without the client really having a clue.

There were limits to how much I could charge without raising eyebrows, but the federal rules only required that markups be “fair and reasonable,” whatever that means. I couldn’t find any other guidelines to help me decide what to charge one client versus another.

I also discovered that most prospective clients didn’t know the markup existed. They said “their guy” didn’t charge them anything to buy bonds. To hear these clients tell it, the brokerage industry was suddenly filled with nonprofits. Even if people had known about the markup issue, they had no way of verifying what they were told. The bond market was (and is) that opaque.

Most of the people I’ve worked with in the industry since then have managed this conflict by being transparent. They’ve told clients what they get paid and agree on what everyone thinks is fair, but the process is still filled with conflicts. Like Warren Buffett said, “Never ask your barber if you need a haircut.” It’s pretty clear who the answer will favor.

Don’t be afraid to ask, “What does it cost me to buy this bond?” If you get the answer, “Nothing,” I would run. Find a new adviser. Surely it’s costing you something, and it may be included in the fee you pay for advice, but that’s a different answer than “Nothing.”

You can go a step further and ask, “Did your firm mark up this bond before you sold it to me?” Again, it’s about transparency, not right or wrong. You need to be in on the discussion about what’s fair and reasonable. We all understand that conflicts exist, but we need to make sure they’re out in the open.

Transparent advisers will have no problem with specific, pointed questions, and asking them gives you the chance to level the playing field a bit. For now, the world of muni bonds may still be opaque, but it’s your money, and you have the right to know where it goes.

BDA’s CEO Michael Nicholas writes a commentary in The Bond Buyer regarding the latest tax policies in Washington.

The three main credit agencies have all released new reports or evaluations about Chicago’s credit-worthiness. While they all say the city’s massive pension liability is a big concern, they arrive at different conclusions about the city’s actual rating. To quote a Sound of Music song (points for knowing which one), let’s start at the very beginning:

During the last week of February, Fitch assigned an A- rating, the lowest level of the A-rating tier, to Chicago’s upcoming General Obligation (GO) $388 million bond issuance. The outlook for the financial health of these bonds was negative, Fitch said. The ratings agency cited a “lack of meaningful solutions to both the near- and long-term burdens associated with the city’s underfunded pension plans” as a key rating driver.

A few days later that same week, Standard & Poor’s weighed in on the city. In a report titled “Will Chicago Suffer Detroit’s fate?” S&P said its A+ rating on Chicago’s GO debt (two steps higher than Fitch’s) “reflects our view of its overall solid credit quality, with support from a strong local economy.” The report did note that Chicago and Detroit (which is rated D, the lowest level possible), shared an inability to afford their growing liabilities. It noted in 2012, debt service as a percent of total governmental fund expenditures was 12 percent in Chicago and 14 percent in Detroit. (There. obligatory Detroit reference accomplished.)

Finally, last week, Moody’s announced it rated Chicago’s upcoming GO debt issuance Baa1 – just two steps above junk bond status. The report says the city’s unfunded pension liabilities “threaten the city’s fiscal solvency absent major revenue and other budgetary adjustments adopted in the near term and sustained for years to come.”

For the backstory on why ratings agencies don’t agree with each other much these days, check out this explainer via Governing’s Finance 101 series.

Liz Farmer |
lfarmer@governing.com @LizFarmerTweets

Lawyers for the City of Detroit and a retiree committee have reached an agreement to protect committee members from potential lawsuits from retirees unhappy with pension cuts, lawyers said Tuesday,

The experts call it “the Detroit penalty.”

That’s the extra cost Michigan municipalities face when selling new debt now that Detroit is trying to make investors holding its bonds eat a loss of 80 cents on the dollar.

How expensive can it get?

The authority that runs Cobo Center plans to sell $315 million in bonds this fall to refinance old debt. When Cobo’s financial advisers added up the numbers, they estimated the authority could pay a combined “Michigan penalty” and a “Detroit penalty” that could raise the interest rate by as much as a full percentage point.

Over 25 years, that higher rate would cost the authority about $56 million that would otherwise flow to each of the state’s 83 counties.

Michigan could stave off higher bond rates by passing legislation similar to laws in Rhode Island, California and a handful of other states that protect bond investors. But even with the threat of higher rates, both state Treasurer Kevin Clinton and Gov. Rick Snyder say there’s no need to erect a legal firewall to keep the state’s other cities, townships and authorities from being hit with higher bond rates.

Behind the bond market’s pique is the feeling that the city wants to stiff holders of its unlimited tax general obligation bonds. General obligation bonds are an integral part of financing any city or municipal authority that needs to raise a large lump sum to build schools, fix sewers or buy buses. These bonds are paid from city taxes, which, if the city falls short, can by hiked until there’s enough money to make the payments — that’s the unlimited part.

In the past, a city in trouble would either refinance general obligation bonds or, in the rare event of a municipal bankruptcy, treat the bonds as secured debt, giving the bond investors first shot at whatever assets were available. Since the Great Depression, the average recovery on such bonds has been 75 percent, not the 20 percent Detroit proposes. After that, pensioners, or their widows, would join other unsecured creditors who, in many cases, received nothing.

In Detroit’s case, the governor’s appointed emergency manager wants to put pensioners first and hand bondholders a huge loss.

“You have to recognize that you’re going to need to borrow again,” said James Spiotto, managing director of the bond consultancy Chapman Strategic Advisors in Chicago. “If you take the short-term view and say, ‘I’m going to stomp on bondholders so I can pay others,’ what you wind up doing is costing yourself more in the long term.”

A spokeswoman for Snyder said she’s not aware of any discussion about such legislation.

“We acknowledge the questions and potential concerns out there, but believe that Detroit is an incredibly unique situation,” spokeswoman Sara Wurfel said in an email. “We have strong confidence in the amount and type of sound, smart investments to be made in Michigan and our local communities across the region and state.”

Anthony Minghine, associate executive director of the Michigan Municipal League, said he’s heard the suggestion that the state pass legislation securing general obligation bonds, but that it hasn’t picked up support in the state Capitol.

“Some of the bond community is hyper-focused on protecting the creditors, which is understandable, but I have not heard that being talked about in Lansing,” Minghine said.

When Detroit’s bankruptcy was announced, “I know the market kind of hiccuped, but from everything I’ve seen it seems like it’s settled down,” Minghine said.

The hiccups included Saginaw County postponing an August bond issue after Detroit declared bankruptcy, then paying more to issue those bonds in January. Despite a top credit rating, Troy paid half a point to a full point more for bonds it issued in September, while Genessee County paid 1 percent more, according to Bloomberg News.

Even the state took a hit, with two-year general obligation bonds going at a 20 percent premium in November, according to Bloomberg.

Nonetheless, “It is important to note that municipalities and the state have successfully completed a number of transactions, some of which received exceptional interest rates,” Treasury spokesman Terry Stanton said in a statement to The Detroit News. “Michigan is home to some 650 local communities which are rated by the credit agencies, and only a scant few are not considered investment grade.”

Some Michigan bonds aren’t suffering — the ones that are guaranteed to be paid off. The credit agency Standard & Poor’s just reaffirmed its high-quality rating on a batch of Detroit state aid bonds. There’s little to no risk to investors because the money is guaranteed by the state.

But without such guarantees for general obligation bonds, any sense that the market has gotten over the shock of Detroit’s bankruptcy filing could come undone if bankruptcy Judge Steven Rhodes OKs the city’s plan to slash millions of dollars of value from its general obligation bonds.

“If this is approved, issuers in Michigan and in other states that don’t have protection for general-obligation bonds could see their borrowing costs rise,” said Lisa Washburn of Municipal Market Advisors, a Concord, Mass., municipal bond consultant.

That’s part of what’s fueling fears that bond rates will rise for Cobo Center. The worst case scenario is an interest rate that’s a full percentage point higher, although Patrick Bero, chief executive officer of the Detroit Regional Convention Facility Authority that runs Cobo, thinks he can make a strong case to investors and keep the damage to just a quarter of a point or less.

But as Detroit and its bondholders continue to wrestle in court, what happens between now and September is anyone’s guess.

Washburn and other bond analysts say the way to wipe out the doubts and fears dogging bonds from Michigan is simple: Get the state Legislature to pass a law stating that general obligation municipal bonds are protected as property liens in a bankruptcy.

That’s what happened when Central Falls, R.I., fell into bankruptcy in 2010. After the city of 19,376 filed for Chapter 9 protection, the Rhode Island assembly moved to protect all the state’s bonds, including those in Central Falls, explained Rosemary Booth Gallogly, director of the state’s Department of Revenue.

“Even as small as Central Falls is in the state, we were concerned about the impact of contagion on other municipalities and the rates they’d have to pay,” Gallogly said. Once a law was signed creating a statutory lien for state bonds in 2011, “We did not see a negative impact for other municipalities,” she added.

The bottom line was that the Central Falls bonds were paid off at 100 cents on the dollar and other cities — even those in trouble — haven’t seen any increases on their bond rates, Spiotto noted.

“Rhode Island has not suffered,” Spiotto said. “Actually, I think they’ve gotten some benefit in access and cost that they wouldn’t have gotten otherwise. When Providence had problems, they still had access to the market at a reasonable cost.”

For now, the market is taking a wait-and-see attitude about bond rates in Michigan, at least until the bankruptcy judge rules and the inevitable chain of suits and appeals wend their way through court to reveal the bottom-line hit for Detroit bondholders. Until then, fears of the “Detroit penalty” will continue to play out, Spiotto warned.

“Some states are already saying ‘We’re different than Detroit, we have a statutory lien and you should have no fear,’ ” Spiotto said. “You really want your state to be able to claim the lowest borrowing cost, not the highest.”

Brian J. O’Connor
Detroit News Finance Edito
boconnor@detroitnews.com
(313) 222-2145

From The Detroit News: http://www.detroitnews.com/article/20140311/BIZ/303110020#ixzz2vs1sphjo

In my last post , I shared my views on why pension reform is gaining traction in states throughout the country, and why this is generally good news for muni investors. While we do not believe pension problems threaten to harm state and local finances to the point of breaking the municipal bond market (a view shared by the Center for Retirement Research at Boston College ), they are a source of financial pain in some locales. And in rare cases, overly burdensome pension liabilities, when combined with a generally weak credit profile, may be reason to avoid investing in the municipal debt of certain issuers.

So how do we spot pension tension? To identify the potential trouble spots, we ask ourselves three questions:

• Does the state or city in question have a pension funded ratio of below 60%?
• Has that state/municipality issued pension bonds to fund that gap? (Incidentally, those bonds are taxable, not your traditional tax-exempt municipal debt.)
• Does that state/municipality also have municipal debt outstanding?
• If the answer to all three questions is yes, that’s a signal of pension-induced stress. Importantly, three yeses are required to indicate that the pension problem is having an impact on the local municipal market. Anything less is not quite as worrisome. In addition, the pension problem would need to be accompanied by signs of a weak credit profile to really raise eyebrows. Factors that would elicit red flags around an issuer’s credit profile include population declines, low per-capita income, high unemployment rates and high rates of home foreclosure, to name a few.

Detroit is a clear example of a weak credit profile and severe pension pain. The ratings agencies had downgraded Detroit to junk status a few years before its Chapter 9 filing. Pittsburgh, in contrast, also had a large pension problem, but a relatively stronger credit profile. The Pennsylvania city was able to initiate pension reform and ultimately avoided Chapter 9. Pittsburgh now has a better funded ratio, a stronger economy, and was upgraded by the agencies in 2013.

Ratings: An Rx for Change?

Notably, the ratings agencies are being much more proactive in downgrading municipalities and states that are not taking action to address their pension problem. They are acknowledging that states have a significant long-term liability to plan for, which could potentially impair their ability to repay current debt. (I talk about it in my recent Point of View .) And they are grading states and cities accordingly. This is good news for municipal bond investors. Clarity is always a benefit (albeit not a substitute for thorough credit research ).

So what’s the upshot for muni investors? Pensions are a long-term liability, but a pressing concern for some already weak municipal issuers. More so than ever, ratings agencies and market spreads are factoring in a state’s pension status. Where the burden is outsized, the agencies are taking notice and penalizing inaction by issuing rating downgrades. And that has been the impetus for pension reforms which, ultimately, should help bolster states’ long-term fiscal health and contribute to the underlying strength of the municipal market.

By BlackRock, March 10, 2014, 12:36:36 PM

Peter Hayes, Managing Director, is head of BlackRock’s Municipal Bonds Group and a regular contributor to The Blog.

Read more.

(Reuters) – Illinois is paying an extra premium in the U.S. municipal bond market because of its poor fiscal reputation, according to a study released on Monday.

The state’s general obligation bonds fetch higher yields in secondary market trading than other states as festering fiscal problems, including a big backlog of unpaid bills, have given Illinois the lowest credit ratings among U.S. states.

Illinois’ GO bonds due in 10 years yielded 120 basis points over Municipal Market Data’s benchmark triple-A yield scale in the week ended Feb. 28. Illinois has the widest so-called credit spread after Puerto Rico among major muni debt issuers tracked by MMD, a unit of Thomson Reuters.

But an analysis by the Fiscal Futures Project at the University of Illinois’ Institute of Government and Public Affairs found that even after controlling for different credit ratings and fiscal, economic and financial factors between Illinois and other states that sold GO bonds between 2005 and 2010, the yields on Illinois bonds were still higher.

“These findings suggest the presence of a reputational risk premium on Illinois debt that is in excess of the risk premium associated with the state’s actual default risk,” the analysis said.

The premium for Illinois was 21 basis points for bonds due in five years, 12 basis points in 10 years and 7 basis points in 20 years, according to the analysis. It added that the premium’s present value cost “could be well over $80 million” on the more than $10.4 billion of GO bonds Illinois sold between 2005 and 2010.

Martin Luby, an assistant professor at DePaul University’s School of Public Service who co-wrote the study, noted that Illinois’ fiscal standing deteriorated after 2010 as the state failed to address its huge unfunded public pension liability, prompting downgrades from the credit ratings agencies.

“We think this risk premium is a conservative estimate,” he added.

In December, the state finally enacted comprehensive pension reforms aimed at easing a $100 billion pension funding shortfall.

However, state workers, retirees and labor unions have filed five lawsuits challenging the law on state constitutional grounds.

As the muni market waits to see if the law will be upheld by state courts, Illinois must also deal with income tax rate hikes enacted in 2011 that will partially expire halfway through the state’s next fiscal year.

A rollback in the rates would cut revenue by an estimated $1.4 billion in fiscal 2015.

In third-quarter 2013, the quarter for which the latest data is available, the gap in delinquencies between U.S. housing finance agencies’ (HFA) single-family whole-loan mortgages and comparable prime state portfolios we rate widened significantly. HFA loan delinquency rose to 7.48% of the total balance (compared with 7.06% a quarter earlier), and state loan delinquency declined slightly to 5.23% from 5.26% in second-quarter 2013. The 1.8 percentage point jump to a 2.25 percentage-point gap created the largest discrepancy we have recorded. However, the higher HFA delinquency rate is almost entirely due to greater loan delinquencies from the New Jersey Housing and Mortgage Finance Agency and the Pennsylvania Housing Finance Agency, which now have the two highest delinquency rates in our survey.

March 11, 2014—The Governmental Accounting Standards Board (GASB) has released a new online pension implementation toolkit. The toolkit is designed to help preparers, auditors, and users of state and local government financial reports understand and apply the revised pension accounting and financial reporting standards that the GASB approved in June 2012. The toolkit is available at no cost at the GASB website.

Investors Pay Twice as Much for Municipal Debt as for Corporate Bonds

Investors who put cash into municipal bonds—a widely popular strategy for those seeking safe, tax-free bets—are paying about twice as much in trading commissions as they would for corporate bonds, according to a study for The Wall Street Journal.

Regulators largely bypassed municipal debt as they transformed much of Wall Street over the past 20 years, but are studying it more closely now.

Individuals are the biggest participants in the $3.7 trillion industry, which provides funding for states, cities, hospitals and school districts across the country.

A study of 53,000 municipal and corporate bonds by S&P Dow Jones Indices for The Journal shows how much more investors are trading for the municipal assets.

Individual investors trading $100,000 in bonds of a municipality, such as Washington state, in December paid brokers an average “spread” of 1.73%, or $1,730. That compares with 0.87%, or $870, paid on a comparable corporate bond, such as one issued by General Electric Capital Corp., the data show.

More
How Retail Investors Can Get Info Pros Won’t Share
Brokers of stocks and corporate bonds must disclose market pricing and give individuals “best execution” on trades, ensuring they receive the best prices possible. In the municipal-bond industry, those protections are absent, allowing brokers to pocket higher spreads by buying the bonds low and selling them high.

Individual investors, especially retirees, have long been attracted to municipal debt as a relatively safe investment whose interest payments aren’t taxed. They own 45% of all municipal bonds directly and another 28% through mutual funds, amounting to a combined $2.7 trillion, according to data from the Federal Reserve.

The market is supervised by several regulators and structured differently than the stock and corporate-debt markets, and regulation of muni-bond trading has been slow to evolve.

“I think we can do more here for retail investors,” said Michael Piwowar, one of five commissioners on the Securities and Exchange Commission, in an interview. “We spend an awful lot of time on the equities side of the market where spreads are counted in pennies—and in the ‘muni’ market, spreads are counted in dollars.”

Brokerages say that municipal bonds cost more to trade because they change hands far less frequently and in smaller amounts than do other securities. They have warned that regulatory changes could hurt activity in the municipal market.

The SEC held hearings on the issue in 2010 and 2011 and proposed changes in a 2012 report, but they haven’t been implemented.

Investors bought and sold $183 billion of municipal bonds last year in trades of $100,000 or less, in line with recent years, according to data from the Municipal Securities Rulemaking Board.

One of those investors was Jack Leonard, a 67-year-old resident of Ipswich, Mass., who on July 23 sold bonds promising a 5% annual interest payment from his home state in two lots of $100,000 each.

The broker buying the bonds told Mr. Leonard the best price he could get was about $1,030 per bond, or $206,000.

The following day, a broker sold the same amount of 5% bonds to investors for $1,060 a bond, or $212,000, according to an online history of trading prices maintained by the MSRB. The difference of $6,000 in the two transactions is equal to 3% of the bonds’ value.

It wasn’t possible to verify that both trades involved Mr. Leonard’s bonds from the MSRB database, which doesn’t identify trade participants. But in July, MSRB records show brokers collectively sold $1 million in Massachusetts bonds to investors at a 3% average markup from the prices they paid for them, amounting to $30,000 in profits.

“That’s a lot of money, and the real question is: Why are they allowed to do it?” said Mr. Leonard.

Mike Becker, a retired options trader in Boca Raton, Fla., said he has grown frustrated trying to get his broker at the Merrill Lynch unit of Bank of America to tell him the best bid being offered for the Florida state bonds he wants to sell and has petitioned the SEC to pass rules giving “the public a fairer shake.” Josh Ritchie for The Wall Street Journal
The SEC oversees the MSRB, which sets rules for the industry, and the Financial Industry Regulatory Authority, which enforces them. Oversight coordination has been poor at times because the market is supervised by three regulators rather than one and the issue has had a low priority in Washington, said Hester Peirce, a former SEC staff attorney who is now a research fellow at George Mason University in Arlington, Va. “I think it’s going to be under more scrutiny” going forward, she said, referring to Mr. Piwowar’s push and recent proposals by the MSRB.

MSRB Executive Director Lynnette Kelly said the board “is working closely with the SEC to address market structure issues in a realistic time frame.” John Nester, a spokesman for the SEC, said his group and others “work cooperatively on issues affecting the municipal securities market.” Staff from Finra and the MSRB meet frequently “to ensure and sustain this collaborative approach,” a Finra spokesman said.

Proposed changes face opposition from brokers, which fund both the MSRB and Finra. Firms such as Charles Schwab & Co. and Wells Fargo Advisors LLC have lobbied against some changes.

“The devil is always in the details when it comes to new regulations, but we commend the MSRB for bringing this issue forward and urge them to continue this important effort,” said Jeff Brown, senior vice president of legislative and regulatory affairs at Schwab. Wells Fargo declined to comment.

Meanwhile, the lack of pricing information gives mom-and-pop investors little leverage to negotiate.

“I don’t know what the market is, because they won’t show me,” said Mike Becker, a retired options trader. The 70-year-old Boca Raton, Fla., resident said he has grown frustrated trying to get his broker at the Merrill Lynch unit of Bank of America Corp. to tell him the best bid being offered for the Florida state bonds he wants to sell and has petitioned the SEC to pass rules giving “the public a fairer shake.”

“We have policies and procedures in place that adhere to MSRB guidelines as they pertain to fair pricing,” a Merrill spokeswoman said.

The MSRB proposed a municipal-bond best-execution rule last week that it hopes to enact this year or next and is working on a digital pricing platform, a person familiar with the matter said.

MSRB Chairman Dan Heimowitz, a banker at RBC Capital Markets Corp., said he is working to balance necessary changes against the risk that a rushed overhaul could spur brokers to quit the market, making it harder for individuals to trade. “That is why we go slowly and methodically, but we haven’t given up on this by any means,” he said.

Mr. Piwowar, a former economist who studied trading costs in corporate and municipal bonds, is pushing for fixes he hopes the SEC can enact this year, like requiring brokers to give clients more price information ahead of potential trades. He said stock and corporate-bond brokers also complained that similar reforms would stifle trading when it was imposed on their markets, “but in fact, all the evidence suggests the opposite.”

Peter Coffin, a municipal-bond manager for wealthy individuals at Boston-based Breckenridge Capital Advisors, said it is about time the muni market got an overhaul. “You think of how the retail industry has gone from the local grocery store to Wal-Mart to Amazon,” he said. By contrast, he said, “In municipal bonds, we’re still shopping at the local grocery store.”

By MATT WIRZ
March 10, 2014 7:44 p.m. ET
Write to Matt Wirz at matthieu.wirz@wsj.com

Today President Obama has released his $3.9 trillion FY2015 budget proposal.  The President’s plan in totality does not have a path forward in Congress, but serves as a key platform for Democratic principles heading into the mid-term elections. As in previous budgets, this release underscores the priority of income inequality, which is addressed through several proposed changes to the tax code. A detailed summary of Treasury Department provisions, known as the “Green Book,” is available.

Based upon our very preliminary review of these two documents, we wanted to call your attention to budget provisions of interest to the municipal market. The budget proposal would:

• As in previous budgets, impose a 28% cap on itemized deductions and other benefits, including tax-exempt interest, for individuals earning more than $186,350 and families earning more than $227,850.
• Impose the “Buffett Rule,” a 30% minimum tax on income, after charitable donations, for households earning more than $1 million a year.
• Establish a National Infrastructure Bank as a Government entity intended to lever­age private and public capital to support in­frastructure projects of national and region­al significance. The entity would be able to invest through loans and loan guarantees in a broad range of infrastruc­ture, including transportation, energy, and water projects.
• As in previous budgets, create an America Fast Forward (AFF) Bonds program based on the Build America Bonds program. AFF Bonds are described as attracting new sources of capi­tal for infrastructure investment — including from public pension funds and foreign inves­tors that do not receive a tax benefit from traditional tax exempt debt. (Note that the Budget also proposes changes to the Foreign Investment in Real Property Tax Act aimed at enhancing the attractiveness of invest­ment in U.S. infrastructure and real estate to a broader universe of private investors).
• Use one-time repatriation revenue from US-based multinationals to fill the Highway Trust Fund funding shortfall and make infrastructure investments as part of a four-year trans­portation reauthorization proposal.
• Remove the volume cap on private activity bonds for water projects.
• Impose a “financial crisis responsibility fee” of 17 basis points for financial institutions with over $50 billion in worldwide consolidated assets. A 50% discount would be provided for “more stable sources of funding” and this fee would also be deductible from corporate income tax.
• Require current inclusion in income of accrued market discount for bonds, in the same manner as original issue discount, subject to certain limits.
• Simply arbitrage investment restrictions for tax-exempt bonds, and increase the small issuer exception to arbitrage rebate requirements.
• Reform and expand the Low-Income Housing Tax Credit.
• Continue the “responsible implementation” of Dodd-Frank. The Budget also provides funding increases for the Commodity Futures Trading Commission and the Securities and Exchange Commission, whose funding in the Budget increases 30% and 26%, respectively, over their 2014 enacted levels.

Other items that will generate attention include proposals to:

• Expand the earned income tax credit to taxpayers without children.
• Expand the child tax credit to more than 1.7 million low-income families.
• Tax carried interest as regular income.
• Enact the “myRA” retirement account first mentioned during his State of the Union Address — while also preventing additional tax-preferred savings by individuals who have already accumu­lated tax-preferred retirement savings suf­ficient to finance an annual income of over $200,000 per year in retirement — more than $3 million per person.
• Provide $56 billion in new stimulus spending above the aforementioned budget deal, which would be entirely offset by cuts to other programs and tax increases.
• Increase the minimum wage to $10.10 an hour.
• Maintain the budget parameters outlined in the bi-partisan budget agreement from December, including maintaining current sequestration levels.

Below are summaries of the best practices recently approved by the GFOA’s Executive Board and listed by the committee in which they originated.

Committee on Governmental Budgeting and Fiscal Policy

• Financial Forecasting in the Budget Preparation Process (revised). This revised best practice updates the Financial Forecasting in the Budget Preparation Process (1999) and The Use of Trend Data and Comparative Data for Financial Analysis (2003). The committee merged these best practices and made fairly extensive changes in the process, resulting in the new Financial Forecasting in the Budget Preparation Process. This revised best practice recommends that governments at all levels forecast major revenues and expenditures for several years into the future, and that the forecast, along with its underlying assumptions and methodology, should be regularly monitored and periodically updated.
• Effective Presentation of the Budget Document (revised). Last updated in 1996, this revised best practice recommends that governments incorporate guidelines into their budget organization process to facilitate broader consumption and greater comprehension of the budget document. These guidelines include organization, detail, design, consistency, highlights and format.
• Establishing Government Charges and Fees (revised). Last updated in 1996, this revised best practice makes recommendations on the process for setting charges and fees for the purpose of financing governmental goods and services.

Committee on Accounting, Auditing and Financial Reporting

• Implementing OMB Uniform Guidance (new). This new best practice provides recommendations on steps that state and local governments should take to ensure that they fully comply with the U.S. Office of Management and Budget’s final guidance on Uniform Administrative Requirements, Cost Principles, and Audit Requirements for Federal Awards (Uniform Guidance). The Uniform Guidance was developed by OMB to streamline the federal grant-making and monitoring process, to ease administrative burden for grant applicants and recipients, and to reduce the risk of waste, fraud, and abuse.
• Indirect Cost Allocations (new). This new Best Practice encourages governments to allocate their indirect costs, and provides considerations for governments to keep in mind in connection with indirect cost allocation.

Committee on Retirement and Benefits Administration

• Actuarial Audits (new). This new best practice was developed to provide guidance to public pension plan fiduciaries on the types of actuarial audits, and to encourage fiduciaries to gain provide for actuarial audits at least once every five years.
• Developing a Process for Complying with the Patient Protection and Affordable Care Act (revised). Last updated in 2011, this revised best practice recommends that state and local government employers that sponsor group health plans implement a process for reviewing federal health-care benefit requirements at least quarterly to ensure that they are aware of any newly issued or soon-to-be issued regulations related to the Affordable Care Act.

Committee on Governmental Debt Management

• Selecting and Managing the Method of Sale of State and Local Government Bonds (revised). Updated to alert members to changes in the conduct and business practices of underwriters and municipal advisors, which state and local governments should be aware of following the SEC’s approval of a final Municipal Advisor Rule in September 2013. The rule is scheduled to go into effect July 1, 2014.
• Selecting and Managing the Engagement of Municipal Advisors (revised). Updated to alert members to changes in the conduct and business practices of underwriters and municipal advisors, which state and local governments should be aware of following the SEC’s approval of a final Municipal Advisor Rule in September 2013. The rule is scheduled to go into effect July 1, 2014.
• Selecting and Managing the Engagement of Underwriters for Negotiated Bond Sales (revised). Updated to alert members to changes in the conduct and business practices of underwriters and municipal advisors, which state and local governments should be aware of following the SEC’s approval of a final Municipal Advisor Rule in September 2013. The rule is scheduled to go into effect on July 1 of this year.

Committee on Treasury and Investment Management

• Use of Cash Flow Forecasts in Treasury Operations (revised). This best practice, last updated in 2011, is revised to recommend that state and local governments take into account a series of factors (described in the document) when undertaking cash flow forecasting.
• Procurement of Banking and Related Services (revised). Incorporating best practices in selecting banking services will help a government procure appropriate and cost-effective banking services that best meet the needs of the government, while minimizing risk of loss. This updated best practice recommends that state and local governments establish a process to assure the periodic review and procurement of banking services.
• Electronic Payment and Electronic Collection Systems (revised). Last updated in 2010, this revised best practice recommends that state and local governments perform cost/benefit analyses, implement safeguards, and routinely evaluate opportunities to make and receive electronic payments that are suitable for their specific needs.
• Merchant Card Acceptance Internal Controls (new). This new best practice recommends that state and local governments establish internal controls for merchant card acceptance programs and provides factors to consider when establishing these controls.

Links to the full text here:

http://www.gfoa.org/index.php?option=com_content&task=view&id=2963

Moody’s Investors Service is asking for comments on a proposed methodology for rating bonds backed by U.S. rental homes, after assigning top grades to a portion of the market’s first deal last year.

The document released today reflects Moody’s plan to create a formal outline of its approach to rating the debt, which it has previously explained in reports and statements, Thomas Lemmon, a spokesman, said by telephone. When ranking a type of securities before creating an official methodology, the firm offers more information on its views as it rates individual deals, he said.

For the initial securities, the New York-based company’s assessment of the transaction’s “ultimate ability to repay investors was based on the liquidation value of the homes under a heavily stressed scenario,” Moody’s said today in an e-mailed statement.

Competitor Standard & Poor’s said Feb. 27 that rental-home securities haven’t met the criteria for its top AAA rankings, following a similar statement by Fitch Ratings in November. Moody’s, Kroll Bond Rating Agency and Morningstar Inc. assigned top grades to 58 percent of the bonds in the $479.1 million offering in November by Blackstone Group LP’s Invitation Homes, the only of its type so far.

Moody’s said today in its request for comment that when grading such deals it plans to focus “on two sources of cash flows that are available to repay the loan: the rental income that the underlying properties will generate, and the proceeds from the sale of the underlying properties.”

Its analysis of the income and legal issues is derived from its process for ranking commercial-mortgage bonds, while its approach for residential securities informs how it assesses property valuations, Moody’s said.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net

To contact the editor responsible for this story: Shannon D. Harrington at sharrington6@bloomberg.net

New York, March 06, 2014 — The availability of federal Medicare coverage for a growing number of state and municipal retirees is helping these governments achieve significant savings on their retiree health care costs by reducing “other post-retirement benefits,” or OPEB, liabilities, says Moody’s Investors Service in a new report.

“Even small reductions in the cost of health benefits for Medicare-eligible retirees can have considerable positive impact on future costs, because savings compound over retirees’ growing lifetimes,” says Marcia Van Wagner, a Moody’s Vice President and Senior Analyst in the report, “US Municipal Governments Can Leverage Federal Medicare to Lower Costs.”

“Governments have already begun to trim OPEB costs and are likely to continue this trend given the growing population of retirees age 65 and over eligible for baseline health coverage offered by the federal program,” says Van Wagner.

In addition to demographic shifts, two factors will drive the portion of government retirees who are over 65. First, governments have been raising retirement ages. Second, the portion of those ineligible for Medicare will shrink because participation in Medicare has been mandatory for state and local government employees since 1986.

Initiatives to trim the costs of benefits to Medicare-eligible retirees include cost-shifting, such as requiring increased co-payments or premium contributions for supplemental benefits, as well as initiatives to reduce the growth of health costs more directly.

Moody’s says the portion of retirees eligible for Medicare tends to be smaller for local governments than states because more municipal retirees are firemen and policemen, who tend to retire before they become eligible for Medicare at age 65.

“This difference demonstrates that Medicare-based reforms will provide greater long-run cost savings in some jurisdictions than in others,” says Van Wagner.

Some governments have significantly reduced OPEB liabilities by requiring employees to pay a greater share of supplemental health insurance costs and reducing prescription drug costs. For example Aaa-rated Maryland reduced its OPEB liability to $9.4 billion from $16.1 billion in 2010 through a 2011 change that requires retirees to enroll in Medicare Part D (prescription drug coverage) starting in 2020, in addition to increased prescription drug copayments, retiree premium payments, and out-of-pocket maximums.

The Affordable Care Act offers governments a way to reduce pharmaceutical costs through its Medicare Part D employer group waiver plan, which provides subsidies and also allows employers to take advantage of manufacturers’ discounts. For example, New York State reduced its OPEB liability 9%, in part due to implementing such a plan.

Unfunded OPEB liabilities reported by state governments total more than $530 billion, an amount comparable to their total net tax-supported debt, says Moody’s.

For more information, Moody’s research subscribers can access this report here.

Chicago’s financial standing took a hit Tuesday when a major bond rating agency once again downgraded the city’s credit worthiness because of a huge government worker pension shortfall and the overall amount of money it owes.

Moody’s Investor Service rated the city’s upcoming $388 million bond issuance at Baa1, down from A3, a level set last year after an unusual triple downgrade. The new rating is still investment grade, but puts the city on a lower tier. Moody’s also gave the city a “negative outlook.”

The move could end up costing Mayor Rahm Emanuel’s administration more to borrow money. Two other major agencies earlier had maintained their existing Chicago debt ratings for the upcoming city bond issue, but Moody’s move could raise interest rates if it reduces investor confidence in the city’s ability to make the required repayments.

The rating “reflects the city’s massive and growing unfunded pension liabilities, which threaten the city’s fiscal solvency absent major revenue and other budgetary adjustments adopted in the near term and sustained for years to come,” the new rating report stated. “The size of Chicago’s unfunded pension liabilities makes it an extreme outlier.”

Moody’s concluded Chicago has the highest level of unfunded pension debt “of any rated U.S. local government.” Even if Emanuel secures changes to pension obligations that he seeks from the General Assembly, the city may still not contribute enough money to pension systems to restore their health because of practical and political considerations, the report concluded.

“As such, the city’s financial operations will remain structurally imbalanced,” the report stated. It also noted the city’s high levels of debt, as documented in the Tribune’s “Broken Bonds” series.

The Emanuel administration said the move underscored the need for pension changes during the General Assembly’s spring session.

View Full Story from the Chicago Tribune.

WASHINGTON — The total amount of outstanding municipal securities in the market fell almost 1.2% to $3.67 trillion last year from 2012, while munis held by banks jumped 14.68% to $416.4 billion over the same period, according to the Federal Reserve’s latest Flow of Funds report released Thursday.

The drop in outstanding munis “is consistent with the trend over the last several years” and shows that new money issues are not keeping up with refundings and redemptions, said Michael Decker, managing director and co-head of munis at the Securities Industry and Financial Markets Association.

But while the level of outstanding munis for 2013 has fallen to about what it was in 2009, banks have almost doubled their muni holdings over that same period. They held only $224.3 billion of munis in 2009.

“That’s a very notable trend,” said Decker. “Banks are much more relevant to the muni market. They are buying new issues to a much larger degree. They’re really filling the gap for short-term and variable rate products that is left from the shrinking variable rate demand obligation market and auction-rate securities market, what’s left of it.”

The financial crisis basically killed the ARS market and made VRDOs less attractive because of higher costs and the risks associated with renewing liquidity facilities and the possibility the liquidity provider could be downgraded. Costs have come down. But short-term floating rate notes provide the same benefits but are less complex. Issuers have been selling them and banks have been buying.

Banks also “have a lot of cash and they’re looking for investment opportunities,” Decker said. “Their cost of funding is very, very low, which means the tax hit associated with buying munis is low.”

Decker said he sees banks continuing to increase their muni holdings in the near-term.

The outstanding munis of state and local governments and nonprofit organizations were down, 1.3% and 5.5%, respectively, this year from last. But the outstanding munis of nonfinancial corporate businesses were up 1.85% to $518.5 billion this year, according to the report.

Retail investor and other household sector holdings of munis fell to $1.62 trillion last year from $1.65 trillion in 2012. The household sector is a catch-all category that mostly made up of retail investors but also includes some domestic hedge funds, private equity funds and personal trusts, a Federal Reserve spokesman said.

Property-casualty insurance company muni holdings rose 1.43% to $332.3 billion last year from 2012 while life insurance company holdings of munis increased 2.82% to $135.1 billion.

Money market fund holdings of munis fell 8.4% to $308.3 billion at the end of the year from the previous year, while mutual fund holdings were down 2.6% of munis to $610.9 billion. The outflows were mostly driven by sustained low yields and investors looking for yield elsewhere, although it is possible that the financial and bond-related problems of Detroit and Puerto Rico could have had some small effect, Decker said.

BY LYNN HUME

MAR 6, 2014 4:18pm ET

The United States has a network of over 4 million miles of public roads. That system has faced increasing demands over time: The number of vehicle miles traveled (both passenger and commercial) rose from approximately 700 billion in 1960 to just under 3 trillion in 2012 (see the figure below). In 2012, the federal government and state and local governments spent about $155 billion (in 2013 dollars) to build, operate, and maintain roads. (This testimony adopts the practice of the Federal Highway Administration in using the words “highway” and “road” synonymously.) Almost all of those infrastructure projects were undertaken using a traditional approach in which a state or local government assumes most of the responsibility for carrying out a project and bears most of its risks, such as the possibility of cost overruns, delays in the construction schedule, and, in the case of toll roads, shortfalls in the road’s revenues.

Some observers assert that an alternative approach, using a public-private partnership, could increase the money available for highway projects and complete the work more quickly or at a lower cost than is possible through the traditional method. Specifically, such a partnership could secure financing for a project through private sources that might require more accountability and could assign greater responsibility to private firms for carrying out the work. For example, a private business might take on the responsibility for specific tasks, such as operations and maintenance, and their accompanying risks.

This testimony addresses the potential role of the private sector in two aspects of carrying out highway projects: the financing of projects and the provision (that is, the design, construction, operation, and maintenance) of highways. In particular, CBO concludes the following:

Private financing will increase the availability of funds for highway construction only in cases in which states or localities have chosen to restrict their spending by imposing legal constraints or budgetary limits on themselves. The reason is that revenues from the users of roads and from taxpayers are the ultimate source of money for highways, regardless of the financing mechanism chosen.

The cost of financing a highway project privately is roughly equal to the cost of financing it publicly after factoring in the costs associated with the risk of losses from the project, which taxpayers ultimately bear, and the financial transfers made by the federal government to states and localities. Any remaining difference between the cost of public versus private financing for a project will stem from the effects of incentives and conditions established in the contracts that govern public-private partnerships.

On the basis of evidence from a small number of -studies, it appears that such partnerships have built highways slightly less expensively and slightly more quickly, compared with the traditional public-sector approach. The relative scarcity of data on public-private partnerships for highway projects, however, and the uncertainty surrounding the results from the available studies make it difficult to apply their -conclusions definitively to other such projects.

Read complete document:

http://www.cbo.gov/sites/default/files/cbofiles/attachments/45157-PublicPrivatePartnerships.pdf

OppenheimerFunds Inc. and Nuveen Asset Management LLC lead municipal-bond investors that may see as much as $1 billion of combined holdings wiped out as Energy Future Holdings Corp. teeters on the brink of bankruptcy.

The Texas utility, previously known as TXU Corp., borrowed through three river-management agencies more than a decade ago to pay for pollution control equipment. The company was bought in 2007 in the largest leveraged buyout in history, which added debt to its balance sheet and bumped holders of its munis below other creditors in payment priority. The owner of Texas’s biggest electricity provider has struggled as natural-gas prices sank, and some of the bonds have lost 97 percent of their value.

“It could get pretty ugly,” said Triet Nguyen, managing partner with Axios Advisors LLC, a research firm in Lake Forest, Illinois, who predicts nearly total losses for holders of Energy Future-backed munis. “They don’t rank very high in the capital structure.”

The muni obligations are part of the $45.6 billion of debt that the Dallas-based company is trying to restructure after losses in 10 of the past 11 quarters. Warren Buffett, chairman of Berkshire Hathaway Inc., said the utility will “almost certainly” file for bankruptcy this year, unless natural-gas prices soar and raise the cost of electricity. Berkshire suffered an $873 million pretax loss on Energy Future corporate debt and exited the holding last year, Buffett said March 1.

Largest Holders

OppenheimerFunds, Nuveen and Federated Investors (FII) Inc. were the largest institutional holders of Energy Future munis, with about $240 million combined, according to the most recent company filings to Bloomberg. About $400 million was held by mutual funds and banks.

The positions may have changed since the release of the filings, some of which date to 2012. Some of the debt, including holdings of Federated Municipal Obligations Fund (MFCXX), is backed by letters of credit from Citigroup Inc. that expire Sept. 1. The letters give bondholders a backstop.

Kathleen Cardoza, spokeswoman for Chicago-based Nuveen, didn’t respond to a request for comment. Kaitlyn Downing at OppenheimerFunds in New York declined to comment, as did Scott Helfman, a spokesman for New York-based Citigroup, and Allan Koenig of Energy Future in Dallas.

Meghan McAndrew, a spokeswoman for Pittsburgh-based Federated Investors, confirmed that debt the company owned is backed by a letter of credit.

Safety Record

Local-government bonds are typically safer than corporate securities. The default rate for munis graded by Moody’s Investors Service averaged 0.03 percent for the five years through 2012, according to the firm. Company-bond default rates averaged 1.3 percent in 2012, according to Moody’s.

The potential for losses on Energy Future munis shows the risk of the segment of the $3.7 trillion municipal market where companies borrow through local authorities.

Such securities, called industrial-revenue bonds, have produced about 9 percent of muni defaults since 2009, fourth behind land-secured debt, multifamily housing and retirement projects, said Matt Fabian, an analyst with Concord, Massachusetts-based Municipal Market Advisors.

Standing Back

Richard Larkin, director of credit analysis at Iselin, New Jersey-based Herbert J. Sims & Co., said he soured on munis backed by the utility as the company took on debt and its management structure changed.

“It was a good, well-run utility” before the changes, he said. “After 2008, I wouldn’t touch it with a 20-foot pole.”

Standard & Poor’s predicted in October that investors wouldn’t recover any money on the utility’s unsecured and subordinated bonds, while Moody’s predicted in a September report that holders of unsecured debt would see “very low recoveries.”

Prices of the bonds have come close to reflecting that expectation. Bonds sold through the Brazos River Authority and maturing in October 2038 traded at about 2.7 cents on the dollar on Feb. 12, data compiled by Bloomberg show.

The munis were sold through local agencies, including the Brazos agency, and authorities for the Sabine and Trinity rivers.

Peak Purchase

The buyout of TXU in 2007 for $48 billion came at the peak of the private-equity boom that ended a year later with the financial crisis.

Energy Future may become the biggest failure of a private equity-backed company since Chrysler Group LLC in 2009.

Auditors may raise doubts about the company’s ability to remain a going concern at the end of this month. Such a qualification would constitute a default under terms of the company’s secured debt, Fitch Ratings analysts Shalini Mahajan and Philip Smyth wrote in a December note.

Energy Future assumed muni debt that TXU had taken on early in the decade.

The buyout — led by KKR & Co. (KKR), TPG Capital and Goldman Sachs Capital Partners — was a bet that natural gas prices would rise, allowing the company to charge more for electricity. Instead, they have have fallen 67 percent from their 2008 peak amid the development of hydraulic fracturing.

To contact the reporter on this story: Darrell Preston in Dallas at dpreston@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

Charles Schwab has extended its agreement with J.P. Morgan to provide Schwab clients with access to a broad range of J.P. Morgan’s fixed income securities.

The agreement, originally signed in 2010, gives Schwab’s 9.1 million client brokerage accounts1 access to J.P. Morgan’s new issue and secondary municipal bonds and corporate debt securities. Schwab clients have had access to more than 800 new corporate issues through J.P. Morgan since 2011. In 2013, total orders for these corporate new issues saw an increase of 70 percent over 2012, and the total face value of those orders well more than doubled in that time.

“Retail demand for access to this traditionally institutional product has exceeded our expectations,” said Peter Crawford, senior vice president at Charles Schwab. “The response has been significant, and I’m thrilled that we’re continuing this successful program with J.P. Morgan.”

Crawford continued, “We believe this agreement has been an important step on the road to changing a market that previously was the near-exclusive domain of institutional investors.” As access to bond issues has become possible for more investors, he noted, demand and participation by both retail clients and Registered Investment Advisors (RIAs) has grown dramatically, particularly in the area of new corporate bond issuance.

Additionally, since the agreement was put in place, Schwab clients have participated in nearly 1,200 negotiated and competitive municipal deals, placed more than 12,300 orders and invested more than $1.9 billion in new issue municipal securities offered by J.P. Morgan.

“Our fixed income issuer clients have benefitted from exposure to one of the largest retail brokerage platforms in the country,” said Paul Palmeri, head of Public Finance at J.P. Morgan. “We are pleased to be able to continue bringing Schwab clients access to our fixed income primary and secondary offerings.”

Charles Schwab is a longtime advocate for increasing access to the bond market for retail investors. Schwab BondSource offers access to more than 36,000 new issue and secondary bond offerings from more than 200 dealers2, including J.P. Morgan, and connects investors to multiple major bond trading platforms, not just one.

In 2013, J.P. Morgan underwrote approximately $438.8 billion in the global debt markets, according to Dealogic, and approximately $53 billion in the U.S. municipal markets, according to ThomsonReuters.

The upcoming Puerto Rico bond offering will be sold to hedge funds.

Current Puerto Rico bonds are held by retail investors.

These two groups are likely to clash.

Puerto Rico is heading toward a $3.5 billion bond offering this month which would be used to help stabilize the island’s finances and pay interest on its $70 billion in current debt. A major question arises as to whether investors in this new debt will be given priority over existing investors who are largely Mom and Pop investors.

Not everyone in Puerto Rico is a fan of the new bond offering.

According to an Associated Press report, senators who voted against the $3.5 billion offering said it would “force Puerto Rico deeper into debt and warned that the government would not likely be able to pay the money back.”

Regardless, some “alternative” investors like hedge funds are licking their chops over the offering, for both the juicy 10% yields on the Puerto Rico junk bonds as well as the favorable terms they can extract from the island commonwealth because of its desperation. One thing is certain, hedge funds buying Puerto Rico’s debt will attempt to gain every possible advantage in the transaction.

This is how hedge funds operate. They are putting their money up at a critical time in Puerto Rico’s history. The island commonwealth’s bond rating this year has been downgraded to “junk” status and they desperately need a cash infusion to service its enormous debt load. Puerto Rico’s solvency is shaky at best, thus, hedge fund investors will want to be compensated for this increased risk.

Indeed, these “alternative” investors, or hedge funds that welcome risk and its potentially greater returns, may square off against retail Mom and Pop investors who are holding a large chunk of the existing $70 billion in Puerto Rico Bonds and municipal bond funds, according to a Reuters report by Brian Chappatta.

“After the island’s credit rating was cut to junk last month, it will probably tailor the deal to non-traditional muni buyers such as hedge funds,” Chappatta reported, citing three municipal bond sources.

This is an important shift in the market for such municipal bonds, and Mom and Pop investors could be hurt by this change if hedge funds demand to have their interests placed in front of owners of the older Puerto Rico bonds.

“In contrast to the hedge fund investors, the muni-bond investors have traditionally been viewed as ‘risk averse’ who are looking for extremely safe investments,” according to another Reuters reporter, Dunstan Prial. “This is the difficult environment in which Puerto Rico now plans to raise $3 billion as sort of a bridge loan to help it pay its debts and cover its expenses until a handful of recently approved financial reforms start to have a meaningful impact on the commonwealth’s budget.”

“And that’s why the proposed bond sale is expected to attract investors such as hedge funds that actively seek risk as a means to larger returns,” Prial reported. “They are a very different breed than those seeking the safety of an Oppenheimer-managed bond fund.”

One bankruptcy attorney told Reuters’ Prial that “these ‘alternative’ investors might even seek to leverage Puerto Rico’s desperation to negotiate terms favorable to them, terms that might include a provision that guaranteed them first-lien status with regard to Puerto Rican revenues earmarked to pay down debt, which would mean they would get paid first in the event the island began defaulting on its debts.”

Meanwhile, all of this has undoubtedly raised concerns among current bondholders that the commonwealth’s ongoing fiscal troubles combined with $3.5 billion in additional debt obligations could crowd out revenue to pay existing investors.

The clash for repayment priority of hedge fund investors over retail investors is likely to come to a head in the near future. Given that the hedge funds are the latest investors and their money is desperately needed, it looks like they would use their leverage to come out on top.

Look for the hedge funds to demand assurances, possibly even a change to Puerto Rico’s constitution. In some cases, the constitution guarantees that bond investor payments take priority over general obligations of Puerto Rico. That could be scrapped or changed.

Stay tuned. The fight between these two sets of investors is just beginning.

Zamansky LLC are securities and investment fraud attorneys representing investors in federal and state litigation against financial institutions. For more information about Zamansky LLC, please visit http://www.ubspuertoricofunds.com/.

While bond funds overall saw investor withdrawals in 2013, popular launches included world-bond portfolios and nontraditional approaches.

A year of turmoil in the bond market didn’t stop some fund companies from rolling out a host of new bond vehicles—and some attracted a lot of cash.

The most popular, as measured by net cash inflows, was Vanguard Total International Bond Index, for which traditional mutual-fund and exchange-traded shares are available. From its May launch through year-end, it took in $19.5 billion, according to Morningstar Inc.

More than $14 billion of those assets come from the behemoth fund company’s target-retirement funds and target-retirement trusts, according to a Vanguard Group spokeswoman. Before last year, Vanguard’s target-date retirement funds didn’t hold an international bond fund.

But analysts say the timeliness of the fund’s strategy as well as the Vanguard name also help explain its popularity. The fund buys a broad mix of investment-grade government and corporate bonds outside the U.S.

Looking outside the U.S. for higher yield was a theme in 2013 bond-fund launches, says Todd Rosenbluth, director of ETF and mutual-fund research at S&P Capital IQ. “International bonds offer higher yields and provide the benefits of economic growth in other countries,” he says.

Of roughly 160 bond funds and ETFs launched last year, 15 invest in world bonds and 22 focus specifically on emerging-markets bonds, according to Morningstar. World bond funds as a category saw inflows of $23.6 billion, Morningstar says. According to TrimTabs Investment Research, meanwhile, investors withdrew a net $86 billion from U.S. bond mutual funds and exchange-traded funds overall.

Another new bond fund last year benefited from large inflows in the same way that much of the flow into Vanguard’s fund came from other Vanguard funds: Bridge Builder Bond attracted $5.9 billion in net new cash in 2013 following its late-October launch. The fund is a proprietary bond fund sponsored by the St. Louis-based securities firm Edward Jones and designed specifically for clients invested in the firm’s fee-based accounts. Most of the flows into the fund were reallocated client assets already invested in various fixed-income funds in the company’s advisory solutions program, according to Steve Seifert, investment advisory principal at Edward Jones.

There were some surprises among the most popular new bond funds launched last year, including Nuveen Short Duration High Yield Municipal Bond. The fund, which launched in February 2013, took in more than $700 million, even though “last year was not a good year to be a muni bond fund, between headline risk of Detroit and Puerto Rico,” says Mr. Rosenbluth.

But as income-oriented investors continue to scramble for decent returns, some are opting to accept more default risk instead of going with longer maturities and risking price drops whenever rates do eventually rise.

John Miller, the Nuveen fund’s portfolio manager, says he dealt with investor concerns about credit risk in municipal bonds on a daily basis by pointing to the fund’s limit on duration of 4.5 years. For a fund with a duration of 4.5, a one-percentage-point rise in rates would lower the price by 4.5%. A one-point decline would boost the price by 4.5%.

Daniele Donahoe, president and chief investment officer of Rinehart Wealth Management in Charlotte, N.C., says her firm bought into the Nuveen fund last fall precisely because of this limited duration. After the summer selloff in the muni market, her firm, which manages about $300 million in client assets, saw a buying opportunity in short-duration, high-yield munis, she says. “We wanted to move into higher-risk bonds with lower duration,” she says. “We didn’t have that in our portfolio.”

In the 12 months through February, the Nuveen fund returned 1.0%, compared with an average 2.8% loss for Morningstar’s high-yield muni category.

Bank-loan funds are another category that saw very strong flows of cash from investors last year. The funds invest in loans with floating rates and are seen as a relatively safe choice in a time of rising rates, even though the loans are made mostly to companies with low credit ratings.

Among the most popular launches in this category in 2013 was the SPDR Blackstone/GSO Senior Loan ETF, which opened for business in April and attracted more than $500 million.

One trade-off for investors in this type of fund is that the higher credit risk means bank-loan funds will behave more like stocks in a volatile market, notes Sarah Bush, a fund analyst with Morningstar. “Investors who are switching out of core bond funds into these funds aren’t going to get the same diversification if equity markets were to underperform.”

Strictly by the number of new bond funds and ETFs, the most popular category in 2013 was nontraditional bond funds, a category that includes funds that try to protect investors from rising bond yields, such as unconstrained bond funds and so-called absolute-return bond funds. Some 32 nontraditional bond funds and ETFs were launched in 2013, according to Morningstar. Among the new launches were John Hancock Global Conservative Absolute Return, which took in $100 million in 2013, and First Trust High Yield Long/Short ETF, which took in $91 million.

By Corrie Driebusch

Bloomberg News

Norwalk, CT, February 27, 2014—The Governmental Accounting Standards Board (GASB) today issued an Exposure Draft, The Hierarchy of Generally Accepted Accounting Principles for State and Local Governments. The hierarchy of generally accepted accounting principles (GAAP)—or “GAAP hierarchy”—comprises the types of guidance that state and local governments follow when preparing financial statements. The GAAP hierarchy lists the order of priority for pronouncements to which a government should look for guidance.

The proposed Statement would reduce the GAAP hierarchy to two categories of authoritative GAAP from the four categories under GASB Statement No. 55, The Hierarchy of Generally Accepted Accounting Principles for State and Local Governments. The first category of authoritative GAAP would consist of GASB Statements of Governmental Accounting Standards. The second category would consist of GASB Technical Bulletins and Implementation Guides, as well as guidance from the American Institute of CPAs that is specifically cleared by the GASB.

These proposed changes would improve financial reporting for governments by clearly identifying the appropriate accounting guidance to apply. The proposal also would improve implementation guidance by elevating its authoritative status and, therefore, requiring that all implementation guidance be exposed for public comment.

“Applying accounting standards can sometimes be complex but identifying the right standards to apply should not be,” said GASB Chairman David A. Vaudt. “The GAAP hierarchy proposal will help stakeholders be more efficient by bringing all authoritative accounting and financial reporting literature together in one place.”

The GASB also issued an accompanying proposed implementation guide, Implementation Guide No. 20xx-1, which is a culmination of all implementation guidance to date. The Board’s decision to elevate the level of the implementation guidance in the GAAP hierarchy would require that implementation guides be exposed for a period of broad public comment, as with other GASB pronouncements. The change in the authoritativeness level of implementation guidance necessitated certain changes to the existing guidance; a list and description of changes can be found in Appendix C of the proposed implementation guide.

“Providing stakeholders with a greater opportunity to submit their input on the GASB’s implementation guidance will undoubtedly improve its usefulness,” said Mr. Vaudt.

The requirements of the proposed guidance would be effective for financial statements for periods beginning after June 15, 2015.

Both the Exposure Draft and the proposed implementation guide are available free on the GASB website. Stakeholders are encouraged to review the proposals and provide comments by December 31, 2014.

Read the Exposure Draft.

Bankruptcy grabs the headlines, but distressed cities are a more widespread problem – one that few states know how to address.

Like other cities that have lost their main industries, Scranton has been suffering through an eroding tax base, aging population, and rising costs.

Hanging on the door of his city hall office in Scranton, Pa., David Bulzoni has a framed print of a train. It’s there for two reasons: First, it’s a reminder of Scranton’s proud history as a railroad and cultural hub. Second, it’s a nod to the movie Unstoppable, the story of a runaway freight train and the two men who attempt to stop it. As the business administrator for a distressed city, Bulzoni sees ties between his job and the characters in the movie. “You’re just on an unstoppable train,” he says.

Scranton, a city of about 76,000, has been sliding into fiscal trouble ever since coal mining collapsed here in the 1950s. Like other cities that have lost their main industry, it has been suffering through an eroding tax base, aging population, and rising retiree and personnel costs. In recent years, political animosity among its leaders has exacerbated the city’s financial situation and led Scranton to default on a parking authority bond, earning it scorn from lenders and banks.

Officials have long been aware of the city’s fiscal failings. In 1992, the city council voted to enter into the state’s Act 47 program, which provides loan and grant money to financially distressed governments and helps them develop financial recovery plans. Few cities that have volunteered for the program have actually emerged from it. Twenty-one have entered and six have exited. Scranton is one city that has failed to flourish since it entered the program, and divided leadership has worsened its outlook.

Scranton’s woes and vulnerable fiscal footing are by no means unique. While municipal bankruptcies have gotten a lot of national headlines, it’s not the bankrupt cities that are the widespread problem. It’s the ones on the edge—the “distressed” cities. These are places that likely will never declare bankruptcy but are nonetheless struggling to become economically viable again.

Complicating the problem is the tense relationship between the stressed cities and their states. Cities don’t want to be treated like children. Duly elected city officials don’t like being told what to do by state overseers; they want a partnership, not a dictatorship.

Like their cities, states also want a partnership, but the difference often lies in what that should look like. From the state’s point of view, struggling cities are a poor reflection on the financial health of the state, and a danger to its economy. Yet the states don’t have the money for a bailout—never mind the political will to provide one, as many believe that wouldn’t put cities on sound footing in the future anyway. States want cities to settle down and take their advice, even if it’s tough medicine.

The question for both parties—the stressed city and the paternalistic state—is simple: How can we work toward a common goal of fiscal health? Finding a common solution, however, is more difficult.

Many states have put some legislative thought into how they will deal with troubled cities. All told, 19 states have intervention programs for distressed municipalities, but the potential level of involvement varies. The most assertive state is North Carolina. In a program that dates back to the Great Depression when more than 400 local governments and public authorities in the state defaulted on debt, the state’s Local Government Commission (LGC) was created to sign off on all local debt issuance. Today it still monitors local property tax intake and will not allow localities to issue debt if fund balances drop below a certain point. Officials in North Carolina claim LGC oversight is the key reason the state’s municipalities have strong credit ratings. Recently, Tennessee replicated North Carolina’s approach—albeit with a lighter hand. After the Great Recession, a number of local governments were drowning in debt thanks to investments in risky variable rate debt. That prompted Tennessee to mandate that local governments borrowing money draft debt management policies following very specific guidelines.

Similarly on the aggressive front, New York Comptroller Thomas DiNapoli and Gov. Andrew Cuomo launched a fiscal monitoring system a year ago designed to flag struggling municipalities. A new fiscal restructuring board will advise local governments seeking help and could offer a loan or grant of up to $5 million to those following their advice. Pennsylvania also has an early warning system for its cities. It was developed in the mid-2000s, two decades after the Act 47 program.

Many observers wish more states would consider monitoring their local governments’ finances. “It’s a really proactive way to reveal budget distress,” says Steve Fehr, co-author of a Pew Charitable Trusts report on state intervention programs. States with more conventional intervention protocols, he suggests, “don’t react until it’s too late.”

Part of the dilemma for cities, of course, isn’t monitoring, but the way local finances have been reconstituted in recent history. Over the last century, city revenue streams have gone from being based almost entirely in property taxes to being more weighted in charges and fees, notes Michael Pagano, dean of the College of Urban Planning and Public Affairs at the University of Illinois at Chicago. That has played heavily in the state-city tension as cities try to rebalance their fiscal footing. “States continue to restrict the authority of municipals to create a lasting revenue structure,” Pagano says. That said, he adds that the idea that more taxing power would be a fix is still largely theoretical. “We can point our fingers at the state because they do have enormous amounts of discretionary control over what cities do.” And it is unclear whether expanded taxing authority would actually solve cities’ fiscal problems, he says. “Whether it would actually be better is the question.”

Many of these issues over state intervention are on view in Scranton. Act 47 and Scranton’s financial turmoil have played out in city council meetings, on balance sheets and on Wall Street—even though on the surface, Scranton doesn’t look like a city that can’t pay its bills. White tablecloth restaurants dot downtown and smiling residents shout conversations at one another across the street. “This isn’t a run-down, hopeless, we’re-never-going-to-get-better community,” says Mike Washo, a former county commissioner and now the appointed receiver for the city’s troubled parking authority.

Over the past 20 years, this center of northeastern Pennsylvania has developed into a tourist destination, spawned a medical school and seen demand for downtown living soar. Former Mayor Chris Doherty was able to round up tens of millions of dollars in economic development efforts: Downtown’s silent, century-old relics have been restored and turned into restaurants, apartments and retail. The city even gained a bit of fame as the setting for the Dunder Mifflin Paper Company, the fictional paper sales company featured in the television series “The Office.”

“Scranton is not on fire,” says Chamber of Commerce President Robert Durkin, despite the “very challenging, complicated financial problems of the city government.”

Exacerbating Scranton’s problems has been political infighting, triggered by the prospect of state intervention. Even Scranton’s decision to seek Act 47 status was divisive—the city council unanimously approved the decision despite the vehement opposition of then-Mayor Jim Connors. Connors, who viewed the act as abdication to an unelected entity, immediately butted heads with the nonprofit assigned by the Pennsylvania Department of Community and Economic Development (DCED) to coordinate Scranton’s recovery. It’s that sort of knee-jerk resistance by local officials that really frustrates a state, says Clyde “Champ” Holman, DCED’s deputy secretary of community affairs and development. “It really comes down to personalities,” he says. “Some have the attitude as if we’re taking over. And that’s the wrong attitude.”

But in Scranton, even a subsequent—and more cooperative—administration under Doherty resulted in little progress. Doherty and the state hinged Scranton’s recovery plan on its ability to change costly union contract provisions using Act 47 as legal justification for doing so. Fire and police unions fought the recovery plan and the state Supreme Court agreed, ruling in 2011 that the city must pony up what is now a roughly $30 million award in back pay. It ultimately weakened Act 47’s protection by granting the award despite Scranton’s distressed status and without consideration of the city’s ability to afford the payment.

The adverse court ruling aggravated already negative fiscal pressures. Political wrangling after the Supreme Court decision resulted in the city council forcing the city parking authority into default on its bonds. The move cut off the city from credit markets for months. Cash flow problems forced Doherty to temporarily cut workers’ salaries to minimum wage.

Even today the fiscal picture continues to look shaky. The 2014 budget includes a 57 percent property tax hike and a 69 percent garbage fee hike to help close what was a $20 million projected deficit. The city still struggles with credit: After one bank backed out of a financing deal, Scranton scrambled to find a lender that would let it borrow enough money for paydays until tax receipts come in. It was a tough sell. “Once you default on a bond issue, you have hell to pay for years,” Bulzoni says.

From the state’s perspective, Scranton’s political divisiveness is the main reason it has struggled to shed the distressed cities label. “Doherty was really willing to work with us,” says Holman. “The council president [Janet Evans] never, ever stepped foot in our department and resisted us every step of the way.” Evans, who retired from the council after 2013, has long maintained that the DCED has not done enough to assist Scranton’s recovery. In a tense council meeting in 2012, she blamed the state for the Supreme Court outcome, saying that “the state and DCED had turned their backs on Scranton taxpayers” and that the department had ignored her request to appoint a different recovery coordinator for the city.

At its core, Scranton is like many other distressed cities. As the employment center for the region, it bears the brunt of the daily influx of workers without the benefits of a matching tax base. From Pagano’s perspective, this means that a distressed city’s problems should really be viewed as a regional issue. Where states can help is in facilitating that conversation. “It’s a great opportunity to start rethinking all of these relationships between cities and states and what controls states ought to have,” says Pagano. “We don’t seem to be having that conversation.”

In New York, Syracuse Mayor Stephanie Miner couldn’t agree more. The 20th-century framework for cities that relies on property taxes doesn’t work when the main industry skips town, she says. Even though Syracuse qualifies for consulting and a loan from the state restructuring board, it isn’t taking the help. The city has already hired consultants, pored over its books and made the suggested changes. A small state loan, Miner says, won’t put a dent in the city’s multimillion dollar problem.

Instead, Miner suggests the state can get in the game by facilitating talks between mayors and their neighboring county executives. It could loosen business regulations in some circumstances or give up control of restrictive labor practices. “You can’t tax your way out of the dynamic,” Miner says. “And in order to change that dynamic, you have to have the state change it.”

About 30 miles north of Syracuse, Fulton Mayor Ron Woodward is eager to open his books to the state. Fulton is one of the first cities to take New York up on its offer to work with the financial restructuring board, which is interviewing city leaders to develop an action plan for Fulton. Woodward speculates it may include consolidation of services and debt reform. The city of about 12,000 has been crippled by the loss of food manufacturers and rising pension costs, but Woodward says New York’s expensive business policies have been the nail in the coffin for not just Fulton but much of upstate New York. Fulton lost two manufacturers to Wisconsin, where energy costs and workers’ compensation insurance are far cheaper. “I don’t think anybody at the state level is intentionally at fault,” he says. “The state deals with much bigger issues and I don’t think they really understand what’s happening [with the local economic structure].”

Woodward’s point is that cities feel as if they’re not being heard. Sometimes it is because there is too much political commotion at the local level. But this isn’t true for every case. And in spite of that, cities still see themselves as the doers when compared with their states—cities deliver services. If city issues are not approached early on and with this sensitivity, state intervention can aggravate the local attitude. “Most people now think that cities are the only level of government that works,” Miner boasts. “The irony in all this is people’s perception that cities solve all the problems—and we’re the ones in crisis.”

BY LIZ FARMER | MARCH 2014

lfarmer@governing.com @LizFarmerTweets

A bearded man in a fisherman’s sweater leans back in his swivel chair and adjusts his headset. He skims the computer screen that displays caller information.

“That’s a really good product,” he says to the voice on the other end. “But did they talk to you about the possible side effects?”

The operator is one of several dozen employees at the Illinois Tobacco Quit Line, a $2 million-a-year call center on the western outskirts of downstate Springfield, Ill.

The 85,000 calls the center handled last year reflects a steady drop in tobacco use.

But while the downturn in smoking is good news for cancer rates and tobacco-related deaths, it could soon mean trouble for municipal bond investors.

Tobacco taxes, e-cigarettes and a decline in smoking threaten the viability of tobacco bonds, already one of the weakest areas of municipal debt.

As security for the sale of the bonds, many states pledged future revenue from a 1998 lawsuit settlement, known as the “Tobacco Master Settlement Agreement.”

This ended a landmark case in which attorneys-general from 10 states sued the nation’s major tobacco companies seeking reimbursement of state Medicaid funds used to cover smoking-related medical care costs.

A key clause of the agreement provided for payments to states, in perpetuity, based on the volume of cigarettes sold annually.

In 2010 Illinois lawmakers used the expected cash to back the sale of $1.50 billion in municipal bonds. The bonds helped shore up a $2 billion budget deficit.

But they also marked a troubling chapter in the state’s growing budget crisis, said Peter Matuszak, a senior policy analyst at the tax watchdog group Civic Federation.

“Every time you see a government borrowing or using bonds to pay for its operations, you know it’s in terrible shape,” he said.

While Illinois landed the fifth-largest settlement — initially projected at $9.12 billion through 2025 — payouts have increasingly dwindled as smoking rates decrease.

The payments are adjusted each year for inflation and market share, so as cigarette sales have declined, so have payouts from tobacco companies.

From 1998 to 2013, Illinois received $4.25 billion in actual payments, according to the National Association of Attorneys General. That’s only 47 percent of the total payments originally projected from the settlement.

Illinois was among 10 states and Washington D.C. to issue bonds against their entire tobacco proceeds, according to Standard & Poor’s Ratings Services.

Illinois’ tobacco bonds — known as “Rail-splitter Bonds” — built insurance into the deal. While the state’s settlement payments are set to increase by 3 percent each year, it also accounts for a 10 percent slip through 2028.

That’s put the state in a better position than most tobacco bond issuers, according to Richard Larkin, director of credit analysis at Herbert J. Sims & Co.

“Illinois built in a much bigger cushion. Other states aren’t as lucky,” he said.

Still, Fitch Ratings Inc. currently has Illinois tobacco bonds graded at BBB-plus — “Outlook Negative” — three notches above the non-investment speculative grade ranking.

A 10 percent jump in cigarette prices would cut smoking rates by more than 3 percent, according to the Congressional Budget Office.

In July 2012, Moody’s Investors Service Inc. predicted nearly 75 percent of the highest-rated tobacco settlement bonds would default if cigarette sales slipped at that 3 percent rate.

Cigarette shipments in the U.S. have dropped about 4 percent annually since 1997, according to the National Association of Attorneys General.

In Chicago, whose $7.17-per-pack tax leads the nation, cigarettes can cost close to $13 per pack.

Price hikes and health concerns have many cigarette smokers calling it quits.

Kate Silver, a freelance writer in Chicago, smoked cigarettes — Marlboro Light 100s and later Camel Light 99s — on and off for a decade.

“I thought nothing of standing in triple digit temperatures to smoke a cigarette in the summer,” she said. “Cigarettes started to feel like a leash that kept tightening.”

After repeated attempts to quit, she finally succeeded after distancing herself from friends who smoked and “wasn’t around any temptations.”

Other smokers have instead trended toward other tobacco products, such as battery-powered nicotine inhalers, “e-cigarettes.

That shift could also jeopardize the future of the bond repayments, Larkin said.

Since e-cigarettes were not included in the settlement, cigarettes for all major companies will continue to lose market share as the product gains popularity.

That would mean even less money from the settlement payments, which accelerates the odds that some states will default on bond obligations.

E-cigarette use could jump up to 50 percent in the next year, according to Fitch.

Bloomberg Finance LP  reported in October that worldwide e-cigarette sales could surpass traditional cigarettes by 2040.

A slip in tobacco settlement income could also impact the programs they currently fund.

Tobacco companies paid Illinois about $300 million last year in settlement payments, approximately half of which went to Medicaid funding.

Much of the rest goes toward other public health programs, according to the Illinois Office of Management and Budget.

And as tobacco settlement coffers tighten, those programs could also face budget cuts.

At Evanston Township High School, slated to get $39,258 this year in settlement money, administrators plan to launch several wellness programs.

The initiatives could include body-mass index measurements in gym classes and health seminars for staff, said William Stafford, chief financial officer at the school.

“We get the fact that it’s from the settlement and we plan to use it to improve the health of our students and staff,” he said.

But Illinois isn’t the only state with an uncertain future regarding its settlement funding. In January Moody’s placed 31 tobacco settlement bonds under review.

The ratings agency said in a statement those states could receive just 54 percent of the $4 billion in question, “significantly less than the 100 percent [they] expected.”

Twenty-two states in 2013 reached settlements on back-payments from tobacco companies, which increased total settlement income 21.6 percent, according to Fitch.

Tobacco producers had withheld more than $7 billion in payments from 2003 to 2012.

Six states lost in arbitration proceedings, while Illinois, in September, was among nine states that won.

But it could be a double-edged sword. As more states win arbitration, their refunds will increase, which could reduce as much as 65 percent of their normal annual settlement payment, Larkin wrote in a September report.

“If you’re a tobacco bond holder, you’re smoking in the wind,” he said.

BY MATT MCKINNEY

FEB 25, 2014

DETROIT, MI – Fitch Ratings said Monday that Detroit’s bankruptcy adjustment plan sets a bad precedent for the municipal bond market because it favors certain debts over others as it seeks to alleviate up to $18 billion in obligations.

Fitch said the plan, filed in bankruptcy court Friday, gives preferential treatment to pension-related creditors

“The plan calls for pension creditors to receive a higher recovery, based upon approximately $830 million of contributions from private foundations, the Detroit Institute of Art (DIA) and the state,” Fitch said in a release. “These contributions are proposed in order to avoid the liquidation of a particular city asset, the DIA art, These payments, however, are restricted for the benefit of only one class of unsecured creditor, the pension creditors, rather than for all creditors, as might have been expected.”

Fitch also took issue with the plan’s treatment of unlimited tax general obligation bonds as “unsecured.” Insurers of those bonds have already sued the city.

The full statement from Fitch is below.

The adjustment plan is a proposed route for addressing Detroit’s massive debt. U.S. Bankruptcy Judge Steven Rhodes will have final say over whether the plan goes forward.

Detroit Emergency Manager Kevyn Orr, appointed by the state to take over Detroit government last year, took the city into bankruptcy proceedings in July 2013.

The bulk of the city’s debt, according to Orr’s estimates, lies in obligations tied to the water department – about $6 billion, retiree pensions and health care – about $9.2 billion, and general obligation bonds – about $2 billion.

Here’s the full statement from Fitch Ratings:

“Fitch Ratings believes the recent Detroit plan of adjustment (the plan) filed with the Bankruptcy Court on Friday, Feb. 21, 2013, if confirmed, would set a troubling precedent in the municipal market. The plan not only classifies unlimited tax general obligation (ULTGO) bonds as ‘unsecured,’ but further degrades ULTGO value by giving other similarly classed ‘unsecured’ creditors preferential treatment, including unfunded pension and retiree healthcare liabilities. The city’s choice to treat ULTGO bonds as unsecured is particularly concerning, as they are backed by a separate property tax approved by the voters for the sole purpose of paying debt service on the bonds.

The judge in the case ruled last month that nothing distinguishes pensions from other debts, but the city and state are taking a different tack. The plan calls for pension creditors to receive a higher recovery, based upon approximately $830 million of contributions from private foundations, the Detroit Institute of Art (DIA) and the state. These contributions are proposed in order to avoid the liquidation of a particular city asset, the DIA art. These payments, however, are restricted for the benefit of only one class of unsecured creditor, the pension creditors, rather than for all creditors, as might have been expected.

Fitch also finds troubling the city’s legal attempt to invalidate the certificate of participation (COP) debt, which would further skew the equitableness of the plan away from debtholders’ interests. The plan includes reducing COPs recovery to zero while remaining silent on whether or not the pension system, which benefited from the sale of the COPs, would return any of the borrowed assets.

Fitch considers Detroit’s plan of adjustment to be hostile to GO bondholders. If this priority of creditors is upheld, Fitch expects that this disregard for the rights of bondholders will factor into higher borrowing costs for local issuers, and ultimately for local property taxpayers, in Michigan.”

Print By David Muller | dmuller@mlive.com

David Muller is the business reporter for MLive Media Group in Detroit. Email him at dmuller@mlive.com or follow him on Twitter or Facebook.

Local officials in at least 10 states are trying to cut pensions of municipal workers, or eliminate defined-benefit plans, pointing to Detroit as a symbol of the peril of growing retirement costs.

From New York to California, mayors and county officials are asking legislatures, courts or voters to allow the changes as a way to maintain government services as pensions consume a larger portion of budgets. The pressure may help extend a rally in municipal debt of issuers such as cities and school districts after the securities trailed the $3.7 trillion municipal market for the past five years.

Elected officials are intensifying efforts to trim benefits even as local economies and tax revenue recover more than four years after the longest recession since the 1930s. They’re searching for ways to reduce the costs of pensions that cover more than 14 million workers and are underfunded by at least $1 trillion, according to a January report by the Nelson A. Rockefeller Institute of Government in Albany, New York.

“Detroit should give everyone a long pause,” said Tom Tait, the Republican mayor of Anaheim, California, who is pushing a statewide ballot initiative to allow local governments to cut benefits for current employees. “It’s a necessary tool to save the cities and, as we’ve found in these other cities, to save the pension plans.”

Cost Cut

Legislatures in many instances have changed laws to reduce benefits of state employees, or forced them to pay more. Seven states, including Virginia and Tennessee, have agreed to phase out defined-benefit plans for certain employees, including some from local governments who are included in the state program.

Cities pressing for more control over pensions include Chicago, Houston, New Orleans, San Jose, California, and Syracuse, New York, where mayors say they have limited ability to control costs.

In Houston, the fourth most populous U.S. city, pensions accounted for 11 percent of the $2 billion budget, up from 6.9 percent a decade earlier, according to budget documents. In San Jose, the 10th most populous, pensions totaled 20 percent of the $1.1 billion budget, up from 9 percent in 2004.

Reducing Yields

Some municipal efforts to cut pension costs probably will succeed, boosting investor confidence and reducing yields, said Greg Donaldson, chief investment officer at Evansville, Indiana-based Donaldson Capital Management, which oversees $300 million in munis.

“The math in many of these pension plans just doesn’t work,” Donaldson said.

Investors are showing confidence in local-government debt in 2014, driving the securities to a 3.7 percent gain, while the entire municipal market has earned 3.3 percent, Bank of America Merrill Lynch data show.

A muni rally drove benchmark 10-year yields to an eight-month low of 2.5 percent yesterday, Bloomberg data show. For local debt, the outperformance marks a reversal after five years where city and county debt trailed the rest of the market.

Pension shortfalls emerged as the 18-month recession that ended in 2009 drove down stocks, trimming the value of investments used to pay benefits. Governments for years had also failed to put aside enough money.

Public pensions around the country remain “on a risky and shaky foundation” and some retirees won’t receive promised benefits, according to the Rockefeller Institute report.

