Session 2 reining incentive to pay how recent

Incentive To Pay: How Recent Bankruptcies Inform Analysis Of Distressed Local Government Credits Primary Credit Analyst: Lisa R Schroeer, Charlottesville (1) 434-220-0892; lisa.schroeer@standardandpoors.com Secondary Contacts: Horacio G Aldrete-Sanchez, Dallas (1) 214-871-1426; horacio.aldrete@standardandpoors.com Jane H Ridley, Chicago (1) 312-233-7012; jane.ridley@standardandpoors.com Matthew T Reining, New York (1) 415-371-5044; matthew.reining@standardandpoors.com

Table Of Contents Legal Structure: Structural Enhancements Can Lead To Higher Ratings Comparables: Distressed And Bankruptcy Payment Examples Revenue Pledges For Distressed Credits Recent Examples Summary

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Incentive To Pay: How Recent Bankruptcies Inform Analysis Of Distressed Local Government Credits Though rating trends are overwhelmingly upward across all municipal sectors (see "U.S. Public Finance Positive Ratings Streak Reaches 14-Year High," Sept. 2, 2015) Standard & Poor's Ratings Services has also seen borrowers like Atlantic City, N.J.; Wayne County, Mich.; and, most recently, Hillview, Ky., trying to work through fiscal stress.

Though comprising only a very small percent of overall local government ratings, distressed credits bring into play analytical considerations that aren't usually a factor in this overall strong sector.

Often the hallmark of extremely distressed credits is concern regarding sufficient liquidity, whereby issuers may face a decision on who to pay: Peter or Paul (or Jane or Jenny, for that matter). While the framework of our local government criteria applies to all of our local government ratings, for distressed credits, where rating caps are often invoked, we address the questions regarding management's incentives to pay under strain. This report will focus on the somewhat unique analytical considerations we believe play into this subset of issuers.

Overview • Pockets of stress continue to arise in the local government sector, though we still anticipate municipal bankruptcies and defaults will remain extremely low.

• Prioritization of payments during distress and while in bankruptcy may not be precedent-setting, but inform our analysis of how governments may act under stress.

• We continue to apply our criteria and insights gained to our analysis and the often unique set of incentives issuers have to prioritize payments. Standard & Poor's U.S. public finance credit ratings reflect the likelihood of default and do not incorporate recovery.

From Standard & Poor's Ratings Services' perspective, municipal bankruptcies are opportunities to help inform our analysis of distressed issuers with respect to the incentives to pay certain obligations. Our view is that the small number of bankruptcies and credits in distress we have seen do not enable us to predict conclusively which obligations will or will not be impaired in bankruptcy. Accordingly, our local government ratings do not reflect our assessment of expected recovery post-bankruptcy. Our ratings instead reflect our assessment of whether the issuer will pay the bonds in full and on time. There are, however, several factors we believe can inform our view of the likelihood of payment on specific obligations for distressed credits.

Legal structure. We believe there are analytical considerations regarding how a legal structure can drive an issuer's incentives to pay during times of distress (see "Statutory Liens: Not A Game-Changer, But A Possible Boost To Distressed Credits In Bankruptcy States," March 24, 2015). Given the lack of legal precedent, at this time we do not take the view that any legal structure will ensure or guarantee on-time and in-full payments in bankruptcy for obligations we rate in the local government sector. Our analytical considerations do not reflect our view of what a bankruptcy judge would decide; rather they inform our opinion of the issuer's incentive to pay its various obligations.

Examples of legal structures that may drive payment incentives include statutory liens, designation of special

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revenues, state support of bonds, and differing flow of funds.

"Comparables". We look at previous examples of credits in distress for guidance regarding an issuer's possible incentive to pay its various obligations. This analysis looks to past examples, but the analysis is credit-by-credit, and incorporates all aspects of the challenges and opportunities for the specific issuer. Examples of credit distress scenarios include various types of legal structures; payment choices amongst obligations by issuers; settlements or negotiations made during bankruptcy; parallel situations of management transition (e.g. state oversight, or emergency manager).

Revenue pledge. We review the legal pledge supporting an issuer's bonds and take into account the issuer's full debt and liabilities portfolio to analyze possible differentials in the issuer's incentive to pay. Examples of revenue pledges include: unlimited tax; limited tax; certificates of participation with and without a leased asset; general fund pledge, and multiple revenue pledges where there is additional revenue to support debt payments.

