Kurtter, robert

Global Interdependence Center Focus on American Cities

Robert Kurtter, Managing Director US Public Finance Hamilton, Bermuda

October 11, 2013

State Update 2013

Global Interdependence Center, October 11, 2013

2

Distribution of State G.O. & Issuer Ratings

State Ratings 16

15

15

14

12

12

» 40 stable outlooks » 6 negative outlooks

10

» 2 positive outlooks

8 6

3

4 2

1

1

1

A1

A3

Baa3*

0 Aaa

Aa1

Aa2

Aa3

* Puerto Rico

Global Interdependence Center, October 11, 2013

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Distribution of State G.O. & Issuer Ratings

Global Interdependence Center, October 11, 2013

4

State Sector Outlook Revised to Stable

Rationale for stable outlook includes: Continued economic stability

» –

Federal cuts are more predictable and measurable; less likely to undermine economy

Aggregate revenue growth continues, faster than expected and surpassing prerecession levels in 4th quarter 2012

» –

Personal Income Tax leads growth, may be one-time

–

State revenues are highly economically sensitive

»

Highly rated states rebuilding reserves to levels consistent with long-term median

»

Areas of caution remain and some states will continue to see credit pressure –

Employment levels still weak

–

Federal deficit reduction

–

Pensions squeeze budgets

Global Interdependence Center, October 11, 2013

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Rating Actions Reflect Improved Stability 2013

2012 »

»

Downgrades – 4: ˗

Connecticut to Aa3

˗ ˗

Illinois to A2 Pennsylvania to Aa2

˗

Puerto Rico to Baa3

»

˗

»

Negative Outlooks Assigned – 3: ˗ Illinois, Maine, Washington

»

Positive Outlooks Assigned – None

»

US government rating outlook negative

Downgrades - 1:

»

Stable Outlooks Assigned – 6: ˗

Minnesota, Washington

˗

Maryland, Missouri, New Mexico, Virginia

Positive Outlooks Assigned – 2: ˗ ˗

»

Illinois to A3

Michigan New York

US government rating outlook revised to stable

Global Interdependence Center, October 11, 2013

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Key Economic Indicators Have Stabilized Total

YOY % Change in Monthly Employment

6.00%

Private

Government

4.00% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Source: US Bureau of Labor Statistics

»

Payroll employment increased by 169,000 in August and 7.3% unemployment rate is lowest since 2008

»

Residential construction permits up 26% since July 2012 (Moody s Analytics); existing home sales up 13.2% since August 2012 (National Association of Realtors)

»

Consumer confidence rising despite federal tax increases –

Vehicle sales, a key indicator of consumer confidence, increased to almost 16 million annually in June 2013, near the pre-recession long-term trend

Global Interdependence Center, October 11, 2013

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Quarterly Tax Revenues Surpass Peak Year-Over-Year Quarterly Percentage Change in State Tax Revenue

30 20 10 0 2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

-10 -20 -30

Source: Rockefeller Institute of Government Total Tax Collections

Personal Income Tax

Sales Tax

»

In the first quarter of 2013, state tax revenues exceeded the same quarter in 2008 by 4.4% when adjusted for inflation, according to Rockefeller Institute

»

Early in 2013, states’ estimates for total tax revenues increased 1.5% over earlier predictions, and 40 states reported that collections would meet or exceed budget (NASBO)

»

Anticipation of tax law changes in 2013 led to one-time revenues in the fourth quarter of 2012 Global Interdependence Center, October 11, 2013

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Slow but Steady Reserve Replenishment GAAP Reserves Reach 10-Yr Median 20.0 10.0 0.0 -10.0 -20.0 -30.0 -40.0 2003

2004

2005 Aaa

2006

2007 Aa

2008 A

2009

2010

2011

2012

10-Yr Median

Source: Moody’s Investors Service; State CAFRs

»

States have worked to balance budgets through tight budgeting and fiscal restraint

»

Median estimated FY13 budget reserves increased to 2.6% of expenditures from 1.3% in 2010, but remains below the 8.3% fiscal 2008 median (NASBO)

»

However, reserves close to10-year median of 4.5% of revenues, GAAP basis

»

Seven states report that budgetary reserves will be below 1%, down from 12 in 2010 (NASBO) Global Interdependence Center, October 11, 2013

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Local Governments

Global Interdependence Center, October 11, 2013

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US Local Government Outlook Remains Negative »

Despite overall economic rebound, local government credit remains strained

»

Local governments benefit less directly from factors driving state credit conditions

»

Although housing markets in some regions are rebounding, gains have not resulted in property tax revenue growth yet

