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November 5, 2018 Mid-Term Elections 2018
September 27, 2018 3rd Quarter 2018 Review and Outlook
September 24, 2018 State 'Rainy Day' Funds: Who's Prepared for the Next Recession?
August 2, 2018 California Fires
July 6, 2018 U.S. Supreme Court's Ruling on Union Fees
June 29, 2018 Onset of the Internet Sales Tax and the Impact on U.S. Municipalities
June 26, 2018 2nd Quarter 2018 Review and Outlook
June 22, 2018 State of the States - Midyear 2018
May 29, 2018 Sports Betting Ruling is a Win for U.S. States
May 17, 2018 Most States Have Room to Increase Their Debt
April 11, 2018 The State of Connecticut, the City of Hartford, and the Contract Assistance Agreement
March 28, 2018 1st Quarter 2018 Review and Outlook
March 21, 2018 New Tariffs and the Impact on U.S. States and Local Governments
March 12, 2018 Higher Education: Remain Cautious with Small, Private Universities and Expect Additional Mergers
March 5, 2018 Higher Oil Prices and the Impact on the Top Energy-Producing States
February 26, 2018 President Trump's Infrastructure Plan
February 5, 2018 The Legalization of Cannabis in California
January 30, 2018 Amazon's HQ2
January 22, 2018 Credit Comment on California's Latest Budget Proposal
January 8, 2018 Municipal Bond Market – Credit Outlook for 2018
December 27, 2017 4th Quarter 2017 Review and Outlook
November 8, 2017 Municipal Bond Market – Proposed Tax Reform 2017
October 19, 2017 Chicago's New Securitization
September 29, 2017 3rd Quarter 2017 Review and Outlook
September 12, 2017 Impact of Hurricane Irma on the State of Florida
August 28, 2017 Impact of Hurricane Harvey on Southeast Texas
August 16, 2017 State of the States - Midyear 2017
July 20, 2017 Growing Cybersecurity Risks at U.S. Public Power Electric Utilities
June 29, 2017 2nd Quarter 2017 Review and Outlook
May 22, 2017 Challenges Facing the Transportation Sector
April 27, 2017 The Impact of New York State's "Free Tuition"
April 12, 2017 Bank Liquidity Rules Could Boost Demand for Municipal Bonds
April 4, 2017 U.S. States Forecast Sluggish Tax Revenue Growth as 2018 Budgets Established
March 30, 2017 1st Quarter 2017 Review and Outlook
January 26, 2017 Trump's Transportation Infrastructure Plan
January 18, 2017 Trump and the Municipal Bond Tax-Exemption
January 14, 2017 Credit Comment on California's Latest Budget Proposal
January 10, 2017 Municipal Bond Market – Credit Outlook for 2017
December 30, 2016 4th Quarter 2016 Review and Outlook
December 9, 2016 The Repeal and Replacement of Obamacare
November 17, 2016 The Coming Showdown for Sanctuary Cities?
October 27, 2016 Municipal Bond Market - Tax Reform Forecast Post-2016 Election
October 24, 2016 U.S. Cities' Finance Officers Remain Cautiously Optimistic
September 30, 2016 3rd Quarter 2016 Review and Outlook
September 9, 2016 U.S. States Not Having Much Luck with Gambling
August 25, 2016 The Zika Virus and its Impact on the Miami-Dade County Region
June 29, 2016 2nd Quarter 2016 Review and Outlook
June 20, 2016 Philadelphia Hits Soda Industry With Historic Tax
June 13, 2016 State of the States - Midyear 2016
May 3, 2016 Comment on Puerto Rico's Default
April 18, 2016 Colorado's Challenge: Financial Caps and Debt Limitations
March 31, 2016 1st Quarter 2016 Review and Outlook
March 29, 2016 California and the Minimum Wage Hike
February 23, 2016 Flint (Michigan) and the Credit Implications
January 19, 2016 Credit Comment on California's Latest Budget Proposal
January 7, 2016 Municipal Bond Market – Credit Outlook for 2016
December 30, 2015 4th Quarter 2015 Review and Outlook
November 19, 2015 Are Some U.S. Universities' Endowments 'Too Large'?
October 8, 2015 For Financially-Strapped Municipalities, New Prisons May Not Be The Answer
September 29, 2015 3rd Quarter 2015 Review and Outlook
August 25, 2015 Credit Update on the Not-for-Profit Healthcare Sector
June 30, 2015 2nd Quarter 2015 Review and Outlook
June 19, 2015 State of the States - Midyear 2015
April 30, 2015 U.S. Transportation: State Highway Funding Crisis
April 24, 2015 MTAM Recommendation: Remain Cautious with Small, Private Universities
April 13, 2015 Pension Obligation Bonds - A Credit Neutral At Best
March 30, 2015 1st Quarter 2015 Review and Outlook
March 6, 2015 The Impact of the Supreme Court's Decision on Obamacare
March 3, 2015 After the Labor Slowdown:
West Coast Ports are Challenged, but Remain Very Competitive
January 23, 2015 Qualified Public Infrastructure Bonds: A Public-Private Partnership Proposal
January 5, 2015 Municipal Bond Market – Credit Outlook for 2015
December 30, 2014 4th Quarter 2014 Review and Outlook
November 12, 2014 Investor Lessons from the Detroit Bankruptcy Exit Plan
November 6, 2014 Lower Oil Prices and the Impact on the Top Energy-Producing States
November 3, 2014 Municipal Bond Market - Tax Reform Forecast Post-2014 Election
October 30, 2014 Ebola and the Not-for-Profit Healthcare Sector
October 23, 2014 What are Green Bonds?
October 1, 2014 3rd Quarter 2014 Review and Outlook
September 30, 2014 Impact of Climate Change on Municipal Credits
September 12, 2014 New Jersey's Financial Challenges Continue
August 19, 2014 Atlantic City (NJ): A Lesson in the Merits of Economic Diversification
July 29, 2014 Credit Update on the Higher Education Sector
July 1, 2014 2nd Quarter 2014 Review and Outlook
June 23, 2014 State of the States - Midyear 2014
May 27, 2014 Credit Comment on California's 'Rainy-Day' Reserve Fund Bill
May 4, 2014 Municipal Bond Market - Default Outlook Improves
April 4, 2014 Puerto Rico: Is Statehood the Answer?
April 1, 2014 1st Quarter 2014 Review and Outlook
March 6, 2014 Chicago is Not Detroit
February 27, 2014 The High Cost of Winter Weather
February 4, 2014 Credit Comment on California's Drought
January 22, 2014 Credit Comment on California's Latest Budget Proposal
January 13, 2014 Municipal Bond Market – Tax Reform Forecast for 2014
January 3, 2014 Municipal Bond Market – Credit Outlook for 2014
December 31, 2013 4th Quarter 2013 Review and Outlook
December 4, 2013 Impact of the Detroit Bankruptcy on the Municipal Bond Market – Part 2
November 7, 2013 New Jersey and the Minimum Wage Hike
October 4, 2013 Impact of the Federal Government Shutdown on Municipal Bond Credits
September 30, 2013 3rd Quarter 2013 Review and Outlook
September 16, 2013 North Carolina and the Impact of Tax Reform

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Mid-Term Elections 2018

Monday, November 5, 2018

This week's mid-term elections will determine who will lead states in the coming years, with voters also deciding the fate of wide-ranging initiatives that are relevant for state, health care, and public power credits.

Voters will decide on $76.3 billion of bond sales on Tuesday, the most in an election since 2006. States and cities are less hesitant to borrow amid a growing economy that has pushed unemployment to the lowest levels in 48 years. That is a shift after delaying infrastructure investment following the last recession.

The referendums would support water infrastructure projects and housing programs in California, road and bridge expansions in Colorado, school construction in San Diego, Texas, and North Carolina, and affordable housing development in Oregon.

A bulk of the bond ballots are in California, with nearly $16.4 billion of state borrowing proposed to upgrade water infrastructure, support housing programs, and renovate children's hospitals. Cities and school districts in Texas will weigh in on $9.2 billion of proposed bond issues.

Votes for governor in 36 states and the majority of state legislative seats will be determined this week. Although MTAM rates to fundamentals rather than the political cycle, a material change in fiscal policy and/or increased or reduced contention in financial decision-making can be relevant for credit performance, particularly if and when the broader economy slides into recession. Due to biennial cycles, most states will be debating budgets in 2019.

Voters in several states are considering limits on revenue raising powers, a trend that we note with concern because it reduces operating flexibility. States to watch in this area include California and Florida.

Medicaid expansion, a proven boost for health care providers in expansion states, will come to the forefront for voters in Idaho, Montana, Nebraska, and Utah, who are weighing in on Medicaid expansion under the Affordable Care Act.

The broader wildcard is party control at the federal Congressional level, which is relevant for state credit. Uncertainty at the federal level, particularly as it relates to Medicaid funding and tax and trade policy, continues to be a key risk for states. More clarity about future federal policy direction would support more informed forecasting and policymaking at the state level.

If Democrats win control of the U.S. House, it could lead lawmakers to push for proposals that would support municipal bond issuance, including the revival of subsidies for a key type of refinancing. A Democratic victory could mean a change in leadership for some committees to members who are in interested in making it easier for states and local governments to take advantage of the municipal bond market, such as by restoring the ability to advance refund older, higher interest rate debt and to provide a new mechanism to encourage the use of municipal bonds to finance infrastructure.

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3rd Quarter 2018 Review and Outlook

Thursday, September 27, 2018

Negative returns were prevalent for municipal bond investors in the third quarter, as the market succumbed to a constant flow of strong economic data. Even the previously stalwart demand for shorter-maturity bonds gave way as market yields climbed all along the yield curve. While lower-than-expected municipal bond supply acted as a shock absorber of sorts on the path to higher yields, it was clear to participants that diminished liquidity in the asset class required a repricing lower of bond prices.

Overall, municipal credit quality continued to improve during the previous quarter as a strong domestic economy kept finances of many municipalities firmly in the black. Market returns reflected greater enthusiasm for lower-rated credits as investor concern over potential defaults diminished somewhat. Perhaps participants are too apathetic concerning municipal credit quality in our view. What should always be considered during Federal Reserve tightening cycles is that, historically, our central bank has tended to go too far. Investors should pay attention to the puny spread between two-year and ten-year U.S. Treasury note yields. In our view, this reflects market participants' rising concerns over the potential for much slower economic growth down the road. Given all the good news priced into municipal credit spreads, we believe some caution should be exercised in the coming quarters. Look no further than a recent proclamation from a major rating agency that currently no state has been assigned a "negative" outlook. Sounds to us like a top in credit is close at hand. Our focus here at MTAM will be to bias overall portfolio credit quality higher as the Federal Reserve continues its tightening of credit.

Moving forward, investors have a full plate of potential market moving events. These include the midterm elections, trade tensions with China, and the possibility of the European Central Bank stepping away from its quantitative easing policy. However, from our perspective, America's own Federal Reserve and its ongoing tightening of monetary policy will be what ultimately dictates the tone of our financial markets. MTAM is concerned that the historically lagged effects of the many rate hikes already enacted by the Federal Reserve have yet to fully work their way through the United States economy. Simply put, we believe it is time for the Fed to pause in their tightening of monetary policy for a period of time in order to fully assess where consumers and businesses are after the tailwinds of the tax cuts begin to wane. Unfortunately, we do not hold out a lot of hope that this Federal Reserve will take this precaution. Should the central bank of the United States proceed to raise rates without a pause, we figure that the economy will experience a "Wile E. Coyote" moment after two more hikes. Municipal market yields are quite attractive now in our view. Given our outlook, we suggest you start buying when you can—not when you "have to."

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak

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State 'Rainy Day' Funds: Who's Prepared for the Next Recession?

Monday, September 24, 2018

The nine years that have passed since the end of the last recession seem to have given many U.S. states enough time to save for the next one. Twenty-three state governments have sufficient reserves to weather the budget shortfalls that would come with a moderate economic contraction, up from 16 last year, according to Moody's Analytics. Another 10 states have most of what they would need, according to Moody's.

The savings have left states in a much better position than they were a decade ago, when the housing-market bust and financial crisis left them reeling from deep budget deficits. That may leave them exerting less of a drag during the next recession by lessening the need to cut spending deeply and eliminate government jobs.

However, a troubling number of states are still not ready. While the number of well-prepared states has grown, so has the number of those that are not. Seventeen do not have the savings for a moderate recession, up from fifteen a year ago.

Louisiana, North Dakota, and Oklahoma were rated the least prepared for the second year in a row, though their finances have shown some improvement. Arkansas, Michigan, Mississippi, New Hampshire, Kansas, Wisconsin, Pennsylvania, Illinois, Arizona, Missouri, Virginia, Kentucky, Montana, and New Jersey also performed poorly in stress tests.

On average, a state would need to have reserves sufficient to cover about 11 percent of its budget in order to withstand the next recession without raising taxes or cutting spending.

Standard & Poor's

For the first time since the financial crisis, no state government appears likely to have its bonds downgraded anytime soon by S&P Global Ratings. S&P recently removed the negative outlook from New Mexico's grade, a step that indicates it no longer thinks the state's standing could be cut over the next two years. That followed similar changes to Mississippi and Louisiana and pushed states passed a bond-market milestone of sorts: none of them have a negative outlook on their ratings from S&P for the first time since 2008.

The shift reflects the financial gains that state governments are reaping from the swift pace of the nation's economic expansion, stoked in part by a tax-collection boost this year as residents shifted some income into 2017 before limits on local deductions kicked in. All but a handful of states saw revenue outpace their projections during the 2018 fiscal year, allowing them to increase their savings, pay down debt, or cover delayed expenses, according to the National Association of State Budget Officers.

Some of the pressure has been eased by declining unemployment, which has reduced spending on the Medicaid health program for low-income residents. At the same time, last year's federal corporate tax cut further stimulated the economy, helping produce the faster-than-expected revenue gains. That provided an immediate jolt, immediate fiscal relief to states that have been under pressure since the start of this recovery.

But states should not anticipate that the recent gains will be part of a long-lasting trend. S&P expects the economy's growth to slow to about 1.8 percent in 2020, assuming the second-longest expansion on record is not derailed. That compares with 4.2 percent growth in the second quarter. Even the baseline forecast means there could be renewed pressure.

More Detail

States increased their cumulative rainy day funds for a seventh straight year to a record $54.7 billion in fiscal year 2017, enough to run government operations for a median of 20.5 days, according to Pew Charitable Trusts. The National Association of State Budget Officers expects that 2017 figure to be surpassed when final fiscal 2018 data becomes available. Most states ended their fiscal years on June 30, but Texas does not close its fiscal year until August 31 while Alabama and Michigan end theirs on September 30.

NASBO Executive Director John Hicks said that deposits made to rainy days funds from budget surpluses will likely bring the total to more than $58 billion for fiscal 2018. Two of the three states that Pew reported to have nothing in their rainy day accounts at the end of fiscal 2017 – Kansas and Montana – recently created rainy day funds. That leaves New Jersey as the only state with the dubious distinction of not having any money stashed away to weather an economic downturn.

One example of the upturn is Oklahoma, which announced it would deposit $381.6 million into its rainy day fund, its first deposit in four years. The fund previously had $93 million.

Rebuilding rainy days funds has been a very slow process for many states since the end of the Great Recession in June 2009. Nationally, total state tax revenue recovered in mid-2013 from its plunge during the recession but has rebounded more slowly than after the three previous downturns, Pew said. But only 34 states were taking in more revenue at the end of fiscal 2017 on an inflation-adjusted basis than they did for the Great Recession.

Rainy days funds are important factor in determining credit ratings. Well-managed states administer rainy day funds in a way that reinforces structural balance, or a budget that is financially sustainable over several years. This means that policymakers make deposits into reserves during times of economic expansion and revenue growth, while they make withdrawals during times of distress when revenue falls.

Rainy day funds have heightened importance in states with the greatest revenue volatility. The boom-and-bust cycles of the oil and gas sector have given Alaska, North Dakota, and Wyoming the highest revenue volatility.

Severance tax was the most volatile revenue source in eight of the nine states where it accounted for enough revenue over the past decade to be considered a major tax. Broad-based personal income tax and statewide sales taxes were found to be less volatile. Forty-one states levy broad-based income taxes and 45 have statewide sales taxes.

Kentucky and South Dakota have the lowest revenue volatility. Both states rely on relatively stable tax streams for over half of their revenue — sales for South Dakota and sales and personal income for Kentucky. In 18 of the 22 states where the corporate income is a major tax, it was the most volatile source of revenue.

Conclusion

Rainy day funds are especially important to pay attention to amid projections that another U.S. recession is likely in the next year or two. They can also signal improvement in credit quality: states like California, New York, Washington, and Ohio have boosted their total balances from pre-recession levels, a good sign for investors owning the debt. Outgoing California Governor Jerry Brown has made the rainy day fund a priority during his tenure. Doing so has paid off as S&P pointed to the creation of the rainy day fund in 2015, when it lifted the state's credit rating to the highest level since 1999.

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California Fires

Thursday, August 2, 2018

California appears to be on track for a fire season nearly as devastating as last year's — the worst fire season in the state's history. So far this year, Cal Fire has battled nearly 3,800 wildfires that have burned more than 292,000 acres, a sharp increase from previous years and far above average for this time of year, according to the state's fire agency.

Though natural disasters wreak havoc causing property damage and loss of life, the hit to local economies — and their bonds — tends to be ameliorated by money from the states, the federal government, and insurance companies.

Natural disasters have become increasingly acute and chronic, which is presenting operational and financial challenges to some U.S. state and local governments. The federal government's role in disaster response is critical in mitigating natural disaster risk for ratings on state and local governments.

The federal government approved $130 billion in aid for natural disasters last year, a considerable 0.7% of the country's $19.7 trillion economy. That said, financial support from the federal government is not guaranteed. Additionally, proposals by current and past administrations have been presented to address the burden of disaster recovery assistance on the federal budget. And although we do not currently anticipate this, a pullback in the level of federal government aid would be viewed as a negative credit factor for state and local governments.

Rating actions directly linked to natural disasters have historically been limited, a notable anomaly being Hurricane Katrina and subsequent downgrades of the State of Louisiana and affected areas. However, the damage to vital infrastructure and widespread repopulation that was seen during Katrina has become more commonplace, most recently with Hurricanes Harvey, Maria, and Irma last year.

State governments' exposure to environmental risk is limited thanks in large part to the sovereign powers bestowed on states under the U.S. government framework along with ample economic resources that ensure fiscal flexibility and resilience to event risks and systemic challenges. Local government ratings, by contrast, are more vulnerable, particularly governments that encompass a small geographic territory or feature a concentrated revenue base. In response, local governments are incorporating environmental risk mitigation and adaptation strategies within long-term financial and capital plans more broadly than in the past.

Local governments have history on their side in terms of showing financial resilience and prioritizing spending where needed, which in concert with federal and state recovery aid can mitigate credit risk to natural disasters.

Case in point, the recent volcanic eruption in Hawaii County, known as the Big Island, has had a limited credit impact, citing preliminary tourism figures. The numbers represent particularly good news for Hawaii County because it suggests the volcanic activity at Kilauea will have a manageable effect on the county's financial health. Total air-travel visitors to Hawaii rose 8% in May, compared with the same period a year earlier, with increases for Honolulu, Kauai, and Maui and just a 1.6% drop for the Big Island. Cruise ship visitors to Hawaii County fell 67%, but these kinds of visitors have historically made up just 3% of total visitors to the islands.

The volcano on Hawaii County started erupting on May 3rd and has destroyed at least 657 homes. There has been an estimated $372 million in private property damage from the eruption, which means a projected $5 million possible loss in property tax collection. The damaged property represents only 1.2% of the county's 2018 full value. County officials also expect the cost of the eruption response was $3 million in May and an additional $2 million in both June and July.

Hawaii County has the tools to address any fiscal issues that come, including the ability to hike property tax revenue with a simple majority vote of its council to make up the lava losses. In addition, the state has given the county $12 million for disaster efforts and more reimbursement from the Federal Emergency Management Agency is expected.

Carr Fire

The Carr Fire in far Northern California has destroyed hundreds of structures and spurred California fire officials to order evacuations in what is a roughly 300-square-mile-area encompassing the western half of Redding and all of Shasta Lake. While it is too early to know what the extent of physical and economic damage will ultimately be, the recent history of municipal obligors in areas that experienced fire damage suggests to us that credit deterioration is unlikely. We will continue to monitor the situation.

We have found that federal and state programs and fiscal backstops have helped local communities respond to immediate disaster conditions and recover over the long term. For example, the California Department of Forestry and Fire Protection coordinates emergency response to fire events and the state chose to backfill $53 million in lost property tax revenue associated with fires in 2017 as part of its fiscal 2019 budget.

With federal and state aid and insurance payouts estimated in the billions, investors, analysts, and government finance officials all expect that homes and businesses will be rebuilt, and that the impact on local government bottom lines will not be as devastating as the fires' wrath.

Given the nature of the structural damage, the rebuild will likely take years to complete, and because of high property values in the affected areas and the availability of insurance proceeds, we expect most home and business owners to rebuild. As that process gets underway, Californians will be aided by state laws designed to ease the burdens they face, including property tax reductions. However, while providing support to residents, these incentives could create pressure for local governments.

State law provides for property value reassessments and corresponding property tax adjustments. The state also has a Special Fund for Economic Uncertainties that can backfill property tax losses to local governments impacted by reassessments. The Department of Finance can allocate funds from the special fund if authorizing legislation is enacted. Since that involves the state budget process, several months could pass before local governments see such relief.

Though local governments could experience a short-term crunch, the rebuild will likely result in a boost to sales tax and assessed value further along in the rebuild.

California Governor Jerry Brown has declared a state of emergency in several areas of the state, a move that triggers federal funding. He also sent the National Guard into one area to help extinguish the fires. Firefighting costs, covered by the California Department of Forest and Fire Protection are at $114.7 million for 2018-19, which began on July 1, according to Cal Fire. Last year's fires cost an estimated $505 million. Brown allocated money in the 2018 budget to cover the cost of last year's fires and a reserve fund to cover this year's. The state also has an estimated $8 billion surplus in this year's budget.

Brown also announced that the state has secured a presidential declaration providing direct federal assistance to further support the communities impacted by the Carr Fire, following an emergency proclamation issued for Shasta County. The Governor has issued emergency proclamations for Riverside and Mariposa counties this week due to fires.

Conclusion

The Carr Fire is the largest of nearly a dozen fires burning throughout California. While it is too early to know what the extent of physical and economic damage will ultimately be, the recent history of municipal obligors in areas that experienced fire damage suggests to us that credit deterioration is unlikely.

Municipal budgets are most vulnerable to the loss of property taxes when houses burn. The tax assessor's offices in the areas devastated last year were busy reassessing property values in areas where people lost their homes, to reflect the decreased value. But it takes several months after fires are extinguished to assess the reduction in property taxes. Insurance companies and federal agencies come to the aid of homeowners in areas declared a natural disaster. California also has always approved legislation to provide funding to municipalities that take a hit to their tax base in a natural disaster.

Past history, including the rash of fires that devastated regions in northern and southern California last fall, demonstrated that federal and state programs and fiscal backstops have helped local communities respond to immediate disaster conditions and recover over the long term.

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U.S. Supreme Court's Ruling on Union Fees

Friday, July 6, 2018

Last week's U.S. Supreme Court's ruling regarding the funding of public sector collective bargaining activities is likely to have a modest impact on state and local government finances. The ruling for the plaintiff in Janus vs. AFSCME Council 31 eliminates the requirement that non-union public sector employees pay "agency fees" to contribute to the cost of collective bargaining and related activities. It reverses a 40-year-old Supreme Court decision that allowed public sector unions to require such fees.

No financial issue has dominated U.S. states and cities in recent years as much as the massive shortfalls in their workers' retirement funds, which have triggered battles between politicians and unions from New Jersey to California and helped push Detroit into a record-setting bankruptcy. The Supreme Court's decision may have given governments a bit more of an upper hand. The Court ruled 5-to-4 that government employees have a constitutional right not to pay union fees, dealing a potentially heavy blow to the economic clout of the labor movement through a decision that affects 5 million workers. That may leave unions with a weaker voice in benefit and pay negotiations and curtail their power at the polls.

State and city pension funds were negatively impacted by the credit market crisis a decade ago, when stock prices plunged. That has left them with $1.8 trillion less than they need to cover all the promised benefits, putting pressure on governments and workers to set aside more money to make up the difference.

Such unfunded obligations contributed to bankruptcies in Detroit and Puerto Rico that left bondholders and pensioners battling in court. In New Jersey, former Republican Governor Chris Christie fought with the state's labor unions over their benefits for years, even as his failure to make full annual pension payments caused the pension system to fall deeper behind. Illinois's bonds have been downgraded to one level above junk because of retirement system debt that stood at $137 billion by last June.

Union opposition to pension changes has been a major force in Illinois. In 2013, Illinois lawmakers approved a restructuring of the pension system, seeking to cut cost-of-living adjustments and raise the retirement age for some workers. But unions sued, and the state's supreme court sided with unions, saying it illegally cut benefits protected by the Illinois constitution.

While the legal obstacles have not changed, the Supreme Court decision could chip away at the resources that unions can bring to such fights. That could help states and local governments seeking to lower salaries and reduce benefits.

Twenty-eight states have adopted right-to-work laws. The Janus ruling essentially creates the same framework for the other 22 states and the District of Columbia for public-sector employees. States with right-to-work laws that limit collective bargaining powers can still confront labor-related spending pressures.

MTAM expects the Supreme Court decision will lower public union revenues, membership, and bargaining power in the 22 states that can no longer allow mandatory fees. These developments could change how state and local governments set employee wages and pensions, resulting in a positive long-term impact on government finances.

However, state and local governments remain limited in their ability to control labor spending. Any change to a state or local government's expenditure flexibility that arises from the decision is likely to be incremental.

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Onset of the Internet Sales Tax and the Impact on U.S. Municipalities

Friday, June 29, 2018

The U.S. Supreme Court freed states and local governments to start collecting billions of dollars in sales taxes from internet retailers that do not currently charge tax to their customers. Broader taxing power will let state and local governments collect an extra $8 billion to $23 billion a year, according to various estimates. Only five states -- Alaska, Delaware, Montana, New Hampshire, and Oregon – do not have a sales tax.

Siding with states and traditional retailers on a 5-4 vote last Thursday, the Court overturned a 1992 ruling that had made much of the internet a tax-free zone. That decision had shielded retailers from tax-collection duties if they did not have a physical presence in a state. Writing for the Court, Justice Anthony Kennedy said the 1992 ruling, which involved catalog sales, was obsolete in the e-commerce era.

The Court upheld a South Dakota law that requires retailers with more than $100,000 in sales or 200 transactions annually in the state to pay a 4.5 percent tax on purchases. Traditional retailers have been waiting for this day for more than two decades as this ruling clears the way for a fair and level playing field where all retailers compete under the same sales tax rules whether they sell merchandise online, in-store or both.

The measure was opposed by Wayfair, Overstock, and Newegg. They said small sellers would be hit with heavy costs of complying with rules for thousands of products in thousands of taxing jurisdictions. Sixteen states already have laws that will let them require tax collection by internet retailers in the coming months, and more could follow quickly.

Internet retailers say they are especially worried tax collectors will try to impose years of retroactive liability, which the laws of many states allow. South Dakota and its allies say those concerns are overblown for practical and legal reasons.

Justice Kennedy did not directly decide whether states could try to collect taxes retroactively, but he said the issue was not a reason to keep the physical-presence rule. He said the Court had other legal tools to ensure that sales taxes do not become an "undue burden" on small businesses and startups. He wrote that "each year, the physical presence rule becomes further removed from economic reality and results in significant revenue losses to the states."

Justices Clarence Thomas, Neil Gorsuch, Ruth Bader Ginsburg and Samuel Alito joined Kennedy in the majority. In dissent, Chief Justice John Roberts said the Court should have left it to Congress to change the physical-presence rule. Congress could still intervene. Amazon and Overstock are among the companies that say they support a nationwide law that would relieve retailers from dealing with a patchwork of state tax laws.

The 1992 ruling, Quill v. North Dakota, turned on the so-called dormant commerce clause, a judge-created legal doctrine that says states cannot unduly burden interstate commerce unless authorized by Congress. The Trump administration backed South Dakota in the case, urging that Quill be overturned or at least limited to catalog sales. South Dakota urged the Court to let sales taxes be imposed on companies with an "economic presence" in a state -- a test South Dakota said its law would pass.

The Supreme Court ruling gave U.S. states – and their bondholders -- another big win. The decision comes weeks after the justices allowed states to legalize gambling on individual sporting events, permitting another opportunity for them to raise revenue. The ruling is a win for localities that have struggled with slow tax revenue growth even amidst the second-longest economic expansion on record, and have seen their tax bases erode as more consumers shop online.

MTAM believes the decision will have a positive impact nationwide, though it will vary in each state. In terms of their tax structures, it should certainly assist the states in moving into more modern tax structures than they have now, which are fundamentally based on an industrial economy that we have not seen in decades.

An expanded sales tax would give the biggest benefit to California and its local governments, which could have seen between $1 billion and $1.7 billion in additional revenue from the expanded tax collection authority on out-of-state sales in 2017, according to a U.S. Government Accountability Office report.

Six states -- Texas, Washington, Florida, South Dakota, Nevada, and Tennessee -- get more than half their revenue from sales taxes. Texas could generate $1.2 billion, or 1 percent of its taxes, from online retailers. Sales tax reliance by local governments is highest in Louisiana, Arkansas, Oklahoma, and Alabama.

The decision will also be a boost to municipal bonds backed by sales-tax revenue because it will expand the base of items that are taxed.

Conclusion

MTAM believes the U.S. Supreme Court's decision allowing states to require out-of-state online retailers to collect sales tax will stem state tax erosion in a changing economic environment. In 2017, e-commerce grew 15.9 percent, while retail sales without e-commerce grew only 3.4 percent, continuing a long-term trend. We expect most states that impose retail sales tax to enact new legislation that require at least large out-of-state online retailers to collect sales tax at time of sale. This should provide a welcome incremental addition to state coffers.

We anticipate local governments that levy sales and use taxes will benefit similarly, broadening a revenue source integral to operations for many municipalities. The ability to capitalize on an expanded base should help support some of their growing operational obligations, such as infrastructure and pensions.

Nevertheless, we do not anticipate any immediate rating changes because of the Court's decision. It will take time to pass implementing legislation, and the additional revenue will represent a relatively small portion of overall state and local revenues.

E-commerce retail sales comprised only 8.9 percent of national retail sales in 2017, and sales taxes are generally not a majority of states' general fund revenue. Many states already receive a portion of online retail sales tax through aggressive state legislation that expanded what constituted a "nexus" requiring out-of-state retailers to collect tax, or report retail sales, if there was presence in a state. In addition, many major online retailers already collect sales taxes, either as a matter of policy or because they had a physical presence in many states. Amazon in particular, which accounts for over 40 percent of online retail sales, already remits sales taxes to all states imposing them. (Amazon, however, does not currently collect sales tax for most third-party sales, which represent half of its total sales.)

At the same time, states struggling with rising health care and pension costs will welcome the additional tax revenue, which in effect represents revenue otherwise lost from brick and mortar stores. It may also help local retail malls avoid a competitive disadvantage, potentially supporting local government assessed values and downtown commercial cores.

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2nd Quarter 2018 Review and Outlook

Tuesday, June 26, 2018

Municipal bond investors earned positive returns during the second quarter as longer-maturity bonds reached yield levels that generated solid interest from both domestic and overseas buyers. A solid technical backdrop for tax-free bonds enticed investors to re-engage in municipals, as supply remained unusually low during the quarter. The march to higher yields hit a number of speed bumps during the quarter as the U.S. Treasury market saw demand spike as emerging market economies began to feel the pain of the ongoing tightening cycle of the Federal Reserve. Also supporting the U.S. bond market were nascent fears that Italy may ultimately decide to leave the European union. This bears close watching in the coming months as it could immediately put the brakes on any further rate hikes by our central bank.

Not to be outdone by Italy, the municipal market has its own potential break-up to contend with, as an initiative to separate the State of California into three states has qualified for the November 2018 ballot. If approved by California voters and the U.S. Congress, the arrangement would hit the municipal market hard. This is due to the fact that California, which has over $74 billion of long-term debt outstanding, is the largest U.S. seller of bonds financing state and local government operations. Under billionaire Tim Draper's measure, California's debt would be distributed among the three states based on the population—and investors will not get a say in that.

In 2014, the Silicon Valley political-eccentric Draper sponsored a ballot initiative to divide California into six states. The effort failed, considered by many to be politically impractical and legally untenable. As a result, Draper has scaled back his ambitions.

According to Draper, the most populous U.S. state and the world's 5th-largest economy is "nearly ungovernable" under the current system. The measure calls for three smaller state governments: Northern California, encompassing San Francisco and 39 other counties; California, covering Los Angeles and five other counties; and Southern California, accounting for areas including Fresno and San Diego.

MTAM believes that a California split is a long-shot, to say the least. Even if voters decide Draper's idea is a good one, there has not been a break-up of a state since the Civil War. Government law experts say a plan would probably require an act of Congress—and it is unlikely that Republicans in Washington would welcome the idea of potentially adding more solidly blue states. Nonetheless, it cannot be understated that the potential for a seismic reaction by investors is possible should this initiative pass. As we move closer towards November, "poll watching" could ignite some volatility should the initiative gain traction with voters. MTAM has always stressed the importance of highly diversified portfolios, and given the potential disruptions to markets from overseas (Italy, emerging economies) and within our borders (California), we would strongly suggest advisors and individual investors follow our lead. Whether clients of MTAM have national or state specific portfolios with us, they see the great lengths we go to when investing in tax-free bonds to diversify their portfolios.

The potential for some amount of economic disruption is likely as the trade wars heat up between America, Europe, and China. This combined with the Federal Reserve's ongoing quest to slow the U.S. economy signals to us that municipal bonds have the potential to pleasantly surprise investors with generous returns in the second half of 2018.

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak

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State of the States - Midyear 2018

Friday, June 22, 2018

Fiscal 2019 will mark the ninth consecutive year of modest state spending and revenue growth, according to governors' budget proposals, as well as enacted budgets for some biennial budget states. Compared with this time last year, state fiscal conditions show signs of improvement and greater stability. General fund revenue collections have been on the upswing in fiscal 2018, giving governors more flexibility in their spending plans for fiscal 2019 compared with this time last year. The vast majority of states are meeting or exceeding their original revenue projections for fiscal 2018, following two straight years where at least half of states missed their targets. As a result, far fewer states have had to make midyear spending reductions in fiscal 2018 compared with the last couple of years. States also continue to prioritize their rainy day funds, with most states recommending increases in their reserve balances in fiscal 2019. While conditions have improved overall, states continue to face long-term budget challenges as spending demands for fixed costs such as pension contributions and health care are expected to grow faster than revenues over the long term. States are also assessing the impacts of the new federal tax law on their revenues, and it remains uncertain how much of the revenue acceleration states are seeing in fiscal 2018 will continue into fiscal 2019 and beyond.