We view these examples as opportunities to help further inform our analysis while recognizing that each credit has a unique set of incentives including differing levels of state support, and different laws guiding payments of bonds or pensions. While none of these cases provides a specific result to hang the proverbial hat on, they all together provide us with additional analytical insight that informs our rating decisions.

Legal Structure: Structural Enhancements Can Lead To Higher Ratings Unlike with most of the rated municipal universe, where an issuer has an incentive to uphold all of its obligations so as to maintain good market access, with distressed issuers who are choosing which obligations to pay, we believe the incentive to pay could vary across bond types and pledges. Additionally, we recognize that there may be distressed situations where an issuer indicates a lack of willingness or ability to pay any obligations, in which case we could view all pledges as equally unlikely to be paid. However, when the municipality is still working to salvage some payments to try to avoid further distress or bankruptcy, we believe one factor that can impact the incentive to pay is a perceived likelihood that those revenues would be dedicated to bond payments even during bankruptcy. Barring sufficient court cases and precedent, we believe the perception that certain laws would be regarded as protecting bondholders can enhance the likelihood of payment, regardless of whether a court would actually uphold a certain legal designation.

Several examples of statutory amendments for bondholders have emerged recently in the municipal market where states have designated bonds as having a statutory lien, such as in California with SB 222, which was signed into law on July 13, 2015. The California law provides that voter approved bonds for local governments and school districts shall be "secured by a statutory lien on all revenues received pursuant to the levy and collection of the tax." Prior to California's legislative action, in response to financial distress in the city of Central Falls, Rhode Island amended laws in Chapter 45-12-1 to identify the pledge of ad valorem taxes and general fund revenues to be a statutory lien.

Additionally, Michigan enacted a law designating a statutory lien for Detroit's recently rated income tax bonds (see our analysis published July 29, 2015). In our "Statutory Lien Not A Game Changer" commentary, we note that the existence of a statutory lien does not change our general approach for rating issuances by local governments in states that have statutory lien laws. However, as reflected in our ratings for Central Falls' general obligation bonds and Detroit's income tax bonds, the presence of the statutory lien was factored into our analysis and resulted in higher ratings than they would have without the applicable statutory liens. These analyses incorporated our belief that the statutory lien factors into an issuer's incentive to pay.

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Another possible factor that might impact an issuer's incentive to pay general obligation bonds is if there is a potential they would be viewed as special revenue bonds. This issue of special revenues arose during the Detroit bankruptcy case. In connection with Detroit's plan of adjustment, the city and the insurers of the city's unlimited tax general obligation bonds agreed that the insurers would accept a bond payment haircut and that the bonds were "special revenue bonds." Although the parties in this instance agreed that these bonds were special revenue bonds, we do not believe there is sufficient legal precedent to support the conclusion that similarly structured bonds are special revenue bonds. However, from our perspective, the view that some general obligation bonds could be viewed as special revenue bonds, like the presence of a statutory lien, could serve as an incentive for the distressed issuer to pay.

The perception that general obligation bonds may be secured by a statutory lien or are special revenue bonds provides us with an analytical basis to incorporate the possibility that a distressed issuer could have a higher incentive to pay these types of bonds than it would to pay other bonds without these structural features.

Comparables: Distressed And Bankruptcy Payment Examples Given the few examples of municipal distressed debt situations and bankruptcies available it can be difficult to draw strong analytical and rating comparisons, particularly across states which employ different standards for state intervention for distressed municipalities. Drawing any concrete conclusions about whether obligations will be honored by issuers during chapter 9 bankruptcy cases, based on this handful of examples, is in our opinion tenuous.

Thus, while we monitor municipal bankruptcies and the treatment of bonds in those cases, our rating will include a credit-by-credit analysis that incorporates all aspects of an issuer's challenges and opportunities.

Standard & Poor's believes that municipal bankruptcy cases can help inform our rating analysis and provide some insight into how distressed issuers, such as Wayne County, M.I., Detroit Public Schools, and Atlantic City, N.J., could approach bond payments when facing a potential bankruptcy. Rather than serving as a rulebook, the examples provide guidance as to how we can approach various aspects of our analysis, and insight into what issues could play into why and how a distressed issuer might choose to pay certain obligations and not others. While Standard & Poor's does not rate to recovery, we believe the treatment of bonds in bankruptcy can influence a municipality's incentive to honor its current obligations.

Revenue Pledges For Distressed Credits We review the legal revenue pledge and take into account the issuer's full debt and liabilities portfolio to analyze possible differentials in the issuer's incentive to pay. For distressed issuers, we may also look at the difference between unlimited tax and limited tax pledges, take into account possible rating differences for certificates of participation (COPs), lease revenue bonds, or general fund pledges with and without a leased asset, and consider multiple revenue pledges where there is additional revenue to support debt payments, along with the competing pension payment obligations.

