Jim Spiotto

“Only 62 cities, towns, villages and counties have filed Chapter 9 since 1954. And they’ve been small ones, except for Bridgeport, Connecticut, in 1991, Orange County in 1994, Vallejo in 2008, Harrisburg last year but they got dismissed, Boise last year and then Jefferson County. Then Stockton and San Bernardino this year. They don’t want to give up the right to fund infrastructure locally and borrow money locally at a low cost. And if you file Chapter 9, access is either going to be limited or you’re not going to have it. That’s why I’m not surprised there have only been three. They’re for the most part only small municipalities. Big cities have to work with the state to try to find a solution. If they go into bankruptcy, the stigma of that could be fatal to them.” ~ Jim Spiotto, Chapman & Cutler

Spiotto II: What’s the most common misconception people have about Chapter 9 bankruptcy? A: “People don’t realize until they get in it how complicated, time-consuming, and uncertain it is, and it costs money. Vallejo spent more than $10 million in attorney fees. That’s $10 million you could have paid to creditors. It’s there as a last resort. It will get you results, but you probably won’t like it. It’ll probably take longer than you thought, and it’ll probably be far less efficient than you thought. But you will get there. In other countries, states and municipalities just kind of melt away.” 

 

Missed Connections

Monticello, Minnesota (not Virginia) is facing a potential default of the bonds it issued for its broadband network (The subject was put to referendum in 2007 and it passed with a 74% majority in favor of the system.) -- a system once envisioned as a potential model for other local governments to follow, but it’s system that today is failing to generate enough revenues to service $26.4 million of tax-exempt revenue bonds issued in 2008, and it is challenged by stiff competition from private competitors that lowered their prices to keep customers. With the system’s revenues falling short, the trustee has been drawing from various bond reserves to cover debt service payments. Between July 2011 and June 2012, the city, which issued the bonds and owns the system, covered debt service by loaning the project money generated by its liquor sales operations. Under no obligation to make up the shortfalls, Monticello, located just north of the Twin Cities, informed the trustee of its intention to halt that practice in June as it sought out a restructuring. Without any agreement between bondholders and the city on a restructuring, and with the city in default on bond terms for failing to raise rates to a level sufficient to cover debt service, trustee Wells Fargo Bank NA last month obtained a court order allowing it to not make a payment last Saturday for $883,000: the trustee is preserving existing reserves to cover various expenses which could include a potential legal battle with the city. The city’s decision to stop supplementing debt service prompted the trustee’s decision to undertake a trust instruction proceeding in Hennepin County District Probate Court. Proceeds of the bond were used to finance the city’s costs of acquiring and construction a fiber optics broadband communications network to provide cable television, internet access, and telephone services to businesses and residents; but the system entered July with just one-third the number of customers projected in the bond offering documents. The system was mostly complete as of March, providing more than 1,000 voice lines, 1,000 video connections, and nearly 1,400 internet connections. While the city is not under obligation to repay the bonds from any source other than the system’s revenue, the indenture does require it to establish rates and charges from its users to cover debt repayment. City financial reports note that the city failed to comply with that provision for the fiscal year ending Dec. 31, 2011. Such a move would likely cause more customers to turn to the competition. The reports showed the system’s expenses exceeded revenues by more than $2.6 million in fiscal 2011. Monticello reported in its own notices posted on EMMA earlier this year that it was “actively undertaking all reasonable actions and exploring all available options to make the system” financially successful while continuing to provide high quality services to its customers. Monticello is exploring strategic options with the goal of reducing costs, improving revenues, restructuring or refinancing debt.