State general fund budgets are expected to increase 3.2 percent in fiscal 2019 (without adjusting for inflation), totaling $861.8 billion, according to governors' recommended budgets, in line with the average annual growth rate proposed by governors since the Great Recession. This represents an improvement over this time last year, when states were dealing with the impacts of lackluster revenue growth for multiple years, causing governors to propose extremely cautious budgets with a total general fund spending increase of just 1.0 percent for fiscal 2018. Overall, 42 states plan for general fund spending increases in fiscal 2019, including 35 states with planned increases of 2 percent or more. By comparison, this time last year, governors' spending plans for fiscal 2018 called for increases in just 35 states, and only 24 states were expecting growth of more than 2 percent. Governors' recommended spending changes by program area for fiscal 2019 reflect an improved fiscal environment relative to last year. For the upcoming fiscal year, governors called for general fund spending increases across all program areas totaling $26.5 billion (compared with enacted fiscal 2018 appropriation levels). While a modest increase, this figure represents a return to relative stability when compared with this time last year, when governors called for general fund spending increases of just $8.7 billion across all programs. K-12 education would once again receive the largest spending boost, not surprising given that it is the largest category of state general fund spending. Medicaid, the second largest component of state general fund spending, would also see a sizeable bump in general fund spending.

Improved revenue conditions in states this fiscal year led to significantly fewer states making mid-year budget reductions compared with the last couple of years. Nine states reported making net mid-year budget cuts totaling $830 million in fiscal 2018, compared with this time last year, when 23 states reported mid-year cuts totaling $4.9 billion in fiscal 2017 – which was later reduced to 22 states making $3.5 billion in cuts when states reported on final fiscal 2017 spending changes. Overall, 19 states increased their fiscal 2018 budgets in the mid-year, resulting in a net spending increase of $1.6 billion across all program areas, compared with original enacted budgets. Overall, estimated general fund spending in fiscal 2018 increased 3.4 percent – higher than what was originally recommended and what states enacted, due to a combination of mid-year spending increases in fiscal 2018 and actual spending coming in lower than previously estimated for fiscal 2017. In the aggregate, estimated general fund spending in fiscal 2018 is slightly above the inflation-adjusted spending 50-state total in fiscal 2008, the pre-Great Recession peak one decade ago. Budget situations continue to vary by state. Twenty-seven states report general fund spending levels in fiscal 2018 that are lower than their fiscal 2008 levels, after adjusting for inflation – including 11 states with spending levels more than 10 percent below their pre-recession peak levels. At the same time, nine states have inflation-adjusted general fund spending amounts more than 10 percent above their fiscal 2008 levels.

Most states have seen improved revenue conditions in fiscal 2018 following the slowdown experienced in tax collections in fiscal 2016 and fiscal 2017. Total state general fund revenues grew an estimated 4.9 percent in fiscal 2018, after growing 2.3 percent in fiscal 2017. This improvement reflects continued job growth, a stronger performance of the stock market in calendar year 2017, and a modest recovery in some energy-producing states following steep oil and gas price declines. Fiscal 2018 revenues in a few states were also bolstered by enacted tax increases. The federal tax changes under the Tax Cuts and Jobs Act (TCJA) have implications for state revenue collections as well, and states are still working to better understand the new federal law's effects on their revenues. Note that the total estimated revenue growth rate is driven in part by faster growth in several large states – in fact, five out of the six most populated states in the country reported estimated general fund revenue growth above 6 percent for fiscal 2018. The median revenue growth rate for fiscal 2018 is much lower, at 2.7 percent, with a majority of states estimating revenue growth below 3 percent. At the time of data collection for this survey, 39 states were meeting or exceeding their original budgeted revenue projections – with 24 states coming in higher and 15 states on target. Based on updated general fund revenue information from states, the number of states exceeding their budget targets seems likely to rise further before the end of the fiscal year, which is June 30 for 46 out of the 50 states. General fund sales and personal income tax collections were both significantly exceeding original budget targets in the aggregate for fiscal 2018, by 2.1 percent and 0.9 percent, respectively. Among the states that have revised their fiscal 2018 revenue estimates since releasing their governors' recommendations for fiscal 2019, the vast majority made upward revisions for the current fiscal year. Compared with fiscal 2017 levels, sales and use tax collections are estimated to grow 3.6 percent (median rate of 3.7 percent), personal income tax collections by 7.0 percent (median of 4.8 percent), and corporate income tax collections by 3.2 percent (median of 2.8 percent) in fiscal 2018.

According to governors' budgets for fiscal 2019, states predict that general fund revenue collections will increase modestly, with total revenues growing 2.1 percent and 40 states forecasting positive revenue growth. The median growth rate for fiscal 2019 is higher, at 2.8 percent. Similar to the spending side, 27 states forecast revenues to increase between 2 and 5 percent compared with estimated fiscal 2018 budgets, with seven states forecasting growth above 5 percent, six states predicting growth between 0 and 2 percent, and the remaining 10 states forecasting revenue declines. Sales and use tax collections (31 percent of total general fund revenues) are forecasted to grow by a median rate of 3.5 percent in fiscal 2019 (total growth of 2.3 percent). Personal income taxes (45 percent of general fund revenues) are projected to grow at a median rate of 4.2 percent (total growth of 2.9 percent). Corporate income taxes, the third largest component of general fund revenues at 6 percent, are estimated to grow at a 5.0 percent median rate in fiscal 2019 (total growth of 8.4 percent). Large fluctuations in revenue collections in some states can skew 50-state total growth rates, while a median growth rate – the "middle" percentile when states' revenue growth rates are ranked lowest to highest – tends to be more representative of the "average" state. While total general fund revenue growth is expected to slow in fiscal 2019 relative to fiscal 2018, the median growth rates for the two years are nearly identical, and both fairly modest. Significant uncertainty surrounds these revenue forecasts, however, as states continue to analyze and predict the effects of federal tax changes under Tax Cuts and Jobs Act (TCJA) – including both the impacts related to how a state conforms with the federal code as well as behavioral responses by taxpayers to shift the timing of income. Most governors' budgets came out before states were able to incorporate the effects of the TCJA into their revenue forecasts. The federal tax changes have already affected state revenue collections for the current fiscal year – states saw a significant uptick in their December personal income tax collections, believed to be largely driven by high-income taxpayers making advance payments to take advantage of expiring tax breaks. While some expected April tax collections to be lower as a result, preliminary data available indicate that states saw strong growth in their collections in April too. States are still working to untangle and better understand these trends and the impacts of the federal tax law on their revenues, and it remains to be seen how much of the revenue increase this fiscal year will carry into fiscal 2019 and subsequent years.

Fiscal 2019 revenue projections in this survey incorporate the mostly modest tax proposals included in governors' recommended budgets. Governors in 14 states recommended net increases in taxes and fees in fiscal 2019, while 12 states recommended decreases, resulting in a net increase of $2.8 billion, including general fund and other state fund revenues. The revenue proposals with the largest dollar impact include packages of tax increases recommended by the governors of New Jersey and Oklahoma. Additionally, 16 states provided information on revenue measures, which would result in a net revenue increase of $3.0 billion. Most of this impact comes from the proposed drawdown from Alaska's Permanent Fund account, along with a recommendation to move New Jersey's energy sales tax revenues on budget. These measures usually enhance general fund revenue but do not affect taxpayer liability. Some of the personal and corporate income tax changes proposed during 2018 legislative sessions were prompted by or in direct response to the new federal tax law passed in December 2017. States have reacted to the Tax Cuts and Jobs Act in a variety of ways, depending on how their tax code conforms to federal law, political priorities, and other factors. Governors' revenue proposals responding to federal tax changes included actions to cut state tax rates, decouple from the federal tax code to prevent state revenue increases (or decreases), expand family tax credits, create options for taxpayers to mitigate the impact of the cap on state and local tax deductibility, and other provisions. Due to the deadlines for submitting proposed budgets, governors in many states made or endorsed later recommendations in reaction to the federal tax law changes.

Rainy day fund balances – budget stabilization funds and/ or reserve accounts set aside to respond to unforeseen circumstances – are a crucial tool that states rely on during fiscal downturns and to address shortfalls. States have made building up their reserves a priority in the years following the Great Recession, when rainy day fund balances fell to $21.0 billion in fiscal 2010 (or just $10.7 billion when excluding Alaska). Significant progress has been made since then – from fiscal 2011 to fiscal 2018, the median rainy day fund balance grew from 1.9 percent as a share of general fund expenditures to 5.8 percent, surpassing the pre-recession peak of 4.9 percent. The median balance is projected to rise to 6.2 percent in fiscal 2019, as governors continued to prioritize rainy day funds in their budgets, with 28 states recommending increases in their rainy day fund balances and only three states projecting declines. Rainy day fund levels, as a share of expenditures, vary across states. This variation is related to differing fiscal conditions, rainy day fund structures, policy decisions, revenue volatility levels and other factors. Three states – Georgia, Oklahoma and Wisconsin – were not able to report on their rainy day fund balance levels for fiscal 2018 and/or fiscal 2019. Excluding these three states, rainy day fund balances are expected to total $52.0 billion in fiscal 2017, $53.6 billion in fiscal 2018, and $58.1 billion in fiscal 2019. Total balances include both general fund ending balances and the amounts in states' rainy day funds. Total balances reflect the surplus funds and reserves that states may use to respond to unforeseen circumstances and to help smooth revenue volatility, though in some states, part of the ending balance may already be reserved for expenditure in a subsequent year. Total balances are estimated at $78.0 billion in fiscal 2018 (excluding Oklahoma), little changed from fiscal 2017, and they are projected to dip somewhat to $74.6 billion in fiscal 2019 (excluding Oklahoma and Wisconsin).

The median growth rate for Medicaid spending from all fund sources is estimated at 5.2 percent for fiscal 2018. Looking just at spending from state fund sources, the median growth rate is 4.5 percent, while spending from federal funds has an estimated median growth rate of 5.9 percent for fiscal 2018. Looking ahead, Medicaid spending growth is forecasted to slow considerably in fiscal 2019, based on governors' budgets. The median growth rate for total Medicaid spending is projected at 1.9 percent for the upcoming fiscal year. State fund spending is projected to grow by 1.5 percent (median), while federal fund spending is expected to increase by a median of 2.3 percent. Given large swings in some states that can substantially influence total Medicaid spending growth rates, examining the median percentage change often better reflects underlying trends, though timing issues can still skew the data. While Medicaid spending growth shows signs of slowing in the short term, the long-term growth projections for the program are expected to be closer to historical growth levels, about 5.5 percent per year, according to the Congressional Budget Office (CBO). The Medicaid program continues to pose long-term spending pressures for states as they monitor the impacts on their budgets of rising prescription drug costs, the growing elderly and disabled population, changes in federal laws and regulations, and costs associated with the opioid epidemic. States reported on continued cost containment and delivery service reform efforts, with states passing or considering policies to cut drug costs, enhance program integrity, and expand managed care. At the same time, with budget conditions fairly stable in most states, a number of states reported increasing provider payments and expanding Medicaid benefits, while fewer states reported restricting payments or benefits. States that expanded Medicaid also reported on their expenditures for the new adult eligibility group (including both "newly eligible" and "not newly eligible") by fund source. As states have begun to pick up a larger share of the cost, Medicaid expansion spending from state funds is estimated to increase $3.6 billion in fiscal 2018. Most states are planning for increases in state fund spending on Medicaid expansion in fiscal 2019 as well, though 50-state total spending from state funds is projected to decrease.

Conclusion

Overall, state fiscal conditions show signs of improvement compared to this time last year by a number of measures. General fund revenue growth accelerated in fiscal 2018, the vast majority of states are seeing tax collections come in on target or above budget projections, and relatively few states have had to make mid-year budget cuts in fiscal 2018. In this more stable environment, most governors recommended modest general fund spending increases in their budget proposals for fiscal 2019. Last spring, states were also facing tremendous federal uncertainty regarding future federal funding levels, health care and Medicaid financing, and the prospects for tax reform. Much of this uncertainty has been eliminated or significantly reduced – at least for the time being – after Congress reached agreement on a two-year spending framework, made no changes to Medicaid's federal/state sharing arrangement, and enacted the largest set of changes to the federal tax code in more than 30 years. States are now trying to untangle the complicated effects of the recent federal tax changes on their revenues, and it remains to be seen how much of the revenue uptick states are experiencing in fiscal 2018 will continue into fiscal 2019 and beyond. While budget conditions vary by state, all states to some extent are facing long-term spending pressures in areas ranging from health care and pensions to adequately funding K-12 education and infrastructure. States are also working to prepare for the next downturn by strengthening their reserve funds.

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Sports Betting Ruling is a Win for U.S. States

Tuesday, May 29, 2018

The Supreme Court of the U.S.' ruling last Monday overturned a 1992 federal law -- the Professional and Amateur Sports Protection Act (PASPA) -- that banned states from allowing sports betting. Many states are likely to welcome this new revenue source as years of slow economic growth have resulted in slim or negative operating margins. MTAM does not believe the ruling alone is likely to result in any rating upgrades, but the potential for an additional increment of revenue is welcome and has the potential to somewhat ease negative pressure on credit quality. This new opportunity for states may result in 2018 being the single largest year for gaming expansion.

New Jersey had challenged the law's constitutionality, saying that PASPA violates states' right to modify or repeal existing state laws, which is protected by the 10th Amendment. Since oral arguments in December, it was widely expected the law would be overturned. Under PASPA, sports betting was prohibited in all states except Delaware, Montana, Nevada, and Oregon, which already had existing laws allowing it. Across the country, states have hedged their bets by enacting or introducing legislation to begin expanding sports gambling as soon as the case is decided.

States most likely to expand gambling to include sports betting are those with existing off-track betting (OTB) facilities and casinos. While a number of states have existing tribal casinos, adding sports betting at those facilities may require amendments to existing gaming compacts. Some examples of states with existing sports gambling legislation include the following:

-- Connecticut enacted a law (PA 17-209) last year increasing OTB facilities by six and allowed development of regulations for sports betting should it become legal.

-- Mississippi passed HB 967 last year, allowing for sports betting should it become legal.

-- New Jersey already has enacted a law to expand sports betting and petitioned the Supreme Court to hear the case.

-- New York had allowed for implementing sports betting when legal as early as 2013 at commercial casinos under the Upstate New York Gaming Economic Development Act.

-- Pennsylvania's 2017 gaming expansion (Act 42) cleared the way for sports betting should it become legal.

-- The governor of Rhode Island's proposed fiscal 2019 budget included a provision to legalize wagering on sporting events and expects $23.5 million in revenue for the year.

-- The West Virginia Sports Lottery and Wagering Act became law in March, making it the first state to allow sports gaming in 2018.

Nearly 15 other states have proposed legislation to expand sports gambling. While some legislation would authorize the expansion at existing gaming facilities through statutory changes, some may require a voter referendum.

States are looking to bring in additional tax revenue from legalizing a market that has reached $150 billion. However, legalized sports gaming will not add to state coffers unless operators and players participate. MTAM believes that Pennsylvania's $10 million initial operator license fee, 34% state tax on gross gaming revenue (GGR) and 2% GGR local share assessment are likely to deter certain operators' interest and could incentivize them to outsource sports betting operations. By contrast, West Virginia's 10% GGR tax rate and much lower licensing fees are expected to generate greater operator interest.

Casino operators could grow sports betting to a wider range of locations. However, the growth will depend on several local factors. Setting competitive tax rates will be required to draw participants from existing illegal or informal wagering pools and could limit the growth of some markets. Higher tax structures, such as Pennsylvania's, or those with a handle-based integrity fee, which charges approximately 1% on each wager and pays it to the sports league, will limit margins for casino operators and could lower their ability to be competitive in those markets.

The impact of this expansion on casino operators will be small. We expect casino operators to set up sports books, or partner with companies such as William Hill, to offer betting at their facilities or, if permitted, online. The revenue effect will be small and we expect sports books to be offered as amenities to drive higher visitation, rather than raise revenue.

We do not expect the growth of other markets to have a negative impact on casino operators in Las Vegas. We do not anticipate sports books in regional markets will materially compete with Las Vegas during marquis sporting events, such as the NCAA Final Four or the NFL Super Bowl, as Las Vegas has firmly established its attractiveness as a leisure destination.

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Most States Have Room to Increase Their Debt

Thursday, May 17, 2018

Despite elevated credit pressures in fiscal 2017, state debt levels for the most part stayed constant. Although we anticipate more positive credit conditions heading into fiscal 2019, we think it is unlikely that there will be a significant uptick in debt levels. In our view, this speaks to the highly managed nature of state debt, in contrast to the cyclical nature of tax revenues and decades of inadequate pension funding.

Overall debt levels remain sustainable, with few exceptions. While affordability studies and debt management policies seek to curb debt issuance, they do not necessarily result in restraint.

Total state tax-supported debt increased 0.1% to $492.4 billion in fiscal 2017, following two years of modest declines (0.4% in 2016 and 1% in 2015), indicating that even as economic indicators have improved, states have not been willing to take on more debt. Median debt ratios in comparison with population, personal income, and gross state product also remained the same or fell slightly, suggesting that slow economic growth alone has not limited bonding capacity.

The reticence to borrow persisted despite anticipation that the Federal Reserve would continue to raise interest rates, giving them a strong incentive to capture low interest rates while they still could to finance roads, bridges and other public works. The prolonged weakness in states issuing new debt is linked to slower growth in state revenues and an environment that makes issuing new debt difficult. The slow growth in debt has caused a slowdown in state infrastructure spending, with these projects now largely financed by current spending.

The average net-tax supported debt among states was $1,477 per capita, with 31 states under that figure. Connecticut had the highest in net tax-supported debt per capita at $6,544. Nebraska had the lowest -- just $20.

While most states exercised fiscal restraint, Illinois, the lowest rated U.S. state, bucked the trend last year by increasing its debt 16%. That was not because it was investing in infrastructure, though: Illinois sold $6 billion in bonds to pay off a backlog of bills left from a long-running standoff over the budget. That boosted Illinois' net tax-supported debt per-capita to $2,919, the sixth highest in the country.

General obligation debt continues to comprise the largest share of state debt outstanding at 52.2% of all debt issued in 2017. Appropriation and lease debt remains the second largest share of state debt outstanding at 19.7%. Special tax debt is third largest, accounting for 13.4% of net-tax supported debt.

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The State of Connecticut, the City of Hartford, and the Contract Assistance Agreement

Wednesday, April 11, 2018

One of the nation's most indebted states will see what it owes get even larger under a recently signed agreement to rescue its beleaguered capital from bankruptcy. Last week, the State of Connecticut cemented its commitment to the City of Hartford's general obligation bondholders through the contract assistance agreement (CAA) that provides for the State to assume annual debt service on the City's $550 million in outstanding GO bonds. The CAA alters the security pledge supporting bond repayment from a City GO commitment to a full faith and credit pledge of the State.

Hartford, a 123,000-resident city whose government has struggled to close budget shortfalls and revive its economy, owes $755 million in principal and interest through 2036. This will add to the financial burdens on Connecticut, which has been contending with its own chronic deficits. At $6,505, Connecticut's net tax-supported debt per capita was the highest of any state, according to a Moody's report last year. The figure has grown from $5,185 in Moody's 2013 report.

While U.S. states have a history of stepping in to help distressed cities, it is rare for a state to take on debt payments for a locality. "Our goal is to use this period of stability to continue to push for economic growth that will strengthen the City's financial position down the road," Mayor Luke Bronin said.

As part of the agreement, the City must provide ongoing financial reports and a rolling three-year fiscal plan to the state treasurer and secretary of the Office of Policy and Management. Hartford's fiscal 2019 budget must be approved by the Municipal Accountability Review Board (MARB), which was created by Connecticut in 2017 to help cities experiencing distress.

If the City has a cumulative unassigned general fund balance deficit of 1.5% or more than its general fund revenues, then it would trigger higher levels of oversight. Such scrutiny from the State also would be triggered by a default or if the City seeks approval for bankruptcy protection.

The agreement illustrates the lengths that states will go to in order to prevent municipalities from filing for bankruptcy -- a rarity in the $3.9 trillion municipal-bond market and something that can cause higher borrowing costs for other localities nearby.

Connecticut has a history of stepping in to help its localities: In 2001, the State established oversight of the City of Waterbury that lasted five years. Connecticut guaranteed deficit financing bonds issued by Waterbury in 2002, and put in place a control board that could cancel union contracts and renegotiate.

Since the recession, more states have created mechanisms for dealing with municipal distress. In New Jersey, former New Jersey Governor Chris Christie's administration took control of gambling hub Atlantic City's finances in 2016, a move that local officials resisted at the time.

In 2010, Rhode Island's legislature passed a law that allows the State to appoint a receiver if a locality is undergoing a fiscal emergency. It also allows for the state revenue director to make debt payments if an issuer seems unlikely to pay. Still, the State can charge those costs against any aid due to the locality. Ohio added designations in 2011 to identify practices that could result in a declaration of fiscal emergency.

Michigan, known for a longtime state law that allows for the placement of an emergency manager, passed laws in 2017 that requires municipalities with underfunded pensions to develop action plans to fix them. Pennsylvania in 2011 passed legislation establishing a state receivership process to address the fiscal woes of its capital Harrisburg.

The Connecticut deal also allows Hartford's debt to be refinanced using the State's full faith and credit backing. That step is more commonly used by states: In 1975, New York allowed for the creation of a corporation to issue debt on behalf of New York City, which was on the brink of bankruptcy at the time. Pennsylvania also created a similar mechanism for Philadelphia in 1991 when its largest city was struggling with a financial crisis.

But few, if any, states have taken on the debt load of their cities to provide relief. And doing so adds to the financial burden on Connecticut, which is now on the hook for Hartford's general obligation bond payments through 2036.

"Strong urban centers are vital to the State's well-being," Denise Nappier, Connecticut's state treasurer, said. "Declining to help Connecticut's capital city could have adversely affected the financial health and vibrancy of surrounding towns, while helping Hartford actually might make a potential slippery slope less likely."

Mayor Bronin said he thinks the plan will be beneficial for the State as well. "If we want Connecticut to be economically competitive, we have to have strong, vibrant cities that can help drive that economic growth," he said.

MTAM believes the CAA is consistent with the State's articulated policy goals and appropriations included in the 2018-2019 biennial budget, although we observe the addition, albeit modest, to the State's already high debt burden from this undertaking. The CAA is not expected to have a negative impact on the State's ratings at this time.

Once viewed as a challenged but relatively stable credit, Hartford's financial standing became more precarious in recent years to the point where bankruptcy and default were recently considered serious possibilities. In reaction to these risks, the State's 2018-2019 biennial budget incorporated multiple responses to the situation, including the newly formed Municipal Accountability Review Board (MARB). The budget also included two successive, $48 million appropriations to accommodate expected payment for Hartford's annual debt service in fiscal years 2018 and 2019 of $40 million. The remaining allocation is available for other local governments under MARB's oversight. The City of West Haven is currently the only other municipality in the State under this supervision.

MARB was created to provide financial assistance and fiscal oversight for any of the State's distressed municipalities that apply for it. It classifies municipalities based on financial distress criteria and assigns them to one of four tiers, with the highest tier calling for a stronger degree of state oversight and control. The MARB legislation permits Tier III and IV municipalities to enter into a CAA for debt service assistance.

We view the reassigned Hartford debt service requirements as modest within the State's $18 billion annual budget, with no measurable change to carrying costs. The assumed principal increases the State's debt burden by only 0.2% of personal income, to 10%. While we view the increase as negligible, Connecticut's high liability burden has weighed on its credit for many years and remains a concern. A more widespread assumption of municipal debt obligations, currently believed to be an unlikely scenario, would become a credit concern given the State's high debt load.

We do not anticipate a surge in municipalities seeking MARB assistance as no other municipality, aside from West Haven, has reported fiscal stress comparable with Hartford and, perhaps more importantly, due to the strict conditions that are placed on local governments under MARB's oversight. These conditions, which are dependent on a municipality's level of financial stress, are likely to limit interest in the program.

Depending on the assigned tier, municipalities under MARB's oversight are required to submit multi-year financial plans and seek contract and collective bargaining approvals, and could be subject to revenue increase limitations and other stipulations that relieve a municipality of its home rule authority. State statute also provides Connecticut with the authority to compel Tier III (Hartford and West Haven) and Tier IV municipalities (considered most distressed) to restructure any GO obligations for which the State has assumed debt service payments at any time to ease the financial burden on the State. Additional aid provided to MARB-municipalities does not guaranty that they will receive the same amount of state revenue sharing in future years and they could experience cuts in municipal grants, cost sharing allocations, or PILOT payments.

We consider the State's creation of the MARB as a positive for local government bondholders and other municipalities in the State. The MARB legislation outlines financial distress measures that state officials can monitor to help prevent fiscal distress and permits oversight and controls, similar to other states with fiscal oversight boards, and represents a proactive strategy by the State to assist its local governments.

In response, Moody's last week upgraded the City of Hartford's general obligation bonds to A2 from Caa3 based on the contract for financial assistance with the State of Connecticut effectuated March 27, 2018. The A2 rating on the City of Hartford's GO bonds reflects the strong legal provisions governing the State's obligation to make contract assistance payments on the bonds, and the essentiality of the State's commitment to its capital city. The obligation to make the payments to Hartford is a full faith and credit obligation of the State, and the state treasurer is required to make payments from the State's general fund to Hartford's paying agent without further need for appropriation. The rating is one notch off the State's GO rating to reflect the possible risk of payment interruption or reduction should Hartford file for bankruptcy.

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1st Quarter 2018 Review and Outlook

Wednesday, March 28, 2018

Many investors in intermediate tax-free municipal bonds experienced small negative total-returns in their portfolios during the first quarter of 2018. As we correctly speculated in our last quarterly commentary, shorter maturity municipal bonds significantly outperformed during the first quarter, posting essentially unchanged returns as investors embraced lower duration assets to shelter their portfolios from rising market interest rates. Bearish sentiment in regards to the prospects of increased issuance of U.S. Treasury bonds steadily guided interest rates higher during the quarter, proving too much of an impediment to municipal yields remaining stable. We suspect the treasury market has—at a minimum—approached yield levels where domestic and global institutional demand may act as a speed bump to even lower bond prices which can be construed as a sign that the bulk of the sell-off may be behind bond investors.

Growth and employment in the U.S. economy remained quite healthy during the first quarter, undoubtedly assisted by the tax cuts recently enacted by Congress. Interestingly enough, the Federal Reserve continued to "lean against" the benefits of the tax cuts to the economy by once again electing to raise short-term interest rates. From a historical perspective, the timing of fiscal policy being stimulative (tax cuts) whilst monetary policy becomes more restrictive (higher rates) is about as difficult as handicapping the outcome of the first fight between Muhammad Ali and Joe Frazier. Dubbed the "fight of the century" in 1971, both gladiators entered the ring with impeccable records of success as both were undefeated in their careers. Fiscal stimulus and tighter monetary policy also have robust records of achieving their desired outcomes of strengthening and slowing the economy. Miller Tabak Asset Management expects an economic "draw" during the remainder of 2018 as these two divergent policies fight it out to see if higher growth or recession gain the upper hand. However, it is in 2019 where we see a Mike Tyson versus Michael Spinks outcome for the economy. You may recall that both fighters were also undefeated in their careers when they met in 1988. The outcome of this fight was much more pronounced—it ended quickly, and Spinks never fought again. Much like Michael Spinks, we see the economy hitting the canvas in 2019 as the constant body blows administered by a Mike Tyson-like Federal Reserve bring the economy to a halt (as our central bank historically always tightens policy too much).

Moving forward, the correction to higher yields of longer-dated municipal bonds has us approaching the market with a bias to marginally extend portfolio duration should the opportunity present itself to buy top quality municipal issuers at a bargain price. Given our view that the Federal Reserve will ultimately prevail in slowing the economy, we are biased towards higher overall portfolio credit quality, as protecting client capital remains our primary focus. By way of a review, here are the core disciplines of Miller Tabak Asset Management to ensure your municipal bond portfolio never hits the canvas:

  • All holdings rated "A3" or higher in terms of credit quality as judged by our internal proprietary research
  • Avoiding riskier sectors of the municipal market, such as health-care and tobacco bonds
  • No bonds purchased will be longer than fifteen calendar years to maturity
  • Any municipal issuer that refuses to disclose timely economic, financial, and debt updates will immediately be sold

Advisors and clients should visit our website during the quarter, as we have an extended library of research on a multitude of topics relevant to municipal bond investors.

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak

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New Tariffs and the Impact on U.S. States and Local Governments

Wednesday, March 21, 2018

State and local government budgets and infrastructure projects could be at risk from the tariffs the Trump administration recently imposed on steel and aluminum. A shift toward protectionist trade policies may also have negative implications for most state economies. The economic and tax revenue implications could force states and localities to reevaluate the forecasts that underpin their key budget assumptions. Our overall assumption is that the tariffs will have enough exemptions to them that their impact should be minor.

There are 11 states that count on exports for more than 10% of their economic output, leaving them most at risk if President Trump's steel and aluminum tariffs prompt other countries to retaliate against U.S. businesses.

Louisiana (21%), Washington (17%), and South Carolina (15%) rely on exports the most, leaving them the most exposed. Higher steel and aluminum import prices would affect states where these imports represent a larger share of total imports, among them Missouri, Louisiana, Connecticut, and Maryland. Smaller cities reliant on export-heavy manufacturing have a potential for economic disruption.

And although President Trump's decision to exempt Canada and Mexico removed most of the negative economic consequences from the tariff increases, we nevertheless believe that the specter of a trade war triggered by the tariffs could lead to a small pickup in inflation, which could cause the Federal Reserve to be more aggressive in raising interest rates. This could risk a sharper economic slowdown in 2019 than forecasted.

We could witness slower economic growth than most states have assumed in their forecasts. Such an outcome could translate to lower tax revenue growth rates, further squeezing state fiscal margins, which have already been under pressure in recent years.

Any slowdown in U.S. economic growth stemming from shifts in trade policy could have a similar dampening effect on local governments, and trade-related changes would only exacerbate this for local economies heavily dependent on the export industry.

In the past when the U.S. has turned to tariffs, it has resulted in trading partners responding by enacting their own duties on U.S. exports. The proposed tariffs that take effect March 23 prompted retaliatory threats from countries around the globe.

The European Union and China are among those that have said they would retaliate by placing tariffs on U.S. products exported to their countries. Mexico and Canada, which comprise 25% of steel and 45% of aluminum imports to the U.S., were exempted from the metal tariffs. The Trump administration is considering tariffs on $60 billion in Chinese goods, which could further pressure retaliatory measures from China.

It is not necessarily the metal tariffs, but retaliation from trading partners, particularly Europe, Japan, and China that represent the risk to budgetary forecasts. If the tariffs led to retaliatory measures the Federal Reserve could raise rates more than most forecasts assume, which would impact retail sales.

The State of California has a fairly significant stake in the potential fallout if trading partners decide to retaliate because logistics and trade are significant economic drivers for the state. California is also a destination for manufactured goods from Asia that are then trucked throughout the country.

Slowed U.S. economic growth resulting from shifts in trade policy would most heavily impact local governments dependent on the export industry. Seattle, Los Angeles, Chicago, Houston, and New York together account for 15% of all U.S. exports, according to U.S. Census Bureau data. The impact on credit quality to those cities could be less significant because of their economies being diverse. For smaller cities where export-heavy manufacturing can dwarf other sectors, a shift in the pace of exports creates greater potential for economic disruption and credit deterioration.

We also deem the tariffs a credit negative for the U.S. infrastructure sector because they are likely to cause steel and aluminum prices to increase, making projects that need those supplies more costly.

Projects that could see cost increases include renewable and fossil fuel power plants, pipelines and liquefied natural gas export facilities, airport terminal construction, transportation projects, and seaports.

U.S. ports will experience the greatest impact, because they will be affected on both the expenditure and revenue side. The Port of New Orleans could be affected the most, because 15% of its imports are steel. Houston and Los Angeles have comparable volumes of steel, but steel represents less than 2% of revenues for those ports, so less of an impact is anticipated.

We are expecting both imports and exports to remain at current levels or grow with the health of the economy. The ports are on the front line if any type of expansive trade war develops. We are not expecting this to initiate a widespread trade war, but the situation is still developing.

Gulf ports including New Orleans, Houston, and Mobile, Alabama that are heavily into oil refining and have the largest share of steel and aluminum imports are probably the most impacted. If there is retaliation from trading partners, the risk could spread to other ports.

It could stall what has been a very good year for the twin ports of Los Angeles and Long Beach, both of which have seen an increase in port traffic this year. The Los Angeles port processed 725,000 twenty-foot equivalent units in February, the busiest February in the port's history – and a 16% jump over last February's number, while the Long Beach port processed 661,790 TEUs, a 32.8% increase over last February, according to officials from each port. Steel represents only 2% of the Los Angeles port's business, but officials are concerned about the impact on Asia, because that is where the bulk of the port's cargo comes from.

In addition, the smaller economies of the Upper Midwest and the Southwest border states would be the most negatively affected state economies if the U.S. withdraws from the North American Free Trade Agreement (NAFTA), due to the states' high exposure to export trade with Canada and Mexico. Withdrawal would negatively impact employment and growth in these states, which would mean lower tax revenue, likely leading to constrained budgetary flexibility and higher unemployment. The entire U.S. economy would be less affected by withdrawal as exports of goods and services accounted for only 12% of U.S. GDP in 2016. Exports to Canada and Mexico accounted for 18% of all U.S. exported goods in 2016 or 1.4% of GDP.

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Higher Education: Remain Cautious with Small, Private Universities and Expect Additional Mergers

Monday, March 12, 2018

The credit outlook for U.S. colleges and universities is stable in 2018, though the gap is widening between larger, stronger universities and some of their smaller counterparts.

Operating revenue pressures will likely intensify for small, tuition-dependent schools in demographically declining areas or highly competitive regions. Barring those outliers, operating performance is expected to remain strong sectorwide, which coupled with steady student demand and enrollment and solid financial resources, supports a stable sector outlook.

Operating revenue also stands to be affected by the recently passed tax reform legislation, with annual charitable gift revenue and both state and federal funding to feel those effects most acutely. Most vulnerable are institutions already facing revenue pressures related to enrollment, tuition dependency, or those with limited liquidity profiles lacking material foundations or endowments.

Nonetheless, the majority of U.S. colleges and universities enjoy ample financial flexibility and have been proactive in minimizing the volatility of investment returns and increasing the overall liquidity of their total holdings. Well-positioned institutions retain meaningful balance sheet resources, solid demand, and increasing tuition revenue while keeping leverage in check. Most colleges are also effectively balancing the desire to maximize long-term investment returns and the need for capital investments against the need for sufficient working capital and liquidity.

This being said, some U.S. colleges and universities will continue to shutter, merge, or sell assets in 2018 as enrollments decline and states cut aid, which could lead to a small number of bond defaults. States with rising fixed costs and slow revenue growth will look to cut discretionary spending. Of 22 states with mid-year budget cuts in fiscal 2017, 17 cut an aggregate of $344 million out of their higher-education budgets.

Smaller, tuition-dependent private colleges that serve a more localized area, and public universities without strong national demand in fiscally-challenged states, will have a more difficult time. As several states add tuition-free programs at community colleges and state universities, the enrollment declines at these schools will likely be exacerbated.