State Laws

State laws often don’t allow localities to reduce employee pensions because they’re part of statewide funds that pay uniform benefits, said David Matkin, a professor of public administration at the State University of New York in Albany.

Detroit’s pension deficit of as much as $3.9 billion gained public attention last year as the city filed the largest U.S. municipal bankruptcy, emboldening local officials to advocate for reduced benefits. Detroit’s emergency manager, Kevyn Orr, estimates pension and retiree health-care liabilities make up half of Detroit’s $18 billion in debts cited in its July bankruptcy filing.

Orr this month proposed cutting pensions by as much as 10 percent for retired police officers and firefighters and as much as a third for other municipal retirees. U.S. Bankruptcy Judge Steven Rhodes, who is overseeing the Detroit case, ruled last year that pensions can be cut.

‘Lightning Rod’

“Detroit has presented something of a lightning rod for the elected officials,” said Teague Paterson, a Sacramento, California, attorney representing municipal workers’ unions in the state.

“Until recently, government agencies have been reticent to make changes, especially for public safety employees, who have been the golden children of the public sector workforce,” Paterson said. “But with the cries for reform we are now hearing, the police and fire unions are also in the hot seat.”

Local officials in the 10 states — including Michigan, Rhode Island and Pennsylvania — said in interviews that they’re seeking to change pension plans for existing or new employees, or both.

Lawmakers in at least three states, Florida, Illinois and Oklahoma, are considering legislation that would allow local governments to offer pension plans with lesser benefits for new employees or reduce benefits for existing workers, said Steve Kreisberg, director of collective bargaining for the American Federation of State, County and Municipal Employees, a union representing 1.6 million workers.

Raising Taxes

In Pennsylvania, 23 mayors are seeking legislative approval to freeze cost-of-living increases for current workers and revise a defined-benefit plan in a way that would result in reduced government contributions, said Rick Schuettler, executive director of the Pennsylvania Municipal League. The group’s members include cities and towns.

Some Pennsylvania cities have already raised taxes to meet higher pension costs and can’t boost them further without driving out businesses and residents, said Ed Pawlowski, mayor of Allentown and president of the state Municipal League.

“The more you raise taxes, the more folks move out and the more you lose in revenues,” said Pawlowski, a Democrat.

Houston, with about 2.2 million residents, filed a lawsuit in state court last month against the firefighters’ pension fund seeking permission to negotiate benefits, saying a law preventing the city from doing so violates the Texas constitution. The lawsuit said the city shouldn’t “ignore the lessons to be learned from the recent Detroit bankruptcy.”

Changing Rules

The board that controls the firefighters pension is fighting the lawsuit. No trial date has been set.

“When a firefighter joins the Houston Fire Department, he is told what benefits he or she will receive, and the city is wanting to change the rules mid-stream,” said Todd Clark, a firefighter who is chairman of the board.

In New York, Syracuse Mayor Stephanie Miner is pushing for localities to get power to cut benefits. Syracuse’s annual pension cost doubled to $32.5 million in her first four-year term, said Miner, a Democrat re-elected last year. The city projects operating budget deficits of more than $20 million annually through 2016, exacerbated by pension obligations, she said.

The state retirement system, which the city pays into for its workers, “just sends us a bill and the bill keeps escalating,” she said. “It’s an emergency right now.”

Risking Lives

Mayors face battles when seeking pension cuts at state capitols, said Matkin, the public-administration professor.

“The cities say they want more discretion, then the firefighters come in their uniforms and stand before subcommittees and say, ‘We are risking our lives every day to keep you safe. We run into burning buildings. Don’t touch our pensions,” he said.

Rather than penalize public workers, cities should curb budget deficits by raising taxes or eliminating corporate tax breaks, said Ron Saathoff, pension resources director of the International Association of Fire Fighters, a Washington-based union representing 240,000 members.

“Both at the state and local levels there are efforts to change existing laws and remove the constitutionally protected rights that people have earned,” Saathoff said.

By David Mildenberg  Feb 27, 2014 5:00 PM PT

To contact the reporter on this story: David Mildenberg in Austin at dmildenberg@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

LOS ANGELES – As underwriting fees on municipal bonds continue to decline and compliance costs rise, mergers and acquisitions offer firms a way to better manage these challenges.

The trend of lower underwriting spreads is nothing new, as underwriters have been dealing with declining fees since the 1980s. However, following the financial downturn, firms have been faced with the growing costs associated with an increase in rulemaking and regulation.

A handful of mergers and acquisitions among underwriting firms have been announced lately, including the recent acquisition of Los Angeles-based public finance investment banking boutique De La Rosa & Co. by Stifel Financial Corp., the parent company of Stifel, Nicolaus & Co.

“I think firms are trying to find ways to deal with the increased costs imposed by new regulatory and compliance requirements,” said Chris Mier, chief strategist and director of the analytical services division at Loop Capital Markets. “One way is through mergers, but there are others.”

Mier said greater costs from such requirements show up in the form of expensive compliance-related software, having to hire additional compliance and legal staff, outside legal counsel, and consulting costs, among others.

While the acquisition of De La Rosa & Co. will certainly help manage compliance costs, the decision to join Stifel was “a proactive one that reflected an optimism and belief in the strength of the California market,” according to the firm’s president, Ed De La Rosa.

After starting the company 25 years ago and growing it to become one of California’s top underwriters, De La Rosa said he began to notice that other competitors in the top ten were large global firms or publicly traded companies.

“We felt that if we were going to continue to grow in this market, and to gain more market share against these competitors, we needed to get our hands around more resources and more capital to offer to our clients,” he said.

De La Rosa, which focuses solely on the California market, ranked 11th among senior managers in the state in 2013, according to Thomson Reuters data.

Stifel, which acquired the eight-decade-old California municipal bond underwriting stalwart Stone & Youngberg LLC in 2011, ranked number seven.

About two years ago De La Rosa realized that his firm could not achieve its goals solely through organic growth, and began looking around for other opportunities. By the fall of 2013, he said his company had a number of offers to consider but Stifel was the best fit.

“We came to admire the amount of goodwill they’ve developed in California, because of their reputation for excellence in financial matters, for their creativity and for their ethics,” De La Rosa said of both Stone & Youngberg and Stifel professionals. “These are the same attributes we’ve always aspired to, so it seemed that the combination of De La Rosa with Stifel and its California presence would be very powerful.”

Of course, one advantage of combining resources with a larger firm is having more resources to help deal with some of the growing costs in the industry.

“It will be tremendously beneficial to have a larger compliance and legal department that covers the needs of all securities firms under the Stifel umbrella who can help with that — they can bring expertise and help spread the costs,” De La Rosa said.

This is particularly important in the new regulatory environment because the burden is increasingly on the dealer to prove that they’ve complied with trading rules and due diligence rules, he said.

“All dealers have had to adopt policies and procedures and processes by which they monitor the activities of their professionals,” De La Rosa said. “They’ve had to beef up the number of staff so they can demonstrate compliance when they get audited by [the Financial Industry Regulatory Authority] or the [Securities and Exchange Commission].”

To deal with falling underwriting spreads — which have been declining ever since De La Rosa started his company in 1989 — he said the smart market participants will always find a way to serve that market in the most economical way so they can operate profitably.

“We’ve always managed our costs and arrayed our resources so we could provide value-added service, ideas and products within the existing fee structure at the time,” De La Rosa said. “That’s been a big part of our recipe for success, and I expect that Stifel will help us to become even more efficient in this area.”

Other movement among underwriting firms includes the acquisition, completed in July, by Minneapolis-based investment bank and asset management firm Piper Jaffray of Seattle-Northwest Securities Corporation, a Seattle firm with a homegrown focus on underwriting and advising on municipal bonds in the Northwest.

Piper Jaffray ranked 10th among senior managers in 2012, with 568 issues totaling $9.3 billion. Seattle-Northwest ranked 29th with 101 issues worth $1.8 billion. In 2013, Piper Jaffray moved up to the ninth spot with $11 billion in 624 issues.

In April 2012, Raymond James Financial, ranked 15th among senior managers in 2011, acquired Morgan Keegan, which held the ninth spot. The following year, Raymond James moved up to ninth place.

In a more recent move, M.R. Beal’s founder, Bernard B. Beal shuttered the firm and moved, along with several employees from the company, to join Oakland, Calif.-based investment bank and financial services company Blaylock Robert Van LLC.

Beal will serve as chairman of Blaylock, and oversee the firm’s municipal banking, underwriting, sales, and trading activities.

The firm has been renamed Blaylock Beal Van, LLC, pending regulatory approval.

M.R. Beal ranked 13th among co-managers with 218 issues totalling $47.4 billion in 2013. Blaylock was 40th, with 33 deals totaling $11 billion.

Among all senior managers, Beal ranked 35th, and Blaylock ranked 144th.

“One of the biggest costs of business right now for a firm is their legal and their compliance costs because regulators are putting more regulations on the board,” said Peter Stare, senior vice president at First Southwest. “There’s the Dodd-Frank Act that we all have to deal with, and the staff that you have to have to manage those things is constantly growing.”

Under Dodd-Frank, the Securities and Exchange Commission approved final rules that require municipal advisors to register with the commission if they provide advice to municipal entities on issuing bonds or other investment strategies.

The rule will affect financial advisory firms as well as many broker dealers involved in advisory work. It goes into effect on July 1.

Other regulations that firms are dealing with include a Volcker Rule that does not exempt tender option bonds, Basel III, which imposes new capital and liquidity rules on banks, and Rule G-17 of the Municipal Securities Rulemaking Board, which requires dealers to request issuers to acknowledge a receipt of disclosure.

Michael Decker, managing director and co-head of municipal securities at the Securities Industry and Financial Markets Association, said he hasn’t seen any hard data on industry-wide trends in compliance costs, but based on many anecdotal stories he’s heard from SIFMA members, there is no doubt that compliance costs are increasing across the board.

“When we talk to managers at firms about what keeps them up at night, it’s typical that the number one answer is costs of compliance and understanding and managing new regulations,” he said. “That is an overriding concern for managers of broker dealer firms.”

The new regulations generally impose record-keeping and documentation requirements and surveillance requirements, which require additional personnel, he said.

And there is also the possibility that a firm could be found in violation of any of the new provisions, in which case it could be subject to fines or limitations on its business. The costs associated with negotiating an enforcement action or responding to an enforcement action and the costs associated with managing the examination process are significant, he said.

“The spike in compliance costs probably affects small dealers more acutely because there’s a certain portion of costs that are fixed and they have to spread it a cross a smaller pool of revenue,” Decker said. “But it’s really an across-the-board issue, affecting big firms and small firms and it really is a very notable trend in the industry.”

A way that SIFMA tries to help the industry address these issues is through initiatives like model documentation, Decker said. This helps provide some standardization in terms of the documents the firms are using for compliance purposes and it also helps share the costs among firms of developing documentation and practices to help address compliance concerns.

“The trend of deregulation or light regulation of the industry is definitely past us,” Decker said. “The regulators are responding aggressively to the crisis and I think it’s likely that for the foreseeable future we’re going to see strong action by the regulators in terms of strengthening industry regulations.”

While the growing cost of compliance takes the spotlight in terms of major challenges facing the industry, it’s not the only one. Decker said that if he had to point to the second major challenge underwriters face, it would be risk management — managing a firm’s exposure and dealing with pressures whenever the market weakens.

“Costs are increasing for firms of all sizes,” said Mier. “Declining underwriting spreads and lower new issue volume put pressure on revenue. Everyone is being squeezed.”

The average fee state and local governments have paid underwriters on all bonds during 2013 to $4.92 from $5.56 the year before, according to Thomson Reuters data. That number was down from $5.65 in 2011 and $5.97 in 2010.

Spreads have come down almost 21% since peaking at $6.21 in 2009, after the economic downturn and global financial crisis, when deals were riskier to underwrite and fewer banks were competing for business.

Before that spreads had steadily declined from $5.73 in 2003 to $4.89 in 2008.

“Not only are spreads narrower but there’s less product to go around and that’s going to make for even more competition, which is going to compress spreads and compress rates further,” Stare said. “There are just not that many deals around anymore.”

Overall new issue supply was down 12.5% in 2013 to $334.6 billion from $382.4 billion in 2012, according to Thomson Reuters.

The decline was largely driven by a substantial drop in refunding deals as interest rates began to rise half-way through the year.

“There comes a point in time where your overhead just gets to be too much and you’ve got to look for other options, whether it be a strategic merger with another firm, or whether it calls for just closing the door,” Stare said.

BY TONYA CHIN

FEB 25, 2014 3:52pm ET

“Sentiment surrounding new security issuance reflects the overall sense uncertainty that is prevalent in today’s capital markets,” said Richard Peterson, Director, Global Markets Intelligence, S&P Capital IQ. “While the appetite for new U.S. corporate issuance remains strong, significant declines in municipal bond and international debt ID request volume underscore a ‘wait-and-see’ sensibility among many issuers.”

February 19, 2014

View the CUSIP Trends Global Issuance Report:

http://img.en25.com/Web/StandardandPoors/Trends_Report_14FEB_FINAL.pdf

Paul Ferrarese to Head Business Development at Whitehaven Asset Management

The head of municipal-bond institutional sales at Goldman Sachs & Co. is joining a new hedge fund manager, seeking to take advantage of opportunities in a market that has been rattled by Detroit’s record-setting bankruptcy and fiscal problems in Puerto Rico.

Paul Ferrarese is joining Whitehaven Asset Management LP, where he will serve as head of business development and be charged with finding new investors and managing existing ones. Mr. Ferrarese will also help Scott Richman, who founded the firm in 2013, with investment decisions.

Earlier this year, Whitehaven launched the Whitehaven Credit Opportunities Fund, joining the small but growing ranks of hedge funds that focus on the $3.7 trillion municipal-bond market. The fund has $31 million in assets and another $4 million in commitments, Mr. Richman said in an interview.

Mom-and-pop investors attracted to the perceived safety and tax benefits of municipal bonds continue to dominate the market. But Mr. Richman said a slew of new and at-times more complicated investments, and the fact that many mutual funds focus on bonds from a single state, offer openings for hedge funds with a more flexible strategy.

For example, there are more municipal bonds where the interest is taxable, municipal bonds backed by corporations and municipal bonds backed by tobacco sales than there were about 10 years ago. Highly rated bond insurers that guaranteed municipal bonds saw their ratings cut in the aftermath of the financial crisis, making it more important for investors to understand the financial health of the municipalities issuing the debt.

“Post-2008, with the decline of bond insurance, and the increased headlines in the municipal space, there is a significant opportunity for a hedge fund with municipal credit expertise to capitalize on the inefficiencies in the market,” Mr. Richman, 31 years old, said.

Mr. Ferrarese, 46, was Mr. Richman’s salesman at Goldman, a unit of Goldman Sachs Group Inc., while Mr. Richman was head of municipals at hedge-fund-manager Gracie Asset Management. Mr. Ferrarese previously worked at Merrill Lynch and Citigroup.

Joining Whitehaven is “really appealing after 21 years working for three really large institutions,” said Mr. Ferrarese, who will start on March 24. “There’s definitely elements of entrepreneurism there but nowhere near the degree of trying to launch your own investment product.”

Detroit, which filed for bankruptcy after years of economic decline and population exodus, recently submitted a reorganization plan with steep cuts for existing bondholders. Puerto Rico is seeking to complete a bond sale that could top $3 billion, and market participants expect many of the buyers to be hedge funds. Mr. Richman declined to comment on whether his fund would be one of them.

By MIKE CHERNEY

Feb. 26, 2014 7:00 a.m. ET

Write to Mike Cherney at mike.cherney@wsj.com

Financial advisers to some of the wealthiest Americans see struggling Puerto Rico as an outlier in the $3.7 trillion local-debt market, leading them to add municipal bonds as the steepest federal tax rates in more than a decade loom.

Puerto Rico’s downgrade to junk this month influences investors nationwide as the U.S. commonwealth’s debt is held in 70 percent of municipal mutual funds. Money managers for high-net-worth clients say they’re more focused on the improving fiscal outlook for mainland issuers. States and cities benefiting from a growing economy are mending their finances almost five years after the longest recession since the 1930s.

Last year’s rally in stocks helped drive municipal debt to the worst annual losses since 2008. Now, less than two months before the deadline for filing individual returns, tax-exempt securities are gaining appeal as some top earners face levies on debt interest payments are as much as 24 percent higher than for 2012.

“People are going to be shocked by their tax bills this year,” said Patrick Bittner, head of investment-grade fixed income for Silvercrest Asset Management Group, a New York firm whose average client has about $33 million with the company. “More people will seek out tax-free income, which makes muni bonds more valuable.”

Individuals’ Role

Increased demand from individuals, who own about 60 percent of the municipal market either directly or through mutual funds, may add momentum to a 2014 rally in local debt that has driven benchmark yields close to the lowest since June. Munis have earned 2.8 percent this year, after a 2.6 percent drop in 2013, S&P Dow Jones Indices show.

Detroit’s record bankruptcy filing in July and bets on rising interest rates fueled $58.4 billion in outflows from muni-bond funds in 2013, the most since at least 1984, according to Investment Company Institute data. The trend has reversed this year, with the funds adding $589 million in January.

“All of the selling has created opportunities,” said Dave Grecsek, New York-based director of investment strategy and research at Aspiriant, a wealth-management firm overseeing more than $7 billion.

Individuals usually buy munis for their tax-free income. The bonds are generally exempt from federal, state and local taxes for residents in most states where they’re issued. Puerto Rico bonds are exempt from federal, state and local levies nationwide, explaining why the territory’s finances have an impact beyond the shores of the Caribbean getaway.

April Bill

This year, high earners face bills due by April 15 that for the first time include federal tax increases that took effect last year: a top marginal rate of 39.6 percent, up from 35 percent; and a 20 percent tax on long-term capital gains and dividends, up from 15 percent. The top tax bracket hasn’t been this high since 2000.

The increases coincide with a new 3.8 percent tax on investment income applied to top earners last year as a result of the 2010 health-care law.

“With tax rates at these high levels, long munis offer investors attractive after-tax income,” Philip Condon, head of U.S. fixed income and munis at Deutsche Asset & Wealth Management in Boston, wrote in a report this month. “There is no fixed-income alternative with similar opportunity.”

Clients’ Demand

With the top federal tax rate reaching 43.4 percent when including the new tax on investment income, the 2.61 percent yield on benchmark 10-year munis is equivalent to a taxable interest rate of 4.61 percent. Treasuries of that maturity yield 2.74 percent.

As clients increasingly demand tax-free income, municipal credit is strengthening, said Brendan Connaughton, chief investment officer at advisory firm ClearPath Capital Partners in San Francisco.

“State governments are improving and improving at a dramatic pace,” he said.

Tax collections have probably grown for 16 straight quarters, according to the Nelson A. Rockefeller Institute of Government in Albany, New York. Meanwhile, 60 issuers defaulted for the first time last year, down from 107 in 2012, data from research firm Municipal Market Advisors show.

Asset Switch

Aspiriant has trimmed equities for some clients and shifted into munis, especially for residents in high-tax states such as California, New York and New Jersey, Grecsek said. The Standard & Poor’s 500 index of shares is little changed in 2014, after a 29.6 percent gain in 2013.

The firm’s typical client has about $10 million in investable assets, and munis average 20 percent to 30 percent of holdings, he said.

For some advisers, the extra yield on Puerto Rico bonds may be worth the risk.

Puerto Rico general obligations due in July 2041 traded yesterday with an average yield of 7.79 percent, the lowest since November, data compiled by Bloomberg show. The extra yield investors demand over benchmark munis was 3.9 percentage points, down from 5 percentage points at year-end.

Debt of the self-governing commonwealth has rallied as officials said they plan to issue about $2.9 billion of general-obligation bonds next month to satisfy cash needs through mid-2015.

Credit View

S&P cut the island to speculative grade on Feb. 4, followed by Moody’s Investors Service and Fitch Ratings amid concern that the territory won’t be able to repay investors as its economy contracts.

Bill Hayes, a principal at Charles Carroll Financial Partners in Kingston, Massachusetts, said he’d buy the island’s debt for clients if it becomes available to more than institutions.

“Any coupon above 5 percent would be a wonderful opportunity,” Hayes said.

For advisers such as Sam Katzman, chief investment officer at Constellation Wealth Advisors in New York, Puerto Rico bonds are still too risky.

He said he’s looking for revenue bonds with a AAA rating or two steps lower, that yield at least 3.5 percent and have durations of five to 10 years.

“People are crossing the 50 percent threshold,” he said of combined federal and state levies. “The idea of sheltering income becomes more attractive and the intrinsic value of munis becomes more attractive.”

By Margaret Collins  Feb 24, 2014 5:00 PM PT

To contact the reporter on this story: Margaret Collins in New York at mcollins45@bloomberg.net

To contact the editors responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net; Stephen Merelman at smerelman@bloomberg.net

With the ways for funding transportation infrastructure changing, what options do Congress and the states have left?

Bridges need replacing. Transit systems await expansion. Roads are in want of repair — a long-delayed problem made worse by the potholes left in the wake of this winter’s storms. But the traditional system for financing transportation infrastructure — money from the Highway Trust Fund and from Congressional legislation (Moving Ahead for Progress in the 21st Century or MAP-21) — has diminished or is not being reauthorized. In a recent newsletter on transportation infrastructure, transportation expert Kenneth Orski, editor and publisher of Innovation News Briefs, heralded this information with an interesting storyline: “States are taking matters into their own hands.”

Given the turmoil and pressure on state budgets in the past five years, I wondered how Orski saw the states taking over. In a recent interview, I talked to him about that. The interview has been edited for clarity and length.

What do you seen happening with MAP-21? Will it be reauthorized and will there be money in it for state projects?

Funding will dominate the agenda for reauthorization. Where does Congress find the money to finance the bill? A rise in the gas taxes is unlikely. It’s a dead issue in this Congress and probably in the next one as well.

Is that an opening for the states to raise their gas taxes?

Four states enacted gas tax increases in 2013. This year there are three or four states where the issue is very much alive. I expect that states will regard a gas tax increase more favorably than Congress will.

What other funding might Congress look at?

A federal mileage tax (a VMT or vehicle miles traveled) has been a favorite of academics and policymakers for some time. The trouble is, when you look at what is happening across the country, only a few states are seriously viewing VMT fees as an alternative or supplement to other revenues. So far, the feeling on VMT is that, if it comes about at all, it is a long-term prospect. It’s not ready for prime time — not in this or the next reauthorization.

General funds are responsible for injecting money into the Highway Trust Fund. But the prospect of using general funds has been basically ruled out by the budget agreement that was passed a few months ago. It requires general fund transfers to be fully offset during the year in which the transfer occurs. That device had been used before [in earlier iterations of MAP-21] but those offsets were to be spread out over a period of up to 10 yrs. This time around the offset is during the same year. So I would rule this out as possibility.

There’s one more perennial proposal: tolling. Tolling does have a place in the spectrum of supplements to the gas tax but only in certain states. Some states, especially on the eastern seaboard, are receptive to tolling because there’s a long tradition of tolling. But in Midwest and Far West states, tolling is viewed very skeptically. So it could be a partial solution in certain states for state-based revenue but not in others.

What about President Obama’s suggestion that savings from closing corporate loopholes could be used to finance transportation projects in the states?

He mentioned this in his State of the Union but he was not very specific as to exactly what those tax loopholes are. That proposal met with skepticism. Transportation lobbyists consider it highly speculative.

Where do you see states finding revenue to finance big-ticket items? You mention bonds in your newsletter, but states have debt limits.

Through public private partnerships [P3s] states can borrow quite a bit. There are public financing instruments, notably private activity bonds. We are told there are many billions of dollars available in private credit. So you can combine the public credit assistance through TIFIA [Transportation Infrastructure Finance and Innovation Act, a credit assistance program] with the private equity and use P3s to finance these major projects-such as bridge replacements, large reconstruction programs, hot lanes. It’s not just roads and bridges. Maryland’s Governor Martin O’Malley recently announced that the Purple Line, a $2.2 billion, 16-mile light rail line connecting two suburban counties in the Washington metro area, will be built, financed and operated through a public-private partnership — the first of its kind, but almost certainly not the last.

You also talk about availability payments. How does that work?

That’s basically a technique of financing used for large infrastructure projects that cannot generate sufficient revenue to pay for themselves. The sponsoring agency uses sources of income (tolls or dedicated sales taxes) and makes up the shortfall with its own money. In this way it is able to pay private partners for participating in large construction projects. Some 12 major highway and bridge projects are being financed this way. So that’s another way states can approach this lack of help from the federal side.

Potholes are a politically volatile issue. Where will states find the money to fill those car-devouring holes?

State and local governments generally set aside funds for snow removal every year. What has happened this year, we’ve had an unusually severe winter that nobody anticipated. So there’s a mini-crisis in state funding for snow removal. Some states are drawing on reserves. In many states those reserves are exhausted. To some extent states are drawing on disaster relief that was made available during the big storm. I don’t know whether some state DOTs [Departments of Transportation] may request supplementary help from state legislatures. Others will just muddle through.

We’ve all been reading about smart cars-cars that can drive themselves, for instance. When these smart cars come on line, won’t they need smart roads? How will governments pay for that?

When it comes to the latter part of 21st century (and that’s what we’re talking about) it’s hard to speculate about what kind of investment will be necessary to implement that kind of system nationwide. What I see happening is small-scale experiments at the state level to deploy the technology before states try any large scale implementation. Clearly a nationwide effort would require huge sums of money — hundreds of billions of dollars. I don’t know where we will find that money.

Unlike most issues the states are dealing with today, transportation funding seems to be less volatile.

States can no longer count on an endless stream of federal dollars for their transportation needs. They are experimenting with ways to become more self sufficient. This experimentation is taking place in both Red and Blue states. Both political parties are equally anxious to find ways of increasing transportation independence. State legislators and governors are pragmatists. They take an approach that’s largely devoid of partisan politics.

BY PENELOPE LEMOV | FEBRUARY 27, 2014

plemov@governing.com

Bond Investors Who Loaned $35 Million Say They Wouldn’t Be Paid Fairly

Municipal-bond investors who lent $35 million to Stockton, Calif., for city improvements are protesting its Chapter 9 exit plan. They contend that, if approved by a bankruptcy judge, the plan would unfairly pay them less than a penny on the dollar.

The Franklin High Yield Tax-Free Income Fund and the Franklin California High Yield Municipal Fund, both managed by Franklin Templeton Investments, filed an objection Wednesday with the U.S. Bankruptcy Court in Sacramento requesting that Judge Christopher Klein not approve the city’s restructuring plan.

Franklin—which is slated to recover $94,000, or 0.25% of its investment, under Stockton’s plan—said it is being treated unfairly. The firm said Stockton’s other creditors would recover 52% to over 100% of their claims from future revenues over the next 40 years. Federal bankruptcy rules state the city’s plan must be “fair and equitable.”

For its part, Stockton said it has reduced its general workforce by an aggregate of 30% during the years leading up to its bankruptcy. The city has also stated that retiree health benefits worth about $1 billion have been eliminated as a result of negotiations.

“The plan is a Spartan one,” the city said in documents filed with the court. “It returns the city to financial and public service provider solvency,” but without a deal with creditors, Stockton’s lawyers said the city could lose control of two golf courses and a park.

The city’s chief information officer said Friday the city wouldn’t be in a position to provide comments until next week, when it had further reviewed the objection.

In 2009, Franklin lent $35 million to Stockton, a city of 300,000, to build and equip a fire station, modernize another fire station, relocate the police communications center, acquire land for and construct seven city parks, and complete numerous street-improvement projects.

“Franklin’s funds were put to good civic use,” Franklin said in documents filed with the court.

Stockton made four interest payments before defaulting on the 30-year loan, when it missed a payment on March 1, 2012, several months before the city filed for bankruptcy.

The city, in an evaluation of its finances before filing for bankruptcy, initially offered to restructure and extend Franklin’s loan through a proposal in which the fund would ultimately recover 54.5%. Now, Franklin alleges that Stockton is trying to force through a plan that wouldn’t use any future revenue to pay down the loan, providing a much smaller recovery, according to court documents.

Franklin criticized city leaders for not demanding lower payments to the California Public Employees’ Retirement System. The city owes about $125 million in pension bonds, its largest debt. In total, Stockton’s reorganization plan involves nearly $300 million in claims.

Additionally, much of Franklin’s argument centers on the use of public facilities fees, called PFFs. PFFs are essentially a tax on the issuance of building permits, which are used to pay for municipally owned facilities. In court documents, Franklin said the Stockton plan’s estimate of $500,000 in annual fees is enough to service its loan.

Stockton’s leaders put the city into bankruptcy on June 28, 2012, blaming the real estate crash that crippled its tax revenue. The city, located about 80 miles inland from San Francisco, was declared “ground zero” for the subprime-mortgage crisis by Judge Klein.

By TOM CORRIGAN

Feb. 28, 2014 5:53 p.m. ET

—Katy Stech contributed to this article.

Feb 28 (Reuters) – The supply-starved U.S. municipal bond market will get some relief next week when debt sales are expected to jump to $5.16 billion from this week’s $2.42 billion, with top-rated deals from Texas and Maryland on tap, according to Thomson Reuters estimates on Friday.

February’s $14.1 billion issuance was the lowest for a month since January 2011, according to Thomson Reuters data. Year-to-date sales of muni debt totaled $32.4 billion, down 35 percent from the same period in 2013.

Negotiated deals will total an estimated $3.78 billion next week.

The Texas Transportation Commission will sell $1.19 billion of AAA-rated state highway fund tier revenue bonds in two series through Piper Jaffray & Co on Thursday.

Nearly $892 million of new and refunding bonds carry maturities from 2017 through 2024 and in 2031, 2033 and 2034, according to the preliminary official statement. Another $300 million is made up of SIFMA Index floating-rate bonds maturing in April 2032.

New York City will sell $650 million of general obligation bonds with serial maturities of 2016 through 2039 and about $50 million of bonds that mature in 2024 through 2027, according to the POS. Citigroup will hold a retail presale period starting on Monday with formal pricing on Wednesday.

The city will also sell GO index rate bonds in three series next week – $100 million through Siebert Brandford Shank & Co, $100 million through Morgan Stanley and $50.25 million through Loop Capital Markets.

Topping the week’s competitive calendar is $741 million of Maryland GO state and local facilities bonds in three series selling on Wednesday.

The triple-A-rated debt will be offered as $450 million of new bonds with serial maturities from 2018 through 2029, $241 million of refunding bonds maturing from 2014 through 2021 and $50 million of taxable bonds due in 2017 and 2018, according to the POS.

CHICAGO — A pair of bond insurers that wrap a chunk of Detroit’s unsecured debt condemned the debt adjustment plan the city filed in bankruptcy court Friday, saying it would only lead to more litigation.

It was one in a series of negative comments municipal bond market participants directed at the city’s proposal to treat general obligation bondholders as unsecured creditors.

The city wants to pay GO holders 20 cents on the dollar. Pensioners would see recovery rates of around 30% on the unfunded portions of their pension plans, and potentially more if an $820 million arts-for-pensions plan put together by the state and a group of foundations is realized.

“While we understand that favoring pensioners and discriminating against bondholders might be politically popular, we believe this is contrary to bankruptcy law and will result in costly litigation that will hamper the city’s emergence from bankruptcy,” Steve Spencer, financial advisor to bond insurer Financial Guaranty Insurance Co., the city’s largest unsecured creditor, said in a statement.

“Any plan of adjustment that fails to maximize the value of the city’s numerous valuable assets to enhance recoveries for creditors will leave billions on the table and fail to meet requirements of bankruptcy law, increasing the chances of drawn-out litigation that nobody wants,” he said.

Syncora Guarantee, which, with FGIC, insures the city’s $1.4 billion of pension certificates, also protested the plan, saying Detroit emergency manager Kevyn Orr is leaving “more than half a billion dollars” in potential savings on the table by failing to improve city services or boost revenues.

For the muni market, the city’s treatment of unlimited-tax GOs as unsecured has rattled traditional beliefs about the debt being among the safest of investments.

“We have serious concerns about general obligation bonds being treated as unsecured debt,” said Leslie Norwood, associate general counsel and co-head of the municipal securities group at the Securities Industry and Financial Markets Association. “We think municipalities, investors, and taxpayers should care about this.”

Norwood said that reduced investor confidence in GO bonds could lead to a reduction in market access and higher borrowing costs for Detroit and other Michigan issuers, which will in turn lead to higher taxes on residents.

“It will potentially have impacts not just on Detroit, but on other cities,” Norwood said.

Fitch ratings analyst Arlene Bohner said the plan’s preferential treatment of pensioners over GO holders is “troubling,” an depending on the outcome of the bankruptcy court’s decision, could affect Fitch’s rating methodology.

“This could potentially cause us to review our policies and change how we view GO bonds in Michigan,” Bohner said.

Municipal Market Advisors, in a comment issued Feb. 18, warned that the treatment of unlimited-tax GOs as unsecured could drive up local GO borrowing costs by 25 basis points across the country.

The Bond Dealers of America warning that Detroit’s approach to GOs has national implications for the market.

Detroit’s decision to treat GO holders as unsecured is a “step in the wrong direction,” the BDA said. “If ultimately accepted by the bankruptcy court, this treatment has national implications for general obligation bonds,” the group said. “Full faith and credit general obligation bonds are a lifeblood for meeting state and local government financing needs, and the pledge they represent should not become undermined by specific, localized bankruptcy cases.”

The plan didn’t just upset the muni market. Local Detroit media Friday was reporting that retirees were complaining about the proposed settlement, which would require them to give up cost-of-living adjustments and health care.

A national pension advocacy group also blasted the plan.

“Gov. Rick Snyder and Kevyn Orr might consider this blueprint a ‘comeback’ and ‘the best path forward,’ but don’t believe the hype,” said Jordan Marks, executive director of the National Public Pension Coalition. “A more than 30% cut combined with the virtual elimination of health care is devastating to the people who dedicated a career to Detroit. Wall Street, which posted record profits in 2013, can afford to pay for the damage it reaped on the city.”

BY CAITLIN DEVITT

FEB 21, 2014 4:54pm ET

When it comes to interest rate swaps, Detroit is not alone.

More than five years after the 2008 financial crisis upended the world of credit and debt, dozens of states, counties, cities, school districts and other public entities tapping the $4 trillion muni bond market are still feeling the hangover from these risky bets.

As the architects of Detroit’s bankruptcy are trying to negotiate a deal to end the nearly $4 million a month in payments to holders of the city’s swaps contracts, dozens of other states and cities are spending millions of taxpayer dollars on swaps contracts currently in force.

A full accounting is not possible, because there is no single list of swaps outstanding. Unlike the muni bonds that these hedges are attached to, states and cities are not required to register them with regulators. Instead the details of these deals are buried in the Comprehensive Annual Financial Reports that municipalities file every year—months after the end of each fiscal year.

A review of these CAFR reports by the Service Employees International Union—the second-largest public employee union representing more than 1 million local and state government workers—found more than 500 swaps contracts—were still in force with more than 70 public entities representing annual payments of than $1.3 billion a year, as of the latest publicly available reports.

Those reports represent a snapshot in time; some swaps may have been terminated since they were filed.

These complex derivatives—cousins of the credit instruments used to package subprime mortgages—were sold as a surefire hedge against the risk to taxpayers that rising interest rates could raise borrowing costs for cities, states and schools. Instead, the bet backfired.

After the Federal Reserve flooded the financial system with cash in 2008 to protect the shattered banking system, interest rates fell to zero—turning many of the these swaps upside down and saddling the government entities on the losing side of the bet with annual payments to Wall Street bankers who arranged the deals and the counterparties who ended up on the winning side.

Like other critics of these deals, the union contends that these swaps are diverting precious taxpayer funds from badly needed public service—and the pensions owed to the public employees they represent.

But municipal finance experts note that some cities and states saved millions of dollars in borrowing costs on these deals before the 2008 crisis. In any case, the swap represents a binding commitment with the same force as the bond the swap is attached to.

Some cities and states have decided to bite the bullet and pay a hefty “termination fee” which, not unlike a homeowner paying off a mortgage, ends the burden of annual swap payments. In 2012, for example, New York state paid $243 million to terminate its swap deals, using $191 million in new borrowing to do so.

Terminating swaps may help free up cash in the short run but—depending on the terms of the swap—it may mean throwing good money after bad.

The cost of canceling the deal also varies based on changes in interest rates. Just as the drop in rates increased the cost of these deals, rising rates will gradually ease financial pain.

In some cases, say municipal finance advisors, states and cities holding costly swaps may be better off waiting for rates to rise to more historical levels before trying to restructure them with fresh debt.

—By CNBC’s John Schoen. Follow him on Twitter @johnwschoen or email him.

Click here for version with charts and graphs:

http://www.cnbc.com/id/101435468

Delay in Providing Information Could Have Negative Rating Implications

Standard & Poor’s Ratings Services is ratcheting up pressure on cities, towns and counties to more quickly disclose private loan deals with banks, warning in a report Tuesday that a delay in providing the information could have “negative rating implications.”

Municipalities have been increasingly turning to banks for their financing needs in recent years, either in the form of a loan or where a bank buys bonds directly from the municipality. S&P estimates that $50 billion to $60 billion of such deals are getting done annually. But it says any increase is challenging to quantify because of the lack of disclosure.

S&P says it can be difficult to come up with accurate credit ratings if municipalities don’t discuss private bank deals. A bank loan can add to a municipality’s debt load, which is an important factor in credit ratings. The private deals could also have terms and conditions that are significant to a municipality’s fiscal health.

S&P has called for more disclosure on bank loans in the past, but says transparency is even more important now that direct bank lending to municipalities appears to be growing. S&P’s comments are in line with other efforts in recent years to make it easier to find information in the $3.7 trillion municipal bond market, which has historically been relatively opaque even though it is largely the domain of mom-and-pop investors.

“Disclosure, transparency, timeliness…there’s been a consistent clamoring for more of that in recent years,” said Steve Murphy, senior managing director and head of U.S. public finance at S&P. But getting information on bank financing has been “going in the other direction.”

The Municipal Securities Rulemaking Board, which sets rules for municipal securities dealers and municipal advisers, doesn’t require municipalities to disclose their loans with banks when the deal is completed, though it encourages them to do so. Investors may not learn of a bank loan until a municipality releases its annual financial report, which can be months after the bank deal is done.

A 2013 white paper from the National Federation of Municipal Analysts and other groups suggested guidelines for municipalities if they decided to disclose their bank loans. Among them was posting information to the MSRB’s Electronic Municipal Market Access website, where investors can see other financial information from municipalities as well as real-time trading data.

In its report Tuesday, S&P urged municipalities to provide it information on bank deals when the agreements are being planned and completed. Bank loans have negatively impacted a municipal issuer’s rating in the past, including a Michigan hospital in 2011, which had its ratings outlook revised to negative, according to an S&P spokesman.

“We need to know because what we’re sharing with the marketplace is our most current appropriate rating,” Mr. Murphy said. “If it’s not disclosed, we could be putting forth an assessment of credit that isn’t true.”

Lending directly to municipalities has become more popular for banks in part because they can make more interest on direct loans than from low-yielding U.S. government securities, said Duane McAllister, a portfolio manager at BMO Asset Management, which oversees about $4 billion in munis. The improving economy is also boosting municipal finances overall, making them more attractive for banks, Mr. McAllister said.

Mr. McAllister said he is more concerned with the lack of bank-loan disclosure from lower-rated municipal issuers. “Sometimes it takes having to physically contact the authority,” he said.

By MIKE CHERNEY

Feb. 18, 2014 5:26 p.m. ET

Write to Mike Cherney at mike.cherney@wsj.com

CHICAGO — Detroit’s attempt to invalidate $1.4 billion of pension certificates as part of its bankruptcy is a “radical” move that is unlikely to be copied by other issuers even if successful, according to Moody’s Investors Service.

“The attempted repudiation of municipal debt is an extremely rare and unusual act,” Moody’s said in a comment released Friday titled “Desperate Times Call for Desperate Measures: Detroit’s Attempted COPs Repudiation an Extreme Act.”

“Ultimately, the city’s repudiation attempt is unlikely to impact the broader municipal market because it is so rare. Should the city prevail, the case is still likely to have limited implications for COPs holders elsewhere,” analysts wrote.

Detroit filed the lawsuit challenging the certificates of participation on Jan. 31, arguing that the debt structure, which relied on service corporations, is illegal because it was set up solely to allow the city to avoid state debt limits.

The lawsuit is part of the city’s ongoing effort to settle with its swap counterparties, who hedge $800 million of the COPs.

If the city wins in court, it could be positive for other creditors because it would mean more money to go around, Moody’s notes.

But it’s also possible that the city could be made to return the proceeds of the $1.4 billion sale, which were used to fund its two pension systems. That would severely weaken the pension funds’ assets and could roil the bankruptcy case.

The last time a government tried to repudiate debt on such a scale was in 1983, when the Washington Public Power Supply System successfully argued that its take-or-pay contracts were illegal and invalidated $2.25 billion of revenue bonds.

“We do not expect debt repudiation to become a frequently used tactic for local governments given the very strong credit fundamentals of the vast majority of COPs issuers,” Moody’s said. There are very few other Michigan issuers who have used similar debt instruments, and many states recognize lease-back obligations as valid, according to Moody’s.

In related news, Bankruptcy Judge Steven Rhodes, who is overseeing Detroit’s Chapter 9 case, set a hearing date of Feb. 19 for a key dispute that goes to the heart of the city’s effort to treat its unlimited-tax general obligation bonds as unsecured.

National Public Finance Guarantee Corp. and Assured Guaranty Municipal Corp. sued Detroit in November over the city’s treatment of the ULTGOs as unsecured. Ambac Assurance has filed its own suit, which includes the limited-tax GO bonds.

The insurers are arguing that the ULTGOs are secured because they are paid for with a special property tax levy imposed specifically for those bonds and as such are special revenues. State law requires that those tax revenues raised under the levy not be diverted for any other purpose than debt-service on the bonds, in or outside of bankruptcy, according to the insurers.

Detroit is current using the tax money raised under the levy for general operations.

“The ‘pledge’ of special ad valorem taxes is not, and is not intended to be, a mere ‘promise,’” the insurers argued in a recent filing that counters the city’s claim that a pledge is distinct from a statutory lien.

The city claims that the pledge is similar to the “pledge of allegiance,” and therefore not a promise or a lien, the insurers say in a footnote.

“In fact, it is a pledge of specific and identifiable property,” the insurers claim. “The appropriate analogy is not ‘I pledge allegiance to the flag,’ as defendants argue, but rather, ‘I pledge this flag for repayment of my debt.’”

The issue is a key one for the municipal market, which traditionally has treated ULTGOs as among the safest debt available, secondary to treasuries, noted Richard Ciccarone, president and chief executive officer of research firm Merritt Research Services LLC.

Critics point to the apparent lack of a statutory lien, but from a “common sense perspective, it has all the markings of a special revenue designation,” Ciccarone said. “Going to intent and common sense, you have to ask, what else are you going to use that money for?” he said. “It doesn’t make sense and it’s harmful to the entire municipal credit structure if you let the GO go that easily.”

by Caitlin Devitt

FEB 14, 2014 10:00am ET

On January 31, the City of Detroit, MI (Caa3 negative) filed a motion with the bankruptcy court to invalidate $1.45 billion of pension obligation Certificates of Participation (COPs). The attempted repudiation of municipal debt is an extremely rare and unusual act. A successful repudiation is still subject to court approval and would be credit negative for holders of the city’s COPs and potentially for pensioners and other bondholders if the city were also required to return the proceeds of the certificate sale. The return of proceeds is a possibility since they were used to fund the city’s previously unfunded pension liabilities and are part of the assets of the pension system. Ultimately, the city’s repudiation attempt is unlikely to impact the broader municipal market because it is so rare. Should the city prevail, the case is still likely to have limited implications for COPs holders elsewhere.

While repudiation is radical, some creditors may actually benefit if the court invalidates Detroit’s COPs, simply by making more funds available for unsecured creditor recovery. The city would no longer need to include repayment for $1.45 billion in COPs principal in its reorganization plan, including a projected $676.3 million in cumulative COP debt through 2023 and $498 million of forecasted expenditures for swaps related to the COPs, according to analysis presented in the city’s Proposal to Creditors in June 2013. Because COP proceeds funded pension liabilities, the funded status of the pensions could be severely weakened, however, if the court disgorges those proceeds following the repudiation. The ultimate disposition of the proceeds, should disgorgement occur, is unknown.

It is rare for a US municipal issuer to repudiate debt. The most recent example of a successful repudiation occurred in 1983, when a state court ruled that the Washington Public Power Supply System’s (WPPSS) Projects 4 and 5 take-or pay contracts were illegally executed. The municipal participants challenged the contracts after the projects were cancelled due to cost overruns and other complications. After the court invalidated the contracts, WPPSS defaulted on $2.25 billion of revenue bonds secured by the contracts. In contrast, Richmond Unified School District, CA failed in its attempt to repudiate its COPs lease obligation after defaulting on a COP lease payment in August 1991. While the district argued that the COPs were invalid because the underlying lease created debt in violation of the state’s constitutional debt limit, the court ultimately ruled that the lease was valid and enforceable. The district settled with the trustee for repayment. Neither of these examples involved an entity in bankruptcy.

Detroit similarly alleges that it issued pension obligation COPs illegally by violating the city’s statutory debt limit, despite the legal disclosure at the time of issuance to the contrary. Setting aside the legal merits of the city’s claim, the broader market impact of a favorable ruling for the city would likely be limited. COPs and instruments of this type are extremely rare in Michigan. Only one other Moody’s rated issuer has used a similar structure, and there is little precedent or case law in other jurisdictions where financings of this type are more common. In many states, the law recognizes lease-backed obligations as valid structures. Moreover, in the context of Detroit, debt repudiation is not completely surprising, given the depth of Detroit’s credit challenges. We do not expect debt repudiation to become a frequently used tactic for local governments given the very strong credit fundamentals of the vast majority of COPs issuers.

VOD: The reports above from the Bond Buyer and Moody’s belie Wall Street’s role in pushing the COPS loan, and profiting from it. They also show alarm at the lawsuit filed against it, and threaten Detroit’s pension systems with having to repay the loan, instead of UBS AG, Bank of America Merrill Lynch, and Siebert, Brandford and Shank, the lenders who profited from it.

It was predatory mortgage lending by these banks and others that was largely responsible for the 2008 global economic collapse, and for the devastation of Detroit’s neighborhoods and tax base. Wall Street reps shown at top pushed this loan KNOWING that danger lay ahead, but assuring the City Council it was safe.

It’s a single sentence in a bankruptcy document that clocks in at roughly 440 pages, but it’s bound to draw a great deal of attention as Detroit tries to increase its revenues and pull out of its fiscal dilemma.

Emergency Manager Kevyn Orr’s restructuring plan released Friday includes a proposal to try to collect income taxes from Detroit residents who work outside the city limits.

“The city is considering the enactment of a local ordinance that would require employers to withhold city income taxes of reverse commuters,” the disclosure statement reads. It’s not a new strategy, but one likely to draw opposition in some circles.

When city and state officials crafted a consent agreement in 2012, it included assistance for Detroit’s efforts to collect those income taxes. But that plan failed and other legislative attempts to have suburban communities help have gained little traction.

A study released by consultants McKinsey & Co. estimated that uncollected income taxes from Detroit residents working outside the city, or reverse commuters, totaled more than $140 million in 2009. That means the city took in slightly less than half of what it should.

On Friday, a spokeswoman for Gov. Rick Snyder said Orr’s current plan is consistent with what was included in the consent agreement.

“It’s just a way for the state to help assist the city in ensuring effective and streamlined tax collection and compliance with existing laws and provisions,” said Sara Wurfel. “Details and particulars are in the early stages and will need to be worked out.”

The bankruptcy plan unveiled Friday by Orr’s team would mean sacrifice from many of Detroit’s sectors, particularly its pensioners — many of whom could see their payments cut by as much as 34 percent. Going after personal income taxes for those working outside the city would mean asking outsiders — namely businesses — to share that sacrifice.

And that makes it a difficult sell.

View Full Story from The Detroit News:

http://www.detroitnews.com/article/20140223/METRO01/302230010#ixzz2uByTdPRH

FEBRUARY 24, 2014

Court reinstates judges’ cost-of-living increases

A unanimous Arizona Supreme Court ruling will restore cost-of-living raises to retired judges and elected officials at an eventual cost of roughly $375 million to the retirement system and taxpayers.

The 5-0 decision made public Thursday upheld a Maricopa County Superior Court ruling that declared unconstitutional the Arizona Legislature’s actions in 2011 to suspend raises because of the pension trust’s poor financial health.

“It’s a pretty clear indication of what the law in Arizona is now,” said Ken Fields, a retired Maricopa County Superior Court judge and one of two retirees who sued to reinstate the raises. “It was a difficult decision, but it’s not going to be a popular decision.”

Elected officials and judges share the most generous pension program in the state. In their ruling, the justices noted that their decision eventually will benefit them as retirees.

A key state lawmaker said the ruling likely will pressure the Legislature to put a measure before voters, possibly this fall, to amend the Arizona Constitution by inserting provisions that could diminish benefits and rein in the rising cost of public pensions.

“This ruling wipes out most of the pension-saving reforms we enacted a few years ago,” said Rep. John Kavanagh, R-Fountain Hills, who is pushing for a voter referendum. “This will cost a lot of money and a lot of taxpayer money to buttress this system that has been poorly managed.”

The ruling also will restore cost-of-living increases to retired public-safety and correctional officers, who, like judges and elected officials, are part of the Public Safety Personnel Retirement System trust and saw their pension raises suspended by legislative action nearly three years ago.

System Administrator Jim Hacking said in a statement that retroactive raises for all PSPRS retirees will cost the trust $40 million immediately. He said an additional $335.6 million will be set aside to fund cost-of-living adjustments going forward.

Among those getting retroactive raises are 978 retired judges and elected officials who will receive $7.9 million, according to the pension system. Those payments are not shared equally. But, on average, that amounts to more than $8,000 per retiree.

The system did not provide the ruling’s precise cost to taxpayers, but Hacking said it will force the system to increase what it charges governments for pension benefits.

Governments are assessed at a rate applied to an employee’s wages based on total liabilities.

Rates for some governments could exceed 50 percent of each employee’s wages, and major increases are expected to occur in July 2015, according to the pension system.

The Arizona Republic found last year that lower-than-anticipated investment returns and pension enhancements caused employer trust payments to rise so much that some governments were unable to hire new police officers and firefighters because of the associated pension costs.

Contributions to the trust from employers have increased about 425 percent in the past decade to $451 million annually, according to trust financial statements.

The system manages a $7.2 billion trust that provides retirement benefits for more than 53,000 retirees, beneficiaries and active members.

Judges are part of the Elected Officials’ Retirement Plan. With slightly more than 2,000 members, half of whom are retired, they make up the smallest group in the system.

That plan was closed this year to new members, but it has allowed elected officials and judges to receive 80 percent of their ending salaries after 20 years of service.

Trust records show that 151 retirees have lifetime pensions in excess of $100,000 a year.

Retirees in the plan received a partial 2.47 percent cost-of-living adjustment in 2011, after receiving guaranteed 4 percent annual bumps in prior years regardless of the trust’s investment returns.

No raises were given the past two years because of the Legislature’s 2011 action to curb costs in the face of the trust’s eroding financial position.

The trust currently is underfunded by nearly $5.7 billion, trust financial records show.

Permanent benefit increases have allowed some elected officials, including judges, to make nearly as much — or more — in retirement as when they served.

Trust records show that Fields, for example, has an annual pension of $125,264, while his ending salary was about $135,844 when he retired in 2007.

The ruling notes that the raises were given even though the funding ratio — a measurement used to determine the trust’s financial health and taxpayer contributions — had gone from nearly 142 percent in 2000 to nearly 67 percent in 2010.

In layman’s terms, it had nearly half again as much money as it needed to fund its current and future pension liabilities in 2000.

By the end of the decade that followed, it had only enough money to pay for 67 percent of its current and future liabilities.

The funding level for the elected officials’ plan now stands even lower, at 55 percent, worst among the three retirement plans in the system. Its funding level dropped because of previous investment losses and financial sweeteners given to retirees.

Overall, the entire Public Safety Personnel Retirement System has a funding ratio of nearly 59 percent.

The system’s increasingly perilous financial condition and over-reliance on taxpayer-funded contributions caused the Legislature in 2011 to pass sweeping reforms that required those in the systems to pay more for their retirement benefits, while cost-of-living pension increases were temporarily suspended and adjustments were made for future cost-of-living raises.

A separate lawsuit that challenges members’ increased payments into the system also is working its way through the courts.

Fields and Jefferson Lankford, a retired state court judge, sued on behalf of themselves and other retirees in September 2011, claiming the Legislature’s cost-containment measures were illegal.

They cited federal contract law and Arizona’s Constitution, which was amended by voters in 1998 to say “public retirement benefits shall not be diminished or impaired.”

Though Arizona is a right-to-work state and not considered friendly to public employees or unions, it now has one of the nation’s strongest constitutional protections for public pensions.

The judges won their case in Maricopa County Superior Court, but the retirement system appealed to the state’s high court.

The Supreme Court justices held that when the Legislature curbed raises, it diminished retired members’ benefits and violated the Constitution.

The justices also noted that although they are not currently members of the pensioner class, they will be eligible for the benefit increases when they retire.

Their opinion said, “(T)he rule of necessity establishes that a judge is not disqualified because of a personal interest if no other judge is available to decide the case.”

Because a disqualification would “result in a denial of a litigant’s constitutional right,” the judges had to decide the matter, the ruling said.

Those who became elected officials or judges this year are no longer part of the plan. Gov. Jan. Brewer last year signed into law legislation that will eventually close the Elected Officials’ Retirement Plan and put new politicians into a 401(k)-style savings plan similar to that of private-sector employees.

Kavanagh, the House Appropriations chairman, said he would prefer to not make similar 401(k)-style changes to pension plans for future public-safety and corrections officers.

A defined-benefit plan is the best way to recruit public-safety employees, and it provides them with secure retirements, he said.

However, he said lawmakers may have no choice but to change those pension plans.

“If the very fortunate recipients of this system keep resisting reasonable reforms, then opponents of defined (pension) benefits will prevail, and it will be the end of them for public employees,” Kavanagh said. “Taxpayers will not continue to bail out people with platinum pensions when they are struggling.”

By Craig Harris

The Republic | azcentral.com

Thu Feb 20, 2014 11:47 AM

Jacksonville, Florida, with the third most underfunded pensions of the largest U.S. cities, is considering an unprecedented solution that may preserve its credit rating at the expense of its utility’s.

Jacksonville, rated the second level of investment grade by Moody’s Investors Service, wants JEA, which provides water and electricity to the state’s most populous city, to contribute $40 million annually to help avoid a downgrade. The utility, ranked two steps lower and trying to dodge a cut of its own, says it can’t afford the payment.

The city’s effort shows how the creditworthiness of municipalities is under pressure with state and local government pensions underfunded by at least $1 trillion, according to a January report by the Nelson A. Rockefeller Institute of Government in Albany, New York. Taking money from JEA may ultimately help the city and hurt the utility, according to Wasmer, Schroeder & Co.’s Reid Tomlin.

“The situation can be a zero-sum game if the city of Jacksonville is punting this to the utility,” said Tomlin, director of municipal research at the Naples, Florida-based firm, which oversees about $3.5 billion in munis, including JEA debt. “If you take money from the utility, there could be credit implications there as well.”

Reducing Benefits

Cities across the country have scaled back retiree benefits and searched for revenue to cover growing pension liabilities. Los Angeles and Jersey City, New Jersey, raised the retirement age and reduced payments. Allentown, Pennsylvania, leased its water and sewer system last year to help pay its pension costs.

Among the 25 largest U.S. cities, only Chicago and Philadelphia have pensions that are more underfunded than Jacksonville’s, according to a November report by Morningstar Inc. (MORN)

JEA’s “first obligation is to the ratepayers,” not solving the city’s pension woes, said Mike Hightower, chairman of the utility’s board.

“My initial reaction was, we don’t have $40 million,” Hightower said. “If we had $40 million, first we would either give it to back to our ratepayers or we would be reducing our debt.”

Cost Cutting

Jacksonville Mayor Alvin Brown, who proposed the JEA plan, said that the utility could cut costs to offset the extra payment and avoid a downgrade. The utility already transfers about $106 million annually to the city.

“For JEA to be successful, the city has to be successful,” Brown said.

Pension costs in Jacksonville have risen more than six-fold since 1992 and now account for about 19 percent of its $983.7 million annual budget.

The pension for police officers is 39 percent funded, and the city’s total $5.2 billion unfunded liability is four times the size of its operating revenue, the fourth-highest ratio in the nation, according to Moody’s.

“There’s a finite number of resources available to the operating budget and the pension has consumed an increasingly larger share very quickly,” said Michael Rinaldi, a Fitch Ratings analyst in New York.

Investment Performance

The shortfall stems from underperforming investments and generous retiree benefits, said David Draine, who has studied the city as a senior researcher at Pew Charitable Trusts. The Philadelphia-based non-profit is providing free advice to Jacksonville and other cities trying to reduce pension costs.

Moody’s said it may downgrade Jacksonville by one or two steps from Aa1 by mid-April, because of rising pension costs, Dan Seymour, a Moody’s analyst, wrote in a Jan. 15 report.

Fitch rates JEA’s bonds AA, its third-highest grade, with a stable outlook. Christopher Hessenthaler, a Fitch analyst, wrote in a Feb. 7 report that the Jacksonville mayor’s plan is a “credit concern” for JEA, formerly called the Jacksonville Electric Authority.

Aside from the pension costs, Jacksonville’s financial profile is improving, with seven consecutive years of budget surpluses and a “strong” growth in reserves, Rinaldi said. The city’s unemployment rate was 5.6 percent in December, lower than U.S. rate of 6.6 percent in January. The U.S. Navy is the city’s largest employer.

‘Stable’ Finances

Jacksonville has “a history of sound, stable financial performance, despite the pension pressures,” he said. “They have a very good track record with respect to generating surpluses at year-end.”

Jacksonville, with a population of about 836,500, is holding off on new bond sales until adopting a solution to the pension shortfall, said C. Ronald Belton, Jacksonville’s chief financial officer. Borrowing costs may go up further if the city is downgraded, he said.

JEA is in the process of selling about $74 million in refunding revenue bonds.

Brown said a $560 million contribution from JEA — $40 million annually for 14 years — may help the city’s pension system become 80 percent funded by 2028. Brown said his plan, which includes scaling back some retiree benefits, may save the city $2.75 billion over 35 years.

The utility serves more than 400,000 customers and had revenue of $1.9 billion in 2012. It has $5.6 billion in debt, which is “high” and stands as “a sensitivity to its rating,” Hessenthaler said.

Negative Outlook

Jacksonville had $2.5 billion in outstanding bonds, according to an August report by Moody’s that described the debt level as “moderate.”

In July, Brown unsuccessfully attempted to reduce worker benefits to bring down pension costs. The City Council killed the plan.

A month later, Fitch changed its outlook on Jacksonville bonds to negative, threatening to downgrade the city’s AA rating, the company’s third highest rating, “at least one notch” if the pension overhaul effort stalls. The city has not been downgraded in at least 12 years.

A city-commissioned task force has been seeking ways to cut pension costs, which have crowded out spending on education, public safety and social services.

Hightower, the JEA official, said the utility’s board would consider the city proposal. The mayor has offered to help JEA find savings in its $1.8 billion budget to offset the additional payment. If JEA’s seven board members, appointed by the mayor, sign off on the extra payment, the city council could then ratify it as part of a pension rewrite.

Yield Spread

JEA revenue bonds maturing in October 2031 traded Feb. 5 with an average yield of 3.98 percent, or about 1.94 percentage points above benchmark munis, according to data compiled by Bloomberg. The spread was the highest since April.

The average yield spread on some Jacksonville bonds has risen since Fitch revised the city’s outlook to negative in August, Bloomberg data show. Limited-obligation bonds maturing in October 2030 have had an average spread of 1.47 percentage points over benchmark debt since Aug. 27. In the five months before the outlook changed from stable to negative, the extra penalty averaged 1.18 percentage points.

Unlike other cities facing pension shortfalls, Jacksonville has not skipped payments on its required annual contribution to retiree benefits.

Jacksonville has funded its growing pension obligation by cutting services, reducing its payroll and raising taxes, Belton said. With the pension contribution set to increase to $181 million this year and continue rising, the city is looking for a plan to pay down the unfunded liability without gutting social services.

“We need to deliver if we want to maintain and enhance our city’s already strong credit rating,” Brown, a 52-year-old Democrat, said at a Jan. 29 meeting of Jacksonville’s Retirement Reform Taskforce. “A downgrade in that credit rating would not only hurt our city prestige but also hurt taxpayers.”

By Toluse Olorunnipa  Feb 19, 2014 5:00 PM PT

To contact the reporter on this story: Toluse Olorunnipa in Tallahassee, Florida at tolorunnipa@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

The city of Detroit plans to file details of a proposed swaps settlement with UBS and Bank of America Merrill Lynch within three to four days.

An attorney representing the city in its bankruptcy told Judge Steven Rhodes today of Detroit’s plans to file a third proposed settlement. Rhodes nixed the first settlement that would have paid the banks $230 million. A $165 million proposal also was shot down last month. Detroit had lined up a loan to pay for the settlements.

In 2009, Detroit pledged casino taxes as collateral to avoid defaulting on pension debt payments. The city locked itself into high interest rates on bonds. The deal became too costly when interest rates plunged.

The announcement about the settlement proposal was made at the start of a hearing about the treatment of general obligation bondholders; city attorneys argued that these bondholders should be treated as unsecured. Bruce Bennett, one of the attorneys leading Detroit’s bankruptcy case, urged Rhodes today to reject a demand by bond insurers that the city segregate taxes collected to repay certain bonds.

The bond insurers have sued Detroit, claiming a proposal by the city’s emergency manager to cut payments to general obligation bondholders is illegal. The insurers say that pledges the city made when the bonds were issued give bondholders certain rights over the taxes.

The dispute may require the judge to weigh in on a long-running debate among legal scholars about whether certain municipal bonds get priority over more traditional unsecured creditors, such as public employees or suppliers.

“There is not a lien, there is no property interest, and these creditors are just like all others,” Bennett told Rhodes.

Bennett argued the city’s pledges to bondholders are no different from those made to all unsecured creditors. Such general promises mean the municipal bonds in dispute are unsecured, he said. Detroit didn’t set aside any property that could be used as collateral for the bonds or create a special lien on the taxes, according to Bennett.

Rhodes was scheduled to hear this afternoon from lawyers for the bond insurers, including National Public Finance Guarantee Corp. and Assured Guaranty Municipal Corp.

Also up for discussion in court today: the need for an unsecured creditors committee that was formed by the U.S. Trustee. City attorneys argued that the committee should be disbanded because it is not needed and would be costly; Rhodes said he would issue a written opinion on the matter.

By Crain’s staff and wire reports

February 19, 2014 1:18 PM

Management’s discussion and analysis (MD&A) is a narrative introduction to the annual audited financial report. Intended to make the financial report easier for experienced analysts to analyze and more accessible to less-sophisticated readers, MD&A can be one of the most valuable parts of the financial report required by GASB Statement No. 34, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments.

In an environment that often allows little time to make a decision or recommendation to buy bonds, a good MD&A is a significant time saver—both for the analyst and the finance officer.

What makes for a good MD&A? In 2004-05, the GASB interviewed more than 250 users of governmental financial information, a significant majority of who lauded MD&A. They were quick to point out, however, that not all MD&A are equally useful. The best MD&A, in the estimation of bond analysts, answered the questions they typically have to call a government’s chief financial officer to ask. In an environment that often allows little time to make a decision or recommendation to buy bonds, a good MD&A is a significant time saver—both for the analyst and the finance officer.

Some MD&A, however, could be more useful. Analysts mentioned seeing boilerplate MD&A from multiple governments. It appears that the MD&As were prepared using a common template, a circumstance that runs contrary to the intended purpose of MD&A—to convey the uniquely knowledgeable insights of government’s management.

These divergent views were heard again last year when the GASB conducted 11 research roundtables in eight cities around the country, seeking feedback on Statement 34. The roundtables included a variety of types of stakeholders both inside and outside of government. They echoed the view that MD&A often was the most valuable part of the financial report but, in practice, MD&A sometimes falls short of being the valuable document it was intended to be.

Recognizing governments’ time and resource constraints, the GASB studies demonstrate that a well-written MD&A pays dividends.

What does it take to prepare a valuable MD&A, according to the GASB’s stakeholders? First, MD&A should be developed throughout the process of preparing the financial report; it is not necessary to wait until every number has been thoroughly vetted by the auditor before drafting the document.

Second, the writers of MD&A should think about the questions they commonly receive from readers and answer them proactively. MD&A is required to cover a specific set of topics, but governments can include additional information that they consider relevant to those topics.

Third, MD&A should actually discuss and analyze. When MD&A states what numbers went up and down but fails to explain why amounts changed from year to year, it does not provide useful information. No one is better situated to help the reader understand what happened during the year than a government’s finance officers, the typical authors of MD&A.

Lastly, the writers of MD&A should ask themselves, “Would my elected officials understand this? Would the taxpayers?” Communicating about financial information understandably is undoubtedly an acquired skill, yet it is one that finance officers demonstrate routinely with their governing bodies and constituents throughout their budget process. That same talent, applied to MD&A, promises to bear fruit for the preparers, auditors, and users of financial reports alike.

Feb 18 (Reuters) – Uncertainty about the future of federal transportation funding has cast a shadow over many U.S. states’ highway and transit agencies, and Moody’s Investors Service on Tuesday downgraded the ratings of 16 municipal bond issues tied to U.S. road money.

Known as “GARVEES” for Grant Anticipation Revenue Vehicles, the bonds are repaid through federal transportation grants. The rating agency said it had decided to cut the scores of those GARVEES that rely solely on federal monies and lack cash-funded debt reserves or other structural protections against possible interruption to the flow of federal money.

“The downgrades reflect changes in federal liquidity management which increase the risk of interruption of timely payments of federal transportation aid due to states and transit entities,” Moody’s said in a statement. “These include the government’s recurring episodes of threatened debt ceiling expirations, government shutdowns, and the threat of depletion of the highway trust fund balance later this year due to the fund’s persistent structural imbalance.”

The major funding bill for the nation’s roads and bridges, commonly called the Highway Bill, is set to expire at the end of September.

While the Senate public works committee is aiming to finish drafting a new version by April, governors and mayors are worried the legislative process will drag out and tie up money for much-needed repairs.

The current authorization took three years to work its way through Congress before it was passed in 2012, and states had to rely on temporary funding measures that left them unable to commit to major projects.

Meanwhile, the federal account used for transportation, which is funded by a tax of 18.4 cents per gallon charged motorists at the pump, will likely go broke next year.

Moody’s cut most of the ratings to A1 from Aa3. Those GARVEES were issued by agencies in California, Georgia, Idaho, Kentucky, Maine, Michigan, Montana, New Hampshire, North Carolina, Oklahoma, Rhode Island, Washington, West Virginia and Washington, D.C.

It also cut the ratings of GARVEES issued by Michigan as well as agencies in New Jersey to A2 from A1.

The agency did not say how much debt was affected.

WASHINGTON Tue Feb 18, 2014 6:01pm EST

The Los Angeles Unified School District, the nation’s largest outside New York City, owes so much for retiree health care that paying off its debt would cost $17,500 for each student — and there are 640,000 of them.

Local governments typically haven’t been punished by investors for underfunding retiree health care and insurance, unlike pensions. Investors believe that, in a pinch, the governments can walk away from the obligations, said Michael Ginestro, head of fixed-income research for Bel Air Investment Advisors LLC, which manages $2.8 billion in Los Angeles.

A group of California state court decisions have upended that assumption, treating “other post-employment benefits,” or OPEB, as vested rights that can be changed only through contract negotiations. The decisions threaten to add to the fiscal strains of cities and counties whose pension obligations are already putting pressure on their creditworthiness.

“If push comes to shove, they can be impaired,” Ginestro said. “It is a big concern. One of the things we look at is whether they’re addressing it with a reserve. If not, it’s a credit negative.”

U.S. states have $529 billion in unfunded liabilities for non-pension retirement benefits, down 3 percent in two years, Standard & Poor’s said in a November 2013 report. The states have $833 billion in unfunded pension liabilities and $488 billion in tax-supported debt such as bonds, according to the report.

Mixed Signals

California courts, in four separate cases, have differed on how much leeway public agencies have in changing retiree health-care and insurance benefits.

The California Supreme Court ruled in 2011, in a case in which Orange County retirees had sued to keep their health insurance premiums pooled with those of active workers, that it was possible for a county to be bound by implied contract terms involving health benefits for retirees.

In Los Angeles, Superior Court Judge Luis A. Lavin in September blocked the city from threatening to freeze the health-care subsidies of retirees unless their unions agreed to an employee contribution of 4 percent. The judge said workers had a vested right to the health insurance premium subsidy.

Voter Approved

In San Jose, Superior Court Judge Patricia Lucas issued a tentative decision on Dec. 19 striking down part of a voter-approved overhaul of public worker retirement benefits.

Unfunded pension liabilities are the responsibility of the city, the judge said, barring San Jose from demanding higher employee contributions. However, she ruled that the city can require employees to contribute to unfunded retiree health care liabilities. The judge said city employees had a vested right to pay no more than 50 percent of the costs of retiree health care, according to the ruling.

On Dec. 26, the California Court of Appeal in San Diego upheld a lower court’s ruling that the city could cap its contribution to health care premiums of retired police officers because it wasn’t a vested benefit.

“Retiree health is not a benefit under the retirement system; it is an employment benefit that is renegotiated every few years by the city’s labor organizations and the city,” the appellate court said in a unanimous decision.

The decision may reduce San Diego’s unfunded liability for the benefits by 31 percent, to $969 million from $1.4 billion, Moody’s Investors Service said in a Jan. 9 note.

Challenge Assumption

The Los Angeles decisions directly affected a small number of workers. Its effect was broader, Fitch Ratings said in an October note, by challenging the assumption that retiree health care is more flexible than pensions.

“This decision shows that enacted pension and OPEB reforms could be successfully challenged in court and other forums,” Fitch analyst Jessalyn Moro wrote of the Los Angeles ruling, concluding that the ruling could harm the credit of numerous local governments.

The growing health-care liabilities should concern investors, said Scott Minerd, global chief investment officer of Guggenheim Partners in Santa Monica, California.

It’s often difficult for municipal investors to determine how much local governments owe, because unlike pensions, there’s no standard for how to report the retiree health liabilities, Minerd said.

“There are a lot of liabilities piling up that are going to have to be paid,” Minerd said by telephone. “Something will have to be done akin to Proposition B in San Diego.”

Rolled Back

Voters in California’s second-largest city in 2012 rolled back retirement benefits by placing new non-police employees in 401(k)-style plans and by limiting San Diego’s contribution to retirement benefits.

Two years earlier, San Diego froze its contribution for retiree health care, prompting a lawsuit from former employees. A state court judge ruled that unlike pensions, retiree health care can be modified without a vote of current and retired workers.

The Los Angeles school district, with $7 billion in operating funds, is paying $50.6 million to partially pre-pay retiree health care this year. It projects that cost will grow to $75.9 million next year and $113.9 million in the school year ending in 2016. The district expects to pay about $305.4 million this year toward pensions.

The school system has an unfunded liability for OPEB of $11.2 billion over 30 years, according to its 2012 annual report. In November, the school board established a trust fund for retiree health care, said Gayle Pollard-Terry, a spokeswoman.

Liabilities Fall

Contra Costa County, east of San Francisco, is being sued after reducing unfunded retiree health liabilities to $1.02 billion in 2010. The plan’s assets covered just 6.3 percent of expected costs, according to an annual report.

The liabilities fell from $2.57 billion in 2006 after the county stopped offering retirement health care to new employees, said David Twa, the county administrator. The county also capped its contribution to health insurance, drawing a lawsuit from retirees that’s pending, Twa said.

The county’s unfunded liability for retiree health care is about half the total for pensions, he said.

“It is a risk,” Twa said. “We’re trending in the right direction. We have a long way to go.”

Court rulings in retiree health care cases will be critical to the fiscal health of California cities and counties, said Arthur Hartinger, a principal at Meyers Nave Riback Silver & Wilson in Oakland, California, who has represented cities in lawsuits over retirement guarantees.

Many local governments underestimated costs of both pensions and retiree health care, leading to shortfalls in plans and costs that eat into law enforcement and other public services, he said

“It all comes down to what obligations were granted in the first place,” Hartinger said in a telephone interview.

To contact the reporters on this story: James Nash in Los Angeles at jnash24@bloomberg.net;

Edvard Pettersson in Federal court in Los Angeles at

epettersson@bloomberg.net

To contact the editors responsible for this story: Stephen Merelman at smerelman@bloomberg.net; Michael Hytha at mhytha@bloomberg.net

By James Nash and Edvard Pettersson  Feb 18, 2014 6:44 PM PT

Municipal governments not exempt from ACA-driven fee increases in health coverage.

For a municipal government, a little less than $1,000 a month might not seem like much.

But the village of Berrien Springs, Mich., isn’t your average municipality, says Milt Richter, the village president, not with its 11 full-time employees and a declining population of 1,800. So when it was notified recently that its monthly health insurance cost had risen by $983 a month, it caught Richter’s attention.

He wasn’t happy and still isn’t. Blaming the increase on provisions in the Affordable Care Act, or Obamacare as it’s generally known, Richter fired off a letter to U.S. Rep. Fred Upton, R-St. Joseph. The chairman of the House Energy and Commerce Committee and an outspoken critic of the ACA, Upton responded Wednesday by meeting in Berrien Springs with Richter and other municipal leaders.

At a news conference that followed, the congressman said those local officials expressed complaints similar to Richter’s. In the city of St. Joseph, health-insurance costs jumped $75,000 a year, he said, adding the situation was similar in the much smaller municipality of Chikaming Township.

“I listened for a good hour. It reminded me of ‘If you like your health care plan, you can keep it,’’’ Upton said, invoking President Barack Obama’s pre-ACA pledge that turned out to be false when many U.S. policyholders discovered their coverage had either been dropped or costs had increased significantly.

The situation prompted Upton to author the “Keep Your Health Plan Act’’ that passed the House with bipartisan support 261-157. Although the Senate didn’t take it up in 2013, Upton said it could resurface this year.

Contacted by The Tribune, Paul Clements, the Kalamazoo Democrat who will seek Upton’s 6th District seat in the fall general election, released the following statement:

“I agree with Congressman Upton that policyholders should be able to keep their plans for another year and that we must hold the White House accountable when they fail to make basic technology work,’’ he said, referring in part to problems Americans have had signing up for insurance on state registries.

“However, where we disagree is that I do not think insurance companies should be allowed to deny coverage to people with pre-existing conditions, discriminate against women or drive up prescription costs for seniors, which is precisely what would happen under Fred Upton’s plan. That’s not acceptable.’’

As for other possible changes to the ACA not related to costs, Upton mentioned U.S. Sen. Joe Donnelly’s bill to change the legislation’s 30-hours–per-week definition for full-time employees to 40. As it stands, Donnelly, a Democrat from Granger, has said some employers have attempted to reduce the minimum employee count mandate for offering insurance by cutting back workers’ hours to less than the 30-hours-per-week threshold.

“I remain encouraged we can make some fixes to a pretty flawed bill,’’ Upton said.

Richter said that when village officials received notification of the cost hike, they initially believed the village was exempt based on its tax exemption as a municipal government. However, it was later informed no one is exempt from the charges, he said.

In his letter to Upton, Richter said adding such “a huge fee for such a municipality is a real injustice.’’

“Our employees do not make top-dollar incomes and to pass this increase on to them would be unfair. It is also unfair to expect our village residents to carry this burden,’’ Richter wrote.

Upton asked that leaders of municipal governments with similar concerns contact him so he can discuss the issues with colleagues and possibly legislate changes. Letters can be sent to his local office at 800 Centre, Suite 106, 800 Ship Street in St. Joseph, MI, 49085.

Upton promised the ACA problems “won’t be swept under the rug,’’ mentioning other pre-legislation claims such as a $2,500 annual reduction in policyholders’ premiums.

“Let’s face it. It’s a mess right now,’’ he said.

Richter said it’s evident the ACA isn’t as affordable as touted.

“What scares me more is what’s coming down the road,’’ he said.

BY LOU MUMFORD, MCCLATCHY NEWS SERVICE / FEBRUARY 20, 2014

©2014 the South Bend Tribune (South Bend, Ind.)

Detroit’s latest plan to reduce its $18 billion debt load and exit bankruptcy guarantees police and firefighters at least 90 percent of their pensions, while giving bondholders only about 20 percent of what they are owed.

The city’s debt-adjustment plan, filed today in U.S. Bankruptcy Court in Detroit, provides more details for creditors, who saw an early draft of the proposal last month.

With the filing, Detroit begins a new, potentially more litigious phase of the biggest U.S. municipal bankruptcy. Unless confidential mediation sessions produce settlements, U.S. Bankruptcy Judge Steven Rhodes will be asked to approve the plan over creditor objections, including those from unions that lashed out at the city today.

“The proposed plan of adjustment is a gut punch to Detroit city workers and retirees,” the American Federation of State, County and Municipal Employees said in a statement. “Retirees cannot survive these huge cuts to the pensions they earned. The plan is unfair and unacceptable.”