Waiting for 60 Minutes to Own Up

It is just about two years since the infamous Meredith Whitney’s 60 Minutes declaration that we “could see fifty to a hundred sizable (municipal) defaults” that would result in billions of dollars’ in losses for municipal bond holders. Neither 60 Minutes nor Ms. Whitman have apologized, and now Ms. Whitman apparently wants to double down. Trying to profit again on the backs of state and local leaders, she has a new book, Downgraded, scheduled for publication this spring. Ms. Whitney, whose, Joe Mysak notes, “prognostications about local leaders and governments have bordered on the outrageous, despite the egregious sums she has charged,” is now expanding her efforts for profit, having told attendees of a Grant’s Interest Rate Observer conference last April (“The Municipal Finance Crisis – Just Wait,” and subtitled, “The bifurcation of states will dictate contraction and expansion of regional economies over the next two decades,” that by her calculations, the Coasts, especially California and New York, lose. The Dakotas, Kansas, Nebraska, Iowa, Oklahoma, and Texas will win. Mr. Mysak, a long-time, tell-it-as-it-is, astute observer, does not buy either theory of the wealthy “the sky is falling” author: “I don’t buy it, for two reasons. On the one hand, the conclusion that a “crisis’’ is either at hand (Forbes) or in the cards (Ms. Whitney) presumes that state and local officials are feckless, and won’t or can’t change course when faced with challenging situations. The only thing these officials can do, according to what might be termed the demographic determinists, is to raise taxes and, at some point, cut services to the bare-bones level and so make their locales unappealing and so spur more people to move out….I think that with some of the more hysterical headliners who choose to write about this asset class, you have to say not, ‘That hasn’t happened,’ but ‘That doesn’t happen.’ The municipal market isn’t a movie. There’s no climax car chase and big explosion at the end. What happens is that things muddle along.” What you won’t hear from Ms. Whitney or 60 Minutes: Adding in yields, the total return for the iShares Muni ETF is more than 25% over that that past two years, compared to 12% for the Vanguard Total Bond market ETF. Given the depth of the Great Recession, and the near bankruptcy of the federal government, it is a remarkable testament to how extraordinary sta5te and local leaders have managed—especially compared to Ms. Whitman’s predictions.

Wolverine Blues

Meanwhile Michigan Governor Rick Snyder and key members of the legislature intend to introduce legislation today under which financially distressed Michigan cities and school districts could choose between mediation with creditors, bankruptcy or a state-appointed emergency manager—legislation intended to replace last year’s local fiscal distress law (Public Act 4) repealed by Michigan voters last month. Five cities and three school districts in Michigan currently operate with emergency managers under a prior 1990 law, which would be replaced by the new measure. Gov. Snyder fears the repeal of Public Act 4 left the state without enough ability to rescue cities and schools (and the federal government…) from insolvency. The new financial rescue proposal would retain the state’s power to declare financial emergencies in cities and school districts, but would also give local governments the options to reach a consent agreement with the state, similar to one Detroit has: mediation, an emergency manager, or a Chapter 9 federal bankruptcy filing. Under current Michigan law, the state must approve a bankruptcy request. The proposed new law would tie a Chapter 9 filing to a full state review of city or school district finances. While the new bill would reinstate broad powers for emergency managers, local officials would have authority to approve certain decisions made by the managers, or develop alternate solutions that produce equal savings. The proposal would also permit local officials to ask the governor to remove emergency managers after a year, or dismiss them with a two-thirds vote of the governing body, such as a city council.

Detroit

Running Low on Fuel in Motor City
Motor City emergency manager, the top official in Detroit Mayor Dave Bing’s administration, told the City Council this week that getting Michigan to release bond funds is the only way to make it through the city’s latest cash crisis: “We have to take strong action to right our own house so the only lender we have available to us — the state — is comfortable in release of the bond proceeds,” said program manager William “Kriss” Andrews, who oversees the consent agreement Detroit inked with Michigan earlier this year to avoid an emergency manager; “We’re all capable of running it better than this, and the sooner we get help the sooner we get it fixed,” he added. The meeting came with the council to discuss Detroit’s precarious fiscal position and the steps needed to make it through the end of the calendar and fiscal years. In addition to approving measures required by Michigan to win bond proceeds from a state-controlled escrow account, the council also needs to approve a budget amendment that will allow the city to file its annual audit by the end of the year to secure the latest installment of state revenue aid. The council will meet Wednesday to vote on the budget amendment, which features a payment plan to address a $29 million shortfall in the city’s annual pension contribution. The 2012 budget apparently did not include the payment, and the city has scrambled over the last two weeks to cobble together a plan with Detroit’s enterprise agencies, including the water, sewer and transportation departments, to make the payment to avoid a hit to the general fund, finance director Cheryl Johnson told the council. The pension payment will allow the city to complete its 2012 Comprehensive Annual Financial Report on time. A timely CAFR filing is needed to win release of the latest installment of state revenue aid. Meanwhile, Bing is expected to meet with the council Dec. 11 for another special session that could include a new vote on a controversial contract hiring of public finance firm Miller, Canfield, Paddock and Stone PLC as special counsel to oversee the consent agreement. The contract is one of three so-called milestones Michigan is requiring to release $30 million of bond proceeds from a bond transaction last August. Without approval, the state has said it will not release the funds on Dec. 20 as scheduled. The council already rejected the three-year contract, but Bing has asked for a new vote. Even if Detroit wins release of the $30 million, a shortfall remains. The most recent fiscal forecast, released last month, projected a $47 million shortfall by next July without new revenue sources. The city’s only option is to continue to meet the state’s requirements for releasing more bond proceeds, Andrews told council members. Mr. Andrews noted: “The cash hole is deeper than any of us would prefer,” Andrews said. “We’re going to have a little greater difficulty in pulling in all of the bond proceeds beyond that $30 million. The only thing we can do is exercise the maximum self-help so our lender, the state, is confident we’re acting appropriately and responsibly, and will release more rather than fewer of the proceeds. I see that as the only avenue to get through this.”