The number of high school graduates are expected to decline by 2% by the 2022-2023 academic year. The Northeast and Midwest, which have the highest concentration of smaller, less-competitive 4-year private institutions, are projected to have a high school graduate decline of more than 2% while the South and West will see growth.

There has been a surge in mergers among colleges and universities since the recession, with bigger schools snapping up smaller rivals to extend their geographic reach or competitive advantage. But there have been few mergers between small private schools, which have been squeezed by heightened competition because the number of high-school graduates has shrunk and some students have shunned taking on costly loans to cover tuition.

There have been at least 55 merger and acquisition transactions among colleges and universities from 2010 and 2017. A 'mergers of equals' has been rare.

Public university systems in Georgia and Wisconsin plan to consolidate campuses within their systems or have already done so. Last year, Boston University said it would acquire the much smaller Wheelock College, with just over 1,000 students.

When you combine two entities, once you get past a year or a year and a half of implementation, you may see the power of the two institutions having been merged together under one university. If done effectively and efficiently, the financial and credit profile could improve dramatically. Merged entities can benefit from increased enrollment, size, and programmatic diversity. As such, we expect the pace of mergers to increase.

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Higher Oil Prices and the Impact on the Top Energy-Producing States

Monday, March 5, 2018

In November 2014, MTAM released a special report entitled 'Lower Oil Prices and the Impact on the Top Energy-Producing States'. Consistent with our long-held view, outsized budget reserves in most of the oil-producing states appears to have provided an effective fiscal cushion as they transitioned to lower oil prices. Since then, oil prices have rebounded and we decided to revisit the topic.

The rising price of oil and crude oil production increases are improving the economic and financial stability in most oil-producing states. However, the natural resource states' revenue growth prospects remain constrained and, for some, financial resiliency has become weaker.

The U.S. oil industry's rise has benefitted Alaska, Louisiana, New Mexico, North Dakota, Oklahoma, and Texas (natural resource states). Economic growth and tax revenues tied to higher prices and production have risen. However, financial operations for many could remain tight as the fallout from successive one-time actions, including substantial reserve use, applied in recent budgets in response to the multi-year price and production downturn continue to challenge them. In addition, the recent oil bust could temper these states' expectations of a long-term turnaround in the industry.

The U.S. oil industry's recovery is underpinned by strong production growth. It grew by 11% in 2017 on the expansion of shale companies' production after organization retrenchments necessitated by the late-2014 price plunge that bottomed at $26.21/barrel (bbl; West Texas Intermediate [WTI]) in February 2016.

Prices have been rising as well. An OPEC/Russia agreement to limit production and growing global demand have pushed oil prices up beginning in 2017 from $52.33/bbl to $59.64/bbl by year's end. The 2017 acceleration boosted U.S. rig counts to 930 at the end of the year; up 36% from January 2017, but still far below the 1,904 rigs in service in September 2014.

Forecast

The U.S. Energy Information Administration (EIA) forecasts a 1 million bbl/day increase in U.S. oil production in 2018 from 2017. The EIA expects a 2018 average of 10.3 million bbl/day in production, rising to 10.8 million bbl/day in 2019. Growth regions identified by the EIA include the Permian region in Texas and New Mexico and the federal Gulf of Mexico. Production in Alaska is expected to remain flat in both 2018 and 2019. The forecast for the WTI price is $50.00/bbl for 2018 and $52.50/bbl for 2019; the long-term forecast is a subdued $55.00/bbl, reflecting the high level of market uncertainty and lower global production costs that are unlikely to result in a sustained period of materially higher prices.

Many factors could have an impact on these expectations, including deteriorating compliance within the OPEC/Russia production cuts, and U.S. producers' response to recent price increases.

Throughout 2017, there was a confluence of developments supporting higher oil prices, and MTAM believes that is likely to continue this year. These include the continuation of OPEC production cuts, ongoing supply disruptions, globally synchronized growth portending solid demand, reported declines in crude inventory levels, and a weakening U.S. dollar.

The energy-industry states will likely see continued economic growth this year as the price of oil rebounds. That promises a much-welcome boost to governments that saw revenue disappear after oil prices began collapsing four years ago, triggering downgrades to some states' bonds.

Conclusion

Oil prices, which slipped to as little as $26 a barrel two years ago, have since more than doubled to $63, just shy of the more than three-year high hit last month.

All major oil-producing states are likely to see their economies expand in 2018, with Texas poised to lead with 4% growth, according to data from IHS Markit. These states rely on energy production as a key driver of their economies and for taxes levied directly on the industry.

Stabilizing economic performance combined with a range of fiscal adjustments implemented in the energy-producing states has brought about an easing of the negative pressure on the credit quality they were experiencing. The higher prices have not resulted in any rating upgrades for the states yet. Still, municipal bond investors have responded to the recent rise in the price of oil by demanding less compensation on at least two oil-producing states' debt, signaling that credit risk may be abating.

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President Trump's Infrastructure Plan

Monday, February 26, 2018

The Trump Administration last week released the long-awaited details of its plans to fix the nation's broken and crumbling infrastructure. President Trump's "Legislative Outline for Rebuilding Infrastructure in America" framework is aimed at shaking up the federal government's role in infrastructure investment. The administration's infrastructure proposal, part of its fiscal year 2019 budget request, faces an uncertain path through Congress.

The plan unveiled three new programs and other changes intended to provide $200 billion in federal funding which, combined with state and local funds and private capital, could lead to $1.5 trillion of new infrastructure investment. The plan also pledges to dramatically shorten the time it takes to obtain permits, and outlines a host of other features that could revamp state and local governments' infrastructure investment decisions while opening the door to the private sector.

The Trump administration's infrastructure proposal would significantly expand private activity bond (PAB) usage and speed the approval process. Both developments would be a credit positive for infrastructure projects. However, the proposal's effects on overall infrastructure development would be small as the proposal lags the need in the U.S. by trillions of dollars. In addition, there are political risks to implementation with uncertainties including legislative support and potential opposition from states.

The proposal would make PABs applicable to a broader array of infrastructure projects and would also increase the amount of PABs that could be issued by raising state volume caps. An expansion of PABs would give project finance a bigger set of funding options and could mean more private investment in infrastructure, both of which would help address the aging infrastructure in the U.S.

The infrastructure proposal includes $200 billion in federal funding over 10 years, largely repurposed from existing transportation programs. States and locals are asked to provide up to an 80% match for competitive grants and loans for $120 billion of this total. In contrast, most current federal funding operates on a 80% federal to 20% state and local match ratio. In the proposed plan, $50 billion will go directly to governors for rural infrastructure, while $10 billion will be for federally owned infrastructure, and $20 billion will fund expansion of existing federal loan programs and private activity bonds. The $200 billion represents limited increased federal funding over the next decade with much of it reallocated from existing transportation programs including Amtrak and the Federal Transit Administration's Capital Investment Grants (New Starts).

Many states have implemented transportation funding increases in recent years at a time of federal inaction. This will limit their willingness to pursue the additional revenue increases required by the proposal. Since 2013, 26 states and the District of Columbia have implemented transportation funding changes according to the National Conference of State Legislatures. Often, the additional funding has been directed to specific initiatives with a heavy focus on maintenance of existing facilities. We anticipate these states in particular will be challenged to meet the proposed 80% match requirements for new projects.

The new cap on the SALT deduction implemented with the December 2017 Tax Cuts & Jobs Act (H.R. 1) further limits state and local governments' flexibility to generate the funding called for in the administration's plan. Taxpayers in 19 states and the District of Columbia had average SALT deductions exceeding the $10,000 cap imposed by H.R. 1, according to the Government Finance Officers Association (GFOA). The average deduction exceeded $9,000 in another 12 states in the GFOA analysis, which was based on 2015 Internal Revenue Service data. Tepid growth in state tax collections, which makes meeting operating spending demands for education and health care an ongoing challenge, further complicates states' ability to dedicate funding to a new federal transportation program.

The problem for U.S. infrastructure has never been a shortage of private capital, but rather how it is paid for. Even if policymakers reject the overall plan and its role for private capital, we see an inevitable need for Americans to accept paying more to use the nation's infrastructure. At its very essence, the plan forces into the political debate a conversation about who will support new infrastructure because massive federal funding is no longer on the table. And if the gap cannot be bridged by local and state governments alone or through additional direct federal spending or programs, the private sector will inevitably have to be involved in the solution.

The proposal did not include a solution for the Highway Trust Fund (HTF). The HTF collects federal fuel tax of 18.4 cents per gallon on gasoline and 24.4 cents per gallon of diesel fuel and other excise taxes. The Congressional Budget Office estimates the HTF will become insolvent under current law by 2020, threatening a primary source of existing federal support for infrastructure. The HTF provides $40 billion in highway spending and $10 billion in transit spending to states annually. The Federal Highway Administration reports that since fiscal year 2008, trust fund spending has outpaced revenues, requiring $140 billion in congressional transfers from other funds, mainly the treasury's general fund.

Conclusion

The Trump administration's infrastructure proposal relies heavily on funding from state and local governments. MTAM believes that providing funding from tax revenues could be challenging for some state and local governments as many have already raised revenues in recent years to fund infrastructure investments, and general revenue growth has been slow. While opening the door to the private sector, the plan includes limited additional federal funding and lacks a long-term solution for the federal highway trust fund, which serves as the primary source of existing federal infrastructure funding. Highway trust fund insolvency remains a significant long-term federal infrastructure issue.

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The Legalization of Cannabis in California

Monday, February 5, 2018

As acceptance for cannabis legalization expands, the widely varied regulation and tax structures at the state and local levels have led to a measurable - and in some cases substantial - revenue boost. Tax provisions have been central to nonmedical legalization, as a way to gain public support and discourage consumption, similar to other vice taxes. Cannabis is now legal in some form in 30 states where 64% of Americans reside.

The benefits of cannabis legalization as a harm-reduction strategy appear likely to supplement gains from new revenues. States may see decreased public safety costs, including reduced arrests, prosecutions, and jail-time. Public health costs may also be positively impacted, notably by a potential decline in opioid abuse.

Negative outcomes may become more apparent over time, but appear likely to be less consequential than impacts from other legal substances, such as alcohol or tobacco.

Taxes are most significant in states that have legalized nonmedical cannabis, a market that appears likely to dwarf the medical cannabis market based on the broader pool of potential consumers. The low end of cannabis taxation stands at 10%-20%, while the higher end - due to multiple state and local taxes - can reach as high as 50%.

In California, the retail sale of nonmedical cannabis began on January 1, 2018 following California voters' approval of the Control, Regulate and Tax Adult Use of Marijuana Act (Proposition 64) in November 2016. In addition, residents of seven California cities voted to impose local taxes on cannabis in the November' 2017 elections. With retail sales beginning on January 1, the newly approved measures will add to the already substantial tax burden on legal cannabis, potentially undermining California's fledgling legalization initiative.

Voters in the cities of Cotati, Farmersville, Modesto, Pacifica, Palm Springs, Rio Dell, and Woodlake approved cannabis measures, joining local governments across the State that adopted local taxes in prior elections. In total, 67 of California's 540 cities and counties have adopted local cannabis taxes to date, contributing to combined state and local tax rates that could be as high as 45%. Taxes include a 15% state excise tax, state cultivation taxes of $9.25 per ounce for cannabis flowers ($2.75 per ounce for leaves), and state and local sales taxes ranging from 7.75% to 9.75%. By comparison, Oregon taxes nonmedical cannabis at 20% and Alaskan taxes range from 10% to 20%.

High taxes increase prices in legal markets, and have the effect of reinforcing price advantages to long-established black market cannabis. Taken together, state and local tax burdens put California at the high end of the tax range for states that have legalized nonmedical cannabis.

In Colorado and Washington, revenues, though initially short of expectations, have ultimately exceeded estimates measurably. Monthly growth rates have slowed more recently, suggesting some maturation of the legal cannabis market.

California's high cannabis taxes may encourage black market sales and limit potential local government revenues from this new market. The State's black market will also benefit from its long history as a supplier to states where nonmedical cannabis remains illegal.

California became only the latest of the states to contend with black market staying power. Colorado, Washington, and Oregon each lowered their cannabis taxes following legalization to address black market competition. Proposition 64 and most local tax measures included provisions that could permit reductions in tax rates over time. However, future tax cuts may be politically challenging to implement.

Federal restrictions pose an additional and ongoing risk to revenues in states that have legalized medical and nonmedical cannabis. The risk of intervention has risen under the current presidential administration following the U.S. attorney general's call for increased enforcement of drug laws that continue to classify cannabis alongside heroin and LSD. Rising popular support for cannabis legalization nationally may mitigate such risks over the longer term.

In the mean time, California is searching for a solution to the lack of access to banking for the State's cannabis businesses. As the State closes its first month of legal recreational cannabis sales, the governor, state treasurer, attorney general, and the legislature are all working on the issue.

"We are contending with a multi-billion dollar cannabis industry that needs banking services, and a private banking industry that is stymied by federal law in meeting the needs of the new industry," said Treasurer John Chiang.

Federally insured and regulated banks have refused to handle transactions from cannabis businesses, because the federal government still considers marijuana an illegal drug, one facing increasing hostility under the Trump administration.

The lack of access to banking means that cannabis businesses keep a great deal of cash on hand making them targets for robberies.

The state attorney general's office and treasurer's office are both moving forward on dual, separate feasibility studies to create a state bank to provide the industry with banking services. The state attorney general's office study will look at the legalities while the treasurer's study would look at operations. The studies will consider the costs, benefits, risk, and legal and regulatory issues.

That would include considering whether an online bank or a bricks-and-mortar institution would be a better solution and potential alternatives for capital and whether bonds might be part of that.

In separate efforts, California Governor Jerry Brown has proposed a correspondent bank, which would act as a wholesaler for a network of smaller banks. And, state Senator Bob Hertzberg, D-Van Nuys, introduced a bill that would give a new state charter to financial institutions that are not federally insured to issue certified checks and handle payroll for cannabis workers licensed by the State.

U.S. Attorney General Jeff Sessions rescinded a trio of Obama-era memos on January 4 that stipulated a policy of non-interference with cannabis-friendly states. The moves means federal prosecutors across the country now have to decide how to enforce federal laws regulating cannabis possession, distribution, and cultivation of the drug in states where it is legal.

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Amazon's HQ2

Tuesday, January 30, 2018

Amazon recently announced that it has narrowed its choices of potential second headquarters sites to 20 communities. The company expects to select a site by the end of 2018 that it says could eventually encompass $5 billion in real estate investment and 50,000 mostly high-paying jobs (over the next 10 to 15 years). Aside from Toronto, the remaining 19 cities are domestically-based, with nearly half on the East Coast.

While the city that Amazon chooses for its second headquarters will likely experience an improvement in credit quality, the incentive packages that some cities may have to offer could offset the revenue gains. In evaluating the credit effects of Amazon's site decision, we expect to examine the potential positive economic and revenue effects of the investment against the cost of any incentives.

The scale of the proposed real estate investment and addition of high-paying jobs would have mostly positive local economic and governmental revenue effects, which would be most noticeable in communities that are relatively small or have lower per capita effective buying incomes.

Amazon wants the city that lands its second headquarters to have a "stable and business-friendly environment." To corporate America, that means no surprise tax increases, please. Some cities may forego increased tax revenues, expecting to capture trickle-down economic benefits.

But eight of the 20 finalists have high debt and pension-fund bills, a potential red flag that they may come looking for extra revenue in the years ahead. Atlanta, Austin, Chicago, Dallas, Indianapolis, Los Angeles, Philadelphia, and Pittsburgh are among the cities with more than 250,000 residents that spend the greatest share of their budgets on debt, pensions, and retiree medical benefits.

Among the other 12 finalists, Columbus and Denver can boast relatively low debt and pension burdens.

The 20 finalists have various levels of fiscal health. Using the fixed-cost ratio as a determinant for the level of financial flexibility, several cities on the list struggle under the weight of debt service and legacy retirement costs, including the population centers of Los Angeles and Philadelphia. Each of these cities has fixed-cost ratios above 25%. Yet Philadelphia appears more stressed with a poverty rate in excess of 26% vs. 18% for Los Angeles.

Many studies have been conducted on the economic benefits outweighing the costs of tax incentives necessary to lure a desired new corporate citizen. In looking at the issues facing Seattle -- such as increased traffic, rents, home prices and homelessness -- this windfall may come at a price.

Amazon is the fourth-largest employer in the Seattle area, but does not even enter the top-10 largest customers for Seattle Light and Power, despite the large sums the utility spent on Amazon's current location. Spending by the utility to facilitate the build-out of almost 8.1 million square feet of office space is just one form of subsidization that a new host city should keep in mind. Seattle Light spent upwards of $210 million to build out a new substation in the Denny Triangle portion of Seattle.

With few options to outgrow fiscal woes, some cities -- and even states -- may resort to an all-out, high-risk financial proposition to land Amazon HQ2. One example is Newark (NJ), which has offered $2 billion in local tax incentives and another $5 billion in state tax breaks, as the state searches for new revenue sources.

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Credit Comment on California's Latest Budget Proposal

Monday, January 22, 2018

The State of California is enjoying its highest credit ratings (Aa3/AA-/AA-) since the turn of the century, primarily due to a record-setting stock rally, a resurgent real estate market, and a Silicon Valley boom that swept away once crippling budget deficits. Yet Governor Jerry Brown's latest annual spending plan is focused on risks ahead. The governor has proposed a fiscally-restrained budget with a large rainy day fund pointing to uncertainty in State revenues and the potential fallout from the federal tax overhaul enacted last month.

Governor Brown, who took office seven years ago, has overseen a financial turnaround for the most-populous U.S. state that has been lauded by Wall Street. After revenue rebounded, in part because of tax increases, the governor used some of the windfall to pay off debt and add to the savings account that can be tapped the next time the economy stumbles.

California's revenue is volatile because it draws a large share of taxes from wealthy residents whose incomes are tied closely to the stock market, which saddled the State with huge budget deficits after the Internet and real estate bubbles burst. The top 1% of earners accounted for nearly half of the State's personal income tax collections in 2015. Voters in November 2016 approved a 12-year extension of higher tax rates on the wealthy, deepening the reliance on their fortunes.

There is some volatility and some risk that California has that other states do not. In periods of economic growth, the State is going to outperform; in periods of recession, the State is going to underperform. State officials' ability to mitigate those swings is going to be manifested through their budgeting practices.

Recent Financial and Economic Results

California tax revenues came in $85 million below estimates in November, but were ahead by $588 million on the $40.5 billion year-to-date forecast, according to the California Department of Finance.

Both personal income tax revenues and sales use tax receipts came in below expectations for the month, though corporation tax revenues came in ahead of projections. Personal income tax revenues were $86 million below the month's forecast of $4.9 billion. Sales and use tax receipts came in $48 million below the month's forecast of $2 billion. Corporation tax revenues came in $88 million above projects, which were expected to be a negative $108 million.

Economic indicators were positive. California real gross domestic product rose by 2.1% in the second quarter, compared with only 0.6% growth in the first quarter. U.S. real GDP rose 3.1% in the second quarter.

California's seasonally adjusted unemployment rate fell by 0.2% to 4.9% in October. While this rate equaled the pre-recession low from March to December 2006, it remained 0.2% higher than the 4.7% in May and June of this year, according to the Department of Finance.

California housing permits jumped to their highest level since March 2007 with 141,000 permits issued in October 2017 on a seasonally adjusted annualized basis. Multifamily housing permits led the gains, rising 127% to 79,000 units, while single-family housing permits rose 4.9% to 62,000 units. Through the first ten months of 2017, California housing permits averaged 112,000 units, 11.4% above last year's year average.

2018-19 Budget Details

On January 10th, 2018, Governor Brown unveiled his $131.7 billion general fund ($190 billion all-funds) budget proposal for fiscal 2019 (the final of his governor's tenure). The proposal is favorable from a credit perspective. It recommends materially increasing budget reserves, seeking to preserve for more difficult economic conditions some of the fiscal gains the State has achieved during the past seven years.

Governor Brown, who took office in 2011 while the State was still reeling from the effects of the recession, has strove to keep more of a cushion for future downturns, a theme he kept in his last proposed budget as governor. He boosts the rainy day fund to $13.5 billion with a supplemental transfer of $3.5 billion. The additional deposit in the coming year would make the rainy day fund fully meet the constitutional goal of saving 10% of tax revenue.

The governor's proposed budget indicated that California also plans to slow the pace of general obligation bond sales. Brown estimated the State would sell $4.1 billion of general obligation bonds over the 2018 calendar year. Such sales would total $2.5 billion from January through June and $1.6 billion from July through December. Early last year, Brown had projected the State would sell $5.7 billion in the 2017 calendar year vs. $4 billion projected in 2016, and $3.6 billion in 2015.

Obstacles ahead include possible federal setbacks ranging from the effects of the recently enacted tax overhaul -- which will fall heavily on some residents by capping state and local tax deductions -- to the potential loss of funding for children's health insurance.

The biggest battle in this year's California budget process is likely to be about what to do with an estimated $7.5 billion budget surplus. The governor's budget would direct $3.5 billion into the rainy day fund in addition to the $1.5 billion constitutionally required through legislation that created the fund in 2014. Brown's budget would also place $2.3 billion into an operating reserve fund in addition to the money going into the rainy day fund. The Legislature's Democratic majorities have signaled that they think some of the surplus should be used to bolster social programs, particularly those for the very poor.

Given the uncertainty at the federal level and the likelihood of more federal cuts to social programs, the governor could strike "a better balance between putting funds away for later and boosting state investment now to help more households to make ends meet and climb the economic ladder, especially in light of our State's highest-in-the-nation poverty rate," said Chris Hoene, director of the California Budget & Policy Center, a think tank that focuses on how the State's budget policies impact poor and middle-class residents.

The much-outnumbered Republican caucuses have their own ideas for the surplus. They want $2 billion to be used for reserves, $2 billion to pay down pension liabilities, and $2 billion to go to local government to fund housing incentives, homeless shelters, and fix local streets and roads.

Senator Jeff Stone, R-Riverside County, supported the governor's plan to bolster the rainy day fund, but suggested that the level of the surplus gives the State plenty of room to return some of the money to taxpayers "to mitigate any negative impacts that may come from the recently adopted federal tax reform legislation."

Brown's budget would also send money to local governments with $8 billion in flexible funding to help counties as they continue to deal with the shift that began in 2011 of non-violent offenders from state prison to county jails. He also would allocate $3 billion for K-12 schools through local control funding to put more money in the hands of schools that have higher concentrations of impoverished students and English learners.

Brown's budget also takes aim at the State's estimated $67 billion in deferred maintenance. The 2015 and 2016 budgets allocated $960 million to the most critical deferred maintenance projects such as levees and high-priority state facilities including office buildings and the Capitol Annex.

This budget takes into account the passage of Senate Bill 1, the gas tax, which it says will provide $55 billion in new transportation funding over the next 10 years, split equally between state and local projects.

The governor's spending plan would allocate $4.6 billion in new transportation funding in fiscal 2018-19 including $2.8 billion to repair neighborhood roads, state highways and bridges, $556 million for trade and commute corridors, $200 million for high-priority transportation projects and $721 million for passenger rail and public transit modernization.

Brown's budget would direct $1.3 billion to natural resources and housing infrastructure spending presuming that state bond measures passed by the Legislature last year will be approved by voters in November. The Legislature approved 15 bills last year to encourage housing construction to help fill an annual 180,000-unit of homes that need to be built over the next 10 years to alleviate the housing crisis. One placed a $4 billion general obligation housing bond measure on the statewide ballot in November, while the other is expected to bring in $250 million a year through a $75 fee to most real estate transaction documents, except on the purchase or sale of property.

The governor's January proposal is an opening gambit in the long march toward a budget that is to be adopted in June, before the July 1 beginning of the fiscal year. The governor will release a revised budget proposal in May using updated revenue figures from April's income tax filings.

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Municipal Bond Market – Credit Outlook for 2018

Monday, January 8, 2018

Municipal bond issuers will continue to face several credit challenges in 2018, but MTAM expects that the vast majority of municipalities will successfully manage through most difficulties with a combination of spending cuts and revenue enhancement plans.

Notwithstanding the challenges facing municipal bond issuers, there are always good opportunities, even for the very conservative investor. Despite our expectations for moderate levels of economic growth, we still expect defensive credits like water and sewer bonds, special tax bonds, and public power bonds to perform better from a fundamental perspective. These types of bonds tend to have revenue streams that are less subject to economic volatility, have strong covenants, or are tied to an "essential service", making debt service payment more certain. In addition, there is legal precedence that bonds backed by a dedicated revenue stream may be protected in the case of a municipal bankruptcy. We prefer bonds that have a clean flow of funds, broad revenue streams, and high debt service coverage tests.

State Governments

U.S. states are well positioned to meet budget forecasts in 2018 so long as the economy continues to grow, though five states could run into some issues. The credit outlooks for most U.S. states are stable and expected to remain so over the next 12 months. Federal action remains the pre-eminent factor driving state credit ratings this year. Decisions around Medicaid and tax policy present the most immediate risks while infrastructure, trade, and other policy areas will affect economies and budgets over time, all with varying degrees by state.

Nearly one year into the new federal administration, many areas of policy remain unresolved. Throw in increasingly contentious state budgeting sessions and policy becomes more of a challenge for states this year. However, state budget makers are historically conservative, which should make budget forecasts attainable for the vast majority of U.S. states.

Helping matters is the likelihood of the broader economy continuing to grow in 2018, which is what MTAM is projecting. Changes to federal funding could present a challenge without mandate relief, though states would likely rely on their strong ability to manage budgets and download fiscal challenges were federal changes to take place, protecting ratings.

The overall stable outlook for the sector, however, is not without its outliers. Not surprisingly, Illinois and New Jersey are once again on MTAM's 'states to watch' list in 2018 along with Connecticut, Kentucky, and Louisiana. Illinois will enter 2018 with an enacted budget for the first time in nearly three years, though whether the budget will be successfully implemented remains a lingering question mark. If Illinois reverts back to a pattern of deferring payments for near-term budget balancing, their credit rating could face more immediate pressure.

U.S. states continue to keep overall debt largely in check, though their pension burdens are larger and rising. Our calculations showed a modest year-over-year increase in median state long-term liability burdens at 6% of 2016 personal income compared with 5.6% one year earlier. We attributed the entire year-over-year increase to defined benefit pension liabilities versus bonded debt. Nonetheless, we still deem the median state liability burden low relative to state resources.

A different picture emerges when assessing liability burdens for individual states. We calculated that six states have liability burdens eclipsing 20% of personal income. Illinois tops the list with a total liability burden equal to 28% of personal income, followed by Connecticut, Kentucky, New Jersey, Alaska, and Massachusetts. By contrast, 38 states carry liability burdens below 10% of personal income, with Nebraska the lowest at 1.4%.

The disparity in liability burdens is driven mostly by pension obligations. Many states with elevated pension burdens provide pensions not only to state retirees but also to local teachers. Additionally, a history of weak contribution practices has resulted in actuaries forecasting that pension assets will be depleted for many states with the highest pension burdens. This requires a more conservative calculation of pensions under current accounting rules.

Unlike bonded debt, state pension burdens continued to rise. Factors driving this growth include weaker than expected asset performance during the most recent reporting period, inadequate contributions by some governments, long-term demographic trends and the continued shift by states toward lower discount rates.

Local Governments

Numerous questions concerning Federal policy and infrastructure adequacy will not impede the financial resiliency of U.S. local government ratings in 2018. Our stable outlook for U.S. local government ratings remains in place for 2018 thanks in large part to their financial dexterity in uncertain times, both economic and otherwise.

Local governments have long demonstrated the ability to close budgetary gaps throughout economic cycles. Also helping matters are reserve levels, which going into 2018 are well in excess of what is needed to offset a recessionary revenue decline.

Federal policy uncertainties around Medicaid, the federal tax system, and international trade could heighten the risks associated with local government non-property tax revenue. Depending on the outcome of each of these areas, school districts would be most at risk as a result of changes to Federal policy since they are most reliant on state aid. Also worth watching are localities bordering Canada and Mexico that would be vulnerable to loss of direct revenues resulting from changes in trade policy.

Infrastructure remains an ongoing concern and more so in light of Hurricanes Harvey, Irma, and Maria, which caused widespread damage in parts of Texas, Florida, and much of Puerto Rico and the Virgin Islands. That said, local government ratings should remain well-insulated from ongoing rebuilding costs as they are largely shouldered by the federal government. Local governments will not have to issue much debt that is not reimbursable by the federal government, so the recent storms should not affect debt service or long-term liability burdens.

Another area of note in the coming year is the desire by some local governments to create structures that protect bondholders from a government's general operating risk. One such structure is securitization, as evidenced by the recent creation of Chicago's Sales Tax Securitization Corporation.

Several California issuers along with the Chicago Board of Education have also issued bonds secured by tax revenues that lead municipal market participants to analyze the debt without regard to operations, and increased interest among some other local government entities is a real possibility in 2018.

Not-for-Profit Hospitals

Regulatory, political, and competitive challenges will intensify for U.S. not-for-profit hospitals and healthcare systems headed in 2018, resulting in a negative credit outlook for the sector. Growth in Medicare and Medicaid volumes are weakening provider payor mixes at a time when providers are moving from volume-based to value-based reimbursement in greater numbers.

Profitability will also continue to weaken gradually for the sector in 2018, although operating performance should largely be stable, similar to what was seen in 2017. That being said, growing pressure on salaries and wage expense and continued erosion in payor mix could adversely affect operating performance for lower-rated hospitals.

Operating expenses have risen faster than expected and Affordable Care Act reimbursement cuts and Medicare sequestration make it difficult for a hospital to be profitable. Tax reform legislation will also likely raise borrowing costs for all hospitals, especially smaller and lower-rated hospitals that have fewer financing options.

The proven operational resilience of hospitals should prevent steep sector-wide declines in performance in 2018; however, we do expect further divergence in financial performance depending on a hospital's size and geography. For many standalone or smaller hospitals located in low density areas with slow or stagnant population growth, operating margins have narrowed more quickly or turned negative already.

There is an expected renewed uninsured growth as Congressional Republicans are expected to continue undoing elements of the Affordable Care Act and the tax reform's repeal of the individual mandate will factor in more uninsured patients.

Republican leadership declared entitlement reform to be a top legislative priority in 2018. Should there be significant changes to Medicare and Medicaid, state finances are likely to quickly come under pressure, with negative downstream effects on hospitals.

Transportation

An otherwise stable outlook for U.S. transportation infrastructure in 2018 will be clouded somewhat by questions surrounding tax reform. Potential changes in tax, trade, and border policies could affect growth for some transportation segments. While tax reform will increase costs for capital improvements for U.S. transportation assets in the near-term and may limit issuer options, it may deepen the pool by opening up investments to a larger investor base. The government subsidy will need to grow modestly for projects that already need some public investment.

Broader questions aside, most major transportation segments are set for another stable year in 2018 with volume growth likely to mirror GDP and fuel prices remaining low. Moderate traffic growth is expected for U.S. toll roads, while some projects nearing capital plan completion may prompt MTAM to take some positive rating actions.

Our credit outlook is stable for U.S. ports in 2018, reflecting the expectation of healthy cargo and cruise growth balanced by a weak pricing environment, and continued overcapacity in the ocean carrier industry.

We expect loaded container growth to moderate to 2%-3% in 2018, consistent with growth in GDP and retail sales. Strong growth in consumer demand for goods and faster growth in exports will continue to support the sector.

Our stable outlook is also supported by projected low oil prices, which will alleviate transportation costs throughout the supply chain. Low oil prices also support the purchasing power of U.S. consumers, which is the primary driver of demand for import cargo and cruise travel.

While demand for U.S. ports will remain healthy in 2018, our outlook is tempered by a still-weak pricing environment. Many ocean carriers continue to operate at losses, which reduces seaport operators' flexibility to increase terminal charges or scale back service and investment levels. Further consolidation among shipping companies will increase carriers' negotiating leverage over seaport operators.

The ocean carrier industry has demonstrated modest success in efforts to reduce supply and improve profitability, but the continued supply-demand imbalance remains a risk for ports.

Large infrastructure projects, such as the expansion of the Panama Canal and the elevation of the Bayonne Bridge at the Port of New York and New Jersey, support the deployment of larger cargo ships to ports in North America. As ports continue to improve harbors and terminals, users can access them more efficiently, which lowers costs and increases the competitiveness of U.S. routes in carriers' networks.

Although some Caribbean islands were devastated by hurricanes in 2017 directly before the winter booking season, we expect that the cruise industry will revise its itineraries away from the affected ports of call, sparing U.S. ports any significant loss of traffic.

Our outlook could be revised to positive if container growth exceeds 4% and ocean carriers exhibit greater financial stability that supports an improved pricing environment for terminal operators. The outlook could be revised to negative if container growth falls below 1% and there is renewed weakness among ocean carriers and a weaker pricing environment for ports.

MTAM is maintaining our positive outlook on the U.S. airports sector, reflecting the expectation that continued economic expansion will lift enplanement growth to 3.7% in 2018. Enplanement growth -- the increase in the number of passengers using an airport to depart on a flight -- is a key indicator for the U.S. airport industry outlook since it generally translates to higher parking and concession revenues, which account for about half of total airport revenue. Historically, enplanement growth is highly correlated with the average of GDP and airline seat growth.

The enplanement growth rate for large airports may slow in 2018, however, reflecting constrained capacity growth at primary connecting hubs for legacy carriers like American Airlines and Delta Airlines. We anticipate small and non-hub airports will see the strongest enplanement growth in 2018, reflecting the capacity investment in these markets by low- and ultra-low cost airlines. For example, Long Beach (City of) CA Airport Enterprise and Colorado Springs (City of) CO Airport Enterprise both saw 29% enplanement growth from September 2016 to September 2017 thanks to new service from Southwest Airlines and Frontier Airlines, respectively. All told, the increased net revenue will provide stronger debt coverage and, in most cases, result in greater liquidity.

Challenges for the sector include parking revenue declines as passengers continue to use services like Uber and Lyft to get to and from airports. While data from 2016 did not register a significant impact, data from fiscal 2017 shows some year-over-year declines in total parking revenue.

If airlines grow seat capacity at the low end of our estimate or if GDP growth fails to meet expectations, the enplanement growth rate for the sector could suffer. We would consider revising our outlook to stable if enplanement growth drops below the threshold of 3% and was expected to result in stagnation or weakening of revenue.

Water and Sewer

Uncertainties around the regulatory environment will not deter the stable outlook for the U.S. water and sewer sector in 2018.

The U.S. Environmental Protection Agency's (EPA) Lead and Copper Rule (LCR) may roll out revisions in 2018 following numerous stops and starts. Added capital and operating expenses could be meaningful depending on how significant the changes to LCR are. That said, any costs would likely be phased in over several years. Wastewater utilities will continue to face pressure from enhanced nutrient removal requirements as discharge permits are renewed periodically.

Despite the regulatory uncertainty, water and sewer municipalities have strong balance sheets that give them flexibility should capital demands increase. In addition, the latest medians point to slightly lower capital spending in 2018 and beyond from recent levels. Over time, however, sustained capital investment increases will be necessary to address deferred maintenance and preserve service levels over the long term for water and sewer municipalities.