»

Fixed costs remain high and are increasing

»

Downgrades continue to outpace upgrades at relatively high levels Rate of Downgrades in 2013 Remains Consistent with 2012 400

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

350 300 250 200 150 100 50 0

1Q07

3Q07

1Q08

3Q08

Upgrades

1Q09

3Q09

Downgrades

1Q10

3Q10

1Q11

3Q11

1Q12

3Q12

1Q13

Downgrades as % of Ratings Revisions

Source: Moody’s Investors Service

Global Interdependence Center, October 11, 2013

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Pace of Economic Recovery Varies Widely by Region »

West and South leading in recovery, although gap may be closing somewhat

»

Unemployment rates are converging among the regions, although disparities remain within regions

»

Home price gains concentrated in areas with most declines during downturn

Housing Market Growth Strongest in West Top Metro-Area Increases in Case-Shiller Home Price Index, % annual change, June 2013 20-metro composite Portland Seattle Miami Detroit Atlanta San Diego Phoenix Los Angeles San Francisco Las Vegas 0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

Source: Standard & Poor’s Case-Shiller

Global Interdependence Center, October 11, 2013

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Top Local Government Revenues are Still Constrained Local Government Revenues by Source

Property Taxes 29%

State Aid 34%

Sales Taxes, Income Taxes, Other Taxes 10%

Charges for Service 16%

Federal Aid 4%

Miscellaneous 7%

Source: US Census Bureau

Global Interdependence Center, October 11, 2013

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Top Local Government Revenues are Still Constrained »

Sales and income taxes are recovering, but comprise a relatively small portion of the sector’s overall operating revenue base

»

In many states, aid to local governments remains below pre-recession levels »

»

e.g., Kansas, California, Michigan

The housing market recovery will have a delayed and/or limited impact on property tax revenues for many local governments Property Taxes

Sales Taxes

Income Taxes

35% 30%

29%

25% 20% 15% 10% 7%

5%

1%

0% -­‐5%

1Q 2 010 2Q 2 010 3Q 2 010 4Q 2 010 1Q 2 011 2Q 2 011 3Q 2 011 4Q 2 011 1Q 2 012 2Q 2 012 3Q 2 012 4Q 2 012 1Q 2 013 Source: US Census Bureau

(4 Q uarters Ending)

Global Interdependence Center, October 11, 2013

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Local Governments Have Made Difficult Decisions, More to Come »

Local governments have made deep cuts, mainly by reducing staff sizes and freezing salaries and wages

»

Fixed costs continue to rise steeply, outpacing revenue growth

»

Some local government management teams find it difficult to identify new areas of cost containment without adversely impacting services Pace of Local Government Job Cuts is Slowing Annual Change in Average Local Government Employment

5.0% 4.0% 3.0% 2.0%

United States

1.0%

New York MSA

0.0%

Los Angeles MSA Dallas MSA

-1.0%

Chicago MSA

-2.0% -3.0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013*

*Forecast

Source: US Bureau of Labor Statistics, Moody’s Analytics

Global Interdependence Center, October 11, 2013

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Speculative Grade GO Ratings Continue to Grow »

Indicates level of distress within the local government sectors

»

Still a small number relative to total rated universe (37)

»

State oversight of local governments integral to management of distress General Obligation Non-Investment Grade Ratings Growth

30

25

20

15

10

5

0

Ba Source: Moody’s Investors Service

B 2011

2012

Caa 2013

Global Interdependence Center, October 11, 2013

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Despite Pressures, Most Local Governments are Highly Rated and Will Likely Remain So 35%

30%

25%

20%

15%

10%

5%

0% Aaa

Aa1

Aa2

Aa3

A1

A2 City

County

A3

Baa1

Baa2

Baa3

Ba1

Ba2

Ba3

School District

Global Interdependence Center, October 11, 2013

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Municipal Bankruptcy & Default

Global Interdependence Center, October 11, 2013

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Implications of Recent Municipal Bankruptcies and Defaults »

Default and bankruptcy are not the same

»

Bankruptcy treatment is an explicit part of credit evaluation for distressed credits

»

Some severely distressed local governments may be facing “service insolvency”

»

Revenue bondholders not necessarily in much stronger position than distressed GO

»

Ranking of pension vs. debt obligations to be tested in CA and MI cases

»

Recent default recoveries are lower than in the past

Global Interdependence Center, October 11, 2013

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‘Service Insolvency’ Heightens Risk to Bondholders » Costs of funding health and public safety starts to compete fiercely with debt service – Detroit, Stockton and San Bernardino cited “service insolvency” as rationale for bankruptcy filings – San Jose and Chicago have alluded to insolvency as leverage in bargaining