Motor City II
Michigan State Treasurer Andy Dillon met with Detroit elected officials to discuss an expected fresh review of Detroit’s finances, the possible appointment of an emergency financial manager, and the role Detroit Mayor Dave Bing and other elected officials would play, according to local reports. Marshall Dillon reportedly said the city must implement a series of immediate changes to avoid the appointment of such a manager. A state spokesman said a new review, which could take up to 30 days, would likely begin next week. That could lead to the appointment of an emergency financial manager, who could ask the governor to approve a Chapter 9 bankruptcy filing. Mayor Bing was set to meet with the council next week to urge passage of a measure hiring Miller Canfield Paddock and Stone PLC as the city’s legal counsel for the consent agreement. The contract is one of several requirements from the state before it will release bond proceeds.

Rhode Island Pensionary Red

As the Ocean State heads to court this morning to defend its landmark pension overhaul law against a challenge from public sector unions, it’s not clear the state will sport a united front. Gov. Lincoln Chafee this week expressed his view that the state should explore “reasonable settlement options,” while Treasurer Gina Raimondo wishes to remain steadfast: “We should litigate that case forcefully. The law is on our side and we have a very good case.” The kerfuffle is over the legal challenge to the Rhode Island Retirement Security Act of 2011, which Gov. Chafee signed into law a year ago last month, new law that created a hybrid plan merging conventional public defined-benefit pension plans with 401(k)-style plans. It also included a suspension of cost-of-living adjustment increases for retirees and raises the retirement age for employees not yet eligible for retirement. The new law was guesstimated to cut Rhode Island’s $7 billion unfunded pension liability by roughly $3 billion over 20 years—and the state’s hard-pressed cities and towns $1 billion over the next two decades. Five public-sector unions are challenging the law in the Rhode Island Superior Court.

Innovative Distress Study

In response to the number of municipal bankruptcies and ongoing local fiscal distress in the Golden State, the California treasurer’s office has embarked on a project aimed at predicting municipalities’ likelihood of default. Treasurer Bill Lockyer has hired San Francisco-based research organization Public Sector Credit Solutions and San Jose State University economist Matthew Holian to head up the effort, which aims to create a “default probability model for city bonds” by means of a model which will generate “numeric scores” that will seek to quantify the likelihood of defaults, with the projected model and default predictions for more than 200 California cities expected to be ready by next May. The Treasurer hopes the project will help give the state an early warning of local governments in financial distress and help “raise red flags” at the state level. The effort is also intended to help make the financial conditions of municipalities more transparent to investors and the public. Subsequently, in an effort comparable to the focus underway at George Mason University at our Center for State and Local Leadership, California will work to create a “response system” to help assist troubled municipalities. The California effort will test the tensions between the state and its cities—the state constitution largely prohibits the state from meddling in cities’ financial affairs, and the effort appears to be outside of any partnership with the California League of Cities. The calculation for each city will be based on financial data found in the city’s financial statements, budgets, and projections—with the key data focused upon being interest expense, revenue, and annual change in revenue. 