Also solidifying the sector's stable outlook in 2018 will be a manageable debt profile, with MTAM projecting growth in debt to be muted. The likelihood of water and sewer utilities keeping new debt issuance modest in the coming year will also keep the debt profile sustainable even if interest rates rise.

Public Power

MTAM is maintaining a stable outlook on the U.S. public power sector for 2018, reflecting our expectation of timely cost recovery and lower capital spending requirements. The willingness and ability to set retail electricity rates is a fundamental credit strength of public power utilities, and serves as the key indicator for our sector outlook.

Fuel and interest cost trends, demand projections, and the pace of environmental regulation all indicate stable finances for the sector in 2018. We expect public power utilities will continue to evaluate their rate structures to ensure adequate recovery and maintain their competitive positions.

We project the median fixed obligation charge coverage ratio will be approximately 1.80x in 2018, in line with 2017 levels. Debt leverage in the sector will continue to moderate near 50%, reflecting less debt issued to fund new generation. Instead, public power utilities are shifting toward using regional energy markets and less capital-intensive generation.

Competitive customer retail rates will continue to be supported in 2018 by a combination of low interest rates, low fuel costs, better plant efficiency, and substantial excess power in most regions. Excess generation capacity will also keep rates down as public power utilities turn to regional energy markets for their customers while running owned generation less often.

While carbon emission policy at the federal level has slowed, many states and municipalities will maintain the pace of their existing renewable energy standards, posing challenges to some public power utilities. The cost of renewables continue to decline, which mitigates some carbon transition risk. But differing customer preferences are also affecting procurement decisions and creating regional differences.

While the sector continues to demonstrate resilience and adaptability to market challenges, risks from industry transition driven by technological developments such as energy storage will remain a near-term focus. Capital investment for protection against cybersecurity risks, meanwhile, is likely to represent a growing cost.

Our credit outlook could change to positive if the median fixed obligation charge coverage ratio were to exceed 2.0x. The outlook could be changed to negative if the ratio were to fall below 1.50x, or if there were a successful challenge to the fundamental credit strength of self-regulated cost recovery.

Colleges and Universities

The credit outlook for U.S. colleges and universities sector is stable in 2018, though the gap is widening between larger, stronger universities and some of their smaller counterparts.

Operating revenue pressures will likely intensify for small, tuition-dependent schools in demographically declining areas or highly competitive regions. Barring those outliers, operating performance is expected to remain strong sectorwide, which coupled with steady student demand and enrollment and solid financial resources supports a stable sector outlook.

Operating revenue also stands to be affected by the recently passed tax reform legislation, with annual charitable gift revenue and both state and federal funding to feel those effects most acutely. Most vulnerable are institutions already facing revenue pressures related to enrollment, tuition dependency, or those with limited liquidity profiles lacking material foundations or endowments.

Nonetheless, the majority of U.S. colleges and universities enjoy ample financial flexibility and have been proactive in minimizing the volatility of investment returns and increasing the overall liquidity of their total holdings. Well-positioned institutions retain meaningful balance sheet resources, solid demand, and increasing tuition revenue while keeping leverage in check. Most colleges are also effectively balancing the desire to maximize long-term investment returns and the need for capital investments against the need for sufficient working capital and liquidity.

Housing

MTAM has revised its outlook for the U.S. state housing finance agency (HFA) sector to stable from positive, reflecting the expectation that margin growth will slow in 2018. A combination of stable single-family loan originations and a gradual shift back to bond issuance will hold margins near 16% in 2017 and 2018. While HFA margins remain high, limited growth potential within the sector prompted us to change our outlook to stable.

HFA origination volume doubled between 2014 and 2016 due to interest rate subsidies and down payment assistance on mortgage products, high consumer confidence, a growing borrower base and effective use of the secondary market as an alternative financing tool.

For the next several years, however, a limited supply of affordable housing on the market will constrain originations near 2016 levels. First-time homebuyers with low to moderate income are the primary consumers of HFA mortgage products. In addition to flattening originations, a gradual move toward bond financing will also temper margin growth in 2017 and 2018.

The shift will have a positive effect on loans and bonds outstanding on HFA balance sheets, but will have a neutral to negative effect on margins. The scale depends on the extent to which bond financing cannibalizes their high margin secondary market business.

In the decade since the financial crisis, HFAs have actively strengthened their risk profiles by diversifying their loan origination channels, shifting their mortgage insurers to government providers and mortgage-backed securities and altering the structure of their variable rate debt. As a result, they are better prepared to face a future housing and financial crisis of the same magnitude, a strength that supports the stable sector outlook.

MTAM could change its outlook to positive if margins climb over 15% with a potential for growth. Operating margins of 10%-15% support a stable outlook, while margins of under 10% could lead to a negative outlook.

Default Outlook

Defaults in the U.S. municipal bond market continue to be rare, with just four in 2016 (most recent official data available), all related to the Commonwealth of Puerto Rico. The defaults, which included a Puerto Rico agency, compare with four in 2015, zero in 2014, and seven the year before. While the majority of bond issuers remain stable, more are confronting pressure from underfunded pensions, infrastructure bills, and other expenses.

Total debt affected was $22.6 billion in 2016, by far the highest annual default volume in a 47-year study period. The number of municipal defaults will more than double in 2017 if the various Puerto Rico credits now entering court-ordered resolution are restructured with bondholder losses or otherwise default. An additional $41.7 billion debt is at risk.

Municipal defaults and bankruptcies have become more common in the last decade, but are still rare overall. The five-year municipal default rate since 2007 was 0.15%, compared with 0.07% for the entire study period. In contrast, the five-year global corporate default rate was 6.92% since 2007. Competitive enterprises, such as housing and healthcare, account for most default events since 1970, while general governments and municipal utilities led in default volume.

Conclusion

Despite uncertain fiscal, economic, and regulatory pressures, U.S. municipalities will benefit from moderate economic expansion that will support revenue growth and stability. MTAM continues to recommend that investors select high-quality municipal issuers that understand the new financial reality and have made or are making budget adjustments. Essential service revenue bonds without the budgetary concerns of state and local governments and limited payrolls can be attractive, but we stress that an essential service issuer cannot flourish if the underlying governmental entity is in dire economic circumstances. A healthy outlook holds for most infrastructure issuers due to fundamental strengths reflected in the provision of essential public services, adequate balance sheets, and generally sound governance and fiscal management practices. In the case of the enterprise sectors comprised of higher education, health, and housing, credit quality will be maintained primarily as a function of their ability to increase fees, control costs, and improve overall operating margins. Sound debt and fiscal management practices, preservation of adequate liquidity, and strong governance oversight will be significant determinants of credit quality for issuers during the coming period of financial adjustment.

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4th Quarter 2017 Review and Outlook

Wednesday, December 27, 2017

Negative returns were prevalent in the fourth quarter of 2017 for municipal bond investors as a tidal wave of new issue supply overwhelmed the market and weakened prices in systematic fashion. The driving force behind this surge in supply was the tax reform bill that grabbed everyone's attention once it was divulged that issuers would no longer be able to "advance refund" their debt in 2018. Once the word got out about this shocking provision, municipal issuers worked around the clock to bring any debt to market that they could advance refund before the year ended. In fact, the month of December broke the all-time record for municipal debt coming to market — a whopping $55.6 billion. This provision of the tax reform bill did become law, so the municipal market has said "sayonara" to advanced refundings and with that, participants expect about 20% less new issue supply in 2018 and thereafter.

The future of "private activity" bonds also came under a cloud during the last quarter as the House of Representatives initially called for the end of tax-free financing in this sizeable sector of the market that includes universities, hospitals, and airports. While it was later learned that the Senate sought to preserve private activity bond issuance in their version of tax reform, it was too late to stem the onslaught of issuers who became concerned that market access may not have been possible in 2018. As a result, the onslaught of private activity bond deals commenced almost immediately to add to the overwhelming supply of municipal bonds last quarter. Ultimately, the final version of tax reform that President Trump signed preserves the tax-exempt status of private activity bond issuers.

Now that tax reform has been signed into law, it is important for tax-free bond investors to consider its potential long-term consequences on the municipal market moving forward:

  • The end of advance refundings → less supply → positive for prices overall
  • Federal deduction for payment of state and local taxes capped at $10,000.00 → will likely increase demand for in-state bonds → positive for prices of bonds of high tax states
  • Corporate tax rate dropping to 21% → less demand for municipals from banks and insurance companies → negative for prices overall

Interestingly enough, the technical forces of the municipal bond market (less supply) and the United States treasury market (higher deficits - more supply) are set to diverge in the coming months which bodes well for potential outperformance of tax-free bonds. In particular, shorter-term municipal bonds are oversold and excessively cheap to U.S. Treasuries in our view. We would not be surprised at all if shorter maturity bonds stage a comeback of sorts in January as billions of dollars of cash hit individuals' portfolios.

Moving forward, there is a plethora of unknowns relating to tax reform that will take many months to become more apparent to municipal market participants. However, what is unambiguously clear at this time is that market yields are somewhat elevated due to an excessive amount of supply that will not be repeated anytime soon. This keeps us here at Miller Tabak Asset Management quite focused on having your portfolios as fully invested as possible. "Scarcity" is a word tax-free bond investors are likely to hear in the coming months. For that reason, a strong buy signal has emerged in our view.

Happy New Year!

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak

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Municipal Bond Market – Proposed Tax Reform 2017

Wednesday, November 8, 2017

The House Republicans' "Tax Cuts and Jobs Act," if enacted, could mean shrinking the tax-exempt municipal market by at least one-third, and possibly as much as 40 percent, depending on the direction of interest rates. The important news is contained in the section "Subtitle G - Bond Reforms." The bill proposes terminating private activity bonds (PABs), repealing the use of advance refunding and tax-credit bonds, and prohibiting the sale of tax-exempts for professional sports stadiums.

We note that the likelihood of the passage of this proposed legislation into law remains far from certain and will be subject to potentially key changes as it proceeds through the House and the rest of Congress.

To appreciate the enormity of the Republicans' assault on future municipal market supply, you have to go to the Municipal Securities Rulemaking Board's glossary and look at the definition of "Private Activity Bond." And there you will find bonds sold for airports, docks and "certain other transportation-related facilities; water, sewer and certain other local utility facilities," single- and multi- family mortgages, blight redevelopment and student loans. And then: 501(c)3s, which means museums, hospitals, colleges and universities.

The tax reform proposal by Republicans in the U.S. House of Representatives could affect some states' and local jurisdictions' revenues if passed. Nonprofit hospitals could see a key funding stream evaporate if the tax bill becomes law. Private activity bonds, which are issued by governmental authorities to help private organizations pay for facilities and capital improvements, are currently exempt from taxation in certain circumstances, including when the proceeds of the bonds go to support qualified 501(c)(3) organizations, like most hospitals. The Republican proposal eliminates the tax exemption for the bonds altogether, which could increase the borrowing costs for hospitals and, in turn, force them to raise the rates for patient care.

The proposal could limit tax raising flexibility, particularly for the states that charge higher taxes, as it would substantially reduce the federal tax deduction for state and local taxes. This would cause an increase in the impact of state and local taxes, as they would be without an offsetting federal deduction. Residents in states with comparatively high taxes, such as California, Connecticut, Massachusetts, New Jersey and New York, would be more affected and may have less tolerance for higher taxes going forward. The proposed tax cuts for the higher-income taxpayers most likely to benefit from the current deduction for state and local taxes, including rate reductions and elimination of Alternative Minimum Tax, could somewhat offset this effect. Most states are not in a position to lower taxes in response to the federal tax increase due to tepid revenue growth and ongoing spending pressures.

If the proposed changes to the deduction of mortgage interest and the cap on the deduction for property taxes reduce the incentive to buy houses, assessed property values in areas with high average home prices could see lowered growth or even decline and reduce the amount of property tax local governments collect. This change could result in lower revenue growth prospects for local governments absent tax rate increases.

A proposed 1.4% excise tax on net income from the largest private colleges' endowments would be an incremental financial stress but would likely not have significant near-term credit effects on colleges or universities. The impact would be narrow. For example, only 140 endowments had funds in this range according to 'The Chronicle of Higher Education.' However, it could lower the incentives for donors to fund endowments and raise the possibility of higher and more onerous taxes on endowments in the future.

The potential elimination of private activity bonds and 501(c)3 non-profit bonds would likely lower the interest in and feasibility of public-private partnerships, which have increasingly been used to procure transportation projects. Eliminating PABs would raise airport financing costs and possibly cause a reduction in private participation in water projects.

Termination of advance refundings would hurt future supply of tax-exempt bonds. Under current law, governmental bonds are allowed one advance refunding. Advance refundings help issuers when interest rates plummet. They can advance refunding their bonds and reap considerable savings so they are not stuck with the higher coupon bonds. Sometimes advance refundings are needed to change covenants in bond documents that become outdated.

The PAB and advance refunding proposals in the House GOP's "Tax Cuts and Jobs Act" could significantly shrink the municipal bond market. PABs make up 15 percent to 20 percent of the municipal market. Advance refundings vary widely depending on interest rates, but three years ago they represented half of all new municipal issuances.

The bill also would put new limits on the federal deductibility of state and local taxes. It would limit the deductibility of property taxes to $10,000 annually while other state and local taxes would be deductible only for households with incomes under $400,000. The mortgage interest deduction, another key component for households that claim the SALT deduction, would be capped for future mortgage loans of $500,000. Current mortgages would be grandfathered.

Households would get a larger standard deduction of $24,000 for families and $12,000 for individuals. Personal exemptions would be replaced with a $300 credit for adults and a larger credit tax credit of $1,600 instead of the current $1,000.

Conclusion

MTAM remains bullish on holding and buying municipal bonds. The proposed tax plan is telling us that investors may not own enough longer duration tax-free municipal bonds. We believe the strong returns in the municipal market could be seen as rational given the tax plan's goal of decreasing future supply. Lately, the longest-dated municipal bonds have staged their strongest rally in 11 months as the Republican tax bill promises to sharply cut sales of new tax-exempt bonds. The efforts in Congress, if successful, also have the potential to increase demand for debt issued by higher-tax states such as California and New York by rolling back the ability to deduct local taxes from their federal income. That will leave residents interested in investments that will reduce their tax liability. MTAM strongly suggests raising investors allocation to this asset class, as the potential for a notable decline in supply could lead to higher prices and lower yields over time.

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak

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Chicago's New Securitization

Thursday, October 19, 2017

Last week, the Chicago City Council authorized a new bonding tool to refinance as much as $3 billion of debt in a move that officials say will lower borrowing costs for the junk-rated City (Ba1/BBB+/BBB-).

Council members approved the creation of a corporation that is legally and structurally insulated from the City, whose credit rating has been cut to junk by Moody's partly due to $35.8 billion of pension debt. Mayor Rahm Emanuel said the new authority would allow the City to "pay less to Wall Street".

The State of Illinois fiscal 2018 budget plan included a provision allowing municipalities to sell debt secured by state funds it receives.

About $700 million of the proceeds will be used to retire existing sales tax bonds and another $2.3 billion will be used to refund some of the City's outstanding general obligation bonds. Chicago Chief Financial Officer Carole Brown said she expects the debt to win a higher rating than the City's, leading to a lower interest rate and cost savings. Brown wants the corporation to sell the bonds in four separate deals with the first transaction of an estimated $600 million to $700 million occurring in late November, depending upon the underwriters' recommendation.

Brown told aldermen -- some of whom expressed skepticism and want more time to assess the program's benefits -- that the new credit structure will lower debt service costs without adding to the City's risk profile. The bankruptcy-remote legal provisions of the structure, removal of City operating risk, and statutory lien "should give us a better rating" and in turn "that should give us much lower rates," Brown said.

The City will assign its sales tax revenue to the new corporation that will issue bonds backed by the revenue, insulating the bonds from potential future City distress. Similar structures used in New York, the District of Columbia, and Philadelphia have won high-grade ratings.

Brown tried to quell the misgivings of aldermen who worry that their oversight powers will be diminished. Aldermen have been stung in the past for rubber stamping Emanuel's and former Mayor Richard Daley's bond financings and Daley's asset lease deals. That led to criticism as the public soured on the 2008 parking meter system lease, and the City's practice of using debt for budget relief made headlines.

The promised savings tamp down the worry for many aldermen, especially as the City is trying to erase $260 million of red ink in its next budget that will be unveiled this week. The precise savings is still unclear as the market may impose some penalty for both the Chicago and Illinois names. However, it is a new credit, so buyers constrained by their current holdings can participate in the deals. The lockbox on revenues is also appealing.

Brown said structuring details on maturities are still in the works so she cannot say with certainty that some existing debt will not extend beyond its current maturity but she stressed that "our intent is to do refunding" for traditional debt service savings and not for "restructuring" purposes.

Future use adding to the City's debt burden remains a worry for some aldermen. Brown left the door open during the hearing to using the program to tap other revenue streams and possibly to raise new money. The state legislation included in the fiscal 2018 budget packages allows for home rule units to securitize revenue streams that flow through the state. They include sales taxes, motor fuel revenues, gambling, and other taxes. Brown also left open the door to consider using the entity to eventually raise new money at "a lower cost to taxpayers," but made clear that was not her current recommendation.

Improved spreads seen after the City announced its intentions could reflect the market's initial view that the new program will ease some pressure on the City's GO credit and make it scarcer. But multiple market participants cautioned that the bankruptcy remote structure is not sure proof until truly tested. Greater interest in the use of securitization and dedicated revenue structures have grown out of Detroit and Puerto Rico's bankruptcies, where structures once thought safe were challenged.

In a potential bankruptcy situation, the inevitable question will once again arise: if more credits can get to the front of the line, then who gets left behind? The holders of the original full faith and credit GO bondholders of course. Brown sought to quell concerns. To existing GO bondholders, she offered the reminder that a portion of the sales tax is already tapped to back existing bonds and to pensioners who could see their position also diminished in a distressed situation she stressed that bankruptcy is not an option.

"The City doesn't have the ability to file bankruptcy" under state law and it does not have the "intention" to seek such approval, she said. The City has also put in place over the past year new funding streams to improve its weak pension system and she said the mayor would not "renege" on his commitment to the funds.

Brown told aldermen the program coupled with a show of "fiscal discipline" on pension funding, chipping away at the structural deficit, and shedding poor debt management practices, the City could improve its GO ratings in the coming years. She cited rating gains by New York, D.C., and Philadelphia. MTAM believes other factors contributed to these cities' upgrades, as all three have been under some type of oversight that required fiscal discipline.

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3rd Quarter 2017 Review and Outlook

Friday, September 29, 2017

Tax-free municipal bond investors earned marginally positive returns as still low inflation vexed bearish market participants who incorrectly positioned their portfolios for much higher market interest rates. Specifically, investors who positioned their investments in longer-dated municipal bonds (which are more sensitive to inflation expectations) were rewarded with greater returns as a tight U.S. labor market continued to surprise many with relatively anemic wage gains. Demand for municipal bonds continued unabated during the quarter, assisted by sophisticated investors rebalancing their portfolios away from a surging U.S. equity market. A nuclear-capable North Korea firing intercontinental ballistic missiles over Japan's air space undoubtedly added to the demand for fixed-income.

Municipal bond supply should pick up significantly in the coming weeks as municipalities look to take advantage of attractive financing rates before potential changes to the tax code take place. It will be interesting to watch prices of outstanding Illinois State general obligation bonds as they are likely to come under pressure as the State will be looking to sell six billion dollars of bonds to help pay a backlog on unpaid bills that currently exceeds sixteen billion. We would urge investors to watch the financial condition of the "Prairie State" closely as history suggests that excess borrowing rarely leads to economic prosperity.

Actions by the Federal Reserve should be front and center in the coming months, as they have conveyed an intention to reduce (taper) the amount of bonds purchased to support the economy. With inflation still trending low and the U.S. economy stuck in a 2% growth range, it is easy to see a scenario where "recession" indicators begin to burn a little brighter. History suggests that the Federal Reserve "overshoots" when tightening monetary policy, and the much sought after "soft landing" for the economy rarely occurs. With all due respect, Janet Yellen is no Chesley Sullenberger. As such, it will be our intention here at Miller Tabak Asset Management to keep cash balances low and portfolio credit quality high as monetary policy circles over the Hudson River.

Last but not least, it is largely anticipated (and priced into the market) that some sort of tax reform will occur. Should that eventual legislation fail to impress (or go the way of repealing Obamacare), a significant re-pricing of financial assets will commence. A bet on a tax package that is more attractive than what the market is expecting is a bet on bipartisanship—the ultimate "black swan."

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak

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Impact of Hurricane Irma on the State of Florida

Tuesday, September 12, 2017

While MTAM expects short-term economic disruption following Hurricane Irma, we believe the State of Florida is well-positioned, to the extent possible, to confront the potential demands of a catastrophic storm, namely Hurricane Irma, given the State's strong economy, governing framework, and infrastructure.

On September 4, 2017, Governor Rick Scott declared a state of emergency for all of Florida in anticipation of Irma. The governor also authorized activation of the Florida National Guard for the emergency, as needed, and approved the waiver of tolls and fees on public highways to facilitate evacuation of affected counties. Governor Scott also designated the Director of the Division of Emergency Management as the State's coordinating officer as outlined in Florida's existing statutes. Florida Statutes provide the division with the powers to coordinate allocation of resources and seek assistance from the federal government and from other states in an emergency. In addition, Florida has the resources available to meet immediate potential costs for State agencies.

Hurricane Irma weakened as it moved past Tampa, leaving in its wake at least 4.7 million without power, millions temporarily displaced, and a forecast for as much as 15 inches of rain in what may go down as one of the worst storms in Florida's history. The system's center was expected to soften to a tropical storm Monday morning and a tropical depression by Tuesday afternoon, the National Hurricane center said in an advisory. A storm surge warning was discontinued for parts of southern Florida as the storm headed north. Enki Research's estimate for total damages dropped to $49 billion from $200 billion earlier, mainly due to Irma's dwindling to a Category 2 before reaching the Tampa Bay area. With flood waters still flowing -- and before Tampa's defenses were tested -- some residents in the southern part of the State were counting themselves fortunate that the most dire predictions evaporated.

MTAM Monitoring

MTAM is closely monitoring the impact of damage related to Hurricane Irma in Florida, and its effects on general governments, utilities, educational and healthcare facilities, and transportation systems. Over the coming weeks and months, as more information on the level of damage and prospects for reimbursement and rebuilding become available, MTAM will continue to examine our internal ratings in affected areas and make adjustments if and when appropriate. We will be focusing on the governments that were relatively less prepared, that had lower levels of liquidity, and less robust contingency plans.

Most of the local governments hit by Hurricane Irma have contingency reserves for weather events, and will also be eligible for aid from the Federal Emergency Management Agency. For disaster areas, the federal government pays 75% or more of emergency costs, and up to 75% for hazard mitigation projects. States sometimes help local governments bridge any gaps in cash flows if there are delays in federal reimbursements. In the wake of Hurricane Irene, for example, Vermont accelerated local aid and allowed local banks to borrow from the state's Municipal Bond Bank to fund short-term loans for municipalities for clean-up costs.

But there can be serious risks to municipal credits. Those risks include: upfront cleanup costs that exceed budgeted contingencies; a lag in aid from state or federal governments; and delays in insurance reimbursements. Hospitals in hard-hit areas also may suffer from a significant decline of patients or the closures of outpatient clinics and doctors' offices. In addition, there could be expenses for overtime staffing of emergency workers and the costs of cleanup. Insurance may cover a majority of the costs associated with storm-related damage, but is unlikely to cover all of what will likely be higher expenses for the period.

In the immediate aftermath of a number of past disasters, a consequent reduction in the credit strength of municipal debt seemed inevitable. However, any economic and financial impact of those events has proven manageable in the short-term and not detrimental to long-term credit quality. Ratings have rarely been adjusted based solely on the impact of disaster-related damage. Property is often rebuilt or replaced, largely with funds that are reimbursed by other levels of government and private insurance. The replacement property may be of higher value than the original.

In the near term, MTAM will be most concerned about the magnitude of damage in a particular locality, and the extent to which management was prepared for a major storm event. MTAM takes this level of preparedness into account in assigning internal ratings, but if damage is more acute than envisioned, we will assess the risk that sufficient funds may not be available for non-discretionary costs including debt service. If we perceive heightened risk, a given rating will be re-evaluated.

In the longer term, MTAM will become concerned if damage appears to be of a magnitude that fundamentally changes a municipal issuer's economic prospects. The highest level of concern is likely to be in areas in which rebuilding is prolonged, incomplete, or costly to the locality, or in which population out-migration appears long-lasting. This could reduce the community's tax base or impair its growth potential.

MTAM believes that widespread downgrades of revenue bonds due to Hurricane Irma-related damage are unlikely largely for the reasons stated above. However, particular risks to entities whose ongoing operations are critical to pledged revenue generation may make their bonds more susceptible to downgrade. The most vulnerable kinds of debt include: sales and special tax revenue bonds, revenue bonds supported by operations of health care, educational, housing or other enterprise entities, and issuers of other revenue bonds. Similar to issuers discussed above, our analysis will include the magnitude of damage and the municipality's preparedness for such an event. Those with severe damage and weaker cash flows prior to the storm will be of greatest concern.

Municipal utility issuers in the affected area are likely to experience operational disruption, but generally maintain sufficient resources and liquidity to buffer the financial impact until more permanent funding arrangements are secured. Additionally, the authority and capacity to increase rates as necessary to maintain adequate cash flow is viewed as a fundamental credit strength for these issuers.

For higher education institutions that have experienced some facility damage, MTAM believes most have the ability to manage the increased costs associated with repairs. If there are institutions that remain closed for an extended period of time due to more extensive damage, we will monitor on a case by case basis to determine whether there will be longer-term negative repercussions, including potential impact on future student demand.

Credit Review of the State of Florida

As Florida heads into the 2017 hurricane season, the State's economic performance has been among the strongest nationally, and its available budgeted reserve levels are strong, at an estimated $2.75 billion or 8.9% of expenditures in fiscal 2017. Including trust fund balances of $2.45 billion, total reserves of $5.2 billion represented 16% of general appropriations, which we consider very strong. Beyond budgeted reserves, Florida also has the flexibility to inter-fund borrow from its treasury pool, which had a substantial $16 billion of liquidity on hand at the end of July 2017. Florida's service-based economy is driven by healthy tourism (including over 112 million person trips in 2016 per Visit Florida), which could experience declining trends in the aftermath of a storm.

Tourism comprises 13% of general revenue sales taxes, although tourism centers are distributed throughout the State and local effects could potentially be more severe. In addition, Florida's revenue base largely depends on sales tax revenue that could benefit from long-term recovery efforts. The timing of Hurricane Irma, at the beginning of the State's fiscal year, provides better odds that disrupted revenue will have time to rebound during subsequent recovery efforts. We believe the State's healthy budget reserves will aid in Florida's ability to withstand the expected hit to sales tax receipts in the immediate aftermath of the hurricane.

MTAM's internal rating (Aa1) and stable outlook on Florida continue to reflect the State's strong financial reserve levels and structural budgetary balance to date, with above-average economic and revenue performance in the past several years, including strong employment and population growth, despite a service-based economy that remains driven by tourism and in-migration. As always, we will continue to monitor events to determine the extent of the damage and the State's response to potential challenges related to hurricane remediation costs in the short-term.

Florida Citizens Property Insurance Corp. and the Florida Hurricane Catastrophe Fund

MTAM's stable credit trends on the debt issuance of Florida's state-run property insurers, including Florida Citizens Property Insurance Corp. (Citizens) and the Florida Hurricane Catastrophe Fund (FHCF), are unlikely to be affected by damage caused by Hurricane Irma. While Irma has left behind significant property damage, Florida Citizens and the FHCF are well-positioned to meet claims while continuing to provide strong bondholder protections. Both entities have accumulated exceptional levels of liquidity over the course of 12 years with minimal hurricane activity. Moreover, our stable credit trends on the debt of Citizens and FHCF are based on the entities' ability to assess a vast resource base as needed, rather than on their existing levels of liquidity.

Although Florida Citizens and the FHCF provide different insurance products (property insurance by Citizens and a form of reimbursement by the FHCF), both entities issue debt payable from emergency assessments on a large and diverse assessment base that includes virtually all insurance policies in the State. The assessment base totaled $44 billion as of December 2016. Our stable credit trends on bonds issued for Citizens' Personal Lines Account/Commercial Lines account and Coastal Account and for the FHCF (bonds issued by the State Board of Administration) reflect the ability of each issuer to access this base and are unrelated to insurance operations. Our analysis reflects growth prospects for assessment revenues that are strong given the assumption of continued expansion in the Florida economy. The analysis also reflects the revenue-generating potential inherent in the entities' assessment powers that provides robust resiliency through a downturn scenario despite volatility.

Following low catastrophe losses over the past 12 years, improved liquidity in each of these issuing entities provides strong ability to cover claims or reimbursement obligations. In the event of storm-related claims, each would draw upon accumulated resources to meet their obligations prior to levying emergency assessments or issuing bonds. MTAM assumes that this liquidity will be tapped and resources reduced following a major storm event and does not condition the credit trend on maintenance of high internal resources. A need to access the market after internal liquidity is depleted following a major storm would not in and of itself trigger a negative credit action. Rather, the entities are sensitive to fundamental changes in the Florida economy that materially reduce the claims-paying base and increase the magnitude of potential debt issuance relative to the existing resource base. While the circumstances that would drive the need to access the market may overlap for these issuers, we do not expect storm activity to fundamentally change prospects for the Florida economy.

Conclusion

Local governments in Florida hit hardest by Hurricane Irma could face downward pressure on their credit ratings if they have significant unbudgeted costs for cleanup that are not covered by insurance or various kinds of aid. But such downgrades should be rare and only in extreme cases. U.S. municipal issuers have an extremely strong track record of recovering from natural disasters [such as Hurricanes Katrina, Sandy, and Irene] without impairments to bondholders. The immediate disruptions of these disasters tend to cause short-term liquidity problems, but subsequent spending from insurance, federal aid, state support, and private charitable donations is very stimulative for local and regional economies.

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Impact of Hurricane Harvey on Southeast Texas

Monday, August 28, 2017

As Hurricane Harvey's winds die down, trouble for Texas may have just begun with forecasts for unprecedented flooding across the heart of U.S. energy production and in Houston, the nation's fourth-largest city. Hurricane Harvey will almost certainly turn out to be one of the costliest U.S. storms on record. Given the scope and severity of the damage, it is difficult to estimate the costs from the floods, wind and rain. The most expensive U.S. storm so far, 2005's Hurricane Katrina, caused $47.4 billion in damages.

Harvey came ashore as a Category 4 hurricane Friday near Rockport (TX). Harvey was the strongest storm to hit the U.S. since 2004. After making landfall, it was downgraded to a tropical storm and came to a near-standstill near the Town of Victoria (TX). Two deaths have been attributed to the storm, which has also halted about one quarter of oil production in the Gulf of Mexico and 5% of U.S. refining capacity. Its second act could be worse as Harvey stalls and promises to dump more than 3 feet of rain onto Texas for the next few days.

Harvey is flooding a region that has a cluster of refineries that process 5 million barrels of oil a day. About 1 million barrels a day of crude and condensate refining capacity in Texas have been shut by companies including Valero Energy Corp. Its path through the Gulf shuttered 24% of oil production, along with the Port of Corpus Christi, which ships the largest amount of U.S. crude overseas.

In addition to the energy threat, crops and livestock may struggle to cope with rising waters, while airlines have canceled flights at multiple Texas airports. At least 1,140 inbound and outbound flights were canceled Saturday from Texas airports in Houston, Dallas, Corpus Christi, Austin, and San Antonio. Another 1,224 were scrubbed on Sunday, with 1,389 planned cancellations for Monday. At least 291,300 customers were without power across the state. The drop in electricity demand could depress natural gas prices.

The rain is also wreaking havoc on the largest U.S. cotton producer, hitting Texas at a time when many farmers are storing excess supplies on fields following a bumper harvest. At least 100 cotton storage modules -- capable of holding 13 to 15 bales -- blew away near the coastal community of Gregory (TX). Ports at the Texas Gulf account for 24% of U.S. wheat exports, 3% of corn shipments, and 2% of soybeans.

President Donald Trump approved a major disaster declaration, making federal assistance available to supplement state and local recovery efforts. The U.S. Environmental Protection Agency waived certain fuel requirements for gasoline and diesel supplies in Texas, including the Dallas-Fort Worth area, to allay concerns of fuel shortages. If the storm does significant damage to the refineries in the region, or causes the Colonial pipeline to go offline, the effects could ripple to other parts of the country that rely heavily on the Gulf Coast for fuel supplies. Gasoline futures settled at a three-week high Friday as the storm approached.

MTAM Monitoring

MTAM is closely monitoring the impact of damage related to Hurricane Harvey in southeast Texas, and its effects on general governments, utilities, educational and healthcare facilities, and transportation systems. Over the coming weeks and months, as more information on the level of damage and prospects for reimbursement and rebuilding become available, MTAM will continue to examine our internal ratings in affected areas and make adjustments if and when appropriate. We will be focusing on the governments that were relatively less prepared, that had lower levels of liquidity, and less robust contingency plans.

Most of the local governments hit by Hurricane Harvey have contingency reserves for weather events, and will also be eligible for aid from the Federal Emergency Management Agency. For disaster areas, the federal government pays 75% or more of emergency costs, and up to 75% for hazard mitigation projects. States sometimes help local governments bridge any gaps in cash flows if there are delays in federal reimbursements. In the wake of Hurricane Irene, for example, Vermont accelerated local aid and allowed local banks to borrow from the state's Municipal Bond Bank to fund short-term loans for municipalities for clean-up costs.

But there can be serious risks to municipal credits. Those risks include: upfront cleanup costs that exceed budgeted contingencies; a lag in aid from state or federal governments; and delays in insurance reimbursements. Hospitals in hard-hit areas also may suffer from a significant decline of patients or the closures of outpatient clinics and doctors' offices. In addition, there could be expenses for overtime staffing of emergency workers and the costs of cleanup. Insurance may cover a majority of the costs associated with storm-related damage, but is unlikely to cover all of what will likely be higher expenses for the period.

In the immediate aftermath of a number of past disasters, a consequent reduction in the credit strength of municipal debt seemed inevitable. However, any economic and financial impact of those events has proven manageable in the short-term and not detrimental to long-term credit quality. Ratings have rarely been adjusted based solely on the impact of disaster-related damage. Property is often rebuilt or replaced, largely with funds that are reimbursed by other levels of government and private insurance. The replacement property may be of higher value than the original.

In the near term, MTAM will be most concerned about the magnitude of damage in a particular locality, and the extent to which management was prepared for a major storm event. MTAM takes this level of preparedness into account in assigning internal ratings, but if damage is more acute than envisioned, we will assess the risk that sufficient funds may not be available for non-discretionary costs including debt service. If we perceive heightened risk, a given rating will be re-evaluated.