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Appropriations/general fund debt The municipal bankruptcies in California and Detroit's chapter 9 case, as well as other distressed credits, can inform our view regarding an issuer's incentives to pay appropriation, general fund pledge, and lease revenue debt when in distress. These recent examples highlight the possibility of different incentives to pay appropriations or general fund debt. There may be stronger incentives to pay for leases with essential properties compared with debt that has no leased asset or an asset not viewed by the municipality to be essential to its needs going forward. (See Appropriation-Backed Obligations criteria, June 13, 2007.)

Limited/unlimited tax The treatment of unlimited and limited tax in bankruptcy proceedings informs our decisions regarding notching for distressed credits. As credits become more distressed, the difference in the incentive to pay may grow, favoring the unlimited tax. (See Limited Tax GO criteria, Jan. 10, 2002.)

Relationship between pension and bond payments The issue of pension payment versus bond payment priority in bankruptcy cases remains very cloudy. In the bankruptcy cases involving California municipalities, pension payments to date have been made without interference (if any reforms occurred before or after they were not required by the bankruptcy). However, in the Stockton bankruptcy case the bankruptcy court ruled that a challenge to pensions payments might be acceptable. Though no party in interest challenged Stockton's pension payments, the perception that the court could be open to challenging pension payments could be viewed as leaving the door open for future distressed credits. Additionally, in Detroit's bankruptcy case, the city developed a plan of rehabilitation that cut bond payments more significantly than pension payments. Stockton's and Detroit's payments contrast strongly with other bankruptcies like Central Falls, R.I. (which exited bankruptcy in October 2012), where the state enacted a law creating a priority of payments that placed municipal GO bondholders first in line for those revenues in the case of insolvency, which resulted in on-time and in-full bond payments but pension benefits were cut.

For distressed credits, there appears to be no uniform approach to the incentives to make pension payments. A municipality's resolutions and payment decisions regarding what obligations to challenge or to pay are likely to be highly reliant on various factors, including applicable state law, the strength of the municipality's unions, the weight of pension precedent, the size and influence of the pension plan administrator, and other political and legal issues.

For more information on how we view pension costs within our local government analysis, see "Incorporating GASB 67 And 68: Evaluating Pension/OPEB Obligations Under Standard & Poor's U.S. Local Government GO Criteria," Sept.

2, 2015. Our analysis of pensions and other contingent liabilities continues to be assessed on a combined basis for issuers facing high costs. We review the total fixed cost debt payment, annual pension payment and other post-employment costs on a pay-go basis.

Intercept programs/state programs Distressed credits have accessed the market through either joint obligors for bonds backed with state aid, or programs with revenue intercepts intended to ensure bond payments. In order to analyze bonds issued through these state aid or intercept programs, we may consider an issuer's incentive to pay these bonds or consider the incentives for payment with respect to the state program or intercept. To aid our analysis, we consider recent examples of these programs and

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also assess the flow of funds, the purpose of the pledged revenue, and any other incentives there may be to maintain the integrity of the applicable program. While we can make analytical judgments on incentives to pay, given the limited scope of municipal bankruptcy case law, it is uncertain whether, in the event of bankruptcy, a bankruptcy court would determine that any state aid funds or other intercept programs would be allocated and withheld to support the bonds. Therefore, our analysis of bonds issued under these state aid or intercept programs reflect our analytical assessment of the incentive to pay, not whether the issuer will be compelled by a bankruptcy court to make payments on the bonds in full and on time.

In the table below, we discuss several examples of these bonds.

Special tax and bonds with additional revenue pledges Unlimited-tax, limited-tax, appropriation, or general fund pledge may also be supported by additional revenues, such as special taxes like sales tax, income tax, and tax increment revenues, or enterprise revenues. The presence of a special tax or additional revenue pledges can impact a bond's rating when it is combined with a unlimited-tax, limited-tax, appropriation, or general fund pledge. With multiple revenue stream pledges, we factor all pledges into our analysis and if they can be rated by our criteria the bonds will hold the highest rating, pursuant to our criteria. (See Methodology: Rating Approach To Obligations With Multiple Revenue Streams, Nov. 29, 2011.)