Under the plan, the city’s retired general employees, represented by AFSCME, wouldn’t get as much as police and firefighters. If Rhodes approves the plan as-is, the general workers would be forced to take 66 percent of their current pensions. If the workers voluntarily accept the proposal, they would get 74 percent, and police and firefighters 96 percent, according to the filing.

Retiree Committee

A committee approved by Rhodes to represent more than 23,500 retired city workers in the case also condemned the plan, claiming in a statement that the proposal would force 20 percent of current city retirees into poverty in the next 10 years.

The new plan reduces what the city said last month it would pay investors who hold two types of general obligation bonds. The limited and unlimited versions of the bonds would be paid only 20 percent of about $539 million outstanding, down from a maximum of 31 percent and 48 percent respectively.

Bond insurers, who would be expected to pay any losses on the bonds they back, have sued the city, arguing that the debt is guaranteed by property taxes and should have a higher repayment priority than other creditors, such as retired city workers.

The proposal doesn’t include any cash for creditors from a potential new source of money, the creation of a Great Lakes Water and Sewer Authority, which would take over those responsibilities from the city. Detroit has said it wants to create the authority and then lease its water and sewer operations to it to boost creditor recoveries.

Water Bonds

Under the plan the city would fully repay water and sewer bonds, as well as other debt that is backed by collateral.

Detroit water bonds maturing in July 2034 traded today at 94.5 cents on the dollar, the highest since July 17, the day before the city’s bankruptcy filing, according to data compiled by Bloomberg. Yesterday the debt exchanged hands 20 times, the most since July 23, the data show. The securities are insured by Assured Guaranty Municipal Corp.

Detroit filed for bankruptcy on July 18 after decades of decline, saying it couldn’t pay creditors while also providing basic services. The city’s emergency manager, Kevyn Orr, set an aggressive timetable for the case, seeking to finish by September 2014, when he can be removed from his post by the City Council.

Auto Center

Once the center of the U.S. auto industry, Detroit has seen factory jobs dwindle in recent decades. During the financial crisis, General Motors Co. and Chrysler Group LLC went through bankruptcies of their own. Both companies have since reorganized and are thriving again, while the city continues to cope with broken streetlights, blighted neighborhoods and overstretched emergency services.

The plan is meant to both cut debt and reinvest in the city, Orr said in a statement. Under the proposal, Detroit would spend $1.5 billion over 10 years on capital improvements and equipment and technology upgrades. As much as $500 million of that would be spent in the next five years on blight removal in a city with tens of thousands of abandoned properties.

Rhodes initially must decide whether the proposal contains enough information for creditors to vote on it. In court on Feb. 19, the judge said he expected the city to keep talking to creditors even after a plan was filed.

More Talks

“Mediation won’t be over until every last single issue has been settled or decided by me,” Rhodes warned the parties this week during a court hearing. “Maybe even it will continue until the case is on appeal.”

Rhodes encouraged the city to reach an agreement over what priority to assign some bond debt. If the judge is forced to rule on the matter, he may choose to lump the bondholders in with other unsecured creditors, such as pension funds and suppliers, a precedent that could make it costlier for other municipalities to raise money.

In December, Rhodes found the city eligible for bankruptcy protection, overruling the unions that want the case dismissed. Earlier today, the unions and retired public workers won permission to take their challenge to the city’s eligibility directly to a federal appeals court, bypassing the district court, possibly speeding up a resolution.

Orr and Michigan Governor Rick Snyder, the Republican who appointed him, both said after July’s bankruptcy filing that the September deadline would be hard to meet. Should they succeed, Detroit, whose case involves more than twice the debt of all four of the largest municipal bankruptcies since 2008 combined, would also be the fastest to complete the process.

Cram-Down

After a vote, creditors can raise further objections at a confirmation hearing. Rhodes will take the votes and the objections into account before deciding whether to confirm the plan. Bankruptcy law permits him to override a “no” vote through a process known as a cram-down.

The city of Vallejo, California, needed more than three years to win court approval of its debt-adjustment plan and end the active part of its bankruptcy. Jefferson County, Alabama, took more than two years to complete its $4 billion case, while the California cities of Stockton and San Bernardino have been under court supervision since mid-2012.

San Bernardino hasn’t yet filed its debt-adjustment plan, while the earliest Stockton could win approval of its plan is May, according to court records.

The case is In re City of Detroit, 13-bk-53846, U.S. Bankruptcy Court, Eastern District of Michigan (Detroit).

By Steven Church  Feb 21, 2014 10:57 AM PT

To contact the reporter on this story: Steven Church in Wilmington, Delaware, at schurch3@bloomberg.net

To contact the editor responsible for this story: Andrew Dunn at adunn8@bloomberg.net

Disagreement from both bond insurers and unions signals a more contentious negotiation phase

Detroit’s plan to end its $18 billion bankruptcy assumes bondholders offered 20 cents on the dollar will eventually swallow a deal that guarantees police and firefighters collect 90 percent of their pensions.

The city’s debt-adjustment plan, filed on Friday in U.S. Bankruptcy Court in Detroit, is built on $820 million in contributions from private foundations and the state. Those groups say no money will flow without a settlement that protects the city’s valuable art collection from liquidation by bondholders and other creditors.

Within hours of the plan being filed, the creditors that city officials must win over rejected the proposal, even as they continue talking behind closed doors. Unions and bond insurers both registered their displeasure.

“While we understand that favoring pensioners and discriminating against bondholders and other creditors might be politically popular, we believe this is contrary to bankruptcy law and will result in costly litigation that will hamper the city’s emergence from bankruptcy,” Steve Spencer, a financial adviser for bond insurer FGIC Corp., said in an e-mailed statement.

The filing opens a new, potentially more contentious phase of the biggest U.S. municipal bankruptcy. Unless confidential mediation sessions produce settlements, U.S. Bankruptcy Judge Steven Rhodes will be asked to approve the plan over objections from creditors, including unions.

‘Gut Punch’

“The proposed plan of adjustment is a gut punch to Detroit city workers and retirees,” the American Federation of State, County and Municipal Employees said in a statement. “Retirees cannot survive these huge cuts to the pensions they earned. The plan is unfair and unacceptable.”

Under the plan, the city’s retired general employees, represented by AFSCME, wouldn’t get as much as police and firefighters. If Rhodes approves the plan as-is, the general workers would be forced to take 66 percent of their current pensions. If the workers voluntarily accept the proposal, they would get 74 percent, and police and firefighters 96 percent, according to the filing.

A committee approved by Rhodes to represent more than 23,500 retired city workers in the case also condemned the plan, claiming in a statement that the proposal would force 20 percent of current city retirees into poverty in the next 10 years.

Offers Less

The new plan offers less than what the city said last month it would pay investors who hold two types of general obligation bonds. The limited and unlimited versions of the bonds would be paid only 20 percent of about $539 million outstanding, down from a maximum of 31 percent and 48 percent respectively.

Bond insurers, who would be expected to pay any losses on the bonds they back, have sued the city, arguing that the debt is guaranteed by property taxes and should have a higher repayment priority than other creditors, such as retired city workers.

‘All In’

The city’s emergency financial manager, Kevyn Orr, told reporters yesterday that the $820 million contribution hinges on an “all in” deal.

“We need a settlement from everybody,” he said. The foundations supplying the money are trying to protect the artwork in the city-owned Detroit Institute of Arts.

The proposal filed yesterday doesn’t include any cash for creditors from a potential new source: a Great Lakes Water and Sewer Authority, which would take over responsibilities from the city. Detroit has said it wants to create the authority and then lease its water and sewer operations to it to boost creditor recoveries.

Under the plan, the city would fully repay water and sewer bonds, as well as other debt that’s backed by collateral.

Water Bonds

Detroit water bonds maturing in 2041 fell more than 1 percent on Friday to 87.6 cents on the dollar, according to data compiled by Bloomberg.

Detroit filed for bankruptcy on July 18 after decades of decline, saying it couldn’t pay creditors while also providing basic services. Orr set an aggressive timetable for the case, seeking to finish by September 2014, when he can be removed from his post by the City Council.

Once the center of the U.S. auto industry, Detroit has seen factory jobs dwindle in recent decades. During the financial crisis, General Motors Co. and Chrysler Group LLC went through bankruptcies of their own. Both companies have since reorganized and are thriving again, while the city continues to cope with broken streetlights, blighted neighborhoods and overstretched emergency services.

Reinvestment Plan

The plan is meant to both cut debt and reinvest in the city, Orr said in a statement. Under the proposal, Detroit would spend $1.5 billion over 10 years on capital improvements and equipment and technology upgrades. As much as $500 million of that would be spent in the next five years on blight removal in a city with tens of thousands of abandoned properties.

Rhodes initially must decide whether the proposal contains enough information for creditors to vote on it. He has said he expected the city to keep talking to creditors even after a plan was filed.

“Mediation won’t be over until every last single issue has been settled or decided by me,” Rhodes warned the parties this week during a court hearing. “Maybe even it will continue until the case is on appeal.”

Eligibility Appeal

In December, Rhodes found the city eligible for bankruptcy protection, overruling the unions that want the case dismissed. Yesterday, the unions and retired public workers won permission to take their challenge to the city’s eligibility directly to a federal appeals court, bypassing the district court, possibly speeding up a resolution.

Orr’s plan would reduce benefits for some retirees who may have benefited from an annuity savings plan operated by the pension system. The optional savings plan boosted payouts by hundreds of thousands of dollars for some retirees who contributed their own money and reaped a guaranteed investment return, even in years when the pension fund lost money in the market.

Money paid from the pension fund to the annuity savings program from 1999 through 2012 would be put back in the fund. Orr didn’t divulge how much the restitution would cost the employees and retirees who may have received the payments, which totaled about $756 million from 1985 through 2007, according to city records.

Retirement Restrictions

The plan also places restrictions on the city’s two retirement programs, and leaves open the door to changing their governing boards under a mediated settlement that includes Republican Governor Rick Snyder and the GOP-controlled legislature. The pension board would be required to limit to 6.25 percent their expected returns on investment.

After a vote, creditors can raise further objections at a confirmation hearing. Rhodes will take the votes and the objections into account before deciding whether to confirm the plan. Bankruptcy law permits him to override a “no” vote through a process known as a cram-down.

Feb 23, 2014 @ 11:12 am (Updated 12:44 pm) EST

Citations: S. 1957; Partnership to Build America Act of 2014

S. 1957, the Partnership to Build America Act of 2014, introduced by Senate Finance Committee member Michael F. Bennet, D-Colo., would establish a fund to provide bond guarantees to states, localities, and infrastructure providers for infrastructure investments, and provide a foreign earnings exclusion for the purchase of infrastructure bonds.

113TH CONGRESS

2D SESSION

S. 1957

To establish the American Infrastructure Fund, to provide

bond guarantees and make loans to States, local governments,

and infrastructure providers for investments in certain

infrastructure projects, and to provide equity investments

in such projects, and for other purposes.

IN THE SENATE OF THE UNITED STATES

JANUARY 16, 2014

Mr. BENNET (for himself, Mr. BLUNT, Mr. WARNER, Ms. AYOTTE, Ms.

LANDRIEU, Mr. KING, Mr. GRAHAM, Mr. COATS, Mr. HOEVEN, Mr. BEGICH,

and Mr. KIRK) introduced the following bill; which was read twice and

referred to the Committee on Finance

A BILL

To establish the American Infrastructure Fund, to provide bond guarantees and make loans to States, local governments, and infrastructure providers for investments in certain infrastructure projects, and to provide equity investments in such projects, and for other purposes.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the “Partnership to Build America Act of 2014”.

SEC. 2. AMERICAN INFRASTRUCTURE FUND.

(a) AMERICAN INFRASTRUCTURE FUND. —

(1) IN GENERAL. — There is established a wholly owned Government corporation —

(A) which shall be called the American Infrastructure Fund (referred to in this Act as the “AIF”);

(B) which shall be headed by the Board of Trustees established under subsection (b);

(C) which may have separate subaccounts or subsidiaries for funds used to make loans, bond guarantees, and equity investments under this section;

(D) which shall be available to the AIF to pay for the costs of carrying out this section, including the compensation of the Board and other employees of the AIF; and

(E) the funds of which may be invested by the Board in such manner as the Board determines appropriate.

(2) DEPOSITS TO AIF. — All funds received from bond issuances, loan payments, bond guarantee fees, and any other funds received in carrying out this section shall be held by AIF.

(3) LIMITATIONS. — The charter of the AIF shall limit its activities to those activities described as the mission of the Board under subsection (b)(2).

(4) OVERSIGHT. — The AIF shall register with the Securities and Exchange Commission and the Chairman shall report to Congress annually as to whether the AIF is fulfilling the mission of the Board under subsection (b)(2).

(5) TREATMENT OF AIF. —

(A) ACCOUNTS. — Title 31, United States Code, is amended in each of sections 9107(c)(3) and 9108(d)(2) —

(i) by inserting “the American Infrastructure Fund,” after “the Regional Banks for Cooperatives,”; and

(ii) by striking “those banks” and inserting “those entities”.

(B) BONDS. — Section 149(b)(3)(A)(i) of the Internal Revenue Code of 1986 is amended by inserting “American Infrastructure Fund,” after “Federal Home Loan Mortgage Corporation,”.

(b) BOARD OF TRUSTEES. —

(1) IN GENERAL. — There is established a Board of Trustees of the AIF (referred to in this subsection as the “Board”), which shall be composed of 9 members who —

(A) have substantial experience in bond guarantees or municipal credit; and

(B) to the greatest extent practicable, have extensive experience working with municipal credit, risk management, and infrastructure finance.

(2) MISSION. — The mission of the Board is —

(A) to operate the AIF and its subsidiaries to be a low cost provider of bond guarantees, loans, and equity investments to State and local governments and infrastructure providers for urban and rural infrastructure projects that —

(i) provide a positive economic impact; and

(ii) meet such other standards as the Board may develop;

(B) to operate the AIF in a self-sustaining manner so as to allow the AIF to repay its infrastructure bonds when such bonds are due;

(C) to not have a profit motive, but to seek at all times to pursue its mission of providing low cost bond guarantees and loans while —

(i) covering its costs;

(ii) maintaining such reserves as may be needed; and

(iii) applying prudent underwriting standards;

(D) to only consider projects put forth by State and local governments and not to seek projects directly;

(E) to always make clear that no taxpayer money supports the AIF or ever will support the AIF; and

(F) to engage in no other activities other than those permitted under this section.

(3) MEMBERSHIP. —

(A) INITIAL MEMBERS. —

(i) APPOINTMENT. — Not later than 150 days after the date on which bonds are first issued under subsection (d), the President shall appoint, with the advice and consent of the Senate, as members of the Board —

(I) 2 individuals from a list of at least 5 individuals selected by the Speaker of the House of Representatives;

(II) 2 individuals from a list of at least 5 individuals selected by the Minority Leader of the House of Representatives;

(III) 2 individuals from a list of at least 5 individuals selected by the Majority Leader of the Senate;

(IV) 2 individuals from a list of at least 5 individuals selected by the Minority Leader of the Senate; and

(V) 1 individual selected at will by the President.

(ii) SUBMISSION OF LISTS. — Each of the lists described in clause (i) shall be submitted to the President not later than 90 days after the date on which bonds are first issued under subsection (d). If any of such lists are submitted after the date required under this clause, the President may appoint the 2 members of the Board who were to be selected from such list at will.

(B) STAGGERED TERMS. — The members of the Board appointed pursuant to subparagraph (A)(i) shall serve staggered terms, with 2 each of the initial members of the Board serving for terms of 5, 6, 7, and 8 years, respectively, and the initial Chair selected under subparagraph (D) serving for 9 years. The decision of which Board members, other than the Chair, serve for which initial terms shall be made by the members of the Board drawing lots.

(C) ADDITIONAL MEMBERS. —

(i) IN GENERAL. — Except as provided in subparagraph (A), if the term of a member of the Board expires or otherwise becomes vacant, the President shall appoint a replacement for such member, with the advice and consent of the Senate, from among a list of at least 5 individuals submitted by the Board.

(ii) TERM OF SERVICE. —

(I) IN GENERAL. — Each member of the Board appointed to replace a member whose term is expiring shall serve for a 7-year term.

(II) VACANCIES. — Any member of the Board appointed to fill a vacancy occurring before the expiration of the term to which that member’s predecessor was appointed shall be appointed only for the remainder of the term.

(D) CHAIR. — The members of the Board shall choose 1 member to serve as the Chair of the Board for a term of 7 years, except that the initial Chair shall serve for a term of 9 years, pursuant to subsection (B).

(E) CONTINUATION OF SERVICE. — Each member of the Board may continue to serve after the expiration of the term of office to which that member was appointed until a successor has been appointed.

(F) CONFLICTS OF INTEREST. — No member of the Board may have a financial interest in, or be employed by, a Qualified Infrastructure Project (“QIP”) related to assistance provided under this section or any entity that has purchased bonds under subsection (d). Owning municipal credit of any State or local government or owning the securities of a diversified company that engages in infrastructure activities, provided those activities constitute less than 20 percent of the company’s revenues, or investing in broadly held investment funds shall not be deemed to create a conflict of interest. The Board may issue regulations to define terms used under this subparagraph.

(4) COMPENSATION. — The members of the Board shall be compensated at an amount to be set by the Board, but under no circumstances may such compensation be higher than the rate prescribed for level IV of the Executive Schedule under section 5315 of title 5, United States Code.

(5) STAFF. — The Board shall employ and set compensation for such staff as the Board determines as is necessary to carry out the activities and mission of the AIF, and such staff may be paid without regard to the provisions of chapter 51 and subchapter III of chapter 53, United States Code, relating to classification and General Schedule pay rates.

(6) PROCEDURES. — The Board shall establish such procedures as are necessary to carry out this section.

(7) CORPORATE GOVERNANCE STANDARDS. —

(A) BOARD COMMITTEES GENERALLY. — The Board shall maintain all of the committees required to be maintained by the board of directors of an issuer listed on the New York Stock Exchange as of the date of the enactment of this section.

(B) RISK MANAGEMENT COMMITTEE. — The Board shall maintain a risk management committee, which shall —

(i) employ additional staff who are certified by the Board as having significant and relevant experience in insurance underwriting and credit risk management; and

(ii) establish the risk management policies used by the Board.

(C) STANDARDS. — The Board shall, to the extent practicable, follow all standards with respect to corporate governance that are required to be followed by the board of directors of an issuer listed on the New York Stock Exchange as of the date of the enactment of this section.

(8) BIENNIAL REPORTS. — Not less frequently than once every 2 years, the Board shall produce a report that describes, of the materials, goods, and products that were used to construct, or to support the construction of, qualified infrastructure projects (as described in subsection (c)) and received financing from the American Infrastructure Fund within the most recent 2 calendar years, the percentage of such materials, goods, and products that were created, sourced, or manufactured in the United States.

(c) INFRASTRUCTURE INVESTMENT. —

(1) ENTITIES ELIGIBLE FOR ASSISTANCE. — The AIF may provide assistance to State and local government entities, nonprofit infrastructure providers, private parties, and public-private partnerships (referred to in this section as “eligible entities”) to help finance qualified infrastructure projects (referred to in this subsection as “QIPs”).

(2) FORMS OF ASSISTANCE. — The AIF may —

(A) provide bond guarantees to debt issued by eligible entities;

(B) make loans, including subordinated loans, to eligible entities; and

(C) make equity investments in QIPs.

(3) QUALIFIED INFRASTRUCTURE PROJECTS. — A project qualifies as a QIP under this section if —

(A) the project is sponsored by a State or local government;

(B) the infrastructure is, or will be, owned by a State or local government;

(C) the project involves the construction, maintenance, improvement, or repair of a transportation, energy, water, communications, or educational facility; and

(D) the recipient of bond guarantees, loans, equity investments, or any other financing technique authorized under this Act provides written assurances prescribed by the AIF that the project will be performed in compliance with the requirements of all Federal laws that would otherwise apply to similar projects to which the United States is a party.

(4) APPLICATION FOR ASSISTANCE. —

(A) IN GENERAL. — A State or local government that wishes to receive a loan or bond guarantee under this section shall submit an application to the Board in such form and manner and containing such information as the Board may require.

(B) REQUIREMENT FOR PUBLIC SPONSORSHIP OF PRIVATE ENTITIES. — A private entity may only receive a bond guarantee, loan, or equity investment under this section if the State or local government for the jurisdiction in which the nonprofit infrastructure provider or private partner is located submits an application pursuant to subparagraph (A) on behalf of such nonprofit infrastructure provider or private partner.

(5) LIMITATIONS ON SINGLE STATE AWARDS. —

(A) ANNUAL LIMITATION. — The Board shall set an annual limit, as a percentage of total assistance provided under this section during a year, on the amount of assistance a single State (including local governments and other infrastructure providers within such State) may receive in assistance provided under this section.

(B) CUMULATIVE LIMITATION. — The Board shall set a limit, as a percentage of total assistance provided under this section outstanding at any one time, on the amount of assistance a single State (including local governments and other infrastructure providers within such State) may receive in assistance provided under this section.

(6) LOAN SPECIFICATIONS. — Loans made under this section shall have such maturity and carry such interest rate as the Board determines appropriate.

(7) BOND GUARANTEE. — The Board shall charge such fees for Bond guarantees made under this section as the Board determines appropriate.

(8) EQUITY INVESTMENTS. — With respect to a QIP, the amount of an equity investment made by the AIF in such QIP may not exceed 20 percent of the total cost of the QIP.

(9) PUBLIC-PRIVATE PARTNERSHIP REQUIREMENTS. — At least 35 percent of the assistance provided under this section shall be provided to QIPs for which at least 10 percent of the financing for such QIPs comes from private debt or equity.

(10) PROHIBITION ON PRINCIPAL FORGIVENESS. — With respect to a loan made under this section, the Board may not forgive any amount of principal on such loan.

(d) AMERICAN INFRASTRUCTURE BONDS. —

(1) IN GENERAL. — Not later than 90 days after the date of the enactment of this Act, the Secretary, acting through the AIF, shall issue bonds, which shall be called “American Infrastructure Bonds”. The proceeds from the American Infrastructure Bonds shall be deposited into the AIF.

(2) FORMS AND DENOMINATIONS; INTEREST. — American Infrastructure Bonds shall —

(A) be in such forms and denominations as determined by the Secretary, and shall have a 50-year maturity; and

(B) bear interest of 1 percent.

(3) NO FULL FAITH AND CREDIT. — Interest and principal payments paid to holders of American Infrastructure Bonds shall be paid from the AIF, to the extent funds are available, and shall not be backed by the full faith and credit of the United States.

(4) AMOUNT OF BONDS. — The aggregate face amount of the bonds issued under this subsection shall be $50,000,000,000.

(5) SALE OF AMERICAN INFRASTRUCTURE BONDS. —

(A) COMPETITIVE BIDDING PROCESS. — The Secretary shall sell $50,000,000,000 of American Infrastructure Bonds —

(i) through a competitive bidding process that encourages aggressive bidding;

(ii) with prospective purchasers bidding on how low of a multiplier they will accept (for purposes of subsection (b)(1) of section 966 of the Internal Revenue Code of 1986) when purchasing the American Infrastructure Bonds, for purposes of applying the foreign earnings exclusion described under that section; and

(iii) in a manner that ensures no entities participating in the bidding may collude or coordinate their bids.

(B) LIMITATION. — The multiplier described in subparagraph (A)(ii) may not be greater than 6.

(6) REIMBURSEMENT OF COSTS. — The Board shall repay the Secretary, from funds in the AIF, for the costs to the Secretary in carrying out this subsection.

(e) ADDITIONAL BONDS. —

(1) IN GENERAL. — The Board may issue such other bonds as the Board determines appropriate, the proceeds from which shall be deposited into the AIF.

(2) NO FULL FAITH AND CREDIT. — Interest and principal payments paid to holders of bonds issued pursuant to paragraph (1) shall be paid from the AIF, to the extent funds are available, and shall not be backed by the full faith and credit of the United States.

(f) DEFINITIONS. — For purposes of this section:

(1) INFRASTRUCTURE PROVIDER. — The term “infrastructure provider” means an entity that seeks to finance a QIP.

(2) SECRETARY. — The term “Secretary” means the Secretary of the Treasury.

(3) STATE. — The term “State” means each of the several States, the District of Columbia, any territory or possession of the United States, and each Federally recognized Indian tribe.

SEC. 3. FOREIGN EARNINGS EXCLUSION FOR PURCHASE OF INFRASTRUCTURE BONDS.

(a) IN GENERAL. — Subpart F of part III of subchapter N of chapter 1 of the Internal Revenue Code of 1986 is amended by adding at the end the following new section:

“SEC. 966. FOREIGN EARNINGS EXCLUSION FOR PURCHASE OF INFRASTRUCTURE BONDS.

“(a) EXCLUSION. — In the case of a corporation which is a United States shareholder and for which the election under this section is in effect for the taxable year, gross income does not include an amount equal to the qualified cash dividend amount.

“(b) QUALIFIED CASH DIVIDEND AMOUNT. — For purposes of this section, the term ‘qualified cash dividend amount’ means an amount of the cash dividends which are received during a taxable year by such shareholder from controlled foreign corporations equal to —

“(1) the multiplier determined under section 2(d)(5) of the Partnership to Build America Act of 2014 for such shareholder, multiplied by

“(2) the face amount of qualified infrastructure bonds acquired at its original issue (directly or through an underwriter) by such shareholder.

“(c) LIMITATIONS. —

“(1) IN GENERAL. — The amount of dividends taken into account under subsection (a) for a taxable year shall not exceed the lesser of —

“(A) the cash dividends received by the taxpayer for such taxable year, or

“(B) the amount shown on the applicable financial statement as earnings permanently reinvested outside the United States.

“(2) DIVIDENDS MUST BE EXTRAORDINARY. — The amount of dividends taken into account under subsection (a) shall not exceed the excess (if any) of —

“(A) the cash dividends received during the taxable year by such shareholder from controlled foreign corporations, over

“(B) the annual average for the base period years of the cash dividends received during each base period year by such shareholder from controlled foreign corporations.

“(3) REDUCTION OF BENEFIT IF INCREASE IN RELATED PARTY INDEBTEDNESS. — The amount of dividends which would (but for this paragraph) be taken into account under subsection (a) shall be reduced by the excess (if any) of —

“(A) the amount of indebtedness of the controlled foreign corporation to any related person (as defined in section 954(d)(3)) as of the close of the taxable year for which the election under this section is in effect, over

“(B) the amount of indebtedness of the controlled foreign corporation to any related person (as so defined) as of the close of the preceding taxable year.

“(4) TREATMENT OF CONTROLLED FOREIGN CORPORATIONS. — All controlled foreign corporations with respect to which the taxpayer is a United States shareholder shall be treated as 1 controlled foreign corporation for purposes of this subsection. The Secretary may prescribe such regulations as may be necessary or appropriate to prevent the avoidance of the purposes of this subsection, including regulations providing that cash dividends shall not be taken into account under subsection (a) to the extent such dividends are attributable to the direct or indirect transfer (including through the use of intervening entities or capital contributions) of cash or other property from a related person (as so defined) to a controlled foreign corporation.

“(d) DEFINITIONS AND SPECIAL RULES. — For purposes of this section —

“(1) QUALIFIED INFRASTRUCTURE BONDS. — The term ‘qualified infrastructure bond’ means a bond issued under section 2(d) of the Partnership to Build America Act of 2014.

“(2) APPLICABLE FINANCIAL STATEMENT. — The term ‘applicable financial statement’ means, with respect to a taxable year —

“(A) with respect to a United States shareholder which is required to file a financial statement with the Securities and Exchange Commission (or which is included in such a statement so filed by another person), the most recent audited annual financial statement (including the notes which form an integral part of such statement) of such shareholder (or which includes such shareholder) —

“(i) which was so filed for such taxable year, and

“(ii) which is certified as being prepared in accordance with generally accepted accounting principles, and

“(B) with respect to any other United States shareholder, the most recent audited financial statement (including the notes which form an integral part of such statement) of such shareholder (or which includes such shareholder) —

“(i) which is certified as being prepared in accordance with generally accepted accounting principles, and

“(ii) which is used for the purposes of a statement or report —

“(I) to creditors,

“(II) to shareholders, or

“(III) for any other substantial nontax purpose.

“(3) BASE PERIOD YEARS. —

“(A) IN GENERAL. — The base period years are the 3 taxable years —

“(i) which are among the 5 most recent preceding taxable years ending before the taxable year, and

“(ii) which are determined by disregarding —

“(I) 1 taxable year for which the amount described in subsection (c)(2)(B) is the largest, and

“(II) 1 taxable year for which such amount is the smallest.

“(B) SHORTER PERIOD. — If the taxpayer has fewer than 5 taxable years ending before the taxable year, then in lieu of applying subparagraph (A), the base period years shall include all the taxable years of the taxpayer ending before such taxable year.

“(C) MERGERS, ACQUISITIONS, ETC. —

“(i) IN GENERAL. — Rules similar to the rules of subparagraphs (A) and (B) of section 41(f)(3) shall apply for purposes of this paragraph.

“(ii) SPIN-OFFS, ETC. — If there is a distribution to which section 355 (or so much of section 356 as relates to section 355) applies during the 5-year period referred to in subparagraph (A)(i) and the controlled corporation (within the meaning of section 355) is a United States shareholder —

“(I) the controlled corporation shall be treated as being in existence during the period that the distributing corporation (within the meaning of section 355) is in existence, and

“(II) for purposes of applying subsection (c)(2) to the controlled corporation and the distributing corporation, amounts described in subsection (c)(2)(B) which are received or includable by the distributing corporation or controlled corporation (as the case may be) before the distribution referred to in subclause (I) from a controlled foreign corporation shall be allocated between such corporations in proportion to their respective interests as United States shareholders of such controlled foreign corporation immediately after such distribution.

“(iii) EXCEPTION. — Subclause (II) of clause (ii) shall not apply if neither the controlled corporation nor the distributing corporation is a United States shareholder of such controlled foreign corporation immediately after such distribution.

“(4) DIVIDEND. — The term ‘dividend’ shall not include amounts includable in gross income as a dividend under section 78, 367, or 1248. In the case of a liquidation under section 332 to which section 367(b) applies, the preceding sentence shall not apply to the extent the United States shareholder actually receives cash as part of the liquidation.

“(5) COORDINATION WITH DIVIDEND RECEIVED DEDUCTION. — No deduction shall be allowed under section 243 or 245 for any dividend which is excluded from income by subsection (a).

“(6) CONTROLLED GROUPS. — All United States shareholders which are members of an affiliated group filing a consolidated return under section 1501 shall be treated as one United States shareholder.

“(7) REPORTING. — The Secretary shall require by regulation or other guidance the reporting of such information as the Secretary may require to carry out this section.

“(e) DENIAL OF FOREIGN TAX CREDIT; DENIAL OF CERTAIN EXPENSES. —

“(1) FOREIGN TAX CREDIT. —

“(A) IN GENERAL. — No credit shall be allowed under section 901 for any taxes paid or accrued (or treated as paid or accrued) with respect to the excluded portion of any dividend.

“(B) DENIAL OF DEDUCTION OF RELATED TAX. — No deduction shall be allowed under this chapter for any tax for which credit is not allowable by reason of the preceding sentence.

“(2) EXPENSES. — No deduction shall be allowed for expenses directly allocable to the excludable portion described in paragraph (1).

“(3) EXCLUDABLE PORTION. — For purposes of paragraph (1), unless the taxpayer otherwise specifies, the excludable portion of any dividend or other amount is the amount which bears the same ratio to the amount of such dividend or other amount as the amount excluded from income under subsection (a) for the taxable year bears to the amount described in subsection (c)(2)(A) for such year.

“(4) COORDINATION WITH SECTION 78. — Section 78 shall not apply to any tax which is not allowable as a credit under section 901 by reason of this subsection.

“(f) ELECTION TO HAVE SECTION APPLY. — A taxpayer may elect to have this section apply for any taxable year.”.

(b) CLERICAL AMENDMENT. — The table of sections for subpart F of part III of subchapter N of chapter 1 of such Code is amended by adding at the end the following new item:

“966. Foreign earnings exclusion for purchase of infrastructure bonds.”.

(c) EFFECTIVE DATE. — The amendments made by this section shall apply to dividends received for taxable years ending after the date of the enactment of this Act.

It’s always going to be expensive, but getting it right is critical.

No local-government leader wants to file for municipal bankruptcy. Not only is it perceived as an admission of failure, but it’s expensive. Every dollar spent for legal and accounting costs is a dollar less to get the city or county back on its feet with a realistic chance for the future. It is a dollar less for a police car, a snowplow or a pension payment down the road. Every dollar spent on the bankruptcy process is a dollar less to invest in critical public safety and the infrastructure so vital to a lasting recovery.

Robert Fishman, the U.S. Bankruptcy Court-appointed fee examiner in Detroit’s bankruptcy, has reported that in just the first three months of the proceedings the Motor City’s lawyers and some of its numerous consultants sent taxpayers bills totaling $11.4 million for their services-not including Fishman’s firm’s costs, which added another nearly $2 million. He told U.S. Bankruptcy Judge Steven Rhodes that he believes that all of the requested fees are “commensurate with the complexity and speed of the case.”

But those early costs are likely to pale in comparison to those of the last few months, when the city and its creditors were in court on an almost-weekly basis. And if that weren’t bad enough for Detroit’s taxpayers, they have since been stuck with a tab of more than $1.16 million for the legal defense of former mayor Kwame Kilpatrick and his father in their the City Hall corruption case. The former mayor, who was convicted, appears to have played a central role in the events that steered the iconic city into municipal bankruptcy.

If Jefferson County, Ala., is a guide, Detroit’s taxpayers are in for a lot more fiscal pain. Best estimates are that the county, with a population of nearly 80 percent of Detroit’s, has so far spent nearly $35 million in legal fees to exit municipal bankruptcy. Vallejo, Calif., with a population of about 116,000, has spent about $13.2 million. Stockton, Calif., has spent about $12 million. It’s almost mind-boggling to consider the size and cost of these legal and accounting bills after a locality has become — after all — insolvent.

The issue in each of these cases is the complex challenge of obtaining certainty with regard to the amount of debt being addressed, as well as the number of competing interests that must be considered. In its bankruptcy filing, San Bernardino, Calif., lists its debtors in 86 tiny-print pages. In Detroit, the federal bankruptcy court could begin to consider as early as next month whether the city’s proposed plan of allocations — or “haircuts” — to be divvied up among its more than 100,000 creditors is fair. It is mind-bending to even imagine the number of diverse problems that must be simultaneously considered and solved in these cases. So getting the facts right, trying to weigh and balance the merits and equities of each creditor’s case, and trying to ensure avoidance of further legal challenges or appeals requires meticulous care. That is always going to be an expensive process.

With more than a million U.S. corporations seeking federal bankruptcy protection last year, we can understand how misfortune, poor decisions and other factors can lead to insolvency. But for a city or county, simply ceasing the provision of essential services — locking the doors to City Hall and walking away — is not an option. So getting it right requires what seems an extraordinary investment. But it is an investment not just important to ensuring a sustainable future for a municipality but also to try to ensure that the final plan put before the bankruptcy court can offer a quidepost for the future.

Detroit and San Bernardino, in particular, carry an extra burden. The 6th and 9th U.S. Courts of Appeal have pending before them cases challenging these cities’ bankruptcy proceedings — cases that could go all the way to the U.S. Supreme Court and set a precedent for every local government in the country.

These cases are in uncharted waters, but these are cities that are responsible for the health and safety — and future — of hundreds of thousands of Americans. The quality of care and commitment to getting it right could have a profound impact on the future of governance and federalism in America.

Governing

Frank Shafroth  |  Contributor

At 2 a.m. on Oct. 29, 2012, the Metropolitan Transportation Authority (M.T.A.) shut down the New York City subway system in preparation for Hurricane Sandy.  By 9 p.m. storm surges reached nearly 14 feet at Manhattan’s Battery, as the waves of the East and Hudson Rivers deluged the city’s rail stations and tunnels, flooding tracks, corroding antiquated electric controls and wreaking $5 billion in damage on the largest regional transportation provider in the Western Hemisphere.  As it emerged from Sandy’s wreckage, the M.T.A. found it impossible to buy any existing kind of insurance against future storms.

Not for the first time in New York City, necessity has bred an interesting kind of financial invention.  In the wake of Sandy, the M.T.A. worked with the First Mutual Transportation Assurance Company (F.M.T.A.C.), its “captive” (or in-house) insurer to obtain reinsurance — that is, insurance for the insurer — by issuing the world’s first “catastrophe” bond designed specifically to protect against storm surge.  With extreme weather becoming routine and public resources stretched thin, governments across the world — particularly at the local (and sea) level — are taking note.

In the wake of the 2008 economic crash, the bailout of many of our major financial institutions socialized (absorbed with tax payer money) the risks — and bad bets — taken by private investors with “financial innovations” like credit default swaps.  When it comes to natural disasters, we are increasingly accustomed to the same: government’s covering a large share of private losses.  Recently, however, and notably at the local level, we have observed the emergence of new kinds of financial innovations that do the reverse.  They seek to bring public needs to the private markets: to privatize risk for public gain.  The M.T.A.’s catastrophe bond is the latest in this series of creative public finance instruments.

Catastrophe (“cat”) bonds are not entirely new, though the market for them has grown substantially in the last few years.  They were first explored after 1992 when Hurricane Andrew decimated parts of Florida, and with them the ability of insurance and reinsurance companies to cover their losses: more than 10 insurance companies went bankrupt trying to cover $15 billion in damage.  As the frequency and intensity of these storms increased, often striking places that were well developed and thus vulnerable to billions of dollars in damage, it was clear that traditional insurance instruments were no longer adequate.  In response, reinsurance companies turned to the capital markets to help mitigate risk.

Since 1994, when Hanover Re created the first successful cat bond, approximately 230 have been issued to investors.  Although most cat bonds focus on things like hurricanes in the United States (approximately 70 percent of the total market), insurers soon realized that cat bonds could be a useful way to cede or transfer risk off their balance sheets for a range of natural disasters, from earthquakes in California and Japan to windstorms in Europe and “extreme mortality” resulting from things like pandemics.  Recently, there has been discussion by insurers and policy makers about the ways in which cat bonds might play a greater role in covering man-made perils like a terrorist attack.

The theory of the cat bond is relatively simple: insurers transfer their risk to capital market investors who are betting against catastrophe; that a hurricane or an earthquake won’t hit a particular place in a specified period of time.  If this proves true, investors are repaid principal plus relatively high interest.  If disaster strikes, however, the cat bond investors are on the hook and lose their principal.  In practice, the bonds have a number of complex parts.  They typically require the creation of a special purpose reinsurance entity.  They are also structured around sophisticated modeling of the risk of catastrophe, which must occur at a specific “event level” (i.e., intensity of wind gust, magnitude of earthquake), geographic area and time period to “trigger” a payout.

In New York, the M.T.A. and F.M.T.A.C. worked with GC Securities and Goldman Sachs to create MetroCat Re, a reinsurer that could collateralize the reinsurance coverage it provided to F.M.T.A.C. by selling $200 million in cat bonds to 20 investors, each betting that the city would be safe from Sandy-level storm surges for the next three years.  They are probably right; Risk Management Solutions, the firm that assessed the risk, calculates that there is only a 1.67 percent chance of this kind of storm surge each year.

There are a number of innovative firsts in the M.T.A. deal.  It is the first cat bond specifically designed to protect public transportation infrastructure; to date, much of the cat bond market has grown up around coverage of private property.  It is also the first where the payout trigger is solely linked to storm surge levels.  This means investors in the MetroCat Re cat bond pay only if coastal waters rise above 8.5 feet in the Battery, Sandy Hook and the Rockaways (where much of the damage to the subway system from Sandy occurred) or higher than 15.5 feet in East Creek and Kings Point.  If there are no such storm surges before August 2016, they get their principal investment and returns of 4.5 percent annually above Treasury rates.

These kinds of yields help explain why the MetroCat Re placement was oversubscribed — and why the cat bond market has grown exponentially: over $40 billion has been issued in the last decade, and there is now approximately $20 billion outstanding, up from $4 billion in 2004.  In addition to the returns, institutional investors like cat bonds as a way to diversify; natural catastrophes are not correlated with other economic conditions (or the stock market).

While cat bonds are compelling for investors, do they make for good public policy?  In theory, and at the federal level, the vast resources of the United States government should allow for self-insurance, absorbing the risk of catastrophe without paying a premium for coverage in the private markets.  Typically, however, natural disasters strike locally, and in practice state and city governments are on the hook for much of the immediate response and rebuilding.  Last month Governor Andrew M. Cuomo unveiled a plan to invest billions of dollars of federal disaster aid to improve New York’s infrastructure to withstand future shocks.

Yet strengthening resilience is not just about building better or smarter; it is about how these investments are financed.  The M.T.A., in the face of significantly increased prices in the traditional reinsurance market, found an inventive way to target the specific and costliest sources of property damage, the surge.  “This is now an important risk financing tool for us,” said Laureen Coyne, the director of risk and insurance management at the M.T.A., where the team spent three months designing the cat bond’s risk assessment and pricing.  Although tailored to the specific needs of the transportation assets of the MTA (and small relative to the total magnitude of Sandy’s destruction), it is possible that this kind of tool may lend itself to other vulnerable municipalities.  And there are more than a few.  By some estimates, 90 percent of the world’s cities have developed along waterways (lake, rivers, oceans) and are prone to flood.  Those along a coast, like New York, are also exposed to wind-induced storm surge.

To date, most cat bonds have been issued to protect against disasters in developed economies with mature insurance markets, where the probabilities and potential losses associated with hurricanes and earthquakes can be reasonably well modeled and political risk is low.  But increasingly, developing countries are hopeful that cat bonds might help bring much-needed private sector investors to help absorb some of the risk from natural disasters.  In these cases, cat bonds also serve as important tools for economic development, the rationale underpinning the World Bank’s MultiCat program, created in 2009 to help member countries enter the cat bond market.  Through this initiative, Mexico issued cat bonds in 2009 and 2012 to protect against earthquakes and hurricanes.  In April 2013 the government in Turkey placed a $400 million cat bond for earthquake protection.

Only a handful of the 230 or so cat bonds sold have generated a payout following a natural disaster, including Hurricane Katrina in 2005 and the earthquake and tsunami in Japan in 2011.   Payouts are infrequent because the parameters used to measure the risk — location, time period, specific intensity of the event — are so narrowly defined.   Notably, a hurricane the scale of Katrina prompted only one of nine cat bonds in the gulf region.   Even so, the increased frequency and intensity of storms have only whet the appetite for the instruments on the reinsurance side.  Though expensive, they sometimes prove to be the most cost-effective coverage in the aftermath of a catastrophe, when traditional insurance prices spike — as the M.T.A. discovered post-Sandy.  Investors, particularly those seeking higher yields in a period of low interest rates, seem to believe the returns are commensurate with the risk.  Then again, as Governor Cuomo observed, “The new reality in New York is we are getting hit by 100-year storms every couple of years.”

By GEORGIA LEVENSON KEOHANE

(Reuters) – The city of Detroit’s effort to declare some of its general obligation bonds as unsecured debt will be challenged in bankruptcy court Wednesday in what could be a precedent-setting turn in the largest-ever municipal bankruptcy in U.S. history.

The issue in front of federal bankruptcy Judge Steven Rhodes is whether a pledge of Detroit tax revenue to pay off the voter-approved bond issues is a binding obligation under Michigan law, as argued by bond insurers in two lawsuits, or merely a promise.

The outcome of the dispute could have a far-reaching impact on the $3.7 trillion municipal market, where general obligation bonds made up some 60 percent of the issues sold in the last decade.

That could reduce investor interest in not only any future Detroit borrowings but in debt from other Michigan municipalities, forcing them to pay higher interest rates. And it could trigger similar concerns for municipal borrowers in other states.

Investors always have considered the full faith and credit pledge by cities, school districts and other issuers to pay off those bonds “sacrosanct,” according to Natalie Cohen, the head of muni research at Wells Fargo Securities.

But Detroit’s effort to declare some of its GO bonds to be unsecured debt could change that assumption.

“This is a significant issue for the bond community, not just in Detroit but in all cases, because the implication is that if the court finds these aren’t secured, this will go far beyond Detroit,” said Michael Sweet, a bankruptcy attorney with Fox Rothschild in San Francisco.

The outcome could revolve around the meaning of the word “pledge” under Michigan law.

In the proceeding on Wednesday, Rhodes will hear Detroit’s argument that the city’s pledge to repay some $410 million of general obligation bonds outstanding as of the end of the city’s fiscal 2012 is far less than binding.

In their lawsuits, bond insurers on the hook for making up missed payments on the bonds have asked Rhodes to rule without hearing any testimony, in what is known as a summary judgment.

Rhodes could rule for either side, or he could send the matter to a trial and allow both sides to begin taking depositions and finding expert witnesses to support their arguments. In a December hearing, Rhodes said he might want testimony about how the dispute impacts other creditors.

PROMISE VS OBLIGATION

Detroit must treat the bonds as secured only if a legal lien exists, and under Michigan law, there is no lien, Detroit argues. When Detroit issued the bonds, its pledge to repay the borrowed funds, was, under state law, only a synonym for “‘promise,’ as in ‘I pledge allegiance to the flag,'” the city argued in a court filing.

The three bond insurance firms do not see it that way. National Public Finance Guarantee Corp, the public finance subsidiary of MBIA Inc, and Assured Guaranty Municipal Corp jointly filed one lawsuit, and Ambac Assurance Corp filed another, soon after Detroit defaulted on a $9.4 million interest payment last October 1. That was its first GO bond default under Kevyn Orr, the city’s state-appointed emergency manager.

They claim bondholders and the insurers have a statutory lien on property-tax revenue specifically earmarked for the bonds. Instead of repaying the bonds, the city is using that tax money for general purposes and has no right to do so, the insurers argue.

“Nothing in Chapter 9 or elsewhere in bankruptcy law allows the city to disregard the state law restrictions imposed on the restricted bond taxes and use the funds for unauthorized purposes,” said a court filing by National Public Finance and Assured.

But the city in its motion to dismiss the lawsuits counters that Chapter 9 of the U.S. Bankruptcy Code trumps state law while Detroit is in bankruptcy. The insurers are seeking protections granted under Chapter 9 only to creditors with a lien. Detroit further argues that the insurers lack standing to enforce state law provisions governing the bonds.

THE PRICE OF VICTORY

A lot is at stake for the insurers.

“Secured in this bankruptcy and not secured can mean the difference between getting paid in full and half your money,” said John Pottow, a professor at the University of Michigan Law School.

If Judge Rhodes rules in Detroit’s favor, the city could find itself paying unofficial penalties next time it seeks to borrow money, warned James Spiotto, managing director of Chapman Strategic Advisors.

Should Rhodes declare the GO bonds to be unsecured, Detroit could find itself paying an extra 200 basis points or more on future borrowings, he said. “Either your (market) access or costs or both will be impaired, and you’ll be paying more,” Spiotto said.

Michigan governments likely could see costs rise, too. And muni investors would be forced to sort through which states have laws and history that support the treatment of GO bonds as secured debt, Spiotto added.

If the bond insurers lose, the chief effect will be that liens and other protections will be better documented for future deals, said Sweet, the Fox, Rothschild bankruptcy lawyer.

“It doesn’t mean there won’t be deals,” he said. “They will just be more careful.”

(Reporting By Karen Pierog and Tom Hals; Editing by David Greising, Martin Howell and Jan Paschal)

In this week’s issuer brief, Municipal Market Advisors warns issuers who have not sold bonds in recent years that they could be at risk of a superdowngrade this year if they decide to go to the market. (A superdowngrade is having your current rating lowered by at least three levels.) Thanks to methodology changes credit ratings agencies have imposed since the financial crisis, MMA says that many issuers who are applying for a rating for the first time in many years “can be negatively affected.” And in case that hasn’t spooked anyone, MMA also warns that “reconsiderations by the rating agencies of pension obligations and lack of robust issuer practices could trigger more of this activity” for local governments. On the bright side, the number of superdowngrades fell by 50 percent last year to 125 total.

Read the brief at:

http://www.mma-research.com/MMA/NonMembers/MMAIssuer/content/2014/MMA_Issuer_2014-01-27.pdf

WASHINGTON — Rep. Richard Neal has introduced a bill that would among other things, make the Build America Bond program permanent with reduced subsidy payments and repeal the alternative minimum tax for private activity bonds.

The bill is called the Invest in United States Act of 2014 (H.R. 3939) and Neal, a Democrat from Massachusetts, is ranking minority member of the House Ways and Means Committee’s select revenue subcommittee. The measure has been referred to the Ways and Means as well as the Transportation and Infrastructure and Education and the Workforce committees.

“This legislation will go a long way in creating an environment where our economy can take off by making the strategic investment needed to spur growth,” Neal said in a news release.

The BAB program, created by the American Recovery and Reinvestment Act, allowed state and local governments to issue taxable bonds in 2009 and 2010 and receive subsidy payments from the U.S. Treasury equal to 35% of their interest costs. Subsidy payments to BAB issuers have been reduced as a result of across-the-board spending cuts known as sequestration and have also been offset by issuers who owe the federal government money.

Under Neal’s bill, BABs would have a lower subsidy rate, depending on the years in which they were issued of 31% in 2014, 30% in 2015, 29% in 2016 and 28% in 2017 and thereafter.

The bill contains a provision that would make issuers whole even if sequestration is in effect and allow them to receive subsidy payments in the amount they were originally owed. The legislation also would allow qualified BABs to be current refunded.

Neal introduced another bill with the same BAB provisions about a year ago but it never moved forward.

This more recent bill would eliminate the AMT for PABs, which currently leads to higher interest rates and project costs for muni issuers.

Exempt-facility bonds issued by water and sewage facilities would be exempted from the annual state volume caps on PABs, under the bill. Excluding these types of bonds from the caps “makes additional private investment capital available for these types of infrastructure facilities,” the bill summary said.

Additionally, the bill would create an infrastructure bank called the American Infrastructure Financing Authority, which would provide loans and loan guarantees for transportation, water and energy infrastructure projects.

To be eligible for financial assistance from the authority, a non-rural project’s expected costs would have to be at least $100 million and a rural project’s expected costs would have to be at least $25 million. The Treasury would make available $10 billion in seed money for the authority, and the bank would not be allowed to finance more than 50% of any one project.

“Traditional municipal bonds issued by state and local governments are proven to work and have been a part of the tax code for over 100 years, and additional infrastructure financing options can be created at the federal level to complement the current system to best meet infrastructure needs,” the findings and purpose section of the bill said.

Other provisions in the bill include increase the federal minimum wage to $10.10 an hour from $7.25 an hour over four years and extending and expanding the new markets tax credit and the research and development tax credit.

Aides to Neal said that, while the congressman would love for the bill to become part of a larger legislative package, parts of the bill could be other legislation.

BY NAOMI JAGODA

FEB 4, 2014 4:42pm ET

The U.S. Communities Government Purchasing Alliance, the only purchasing cooperative sponsored by the National League of Cities, recently honored the City of Orlando, Fla. for saving taxpayer dollars through the use of cooperative purchasing.

Orlando was presented with a U.S. Communities 2014 Customer Appreciation Award for supporting cooperative purchasing and utilizing multiple U.S. Communities contracts over the past three years and purchasing more than $3 million of products and services since joining the program. The city has saved as much as five hundred thousand dollars through its participation in U.S. Communities. Since it began in 1996, U.S. Communities has saved local agencies across the country more than $1.5 billion.

NLC Executive Director Clarence Anthony applauded the city for its accomplishment. “It is with great pleasure that we congratulate Orlando for receiving the Customer Appreciation Award from the U.S. Communities Government Purchasing Alliance. As a founder and sponsor of this great public benefit program, NLC is pleased that the city has actively used U.S. Communities contracts and achieved savings from the best pricing on products and solutions available through our cooperative purchasing program,” Anthony said.

David Billingsley, Orlando’s Chief Procurement Officer, accepted the award on behalf of the city from U.S. Communities’ Program Manager David Kidd.

Among the products and services purchased by Orlando were roofing supplies, electrical supplies, hardware and related supplies, elevator services, auto parts, playground equipment, janitorial supplies and office furniture.

In 2013, Chicago, Phoenix and Raleigh, N.C. were among the recipients of the Customer Appreciation Award. The use of government purchasing cooperatives is recognized as a procurement best practice by NIGP, the Institute for Public Procurement.

For more information about U.S. Communities, contact Marc Shapiro or visit the U.S. Communities website.

http://www.uscommunities.org/

JANUARY 27, 2014

By Marc Shapiro

This innovative, results-focused funding model is gaining traction as a way to attack social problems while minimizing risk to taxpayers.

Deciding which social-services programs to cut and which to save shouldn’t grind government to a halt. By only paying for success, a new funding tool known as “social impact bonds” (SIBs) that is gaining traction across the country shows real promise for moving the needle on longstanding social problems. This funding model gets better results with existing resources, minimizes risk to taxpayers and ends programs that are not working.

A social impact bond is a partnership between government and philanthropies, nonprofits and private-sector investors. Government first identifies a desired goal, then contracts with private investors who raise money to fund a project designed to achieve that goal. A philanthropy or nonprofit manages the project. After the project ends, it undergoes rigorous independent evaluation to determine if it achieved predetermined outcomes. Since the private-sector partners don’t get paid if they don’t produce, the taxpayers’ risk associated with potential failure is minimal.

Two of the nation’s first SIBs were conceptualized in Massachusetts to address youth criminal recidivism and chronic homelessness. Colorado, New York, Ohio, South Carolina and other states also are pursuing this innovative approach to tackle problems that have plagued local communities for decades.

Massachusetts partnered with Third Sector Capital Partners and other organizations, including New Profit Inc. and the Boston nonprofit Roca, to provide job training, counseling and other services to prevent at-risk youth from becoming repeat offenders. To reduce homelessness, that project’s partners — the Massachusetts Housing and Shelter Alliance, the Corporation for Supportive Housing and the United Way of Massachusetts Bay and Merrimac Valley, assisted by Third Sector — hope to find housing for hundreds of chronically homeless people, thereby reducing the expensive over-use of acute and emergency medical services. And just last week, Massachusetts announced a $27 million initiative — the nation’s largest financial investment in a social impact bond — designed to improve outcomes for at-risk young men in the probation system or leaving the juvenile-justice system.

Massachusetts Gov. Deval Patrick hailed these programs, describing them as “innovative ideas and strategies to tackle challenging, long-term social issues.” Thanks in part to the Rockefeller Foundation and the Social Impact Bond Technical Assistance Lab (SIB Lab) at the Harvard Kennedy School, the SIB approach is spreading. Rockefeller and the SIB Lab recently announced the first six winners from a national competition for social impact bonds. Winners get a full-time Government Innovation Fellow from the Kennedy School, guidance from SIB Lab director Jeffrey Liebman and other experts, and some flexible funding to remove barriers to implementation.

The competition drew interest from 28 local and state governments and bipartisan praise from the winners. “Not only does this approach help pursue solutions to tough problems,” said Ohio’s Republican governor, John Kasich, “but it does so in an accountable, results-oriented way.” South Carolina Gov. Nikki Haley, another Republican, put it succinctly: “I love this pay-for-success model.” Colorado Gov. John Hickenlooper, a Democrat, plans to use the SIB approach to target homelessness, and New York’s Democratic governor, Andrew Cuomo, praised it as cost-effective, adding that “solutions that work can be brought to scale.”

These governors are right. Not only does this innovative approach have the potential to ease persistent social problems, but because of its results focus and limited risk to taxpayers, successful programs are easier to scale, allowing them to spread to more communities.

Congress should build on ideas like this and support evidence-based funding models like social impact bonds instead of falling back on blind budget cuts. Since government only pays when programs actually deliver results, what do we have to lose?

BY MICHELE JOLIN, GEORGE OVERHOLSER | FEBRUARY 6, 2014

Michele Jolin  |  Contributor

resultsforamerica@americaachieves.org @results4America

George Overholser  |  Contributor

goverholser@thirdsectorcap.org @

Crucial (and complicated) concepts in public money explained.

This is part of an ongoing series called Finance 101 that goes back to the basics to help public officials.

13th check

A perk of some pension programs, the 13th check refers to an extra check retirees (and in some cases, current employees) receive at the end of a fiscal year if a pension fund has performed better than expected. The practice is controversial because pension fund rates of return vary from year-to-year and actuaries rely on an average rate of return over multiple years to do their accounting of the fund’s liability. For example, in 2013, San Diego’s pension fund realized investment earnings for the fiscal year (ending June 30) of $241.7 million. Costs for the fund, including retiree payments and broker fees, were $150.7 million. That left a balance of $91 million that was large enough to trigger that city’s 13th check program and retirees received a check at the end of 2013.

Basis Point

1/100 of a percent. Basis points are used as a unit of measurement in contexts where percentage differences of less than 1 percent are discussed. This is commonly used when referring to interest rates or investment yields.

Cash Balance Pension Plans

A cash balance plan is a common type of hybrid pension plan. Like a Defined Benefit plan, contributions from employees and employers are pooled and professionally managed. But the benefits employees actually get is based on the amount accumulated in the account (not on a formula based on salary and years of service). Employers guarantee a minimum rate of return, though the payout is likely to yield lower yearly returns than a traditional pension plan. This model helps reduce and manage future liability for the employer.

Defined Benefit Pension Plan

Often referred to as a “DB” plan, these retirement plans have up until recently been the mainstay for pension plans in both the public and private sector. Here, employees contribute money from their paychecks every pay period. But what is specified (or “defined”) as the employee’s benefit is what the employer will pay out each year following the employee’s retirement. Therefore, the risk is being taken on by the governments. Projecting what governments will actually have to pay out is difficult, especially when retirees live for a long time.

For example, a government hires an employee who will earn a pension that will amount to 75 percent of his $80,000-a-year salary once fully vested. After 25 years, the pension vests and he retires to a $60,000-a-year pension.  The pension will encourage the employee to stay with the government for most of his career, giving the government stability in personnel. But the government is taking on the investment risk – there is no guarantee that the money invested in the employee’s pension over the course of his career will cover the annual $60,000 payout. But the government is still on the hook.

Defined Contribution Pension Plan

Often referred to as a “DC” plan, these retirement planscan include 401(k)s (most common in the private sector), 403(b)s (used by educational institutions) and cash balance plans. In these plans, what is actually specified (or defined) as the employee’s benefit is the employer’s contribution to the retirement plan each pay period. (Of course, employees contribute too.) The benefit to governments is that the risk is taken on by the employee and makes planning for retirement benefits much easier. For example, Employee X will contribute 10 percent from his paycheck (pre-tax) to his pension fund and the government will match that. If the employee earns $80,000 per year that means that $16,000 is being stocked away in his retirement account annually. If that person works for 25 year, that means that a total of $400,000 will be invested into the retirement fund over that time

But that’s where the guarantee ends – depending on how the market does over those 25 years that employee’s pension could be worth more than double what was invested or it could be less than $400,000. That’s why the risk is taken on by the employee in 401(k)-style plans as there are no guarantees on what the employee will have upon retirement.

General Obligation Bond

The gold standard of bonds, these are issued directly by state or local governments or their agencies to meet essential government functions (e.g. infrastructure funding). These bonds are backed by the full faith and taxing power of the issuing government and, as such, are considered the bonds least likely to be subject to a default. A government’s credit rating usually refers to its GO bond rating.

Hybrid Pension Plans

These plans are growing in popularity as a middle ground between keeping Defined Benefit plans and doing away with them altogether by switching to a Defined Contribution plan. Hybrids can take varying forms but, in short, they are a defined contribution plan backed up by a lower-level defined benefit plan. For example, one type of hybrid plan caps the employer’s contribution to a defined-benefit plan. If the plan’s costs are higher than the cap, employees make up the difference. The goal is to have the employee and employer share the investment risk. This helps the employer keep retiree benefit costs in check and gives the employee more retirement security than a DC plan.

Hybrids have been around for years (Indiana has had one since the 1950s) although they have been growing in popularity as more states and localities revise their pension programs. Currently, 15 states and a handful of cities have adopted a hybrid pension plan for their employees – in most cases just for their new hires.

Moral Obligation Bond

A type of tax free revenue bond where government is not legally obligated to appropriate funds to pay a bond debt, but has great incentive to do so in order to avoid a default. For example, a housing authority issues debt for a project but because property values fall, the projected revenue stream is not enough to make its payments to bond holders. In order to keep its good standing on Wall Street and low borrowing costs, the government overseeing that housing authority is obligated to cover the debt payments through other funding mechanisms.

OPEB (Other Post-Employment Benefits)

Generally speaking, OPEB refers to retiree healthcare but can also include other benefits for retirees like life insurance or legal coverage. Unlike pensions, which is also a “post-employment benefit,” retiree healthcare is generally not protected or guaranteed. There is also no requirement to pre-fund the benefits whereas pension benefits are paid out of an investment fund maintained by the government. These characteristics have two main consequences: 1) OPEB costs are (except in a very few jurisdictions) are “pay as you go” and governments budget only enough money each year to pay the immediate bill for the retirees. 2) Mounting OPEB liabilities generally don’t get the same attention pension liabilities do even after accounting rules were changed in 2007 to require that governments estimate their OPEB liabilities on their balance sheets.

As Joshua Franzel, vice president of research for the Center for State and Local Government Excellence, puts it: “For the most part it’s easier to change the benefits or eliminate benefits [as] governments can tweak around the edges or cut out a lot of the subsidies they provide. [So] when these costs continue up, states are shifting more costs over to the retiree.”

Revenue Bonds

Bonds issued by a government that are paid through a secured stream (i.e. derived from the financed project, outside grants, or other taxes related to the project). Generally, voter approval is not required for these types of bonds.

BY LIZ FARMER | JANUARY 28, 2014

lfarmer@governing.com @LizFarmerTweets

Failure to understand financial outcomes is more dangerous to states and localities than ever, and there’s a big gap between what public leaders know about finance and what they need to know.

This is part of an ongoing series called Finance 101 that goes back to the basics to help public officials.

In the fall of 2012, the Minneapolis suburb of Vadnais Heights found itself with a credit rating downgraded to junk status. Local leaders in the town of 12,000 were not only insulted, but shocked. Vadnais Heights owed its disgrace to one action it didn’t think was that crucial: It had stopped making bond payments on a $25 million sports complex. The town had expected the complex to meet its borrowing costs through added revenue, but it had fallen short of estimates. So town officials had ceased paying bondholders rather than choosing to bill taxpayers for the unexpected costs.

Mayor Marc Johannsen called the credit downgrade “not fair” and “not reflective of the overall financial condition” of the community. “We’ve never missed a bond payment in the history of the city,” Johannsen said, “and we’ll never miss a bond payment that we’re obligated to do.”

The city was right in claiming that it had done nothing illegal. Lease revenue bonds like the ones issued for the sports facility don’t carry a contractual obligation. But Wall Street rating agencies don’t make that distinction. To them, a default is a default, and the town had evaded its responsibility.

Vadnais Heights wasn’t really guilty of mismanagement; it was guilty of ignorance. It didn’t realize the consequences of what it had done. Other communities have found themselves in similar situations. Earlier in 2012, Wenatchee, Wash., got its credit rating reduced below investment grade because it failed to support a regional sports arena that defaulted on nearly $42 million in debt. For nearly half a year, the city had covered interest payments to bondholders. When it stopped, ratings agencies dinged Wenatchee’s overall credit score, even though revenue-based bonds had been issued to pay for the project.

The idea that a city can be penalized only when it breaks the law is a common misperception. “I don’t get a sense many local governments understand bond math or securities,” says Matt Fabian, managing director at the bond analytics firm Municipal Market Advisors. “They get into leases connected to a project and don’t realize that a default on that lease is tantamount to a default on a general obligation bond.”

Failure to understand financial outcomes, even when combined with good faith, is more dangerous to states and localities than it has ever been. Tougher ratings standards are part of the picture, but the problem goes far beyond those. Municipal and state leaders face an entirely new regulatory climate with the passage of the federal Dodd-Frank Wall Street Reform and Consumer Protection Act. That law, which is still being implemented, is bringing increased scrutiny of government financial performance on all levels.

The Securities and Exchange Commission (SEC) now has a Municipal Securities and Public Pensions Unit, with a mission to root out misdeeds in public finance. The new rules became painfully evident to Harrisburg, Pa., in May of last year, when the SEC sued the city for securities fraud. One of the documents the SEC cited in its case was then-Mayor Stephen Reed’s 2009 State of the City address, which called the debts of the city’s waste treatment facility an “issue that can be resolved.”

Reed failed to mention that because the troubled facility wasn’t meeting its projected revenue, Harrisburg was already being forced to cover its debt payments. At the time of his speech, the city had paid out $1.8 million; by the time of the SEC action, it held about $260 million in debt related to the facility. Reed may not have intended to mislead anyone. But these days, fiscal innocence isn’t enough to forestall legal trouble.

“It’s not that you have to know every single debit and credit,” says Kinney Poynter, executive director of the National Association of State Auditors, Comptrollers and Treasurers. “But you have to have an understanding of when something just doesn’t sound right.”

These are not isolated cases. Elected officials practically everywhere are forced to make difficult financial decisions without the benefit of knowing exactly how the mechanics work. This has always been true to some extent, but the learning curve is much steeper now, due not only to the new regulatory climate but to the use of complex Wall Street trading products and gimmicks.

Most smaller jurisdictions are led by people whose understanding of intricate financial dealings is limited. And yet they have no choice but to engage in those dealings. They don’t always know the right questions to ask, and if a decision comes back to haunt them, as it did in Wenatchee and Vadnais Heights, they tend to be genuinely surprised. The biggest cities and states have the manpower and resources to pick their way through the new economy, but they are not immune to bad advice or poorly understood decisions.

Sometimes it is a fine line between fiscal ignorance and willful inattention to the risks of a decision. In 2005, Detroit’s then-Mayor Kwame Kilpatrick worked out a deal with Wall Street that sounded terrific. An elaborate $1.4 billion borrowing transaction that involved a series of credit swaps, it was projected to save Detroit $277 million over 14 years, while helping with the city’s $1.2 billion unfunded pension liability. Kilpatrick believed it would save a significant number of city jobs.

But when the recession hit a couple of years later, Detroit’s gamble didn’t pay off. The swaps forced the city to settle its debt at a locked-in 6 percent interest rate even as the market crash made it impossible to earn that large a rate of return. A condition of the swap agreement also caused Detroit to fall even further into the hole when its bond rating was sharply downgraded. “They were basically either not aware of this possibility or ignored it because they were so desperate to get the $1.4 billion,” says Sujit CanagaRetna, senior fiscal analyst at the Council of State Governments. It’s now estimated that the deal could cost Detroit $2.8 billion over the next 22 years. This represents about one-sixth of the $18 billion in debt the city cited in its bankruptcy filing in 2013.

No one is suggesting that the swap-deal-gone-wrong is the sole reason Detroit filed for bankruptcy. But it was a contributor. Localities all over the country made similar missteps, albeit mostly smaller ones, in the boom years that preceded the Great Recession. The idea that the good times would simply continue created its own set of headaches that officials today are faced with fixing. If this was not outright ignorance, it clearly qualifies as a form of fiscal naiveté.

So does the assumption California lawmakers made in the 1990s that high market returns would continue in perpetuity and pay for generous pension increases for state retirees. During the dot-com boom at the end of that decade, then-Gov. Gray Davis granted significant increases at the urging of the California Public Employees’ Retirement System—while letting the state take a break from actually contributing to the pension fund. After the crash, the promises became a painful legacy the state is still dealing with.

Most elected officials don’t like to talk much about these issues. But they know that even at the most basic levels, government finance and accounting are anything but intuitive. Successful candidates often win their jobs on the basis of personal appeal, not on their mastery of policy or management details, and certainly not on their knowledge of Wall Street trading. Once in office, they are forced to learn an entirely new language—if they choose to. “You have people coming in who have absolutely no idea how the appropriations process works,” says Connecticut Rep. Diana Urban, who is also a former economics professor. “Oftentimes they don’t know what constitutes a fiscal year, and they certainly don’t know that you can push something into the next fiscal year to make it work.”

Budget documents and balance sheets are obscure papers with arcane difficulties lurking beneath the numbers. For example, the bonds that a locality issues to pay for a project will show up as revenue on a general fund statement. That statement is simply a tally of all operations and activities paid for out of general treasury accounts. But those same bonds will count as a liability on the overall government statement, which accounts for debt service and other special funds. Then there are legacy costs such as pension liabilities, which have their own unique accounting. It can make grasping a government’s actual financial status an impossible task for the untrained.

“When you think about it, I’m a retired cop and now I’m chairman of a finance committee of a $3 billion organization and the 10th largest city in the nation,” says San Jose, Calif., Councilman Pete Constant. “Can you imagine a corporation taking someone like that and putting them in charge of it with so little experience?” The same could be said for elected finance officer positions—Nevada Controller Kim Wallin, for example, is the first accountant elected to the job in that state in 50 years.

In many jurisdictions, term limits contribute to the financial literacy problem. “Even assuming a person hits the ground running, they’re on such a steep learning curve, by the time they learn anything they are term-limited out,” says Houston Controller Ron Green, who ran for his position after hitting his six-year limit on the city council.

LaVonne Griffin-Valade, the city auditor in Portland, Ore., was shocked when she started her job in 2009 and found out that no one had told council members about the burden of retiree health-care costs, otherwise known as Other Post-Employment Benefits. As in most jurisdictions, retiree health care in Portland is not prefunded the way pensions are. It simply shows up without much context as a line item cost in the government budget. After four years, Griffin-Valade isn’t sure how much progress her education campaign has made. “I think if I quizzed them individually today,” she says, “they still wouldn’t necessarily understand the underlying issues. It’s just not been on anyone’s radar.”

Dodd-Frank may help in some regards, but it will complicate the lives of elected officials in other ways. The new law includes rules written to define more precisely who constitutes a financial adviser qualified to work with governments. But, as is characteristic of the new web of regulatory reforms, the rules alone total nearly 800 pages of explanation. Deciphering the full impact has been a daunting task that even financial analysts are still piecing together. This year as well, new accounting guidelines for pension liability reporting will make some governments’ liabilities appear to increase dramatically—a change that will cause alarm among those who don’t know where it’s coming from and one that will surely be used by those with a desire to embarrass those holding office.

The solution to the problem of insufficient expertise is, of course, education. But where will it come from? At the most direct level, those decision-makers who do have a financial background can help their colleagues who don’t. But politics often gets in the way. “I have to be really careful when I am advising other board members who come to me,” says Jay Fountain, chair of the Fiscal Committee for Stamford, Conn.’s Board of Representatives and a former long-time researcher for the Governmental Accounting Standards Board. “I know that what I’m saying doesn’t count for just my vote.”

Still, there are some well-trained officeholders who have made it their business to inform the financially challenged within their governments. In Portland, Griffin-Valade issues regular reports designed to educate the city council about the city’s actual financial health. Her 2011 report challenged the council’s decisions regarding, among other things, the city’s rainy day fund, health-care and pension costs. With her second report in 2013, Portland began looking at a budget surplus and the council voted to use some of it to pay down the city’s debt. Portland’s new mayor pushed for the move, but the decision was also a clear result of the education effort from the auditor’s office.

State financial stewards can provide help to localities, and some are starting to do so. New York Comptroller Thomas DiNapoli has established a Fiscal Stress Monitoring System for the state’s cities, designed to stave off drastic measures such as control boards or bankruptcy. In Tennessee, a number of local governments were drowning in debt after the recession because they invested in risky variable rate instruments to finance infrastructure projects. The Tennessee State Funding Board now mandates that local governments taking on debt draft their own debt management policies. These have to follow state-directed principles, including the disclosure of costs and risks.

Professional organizations are also recognizing the need for more education. The Municipal Securities Rulemaking Board (MSRB) has launched an initiative designed to help local governments with everything from the basics of issuing bonds to the ins and outs of the new regulatory climate. “Post-financial crisis and Dodd-Frank, it absolutely is a more complicated world,” says MSRB Chair Daniel Heimowitz. “From the regulatory landscape and understanding what your relationship with a dealer is, to what your own obligations are, there’s a much more heightened sense and understanding that everybody needs to pay attention.”

The National Association of State Budget Officers (NASBO) is launching an online video series designed to help the public and government officials with the basics. The first video explains the state budget process, drilling down to items as rudimentary as explaining what a fiscal year is. “People don’t mind the very basics,” says NASBO Executive Director Scott Pattison. “So [there’s no such thing as] dumbing it down too much.”

But the onus is on individuals in government to take up the cause either for themselves or for their colleagues and jurisdiction. The plain truth is, in this era of austerity and increased accountability, decision-makers must own their choices more than ever. Whether government officials like it or not, the public tolerance for unawareness has been whittled down to an unforgiving nub. “If you don’t have at least a comfortable understanding of the process, then you’re really out of the discussion loop,” says Connecticut’s Urban. “If we had a better understanding of how all this works, I think we could have more truth in budgeting.”

Some elected officials are always going to avoid the hard studying, but a few revel in it. One of the latter is San Jose’s Constant. After joining the city council in 2007, he was given a spot on the pension board. He decided to take a few classes to educate himself on his new job. Now he’s a Ph.D. candidate writing his dissertation on public pension governance.

“It became apparent to me,” he says, “that I was in a decision-making role and not feeling comfortable I had all the tools to make the right decision. You can sit in a room with all these experts but you have no idea if they are guiding you in the right direction or wrong direction. I at least wanted to know the right questions to ask.”

BY LIZ FARMER | FEBRUARY 2014

lfarmer@governing.com @LizFarmerTweets

The Denver-area union blames privatization, but the causes for its retirement fund’s troubles are familiar ones that run deeper.

Start with the public-transit industry, where employees often pay next to nothing toward their pensions and federal law provides them with up to six years of full pay and benefits if they’re laid off, then add what have become the usual public-sector pension sustainability problems, and the result is a particularly toxic brew. That’s the case in Colorado, where 1,670 Denver Regional Transit District (RTD) employees and retirees just got some very bad news about their local pension fund.

A consultant’s study found that the $200 million Amalgamated Transit Union 1001 (ATU) pension fund was more than 100 percent funded in 2002, but problems became apparent the following year. By 2008 it was down to 86 percent funded, and last year, in the aftermath of the financial crisis, the pension stood at less than 50 percent. Gabriel Roeder Smith & Co., which conducted the study, says the fund is on course to be fully depleted in 2032.

ATU members currently contribute 3 percent of their salaries to the pension fund, and the RTD kicks in 8 percent. Under the terms of a deal signed last year, the RTD’s contribution will rise to 12 percent for the next two years, then to 13 percent through 2017. The transit workers’ contributions will rise to 4 percent for the next two years, then to 5 percent. Even then, the contributions will be far less than what is needed to stabilize the fund.

Some blame privatization for the problem. A 1988 state law required the RTD to contract out at least 20 percent of its bus service, and today private companies operate about half the service. The president of the ATU local, Julio Rivera, said 800 bus operators who would otherwise contribute to the union retirement fund now work for two private operators. “If not for privatization, all of our members would have a pension and it would be in a much better shape,” Rivera told the Denver Post.

But those 800 bus operators who aren’t contributing to the pension fund also won’t collect from it. Taxpayers deserve the best service at the lowest price regardless of whether a driver works for the RTD or a private company. Requiring a portion of the service to be privatized may well be unwise, but Rivera’s comment leads one to wonder whether he believes the RTD should be run to benefit customers and taxpayers or members of his union.

A closer look at the ATU pension’s problems reveals all the usual suspects. Making pension contributions subject to collective bargaining inevitably results in insufficient employee contributions. Then there are classic public transit-employee perks, such as allowing vesting in the pension plan after just five years on the job and making employees with at least 20 years of service eligible for full retirement benefits at age 55. A state law hat took effect in 2011 will require new employees to work 10 years before vesting and increase the age for retiring with full benefits to 60, but with life expectancy on the rise, many retirees still will be collecting for a very long time.

The plan’s investment strategy may also be less than optimal. In a very good year for markets, the pension fund for RTD’s salaried employees achieved investment returns of about 20 percent last year, while the ATU plan returned 14 percent. (One thing the ATU plan does get right is its assumed rate of return. Unlike so many public-pension plans that paint an overly rosy picture by assuming unrealistic annual investment returns, ATU assumes a more reasonable 7 percent.)

If public employees want to remain the last bastion of traditional defined-benefit pensions, they’re going to have to make the contribution and benefit changes needed to make those plans sustainable. Perhaps RTD board member Natalie Menten said it best: “The fact that RTD employees are paying only 4-5 percent versus the taxpayers’ contribution at 12-13 percent should be a wake-up call to voters, taxpayers, union members and public-transportation users.”

BY CHARLES CHIEPPO | FEBRUARY 4, 2014

Charlie_Chieppo@hks.harvard.edu

These buzzwords can instill fear and trepidation in even the most progressive and tech-savvy public officials, but open information really does improve how cities operate.

This is part of an ongoing series called Finance 101 that goes back to the basic to help public officials.

Let’s face it – accountability and transparency are great buzz words but they can also instill fear and trepidation in even the most progressive and tech-savvy of public officials. After all, the more information you put out there, the more vulnerable to attacks you can be, right?