Pensionary Potential Pitfalls

If the California Public Employees’ Retirement System prevails in having courts define San Bernardino’s obligations to the pension fund as immutable in the city’s bankruptcy case, it could have widespread ramifications including sweeping bond downgrades, according to Matt Fabian, managing director of Municipal Market Advisors (MMA): “With recent rating agency actions taking a dimmer view on California general fund obligations generally, we suspect success by Calpers would trigger sweeping downgrades across the state…We also assume a strong pullback by lenders, perhaps exceeding the rating impact, implying steep funding costs for issuers attempting to sell new lease debt.” If CalPERS succeeds, lease-backed debt such as certificates of participation may be untenable, the report said. Protections afforded pension funds in the California state constitution have also hampered efforts by the state and cities to reform the benefits of current employees. MMA estimates California local governments have about $33 billion in outstanding COPs, plus more unsecured, general fund backstopped debt, noting: “If pension obligations cannot be adjusted—even in bankruptcy—this debt will be effectively subordinated to a permanently-extendable obligation to Calpers.”

San Bernardino

The California city’s road to federal bankruptcy protection is now confronted by a major state obstacle from the city’s largest creditor, the California Public Employees’ Retirement System or Calpers. The city, which filed its plan in U.S. Bankruptcy Court last Friday, outlining how the city will conduct its finances while it works its way through the bankruptcy process, also filed documents responding to objections to its eligibility for bankruptcy from Calpers and a city employees union, with the city arguing that the city union and Calpers objections are without merit and were filed “despite ample and compelling evidence of the city’s eligibility for Chapter 9 relief.” Calpers had filed its motion the day after the city council voted to approve its request for Chapter 9 protection and requesting relief from an automatic stay that prevents it from suing the city in state court over $6.9 million in missed payments. Calpers asserts that a federal bankruptcy court does not have the jurisdiction under Chapter 9 bankruptcy code to order the city to pay its bills, but the state court does: “This legal action would allow us to collect the employer contributions from San Bernardino which are required by state law, to maintain the integrity of the San Bernardino pension plan for its public employees and retirees,” CalPERS chief executive officer, Anne Stausboll, said in a statement. San Bernardino’s pendency plan would defer $12.9 million in Calpers payments until fiscal 2013-14 to help close the insolvent city’s $48.5 million budget gap. The plan also mentions negotiations with Calpers’ actuarial staff to reamortize its pension fund liability over the next 30 years for a fresh start for a $1.3 million savings per year. San Bernardino, however, plans to make some payments to Calpers in fiscal 2012-13 and is working to negotiate repayment with the pension fund, according to court documents filed by the city.

Catch-22. In the Chapter 9 case involving Stockton, insurance companies filed motions against the city as it remained current on its Calpers payments while defaulting on its bonds, but San Bernardino is saying in its pendency plan that it does not have sufficient resources to fund the bankruptcy case and cover expenses that protect the public health, safety and welfare of its citizens (e.g. essential services). The guru of municipal bankruptcy, in response to a question from Bloomberg this week aptly replied:

“You can impair contract obligations where it’s necessary for a higher public good. That’s why you can condemn property. The higher public good is that we’re not going to forfeit essential public services to pay for pensions that are not affordable. That’s part of the legal basis. You could set up a quasi-judicial body that makes fact determinations. Both the city and the state and the unions could present their sides and they’ll make the determination.”

San Bernardino submits its spending plan this a.m. The City believes its plan will resolve the chief complaint of the California Public Employees’ Retirement System, according to its papers filed in U.S. Bankruptcy Court. Calpers is seeking to sue San Bernardino over missed pension payments as well as asking U.S. Bankruptcy Judge Meredith A. Jury (really) to dismiss the city’s Chapter 9 petition. Should Judge Jury grant either request, Calpers would be free to sue San Bernardino in state court to seize property or find some other way to collect the debt the pension fund is owed. Calpers spokesman Brad Pacheco said he couldn’t immediately respond to a request for comment on the filing. In August, San Bernardino became the third California city to file bankruptcy in less than three months.