» Corporate, project finance and health care entities in distress undergo ‘straight-line’ decline – Cash, reserves, and revenues dwindle until sale or merger, or closure; bondholders divide remaining assets

» General governments may decline until ‘service insolvency’ diverts all resources to operations – Bondholders may be put on hold until crisis is resolved

Global Interdependence Center, October 11, 2013

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Debt Obligations vs. Pension Obligations to be Tested » Priority of claim for bonds versus pensions is not clear – Security for pensions and ranking vs. other obligations is generally untested by courts – Priority outlined in bond documents or state statute may not necessarily hold up in Chapter 9 bankruptcy

» Treatment of debt versus pensions may prove to be most significant and far-reaching result of the Detroit and California bankruptcies – Only in Rhode Island, so far, does debt come before pensions in a stressed situation – California distressed cities assert that pension are paid ahead of debt – In Detroit EM’s plan, tax-supported debt is treated on parity with unfunded pensions (up-sized to reflect more conservative assumptions) and OPEBs

» Depending on Detroit outcome, additional stressed local governments may turn to bankruptcy as a tool to reduce or restructure their debt and pension obligations

.

Global Interdependence Center, October 11, 2013

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Recoveries for Recent Government Defaults are Lower » Local government recoveries have historically been high - 80% vs. 50% for corporate recoveries » Prior to recession, most local government defaults reflected liquidity problems that interrupted debt service but were fully recovered – e.g. Orange County, Polk County, Baldwin County had 100% recovery

» Recent defaults have resulted from insolvency and may result in lower recoveries – Detroit, Stockton, Harrisburg, Jefferson County – In insolvency scenario, assets diminish while services must continue to be provided

» Treatment of bondholders in bankruptcy or default is uncertain – Central Falls paid bonds, cut pensions; Vallejo paid pensions, haircut debt – Detroit’s proposal to creditors treats GO bonds as “unsecured” next to pensions and OPEBs

» Bondholders may accept losses to avoid a protracted legal battle

Global Interdependence Center, October 11, 2013

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Appendix

Global Interdependence Center, October 11, 2013

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Illinois: State Faces Daunting Pension Challenges »

Illinois has been downgraded five times in the past four years, largely because of state’s failure to address unfunded pension and backlog of unpaid bills

»

Its current GO rating (A3/ negative) is well below the Aa1 average for US states and two notches below the next lowest-rated state, California

»

Rationale for downgrades of related credits is explained in recent special comment (“Illinois-Linked Credits Capped at State GO Rating”)

»

General Assembly (state legislature) has repeatedly failed to reach consensus on pension reforms, but may do so in time for “veto session” starting October 22

»

–

Legislative leaders seeking accord on reforms that will be both meaningful and able to survive litigation

–

Implementation of a credible, comprehensive pension funding program would improve the state’s credit quality

–

Current rating and outlook assume inability to enact substantial reforms

Other challenges include impending expiration of 2011 tax increases –

Revenue loss from tax phase-out (starting in 2015) appears likely to exacerbate backlog of unpaid bills

Global Interdependence Center, October 11, 2013

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Commonwealth of Puerto Rico (Baa3 Negative) What are we watching?

What are we seeing/ expecting?

Private sector employment and other trends

Private sector job loss in 2013 of 2-3%; continued decline in pharmaceutical operations; continued population decline

Prospects for widening structural budget gap and greater need for deficit financing

Possible decline in base revenues (vs. modest growth in budget) and likely shortfalls against new tax estimates, which will widen deficit financing need from budgeted $820 million

GDB net liquidity position (net of restricted funds and short term external debt of GDB, Commonwealth, and Authorities)

Pension Liabilities

GDB net liquidity position of $1.5 billion (unaudited 6/30) looks sufficient to cover 1 additional year of moderate stress-case budget deficit - without new market access and before any new loans to authorities & municipalities

TRS Reforms

Global Interdependence Center, October 11, 2013

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Puerto Rico’s Bond Spread Over BBB Rated Bonds »

PR 30y GO v. BBB 30y GO Spread 700

40,000

35,000

600

JulyEAI released 30,000

500

400 Basis Points

Detroit Bankruptcy Filing

Negative PR Mainstream Press

300

20,000

15,000

in Millions

25,000

Sharp increase in PR spreads versus the rest of the municipal market and a pivot to short term cash flow borrowing by the commonwealth to wait out volatility ˗ $1-1.2 billion of GO TRANS expected by end of 2013 ˗ $400 million of PRHTA BANS - paid off $400 million of $2.2 billion in GDB LOCs ˗ Cost of funds relatively unchanged, but refinancing risks increased