It’s not that this is wrong so much as putting the information out there should encourage better behavior and improve the performance of the city. Vulnerable to attacks isn’t a problem if employees are doing a good job, right?

In Baltimore, for example, top officials have pushed for more performance accountability. Citistat, a program that uses real-time data to track performance, was introduced in 1999. (The idea was based on a similar program the New York City Police Department started in 1994 to reduce crime.) Four years ago, Baltimore moved to outcomes-based budgeting, a process that identifies services that most efficiently meet citizens’ needs, allocated money to agencies to provide those services and monitors agency performance on meeting their goals. And in 2011, Mayor Stephanie Rawlings-Blake introduced Open Baltimore, a website loaded with city data ranging from employee salaries to traffic camera violations.

“Every step of the way you should anticipate getting pushback from whoever’s been there the longest,” Rawlings-Blake said recently at the U.S. Conference of Mayors winter meeting in Washington, D.C. “Making all the data as real time as possible doesn’t sit well with some people.”

But she and others who have taken the plunge extoll its benefits. For one, it give the chance for regular citizens to notify the city about any mistakes they see. In Baltimore, residents earned the city revenue when they saw that the wrong type of property tax was being collected on a building. Of course, Rawlings-Blake said, she’d prefer her employees catch the error but “ultimately I’m more concerned about fixing the problem, not who caught it.”

But even more importantly, focusing on data and results has allowed Baltimore to hone a 10-year plan financial plan that uses the data to both take stock of its starting point and to outline its future. In other words, you have to know where you are order to figure out how to get to your destination.

“Long-term planning is at the heart of being accountable for your city’s future,” Rawlings-Blake. “I know how tempting it is to make financial decisions that postpone tough choices. I think we inherited a lot of those decisions.”

In Louisville, Mayor Greg Fischer has embraced “a culture of auditing.” Like Baltimore, Louisville has adopted aggressive performance and data-based reporting aimed at improving the city’s day-to-day performance. One of LouieStat’s high-profile successes so far is the drastic reduction of fingerprinting errors made by employees at the city’s jail, which dropped from more than 300 per month to fewer than 10. When Fischer, who was a Governing Public Official of the Year in 2013, took office in 2011, audits between 2008 and 2010 had tallied a total of 17 material weaknesses and 42 deficiencies related Louisville’s financial statements. Last year, Fischer said, there were zero deficiencies.

Positive results change attitudes, Fischer said. “Now [employees] don’t say, ‘Oh no the auditors are coming, we got to get ready for them,’” he said. “I’m not sure anyone’s celebrating, but they at least don’t grumble about it publically anymore.”

And as far as making the city vulnerable to attacks or “gotcha” journalism? Rawlings-Blake advises that providing this information is mostly useful in terms of improving performance, which city employees want to do. And residents appreciate this effort at improvement. Spend time talking to the people who show up at your citizen forums, she said, and listening to what they need.

“When actual taxpaying citizens…come [to these forums], they like the discussion,” she said. “And they appreciate being able to give their feedback on the current problems we face.”

BY LIZ FARMER | JANUARY 28, 2014

lfarmer@governing.com @LizFarmerTweets

Detroit’s bankruptcy is rapidly shaping up as a battle of Wall Street vs. Main Street, at least as far as the city’s creditors are concerned.

Amy Laskey, a managing director at Fitch Ratings, said in a recent report that she sensed an “us versus them” orientation toward debt repayment. And in the view of bondholders, bond insurers and other financial institutions, it only grew worse last week after the city circulated its plan to emerge from bankruptcy and filed a lawsuit on Friday.

The suit, brought by the city’s emergency manager, Kevyn D. Orr, seeks to invalidate complex transactions that helped finance Detroit’s pension system in 2005. In a not-so-veiled criticism, the city said the deal was done “at the prompting of investment banks that would profit handsomely from the transaction.”

The banks that led the deal were Bank of America and UBS. They helped Detroit borrow $1.4 billion for its shaky pension system and also signed long-term financial contracts with the city, known as interest-rate swaps, to hedge the debt. Detroit has already stopped paying back the $1.4 billion, but for the first six months of its bankruptcy it kept honoring the swaps contracts and at one point offered to pay the two banks hundreds of millions of dollars—money it would have had to borrow—to end them. But the lawsuit now seeks to cancel the swaps, arguing they were illegal from the outset along with the related debt transactions.

Perhaps of even greater concern to creditors is the city’s 99-page “plan of adjustment,” the all-important document that details how Detroit proposes to resolve its bankruptcy and finance its operations in the future. Banks, bond insurers and other corporate creditors think they are being asked to share a disproportionate amount of pain under the plan, still in draft form and not yet filed with the bankruptcy court.

“The essential issue is the near-total wipeout of the bondholders,” said Matt Fabian, a managing director of Municipal Market Advisors. He said Detroit’s case appeared to be heading toward a “cramdown,” or court-ordered infliction of losses on unwilling creditors.

Municipal bonds have been renegotiated and restructured in the past, both in and out of bankruptcy, with a reduction in interest rates and extension of payments. But bankruptcy specialists say that, until now, municipal bondholders have not had losses of principal forced on them by a court. Participants in the municipal bond markets say the dreaded cramdown may be looming in Detroit, where they are finding themselves increasingly portrayed as greedy, and where plans are taking shape to elevate pensions above municipal bonds, though both are unsecured in bankruptcy.

Bankruptcy law is based on the idea that losses can be kept to a minimum if all parties work together to share the pain instead of cutting preferential deals for themselves at the expense of other creditors. From the beginning of Detroit’s bankruptcy last summer, Gov. Rick Snyder of Michigan has said the intent was to “determine the best path forward that respects, and is fair to, pensioners and all parties.”

But now Detroit’s capital-markets creditors—its bondholders, bond insurers and other financial institutions—say the plan of adjustment is unfair. It calls for the city to give pensioners up to 50 cents on the dollar for their claims, while other unsecured creditors, like those that bought Detroit’s general-obligation bonds, would end up with about 20 cents on the dollar. The pensioners’ claims would be paid with cash, while general-obligation bondholders would receive notes that Detroit proposes to issue.

“The capital-markets guys can still sue against this as unfair, and they will,” Mr. Fabian said.

The debt that raised $1.4 billion for the city pension system in 2005 would suffer bigger losses still. The plan of adjustment does not accept the entire $1.4 billion as a valid claim, only about half of it. So the investors who bought that debt, called “certificates of participation,” often called COPs, would end up with about 10 cents on the dollar. It would come in the form of a different series of notes, which has lags built into the payment schedules.

“We understand discriminatory treatment of the COP deal might be politically popular, but we believe it to be flawed both legally and as a matter of public policy,” said Derek Donnelly, a managing director for the Financial Guaranty Insurance Company, a bond insurer that promised to backstop the certificates in 2005. The insurance made it easier for Detroit’s underwriters, Bank of America and UBS, to market the certificates. And Detroit paid a lower rate of interest on the debt until it defaulted last summer just before the bankruptcy.

The financial institutions that helped raise money for Detroit’s pension system are dismayed now to see themselves portrayed as shady characters in the new lawsuit, according to people briefed on the matter. The suit contends their transaction “has put very fatal strains upon the city’s finances,” but as they see it, the city already had a crushing debt to its own workers, much of which was hidden, before they arrived on the scene. Some of them are now talking privately about lawsuits that would unwind the 2005 borrowing and force Detroit’s pension funds to return the money.

Spokesmen for Bank of America and UBS declined to comment on the lawsuit.

Ms. Lasky and Mr. Donnelly both expressed concern that by giving the pensions priority over capital-markets debts, Detroit’s lawyers could be making it harder for other Michigan cities, counties and school districts to raise money in the future. Ms. Lasky said that because municipal bankruptcies are so rare, and Detroit’s debts so big, the city stood to set an outsized precedent that might even affect cities outside of Michigan.

“Actions and rhetoric that suggest bondholder rights are not an important consideration will continue to damage market perception of the state and its local governments,” Ms. Lasky said.

Bankruptcy experts who are not involved in Detroit’s case said it would, in fact, be possible for the city’s pensioners to come out at the top of the pecking order, even though they were on par with the general-obligation bondholders when the bankruptcy began.

“You can treat general creditors differently, as long as you have a good reason to treat them differently,” said David A. Skeel, a law professor at the University of Pennsylvania who specializes in bankruptcy issues. “You don’t have to give them exactly the same percentage, but you can’t treat them wildly disproportionately.”

He said it was not at all rare for a bankruptcy judge to approve a higher rate of recovery for a creditor with some essential business relationship with the bankrupt party. While it would be hard to say that Detroit’s retirees fill a conventional business purpose, the city could still make valid arguments that its finances would be hurt if it cut the retirees’ benefits too drastically because it would then have to find money to support them in other ways.

“There’s also a humanitarian interest in not wanting to cut the pensions severely as well,” Mr. Skeel said.

—By Mary Williams Walsh of The New York Times

Published: Tuesday, 4 Feb 2014 | 11:24 AM ET

(Reuters) – Leaders of U.S. cities and states criticized bank regulators’ proposal to block banks from counting municipal debt toward buffers of easy-to-sell assets they will have to hold in case of a credit crunch.

The proposed rules, which require banks to hold enough liquid assets to meet cash needs for 30 days, are a key portion of an international plan to make banks safer after the 2007-2009 financial crisis.

The idea is that, in a crunch, banks should have enough government debt and other assets on hand to cope with customer withdrawals and to post collateral.

In October, the Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp proposed implementing much tougher rules for U.S. banks than required under the Basel III international agreement.

Those included prohibiting municipal bonds from being counted toward the liquid asset buffer. The comment period on the proposed rules ends on Friday.

That decision “will rob financial institutions of a very safe source of liquidity and prevent institutions from using municipal bonds to diversify their portfolios,” Janet Cowell, North Carolina’s treasurer, wrote in a comment letter on the proposed rule.

“This will increase borrowing costs, leading to increased taxes and rates for citizens and delayed or foregone capital projects,” Cowell said.

Several cities and towns in North Carolina filed similar comments, as did leaders from Houston; Junction City, Kansas; and Washington County, Pennsylvania.

Ratings agency Fitch said on Thursday that U.S. banks held about $404 billion in outstanding municipal securities and loans, and the proposed rules could cause them to reduce those holdings.

“It would be more expensive for banks to hold municipal bonds on their balance sheets and therefore banks that also serve as dealers may become hesitant to provide liquidity in the secondary market using proprietary capital, increasing liquidity risk for municipal bond holders,” the agency said.

The proposed liquidity rules are meant to respond to experiences during the crisis, when some banks had significant assets but did not have enough cash on hand to survive runs.

Banks with $250 billion or more in assets, such as JPMorgan Chase & Co and Goldman Sachs Group Inc, must meet the full requirement, while mid-sized banks face a less stringent liquidity requirement.

Regulators want U.S. banks to meet the new requirements two years before most foreign banks must comply, and they also excluded covered bonds and private-label mortgage securities from the liquid asset buffer.

Further, they created a new method for calculating how much liquid assets banks need that would likely mean U.S. banks would have to hold more than foreign banks would.

In comment letters filed with the regulators, several big banks said these extra requirements go too far.

“The U.S. proposal includes a number of new operational requirements … that introduce uncertainties and unnecessary burdens,” wrote Gregory Hackworth, Bank of America Corp’s treasurer.

BY EMILY STEPHENSON

WASHINGTON Fri Jan 31, 2014 5:52pm EST

Read the report at:

http://media.navigatored.com/documents/CA+Drought.pdf

Read the letter at:

http://www.nasact.org/downloads/CRC/LOC/01_14_PFN_Letter_on_LRC_Proposal.pdf

Norwalk, CT, January 30, 2014—The Governmental Accounting Standards Board (GASB) today published an Implementation Guide for the new GASB standards regarding accounting and financial reporting for pensions. The Guide to Implementation of GASB Statement 68 on Accounting and Financial Reporting for Pensions is an authoritative resource designed to assist preparers and auditors of state and local government financial statements as they implement the Statement, which is effective for periods beginning after June 15, 2014.

Prepared by the GASB staff and cleared for issuance by the Board, GASB Implementation Guides are classified as category (d) in the hierarchy of generally accepted accounting principles. This category also includes practices that are widely recognized and prevalent in state and local government.

The Implementation Guide for Statement 68 answers key questions about putting the new standards into practice. Topics addressed in the Guide include:

• The scope and applicability of GASB Statement No. 68, Accounting and Financial Reporting for Pensions
• Considerations regarding the identification of special funding situations
• Measurement of defined benefit pension liabilities of employers and nonemployer contributing entities
• Pension expense and deferred inflows and outflows of resources related to pensions
• Note disclosures and required supplementary information
• Unique issues related to cost-sharing employers and certain nonemployer contributing entities
• Transition to the new standards.
• Questions and answers are supplemented with several appendices, including a glossary of terms and nonauthoritative illustrative material. Illustrations include material based on that initially presented in Statement 68, accompanied by five additional illustrations developed specifically for the guide.

“Preparers and auditors of governmental financial reports posed questions to the GASB staff regarding the application of the pension standards throughout their development and after their issuance,” said GASB Chairman David A. Vaudt. “The Implementation Guide is in a question and answer format that includes illustrative examples to assist these stakeholders in understanding and applying the pension standards.”

“We are pleased to announce that an electronic version of this Implementation Guide is available for download on the GASB website at no cost—as are all GASB Implementation Guides,” Mr. Vaudt added.

Beginning in mid-February, a hard copy bound edition of the Guide will be available for purchase for $46.50 plus shipping by visiting the GASB store, or by calling the GASB Order Department at (800) 748-0659.

The GASB also published an Implementation Guide on Statement No. 67, Financial Reporting for Pension Plans, in June 2013. For more information and resources relating to Statements 67 and 68, visit the GASB website.

The Implementation Guide is available at:

http://www.gasb.org/cs/ContentServer?c=Page&pagename=GASB%2FPage%2FGASBSectionPage&cid=1176163026371

About the Governmental Accounting Standards Board

The GASB is the independent, not-for-profit organization formed in 1984 that establishes and improves financial accounting and reporting standards for state and local governments. Its seven members are drawn from the Board’s diverse constituency, including preparers and auditors of government financial statements, users of those statements, and members of the academic community. More information about the GASB can be found at its website, www.gasb.org.

NEW YORK — Fitch Ratings has taken various conforming rating actions on enhanced municipal bonds and tender option bonds (TOBs) corresponding to actions taken on their associated enhancement providers or underlying bonds.

Long-term ratings on enhanced municipal bonds may be higher than those of their enhancement providers as discussed in Fitch’s ‘Dual-Party Pay Criteria for Long-Term Ratings on LOC-Supported U.S. Public Finance Bonds’, dated March 8, 2013.

Short-term ratings on enhanced municipal bonds may be lower than those of their liquidity providers, as discussed in Fitch’s ‘Rating Guidelines for Variable-Rate Demand Obligations Issued with External Liquidity Support’, dated Jan. 31, 2013.

Long-term ratings assigned to TOBs are the higher of the ratings assigned by Fitch to the applicable enhancement providers supporting the bonds and the ratings assigned by Fitch to the underlying bonds deposited in the issuing trust. Short-term ratings on TOBs, if assigned, are based on ratings assigned by Fitch to their liquidity providers, with consideration given to the TOBs’ long-term ratings.

Additional information is available at ‘www.fitchratings.com’.

Applicable Criteria and Related Research:

–‘Rating Guidelines for Letter of Credit-Supported Bonds’ (June 14, 2013);

–‘Rating Guidelines for Variable-Rate Demand Obligations and Commercial Paper Issued with External Liquidity Support’ (Jan. 31, 2014);

–‘Dual-Party Pay Criteria For Long-Term Ratings on LOC-Supported U.S. Public Finance Bonds’ (March 8, 2013);

–‘Guidelines for Rating Tender Option Bonds’ (May 9, 2013).

Applicable Criteria and Related Research: Fitch Takes Various Rating Actions on Enhanced U.S. Municipal Bonds and TOBs

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=734355

Guidelines for Rating Tender Option Bonds

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=707849

Dual-Party Pay Criteria for Long-Term Ratings on LOC-Supported U.S. Public Finance Bonds

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=701572

Rating Guidelines for Variable-Rate Demand Obligations and Commercial Paper Issued with External Liquidity Support

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=730736

Rating Guidelines for Letter of Credit-Supported Bonds

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=710476

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=818811

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.

Read more here: http://www.heraldonline.com/2014/01/31/5633152/fitch-takes-various-rating-actions.html#storylink=cpy

January 31, 2014

Arizona’s La Paz County, whose residents earn about 20 percent less than the state average, is generating cash by lending its name as the issuer of municipal bonds for a Louisiana prison operator.

A La Paz authority that finances industrial development stands to receive $70,000 annually by selling debt this month for LCS Corrections Services Inc., which has eight prisons in Alabama, Louisiana and Texas at least 1,200 miles (1,931 kilometers) to the east. The county has no obligation for the $297 million of securities, which LCS is using to pay off bank debt and lower interest costs, said Lori Sullivan, managing director at Raymond James Financial Inc., the lead underwriter.

La Paz joins issuers in states including Colorado and Wisconsin that allow the type of financing, which provides riskier borrowers from charter schools to private prisons access to the $3.7 trillion municipal market. Forty states prohibit agencies from selling bonds for borrowers from outside their borders, said Toby Rittner, president of the Council of Development Finance Agencies in Columbus, Ohio.

“We are guaranteed an annual fee for 10 years, which will generate a significant amount of money for economic development,” said D.L. Wilson, chairman of the La Paz county board of supervisors and a retired utility manager. “Under Arizona statute, we can finance a project anywhere as long as there is an economic benefit to the state and county.”

Mining Past

About 20,300 people live in the jurisdiction, which borders California and is named after a deserted gold-mining town 280 miles east of Los Angeles. Greenlee, with 8,800 residents in southeast Arizona, is the state’s only county with fewer residents.

Money earned from issuing the bonds will go to the local economic-development agency and chambers of commerce, which promote business to complement farms growing cotton, pistachios, melons and alfalfa, Wilson said. Some will also be used to tout a 16-mile section of the Colorado River, called the Parker Strip, which attracts boaters and water skiers.

County residents make less money than most Arizonans, and have a harder time finding work. The median wage of about $27,500 in 2012 compared with the state average of $33,977, Department of Administration data. Its December jobless rate of 9.2 percent exceeded the 7.6 percent Arizona average.

Wisconsin Outlet

The biggest issuer of such debt is the Wisconsin Public Finance Authority, according to Rittner. The agency has arranged more than $1 billion in bonds for businesses in 36 states, said Mike LaPierre, a program manager. Borrowers have included Northwest University, a Kirkland, Washington, school founded by the Assemblies of God denomination, according to the authority’s website.

In Colorado, the state Educational & Cultural Facilities Authority has sold bonds for borrowers including The Nature Conservancy, which used the funds to refinance debt on its Arlington, Virginia, headquarters.

Rittner said issuance for out-of-state borrowers has prompted more questions from debt managers than any other topic in recent years.

“Many feel that public finance is their state’s prerogative and they get nervous when an outside issuer does work in their state,” he said.

Pushing Back

“There has been some push-back because some states want to have input into these deals,” said James Parks, president of the Louisiana Public Facilities Authority in Baton Rouge. He said his agency could have managed the transaction.

When La Paz sold the bonds, proceeds funded a loan to LCS, which is based in Lafayette, Louisiana, and is using the money to refinance mortgages on its prisons. The facilities house as many as 6,652 inmates, offering documents show.

The documents cite risks to bondholders, including the possibility that demand for the facilities may wane, or that trustees may be unable to sell the assets and generate money to repay the obligations in the event of a default.

Investors on Jan. 16 demanded a 7.5 percent yield for LCS’s 20-year bonds, which are federally taxable, and which Standard & Poor’s rates BBB, two steps above junk. The yield was about 3.9 percentage points more than Treasuries maturing in February 2036. It was also about 2.3 percentage points more than on corporate bonds with a similar rating, Moody’s Investors Service data show.

Default Outlier

About 1.5 percent of jail-related bond issues are in default, the fifth-highest rate among more than 25 types of debt, according to a Jan. 6 report by Matt Fabian, managing director of Concord, Massachusetts research firm Municipal Market Advisors. Less than 0.2 percent of state and local bonds default, Fabian said.

“Private prison bonds are absolutely the red-headed stepchildren in the muni industry,” said David Jaderlund of Jaderlund Investments LLC, which manages $500 million of bonds in Santa Fe, New Mexico. The bonds are often based on leases with government agencies that may be broken if inmate populations decline or local officials change policies, he said.

Private prisons held 8.7 percent of inmates in 2012, according to a U.S. Department of Justice report issued in December. The facilities are gaining share as more localities decline to build jails because of budget pressures, Sullivan said.

Issuance Experience

LCS picked La Paz in part because it had experience as the issuer in May for a prison in Holtville, California, owned by a Utah company, she said.

“We wanted to have an issuer with some name recognition,” she said.

The California prison was the authority’s second transaction since it was formed in the 1980s, Wilson said. The unrated bonds, which are tax-exempt and mature in October 2039, traded as recently as Jan. 14 with an average yield of 7.8 percent, data compiled by Bloomberg show.

LCS reported net losses of $13.1 million in 2012 and $16.6 million in 2011, as interest expenses exceeded $17.9 million both years, according to the offering statement for the bonds sold this month. Revenue grew to $69.9 million in 2012 from $58.6 million in 2011.

An LCS spokesman, Richard Harbison, declined to comment on the financing, and he said Chairman Jerry Gottlieb also declined to comment.

Development authorities in Arizona have issued bonds for about 20 out-of-state deals over the past six years, said Patrick Ray, a lawyer at Kutak Rock LLP in Scottsdale, who represents La Paz and other counties. While some transactions have required restructurings, none are in default, he said.

By David Mildenberg  Jan 30, 2014

To contact the reporter on this story: David Mildenberg in Austin at dmildenberg@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

New York, January 30, 2014 — Moody’s adjusted net pension liabilities (ANPLs) widened for most US states in fiscal year 2012, says Moody’s Investors Service in a new report “US State Pension Medians Increase in Fiscal 2012.” The year could well prove the cyclical peak for these liabilities, however, given increases in investment returns and interest rates since then.

“The widening in ANPLs in fiscal 2012 was mainly a result of minimal investment returns and a decrease in the interest rate used to derive the present value of liabilities,” says Moody’s Associate Analyst John Lombardi, who wrote the medians report. “We expect a more favorable stock market and interest trends in 2013 to bring ANPLs down across the sector.”

Moody’s says most states have three-year average ANPLs that remain in the low-to-moderate range relative to measures of their capacity to pay, such as governmental revenues. However, the burden varies enormously, with adjusted pension liabilities relative to revenues for individual states ranging from Nebraska’s 12% to Illinois’ 318%.

The median ratio of ANPL to government revenue increased to 64% for fiscal 2012 from 45% for fiscal 2011. In all, adjusted net pension liabilities increased for 38 states, with the 10 states with the largest pension burdens seeing increases ranging from 35% to 77%.

In aggregate for all the states, the adjusted net pension liability increased 24% to $1.2 trillion in fiscal 2012, from $998 billion in fiscal 2011.

After Illinois, the states with the highest pension burdens in fiscal 2012 were Connecticut (ANPL as percent of revenue 243.4%), Kentucky (211.3%), Hawaii (199.1%), and Louisiana (183.9%).

After Nebraska, the states with the lightest pension burdens by this measure were Wisconsin (13.8%), New York (16.5%), Tennessee (20.8%), and Washington (25.2%).

Moody’s uses measures comparing the size of adjusted net liabilities to state resources in its credit analysis because they indicate the strain the liabilities are likely to place on finances. Adjusted net pension liability relative to governmental revenue is a measure of pension burden that Moody’s employs in its state rating methodology scorecard. Pension liabilities are one of many factors Moody’s considers when determining a state’s credit rating.

For more information, Moody’s research subscribers can access this report at https://www.moodys.com/research/US-State-Pension-Medians-Increase-in-Fiscal-2012–PBM_PBM163311.

U.S. and international standard setters on January 23 considered the most appropriate path forward to resolve stakeholder concerns regarding a planned change in lease accounting and to provide cost relief for applying those new requirements to smaller lease transactions.

U.S. and international standard setters on January 23 considered the most appropriate path forward to resolve stakeholder concerns regarding a planned change in lease accounting and to provide cost relief for applying those new requirements to smaller lease transactions.

At a joint videoconference, the Financial Accounting Standards Board and the International Accounting Standards Board were presented with alternatives for a proposed model on lessee accounting that were developed in response to constituent feedback received on the 2013 exposure draft, “Leases (Topic 842): A Revision of the 2010 Proposed Accounting Standards Update, Leases (Topic 840).”

FASB and the IASB were not asked to reach any substantive decisions on the lessee accounting model at the meeting, but rather the views expressed would be used by the staff to develop the accounting approaches that would be considered at a joint meeting in March.

Scott Muir, a practice fellow at FASB, said all three approaches to lessee accounting recognize a lease liability and a right-of-use (ROU) asset for all leases other than short-term leases, and measure the ROU asset in the same manner at lease commencement. All three approaches would also measure the lease liability in the same manner throughout the lease term, he added.

According to Muir, the lessee approaches vary regarding the subsequent measurement of the ROU asset as well as the timing and presentation of lease expense.

Muir said Approach 1 would account for all leases as the purchase of an ROU asset on a financed basis. A lessee would recognize amortization of the ROU asset on a generally straight-line basis separately from interest on the lease liability, which is determined using the effective interest method, he said, adding that the lessee would account for all leases as Type A leases by recognizing amortization of the ROU asset.

Approach 2, according to Muir, would classify leases as Type A or Type B in a manner similar to the proposals in the 2013 exposure draft. He said that under Approach 2, a lessee would account for all leases of assets other than property as Type A leases, and most property leases — which would be defined as land, buildings, and integral equipment — as Type B leases for which the lessee would recognize a single lease expense.

Muir said Approach 3 would classify leases as Type A or Type B based on the lease classification principle consistent with Accounting Standards Codification (ASC) Topic 840, “Leases,” and International Accounting Standard (IAS) No. 17, “Leases.” Under that approach, a lessee would account for the vast majority of existing capital or finance leases as Type A leases, and the vast majority of existing operating leases as Type B leases, he said.

Board members expressed differing opinions on their preferred approach for lessee lease classification.

IASB Chair Hans Hoogervorst said Approach 1 is the most conceptually sound and would receive the most support from financial statement users, but he also suggested the option of permitting some companies with large property portfolios to use Approach 2. “I don’t know if that can be done, but I would like that to be explored,” he said.

FASB Chair Russell Golden said Approach 3 is the simplest to apply and would solve the primary objective of reporting assets and liabilities associated with leases on the balance sheet. He added that this approach would also address concerns about the cost and complexity of having to implement multiple accounting systems because there wouldn’t be a need to rethink how a leasing transaction should be classified.

IASB Vice Chair Ian Mackintosh said, however, that if FASB and the IASB are going to further consider Approach 3, the boards should be upfront and admit that this lessee accounting model is being developed on the basis of requiring less work from financial statement preparers.

Regarding lessor accounting, the staff recommended that FASB and the IASB pursue a model that would not change lessor accounting for most lessors.

Muir said the cost of a fundamental change to lessor accounting may not be justifiable in light of user feedback on existing lessor accounting, and the consideration of the appropriate lessor accounting model can occur independent of the boards’ decisions on how to change lessee accounting.

Muir said the staff rejected a proposal to eliminate consideration of lessor accounting from the leases project because doing so would negate the converged nature of the proposed standard and ignore the existing differences between U.S. generally accepted accounting principles and international financial reporting standards.

According to Muir, the staff thinks the inclusion of lessor guidance within a final standard would ensure needed consistency with any final lessee guidance regarding scope, definitions, and identifying leases. “We believe retaining existing [ASC] Topic 840 and IAS 17 for lessors while issuing a new lessee accounting standard carries the risk of unintended consequences,” he said.

After some discussion, Hoogervorst concluded that the boards seemed to favor abandoning the prior attempt to prescribe symmetrical accounting for lessees and lessors and to instead begin working on targeted improvements of the current lessor accounting models in U.S. GAAP and IFRS.

FASB and the IASB also reviewed various methods to provide cost relief related to the accounting for “small ticket leases” held by a lessee.

Sarah Geisman, a technical manager at the IASB, said small ticket leases represent transactions that are large in number but small in dollar value, are secondary to a lessee’s overall business, and involve underlying assets such as information technology equipment, office equipment, and automobiles.

Geisman said several constituents argued that it would be costly to apply the proposals in the 2013 exposure draft to those small ticket leases. As a result, the staff suggested introducing guidance into the leases standard that explicitly allows the guidance to be applied to portfolios of leases, she said, adding that the amendment should provide cost relief to preparers while maintaining information that may be relevant for users.

According to Geisman, the staff also supported changing the definition of short term to align with the definition of lease term. The change would increase consistency and simplicity within the guidance and address concerns related to daily rentals or month-to-month leases that do not meet the definition of a short-term lease, she said.

IASB member Takatsugu Ochi responded to the staff proposal, saying that the boards should consider making the leases standard applicable only to those transactions with a lease commitment that exceeds 5 percent of the lessee’s noncurrent assets. That threshold should significantly reduce the amount of entities within the scope of the project, he added.

by Thomas Jaworski

In leveraging public-private partnerships to replace many of its deficient bridges, Pennsylvania’s new approach is realistic about the true costs of a transportation asset.

Pennsylvania’s reign as the nation’s leader in structurally deficient bridges will likely come to an end over the next few years, thanks to a 2012 state law that will dramatically boost infrastructure investment by authorizing public-private partnerships on a wide range of transportation projects.

About 18 percent of Pennsylvania’s bridges are structurally deficient, which means deterioration of at least one component puts the bridge at risk for weight restriction and eventual closure. The national average is less than 8 percent.

But beginning next year, at least 500 of the Keystone State’s more than 4,000 structurally deficient bridges will be rebuilt under the Pennsylvania P3 Act. Absent the act, the bridge replacements would take 15 to 20 years, according to Pennsylvania Department of Transportation (PennDOT) spokeswoman Erin Waters-Trasatt.

Since most of the new bridges will have similar designs and construction standards, PennDOT will save money by bundling the projects rather than designing and building them one at a time. And unlike traditional rebuilds, these projects won’t be considered complete once the new bridges are built: Recognizing that operations and maintenance account for 80 to 90 percent of costs over the lifetime of a transportation asset, the private partners will also operate and maintain the bridges for as long as 40 years.

“With the requirement to take maintenance costs into consideration, the project team may decide it is more cost effective to build the bridges in a way that reduces the amount of anticipated maintenance in the future,” Waters-Trasatt told the Pittsburgh Post-Gazette. “The department anticipates realizing value from this by reducing not just the construction cost but the whole lifecycle cost of the bridge,” Payment will be based on the contractor’s performance at limiting lifecycle costs.

The Pennsylvania P3 Act that expressly authorizes projects like the bridge replacement is expected to spark about $3.5 billion annually in additional transportation infrastructure investment without relying exclusively on tax revenue to fund it. PennDOT can give private partners the right to use or control an asset for up to 99 years. Operations, maintenance, collection of revenue and/or user fees and financing are among the things the law authorizes private partners to do.

Given the law’s focus on long-term savings, it wisely calls for best value as the selection criteria. Under the traditional low-bid approach, saving a dollar on construction too often results in spending far more on operation and maintenance costs down the line.

Projects will be overseen by a Public-Private Transportation Partnership Board chaired by the state’s secretary of transportation and including the budget secretary and five other members from both the public and private sectors. If the board determines that a state project would be more cost-effectively administered or delivered by a private company, the appropriate transportation agency then can advertise a competitive RFP and enter into a contract with a company to completely or partially deliver the service or project.

There is no shortage of opinions about just how much transportation infrastructure investment our nation really needs. But the Pennsylvania P3 Act reflects a reality about which most observers do agree: Whatever the magnitude of the need, it’s unrealistic to expect it to be addressed with tax revenue alone.

BY CHARLES CHIEPPO | JANUARY 28, 2014

Although downgrades continued to dominate rating actions, US public finance rating revisions for 2013 showed signs of improving credit conditions, says Moody’s Investors Service in the new report “Downgrades Reign in 2013, but Par Value of Upgrades Reach Highest Level Since 2010.” In 2013, downgrades accounted for 79% of all rating actions, nearly matching the 82% share in 2012, but were only 69% of the rating actions in the fourth quarter, the lowest quarterly level since 2010.

Downgraded par value of rated debt, however, dropped by nearly a third in 2013, to $208 billion from $311 billion. Upgraded par value for 2013 increased to $41 billion, the highest level since 2010 and a 68% increase from 2012’s $24 billion.

Overall there were fewer rating changes in 2013 compared to the prior year, with the number of rating changes decreasing 12% to 885, from 1,011 and the par value of affected debt decreasing 26% to $249 billion, from $336 billion. The large majority of public finance ratings were stable in both years, with only 6.3% of unique Moody’s-rated public finance issuers seeing a rating change up or down in 2013 and 7.2% in 2012.

“The rating activity is consistent with recent revisions of most of our sector outlooks to stable from negative, many becoming stable for the first time since the recession began,” said Chandra Ghosal, Analyst at Moody’s and co-author of the report. “Despite increased stability, pockets of credit pressure remain throughout the country, and we do not expect credit conditions to change materially over the next 12-18 months.”

In the local government sector, the amount of debt upgraded nearly quadrupled during 2013, to $20.2 billion from $5.3 billion the year before. The amount of downgraded debt decreased slightly during the year, to $87.8 billion in 2013 from $94.4 billion in 2012. In all, there were 120 upgrades and 514 downgrades in 2013, compared to 112 upgrades and 608 downgrades in 2012. Rating changes in the quarter mirrored the rest of the year, with changes concentrated in California, Illinois, Michigan and New York.

States and state-related issuers experienced a dramatic drop in the amount of debt downgraded, with $47.6 billion of debt downgraded in 2013 compared with $127.3 billion in 2012. A total of $5.8 billion of debt was upgraded in 2013, versus $3.5 billion the year before. In all, there were four rating upgrades among these issuers in 2013 and nine rating downgrades, compared with five upgrades and 42 downgrades in 2012.

The higher education sector experienced more rating activity in 2013 than in 2012. Last year there were 14 upgrades and 41 downgrades (55 actions total), compared with three upgrades and 34 downgrades (37 actions total) the year before. In all, Moody’s upgraded $2.4 billion of higher education debt in 2013, compared with $169 million in 2012, and downgraded $7.2 billion, versus $5 billion the year before.

For more information, Moody’s research subscribers can access this report at: https://www.moodys.com/research/US-Public-Finance-Rating-Revisions-for-2013-including-Q4-Downgrades–PBM_PBM163180

Global Credit Research – 27 Jan 2014

NEW YORK — The proposed high quality liquid asset (HQLA) rule could negatively affect liquidity in the municipal bond market. The U.S. Office of the Comptroller of the Currency, the U.S. Federal Reserve System, and the U.S. Federal Deposit Insurance Company proposed the rule to implement a quantitative liquidity requirement consistent with the liquidity ratio standard established by the Basel Committee on Banking Supervision. If implemented as currently written, it will exclude municipal bonds from the definition of HQLA used in calculating a bank’s liquidity coverage ratio.

As of the Fed’s third quarter 2013 Financial Accounts of the United States release, U.S.-chartered depository institutions held approximately $404 billion of the current $3.69 trillion outstanding municipal securities and loans. Fitch believes that the proposed HQLA definitions may cause banks to begin reducing their holdings in municipal bonds and reinvesting in securities that can be counted as HQLA. Due to the fact that municipal bonds would not count as HQLA, it would be more expensive for banks to hold municipal bonds on their balance sheets and therefore banks that also serve as dealers may become hesitant to provide liquidity in the secondary market using proprietary capital, increasing liquidity risk for municipal bond holders.

The full impact of HQLA remains unclear at this point and the ‘Liquidity Coverage Ratio: Liquidity Risk Measurement, Standards, and Monitoring’ rule is open for public comment until Jan. 31, 2014. Fitch will continue to monitor regulatory updates with regard to HQLA and provide comments as revisions to the rule are released.

The proposal’s intent is to strengthen the banking industry by imposing a standard for the liquidity risk profile of certain internationally active banking organizations. In order to comply with the new standards, these banks would hold a combination of liquid assets designated as level 1, 2A, or 2B, sufficient to withstand a 30- or 21-day liquidity stress scenario (depending on the size of total assets of the bank).

January 30, 2014

Bonds backed by billions of dollars in pot sales taxes could shore up hard-hit state budgets — that is, if the feds would get out of the way.

FORTUNE — Thomas Doe, an analyst in the municipal bond market, was in Denver to give a speech last September when an unmistakable scent caught his attention. He’d been walking down the 16th Street Mall, the city’s main retail drag, “and I’m smelling it in the air,” says Doe, who goes by Tom. Then, completing the tableau, Doe popped into a hotel lobby and spotted three dudes wearing tie-dye and snacking on chips — this just a few months before marijuana for recreational use went on sale in Colorado.

That’s when things really started to click for the 55-year-old founder and CEO of Municipal Market Advisors, a research firm with subscribers including some 300 institutional investors, along with government regulators. Earlier last year Doe and his colleagues had joked about whether a market for medical marijuana tourism could revive the flagging finances of a place like Puerto Rico, whose bond rating has dropped in recent years.

After Doe’s trip to Denver, though, his thoughts on the matter of cannabis and credit ratings turned serious, particularly in light of certain revenue projections. The Colorado Legislative Council Staff estimated additional revenues from legalization, for example, at $100 million over two years. In Washington State, where recreational sales will begin later this year, a fiscal impact study said tax revenue could reach up to $1.9 billion over five years, averaging nearly $400 million annually. Indeed, legalizing marijuana nationwide, to believe a 2010 report by the Cato Institute, would generate some $8.7 billion in tax revenue, in addition to billions in cost savings related to law enforcement.

Doe believes that’s enough money to help cash-strapped municipalities meet pension obligations, undertake construction projects, and lower their borrowing costs in the bond market — and, therefore, enough to inspire other states to legalize marijuana, too. “It would be a real positive for states that are struggling right now,” he tells Fortune. “They’ve got such an infrastructure funding gap — and they have challenges with funding their pensions — that this is significant revenue.”

Gregory Whiteley, portfolio manager for government securities at Jeffrey Gundlach’s DoubleLine Capital, agrees about the potential upside. “By all accounts the legal recreational marijuana market is potentially quite large, so the impact on state and local finances could be significant,” he says.

It’s not a totally new idea. Back in 2010, hundreds of attendees surveyed at a Bond Buyer conference in California agreed that bonds backed by marijuana taxes would materialize were the state to legalize the recreational use. (That measure, Proposition 19, failed the same year.) A state estimate, from 2009, had put revenue potential at $1.4 billion a year.

Though solid data is still lacking, Whiteley says that for now the subject is “definitely on my radar.”

Doe, meanwhile, has been busy putting the issue on the radar of analysts and investors. He began to speak publicly last fall about the future of marijuana and public finances — first to attendees at a bond market industry conference in Chicago in October, then to institutional investors at the Massachusetts Investor Conference in December. This month he told clients in a research note that “a successful experience in Colorado” could result in a domino effect of legalization across the country.

“Colorado’s legalization of marijuana on Jan. 1 will provide hard data as to the potential revenue source from the cannabis product directly as well as ancillary products and services,” according to the note provided to Fortune. “Should tax revenue match projections then other states and cities are apt to follow the lead of Colorado.”

State budget planners aren’t convinced by marijuana’s potential just yet. “Budget office folks are going to be very cautious until they see money coming in,” says Scott Pattison, executive director of the National Association of State Budget Officers. NASBO’s membership would also want to see whether any revenue gains are offset by expenditures resulting from legalization — say, additional costs related to law enforcement or public health. In other words, Pattison notes, “Are there extra expenses, or do we spend less in certain areas?”

Budget officers would certainly “take notice,” however, of revenue figures that exceed 2% of a state’s budget. “Then I think they’ll start to say, Yeah, wow,” Pattison says.

By Doe’s reckoning, $400 million is enough to fund, hypothetically, 10 social service programs that cost $40 million each, or to finance major construction. “$400 million of new tax revenue would be material,” he says, adding, “I’ve seen states borrow $400 million to help fund infrastructure projects.”

That said, skeptics list a host of reasons why marijuana sales won’t ultimately make a dent in state finances, or the bond market for that matter. Craig Mauermann is managing director and senior portfolio manager at BMO Global Asset Management U.S. He does think that other states will be enticed to follow the lead of Colorado and Washington — but that doing so will only dilute the revenue stream in the end. “The so-called boon is pretty much going to be spread out,” he says.

Mauermann questions, too, whether marijuana sales will end up eating into consumers’ “disposable vice income” for products like cigarettes and alcohol, which also generate sales tax revenue for states.

Then there’s the illegal competition. Mark Tenenhaus, director of municipal research at RSW Investments, doubts that high-priced legal pot could steal substantial market share from the underground economy. In Colorado, retailers have been peddling marijuana at around $400 an ounce, according to media reports. “I don’t think you’re ever going to get rid of the black market,” says Tenenhaus.

Like their lawbreaker competitors, legal purveyors of recreational and medical marijuana (permitted in 20 states and in Washington, D.C.) have another challenge to confront: the feds. Marijuana remains an illegal substance under federal law. If a municipality wanted to back a bond offering, in part, with revenue from marijuana sales, bondholders would have to be advised of the risk that sales could be shut down. “In this environment, it’s a pretty strong risk,” says attorney Robert Christmas, a partner at Nixon Peabody who specializes in bankruptcy and government insolvencies.

Tom Doe agrees that federal prohibitions, particularly banking restrictions, pose a big impediment to the growth of a legal marketplace. Right now banks won’t touch the transactions or proceeds from sales, forcing merchants to deal in cash, including when they pay taxes. “The banking laws will have to be adjusted,” Doe says.

But Doe also believes the political sentiment is already shifting. Polls by Pew Research Center and Gallup have found that a majority of Americans favor legalizing marijuana. Just this month, states including New York, New Hampshire, and Florida have made moves in favor of some form of legalization.

Even President Obama appeared to have softened his tone on pot, when he told The New Yorker that he thinks the drug is less dangerous than alcohol “in terms of its impact on the individual consumer.”

His administration is working on guidance so that marijuana businesses can make better use of the banking system and not have to deal solely in cash, Attorney General Eric Holder said at an event at the University of Virginia last week.

“If the electorate is supportive then I think the politicians go with it,” Doe says.

Similarly, long-time advocates of marijuana reform say interest in “cannabis commerce” is having an effect on the political climate, too. Allen St. Pierre has worked at the National Organization for the Reform of Marijuana Laws (NORML) since 1991. Two decades later, St. Pierre, now executive director, is suddenly hearing from people like Doe, along with reps from “hedge funds, angel investors … and big, big law firms that are wondering whether or not to put a toe in the water.”

“Those folks have the ear and the sway of those politicians far more than we do,” he says.

Aging Baby Boomers may prove another pressure point on pols. “They want health care options,” says Doe. He envisions a future in which Boomers become strong advocates for medical marijuana because it “may be a less expensive and a more desired therapy for diseases” that are impacting them.

But the money may talk soon enough. Colorado’s new pot businesses will report their first round of sales tax revenue on Feb. 20, and the state’s Department of Revenue will post the numbers. “Bottom line,” says Doe, “you’ve got a state that’s going to provide real data, and we’ll see where all of this ends up.”

By Catherine Dunn

A new report examines pension liabilities for all types of retirement systems in select jurisdictions, showing sizable fiscal burdens in some cities.

Closely-scrutinized unfunded pension liability figures paint a bleak picture in cities’ financial statements. But in some cases, local taxpayers are actually on the hook for far greater unfunded liabilities.

That’s because there are other overlapping governments often saddled with unfunded pension liabilities of their own. So along with city governments, the same taxpayer base will also need to foot the bill for their state, school district and any other special district’s employee pension plans.

In a new report, Morningstar Municipal Credit Research examined all such pension plans and tallied the total unfunded pension burden for residents in the 25 most populous cities and Puerto Rico, arguing state and local pensions shouldn’t be examined in a vacuum. In a few localities, adding up pension liabilities revealed a sizable fiscal burden.

“There’s got to be some give at some point,” said Rachel Barkley, a Morningstar analyst who wrote the report. “Residents can only contribute so much of their income [to pensions].”

The report found the median aggregate unfunded pension liability for the cities examined to be $3,550 per resident.

In no major city was the pension burden greater than Chicago. The city’s reported unfunded liability continues to remain high, with an actuarial accrued liability of $19.4 billion, or $7,149 per resident. The state system’s pension woes push up the total liability to $14,570 per capita. Factoring in pension systems for Chicago Public Schools and Cook County further raise the total per capita burden to $18,596, according to the Morningstar report.

That total is, by far, the largest of any locality examined, although the figure should dip somewhat with the state legislature’s recent pension reforms.

After Chicago, Puerto Rico ($9,987), New York City ($9,842) and Boston ($7,802) recorded the highest per capita unfunded actuarial accrued liabilities in the report.

The following table lists the per capita unfunded actuarial accrued liabilities (UAAL) for each city Morningstar examined, with amounts shown for the most recent fiscal year available (mostly fiscal 2012):

City Per Capita City Pension UAAL Per Capita Total Pension UAAL

Chicago, IL $7,149 $18,596

Puerto Rico, PR $9,987 $9,987

New York, NY $8,726 $9,842

Boston, MA $4,465 $7,802

Philadelphia, PA $3,308 $7,057

Columbus, OH n/a $6,814

San Francisco, CA $2,866 $6,453

Los Angeles, CA $1,895 $6,426

San Jose, CA $1,542 $6,014

San Diego, CA $1,642 $5,973

Denver, CO $709 $5,356

Detroit, MI $911 $3,758

Jacksonville, FL $2,586 $3,675

Indianapolis, IN $1,011 $3,426

Phoenix, AZ $1,649 $3,351

Austin, TX $1,571 $3,009

Dallas, TX $1,373 $2,733

Houston, TX $1,196 $2,622

Fort Worth, TX $986 $2,377

El Paso, TX $736 $2,149

Seattle, WA $1,837 $1,997

San Antonio, TX $251 $1,623

Nashville, TN $876 $1,291

Memphis, TN $317 $893

Charlotte, NC n/a $585

Washington, DC -$409 -$409

Source: Morningstar Municipal Credit Research, “Determining the Aggregate Per Capita Pension Liability”

It’s important to note that the figures shown here are not normalized – Morningstar used each individual system’s actuarial methods and interest rate assumptions. And these, of course, can vary greatly from system to system.

Changes in actuarial methods or assumptions often yield major swings in unfunded liabilities. Take New York City, which posted an unfunded actuarial accrued liability of $1,112 per capita in fiscal 2011. Then in 2012, the plan’s actuarial cost method changed to the entry age method and the assumed interest rate dropped from 8 to 7 percent. The two changes ended up raising the city’s per capita liability to $8,472 that year, while the funded ratio fell from 91.9 to 60.1 percent, according to the report.

Morningstar’s Barkley also points out that there are limitations to examining unfunded liabilities on a per capita basis. Some cities, for instance, derive more revenue from commercial properties or businesses than others. The numbers also don’t reflect taxes on nonresidents, such as Philadelphia’s wage tax, which applies to both residents and non-residents working in the city.

BY MIKE MACIAG | JANUARY 23, 2014

The IRS instructs exempt organizations staff to determine whether an applicant for section 501(c)(4) status engages primarily in social welfare activities by interpreting “primarily” to generally mean 51 percent, but it does not assign a specific measurement for use in identifying nonqualifying activities such as political campaign intervention.

The instructions appear in training materials that were released to Tax Analysts on January 15 following a Freedom of Information Act request. The documents offer guidelines for employees working in the IRS EO Determinations unit on how to decide whether an organization engages primarily in social welfare activities and thus qualifies for exemption under section 501(c)(4).

In Exempt Organizations Determinations Unit 1b , the IRS tells trainees that 501(c)(4) organizations must operate “exclusively” for social welfare purposes but that “exclusively” means primarily. In determining whether the organization’s primary activity is social welfare, employees must not consider political campaign intervention or lobbying that is not germane to the purpose of the organization to be social welfare, the IRS instructs.

Although the trainee manual does not specify how to define “primary,” a separate document  providing notes to the instructor on how to teach Lesson 2 of Unit 1b says that “primary” is generally understood to mean 51 percent.

That percentage also appears briefly in Exempt Organizations Determinations Unit 2 , in a section explaining that exempt organizations other than 501(c)(3) organizations “may generally make expenditures for political activities so long as such activities, in conjunction with any other non-qualifying activities, do not constitute the organization’s primary activity (51%).

“Take note that there is no established method to determine this percentage,” the section continues. “One method is simply to compare expenditures for non-qualifying activities to those of qualifying activities. However, this figure may prove unreliable for an organization using mainly volunteers to carry out their activities. An alternative method is to analyze the staff hours, both paid and volunteer, devoted to qualifying and non-qualifying activities.”

At a May 17 House Ways and Means Committee hearing, Rep. Charles B. Rangel, D-N.Y., asked former acting IRS Commissioner Steven Miller if 501(c)(4) organizations can make political contributions as long as it’s not the organization’s primary purpose. “You can do this for 49 percent of whatever the activities are, without technically violating the law?” Rangel asked Miller.

“That test is whether your primary activities are social welfare in nature,” Miller responded.

Rangel restated, “Primary means that technically you could [go up] to 49 percent political.”

“We’ve never been that precise,” Miller said.

Gregory L. Colvin of Adler & Colvin said he agrees with Miller. “The IRS has never been that precise with the 49 percent or with the 51 percent, because precision would require something definite to be measured — expenditures, staff time, volunteer time, amount of text appearing in communications, etc.,” he told Tax Analysts. “And the IRS would need to specify the allocation of overhead and other non-program expenses between primary and secondary activities, which it hasn’t done. The fact that Connie Rosenberg used percentages 25 years ago in order to convey the general sense of various conceptual adjectives and adverbs in informal training sessions does not rise to the level of setting or communicating a standard of compliance.”

Colvin was referring to Conrad Rosenberg, former branch chief of the IRS EO division, and “Rosenberg’s rules” , which assign percentages to words such as “solely,” “exclusively,” “substantially all,” and “primarily.”

According to an instructor note in the instructor guide to Exempt Organizations Unit 1a , the IRS hands out Rosenberg’s rules when explaining to EO employees in training how to interpret when a 501(c)(3) organization “operates exclusively” for one or more exempt purposes.

The instructor note says to stress that the percentages listed in Rosenberg’s rules are not law, but a useful guideline. “The various percentages were taken from different court cases, and different court cases assign different percentages for the same terms,” the note says.

Bloomberg News reported that the materials appear to contradict Miller’s testimony.

by Lindsey McPherson

Municipal bond demand should increase in 2014 in an environment of expected higher interest rates, improved economic growth, lower issuance and richer valuations to Treasuries.

Tax-exempt investors have arrived at what could well represent a “new equilibrium” for interest rate levels, Chris Mier, a managing director in analytical services at Loop Capital Markets, told clients Thursday afternoon during the firm’s sixth annual outlook conference call. Accordingly, most of investors’ work has already been done in their adjustments to current levels, he said.

“You’re going to want to make some adjustments on the curve,” Mier said. “There will be some new opportunities this year. But you may not be as far away from where you want to be as you think. … We feel the new equilibrium range is dominant probably in our marketplace.”

Loop predicted growth of 3.25% in gross domestic product for 2014, a slightly higher estimate than the Federal Reserve’s forecast range of 2.8% to 3.2%. That growth in nominal GDP should push interest rates higher, which should bring tax-exempt yields back to comfortable levels the market last saw around 2003 and 2006, he said.

“That will take the chill off retail demand in muni market,” Mier said.

The one-to-30-year muni yield curve slope, at 376 basis points, per Municipal Market Data numbers through Thursday, will get steeper in 2014, but only to a point. And more investors will buy debt with longer maturities if and when it does, Mier said.

In fact, Loop expects steepening in the first half of 2014 and flattening in the second half.

The steepness of the slope at different parts of the curve means that investors moving down the curve, say from 14 years to 10 years for shorter duration strategies, could give up significant income.

In addition, muni ratios to Treasuries, with the 10-year at 92% through Thursday, should fall into much richer territory — as much as 10 percentage points from current levels. Lower new-issue supply, continued lower inflation and higher yield levels, due to historical relationships, lie behind the move.

With higher interest rates, muni spread compression may ease, Mier said. “Credit conditions are positive for states and slightly negative to neutral for local units,” he said.

Loop also expects muni bond mutual fund flows to reverse in the second quarter of 2014, and remain positive for most of the balance for the year. Lipper FMI numbers showed inflows to weekly reporting muni bond funds for the first time in 34 weeks for the period ending Jan. 15.

Finally, most metrics for the tax-exempt market are moving in a favorable direction, Mier said. Muni ratios to corporate bonds show how cheap munis have become, which stands as a positive sign. Muni yields have also cheapened dramatically against dividend-paying stocks, which is good for muni investors, including dividend investors who need cash flow.

And tax-exempt yields should outpace inflation, Mier said.

“Since we expect muni yields to rise faster than inflation,” he said, “muni attractiveness relative to inflation should increase as the year progresses.”

That means investors need to be wary of shortening too much and sacrificing coupon and roll-down. They should also be aware of growing spread differences in price between desirable and less-desirable muni credits, Mier said, due to increasing demand and shrinking supply.

BY JAMES RAMAGE

JAN 17, 2014 12:49pm ET

The Financial Accounting Standards Board on January 15 released final guidance designed to improve the accounting for investments in affordable housing projects that qualify for the low-income housing tax credit (LIHTC) and to provide banks with a better approach for communicating investment performance.

Accounting Standards Update (ASU) No. 2014-01, “Investments — Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects,” allows a reporting entity to account for an investment in a qualified affordable housing project using the proportional amortization method when specific conditions are met.

ASU 2014-01 directs entities to amortize the initial cost of the investment in proportion to the tax credits and other tax benefits allocated to the investor, and to recognize the net investment performance amortization in the income statement as a component of income taxes.

The guidance also notes that if the conditions for the proportional amortization method are not met, the investment should be accounted for as an equity method investment or cost method investment in accordance with Accounting Standards Codification Topic 970, “Real Estate — General.”

According to FASB, the amendments in ASU 2014-01 should enable more entities to qualify for the proportional amortization method to account for affordable housing project investments than the number of entities that currently qualify for the effective yield method. After releasing the initial proposal, FASB’s Emerging Issues Task Force decided to change the method of accounting provided in the guidance from the effective yield method to the proportional amortization method.

In a June 17 letter submitted to FASB, the American Bankers Association expressed support for the board’s proposal, saying that the presentation of all components of the net return from LIHTC investments within income taxes will improve financial reporting. Under current accounting requirements, some components of the net return could be included within investment income and other components could be included within income taxes, the association said.

The association said that both financial statement users and management will be well served by the new guidance because a company’s income tax disclosures will have a clearer connection to the amounts reported as income tax expense in the financial statements.

Michael L. Gullette of the American Bankers Association told Tax Analysts that the new FASB guidance should help reflect what a bank is hoping to accomplish with its tax credit investment by better portraying the entity’s return on investment.

However, Gullette was unconvinced that the accounting changes would result in improvements to the business of affordable housing development, adding that LIHTC investing activity is largely dependent on current economic conditions and the tax environment.

Gullette said the association was also concerned about expanding the scope of the guidance to include other tax credit investments that could be accounted for in the same manner as the eligible LIHTC investments. He said that while banks can invest in similar tax credit partnerships, such as renewable energy and historic rehabilitation tax credit investments, the related incentives can also involve significant profit motives.

Despite those concerns, Gullette supported FASB’s decision to perform additional research on the applicability of the guidance on LIHTC investments for other types of tax credit investments.

ASU 2014-01 will be effective for the annual and interim reporting periods of public entities beginning after December 15, 2014, and for the annual periods of all other entities beginning after that date. The standard requires retrospective application to all periods presented, and early adoption will also be permitted.

http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176163741058.)

by Thomas Jaworski

(Reuters) – The U.S. Supreme Court on Tuesday will hear arguments in a case brought by home health workers in Illinois that challenges the mandatory payment of union dues by public-sector employees.

Harris v. Quinn could upend a decades-old practice involving so-called fair-share agency fees, or union security clauses, in collective bargaining agreements, legal experts said.

The provisions require public-sector employees to pay union dues so long as the money is not spent on political activity. The Supreme Court affirmed the practice in the 1977 case Abood v. Detroit Board of Education.

But several of the court’s current justices indicated in an unrelated case last term that they were skeptical of the legality of such provisions.

The legal team backing Pamela Harris in the case that will come before the court on Tuesday contends that the union dues she paid violated her right to free speech. Harris is an Illinois resident who cares for her 25-year-old son Josh Harris. He has a rare genetic syndrome and requires round-the-clock assistance. They participate in a program whereby Josh gets monthly Medicaid checks that pay Pamela for his care.

Due to an executive order signed by its governor, Illinois, like many states, considers home-based health workers paid with Medicaid funds to be state employees.

Home health workers in Illinois are represented by SEIU Healthcare Illinois-Indiana. The bargaining agreement between SEIU and the state says that all “personal assistants” must pay “compulsory fees” to the SEIU, said court documents.

In a promotional video about the case released in December, Harris said the dues subtracted from her check “interfere with Josh’s care” and “intrudes” on her family.

ADVOCACY GROUPS INVOLVED

“Pam Harris isn’t an employee, she’s a mom … to treat her as a state employee and have her unionized just doesn’t make any sense,” said Paul Kersey, director of labor policy at the Illinois Policy Institute, in the video.

The institute is a free-market advocacy group that has filed a friend-of-the-court brief supporting Harris’ position.

The case is one of two this term backed by the National Right to Work Legal Defense Foundation, which represents workers in each case who do not want union representation.

Harvard Law School professor Benjamin Sachs told Reuters when the court agreed to hear the case that he expected the plaintiffs will advance two arguments on Tuesday.

First, that compelled dues are compelled association and therefore compelled speech. Second, that the personal assistants in the case are not state employees.

“What they’re trying to get the court to be afraid of is that a state could reach out into the population and say ‘Presto! You guys are employees!'” Sachs explained.

“The petitioners are trying to say you should be very afraid of states willy-nilly deeming people to be employees to get them into unions to pay dues,” he added.

The case is Pamela Harris, et al v. Pat Quinn, Governor of Illinois, U.S. Supreme Court, No. 11-681.

Amanda Becker

New York, January 15, 2014 — Moody’s Investors Service has placed 256 US local government general obligation bond ratings under review – 52% for upgrade and 48% for downgrade (132 and 124, respectively) – in conjunction with its updated rating methodology published today. Moody’s has also placed on review ratings that are dependent on these affected general obligation ratings. The methodology increases the weight in Moody’s overall assessment on debt and pensions to 20% from 10%, decreases the weight on economic factors to 30% from 40%, and introduces a scorecard for US local governments to enhance the transparency of key rating considerations.

Moody’s expects most rating changes resulting from the current reviews to be one or two notch movements and, depending on mitigating factors, some ratings could be confirmed at their current rating level. Most reviews should be completed within 90 days, but some could take as long as 180 days, if necessary. Moody’s rates approximately 8,300 US local governments, mostly cities, counties and school districts.

The new scorecard provides a composite score based on various measures of the key factors Moody’s considers most important to local government GO credit analysis. The scorecard, plus a number of “below-the-line” analyst adjustments, are used as a part of the rating process. “The scorecard is not intended to produce a final rating, only a starting point for analysis,” says Matt Jones, Moody’s Senior Vice President and one of the authors of the new methodology.

The increase in the weight attached to debt and pensions recognizes the potential for large pension liabilities to constrict a local government’s financial flexibility, says Moody’s. Because pension liabilities and debt each represent enforceable claims on the resources of local governments, Moody’s has weighted the debt portion of its current methodology more heavily to capture the combined financial impact of both debt and pensions.

The reduction in weight attached to economic factors acknowledges that some local governments are either unwilling or unable to convert the strength of their local economies into revenues, says Moody’s. Tax caps, anti-tax sentiment, the natural lag between economic activity and its conversion into government revenues, often place obstacles between municipal governments and the income generated by their local economies, as do a variety of other factors.

“There is an economic limit on the level of taxation that a municipality’s tax base can bear,” said Julie Beglin, Moody’s Vice President and one of the authors of the new methodology. “From a legal perspective, the local government’s mandate to provide essential public services and pay retiree pensions may also have strong claims on a government’s revenue and taxing power, depending on the particular state’s laws.”

This final publication follows a Request for Comment period on the proposed methodology, which was open from August to November 2013. Market comments led to several small adjustments in the scorecard of the methodology as published. Certain scorecard breakpoints and notching factors were amended, and the language in the methodology was bolstered to add transparency around the types of considerations that can lead to scorecard adjustments.

The publication “US Local Government General Obligation Debt” is available on Moodys.com at http://www.moodys.com/viewresearchdoc.aspx?docid=PBM_PBM162757

A link to the list of ratings under review is here: http://www.moodys.com/viewresearchdoc.aspx?docid=PBM_PBM162766

The principal methodology used in this rating was US Local Government General Obligation Debt published in January 2014. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody’s rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the rating action on the support provider and in relation to each particular rating action for securities that derive their credit ratings from the support provider’s credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody’s legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Date: February 6, 2014

Time: 2 p.m. Eastern Time

Learn about:

• Reporting requirements for accountable plans vs. non-accountable plans
• Whether allowances are taxable fringe benefits
• Reporting requirements for group term life insurance
• “Day meals” – what are they and if they are taxable
• When stipends, bonuses, and gift cards are taxable fringe benefits

What else: The IRS is offering 1 hour Continuing Education Credit (CE, formerly known as CPE) for this event. Please note to receive the credit you must attend at least 50 minutes of the presentation.

To register: Click here. You will use the same link to attend the event.

http://www.visualwebcaster.com/IRS/97598/reg.asp?id=97598

Read the report at:

http://img.en25.com/Web/StandardPoorsRatings/A%20Bumpy%20Road%20Lies%20Ahead%20For%20U.S.%20Public%20Pension%20Funded%20Levels.pdf

A $25 million investment loss by the Boston-area transportation authority’s retirement fund demonstrates the need for the same transparency and oversight that other public pensions are subject to.

In 2007, nine months after leaving his post as executive director of the Massachusetts Bay Transportation Authority (MBTA) pension fund to join Fletcher Asset Management, Karl E. White pitched an investment to his former employer. The pension fund invested $25 million, all of which is now gone.

Even greater than the concern over the lost money is the MBTA pension fund’s bizarre legal status in a netherworld between public and private, which made the ill-fated deal possible.

The MBTA pension fund was the only investor in the Fletcher fund. Although the company sent reports to the retirement board as late as 2011 that showed the value of the investment rising, the Fletcher fund was probably insolvent by 2008. White didn’t notify the MBTA retirement board that that was the case when he left the company in November 2008.

In March of 2011, the MBTA pension fund asked for $10 million back, but the request was never fulfilled. A series of Fletcher hedge funds have gone bankrupt, and the bankruptcy trustee told the Boston Globe that those funds have “many of the characteristics of a Ponzi scheme.” The FBI, the Securities and Exchange Commission, and Massachusetts’ attorney general are all investigating.

The root of the problem can be traced back to the MBTA pension fund’s status as a private trust, which has been upheld by two rulings from Massachusetts’ highest court.

Legislation enacted last summer required the fund to publish a database of retirement benefits, but it still isn’t subject to the same oversight as Massachusetts’ other 105 public-pension systems. Moreover, someone in White’s position would normally be prohibited from selling investments to a former employer for at least a year and possibly forever, but the MBTA pension fund is exempt from state ethics rules.

The fund is not overseen by the state Public Employee Retirement Administration Commission and isn’t subject to the same disclosure rules as other public pension funds. The Fletcher investment was not mentioned in the MBTA Retirement Fund’s 2007 annual report, nor was there any mention in the 2011 annual report of the unfulfilled request to have $10 million of the $25 million investment returned.

The lack of disclosure is particularly concerning because it appears that the pension fund’s financial condition is deteriorating. It went from being 95 percent funded in 2006 to being 68 percent funded in 2011. From what we can piece together, it appears that part of the reason is that the retirement board has skimped on its annual contribution. In fiscal 2012, it contributed just 71 percent of the costs accrued that year.

Another part of the problem isn’t new. MBTA employee pension contributions are subject to collective bargaining, which is not the case for state employees. The latest cohort of state workers contributes about 11 percent of salary to their pensions, and state government kicks in about 4 percent. In fiscal 2013, on the other hand, most MBTA employees paid only 5.5 percent, while the pension fund had to contribute over 20 percent of employee salaries.

The loss of $25 million in an investment that would not have been possible if the MBTA pension fund were considered public demonstrates that it’s time to end the charade. The public — not to mention thousands of MBTA employees and retirees — deserves to know what is going on. Subjecting MBTA’s retirement fund to the same oversight as other public-pension funds would allow sunlight to perform its much-needed disinfecting magic.

BY CHARLES CHIEPPO | JANUARY 13, 2014

California is moving to pay down debt and boost reserves after an economic rebound left it with the biggest surplus in more than a decade. Hawaii may increase spending on education. Officials in Florida, New York, Minnesota and Wisconsin are considering tax cuts.

The fiscal turnaround for states, a majority of which confronted budget deficits just two years ago, is also paying off for investors in the $3.7 trillion municipal market.

State bonds are proving a haven amid the biggest muni losses since 2008. The extra yield bondholders demand on the governments’ general obligations is about 1 percentage point less than the market average, close to the widest advantage since August 2011, Bank of America Merrill Lynch data show.

“The backdrop for states today is much improved versus just a few years ago,” said Robert Amodeo, head of munis in New York at Western Asset Management Co., which oversees $28 billion in local debt. “They’re growing and they’re looking to continue to increase their share of the national economy.”

The fiscal rebound is easing pressure on state credit ratings. Moody’s Investors Service raised its outlook on the governments to stable from negative in August.

Economy Tailwind

State and local spending began adding to economic growth in the second quarter of last year, a reversal from 2010 to 2012, when it exerted the biggest drag on growth since World War II, Commerce Department figures show. Two years ago, 31 states faced collective deficits of $55 billion, according to the Center on Budget and Policy Priorities in Washington.

Florida, one of the places hit hardest by the real-estate crash, may cut taxes as a result of a $1 billion surplus projected during the next budget year. Michigan anticipates about $1 billion in extra funds. California Governor Jerry Brown has proposed using surplus funds to boost spending, bolster reserves and repay debt used to fill prior shortfalls.

California general obligations maturing in October 2023 traded this week at an average yield of 2.74 percent, or about 0.5 percentage point more than benchmark munis, data compiled by Bloomberg show. That compares with an average gap of 0.8 percentage point since July 30.

Credit Move

Standard & Poor’s cited the plans by Brown, a Democrat, when it raised the outlook this week to positive on $75 billion of California debt, a step toward raising its A rating, five levels below the top.

Not all states provide forecasts and some haven’t released plans for next fiscal year, which begins July 1 in most municipalities. Yet at least a dozen states, including Texas, Florida and Michigan, see surpluses after revenue exceeded projections.

States also stand to benefit when individuals file income-tax returns this year, after the stock-market rally that has pushed the S&P 500 index of shares to record highs, said Scott Pattison, executive director of the National Association of State Budget Officers in Washington.

“A lot of states are going to have some pretty decent surpluses,” said Pattison. “I expect there will be some fairly robust revenue surprises coming in.”

Revenue Surprise

States had anticipated that revenue growth would slow this year to 0.8 percent, from 5.7 percent in 2013, according to the budget officers group. In the July-to-September quarter, collections exceeded the projected pace, rising by 6.1 percent, according to the Nelson A. Rockefeller Institute of Government in Albany, New York.

Local governments remain hesitant to borrow after emerging from the longest recession since the 1930s. Muni bond issuance fell 15 percent last year. Nor have governments payrolls returned to peak levels. There were 163,000 fewer state workers in December than in August 2008, Labor Department figures show.

Illinois, Pennsylvania and Maryland are among states still facing deficits.

“States are in a lot better shape than they were,” said Pattison of the budget officers group. “But you still had a lot of states that cut budgets significantly, and they’re not going to have enough money to make up for all the cuts that were made.”

In New York, Governor Andrew Cuomo, a Democrat, this month proposed using a surplus to cut taxes by $2.2 billion, much of which would be used to limit increases on property levies. In Minnesota, Democratic Governor Mark Dayton may cut business taxes as a result of a $1 billion surplus expected there. Florida Governor Rick Scott, a Republican, is using the state surplus to press for a $500 million tax reduction.

Prudency Pause

“Things certainly are better for states, but the question is when things have improved, when revenues have increased, whether or not they remain prudent,” said Konstantine “Dino” Mallas, who helps oversee $20 billion of munis at T. Rowe Price Group Inc. in Baltimore. “That’s always the challenge.”

Issuers nationwide have scheduled about $7 billion of sales in the next 30 days, down from the one-year average of $9.1 billion.

They’re issuing with yields close to a two-month low. Individual investors added money to muni mutual funds this week for the first time since May, Lipper US Fund Flows data show.

The interest rate on AAA 10-year munis is 2.71 percent, the lowest since November and compared with 2.84 percent on similar-maturity Treasuries.

The ratio of the yields, a measure of relative value, is about 95 percent, close to the lowest since May. The smaller the number, the more expensive munis are compared with federal securities.

To contact the reporters on this story: William Selway in Washington at wselway@bloomberg.net; Brian Chappatta in New York at bchappatta1@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

By William Selway and Brian Chappatta  Jan 16, 2014 5:00 PM PT

WASHINGTON, D.C. – America’s counties will have no option but to severely reduce or eliminate critical county services to the public if Congress fails to deliver funding for the Payment in Lieu of Taxes (PILT) program in the FY2014 Omnibus spending bill.

Without annual PILT payments, many services including fire and EMS, search and rescue, public health, law enforcement and justice operations could be affected. In many cases, counties will face more severe consequences including insolvency, default, and bankruptcy.

“We are deeply concerned that Congress would turn its back on more than 1,850 counties impacted by the presence of the U.S. government’s extensive holdings of public land,” said Matt Chase, Executive Director of the National Association of Counties (NACo).  “Since October, counties have in good faith delivered vital county services to our citizens and visitors with the expectation that the federal government would honor its 37-year commitment to county governments who are unable to collect property taxes on more than 600 million acres of federal land.”

Through the federal government shutdown and despite the uncertainty in the federal budget, counties have been open for business. In many cases, counties have had to front the costs of services typically supported with annual PILT payments, something that most rural counties cannot afford to do much longer.

“There is still time to act, and we respectfully ask that the House and Senate leadership work to fully fund PILT for the current fiscal year in the Omnibus spending bill or through another legislative vehicle,” Chase said.

Since 1976, PILT has provided critical funding to nearly 1,850 counties in 49 states. The PILT program funds offset losses in tax revenues due to the presence of substantial acreage of federal land in their jurisdictions. In many counties, more than 50 percent of the land is owned by the federal government.

PILT payments allow local governments to provide critical government services for residents such as education, solid waste disposal, law enforcement, search and rescue, health care, environmental compliance, firefighting and parks and recreation.

by  Hadi Sedigh  on 1/13/2014 4:08 PM

In November 2013, Invitation Homes LP, the Blackstone subsidiary that is the largest of the REO-to-rental operations, completed the first securitized financing of REO-to-rental properties (Invitation Homes 2013-SFR1). The private placement was very well received by the market, producing more favorable terms than many had anticipated. In this short article, we walk through why the deal was done, how it was structured, and what the financing means for the market.

In November 2013, Invitation Homes LP, the Blackstone subsidiary that is the largest of the REO-to-rental operations, completed the first securitized financing of REO-to-rental properties (Invitation Homes 2013-SFR1). The private placement was very well received by the market, producing more favorable terms than many had anticipated. In this short article, we walk through why the deal was done, how it was structured, and what the financing means for the market.

Motivation for the Deal

The first question many people have is why this securitization was done. The answer is straightforward: Invitation Homes owns and manages approximately 39,000 scattered-site single-family rental homes, and property managers can generate a higher return for their equity investors if they use leverage. With home prices up nationwide by 22 percent from their 2011 low, and up even more where REO-to-rental investors are active, moderate leverage is needed to attract new money to the space and to keep returns attractive to current equity investors. Leverage can take the form of securitization, bank loans, or preferred stock offerings. Invitation Homes is the first securitization.

An example will make this clear. Let’s assume a home sold for $90,000 and needed $10,000 of repairs, for a total cost of $100,000, and it could be rented out at $1,200 a month, or $14,400 a year. That home would be generating a gross cash-on-cash return (often referred to as a gross capitalization rate) of 14.4 percent ($14,400/$100,000). Out of this, the property owner must pay taxes, insurance, homeowners’ association dues, and both routine and emergency maintenance on the property. The property owner must also account for tenant turnover: the property may sit vacant part of the year, an agency may charge fees to rent to another party, and there will be fees to screen potential tenants and repaint the home. Let us assume these fees total $500 a month, or $6, 000 a year. Taking all these expenses into account, the property owner would be left with a net cash-on-cash return (net capitalization rate) of 8.4 percent ($8,400/$100,000), plus any property appreciation.

Now assume that $90,000 home goes up in value and sells for $120,000, plus the same $10,000 in repairs, for a total cost of $130,000. If the rent and expenses stay the same, the gross capitalization rate is 11.1 percent ($14,400/$130,000), and the net capitalization rate is 6.5 percent ($8,400/$130,000), much less attractive than the original 8.4 percent. Moreover, part of the anticipated price appreciation has been achieved, reducing potential future returns. (This example is fairly realistic; on the Invitation Homes deal, the actual net capitalization rate is 6.37 percent.)

Leverage can restore the appeal of the investment. Assume the property owner can borrow 75 percent of the purchase price to finance new properties, these properties also have a net capitalization rate of 6.5 percent and the rate on this borrowing is 4 percent. The investor would be receiving 6.5% + 0.75(6.5%-4%) = 8.4 percent, restoring the cash-on-cash return of 8.4 percent. In addition, because this transaction serves as the financing vehicle for further purchases, the property owner is entitled to any property appreciation on additional purchases. Thus, for each $100 investment, an investor who has borrowed 75 percent of the purchase price can purchase an additional $75 of homes, and will be entitled to the appreciation on $175.

Deal Description

The collateral for the Invitation Homes deal consisted of 3,207 properties with a total value of $638.8 million and an average value of $199,200. The loans in this deal were all acquired in the second and third quarters of 2012, had been repaired, and were currently leased. The properties had been leased for an average of 8 months; the longest lease was 16 months. The top three MSAs (as measured by balance) were Phoenix, AZ, with 34 percent; Riverside, CA, with 17.2 percent; and Los Angeles, CA, with 12.0 percent. The top three total, 63.2 percent, reflects the geographic concentration of REO-to-rental operations.

The security is collateralized by a single loan that is in turn secured by first-priority mortgages on the 3,207 income-producing single-family residences. The three rating agencies that rated this transaction (Moody’s, KBRA [Kroll], and Morningstar) consider the mortgage structure superior to a loan secured solely by an equity pledge, because the trust will have a first-priority lien on the properties. In the event of a default, the trust would be able to acquire the properties, rather than being limited to the sponsor’s equity. This structure also helps protect against the bankruptcy of the guarantor or sponsor.

Structure of Invitation Homes 2013- SFR1

Capital Structure

Class Ratings (Moody’s/ KBRA/Morningstar) Original Balance ($MM) Certificate Principal to BPO Value Ratio (%) Initial Maturity Date WAL (yrs.) Fully Extended Maturity Date WAL (yrs.) Assumed Final Distribution Date Rated Final Maturity Date

A Aaa(sf)/AAA(sf)/AAA 278.7 43.6 [2.0] [4.9] December 2015 December 2025

B Aa2(sf)/AA(sf)/AA 34.3 49.0 [2.1] [5.1] December 2015 December 2025

C A2(sf)/A(sf)/A 47.1 56.4 [2.1] [5.1] December 2015 December 2025

D Baa2(sf)/BBB(sf)/BBB+ 31.5 61.3 [2.1] [5.1] December 2015 December 2025

E -/BBB-(sf)/BBB- 46.0 68.5 [2.1] [5.1] December 2015 December 2025

F -/BB(sf)/- 41.5 75.0 [2.1] [5.1] December 2015 December 2025

Property Loan

Property Count 3,207 Loan Balance 479,137,000

Issuer Purchase Price ($mm) 444.7 Loan Term 2 years initial, three 1-yr extension options

Issuer Cost Basis ($mm) 542.8 Amortization Amt. 1% per year

BPO Value ($mm) 638.8 Libor Cap 2.497%

Source: Moody’s, KBRA, and Morningstar.

The deal contains six tranches (A, B, C, D, E, and F), shown in table 1. Class A, the AAA tranche, was $278.7 million (43.6 percent of the $638.8 million value of the properties); the six tranches together were $479.1 million (75 percent of the $638.9 million value of the properties). The stated maturity of the deal is two years from issuance (December 2015), with three one-year extensions. The principal pay downs are made first to Class A, until that Class reaches a zero balance, then in sequential order to the other tranches. Interest accruals are also distributed sequentially. Realized losses are allocated in reverse sequential order. Just as in commercial mortgage backed securities deals, a Special Servicer, in effect chosen by the most subordinate tranche outstanding, is responsible for the servicing and administration of the loan if there is a default or reasonably foreseeable default.