For example, additional revenue pledges may be, on their own, of weaker credit quality than the GO pledge. However, when issuers become distressed, these pledged revenues can add to the likelihood of the bonds being paid. We believe there may be a higher incentive for issuers to pay these types of bonds because issuers would not view the additional pledged revenue as a regular operating pledges and then the issuer may believe it is less likely to be impacted by bankruptcy. Prior to bankruptcy, if an issuer has a revenue stream dedicated to pay debt service that cannot be used for operations, the decision to pay the bonds may be easier to make since the revenue cannot be used for other obligations.

While there are reasons to distinguish our ratings for distressed issuers, based on the presence of multiple revenue streams, ratings can become more closely linked when there are some shared financial aspects, common management, or extreme financial distress that indicates an inability or unwillingness to make debt payments.

Standard & Poor's continues to evaluate the relationship among ratings regarding special tax and revenue pledges.

(See " Rating Correlations For U.S. Local Governments: Proximity Doesn't Always Matter," Sept. 24, 2015.)

Recent Examples Issuer

Rating

Analytic considerations

Analyst

Atlantic City(1) (example where a state program can lead to a higher rating)

B/CWN (GO); A-/Stable (QBA)

Our view of the purpose of the program; QBA's intent to facilitate distressed municipal issuers' access to the capital markets and its structural mechanisms to segregate withheld state revenues from the qualifying issuer municipality

Tim Little

The QBA instructs the state treasurer to withhold qualifying state aid from an issuer municipality and instead direct that aid to a paying agent to service debt on bonds issued pursuant to the QBA.

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We rate bonds issued under the QBA one notch below New Jersey's (GO) bond rating because the withheld state aid that supports debt service on QBA bonds is subject to appropriation by the state.

Detroit Public Schools (example of a special tax security with structural enhancements)

A/Negative (1st lien state aid); A-/Negative (2nd lien state aid); NR (GO)

A pledge of all state aid appropriated by the state.

John Sauter

Constitutional commitment of the state for education funding.

Intercept mechanism providing for the payment of all of the district’s monthly state aid directly to the trustee from the state.

The ability of the state treasurer to advance to the trustee any state aid that has been appropriated by the state for the district, regardless of when that state aid is due.

Detroit Public Schools (example of a state enhancement program)

AA-/Positive (program rating); NR (GO)

Our view of the district’s eligibility for, and participation in, the Michigan School Bond Qualification and Loan Program.

John Sauter

The program’s intent to provide districts access to funds to avoid a default on qualified debt.

Under the program, if a district fails to meet its debt service obligation for qualified debt, the state treasurer is notified and the state will pay the required debt service from its loan fund, and payment to bondholders will be uninterrupted.

We view the fund an obligation of the state, as such, the program is rated on par with the state's own GO debt.

Detroit(2) (example of a double pledge)

B/Stable (GO)' A/Stable (income tax bonds)

Creation of a statutory lien

Jane Ridley

Strong revenue coverage Legal structure (1) Based on the QBA's intent to facilitate distressed municipal issuers' access to the capital markets and its structural mechanisms to segregate withheld state revenues from the qualifying issuer municipality, we believe that it is unlikely there will be a disruption in the full and timely payment of principal and interest on the bonds in the event of a bankruptcy filing by Atlantic City. See our Atlantic City analysis of Atlantic City, April 30, 2015.

(2)During the 2015 legislative session, Michigan passed Act 17, which places a first-priority lien on the city's income tax revenues as soon as they become due, as part of the trust pledged to the bonds. Pursuant to the legislation, the pledge constitutes a statutory lien and is paramount and superior to all other liens and interests of any kind, for the sole purpose of paying the principal of and interest on bonds. The lien and trust is created for the benefit of bondholders, and the tax revenues held by the trustee are for the sole benefit of bondholders. They cannot be levied upon, taken, sequestered, or applied toward paying the debts or liabilities of the city other than for payment of debt service on the bonds. See our Detroit analysis, July 29, 2015.

Summary Pockets of stress continue to arise in the local government municipal sector, though we still anticipate municipal bankruptcies and defaults to be extremely low for this rated sector overall. Our ratings do not reflect our assessment of post-bankruptcy recovery; rather, they reflect our view of timely, in-full bond payments. As we evaluate these distressed credits, examples inform our analysis when assessing the incentives to pay for distressed issuers. Legal structure, political incentives, additional pledge revenues, and comparable situations all factor into our analysis. When looking at our distressed issuers, our analysis incorporates historic actions while taking into account the unique credit profile of each issuer. We integrate these analytic factors to analyze our rated distressed issuers incentives to pay when assigning credit ratings.

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

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of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

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