200 10,000

100

5,000

0

0 6/3

6/10

6/17

6/24

7/1

7/8

7/15

BBB Spread (left)

7/22

7/29

PR Spread (left)

8/5

8/12

8/19

8/26

9/2

9/9

Volume (right)

Global Interdependence Center, October 11, 2013

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Pension Obligations

Global Interdependence Center, October 11, 2013

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Bond index discount rate provides a balance sheet measure of pension liability » Our approach is similar to private sector standard set by FASB » Discounts the promised benefit payments using current market interest rate – Treats pension benefits as bond-like obligations – Liabilities are measured independently of asset mix or performance – Liabilities of identical pension plans (government, hospital, or manufacturer) measured on the same day should be identical

» Contrasts with public sector approach focused on funding – Discounts using assumed investment rate of return based on asset mix – Estimates the PV of employer contributions, if assumptions are met – Market risk in this approach increases as the return assumption increases

Global Interdependence Center, October 11, 2013

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States’ Adjusted Net Pension Liabilities Vary Widely Nine states had 2011 ratio of ANPL to revenues exceeding 100% A3 to A1

Aa3 to Aa1

Aaa

unrated/no GO debt

18 16

Number of States

14 12 10 8 6 4 2 0 <25%

25-50%

50-100%

100-200%

200-300%

ANPL/Revenue grouped by range

Source: Audited financial reports for states and various pension plans and Moodyâ&#x20AC;&#x2122;s calculations Ratings include state general obligation ratings and issuer ratings

Global Interdependence Center, October 11, 2013

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30 Out of 50 Largest Local Governments Had Moodyâ&#x20AC;&#x2122;s ANPL Greater than 100% of Revenues in Fiscal 2011

Number of "Top 50" Local Governments

25

20

15 Speculative A 10

Aa Aaa

5

0 < 0.5x

0.5x - 1.0x

1.0x - 3.0x

3.0x - 5.0x

> 5.0x

ANPL / Revenue Grouped by Range

Global Interdependence Center, October 11, 2013

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Pace of legislative reforms is a positive factor » Unprecedented pace of reform activity, with legislation passed in most states in recent years – Expect to continue, with some passing second or third rounds (as in VA)

» Most reforms geared toward new employees and/or existing employees on a going-forward basis (e.g. IL, CA, FL, NY) – Reduces normal cost (NC) rather than prior service liability – NC reduction is positive for budget, especially if existing employees included (FL and VA)

» Some have enacted COLA reductions/ suspensions affecting retirees – Meaningful reductions in UAAL, but subject to ability to withstand legal challenges (MN and CO upheld, RI, NJ, NM ongoing, OH not challenged) – Providence (RI) COLA suspension based on negotiation with employees & retirees to avoid litigation – Ballot measures another route, but also subject to legal challenges

Global Interdependence Center, October 11, 2013

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Overlapping Debt and Pension Liabilities Far Higher in Detroit Than Other Large Cities $ in billions – financial repor0ng year 2011 GO Ra>ng

New York

Los Angeles

Chicago

Houston

Philadelphia

Detroit

Aa2

Aa2

A3

Aa2

A2

Caa3

Net Direct Debt

$70.3

$3.5

$8.9

$3.3

$4.3

$2.2

ANPL

$69.0

$14.6

$28.5

$6.1

$7.3

$2.0

Direct Debt and Pension Sub-­‐total

$139.3

$18.1

$37.3

$9.4

$11.6

$4.3

2011 Full Value

$793.7

$401.3

$225.6

$141.8

$63.0

$18.9

Direct Debt and Pensions as % of Full Value

18%

5%

17%

7%

18%

23%

Overlapping Debt

$0.0

$14.1

$9.9

$6.4

$2.9

$1.9

Overlapping ANPL

$0.0

$16.9

$17.4

$1.9

$1.7

$2.5

Overlapping Sub-­‐Total

$0.0

$31.0

$27.3

$8.4

$4.6

$4.4

$139.3

$49.1

$64.6

$17.8

$16.2

$8.6

18%

12%

29%

13%

26%

46%

Total Direct and Overlapping Debt and Pensions

Total Direct and Overlapping Debt and Pension as % of Full Value

Global Interdependence Center, October 11, 2013

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Bob Kurtter Managing Director Robert.Kurtter@moodys.com

Global Interdependence Center, October 11, 2013

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Global Interdependence Center, October 11, 2013

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