Protections for the Bondholders

The deal contains a number of protections for the bondholders:

• While rents are fixed for a period, the interest payments are based on LIBOR (London Interbank Offer Rate) plus a spread. The sponsor was required to buy an interest-rate cap for the initial period to ensure the trust has sufficient cash to pay the bondholders if LIBOR increases. If the deal is extended, future extensions also require the purchase of an interest-rate cap.
• There are modest prepayment penalties during the first year for prepayments arising from casualty or condemnation, or prepayments made in connection with the transfer of disqualified properties that do not meet certain representations and warranties.
• When individual properties are released from the securitization, the sponsor must pay the trust 105 percent of the allocated loan amount, if the released properties make up less than 10 percent of the initial balance of the securitization. This increases up to 120 percent of the allocated loan amount if released properties make up more than 20 percent of the initial balance of the securitization.
• If the loan’s debt yield falls below 90 percent of the closing date debt yield (a low debt yield period), excess cash is directed to the bondholders.

Criticisms of the Deal

Whether investor ownership of single-family rental property is positive or negative for communities continues to be debated; securitization will be another factor in that discussion. Here we focus on the criticisms of the transaction raised by the rating agencies that did not rate the deal and the investor community, namely these four:

• the lack of a long term history of rents for comparison
• the geographic concentration of the homes
• Blackstone’s limited equity in the deal ($63.7 million)1 may reduce the incentive to maintain the properties
• the “release of properties” clause

The first two points are inherent in any securitization of single-family rentals; the industry is new and geographically concentrated. The rating agencies clearly recognized these points, and protection has been built into the securitization, via additional required subordination. For example, the AAA bond is sized to be only 43.6 percent of the overall property value, smaller than in most commercial real estate securitizations. As to the third point, we believe any REO-to-rental operator will do the best it can for its equity investors. This means maximizing rental income and selling at as good a price as possible. Both require the properties to be maintained.

The bigger concern for investors (and also for alignment of interest) is the release-of-properties clause. In some circumstances, the interests of the debt holders and the equity holders are not aligned. In particular, the manager, representing the interest of the equity holders, may want to sell off “winning properties” (those that have appreciated) while retaining in the securitization properties that have fallen in value. As an example, recall that all properties in the Invitation Homes securitization are initially valued at 75 percent of property value. Now assume the value of 50 percent of the properties doubles while the value of the other 50 percent decreases by half. If all the appreciated properties were sold, the trust would receive 1.2 times the loan amount initially allocated to those properties. Thus, the total value of the cash plus the remaining properties in the securitization is calculated as (50% x 75% x 1.2) + (50% x 50%), which equals 70 percent of the initially allocated loan amount, although 75 percent is necessary to repay the investors. This example is very unrealistic, but investors would have been better protected had the manager been required to repay the securitization trust the greater of the allocated loan amount times 1.2 or 75 percent of the sales price. Mitigating this concern is the fact that Invitation Homes has only securitized a small amount of its total portfolio (3,207 of its approximately 39,000 homes). With the longer-run interests of their equity investors in mind, Invitation Homes is incented to keep this channel of financing available, which requires them to do a good job for debt holders.

The Future: More Securitizations, as Well as Other Sources of Leverage

The pricing on this transaction was very favorable, with most of the securities selling at higher-than-expected levels. As a result, more such transactions are likely. Both American Homes 4 Rent (AMH), an REO-to-rental operation with 21,000 single-family homes for rent, and Colony American Homes, which has 15,000 single-family homes, have announced they are looking at similar transactions. In addition, many REO-to-rental operators have arranged for bank financing, and a number of banks have made substantial investments in the systems to monitor the risk in this lending. And AMH has already concluded two very favorable preferred stock offerings.2

One fact is abundantly clear. With home prices up from the levels at which properties were bought, and continuing to rise, institutional investors need to add moderate leverage to deliver attractive returns to their equity investors. Look for many more institutional investors in single-family properties to add leverage in 2014.

Notes:

1. The sponsor’s total cost basis in the securities is $542.8 million, consisting of a purchase price of $444.7 million, closing costs of $7.9 million, other related costs of $22.5 million, and rehabilitation costs of $67.7 million. The par amount of the securities is $479.1 million, leaving Invitation Homes with hard equity exposure of $63.7 million.
2. The offerings took place in October and December 2013. They carry a lower coupon than debt but have added return potential equal to 50 percent of the home price appreciation in AMHs top 20 markets, using the FHFA’s home price indices. By offering a home price appreciation kicker, AMH was able to lock in a lower rate on the transactions.

Laurie Goodman

DETROIT—Michigan Gov. Rick Snyder’s talks with state legislators about a possible funding plan for the bankrupt city of Detroit could be part of a much broader push to shore up municipal pensions statewide, a person familiar with the matter said Thursday.

“I think it is going to be bigger than just Detroit,” this person said. “You can’t just sell a Detroit-only bailout.”

People familiar with the matter said that the governor told legislative caucuses in the state capital of Lansing Wednesday that the state could speed Detroit out of its bankruptcy by at least matching the $330 million by local and national foundations to preserve public access to the collection of the city-owned Detroit Institute of Arts while helping to fund the city’s pension obligations.

Last week, the federal mediator in the city’s municipal bankruptcy case—the nation’s largest—had several long conversations with Gov. Snyder, hoping to convince him that the state should consider a direct aid. Sources said that time is now running low because Detroit Emergency Manager Kevyn Orr, appointed by Gov. Snyder in March, plans to issue by Feb. 1 his plan to the bankruptcy court for cutting the city’s estimated $18 billion in long-term debt.

The governor “thought it was important to start dialogue and discussion with lawmakers,” Sara Wurfel, the governor’s spokeswoman, said in an email Wednesday night. She added that any additional funding from the state for Detroit “would be in partnership with the Legislature.”

Pushing for a bailout through the GOP-led state legislature could be a tough task for Gov. Snyder, a first-term Republican governor likely to run for a second term this year. Sources said that the governor has to straddle competing political interests wanting to limit the state’s spending in cash-poor Detroit versus those expecting Detroit to be out of bankruptcy by the time of the gubernatorial election in November.

The governor and his advisers had hoped to keep the confidential briefings under wraps. But with its disclosure Wednesday night, Gov. Snyder may be more inclined to provide details about his idea during his state of the state address scheduled for Thursday evening.

In talks with legislators, the governor floated the idea of using part of the state’s tobacco-litigation settlement fund as a way to pay for the bailout without new appropriations, according to the person familiar with the matter. Michigan received $256 million in fiscal year 2012 from a 1998 settlement Michigan and other states reached with tobacco manufacturers, but that annual payment is expected to decline in part due to declining cigarette sales, according to a state legislative report.

Until now, the governor has been noncommittal about whether he would financially support a rescue plan unveiled earlier this week designed to preserve the holdings of the Detroit Institute of Arts and to help reduce the city’s obligations to its municipal pension funds.

On Monday, nine local and national foundations said they pledged $330 million to help pay the city for its art and place its holdings at the Detroit Institute of Arts into the hands of a new nonprofit public trust. In turn, the city could use the proceeds to help make up the shortfall in its municipal pension system, estimated by Detroit’s emergency manager at $3.5 billion.

Without a bailout, there is growing fear that potential lawsuits over a possible sale of the art and a dispute over cuts to pension payments would tie up the Detroit bankruptcy case for months, if not years, people familiar with the matter said.

Originally, the federal mediator in the bankruptcy case estimated that the art deal required $500 million in outside support. But since confidential meetings began in November, the judge has indicated that the number is expected to grow, according to two people familiar with the matter.

In fact, in order for the city to be able to satisfy union and pension funds, Detroit may need to come up with close to $1 billion to help fill the pension shortfall, according to a person familiar with the matter. Then unions and pension funds would be asked to help make up the difference by accepting cuts or agreeing to benefit reductions to save money, this person said.

By MATTHEW DOLAN

Jan. 16, 2014 10:52 a.m. ET

WASHINGTON — Congress should reexamine the Tower amendment and consider authorizing the Securities and Exchange Commission to require issuers to comply with “sensible” disclosure requirements as well as robust accounting standards, the State Budget Crisis Task Force recommended Tuesday in its final report.

The task force — led by former Lt. Gov. of New York Richard Ravitch and former Federal Reserve Board Chairman Paul Volcker — also made other recommendations aimed at improving accountability and transparency of state and local governments’ budgeting and financial reporting. It also said the federal government should be more aware of the impact of federal deficit reduction on state and local governments.

The Tower amendment, which was added in 1975 to the Securities Exchange Act of 1934 by former Sen. John Tower, R-Tex., prohibits the SEC and Municipal Securities Rulemaking Board from requiring issuers to directly or indirectly to file any information with them before the sale of their munis.

No other entity has the obligation or authority to require full transparency and disclosure of risk from municipal issuers, the report said. The SEC and MSRB place disclosure requirements on underwriters of munis rather than issuers. The task force wants there to be adequate disclose of the terms, conditions and risks of municipal finances.

In an interview with The Bond Buyer, Ravitch noted that the task force is not recommending repeal the Tower amendment but rather wants the issue to be publicly discussed.

In October, the National Association of State Treasurers readopted a resolution that opposes repealing or modifying the Tower amendment.

Ravitch acknowledged that requiring more disclosures ahead of sales “would be unpopular for mayors and governors and the municipal bond industry” but said that investors would be appreciative of such a change.

“It’s important to maintain liquidity for cities and states,” he said, adding that “these markets have to be sound, liquid, creditworthy.” Sometimes governments have appetites for borrowing when they should refrain from issuing debt, such as Puerto Rico and Detroit, Ravitch said.

The former New York lieutenant governor was not aware of any interest in Congress to revisit the Tower amendment, but said, “We’re going to try to rev some up.”

The recommendation was among many the report made in an effort to improve states’ accountability and transparency. Having reliable budget estimates and accessible data on financial and programmatic results is important for preventing and solving financial problems and could increase the public’s trust in government, the report said.

The financial crisis that began in 2008 revealed states’ and localities’ structural budget problems, as opposed to creating the problems. “This suggests that had government, the media, taxpayers, and the electorate been aware of the poor fiscal condition of state governments and the underlying trends and causes of those conditions, they may have been able to implement preventive and ameliorative steps,” the task force said.

“At their heart, the economic events beginning in 2008 generated a severe revenue crisis. Lack of transparency and accountability constitutes bad financial, government, and political practice. Self-deception, either deliberate or unwitting, causes inaction and ignorance,” the report continued. “Thus, not only is transparency in budgetary and fiscal reporting desirable, the absence of it can be a major cause of government fiscal problems.”

Other recommendations for state and local governments include: using modified accrual budgeting instead of cash-based budgeting; having multi-year financial plans; having reserve funds that are adequate to meet any reasonably anticipated need; and making sure that the proceeds of short-term borrowings are repaid and not treated as an element of revenue.

Ravitch said many of the recommendations in the report were similar to actions taken for New York City to avoid bankruptcy in 1975.

The task force also recommended in its report that: states have statutory processes for imposing corrective actions on local governments that have a high risk of not meeting their obligations; state and local governments produce easily understandable financial reports; the federal government be more aware of the effects of its actions on the fiscal condition of states and localities; and, the federal government be required to make projections about how its actions and policies will impact state and local finances and services.

In addition, the report makes recommendations about how to better manage the impact of federal deficit reduction. “There can be an alarming disconnect between federal and state policymakers,” the task force said.

The report urged the creation of a centralized, independent mechanism for improved reporting and analysis of state financial data, which could be housed in a federal department or the Congressional Budget Office. It also recommended the president issue an executive order to require cabinet agencies to coordinate with state and local governments on major actions affecting them. Additionally, the task force recommended that the federal government work with states to engage in a major review of policies affecting state governments.

BY NAOMI JAGODA

JAN 14, 2014 12:01am ET

A measure of U.S. municipalities’ variable-rate borrowing costs is the lowest in more than two decades as issuance of such debt is down 87 percent since 2007.

The Sifma Municipal Swap Index, which tracks 7-day, variable-rate demand notes, fell to 0.03 percent on Jan. 8, Katrina Cavalli, a spokeswoman for the Securities Industry and Financial Markets Association, said in an e-mail. That’s the lowest since the measure began in July 1989, data compiled by Bloomberg show. Sifma, which calculates the index, is a New York-based trading group representing banks and investors.

The yield is falling as localities avoid adjustable-rate securities, said Michael Decker, co-head of Sifma’s municipal securities division. They’re favoring fixed-rate debt to lock in long-term financing as interest rates remain below historical averages. Twenty-year general obligations yielded 4.68 percent on Jan. 2, compared with the five-decade average of 5.87 percent, according to a Bond Buyer Index.

“It’s a supply-demand issue,” Decker said. “There really is a shortage of variable-rate securities and that’s driving rates down.”

The Federal Reserve’s policy of keeping its benchmark for overnight interest rates near zero is also pushing down the index, Decker said.

Local governments from California to New York issued $25 billion of variable-rate securities and derivatives in 2013, Bloomberg data show. That’s down from $195 billion in 2007. The Sifma index has averaged 2.81 percent since it began in 1989.

The dropping index means smaller payments to investors. Bondholders receive 0.46 percent on Massachusetts general obligations that mature in January 2018 and adjust according to the Sifma index. That’s down from 0.56 percent when the bonds were issued in December 2012.

The floating-rate index will probably rise in the next few weeks as issuance picks up across the municipal market from a January lull, said Lyle Fitterer, who helps manage $31 billion of munis, including the Sifma-based Massachusetts general obligations, at Wells Capital Management in Menomonee Falls, Wisconsin.

The Sifma may climb to about 0.1 percent in that period, he said.

Interest rates also fell on fixed-rate municipal debt this week as scheduled issuance remained below the one-year average.

Yields on benchmark 10-year munis fell to 2.8 percent today, the lowest since Nov. 13, data compiled by Bloomberg show. The interest rate has declined 0.19 percentage point this week, the steepest drop since December 2011.

To contact the reporter on this story: Michelle Kaske in New York at mkaske@bloomberg.net

By Michelle Kaske January 10, 2014

Market Had $103 Million Inflow as Investors Saw Value in Beaten-Down Bonds.

Investors put a net $103 million into municipal-bond funds in the latest week, breaking a 33-week redemption streak that has weighed heavily on the market, Lipper said Thursday.

Redemptions surged in 2013 as investors first reacted to rising interest rates, and later to credit worries caused by Detroit’s record municipal bankruptcy and speculation that Puerto Rico’s debt would be restructured. The Lipper data include exchange-traded funds.

Municipal bonds declined 2.55% last year making it the market’s worst performance since 1994, according to the Barclays Municipal Bond Index.

The fund flow data “is positive for the market considering it’s the first inflow numbers we’ve seen in half a year,” said Chris Mauro, a muni strategist at RBC Capital Markets.

The muni market has started to improve this year as fund outflows eased and fund managers saw value in bonds dragged down by the widespread selloff. Ten-year municipal-bond yields this week declined to as low as 91.29% of Treasurys, the lowest ratio since May 24, according to Thomson Reuters Municipal Market Data. The ratio was 91.90% on Thursday.

However, fixed-income funds are facing tough competition for investor cash from equity funds, which drew $5 billion in new cash in the latest week, Mr. Mauro said.

By AL YOON

Jan. 16, 2014 6:14 p.m. ET

National and local philanthropic foundations have committed $330 million toward a deal to avoid cuts to Detroit retirees’ pensions and to save the Detroit Institute of Arts’ renowned collection, federal mediators involved in the city’s bankruptcy proceedings announced on Monday.

The plan was a first both in the foundation world, which has not been a source of money to shore up public-sector pensions in the past, and in municipal bankruptcy cases, experts said. It also offered the first indication of progress in the intense mediation with Detroit’s creditors to resolve the city’s financial crisis. Those talks have been proceeding under strict secrecy guidelines.

Nine foundations, many with ties to Michigan — including the Ford Foundation, the Kresge Foundation and the John S. and James L. Knight Foundation — have pledged to pool the $330 million, which would essentially relieve the city-owned Detroit Institute of Arts museum of its responsibility to sell some of its collection to help Detroit pay its $18 billion in debts. In particular, the foundation money would help reduce a portion of the city’s obligations to retirees, whose pensions are at risk of being reduced in the bankruptcy proceedings. By some estimates, the city’s pensions are underfunded by $3.5 billion.

“The Wedding Dance,” at the Detroit Institute of Arts, was valued at $100 million to $200 million. Fabrizio Costantini for The New York Times

As part of the plan, which negotiators have been working on quietly for more than two months, the museum would be transferred from city ownership to the control of a nonprofit, which would protect it from future municipal financial threats. The foundations would stipulate that Detroit must put the money into its pension system, said Alberto Ibargüen, president of the Knight Foundation.

The unusual effort by the foundations was not the first instance of charitable groups’ and high-profile figures’ trying to help the ailing city. Previous contributors include Lloyd C. Blankfein, the chief executive of Goldman Sachs, and Warren E. Buffett, the billionaire investor, who attended an event with city and state leaders in November to announce a $20 million initiative to help small businesses in Detroit.

But it is far from certain whether the new pledges will bring about a deal to save the museum while also helping the city meet its pension obligations, and several possible roadblocks remain. As much as $500 million may be needed to protect the art from an auction, officials have said, so additional philanthropic donations are being sought. Detroit is also contending with some 100,000 creditors in its federal bankruptcy case, and some are expected to oppose the plan. Even if the notion were to proceed, it would not be enough to resolve the city’s pension underfunding, but merely to ease it somewhat.

Moreover, the foundation deal would address only a portion of the larger bankruptcy puzzle, a vast array of debts, creditors and assets that must be rearranged before the city can emerge from the nation’s largest municipal bankruptcy.

“There’s a lot of detail to work out here — it’s a moving target,” said Mariam C. Noland, president of the Community Foundation for Southeast Michigan, a 30-year-old philanthropy organization in Detroit that began rallying national foundations last fall after the federal judge mediating the bankruptcy case, Gerald E. Rosen, approached her with the idea.

Still, many people saw the proposal as a positive development, and perhaps as a sign that more agreements may be coming in a case that no one wants to see linger.

“When you start seeing first settlements come down the road, you’re seeing the dawn of a Chapter 9 plan that is to be confirmed,” said James E. Spiotto, an expert on federal municipal bankruptcy, known as Chapter 9.

Kevyn D. Orr, Detroit’s emergency manager, who led the city to file for bankruptcy, said he welcomed the foundation proposal but emphasized in a statement that many issues remained.

City pension officials praised the unusual approach being taken to shore up the pension funds that are essential to 20,000 city retirees and 10,000 current workers. “Any way the process can raise funds to meet its pension obligations, we’re in support of this,” said Bruce Babiarz, a spokesman for the pension system.

Among other creditors, many of whom declined to speak on the record because the private talks were continuing, the proposal drew a more mixed response.

Some saw it as appealing, if only because it would bring the city that much closer to a relatively speedy, consensual resolution of the bankruptcy. Others objected, saying that the deal appeared to give pensioners priority over some other creditors and that the city might get more for the art by selling it.

Last year, Mr. Orr’s office hired Christie’s to appraise a portion of the collection that included many of the museum’s masterpieces. The auction house said that selling this portion would generate $454 million to $867 million. A group of creditors, including unions and financial institutions, is scheduled to challenge the appraisal in bankruptcy court next week.

Even before Detroit filed for bankruptcy, the fate of the art collection — one of the few city assets that is both highly valuable and easily portable — became linked in the public mind with the fate of pensioners. Yes, the art is a cultural and historical treasure, the reasoning went, but is it more important than payments people rely on for food and bills? If selling the paintings could help pay those checks, shouldn’t the paintings be sold? Museum officials and supporters worried about the debate’s being framed in such a way and warned that the thinking was flawed and shortsighted.

Ms. Noland, the community foundation president, said a plan to help pensioners and protect the art began to form last fall when Judge Rosen, whom she knows, called her. His office “reached out to me and said: ‘We have an idea. What do you think about raising $500 million?’ ” she said. “And I said, ‘Are you crazy?’ Actually, I didn’t say that — you don’t say that to a federal judge. I said, ‘Let me call some people I know.’ ”

Ms. Noland called a dozen foundations across the country — many with more substantial means than hers, which has about $650 million in assets — and on Nov. 5, representatives of many of those foundations met in a conference room in Detroit’s federal court building to discuss how much they would be willing to contribute.

“It became a very attractive and persuasive idea,” Ms. Noland said.

Darren Walker, president of the Ford Foundation — the nation’s second-largest private foundation, with $11 billion in assets — said that it was “unprecedented and monumental for philanthropies to undertake this kind of initiative,” but that “if there was ever a time when philanthropy should step up, this is it.” He said he was confident that the $500 million could be raised, but warned that aside from raising the money and offering a way to “break the logjam,” the foundations had no other power to broker a deal.

When the idea was first proposed, foundations were not sure how to react. “It seemed like an enormous amount of money for an idea that nobody had thought through,” said Mr. Ibargüen, the Knight Foundation president. “I think nobody thought then — that day, that night — that we would be able to move this as fast as possible.”

Ultimately, the Knight Foundation committed $30 million, the largest single sum it has ever pledged.

By RANDY KENNEDY, MONICA DAVEY and STEVEN YACCINOJAN. 13, 2014

Bank of America Corp. managed the most municipal bond issues for the second-straight year.

Fees that Wall Street charges U.S. cities and states to sell their bonds fell for a fourth straight year in 2013 as dwindling debt issuance intensified competition among banks for underwriting business.

In one example of an issuer that benefited, the New Jersey Turnpike Authority in March paid banks led by JPMorgan Chase & Co. (JPM) about $1.85 million to sell $1.4 billion of bonds backed by tolls, according to an offering statement for the debt. The fee of $1.32 per $1,000 of bonds was one-third of the cost in 2010, said Donna Manuelli, chief financial officer of the agency.

The average expense last year for municipalities to issue long-term, fixed-rate bonds in the $3.7 trillion market fell to $5.42 per $1,000, the lowest since at least 2009, data compiled by Bloomberg show.

“In a declining market, they’re trying to pick up market share,” Manuelli said in a telephone interview. Other banks proposed similar fees, she said.

More than four years after the longest recession since the 1930s, municipalities are loath to borrow as they are starting to mend their finances, said Bart Mosley, co-president of Trident Municipal Research in New York. Long-term fixed-rate U.S. municipal bond sales fell 15 percent to about $294 billion in 2013, Bloomberg data show.

Scaling Back

U.S. localities also scaled back refinancing as Detroit’s record bankruptcy filing in July and speculation that the Federal Reserve will curb its bond buying pushed borrowing costs to the highest in more than two years in September. Interest rates soared from generational lows set at the end of 2012.

Municipal issuers refunded much of their higher-cost debt before 2013 as the Fed kept its benchmark overnight interest rate near zero and purchased long-term bonds to stimulate the economy, Mosley said.

The Federal Open Market Committee in December decided to cut monthly purchases of Treasuries and mortgage debt by $10 billion, to $75 billion, citing improvement in the labor market that pushed the jobless rate to a five-year low of 7 percent in November.

“Issuers know that banks are competing for a dwindling pool of business,” Mosley said. “Price becomes the differentiating factor.”

The shrinking commissions also reflect decisions by states and local governments to eschew complex deals laden with derivatives, which generated higher fees, in favor of simpler structures, he said.

No. 1

Bank of America Corp. managed the most municipal bond issues for the second-straight year. The Charlotte, North Carolina-based bank handled $42.2 billion of long-term, fixed-rate sales, according to Bloomberg data. New York-based JPMorgan ranked second for the second year in a row, managing about $38 billion.

The New Jersey authority oversees the 148-mile (238-kilometer) turnpike and the 172-mile Garden State Parkway. Its debt carries an A3 rating from Moody’s Investors Service, six steps below the top, and an A+ rating from Standard & Poor’s, two levels higher.

Demand for the agency’s tax-free obligations typically outstrips supply, reducing the chance that underwriters will be left with unsold bonds, said Manuelli, the chief financial officer. New Jersey residents’ top income-tax rate ranks fifth among U.S. states that assess the levy, according to the Tax Foundation, a nonprofit research group in Washington.

Excess Orders

“We’re always oversubscribed,” meaning investors place orders for more bonds than are being offered, she said. Underwriters “view the risk as a minimum.”

Manuelli said JPMorgan assured her that the lower fees wouldn’t affect the pricing of the bonds and increase borrowing costs. Ten-year Turnpike Authority bonds were priced on March 20 to yield 2.57 percent, or 0.06 percentage point below a Bloomberg index of A rated revenue bonds.

Jessica Francisco, a JPMorgan spokeswoman, declined to comment, as did Zia Ahmed, a Bank of America spokesman.

Colin MacNaught, assistant treasurer of Massachusetts, also said underwriting costs have declined.

In November, fees on long-maturity bonds typically sold with a $5 commission were issued with a $3.75 fee, the lowest in MacNaught’s six years with the state and saving taxpayers almost $500,000, he said.

Bank Bids

A September auction of about $800 million of short-dated debt drew 106 bids from 20 banks, MacNaught said. The state paid $6,500 in fees on the deal, he said.

Massachusetts issues 80 percent of its debt by competitive bid, in which underwriters bid against each other for the securities.

Nationwide last year, about 20 percent of the dollar volume of munis were sold with that method.

Localities offered the remaining 80 percent through negotiated sales, in which issuers select a bank and negotiate fees in advance of a sale, comparing qualifications, performance and fees.

The average cost for negotiated offerings in 2013 was $5.37 per $1,000 of debt, compared with $5.71 for competitive offers, Bloomberg data show.

Same Dynamic

States and localities stand to reap the benefits of lower fees for the next few years, Mosley said.

“I don’t see anything in the next few years that changes the dynamic,” he said.

The borrowing slowdown is extending into 2014, with localities scheduling about $6.5 billion of debt sales in the next 30 days, about 29 percent below the one-year average.

The issuance lull is feeding lower debt costs. Benchmark 10-year munis yield 2.84 percent, the lowest since Dec. 2, and compared with 2.97 percent on similar-maturity Treasuries.

The ratio of the interest rates, a measure of relative value, is about 96 percent, close to the lowest since May, compared with a five-year average of 99 percent. The lower the figure, the more expensive munis are compared with federal securities.

By Martin Z. Braun  Jan 9, 2014 5:00 PM PT

To contact the reporter on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

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LOS ANGELES — Municipal bond underwriters can now apply to two Los Angeles requests for qualifications seeking financial advisors, but they aren’t likely to find the restrictions encouraging.

Los Angeles officials say a protest from Dallas, Texas-based FirstSouthwest against the exclusion of underwriting firms had nothing to do with the decision to modify the RFQs.

“We are trying to obtain as large of a pool as possible to insure that we have the best financial advisors in that pool,” said Miguel Santana, Los Angeles’ City Administrative Officer.

The city deleted the section that FirstSouthwest disputed in the original RFQs issued in November that excluded firms “that underwrite or otherwise trade in municipal bonds.”

But it added a new section stating that applicants must submit with their proposals an affirmative statement acknowledging that their firm will be precluded from participating in the underwriting or purchasing of bonds of issuers within California during the term of the contract, plus two years after the city contract ends.

It also extended the deadline for proposals to Jan. 28.

Santana said Los Angeles changed the language to have as large a financial advisor pool as possible, while still being able to conduct competitive procurements for city bond issues.

“We wanted to provide more clarity as to what the city’s expectations are, so we made some minor changes,” he said.

The Los Angeles CAO did not view excluding underwriting in the entire state for selected financial advisors as particularly conservative.

“As underwriters selling bonds in California, they might be competing in the same marketplace as our bonds,” Santana said. “If you look at the marketplace, it is not just exclusively related to the city.”

Jack Addams, vice chairman of FirstSouthwest, said his firm doesn’t agree with the stipulation that applicants agree not to underwrite bonds anywhere in California, the largest market for municipal bond issuance.

“We are not fine with the entire state of California,” Addams said. “I don’t understand how you get from implementing GFOA [Government Finance Officers Association] best practices to there.”

FirstSouthwest intends to apply for both RFQs, but the company’s affirmative statement will only state that it agrees to not act as an underwriter for Los Angeles – not all of California – if selected to act as a financial advisor for the time frame mentioned, Addams said.

“We agree with the GFOA recommendation that you can’t underwrite during the period of time you are acting as financial advisor for that issuer; and even having to lock out of underwriting for a couple of years after,” Addams said.

The broker-dealer acted as an underwriter on two California transactions during 2013 totaling roughly $70 million, according to Thomson Reuters.

It was a co-manager in a syndicate that won the competitive bid for $55.7 million of general obligation refunding bonds sold by the Los Angeles Community College District in May.

It also acted as sole underwriter on $14.04 million of water revenue bonds sold through negotiation by the Tustin Public Financing Authority in October.

“We are not a big player on the underwriting side,” Addams said. “It is the principle of the thing.”

FirstSouthwest has hired two new bankers to expand its underwriting business in California. Mike Awabis as a senior vice president in Santa Monica and Ryan Chiriboga as an assistant vice president in Phoenix, but who does all of his business in California.

“It is not a business we want to give up, because we are going to go after both financial advisor and underwriting business in California,” Addams said. “We have never been a major player underwriting in California, but I want to build that business.”

Santana said his staff has been working with the city attorney to develop language to attract a broad pool, but they didn’t want any conflicts with underwriters who do financial advisor work in California.

“This concern predates any action by the GFOA or the MSRB [Municipal Securities Rulemaking Board]”, Santana said. “We have been mindful of this conflict for a long time.”

The city’s debt management policy, adopted in 2005, deems it a conflict of interest for firms to do business with the city as both an underwriter and financial advisor.

Los Angeles’ actions come against a backdrop of regulatory changes from both the federal government and industry associations.

Regulations adopted by the MSRB, Dodd-Frank legislation, and changes proposed by the U.S. Securities and Exchange Commission that go into effect in mid-January have changed the playing field with rules regulating how FAs operate.

In November 2011, MSRB’s Rule G-23 was modified to prohibit dealers from serving as FAs and underwriters on the same municipal bond deal.

The city used underwriters as co-financial advisors before the MSRB came out with its rules, but typically only in special situations where it wanted sell-side advice on an issue, city officials said.

The MSRB is holding a press conference on Jan. 9 to discuss a proposed standards to guide the conduct of municipal advisors, including regarding their fiduciary duty to put client’s interests first.

Dodd-Frank legislation imposed a fiduciary duty on MAs and required for the first time that non-dealer MAs be subject to the same MSRB rules as broker-dealers.

BY KEELEY WEBSTER

JAN 8, 2014 4:37pm ET

A new study finds reasons for optimism for municipal finances. But California is the outlier.

It might seem, given the spate of municipal bankruptcies of recent years, that there’s little to be hopeful about for some of America’s harder-pressed cities. But the picture may not be as bleak as we’ve thought.

A recent study from Boston College’s Center for Retirement Research finds that in the wake of Detroit’s bankruptcy, other cities are not poised to fall like dominoes. And contrary to what we hear with increasing frequency, pensions are not the biggest problem for cities that are in financial trouble.

But the relatively good news comes with one major caveat: None of this applies if you happen to live in California. It is from California’s mistakes that other state and municipal leaders should learn.

The study, “Are City Fiscal Woes Widespread? Are Pensions the Cause?”, looked at 32 American cities identified in press reports as being in financial trouble. The authors applied various measures of financial mismanagement, overall economic condition and pension burden to each city and found that financial mismanagement has the biggest impact and pension burden the least.

But California is the outlier. It is home to 10 of the 32 cities identified as being in financial trouble. For them, pensions are indeed a major problem.

The authors identify three causes of California’s woes. First is the explosion of government-by-initiative that occurred in the wake of Proposition 13 in 1978, which limited skyrocketing property tax hikes. To prevent state leaders from making up for the loss of property tax revenue by raising other taxes, the measure required a two-thirds legislative majority for any tax increase.

A spate of subsequent initiatives have called for either tax cuts or new programs but, due to the required supermajority for new taxes, simply punted on finding the money to fund the initiatives. As a result, the state has lost control of its finances, and local governments have borne much of the impact.

The problems were magnified when California was hit harder than most other states by the 2008 financial crisis and subsequent recession. Even now, the state’s rate of municipal revenue growth is far lower there than in most other states.

On the pension front, California retroactively expanded benefits in the 1990s, which has made its pension costs among the nation’s highest. State law also protects the pension benefits of current public employees, which takes away some of the flexibility needed to address the problem.

California succumbed to two classic temptations. First, it became convinced that the good times would last forever and conferred benefits that could not be sustained during lean years. Second, it sacrificed the future for short-term political gain by enacting popular new programs or tax cuts without paying for them.

If the authors of the Boston College study are right, many municipal leaders can exhale. But their constituents can’t afford for them to fall into the same traps that still have Californians reeling.

Read the study at:

http://crr.bc.edu/wp-content/uploads/2013/12/slp_36.pdf

BY CHARLES CHIEPPO | JANUARY 8, 2014

As a candidate for Seattle mayor last fall, Ed Murray campaigned on a pledge to lift his city’s minimum wage to $15 an hour, which could make Seattle the first major U.S. city to have a wage floor that high. But Murray quickly encountered a problem that may serve as a lesson to other government leaders who chastise the private sector for paying low wages: Seattle city government would see an increase of $690,000 in labor costs if it met the standard Murray proposed, according to reporting by Crosscut.com, a nonprofit news site. That’s because 663 city government employees — about 6 percent of city staff — currently make less than the living wage Murray says he wants for all workers in Seattle.

So far, the budget impact hasn’t scared off Murray. For his first executive order, signed last Friday, he directed the city budget office and personnel department to draft a plan for implementing a minimum wage of $15 an hour for all full-time city employees. Ultimately, any proposal would require legislation from the city council. The estimated cost of raising wages would be less than a quarter of 1 percent of all spending in the city’s 2013 budget. Still, the fact that Seattle, a bastion of liberal policy making, doesn’t already pay its own employees $15 an hour, hints at the uphill battle labor unions and advocates for the working poor may face as they try to convince the private sector to increase pay amid a slow economic recovery.

Murray’s interest in ratcheting up the wage floor comes at a time when President Barack Obama and Democrats in the U.S. Senate are calling for an increase to the federal minimum wage. Fast food workers have scheduled at least two national strikes in past year demanding higher pay. Last year several states decided to elevate their minimum wage above the federal standard of $7.25 an hour, either by popular vote or through legislation. The topic is likely to become a focus for some Democratic governors, such as Maryland Gov. Martin O’Malley, and other left-leaning local elected leaders in 2014.

A poll by the Pew Research Center and USA TODAY last year found that 71 percent of Americans favored a higher minimum wage (from $7.25 to $9) but support varied by political persuasion. About 87 percent of Democrats favored the proposal, but only 50 percent of Republicans. Independents fell between the two groups, with about two-thirds supporting an increase. Even when Republicans support a wage hike, as New Jersey Gov. Chris Christie did last year, it’s typically with caveats, such as a multi-year phased-in approach that dilutes the impact relative to annual cost-of-living increases.

When the New Jersey State Legislature evaluated a bill to increase the state’s minimum wage from $7.25 to $8.25 an hour — a more modest proposal than what’s being discussed in Seattle — legislative fiscal analysts concluded that some city and county governments would see their labor costs go up. Essex County, for example, paid 211 seasonal employees in the parks department a wage of $8 per hour in 2012. Assuming the county continued to pay these workers minimum wage and kept the same number of staff, it would pay $25,800 more in labor costs. The analysis also noted that some private contractors that provide services on behalf of state, county and city government may pay their employees minimum wage and would see an increase in labor costs.

By contrast, in the District of Columbia, raising the minimum wage by $3.25 over three years would hardly make a dent in the district’s labor costs. That’s because no hourly government employee who works for the district today makes less than $11.75 an hour. The chief financial officer did note, however, that the district would have to hire two auditors and an administrative assistant to implement and enforce the policy change, amounting to about $225,000 per year in new labor costs for those three positions.

The Seattle proposal is on the high end of state and local minimum wages across the country. In December the city council in the District of Columbia passed legislation that would set the minimum wage at $11.50 by 2016, with future increases tied to the local Consumer Price Index (CPI), a proxy for the rising cost of living. San Francisco’s wage floor is $10.74, with automatic increases each year. Washington state has the highest state-level minimum wage at $9.32 per hour, which also goes up automatically each year.

Voters in SeaTac, a small city with a population of 27,000 residents that is best known for its international airport, passed a ballot measure in November that sets the local minimum wage at $15 an hour; however a King County Superior Court judge ruled that the law doesn’t apply to workers at the airport, so the law only affects about 1,600 people who work at hotels and car services outside the airport.

Like private employers, governments can absorb the higher labor costs by reducing other costs, including the number of staff, and by charging more for services; in Seattle, for example, the city could glean extra revenue from parking fees and facility rentals at the former Seattle Sonics basketball stadium, Key Arena.

The Seattle budget office estimates assumed that the city would increase its minimum wage immediately, rather than phasing in higher wages over several years — as the District of Columbia and its neighboring Maryland counties decided to do in December. Murray has carefully worded his support of raising the minimum wage as “moving towards a $15 living wage” and has left open the possibility that Seattle would also increase the wage floor in increments.

BY J.B. WOGAN | JANUARY 7, 2014

As Detroit struggles to come up with money to improve services for its residents, two large banks are poised to receive hundreds of millions of dollars to cancel a deal that helped push the city into bankruptcy in the first place.

The two banks, UBS and Bank of America, were the only creditors that managed to reach a settlement with Detroit before the city declared bankruptcy last July. They agreed to let Detroit out of financial contracts called interest-rate swaps for 75 percent of what the city owed, or about $230 million. They also agreed to give up some casino tax proceeds that Detroit had pledged to them as collateral for the swaps.

The 75 cents on the dollar is a far better deal than the city’s other creditors will probably get. And because of an unusual provision in the federal bankruptcy code, these two banks actually have a legal right to 100 cents on the dollar. The provision gives traders in swaps, options and other derivatives a so-called safe harbor, exempting them from the usual stay that blocks creditors’ efforts to collect debts.

The provision has turned on its head the meaning of safe harbor in bankruptcy. Bankruptcy proceedings are supposed to give debtors like Detroit a safe place to negotiate a way out their problems under the protective eye of a federal judge.

Bankruptcy law rests on the bedrock principle that the best outcome can be achieved if everybody shares equitably in the pain and losses. But in the brave new world of municipal bankruptcy, the law gives derivatives traders an even safer harbor than Detroit’s.

“These safe harbors make no logical sense in this context,” said Steven L. Schwarcz, a professor at Duke University School of Law who has written on the special treatment of derivatives in corporate bankruptcies. Detroit was in bankruptcy court last week seeking approval for its deal with Bank of America and UBS.

But on Friday, the bankruptcy judge, Steven W. Rhodes, sent the city and the banks back to confidential mediation to improve the terms for the city. The mediation was expected to continue through Christmas Eve.

But in the tangle that is Detroit’s finances, the swaps deal is only one part of the equation. The city is seeking to borrow $350 million from another bank, Barclays Capital, to finance its operations in bankruptcy, and it needs to resolve the swaps deal before it can get the loan. Without the loan, lawyers for the city say, it soon might not be able to meet its payroll.

But any time a debtor tries to borrow in bankruptcy, it stirs opposition, since the new loan will worsen the insolvency. The Barclays deal also gives it priority over all the existing creditors. And the bulk of the $350 million loan will go to pay UBS and Bank of America to terminate the swap contracts. Since those two banks would no longer need Detroit’s casino revenue as a backstop, the city could then use that money as collateral for the new Barclays loan.

The rest of the proceeds from the loan, $120 million, would go to the streetlights, the police, the razing of dilapidated properties and other city services that the residents of Detroit sorely need.

Last week’s hearing over these arrangements broke down when Judge Rhodes asked the city’s emergency manager, Kevyn Orr, to explain why 75 cents on the dollar was a good deal. Mr. Orr declined to answer the question and asked instead for the hearing to be suspended.

If the current mediation talks fail, the two banks would once again have the safe harbor advantage under law, leaving Detroit to fight back in court by arguing that the swaps were flawed in some way and unenforceable. James E. Spiotto, a bankruptcy lawyer with the law firm Chapman and Cutler in Chicago, who is not involved in Detroit’s case, said that prospect might explain why Mr. Orr was unwilling to sing the praises of Detroit’s swap settlement in court. If he had, it would be hard for Detroit to come back with a lawsuit contending the swaps were no good.

Bank of America and UBS declined to comment.

Congress created the safe harbor for derivatives because they could pose systemic risk — if one bankrupt institution failed to make payment, it could swiftly bankrupt its trading partners, and they, in turn, might bankrupt their other trading partners, setting off a toxic cascade.

But some bankruptcy experts question the fairness or even the effectiveness of this exception.

Professor Schwarcz said it was not clear that the safe harbors were serving their intended purpose even in cases where the debtors are companies — let alone in a municipal bankruptcy like Detroit’s, where thousands of residents are being dragged along on the miserable journey.

“When you’re in a municipal bankruptcy, where the debtor is a municipality, there are very strong public-interest considerations that ought to be balanced,” Mr. Schwarcz said. He and other specialists said there had not been any such discussion in Detroit’s case. Nor, they said, has anyone in Congress asked whether this part of the bankruptcy code was working properly.

“There is very, very strong interest-group support for keeping the safe harbors, but there’s not a well-developed interest group that understands the need to change them,” said David A. Skeel Jr., a corporate law professor at the University of Pennsylvania. “In my view, there ought to be strong pressure to change the safe harbors.”

Congress began exempting derivatives from the automatic stays on collecting debts in bankruptcy in 1978. The initial exemptions — options and futures, among them — were narrow, Mr. Schwarcz wrote in a legislative history of the safe harbor. But every few years after that, Congress broadened them and added new types of derivatives, including swaps in 1990.

Mr. Schwarcz found in his research that the expansion of the safe harbor helped the derivatives industry to grow. The growth then led to bigger risks of a meltdown, prompting calls from the derivatives industry for Congress to expand the safe harbor even further.

In all that growth and expansion, he said in an interview, no one stopped to make sure the safe harbor was truly reducing systemic risk or covering the right types of institutions. The surfacing of safe harbor in a bankruptcy like Detroit’s seemed especially jarring.

Detroit entered into the swap contracts back in 2005, when it tapped the municipal bond market for $1.4 billion to put into its workers’ pension funds. Much of the deal was structured with variable-rate debt, and the swaps were intended to work as a hedge, to protect Detroit if interest rates rose. But as things turned out, rates went down, and under those circumstances, the terms of the swaps called for Detroit to make regular payments to UBS and Merrill Lynch Capital Services, now part of Bank of America. Detroit has been doing so, even in bankruptcy. The swaps now cost it about $36 million a year.

In retrospect, it seems clear that Detroit was already struggling in 2005 and a poor candidate to borrow the $1.4 billion. The borrowing required an unusual structure to avoid violating the city’s legal debt limit. In 2009, the debt was downgraded to junk, putting the city out of compliance with the terms of the swaps. So Detroit restructured the swap obligations, offering the two banks the tax revenue that it received from local casinos as a backstop.

The city’s finances went from bad to worse after that. Now that Detroit is bankrupt, it needs those casino revenue, and some of its biggest battles are being fought over how it dealt with that swap restructuring back in 2009.

“You look at this transaction, and you say it smells,” said Mr. Skeel, who is currently a visiting professor at New York University’s law school. “It looks exactly like the sort of thing that you would want a bankruptcy judge to be in a position to sort out, and reverse if that is necessary. That’s something that the safe harbors make a lot harder.”

BY MARY WILLIAMS WALSH

In 2013, the FASB continued to work with the IASB on the boards’ various convergence projects. In addition to continuing their discussion of the feedback on the proposed leases standard, the boards have essentially completed their redeliberations of their joint revised revenue recognition ED and are planning to issue a final standard on this topic in the first quarter of 2014.

In other news, the SEC has continued to focus on its rulemaking in response to mandates of the Dodd-Frank and JOBS acts by, for example, issuing final rules on registration of municipal advisers and general solicitation related to securities offerings. The Commission has also issued FAQs on its controversial final rule on conflict minerals, which was recently upheld by a federal court.

These and other developments are discussed in Deloitte’s 2013 edition of Accounting Roundup: Year in Review. The publication summarizes final guidance that affects reporting and disclosures for the coming reporting season, and covers new standards and exposure drafts in accounting, auditing developments, governmental accounting and auditing developments, and regulatory and compliance developments. It also contains an appendix listing significant adoption dates and deadlines.

With the exception of guidance issued in December, proposed guidance, such as exposure drafts and invitations to comment, is not included. Please see our 2013 monthly and quarterly issues of Accounting Roundup for more information about these documents. In addition, note that in this year-end edition, an asterisk in the article title denotes events that occurred in December or that were not addressed in previous 2013 issues of Accounting Roundup, including updates to previously reported topics. Events without asterisks were covered in those previous issues.

So what will be the focus for 2014? In addition to issuing their joint revenue standard, the FASB and IASB expect to issue final guidance related to the classification and measurement and impairment phases of their project on financial instruments. Further, the FASB, in coordination with the PCC, is expected to issue final ASUs on its private-company alternatives related to goodwill and hedge accounting in early 2014.

View the report at:

http://deloitte.wsj.com/riskandcompliance/files/2014/01/Accounting_Roundup_2013_Review.pdf

Bankers who sold Detroit interest rate swaps placed “a ticking time bomb” in their structure, the city’s emergency manager said in court as a trial resumed over a proposal for ending the swaps.

Although the city collected $40 million over eight months from the swaps deal, falling interest rates helped the banks behind the deals turn a profit, Orr testified today before U.S. Bankruptcy Judge Steven Rhodes in Detroit. Since 2009, the city has paid more than $200 million to the banks behind the swaps, according to public records.

The city has proposed paying UBS AG (UBSN) and Bank of America Corp. a $165 million termination fee to get out of the swaps contract.

Days before Detroit filed the biggest ever U.S. municipal bankruptcy in July, Orr negotiated an agreement to end the swaps at a discount. After that deal was attacked by creditors and questioned by Rhodes, the city on Dec. 24 announced a renegotiated termination payment about $65 million less than the original.

The swaps are tied to pension obligation bonds issued in 2005 and 2006. They were designed to protect against rising interest rates by requiring the banks to pay the city if rates rose above a certain level. When rates instead went down, the city was required to make monthly payments.

SEC Consulted

Orr testified that after he became emergency manager last year he had “plenty” of concern over whether the swaps were fraudulently put together. He said he asked the U.S. Securities and Exchange Commission if it would be willing to investigate the deal.

Megan Stinson, a spokeswoman for Zurich-based UBS, said the bank couldn’t immediately respond to Orr’s comments.

Eventually, Orr testified, he decided to settle with the banks instead of suing them in order to avoid a risky trial and prevent any threat to casino taxes used to guarantee payment of the swaps.

Creditors led by bond insurer Syncora Guarantee Inc. oppose the settlement, saying it’s too costly. The city didn’t prove it would lose if it sued to cancel the contracts instead of settling with the banks, Syncora said.

Syncora said in court papers that the deal could cost it money as the insurer of some of the bonds and swaps. Under the settlement, Syncora would be released from any obligations related to the swaps, according to the city.

Bond insurer Ambac Assurance Corp. claimed Detroit could win any lawsuit against UBS and Charlotte, North Carolina-based Bank of America over the swaps.

A mediator who helped craft the latest deal recommended the $165 million settlement, saying it was in the best interest of all parties involved.

The case is In re City of Detroit, 13-bk-53846, U.S. Bankruptcy Court, Eastern District of Michigan (Detroit).

To contact the reporters on this story: Steven Church in Wilmington, Delaware at schurch3@bloomberg.net; Steven Raphael in Detroit at sraphael5@bloomberg.net

To contact the editor responsible for this story: Andrew Dunn at adunn8@bloomberg.net

Bloomberg

Public finance in 2014 looks to be more stable than in previous years. But stable doesn’t mean easy. Here are some predictions for the coming months.

Less action in the municipal market

The recent trend of money flowing out of the municipal market will continue into 2014. Several analysts are predicting a 12 percent decline in overall municipal bond sales (called new issue volume) next year to $285 billion total. This is mostly due to rising interest rates (thanks in part to the Fed slowing its bond buying program) curbing refinancing (or refunding) activity.

So what does this mean for governments that issue bonds? It’ll be more expensive to borrow money but it’s not all bad. Rising interest rates are not expected to dampen the trickle of new bond sales. RBC Capital Markets’ Chris Mauro predicts that “pent-up demand, in conjunction with improved state and local government fiscal profiles” will actually push an increase in new bond sales for governments. He estimates that new issuances like these will total $185 billion in 2014 from approximately $160 billion in 2013. That’s a far cry from the $252 billion-per-year average between 2000 and 2010, but it’s at least moving in a positive direction.

Still more ratings confusion

The credit ratings agencies will continue to disagree on the financial stability of municipalities. Fitch Ratings Agency this month announced it expects to continue its trend of downgrading more local governments than it will upgrade. Fitch, which gives a negative outlook for local governments, cites slow revenue growth and increased spending pressures on localities.

Meanwhile, Moody’s Investors Service revised its outlook this month for the U.S. local governments from negative to stable. The outlook cites stabilizing housing markets and municipalities’ fund balances, and notes that cities and school districts have adjusted their expenses. Still, Moody’s notes that conditions will remain more difficult for local governments than they were before the 2008 recession and pockets of serious credit pressure remain. “The ‘new stable’ will be an era of constrained resources, but the worst is over for local governments in most of the country,” wrote Naomi Richman, a Moody’s managing director, in the report 2014 Outlook — US Local Governments.

Budget stability

Capitol Hill watchers are quick to point out it’s not time to sing Kumbaya and break out the marshmallows for roasting around the campfire just yet. But the proposed bi-partisan budget deal, which has cleared Congress and observers expect the president to sign, at least gives a two-year window of stability to what has been an incredibly hard four years since the economy bottomed out in 2009. The deal would increase the cap on defense and non-defense discretionary spending for the remainder of the 2014 fiscal year, which began on Oct. 1. This means that state and local programs that rely on federal grants and other funding should have a clearer picture of their operating budgets through the next two years.

That kind of relative certainty is a reprive from several years of lurching from one continuing resolution to the next and political brinksmanship forcing stalemates, which culminated in a 16-day government shutdown in October. As Chris Coleman, the National League of Cities president told Governing earlier this month, “We just can’t go through what we went through this past year, the uncertainty for our communities but also the uncertainty for the market and for businesses. It’s a disaster.”

Of course one tiny little snag — the nation’s debt ceiling — could result in another showdown when Treasury reaches its borrowing limit some time in February. Still, the consensus is that congressional lawmakers are inclined to avoid such drama after the negative fallout from October’s shutdown.

Seeking advice on advising

The Securities and Exchange Commission finally issued its highly-anticipated rules on who constitutes a municipal adviser this fall and the nearly 800-page document has raised some questions. By the end of the year the commission will publish a Q&A on its definition of municipal advisers (financial advisers to state and local governments) as an effort to help folks understand how the rules should be applied come Jan. 13. But the transition will be bumpy and will likely require even more clarification as the rule is put into practice.

One big issue so far is that while the SEC’s rules say who constitutes an adviser, the definition does not address what constitutes advice. Numerous groups representing issuers, bankers and lawyers have already requested clarification from the SEC on how to engage with issuers without it being considered advice (for example, providing issuers statistics compiled by the firm) as well as other aspects of the definition.

BY LIZ FARMER | JANUARY 2, 2014

Many local governments across the U.S. face steep budget deficits as they struggle to pay off debts accumulated over a number of years. As a last resort, some filed for bankruptcy.

Governing is tracking the issue, and will update this page as more municipalities seek bankruptcy protection.

Most recently, a federal judge ruled Detroit was eligible to enter bankruptcy, the largest city to ever do so. The state previously appointed an emergency financial manager for the city, saddled with debts totaling an estimated $18 billion.

Overall bankrupt municipalities remain extremely rare. A Governing analysis estimated only one of every 1,668 eligible general-purpose local governments (0.06 percent) filed for bankruptcy protection over the past five years. Excluding filings later dismissed, only one of every 2,710 eligible localities filed since 2008.

The majority of filings have not been submitted by bankrupt cities, but rather lesser-known utility authorities and other narrowly-defined special districts throughout the country. In Omaha, Neb., a dozen sanitary districts have filed for bankruptcy, accounting for nearly a third of all Chapter 9 filings since 2010.

It’s also important to note that only about half of states outline laws authorizing municipal bankruptcy. View our bankruptcy laws map for each state’s policies:

http://www.governing.com/gov-data/state-municipal-bankruptcy-laws-policies-map.html

List of Bankruptcy Filings Since January 2010

All Municipal Bankruptcy Filings: 38

General-Purpose Local Government Bankruptcy Filings (8):

— City of Detroit

— City of San Bernardino, Calif.

— Town of Mammoth Lakes, Calf. (Dismissed)

— City of Stockton, Calif.

— Jefferson County, Ala.

— City of Harrisburg, Pa. (Dismissed)

— City of Central Falls, R.I.

— Boise County, Idaho (Dismissed)

Municipal Bankruptcies Map

The map below shows all municipalities filing for Chapter 9 bankruptcy protection since 2010, along with local governments voting to approve a bankruptcy filing.

Cities, towns and counties are shown in red. Utility authorities and other municipalities are displayed in gray. Click a marker to view details of each filing. Multiple municipalities have filed for bankruptcy in some cities, such as Omaha, Neb., so not all markers are visible without zooming in on the map.

View the map at:

http://www.governing.com/gov-data/municipal-cities-counties-bankruptcies-and-defaults.html

Please note that several municipal bankruptcy filings have been rejected, as indicated.

Map data ©2014 Google, INEGI

Read the report at:

http://img.en25.com/Web/StandardPoorsRatings/2013_1125%20State%20OPEBS%20Liabilities.pdf

Read the report at:

http://img.en25.com/Web/StandardPoorsRatings/Standard%20%26%20Poor%27s%20Does%20Not%20View%20Detroit%27s%20Chapter%209%20Filing%20As%20The%20Start%20Of%20A%20New%20Trend.pdf

Winter weather is tightening its grip on cities. And when the temperature drops, expenses can quickly rise, as snow removal and other costs pile up along with the snow drifts.

Predicting just how much a local government will need to spend for the upcoming winter is only a best guess. Costs vary widely from year to year, depending not only on the severity of the weather, but where on the calendar storms fall and even the time of day a storm hits.

The city of Minneapolis attempts to project its snow and ice removal costs by looking at averages over the previous three to five years. For fiscal year 2013, the city budgeted about $10 million. In recent years, though, the total bill has ranged from slightly more than $7 million all the way up to $12 million. “We try and budget for an average year,” says Deputy Public Works Director Heidi Hamilton. “But there’s never an average year.”

Snow emergencies—usually when the city receives at least four inches—are particularly costly, Hamilton says. But when storms hit also matters, as overtime costs climb on the weekends. Even the mere threat of snow means crews must go out and treat roads.

This unpredictability can quickly drive up costs. Last winter, Worcester, Mass., got hit with about 80 inches of snow, one of the highest tallies in the country. The city spent about $5 million digging out. Matt Labovites, the city’s assistant commissioner of operations at the Department of Public Works and Parks, says he can’t remember the last time the city didn’t exceed its snow program budget. “It’s virtually impossible to closely budget for it,” he says. Fortunately for Worcester, snow removal costs are one of the few services for which Massachusetts allows its localities to deficit spend without incurring a penalty.

Even a single storm can wreck a budget. Back in 2011, for example, an early season storm blanketed Worcester with more than a foot of snow in the last week of October. City equipment and contractors weren’t yet ready, Labovites says. To make matters worse, residents had raked leaves in gutters for leaf collection right before it hit.

Cities, particularly those in snowbelts, opting to budget on the low end take a chance they’ll need to dig themselves out of deeper deficits if they’re hit hard. “If you’re a city that gets 30 inches of snowfall, maybe you do look at it a little bit differently” says Paul Holahan, who heads Rochester, N.Y.’s Department of Environmental Services. Rochester, which receives around 100 inches of snow each winter, budgets for an “above-average” winter. “There’s too big of a potential for a huge [snow] budget that you don’t want to try to absorb,” Holahan says.

BY MIKE MACIAG | JANUARY 2014

Bank regulators’ recent proposal to exclude municipal bonds from the standards for receiving HQLA status would impair Munis’ demand, notes Citi in its recent report.

George Friedlander and others at Citi Research believe a very strong case exists for including a very large proportion of investment grade municipals as HQLA. They believe municipal bonds should be given level 2A status in many cases and level 2B status in most other cases.

Several reasons for inclusion of Munis as HQLA

Recently, bank regulators proposed a set of standards that would, among other things, measure the extent to which bank holdings would meet certain standards as High Quality Liquid Assets.

According to Citi analysts, there are several compelling factors for inclusion of municipal bonds as HQLA.

For instance, the analysts point out that during 2008, when the capital markets received their most severe tests in recent decades, both municipal general obligation bonds and revenue bonds held their value better than higher-grade and lower investment grade corporates. Furthermore, they did so roughly as well as GSE secured bonds such as those issued by Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC).

Commercial banks holdings in munis

As can be deduced from the above table, the net increase in holdings of municipal bonds by commercial banks is much greater than that of municipal bond funds. Citi analysts anticipate erosion in the value of outstanding municipal bonds without the support from commercial banks. Such a situation would also accentuate the borrowing costs of state and local governments.

Citi analysts also note the continuing superior credit strength and default history of municipal bonds in comparison with other similarly rated credits also strengthens their view for inclusion as HQLA.

The analysts also point out under Moody’s credit standards, the average investment grade municipal bond (by count, not volume) is rated AA3, while the average corporate bond is rated Baa1.

Other factors justifying Munis’ inclusion as HQLA

George Friedlander and team at Citi Research believe a number of sectors with greater gap-down risk than munis have been given potential HQLA standing, while municipals have not.

Furthermore, the analysts believe the following key factors also provide a strong case for inclusion of munis as HQLA and would reduce the liquidity risk profile of banks rather than increasing it. These factors are: the collapse of the municipal bond insurance sector, the severe erosion of the variable rate market as a source of capital, the collapse of the auction rate securities market, the rapid erosion and virtual disappearance of leveraged, hedged holders of municipal bonds between 2007 and 2008.

Citi analysts also believe the Agencies should adjust for the higher credit strength in the sector and for the capacity of the market to evaluate CUSIPs for a given issuer that do not trade, based upon spread to the MMD high-grade curve for those that do. The analysts opine that it would be consistent with international standards as well as public policy to include municipal securities as HQLA in the same manner that foreign state obligations are already included in the proposed rule.

Their investments expose government budgets and taxpayers to 10 times more risk than in 1975.

The threat that public-employee pensions pose to state and local government finances is well known—witness the federal ruling earlier this month that Detroit’s pension obligations are not sacrosanct in a municipal bankruptcy. Less well known is that pensions are larger and their investments riskier than at any point since public employees began unionizing in earnest nearly half a century ago.

Public pensions have long been advertised as offering generous, guaranteed benefits for public employees while collecting low and stable contributions from taxpayers. But with Detroit’s bankruptcy filing, citing $3.5 billion in unfunded pension liabilities, and with four of the five largest municipal bankruptcies in U.S. history occurring in the past two years, reality tells us otherwise.

How much riskier are public pensions now? According to my research, public pensions pose roughly 10 times more risk to taxpayers and government budgets than in 1975. And while elected officials—a few Democratic mayors included—are now pushing for reforms, even they may not realize the danger.

In 1975, state and local pension assets were equal to 49% of annual government expenditures, according to my analysis of Federal Reserve data. Pension assets have nearly tripled to 143% of government outlays today. That’s not because plans are better funded—today’s plans are no better funded than in 1980—but mostly because pension plans have grown as public workforces have aged.

The ratio of active public employees to retirees has fallen drastically, according to the State Budget Crisis Task Force. Today it is 1.75 to 1; in 1950, it was 7 to 1. This means that a loss in pension investments has three times the impact on state and local budgets than 40 years ago.

And pensions can expect to take losses more often because of increased investment risk. Public plans have historically assumed roughly an 8% rate of return. But thanks to falling yields on safe assets, pensions must invest in riskier assets to have any hope of getting 8% returns. A one-year Treasury bond in 1975 yielded a 5.9% return. In 1980, it offered 14.8%, and in 1985 an investor could expect 6.5%. Today, the Treasury yield hovers at 0.1%.

Meager yields leave America’s enterprising public-pension plan managers with a choice: Accept a lower return—forcing higher taxpayer contributions—or take on more risk to keep 8% returns flowing. My estimate, based on Treasury yields and analysis from economists at the Office of the Comptroller of the Currency, is that a pension today must build a portfolio with a standard deviation—how much returns vary from year-to-year—of 14%. Such high volatility means that a fund would suffer losses roughly one out of every four years.

By contrast, in 1975 a plan could achieve 8% expected returns with a standard deviation of just 3.7%. Those portfolios would lose money once every 65 years. This level of risk varied little through the 1980s and 1990s: An 8% return portfolio in 1985 would require a standard deviation of 2.7%, and 4.3% in 1995. Risk began inching upward after 2000 and has increased rapidly since the recession as low-risk assets continue to fall.

These figures aren’t theoretical. They represent public pensions’ decades-long shift from safe bonds to risky stocks, along with the recent growth of “alternative investments” such as hedge funds and private equity. These alternatives are, according to Wilshire Consulting, 60% riskier than U.S. stocks and more than five times riskier than bonds.

Larger pensions and riskier investments combine to increase risk to state and local budgets. The standard deviation of public pension investments equaled 1.8% of state and local budgets in 1975. That figure crept upward to 2.2% in 1985, and reached 5.8% in 1995. Today it stands at 19.8%. Pension investment risk to budgets has risen roughly tenfold over the past four decades.

As pension plan managers in Detroit, California and elsewhere can attest, there aren’t easy solutions. Mature pensions should move their investments away from risky assets, but many plan managers are doing the opposite in a double-or-nothing attempt to dig out of multitrillion-dollar funding shortfalls. In most instances, significant benefit cuts for current retirees who made the contributions asked of them is difficult to justify and legally problematic.

The only real option, then, is to make structural changes, including more modest benefits and increased risk-sharing between plan sponsors and public employees. But that will only happen if elected officials accept that they can’t continue with business as usual without accumulating tremendous risk.

By ANDREW G. BIGGS

Dec. 15, 2013 6:26 p.m. ET

Mr. Biggs is a resident scholar at the American Enterprise Institute.

Miami-Dade County’s mayor is pushing a compromise plan that may help get this budget-buster under control.

Miami-Dade County is the latest flashpoint in the battle to figure out how the burden of skyrocketing health-care costs should be allocated between governments and their employees. In the midst of often-intense debate, Mayor Carlos Gimenez is showing that responsible compromise is possible.

Since 2010, county employees (Miami-Dade has a consolidated city-county government) have been paying 5 percent of their base salary toward group health-care costs. The deduction was designed as a temporary measure to get the county through lean times and was intended to expire this coming Jan. 1. Earlier this month, county commissioners voted to let the contribution expire as planned for most workers.

But the rise in health-care costs is unrelenting. Allowing the contributions to sunset would open a $56 million hole in the county’s $4.4 billion operating budget for this fiscal year and create an even bigger gap next year, which caused Mayor Gimenez to veto the commissioners’ action.

Along with his veto, however, Gimenez sent commissioners a countermeasure that would give a one-time bonus to the lowest-paid county workers — about 7,800 of Miami-Dade’s nearly 26,000 employees. Employees earning under $40,000 annually would get $1,500, while those earning between $40,000 and $50,000 would get $1,000. So an employee earning $30,000 would get his or her entire $1,500 health-care contribution back; a worker earning $20,000 would get his or her $1,000 back plus an extra $500.

The $10.2 million cost of the bonuses is a fraction of the $56 million cost of eliminating the health-care contributions, and going forward the county would not be faced with paying the full cost of ever-rising health-insurance premiums.

Although Gimenez’ ability to sustain the veto appeared uncertain, on Tuesday one commissioner who originally voted to let the measure expire changed her vote and the veto was upheld. The fate of the mayor’s bonus plan remains uncertain, with some commissioners saying they would prefer to permanently restore a portion of employees’ pay. But the action avoids blowing up the county budget and setting a dangerous precedent by not requiring employee health-care contributions.

This case also highlights a basic problem with the way Miami-Dade approaches the allocation of employee health-care costs. In the long term, getting costs under control will require workers to be aware of the comparative expense of various insurance plans and have an incentive to select ones that don’t offer more coverage than they require. Rather than charging all employees 5 percent, the county would be better served to provide workers with a variety of plans at different price points and have each employee pay a portion — perhaps one-quarter — of the plan he or she chooses.

As is almost always the case wherever this issue comes up, Miami-Dade’s reaction to the employee health-care contribution issue was imperfect. But Mayor Gimenez deserves credit for coming up with a creative compromise. And if the county commissioners go along with something along the line of Gimenez’ bonus proposal, there’ll be plenty of credit to spread around.

BY CHARLES CHIEPPO | DECEMBER 19, 2013

LOS ANGELES — U.S. Bankruptcy Judge Steven Rhodes’ ruling in the Detroit Chapter 9 bankruptcy that pensions are not in a special class above other creditors could bolster movement already made in that direction in the San Bernardino, Calif. bankruptcy.

The Detroit judge’s decision is likely already impacting San Bernardino because the parties were in mediation talks led by U.S. Bankruptcy Judge Gregg Zive of Reno, Nev., hammering out the term sheet for the bankruptcy plan when “a sea change in opinion on whether pensions could be impacted” was handed down, said Karol Denniston, an authority on the California bankruptcies and partner in the San Francisco office of law firm Schiff Hardin.

As part of his favorable ruling on Detroit’s eligibility to be in bankruptcy, Rhodes said that Chapter 9 allows the city to cut its pensions, despite state constitutional protections.

Rhodes found in his ruling that Michigan’s constitutional protection of pensions does not apply in federal court. As contractual rights, he said pensions are subject to the bankruptcy court’s authority to impair contracts.

He added that does not mean he will necessarily confirm a plan that impairs the benefits.

There have been signs that U.S. Bankruptcy Judge Meredith Jury might be willing to impair pensions in the San Bernardino bankruptcy, Denniston said. Jury, who is handling the San Bernardino bankruptcy, asked Zive to oversee mediation on the term sheet. He placed a gag order on the mediation, rendering all discussions confidential.

“If you look at the last paragraph of Jury’s ruling when she found San Bernardino eligible to be in bankruptcy,” Denniston said. “It looks like she is likely to impact pension contracts because the city has no money.”

Judge Jury has asked the California Public Employees’ Retirement System why it is fighting so hard when there is no money, Denniston said.

For its part, CalPERS blasted out a press release shortly after the Detroit ruling was announced calling it “short-sighted” and attempting to highlight differences between Michigan and California law.

“Unlike Detroit, CalPERS is not a city pension plan,” according to a statement reacting to the decision from the giant pension fund. “CalPERS is an arm of the state and was formed to carry out the state’s policy regarding public employees.”

The bankruptcy code is clear that a federal bankruptcy court may not interfere in the relationship between a state and its municipalities, CalPERS said.

“The Detroit court failed to recognize the difference between a two-party contract and the unique nature of a state public employee retirement system, which creates a three-way relationship among a public agency, its employees and the retirement system,” CalPERS said. “In California, our members’ vested rights to their pensions are protected by the California constitution, states and case law.”

In federal bankruptcy court, Denniston said, Rhodes’ opinion carries a lot of weight, in part because it is the only ruling made on the issue so far. Michigan law is actually stronger on the issue than California, she said, because the protection was added to Michigan’s constitution after being approved by voters in 1963.

“That is much stronger than in California where it was read into case law,” Denniston said. “We don’t have a provision that is as strongly worded as Michigan.”

Rhodes opinion, as a bankruptcy judge, could trump previous case law on the issue, she said.

CalPERS’ arguments that it is a pension fund, not a pension plan like those in Detroit, also might not be enough.

Although CalPERS functions as a pension plan for its members, the contract between CalPERS and the city is for the pension fund to administer the contract agreed upon with city employees.

“If there is a shortfall, CalPERS doesn’t pay, the city pays,” Denniston said. “So the cities, which are under their own contract with employees, should be able to renegotiate with city employees consistent with the ruling in Detroit.”

Matt Fabian, a managing director with Municipal Market Advisors, said the ruling is specific to Michigan law, its history and related legal precedents; and that a ruling from a judge in California would be needed to set official precedent that applies in the Golden State.

“This likely limits its transferability to other states or pension systems without court interpretation,” Fabian said.

The near term effect in San Bernardino is most likely to be political or rhetorical, Fabian said.

“It helps provide political cover to issuers like San Bernardino who are interested in putting losses on pensioners,” Fabian said. “But it doesn’t set legal precedent. They would need their judge to rule that precedent in Detroit applies here.”

Although Fabian doesn’t believe the ruling carries formal weight in other states, he did say that the ruling is positive for bondholders.

The ruling means that pensions are not established as superior to other obligations, he said. If pensions can be impacted in a municipal bankruptcy, it could lessen the impact for bondholders, he said. He added it could result in meaningful out of court negotiations between municipalities and unions, which would be beneficial to bondholders.

BY KEELEY WEBSTER

DEC 10, 2013 3:38pm ET

The GFOA updated and reposted the issue brief it developed on the SEC’s final definition of the term “municipal advisor.” The rule will become active January 14, 2014. The update contains all of the information provided in the original issue brief, along with some new information.

The SEC is expected to release a FAQ document within the next few weeks to help the market better understand certain aspects of the rule. The GFOA has asked for clarifications related to: the status of underwriter pools; when a municipal advisor can be considered to be engaged with the issuer on a transaction, and how that should be completed in writing; a clear definition of “RFP”; and at what time in a transaction can the underwriter be considered to be engaged with the issuer for the transaction. When information on the SEC’s FAQ release is available, it will be included in the GFOA’s weekly newsletter.

The updated issue brief is available here:

http://gfoa.org/downloads/MARuleBrief.pdf

GASB Statement No. 67, Financial Reporting for Pension Plans, revises existing guidance for the financial reports of most pension plans for state and local governments. This Statement replaces the requirements of Statement No. 25, Financial Reporting for Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans and Statement 50 as they relate to pension plans that are administered through trusts or similar arrangements meeting certain criteria.

The Statement builds upon the existing framework for financial reports of defined benefit pension plans, which includes a statement

of fiduciary net position (the amount held in a trust for paying retirement benefits) and a statement of changes in fiduciary net position.

Read more: http://www.gasb.org/cs/ContentServer?c=Page&pagename=GASB%2FPage%2FGASBSectionPage&cid=1176163527830

Download the original text of all GASB Statements, Concepts Statements, and other pronouncements for free.

Each of the final Statements of Governmental Accounting Standards issued by the GASB since its establishment in 1984 is designed to provide taxpayers, legislators, municipal bond analysts, and others with information that is useful to their decision-making process regarding governmental entities.

http://www.gasb.org/jsp/GASB/Page/GASBLandingPage&cid=1176160042327

OMB Revises Form SF-SAC Used to Report Audit Results, Audit Findings and Questioned Costs as Required by the Single Audit Act.

View the Notice:

http://www.nasact.org/washington/downloads/announcements/11_13-SFSAC.pdf

View the Form:

http://www.nasact.org/washington/downloads/announcements/11_13-SFSAC_%20Form.pdf

View the Instructions:

http://www.nasact.org/washington/downloads/announcements/11_13-SFSAC_Instructions.pdf

Statement No. 68, Accounting and Financial Reporting for Pensions, revises and establishes new financial reporting requirements for most state and local governments that provide their employees with pension benefits.

Statement 68 replaces the requirements of Statement No. 27, Accounting for Pensions by State and Local Governmental Employers and Statement No. 50, Pension Disclosures, as they relate to governments that provide pensions through pension plans administered as trusts or similar arrangements that meet certain criteria.

Statement 68 requires governments providing defined benefit pensions to recognize their long-term obligation for pension benefits as a liability for the first time, and to more comprehensively and comparably measure the annual costs of pension benefits.

Read more:

http://www.gasb.org/cs/ContentServer?c=Page&pagename=GASB%2FPage%2FGASBSectionPage&cid=1176163527868

Results of Thursday’s Bond Sale Mark Latest Sign Investors Encouraged by State’s Pension Reforms

Illinois sold $350 million of taxable bonds on Thursday at lower yield premiums than a similar sale in April, marking the latest sign that investors are encouraged by the state’s pension reforms.

The state sold the bonds for infrastructure and school construction to Bank of America Corp. BAC -0.46%  at an average yield of 5.4%, or about 2.5 percentage points above benchmark Treasurys, according to a state spokesman. That compares with an average yield of 4.97%, or more than 3 percentage points above Treasurys, at the April sale, he said.

The sale was Illinois’ first test of the municipal bond market since lawmakers last month reached agreement to close a pension gap of nearly $100 billion. The unfunded liabilities have led to credit rating downgrades and reduced demand from investors, resulting in the highest tax-exempt borrowing costs among the U.S. states.

The agreement, signed by Illinois Gov. Pat Quinn last week, faces challenges by unions, however. The law would reduce future costs by shrinking cost-of-living increases for retirees, raising retirement ages for younger employees and capping the size of pensions.

“The state clearly paid less of a penalty,” than in the past, said Kathy Bramlage, director at Treasury Partners, a unit of financial-advisory firm HighTower Advisors. “The issue is whether this [trend] will hold” because it’s likely the reform measures will be fought in court, she said.

Standard & Poor’s this week revised its outlook on Illinois to “developing” from “negative,” reflecting consensus reached by state lawmakers on pension reform. S&P said it could upgrade Illinois’ A-minus rating if the state moves forward with pension reform and takes measures toward a balanced budget.

Bank of America priced the longest-term part of the taxable deal at a yield of 1.75 percentage points over Treasurys, less pre-sale indications of levels above 2 percentage points. Before the pension agreement, yields on Illinois’ long-term taxable debt traded around 2.1 percentage points, Ms. Bramlage said.

Yield premiums on Illinois’ tax-exempt debt have also dropped despite record redemptions in tax-exempt muni bond funds. The spread on 10-year Illinois tax-exempt debt yields over the AAA benchmark rate has declined to 1.58 percentage points from 1.73 points in late November, according to Thomson Reuters Municipal Market Data.

By AL YOON

Dec. 12, 2013 6:26 p.m. ET

View the report at:

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724357

Detroit’s bankruptcy has some investors fretting that the case will set a precedent for $1.1 trillion of U.S. general obligations. That hasn’t kept the debt from beating revenue bonds for the first time since 2010.

A federal judge last week approved the city’s record $18 billion Chapter 9 filing and said its pensions can be cut in bankruptcy. Detroit’s emergency manager has sought concessions from creditors, including retirees and holders of $369 million of general obligations that the city had promised to repay using its unlimited taxing power.

The potential for losses on Detroit G.O.s means investors may now demand extra yield on obligations of localities struggling to balance budgets, said portfolio managers at T. Rowe Price Group Inc. and UBS Global Asset Management. Even with the prospect of added scrutiny, general obligations are outperforming revenue-backed munis in 2013, Bank of America Merrill Lynch data show. The bonds, the safest part of the municipal universe, are benefiting as investors favor their shorter maturities amid mounting bets that a growing economy will drive interest rates higher.

“The market will have to adjust how they price the risk, including how they judge general obligations versus revenue bonds,” said Hugh McGuirk, Baltimore-based head of T. Rowe Price’s muni group, which manages $20 billion. At the same time, “G.O. debt is typically shorter” in maturity, shielding it this year, he said.

Tax Backing

The borrowings account for about 30 percent of the $3.7 trillion municipal market, McGuirk said. Cities and states use the debt to finance projects such as bridges and schools, and repay investors with property-tax receipts or other local levies.

Detroit, which lost a quarter of its population in the decade through 2010, is an example of a shrinking tax base that can’t support certain levels of debt, said Ebby Gerry, who helps manage $15 billion of munis at UBS Global Asset Management in New York.

General obligations “will need to be looked at with greater scrutiny,” Gerry said. “The impression was that they’d just keep raising taxes and I’ll always get my money on coupon payments and maturities. That’s not necessarily the case if you have a horrible tax base.”

Orr’s Plan

In bankruptcy, general-obligation bonds are considered unsecured when they are backed only by a government’s promise to repay, rather than any identifiable collateral or a revenue stream like water or sewer fees.

Before the city filed for bankruptcy in July, Kevyn Orr, its emergency manager, tried to get holders of unlimited general obligations to take less than 20 cents on the dollar. The proposal treated the securities on par with Detroit’s other liabilities, including those to retirees.

Detroit may take “an aggressive posture” toward creditors, Jeffery Yorg, a Moody’s Investors Service analyst, said in a Dec. 3 report.

General obligations of stressed municipalities may merit more scrutiny, Robert Kurtter, a managing director at Moody’s, said Dec. 5 at a National Association of State Treasurers conference in New York.

A general-obligation pledge “simply may not mean anything,” Kurtter said. “It will affect our view of credits that are under stress with high debt and pension burdens, particularly those that are in the speculative-grade space.”

Better Year

Even as bondholders may be forced to take losses on Detroit general obligations, such debt has had a better year than revenue bonds.

The extra yield buyers demand to own revenue bonds instead of general obligations averaged about 0.97 percentage point for the past three months, the most since March 2012, Bank of America data show.