In the longer term, MTAM will become concerned if damage appears to be of a magnitude that fundamentally changes a municipal issuer's economic prospects. The highest level of concern is likely to be in areas in which rebuilding is prolonged, incomplete, or costly to the locality, or in which population out-migration appears long-lasting. This could reduce the community's tax base or impair its growth potential.

MTAM believes that widespread downgrades of revenue bonds due to Hurricane Harvey-related damage are unlikely largely for the reasons stated above. However, particular risks to entities whose ongoing operations are critical to pledged revenue generation may make their bonds more susceptible to downgrade. The most vulnerable kinds of debt include: sales and special tax revenue bonds, revenue bonds supported by operations of health care, educational, housing or other enterprise entities, and issuers of other revenue bonds. Similar to issuers discussed above, our analysis will include the magnitude of damage and the municipality's preparedness for such an event. Those with severe damage and weaker cash flows prior to the storm will be of greatest concern.

Municipal utility issuers in the affected area are likely to experience operational disruption, but generally maintain sufficient resources and liquidity to buffer the financial impact until more permanent funding arrangements are secured. Additionally, the authority and capacity to increase rates as necessary to maintain adequate cash flow is viewed as a fundamental credit strength for these issuers.

For higher education institutions that have experienced some facility damage, MTAM believes most have the ability to manage the increased costs associated with repairs. If there are institutions that remain closed for an extended period of time due to more extensive damage, we will monitor on a case by case basis to determine whether there will be longer-term negative repercussions, including potential impact on future student demand.

Credit Review of the City of Houston

Houston features a large, diverse economy that has inherent exposure to the energy sector. Expansion of healthcare, port, and petrochemical industries over the past several decades has reduced the historically strong reliance on the oil and gas industry. Population and tax base growth continue, and we see the housing market as moderately overvalued due to notable price appreciation over the past few years. Ongoing gains in taxable values illustrate the increased diversity of Houston's economy. Longer term, continued expansion of the healthcare, shipping, and petrochemical industries is expected to be the principal growth driver of the regional economy.

The City has experienced little negative impact from the energy sector downturn on taxable values over the past several years. Taxable assessed valuation for fiscal 2017 totals $222.7 billion, up 8% from the prior year and continuing a trend of solid TAV gains over the past five fiscal years.

Houston is reliant predominantly on property tax revenues, with the energy sector contributing to sales tax volatility. The ability to increase ad valorem revenues is constrained by a 2004 voter approved charter amendment. The pace of spending is expected to be moderately above revenue growth, primarily due to hurricane-related recovery costs and pension-related spending. Management has demonstrated satisfactory cost-cutting ability and willingness, but carrying costs are high.

Debt levels are manageable, and the combined debt and pension burden is moderate as a percentage of personal income. If approved by voters, a proposed pension obligation borrowing will shift a portion of the overall burden from the net pension liability to the City's direct debt total, but should not affect the overall long-term liability burden assessment. The benefit and contribution changes included in a recently approved pension reform package are expected to produce a material reduction in the three plans' net pension liability (NPL), according to current City estimates.

Spending flexibility provides strong gap-closing ability through a down business cycle, although energy sector fluctuations could apply additional pressures periodically. The recently approved pension reforms will require the City to close a chronic gap between annual actuarially determined and actual pension contributions.

Houston's revenue framework is dominated by property and sales taxes. Performance through the last recession was better than many cities, as Texas' economy rebounded well from the 2008 recession. Uncertainty regarding the direction of energy prices is a primary revenue concern.

Houston's general fund revenue growth of about 4% annually over the past 10 years has exceeded both U.S. GDP and CPI for the same period; the gains were driven by increasing sales tax receipts and more recently climbing property tax revenues. Management had projected fiscal 2017 sales tax revenues to decline for a second consecutive year by 3% to $621 million; sales tax collections typically comprise 28% to 30% of general fund revenues.

A charter amendment approved by voters in 2004 (Proposition 1) limits annual property tax revenue growth to the lesser of the amount collected in the previous year plus 4.5% or the amount of property tax revenue collected in fiscal 2005 adjusted for the cumulative combined rates of inflation and population growth. A subsequent measure (Proposition H) adds up to $90 million in ad valorem tax revenues to the annual budget for public safety and related spending, such amount to be added to the following year's ad valorem tax revenue base.

As is the case with most cities, public safety is the largest spending component in Houston's general fund; it comprised two-thirds of fiscal 2016 operating outlays. Spending pressures in this area, as well as pension contributions, have highlighted budgetary concerns over the past several years. The City has demonstrated an ability and willingness to reduce spending and impose layoffs in recent years when budgetary pressures appeared.

Ongoing expenditure pressures are reflected in high carrying costs (debt, pension and OPEB) of nearly 28% of governmental spending for fiscal 2016. Reforms to the City's three pension plans were signed into law in May, and a requirement in the legislation to fund the actuarially determined contribution amount suggests a chronic pension contribution gap will close. If voters approve a proposed $1 billion pension obligation bond (POB) proposal this November, a portion of carrying costs will shift to debt service payments; however, benefit and contribution changes in the pension reform bill are expected to limit increases to overall carrying costs.

An analysis of Houston's operating resilience suggests maintenance of sound reserves during a downturn (even in the absence of any action by management), but this will obviously be tested by hurricane cleanup costs.

Conclusion

Local governments in southeast Texas hit hardest by Hurricane Harvey could face downward pressure on their credit ratings if they have significant unbudgeted costs for cleanup that are not covered by insurance or various kinds of aid. But such downgrades should be rare and only in extreme cases. U.S. municipal issuers have an extremely strong track record of recovering from natural disasters [such as Hurricanes Katrina, Sandy, and Irene] without impairments to bondholders. The immediate disruptions of these disasters tend to cause short-term liquidity problems, but subsequent spending from insurance, federal aid, state support, and private charitable donations is very stimulative for local and regional economies.

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State of the States - Midyear 2017

Wednesday, August 16, 2017

Recommended budgets for fiscal 2018 are extra cautious as states contend with slow revenue growth and limited budget flexibility, in addition to substantial federal uncertainty. Under executive budget proposals, state general fund spending would increase just 1.0% in fiscal 2018 compared with current estimated spending levels for fiscal 2017 – the smallest increase recommended by governors since fiscal 2010, when states were in the depths of the Great Recession. Fiscal 2016 and fiscal 2017 were marked by lackluster general fund revenue growth, resulting in numerous revenue shortfalls and requiring many states to make mid-year budget cuts in one or both years. States are forecasting modest improvement in revenue conditions in fiscal 2018, with some governors also recommending tax and fee changes. At the same time, governors' budget proposals display a significant degree of caution as states grapple with the effects of the recent weakness in their tax collections.

Fiscal 2017 revenue performance has been weaker than forecasted in states' budget projections. General fund revenues from all sources, including sales, personal income, corporate income and all other taxes and fees, are coming in below original budget forecasts in 33 states, on target in four states and above projections in 13 states. This marks the highest number of states reporting revenues coming in below what was budgeted since fiscal 2010, and the second consecutive year where more states came in below forecast than above forecast.

Sales tax collections – typically considered a relatively stable revenue source – are estimated to be $6.6 billion (2.5%) below budgeted levels for fiscal 2017. Personal income tax collections are estimated at $2.7 billion (0.8%) below forecast and corporate income tax collections are coming in $2.8 billion (5.7%) below projections. Data were collected prior to April tax collections coming in, so some of these figures may have changed. Preliminary reports and analyses indicate that many states have seen April personal income tax (non-withholding) revenues decline compared with the same month a year ago. Analysts attribute this – at least in part – to high-income taxpayers shifting income to next year, guided by an expectation of federal tax cuts for calendar year 2017.

A number of factors have contributed to the overall weakness in state tax collections over the past couple of years. Energy-producing states have encountered challenging revenue conditions due to the steep decline in oil and gas prices, as well as declining coal production. Sales tax collections have been especially weak, in part due to low inflation and a greater portion of economic activity falling outside the sales tax base of many states. While steady job growth has helped the withholding component of personal income taxes, other components like capital gains have been highly volatile, and corporate income tax collections are estimated to have declined outright for the second year in a row in fiscal 2017. Not all states have been equally affected by this softening in tax collections. From fiscal 2015 to fiscal 2017, 10 states saw their general fund revenues decline. However, over that same two-year period, eight states saw general fund revenues increase by more than 10%.

Overall, general fund revenues grew 1.8% in fiscal 2016, are estimated to grow 2.4% in fiscal 2017, and projected to increase 3.1% in fiscal 2018. Forty-seven states are projecting positive general fund revenue growth in fiscal 2018. The improved revenue situation expected for fiscal 2018 reflects continued job growth and signs of modest recovery in energy-producing states. In addition, governors in some states recommended tax and fee changes in fiscal 2018 such as increasing sales tax collections through rate hikes or base broadening, as well as increases in cigarette taxes, gas taxes, and other more targeted taxes. Compared with estimated fiscal 2017 collections, fiscal 2018 sales tax revenues are forecasted to grow 2.7% and personal income tax collections are projected to be 4.1% higher.

Since almost all states are required to balance their budgets and few are permitted to carry over a deficit, budget shortfalls that arise during the fiscal year are addressed primarily by reducing previously appropriated spending. In fiscal 2017, 23 states reported net mid-year budget cuts totaling $4.9 billion. All of these states also reported general fund revenue collections for fiscal 2017 coming in below original budget projections. Twenty-three states reporting net mid-year budget cuts is a historically high number outside of a recessionary period.

State budgets are projected to increase just 1.0% in fiscal 2018 according to governors' recommended budgets, the lowest nominal growth rate for general fund spending since fiscal 2010, when general fund spending declined due to the economic downturn and significant federal stimulus funds were provided to mitigate the full impact of that decline. State general fund spending is projected to be $828 billion in fiscal 2018 according to governors' recommended budgets, compared with an estimated $819 billion in fiscal 2017. Overall, 15 governors called for nominal general fund spending decreases in fiscal 2018, signifying the fiscal difficulties a number of states face, particularly after two years of weak revenue growth.

Estimated general fund spending increased by 4.8% in fiscal 2017, the highest rate of growth since before the Great Recession, helping total general fund spending surpass its pre-recession peak level in fiscal 2008 for the first time in real terms, adjusted for inflation. However, total general fund spending growth in fiscal 2017 is driven heavily by an anomaly related to Illinois's unique budget situation; excluding Illinois, general fund spending growth is estimated at a more moderate 4.1%. Total general fund spending growth for fiscal 2017 may also come in lower than these estimates once final data are available. Twenty-four states report estimated expenditures for fiscal 2017 that are still below their inflation-adjusted fiscal 2008 levels.

Governors have recommended extremely modest general fund spending increases in fiscal 2018, totaling only $8.7 billion across all programs – far lower than the $23.9 billion recommended by governors in their fiscal 2017 budgets. Most additional budget dollars are targeted at K-12 education, the largest category of state general fund spending, which would receive a $6.1 billion funding boost on net under governors' budget proposals. Medicaid, the second largest component of state general fund spending, would only see a $1.6 billion increase in general fund spending, though this figure is largely driven downward by a fund accounting change in Ohio.

Governors also recommended a moderate net spending increase for corrections, as well as slight net increases for higher education and public assistance. Additionally, transportation would see a small bump in general fund spending; however, since most states rely primarily on other fund sources to finance transportation spending, general fund spending adjustments are not necessarily reflective of overall recommended state spending changes for transportation. Governors recommended a net decline in general fund spending for all other program areas totaling -$1.1 billion.

Governors are proposing a net tax and fee increase for fiscal 2018. As has been the case in recent years, governors were more likely to recommend tax hikes on general sales, cigarette and tobacco products, motor fuels, and alcoholic beverages, while recommending mostly reductions for personal and corporate income taxes. Fifteen states are proposing net tax increases of $4.9 billion, while 12 are proposing net decreases totaling $1.2 billion, resulting in a net tax and fee increase of $3.7 billion. This net change is driven primarily by tax increases recommended by the governors of Oklahoma, Pennsylvania, and Washington State, which total $3.2 billion combined.

In addition to tax and fee changes, governors also recommended $4.8 billion in revenue measures for fiscal 2018; more than half of this total is accounted for by the Alaska governor's proposed restructuring of the Alaska Permanent Fund. Revenue measures enhance or reduce general fund revenues but do not affect taxpayer liability.

Median general fund spending on Medicaid grew 2.7% in fiscal 2016 and is estimated to increase 5.2% in fiscal 2017, outpacing median general fund revenue growth of 2.4% in fiscal 2016 and 2.5% in fiscal 2017. Median Medicaid spending growth from all funds was 5.0% in fiscal 2016 and estimated at 5.3% for fiscal 2017. For fiscal 2018, the median growth rates projected in governors' budgets for Medicaid are 3.5% from all funds, 4.8% for general fund spending, flat spending from other state funds, and 3.6% from federal funds.

Rainy day fund balances are a crucial tool that states heavily rely on during fiscal downturns and to address shortfalls. State balances in rainy day funds are estimated to remain relatively flat overall for the current fiscal year. Excluding Georgia and Oklahoma, which were not able to provide rainy day fund balance data for all three fiscal years, total rainy day fund balances for fiscal 2017 are estimated at $49.6 billion, compared with $49.7 billion in fiscal 2016. States are projecting a $4 billion increase in rainy day fund balance levels in fiscal 2018, with governors' budgets recommending balance levels totaling $53.5 billion; California's projected balance increase of $2.7 billion accounts for about two-thirds of this expected growth.

Governors continue to prioritize rainy day fund savings accounts to prepare their states for a future downturn or other unforeseen circumstances, in spite of recent weakness in revenue collections. States have made significant progress in bolstering their reserve funds since the Great Recession, when rainy day fund balances fell to $21.0 billion in fiscal 2010 (or just $3.0 billion when excluding Alaska and Texas). Rainy day fund balance levels vary considerably across states, with a projected median of 6.0% as a share of general fund expenditures in fiscal 2018. Twenty-seven states estimate increases in their rainy day fund balances in fiscal 2017, while 13 states reported decreases. For fiscal 2018, 28 states recommend increasing their rainy day fund balances, while just seven states propose declines.

States' total balances – which include rainy day fund balances as well as general fund ending balances (both reserved and unreserved) - reached $80.8 billion in fiscal 2016, but are estimated to have declined to $69.4 billion in fiscal 2017, as some states drew down on their prior-year ending balances to help meet spending demands and close budget gaps while facing lackluster, lower-than-projected revenue growth. For fiscal 2018, governors' budgets estimate that total balances will decline slightly further to $67.6 billion.

U.S. states paid down debt for the second straight year as slow revenue growth and rising expenses for pensions and healthcare restrained borrowing. The tax-supported debts of states declined 0.4% in 2016 following a 1.0% slide in 2015. The drops show that governments are hesitant to rack up new obligations despite the nation's eight-year recovery from the last recession.

While elected officials ranging from President Donald Trump to U.S. Senator Bernie Sanders have lamented the sorry state of the nation's infrastructure, debt levels and transportation spending have remained flat even with the low cost of borrowing. Twenty-nine states have raised taxes or fees since 2012 to fund transportation as gas tax revenue failed to keep up with inflation. But the new revenue was used to offset declines -- or raids on transportation funds -- rather than to increase investment. Transportation as a share of total spending has yet to return to pre-recession levels.

Conclusion

Coming out of two consecutive years of widespread weakness in tax collections, states are approaching fiscal 2018 with caution. Governors proposed nominal general fund spending growth of just 1.0% for fiscal 2018 compared with estimated fiscal 2017 spending levels, though states' enacted spending levels may come in slightly above this projection. Looking ahead, budget conditions are likely to remain tight as states contend with rising spending demands for pensions, health care, and other fixed costs, modest revenue growth, and federal uncertainty, while they also work to bolster their savings accounts to prepare for the next economic downturn.

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Growing Cybersecurity Risks at U.S. Public Power Electric Utilities

Thursday, July 20, 2017

With the increased sophistication of cyber attacks, constantly-updated compliance standards and cooperation between utilities, regulatory bodies, and federal agencies remain essential. Compliance frameworks cannot be expected to prevent all cyber attacks, but given the importance of energy reliability to the nation's economy and security, cyber risk management has become a key consideration for the industry.

Preparedness for a cyber attack strengthens a public power electric utility's credit profile because it indicates grid resilience and quality of management. We are seeing public power electric utilities engage in contingency planning that can increase their electric system's durability. These measures provide strengthened grid reliability, reduce the potential for a loss in revenue, and indicate strong management and governance quality.

While MTAM does not explicitly incorporate cyber risk as a principal factor in our credit ratings, we regard the threat of a cyber attack as an event risk similar to a natural disaster or act of terrorism, with the likelihood of federal aid in a catastrophic event being fairly high, as has been seen for some utilities affected by hurricanes. Our fundamental credit analysis incorporates numerous stress-testing scenarios, and a cyber event could theoretically trigger one of those scenarios.

Increased interconnectivity and the rapid growth of smart devices and services has enabled new efficiencies in the grid; however, the interconnected devices also allow for more points of entry for malicious activity. We foresee the possibility of several adverse scenarios, including digital incursions through home appliances or smart meters, remote hacking of a utility's supervisory control and data acquisition system, and manipulation of distributed generation. While larger electric utilities have more resources to manage cybersecurity risks, their customer bases make them more attractive as targets for cyber attacks than their smaller counterparts.

Due to their unregulated ability to set customer rates, we believe most public power electric utilities would be able to absorb additional expenditures from a cyber information breach. If a cyber attack caused a severe outage resulting in a much higher loss of revenue and litigation costs, the impact on a utility's credit profile could be more severe, depending on its size. Given the critical nature of energy infrastructure, federal and state governments could potentially intervene in the aftermath of a cyber attack, as in natural disasters, to provide assistance to offset financial losses, reducing the extent of rate hikes needed to recover a loss in revenues.

Jumpstarting a discussion of how damage from a cyberattack could have a material effect on electric utilities – and their outstanding bonds – was the revelation last December that the Burlington (VT) Electric Department (BED) had detected that one of its laptops was communicating with an internet protocol address that federal officials warned could be associated with malicious activity. There remains no evidence that a "hack" took place or that the electrical grid was ever threatened. The situation was quickly contained and reported to federal authorities. But the scare was still notable to some analysts.

Although the breached computer was not connected to the electric transmission grid, the attack is an example of the utility sector's vulnerability and its attractiveness to those seeking to disrupt the national electrical grid. BED's up-to-date malware definitions and its responsiveness in immediately reporting its findings to federal authorities are a credit positive, but cyberattacks are a credit negative for all utilities because of the growing risk and the material costs that would result if key infrastructure assets were damaged.

The potential costs of an attack could be enormous. The August 2003 Northeast Blackout, which stemmed from an overload blamed at least partially on a glitch in early warning software, resulted in a loss of power for about 50 million people and took days to fully restore. The Electricity Consumers Resource Council estimated that the event cost between $4.5 and $8.2 billion, including more than $1 billion cost to the affected utilities. Markets operated on backup generators.

As the number and sophistication of attacks grow, the probability of a successful cyberattack that would cause a material disruption to a utility is growing and the financial and reputational implications could be significant.

Such efforts have been a long-term fear of industry professionals and antiterrorism professionals for the crippling impact on national life that an attack on America's highly computer dependent and connected national utility grids could have. U.S. officials already believe that a 2014 attack might have compromised a handful of public utilities. At the time, the Department of Homeland Security said an unnamed utility had been breached by an unnamed "sophisticated" hacking group. DHS, which does not ordinarily disclose every breach it detects, said it had worked with the affected utility to ensure that its systems were not affected by the unauthorized access.

While it is a very legitimate concern for utilities and will likely be an ongoing expense to deal with for the foreseeable future, factoring it into investing decisions is similar to factoring in natural disaster risk. It is very difficult as an investor to properly weigh the risk of events that are largely out of a utility's control. We would expect that most utilities are attempting to defend themselves from hacking, but are not going to publicize those efforts in offering documents – nor should they.

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2nd Quarter 2017 Review and Outlook

Thursday, June 29, 2017

Investors in tax-free bonds were rewarded with solid returns in the past three months, as talk of fiscal stimulus and tax cuts waned, and economic data softened further. Longer-maturity debt performed exceptionally well as inflationary pressures eased, led by a significant drop in oil prices. In fact, the "long end" of the market is giving the Federal Reserve a standing ovation for tightening credit into a slowing economy. This can be seen by the slumping yield spread between the U.S. Treasury two-year and ten-year notes. This "flattening" of the yield curve is often associated with an uptick in the potential for a significant economic slowdown (recession). In our view, market participants are likely to be monitoring the shape of the yield curve closely in the coming months for signs that the Federal Reserve has (again) committed a policy error. The market is keenly aware that most recessions are caused by excessive monetary tightening and oil price shocks (in this case, the shock is how much oil has fallen in price). As a result, the strong returns in municipal bonds so far in 2017 should be of no surprise.

Municipal bond investors have had their level of concern elevated lately as political dysfunction has gripped the "Land of Lincoln" in ways analysts have never seen before. Political brinkmanship between the Democrats and the Republicans in this troubled state has introduced a new risk for bondholders to consider: "ability to govern." In light of the inability to agree on a budget for almost three years running, Illinois has proved the need for municipal specialists to judge independently whether the political structure of a state, county, city, or town is such that it measurably elevates the risk of the timely payment of principal and interest. Miller Tabak Asset Management will now evaluate and grade governments on their "ability to govern" alongside our ongoing evaluations of "ability to pay" and "willingness to pay." Simply put, sharp political divisions exist in our country today that now must be acknowledged and analyzed when choosing a bond to invest in your portfolio. Perhaps endless amounts of printing money and buying huge amounts of government debt by central banks has brought us to a place where politicians no longer covet their government's market access like they should.

MTAM will begin with the same basic methodologies used by the rating agencies to assess the credit quality of municipal issuers. Quantitative models based upon the local economy, fiscal structure, and debt burden are used to access a municipal issuer's capacity to pay their obligations. Going forward, qualitative factors, such as the strength of management, that are more difficult to measure, will be used to assess an issuer's ability to govern.

MTAM assigns its own internal rating on every bond that it holds. Our internal rating incorporates more data than a traditional rating agency. Unlike the agencies that base their ratings upon degree of leverage and probability of default on a particular bond, MTAM focuses on the margin of safety that an issuer will be willing and able to pay of its obligation on a timely basis, giving higher weighting to key socio-demographic measures. Since municipal borrowers are motivated by social and political objectives, compared with corporations that focus on maximizing cash flow, it is very important to understand the local political process, the essentiality and structure of a particular bond financing, as well as the longer term outlook of the service area. Importantly, these internal ratings are not static. MTAM portfolio holdings are revisited frequently and, when applicable, changes are made to the internal credit assessment.

Given that Puerto Rico has been removed as a viable option for conservative investors, and that Illinois may be heading in that direction also, MTAM believes that it is highly likely that issuers with strong financial standings in the municipal bond market will see greater demand for their securities. In particular, we see Utah, North Carolina, and Maryland as three states that will likely see greater amounts of investor interest. While yield will always remain important when considering purchasing a bond, we here at Miller Tabak Asset Management sense a turn coming with regards to investor sentiment on credit risk. Frankly, it is easy to see why, as the recent economic data has been soft and the Federal Reserve remains intent on raising borrowing costs further. This leads us as a firm to want to position portfolio duration modestly longer than benchmark, and to concurrently adjust overall portfolio credit quality higher as insurance against our central bank slowing the economy more than is warranted. For municipal bond investors, the best time to prepare for a recession is before we enter one.

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak

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Challenges Facing the Transportation Sector

Monday, May 22, 2017

Steady growth is forecasted for all major U.S. transportation segments despite longer-term questions brought on by shifting economic, trade, and fiscal policies.

International hub airports are set to lead overall airport passenger traffic growth after passenger enplanements rose 3.5% for calendar-year 2016. Growth in passenger enplanements, however, is and will continue to soften as carriers scale back on service additions; analysts are projecting 2.5%-3% overall growth for 2017.

Growth among ports throughout the country will likely mirror that of the GDP. Much of the upward movement came from West Coast ports in the second half of last year (1.8% growth year-over-year), while East Coast ports rebounded with 3.4% growth in the second half, but only grew 0.4% overall for the year as compared with 2015. Shifting trade agreements or renegotiated tariffs may affect import/export volumes, though the full effects of these changes will likely extend beyond 2017.

As for toll roads, Southeast and Southwest facilities should continue to lead in traffic performance similar to 2016 due to moderate economic and population growth. Toll road revenues are positioned to grow faster than traffic as many authorities implement policies of inflationary toll increases.

Infrastructure Funding Challenges

The 2017 Infrastructure Report Card by the American Society of Civil Engineers cites an $836 billion backlog of road and bridge infrastructure capital needs to maintain and improve current conditions and alleviate traffic congestion. But despite separate $1 trillion infrastructure funding plans pitched by the Trump Administration and Senate Democrats, we expect little progress at the federal level. Federal grants play an important role in building and maintaining highways and other transportation projects, but we expect no significant increase in federal funding given the recent lack of political will, and the depleted state of the Federal Highway Trust Fund.

Looking forward, U.S. states will continue to increase transportation taxes and fees and seek alternative financing mechanisms to meet infrastructure challenges as federal investment remains uncertain. However, hurdles to realizing the full benefit of such measures include political risk, lower gas consumption, and resistance to creating and raising tolls.

Mass Transit

The federal government is the most important source of capital funding for mass transit enterprises in the U.S., and a most transit systems would be challenged to fully fund their programs with lower federal support. Many new projects likely would never proceed, and mass transit enterprises would struggle to fund ongoing expansions.

In addition to providing 42% of mass transit capital funding, the federal government also provides some operating grants, representing 8% of total operating expenditures. Mass transit systems rely heavily on subsidies and are not self-supporting. Farebox revenues account for 36% of operating costs, with subsidies or taxes covering both the remainder of operating expenses and 100% of capital expenses.

If the current budget proposal is enacted, mass transit systems would struggle to replace federal funds, most likely through higher fares or more state and local government subsidies. Even at current spending levels, an estimated $90 billion backlog of capital projects to preserve existing transit infrastructure will grow to $122 billion by 2032. Moreover, ridership peaked two years ago, with most rated mass transit systems reporting declines in fiscal 2016.

A decline in federal capital funding coinciding with a decline in ridership would be a very difficult combination of pressures for mass transit systems to overcome. Any cuts in federal spending to transit funding could also affect grant anticipation revenue bonds (GARVEEs), since the offerings are secured by future federal transportation grants. The budget blueprint does not immediately imperil any transit GARVEEs because the proposed cuts are in programs for grants that do not directly secure any currently outstanding GARVEEs.

Toll Roads

In light of stagnant federal funding and limited capacity for states to increase spending, toll roads will play an increasing role in addressing the funding gap for road and bridge infrastructure needs in the U.S. Based on historical trends, analysts project more toll roads and increased tolling in areas with existing traffic congestion and growing economies, population, and per capita income.

Many states are discussing adding tolls or raising existing tolls to meet capital demands. For example, last month Indiana approved funding to direct $1.2 billion to state roads by 2024 from higher gas taxes and fees. The bill also allows the state to apply to the federal government for a waiver to toll currently un-tolled interstates within. We expect to see other states take similar approaches as tolling the interstates is a viable option.

Tolling and other user fees could be a viable and meaningful component of highway funding if they are carefully implemented. Tolls can be adjusted with inflation with minimal adverse economic or political implications, provided the system is well operated and maintained. For example, the "first-mover disadvantage" can be limited by implementation across the system as raising tolls on one highway near an un-tolled road can hurt toll revenues.

Increasing State Role

U.S. states are likely to increase their direct investments in transportation projects by leveraging recent revenue increases. Six states (CA, MT, IN, TN, SC, WY) have raised gas taxes and fees to fund transportation projects in 2017. Five others are considering bills that would increase gas taxes to raise transportation revenues (CO, WV, MN, OR, WI, ME). Most states are only catching up as gas tax revenues have grown more slowly than inflation for decades. Most recently, South Carolina's House voted last month to override the governor's veto of a bill that includes a gas tax hike and some fee increases. This is the first increase in gas taxes in the state in 26 years. The state's inflation-adjusted gas tax revenues have risen by just 4.1% since 2000.

Higher gas taxes and fees could face risk from higher fuel efficiency. The Corporate Average Fuel Economy standards are set to raise the national fleetwide average mpg to 54.5 in 2025 from 35.5 in 2016. The current administration has called for a midterm review of the standards. However, regardless of how the regulations evolve, technological advances will likely raise average MPG over the next several years.

Furthermore, public-private partnership (PPP) legislation is rising and could be another financing alternative in certain situations. In 2016, three states (KY, TN and NH) enacted types of PPP legislation, according to the National Conference of State Legislatures. PPPs used in the right circumstances allow governments to effectively transfer many project risks to the private sector and provide certainty in forecast costs, though they are not a panacea for all funding shortfalls. In addition, issues of public perception, including a perceived loss of public control and a lack of understanding of potential long-term benefits, can make implementation of PPPs challenging.

Conclusion

States have already taken on a larger share of the infrastructure burden and are allocating more of their total budgets to roads and bridges. Forty states have increased their gas taxes since 1993, the last time that federal gas rates went up. More recently, toll revenues have increased faster than state fuel taxes or motor vehicle fees as a source of transportation funding. In fiscal 2015, toll road operating revenues increased by 8.5% compared with fiscal 2014, while state fuel taxes and motor vehicles increased by 6.4% over the same time period.

High growth, high income regions will see an uptick in tolling since these areas typically experience more traffic congestion and tolling growth has been more robust. Most of the new toll roads built since 2005 have been in areas with rapid population and employment growth where congestion already exists.

While greater use of PPPs could serve as an additional tool for funding infrastructure, a dedicated revenue stream would still be needed to encourage and support private investment. For toll roads, the credit impact of added debt would vary depending on the funding approach, and whether the debt is offset by traffic and revenue growth.

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The Impact of New York State's "Free Tuition"

Thursday, April 27, 2017

The State of New York's fiscal 2018 budget has introduced a "free tuition" program called the Excelsior Scholarship, which may have a credit impact on universities in the U.S. northeast region.

The "free tuition" program will likely raise enrollment uncertainty for colleges and universities in the northeast region, and alter long-term funding requirements for the State University of New York (SUNY). This plan has the potential to shift demand from private institutions with higher tuition sticker prices to SUNY and the City University of New York (CUNY). As most smaller, private universities are tuition-dependent, their ability to prudently manage enrollment is a key credit factor.

The new scholarship may contribute to a modest increase in overall enrollment, but we believe it is more likely these funds will supplant tuition dollars already paid by students from middle-income families. Therefore, it is unlikely to result in substantial new enrollment or funding for New York's public universities.

If enrollment does increase materially for SUNY AND CUNY, the program could have credit negative effects for both systems. Since tuition only covers some of the cost of educating students, the systems would need to cover the additional costs from within their budgets or develop new revenue streams.

Any enrollment shift would have credit negative implications for less wealthy, regionally branded private schools. Many of these schools already confront a highly competitive environment and even small shifts of enrollment to the public sector could have a negative effect on their already tight financial positions. New York's private universities with larger endowments or national brands are less likely to be negatively impacted because they are less reliant on students from New York and have greater budgetary flexibility.

The full impact of the risks will not be known until after the three-year phase-in period ends. However, enrollment shifts may begin in the fall of 2017 as the program becomes effective in the fall enrollment cycle.

New York's higher education budget for fiscal 2018 remains consistent with previous budgets by placing limits on growth of residential undergraduate tuition rates, which will constrain overall revenue growth for both SUNY and CUNY. The $200 tuition increase for resident undergraduates equates to a 3% tuition increase for both systems from fall 2016 tuition charges.

New York State's budget also calls for stable state appropriations through fiscal 2021. While the long-term forecast will help budgeting, growing pension and post-retirement benefits will consume an increasing proportion of the systems' budgets.

The Excelsior Scholarship is projected to reduce the total cost of a four-year degree for students from any SUNY institution by $26,000, assuming no other scholarships or grants. Only families with annual incomes below $100,000 will be eligible in the first year, and the income requirement will increase in each of the next two years. Program recipients must maintain a certain grade point average and remain in New York State post-graduation for a period of time that matches the time they received the funding.

One consequence of this program may be higher enrollment pressures on small private colleges in the region. Many are already dealing with declining enrollment due to demographic trends. The number of high school graduates nationwide grew quickly beginning with the 1995-96 class, according to the U.S. Department of Education's National Center for Education Statistics. However, growth stalled in 2009-10 and will be slow through the 2025-26 academic year.

The number of New York State high school graduates is forecast at just over 205,000 in the 2018-19 year, and is expected to stay near that number through the 2022-23 academic year, according to The Western Interstate Commission for Higher Education.

The initial impact of the Excelsior Scholarship Program on small private colleges may be somewhat muted as the admissions process at most schools for fall 2017 is well underway. In addition, room and board are not covered by the program, which may still deter some low-income non-commuting students from applying/enrolling to SUNY.

One indication of pressure on smaller, private colleges could be a spike in tuition discounting and institutional aid to maintain competitive net pricing with SUNY. Higher than usual "summer melt" among students registered to enter regional private colleges in fall 2017 could also be a leading indicator. "Summer melt" occurs when students who have committed to one institution later decide to either not attend college or choose to attend another institution. Between 10% and 20% of eligible students melt, according to the U.S. Department of Education.

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Bank Liquidity Rules Could Boost Demand for Municipal Bonds

Wednesday, April 12, 2017

U.S. senators have re-introduced bipartisan legislation that would allow banks to use municipal bonds to satisfy liquidity regulations aimed at ensuring lenders can withstand a credit crisis.

The bill would accord state and local debt the same standing as corporate bonds under so-called high-quality liquid asset regulations. "We must ensure a continued and reliable access to capital markets for our local governments," said Democratic Senator Mark Warner, who introduced it along with Republican Mike Rounds, both of whom are on the Senate banking committee. The legislation, supported by other members of the panel, was first introduced last year after a similar measure passed the House of Representatives.

Senators Warner and Rounds had introduced a scaled-down version of legislation that passed the House in February 2016 that would classify investment-grade municipal bonds on par with U.S. agency securities issued by Fannie Mae and Freddie Mac to meet bank liquidity rules. The Senate measure classifies municipal bonds as "Level 2B" assets comparable with certain corporate bonds and stocks.

Level 2B assets are subject to a 50 percent "haircut," meaning if a bank holds $1 million of a municipal bond, $500,000 counts towards its liquidity buffer. The House bill classifies municipal bonds as Level 2A assets, which have a 15 percent haircut. Level 2A and 2B assets can make up no more than 40 percent of total "high quality liquid assets," with Level 2B assets restricted to no more than 15 percent of HQLA.

"As a former governor, I know firsthand how critical it is for states and municipalities to issue bonds that fund their basic operations, including the construction of schools, roads, and local projects," Warner said in a news release. "We must ensure a continued and reliable access to capital markets for our local governments, and this legislation represents a compromise that achieves that while appropriately balancing concerns for the long term stability of our financial system."

Local-government officials and securities-industry lobbyists turned to Congress after regulators including the Fed adopted rules that would restrict or bar banks from including municipal bonds among high quality liquid assets. State treasurers and city finance officers said the new rules, if not changed, would saddle them with higher borrowing costs, eliminating incentives banks have to purchase the bonds.