The bank’s index of general obligations has lost 2.2 percent this year, beating the 3.3 percent drop for revenue bonds. It would be the first time for general obligations to fare better than revenue bonds since 2010.

Investor bets on Federal Reserve policy provide the backdrop for the reversal. As speculation has grown this year that an expanding economy will lead the central bank to curb its bond-buying program, shorter-maturity bonds have held their value the best, as have higher-rated securities.

The Bank of America general-obligation index has an average maturity of 12 years and a credit grade two steps below benchmark debt. For revenue debt, the average maturity is five years longer, and the rating one level weaker.

Revenue Effect

“As long-term returns have been hurt, then that would have a bigger effect on revenue bonds,” McGuirk said.

General obligations have another appeal to investors: They are less prone to default than revenue debt, signaling that any Detroit precedent may have limited influence.

Of 443 issuers in default on payments as of Dec. 3, two — Detroit and Brighton, Alabama — are general obligations, Matt Fabian, a managing director at Concord, Massachusetts-based Municipal Market Advisors, said in an e-mail. The rest are backed by revenue such as from real estate developments and senior-living facilities.

California Treasurer Bill Lockyer said “big states and issuers” won’t see any backlash from Detroit.

“Some investors will be nervous,” Lockyer said after a panel at the treasurers’ conference. “So OK, they don’t buy Detroit. They don’t buy some tiny hospital district issue that comes out every 12 years.”

Market Week

In the municipal market this week, issuers plan to sell $11 billion of long-term debt with yields at a three-month high.

Top-rated 10-year munis yield 2.99 percent, compared with 2.86 percent on similar-maturity Treasuries.

The ratio of the interest rates, a measure of relative value, is about 105 percent, compared with a five-year average of 102 percent. The higher the figure, the cheaper munis are compared with federal securities.

Following is a pending sale:

New York state’s Utility Debt Securitization Authority plans to sell $2.1 billion of revenue bonds this week, data compiled by Bloomberg show. Proceeds will refund a portion of the Long Island Power Authority’s $7 billion of debt.

By Michelle Kaske and Romy Varghese  Dec 8, 2013

To contact the reporters on this story: Michelle Kaske in New York at mkaske@bloomberg.net; Romy Varghese in Philadelphia at rvarghese8@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

DETROIT — In a ruling that could reverberate far beyond Detroit, a federal judge held on Tuesday that this battered city could formally enter bankruptcy and asserted that Detroit’s obligation to pay pensions in full was not untouchable.

The judge, Steven W. Rhodes, dealt a major blow to the widely held belief that state laws preserve public pensions, and his ruling is likely to resonate in Chicago, Los Angeles, Philadelphia and many other American cities where the rising cost of pensions has been crowding out spending for public schools, police departments and other services.

The judge made it clear that public employee pensions were not protected in a federal Chapter 9 bankruptcy, even though the Michigan Constitution expressly protects them. “Pension benefits are a contractual right and are not entitled to any heightened protection in a municipal bankruptcy,” he said.

James E. Spiotto, a lawyer with the firm Chapman & Cutler in Chicago who specializes in municipal bankruptcy and was not involved in the case, said: “No bankruptcy court had ruled that before. It will be instructive.”

For people in Detroit, the birthplace of the Motown sound and of the American auto industry, Judge Rhodes’s decision that the city qualified for bankruptcy amounted to one more miserable, if expected, assessment of its woeful circumstances. The city has lost hundreds of thousands of residents, the judge said, only a third of its ambulances function, and its Police Department closes less than 9 percent of cases.

“This once proud and prosperous city can’t pay its debts,” said the judge, who sits in United States Bankruptcy Court for the Eastern District of Michigan. “It’s insolvent. It’s eligible for bankruptcy. But it also has an opportunity for a fresh start.”

Appeals were expected to be filed quickly. At least one union filed a notice of appeal on Tuesday, and other unions and pension fund representatives said they were considering contesting the outcome as well. But the ruling also allows Kevyn D. Orr, an emergency manager assigned in March by the state to oversee Detroit’s finances, to proceed swiftly with a formal plan for starting over — a proposal to pay off only a portion of its $18 billion in debts and to restore essential services, like streetlights, to tolerable levels.

Mr. Orr said he intended to file the formal blueprint, known as a “plan of adjustment,” by the first week of 2014. That plan could include efforts to spin off city departments to outside entities, to sell city assets and to reinvest in failing city services. Mr. Orr has said his goal is to bring Detroit, the nation’s largest city ever to find itself in bankruptcy, out of the court process by next fall.

“We have some heavy work ahead of us,” Mr. Orr said Tuesday.

Around Detroit, leaders sounded somber but mildly hopeful tones. Mayor-elect Mike Duggan said that Tuesday was a day no one wanted to see, but that the city now needed to move forward. And Dave Bing, the departing mayor, whose tenure in office has been consumed by the financial distress, said it was inevitable that Detroit would ultimately be found insolvent. “We are now starting from Square 1,” he said.

Municipal workers and retirees said they were shaken by the developments, and unsure what to expect. Any cut to pensions, many said, would be crushing.

“The impact of this is going to be catastrophic on families like mine on fixed income,” said Brendan Milewski, 34, a Detroit firefighter who was seriously injured in an arson in 2010 and said he received a pension of $2,800 a month from the city. “Retirees are going to be put out of house and home. They’re not going to be able to afford a car, food or medicine.”

Bruce Babiarz, a spokesman for the Detroit Police and Fire Retirement System, was blunt in his assessment. “This is one of the strongest protected pension obligations in the country here in Michigan,” he said. “If this ruling is upheld, this is the canary in a coal mine for protected pension benefits across the country. They’re gone.”

Since July, Mr. Orr, with approval from Gov. Rick Snyder, a Republican, has sought bankruptcy protection, and most here agree that the city’s situation is dire: Annual operating deficits since 2008, a pattern of new borrowing to pay for old borrowing, miserably diminished city services, and the earmarking of about 38 percent of tax revenues for debt service. A city that was once the nation’s fourth largest has dropped to 18th, losing more than half of its population since 1950. The city was once home to 1.8 million people but now has closer to 700,000.

Judge Rhodes rejected arguments by unions and other opponents that the bankruptcy filing was the result of secret and unconstitutional decisions made by Mr. Snyder and others. He agreed with opponents of the bankruptcy that the city had failed to make “good faith” attempts to negotiate with creditors, but said that such negotiations had been “impracticable.”

In perhaps the most contested portion of the case, the judge made it clear that federal bankruptcy law trumps the state law when it comes to protections for public employees’ pensions, making the pensions of 23,000 retirees fair game for the city to include in its plan of adjustment. But while the judge said pensions could not be treated differently from other unsecured debt, he said the court would be careful before approving any cuts in monthly payments to retirees.

That seemed to be of little comfort to union leaders, who denounced the ruling as illegal and immoral.

Lee Saunders, the president of the American Federation of State, County and Municipal Employees, said the ruling, in essence, put a “bull’s eye” on the backs of municipal workers and retirees by saying pensions are vulnerable. “It sets a bad precedent for cities that are under economic distress to look at doing the easy thing: to attack the workers and attack the retirees,” Mr. Saunders said.

Experts said the decision seemed unlikely to prompt a rush of bankruptcy filings by cities, but was likely to give cities more leverage over pensions in negotiations before bankruptcies. Detroit has included $3.5 billion in unfunded pension liabilities in its larger mound of debt, and city lawyers say it can simply no longer afford its pension plan.

For his part, Mr. Orr said he had a difficult reality to present to retirees. “There’s not enough money to address the situation no matter what we do,” he said. “That is clear.” At another point, he said of the pension question, “We’re trying to be very thoughtful, measured and humane about what we have to do.

By MONICA DAVEY, BILL VLASIC and MARY WILLIAMS WALSH

Published: December 3, 2013

Stockton’s Struggle: Before Detroit, Stockton, Calif. was the largest city to file for bankruptcy. Now, Stockton is working its way back, and city leaders see lessons in its ordeal for other struggling municipalities.

Battered by a collapse in real estate prices, a spike in pension and retiree health care costs, and unmanageable debt, this struggling city in the Central Valley has labored for months to find a way out of Chapter 9. Now having renegotiated its debt with most creditors, cobbled together layoffs and service cuts and raised the sales tax to 9 percent from 8.25 percent, Stockton is nearly ready to leave court protection.

But what Stockton, along with pretty much every other city in California that has gone into bankruptcy in recent years, has not done is address the skyrocketing public pensions that are at the heart of many of these cases.

“No city wants to take on the state pension system by itself,” said Stockton’s new mayor, Anthony Silva, referring to the California Public Employees’ Retirement System, or Calpers. “Every city thinks some other city will take care of it.”

While a federal bankruptcy judge ruled this week that Detroit could reduce public pensions to help shed its debts, Stockton has become an experiment of whether a municipality can successfully come out of bankruptcy and stabilize its finances without touching pensions. It is an effort that has come at great cost to city services and one that some critics say will simply not work once the city starts trying to restore services and hire 120 police officers it promised to get the sales-tax increase passed.

“They wanted to get out of bankruptcy in the worst possible way, and that’s just what they did,” said Dean Andal of the San Joaquin County Taxpayers Association, which fought the sales-tax increase. “If they go ahead and hire those new police officers, the city will be back in insolvency in four years.”

Stockton declared fiscal emergencies in 2010 and 2011, giving it the power to renege on annual pay increases for city workers. City services were slashed. Hundreds of municipal workers were laid off. And many retirees who had been promised health coverage for life learned that they would have to begin paying for it.

“That was the hardest part,” Councilman Elbert Holman said, “looking people in the eye and telling them sorry, you are losing your health care, but it’s absolutely necessary.”

By the time the judge found Stockton eligible for Chapter 9 bankruptcy on April 1, the city had about $147 million in unfunded pension obligations and about $250 million in debt from various bond issues.

The years of fiscal emergency and bankruptcy have left their mark, including a skyrocketing crime rate, which city officials and many residents attribute to staffing and service cuts in the Police Department.

“I suddenly realized a few years ago that, just in my tiny, two-block neighborhood, there had been 11 residential burglaries in the previous nine months,” said Marci Walker, an emergency room nurse.

Cities go bankrupt for many reasons: a collapse in real estate prices, a spike in pension and retiree health care costs, a burden of debt from expensive city projects. Stockton has experienced all three.

When real estate prices shot up in Silicon Valley in the last decade, many commuters decided that Stockton’s cheaper housing was worth the long commute to the Bay Area. That drove up local housing prices, so when the bubble burst it had a bigger impact, giving Stockton one of the nation’s highest foreclosure rates.

City leaders had also gone on a construction spree during the flush years, building a new sports arena, a minor-league baseball stadium and a marina. Citizens still bitterly mention the 2006 concert that opened the arena, where Neil Diamond was paid $1 million to perform.

And through it all, the pension costs for city workers — particularly for police officers and firefighters, who can retire early and draw on those pensions for decades — kept going up.

No part of the city has been left unscathed. Ms. Walker’s comfortable neighborhood near the University of the Pacific campus was hit with rising crime almost immediately after the police layoffs. “When the economy got bad and we lost police officers, it all started,” she said.

So she started the Regent Street Neighborhood Watch, the first of more than 100 such organizations to sprout up in the city in the last few years.

“We don’t confront anybody, we just let them know that we know they’re there,” Ms. Walker said. She added, “Criminals do not like eyeballs on them.”

While the rising crime rate had the biggest effect on the city, other service cuts were also felt, including deteriorating streets and closed libraries and community centers. The other consequences of the downturn — shuttered storefronts, crumbling infrastructure, empty downtown sidewalks — only added to the sense of decline.

“There was just this perception that the city was not safe,” Police Chief Eric Jones said. “Downtown was impacted. Many people were reluctant to go down there.”

The crime problem is a big reason Stockton chose to keep paying into the Calpers system even as it pared other costs, including its payments to bondholders. Officials say that if the city cuts the rate at which its workers build up their pensions, workers will leave — especially police officers who were recruited with the promise of large, early pensions.

Last year, Stockton asked Calpers for a “hardship exemption,” allowing it to slow its contributions. The huge state pension system said no, fearing that if Stockton fell behind, it might never catch up.

Now, even before the ink is dry on Stockton’s proposed blueprint for getting out of bankruptcy, skeptics are worried that the plan is not comprehensive enough to solve its problems and that city leaders will not fulfill their promise to use some of that money to hire police officers.

City officials insist their plan will work. “We got the tax, and thank God it passed,” Councilman Holman said. “I have confidence that the numbers line up.”

Nor does the Detroit ruling this week make Stockton want to revisit pension reductions. Connie Cochran, a city spokeswoman, said that city workers had already seen their pay and retiree health benefits cut. In addition, she said, Calpers told the city that its only option was to pay a $970 million termination fee to leave the system, and Stockton could not afford it.

Mayor Silva said the city’s plan would help it out of bankruptcy sometime late next spring, if all goes well, after the judge hearing the case has time to rule on its fairness and viability and negotiations can be completed with one final bondholding creditor.

“We will lose the stigma of bankruptcy, and it will buy us time,” he said.

One of three new members elected to the City Council in November, Michael Tubbs, said he was convinced that the bankruptcy plan would work, providing $28 million to $30 million in revenue each year for the next decade and allowing the city to pay down its debt while still hiring police officers.

“I am incredibly optimistic,” said Mr. Tubbs, 23, who grew up in Stockton.

Chief Jones said he was counting on the 120 new officers and planned to hire 40 a year for the next three years. In 2008, Stockton had 441 police officers. By this year, the force had fallen to 350, the second-lowest per capita staffing level in the country. The result, he said, is that all violent crimes rose in the city, which had 58 homicides in 2011 and 71 in 2012, both records.

Even before the sales-tax increase passed, Chief Jones said he had decided to reinstate some of the community outreach programs that were curtailed during the budget crunch, even if that meant slower response times for nonviolent crimes.

“We had to tell the community to be patient, we’re going to focus on violent crime,” he said.

The impact was immediate. As of mid-November, there had been only 28 homicides this year.

Still, bondholders complain that Calpers will get 100 cents on the dollar for its city debt, while they must make do with much less. Following months of negotiations, most of Stockton’s bondholders said they would not try to block the city’s plan, but Franklin Templeton Investments was girding for a fight, possibly strengthened by the Detroit ruling that federal bankruptcy law trumps state pension guarantees.

Two Franklin funds hold about $35 million of bonds that Stockton issued in 2009 and are now in default. Stockton is proposing to pay the two Franklin funds just $95,000 to discharge all the remaining debt on those bonds, amounting to less than a penny on the dollar.

Douglass Wilhoit Jr., chief executive of the Stockton Chamber of Commerce, agreed that “the elephant in the room is the pension stuff.” But he said that he was confident this plan would ease the city out of bankruptcy and start a process that would inevitably come to include some sort of pension changes. “Over all, honestly, I think the bankruptcy process has been a positive experience for Stockton,” he said. “We are going to come out of it stronger and better.”

By RICK LYMAN and MARY WILLIAMS WALSH

Published: December 5, 2013

By declining to hear a challenge to New York State’s “Amazon law,” the U.S. Supreme Court has now helped pave the way for states and localities to collect more of the roughly $13 billion that they’re owed each year in uncollected sales taxes on Internet purchases.  That should encourage other states to pass similar laws, though only federal policymakers can solve the problem comprehensively.

First, some background.  Previous Court decisions held that a merchant must have a “physical presence” — generally, employees or facilities — in a state before that state could require the company to charge sales taxes to its customers there.  Although buyers are legally obligated to pay directly to their states any applicable taxes that the merchants don’t charge, very few do.

But the Court has also said that people who aren’t employed by the merchant but help market its goods constitute a “physical presence.”  So, New York enacted a law requiring Internet merchants with in-state “affiliates” to charge sales taxes on all taxable sales to New York customers.  “Affiliates” are companies and individuals that link to an Internet retailer from their own site and receive a commission when someone clicks on the link and buys something on the merchant’s site.

Amazon and Overstock, two of the many large retailers that operate affiliate programs, challenged New York’s law.  But New York’s high court upheld the law, and yesterday the U.S. Supreme Court let that decision stand.

More than a dozen states (including New York) have enacted laws requiring Internet retailers with in-state affiliates to charge tax on all taxable sales in the state (see map).  Now that New York’s law has withstood all legal challenges, other states may follow its lead.  Amazon laws can chip away at the problem even if they don’t represent a full solution, I’ve explained.

A federal law that empowered states to require all sellers to collect sales tax would:

• Help states and localities maintain public services and possibly reinvest in services they cut during the recession — rehiring teachers, freezing college tuition increases, and boosting road and bridge maintenance, for example.
• Create a more level playing field for local store-based retailers, which do collect sales taxes.
• End the unfair sales tax treatment of consumers who don’t shop online, including low-income people who lack computers, Internet access, or credit cards.

The federal Marketplace Fairness Act, which represents a fair and comprehensive solution to the problem of uncollected tax on Internet and other interstate sales, passed the Senate in April but is stalled in the House.  Until it moves, states need to do what they can to address the problem themselves.  The Supreme Court has now cleared a big obstacle in their paths.

‘Scoop and Toss’ Involves Selling New Debt to Pay Off Existing Bonds

A budget-stretching tactic employed by strapped local governments from California to Puerto Rico is coming under market scrutiny, amid fears that Detroit’s record bankruptcy filing could presage further pain for municipal-bond investors.

The maneuver, called “scoop and toss,” involves selling new long-term debt to raise funds to pay off maturing bonds, effectively extending the timetable for retiring municipal borrowings. Refinancings that aim to reduce interest rates typically keep the same maturity schedule.

The practice, which has been around for decades, helps cities, states and other local entities to stay current on their obligations as they try to claw out of one of the deepest economic downturns since the Great Depression.

The debt sales often offer above-market interest rates that appeal to many bond buyers at a time of slow economic growth, easy Federal Reserve policy and low rates on relatively safe investments such as U.S. Treasury securities and bank accounts.

But some observers warn that scoop-and-toss refinancings add to interest costs while allowing civic managers to overlook structural economic difficulties. Investors purchasing the debt take on the risk that the securities will lose value, as they did in Detroit’s $18 billion Chapter 9 bankruptcy case.

“It’s never a good sign to see this,” said John Loffredo, portfolio manager of the MainStay Tax Free Bond Fund. Mr. Loffredo said his firm recently started buying Puerto Rico bonds that carried third-party insurance guaranteeing repayment, citing the high yields.

Among the chief practitioners of scoop and toss is Puerto Rico, which since 2006 has relied on new bond sales and loans to help balance its budget and pay off old bonds coming due. The island commonwealth has restructured about $4 billion in debt from its main operating budget since then. About $70 billion of Puerto Rico debt is outstanding.

Yields on Puerto Rico’s bonds have risen sharply this year, making it much more expensive to sell debt to investors, following rating-company downgrades. Puerto Rico bond prices are down about 16% in 2013.

In 2011, Puerto Rico sold $356 million of bonds that begin maturing in 2024. Some of the proceeds were used to pay off a bond from 1989 that was maturing in 2011—in effect turning a 22-year bond into a 35-year one.

Lyle Fitterer, head of tax-exempt investments at Wells Capital Management, which oversees about $33 billion in municipal-debt investments, said he would like to see cheaper bond prices or a sustainable economic recovery plan before he boosts his firm’s small Puerto Rico holdings.

“The scoop-and-toss strategy might be a good strategy for a short-term solution, if you have a temporary economic recession,” he said. “But obviously, the longer it goes on, the more difficult it is to argue that it’s a good long-term solution.”

Officials in the U.S. territory are seeking to put the island on stronger fiscal footing through tax increases and entitlement reform, and seek to end scoop and toss by 2015. “In the past, it had been restructuring after restructuring,” Puerto Rico Treasury Secretary Melba Acosta said recently in an interview. “We are moving away from that.”

Puerto Rico officials have said they can make it through this fiscal year without borrowing, and have been drawing down a line of credit from the Government Development Bank, according to Fitch Ratings.

U.S. companies frequently issue new bonds to pay off old debt. But investors typically worry less about corporate-debt issuers because the money can be used to expand the business, which can benefit bond buyers.

“If a corporation started going into decline, you aren’t going to see the debt rolling over and being refinanced,” said Stan Garstka, accounting professor at the Yale School of Management.

To be sure, there are signs of progress for municipalities. Over the summer, Moody’s Investors Service raised its outlook for U.S. states to stable from negative, saying “the slowly improving U.S. economy continues supporting state revenues and reserves.”

Other municipal entities have employed scoop-and-toss strategies recently. Suffolk County, N.Y., which recently declared a fiscal emergency, last year sold through an authority about $38 million in bonds backed by tobacco revenues to help cover other debt payments that were due in 2012 and 2013.

In California, the Foothill/Eastern Transportation Corridor Agency, which operates toll roads in Orange County, is looking into a scoop and toss that would pay off bonds from 1999 and extend the maturity of the debt by 13 years to 2053. The bonds are backed primarily by revenues from tolls, but traffic on the roads has grown slower than expected.

Fitch said the plan makes it easier for the authority to pay off its bonds. In 2040, the year the authority will have to pay the most, payments fall to $243 million from $297 million under the new plan. Without scoop and toss, Fitch said it would likely downgrade the outstanding bonds to junk status.

By MIKE CHERNEY

Dec. 2, 2013 8:40 p.m. ET

Worry Is That Banks May Boost Fees to Sell Municipal Securities

Implementing the Volcker rule could result in higher borrowing costs for municipalities as banks may boost fees they charge to sell securities that finance state budgets, schools and other public needs, California’s top treasury official said on Wednesday.

California Treasurer Bill Lockyer said he thought banks may boost fees on bond deals as one way to offset profits lost due to the Volcker rule. Regulators are set to vote on a final version of the rule next week. It is part of the 2010 Dodd-Frank financial overhaul legislation, and intends to curb banks from making risky bets on their own behalf.

“Borrowing costs may increase,” Mr. Lockyer said. The concern is that if banks don’t make a profit from proprietary trading, they will boost the fees they charge to customers, just as they might to anyone with a checking account, he told The Wall Street Journal. Mr. Lockyer was attending a conference in New York of the National Association of State Treasurers.

Mr. Lockyer’s comments come as the municipal bond market suffered this year amid fears of rising interest rates and the ripple effects of large defaults, such as Detroit’s. Investors have redeemed a record $51 billion from municipal bond funds this year, according to Lipper, and some analysts predict the trend to continue into 2014.

California’s bond issues are routinely oversubscribed, suggesting the state is gaining, not losing, investor confidence, Mr. Lockyer said. But there are “segments where there is greater perceived risk,” he said.

While higher fees are a concern, inflation and interest rates are still the “more substantial” long-term concerns surrounding the state’s borrowing costs, he said.

By AL YOON

The ruling by Judge Steven W. Rhodes, who is presiding in Detroit’s bankruptcy case, that public pensions are not protected from cuts could alter the course of bankrupt cities like Stockton and San Bernardino, Calif., that had been operating under the assumption that pensions were untouchable.

Stockton’s bankruptcy case, for instance, is further along than Detroit’s, and until Tuesday it seemed likely to leave public pensions fully intact. Stockton sought bankruptcy protection last year and has already filed a plan of debt adjustment with the bankruptcy court in Sacramento. Its plan, which is subject to court approval, would leave city workers’ pensions unchanged: They would continue to accrue benefits at the same rate as they did before the bankruptcy. (A new state law does permit Stockton to provide smaller pensions to workers hired after Jan. 1.)

That is a better deal than workers at bankrupt companies often receive. City leaders based it on the thinking that public workers had already sacrificed enough, given that the plan of adjustment already calls for them to give up contractual pay increases and valuable retiree health benefits.

Opponents of that plan have raised concerns that it would not save enough money. They point to the city of Vallejo, Calif., which spent three years in bankruptcy, emerged in 2011 without touching its workers’ pensions, and is again having trouble balancing its budget. Many cities in California are struggling with pension costs because of a big benefit increase in 1999 that has been much more expensive than anticipated. State laws make it hard for cities to raise taxes enough to keep up with the costs, and because pensions are considered untouchable, local officials have had to reduce services, like policing, to balance their budgets.

Some say the situation is unsustainable. Last month, another city, Desert Hot Springs, said that its pension costs were unaffordable and that it might have to declare bankruptcy.

Early in Stockton’s bankruptcy, several financial institutions tried to block its case, arguing that it had not negotiated as required with the California Public Employees’ Retirement System, known as Calpers, which administers pensions for many municipalities. Those motions were denied, and in the months since then, all but one of the institutions have reached settlements with the city and stopped arguing about pensions.

The one remaining creditor is Franklin Templeton Investments, a mutual fund company that holds about $35 million worth of Stockton’s bonds. Stockton’s plan of adjustment proposes to give Franklin less than a penny on the dollar for its bankruptcy claims, according to court filings. Federal bankruptcy law allows for such “cramdowns” — deals that force big losses on unwilling creditors — but for a cramdown to be approved by a bankruptcy judge, it must meet certain requirements. It must be “fair and equitable,” for example, and it must not discriminate against one creditor in favor of others.

Even before Tuesday, Franklin was warning that it would challenge to Stockton’s plan. Documents on file with the court suggest it was planning to argue that no plan could be “fair and equitable” if Calpers were paid in full while Franklin received less than a cent on the dollar.

“Their argument just got strengthened,” said Karol K. Denniston, a bankruptcy lawyer at Schiff Hardin in San Francisco who has been advising a taxpayers group that formed after Stockton declared bankruptcy. Referring to the judge’s decision in Detroit, she said, “Franklin Templeton is going to have a lot to say about this ruling.”

Another bankrupt city in California, San Bernardino, has taken a different tack from Stockton. It wants to reduce its pension obligations in bankruptcy and has already stopped sending its regular contributions to Calpers. That is something a company in Chapter 11 bankruptcy would normally do, but Calpers is fighting the move in San Bernardino’s Chapter 9 case. It argues that the city does not sincerely wish to adjust its debts, as required by bankruptcy law, but simply wants to “languish” in court. Calpers maintains that pensions cannot be reduced in California and that the only way for a city to freeze its plan is to pay a giant fee.

So far, San Bernardino’s bankruptcy judge, Meredith A. Jury, has ruled against Calpers and refused to grant it an expedited appeal to the United States Court of Appeals for the Ninth Circuit. The city’s creditors are now trying to come up with a settlement plan in mediation.

“This gives them clarity,” Ms. Denniston said. “It changes the dynamic at the negotiating table in a major way, because we’ve now had a bankruptcy judge say you can impair pensions. We’re going to go through a huge period of uncertainty because that’s going to be appealed, but for right now, that’s the law.”

Judge Rhodes’s decision in Detroit’s bankruptcy case was also noteworthy for what it did not say: It did not offer specific instructions for how large or small any pension cuts should be. Instead, he said the question should be resolved in mediation, which is already running in Detroit but has so far borne little fruit.

James E. Spiotto, a bankruptcy lawyer at Chapman & Cutler in Chicago, said officials in other cities might want to change course now if they worried that they might have promised more than they could deliver.

“If you’re not able to pay, the best thing to do is address it now,” Mr. Spiotto said. “Pay as much as you can without adversely affecting the future of the city.”

By MARY WILLIAMS WALSH

CHICAGO — The Illinois General Assembly approved an overhaul to the state’s pension system billed by its backers as a “landmark” reform that will stabilize both the system and the state’s fiscal foundation.

Critics attacked the plan as being either too hard on workers or too weak to repair a system saddled with $100.5 billion of unfunded liabilities. Some lawmakers also raised concerns over whether the plan can withstand the legal challenge expected from unions after Gov. Pat Quinn signs the package.

After two years of false starts and political bickering among lawmakers over how to restructure the pension system, Gov. Pat Quinn had nothing but praise for the plan and lawmakers who approved it.

“This landmark legislation is a bipartisan solution that squarely addresses the most difficult fiscal issue Illinois has ever confronted,” Quinn, who faces re-election next year, said shortly after the vote. “This bill will ensure retirement security for those who have faithfully contributed to the pension systems, end the squeeze on critical education and healthcare services, and support economic growth.”

In addition to praising the General Assembly’s leaders and members of the conference committee appointed in June to assemble a compromise plan, the Democratic governor said: “I salute the members of the General Assembly who showed great political courage by voting yes for pension reform.”

The plan is estimated to trim $160 billion off state payments owed to the system, with the goal of reaching full funded status in 30 years primarily by cutting benefits and  infusing the system with supplemental state contributions in addition to scheduled annual payments. The changes would trim about $21 billion of the state’s unfunded liability tab.

The state’s five funds are currently just 39.3% funded. Contributions have been rising steadily, consuming 20% of the fiscal 2014 general fund budget, up from 12% in fiscal 2010. Under the existing funding schedule that level would rise to 26% in 2045.

The state’s pension woes and political impasse over how to overhaul the system have driven the state’s credit deterioration, with its ratings now the weakest among states, at the low-single-A level.

In addition to tarnishing its own reputation with investors, the state’s credit struggles have driven up the costs of borrowing for most Illinois-based issuers, especially those dependent on the state for aid, such as its public universities. It’s called by market participants the “Illinois penalty” or “Illinois effect.”

The state hopes to see a positive impact on its interest rates from the action as soon as next week when it takes competitively bids on a $350 million taxable general obligation issue. The three major rating agencies all assign a negative outlook to the credit. It’s unclear whether an outlook shift would occur so quickly as analysts digest the impact of the reforms and a legal challenge looms.

The vote in each chamber was nearly simultaneous and followed several hours of debate Tuesday, less than a week after the General Assembly’s leaders announced they had agreed on a plan.

Without action, House Minority Leader Rep. Jim Durkin, R-Western Springs, warned the rating agencies could “move our credit rating even lower.”

While some lawmakers warned the package didn’t go far enough to warrant a label of “comprehensive” reform, others said it went too far. Sen. William Delgado, D-Chicago, called the changes “morally wrong, morally corrupt” because of the impact on public sector employees and retirees.

The Senate tally came first with 30 members voting for the legislation which was presented in the form of a conference committee report and 24 against and three voting present. The yes votes included 20 Democrats and 10 Republicans.

The House voted 62 to 53 in favor of the report with one voting present. The yes votes included 47 Democrats and 15 GOP members. Democrats hold a majority in the General Assembly.

BY YVETTE SHIELDS

The largest U.S. public retirement systems had an aggregate 0.9% growth in assets in fiscal year 2012, but a 4.1% growth in liabilities, according to the Public Fund Survey released Wednesday. In aggregate, assets increased to $2.67 trillion, while liabilities reached $3.63 trillion at the end of fiscal year 2012.

The survey, sponsored by the National Association of State Retirement Administrators and the National Council on Teacher Retirement, covers 85% of the state and local government retirement systems. The 126 plans in the survey had a median funding level of 73.1%.

The survey found most retirement systems have recognized investment losses incurred in 2008 and 2009, or are close to doing so. Retirement systems with fiscal years ending Dec. 31 had a one-year median return of 13.1%, while those with a June 30 fiscal year-end, which represent three-fourths of the plans, had a median return of 1.2%.

“We’re right on the cusp of two things: having recognized the market losses of ’08 and ’09, and the beginning of recognizing the strong gains experienced in the last months,” said Keith Brainard, NASRA research director, in an interview.

For the first time in the survey’s 12-year history, the median employee contribution rate changed, to 5.7% from 5%. Increasing employee contribution rates has been the most common change in recent years, along with an upward trend in employer contributions, Mr. Brainard said.

BY HAZEL BRADFORD

The Indiana Finance Authority won The Bond Buyer’s 12th annual Deal of the Year award Thursday night for its Ohio River Bridges East End Crossing Project.

The public-private partnership was funded through the sale of around $675 million of tax-exempt private activity bonds, including $195 million of milestone PABs, a new security type that can serve as a template for other P3 concessions.

The deal — the largest P3 PAB offering completed to date in the U.S. municipal market — “financed a large infrastructure project that fulfilled a public need. It was innovative, replicable, and took an immense amount of cooperation across a number of sectors to come to fruition,” said Michael Scarchilli, editor in chief of The Bond Buyer, when presenting the award at a ceremony held at the Waldorf Astoria hotel in New York City.

The transaction also won the Deal of the Year award for the Midwest region, making this the second consecutive victory for that region. It also marked the first time the Deal of the Year award was given to a P3 transaction. WVB East End Partners, a consortium comprised of Vinci Concessions, Walsh Investors and Bilfinger Project Investments, was the private sector partner.

The East End Crossing was Indiana’s portion of the Ohio River Bridges project, which necessitated a bi-state agreement between Indiana and Kentucky to develop two bridges, one in downtown Louisville to be developed by Kentucky, and the East End Crossing in Indiana. Kentucky plans to sell $747 million of tax-exempt and taxable debt in the week of Dec. 9 to fund its portion of the project.

This year’s Freda Johnson Award honoring Trailblazing Women Issuers was given to Philadelphia Treasurer Nancy Winkler. The award recognizes a woman affiliated with an issuer who has been a leader, innovator and mentor.

For more than a decade, the editors of The Bond Buyer have selected the outstanding municipal bond transactions for special recognition, honoring the issuers who overcame myriad challenges to bring these deals to fruition.

This prestigious competition has drawn nominations that represent the full diversity of the communities and public purposes that are served by the municipal finance market. The 2013 awards, which considered deals that closed between Oct. 1, 2012, and Sept. 30, 2013, drew a record number of nominations for transactions ranging in size from a few million to billions of dollars.

Nominees this year faced stiff competition from a host of qualified deals. The transactions considered included financings of hospitals, housing, toll roads and airports. Deals ranged from cost-saving refundings representing turnaround stories for issuers once in distress, to alternative energy financing projects to a host of innovative public-private and public-public partnerships. In fact, this year, The Bond Buyer honored three P3 transactions with Deal of the Year awards, a first for this ceremony.

This year, issuers in eight categories were selected as Deal of the Year awardees. The honorees were first revealed Nov. 4-8 via individual video announcements at BondBuyer.com, along with additional information on the awards.

The other finalists were:

NORTHEAST REGION

The Allentown Neighborhood Improvement Zone Development Authority’s sale of $224 million in tax revenue bonds to fund a new 8,500-seat arena, which would act as a catalyst for further redevelopment in downtown Allentown, Pa. The bonds were authorized under the Neighborhood Improvement Zone Act, under which certain taxes paid by qualified businesses within the NIZ are pledged as security towards the debt.

Allentown’s 50-year concession lease of the city’s water and sewer systems through a public-public partnership with the Lehigh County Authority, which generated a significant up-front payment to stabilize the city’s rapidly growing unfunded pension liability and provided a foundation and path for fiscal stability.

*The two Allentown transactions, which represent a turnaround story from an economically suppressed area, were co-honorees in the Northeast category.

SOUTHWEST REGION

Dallas and Fort Worth, Texas’ $2.73 billion of refunding and new-money transactions on behalf of Dallas/Fort Worth International Airport. The series of financings — mainly to finance the airport’s Terminal Renewal and Improvement Program — accounted for 28% of national airport issuance over the Deal of the Year judging period.

SOUTHEAST REGION

Harnett County, N.C.’s $20 million sale of limited obligation bonds, used to purchase the general obligation debt of the county’s seven small, unrated water and sewer districts, which had difficulty accessing the public capital markets individually.

FAR WEST REGION

The California Pollution Control Financing Authority’s $733 million sale of water furnishing revenue bonds, issued on behalf of the San Diego County Water Authority — to fund the Carlsbad Desalination Project. The deal, executed as a public-private partnership with Poseidon Resources, represents the first-ever project financing of a seawater desalination plant in the municipal market, establishing a new asset class for investors.

NON-TRADITIONAL FINANCING

The New York Metropolitan Transportation Authority’s $200 million sale of principal at-risk variable-rate notes, sold via conduit issuer MetroCat. The proceeds effectively collateralize three years of reinsurance coverage from MetroCat, a newly created Bermudan special purpose insurer, for storm surge losses incurred by the MTA through its captive insurer. The innovative, non-traditional structure allowed the MTA to close its storm surge insurance gap, following $4.9 billion in storm surge-related losses as a result of Superstorm Sandy.

HEALTH CARE FINANCING

The billion-dollar financing program resulting from the New Jersey Medical & Health Sciences Restructuring Act, which provided for the dissolution of the University of Medicine and Dentistry of New Jersey, the defeasance of its $668 million in outstanding debt, and the transfer and integration of UMDNJ assets to Rutgers University, Rowan University, and University Hospital. The complex transaction represented the largest higher education merger in United States history, and provided for the complete overhaul of New Jersey’s system of public health sciences education and research.

SMALL ISSUER FINANCING

The New York State Energy Research and Development Authority’s $24.3 million sale of residential energy efficiency financing revenue bonds. NYSERDA’s collaboration on the transaction with the New York State Environmental Facilities Corp., which guaranteed the bonds through its State Revolving Fund program, provided the first-ever linkage between clean water and clean energy programs. Aggregating and applying QECB allocations, along with the SRF wrap, significantly lowered the bond debt service and established a nationally replicable model.

Bond insurers Assured Guaranty and Build America Mutual are getting less compensation for risk as compressed credit spreads and competition force the businesses to cut insurance prices.

Assured reported a U.S. public finance risk-adjusted pricing ratio, a risk-versus-return measure of an insurer’s portfolio in which a higher score is considered stronger, of 3.55% in the first three quarters of 2013, down from 4.46% in 2012, Standard & Poor’s said in a Nov. 20 report. Build America, which ramped up its business in the beginning of the year, reported RAP of 3.46% for the same period.

The implied premium rate for bond insurance is 20% lower in 2013 than in 2012, with an average of 40 basis points in the second quarter of 2013, compared with the 60 basis point average insurance obtained in previous years.  Persistent low pricing ratios could lead to ratings cuts, analyst Marc Cohen said in the S&P report.

“In a perfect world with only two players you’d think they have the market power to exercise their abilities to extract the best premiums,” Cohen said in an interview. “However, the current market dynamics are hindering the bond insurers’ profitability. With those market dynamics there’s a heightened level of competition among those two players.”

Build America’s launch in July 2012 ended Assured’s post-financial crisis luxury of being the only active insurer. The financial guaranty market began to split, with Assured responsible for 59% of insured bonds as of September 30. The percentage of bonds with insurance fell to 3.53% in the third quarter, from 3.71% in the second quarter, according to data from Reuters.

Issuers are shying away from insurance as interest rates remain low and make guarantees less economically valuable, Cohen said. Instead, insurance has largely been present to provide liquidity and access to the market for smaller issuers.

“When spreads are wider, insurers are able to extract a significant portion of that interest savings, so when credit spreads and muni yields are as tight as they have been, there’s less money on the table to extract from their premiums,” Cohen said.

The difference in yield between single-A and triple-B 10-year municipal bonds, the section on the curve where insurers do most of their business, fell from 85 basis points in November 2012 to 61 points in September. The spread between AAA GO 30-year yields and BBB bonds feel from 131 basis points a year ago to 114 in September. Since September, those spreads have either fluctuated or risen.

Analysts expect theFederal Reserve to begin tapering its quantitative easing program in the near future, which would increase yields and spreads, and encourage issuers to look to insurers for savings on new debt, Cohen said. Assured expects rising interest rates to boost demand for guarantees.

“We’ve already seen the positive effects of rising rates during the summertime when rates were up,” Bill Hogan, director of public finance at Assured, said in an interview. “Higher rates helped us then and we expect them to go a little bit higher next year, which will be beneficial to both penetration and pricing.”

As part of its rating methodology for financial guarantors, S&P places transactions into four risk categories, which determine the capital charge associated with backing a specific deal. Insurers are required to reserve a percent of the average annual debt service associated with the deal against the risk. In 2011, S&P increased that percentage, with deals in category four – charter schools, health care or private schools — requiring the largest capital charge.

Assured’s gross per period weighted capital charge is 16%, compared with BAM’s 11.4%. Insuring deals in the category four area has weakened Assured’s pricing ratio, Hogan said, even though those transactions make up just $200 million in par amount.

“It’s unfortunate that the high capital charges in Category 4 limit our ability to underwrite sound enterprise credits,” Hogan said. Not including category four transactions, Assured’s RAP in the first three months of the year satisfies S&P’s requirements, Hogan said.

Build America does not wrap debt in higher risk categories,

“Given the current spread environment, we are satisfied with our progress to date and look forward to continuing to serve our core market of essential public purpose municipal issuers,” Sean McCarthy, chief executive officer of BAM, said in an emailed statement.

S&P’s scrutiny into the insurers may reflect a more general concern for the industry, Mikhail Foux, a municipal strategist at Citigroup Global Markets. Foux believes insurers will likely see an uptick in market penetration but said rating agencies may be reconsidering how they look at insurers that have exposure to debt in distressed areas.

“They may be concerned about what could happen with stress in the sector and looking at how they separate high quality business from the rest,” Foux said.

The insurers’ pricing ratios are falling short of S&P’s expectations, the rating agency said in the report. S&P looks for insurers to remain in the 4% to 6% risk-adjusted pricing range, and remaining below 4% could lead to ratings downgrades.

Hogan expects the ratios to rise before year-end with large low-capital charge deals on the table.

BY OLIVER RENICK

NOV 25, 2013 4:53pm ET

Illinois legislative leaders are trying to persuade lawmakers to embrace a solution for the nation’s worst-funded U.S. public pension system as unions representing hundreds of thousands of workers and retirees push against the proposal.

The holiday weekend of lobbying is the prelude to the legislature’s Dec. 3 return, when the Democrat-dominated General Assembly will consider the plan designed to save $160 billion over 30 years and restore stability to the retirement system. Within an hour of the tentative deal’s announcement, labor unions mobilized against it.

“If their new plan is in line with what’s been reported from earlier discussions, then it’s an unfair, unconstitutional scheme that undermines retirement security,” We Are One Illinois, a coalition of unions, said in a statement.

Illinois’s five pension systems had 40 percent of the assets needed to cover obligations in fiscal 2011, the lowest ratio among states, data compiled by Bloomberg show. That has led to repeated credit downgrades for the lowest-rated U.S. state.

The proposal would reduce by one percentage point the amount employees contribute from their paychecks, according to a memo released today by House Speaker Michael Madigan’s office. The bulk of the savings would come from reductions in annual cost-of-living payments.

Benefits Delayed

Payments would be calculated against a sum equal to the number of years an employee worked, times $1,000, the memo said. The retirement age for workers younger than 45 would be raised, requiring employees to work as many as five years longer before receiving benefits. Employees could also choose a 401(k)-style retirement plan.

If the state didn’t make annual pension contributions to the funds, the retirement systems would be allowed to go to the Illinois Supreme Court “to compel the state to make the required pension payment,” the memo said.

The proposal, agreed to by Democratic and Republican leaders, follows months of discussions by a special legislative panel appointed to develop a compromise.

“I asked members to draft a plan that eliminated the unfunded pension debt and fully stabilized the systems, and this plan meets that standard,” Democratic Governor Pat Quinn said in a statement. “We have more work to do. I look forward to working with the leaders and members of the General Assembly over the coming days to get this job done.”

Repeated Attempts

Resolving Illinois’s pension shortfall has proven a challenge. Lawmakers have failed at least five times in the last 15 months to restructure the plans covering 761,000 employees and retirees. Despite the backing of legislative leaders, approval by a majority of both houses is not assured.

“The Senate president will be debriefing members of his caucus in the coming days in hopes of garnering support,” said Ronald Holmes, a spokesman for Senate President John Cullerton.

Illinois has the lowest credit standing among U.S. states from the three biggest rating companies, at four steps above junk. The firms have repeatedly cited the pension shortfall as the basis for the reductions.

By Tim Jones – Nov 29, 2013 11:47 AM PT

If Chuck Reed were a private employer and saw his pension costs triple in 10 years, he could cut future benefits as allowed under a federal law known as the Employee Retirement Income Security Act.

Reed, though, is mayor of San Jose, California, and the law doesn’t cover the public employees he oversees. Their pensions are treated as a contract between the government and worker. While cities are allowed to make changes for new hires, union representatives say that future benefits promised to existing workers can’t be modified.

The result is that San Jose, the home of Silicon Valley giants Cisco Systems Inc. (CSCO) and EBay Inc. (EBAY), spent almost one third of its general fund on pensions last year, the highest among the 25 most populous U.S. cities, according to Morningstar Inc. (MORN) Reed, a 65-year-old Democrat, is leading a statewide voter initiative to allow changes in future benefits for existing employees as unions fight to preserve the current rules.

“The statewide measure allows us to begin to deal with the cost of skyrocketing pension and retiree health-care costs,” Reed said in an interview. “If you look at what we’ve done so far, it doesn’t solve the problem.”

San Jose, a city of 983,000 that is California’s third-largest, has been forced to make deep cuts in basic services as its retirement costs soared to $245 million in 2012 from $73 million in 2002. The city’s pension and retiree health-care liability is almost $3 billion, according to Reed, who was first elected in 2006.

Changes Approved

San Jose voters last year approved retirement changes requiring new employees to pay 50 percent of the plan’s total cost, or about twice as much as current employees. Workers already on the city’s payroll could keep their existing plans by increasing their contributions or keep their costs steady by choosing a plan with more modest benefits.

Unions including the San Jose Police Officers’ Association and the San Jose Retired Employees Association sued to block the change. The case is pending.

Reed’s ballot initiative would amend the California constitution to give local governments the power to negotiate changes to existing employees’ future pension or retiree health care, while protecting benefits they’ve already earned.

“What they’re trying to do is overturn decades of case law, Supreme Court decisions and change the California constitution to allow public employers to either change, cut or eliminate public employees’ pensions in the middle of their career,” said Dave Low, executive director of the California School Employees Association and chairman of Californians for Retirement Security, a coalition of public employees and retirees.

“It’s a vested right,” Low said.

Rhode Island

Rhode Island enacted pension changes in 2011 that will delay retirement for state employees and offer them 401(k)-type savings plans that don’t provide guaranteed benefits. Union leaders sued to prevent the measure from taking effect.

“In talking with other mayors around the state, everybody would benefit from having clear authority to be able to negotiate changes for future benefits for work yet to be performed for current employees,” Reed said of his ballot measure.

Mayors Pat Morris of bankrupt San Bernardino, Tom Tait of Anaheim and Bill Kampe of Pacific Grove are backing the plan. Santa Ana Mayor Miguel Pulido dropped out as a formal supporter and was replaced by Vallejo Vice Mayor Stephanie Gomes. Opponents include Oakland Mayor Jean Quan and San Francisco Board of Supervisors President David Chiu.

‘Threatens’ Teachers

Also assailing the plan are the California Public Employees’ Retirement System, the largest U.S. public pension, and the California State Teachers’ Retirement System, the second-biggest U.S. public pension contending with a $70 billion unfunded liability.

The proposal “threatens the retirement security of existing and future educators, who have provided many years of service to California’s students,” Jack Ehnes, the teacher pension’s chief executive officer, said in a statement.

Reed said cities can continue to cut services and raise taxes, make employees pay more, cut benefit payments to retirees or cut benefits for current employees.

“None of those is fair, so it is better to talk about changing expectations of future accruals for future work,” Reed said.

California municipalities have limited ability to boost revenue. They can’t impose higher sales taxes without going to voters, and the state caps real-estate levies at 1 percent of a property’s most-recent sales price. The collapse of the housing market eroded tax dollars for many cities in the wake of the recession.

‘Not Sustainable’

“It’s not sustainable for cities to attempt to provide an appropriate level of health, safety and welfare services and have a significant portion of their general fund go for employment and pension costs,” Karol Denniston, a partner specializing in municipal restructuring at the San Francisco office of Schiff Hardin LLP, said in an interview.

Among potential obstacles to Reed’s plan is California Attorney General Kamala Harris. Unions were her second-largest source of campaign contributions when she won her office in 2010, according to data compiled by the National Institute on Money in State Politics, a nonpartisan group based in Helena, Montana.

Harris is responsible for writing the title and summary of the initiative before it’s circulated for signatures to qualify for the ballot. Most voters never read more than the title and summary of the text, according to the Denver-based National Conference of State Legislatures.

‘Pro-Citizen’

“You have to hope for an attorney general who is pro-citizen and impartial the way an attorney general should be, and they should not be worried about who funds their campaign,” said David Crane, a public policy lecturer at Stanford University near Palo Alto and a former special adviser to former Republican Governor Arnold Schwarzenegger.

Harris hasn’t taken a position on any initiative, Nick Pacilio, a spokesman for her, said by e-mail. Governor Jerry Brown, a Democrat, doesn’t comment on ballot measures, spokesman Evan Westrup said.

Reed said he anticipates unions will try to block signature gathering. The measure needs more than 807,000 petition signers to qualify for the ballot. Low, of Californians for Retirement Security, said he expects to discourage signature-takers.

“We generally try to keep voters informed,” Low said. “Where the signature gatherers are out there, we would probably want to at least have an opportunity to clarify for the voters what they’re signing.”

By Alison Vekshin – Nov 28, 2013 9:00 PM PT

Norwalk, CT, November 25, 2013—The Governmental Accounting Standards Board (GASB) today issued a Statement regarding the transition provisions of GASB’s new pension standards for state and local governments. GASB Statement No. 71, Pension Transition for Contributions Made Subsequent to the Measurement Date—an amendment of GASB Statement No. 68, eliminates a potential source of understatement of restated beginning net position and expense in a government’s first year of implementing GASB Statement No. 68, Accounting and Financial Reporting for Pensions.

To correct this potential understatement, Statement 71 requires a state or local government, when transitioning to the new pension standards, to recognize a beginning deferred outflow of resources for its pension contributions made during the time between the measurement date of the beginning net pension liability and the beginning of the initial fiscal year of implementation. This amount will be recognized regardless of whether it is practical to determine the beginning amounts of all other deferred outflows of resources and deferred inflows of resources related to pensions.

The provisions are effective simultaneously with the provisions of Statement 68, which is required to be applied in fiscal years beginning after June 15, 2014.

Statements 68 and 71 are available on the GASB website, www.gasb.org.

CHICAGO—Top lawmakers in Illinois reached a long-sought agreement to fix the nation’s most broken state public-employee retirement system, but the deal faces likely resistance from some legislators and unions who fear it will mean deep cuts to pension benefits.

Democratic and Republican leaders in the Illinois legislature announced the agreement on Wednesday and are expected to release details Friday. They said the plan would save an estimated $160 billion by reducing cost-of-living increases for retirees, raising the retirement age for younger workers and capping the salary amount used to calculate pension payments. That would close the large gap between promised benefits and current assets to pay for them over the next 30 years, they said.

In coming days, legislative leaders and Gov. Pat Quinn, a Democrat, will try to sell the plan to rank-and-file members of the House and Senate, many of whom have rejected proposed changes to the retirement system over the past two years. Votes are expected Tuesday.

The governor has staked much of his tenure on righting the troubled retirement system, making passage of an overhaul plan particularly important as he prepares to run for re-election next year. He is seen as vulnerable in his bid for a second term, with a crowded field of Republicans vying to challenge him. A poll conducted by Public Policy Polling earlier this month showed 34% of those surveyed approved of Mr. Quinn’s job performance.

The agreement also is expected to provide a template for Chicago Mayor Rahm Emanuel to follow for his city, which for years has paid far less into its retirement system than needed to keep it solvent. City payments to local pension funds are set to more than double to nearly $1.1 billion starting in 2015. Mr. Emanuel has warned that if changes aren’t made, the city will face a combination of property-tax increases and cuts in services, equating the scheduled increase to the cost of having 4,300 police officers on the street.

“Illinois’s pension crisis will not truly be solved until relief is brought to Chicago and all of the other local governments across our state that now stand on the brink of a fiscal cliff,” said Mr. Emanuel, who would face re-election in 2015.

While other states from Wyoming to Rhode Island have been paring back retirement benefits in recent years, Illinois lawmakers have remained deadlocked over how to address a pension-system shortfall that has ballooned to nearly $100 billion. The result: Illinois has the lowest credit rating among U.S. states, and the rating for Chicago is among the lowest for major U.S. cities.

To date, unions have successfully argued that government workers shouldn’t be punished for decades of mismanagement by the state, which underfunded the retirement system. But union leaders have seen support erode as concern over the state’s finances grows and their sway in a statehouse dominated by Democrats ebbs. “This has been an epic pension battle,” said Michael Carrigan, president of the Illinois AFL-CIO. “We are marshaling our resources.”

Dire fiscal problems in such places as Detroit and Puerto Rico have left lenders increasingly leery of Illinois and its largest city. While Illinois and Chicago remain in a considerably stronger financial position than those places, analysts say both Illinois and Chicago are considered distressed. Appetite for such debt has become weaker and interest costs have risen.

Howard Cure, director of municipal research at Evercore Wealth Management LLC, said Illinois finance officials have become more aggressive in marketing their bonds and have been reminding investors the state constitution puts debtholders first in line for payments. Illinois’s 10-year bonds trade at a premium that is more than triple California’s, but well below Puerto Rico’s, according to Thomson Reuters Municipal Market Data.

Mr. Cure said if Illinois can pass an overhaul that delivers significant retirement-system savings, it could begin to win back investors. “It’s a pretty diverse state. It’s not as if Illinois went through what Michigan went through,” he said, referring to the near-collapse of the auto industry during the recessionand Detroit’s recent efforts to refinance its debt through bankruptcy.

But failure to pass an overhaul plan could have an equally damaging effect, with the higher premiums attached to Illinois debt becoming commonplace rather than a temporary exception, said Duane McAllister, a portfolio manager at BMO Global Asset Management.

“It’s not Detroit, and it’s not Puerto Rico. Unfortunately, it gets thrown into the same trading basket,” said Mr. McAllister, referring to Detroit’s bankruptcy filing and a selloff in the island’s bonds amid concerns about a wide budget deficit there. He added that as an owner of Illinois debt, he is guardedly optimistic about the latest agreement.

The agreement is the first time top leaders in the state’s House and Senate have backed the same plan. Senate President John Cullerton, a Democrat, pushed for a proposal earlier this year, backed by unions, that would have given employees choices over benefit cuts and found savings through retirement health care. But House Speaker Michael Madigan, also a Democrat, opposed it, saying it didn’t deliver enough savings.

Now, union leaders are gearing up to fight—first at the capitol and then in court if necessary. They are encouraging members to call their legislators and visit their offices in the coming days in what they have dubbed a pension emergency. If the bill passes, labor leaders expect to sue the state, arguing benefits promised to employees and retirees are protected under the state constitution. The challenge has long been discussed by unions, with the state likely to argue that certain benefits aren’t protected, particularly in light of the state’s fiscal problems.

“You would have a line at the courthouse door,” said Anders Lindall, a spokesman for American Federation of State, County and Municipal Employees in Illinois. “Every teacher, every nurse, every caregiver, every public employee and retiree would have standing to sue.”

By MARK PETERS and AL YOON CONNECT

Updated Nov. 28, 2013 6:29 p.m. ET

The GFOA’s Awards for Excellence in Government Finance recognize innovative programs – contributions to the practice of government finance that exemplify outstanding financial management. The awards stress practical, documented work that offers leadership to the profession and promotes improved public finance. Entries may be submitted for consideration in any of the following categories:

• Accounting, auditing, and financial reporting
• Budgeting and financial planning
• Capital finance and debt administration
• Economic development and capital planning
• E-Government and technology
• Management and service delivery
• Pensions and benefits
• Treasury and investment management

Eight criteria are examined when considering an application for the award: local significance and value, technical significance, transferability, documentation, the cost/benefit analysis, efficiency, originality, and durability. Membership in the GFOA is not required to apply for an award; however, nonmembers and students must be sponsored by an active GFOA member.

Please read the FAQs for complete information about the Awards for Excellence program:

http://www.gfoa.org/index.php?option=com_content&task=view&id=1417

If you have additional questions, send an e-mail to Awards for Excellence:

http://www.gfoa.org/index.php?option=com_contact&task=view&contact_id=84&Itemid=3

Applications for the 2014 Awards for Excellence in Government Finance program are available here:

http://www.gfoa.org/downloads/GFOAAwardsforExcellenceApplication2014.pdf

The impact of Jefferson County’s bankruptcy will reverberate for decades in Alabama and in the $3.7 trillion U.S. municipal bond market.

Creditors, including JPMorgan Chase & Co. (JPM), agreed to forgive $1.4 billion of the county’s $3 billion sewer bonds. Ratepayers, like Charles Hicks, a retired landscaper who lives on a fixed income in Birmingham, will see his sewer rate rise about 8 percent annually for the next four years and 3.5 percent annually thereafter, under a plan approved by a federal judge yesterday.

“There’s a lot of pain going around — bondholders are taking large losses, but ratepayers are as well,” said Matt Fabian, a managing director at Concord, Massachusetts-based Municipal Market Advisors.

For the next 40 years, residents and businesses that already have some of the highest sewer rates in the county will pay back more in principal and interest than they owed before the bankruptcy, according to an analysis by Jim White, a Birmingham-based financial adviser who did a financial analysis for residents challenging the bankruptcy plan. Until Detroit’s July filing, Jefferson County was the nation’s largest municipal bankruptcy.

The willingness of Alabama’s most populous county to enter bankruptcy, along with the losses imposed on creditors, may make bondholders of other distressed municipalities more willing to to negotiate outside of court. Taxpayer groups will look at Jefferson County and see that bankruptcy won’t wipe away their obligations, Fabian said.

Lawyer Fees

“It does take the thunder out of taxpayer groups who are looking to get into bankruptcy just to shed debt, because it shows that those taxpayers could also be put on the hook to contribute in the future,” Fabian said.

Since filing the $4.2 billion case in November 2011, the county has spent more than $24 million on attorneys and other advisers. Most of the payments went to the county’s two main law firms.

Klee, Tuchin, Bogdanoff & Stern LLP in Los Angeles, which is led by Ken Klee, the lawyer who helped rewrite the U.S. Bankruptcy Code in the 1970s, collected $10.1 million in fees and was reimbursed about $204,000 for expenses. The second firm, Bradley Arant Boult Cummings LLP, which has offices in Birmingham, collected $8.2 million in fees and was reimbursed about $294,000 for expenses.

Enforcing Rates

Under an unusual provision in the exit plan approved by a federal judge yesterday, Jefferson County’s commissioners’ power to set and enforce rates will be limited until the $1.84 billion on bonds sold this week to pay creditors are paid off in 2053. The trustee for bondholders can ask the court to force sewer rate increases that may be needed to pay the debt.

The challenges facing the county’s finances and its sewer system won’t end with bankruptcy. Because the new bond issue pushes debt service payments into the future, rising 67 percent in 2024, the county is facing a projected $1.2 billion gap in money available to maintain the sewer system. A consulting firm that conducted a feasibility study for the county said it couldn’t identify where the county would get money to pay for capital spending.

The rate increases pledged to pay debt service will impose a “high burden” on ratepayers, and would cause rates to “approach the limits of reasonableness,” according to the Chicago-based consulting company, Galardi Rothstein Group.

Increasing Costs

Sewer rates will rise 7.9 percent each year for four years, starting in 2014, and by almost 3.5 percent annually through 2053. That’s on top of a 329 percent increase from 1997 to 2008 after the county embarked on a capital program to comply with a U.S. Environmental Protection Agency decree to clean up discharges into the Cahaba River.

The cost of Jefferson County’s sewer system ballooned to $3 billion as the county built treatment plants and laid pipe without a strategic plan and local officials accepted bribes from construction contractors and financial advisers seeking business with the county.

The sewer rate increases will disproportionately affect the poor. Seventy percent of the sewer system’s users reside in the commission districts with poorest residents, according to County Commissioner George Bowman, who voted against the bankruptcy.

“This whole process had been fraudulent to the ratepayer,” said Hicks, 67, who heckled Carrington after U.S. Bankruptcy Judge Thomas Bennett approved the plan.

Wealthy Benefit

Under Alabama law, sewer rates must be reasonable and nondiscriminatory. Ratepayers who objected to the county’s plan are vowing to continue legal challenges.

Some residents in wealthy Birmingham suburbs, who have septic tanks and aren’t connected to the sewer system, don’t have to pay additional charges even though they get the indirect benefit of the county having clean water.

Calvin Wood, president of the Birmingham Chapter of the Southern Christian Leadership Conference, said it was wrong that county officials didn’t spread the pain of rate increases evenly.

“Unless you’re going to put it across the board on everybody, you’re still going to have a lot of trouble,” Woods said. “All of us live in the county.”

By Martin Z. Braun

Los Angeles is seeking financial advisors for bonds issued in several categories, but underwriters need not apply, according to two recent requests for proposals issued by the city.

FirstSouthwest sent a seven-page letter to Los Angeles officials Friday protesting the language in two RFPs seeking financial advisors but excluding firms “that underwrite or otherwise trade in municipal bonds.”

That language appears in the qualifications section of an RFP seeking a financial advisor to work on the city’s general obligation bonds and wastewater system revenue bonds.

“We feel very strongly that the RFPs should be changed to allow bidding by all qualified firms,” wrote Jack Addams, vice chairman of FirstSouthwest. “Because other qualified firms excluded under the current wording may wish to respond, we suggest the city extend the due dates if the RFP’s are modified.”

Addams said in his letter that FirstSouthwest would be responding to the RFP on Nov. 22, regardless of whether changes are made and that they would protest if their response is not considered.

The city doesn’t seem likely to make changes in the middle of an RFP process in which the deadline for responses was Nov. 8; and the city anticipates making a decision on Dec. 2.

Natalie Brill, Los Angeles’ debt manager, said she couldn’t comment on the RFP process until after the final selection is announced Dec. 2.

The protest letter was sent to Brill; City Administrative Officer Miguel Santana; City Attorney Mike Feuer; and Paul Krekorian, chair of the City Council Budget & Finance Committee.

Los Angeles’ debt management policy, adopted in 2005, deems it a conflict of interest for firms to do business with the city as both an underwriter and financial advisor.

“The city has a policy that the financial advisor must be independent and can’t have an underwriting arm,” said Jeremy Oberstein, a spokesman in Krekorian’s office.

FirstSouthwest officials don’t think the issue is quite so clear cut.

Regulations adopted by the Municipal Securities Rulemaking Board, Dodd-Frank legislation, and changes proposed by the U.S. Securities & Exchange Commission that go into effect in mid-January have changed the playing field with rules regulating how FAs operate.

FirstSouthwest would like the city to remove the language excluding underwriters noted in the first RFP and in another RFP seeking a financial advisor for eight different bond categories including general fund lease financings and tax anticipation notes, in which the city explains that while it has “in the past, accepted proposals from investment banking firms to act as financial advisors, the city now only hires independent financial advisors for general financial advisory services and the city’s various bond programs.”

It further says, “In light of the scope of the engagement and the emphasis on non-transaction-related financial advisory services, as well as the city’s desire to hire financial advisors with no vested interest in the issuance of debt, the city will not consider proposals from firms that underwrite or otherwise trade in municipal bonds to serve as the lead financial advisor, in accordance with MSRB [Municipal Securities Rulemaking Board] G-23.”

In November 2011, MSRB’s Rule G-23 was modified to prohibit dealers from serving as financial advisors and underwriters on the same municipal bond deal.

“Their debt policy that is available through their web page is somewhat less restrictive than what is in the current RFP,” said Brian Whitworth, senior vice president for FirstSouthwest.

The city used underwriters as co-financial advisors before the MSRB came out with its rules, but typically only in special situations where it wanted sell-side advice on an issue, city officials said.

Based on the language in the RFP, Whitworth said apparently the category allowing underwriters to act as co-financial advisors is now gone.

“We feel very strongly that all qualified financial advisors should be able to submit an application,” Addams said. “The city should be able to pick whoever they want. We object to the city excluding very qualified FAs from even being able to apply.”

Southwest officials question why the city frequently uses KNN Public Finance as a financial advisor, when the financial advisory firm is a division of Zions First National Bank, an underwriter. FirstSouthwest also was selected to act as a financial advisor for the Los Angeles Housing Department in 2006 and 2010, but was told it would not be considered for the city itself, its port, airports, and the Department of Water and Power, Addams said.

“There is no definition of ‘independent’ in any regulatory rules,” Addams said. “That is why we wanted them to understand the ownership structure of PFM and KNN, who currently work for the city.”

PFM, an advisor the most recent Los Angeles International Airport deal, is owned by a group of private equity investors that includes at least one underwriting firm that has an ownership interest, according to FirstSouthwest’s letter.

The MSRB’s fair-dealing rule requires underwriters to disclose to issuers that they do not have any fiduciary duty and that the transaction will be at arm’s length.

Addams thinks those disclosure rules and similar ones outlined in Dodd-Frank will ensure that if a firm that conducts underwriting business is hired as an FA there is a guarantee it will act in the city’s best interest.

The SEC is about to add its take on the issue when its municipal advisor rules takes effect by mid-January. Its rule would require anyone offering advice about municipal bonds, municipal derivatives, or the investment of bond proceeds to an issuer or other municipal entity or conduit borrower to register as a municipal advisor.

“There have been a lot of changes since the city adopted its debt policy in 2005,” Addams said. “We have made a decision as a company that we will challenge this where we see it.”

In a city as prominent as Los Angeles, Addams said, “it’s very important we challenge this.”

FirstSouthwest was successful in getting Broward County, Fla. and Broward County School District to change the language in its RFPs allowing underwriters to be considered for FA work, according to Addams.

Two issuers interviewed for the story have not heard of anyone other than Los Angeles adopting such a policy, but said they understand why an issuer might do so.

“My guess is that on a practical basis, this will make it easier for all concerned to serve either in a fiduciary, or non-fiduciary role without any overlap,” said Laura Lockwood McCall, director of debt management manager at the Oregon State Treasury.

Julia Harper Cooper, director of finance at the City of San Jose, said issuers might feel better with a “clear delineation” between who their FA is and who their underwriter is, without worrying whether the lines might be blurred.

“It becomes more comfortable for issuers,” she said.

The Government Finance Officers Association “has discussed the issue of recommending that governments use independent FAs vs. those associated with broker/dealer firms in the past,” said Timothy Firestine, GFOA president and chief administrative officer of Montgomery County, Md.

“Due to the forthcoming MA rule, it is likely that this subject will be discussed again, as GFOA looks to ensure that issuer practices are in line with the rule. From my personal experience as a CFO, it is a better practice to use an independent FA. Helps avoid even the appearance of a conflict of interest.”

BY KEELEY WEBSTER

The new Debtor-in-Possession (DIP) financing proposal that the City of Detroit’s Emergency Manager put forth on October 11, 2013 is unprecedented among municipalities, says Moody’s Investors Service. Because of this and some key differences from more common corporate-based DIPs, the ultimate impact of the proposal on the city’s finances and existing bondholders is uncertain, says Moody’s in the report “Detroit: DIPing its Toe into a Corporate Bankruptcy Tool.”

DIP financings are commonly used in the corporate sector to inject liquidity into a bankrupt entity, with the objective of paving the way for eventual recovery. Although structurally similar with respect to most terms, the proposed Detroit DIP has several key differences.

The most significant difference is the use of proceeds. Corporate DIPs are traditionally used to provide operating financing and liquidity, with limited draws on the DIP commitment at closing. Conversely, Detroit’s proposed DIP financing plan would immediately deploy 100% of the transaction proceeds.

“The full utilization of all note proceeds highlights the city’s ongoing narrow cash position that persists despite already ceasing all debt service payments on liabilities deemed unsecured by the state-appointed emergency manager, as well as deferral of the city’s employer pension contributions,” says Genevieve Nolan, a Moody’s Assistant Vice President.

While corporate DIP financing plans can be a credit positive by providing liquidity that facilitates continued operations, the ultimate credit impact of Detroit’s DIP financing proposal is not clear at this time.

“The impact of the proposal on the city’s existing creditors, as well the city’s near-term financial position and long-term financial recovery, are difficult to assess at this point given the number of contingencies that remain,” says Nolan.

Ultimately, it is uncertain whether the judge overseeing the current bankruptcy hearings will permit the DIP financing to proceed.

For more information, Moody’s research subscribers can access this report at https://www.moodys.com/research/Detroit-DIPing-its-Toe-into-a-Corporate-Bankruptcy-Tool–PBM_PBM160112.

A new online toolkit designed to help preparers and auditors of state and local government pension plans implement new accounting and financial reporting standards was released today by the Governmental Accounting Standards Board (GASB). The toolkit is available at no cost at the GASB website: http://www.gasb.org/cs/ContentServer?c=Page&pagename=GASB%2FPage%2FGASBSectionPage&cid=1176163527830

GASB Statement No. 67, Financial Reporting for Pension Plans, revises existing guidance for the financial reports of most pension plans for state and local governments. These plans are required to implement the new accounting standards in fiscal years beginning after June 15, 2013 (that is, for years ending June 30, 2014 or later).

Prepared by the GASB staff, the toolkit includes the following resources:

• The Guide to Implementation of GASB Statement 67 on Financial Reporting for Pension Plans, an authoritative resource guide
• A video featuring GASB Chairman David A. Vaudt discussing the top implementation issues facing pension plans
• A podcast featuring GASB Project Manager Michelle Czerkawski discussing the types of pension plans that will be affected by Statement 67 and the most significant changes to accounting and financial reporting for pension plans
• A background document answering frequently-asked questions regarding Statement 67 and Statement No. 68, Accounting and Financial Reporting for Pensions
• A fact sheet answering frequently-asked questions specifically relating to Statement No. 67
• An article identifying several areas plan administrators and public officials should consider as they plan, prepare, and collaborate when implementing the new standards
• A “Setting the Record Straight” document addressing common misperceptions about the new pension standards, and
• The executive summary and the full text of GASB Statement 67.

“Many of our stakeholders have requested additional educational resources to help them implement the new standards,” said GASB Chairman David A. Vaudt. “This toolkit is intended to provide guidance on how plan administrators can effectively comply with the new rules. In the coming weeks, we will add more resources to the toolkit, including short videos from GASB staff highlighting our most-asked implementation questions.”

Notes from the Bloomberg State & Muni Finance Conference

As previously mentioned in this column, Bloomberg held their State and Muni Conference on November 6th in New York City. Right at the outset, the choice of venue was rather unconventional: the proceedings were held at The Cutting Room, a small rock and blues club owned by “Mr. Big” himself, Actor Chris Noth. Certainly, it was quite interesting for the panelists to be on the same stage where the likes of Ron Wood, Mick Ronson and Marty Balin will be performing.

The 300-pound gorilla in the room was, of course, Puerto Rico (PR).

Since video clips for most of the panels are available for viewing on the Bloomberg conference site, we’ll just go over a few things we found noteworthy.

Perhaps to no one’s surprise, credit topics dominated the discussions at the Conference, particularly those issues with potential “systemic” implications (I sat next to a representative from the FDIC, there to ferret out any and all systemic risks to our banking system!)

The Detroit situation was touched upon by several panels but no new information really emerged from the various discussions.

The 300-pound gorilla in the room was, of course, Puerto Rico (PR). In the very first session, U.S. Treasury Under-Secretary Mary Miller (a brilliant investment professional whom I’ve had the chance to know since her days as a muni analyst at T. Rowe Price) struck a very cautious note regarding potential Federal assistance to Puerto Rico. On the positive side, Mary confirmed that the Administration is closely monitoring the situation and is in close communication with the Padilla financial team. However, she also warned there is no existing Congressional authority for any kind of direct financial assistance to the troubled island. The Feds’ role is currently limited to providing input regarding fiscal management practices and ensure that all federal monies that are due the Commonwealth be expended in the most effective manner possible.

From PR’s side, Treasurer Melba Acosta and Chairman of the GDB David Chaffey were also on hand to hammer home their message to investors: default is not in the cards for now. Of note, after putting out press releases trumpeting stronger revenue collections in October, Treasurer Acosta appeared to back-track a little: she noted there was a special corporate tax payment due in October that could have inflated the numbers somewhat.

The second panel on PR featured Dick Larkin from H J Sims, Hector Negroni from Fundamental Advisors and Emily Raimes from Moody’s. In response to Dick’s unflaggingly strong defense of the PR credit, Hector observed that hedge funds should not be viewed as the “enemy”, since they stepped in to provide liquidity to the market when the traditional buyers could no longer handle the risk. We could not agree more. Like Hector, we feel the muni market should welcome the participation from the hedge funds, as providers of liquidity at a time when the broker-dealer community is retrenching. Crossover distressed players are also more experienced than muni analysts, we believe, in evaluating trading opportunities related to capital structure. Broadening the audience for municipals can only benefit our asset class over the long run, in our view.

The Windy City is currently held hostage by the lack of pension progress at the state level, and Mayor Emanuel is viewed as running out of options.

Being Chicago-based, we were also interested in the panel on the State of Illinois, featuring our local pundit Chris Mier from Loop Capital. Chris pinned Illinois’ fiscal problems on the One-Party rule and the high degree of work force unionization. All the panelists agreed that pension reform is the biggest issue facing the Prairie State, and one that won’t be resolved any time soon. There was a feeling that the legislators in Springfield needed to be shocked by a real crisis – perhaps a failed State bond financing – in order to get off the dime. All noted the wider spreads on Illinois paper, close to +175, but none was willing to declare the credit a “buy” quite yet.

We were somewhat surprised by the lack of focus on the gubernatorial race, aside from a cursory comment from Chris. Surely, much of the legislative foot-dragging on pension reform must be attributable to the political maneuverings surrounding the election. As reported by the Chicago Tribune, “the two-week fall session that starts Tuesday will unfold just weeks ahead of the deadline for candidacy petitions to be filed for next year’s elections. Taking a tough vote on pension reform before then risks drawing a challenger next year.” So, even some clarity as to who might emerge as a strong contender in this electoral season could become a catalyst for progress on pension reform.

In the context of Illinois, Chicago’s fiscal condition also came up and was deemed much more tenuous than the State’s. The Windy City is currently held hostage by the lack of pension progress at the state level, and Mayor Emanuel is viewed as running out of options. Chris Mier pointed out that, although traditionally trading at tighter spreads than Illinois, Chicago bonds have flipped over and now trade at much wider spreads. To that extent, they may eventually become a more interesting credit play than Illinois.

In summary, the overwhelming message we got from the Conference is that the muni credit landscape remains quite unsettled. This should translate into an abundance of muni credit opportunities, as long as you do your homework.

About the Author

Triet Nguyen is the managing partner of Axios Advisors LLC, an independent municipal research and investment advisory boutique specializing in high-income strategies.

Over his 32-year career as a high yield/distressed municipal bond expert, Nguyen has designed, marketed and managed every type of buy-side investment product, from mutual funds to managed accounts and hedge funds.

The Government Finance Officers Association (GFOA) has announced that it has established a professional recognition program for small governments that prepare their financial reports on a modified cash basis.

Download a FAQ Sheet on the New Program:

http://gfoa.org/downloads/GFOAFAQsheetforCofCProgram.pdf

Details on how to become a Participant or Reviewer:

http://gfoa.org/downloads/GFOAConformanceCertificateDetails2013.pdf

The GFOA Certificate of Conformance Program for Small Government Annual Financial Reports is delighted to announce the program’s first winner of the Certificate of Conformance Award.  The Town of Cashion, Oklahoma has demonstrated a high quality of financial reporting on a modified cash basis.  Receiving this award demonstrates the exceptional dedication that the Town of Cashion has to transparency, accountability, and financial reporting.  All parties involved in attaining this distinction for the town should be  commended for their accomplishment.  Congratulations!

If approved, Stockton’s Plan for the Adjustment of Debts (plan of adjustment) identifies negotiation strategies, legal ambiguities, and their potential consequences for future municipal bankruptcies in California and elsewhere, according to a new Fitch Ratings report.

‘Stockton’s ability to achieve significant concessions from labor under threat of bankruptcy provides food for thought about incentives in other potential cases’ said Amy Laskey, Managing Director.

‘The specter of bankruptcy may have motivated labor, although not bondholders, to negotiate.’ In future cases, labor may feel the risks of losing all negotiating power in a Chapter 9 proceeding are too great. On the other hand, they may feel that their employer’s need to continue to provide competitive wages and benefits will adequately protect their interests.

Most notable is the elimination of other post-employment benefits (OPEBs), which was negotiated with current employees and retirees. The reduction in Stockton’s post-employment costs meaningfully improves their affordability.

Despite bondholder objections about ongoing CalPERS payments, the city appears to have acted practically since the proposed two-thirds reduction in retiree benefits would have made those jobs uncompetitive.

Lease revenue bonds are expected to be significantly impaired. Incentive to repay lease debt depends on the importance of the leased assets, although Stockton’s actions highlight the difficulty in assessing essentiality. Fitch assumed the Stockton City Hall would be deemed essential but those bonds’ treatment appears to reveal that City Hall is just another office building. However, another office building with a crime lab and garage are deemed essential by the city and those bonds will be repaid in full.

The plan of adjustment adheres to the Bankruptcy Code’s treatment of ‘special revenues,’ as debt secured by such revenue streams, including utility revenues and tax increment, will continue to be paid to the extent the pledged revenues are sufficient.

In addition to employees, retirees, and bondholders, taxpayers are being asked to contribute to the city’s recovery by approving a three-quarter cent sales tax increase this November.

For more information, a special report titled ‘Stockton Bankruptcy Perspectives’ is available on the Fitch Ratings’ web site at www.fitchratings.com.

This webpage offers a variety of resources designed to support the understanding of GASB Statements No. 67, Financial Reporting for Pension Plans, and No. 68, Accounting and Financial Reporting for Pensions, which substantially improve the accounting and financial reporting of public employee pensions by state and local governments that apply U.S. Generally Accepted Accounting Principles (GAAP).

http://www.gasb.org/jsp/GASB/Page/GASBSectionPage&cid=1176163528472

The California Public Employees’ Retirement System filed an amicus brief last week in support of the state government in a case involving the successor agency to San Bernardino’s former redevelopment agency.