"Having bipartisan, bicameral legislation is an excellent first step," said Emily Brock, federal liaison for the Government Finance Officers Association. "It shows a commitment on their part for what we municipal securities to be, which is high quality and liquid."

If the law is enacted, demand for municipal debt may increase among the large banks, but some critics claim the bonds should be excluded due to their illiquidity.

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U.S. States Forecast Sluggish Tax Revenue Growth as 2018 Budgets Established

Tuesday, April 4, 2017

U.S. states are lowering forecasts for revenue growth this year, anticipating that a slowdown in the pace of the economy will affect income- and sales-tax collections. Based on recent tax revenue data, many forecasts could be revised downward further, creating uncertainty and potentially difficult choices for states.

Revenue forecasters worry about risks and, in their latest forecasts, they were concerned about uncertainties related to the potential federal policy changes from the Trump administration, Federal Reserve Board actions, changing demographics, the global economy, and political risks in Europe.

As governors and lawmakers work on annual spending plans, the median forecast for income-tax growth in the current fiscal year, which typically ends in June, was lowered to 3.6 percent from 4.0 percent, while the expected increase in sales taxes was cut to 3.1 percent from 4.2 percent, according to a study by the Nelson A. Rockefeller Institute of Government.

The states anticipate that income and sales-tax growth will pick up to 4.1 percent and 3.5 percent, respectively, in the 2018 budget year. Even so, that pace is below the average 7.0 percent annual increase seen from 1981 until 2007, before the onset of the last recession.

The projections will determine how much states have to spend on schools, public works, and other programs by giving lawmakers a gauge of how much cash they will have in the coming year. Sluggish revenue growth presents state policymakers with difficult choices, including increasing state taxes, reducing spending, and using reserve funds.

The more conservative forecasts reflect the caution on the part of state government officials, who were forced to deal with massive budget shortfalls after the last economic contraction. While state government's finances have benefited from an influx of revenue, the pace of the U.S. economy slowed last year and it could be affected by further interest-rate increases by the Federal Reserve.

Revenue forecasts vary significantly from state to state, reflecting state economic conditions, oil supplies and prices, financial and real estate market developments, reliance on capital gains, and state-specific policy changes, among other factors.

The tax collections are expected to keep rising in almost every state, according to the Institute's report. West Virginia is the only state projecting a drop in both personal income-tax and sales-tax revenue during the next fiscal year. Ohio is the only other government expecting income-tax collections to fall, while Connecticut is the only other one anticipating a drop in sales-tax levies.

The forecasts for relatively weak revenue growth in fiscal 2018 reflects estimated slow economic growth, low oil prices, the changing consumption and spending habits of Americans, long-term demographic changes, and expected federal tax policy changes that will impact state budgets.

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1st Quarter 2017 Review and Outlook

Thursday, March 30, 2017

After a tumultuous ending to last year, municipal bond investors were rewarded with positive returns during the past three months. Steady demand for tax-free bonds was prevalent during the quarter from income-starved investors who saw opportunity in the higher market yields offered, thanks to the "Trump reflation trade." Sentiment indicators on the U.S. economy remained elevated during the past three months, but "hard economic data" turned a touch softer, which lent support on the margin to fixed-income as an asset class. From a technical perspective, the municipal market was aided by a softening of new issue volume as refinancing of existing debt eased due to the higher interest rate environment.

If the financial markets were a reality show, the program would be called "Washington, D.C. 24/7." Market participants were glued to their computer screens for every headline related to the ambitious economic agenda put forth by President Trump, and the Republican-controlled Congress (which you may recall was rapidly priced into the markets in the days and weeks that followed the election results last November). While it remains to be seen if election promises can be delivered as advertised, it behooves investors—in our view—to approach the market with a "show me" attitude. A market that is priced for cake that may end up with just a donut can be quite volatile as it works off its sugar high. Not to be outdone, the hawkish commentary coming from the Eccles Building (home of the Federal Reserve in Washington, D.C.) surprised many participants with the seemingly more aggressive outlook for interest rate hikes in 2017 than was expected. In our view, the Federal Reserve put the market on notice that tax cuts will be met with more accommodation removal. Could this be a contributor to the stability of market interest rates as of late? Always remember that by raising interest rates, the Federal Reserve is actively trying to slow the rate of inflation and economic growth. This is ultimately supportive of fixed-income as an asset class.

The coming months will get more difficult for municipal bond credit analysis as the potential defunding of "sanctuary cities" by the federal government introduces true downside risk to the bond ratings of hundreds of counties, cities, and perhaps even states. The executive order signed by President Trump on January 25th would end federal funding to jurisdictions that violate 8 U.S.C. 1373, which states in part " ... a Federal, State, or local government entity or official may not prohibit, or in any way restrict, any government entity or official from sending to, or receiving from, the Immigration and Naturalization Service information regarding the citizenship or immigration status, lawful or unlawful, of any individual." Several major cities in the United States have enacted policies that are reported to be in violation of this law, including New York, Los Angeles, San Francisco, Boston, and Chicago. Even if a jurisdiction's status as a "sanctuary city" were clear, the amount and method of implementation of proposed federal cuts is not. For more detail, please review our initial report on the topic posted on our website on November 17th, 2016. As always, Miller Tabak Asset Management will continue to put a significant emphasis on portfolio diversification to mitigate any pressure that may arise from this looming showdown. Superior "bottom up" credit analysis is an absolute necessity in this fast-changing political environment.

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak

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Trump's Transportation Infrastructure Plan

Thursday, January 26, 2017

President Donald Trump has proposed increasing infrastructure spending by $1 trillion over the next 10 years, although funding sources and timelines have not been determined. Even if Trump's plan proceeds, states will continue to have a central role in transportation and infrastructure planning and funding.

President Trump's proposed infrastructure program is based on bringing more private investments to road and bridge projects, and has the potential to reshape U.S. infrastructure funding. The proposal relies on $138 billion of federal tax credits to generate up to $1 trillion of private investments in roads, bridges, and public utilities. The plan will be based on tax credits to bring private investments into the funding mix; tax credits are an effective tool for attracting private equity.

There is no single solution for generating more investment in transportation infrastructure. A variety of options must be considered, including raising and indexing the federal gasoline user fee, other fee options at various points of usage of transportation infrastructure, and possible other tax reform funding sources. The public-private partnerships in the Trump proposal are a good alternative delivery system for projects, but there has to be a revenue source for them to work.

Repairing or replacing aging transportation infrastructure, such as roads and bridges, will also require U.S. states to shoulder additional cost burdens since federal funding has stagnated over the past 20 years. States with large maintenance burdens and backlogs will face budgetary challenges in meeting these needs.

From 2006 to 2016, combined state and federal transportation spending increased to $153 billion from $109 billion, with states picking up 70% of the total increase. As states look to allocate their resources among growing health care and education needs, they cannot devote as much to transportation infrastructure as they might want. States will increasingly leverage motor fuel and other road taxes to issue more debt, which will lead to a faster increase in transportation-related debt than overall state net tax-supported debt.

Federal fuel taxes and other revenues dedicated to the Highway Trust Fund have fallen short of spending levels since 2001 as cars became more fuel-efficient and collections flattened. With the 18.4 cent-per-gallon federal gas tax unchanged for 24 years, 40 states have raised their gas tax a total of 25% to a 50-state average of 24 cents per gallon. For some states, years of underinvestment can lead to a disproportionately large financial responsibility which can reduce future fiscal flexibility.

States generally have low debt levels and have the capacity to tap capital markets to finance a substantial amount of infrastructure. Some states could easily erase their road surface and bridge maintenance backlog; nine states face burdens of less than 5% of fiscal 2014 revenues. Among them, Hawaii has a 1.8%, or $116 million, backlog while Florida has a 2.7%, or $1.1 billion, backlog. Both are manageable. Other states have high backlogs, such as West Virginia, which has a $4 billion backlog, or 63% of annual revenues.

With growing recognition of the need to invest more in infrastructure, states will increasingly augment available federal highway aid with their own revenues, both on a pay-go basis as well as through increased use of debt-financing over the next two to three years. Toll-based funding will also increase to support state bond issuance as well as P3 financings.

Airports are highly visible types of infrastructure many millions of people see while traveling through the U.S. American hub airports handle about 800 million passengers annually, with that number estimated to grow to more than a billion in the next 20 years. Much of the upcoming infrastructure investment will be aimed at adapting airports to modern needs, such as post 9/11 security, as well as at other land-side infrastructure such as parking garages. Airports use tax-exempt bonds for many of their infrastructure improvements, and rely on passenger facilities charges capped by federal law to generate much of their revenue. Trump could be influential as president both in maintaining the tax-exempt status of municipals through any tax reform proposal and in supporting the uncapping of passenger facilities charges to allow localities to set them at levels they feel appropriate.

Backers of bullet-trains, popular internationally but not so far in the states, also see hope under a Trump administration. The U.S. currently has no true high-speed rail service comparable with the bullet trains operating in some other countries. Amtrak's Acela service along the Northeast Corridor between Washington D.C. and Boston can reach speeds of up to 150 miles per hour, but realistically does not maintain those speeds for the majority of the route. The Japanese Shinkansen trains, by contrast, are capable of 200 miles per hour and have reached even greater speeds on occasion. Efforts to build new high-speed lines have met with resistance and financing troubles, as exemplified by an under-development line connecting cities in Northern and Southern California that has come in over the original cost estimates and been fought by some landowners potentially affected by its construction.

States have $267 billion of transportation-related general obligation debt and another $107 billion of lease-appropriation pledges. Total state transportation debt includes $34 billion of outstanding bonds supported by fuel taxes and other road user fees. States also have $9 billion of grant anticipation revenue vehicle (Garvee) debt secured by their annual federal highway funding.

States will have a pivotal role in the $1 trillion infrastructure program proposed by President Trump. We believe implementation of this plan will include public revenue sources that states control, either from availability payments made directly from the state, state-sanctioned tolls on highways and bridges, or other state taxes that provide attractive returns to private equity.

Conclusion

U.S. federal highway aid has seen little growth from fiscal 2009-15, and is projected to remain flat when adjusted for inflation through fiscal 2020. The federal government funds transportation infrastructure through the national gas tax, which last changed in 1993. Transportation spending will require a larger percentage of state capital expenses under current federal policy.

The Trump investment initiative with a stated goal of $100 billion per year of new investments could increase annual infrastructure expenditures by up to 40%. A successful infrastructure package must include more federal funding to states, in addition to the incentives for private investments. Depending on its implementation, the incoming administration's plans may ease states' burden. An increase in federal spending on infrastructure would be a credit positive for states.

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Trump and the Municipal Bond Tax-Exemption

Wednesday, January 18, 2017

The U.S. Conference of Mayors will announce a new campaign to protect the tax-exemption for municipal bonds, the key financing source for cities and counties to build hospitals, schools, water and sewer systems, and roads and highways. President-Elect Donald Trump has spoken out in favor of the tax-exemption, and the nation's mayors want to ensure he can keep his promise by building support for the exemption in the U.S. Congress.

Starting today, a record number of more than 300 of the nation's mayors will convene in Washington, D.C. at the Capital Hilton Hotel to engage with Administration officials, Congressional members, and business leaders to ensure the economic health of America's cities on the eve of the Presidential Inaugural, Tuesday, January 17th to Thursday, January 19th.

The U.S. Conference of Mayors is the official nonpartisan organization of cities with populations of 30,000 or more. There are nearly 1400 such cities in the country today, and each city is represented in the Conference by its chief elected official, the mayor.

Some analysts say the tax-exemption on municipal bonds may be targeted for elimination by the Republican-controlled Congress as a way to help cover the cost of individual and corporate tax cuts.

President-Elect Trump has expressed support for maintaining the tax-exemption on municipal bonds, according to a delegation from the U.S. Conference of Mayors that met with him last month. The delegation advocated for "significant" spending on infrastructure and public safety. The mayor's group also wants to ensure that the president-elect's infrastructure plan includes municipal bonds as a financing tool.

Trump has proposed using tax credits to boost private sector investment in infrastructure by pension funds, insurance companies, and private-equity firms. The $1 trillion infusion over 10 years targeted by Trump is far lower than the $3.6 trillion that the American Society of Civil Engineers has said is necessary. Tax-exempt municipal bonds are needed to close the gap, particularly for projects that can not turn a profit like local schools and roads.

Proposals to eliminate or curtail the $3.8 trillion municipal market's tax break are a perennial, if little-noticed, feature of Washington, D.C., budget and tax debates. Some view the tax-exemption as mostly of benefit to the wealthy and inefficient because the loss of federal tax revenue exceeds the reduction in interest cost for states and local governments.

The municipal tax-exemption is projected to cost the federal government about $420 billion in revenue between 2017 and 2026, according to the Treasury Department, which adds that cost is dwarfed by others, such as deductions for employee health insurance costs or mortgage interest.

Groups representing local government officials such as the U.S. Conference of Mayors, the National Association of State Treasurers, and the Government Finance Officers Association have ramped up lobbying efforts to preserve the exemption. Getting rid of it would force states and cities to raise property and sales taxes while giving more control over infrastructure to the federal government, they say.

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Credit Comment on California's Latest Budget Proposal

Saturday, January 14, 2017

The State of California is enjoying its highest credit rating (Aa3/AA-/AA-) since the turn of the century, primarily due to a record-setting stock rally, a resurgent real estate market, and a Silicon Valley boom that swept away once crippling budget deficits. Yet Governor Jerry Brown's latest annual spending plan is focused on risks ahead. The governor has proposed a fiscally-restrained budget with a large rainy day fund pointing to uncertainty in State revenues and potential erosion in federal funding under a Trump administration.

Last week, the governor proposed cutting expenditures by 0.2% to $122.5 billion in the fiscal year that starts in July, anticipating that revenue will grow more slowly as the national economic expansion heads toward its eighth year. Without such steps, the governor said the State will face annual deficits of as much as $2 billion beginning next fiscal year.

Brown, who took office six years ago, has overseen a financial turnaround for the most-populous U.S. state that has been lauded by Wall Street. After revenue rebounded, in part because of tax increases, the governor used some of the windfall to pay off debt and add to the savings account that can be tapped the next time the economy stumbles.

California's revenue is volatile because it draws a large share of taxes from wealthy residents whose incomes are tied closely to the stock market, which saddled the State with huge budget deficits after the Internet and real estate bubbles burst. The top 1% of earners accounted for nearly half of the State's personal income-tax collections in 2014. Voters in November approved a 12-year extension of higher tax rates on the wealthy, deepening the reliance on their fortunes.

There is some volatility and some risk that California has that other states do not. In periods of economic growth, the State is going to outperform; in periods of recession, the State is going to underperform. State officials' ability to mitigate those swings is going to be manifested through their budgeting practices.

That caution was reinforced by the State's recent revenue collections, which have lagged forecasts for five of the past seven months. Also uncertain is the fate of Medicaid, which California expanded as part of the Affordable Care Act, President Obama's health-care law. Repealing it, as President-elect Donald Trump has promised, "would be extremely painful for California," Brown said. It could cost the State at least $15 billion in federal funds, according to the California Budget and Policy Center.

The drop in spending marks a shift from the current year's budget, which increased spending while boosting the State's reserves. Brown wants to keep adding to that savings account, with his budget proposing to increase it to $7.9 billion from $6.7 billion.

Recent Financial Results

California revenues for December missed projections by $1.87 billion, coming in 12.7% less than anticipated in the State's 2016-17 budget, according to the State Controller's Office. For the first half of the fiscal year that began in July, total revenues of $51.72 billion are $1.66 billion, or 3.1%, below budget estimates.

December revenues came in at $12.85 billion. The "big three" sources of California general fund dollars—personal income taxes, corporation taxes, and retail sales and use taxes—all missed the monthly mark and are now behind fiscal year-to-date estimates.

Personal income tax receipts of $8.58 billion fell short of budget projections by $1.38 billion, or 13.0%—roughly the same percentage by which November PIT receipts topped estimates. Six months into the fiscal year, California has collected total PIT receipts of $34.58 billion, missing estimates by $824.1 million, or 2.3%.

Corporation tax receipts of $1.77 billion for December were $29.4 million lower than expected. Fiscal year-to-date corporation tax receipts of $3.23 billion are $347.7 million below projections in the 2016-17 Budget Act—a shortfall of 9.7%.

Retail sales and use tax receipts of $2.14 billion for December missed expectations by $372.1 million, or 14.8%. For the fiscal year-to-date, sales tax receipts of $12.06 billion are $610.4 million below estimates, or 4.8%.

The State ended December with unused borrowable resources of $20.49 billion, which was $2.01 billion less than predicted in the 2016-17 Budget Act. Outstanding loans of $17.75 billion were $3.98 billion higher than projected. This loan balance consists of borrowing from the State's internal special funds.

2017-18 Budget Details

Brown proposed a $179.5 billion spending plan that he says eliminates a projected $2 billion deficit. The governor called the budget the most difficult the State has faced since 2012 saying that the surging tide of revenue increases appears to have turned. "The trajectory of revenue growth is declining," Brown said.

Though the governor pointed to the potential harm to the State's financial position if Obamacare is repealed, the budget does not take into account any of the potential changes to federal funding. "If there are cuts to Medicaid, we will have a big challenge on hand," Brown said. "We are not trying to anticipate that in the budget, but it is another reason that the legislature needs to be prudent. There are a lot of uncertainties that could put a massive hole in the budget."

Michael Cohen, Director of the State Department of Finance, said the State has run scenarios related to changes to federal funding and potential plans around the uncertainty, but the budget just notes the uncertainty. "The budget reflects the current operation of law, so we will just have to be nimble and reflect that in the May revision," Cohen said.

The governor annually revises his budget proposal in May based on negotiations with legislators and to match the State's current fiscal situation.

The budget slows spending on Proposition 98, which guarantees an annual increase in K-12 spending. K-14 spending will still grow to $73.5 billion in 2017-18, up 55% from 2011-12.

The governor again introduced a transportation package, first introduced in September 2015, that would among other things set the gasoline tax, which now fluctuates, at 21.5 cents a gallon and index it to inflation; impose a new $65 annual fee on all vehicles; increase and index the diesel fuel excise tax. It is supposed to bring in $4.3 billion a year. The legislature has not been able to agree on a plan to tackle the State's billions of dollars in needed highway repairs.

Brown also asked lawmakers to solidify the status of the State's cap-and-trade program, in which polluters pay for the right to emit greenhouse gases in a market-based system. He wants the legislature to approve urgency legislation, requiring two-thirds supermajorities, to extend the cap-and-trade legislation beyond 2020. The budget projects $2.2 billion in annual cap-and-trade expenditures.

Positively, the budget would deposit $1.15 billion in a rainy day fund for a total of $7.9 billion by the end of 2017-18.

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Municipal Bond Market – Credit Outlook for 2017

Tuesday, January 10, 2017

Municipal bond issuers will continue to face several credit challenges in 2017, but MTAM expects that the vast majority of municipalities will successfully manage through most difficulties with a combination of spending cuts and revenue enhancement plans.

Despite the challenges facing municipal bond issuers, there are always good opportunities, even for the very conservative investor. Given our expectations for modest levels of economic growth, we would expect defensive credits like water and sewer bonds, special tax bonds, and public power bonds to perform better from a fundamental perspective. These types of bonds tend to have revenue streams that are less subject to economic volatility, have strong covenants, or are tied to an "essential service", making debt service payment more certain. In addition, there is legal precedence that bonds backed by a dedicated revenue stream may be protected in the case of a municipal bankruptcy. We prefer bonds that have a clean flow of funds, broad revenue streams, and high debt service coverage tests.

State Governments

Although the upcoming change in federal administration introduces significant uncertainty for U.S. states, the outlook continues to be stable in 2017, based on the expectation that modest economic and revenue growth will continue. This will maintain steady credit conditions for most states, but not enough to foster broad credit improvement.

In the next 12-18 months, states' tax revenue will grow at a 2%-3% annual pace, a slowdown from the five-year average of roughly 4%. State tax revenues declined for the first time in two years during the second quarter of 2016, and contributes to the forecast for slower revenue growth.

Some states will remain under fiscal pressure, particularly those dependent on oil or energy production, such as Alaska, Oklahoma, and North Dakota. Others face credit deterioration due to policy decisions that have reduced revenues and allowed expenses to rise. Illinois continues to operate without a strategy to address income tax cuts that took effect almost two years ago. Illinois also faces increasing pension liabilities, as do New Jersey and Connecticut. All three states have already suffered credit deterioration as their unfunded pension liabilities grew.

States are also faced with growing infrastructure needs as roads, bridges, and public buildings will require maintenance or replacement. As a result, debt levels may increase since many state governments have deferred these needs due to political paralysis or budgetary challenges. Any growth in state debt burdens from increased infrastructure borrowing will likely be manageable and have little adverse effect on overall credit quality; moreover, investment in infrastructure will yield economic benefits.

At this early stage it is not possible to predict what policy choices will be made by the Trump administration, or what they will mean for states. Federal changes with a significant impact on states are generally implemented in a way that allows states to adjust, taking advantage of their strong powers to manage budgets and download fiscal challenges.

President-elect Trump's proposal to convert Medicaid to a block grant program, if enacted, would likely lead to materially lower federal funding to states. Reduced Medicaid aid could cause states to tighten overall spending and reduce transfers to local governments.

The biggest concern would be decisions that shift costs from the federal government to states while continuing service level mandates.

The Trump administration's trade policy proposals could be significant for both state economies and revenues, particularly for state economies with pronounced links outside the U.S. Immigration policy changes could also have specific sector or regional implications.

The likelihood of federal tax cuts in 2017 could lead to volatility in personal and corporate income tax revenues for the current fiscal year as taxpayers consider shifting income to 2017 to take advantage of lower rates. The effects could reverberate for several years, similarly to the 2013 federal tax law changes.

If the federal government enacts fiscal stimulus simultaneously with tax cuts, it may mean higher federal debt, higher inflation, and higher rates. This could put wage pressure on states and locals, raise borrowing costs, create headwinds for export-oriented sectors, and, positively, potentially help pension returns, though for the latter this could be offset by higher cost of living adjustments.

Local Governments

The outlook for U.S. local governments will remain stable as the majority of the sector is underpinned by solid property tax revenues and healthy reserves. Property taxes, the bedrock of local governments, remain healthy and will continue growing in 2017 owing to broader local tax base growth returns to pre-recession levels. A combination of property value growth and tax rate increases drove revenues 5.1% higher in the first half of 2016. We expect these factors will continue to support revenue growth of 3%-5% in 2017.

Reserve levels remain healthy for most local governments and provide budget flexibility. Most local governments will continue to actively raise revenues or cut spending as needed to maintain these reserves through 2017. Reserves provide flexibility for local governments in times of unexpected economic stress and unpredictable expenditures.

While manageable for most, overall fixed costs and growing balance sheet liabilities are a long-term drag on the sector. Fixed costs such as pension liabilities, debt service and other post-employment benefit (OPEBs) contributions could, if unaddressed, begin to crowd out essential services. Infrastructure needs are becoming more pressing, and rising fixed costs could hamper the ability to issue debt to address this issue.

Despite general stability across the sector, there is a growing portion, roughly 5%-10% of issuers, facing numerous challenges pressuring their credit profiles. These local governments face revenue stagnation combined with growth in fixed costs, leading to a trend of credit deterioration.

Financial challenges at the state level, particularly in states hit by low energy prices or budget imbalances, could impact some municipalities and school districts as states could either cut aid or shift fiscal responsibilities to local governments.

Despite the sector's stability, there are some uncertainties around revenue generation. Sales tax revenue growth has slowed, and uncertainty about the new federal administration's policies makes assessing growth prospects difficult. The new federal administration may enact policy that could reduce funding to states, and in turn lower aid distributed to local governments. Significant cuts to K-12 education are not expected, but even flat funding would make budget-balancing difficult for school districts as costs continue to grow at least at inflationary rates.

Most local governments will be able to fund operating expenses within available resources, while also maintaining adequate reserves.

The pension burden for most local governments should remain low to moderate, although pension funding practices will cause net pension liabilities to rise faster than personal income.

A national survey of government finance officers indicates the resources available to fund infrastructure repairs and expansion continue to be insufficient. A new federal program that fosters infrastructure investment could ease some of the pent-up needs if it results in funding for basic repairs or construction of essential assets.

Not-for-Profit Hospitals

The sector outlook for U.S. not-for-profit hospitals and healthcare is negative for 2017; the number of downgrades is expected to exceed upgrades in the coming year.

We expect overall industry profitability to be slightly weaker in 2017, but believe the sector can maintain operating performance near 2016 results. The expected pressure on margins reflects the impact of a continued erosion in payor mix in 2017 as the aging baby boom generation moves into Medicare and as newly eligible Medicaid patients access more healthcare services to address deferred care and chronic conditions. The impact of a shifting payor mix is anticipated to be exacerbated by growing wage and benefit pressures due to the improving U.S. economy and the increasing demand for nurses and mid-level clinical staff in particular.

The election of Trump, combined with Republican majorities in Congress, raises the likelihood that fundamental changes will be made to the Affordable Care Act. Although details of Republican plans to 'repeal and replace' ACA are limited, an elimination of the ACA's key coverage expansion provisions - resulting in rising uninsured and uncompensated care levels - would be credit negative.

Over the longer term, the sector will be increasingly challenged by regulatory and political uncertainty, the growth in Medicare and Medicaid payors, and meager rate increases.

Uncertainty and turmoil have been persistent throughout the ACA's nearly seven-year history, and the industry is in for more of the same in 2017. Despite President-elect Trump's campaign promise to repeal the ACA, we do not expect that key coverage expansions under Medicaid and through the insurance exchanges will be eliminated immediately.

Transportation

The outlook is stable for U.S. transportation infrastructure headed into next year, though the sector is not without its uncertainties, part of which stem from the new Presidential administration's plans for infrastructure.

Part of what will drive modest growth for transportation infrastructure will be low fuel prices. Congestion relief and infrastructure renewal needs will continue to necessitate debt borrowing and investing by large transportation enterprises.

Low gas prices will buoy toll roads in particular, with moderate traffic growth projected in 2017. Growth is also forecasted for U.S. airports, with 3% passenger growth projected in 2017, and major market airports to drive the majority of that growth.

Perhaps the biggest uncertainty facing transportation infrastructure in 2017 revolves around political risks, chief among them uncertainty over President-elect Donald Trump's plans for infrastructure spending and state tolling opposition. A detailed plan for infrastructure spending from the new administration, coupled with concrete legislative proposals, could provide longer-term clarity regarding federal funding.

Some of the aforementioned uncertainties also lie with U.S. ports. Shipping and terminal counterparties are undergoing mergers while shifts in strategic alliances are taking place. The new administration's focus on renegotiating trade agreements may also affect cargo volumes in 2017 and longer term. That said, we have a stable outlook for U.S. ports.

The same holds true for grant anticipation revenue vehicle bonds (GARVEE) with the Fixing America's Surface Transportation (FAST) Act giving the sector a shot in the arm. There is some consideration of transferring transit funding to state jurisdiction. While no representations have been made by the incoming administration, we expect that any material changes to federal funding programs for highways or transit will be designed to not adversely impact GARVEE debt that has already been issued.

The outlook for the U.S. airport industry is positive for 2017, reflecting an expected enplanement growth of 2.5%. Enplanement growth -- the increase in the number of passengers using an airport to depart on a flight -- is a key indicator for the U.S. airport industry outlook since it generally translates into higher parking and airport-terminal concession revenues, which account for nearly half of total airport revenue.

More enplanements means higher revenue for airports, which results in stronger debt-service coverage and in most cases more liquidity. Historically, enplanement growth has demonstrated a high positive correlation with the average of GDP and airline seat growth. In 2017, we expect airlines to expand seat capacity between 2.0% and 3.5%. While three of the four largest airlines expect to keep capacity growth low, smaller airlines like JetBlue, Alaska, and Spirit plan to increase capacity by at least 6%.

Continuing recent trends, enplanement growth will mostly be concentrated at large and medium-size hub airports, while small and non-hub airports will see muted growth. The smaller airports are more likely to only be served by large legacy airlines, which use regional jets and will continue to be pressured by a pilot shortage.

Highest rated airports are typically those with a strong underlying market or franchise driving demand, overall stability of cash flows through contractual agreements with airlines and other commercial users, and healthy financial metrics. Conversely, weakest rated airports include those serving small markets or secondary airports subject to competition for passengers, or thinner financial metrics, and elevated leverage.

Water and Sewer

The 2017 outlook for the municipal water and sewer sector and its ratings is stable. The sector continues to be insulated from economic cycles and operating changes due to the essential services it provides, its monopolistic business nature, and rate-setting abilities.

Despite significant news this year related to lead water service lines in Flint (MI), the municipal water and sewer industry is otherwise stable, owing to sound fundamentals and strong operating results. The biggest uncertainty for water and sewer utilities in the coming year stems from the policy decisions of the new administration. Pending changes to the Lead and Copper Rule (LCR), which are expected to be announced in 2017, could be limited or delayed.

The EPA's October 2016 whitepaper outlining potential changes to the LCR suggested potentially mandating the replacement of all lead service lines, which they estimated to cost as much as $80 billion. A mandate of that caliber would affect many municipal water and sewer utilities, so uncertainty surrounding it leaves more questions than answers on what could be a significant investment in water infrastructure.

Outside of the LCR, we believe the EPA will continue to press for reductions in nutrient pollution given its high priority in their current strategic plan. In some cases, the additional related costs can be steep, potentially affecting utility credit quality.

The water and sewer sector should be able to maintain ample cash reserves in 2017.

Although we see stagnant sales and rising costs at some utilities, especially in areas experiencing drought, many utilities have sufficient rate flexibility and cash flows to cover debt service and meet operating and capital pressures.

We expect 2017 will bring a modest increase in planned capital spending, although those figures may rise longer term as utilities confront necessary maintenance that had been deferred. Modest increases next year combined with muted debt issuance means debt profiles will improve relative to 2016. Utilities that do come to market with new debt will likely use proceeds for maintenance and regulatory compliance purposes.

Public Power

The nation's energy and environmental policies are expected to shift toward less regulation under President Trump, but public power utilities committed to emissions reduction should see a stable ratings environment in 2017.

While it is early in the process to assess the policy choices of the next presidential administration, it could reconsider federal policies such as the Clean Power Plan, which could slow the pace of regulation over the next several years. However, we expect that utility policies aimed at reducing carbon emissions will remain.

In his campaign for president Trump called man-made global warming a "hoax" promoted by China, but said after his election that he would keep an "open mind" on the subject. At events attended by coal miners, Trump promised to bring back some of the more than 190,000 jobs lost in the mining industry since September 2014.

In a September 22 campaign speech in Pennsylvania Trump promised to "end the war on coal." "I will rescind the coal mining lease moratorium, the excessive Interior Department stream rule, and conduct a top-down review of all anti-coal regulations issued by the Obama Administration," Trump said, promising to scrap the Clean Power Plan and other initiatives to improve the environment.

About one third of the nation's electricity is currently generated from coal, a figure that has declined in recent years.

Trump has appointed Oklahoma Attorney General Scott Pruitt, a Republican, to head the U.S. Environmental Protection Agency. Pruitt opposed the EPA's power sector regulations under President Obama and has fought stricter environmental rules. He is one of the leaders of a lawsuit federal carbon rules under the Clean Power Plan.

Against the political backdrop, business conditions for public utilities should remain favorable through next year. Low natural gas prices and more affordable renewable power have made it cheaper for some utilities to buy energy in the regional energy markets than to generate it themselves, which means their costs are lower. However, some of the coal-fired or smaller nuclear plants owned by utilities will remain less price competitive.

Low natural gas prices have also made running some coal-fired or smaller nuclear plants uneconomical at certain times of the day, causing some to run less often or to be shut down. For example, between February and April 2016, San Antonio City Public Service officials reported that the highly-rated utility did not run its coal-fired generation units for 57 days, because purchasing energy on the Electric Reliability Council of Texas grid was less expensive.

A major feature of the ERCOT market is that a significant amount of wind energy is available at a lower variable cost, compared with running the utility's coal units. Texas has the deepest penetration of wind generation relative to other states.

The U.S. Energy Information Administration expects that residential energy demand will decline 1.4% in 2017, and that industrial sales will decline 0.3%, about the same pace of decline as this year. Historically, energy demand has followed positive and negative trends in the economy; but the relationship has decoupled over the past decade amid energy-efficiency standards.

Colleges and Universities

Both the sector and rating outlook for U.S. colleges and universities remain stable for 2017, despite uncertainty about policy changes that could be enacted by the new federal administration.

Even prior to the election, the largest institutional endowments were under scrutiny, with some members of Congress interested in tying endowment earnings to increased student aid or student access. Student loans are another area expected to be addressed by the new administration that could have significant financial and enrollment repercussions.

Regardless of the outcome of potential policy changes, we expect affordability concerns to continue to affect all institutions, with smaller, regional institutions that are heavily tuition dependent likely to be most affected.

Overall, we expect ongoing competitive pressures to limit tuition and fee increases for both public and private institutions. While this may help keep tuition more affordable and sustain enrollment at some colleges and universities, it may also pressure budgets by constraining net tuition revenue growth and potentially limiting necessary capital spending.

We anticipate the sector will continue bifurcating, with the stronger institutions maintaining or strengthening their financial and academic positions, and the weaker institutions experiencing enrollment and operating pressures.

Housing

Despite balance sheet contractions, state housing finance agencies (SHFA) have increased overall equity. In fiscal 2015, aggregate adjusted equity rose 2.6% from fiscal 2014 levels and increased 15.9% from fiscal 2010 levels. Marking the fifth straight year of across-the-board declines, aggregate SHFA assets decreased by 0.8%; aggregate debt fell by 2.9%; and aggregate loans declined by 1.8%. Albeit at a reduced rate of decline compared with recent fiscal years, these decreases are reflective of the economic and mortgage-lending environments during that period and the shift in SHFAs' business model in response.

Fiscal 2015 contained the same challenges for SHFAs as the past several years. Low interest rates continued to suppress investment income and low conventional mortgage rates decreased the volume of SHFA-issued debt for originating new whole loan mortgages.

SHFAs sought other ways to remain profitable, such as originating loans through the to-be-announced market, utilizing direct sales of MBS and issuing MBS pass-through instruments. Despite the challenging environment, fiscal 2015 results demonstrated that SHFAs are financially sound, as median ratios, such as Net Interest Spread, Net Operating Revenue, and Debt-to-Equity (DTE), continued to trend positively.

Leverage ratios continued to improve as the median adjusted DTE ratio declined to 3.1x in fiscal 2015 from 3.4x in fiscal 2014. This is significantly lower than the five-year average median and the fiscal 2010 median, which were 3.9x and 5.5x, respectively, and now stands as the lowest median DTE ratio in the past decade.

In 2017, state housing finance agencies should expect sound financial ratios, deleveraging bond programs, equity building, and improved delinquencies. The main drivers for the 2017 stable outlook include the sound financial ratios driven by the deleveraging of bond programs causing increased equity and the utilization of alternative funding tools for new loan production to allow for continuous lending. We anticipate that this sound financial performance will continue through fiscal 2017.