The filing came the same day that U.S. Bankruptcy Judge Meredith Jury ruled against CalPERS’ appeal of the city’s eligibility to be in bankruptcy.

The pension fund’s attorneys argued in the appeal that the judge granted eligibility on Aug. 28 despite shortcomings in the city’s case.

CalPERS filed the amicus brief on Thursday in support of two other state agencies – the Department of Finance and the Office of the State Controller – in their ongoing dispute with the San Bernardino over tax revenues relating to the dissolution of the city’s redevelopment agency and the operations of the successor agency.

The state government shut down redevelopment agencies in 2012, and says San Bernardino inappropriately held on to $15 million that belonged to the former city redevelopment agency.

San Bernardino City Attorney James Penman argued in his filing against the state agencies that the city could not afford the $15 million and would be forced to shut down. Bankruptcy protection prevents creditors from seizing assets or from suing entities under that protection. Penman is trying to make the DOF order part of the bankruptcy case.

The city lost the first round on that issue when Jury ruled on Sept. 11 that the city and the successor agency to its redevelopment agency are separate entities, making it a non-bankruptcy court issue.

In that ruling, Jury said in court documents that if the successor agency had a dispute with the state’s Department of Finance, it should take the issue to state court. Jury also left the door open for the city to file before her a second time, which the city did.

She has yet to rule on the second filing.

The Department of Finance filed an appeal Oct. 1 with the U.S. Ninth District Court of Appeals arguing that Judge Jury doesn’t have jurisdiction on the redevelopment issues.

In its “friend of the court” brief in support of the state agencies, CalPERS argues that the 11th Amendment to the U.S. Constitution protects state agencies from being “hauled into federal court against their will” by a municipality, which is a creation of the state. The brief also describes CalPERS as a state agency in an attempt to point out similarities between the pension fund and the state agencies.

CalPERS has been attempting to get relief from the automatic stay protecting entities in bankruptcy from being sued in state court, in order to file suit in district court against the city for the $17 million in missed fees, payments and interest currently owed by the city.

CalPERS brief argues in support of the DOF’s appeal to district court on the grounds that bankruptcy is not an exception to state sovereignty.

“By characterizing [the city’s] proceeding as merely one to prevent an action to collect on a debt, the bankruptcy court gave short shrift to the serious federalism concerns that this proceeding raises,” according to CalPERS brief.

In CalPERS appeal of the city’s eligibility to be in bankruptcy, the pension fund’s attorneys used some of the same arguments related to state sovereignty.

Jury said in denying without prejudice CalPERS appeal of the city’s eligibility to be in bankruptcy that “the eligibility orders do not finally resolve or seriously affect any substantive rights of CalPERS.”

The judge cited as precedent the case of Silver Sage Partners, Ltd. v. City of Desert Hot Springs, Calif. where the appeals court ruled that, “We are not convinced that Congress’s whole municipal bankruptcy statutory scheme is so skewed in favor of the municipality that the commencement of proceedings itself causes irreparable injury.”

BY KEELEY WEBSTER

Erin Sweeney of Dickstein Shapiro LLP, writing on behalf of the TML Intergovernmental Employee Benefits Pool, has asked the IRS to make clear in proposed healthcare regulations (REG-132455-11) that health benefit pools qualify as minimum essential coverage, thus triggering a reporting obligation under section 6055.

October 3, 2013

Internal Revenue Service

Re: Information Reporting of Minimum Essential Coverage

Sir or Madam:

We write on behalf of the TML Intergovernmental Employee Benefits Pool (“TML IEBP”) to comment in connection with the notice of proposed rulemaking (“Proposed Rule”) published in the Federal Register on September 9, 2013, by the Department of the Treasury and the Internal Revenue Service. The Proposed Rule provides guidance relating to the information reporting requirements of section 6055 of the Internal Revenue Code of 1986, as amended (“Code”), as added by the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010.

In legal terms, TML IEBP is a “risk pool” organized in 1989 pursuant to Chapter 172 of the Texas Local Government Code. A factual and functional description of TML IEBP would be to call it an interlocal cooperation employee benefits pool. A number of these pools have been formed across the country through the interlocal cooperation statutes enacted by the respective states. These entities provide pooled health benefits coverage between local governmental units. Often these pools are self-funded through the combined contributions of the members. TML IEBP is a Texas intergovernmental risk pool providing group accident and health benefits coverage to employees, officials, and retirees of political subdivisions of the State of Texas and to their dependents. This governmental pool has been successfully providing benefits to governmental entities in Texas since 1989.

We write today seeking confirmation that health coverage provided by TML IEBP may qualify as minimum essential coverage, thus triggering a reporting obligation under Section 6055 of the Code. We seek this confirmation because the regulations addressing the Shared Responsibility for Not Maintaining Minimum Essential Coverage (“Individual Mandate Regulations”) are not clear that health benefit pools such as TML IEBP constitute minimum essential coverage because the term “group health insurance coverage” appears to modify the term “governmental plan”. This is significant because many State health benefit pools, including TML IEBP (which are clearly “governmental plans” under section 2791(d)(8) of the Public Health Service Act (“PHSA”)), are exempted from State laws regulating insurance. Without clarification, the proposed rules could be interpreted to exclude health benefit pool coverage provided by governmental plans from the definition of minimum essential coverage.

Specifically, the Individual Mandate Regulations define an “eligible employer-sponsored plan” as “[g]roup health insurance coverage offered by, or on behalf of, an employer to an employee that is . . . [a] governmental plan (within the meaning of section 2791(d)(8) of the [PHSA] (42 U.S.C. 300gg-91(d)(8))) . . .”

“Group health insurance coverage” is further defined in the Individual Mandate Regulations as having the same meaning as in section 2791(b) of the PHSA, 42 U.S.C. 300gg-91(b)(4). Under the PHSA, group health insurance coverage “means, in connection with a group health plan, health insurance coverage offered in connection with such plan.”

“Health insurance coverage” is defined in the Individual Mandate Regulations as having the same meaning as in section 2791(b)(1) of the PHSA, 42 U.S.C. 300gg-91(b)(l). Under the PHSA, health insurance coverage “means benefits consisting of medical care (provided directly, through insurance or reimbursement, or otherwise and including items and services paid for as medical care) under any hospital or medical service policy or certificate, hospital or medical service plan contract, or health maintenance organization contract offered by a health insurance issuer.” Although “health insurance issuer” could be read as applying only to “health maintenance organization contract”, given that policies and certificates are issued by health insurance issuers, the better reading of the language appears to be that “health insurance issuer” applies to each of the delineated items — policies, certificates, plan contracts or health maintenance organization contracts.

Finally, “health insurance issuer” is defined in the Individual Mandate Regulations as having the same meaning as in section 2791(b)(2) of the PHSA, 42 U.S.C. 300gg-91(b)(2). Under the PHSA, health insurance issuer “means an insurance company, insurance service, or insurance organization which is licensed to engage in the business of insurance in a State and which is subject to State law which regulates insurance. Such term does not include a group health plan.” (parentheticals omitted).

While TML IEBP is subject to limited regulation by the Texas Department of Insurance (e.g., financial oversight by the required filing of audited financial statements with the Texas Department of Insurance on an annual basis, application of certain Texas Insurance Code mandated benefits provisions, and the like), TML IEBP is not a health insurance issuer because it is not licensed by the Texas Department of Insurance. It is, however, a governmental plan.

We believe that health benefit pools such as TML IEBP and similar state health benefit pools are examples of coverage that Treasury has authority to clarify — and ought to clarify — are subject to the minimum essential coverage reporting requirements even though the health benefit pools are not subject to State laws regulating insurance. Of course, if Treasury determined that TML IEBP’s health benefit pools constituted minimum essential coverage, TML IEBP would need to separately demonstrate affordability and minimum value with respect to the employer shared responsibility payment.

Thank you for considering this comment submitted in response to the Proposed Rule issued with regard to the information reporting requirements of section 6055. If you have any questions or would like to discuss these comments further, please contact the undersigned at (202) 420-3477.

Sincerely,

Erin M. Sweeney

sweeneye@dicksteinshapiro.com

DicksteinShapiro LLP

Washington, DC

Municipalities Grapple With Burgeoning Retiree-Benefit Costs; A Costly Perk in Springfield, Ill.

It pays for veteran firefighters and police officers here to retire around the anniversary of their hiring date—but it’s costly for this city of 117,000.

Under current labor agreements, employees get a 5% bump in the pay periods around that date every year. Workers who retire during the short window get a perk: Their pensions are based on the temporarily boosted paycheck. The provision, which starts after two decades on the job, adds an average of $65,000 in lifetime payouts for each retiree who takes advantage.

Nationwide, pension costs are eating up more of city general funds, leaving less money to spend on day-to-day needs, such as garbage pickup or parks maintenance. The median spending on pensions among the country’s 250 largest cities rose to 10% of general budgets in 2012, up from 7.75% in 2007, according to data provided to The Wall Street Journal by Merritt Research Services LLC. A few cities weren’t available by August 2013, when Merritt collected the information.

Springfield’s annual payments to the public employee retirement system have nearly tripled in the past decade to $19.8 million. The city says it spent 20% of its operations budget on pensions in the 2012 fiscal year, one of the nation’s highest rates. Merritt puts the percentage at closer to 25%, based on public filings. (Merritt and the city differ on how to treat the calculation for some city employees, including those who work for Springfield’s electric and water utility.)

The price of the problem can be seen around the Illinois state capital. Library branches that closed in the wake of the recession have never reopened. The Springfield Municipal Band, which was established through a 1936 referendum, has shrunk. In older neighborhoods such as Harvard Park, heavy rains overwhelm storm sewers and roads. Vacuum trucks fan out and suck up water because the city hasn’t been able to afford needed road repairs.

“I have seen kids 8 and 10 years old wading waist-deep into it,” said Polly Poskin, president of the Harvard Park Neighborhood Association. “The city has settled for a temporary fix, and we live with a permanent problem.”

In the Enos Park neighborhood, residents have been tearing down blighted houses and building sculpture gardens to reverse years of decline. They hoped to restore the neighborhood’s pockmarked main artery to the historic brick that sits below. The city’s response: It will be able to repave only eventually.

Steve Combs, president of Enos Park Neighborhood Improvement Association, said residents have become resigned to the city’s constraints. For new projects, he said, “there isn’t even a line right now.”

Pension problems have been mounting for years in Springfield. The city contributes to three pension funds: one each for police and fire, which are controlled by local boards, and to a smaller extent, a statewide fund for other city workers. A 2008 report commissioned by the mayor at the time warned that growing pension payments would “squeeze out basic municipal services.”

Years of salary increases and benefits fed the problem. The police and fire departments most recently had five-year contracts with 4% annual pay increases—plus the temporary 5% anniversary bump for veteran officers. Police agreed to a new contract last year with smaller raises, while firefighters are negotiating a new contract. Meanwhile, the number of retirees has grown.

To be sure, police and firefighters contribute a sizable chunk of their salaries to the pension funds—9.91% for police and 9.455% for firefighters. Also, as police and firefighters typically aren’t eligible to collect Social Security, municipalities don’t have to pay Social Security taxes on their salaries.

An analysis by Springfield officials earlier this year said below-par investment returns have exacerbated the pension problems, with the police and fire funds falling far short of the forecast annual return of 7.5%. Actuarial reports, which use an average return over several years to smooth sharp market swings, show the funds met their annual forecast only once in the past decade. That has left them with only about half the assets needed to pay all promised benefits, after being around 75%-funded a decade ago.

The result: The long-term obligations continue to increase, and funding shortfalls keep getting pushed into the future.

The police fund has called the 7.5% target set by the city increasingly unrealistic.

But Mayor J. Michael Houston, a former bank chief and investment management executive, opposes lowering the return target, saying it’s realistic over the long term. In the meantime, he’s cut some city positions and put surplus funds at the end of the last year into the pensions.

“The more money that we’re putting in the pension funds, the less money we can put into other services for people within the community,” Mr. Houston said. “This is not a problem that was created overnight. We need to approach the solution on a long-term basis.”

Chicago-based consultancy Marquette Associates, which has advised the police and fire funds for the past three years, declined to comment.

Standard & Poor’s Ratings Services in its most recent report on the city’s finances acknowledged the steps Springfield is taking to alleviate its problems, including the workforce cuts and additional pension contributions. Still, when city debt is combined with the cost of promised pension and retiree health-care benefits, the total is $6,956 per capita. The credit-rating firm views a number more than $5,000 as high.

Although Illinois is one of only a handful of states with locally run pension funds, the state dictates how they can invest. So while cities control salary negotiations, retirement benefits are set by the Legislature. Lawmakers, for example, voted in 2004 to give the spouse of a retired firefighter continuing benefits after any death, affecting about 290 local funds. Springfield estimated it cost an additional $653,000 in the first year.

In Springfield, the temporary pay spike may soon be a thing of the past. The new police contract ends the perk next year, and the firefighters are likely to lose it, too. Former firefighter John Sullivan, now president of the Springfield Firefighters’ Pension Fund, said the benefit was originally designed to entice more highly paid older employees to leave. But, he said, “ideas have changed.” Also, starting next year, the city will raise the sales tax to 8.5% from 8%. That follows an increase in sewer rates earlier this year.

The state has its own pension woes. Illinois has chronically underfunded its retirement system for state workers, university employees and teachers, while also seeing investment returns fall short of forecast levels. As a result, the state’s credit rating is the lowest in the country.

As for the Legislature, so far lawmakers confronted rising costs only by reducing retirement benefits for newly hired state and local government employees. But those savings will take years to materialize.

“The real question for municipalities like the city of Springfield is: How long can we hang on?” said William McCarty, director of Springfield’s budget and management office.

By MARK PETERS

Desperate to cover a $40 million shortfall in its pension fund for retired police officers and firefighters, the city of Richmond turned to an exotic loan.

But instead of tightening spending after it issued the $36 million pension obligation bond in 1999, city leaders increased the retirees’ pensions.

Today, Richmond still owes more than $12 million on the bond, plus about $5 million in interest, and its pension fund remains roughly $12.5 million short. To narrow that gap and cover the debt, the city is dipping into proceeds from a supplemental property tax on residents and businesses.

The city’s fiscal approach has residents like Joe Bako scratching their heads. “When you’re short on funds, you don’t start spending more,” he said.

Some public officials and investment bankers have portrayed pension obligation bonds as a good way to shore up pension funds. The proceeds can be invested in the stock market, reaping returns potentially higher than the bonds’ interest rate.

Bonds in the red

But that gamble is not panning out so far for at least five pension obligation bonds issued by California public agencies between 1999 and January, an analysis by the Center for Investigative Reporting has found.

In addition to the city of Richmond’s Police and Firemen’s Pension Fund, agencies with bonds in the red include Merced County and the Pasadena Fire and Police Retirement System.

Average returns on investments also have not kept pace with net interest costs on recent bonds in two other California counties: San Diego and San Bernardino. Because those bonds were issued within the past six years, it is too soon to determine how they will perform.

Since 1999, local governments and special taxing districts in California have sold more than $11 billion in bonds to shore up their pension obligations, according to the state treasurer’s office.

Emboldened by the infusion of cash from pension bonds, some municipalities have enhanced employee pensions or buttressed needs elsewhere by suspending pension contributions.

“It is basically a principle where they’re printing money,” said Chester Spatt, a former chief economist for the Securities and Exchange Commission and a finance professor at Carnegie Mellon University. “These (bonds) strike me as irresponsible, especially in light of what we’ve learned” from the 2008 financial crisis.

Sign of larger problems

The bonds do not require voter approval and, by the time they are paid off, many of the public officials who approved them are long gone. “The decision happened before I got here,” said Bill Lindsay, who became Richmond’s city manager in 2005. “Applying hindsight to investment returns, I wish I could do that for my entire life.”

Yet even after the downturn, and with growing knowledge of the risk involved, many governments continued to rely on pension bonds.

In the five places in California where pension bonds are underperforming so far, the shortfall also warns of deeper financial problems, said Thad Calabrese, assistant professor of public and nonprofit financial management at New York University. Residents of such areas might face service cuts and higher taxes, he said – or worse.

“Instead of negotiating with the unions and imposing pension reforms, for example, this is a way of kicking the can,” Calabrese said.

Pension obligation bonds figured prominently in last year’s bankruptcy in Stockton, which issued $125 million in pension bonds in 2007 – after it had improved retirement benefits and compensation several times. Stockton’s invested pension bond proceeds lost about a third of their value in the stock market crash.

Detroit, the largest U.S. city to file for bankruptcy because of a shrinking tax base, declining population and other factors, failed to realize expected returns after issuing pension bonds in 2005 and 2006.

Agencies downgraded

Credit rating agencies increasingly are downgrading the creditworthiness of public agencies with pension bonds, which can make future borrowing more expensive. This year, Moody’s downgraded pension bonds in Santa Clara, Marin, Contra Costa and Sacramento counties.

In 2010, lawmakers in Pennsylvania prohibited the state from using pension obligation bonds, citing the financial risks. And the federal Government Accountability Office has warned that pension bonds can leave some governments “worse off than they were before.”

The nation’s first pension obligation bond was issued in 1985 for $222 million by the city of Oakland with the help of Wall Street. Roger Davis, a lawyer who consulted on the deal, said it was pulled together by the then-city manager and Goldman Sachs, with assistance from his firm, Orrick, Herrington & Sutcliffe. It may well have been conceived, he said, to enrich the pension fund without adding to the debt load.

At the time, that was a safer bet. Public agencies could issue bonds at a tax-exempt interest rate and invest in annuities, in most cases guaranteeing a rate of return higher than the owed bond interest. The next year, federal legislation removed the tax-exempt option.

A growing number of jurisdictions continued to turn to the bonds to cover raises and benefit increases given out in flush years. Then economic downturns sapped the investments.

That was the case in Oakland, which issued another pension bond for $436 million in 1997 and suffered heavy losses when the stock market plunged 11 years later. Debt deepened when the city took a 15-year break from making police and fire pension contributions. The payments resumed in 2011, but last year the city issued another pension bond for $212 million.

“They’re on their third credit card,” said Alameda City Manager John Russo, who voted against the 1997 bond when he was a member of the Oakland City Council.

Oakland’s obligations

Oakland’s current plan is to help balance the budget by taking another pension contribution holiday through June 2017. Budget problems also have forced the city to shed a quarter of its police force since 2008.

A supplementary tax on property owners in the city will generate an estimated $68 million this fiscal year, said Scott Johnson, who until last month was Oakland’s assistant city administrator. That will help repay some of the bond and the system’s unfunded pension obligations, he said.

“I feel we’re in a strong position,” Johnson said.

Jennifer Gollan is a reporter for the Center for Investigative Reporting, the country’s largest investigative reporting team. For more, visit www.cironline.org. E-mail: jgollan@cironline.org

More than 75% of US public finance rating actions in the third quarter continued to be downgrades, says Moody’s Investors Service in “US Public Finance Rating Revisions for Q3 2013: Downgrades Continue but Pace Moderates.” The exact percentage of rating actions that were downgrades in the third quarter, 77%, represented an improvement on the 83% that were downgrades for both the second and first quarters of 2013.

Moody’s expects downgrades to continue to outpace upgrades through the rest of the year despite broader economic improvement as pockets of credit pressure remain.

Specifically, of the 235 rating actions Moody’s took in the third quarter, 182 were downgrades. By par amount, Moody’s downgraded $53.9 billion of public finance debt in the third quarter, down from the $92 billion downgraded in the second quarter but more than the $27 billion downgraded in the first quarter.

The number of quarterly upgrades has increased modestly during 2013, from 36 in the first quarter to 45 and 53 in the second and third quarters. However, the par amount upgraded was $8 billion in the third quarter, down slightly from the $12 billion in each of the previous two quarters.

During the third quarter eight of the 10 largest downgrades in terms of par value were local governments. The most prominent of these were the City of Chicago, to A3 from Aa3, affecting $8.2 billion in debt, Chicago Board of Education, to A3 from A2, affecting $6.3 billion in debt and Philadelphia School District, to Ba2 from Ba1, affecting $3.3 billion.

In all there were 145 downgrades of local governments during the quarter, affecting $42 billion in debt. Nineteen local government downgrades were based on Moody’s new approach for analyzing state and local government pensions, including those taken on the cities of Chicago, Cincinnati, and Minneapolis.

“The preponderance of local government downgrades underscores the credit pressure some local governments continue to face,” says Moody’s Analyst Chandra Ghosal. “We also see that despite broader economic improvement, there are still regional pockets of concentrated credit pressure.”

One sign of these concentrations is the high share of downgrades in California, Illinois, and Michigan, where Moody’s downgraded ratings of 79 issuers, accounting for over 40% of downgrades in the quarter.

The largest upgrade among the local governments was for the City of Atlanta’s Water and Wastewater enterprise bonds to Aa3 from A1, affecting $3.1 billion in par amount of debt.

In the higher education sector, Moody’s downgraded 16 institutions with $3.6 billion in debt in the third quarter, while it upgraded just three institutions with $467 million in debt. Seven of the eight public universities Moody’s rates in Illinois were downgraded because of their high dependence on state funding, which has been delayed or reduced for several years. Among them was the University of Illinois, which Moody’s downgraded to Aa3 from Aa2, affecting $1.56 billion in debt.

In the infrastructure sector, there were no positive rating actions in the third quarter, while there were eight downgrades affecting $4.5 billion. Of the seven, two were municipal electric utilities with exposure to nuclear-generation assets, highlighting the higher costs and risks associated with these facilities.

In the not-for-profit hospital sector, Moody’s downgraded 10 hospitals and $2.67 billion in debt and upgraded eight hospitals with $2.31 billion in debt. Decline in patient admission volumes was a common driver of a majority of the downgrades. One significant upgrade in the sector was for the Indiana University Health, to Aa3 from A1, affecting $1.4 billion par amount of debt.

The housing sector was the only one where upgrades outpaced downgrades, with 10 upgrades on $474 million in debt against two downgrades on $452 million in debt. The majority of rating actions were to privatized military housing credits.

For more information, Moody’s research subscribers can access this report at:

https://www.moodys.com/research/US-Public-Finance-Rating-Revisions-for-Q3-2013-Downgrades-Continue–PBM_PBM159581.

Mergers and acquisitions in the US utilities industry will keep to a steady pace over the next few years, says Moody’s Investors Service, as utilities look to expand and diversify. Moody’s says utility deals have been generally neutral to credit quality because they have been financed with a balanced mix of debt and equity.

Slow growth in electricity use is forcing the utilities to look beyond their service territories for growth, says Moody’s in the report “US Regulated Utilities: Expansion, Diversification Goals Continue to Support Steady Utility M&A.”

“Load growth has been moderating in recent years, the slower pace driven primarily by energy conservation and efficiency, increased distributed generation and the economic downturn,” says Jeffrey Cassella, a Moody’s Analyst. “The slower growth has pushed some utilities to look beyond their service territories for additional load growth in areas that are growing faster than the national average.”

Many utilities are also looking to expand their regulated businesses as a way to increase the stability and predictability of their cash flows, while at the same time they add to their operational efficiency as they spread operating and maintenance costs over a wider customer base.

Declining returns on equity among the utilities will also motivate the utilities to look to mergers as a way to lower costs as they seek to capture synergies and reduce overhead costs.

“The industrial logic behind consolidating a homogenous, fragmented industry sector makes sense,” added Cassella, “because spreading fixed costs across a larger asset platform is more efficient and should benefit consumers longer term.”

Capital markets are likely to be conducive to deals, says Moody’s, access to these markets having improved since the economic downturn. Better access as well as the improved credit quality of the utilities will support more leveraged transactions.

Moody’s expects regulators to remain receptive to consolidation in this fragmented industry, although regulatory intervention remains a risk. Higher interest rates may slow down the pace of debt-financed acquisitions, but rates should still remain at levels that will not hinder the financing of future deals.

For more information, Moody’s research subscribers can access this report at: https://www.moodys.com/research/US-Regulated-Utilities-Expansion-Diversification-Goals-Continue-to-Support-Steady–PBC_159270

BDA’s Public Finance panel from the 5th Annual National Fixed Income Conference is now available on video.

Ronald Bernardi, president and CEO, Bernardi Securities, Inc., moderated a panel discussion on critical municipal bond market topics at the Bond Dealers of America (BDA) annual conference held in Chicago earlier this month.

To access video of the panel, click here:

http://www.bernardisecurities.com/research-insights/webinar/2013-bda-conference-public-finance-panel

After considering public feedback, the Financial Accounting Standards Board on October 30 finalized guidance that will establish a single definition of a public business entity for use in future accounting standards, but the board will not undertake a project on defining nonpublic entities until its future rulemaking agenda is prioritized.

After considering public feedback, the Financial Accounting Standards Board on October 30 finalized guidance that will establish a single definition of a public business entity for use in future accounting standards, but the board will not undertake a project on defining nonpublic entities until its future rulemaking agenda is prioritized.

At a meeting in Norwalk, Conn., FASB directed its staff to prepare a final accounting standards update that would amend the Accounting Standards Codification (ASC), but board members agreed that no effective date will be provided for the standard. Rather, the board decided that the final definition of a public business would be established when the term is used in a future amendment to the ASC.

The board’s discussion indicated that alternative guidance to U.S. generally accepted accounting principles developed by FASB’s advisory group, the Private Company Council, could be the first accounting standards to reference the new definition of a public business entity.

On August 7 FASB issued the proposed accounting standards update “Definition of a Public Business Entity: An Amendment to the Master Glossary,” which set criteria for identifying a public business entity, including a requirement to file or furnish financial statements with the SEC or another regulatory agency for purposes of issuing securities.

Before finalizing the proposed guidance, board members agreed to clarify the proposal to address stakeholder concerns about the criteria for identifying a public business entity and about linking the definition of a public business entity to existing regulatory requirements.

The board ultimately voted against a staff recommendation to eliminate a criterion that an entity that has unrestricted securities and is required to periodically provide publicly available U.S. GAAP financial statements in accordance with all legal, contractual, or regulatory requirements should be considered a public business.

Callie Haley, a postgraduate technical assistant at FASB, said the staff is not aware of many instances in which an entity would be considered a public business entity based on that criterion alone. She added that the criterion conflicts with the project’s objective of simplifying the process of identifying a public business entity because it introduces unnecessary complexity into the definition.

However, FASB member Thomas Linsmeier supported retaining the criterion, saying its scope would help protect the board from having to continually update its definition of a public business entity as the financial markets evolve over time.

The board accepted the staff recommendation to delay its decision about whether to amend the existing definitions of a nonpublic entity in the ASC given the board’s current agenda prioritization effort.

According to Haley, the staff believes that FASB and the Private Company Council should have more time to evaluate any potential implementation issues regarding the final definition of a public business as future accounting alternatives are provided to private entities.

by Thomas Jaworski

Faced with nearly $5 billion in losses from Hurricane Sandy’s storm surge alone, severely constrained in the conventional global reinsurance market and with its premiums for traditional reinsurance essentially doubled, officials from the Metropolitan Transportation Authority turned to an alternative vehicle — catastrophe bonds.

The $200 million MetroCat Re Ltd. Series 2013-1 is the first catastrophe bond that covers storm-surge risk arising from named storms.

The deal is only one example of Sandy affecting public finance. As the one-year anniversary of the megastorm beckons, municipal issuers are still grasping what they need to do, how to do it and how to pay for it.

New York City Mayor Michael Bloomberg in June released a 420-page storm-resistance plan, which also raised a long list of questions. Who would fund what is left for the successor to Bloomberg, who will leave office Jan. 1. Bloomberg’s 250 recommendations include calls for levees, floodwalls, surge barriers, bulkheads and other features for shoreline areas.

At the local level, concerns range from liquidity to the role of the federal government — how much cities and towns will receive and what strings may come — to relocating valuable assets such as police headquarters from vulnerable locations.

According to MTA chairman Thomas Prendergast, the MetroCat deal represents a capital markets breakthrough. “We anticipate that this deal represents the start of a long-term alternative reinsurance option that diversifies MTA’s risk-management strategy,” he said.

Risk Management Solutions Inc. of Newark, Calif., provided the risk analysis, using its North Atlantic hurricane model. RMS officials say it’s the only hurricane model in the industry that quantifies risk from catastrophic hurricane-driven storm surge.

Standard & Poor’s issued its first surge-only rating, assigning BB-minus which reflects the principal at-risk nature of the offering. MetroCat Re is collateralizing the reinsurance through a cat bond and has its own credit rating separate from mainstream MTA credits such as transportation revenue bonds and dedicated tax fund bonds.

Sandy was not even a hurricane at landfall, yet it struck the Northeast with an 18-foot Category 2 surge. Sandy’s $71 billion worth of damage ranks second behind $108 billion Katrina, which hammered the Gulf Coast in 2005.

Peter Nakada, a managing director for capital markets at RMS, has seen a trend the past couple of years — that catastrophe bonds are more mainstream. “There’s a convergence of the capital markets and reinsurance worlds,” Nakada said in an interview.

“What’s happened the past couple of years is that pension funds are investing more in catastrophe bonds. It’s gone from a sort of fringe thing to a mainstream diversified asset.”

That’s a far cry from about three years ago, Nakada said.

“Pension-fund managers used to tell you that the absolute worst thing to happen was for an investment to go uncommonly wrong. If you made a 3% allocation to something like this and the wind blew too hard, they’d fire you. Now it’s mainstream, something to strengthen a diversified asset class. Investors are here to stay,” he said.

“This has expanded the market for insurance,” Nakada said. “A lot of people think that the capital markets and reinsurance are fighting for the same pie. It’s not that at all. This will actually grow the pie.”

According to RMS, surge accounted for nearly two-thirds of Sandy’s total insured loss. The RMS model projects a 20% chance that a U.S. hurricane will cause more damage from surge than wind, and 40% along the Northeast coast.

“Storm surge really is a separate peril,’ said Nakada. “You’ve got to model it separately. It is the driver.

“The geography of New York City is the absolute worst for storm surge. It has a right angle. Waves are driven into the right angle. In New Jersey, New York City, Long Island it gets magnified and you saw that effect.”

The MetroCat parametric index allows MTA to efficiently access capital without requiring investors to underwrite the infrastructure of the MTA, according to RMS. The index proxies MTA exposure to elevated water levels, using measurements at five key tidal gauge locations in the metropolitan area, including Battery Park in lower Manhattan.

The trigger event occurs if during a named storm, surge height reaches 8.5 feet at the Battery or 15.5 feet in Long Island Sound. This also helps the MTA plan for related capital projects such as barriers to entrances.

“The MTA gets a measuring stick and a no-haggle insurance policy,” said Nakada.

According to Alan Rubin, a consultant with law firm Cozen O’Connor LP in New York, said resiliency is today’s buzzword. “It used to be preparedness,” said Rubin.

Federal, state and local officials called Rubin the “hurricane czar” for his work in Miami-Dade County, Fla., after Hurricane Andrew caused more than $30 billion in damage in 1992. While working in Lehman Brothers’ investment banking division, Rubin helped design and underwrite the catastrophe fund for hurricane relief.

“What I like about MTA is that it did use scientific data to determine the surge level,” said Rubin.

“They also used a stepped approach and they found an inexpensive source of funding for this type of protection and activity,’ Rubin said. “The biggest problem, I see, is that they need to look at debt service for these funds so that riders are not inconvenienced with fare increases at the end of the day to pay for it.”

Scientific data itself can be a variable, which can befuddle local issuers.

“You have the European model, the American model, the Asian model, all of which effectively look at different climactic effects,” said Rubin. “It’s a pretty big challenge. Part of the problem is that if you’re off by a foot in terms of a surge, the multiplier is gigantic. You try to project as close as you can get. It’s a major issue for public issuers.

“In Florida, they raise and lower the levels of the canals. Here, how you direct water is different. You have the Hudson and East rivers and essentially you want water to go a certain way.”

Rachel Barkley, an analyst at Morningstar Inc., said Sandy has made the leaders of coastal communities wiser, although planning is still difficult. “Infrastructure and liquidity are still big issues. The leaders of these affected communities want to do the right thing. The question is, what is the right thing and what is affordable? It’s hard to use a scientific approach when the scientific community can’t agree.”

And assessing cost is still incomplete, she said. “Are there capital needs down the road, direct or indirect, as a result of Hurricane Sandy? The MTA, for example, detected wires deep in the tunnels.”

MTA officials, well after extracting water from the tunnels, found corroded wires and other under-the-radar damaged equipment in its saltwater-damaged Montague and Greenpoint underwater tubes. The Montague tube, a pair of 5,000-foot tunnels, carries the R train under the East River between Manhattan and Brooklyn. The shorter Greenpoint tube transports G train riders between Brooklyn and Queens under the Newtown Creek.

“Every time you push a button, there’s a cost,” said Prendergast, while displaying some of the corroded parts at a press conference.

Some protective measures are well within the control of municipalities. Exposed areas of Long Island, for instance, are reconsidering waterfront locations for public works facilities and even first-floor headquarters for police departments.

“When you’re running a municipality, you’re not a weatherman. You wind up with your finger in the air trying to tell which way the wind is blowing,” said Anthony Figliola, the vice president of Empire Government Strategies of Uniondale, N.Y., and former deputy supervisor of Brookhaven, N.Y. “But there are tangible options to try and protect your assets with limited resources.”

Jonathan Peters, a finance professor at the College of Staten Island, said nobody envisions low-lying assets as a problem until the storm arrives. “Then the event becomes a major test,” he said. Peters referenced New Jersey Transit’s $120 million in damage to train cars left in the low-lying Kearney and Hoboken yards — despite the agency having a plan in place for four months to move the trains to higher ground.

The MTA, by contrast, moved cars to higher grounds and minimized damage.

But the MTA was vulnerable at South Ferry station in lower Manhattan, which sustained the most damage in the system — less than four years after the authority spent $600 million on a remodeling — artsy tiling and all — for an asset that sits below the water table.

“A subway station is a 50- to 100-year asset,” said Peters, whose research includes mass-transit financing. “The newest work is essentially a replacement. You can’t be doing this every four years.

“Bus rapid transit might be more reasonable to low-lying areas. The lower end of Manhattan has a lot of unanswered questions. Areas like South Street Seaport, people don’t know what to do.”

How any moves by the federal government affect local policies is still unanswered.

“There’s no clear answer,” said Peters. “No one’s saying they wouldn’t protect Kennedy Airport, but do we protect [nearby] Jamaica Bay?”

Rubin worries that Sandy has spawned “instant experts” on storm protection, further confusing local and state issuers.

“Once you have a situation like this, a very credible disaster, you get all kinds of people coming out of the woodwork, from all the agencies to scientists who say ‘oh boy, this is a chance to get a grant.’ Ninety percent of the stuff is not doable, and you have to drill down on what’s going to work and what isn’t. Otherwise, nothing happens and five years go by.”

By contrast, according to Rubin, a more focused group of engineers enabled the low-lying Netherlands to complete its $8 billion flood-defense system in 1997. It consists of computer-operated dams and sea-surge barriers. Floodgates are quickly lowered during storms.

But Nakada of RMS thinks the more ideas, the better.

“We have what we think is the best detailed surge model — the only sure model — out there, but we’re not claiming to be the single voices of truth,” he said. “We encourage our clients who are investors to do their homework.”

BY PAUL BURTON

The Financial Accounting Standards Board on October 23 tentatively decided by a narrow vote to change the method in which several nonprofit organizations present their operating cash flows.

At a meeting in Norwalk, Conn., FASB members voted 4 to 3 to accept a proposal requiring nonprofit organizations to use the direct method of reporting cash flows from their operating activities. The direct method calls for entities to report cash flows from operating activities directly by displaying the major classes of operating cash receipts and payments.

As a result of the board’s decision, a future exposure draft would amend the existing guidance under FASB Accounting Standards Codification Topic 958, “Not-for-Profit Entities,” that encourages use of the direct method only for reporting net cash flows from operating activities. Under the existing guidance, entities that choose not to report those operating cash receipts and payments are required to report the same amount of net cash flow using an indirect method.

The board tentatively decided to no longer require nonprofits using the direct method to provide a reconciliation of net income and net cash flow provided from its operations.

A staff paper prepared for the meeting said that the feedback received from stakeholders indicated that the direct method of reporting cash flows is more intuitive and understandable for nonprofit financial statement users, in particular donors with limited financial expertise. The paper also said the staff learned that implementation costs wouldn’t represent a significant barrier from requiring use of the direct method.

FASB member Thomas Linsmeier supported the proposal to mandate the use of the direct method for reporting cash flows by nonprofit organizations, saying that the direct method better depicts operating cash flows and would make the statement of cash flows more relevant for those types of entities.

FASB member Daryl Buck, however, expressed concern about prescribing a requirement on cash flow reporting, suggesting that the board instead provide nonprofit entities with the option to select either the direct or indirect method depending on which presentation approach is more suitable for the needs of their financial statement users.

Ronald Bossio, a senior project manager at FASB, said that the cash flow statement can be most valuable for those nonprofit organizations that may experience difficulty generating cash despite receiving long-term donations and assets. “It’s a very early warning sign and can be a very valuable statement,” he said.

The board also considered tentative changes to the existing categories of cash flows that classify donor-restricted cash gifts for long-lived operating assets, cash dividends, and interest income from investing activities, and cash payments of interest expense on long-term capital financing activities.

FASB’s latest decisions were made as part of its project on reexamining the standards for nonprofit financial statement presentation. The board previously decided to replace existing rules that require a nonprofit to present information about its funding and resources.

According to Bossio, the next steps of the nonprofit financial reporting project plan will be to complete discussions on how best to improve the information provided about a nonprofit’s liquidity and address potential improvements to the entity’s statement of functional expenses.

Share-Based Payments

FASB also released the proposed accounting standards update, “Compensation — Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved After the Requisite Service Period.”

On October 2 FASB ratified the final consensus of the board’s Emerging Issues Task Force to invite public comment on proposed guidance that would require that performance targets for share-based payment awards that can be met after the completion of an employee’s requisite service period be treated as a performance condition that affects the vesting of the awards.

FASB will accept written comments on the proposal until December 23.

The proposal is available at:

http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176163531340.)

by Thomas Jaworski

Fitch Ratings-New York-24 October 2013: Fitch Ratings notes that during the third quarter of 2013 (3Q’13) and for the 19th consecutive quarter, U.S. public finance rating downgrades outnumbered upgrades. Both the number of downgrades and upgrades decreased compared to the second quarter. While the number of downgrades was at its lowest level since 3Q’10, it should be noted that the number of downgrades for the first three quarters of this year (164) is similar to the number of downgrades during the first three quarters of 2012 (157).

Negative actions are expected to remain elevated, as Negative Rating Outlooks exceeded Positive Rating Outlooks (3.2:1) at the end of 3Q’13. However, the ratio of Negative Outlooks to Positive Outlooks has been slowly decreasing for the last eight quarters and is at its lowest level since 3Q’09. The vast majority of rating actions (88%) during the third quarter were affirmations, with no change in Rating Outlook or Rating Watch status. Furthermore, 90% of ratings had a Stable Rating Outlook at the end of the third quarter.

Downgrades still account for a small percentage of total public finance rating actions. Fitch Ratings downgraded 39 credits, which represented approximately 4.6% of all rating actions and $40.5 billion in par value. In 2Q’13, Fitch downgraded 68 credits. Fitch upgraded 23 credits, which represented 2.7% of all rating actions and $94.3 billion in par value. In 2Q’13, Fitch upgraded 24 credits.

The number of downgrades exceeded upgrades by a margin of 1.7:1, which decreased from 2.8:1 in the prior quarter. The downgrade to upgrade ratio by par value also decreased to 0.4:1 from 5.5:1 in the prior quarter. The dramatic decrease in the ratio is largely due to the upgrade of California’s GO bonds in August.

The full report ‘U.S. Public Finance Rating Actions for Third Quarter 2013’ summarizes these rating actions by sector and can be found at www.fitchratings.com.

A proposed accounting standard on leases fails to resolve concerns for current lease accounting standards and may impose additional costs on financial statement preparers, the American Institute of Certified Public Accountants said in an October 14 letter to the Financial Accounting Standards Board.

October 14, 2013

Ms. Susan M. Cosper

Technical Director

Financial Accounting Standards Board

401 Merritt 7

P.O. Box 5116

Norwalk, CT 06856-5116

File Reference No. 2013-270

Dear Ms. Cosper:

The Financial Reporting Executive Committee (FinREC) of the American Institute of Certified Public Accountants (AICPA) is pleased to offer its comments on the FASB’s May 16, 2013, Exposure Draft (ED) of a proposed Accounting Standards Update (ASU) Leases (Topic 842).

We appreciate the significant efforts made to address the concerns raised by constituents on the previous exposure draft issued in 2010.

Leasing is pervasive. The depth and breadth of the market, the desire to achieve symmetry between lessees and lessors, as well as the variety of terms and economics inherent in leasing arrangements makes the task of reaching consensus on revisions to leasing guidance a real challenge.

FinREC has been supportive of the board’s project to revise lease accounting and the issues identified in the March 19, 2009, Discussion Paper Leases: Preliminary Views. The FASB and IASB identified three criticisms of current lease accounting requirements:

a. Many leases are off-balance sheet despite the fact that financial statement users believe that they give rise to assets and liabilities that should be recognized in the financial statements of lessees. This forces users to adjust the reported amounts in the financial statements in connection with those transactions.

b. The existence of two very different accounting models for leases means that similar transactions can be accounted for very differently, which reduces comparability for users.

c. Existing lease accounting standards provide transaction structuring opportunities that make the financial statements less transparent for users.

Cost benefit

A cornerstone of the response to these criticisms is that a lessee should recognize the assets and liabilities arising from a lease. We agree with this core principle and with the notion that many leases inherently include a financing component that justifies the recognition of a liability by the lessee, and the conceptual merit of recognizing the associated rights conveyed in exchange for assuming the liability. However, FinREC is concerned that other important objectives have not been met and that the overall standard is not a sufficient improvement over today’s guidance to support adoption of the proposals in the ED. We are also concerned that adoption of the provisions of the ED will impose significant costs on financial statement preparers — both on transition and on an ongoing basis. Some costs represent the investment in new accounting systems and associated controls that may ease financial reporting burdens once implemented. However, the complexity inherent in the construct of the dual model, specifically the distinction based on whether the leased item is property, and the ongoing required judgments, represent a permanent increased level of effort. A lease accounting model that is general enough to consider all the various types of leasing arrangements and provides a single recognition and measurement approach has proven to be a challenge. As such, we understand why the ED proposes a dual model; however, the dual model as currently proposed is not sufficiently operational and does not incrementally improve financial reporting in a cost-effective manner.

We believe that, in formulating a final standard, the board should give robust consideration to cost/benefit. That could include performing additional field testing of the standard and evaluate how to strike a better balance between the technical and practical/operational aspects of any proposed changes to leasing. FinREC believes that any transition to a model with most leases on balance sheet will by necessity involve a significant level of effort. However, it would appear that additional accommodations with respect to classification, transition and remeasurement, some of which we will discuss later in this letter, would reduce the cost without sacrificing transparency objectives of this project.

Impact on Lessors

FinREC believes that the emphasis on recognition of the liability by the lessee, and the desire for symmetry, creates significant challenges for lessors — notably the notion that recognition of the right to use a small portion of a nonproperty asset represents a sale on the part of the lessor of a corresponding portion of the leased asset. FinREC understands the desire for symmetry between lessors and lessees, but we believe this has complicated efforts to achieve consensus on a new standard that meets the key objectives laid out in the discussion paper while providing users with improved relevant and representationally faithful information. While symmetry is a desirable goal it is not a requirement, particularly when it could result in financial reporting that is less relevant to financial statement users than that provided today. Even under today’s model, leasing often results in asymmetrical results (e.g., built-to-suit leasing, real estate sale-leaseback transactions, sales type leases of real estate). Nor is this confined to leasing. Asymmetrical accounting between the parties involved in a transaction is pervasive.

The introduction of the dual model goes some way toward mitigating concerns expressed by property lessors, but does not go far enough for certain lessors of other long-lived assets that they believe share many economic characteristics of property leases. We also have concerns that a model requiring classification based on the nature of the leased asset, rather than the economics inherent in the contract, may not provide users with the most decision-useful information — particularly with respect to lessors.

Lease classification

While the proposals in the ED represent an improvement relative to the initial ED in 2010, the ED’s proposals do not resolve the second and third criticisms of current lease accounting standards identified by the boards. Further, it appears that the proposed disclosure requirements reflect a clear expectation that financial statement users will continue to find it necessary to make adjustments to the reported amounts in the financial statements in connection with leasing transactions, and may even need to do so for more transactions than under current lease accounting standards because users currently do not differentiate between leases on the basis of consumption.

Further, retaining a requirement to classify leases retains significant complexity inherent in today’s GAAP, but with a dividing line that may not properly reflect the economics of the underlying arrangement, which adds unnecessary complexity — particularly in terms of how components are identified and classified. This is particularly apparent in leases of power plants and other assets likely to be seen as a single component but that contain aspects of both property and nonproperty. This will add to the already challenging task of splitting multiple-element arrangements into their components.

FinREC supports an approach for lessee accounting in which all leases other than short-term leases are recognized on-balance sheet by lessees. However, FinREC believes that the board should reconsider the proposed lease classification tests for income statement purposes. The ED’s proposed classification tests do not appear to be responsive to the needs of financial statement users or provide benefits that outweigh the related costs. As an alternative to the current proposals, and in an effort to identify a solution that results in converged lease standards, FinREC recommends a dual recognition method in which the pattern of recognition would depend on whether the economic arrangement is more consistent with an in-substance financed purchase or motivated more by a desire for finite usage of a given asset. We believe this classification test should be based on clearly articulated principles and field tested to ensure that it is operational. Leases consistent with in-substance financed purchases would be accounted for as Type A leases and other leases as Type B leases, both as contemplated in the ED.

If consensus resulted in classification on the basis of the guidance contained in International Accounting Standard (IAS) 17 Leases, we would not object to this split, particularly since it is similar to current proposals for property and to current lease classification guidance under U.S. GAAP but without the much criticized bright lines. This would not alter some of the conceptual and other concerns discussed above. But if a dual model is included in the standard, it may be preferable to use one that is well understood in practice and familiar to financial statement users. Such an approach would —

• Be responsive to constituents who believe there is more than one type of lease arrangement (e.g., some leases are more akin to financing of an asset and others are obtaining the right to use an asset for a finite period).
• Retain a lease classification test that is well understood in practice and familiar to certain financial statement users. This alternative does not eliminate the complexity in today’s accounting guidance but would be less complex than the ED as it benefits from experience of those applying IFRS.
• Still address a key objective of bringing lease-related assets and liabilities on balance sheet.

We are aware that some have called for removing lessor accounting from the proposed guidance. This would retain many of the bright line tests inherent in U.S. GAAP today and carry forward lessor accounting. As such, we also recommend addressing lease classification for lessors in a manner consistent with the preceding paragraph, a solution that would address the above concerns but is likely to otherwise be similar to today’s lessor model.

Other matters

In addition to the concerns we express with respect to the dual model, there are a number of areas in which the concepts contained in the ED could be more clearly articulated, in which current proposals might be challenging to apply, or in which guidance does not appear to produce benefits that are justified in relation to their expected costs.

The primary areas of concern include:

We welcome revisions made to the identification of embedded leases. However, we believe that the guidance as currently proposed may be difficult to apply in practice and could be improved to highlight the key factors that drove the accounting conclusion. This would enhance consistency in application for transactions with similar circumstances. We expect that this issue will be particularly significant in circumstances in which a lease is embedded in a multiple-element service contract.

How preparers should determine whether assets that are functionally interdependent represent one or more than one unit of account. In the ED, the board has provided examples of a power plant and manufacturing facility. The examples concluded that the former has one component and the latter two. This determination has a potentially significant impact on income statement presentation, but the examples are unclear as to whether this conclusion is based on the nature of the asset, the perceived relative costs of separating the property from nonproperty, or some other factor.

How the guidance in the ED will be applied to services contracts where an underlying asset is not the primary motivation for executing the arrangement. A good example of this is naming rights for a sports facility. The primary economic motivation for such an arrangement is marketing, but the arrangement constitutes a right not dissimilar to the use of a billboard.

Irrespective of the decision the board makes, implementing a standard on such a pervasive topic will be a challenge. FinREC recommends that the board establish a post-issuance lease implementation process to ensure consistent application of the final principles across different asset classes and industries.

We provide further information and commentary on these and other areas in our responses to the board’s questions in the ED in the appendix to this letter.

Representatives of FinREC and the FinREC Leases Task Force are available to discuss our comments with board members or staff at their convenience.

Sincerely,

Richard Paul

Chairman

FinREC

Chad Soares

Chairman

FinREC Leases Task Force

American Institute of CPAs

New York, NY

CC:

Hans Hoogervorst, Chairman

International Accounting Standards Board

Attachment

Question 1: Identifying a Lease

Do you agree with the definition of a lease and the proposed requirements for how an entity would determine whether a contract contains a lease? Why or why not? If not, how would you define a lease?Please supply specific fact patterns, if any, to which you think the proposed definition of a lease is difficult to apply or leads to a conclusion that does not reflect the economics of the transaction.

We believe that it is appropriate to evaluate whether an agreement contains a lease based on whether it contains (1) an identified asset and (2) whether the lessee obtains the right to control the use of the asset for a particular period. However, we believe that the guidance and related examples, as currently proposed, may be difficult to apply in practice and could be improved to highlight the key factors that drove the accounting conclusion. This would enhance consistency in application for transactions with similar circumstances. We expect that this issue will be particularly significant in circumstances in which a lease is embedded in a multiple-element service contract.

FinREC believes that control is inherent in a lease relationship and that the focus should be on principles rather than bright lines. However, we believe additional guidance is needed on how to weight factors that seemingly indicate control against factors that would seemingly indicate an absence of control. We are concerned that the examples included in the ED do not clearly illustrate how to evaluate involvement in different phases of the arrangement (relative weight for design versus operation of the asset) or how to identify significant decisions — particularly those made in connection with the delivery of nonlease services contracted for under the arrangement. Some FinREC members also suggested that, in cases in which the asset has no utility without services provided by the lessor, the entire arrangement is better reflected as a service contract. One potential example of this would be cable television boxes, which have little stand-alone value without the associated subscription. It is one simple example of the complexity inherent in applying the control model.

FinREC believes the final standard will benefit from more detailed examples, especially on how to weight conflicting indicators when making “close calls” — this would enhance consistency in application and aid financial statement users in evaluating reported results.

In addition, we are not clear on to how to apply the phrase “throughout the term of the contract” in evaluating whether the customer has the ability to direct the activities that most significantly affect the economic benefits to be derived from use of an asset or can derive substantially all of the potential economic benefits from its use. Is it the Board’s intent to apply a model similar to ASC 810-10/IFRS 10, or does this control model attempt to assign decisions (including those agreed to in the contract) to each of the involved parties?

We also believe it would be helpful to address how decision making inherent in nonlease elements ties into the assessment of control and associated benefits. Is this based solely on output, or must it consider the lessee’s own circumstances and other assets to be used in concert with the leased asset?

FinREC also believes it is important to reconcile the guidance on control in the ED to that for sale-leaseback transactions, which appears to consider control based on risks and rewards (e.g., lease term and present value of lease payments).

FinREC is not seeking bright lines but rather is trying to ensure that the guidance can be applied consistently considering the impact that these judgments could have on preparers’ financial statements.

In addition to seeking clarity regarding control, we believe that the guidance with respect to substitution rights could be improved. Specifically, we believe that the ED’s examples appear to downplay the economic and operational costs of substitution. FinREC believes that when substantive substitution rights are present, they often represent the end of a lease of one asset and the start of the lease of a different asset and substitution is more relevant in considering the lease term than the presence of a lease. Notwithstanding our view, FinREC recognizes that there are contracts in certain industries (e.g., IT outsourcing arrangements) for which substitution rights and attendant costs reinforce the view that the overall arrangement is a service contract more appropriately reflected as an executory contract. This may be especially true when equipment is replaced without the customer’s knowledge and/or control.

Finally, we are also concerned that the board’s proposal to consider not only assets available to the lessor, but also those that could be acquired, assumes insight the lessee likely will lack as well as the availability of additional assets and the willingness of a lessor to acquire or deploy additional assets in support of a contract. FinREC believes it would be better to consider changes in assets available to the lessor as a trigger for reassessing whether the contract is in scope, rather than rely on assumptions that could be highly subjective. Should the board elect to retain the guidance proposed in the ED, we believe that it would be necessary to provide additional guidance on how to evaluate the costs of substitution. Are such costs considered relative to a given asset or to the aggregate value of lease elements in a multiple-element arrangement? Should the analysis factor in lessor incentives with respect to substitution? Under existing GAAP, if utility was an important consideration in determining when an arrangement contained a lease, substitution rights were arguably more relevant considering that a lessee may have little or no control over the asset. With control at the heart of the leasing analysis in the ED, its utility to identifying embedded leases has lessened.

Question 2: Lessee Accounting

Do you agree that the recognition, measurement, and presentation of expenses and cash flows arising from a lease should differ for different leases, depending on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset? Why or why not? If no, what alternative approach would you propose and why?

As discussed in the forepart of this letter, FinREC recommends a dual-model approach for lessee and lessor accounting in which all leases other than short-term leases are recognized on-balance sheet by lessees. However, FinREC believes that the board should reconsider the proposed lease classification tests. The ED’s proposed classification tests do not appear to be responsive to the needs of financial statement users or provide benefits that outweigh the related costs. FinREC recommends a dual recognition method in which the pattern of recognition would depend on whether the economic arrangement is more consistent with an in-substance financed purchase or motivated more by a desire for finite usage of a given asset. We believe this classification test should be based on clearly articulated principles and field tested to ensure that it is operational. Leases consistent with in-substance financed purchases would be accounted for as Type A leases and other leases as Type B leases, both as contemplated in the ED.

If consensus resulted in classification on the basis of the guidance contained in International Accounting Standard (IAS) 17 Leases, we would not object to this split, particularly since it is similar to current proposals for property and to current lease classification guidance under U.S. GAAP but without the much criticized bright lines. FinREC believes that, if a dual model is included in the standard, it may be preferable to use one that is well understood in practice and familiar to financial statement users.

Question 3: Lessor Accounting

Do you agree that a lessor should apply a different accounting approach to different leases, depending on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset? Why or why not? If not, what alternative approach would you propose and why?

FinREC believes that the emphasis on recognition of the liability by the lessee, and the desire for symmetry, creates significant challenges for lessors — notably the notion that recognition of the right to use a small portion of a nonproperty asset represents a sale on the part of the lessor of a corresponding portion of the leased asset. FinREC understands the desire for symmetry between lessors and lessees, but we believe this has complicated efforts to achieve consensus on a new standard that meets the key objectives of this project while providing users with improved relevant and representationally faithful information. While symmetry is a desirable goal, leasing today often results in asymmetrical results (e.g., built to suit leasing, real estate sale-leaseback transactions, sales type leases of real estate), and this is not confined only to leasing. It has been our experience that symmetry is often the exception rather than the rule.

The introduction of the dual model goes some way toward mitigating concerns expressed by property lessors, but does not go far enough for certain lessors of other long-lived assets that they believe share many economic characteristics of property leases. We also have concerns that a model requiring classification based on the nature of the leased asset, rather than the economics inherent in the contract, may not provide users with the most decision-useful information — particularly with respect to lessors.

FinREC believes that the concerns expressed above can be addressed without dropping lessor accounting from the project and by incorporating income statement classification on the basis of

IAS 17. This would leave lessor accounting largely unchanged (with the exception of removing bright line tests and leveraged lease accounting) and symmetrical with proposals for the lessee.

If FinREC’s proposal for revised lease classification guidance is not accepted, we strongly recommend that the board consider dropping proposed changes to lessor accounting until the issues raised by stakeholders can be addressed. If such a path is chosen by the board, FinREC supports a very narrow change to lessor accounting to remove the guidance for leverage leases.

Question 4: Classification of Leases

Do you agree that the principle on the lessee’s expected consumption of the economic benefits embedded in the underlying asset should be applied using the [ED] requirements, which differ depending on whether the underlying asset is property? Why or why not? If not, what alternative approach would you propose and why?

FinREC does not support an income statement classification model based on the nature of the leased asset. This classification approach introduces significant complexity with a dividing line that may not properly reflect the economics of the underlying arrangement and may reduce the utility of information to financial statement users. This unnecessary complexity is likely to only increase the complexity of ongoing compliance with the proposed model — particularly to the already challenging task of splitting multiple-element arrangements into their components.

As discussed in our response to Question 2, FinREC recommends a dual recognition method in which the pattern of recognition would depend on whether the economic arrangement is more consistent with an in-substance financed purchase or motivated more by a desire for finite usage of a given asset. Leases consistent with in-substance financed purchases would be accounted for as Type A leases and other leases as Type B leases, both as contemplated in the ED.

If consensus resulted in classification on the basis of the guidance contained in IAS 17 Leases, we would not object to this split, particularly since it is similar to current proposals for property and to current lease classification guidance under U.S. GAAP but without the much criticized bright lines. We believe the principles-based guidance inherent in IAS 17 is a superior approach to the consumption model, without sacrificing its benefits, and that the concerns about today’s classification approach are largely grounded in the off-balance-sheet nature of operating leases and the associated bright lines, rather than concerns with classification based on risks and rewards.

Question 5: Lease Term

Do you agree with the proposals on lease term, including the reassessment of the lease term if there is a change in relevant factors? Why or why not? If not, how do you propose that a lessee and a lessor should determine the lease term and why?

FinREC supports the board’s view that lease term should be reassessed to reflect changes in relevant circumstances. This will not only limit potential structuring opportunities, but it will also provide more timely information to financial statement users. We also support the board’s proposals that renewals be included only when economic incentives suggest renewal is likely. However, in light of the guidance in the basis for conclusions, we believe that the standard should consider renewals that are “reasonably assured” to avoid confusion as to the possible difference between this concept and that of significant economic incentive.

FinREC believes the proposal should provide explicit examples of indicators that may indicate a change in assumptions. Of the indicators provided in 842-10-55-4, only one, the addition of significant leasehold improvements, is likely to be clear to constituents. The remaining examples cited in the guidance all seem to be market-based indicators, which ASC 842-10-55-5 indicates will not, in isolation, trigger a reassessment. Many preparers have substantial lease portfolios and have expressed concern over the cost of having to consider incentives on what is a highly subjective basis to ensure there has been no change at each balance sheet date. Reassessment is desirable to minimize structuring opportunities and to provide for more decision-useful information for users, but it must be balanced against the cost of compliance. Further clarity is needed on the non-market-based factors a preparer may need to consider when applying this guidance over the life of the lease.

FinREC believes that there should be clarity with regard to how management’s intent is factored into the reassessment model. Many would consider management’s stated intent to be a fairly compelling data point in determining the lease term, but it is not apparent how intent factors into the market-, contract-, asset- and entity-based factors cited in ASC 842-10-55-4.

We believe that the guidance in the ED should be clarified with respect to determination of short-term leases. Specifically, we believe the board should specifically address how lessees and lessors should evaluate month-to-month leases and those that contain one-party termination provisions.

Question 6: Variable Lease Payments

Do you agree with the proposals on the measurement of variable lease payments, including the reassessment if there is a change in an index or a rate used to determine lease payments? Why or why not? If not, how do you propose that a lessee and a lessor should account for variable lease payments and why?

We understand why the board would seek to remeasure the asset and liability for changes to an index subsequent to initial recognition — particularly in jurisdictions where adjustments are significant either annually or over the life of the arrangement. However, there is significant confusion as to the frequency of such adjustments. Some FinREC members believe the lease liability should not be remeasured for changes to the index subsequent to the initial measurement. This would be consistent with how other liabilities (e.g., variable rate debt) would be treated.

FinREC recognizes that, unlike typical variable rate debt, some lease indexation (e.g., based on changes to the Consumer Price Index (CPI)) typically has an upward ratchet only and that the concepts in the ED regarding variable lease payments are reasonable. However, we believe that remeasurement should not be required as this adds an additional layer of complexity to lease accounting for which there may be no significant economic benefit to financial statement users. We instead recommend an update to the future minimum lease commitment disclosure so that when a CPI adjustment is factored into rent payments, the disclosure is updated to reflect the future cash outflows based on the current amount of rent the lessee is paying (which would include increases in CPI). This is information that preparers will have readily available once the index resets, and it will provide users with timely notice of the changes in lease payments. Presenting this on an undiscounted basis is unlikely to hamper its utility but it will reduce the cost of compliance.

If the board moves forward with the requirement to reassess the lease obligation, FinREC recommends that remeasurement be required only when the cash flows related to the lease change. For example, if the lease payments are adjusted annually by reference to the CPI, the lease liability should not be adjusted for interim changes in the CPI but only at the point that cash payments reset for a given lease. Since changes to CPI today trigger updates to lease payments, reassessment at this time is likely to impose less of a burden than the guidance as currently proposed. FinREC believes that remeasurements more frequently than the reset provisions stipulated in a given lease would reflect a false precision and that the cost would exceed the benefits.

Question 7: Transition

The ED states that a lessee and a lessor would recognize and measure leases at the beginning of the earliest period presented using either a modified retrospective approach or a full retrospective approach. Do you agree with those proposals? Why or why not? If not, what transition requirements do you propose and why?

Are there any additional transition issues the Boards should consider? If yes, what are they and why?

FinREC is supportive of the board’s proposed transition provisions overall, but believes that additional improvement is possible. Specifically, we believe that the board should consider additional practical expedients to ease the transition burden for nonpublic entities and to address differences in transition under the revenue recognition standard and those in the ED. Lessors in particular may have to evaluate the same contract twice — once in connection with the adoption of the revenue recognition standard and again with respect to leasing. Depending on the board’s response to our recommendation with respect to the income statement, we believe that the board should consider whether lessees and lessors should be permitted to adopt the proposals in the leases ED using a simplified approach as defined in paragraph 133 of the Proposed Accounting Standards Update on Revenue Recognition and the “modified approach that was decided on in February 2013.

Under the “modified approach” an entity would recognize “the cumulative effect of initially applying the revenue standard as an adjustment to the opening balance of retained earnings in the year of initial application (that is, comparative years would not be restated).” The standard would apply to new contracts created on or after the effective date and to existing contracts as of the effective date but would not apply to contracts that were completed before the effective date.

In the year of adoption, entities would also be required to disclose the financial statement line items that have been directly affected by the standard’s application.

FinREC believes a similar model would mitigate some of the concerns expressed by lessors and likely reduce the population of leases that a preparer must consider. We believe that the simplified approach should be an option, and that the full and modified retrospective approach should also be retained. Whichever method is chosen, focus should be around good disclosure around noncomparable transactions (e.g., real estate sale-leaseback arrangements).

In addition, with respect to current transition options, we believe that the board should clarify certain aspects of transition. For example, although the board has indicated that hindsight can be used in evaluating lease arrangements, it is unclear whether this will be applied by asset class, to all arrangements, or to specific subsets (e.g., to all leases where the preparer is a lessor). Companies have a variety of assets under lease and are often a lessor even when this is not their core activity. Providing greater insight into how to apply these practical expedients would be helpful.

The ED contains very limited guidance with respect to certain aspects of leasing (e.g., leveraged lease accounting, how to transition capital leases arising solely as a result of problematic default provisions). This gap in guidance is likely to create diversity in practice — particularly when considered along with other gaps such as the issue with hindsight mentioned above. In addition, we would ask to board to consider whether to —

• Stipulate that previous sale conclusions for all sale-leaseback transactions need not be reconsidered;
• Stipulate, solely for transition purposes with respect to sale-leaseback transactions, that ownership by an entity may be deemed to occur when title transfers, not when the entity has executed a purchase order or assigned a purchase order to another party in an agreement that contains provisions exposing the entity to constructive risks of asset ownership (e.g., an indemnification of the assignee);
• Permit lessees and lessors to apply the discount rate used to classify and account for a lease under existing GAAP (i.e., the discount rate determined at lease inception) except in cases where incentives would affect the lease term;
• Permit or require lessors applying the discount rate determined at lease inception under existing GAAP to measure the residual asset for leases classified as Type A leases at the present value of the estimated future residual value at lease inception under existing GAAP accreted to the date of initial application;
• Permit lessors to apply a discount rate determined using information at the beginning of the earliest comparative period presented when the residual asset is measured using information as of that date;
• Clarify whether any of the specified transition reliefs are available to entities that elect full retrospective application; and
• Clarify how an entity applying the modified retrospective transition approach would determine the classification of a preexisting lease upon adoption of the proposed requirements.

We would also like the board to consider whether additional guidance should be provided with respect to —

• How a lessor should reflect assets it acquired in a sale-leaseback that contains a lessee purchase option.
• Whether the transition rate should be set at the effective date rather than the implementation date.
• How to evaluate arrangements in which a leased asset is under construction and the lessee is considered the owner of that asset at the transition date. Is derecognition in transition appropriate? Will this require consideration of sale-leaseback accounting? In cases where the lessee has a purchase option, does the application of sale-leaseback accounting affect presentation of the arrangement by the lessor?

Question 8: Disclosure

The ED sets out the disclosure requirements for a lessee and a lessor. Those proposals include maturity analyses of undiscounted lease payments, reconciliations of amounts recognized in the statement of financial position, and narrative disclosures about leases (including information about variable lease payments and options). Do you agree with those proposals? Why or why not? If not, what changes do you propose and why?

FinREC believes the board’s proposals with respect to disclosure would impose a significant burden for both public and nonpublic entities and contain elements that affect the utility for financial statement users. Although additional information may aid users, the depth and scale is significant, and the associated costs must be considered as well. It is also important to consider whether the scale of disclosure is consistent with the notion that the recognition of an asset and liability is of paramount importance to users.

The proposed disclosure requirements appear to be excessive in many respects given the extra visibility lease assets and obligations are proposed to have in the basic financial statements, but appear to be inadequate in relation to variable lease payments (see last point below).

Although the proposals would allow entities to consider the extent of detail provided, the board has not provided sufficient guidance about how to determine the appropriate level of aggregation in the disclosures.

Finally, we believe that the board should consider whether to require disclosure by lessees and lessors of aggregate undiscounted estimated variable lease payments (other than those based on an index or rate) on an annual basis for a minimum period of five years from the balance sheet date, and a comparison of actual variable lease payments with estimated variable lease payments for each comparative period presented. The board should not require discounting or require disclosure beyond a reasonable estimate to avoid the false precision such disclosures may suggest. This, along with the limit to the periods required to be disclosed, should ease preparers’ concerns with respect to the cost and effort of preparing these disclosures while providing users with valuable incremental information. Under proposals in the ED, the only data provided on variable payments will be historical, and that limits its utility to users.

Question 9: Nonpublic Entities

Will the specified reliefs [in the ED] for nonpublic entities help reduce the cost of implementing the new lease accounting requirements without unduly sacrificing information necessary for users of their financial statements? If not, what changes do you propose and why?

FinREC is supportive of including relief for nonpublic entities to help reduce the cost of implementing the proposals in the ED. However, we do not support the proposal to permit a policy election to use a risk-free discount rate to measure the lease liability. We observe that a risk-free rate would almost certainly not be the rate that the lessor charges the lessee and, therefore, would almost certainly result in an inaccurate measurement. We would favor proposals to allow the lessee to apply a best estimates approach to determining the incremental borrowing rate when the implicit rate is not known.

We also noted the board’s proposal for an exception to the requirement that a lessee provide a reconciliation of the opening and closing balances of the liabilities to make lease payments. The basis for this exemption is the fact that users of nonpublic entities’ financial statements generally have greater ability to directly access management and to obtain additional information beyond what is included in financial statements; as a result, the benefits of preparing this information do not outweigh the cost. FinREC does not object to this exemption, but requests that the board consider whether it should be extended to entities that sublease property as an ancillary activity.

We recommend that the board allow private companies the option of deferring the effective date for one or two years after the effective date for public companies. We believe it is appropriate to allow private companies more time to put in place the necessary systems and processes to apply the guidance and also capitalize on the experience of public companies.

Question 10: Related Party Leases

Do you agree that it is not necessary to provide different recognition and measurement requirements for related party leases? If not, what different recognition and measurement requirements do you propose and why?

Transactions between related parties carry with them the inherent risk that contractual terms are not consistent with those that would be available between unrelated parties operating on an arm’s-length basis and may result in lease payments or other contractual terms geared to achieve financial reporting objectives or to permit use of property or nonproperty without an explicit contractual arrangement. However, this risk is not unique to leasing transactions and FinREC agrees with the board that the costs associated with adjusting contractual arrangements to reflect their economic substance does exceed the expected benefit. FinREC believes the appropriate response to this risk is disclosure of the relevant terms and conditions. Such disclosure permits financial statement users to evaluate the arrangement and determine what adjustments, if any, may be appropriate.

Question 11: Related Party Leases

Do you agree that it is not necessary to provide additional disclosures for related party leases? If not, what additional disclosure requirements would you propose and why?

As discussed on our response to question 10, we do not believe that it is appropriate to provide different recognition and measurement requirements for related party leases. However, we believe that the board should consider what additional disclosures may be relevant to financial statement users. FinREC believes that it may be helpful to specifically require management to explain the basis for establishing the terms of its related party leases and, in cases in which the asset is leased from a third party, disclose the terms of the associated head lease.

The dramatic rise in charter school enrollments in the US is likely to create negative credit pressure on school districts in economically weak urban areas. Charter schools tend to proliferate in areas showing economic and demographic stress, and they can pull students and revenues away from districts faster than the districts can reduce their cost.

Press Release:

https://www.moodys.com/research/Moodys-Charter-schools-pose-greatest-credit-challenge-to-school-districts–PR_284505

Purchase the Full Report:

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Live-streaming event

November 7, 2013 – 1:00–5:00 p.m. Eastern

Encore Presentation: December 5, 2013, 1:00-5:00 p.m. Eastern (Register by November 1 and save)

The agenda is available at:

http://www.gfoa.org/index.php?option=com_content&task=view&id=2844

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On October 4, 2013,  the GFOA’s Executive Board approved 14 best practices – eight new and six revised – on topics from managing health-care costs to pension funding policy. Additional information about these best practices is available here:

http://www.gfoa.org/index.php?option=com_content&task=view&id=2840

Municipalities are borrowing at the slowest pace in more than two years, showing how the partial federal shutdown and prospect of a U.S. default are dissuading localities from taking on financing for new projects.

Cities and states are offering $4.3 billion of bonds this week after $3.7 billion last week, when the U.S. government shutdown began, data compiled by Bloomberg show. Excluding holidays, it’s the skimpiest stretch of financing since May 2011, even as benchmark muni-bond yields have fallen from a two-year high.

Enlarge image

San Francisco and a school district in Utah are among issuers that may shift sales scheduled for Oct. 17, the day U.S. borrowing authority lapses. Photographer: David Paul Morris/Bloomberg

As the political stalemate persists, supply may dwindle further. San Francisco and a school district in Utah are among issuers that may shift sales scheduled for Oct. 17, the day U.S. borrowing authority lapses. The ebbing tide of new bonds is echoed in diminished trading: Volatility on benchmark 10-year muni yields has dropped close to a 10-month low.

“Without new issues to give a little bit of price discovery, offers are drying up, bids are getting quiet, and when you add in the politics, the shutdown and the debt ceiling, it seems like people are sitting on their hands,” said Dan Toboja, vice president of muni trading at Ziegler Capital Markets in Chicago. “I would almost call it complete malaise.”

Already Down

The federal gridlock is exacerbating a drop in local financings as interest rates have risen from generational lows seen in December. Cities and states have issued $233 billion of fixed-rate long-term debt through Oct. 4, down 15 percent from the same period last year, data compiled by Bloomberg show.

Municipalities planning their financing amid the standoff in Washington have to consider the potential impact on market interest rates and the economy. The Treasury Department has said any U.S. default from failing to raise the $16.7 trillion federal debt limit could have catastrophic consequences that might last decades.

The Sevier County School District in Utah, with about 4,500 students, has a $36 million bond sale set for Oct. 17. Proceeds from the competitive deal will go toward building a high school. Patrick Wilson, the district’s business administrator, said he has talked with his financial adviser about possibly changing the date.

“I have a little bit of concern” about selling the day of the debt-ceiling deadline, he said in an interview. “The market could be pretty wild.”

Volatility Vanquished

The federal government’s first partial shutdown in 17 years began Oct. 1, halting a rebound in the municipal market fueled by the Federal Reserve’s surprise decision in September to maintain the pace of its monthly bond buying.

Ten-year benchmark muni yields have barely budged over the past two weeks, fluctuating just 0.02 percentage point, Bloomberg data show. Volatility has tumbled, deadening the market swings that generate trading opportunities. For 10-year yields, 60-day volatility is close to the lowest since December, data compiled by Bloomberg show.

A stable muni market is uncommon in October. Benchmark 10-year muni yields have jumped about 0.24 percentage point on average in the month since 2009, Bloomberg data show.

“The market is quiet right now, and that’s pretty rare, especially in October,” Toboja said.

Investing Antipathy

The federal government shutdown has slowed other fixed-income markets too. Corporate bond sales in the U.S. have dropped to $15.2 billion this month from $48.1 billion in the year-earlier period, according to Bloomberg data.

“Underwriters are very hesitant to advise issuers to come to market during somewhat unsettled times,” said Bart Mosley, co-president of Trident Municipal Research in New York. The shutdown and debt-ceiling debate are “keeping investors from feeling like they have to take action, which has led to subdued activity.”

San Francisco plans to sell about $37 million of tax-exempt bonds in a competitive deal Oct. 17 to pay for work at ports, including a cruise-ship terminal, and refinance commercial paper issued to move the project along.

The city has until 1 p.m. local time the day before the sale to postpone, said Nadia Sesay, director of the city controller’s office of public finance.

As Advertised

“We have advertised for a sale on the 17th and we’re hoping we can keep it, but we’re going to continue to monitor the market and see what’s happening with the debt ceiling,” Sesay said in an interview.

Cicero, an Indiana town of about 4,800 residents, has a $2.4 million sewer-revenue bond deal set for Oct. 17. Deen Rogers at H.J. Umbaugh & Associates, the town’s financial adviser, said officials have flexibility to shift the sale if necessary because of the debt-ceiling debate.

Stephen DeGroat, finance commissioner of Rockland County north of New York, said he’s concerned that its $34 million general-obligation issue is scheduled for Oct. 17. He said he plans to call the county’s financial advisers and is open to moving the date.

In 2011, Republicans and Democrats reached a deal to raise the borrowing limit ahead of an Aug. 2 deadline and avoid default. Similar to this month’s reduced volatility, 10-year benchmark muni yields were unchanged that year from the end of June to the end of July, Bloomberg data show.

Offsetting Interests

“Sellers are saying maybe the market will tighten up if we pass the debt ceiling,” Toboja said. “Buyers are saying if we get any kind of supply, the market is going to cheapen up. The end result is you’ve got nobody doing anything.”

Deals in the municipal market this week include a $563 million general-obligation sale from Wisconsin.

The state is issuing with top-rated 10-year munis yielding 2.72 percent, close to the lowest since June. The interest rate compares with 2.66 percent for similar-maturity Treasuries.

The ratio of the yields, a gauge of relative value, is about 102 percent, compared with an average of 93 percent since 2001. The higher the figure, the cheaper munis are compared with federal securities.

The Governmental Accounting Standards Board has begun research reexamining the standards related to the financial reporting model for state and local governments – most notably, Statement No. 34, Basic Financial Analysis – and Management’s Discussion and Analysis – for State and Local Governments.

The Fact Sheet is available at:

http://www.gasb.org/cs/ContentServer?c=Document_C&pagename=GASB%2FDocument_C%2FGASBDocumentPage&cid=1176163449012

Philadelphia on November 7 & 8 at Le Meridien.

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The US Securities and Exchange Commission (SEC) last month adopted rules establishing a permanent registration regime for municipal advisors as required by the Dodd-Frank Act; however, an accountant who provides audit or other attestation services will not have to register as a municipal advisor.

The new rule approved by the SEC on September 18 requires a municipal advisor to permanently register with the SEC if the advisor provides advice on the issuance of municipal securities or about certain “investment strategies” or municipal derivatives.

State and local governments that issue municipal bonds frequently rely on advisors to help them decide how and when to issue the securities and how to invest proceeds from the sales. These advisors receive fees for the services they provide.

Prior to the passage of the Dodd-Frank Act in 2010, municipal advisors were not required to register with the SEC like other market intermediaries. According to the SEC, this left many municipalities relying on advice from unregulated advisors, and they were often unaware of any conflicts of interest a municipal advisor may have had.

After the Dodd-Frank Act became law, the SEC established a temporary registration regime, and more than 1,100 municipal advisors have since registered with the SEC.

While the SEC’s definition of municipal advisor in the original proposed rule would not have required accountants who perform audits of financial statements to register, the rule would have encompassed accountants who perform other audit and attestation services, according to Barry Melancon, CPA, CGMA, president and CEO of the American Institute of CPAs (AICPA).

The final SEC rule states accountants do not have to register as municipal advisors if they provide accounting services that include audit or other attest services, preparation of financial statements, or issuance of letters for underwriters.