SHFAs use flexible approaches to maintain continuous lending contributing to the bottom line, including a combination of alternative funding tools. SHFAs have also used savings from bond refundings to subsidize new loan origination.

With SHFAs no longer using mortgage revenue bond programs as their primary funding source, debt issuance has declined, balance sheets have shrunk, and equity has increased. SHFAs have also grown their equity positions by generating cash up-front through the sale of mortgage backed securities. Overall, increased equity creates flexibility within bond programs.

SHFAs are challenged by the failure of first time homebuyers to return to normal, historical levels of homeownership. This may impact the SHFA's ability to originate new long term assets to ensure SHFA growth, profitability, and sustainability.

Default Outlook

Defaults in the U.S. municipal bond market continue to be rare, with just four in 2015 year (most recent official data available). The defaults, which included a Puerto Rico agency, compare with zero in 2014 and seven the year before. While the majority of bond issuers remain stable, more are confronting pressure from underfunded pensions, infrastructure bills, and other expenses.

Such strains helped drive the share of local governments with speculative-grade ratings to 0.8% from 0.4% at the end of 2011. In 2015, there were more than 20 rating cuts of four grades or more. While revenue growth was muted, pension liabilities were increasing rapidly. A fundamental issue of too much leverage across many credits was emerging, largely because of pensions.

The 2015 defaulters were the Puerto Rico Public Finance Corp., Dowling College in Oakdale (NY), Cardinal Local School District in Ohio, and Cook County Single Family Mortgage Revenue Bond in Illinois. Those were followed in 2016 by ones from the Puerto Rico Infrastructure Financing Authority and its Government Development Bank.

Overall municipal bond default rates remain low at 0.016 percent across all rating categories, with most in housing and health care.

Conclusion

Despite uncertain fiscal, economic, and regulatory pressures, U.S. municipalities will benefit from modest economic expansion that will support revenue growth and stability. The upcoming transition of the federal administration holds potentially significant implications for many sectors across public finance. The transition creates an unpredictable environment for U.S. states and local governments, which are particularly exposed to policies affecting trade, jointly funded programs, and fiscal stimulus.

MTAM continues to recommend that investors select high quality municipal issuers that understand the new financial reality and have made or are making budget adjustments. Essential service revenue bonds without the budgetary concerns of state and local governments and limited payrolls can be attractive, but we stress that an essential service issuer cannot flourish if the underlying governmental entity is in dire economic circumstances. A healthy outlook holds for most infrastructure issuers due to fundamental strengths reflected in the provision of essential public services, adequate balance sheets, and generally sound governance and fiscal management practices. In the case of the enterprise sectors comprised of higher education, health, and housing, credit quality will be maintained primarily as a function of their ability to increase fees, control costs, and improve overall operating margins. Sound debt and fiscal management practices, preservation of adequate liquidity, and strong governance oversight will be significant determinants of credit quality for issuers during the coming period of financial adjustment.

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4th Quarter 2016 Review and Outlook

Friday, December 30, 2016

Negative returns were prevalent all along the municipal bond yield curve during the past three months as investors were caught off guard with the result of the United States presidential election. The municipal bond market drank the Kool-Aid that the pollsters were pushing, and the market was collectively positioned—prior to the election—for a win by the candidate promising to raise taxes, not lower them. That the surprise winner of the presidential race came away with a majority in both chambers of Congress escalated the sell-off in the municipal bond market as investors assumed that, with this backdrop, tax-reform would be a "done deal." There was no place to hide, as the selloff in November in particular was as brutal as any one month in the history of the market. Shorter maturity bonds did outperform as "duration shedding" was the theme for mutual fund portfolio managers who needed to raise cash to meet investor withdrawals.

Adding to the gloom for bond investors in the last quarter was an uptick in economic growth and inflation that essentially put the proverbial golf ball on the tee for the Federal Reserve to lift short-term interest rates again (which they did). Clearly, a sizeable asset allocation shift out of fixed-income and into equities occurred during the quarter as growth expectations ratcheted higher as the dynamics of the election results began to be analyzed. This allocation shift out of bonds essentially punctuated what ultimately will have been seen as a perfect (negative) storm for municipal bond investors during the quarter.

"Market Positioning And What Is Priced In"

Highly compensated investors (i.e. hedge funds) are always looking to jump on the next big "theme" to justify their outsized fees relative to their poor overall performance (some are "worthy," most are not). If you go back and look at the comments and research of this group of "experts," most were predicting dire consequences for the stock market if Donald Trump won the election. The bear market for stocks lasted about twenty-four hours after the election results, and this handsomely paid group of investors chased stock prices significantly higher to remain "in the game." Investors are tuned to seek patterns. Once a clearly seen pattern emerges, almost without exception, it gets overdone to the upside. In July 2016, the ten-year U.S. Treasury note closed at a record low of 1.375% amidst mounting deflation concerns. Now the media is filled with the same experts who likely missed that move lower in yield this summer, predicting it could rise to 6% in the next few years due to inflation taking off. Our point here is to acknowledge that market momentum is a function of what has yet to be fully "priced in." Markets "do" what hurts the most investors. Market positioning before a "black swan" event will almost always be reversed to an extreme, and therefore, should be recognized by savvy investors as an opportunity to reallocate accordingly. There has been significant optimism priced into risk assets, and quite a bit of pessimism priced into tax-free bonds. Keep in mind that market positioning matters when trying to divine the future in 2017.

A record amount of municipal bond issuance in 2016 helped adjust market yields higher, especially in the second half of the year. Given all of the buzz about "infrastructure spending" that permeates the municipal market these days, we would expect a sizeable amount of new issue supply in 2017. For an investor with a separately managed tax-free bond portfolio, potential excess supply should be viewed as an opportunity to upgrade income levels, and to correspondingly upgrade the overall credit quality of the portfolio with the assistance of a highly capable investment manager (that would be us). Investors should always remember that a separately managed municipal bond portfolio is at a distinct advantage during periods of rising interest rates. As long as the individual bonds in the portfolio are held to maturity, the return of capital plus accrued interest is assured.

The economy in 2017 will be interesting to watch as financial conditions have already tightened in the United States, thanks to a slightly more hawkish Federal Reserve ("dot" watching) and the Dollar, which is hitting multi-year highs again. Interest rate sensitive areas of the economy (housing, autos) will be hard pressed to replicate their growth trajectories now that rates have ticked up. The healthcare sector (about 17% of U.S. GDP) faces something akin to a shake out as the new leadership in Washington D.C. looks to overhaul ObamaCare, which could create another temporary headwind to growth in the coming year. We have been adamant in prior writings about the prospects for a significant economic slowdown in the second half of 2017. We stand by that forecast still; the politicians have changed, but the structural problems in the economy have not. Higher yields should be viewed as an opportunity to enhance overall levels of income and to prepare for the inevitable economic slowdown. Very simply, the Federal Reserve raises interest rates to slow the economy and put downward pressure on inflation. Both scenarios are ultimately good for bondholders.

Happy New Year!
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
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The Repeal and Replacement of Obamacare

Friday, December 9, 2016

President-elect Donald Trump will take office with Republican majorities in the both the U.S. House of Representatives and the Senate. While the timing and extent of any potential healthcare policy changes are uncertain, the Republican leadership appears set on implementing healthcare reform of some form. Based on campaign promises and years of rhetoric, Trump and Congressional Republicans can be expected to attempt a repeal and replacement of the Affordable Care Act.

The municipal bond market is facing headwinds from President-elect Trump, and more than $250 billion in hospital debt is most at risk. Under the Affordable Care Act, 20 million people obtained health insurance as 30 states expanded Medicaid, the joint federal-state health program for the poor, and others purchased insurance on exchanges. Repealing or scaling back Obamacare would reduce revenue for hospitals and nursing homes as Medicaid expansion is curtailed and private subsidies cut.

Trump supports letting states administer Medicaid block grants, while promoting tax-free health savings account to encourage people to buy insurance. He also advocates allowing insurance companies to sell policies across state lines.

The Affordable Care Act, which took full effect in January 2014, has been a boon to investors who hold tax-exempt bonds sold by hospitals: Hospital bonds returned 12.72 percent in 2014 and 4.09 percent in 2015, the best of 10 revenue-bond sectors, according to Bloomberg Barclays Indexes. Performance has weakened this year as factors that have driven enrollment growth waned. States, including Texas and Florida, have not expanded Medicaid and are not likely to. Hospital bonds have returned 3.57 percent this year.

While Republicans will control the White House and Congress, they will not have a supermajority in the Senate, and Democrats can use the filibuster to block a repeal. Repealing Obamacare outright would also be difficult politically given how many Americans are now covered by it. Furthermore, hospitals have already built an infrastructure based on Obamacare and transition to value-based reimbursements from a volume-based fee-for-service model.

A Republican repeal of Obamacare without a comprehensive replacement would be a disaster for U.S. hospitals that would cost jobs, limit health programs, and reduce care for the uninsured, two powerful industry lobbying groups have claimed. The trade organizations, which together represent 6,000 hospitals and healthcare systems, have warned against a sudden repeal of the Affordable Care Act.

A repeal must ensure that hospitals do not see a surge in expenses for caring for those who will lose insurance, as well as people covered by federal health programs, leaders of the American Hospital Association and the Federation of American Hospitals have said. Without backup measures, local economies where hospitals are often the biggest employers will also get hurt.

Some congressional Republicans have said the process of repealing President Obama's signature health law will begin immediately after Trump's inauguration in January, although the schedule for replacing it is unclear. On his transition website, the president-elect said last month that his administration will work with Congress and the states to replace the ACA with "a patient-centered healthcare system that promotes choice, quality and affordability," without giving a precise schedule or specifics about hospital payments.

Conclusion

The ACA, which provided health coverage to millions who previously did not have any and thus reduced uncompensated care, lowered reimbursements hospitals receive from Medicare. If lawmakers repeal the law, they must either replace it immediately or restore the Medicare reimbursements.

The most recent bill to repeal the ACA -- which was vetoed by President Obama -- would have cost hospitals $166 billion from 2016 through 2026, according to a study commissioned by the hospital groups and prepared by healthcare consulting group Dobson Davanzo & Associates.

While a repeal without replacement is unlikely, hospitals are girding to battle against the possibility of losing reimbursements for millions of patients who would become uninsured. Many nonprofit hospitals that operate on low margins, and on which low-income communities depend, would be severely affected by any funding reductions. MTAM will continue to monitor the healthcare developments.

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The Coming Showdown for Sanctuary Cities?

Thursday, November 17, 2016

As part of his 100-day action plan, President-elect Donald Trump has pledged to block all federal funding to sanctuary cities. Municipalities that protect undocumented immigrants from deportation may lose billions in federal aid if Trump fulfills promises to starve them financially.

More than 350 counties, cities, and states are so-called sanctuaries. There is not a legal definition for a 'sanctuary city.' But, generally, these places have policies, police department orders or nonbinding resolutions that limit government officials from cooperating with federal immigration enforcement. These 'sanctuary cities' will not turn over people to federal officers seeking to deport them nor share information about them, saying that would rend the social fabric and impede policing.

Since Trump's election last week, mayors including San Francisco's Ed Lee, New York's Bill de Blasio, and Chicago's Rahm Emanuel have vowed not to back down despite Trump's promise.

For the 2016-17 fiscal year, San Francisco's operating budget is $9.6 billion, said Severin Campbell, director of the City's budget and legislative analyst's office. About $478 million comes from the federal government. "Five percent of the budget is fairly significant," Campbell said. At the very least, the City could lose grants for housings and community programs, she explained. "There are also a lot of criminal justice grants that show up in the police and adult probation budgets," she added.

Many cities have calculated that dwindling populations and labor shortages can be ameliorated by immigrants, undocumented or not. The mayors must calculate the point at which resistance harms the communities they are fighting to protect. The evolving confrontation exposes states' and cities' vulnerability to losing some of the $650 billion in federal funds they receive for everything from police to sidewalks as they confront pension obligations and shrinking budgets. "There's an economic benefit from being a sanctuary city, but it doesn't appear to warrant giving up 5 to 10 percent of the city's funding," said Dan White, senior economist at Moody's Analytics.

Congressional Republicans have been trying for years to use federal dollars as leverage. A bill this year by Senator Pat Toomey of Pennsylvania defines a "sanctuary jurisdiction" as any that restricts local officials from exchanging information about an individual's immigration status or complying with Homeland Security requests. The measure would cut off funds including Economic Development Administration Grants, which totaled $238 million last year, and Community Development Block Grants, which amounted to $3 billion last year. Ten of the largest sanctuary jurisdictions were awarded a collective $700 million in block grants in 2016.

The bill was blocked. "The resolutions and the amendments of these bills have been written up," said Alex Nowrasteh, an immigration policy analyst at the Cato Institute. "The idea has been out there for a long time." With a Republican Congress and a Republican in the White House, a law to cut off sanctuary cities is certainly possible, he said.

Most cities say that immigration is a federal responsibility and they should be left out of it. Many say that they simply do not have the time or resources to address it. Some say that singling out undocumented immigrants impedes law enforcement because large populations will shun any interaction with the authorities.

Chicago is particularly vulnerable. Public-employee retirement funds face a $34 billion shortfall, and Emanuel last month proposed a $9.3 billion budget for 2017 that would increase spending to hire and train more police. The spending plan anticipates $1.3 billion in federal grants this year.

In Los Angeles, the police chief said that he would continue a policy of not aiding federal deportation efforts, according to the Los Angeles Times. In New York, de Blasio said last week that he would consider destroying a database of undocumented immigrants with city identification cards before handing such records over to the Trump administration. New York City will receive $7.7 billion in federal grants in fiscal 2017, just under 10% of the City's $82 billion budget.

In New Orleans, which does not consider itself a sanctuary city but whose officers do not ask about immigration status, the specter of losing federal funds is daunting. Some money the City receives is enough to fund nine police officers, said Zach Butterworth, executive counsel for Mayor Mitch Landrieu and director of federal relations.

Lena Graber, special projects attorney at the San Francisco-based Immigrant Legal Resource Center believes Trump will run into legal challenges if he threatens municipal funding. "The federal government can't force state and local law enforcement to use their resources to enforce federal regulatory programs like immigration law," she said. "He can try to offer incentives, but the more that those incentives look like coercion, the more it won't be legal."

In Denver, which has a policy of refusing to hold detainees solely on a request by immigration officials, Mayor Michael Hancock said he will not be cowed. "This is all legal what we are doing here," he said. "The president doesn't have the authority to unilaterally decide how we move forward." In Oakland, California, Mayor Libby Schaaf says she is proud to run a sanctuary city, and is planning to recruit even more towns for the movement. "The best defense is offense," she said. "There is strength in numbers."

Trump made attacks on sanctuary cities a campaign staple, often invoking the shooting death of Kathryn Steinle by an undocumented immigrant in San Francisco. The shooter had been released from a county jail even though federal officials had asked him to be held until they could deport him.

The incoming president has said he would deport more than 11 million people, beginning with gang members, drug dealers, and other criminals. He has also said he would create a special deportation task force within Immigration and Customs and Enforcement. If that is the case, local jurisdictions might see even more requests for cooperation.

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Municipal Bond Market - Tax Reform Forecast Post-2016 Election

Thursday, October 27, 2016

U.S. presidential elections can have outsized significance for the $3.8 trillion municipal market because they often result in changes to tax policy. Typically, Republicans cut taxes on the highest earners, while Democrats raise them.

The interest income from municipals is usually exempt from federal income taxes, making them an attractive option for investors in high-income tax brackets. Those tax advantages also mean changes to the tax code could affect the municipal bond market. The benefit of owning state and local-government bonds over other fixed-income securities declines when levies are reduced and increases when they rise. Yields — which move in the opposite direction as price — fell relative to U.S. Treasuries after Bill Clinton's victories in 1992 and 1996, and again after President Barack Obama's re-election in 2012. They increased after Republican George W. Bush's victory in 2000, which led to tax cuts.

Municipal bonds have gained every year but one since President Obama took office in 2009, according to Bank of America Merrill Lynch indexes, as the Federal Reserve held interest-rates near zero and taxes were raised on the highest earners.

Most investors who buy municipal bonds buy them for their after-tax income and safety—and municipals have generally delivered on both fronts. But tax reform can undermine the value of municipal bonds. The tax plans proposed by Hillary Clinton and Donald Trump differ dramatically, particularly around the highest-earning individuals.

The current top federal tax rate is 39.6%. This equates to 43.4% when we combine the highest marginal rate of 39.6% and the 3.8% Medicare tax.

Clinton wants to increase taxes on the wealthiest Americans by enacting a 4% surcharge on income over $5 million and imposing a 30% minimum tax on taxpayers with income above $1 million—the "Buffet Rule." In contrast, Trump has proposed to lower the top tax rate. He has released two tax plans to date. His original plan lowered the top marginal rate to 25%. His subsequent plan lowered it to 33%.

Tax rates affect the yields and prices on municipal bonds, which are currently exempt from taxation. On the face of it, Clinton's proposal should favor municipal bond prices by increasing demand from the wealthiest taxpayers; Trump's plan should hurt prices by reducing demand. But their tax plans are more complicated than that. Clinton is keeping alive President Obama's proposal of limiting the tax exemption of municipal bonds to 28%. That means that an investor with a top federal marginal tax rate of 43.4% (47.4%, including the 4% surcharge) would pay a tax of 15.4% (19.4%, including the surcharge) on their municipal income.

Trump, although he did not provide details in his initial proposal, had earlier specified his desire to limit the tax exemption of municipals to 10%, thus leaving a 15% federal tax on municipal income. However, because his subsequent plan does not even mention the municipal tax exemption, some political observers believe the exemption could be at risk.

Capping or eliminating the municipal tax exemption or reducing the top marginal tax rate would cause municipal yields to shift higher relative to taxable bonds; at the same time, the value of the bonds would fall, initially. The longer the maturity, the greater the initial price impact. That said, we do not think a cap is likely. This policy has been proposed before but has not gained enough support among Republicans to pass. We believe that if Republicans maintain their majority in the House of Representatives, a cap would again face an uphill battle.

Taxes are not the only proposals the candidates are making that could affect the municipal market.

Over the past several years, the combination of strong demand in the face of weak supply has been a boon to municipal bond prices. In fact, five of the last six years have seen net negative municipal bond issuance. That may seem surprising, given historically low interest rates, and the corresponding surge in corporate bond issuance. Yet politicians have not taken meaningful action.

But it might not stay that way. According to the American Society of Civil Engineers, the nation's infrastructure spending needs through 2020 top $3.6 trillion. And both candidates want to increase investment in our crumbling infrastructure. Clinton's plan totals $500 billion. That involves an increase in federal spending of $250 billion, and an allocation of $25 billion to a national infrastructure bank, which would support an additional $225 billion in direct loans. Trump has mentioned investing up to $1 trillion, though he has provided little in the way of detail.

Even with Clinton's plan, it is unknown how the increased investment would be funded. Would there be direct spending by Washington or by municipalities — in other words, through municipal or Treasury bonds or some combination? More municipal bonds would test the demand side. Fewer would likely keep the prevailing winds strong, supporting municipal prices.

Clinton also wants to breathe life back into the dormant Build America Bond program, which in 2009 and 2010 provided a federal interest subsidy to municipalities for issuing taxable municipal bonds. During the program's short life, municipalities issued $181 billion of taxable municipals in lieu of tax-exempt issuance. Reinstating Build America would reduce tax-exempt issuance, which in turn would likely drive prices higher in the municipal market.

More broadly, the way the candidates approach the economy could also affect municipals. For example, the direction of Treasury rates will likely have a bigger impact on municipal yields than changes to tax laws. So how do the candidates' proposals fare on that point? According to an analysis by Moody's Analytics, Clinton's proposals would lead to greater long-term economic growth, less federal government debt, and a lower debt-to-gross domestic product ration, than Trump's proposals. However, Trump's proposals would cut unemployment more.

Of course, there are many views about how a Trump or Clinton presidency may or may not affect the economy. Our take is that neither candidate will likely be in a position to radically remake the economy. That said, if the next president succeeds in accelerating economic growth, investment grade bond yields would likely rise, pulling municipal yields up with them.

Conclusion

Of course, Congress sets tax law, and no matter who wins, there is little chance our next president will be able to push through his or her entire agenda of tax and infrastructure proposals. We believe that Congress — particularly the Senate — will remain narrowly divided after the electoral dust settles and the new year starts. If Clinton wins, she could struggle to get major changes to the tax code passed, which would leave municipals unaffected. If Trump wins and the Republicans maintain control of the House, tax cuts could follow. Regardless of who wins, consensus will likely be elusive, so we do not expect any major changes.

In general, higher marginal tax rates tend to make municipals more attractive, while lower rates make them less so. In other words, if Trump's plan were enacted in its entirety, the case for municipals would not be as strong, so municipal prices would likely fall and yields would rise. If Clinton's plan—excluding the cap on deductible interest income from municipals—were passed, municipals might actually look more attractive, which could push prices up and yields down.

The proposals create heightened uncertainty and volatility for the municipal market, in addition to any realized effects from whatever plans eventually become legislation. That alone calls for an actively managed bond portfolio with a flexible mandate.

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U.S. Cities' Finance Officers Remain Cautiously Optimistic

Monday, October 24, 2016

Optimism among U.S. finance officers remains close to a record high even with sluggish revenue growth and looming long-term challenges such as infrastructure and employee and retiree benefits, according to the just released National League of Cities' annual survey.

"Better-than-anticipated" general fund revenue growth was 0.5% in 2016, down from 3.7% in 2015. Cities are projecting that financial reserves will reach 21.7% of budgeted expenses in 2016, compared with a record 25.2% in 2015. Despite these declines, 81% of the city financial officials from 277 cities surveyed for the 2016 City Fiscal Conditions report said that they are in a better fiscal position than last year. Just 12% felt that way in 2009. This level of optimism among finance officers is similar to last year, indicative of continuing fiscal recovery in cities.

The largest positive contributions to city budgets are the value of their local tax base, the health of their economy, and decreased gas and oil prices. To balance their budgets, two in five finance officials reported raising fees, while 22% of cities raised local property taxes.

Infrastructure needs and the cost of employee and retiree health benefits weighed the most heavily on city budgets in 2016. Almost 88% of city officials reported that the cost of infrastructure needs increased in 2016, and 81% said health benefits costs rose. These issues are not new to cities, but the confluence of a slow recovery and growing needs are exacerbating the impact of these challenges on local budgets.

Despite low borrowing costs, debt repayment often competes with the basic operating costs of municipalities, which includes infrastructure maintenance and growth. We caution that the long-term economic and community growth potentials of cities may be compromised if infrastructure needs are not addressed.

This year's City Fiscal Conditions survey also found that: Expenditures grew 3.6% in 2015 and are budgeted to increase 3.7% in 2016. Property tax revenue growth is returning to pre-recession levels, with a sizable increase of 3.8% in 2015 and anticipated growth of 2.6% in 2016. Sales tax revenues are continuing to post strong growth, with 5.5% in 2015 and 2.0% expected in 2016. Despite post-recession volatility, income tax revenues grew 5.8% in 2015 and are expected to grow 3.5% in 2016.

Despite improved fiscal stability for day-to-day operations, local budgets continue to confront mounting challenges. Infrastructure and employee- and retiree-related costs, matched with inequitable recovery in some local housing and labor markets, threaten longer-term fiscal sustainability. These concerns are foremost on the minds of city leaders, some of whom are implementing pension reforms and leveraging fiscal planning tools. These strategies are particularly important given that city revenues have not fully recovered from the Great Recession. As a result, many may be operating with suppressed revenues when and if another recession emerges in the coming years. For now, though, city fiscal conditions are showing signs of vitality, with local governments reinvesting in areas critical to growth and community quality of life including infrastructure and public safety.

Going forward, stronger city revenues are building the capacity of cities to deliver critical services and improve quality of life. This trajectory of growth, however, is threatened by a number of persistent concerns: the recovery dynamics of the real estate market, namely low inventory paired with rising prices, are depleting stocks of affordable housing throughout the country. This will lead not only to uncertainty regarding property tax collections, but as workers move further from job centers to find more affordable housing, entire regional economies will be threatened; the prolonged effects of slow and inequitable growth of employment and wages will weigh heavily on future city income tax revenues and sales tax receipts; and as cities move to shore up healthcare and pension liabilities, the additional expenditures required in their general funds will compete for scarce resources with other city services, confronting city leaders with difficult choices among employee and retiree benefits, city service levels, and raising new revenues.

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3rd Quarter 2016 Review and Outlook

Friday, September 30, 2016

Marginally negative total-returns were prevalent all along the municipal yield curve in the third quarter of 2016 including the shortest maturity bonds, which uncharacteristically underperformed on a risk - adjusted basis during that time frame. Assets continued to pour out of municipal bond money market funds during the quarter in response to a Securities and Exchange Commission rule that goes into effect in October that requires floating net-asset values on these products. This combined with the constant threats from the Federal Reserve to raise short-term interest rates (they "punted" once again in September) had an adverse impact on demand for short-maturity bonds, which we sense may not last much longer. Conservative-minded investors should take a stroll through this area of the municipal yield curve as exceptional relative and risk-adjusted value exists in our view.

Market volatility should continue on an upswing in the coming weeks as the United States presidential election draws even greater scrutiny from investors looking to position their portfolios for optimal performance. While the election is clearly very important, it would behoove investors to keep an eye on the United States economy, which continues to grow only lethargically (at best). With over nineteen trillion in U.S. debt (and rising), promises of greener pastures by any of the presidential candidates needs to be taken with a grain of salt in our opinion. There are significant structural "shackles" present upon the United States (and global) economy that suggest low growth, low inflation, and moderate market returns are here to stay.

Moving forward, we here at Miller Tabak Asset Management believe optimal municipal bond portfolio returns will be achieved by moving up the credit spectrum in preparation of an even weaker economic backdrop than currently exists now. We are keenly watching issuers' ability (and willingness) to pay, and will continue to focus on issuer credit selection as the driving force behind preserving client capital in these challenging economic times. In our view, it remains important that investors deploy cash in conservative asset classes in preparation for the high likelihood of negative interest rates coming to the United States by the second half of 2017. Conventional methods of stimulating the economy (and inflation) have long been exhausted. Now unconventional methods are in the process of being "rolled out" (see Japan and Europe) by central banks seemingly unconcerned about the real distortions they are creating in the financial markets. What seems obvious to us is that "savers" will continue to be targeted.

Our advice?

"Stay fully invested in high quality intermediate duration tax-free bonds."

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
www.millertabakam.com

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U.S. States Not Having Much Luck Turning Gambling Revenue Into a Sustainable, Long-term Revenue Source

Friday, September 9, 2016

Gambling is not a reliable and sustainable source of revenue for states or a solution to their budgetary problems, according to a recent report from the Nelson A. Rockefeller Institute of Government. Gambling expansion is understandably appealing to officials wishing to raise revenue without raising taxes, but the long-term revenue is uncertain and potential economic and social costs require careful consideration.

After the 2008 recession, more than a dozen states legalized or expanded certain gambling activities in the hopes that it would help balance their budgets. These states have encountered changing consumer preferences and increased competition, which makes gambling an unreliable funding source for states.

Among the 47 states that receive gambling revenue, 18 states reported a nominal decline in gambling revenue during fiscal 2015. State and local governments raised $27.7 billion in 2015 from major types of gambling, two-thirds of that from lotteries. The total for 2014 was $27.3 billion. Gambling revenue only accounts for between 2% and 2.5% of state own-source general revenues on average.

States typically legalize and expand gambling to raise revenue during times of poor state fiscal conditions as well as to stimulate economic development. Gambling is also implemented to keep gambling residents and tax dollars in-state and counteract interstate competition for gambling revenue.

The expansion of gambling across the Northeast has hurt states such as New Jersey, home to Atlantic City. Four of the City's 12 casinos have closed partly due to increased competition from nearby states.

In addition to competition concerns, states face waning demand. Consumers now have less discretionary income to spend on gambling and younger people are less likely to visit casinos or racinos, which are racetracks that also feature slot machines and table games.

Between fiscal 2008 and fiscal 2015, inflation-adjusted tax and fee revenues from commercial casinos grew by more than $1.3 billion in states with newly authorized casinos, but declined by $1.4 billion in states with established ones. This marked a net decline of 1.5% percent on a national scale.

In fiscal 2015, gambling tax and fee revenues - which combine lottery, casino, racino, video gaming, and Indian casino revenues -- was $27.7 billion, while other sources of government taxes such as personal income tax, sales tax, corporate income tax, motor fuel tax, and property tax was $912 billion.

As of fiscal 2015, 44 states had lotteries, 18 had casinos, 28 had Indian casinos, and 13 had racinos. Since the recession, two states created lotteries, four established casinos, and two set up racinos.

Lotteries, at 66%, accounted for the biggest share of gambling revenues in fiscal 2015, followed by casinos at 19%, racinos at 12%, and video gaming at 2%. Lotteries had $18.2 billion in revenues, casinos had $5.4 billion, racinos had $3.3 billion, video gaming had $672 million, and Indian tribal casinos had $135 million. Accounting for inflation, lottery revenue declined by 0.7% in fiscal 2015, with 27 states experiencing declines.

South Dakota, at 74%, had the highest percentage of lottery contributions transferred to general funds in fiscal 2015. A total of 34 states had transfers of between 20% and 30% during the same period. Three states have implemented lotteries in the past decade: North Carolina in 2006; Arkansas in 2009; and most recently, Wyoming in 2014.

The New England, Plains, mid-Atlantic, Great Lakes, and Rocky Mountain regions all saw decreased compound annual growth rates in lottery revenue between fiscal 2008 and fiscal 2015, while only the Southwest and Southeast regions saw positive growth rates. The U.S. lottery revenue growth rates as a whole remained flat for that time period.

Future growth in gambling revenue will not keep pace with tax revenue or spending, and if gambling revenue is intended to support part of an overall budget, gaps may emerge.

The expansion of state-sanctioned commercial casinos could reduce the yields of Indian tribal casinos, which have existed since 1988. The sheer number of new gaming facilities as a whole outpaces the number of new gamblers. This could mean short-term yields and long-term deterioration. They are ultimately competing for the same pool of gamblers; there are not many new gamblers to each casino.

Going forward, we anticipate a shift in traditional gambling to newer, more electronic-based forms of gaming. There may be more emphasis on daily fantasy sports and interactive gaming, and expansion of new types of gambling.

Conclusion

New gambling activities may generate short-run increases in public revenues, but these increases are getting smaller and their duration shorter, perhaps as more and more states compete for a limited pool of gambling dollars.

State and local government gambling revenues have softened significantly in recent years due to an oversaturation of the gambling market after the rapid casino and gaming expansion following the Great Recession. While gambling revenues may be a good short-term fix for revenue shortcomings, long-term growth is uncertain and oftentimes reverses into a decline. Instead of focusing on gambling, states should make other sources of revenue, such as income taxes, more sustainable.

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The Zika Virus and its Impact on the Miami-Dade County Region

Thursday, August 25, 2016

MTAM continues to monitor the outbreak of the Zika virus in Miami and the surrounding south Florida region. The Centers for Disease Control and Prevention is advising pregnant women to avoid traveling to the affected areas, and more broadly, is advising pregnant women and their partners to postpone "nonessential travel to all parts of Miami-Dade County" if concerned about virus exposure.

MTAM believes the recent developments related to the Zika virus has the potential to reduce travel to the south Florida region that would affect key sources of tax revenue linked to tourism (including sales, gas, and tourist development taxes). However, there is no indication yet as to the latest travel advisory's degree of impact on tourism-related revenues and, ultimately, on credit quality.

Last week, S&P raised Miami's general obligation rating by one step to AA-, its fourth-highest investment grade rank, citing the City's economic expansion, ideal location for international trade, and the regional focus on trade and tourism. S&P most recently affirmed their AA rating, with a stable outlook, on Miami-Dade County's general obligation bonds on June 30, 2016. Miami is rated Aa3, with a positive outlook by Moody's, which has assigned Miami-Dade County a ranking of Aa2 with a stable outlook.

The Centers for Disease Control and Prevention issued the travel advisory two weeks ago for a one-square-mile neighborhood north of downtown Miami encompassing Wynwood, a trendy arts district where the country's first locally transmitted cases of the Zika virus were found in tests on humans. Last week, we learned of a second location in Miami-Dade County where the Zika virus is being spread locally by mosquitoes and, along with it, an expanded travel advisory. Miami Beach joins the Wynwood section of Miami as the only two places in the U.S. (excluding U.S. territories) with confirmed cases of the virus that are not travel-related.

The CDC's travel advisory marks the first time in the agency's 70-year history that people have been warned not to travel to a U.S. location. Extra measures are being taken locally to reduce the spread of the Zika virus by the City, County, and the State. Those include educating residents about standing water where mosquitoes breed and aerial spraying of insecticide.

To date, 46 states plus the District of Columbia have reported Zika cases acquired by people who traveled outside the U.S., the CDC said. The cases reported in Miami-Dade County were acquired by people who had not traveled outside the country.

While most Zika cases are mild or symptom-free, women infected during pregnancy are at increased risk of giving birth to babies with abnormally small heads, a condition called microcephaly. Health investigators are conducting door-to-door surveys, spraying and sampling in the affected zones. Some of those efforts appear to have worked in a 10-block area in the affected zone in Miami, where officials concluded that no local transmission has been detected.

Business and government leaders are hoping the Florida cases will not morph into the kind of epidemic seen in South and Central America, where thousands of infections have occurred, leaving hundreds of babies with severe birth defects. While emergency Zika spending proposals have bogged down in Washington D.C., the State of Florida needs funds to make sure the virus does not create more damage across the rest of the country.

Counterbalancing Zika's negative effect on tourism are good-to-strong debt service coverage levels that allow for some fluctuation in revenues without directly imperiling debt service payments. While the impact of the Zika virus is clearly negative on many levels, whether its affects credit quality will depend on how much tourism and tourism-related revenues decline and the length of time before this is resolved. At this point, it is difficult to estimate how much tourism will be affected by the latest or any future travel advisories, increased knowledge of how the virus affects people, and whether a vaccine can be developed before the start of the high tourism season, among other factors.

While we believe the dominance of property taxes as a source of revenue, in conjunction with the ongoing recovery of the housing market, should insulate Miami-Dade County's budgetary performance should there be a decline in sales tax receipts, of greater concern are the revenues securing the special tax credits in the County and its municipalities.

The stakes for Florida are high. A record 106 million people visited the State in 2015, pumping $89 billion into its businesses, according to Visit Florida, an organization that promotes tourism. In Miami alone, 15.5 million visitors stayed overnight last year, according to the Greater Miami Convention and Visitors Bureau.

Many analysts see Miami as being too attractive to avoid, and are expecting the virus to wane by the beginning of high tourist season in mid-November. Still, the threat of a wider epidemic looms over public health and businesses. Hotel chain Marriott International Inc.'s second-quarter revenue per available room -- a key measure of rates and occupancy -- dropped 2.6% in the Caribbean and Latin America from a year earlier. Concerns about the virus's spread in Brazil also hurt results from Hyatt Hotels Corp. in Rio de Janeiro.