“Accountants providing audit and attestation services are already subject to layers of regulation that are intended to protect investors,” Melancon said in a written statement on September 27. “We are pleased that the SEC expanded the accountant exemption to include audit and attestation engagements, preparation of financial statements, and the issuance of letters for underwriters. We commend the SEC for its flexibility on this issue.”

State and local governments are still slow to provide investors with reports on their fiscal health despite a push by municipal bond investors and regulators to get municipalities to improve their disclosures.

It took almost six months after the end of their fiscal year for state and local governments to complete their audited financial statements, about two months longer than the time frame regulators suggest, a Merritt Research Services study said.

After looking at more than 8,000 fiscal 2012 audit reports from municipal bond issuers received by August 30, Merritt found that states, counties and cities were among the slowest groups to complete their audits, taking an average of 174 days, 172 days and 171 days respectively from the end of their fiscal year.

In the wake of Detroit’s record-setting municipal bankruptcy and amid growing concerns about the fiscal health of Puerto Rico, delayed financial filings are an increasing frustration for municipal bond investors. Puerto Rico, whose bonds have traded recently at yields as high as 10%, just filed its 2012 audit this month, more than a year after the close of that fiscal year and about four months after it was promised to investors.

“The ones that are coming in so late are often the ones we really want to see,” said Richard Ciccarone, Merritt’s president and chief executive. “It creates a problem for bondholders.”

Private universities, hospitals and wholesale electric utilities were among the fastest groups to complete their audits, with median times of 113 days, 109 days and 95 days respectively, Merritt said.

Merritt measured the days it took an issuer to complete an audit by counting the time between a municipality’s fiscal year-end and the date an auditor signed off on its financial report. The median audit time for all 15 municipal bond sectors Merritt studied for fiscal 2012 was 139 days.

Regulators, such as the Securities and Exchange Commission, have encouraged, but not required, municipalities to file their financial audits within 120 days after the close of their fiscal year, but there is no punishment when they don’t comply, Mr. Ciccarone said. The SEC only has the power to go after municipalities in cases of fraud.

For 2012, only about 8% of the cities and counties and roughly 6% of states came within the SEC’s recommended 120-day time threshold, according to Merritt data. About 1% of cities and about 2% counties had their audit done within 90 days. No states filed their audits within 90 days, Merritt data showed.

The SEC requires publicly traded companies to file their audited financials in a 60 to 90 day time frame.

Indeed, there is some evidence that the more fiscally stressed a local government is, the longer it takes that government to complete its audited financials, Mr. Ciccarone said.

Audited 2012 financials haven’t been received from Stockton and San Bernardino, two California cities currently in municipal bankruptcy. Those cities took 506 days and 517 days, respectively, to complete their fiscal 2011 audits, Merritt data showed.

Likewise, Harrisburg–Pennsylvania’s state capital that has flirted with bankruptcy thanks to a debt load from a failed trash incinerator project–took 496 days to turn in its fiscal 2011 audit and hasn’t completed its fiscal 2012 audit, according to Merritt’s data.

For fiscal 2011, the median audit reporting time for all municipal sectors Merritt studied was 146 days, the same as fiscal 2010.

Encore Presentation: December 5, 2013, 1:00-5:00 p.m. Eastern (Register by November 1 and save)

Earn 4 CPE credits with your participation

Brochure: http://gfoa.org/downloads/GFOATrainingGAAPFlyer2013.pdf

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Increased attention on local government fiscal stress and Chapter 9 bankruptcy filings has heightened concerns over municipal bond credit quality in wider circles than ever before.  But while the Securities and Exchange Commission (SEC) requires certain issuers of corporate bonds to file annual audited financial statements within 60 to 90 days after the close of their fiscal year, no such regulatory standards are currently in place for municipal borrowers.

“The SEC charges against the City of Harrisburg, Pennsylvania, which included implications that its financial information was outdated and incomplete, might be considered ’a shot across the bow’ for municipal issuers with a tendency to take their time in releasing secondary market disclosure materials.”

In its third annual study of audit completion times, entitled “Focus on Credit Quality Puts Sharper Spotlight on Municipal Bond Audit Times,” Merritt Research Services found that states, counties, and cities continue to complete their annual financial audits nearly six months after the end of their fiscal year.  Audit time – calculated as the time between the close of the fiscal year and the date of the signature on the audit letter – for several municipal credit sectors showed a slight improvement over the year before, but “on the whole, municipal bond audits continue to substantially lag the completion time for issuers of corporate bonds.”

The expectation for faster audit preparation by municipal borrowers may be on the horizon, according to Richard Ciccarone, President and Chief Executive Officer of Merritt Research Services.

While the Tower Amendment prevents direct regulation of state and local borrowers by the SEC, it still has authorization over dealer requirements setting forth underwriting standards for documentation.  The SEC charges against the City of Harrisburg, Pennsylvania, which included implications that its financial information was outdated and incomplete, might be considered ’a shot across the bow’ for municipal issuers with a tendency to take their time in releasing secondary market disclosure materials, Ciccarone said.

This year’s Merritt audit timing study revealed that governmental bodies that issue general obligation (G.O.) bonds are generally slower to turn in their audits than those that issue revenue bonds.  The median audit time for States and Territories, which have more complicated governmental structures and financial ledgers, was 174 days in 2012.  While the audit time for this sector was an improvement over last year, it remains far beyond the regulators’ 120-day recommendation.

Other highlights from this year’s Merritt audit timing study:

• The Wholesale Electric Public Power sector had the shortest median audit time of 95 days, continuing its six-year run as the fastest sector to complete its audits.
• The Hospital and Private Higher Education sectors took second and third place honors, respectively.
• The median audit time for Cities and Counties was slightly better than for States, but still well above the median across all sectors.
• Size was not a consistent factor in determining the length of time for an issuer to complete its annual audit after the close of its fiscal year. In fact, Rapid River Public Schools, Michigan, one of the smallest school districts in the study, completed its audit in a mere 18 days after the end of its fiscal year. The district has completed its annual audit in less than 60 days in each of the last six years.
• Credit quality did appear to have an effect on audit timing in some sectors, including Cities, Counties, Hospitals, Airports, and to some extent, States. Merritt found a correlation between financial trends and audit completion times, particularly in these sectors.

MuniNetGuide.com

James Spiotto

Richard Ciccarone

Mardee Handler

The NFMA Board of Governors endorsed the “Voluntary Interim Financial Reporting: Best Practices for State Governments” approved by the National Association of State Auditors, Comptrollers and Treasurers (NASACT) in August.

See the press release here:

http://www.nfma.org/assets/documents/position.stmt/pr.nasact.best.practices.9.13.pdf

Live-streaming event

November 7, 2013 – 1:00–5:00 p.m. Eastern (Register by October 4 and save)

Encore Presentation: December 5, 2013, 1:00-5:00 p.m. Eastern (Register by November 1 and save)

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Take advantage of group discounts

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November 3-6, 2013 – Delray Beach Marriott, FL

The 2013 Internal Auditors Society (IAS) Annual Conference brings together financial services audit professionals, industry experts and regulators to share insights and experiences on:

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Join us November 3-6 to network with internal audit, risk and compliance colleagues, and industry regulators, to discuss the future of Internal Audit, and to learn how a strong Internal Audit function can lead to better business results.

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Washington, D.C., Sept. 10, 2013 — The Equipment Leasing and Finance Association (ELFA) raised serious concerns today that a revised proposal to change lease accounting rules would increase the cost and complexity of lease accounting without significantly improving the quality and relevance of financial statements. In a letter to the Financial Accounting Standards Board and the International Accounting Standards Board (the Boards) on the second Exposure Draft of the proposed standard, ELFA concluded that it could not support the issuance of a final standard based on the revised proposal.

The letter is available at: www.elfaonline.org/Issues/Accounting/pdfs/ELFACmntLtr_091013.pdf.

“Leases account for hundreds of billions of dollars in equipment acquisition annually, contributing not only to businesses’ success, but also to U.S. economic growth, manufacturing and jobs,” said William G. Sutton, CAE, ELFA President and CEO. “The primary reasons to lease equipment will remain intact despite the lease accounting proposal. However, it is essential that the standards setters carefully consider comprehensive public input during their re-deliberation period to ensure that if, indeed, a new standard is warranted, it does not harm American businesses and the U.S. economy. We call on the Boards to seriously examine the views and alternatives suggested by our comment letter as well as other comment letters and feedback they receive.”

ELFA’s comment letter argues that the proposed lease accounting rules are unnecessarily complex, create a significant compliance burden for lessees and lessors, and replace sound lessor accounting models with untried approaches that do not reflect the economics of the transaction. The letter cautions that financial reporting by both lessees and lessors will be less transparent and more difficult to understand under the proposal.

The letter highlights significant concerns, including the following:

• The proposed new lessor accounting model is not based on user needs; rather, it reflects an attempt to make lessor and lessee accounting symmetrical without regard to lessor business models.
• The proposed changes to lease accounting present compliance costs and unintended consequences for small- and mid-sized businesses that are unacceptable.
• The new lease classification approach changes the lessee expense recognition pattern for equipment transactions (vs. property leases) from straight-line to front-loaded, which is inconsistent with the economics of the transaction.
• The proposal will have a negative impact on the economy at large by increasing the cost of capital.

More Information

For more information about the Lease Accounting Project, visit the ELFA website at http://www.elfaonline.org/ind/topics/Acctg/.  To schedule an interview with an ELFA expert on the lease accounting project, please contact Amy Vogtat 202-238-3438 or avogt@elfaonline.org.

About ELFA

The Equipment Leasing and Finance Association (ELFA) is the trade association that represents companies in the $725 billion equipment finance sector, which includes financial services companies and manufacturers engaged in financing capital goods. ELFA members are the driving force behind the growth in the commercial equipment finance market and contribute to capital formation in the U.S. and abroad. Its 580 members include independent and captive leasing and finance companies, banks, financial services corporations, broker/packagers and investment banks, as well as manufacturers and service providers. For more information, please visit www.elfaonline.org.

September 10, 2013

Mr. Russell Golden, Chairman

Financial Accounting Standards Board

401 Merritt 7

PO Box 5116

Norwalk, CT 06856

————–

Mr. Hans Hoogervorst, Chairman

International Accounting Standards Board

30 Cannon Street

London EC4M 6XH

United Kingdom

Submitted via electronic mail to director@fasb.org

Re: File Reference No 2013-270, Exposure Draft: Leases (Topic 842): a revision of the 2010 proposed FASB Accounting Standards Update, Leases (Topic 840)

Dear Chairman Golden and Chairman Hoogervorst:

The Equipment Leasing and Finance Association (ELFA) welcomes the opportunity to respond to the request for comments from the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (collectively, the Boards) on the proposal contained in the FASB Exposure Draft (ED), Proposed Accounting Standards Update: Leases (Topic 842).

The Equipment Leasing and Finance Association (ELFA) is the trade association representing over 580 financial services companies and manufacturers in the $725 billion U.S. equipment finance sector. ELFA members are the driving force behind the growth in the commercial equipment leasing and finance market and contribute to capital formation in the U.S. and abroad. Overall, business investment in equipment and software accounts for 8.0 percent of the nation’s GDP; the commercial equipment finance sector contributes about 4.5 percent to the GDP. For more information, please visit http://www.elfaonline.org.

In addition to our summary comments, below, we have included in an attachment our detailed answers to the ED’s Questions for Respondents.

Equipment Leasing and Finance Industry

All types of companies lease and finance equipment, but leasing is an especially significant source of financing of operating assets for small- and medium-sized (SME) companies and large non-investment grade (NIG) businesses. The SME sector is cited as the largest potential source of the job growth needed to reinvigorate the economy worldwide. Access to capital and efficient use of equipment are the major drivers for leasing, as opposed to achieving off balance sheet treatment through operating lease accounting. Based on the ELFA annual Survey of Equipment Finance Activity, we estimate that over 16 million equipment lease contracts are executed each year in the United States. Further, we estimate that approximately 14 million of those leases are with SME and NIG lessees. Many of those leases involve multiple assets that are included in one lease schedule. While the number of transactions is indeed large, the dollar value of individual transactions is small reflecting the nature of the items being leased. These items include various types of office and materials handling equipment, for example. As a result, the ED’s complexity is a major concern. Therefore, in addition to our views on the technical merits of the proposal, much of our commentary will focus on the complexity and compliance costs associated with the proposals and the areas where the ED fails to improve the decision-usefulness of financial statements.

In addition to being lessors, our members are also users of financial statements. When determining whether to enter into a lease contract with a lessee, our member organizations analyze the ability of the lessee to meet its financial obligations according to the contractual schedule. Because SMEs and NIG companies are more prone to bankruptcy than larger investment grade organizations, our members are also concerned with bankruptcy risk, requiring information about which assets and liabilities survive bankruptcy. In making the decision to lease an asset to a lessee, lessors rely on the lessee’s financial statements and, in their pricing, generally model the financial statement effects of the proposed lease investment on future periods. After lease origination, they place significant reliance on the lessee’s financial statements in reassessing credit worthiness and in monitoring compliance with covenants. Accordingly, our comments involve the decision-usefulness of the proposed new accounting for leases from the perspective of both preparer and user.

Economic Nature of Equipment Leases

Leases are a legal construct recognized as distinctly different in their characteristics from secured loans for the purpose of broadening access to asset-based capital. The nature and extent of the defining characteristics of a lease contract vary considerably from jurisdiction to jurisdiction. These jurisdictional differences principally arise from differences in jurisprudence (i.e., whether substance- or form-based), in the economic environment (i.e., private or government sector centric or hybrids, the presence or absence of active secondary asset markets), and the income tax system (i.e., the significance of available government incentives tied to certain asset acquisitions and permitted transfers or sharing of such incentives between the user and the investor). U.S. equipment leases differ markedly from leases originated in non-U.S. jurisdictions, as evidenced by existence of a Uniform Commercial Code (UCC), an arduous process involving each of the 50 state legislatures. The UCC draws a clear distinction in the rights and obligations of the parties involved in leases and secured financings based on the “economic realities” of the contract (notably, whether the party designated as lessor retains a meaningful interest in the residual value of the leased asset such that it must look to the secondary market as a benchmark for recovery of its investment or in asset disposition). The U.S. income tax system provides significant tax benefits for equipment and their transferability and sharing within well-defined guidelines provided the lessor has sufficient “skin in the game.”

True leases are not an accounting construct. The accounting for such leases under existing U.S. GAAP generally mirrors their classification under U.S. commercial and income tax law. Today all U.S. disciplines evaluate leases based on risks and rewards. Leases classified as capital leases are generally classified as secured financings and subject to the same rights and obligations as applicable to the parties to loans. Leases classified as operating leases are generally classified as “leases” under the UCC (Article 2A) with the tax benefits arising from the lessee’s use of the property allocated to the lessor who can economically share part of these benefits in the form of lower rentals, but not otherwise and subject to certain constraints so that the nature of the transactions does not constitute the sale/purchase of such benefits. Similarly, the use of the straight-line method for rentals by lessees is commonly required under existing U.S. GAAP and the U.S. income tax laws and is implicit in U.S. commercial law in defining leases as executory contracts. Hence, we believe a faithful accounting of leases must distinguish between leases based on rights and obligations of the subject jurisdiction and their economic effects.

We believe the lessee accounting model must consider the contract the unit of account and the contract should provide the basis for the accounting for the rights and obligations arising from the lease arrangement. Where we see a major deficiency is in failing to analyze and account for the rights and obligations existing in a lease. We believe that a risks and rewards analysis consistently applied to leases of all asset types identifies the basic information required to account for both capital leases and capitalized operating leases for lessees. The balance sheet and the costs recognized in the P&L must reflect the nature of the distinctly different types of leases to satisfy the basic needs of preparers and credit analysts and lenders. The legal differences between leases are significant and impact the economics of leases. They are especially important in a bankruptcy, which is an important element of credit analysis. If the lease accounting model does not allow for equipment operating lease assets and liabilities to be broken out and clearly labeled on the balance sheet and if equipment operating leases are forced into a front-ended cost pattern where the asset amortizes at a faster pace than the liability, the nature of lease liabilities will be obscured and it will appear that the lessee has claims that exceed the value of its assets. This is not a valid depiction of lease economics for lessees.

We realize that accounting is not a science with natural laws that can have only one outcome that can be proven mathematically or strongly supported by empirical evidence, but in our opinion, commercial law and its economic implications should be a factor in determining the proper accounting for leases. It is also our opinion that there is little operating lease activity in markets where commercial law does not establish clear property rights in lease contracts, and a converged leasing standard need not be developed for systems that do not support leasing markets.

Summary Comments

We appreciate many of the changes made to the lease model since issuance of the first ED. We agree that the revised definition of the lease term and lease payments represent improvements over what was first proposed in 2010. While elements of the model in the ED before us are an improvement over its predecessor, we remain concerned that it does not reflect the economics of many equipment leases and will add complexity to financial reporting by both lessors and lessees alike. Since the proposals do not reflect the economics of many lease transactions nor appear to meet the needs of users of financial statements, we believe the significant costs associated with the proposals will exceed the incremental benefits of the proposed model. Consequently, we do not support the issuance of a final standard based upon this ED.

There are several paths forward for this project. The model needs to either be revised or the Boards should pursue a disclosure-based model in place of one based on recognition and measurement. Consistent with the corporate finance view of leasing, we believe there is a range of lease transactions. Given this range of transactions, development of a single lease model that accurately depicts transactions within the range is not possible. We agree that for accounting purposes, the differences between leases are best reflected using a two-lease model; however, we strongly disagree with the lessee classification methodology proposed in the ED. We believe that leases should not be separated based upon the nature or type of the underlying asset, but rather on the nature of the transaction; we believe an IAS 17 model would provide a reasonable basis for this distinction.

The underlying basis for lessee accounting is not clear in the ED. At times the model refers to the lease contract and at other points it refers to the underlying asset. For example, lease cost allocation is determined by reference to the underlying asset, but initial recognition is based upon the contract. We believe the model needs to be either grounded in the accounting for the underlying asset or in the contract. Our suggestion to use IAS 17 as the basis for classifying leases into Types A or B would ground lease accounting in the accounting for the underlying asset. Alternatively, the model could be based on the contract. An example of this is the display approach, under which a lessee would recognize a lease liability and lease asset based upon the present value of remaining lease payments at each period end. The P&L would reflect rent expense. This is a straightforward model that would achieve the balance sheet recognition goal of the Boards and would be cost-effective to apply.

If the Boards are not able to develop a model that is more representationally faithful and that meets the needs of users of financial statements, we believe a disclosure-based alternative should be pursued. While this would not achieve the goal of recognizing lease liabilities, it would serve the needs of users of financial statements in a cost-effective manner. Groups of financial statement users have advised the Boards they are able to process the existing lease disclosures to make rational investment decisions. These views are also supported in recently published academic research. In “Evidence that Market Participants Assess Recognized and Disclosed Items Similarly When Reliability is Not an Issue” 1, the authors note the following:

. . . The FASB or any other accounting standard-setter should not be primarily concerned that investors and creditors will underweight or ignore altogether disclosed information that meets sufficiently high reliability, accessibility, and interpretability thresholds.

These results support the view that creditors do not appear to price lease obligations differently based on recognition versus disclosure.

The goal of financial reporting is to provide users with decision-useful information and it is important that the goal be met on a cost-effective basis. These goals should not be sacrificed in order to develop accounting constructs that, while achieving certain goals, do so at an unacceptably high cost.

The Boards have generally expressed a preference for a recognition and measurement model over a disclosure-based model, and some have commented that the question of recognition versus disclosure of lease transactions is no different than the recognition debates that surrounded pension and stock option accounting. We believe that lease accounting represents a separate and distinct set of issues. Both pension and stock option accounting were concerned with basic recognition questions. In stock option accounting, the question was whether any compensation expense should be recognized at all. In pensions, it was a question of a minimum liability and how to account for future obligations that were potentially significantly greater than current expenditures. In current leasing standards, there is a recognition system, lease obligations that are not recorded are disclosed, and current rent expense is closely associated with the cash flows that will occur in future periods. Therefore, there is no relevant comparison of leasing to these other accounting debates.

Lessor Accounting

The Boards have made a number of improvements to lessor accounting over what was proposed in the first ED. While the model is improved, we are of the opinion that lessor accounting generally functions well under current GAAP and that a classification approach based upon the type of underlying asset will generally not produce a presentation that will better reflect a lessor’s position in the leased asset and lease contract. The existing classification model, which determines lessor accounting based upon the lessor’s position with respect to the lease contract and leased asset, produces a more faithful depiction. As the Boards move forward, it will be important that they approach lessor and lessee accounting from different perspectives. Lessor accounting is concerned with presenting the lessor’s position in the lease and leased asset as well as with lessor income. Lessee accounting is concerned with the recognition of lease assets and lease obligations and with the allocation of costs arising from a lease contract. Knowing how the lease impacts the parties is important, but these are separate and distinct areas of concern. Therefore, symmetry is not required and should not be a preferred outcome.

If the Boards proceed with the model proposed in the ED, we believe lessors should have the ability to base their financial accounting presentation on their business model, as that is what users desire. Equipment operating lessors share many of the attributes of lessors of property and therefore should be able to use the operating lease method. Conversely, the direct finance lease method is the preferred approach for financial lessors, whose position is generally closer to that of a creditor. The result would be balance sheet and P&L presentations that satisfy users’ needs as they reflect the substance of the respective lessors’ businesses.

We also believe that, similar to current GAAP, any residual guarantee or residual insurance changes the nature of a residual from a physical asset to a financial asset, as the risk is transformed into credit risk. This is important for securitization purposes as financial assets are typically securitized. It would also better reflect the risks transferred when accounting for gross profit, which is inherent in some leases. It is also an area where we believe change in the current approach is unnecessary.

Finally, there should be a place in the proposed lease model for leveraged lease accounting. It is not appropriate to eliminate an accounting method that has been in existence for over fifty years simply because the accounting method no longer fits into contemporary accounting thought. The netting of lease receivables and nonrecourse debt is in line with the rules for the right of offset, as it is a three-party agreement where the parties agree that the rent is to be paid to the lender and cash flows will settle on that basis. Presenting rent and debt on a gross basis gives a false perception of the amount of assets and claims that exist in a bankruptcy analysis. We also believe that the MISF yield revenue recognition treats tax credits as revenue and recognizes that timing differences reduce the net funded position in an investment. Consequently, revenue is recognized to match the interest cost to fund the net investment. The leveraged lease structure may be unique to the U.S. as it has a mature capital markets and it has a tax regime that incents investors to acquire assets via tax credits and accelerated write-off of basis. The accounting accurately reflects the economic effects. The decision to eliminate the structure may be useful to gain worldwide accounting convergence but it is a setback for accounting in the U.S. and those businesses that have come to rely on its benefits. The loss of leveraged lease accounting will increase the pricing for large value leased assets, especially those with favorable tax attributes, such as tax credits that are designed to promote new alternative energy projects.

Cost Versus Benefit Considerations

It is our view that, on balance, the ED does not produce true benefits to the financial reporting system. There is some perceived benefit from the reporting of lease obligations in a lessee’s balance sheet, but the usefulness of the recognized value is uncertain. It is difficult to describe the benefit to users as more accurate reporting of lessee obligations when there are differences between the accounting definition of a liability and the differing needs of investment grade debt, high-yield debt and equity analysts. The lease obligation produced may be more precise and comparable across companies, but it is not more accurate.

The compliance costs and unintended consequences of the proposed approach are significant. These unacceptable costs would be significantly reduced if the core framework of current GAAP is maintained and lease classification based upon a risks and rewards model employed for the Type A/Type B separation. We believe there has not been an assessment of less costly alternative approaches that would still achieve the goal of improving transparency of lessee and lessor financial statements. Further, we do not believe that there has been an adequate assessment of the technology costs involved in systems requirements for both lessees and lessors that involve transition, implementation and ongoing compliance.

There are several aspects of the ED that add complexity and cost, but do not significantly improve the lease model. First, the proposed rules for both the lessee and lessor in equipment leases must be executed on a leased-asset by leased-asset basis. This is a major issue as it will add complexity in implementation and ongoing compliance, especially since this is an element of the model that does not correspond to the needs of any group of financial statement users.

In addition, many leases are routinely entered into on a sale leaseback basis for administrative purposes; a lessee will take delivery of a series of low value assets and then convert to a sale and leaseback. This is possible under current GAAP, but in transition, every lease will need to be evaluated to determine if it was executed using a sale and leaseback, and every sale will need to be reviewed. This evaluation will need to be done by the lessee and the lessor as the proposals impact both parties in a lease. The control criteria should be revisited for sale and leaseback transactions, and, at a minimum, existing sale and leaseback transactions should be grandfathered at transition.

Another feature of the ED that will add unacceptable costs are the new definitions and factors to consider when assessing the term of a lease. While the Boards intent is to bring the factors to be considered in line with existing requirements, the definition introduces new terms and concepts. This will result in the expenditure of significant resources as the new terms are studied, analyzed, implemented and audited. If the Boards’ intent is to maintain existing requirements, the most cost-effective method would be simply extracting the key concepts and descriptions from existing GAAP.

The changes to lessor accounting for Type A leases is another area where changes are being proposed that will alter the way certain leases are accounted for but not to a significant or meaningful extent. The changes in the recognition and subsequent measurement of residuals in what were sales-type leases in current GAAP and the manner in which income is recognized for all Type A lease receivables and residuals represent minor changes to GAAP. In simpler terms, the receivable and residual method is only cosmetically different than current Direct Finance Lease accounting. The changes will, however, cause lessors to incur costs to revise systems and reporting routines.

Finally, the provisions that require active reassessment of lease terms and certain variable lease payments will add costs to financial reporting. The impact of these changes may not be very significant, but they will require significant investments in systems and revisions of reporting routines. If a simpler approach as recommended above is adopted, it would eliminate a portion of the reassessment accounting complexity. Lessors and lessees, however, will still need to review each and every lease contract to identify in their accounting systems the leases that require reassessment. This process will be very time intensive, but will probably have limited impact on the amount of liability recognized.

The Boards should also weigh the cost versus benefit analysis in direct costs, other than the systems and process changes that will be borne by preparers. SME and NIG companies are the heaviest users of equipment operating leases primarily because of their limited access to debt and equity markets, the liquidity benefits of level fixed-rate payments, lower rents due to tax benefits transferred to the lessor and the “balloon effect” on pricing due to the lessor assuming a residual value as a cash flow. SME and NIG preparers are also higher bankruptcy risks and they are forced to agree to debt covenants that protect lenders in a bankruptcy scenario as noted in “Debt Covenants, Bankruptcy Risk, and Issuance Costs”, by Sattar A. Mansi, Yaxuan Qi, and John K. Wald, May 4, 2011 (https://fisher.osu.edu/blogs/efa2011/files/CFE_6_3.pdf). The impact of the ED will be to be to require these entities to renegotiate debt covenants, as the ED does not label capitalized operating lease obligations as a non-debt liability. This will be a potentially costly and time consuming exercise for SMEs and NIG companies. If the lease model and classification tests are not aligned with the legal regime (i.e., the UCC in the U.S.), lenders and credit analysts will ask SMEs and NIGs to recast their lease assets and liabilities so that they may assess their position in a possible bankruptcy scenario. This is not to say we are suggesting accounting for leases assuming a bankruptcy but rather is a suggestion that the lease model should provide vital information to users just as they have under current GAAP.

Concluding Comments

The path to revising lease accounting has been long and difficult for the Boards. Leasing is a complex activity and the range of lease transactions, as noted in the corporate finance literature, is quite extensive. Leasing can range from transactions that are debt-like to transactions that are more equity-service oriented. Development of one model for all lease transactions is not practical as any model that fits one end of the spectrum will not be faithful to transactions at the other end.

We are concerned with many of the elements of the proposed lessee and lessor accounting models, as they will unnecessarily increase the cost and complexity of lease accounting without significantly improving the quality and relevance of financial statements. In some cases, we believe the quality of the information presented will be impaired and the relevance of the financial statements reduced. A lessee model that considers all equipment leases to be the equivalent to the purchase of an asset and the separate incurrence of debt is not a valid accounting model and is not grounded in the economics of leasing. We therefore cannot support the lease accounting model presented in the ED.

The lease asset and lease liability related to operating leases exist together and they should not be subject to separate and distinct accounting after lease commencement, as if they were in fact separate transactions. The accelerated cost recognition that results from the separate accounting for the lease asset and lease liability under Type A accounting should not be accepted as a natural consequence of the right of use model. Leases are not simply the seller financing of an asset sale. Inherently, leases involve the separation of use and ownership. Accordingly, lessee accounting should allocate the total consideration based on usage while lessor accounting should faithfully portray the economics of the investment, including, when significant, the tax risks or rewards arising from the underlying.

The lease accounting model does not have to be as complex as it appears in the ED. The Boards could have met their primary objective, the capitalization of lease liabilities, using a simpler approach to lessee accounting. This would have entailed amending IAS 17, Leases, and ASC Topic 840 to capitalize leases with a lease term greater than one year by merely putting an accurate value on the balance sheet and by revising the approach to allocating lease costs. Alternatively, the Boards could adopt a display only model for lessees that is different from the recognition and measurement approach pursued to date. A display model would have lessees present value their lease obligations and record the resulting liability and asset at the end of each period, with rent expense reflected in the P&L. Either of these approaches would achieve the Boards objective of having lessees recognizing a lease asset and lease obligation without the aspects of the approach in the ED that will cause preparers and users the greatest difficulty.

As the Boards consider the leasing model during redeliberations, we think revisiting the American Accounting Association’s (“AAA”) comments on the G4+1 leasing paper [Exhibit A] is appropriate. In its paper, the AAA observed:

The nature of the property under lease should not affect the accounting, nor should the length of the lease.

The approach to leases should recognize that accounting for leases is a special case of accounting for contracts.

The approach should require that substantially similar lease contracts be accounted for similarly and substantially dissimilar lease contracts not be forced into a misleading appearance of comparability.

The goal for lease accounting is to represent the value of the rights and obligations conveyed by the lease, not the value of the physical assets, unless there is no material difference between the value of the physical assets and the value of the rights and obligations.

These comments were valid when they were written more than 10 years ago, and they still resonate today.

In addition, there are a number of elements in Mr. Linsmeier’s alternative view that merit further consideration. In particular he observes that:

• Users will not have the information they require regarding leasing activities or the information with which to derive the information they need,
• Leases that transfer ownership rights based on IAS 17 classification criteria should be scoped out of the proposed standard and they should be treated as a financed purchase,
• The ROU asset is a unique asset and subsequent accounting should not be defined by reference to other accounting literature,
• Type B accounting should be used as it supports the view that the contract as a whole is the unit of account that should be the basis for lease accounting, and
• There should not be symmetry between lessor and lessee accounting.

We respectfully suggest the Boards consider these thoughts as it re-deliberates the ED.

We certainly appreciate the opportunity to comment on the ED, and we also thank the Boards for their policy of open communications during the standards-setting process. We remain available to help in any way needed, and we are committed to assisting in the creation of a workable lease accounting standard that reflects the economic substance of transactions and improves the clarity in financial reporting.

Sincerely,

William G. Sutton, CAE

President and CEO

Attachment — Questions for Respondents

Exhibit A

* * * * *

Attachment

Questions for Respondents

ED Questions and Answers:

Question 1: Identifying a Lease

This revised Exposure Draft defines a lease as a contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. An entity would determine whether a contract contains a lease by assessing whether:

1. Fulfillment of the contract depends on the use of an identified asset.

2. The contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration.

A contract conveys the right to control the use of an asset if the customer has the ability to direct the use and receive the benefits from use of the identified asset.

Do you agree with the definition of a lease and the proposed requirements in paragraphs 842-10-15-2 through 15-16 for how an entity would determine whether a contract contains a lease? Why or why not? If not, how would you define a lease? Please supply specific fact patterns, if any, to which you think the proposed definition of a lease is difficult to apply or leads to a conclusion that does not reflect the economics of the transaction.

Response

We generally agree with the definitions, but we also believe the Boards could simplify the proposals if they were to exclude transactions that are not leases that transfer a right of use. This would lead to leases that transfer ownership being accounted for under other areas of GAAP and would free the lease model from the perceived need to account for some lease transactions as if they were purchases with financing.

While we agree with the proposed basis for separating leases from service transactions, we believe the definitions require further field testing to determine if they work as intended and that there are no significant unintended consequences.

Question 2: Lessee Accounting

Do you agree that the recognition, measurement, and presentation of expenses and cash flows arising from a lease should differ for different leases, depending on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset? Why or why not? If not, what alternative approach would you propose and why?

Response

We do believe there are differing lease transactions and that a general model for lessees and for lessors is not possible given the range of transactions. We provide further commentary on this point in our response to Question 4.

We do not agree with separating leases for purposes of determining how to allocate the cost of lease transactions based upon the nature of the underlying asset. We believe contracts should be separated based upon the nature of the contract. For example, leases that transfer the significant risks and rewards of ownership or control using an IAS 17 approach could be accounted for using the Type A model and all other leases could be accounted for using the Type B model. The proposed approach in the ED will not reflect the nature of equipment lease contracts and will add costs to the model by making it harder to determine the significance of equipment leases for purposes of materiality given the nature of the Type A model.

If the Boards do not accept a classification approach based upon the nature of the contracts, a display-oriented approach should be pursued. Under this model, lessees would record a lease liability for the present value of rents at the end of each period and an asset for an equal amount. Lease costs would be recognized on the basis of rent. Under this approach, the balance sheet and income statement would not be linked, but we believe linkage is not required in a display approach.

When it comes to allocating costs in lease transactions, we believe that rent expense is the appropriate governor for allocating costs. While some users of financial statements allocate the cost of some lease transactions into interest and amortization components, they do so by allocating rent and usually do not recast the transactions as is proposed in the Type A lessee model. Rent is an important measure of the outflow of resources and the artificial allocation of costs in the Type A model does not appropriately reflect this situation.

Question 3: Lessor Accounting

Do you agree that a lessor should apply a different accounting approach to different leases, depending on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset? Why or why not? If not, what alternative approach would you propose and why?

Response

As indicated in the prior comment, we do believe there are differing lease transactions and that a general model for lessees and for lessors is not possible given the range of transactions. We provide further commentary on this point in our response to Question 4.

Lessor income recognition should either be based upon the nature of the lease transaction or lessors should be allowed to determine the accounting for their investment in a lease using the existing lessor models following a business model approach. Financial lessors like banks and finance companies should use a Type A or finance lease approach. These lessors should not use the operating lease method for their finance leases as it distorts the P&L and financial measures used by analysts. Analysts measure financial lenders/lessors by such measures as net finance revenue over interest cost (net spread/net revenue from invested funds) and operating efficiency (the ratio of net revenue to expenses). The operating lease rent and depreciation bears no relationship to the declining financial asset and its cost to carry. Mixing depreciation of leased assets with assets used in the business makes the bank/finance company appear less efficient. For the same reasons, the Boards must consider the accounting for tax credits and tax benefits for financial lessors. Reporting tax credits as tax expense rather than as a component of lease revenue and failing to recognize the reduction in cost to carry from tax shelter distorts the net revenue and operating efficiency ratios. Users want to see the results of investments considering all the elements of revenue in the appropriate line on the P&L based on the substance of the transaction.

Similarly, operating lessors should continue to use an operating lease model as that model most accurately reflects the nature of their business, which is the management of the asset. If the Boards believe users of financial statements require additional information about lessors’ residual and credit risks, this information should be provided through additional disclosure and not through recognition and measurement.

Question 4: Classification of Leases

Do you agree that the principle on the lessee’s expected consumption of the economic benefits embedded in the underlying asset should be applied using the requirements set out in paragraphs 842-10-25-5 through 25-8, which differ depending on whether the underlying asset is property? Why or why not? If not, what alternative approach would you propose and why?

Response

We do believe that the nature of lease agreements varies, but we do not believe they vary based upon the nature of the underlying asset. A model that proposes to recast transactions into another category of transactions, which is the central element of the Type A model, should be based upon whether those transactions are substantively in the form of the transaction they are being recast into. A nine-year lease of an asset with a ten-year life is probably substantially similar to the separate acquisition and financing of an asset purchase. A two-year lease of the same asset is probably not and should not be forced into a different form through accounting.

We do agree that the relationship of lease term to the economic life of a leased asset is one of the factors used to determine if the rights and obligations in a lease are ownership rights or merely rights of use. The significance of the lease payments in relationship to the underlying asset is another factor. It should not matter what the leased asset is — real estate or equipment. The current GAAP risks and rewards tests accomplish the goal of classifying leases according to their economic and legal nature and those factors should continue to be part of the new lease accounting model. If they are not, then users will have less information.

Question 5: Lease Term

Do you agree with the proposals on lease term, including the reassessment of the lease term if there is a change in relevant factors? Why or why not? If not, how do you propose that a lessee and a lessor should determine the lease term and why

Response

We understand the Boards have attempted to replicate the existing GAAP requirements for determination of lease term. This has been done by using new terms, however, and we believe this will result in new interpretations. If the intent of the Boards is to continue the current requirements, then existing terms should be used as much as is possible to reduce the costs associated with transition and ongoing compliance.

The requirement to reassess leases will add to the costs of the proposals, and we believe that lease term extensions should only be accounted for when they occur. Basing accounting recognition on anticipated outcomes is not consistent with other acquisition or service accounting models.

Question 6: Variable Lease Payments

Do you agree with the proposals on the measurement of variable lease payments, including reassessment if there is a change in an index or a rate used to determine lease payments? Why or why not? If not, how do you propose that a lessee and a lessor should account for variable lease payments and why?

Response

We agree with the treatment of variable lease payments if the payments are indexed, but we also believe if the impact of changes in variable rate lease payments will not result in any significant change in the lease asset and lease liability, they should be excluded from the model on a cost versus benefit basis. Changes in interest rates will not, however, have a significant impact on the measurement of the lease asset and obligation and should be excluded from reassessments.

Question 7: Transition

Subparagraphs 842-10-65-1(b) through (h) and (k) through (y) state that a lessee and a lessor would recognize and measure leases at the beginning of the earliest period presented using either a modified retrospective approach or a full retrospective approach. Do you agree with those proposals? Why or why not? If not, what transition requirements do you propose and why?

Response

Lessee transition for Type A leases is far too complex because the method front loads costs and the transition method attempts to lessen the current period P&L impact. It should also be noted the entry in the 842-10-55-77 example of a Type A lease transition lacks a charge to deferred tax assets.

In 842-10-55-89 the fair value of an asset may not be readily available for many asset types. In 842-10-55-90 it seems to allow the residual to be “written up” if it is higher than the residual value at inception. To simplify things and to conform to the principle that residuals cannot be written up, we would use “at inception/commencement” data for cost/fair value, residual and implicit rate. As a result, the value of the lease at transition will be the PV of the rents and original residual using the original implicit rate as the discount rate to PV the amounts that are recorded at the transition date.

In 842-10-65-1, we would suggest the following language: “For leases that were classified as direct finance or sales-type leases in accordance with Topic 840, the carrying amount of the lease receivable and residual asset at the beginning of the earliest comparative period presented shall be the bifurcated carrying amount of the net investment in the lease immediately before that date (using the implicit rate in the lease to calculate the amounts) in accordance with Topic 840.”

Question 8: Disclosure

Paragraphs 842-10-50-1, 842-20-50-1 through 50-10, and 842-30-50-1 through 50-13 set out the disclosure requirements for a lessee and a lessor. Those proposals include maturity analyses of undiscounted lease payments, reconciliations of amounts recognized in the statement of financial position, and narrative disclosures about leases (including information about variable lease payments and options). Do you agree with those proposals? Why or why not? If not, what changes do you propose and why?

Response

We do not agree that a lessee in a lease with services needs to disclose future non lease components/service contract payments as the same disclosure is not required for a service contract with the exact same terms that is contracted separate from the lease. Also, if an asset is owned and a preparer enters into a service contract on the asset that has the exact same terms as the service contract connected to a lease, it would not need to be disclosed. In all the cases cited, the service contract is legally the same — it is an executory contract.

The requirements in 42-20-50-4 to disclose reconciliations for the assets and liabilities for both Type A and Type B leases present a great deal of information that we question whether users really need. This is a question that should be posed in targeted outreach with lenders, investors and analysts.

The fact that most companies lease many types of assets and have numerous leases means that the requirements in 842-20-50-3 to describe lease terms will result in very general descriptions.

Questions 9, 10, 11, 12

Responses

None

Exhibit A

Excerpts from:

© 2001 American Accounting Association

Accounting Horizons

Vol. 15 No. 3

September 2001

pp. 289-298

COMMENTARY

Evaluation of the Lease

Accounting Proposed in

G4+1 Special Report

AAA Financial Accounting Standards Committee Stephen G. Ryan (Chair); Robert H. Herz; Teresa E. Iannaconi; Laureen A. Maines; Krishna G. Palepu; Katherine Schipper; Catherine

M. Schrand; Douglas J. Skinner; Linda Vincent

CHARACTERISTICS OF A CONCEPTUALLY SOUND LEASING STANDARD

The Committee supports development of a single, conceptually sound approach to accounting for all types of leases and believes that such an approach should have the following characteristics:

1. The approach should recognize that all leases, regardless of their specific terms and conditions, convey rights and obligations, and so create assets and liabilities. The nature of the property under lease should not affect the accounting, nor should the length of the lease.

2. The approach should recognize that accounting for leases is a special case of accounting for contracts. Accounting for all contracts should be placed on a sound conceptual footing, and the principles developed for leases should be both internally consistent and generalizable, in the sense that the principles governing accounting for leases should be suitable for application to accounting for contracts generally.

3. The approach should be robust to shifts in the contractual details of lease contracts when such shifts do not materially alter the economic substance of the arrangements. In particular, the approach should require that substantially similar lease contracts be accounted for similarly and substantially dissimilar lease contracts not be forced into a misleading appearance of comparability.

4. The approach should take account of practiced realities of the leasing market that make measuring lease assets and liabilities difficult. Because lease contracts are frequently tailored to the desires of the parties to the lease, it can be difficult or even infeasible to identify similar lease contracts. Moreover, public information about the specifics of lease contracts is often unavailable. For these reasons, the markets for trading lease assets and liabilities are relatively undeveloped. In addition, the existence of transaction costs associated with relocating and releasing assets under lease may yield incentives that affect the contractual lease provisions.

While the measurement difficulties discussed in point 4 above must be considered carefully, the Committee believes that the principles governing accounting for lease receivables and liabilities should conform to the accounting for other financial instruments. In this regard, we note that in previous comment letters to the FASB (most recently, to its December 1999 Preliminary Views “Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value”), the Committee stated its support for fair value accounting for financial instruments once the conceptual and measurement issues are resolved.

FOOTNOTE

1 THE ACCOUNTING REVIEW Vol. 88, No. 4 DOI: 10.2308/accr-50421 July 2013 pp. 1179-1210.

In June, the GASB issued an Exposure Draft, Measurement of Elements of Financial Statements, and a Preliminary Views, Fair Value Measurement and Application. The Exposure Draft proposes new accounting concepts to guide how the GASB sets standards for the measurement of assets, liabilities, and other items reported in financial statements. The Preliminary Views presents the Board’s initial thinking on how fair value should be determined, what should be measured at fair value, and what note disclosures should be included with those measurements.

The GASB also issued a Plain-Language Supplement that summarizes the proposals for users of governmental financial information. The GASB will be conducting a webcast on September 5 at 3:00 pm Eastern time to explain the proposals and collect feedback from users.

This article summarizes and explains the proposals in the due process documents at a very high level for users of governmental financial information. It addresses the Exposure Draft on measurement concepts first, and then discusses the Preliminary Views on fair value. Information about how to participate in the September 5 webcast and provide your feedback to the GASB is included.

Measurement Concepts

GASB Concepts Statements are meant to provide a framework of interrelated objectives and fundamental concepts that can be used as a basis for the GASB establishing consistent accounting and financial reporting standards. Measurement concepts will address how to calculate the appropriate amounts for assets and liabilities. As such, they will provide a foundation for depicting a government’s financial health as of a specific point in time, referred to as the government’s “financial position,” and its financial activity during a certain period, referred to as the government’s “results of operations” or “financial performance.”

Measurement concepts help the Board to develop standards that require largely the same treatment for similar transactions. This promotes the user’s ability to compare relevant, reliable, and understandable financial information across governments. Ultimately, accounting standards based on these concepts should maximize the likelihood that different governments would come up with comparable measurement amounts for comparable assets or liabilities obtained or incurred under comparable circumstances.

Measurement approaches

A measurement is associated with a point in time; a “measurement approach” tells you what that point in time is. The GASB is proposing that assets and liabilities be measured using one of two measurement approaches:

• Initial Amount—The transaction price or amount assigned when an asset was acquired or a liability was incurred, including subsequent modifications (for example, depreciation) to that price or amount. Initial amounts also are known as initial-transaction-date-based measurements.
• Remeasured Amount—The amount assigned when an asset or liability is remeasured as of the financial statement date. Remeasured amounts also are known as current-financial-statement-date-based measurements.

While initial amounts may be adjusted in later years, such as through amortization or because of impairment, the original value of the asset or liability is not remeasured. Remeasured amounts, on the other hand, are newly measured as of the date of each year’s financial statements. The GASB has proposed two approaches, rather than a single approach for all assets and liabilities, because it believes both are needed to meet the various objectives of financial reporting and to achieve balance among the qualitative characteristics (reliability, comparability, consistency, relevance, understandability, and timeliness) of information in government financial reporting.

The Board believes that the use of initial amounts is generally better suited to achieving reporting objectives associated with the cost of providing services. A capital asset—an elementary school, for example—is acquired at a given time but is used to provide services for many years afterward. Including the cost of the school in the cost of providing services in each of those years is more informative if the cost of the school is measured at the initial amount.

The Board also believes that remeasured amounts are better suited to achieve financial reporting objectives related to portraying financial position. For example, using the remeasured amount for a government’s investments that will ultimately be converted to cash will provide a clear picture of a government’s current financial health and the resources available to it for providing services or satisfying obligations.

The Board recognizes that it may not be possible to report some assets or liabilities using a measurement approach that promotes the objectives of both (a) providing information about the cost of current-year services and (b) providing information about the financial position of a governmental entity to be used in assessing the level of services that can be provided by the governmental entity. Because only one measurement approach should be applied for a specific asset or liability, one objective will necessarily be given priority over the other. In these circumstances, the Board believes that the cost-of-services information has greater relevance in the governmental environment than the service-potential information because of the importance of providing information that can be used to assess interperiod equity.

Measurement attributes

The GASB is proposing to place four basic measurement tools in its conceptual framework tool box that it can use in standards-setting. These tools are referred to as measurement attributes. A measurement attribute is a particular characteristic of the asset or liability that is being measured. The proposed Concepts Statement identifies and defines four measurement attributes:

• Historical cost is the price actually paid to acquire an asset or, with respect to a liability, the proceeds actually received when the liability was incurred.
• Fair value is 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.
• Replacement cost is the price that would be paid to acquire an asset with equivalent service potential in an orderly market transaction at the measurement date.
• Settlement amount is the amount at which an asset could be realized or a liability could be liquidated with the counterparty, other than in an active market.

Historical cost can be used to measure initial amounts only, while the other measurement attributes can be used to measure both initial amounts and remeasured amounts.

Implications for users

The proposed concepts will not directly affect the information that is reported in governmental financial reports because Concepts Statements do not set standards. Indirectly, however, the concepts guide the GASB when it is establishing standards and, therefore, will help to ensure that the standards adequately balance the need for understandable, relevant, and reliable information that is prepared consistently and comparably and presented in a timely fashion.

Fair Value Measurement and Application

Defining fair value

The notion of fair value has been used for many years in the governmental accounting environment to measure investments predominantly, as well as some other assets and liabilities. Under the Preliminary Views, fair value would 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. In the Board’s view, fair value is a market-based measurement and represents an exit price.

Implications for users.

The primary result of the new definition should be to improve the comparability and consistency of governments’ measures of fair value. It clarifies certain issues that are important to pinpointing fair value, such as the fact that it is an exit price rather than an entry price, which under certain circumstances can be very different amounts. The fair value definition also is consistent with the Financial Accounting Standards Board’s definition of fair value—one that many users are already familiar with.

Measuring fair value

The GASB’s Preliminary Views describes three acceptable “valuation approaches” for measuring fair value:

• The market approach uses information resulting from market transactions for identical or comparable assets or liabilities (for example, the stock exchange).
• The cost approach bases fair value on the amount necessary to replace an asset’s present capacity for providing service (for example, an appraisal).
• The income approach calculates fair value by converting future amounts to a single current amount. A government might project cash flows from an asset—like a royalty interest in an oil-producing property—and discount them to their present value, for example.

The GASB’s preliminary view is that the use of a variety of “valuation techniques” for establishing fair value could be acceptable, depending on the specific circumstances of the measurement, provided that:

• The valuation technique used by a government is consistent with the three valuation approaches, and
• The valuation technique is based as much as possible on “observable inputs.”

“Inputs” are the assumptions market participants make when deciding on the price for an asset or liability, such as the degree of perceived risk. Observable inputs are those that are readily accessible to the public, such as the previously mentioned stock exchange. Unobservable inputs are based on assumptions a government uses to best estimate the fair value of an asset or liability in the absence of market data.

The Preliminary Views describes a three-level hierarchy of inputs for measuring fair value:

• Level 1 inputs are quoted prices from markets with many transactions for identical assets and liabilities. When market information that qualifies as a Level 1 input is available for measuring fair value, a government would use the market valuation approach rather than the cost or income approach.
• Level 2 inputs are either directly observable, like quoted market prices but for similar assets and liabilities, or correlated or corroborated from observable market information. Level 2 inputs generally would not be used unless Level 1 inputs are not available.
• Level 3 inputs are assumptions a government develops based on the best information available to it.

Level 3 inputs would not be used unless Level 1 inputs and Level 2 inputs are unavailable.

The distinction between the three levels relates to the reliability of the measurement of an asset or liability’s fair value. Observable inputs are more reliable than unobservable inputs because it is easier to verify observable inputs.

Alternative investments. Some governmental entities hold investments for which there is not a “readily determinable fair value.” These often relate to “alternative investments,” such as shares in a hedge fund. Governments with investments in hedge funds and certain other entities that calculate “net asset value per share” would be allowed to use a practical expedient to determine the value of those investments. In other words, governments would not establish the fair value of their investment themselves but would calculate an amount based on their proportion of the fair value determined by the issuer of the investment (the hedge fund, for example).

Implications for users. The valuation techniques and hierarchy of inputs, which form the basis for determining fair value, are applicable to all investments and, thereby, promote consistency and comparability. They also are consistent with the FASB’s requirements, which are familiar to many users.

A principle concern among users when looking at fair value amounts reported in financial statements is where they came from. Certain sources of fair value, such as market data, are considered inherently more reliable by users, whereas users are more uncertain about fair value determined by governments internally using unobservable inputs. When combined with disclosure requirements that are detailed below, this proposal should have the effect of making it easier for users to assess the acceptability of fair value measures and reduce the degree of uncertainty they face.

Applying fair value

The Board’s preliminary view is that investments generally should continue to be measured at fair value. The GASB has proposed defining an investment as a security or other asset that a government holds primarily for the purpose of income or profit, the present service capacity of which is based solely on its ability to generate cash, to be sold to generate cash, or to procure services.

Exceptions to fair value. At present, several types of investments are not required to be reported at fair value. These include investments with a maturity of one year or less at the time of purchase, investments in 2a7-like external investment pools (which are a type of government-sponsored, short-term investment pool), and most investments in life insurance. Under the GASB’s preliminary view, these exemptions to applying fair value would continue.

Under the preliminary view of the GASB, certain assets currently required to be measured at fair value would be measured at acquisition value instead. These include:

• Capital assets received in a nonexchange transaction, such as capital assets received by donation
• Works of art and historical treasures received by donation
• Certain assets received in nonmonetary transactions.

While fair value is an exit price, acquisition value is an entry price—that is, the price a government would have to pay to acquire a similar asset with similar service capacity.

Transaction costs.

Currently, many defined benefit pension plans and retiree health insurance plans subtract significant related transaction costs when measuring fair value. Under the preliminary view of the GASB, transaction costs would instead be reported as expenses when incurred and not netted against the fair value of investments.

Implications for users. Under the proposed definition of an investment, some items not currently reported as investments could be considered investments going forward. Consequently, governments would have to measure their fair value going forward. Similarly, some assets currently reported as investments would no longer be reported at their fair value. However, it is not expected that the changes would be substantial.

Fair value disclosures

In order to allow users to better understand how governments calculate fair values when they are not based on observable market data, the GASB has proposed a more detailed set of disclosures than is currently required that take into account the levels of inputs a government uses to measure fair value and their characteristic degrees of uncertainty and subjectivity.

These disclosures would be organized by type or class of asset or liability. The extent of disaggregation would depend on a number of factors, including the nature, characteristics, and risks of the assets or liabilities, the level of inputs used to measure the assets or liabilities, whether other standards specifically require separate disclosure (such as derivative instruments), and the value of the assets or liabilities measured at fair value relative to all the assets or liabilities. The GASB is proposing that governments disclose:

• The fair value amounts as of the date of the financial statements and the levels of inputs used in their determination
• The valuation techniques and assumptions used
• Changes in techniques and inputs having a significant impact on the measurement of fair value and the reasons behind the changes
• Additional quantitative information that describes the nature of any significant Level 3 inputs used to measure fair value
• A narrative description of the degree to which fair value measurements are sensitive to changes in Level 3 inputs.

Importantly, the amount of disclosure is greater when Level 3 inputs are used because they are harder to verify. The proposed disclosures would give users the information needed to evaluate the measurement techniques used and the resulting fair value measurements themselves.

To reiterate, governments would be able to use a practical expedient to value certain alternative investments because these investments do not have a readily determinable fair value. Consequently, their value would be less certain and more subjective than the fair value measurements of other investments. As a result, the GASB believes additional disclosures are necessary for alternative investments. These disclosures would include the following for each type of alternative investment:

• The fair value amounts as of the date of the financial statements
• Significant investment strategies of the entities in which the government has invested
• The amount of any related commitments the government has for which it has not set aside resources
• Terms and conditions under which the government may redeem the investments
• Restrictions preventing the government from redeeming an investment that is otherwise redeemable and the expected duration of the restriction
• Other significant restrictions on the government’s ability to sell the investments.

Implications for users.

If the proposals related to fair value disclosures are ultimately reflected in final standards, the fair value information about assets and liabilities by type, class, valuation approach, and input levels would significantly enhance the depth and breadth of users’ understanding of governmental entities’ financial health. Disclosures about the assumptions made in estimating fair value, particularly for alternative investments, directly address the concerns that users have about understanding how fair value is determined.

Disclosures related to Level 3 inputs, particularly those related to more complex items, such as securitized fixed income and alternative investments, would assist users in analyzing the financial condition and activity of governments. For example, these disclosures would potentially provide a clearer understanding of the extent of an entity’s diversification among alternative investments, other inherent risk factors, and the nature and quality of the measurements involved.

How Can Users Help the GASB with These Projects?

When the GASB sets standards and establishes concepts, a critical part of its due process activities involves publishing documents for public discussion and comment. Users of financial statements are in the best position to assist the GASB in understanding whether or not the information that would result from the proposals would be important for fulfilling their informational needs. You can help the GASB by reviewing the Plain-Language Supplement prepared specifically for users of financial statements, and commenting on the questions posed throughout the supplement. You are also invited to comment on the Exposure Draft and the Preliminary Views themselves.

Copies of the Plain-Language Supplement, Exposure Draft, and Preliminary Views may be downloaded free of charge from www.gasb.org. The comment deadline for all three documents is September 30.

As previously noted, the GASB has scheduled a webcast designed specifically with financial statement users in mind for September 5, 2013, at 3:00 p.m. Eastern time. The webcast will summarize the proposals described in this document and provide an opportunity for users to ask questions. The webcast will be followed immediately by a web-based survey allowing users to offer their views. The webcast may be viewed and the survey completed on that date or on any day following through the September 30 comment deadline.

A public hearing on the Exposure Draft and Preliminary Views is scheduled for November 1, 2013, at the Sheraton LaGuardia East Hotel, 135-20 39th Avenue, Flushing, NY. The deadline for providing written notice of intent to participate in the public hearing is September 30.

Additional details on how to provide comments to the GASB and about participating in the public hearing are available in the front of the Exposure Draft and the Preliminary Views.

The objective of this project is to re-examine the definitions of a nonpublic entity and public entity in the FASB Accounting Standards Codification. The project will focus on defining what constitutes a public business entity to distinguish between different types of entities for standard-setting purposes and on determining which companies are to be excluded from the scope of the Private Company Decision-Making Framework. The project will also focus on whether a distinction or distinctions between not-for-profit entities is necessary and, if so, how that distinction or distinctions between particular types of not-for-profit entities might best be made.

The updates are available at:

http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=1176159865920#due_process

The Certified Public Finance Officers Program (Certification Program) of the Government Finance Officers Association of the United States and Canada (GFOA) is a broad educational self-study program designed to verify knowledge in the disciplines of government finance. The Certification Program is governed by the Council on Certification.

Click here for information on the Certified Public Finance Officers Program:

http://www.gfoa-cpfo.org/

Two accounting standards established to improve the consistency and comparability in reporting U.S. state and local governments’ insurance activities achieve their purpose.

That was the overall conclusion of the Post-Implementation Review (PIR) of Governmental Accounting Standards Board (GASB) Statements No. 10, Accounting and Financial Reporting for Risk Financing and Related Insurance Issues, and No. 30, Risk Financing Omnibus, an amendment of GASB Statement No. 10. The Statements establish accounting and financial reporting standards for risk financing and insurance-related activities of state and local governments, including public risk pools.

The review of Statements 10 and 30 was undertaken by an independent team of the Financial Accounting Foundation (FAF), the parent organization of the GASB and the Financial Accounting Standards Board (FASB). The team’s formal report is available at www.accountingfoundation.org.

FAF President and CEO Teresa S. Polley said: “On behalf of the FAF and the GASB, I’d like to thank the stakeholders who helped the PIR team assess the real-world application, usefulness, and effectiveness of the insurance and risk financing standards for state and local governments.”

GASB Chairman David A. Vaudt said: “The post-implementation review report on Statements 10 and 30 identified many positive aspects of the insurance and risk financing standards, including their decision-usefulness to users.

“We are considering the reported findings and will provide our initial response in the coming weeks. Additionally, the FASB is working on a project to amend its guidance for insurance activities. The GASB is actively monitoring that project and, when complete, will determine whether action by the GASB is appropriate.”

The PIR team received input from analysts and other financial statement users, as well as from preparers and auditors. Based on its research, the review team concluded that, overall, Statements 10 and 30 are accomplishing their stated purpose. In particular, their research indicates:

• Statements 10 and 30 resolve the issues underlying their need.
• Preparers and experienced practitioners are able to understand and apply the standards as intended.
• The standards have increased consistency and comparability across governments’ insurance activities.
• The resulting information is reliable and decision useful for those who use it.
• The standards did not result in significant unexpected changes to financial reporting or operating practices, nor did they have any significant unanticipated consequences.
• The implementation and continuing application costs appear to be consistent with the costs that the GASB considered and stakeholders expected, and the benefits appear to be consistent with what the GASB intended.

The PIR team for Statements 10 and 30 also concluded that the standard-setting process worked well overall and contributed to successful standards. The PIR team had no significant standard-setting process recommendations as a result of the review.

GASB Statements 10 and 30 PIR Report:

http://www.accountingfoundation.org/cs/BlobServer?blobkey=id&blobwhere=1175827510281&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs

Registration is now open for the upcoming Governmental Accounting Standards Board (GASB) webcast, IN FOCUS: Overview of GASB Proposals for Financial Statement Users. This live webcast, offered free of charge, will take place on Thursday, September 5, 2013, from 3:00 to 4:00 p.m. Eastern Daylight Time. Participants in the live broadcast will be eligible for up to 1 hour of CPE credit. (Please note that CPE credit is not available for group viewing of the live broadcast.)

The webcast will provide an overview of the GASB’s proposals on asset and liability measurement concepts and the measurement, application, and disclosure of fair value based on its plain-language due process document for users, Measurement Concepts for Assets and Liabilities and Fair Value Measurement and Application. Aimed at users of governmental financial information—for example, representatives from citizen groups (research organizations), those that participate in the lending process (bond analysts), and legislative and oversight bodies (legislative analysts)—its goal is to provide users with the background information they need to participate in the due process associated with the GASB proposals.

The areas covered will include:

• The provisions of the GASB’s proposed Concepts Statement, Measurement of Elements of Financial Statements
• The provisions of the GASB’s Preliminary Views, Fair Value Measurement and Application, and how they would affect:
• How governments measure the fair value of assets
• What assets are measured at fair value
• The fair value information disclosed in the notes to the financial statements
• How the proposals would impact the information that users receive.

At the end of the program, participants will understand the changes the GASB is proposing and their potential effect on the information that users receive in financial statements and note disclosures. They also will be asked to respond to a brief survey after the webcast that will provide the GASB feedback on its proposals. Participants will have the opportunity to email questions to the speakers during the event.

An archive of the webcast will be available on the GASB website through Wednesday, December 4, 2013. (CPE credit will not be available to those who view only the archived webcast.)

Course Description and Registration:

http://www.gasb.org/cs/ContentServer?c=Page&pagename=GASB%2FPage%2FGASBSectionPage&cid=1176158838207

November 3-6, 2013

Delray Beach Marriott | Delray Beach , FL

Early bird rates to end on October 4, 2013.

The 2013 Internal Auditors Society (IAS) Annual Conference brings together financial services audit professionals, industry experts and regulators to share insights and experiences on:

• Enhancing the value of Internal Audit to the organization
• Partnering with the second line of defense
• Regulatory updates and their impact on Internal Audit
• Auditing emerging risks and threats
• Using data mining and analytics to discern actionable information from noise

Join us November 3-6 to network with internal audit, risk and compliance colleagues, and industry regulators, to discuss the future of Internal Audit, and to learn how a strong Internal Audit function can lead to better business results.

Conference attendees will be eligible for 15 hours of CPE credit.

Register at:

https://mbrservices.net/ConferenceRegistration/MeetingRegistration.aspx?meetingid=1152

On May 6 the Senate passed S 763 – the Marketplace Fairness Act by a vote of 69-27.  The legislation would give state and local governments the option to collect taxes on remote sales, which are already owed to them under current law.  Despite the broad bipartisan approval of the measure in the Senate, the legislation has languished in the House and faces an uncertain future without significant engagement by state and local government officials and other supporters.  The GFOA is working with our state and local government coalition partners to encourage House action on the Marketplace Fairness Act, but we need your help to get the House to consider this important legislation!

What Can You Do?

GFOA’s Federal Liaison Center has developed a suite of advocacy materials to assist you in your outreach to your federal elected leaders to request their support for the House version of the Marketplace Fairness Act (HR 684).  These materials include:

Talking points to help you in your discussions with your members of Congress on the bill.

http://www.gfoa.org/downloads/GFOAMFATalkingPoints.doc

A factsheet discussing the inaccuracies of many of the arguments being used against Marketplace.

http://gfoa.org/downloads/GFOADRAFTMFAMythbusterFactsheet.pdf

A draft letter to send to your members of the House of Representatives to request their cosponsorship of the bill (HR 684).

http://gfoa.org/downloads/GFOADRAFTCosponsorMFALtr.docx

A draft thank you letter for you to send to your members of Congress if they are already a cosponsor of the bill.

http://gfoa.org/downloads/GFOADRAFTMarketplaceTYltr.docx

A draft Op-Ed for you to send to your local paper to continue to increase awareness for the need to enact this important bill.

http://gfoa.org/downloads/GFOADraftOPEDMarketplaceFairnessAct2013.docx

GFOA would like to thank everyone who attended the 2013 annual conference.

Missed some sessions from the annual conference? The session CDs are now available.

Click here to access the order form:

http://gfoa.org/downloads/GFOA2013SanFranciscoCDOrderForm.pdf

Washington, D.C., July 24, 2013-SIFMA’s Economic Advisory Roundtable today released its outlook for the second half of 2013 and predictions for 2014, forecasting that the economy will grow at a rate of 1.7 percent in full-year 2013 and 2.6 percent in 2014.

“Our Roundtable maintains their forecast for moderate economic growth for 2013 and 2014, with upside and downside drivers varied among respondents,” said Kyle Brandon, managing director and director of research at SIFMA. “Generally, the continued housing recovery and low energy prices were seen as positive drivers of growth, while external factors such as Europe and emerging markets featured as the downside risks to the economy.”

The Economy

The median forecast called for gross domestic product (GDP) to rise 1.7 percent in 2013 on a year-over-year basis, and by 2.0 percent on a fourth quarter-to-fourth quarter basis. For full year 2014, the median forecast was 2.6 percent year-over-year; on a quarterly basis, the first two quarters of 2014 were expected to stabilize at 2.7 and 2.9 percent annualized GDP growth, respectively.

Unemployment was expected to remain at elevated levels throughout 2013 and 2014. Survey respondents expected the full-year average unemployment rate to decline to 7.5 percent in 2013, a slight improvement from the end-year 2012 forecast of 7.7 percent, and a further decline to 6.9 percent expected in 2014.

Monetary Policy

Three-fourths of respondents expect the FOMC to reduce the pace of securities purchases as early as September 2013, with the remainder expecting a reduction sometime in the fourth quarter of 2013 or at the latest January 2014, an assessment noted by Chairman Ben Bernanke in his semiannual monetary report to Congress. Opinions diverged slightly more when asked about timing for the end of securities purchases, with over half expecting an end in the second quarter of 2014, slightly less than a third expecting an end in the first quarter of 2014, and the balance in the third quarter of 2014.

Impact of Sequestration and the Debt Ceiling

Sequestration, the result of budget negotiations from 2011 and 2012, came into effect on March 1, impacting approximately $85 billion of federal spending. Nearly 90 percent of respondents believed the impact of sequestration lowered GDP growth in full-year 2013 by up to 100 basis points. One respondent noted that higher taxes would be a “larger drag on economic growth in 2013 than spending cuts.”

Respondents were relatively unanimous in their opinion that debt ceiling negotiations would not impact GDP in a meaningful way in 2013, with one respondent noting that a fiscal deal was likely to be reached without a government shutdown or “excessive brinksmanship.” Another noted that the deficit was shrinking “rapidly” and that in fact the resulting increase in revenues as a percentage of GDP “could result in considerable, unexpected fiscal drag in 2014.”

The full report can be found at the following link: http://www.sifma.org/econoutlook20132h/.

Norwalk, CT, July 17, 2013—The Financial Accounting Foundation (FAF) today announced that it will conduct a Post-Implementation Review (PIR) of an accounting and financial reporting standard for state and local governments regarding the impairment of capital assets and insurance recoveries.

Issued in 2003, Governmental Accounting Standards Board (GASB) Statement No. 42, Accounting and Financial Reporting for Impairment of Capital Assets and for Insurance Recoveries, http://www.gasb.org/cs/BlobServer?blobkey=id&blobwhere=1175824062940&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs establishes measurement guidance for capital asset impairments and requires governments to report the effects of those impairments when they occur, rather than as a part of the ongoing depreciation expense for the capital asset or upon disposal of the capital asset. It also provides uniform reporting guidance for insurance recoveries of state and local governments.

Stakeholders who would like the opportunity to participate in PIR surveys on GASB Statement 42, conducted by an independent survey firm on behalf of the FAF, should register online. http://www.accountingfoundation.org/cs/ContentServer?c=Page&pagename=Foundation%2FPage%2FFAFSectionPage&cid=1176159648816

The PIR team recently completed its review of GASB Statements No. 10, Accounting and Financial Reporting for Risk Financing and Related Insurance Issues, http://www.gasb.org/cs/BlobServer?blobkey=id&blobwhere=1175824062544&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs and No. 30, Risk Financing Omnibus, http://www.gasb.org/cs/BlobServer?blobkey=id&blobwhere=1175824063444&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs which establish accounting and financial reporting standards for risk financing and insurance-related activities of state and local governments, including public risk pools. The FAF expects to issue the review report in August.

As part of a project on determining which entities qualify for alternative private company accounting rules, the Financial Accounting Standards Board on July 10 decided to propose guidance that would help define what constitutes a public business

At a meeting in Norwalk, Conn., the board unanimously supported a staff recommendation not to amend the existing definitions of a nonpublic entity in the Accounting Standards Codification (ASC). Rather, the board agreed to propose a new definition of a public business entity that would be added to the ASC master glossary for use in future guidance.

According to the staff, a business entity would be regarded as public if it has met any of the criteria established in prior board decisions for determining which entities should be excluded from the alternative rules developed for private companies. Those criteria include a requirement to file or furnish financial statements with the SEC or another regulatory agency for purposes of issuing securities.

FASB member Thomas Linsmeier supported the staff recommendation, saying that the board must gain more experience making scope decisions about the companies that FASB and its advisory group, the Private Company Council (PCC), will not be considering for potential rulemaking differences.

Linsmeier added, however, that the new definition of a public business entity that will be proposed will create some differences from the existing general definition. “We should think about the entities that will be affected by those differences — if at all possible — and try to seek them out for comment,” he said.

According to Linsmeier, FASB should make an effort to gather feedback from those entities offering unrestricted securities that would be classified as public because they must provide periodic financial reports to the public under a legal or regulatory requirement.

FASB decided that the proposed guidance on defining a public business entity would be released for a 45-day public comment period.

Elizabeth Gagnon, a FASB project manager, said that if the proposal can be released later this month, the timing of the comment period should allow for the feedback to be received before the PCC’s meeting scheduled for October.

Public pension data have become more complex as GASB, the rating agencies, and governments themselves may all be using different sets of pension numbers for different purposes. The GFOA and other leading national associations representing state and local governments, agencies, and officials have developed a one-page summary to help everyone concerned understand the differences among these numbers, the intended purpose and audience, and new resources available to lawmakers to address pension funding.

http://gfoa.org/downloads/JointFundingGuidelinesOverview.pdf

Webcasts Examine Different Aspects of FASB Proposal

Registration is now open for two live webcasts hosted by the Financial Accounting Standards Board (FASB).

IN FOCUS: The Insurance Contracts Project—Part I, Scope will take place on Tuesday, July 30, 2013, from 1:00 to 2:00 p.m. EDT. Participants in the live broadcast will be eligible for up to 1 hour of CPE credit.

IN FOCUS: The Insurance Contracts Project—Part II, The Models will take place on Thursday, August 1, from 1:00 to 3:05 p.m. EDT. Participants in the live broadcast will be eligible for up to 2.5 hours of CPE credit.

(Please note that CPE credit is not available for group viewing of the live broadcasts.)

IN FOCUS: The Insurance Contracts Project—Part I, Scope (1 CPE credit)

The first Insurance Contracts webcast will feature Hal Schroeder, FASB member; Jennifer Weiner, FASB senior practice fellow; and Lauren Alexander, FASB associate practice fellow discussing the scope of FASB’s June 27th Exposure Draft on Insurance Contracts. The proposed guidance would apply to all companies that issue insurance contracts as defined in the Exposure Draft, including those that are not insurance companies, unless those contracts are specifically excluded from the scope. The webcast will cover the following areas:

• Why the proposed guidance would apply to all companies issuing insurance contracts rather than just to insurance companies
• Contractual features that may require contracts to be accounted for using the proposed guidance
• Examples of contracts issued by noninsurance companies to which the proposed guidance would apply
• How the proposal improves existing accounting
• Next steps in the project.

Register at:

http://www.fasb.org/cs/ContentServer?c=Page&pagename=FASB%2FPage%2FSectionPage&cid=1176163088722

IN FOCUS: The Insurance Contracts Project—Part II, The Models (2.5 CPE credits)

The second Insurance Contracts webcast will feature Tom Linsmeier, FASB member; Marc Siegel, FASB member; Jennifer Weiner, FASB senior practice fellow; Christopher Irwin, FASB practice fellow; and Lauren Alexander, FASB associate practice fellow. Topics of discussion will include:

• Why the FASB has an insurance contracts project on its agenda
• When investment and service components should be disaggregated from the insurance component and accounted for using the financial instruments or revenue recognition guidance, respectively
• Determining which approach to apply: the building block approach or the premium allocation approach
• Details of the two approaches, including measurement of the insurance contracts liability/asset and the recognition of revenue and expenses
• How the proposal improves existing accounting
• Next steps in the project.

An archive of each webcast will be available on the FASB website through October 28 and October 30, respectively. (CPE credit will not be available to those who view only the archived webcast.)

Register at:

http://www.fasb.org/cs/ContentServer?c=Page&pagename=FASB%2FPage%2FSectionPage&cid=1176163088783

The Financial Accounting Standards Board (FASB) has published a new Accounting Standards Update that defers indefinitely certain disclosures about investments held by nonpublic employee benefit plans in their plan sponsors’ own nonpublic equity securities. The Update, which was approved on June 12, is available to download at no cost on the FASB website.

Accounting Standards Update No. 2013-09, Fair Value Measurement (Topic 820): Deferral of the Effective Date of Certain Disclosures for Nonpublic Employee Benefit Plans in Update No. 2011-04, applies to disclosures of certain quantitative information about the significant unobservable inputs used in Level 3 fair value measurement for investments held by certain employee benefit plans.

The deferral applies specifically to employee benefit plans—other than those plans that are subject to Securities and Exchange Commission filing requirements—that hold investments in their plan sponsors’ own nonpublic entity equity securities, including equity securities of their nonpublic affiliated entities.

“The Update addresses private company stakeholder concerns that certain disclosure requirements would potentially provide proprietary information when their employee benefit plans’ financial statements are posted on the plan regulator’s website,” said FASB Chairman Russell G. Golden.

The deferral is effective immediately for all financial statements that have not yet been issued.

The full Update is available at:

http://www.fasb.org/cs/ContentServer?c=Page&pagename=FASB%2FPage%2FSectionPage&cid=1176156316498

Norwalk, CT, July 2, 2013—The Governmental Accounting Standards Board (GASB) today issued for public comment a proposed Statement regarding the transition provisions of GASB’s new pension standards for state and local governments. The proposal would eliminate a potential source of understatement of restated beginning net position and expense in a government’s first year of implementing GASB Statement No. 68, Accounting and Financial Reporting for Pensions.

To correct this potential understatement, the proposed Statement would require a state or local government, when transitioning to the new pension standards, to recognize a beginning deferred outflow of resources for its pension contributions made during the time between the measurement date of the beginning net pension liability and the beginning of the initial fiscal year of implementation. This amount would be recognized regardless of whether it is practical to determine the beginning amounts of all other deferred outflows of resources and deferred inflows of resources related to pensions.

The provisions would be effective simultaneously with the provisions of Statement 68, which is required to be to be applied in fiscal years beginning after June 15, 2014.

The Exposure Draft is available on the GASB website, www.gasb.org. Stakeholders are encouraged to review the proposal and provide comment by August 26, 2013.

Read the Exposure Draft at:

http://www.gasb.org/cs/BlobServer?blobkey=id&blobwhere=1175827275726&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs

At its recent meeting in San Francisco, the GFOA Executive Board approved a new best practice, titled Reviewing, Understanding and Using the Actuarial Valuation Report and Its Role in Plan Funding. This new best practice, forwarded by the Committee on Retirement and Benefits Administration, recommends that state and local government finance officials and others with decision-making authority carefully review and understand their actuarial valuation report and use the information it contains to make policy decisions that ensure that pension benefits are funded in a sustainable manner.

http://www.gfoa.org/downloads/GFOABestPracticeonActuarialValuationReports.pdf

Norwalk, CT, June 27, 2013—The Governmental Accounting Standards Board (GASB) today published an Implementation Guide for the new GASB standards regarding financial reporting for state and local government pension plans. The Guide to Implementation of GASB Statement 67 on Financial Reporting for Pension Plans is an authoritative resource designed to assist preparers and auditors of state and local government pension plan financial reports as they prepare to implement the standards, which are effective for periods beginning after June 15, 2013.

Prepared by the GASB staff, the Implementation Guide answers key questions about putting the new standards into practice. Topics addressed in the Guide include:

• The scope and applicability of GASB Statement No. 67, Financial Reporting for Pension Plans
• The classification of pensions as defined benefit or defined contribution
• The determination of the number of pension plans that should be reported
• The recognition of certain transactions and other events in defined benefit pension plan financial statements
• Note disclosures and required supplementary information
• The calculation of the net pension liability

“During the development and after the issuance of Statement 67, users, preparers, and auditors of pension plan financial reports posed questions to the GASB staff regarding the application of the standards,” said GASB Chairman Robert H. Attmore. “This Implementation Guide is written in a question and answer format and provides illustrative examples to assist stakeholders when applying the new standards for pension plan reporting.”

Mr. Attmore continued, “We are also pleased to announce that a digital version of the Guide will be the first guide to be offered on the GASB website as a download at no cost. Furthermore, all subsequent guides will be available on the GASB website at no cost moving forward.”

A hard copy bound edition of the Guide can be ordered for $46.50 plus shipping by visiting the GASB store, or by calling the GASB Order Department at (800) 748-0659.

An additional implementation guide for GASB Statement No. 68, Accounting and Financial Reporting for Pensions, will be available in early 2014. The provisions in Statement 68 are effective for periods beginning after June 15, 2014.

The Implementation Guide is available at:

http://www.gasb.org/cs/ContentServer?c=Page&pagename=GASB%2FPage%2FGASBSectionPage&cid=1176163026371