American Airlines Group Inc., Delta Air Lines Inc., and United Continental Holdings Inc. have all seen yields, the average fare per mile, to and from Latin America drop to 2009 lows amid contraction and Zika fears in the region. JetBlue Airways Corp., which gives passengers traveling to Zika-affected regions additional flexibility to apply for refunds or flight changes, updated its guidelines to include the Miami area.

Conclusion

Given that it is the low season for Florida tourism, the current limited travel guidance is not likely to significantly affect tourism-based tax streams over the next few months. However, if the guidance expands to include the entire City or remains in effect through the fall and into the high season of December to March, these revenue streams could experience declines.

The costs associated with Zika prevention in Miami and the County likely will not have a major effect on their operating budgets given that both have healthy reserves available for contingencies and budget conservatively. However, Miami and Miami-Dade County have become more reliant on sales tax and tourism-based revenues.

In fiscal 2015, sales taxes constituted 5.2% of the revenues in Miami's $599 million general fund, while sales taxes and state-shared revenues accounted for 12.4% of Miami-Dade County's $2 billion general fund. Sales and tourist tax revenues for the City and County have also grown in recent years. Between 2010 and 2015, Miami's sales tax grew at a compound annual growth rate of 6.6%, while tourist tax revenues grew at a rate of 12.6%. Over the same period, the County's local option sales tax grew at a rate of 6.4%, while tourist tax revenues rose by 8.9%.

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2nd Quarter 2016 Review and Outlook

Wednesday, June 29, 2016

Once again, tax-free bond investors earned positive returns on their portfolios as demand remained quite elevated for municipals in the quarter ending June 30th, 2016. Thanks to ambiguous economic data, the Federal Reserve was once again delayed on their well-telegraphed intention of lifting short-term interest rates further. This delay emboldened investors to continue pouring cash into the tax-free bond market at impressive amounts, which kept prices elevated and selling pressure minimal. New institutional sources of demand surfaced from overseas investors desperate for income of any magnitude, as negative interest rates spread like wildfire around the globe.

One of the silliest comments one could hear on cable television or in the newspapers from a market "expert" is that "markets hate uncertainty." Someone needs to explain to us what exactly is "certain" when it comes to investing. Clearly, the results of the referendum of the United Kingdom's membership in the European Union ("Brexit") will turbocharge the "uncertainty" excuse to levels not seen since the financial crisis in 2008. MTAM believes volatility creates opportunity, and within the tax-free bond market space, there is likely to be some dislocations in market liquidity in the coming months as financial institutions reduce risk in response to the powerful changes that lie ahead as a result of Britain's decision to leave the European Union. "Accumulation"—not "liquidation"—should be the prevailing theme in our view in regards to the municipal bond portion of investor portfolios. What could be the immediate impact for municipal bond investors due to "Brexit"?

  • More support on the margin for the U.S. Dollar (deflationary)
  • More overseas demand for U.S. fixed-income (perhaps lower yields for longer)
  • Downward pressure on the finances of municipalities that depend on foreign tourism (rating agency downgrades)
  • "Political risk" may rise substantially as the November presidential election approaches (sector allocation within the municipal bond space will be key)

Moving forward, we here at Miller Tabak Asset Management believe upgrading credit quality in tax-free bond portfolios will benefit relative performance as the U.S. economy heads toward a possible recession. We remain convinced that negative interest rates will be heading to our shores by the second half of 2017. With this in mind, having our portfolios fully invested with minimal cash balances remains our goal.

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
www.millertabakam.com

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Philadelphia Hits Soda Industry With Historic Tax

Monday, June 20, 2016

Philadelphia last Thursday became the first major U.S. city to pass a tax on soft drinks, dealing a significant blow to an industry increasingly facing a consumer backlash over health concerns. In a 13-4 vote met mostly with cheers and applause, the City Council approved a plan to add a 1.5-cents-per-ounce tax on soft drinks containing added sugar or artificial sweeteners. The tax will be shouldered by distributors.

Since 2009, there have been 40 attempts to enact a soda tax in cities across the U.S., including two such tries in Philadelphia. Only Berkeley, California's measure passed. What makes Philadelphia's proposal different this time is that Mayor Jim Kenney focused on the potential fiscal benefits of a tax rather than public health. That change in strategy could prove to be a watershed moment for the soda-tax movement.

When implemented in January, the tax on sugary and diet drinks is expected to generate $410 million over five years, according to Kenney, a first-term Democrat. Of that amount, $314 million would go to programs such as expanding pre-kindergarten and renovating recreation centers and libraries. Over five years, $56 million would go to debt service on general-obligation bonds Philadelphia would sell to finance improvements. And $26 million would flow to the City's pension fund, which has 45 cents for every dollar in liabilities.

The City's goal is to maintain a general-fund balance of 6% to 8% of its general-fund expenditures, and the extra revenue from the new tax would help reach that mark. Currently, the level is approximately 2%.

Soda taxes are another sign of the consumer backlash hitting companies like Coca-Cola Co., PepsiCo, and Dr Pepper Snapple Group. Per capita consumption of carbonated soft drinks fell to a 30-year low in 2015, according to data compiled by Beverage Digest, a trade publication. Tax proposals are active in San Francisco and four other cities, and two states -- Alabama and Illinois -- according to Healthy Food America, an organization that supports soda-tax campaigns across the U.S.

The tax debate has passionate backers on both sides. Advocates say it is a viable way to fund important programs while also addressing obesity, a serious health concern. Opponents say the levy disproportionately affects the poor, unfairly singles out the beverage industry, and provides only a diminishing source of income for city programs.

Philadelphia's plan is precedent-setting because it creates an important new source of tax revenue for municipalities.

Some say the tax is regressive by the strictest economic definition of the term but progressive in that its benefits will largely go to lower-income residents. Diabetes and other illnesses associated with sugary products disproportionately affect the poor. The beverage industry does not agree with that line of reasoning, calling it paternalistic.

Now that the proposal has passed, the American Beverage Association and No Philly Grocery Tax said they plan to take legal action, according to e-mailed statements after the vote. To beverage industry officials who say the tax is unfairly picking on soda over other sugary treats -- or, in this case perhaps the famous Philly cheesesteak -- health experts say the action is warranted.

Soft drinks "really are in a class by themselves," said Marlene Schwartz, director of the University of Connecticut's Rudd Center for Food Policy & Obesity. "They are uniquely associated with excess calories, and they're empty calories. Even a cookie might have some sort of nutrition in it, but there's really zero nutrition in sugary drinks."

Until now, that argument has failed to galvanize support for similar taxes. But the vote last Thursday shows the potentially game-changing benefits of taking a more financially focused route.

Unlike past tax attempts in Philadelphia, where more than a quarter of residents live in poverty, proponents are not dwelling on the negative consequences of high sugar consumption. Instead, they are emphasizing what the $410 million over five years could do to ensure that the City's economic recovery lifts children in a school district where nurses and guidance counselors are luxuries.

In New York, a measure that would have limited the size of sugary drinks to 16 ounces in restaurants, movie theaters, stadiums and arenas was struck down by the state's highest court in 2014. Michael Bloomberg, who had proposed it as the city's mayor, reportedly made a contribution to Philadelphians for a Fair Future, which ran television, radio, and online ads supporting Kenney's push.

In many ways, Philadelphia has recovered from the decline of U.S. manufacturing, which triggered decades of population losses from the 1950s to 2007. At 1.56 million residents, Philadelphia is growing as its educational and medical institutions draw young professionals. The Democratic National Convention's choice of the City as the site of its July presidential nominating convention underscored its rebound.

But fiscal strains persist. Its junk-rated school district, the nation's eighth-largest, has struggled with deficits amid reduced state aid and rising mandatory expenses. It has cut jobs and programs while test scores lag behind benchmarks. To sustain Philadelphia's rebirth, the City must shore up its schools so new residents stay when they have children.

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State of the States - Midyear 2016

Monday, June 13, 2016

The outlook for U.S. states through the remainder of 2016 remains stable as the continuing modest recovery of the U.S. economy drives tax revenue growth, though the sector will not be without its ongoing challenges.

Risks to state revenue growth include anti-tax sentiment prevailing and the volatility of the stock market. With personal income taxes making up 40% of state revenues, and with taxes from high wealth individuals contributing a disproportionately large share, revenues tend to rise and fall with the stock market.

Regional challenges will cause economic and revenue performance to vary across the country. Oil and gas producing states, particularly those with budgets heavily reliant on the sector, have been forced to reduce their budgets and lower their forward revenue assumptions.

Budget negotiations in some states have become increasingly contentious in 2016. Budget managers face ongoing demands for additional spending on one side and tax relief on the other, and the pace of revenue growth is insufficient to satisfy all. Pressures on the budget side include Medicaid, pensions, K-12 education, and deferred infrastructure improvements and maintenance. Expected increases in Medicaid costs and growing pension expenses have constrained the ability of states to increase other areas of spending.

Discussions around the Affordable Care Act have shifted from increased enrollment towards absorbing the new expenses that expansion states are scheduled to take on from the federal government in the next fiscal year. Another pressure point for state ratings in 2016 revolves around transportation. States will increasingly turn towards the public private partnership (P3) model for larger, more complex projects. Pension contributions will also continue to rise next year due to past investment losses and contribution practices, use of more conservative assumptions, and demographic trends.

State tax revenue should rise approximately 4% in 2016. While this is below last year's forecast, it is consistent with the post-recession average. Even with slower revenue growth and headwinds from rising spending costs, we expect most states will successfully keep their financial positions in balance with prudent budgeting.

Tax Revenue Growth

Tax revenue growth in 2016 continues for most states, although some are seeing growth rates slower than expected, with energy states showing the weakest growth.

Energy states are experiencing revenue weakness across the board, ranging from direct taxes on energy production to drops in sales and income taxes due to the weaker energy sector. As growth around the U.S. moderates, we now anticipate 50-state tax revenue growth for the year to be approximately 4%. With the exception of Illinois, whose decline is driven in part by tax policy changes, the states forecasting the largest declines include North Dakota, Oklahoma, Louisiana, and New Mexico. All are energy states.

The state most exposed to the collapse in energy prices is Alaska, which once received more than 90% of its unrestricted general fund revenues from taxes on energy production and is now in the process of fundamentally overhauling its revenue composition.

There are also some non-energy states seeing muted revenue growth due to lackluster economic growth or unfavorable demographics, including Connecticut, Rhode Island, and Kansas. Reasons for the slowdown among non-energy states include lackluster stock market performance, cautious discretionary spending, and sluggish overall growth.

Not all states are experiencing revenue slowdowns. Many Western states, including California, Oregon, Utah, and Colorado are seeing healthy growth. States seeing robust revenue growth are concentrated in the Western U.S., a region with an advantageous industrial base, dynamic demographics, and a well-educated workforce.

Income Tax Measures

Voters in as many as four states in November will consider higher levies on their wealthiest residents as income inequality steers liberal activists and politicians toward more progressive taxation.

Colorado and Maine may raise taxes on top earners, while Minnesota is looking to apply the state's Social Security tax to high incomes to care for senior citizens and people with disabilities. California voters could extend by 12 years a soon-to-expire income tax increase on the wealthy.

If the statewide measures appear on ballots in November, more voters will consider higher taxes for the wealthy than in any year since the 1980s, according to Ballotpedia, an online almanac sponsored by the nonprofit Lucy Burns Institute in Wisconsin. The Occupy Wall Street movement and Bernie Sanders's presidential campaign have brought attention to the widening gap between rich and poor as states and municipalities expect a modest slowdown in tax collections as the economic recovery cools.

Nationally, people earning at least $250,000 paid more than 51% of income taxes in 2014, while accounting for just 2.7% of returns, according to the Pew Research Center. Still, a provision of the federal code that taxes investment income at lower rates than normal earnings, along with reductions in the top income tax rate since the 1960s, have fed perceptions that the wealthy are gaming the system.

While there is disagreement as to the causes, studies have shown that income is increasingly concentrated among top earners, with relative declines among the middle class and the poor. The highest-earning 1% of households increased their income by 275% after taxes between 1979 and 2007, compared with a gain of 40% for the middle 60% of America's income distribution, according to a 2011 study by the Congressional Budget Office.

Congress in 2013 permanently extended the George W. Bush-era tax cuts for most people while raising the top tax rate to 39.6%. The federal rate has not changed since then and efforts to tax the rich more often face opposition from limited-government advocates.

Forty-three states tax personal income, according to the nonprofit Tax Foundation. Eight have a flat tax and the others have some form of progressive taxation. California's rate tops out at 13.3% for income above $1 million, the highest in the country and the result of a 2012 ballot measure to erase a budget gap by increasing sales taxes and levies on income above $250,000. The higher income taxes were supposed to expire after seven years and the sales taxes after four. A union-backed coalition has gathered signatures toward a November ballot measure that would extend the higher income taxes for 12 years, while allowing the sales tax increase to expire. Many analysts believe that raising income taxes would cause many business owners and entrepreneurs to leave California for states such as Nevada, which has no income tax.

Colorado activists need more than 98,000 signatures by August to put on the November ballot a measure that would add an additional 0.5% levy on income of more than $405,000 to the state's current 4.63% flat tax. Minnesota's legislature is considering a ballot measure to fund long-term care for senior citizens and the disabled by extending Social Security taxes to higher wages. Maine voters will decide the fate of a 3% surcharge on income exceeding $200,000 per year, with proceeds earmarked for public schools.

Supporters of a Massachusetts tax increase are aiming for a 2018 ballot measure to expand the current 5.1% flat tax by 4 percentage points on income exceeding $1 million. Massachusetts has a convoluted history with the income tax: measures to replace the flat tax with a graduated rate have been defeated at the ballot five times, while two proposals to eliminate the tax altogether also failed.

State Public Pensions

U.S. state pensions posted the lowest investment returns since the credit crisis, falling far short of targets the funds count on and raising the specter of growing taxpayer contributions to keep them afloat. The government workers' retirement systems effectively had no gains last year, eking out a median increase of 0.36%, the smallest advance since 2008, according to the Wilshire Trust Universe Comparison Service. The returns were depressed by slowing global growth, falling oil and commodities prices, and a strengthening U.S. dollar.

U.S. state pensions had 74% of assets required to meet obligations to retirees in fiscal 2015, down from 77% in the prior year, according to Wilshire. Pension liabilities outgrew assets as an increase in U.S. interest rates in the second quarter of 2015, combined with a stronger U.S. dollar, to hurt the performance of bonds and international investments. Of the 98 state retirement systems that reported actuarial data for 2015, 92% are underfunded, a four percentage point increase from the prior year, Wilshire said. Wilshire forecasts pensions' 30-year median return of 8.3%, 0.8 percentage points more than the median actuarial interest rate assumption of 7.5%.

State pensions count on annual gains of 7% to 8% to pay retirement benefits for teachers, police officers, and other civil employees. When pensions do not meet their targets, governments have to put more taxpayer money into the funds to make up the difference. The need to do so has led to credit rating cuts for New Jersey and Illinois, which are being squeezed by rising retirement bills.

Nationwide, state pensions had a median allocation of 44.2% in U.S. stocks and 13.1% in foreign stocks. Public pensions with more than $5 billion of assets invest less in U.S. stocks and more in alternatives like private-equity and hedge funds, with a median allocation of 16.1% to "alternative investments." Those retirement systems had a median return of 0.54% in 2015, little more than the others.

Some governments are already under increased pressure to pump money into their pension funds after years of skipping contributions, while others are being affected because employees are living longer. Unfunded pension liabilities of U.S. states has been estimated at $1.3 trillion as of fiscal year 2014, using an assumed investment return of 4.3% to discount the value of benefits that are paid years from now.

Thirteen states have pension-funding gaps of more than 100% of their annual revenue. For Illinois, it is almost 300% more.

States are slowly lowering their investment-return assumptions. New York Comptroller Thomas DiNapoli lowered the state pension fund's assumed rate to 7% in September. California's Public Employees' Retirement System, the largest U.S. pension, is also slowly cutting its investment target, now 7.5%.

Public pensions returned a median 7.93% for the three years ending in December, 7.37% over five years and 5.99% over 10 years, according to Wilshire.

Debt Burden

The debt of U.S. states last year remained below its all-time high from 2013, showing officials were hesitant to borrow even with interest rates near record lows and the recession six years in the past.

States' net tax-supported debt edged up 0.6% in 2015 to $512.5 billion. In 2014, the figure fell for the first time in almost three decades, from the record high of $516 billion.

After contending with a long recovery from the recession, states and cities have used the $3.7 trillion municipal bond market in recent years largely for refinancing instead of running up new debt for public works. There has not been a more attractive time in decades for lawmakers to issue long-term bonds: the yield on a Bond Buyer index of 20-year municipal general-obligation bonds fell in February to the lowest since 1965.

The recent slowdown in debt levels highlights states' reluctance to take on new debt despite continued annual increases in tax revenue. Several factors will likely suppress growth in state debt burdens in the next year, including the recent decline in commodity markets along with longer term trends of continued uncertainty over federal fiscal policy and healthcare funding.

Connecticut retained its spot at the top of debt medians, with $6,155 of net tax-supported debt per resident. That is up from $5,491 in 2014. Massachusetts, Hawaii, New Jersey and New York round out the top five, like the year before, each with more than $3,000 per person. Nebraska, Wyoming, North Dakota, Iowa and Montana have the smallest burdens, at less than $250 per resident. Kansas's debt load in 2015 jumped 40%, the most of any U.S. state, after it issued $1 billion of pension bonds. South Dakota's grew 20%.

Conclusion

U.S. states have been hit with a slew of negative credit outlooks by the rating agencies as they struggle with the weakest economic recovery in 40 years. States are paying the price for modest U.S. growth since the end of the Great Recession, an oil price plunge, and an aging population that raised the cost of health and retirement benefits. The new fiscal reality is an environment where revenues are not rising as quickly as they have in the past, but expenditure demand is escalating faster than historical experience.

At heart, the states' financial weakness can be traced to the listless economic recovery. Inflation-adjusted U.S. gross domestic product growth has not hit a 3% rate since 2005. The slow recovery is partly due to unusually low labor productivity growth, which at 1.2% annually, is tied with the 1973-1979 period for the slowest growth rate through a business cycle since 1943.

S&P also estimates the continuing retirement of the Baby Boom generation has shaved about 0.6% from the U.S. growth rate and may take 0.8% in the coming years.

The slowness of the economic recovery has led to a comparatively slow rebound for state revenues. By the second quarter of last year, 29 states had at least as much inflation-adjusted revenue as they did in their pre-recession peaks, according to the "Fiscal 50" report by the Pew Charitable Trusts. By comparison all states except for Michigan had recovered to pre-recession revenue levels six years after the 2001 recession, Pew stated.

According to statistics compiled by Merritt Research Services and The Bond Buyer, in some important respects the states still have not recovered their pre-recession highs. In 2015 dollars the median governmental activities revenue per capita peaked in fiscal 2007 at $2,610. It fell to $2,322 in fiscal year 2010 and returned to $2,567 in fiscal 2015, the most recently available fiscal year. By this measure, the states are still about 1.6% behind their pre-recession peak.

Other measurements from Merritt show a more serious deterioration. State net direct debt plus state unfunded pension liabilities as a percent of state personal income increased to 7.4% in 2014 from 5.0% in 2008. More dramatically, unrestricted net assets as a percent of state governmental activities expenditures slid to negative 17.3% in 2015 from negative 2.4% in 2009.

The unrestricted net assets position is a better long-term gauge to measure financial condition than the traditionally used fund balance since it takes into consideration long-term liabilities like unfunded pensions, other post-employment benefits, operating and cumulative deficits. Debt used for specific infrastructure projects is excluded to the extent that it is offset by related infrastructure assets.

This measure's deterioration is partly due to a Government Accounting Standards Board accounting change that went into effect in 2015 that required inclusion of pension liabilities that had accrued before 1997, something that had previously been excluded.

The immediate future may hold more difficulties. Revised revenue forecasts for fiscal 2016 and projections for fiscal 2017 indicate a generally slower overall revenue environment relative to performances in recent years. U.S. states may be running out of time to put their houses in order before a new recession strikes. According to the National Bureau of Economic Research, the average U.S. post-World War II recovery duration has been 65 months. The current economic recovery has run 83 months.

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Comment on Puerto Rico's Default

Tuesday, May 3, 2016

Puerto Rico will default on a $422 million bond payment for its Government Development Bank, escalating what is turning into the biggest crisis in the $3.7 trillion market that state and local entities use to access financing. Governor Alejandro Garcia Padilla invoked a debt moratorium law approved last month, saying that the Commonwealth needs to focus on providing essential services. The Bank, already operating under an emergency period, had until the end of Monday to make the payment.

The GDB missed payment may open the door to larger and more consequential defaults on general obligation bonds, which are protected by the island's constitution. Puerto Rico and its agencies owe $2 billion on July 1, including $805 million for general obligations. It also could imperil slow-moving efforts by U.S. lawmakers to resolve the biggest crisis in the tax-exempt market.

Puerto Rico officials have been negotiating with creditors to defer payments. No matter which route Puerto Rico took, credit rating agencies saw a default as inevitable. Moody's said last week that any non-payment, even if it is agreed to by creditors, constitutes a default in their eyes. S&P said a distressed debt exchange or temporarily withholding interest is synonymous to default.

The non-payment by the GDB alone will push the amount of outstanding municipals in default up by 44%, to $23.6 billion from $16.4 billion, according to Municipal Market Analytics. That would make 0.64% of the $3.7 trillion market in default, up from 0.44%.

Puerto Rico racked up $70 billion of debt across more than a dozen issuers as it borrowed to paper over budget deficits. Garcia Padilla said 10 months ago that the obligations were unpayable. Yet up until now, the Commonwealth only missed $143 million of payments on appropriation bonds from the Public Finance Corp. and rum-tax securities from the Infrastructure Financing Authority.

The GDB, in contrast to those borrowers, is a prominent, visible and well-known Puerto Rico entity. It is the fiscal agent of the Commonwealth, lending to the island government and localities. For the past few weeks it has operated under a state of emergency to preserve cash.

The House Natural Resources Committee is working on a bill that would establish a federal oversight board to manage any debt restructurings and weigh in on spending plans. It is set to file a new draft after lawmakers return from recess on May 10. The committee last month postponed a vote on the measure as lawmakers from both sides and the U.S. Treasury Department sought to make changes to the bill.

The island's economy has shrunk since 2006 and 45% of residents live in poverty. Puerto Ricans have been fleeing the island at record rates for work on the U.S. mainland. Puerto Rico is struggling to pay fuel suppliers for police cars and emergency vehicles and provide services for special education students. As half of the population receives health care from the government, including prescription medication, the administration must preserve its money for health and safety, Garcia Padilla said.

The GDB reached an agreement with some local credit unions to delay $33 million of bank debt due Sunday, affecting only a portion of the $422 million due that day. The credit unions agreed to swap their securities for debt maturing a year later. The GDB bond in question, which matured May 1, is a $400 million taxable security issued in 2011 with a 4.7% interest rate. It last traded in March at 32 cents on the dollar.

The island owes $470 million in total to bond investors in May, including a small payout to general obligation holders that the government is expected to make. A default on those constitutionally guaranteed bonds would be the first by a state-level borrower since Arkansas missed payments on its debt in 1933. That would likely trigger a restructuring of the Commonwealth's $13 billion of general obligations, which would be the largest-ever in the tax-exempt market.

Impact on the Overall Municipal Market

However, much like how Puerto Rico is an island territory off the coast of the U.S., the trends show that investors are treating the Commonwealth's debt crisis as separate from the broader municipal market. Monday's default, its largest yet, was a long-time coming: Puerto Rico lost its investment grades over two years ago, and 10 months ago Governor Alejandro Garcia Padilla declared its debt too crippling to pay.

Individuals last week poured more money into tax-exempt mutual funds than at any other time this year, just days ahead of the Commonwealth's well-anticipated default on $422 million of GDB debt. Municipals have gained every month this year, only the second time that has happened since 1999. And on the U.S. mainland, prospects are brightening: S&P has upgraded more localities than it has lowered for 13 straight quarters, the longest streak since 2001. Just nine issuers have defaulted in 2016 apart from Puerto Rico, compared with 24 at this time last year.

The clearest sign that the market is shrugging off Puerto Rico is the money flowing into tax-exempt bond funds. Individuals have added assets to municipal funds for 30 straight weeks dating back to October, the longest stretch since March 2010, Lipper US Fund Flows data show. The $1.2 billion inflow in the week through April 27 was the largest of 2016, and came after Moody's warned that a Puerto Rico default was inevitable.

Part of the reason investors have been so willing to buy municipals is because the bonds have gained every month this year, S&P Dow Jones Indices data show. It is just the second time that has happened in the past 18 years. Also padding returns: improving credit quality for states and cities across the country. S&P said in February that it upgraded nearly twice as many issuers as it downgraded in the fourth quarter of 2015. The 13th-straight quarter of elevating more municipalities than it lowered is the longest streak since 2001. And Fitch said last week that the trend continued: It upgraded 29 issuers and lowered 19 in the first quarter. Positive outlooks are the highest since at least 2001, when Fitch began tracking that, while negative outlooks are the lowest since the third quarter of 2008.

Defaults, aside from Puerto Rico, are also slowing among municipal borrowers. Just nine issuers missed payments for the first time in the first four months of the year, compared with 24 at this time a year ago and 15 in 2014, according to data from Municipal Market Analytics.

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Colorado's Challenge: Financial Caps and Debt Limitations

Monday, April 18, 2016

Colorado's growing economy should mean rising revenues for the state government, but maintaining a balanced budget may continue to prove difficult for years to come. The challenge arises from layers of voter-induced constitutional amendments such as the Taxpayer Bill of Rights (TABOR) that cap how much revenue the state can retain and how funds can be used. TABOR also limits the ability of state and local governments to raise taxes and issue debt.

Since voters approved TABOR twenty-four years ago, local governments have struggled to find ways to pay for new infrastructure because of the requirement for voter approval. And due to the lack of Colorado paper, municipal portfolio managers have been forced to purchase national bonds for their Colorado-based clients.

TABOR established spending limits with a cap on the total amount that the state may spend in any given fiscal year. The cap could be adjusted annually for the combination of inflation plus the percentage change in state population, but otherwise it would be "inviolable" and not subject to any findings, determinations, or circumstances that might be found by the state General Assembly or by counties, municipalities or school districts. Revenues that exceeded the cap had to be refunded to taxpayers.

Colorado has one of the most complex state budgets in the nation, not by virtue of the dollar figures — other states are much bigger — but due to the many competing financial caps and spending requirements that have been added to the state constitution over the years. For state lawmakers, meeting the long-term needs of Colorado citizens under this web of incongruent constitutional rules is a delicate balance that can easily be upset by outside factors or the unanticipated impacts of their own actions.

Colorado voters approved the TABOR Amendment in 1992, restricting revenues for all levels of government in the state. Under TABOR, state and local governments need voter approval to raise tax rates and cannot spend revenues collected under existing tax rates if the revenues grow faster than the rate of inflation and population growth. That means an improving economy does not provide an automatic cushion for state, local and school district budgets.

Amendment 23, approved by voters in 2000, required the state legislature to annually increase K-12 school funding by "inflation plus 1%" through 2010 and at the rate of inflation thereafter. It required funding for special education and transportation to increase at the same rate. Another voter approved initiative lowers residential assessment ratios compared with commercial property. Combined, these two initiatives have had the effect of increasing state funding for local school operations, and to some extent crowding out general fund appropriations for other purposes.

In 2005, voters approved Referendum C, which removed the requirement to reset the spending cap each year to the level of the previous year's general fund spending. However, the spending limitation remains, adjusted only for inflation and population increases.

The Colorado Constitution prohibits long-term general obligation debt, but the state has issued general fund appropriation-backed lease revenue debt for a number of general governmental purposes, including school facilities and prisons. The state has not restructured debt other than for ordinary refunding issuances for savings.

Background

Prior to TABOR, debt was defined in Colorado as a transaction in which "a municipality pledged the full faith and credit of the government by promising to raise taxes as necessary to pay debt service." Although TABOR did not redefine "debt," it did impose new restrictions on the government's ability to borrow money. § 4 (b) of TABOR states: "Starting November 1992, districts must have voter approval in advance for: …Except for refinancing district bonded debt at a lower interest rate or adding new employees to existing district pension plans, creation of any multiple-fiscal year direct or indirect district debt or other financial obligations whatsoever without present cash reserves pledged irrevocably and held for payments in all fiscal years." This extends further than the traditional definition of debt. As a result of this wording, there are now several different types of multi-year financial obligations that were not considered to be debt before TABOR. For example, revenue bonds – which are a certain type of bond that is "repaid from revenue derived as a result of improvements to be funded by the bonds or from any other special revenue source," – were not previously considered debt under Colorado law, but fell into the category of multi-year financial obligations. However, there are several key exceptions to this rule to note, most of which are explicitly stated in § 4 (b). § 4 (b) explicitly states that cash reserves may be held and used for future obligations without voter approval. It also states that "refinancing bonded debt at a lower interest rate" is exempt, as well as financing new government employees on district pension plans. Lease-purchase agreements, which are "transactions that were subject to annual appropriation or were subject to annual termination or nonrenewal by the local government," were made exempt shortly after the passage of TABOR by the General Assembly. After being challenged in the courts several times, it was ruled that a lease-purchase agreement can be passed without voter approval if there is a "non-appropriation clause clearly providing that the municipality has no obligation to continue the agreement in future years."

Building a Better Colorado

Building a Better Colorado is a coalition of civic leaders, led by former University of Denver Chancellor Dan Ritchie, trying to help Coloradans understand and ultimately undo the conflicting revenue and spending provisions in Colorado's constitution. These provisions, all approved by voters, include TABOR, which limits state revenue and requires a vote of the people to raise taxes or issue general obligation debt; the Gallagher Amendment, which artificially skews the property tax burden toward commercial properties and away from agricultural and residential property; and Amendment 23, which requires spending increases on education whether or not the state can afford them.

Together, these three provisions and other laws have mandated state expenditures that increase faster than the allowed rate of state revenue growth, even in a strong recovery and with sustained job growth. The result is what Building a Better Colorado leadership calls "a fiscal Gordian knot" that cannot be undone with a single constitutional amendment.

With an eye toward avoiding future tangles like the one they are in now, Building a Better Colorado wants voters also to consider overhauling the rules for getting constitutional amendments on the ballot and passing them. Right now it is halftime for the Building a Better Colorado effort, which has held a series of town meetings across the state. The harder work begins over the next year when Building a Better Colorado actually begins to advocate for the most likely-to-succeed solutions that have come forward, and to develop a strategy for getting those ideas before Colorado voters.

There has been a broad consensus among the engaged participants for making significant tweaks to TABOR to provide for future growth. Specifically, more than 80% of the almost 1,800 participants have supported allowing the state to keep revenue it collects under the Hospital Provider Fee and spend it, rather than refunding that revenue to the citizens.

The 2016 election cycle makes the challenges for Building a Better Colorado even greater. Among them, convincing voters that government should be trusted with more money. One key is to tie spending increases to specific outcomes that the people are willing to pay for. Since the passage of TABOR in 1992, Colorado voters have tended to approve tax increases when it is clear what they will get in exchange, and to disapprove of tax increases where it is not clear what they would get in exchange.

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1st Quarter 2016 Review and Outlook

Thursday, March 31, 2016

Tax-free bond investors experienced positive returns during the first quarter as volatility in other asset classes kept demand for municipal bonds quite high. Longer-maturity bonds continued to generate the best returns, as inflationary pressures remained contained thanks in part to a stronger U.S. dollar and negative interest rates in many overseas bond markets. The continuing high profile financial struggles of issuers such as Puerto Rico and the Chicago Board of Education failed to dent demand for lower-rated bonds, as once again debt rated "BBB" outperformed those rated "AAA."

Mixed signals on the United States economy should continue in the coming months as a confluence of events conspire to keep both uncertainty and volatility high in financial markets. Clearly, the job market is improving to the point where the Federal Reserve may be forced to tighten monetary policy should the unemployment rate continue to trend down. However, the improvement in the employment area continues to be heavily skewed toward lower-paying jobs. Higher-skilled workers are seeing downward pressure on their wages as global trade and advances in technology impair their ability to push compensation requests higher. This dynamic perhaps explains why buoyant employment reports have failed to lift gross domestic product readings past the two percent growth range in the past couple of years. The "Affordable" Care Act has also been anything but as insurance premiums and deductibles have moved higher, easily outpacing tepid wage gains that have been prevalent. This could explain the lethargic retail sales and business spending data of late. Should the Federal Reserve be inclined to tighten monetary policy in this current economic backdrop, we would expect longer-dated maturity bonds to continue to outperform.

Risk assets found a parachute in the first quarter as the European and Japanese central banks went "all in" on expanding their negative interest rate programs. Similar central bank "rescues" may be less prevalent in the coming quarter as seemingly all bullets that could be fired have been exhausted. We would caution investors that the economic fundamentals (instead of central bank stimulus) might re-emerge as the force that drives financial markets in the coming months. In our view, investors may have to wait until the second half of 2017 before the Federal Reserve of the United States joins the negative interest rate "party." Between now and then, we will remain biased towards marginally extending portfolio duration on weakness as we see "hope" pivoting to "anxiety" within some risk asset classes that are optimistically valued in our view. Investors are in a low return environment these days; those who fail to recognize that may be destined to see a reversal of their hard-earned fortunes.

Moving forward, it is Miller Tabak Asset Management's view that investing in high-quality municipal bond issuers will prove to be the most responsible course of action, as global economies remain weak and debt-ridden. While recession here in the United States is not upon us at the moment, it seems likely that the anemic growth rates we have been experiencing are now "structural" in nature. With the Federal Reserve looking to tighten financial conditions further, one should prepare for a hard economic landing here in America.

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
www.millertabakam.com

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California and the Minimum Wage Hike

Tuesday, March 29, 2016

California's legislative Democrats have reached an agreement to raise the minimum wage to $15, the highest in the U.S. The increase will be implemented gradually through 2022, rising to $10.50 on January 1, 2017, $11 in 2018, and then a dollar per year until it reaches $15. After that, it could increase annually by as much as 3.5% based on inflation. The California governor could pause the increase in the event of a budget deficit and negative job growth. Companies with fewer than 25 employees would have an additional year to reach $15.

California, where the minimum wage is currently $10, is among states that have raised the rate as the gap between the rich and poor widens and as Republicans in Congress have refused to act. President Obama has urged Congress to raise the national minimum to $10.10 from $7.25 amid public outcry over income inequality.

The California legislature, controlled by Democrats, still must vote to approve the proposal before it goes into effect. Under the deal, labor unions that were pushing two ballot measures to raise the rate even higher will stand down.

As of the beginning of the year, 29 states and Washington, D.C., had minimum wages above the federal level. In California, 16.4% of residents live below the poverty level and the average income is $29,906, according to Census data. The plan is expected to benefit 5.6 million workers, or 32% of the state workforce.

California's economy is unmatched among U.S. states in size and diversity, and the economy is gaining momentum across most sectors and regions. Although California's job losses during the recession exceeded the U.S. median, its recovery has exceeded the U.S. as well. As of December 2015, non-farm employment had reached 105.6% of its pre-recession peak, above the U.S. median of 101.8%. Non-farm employment increased 2.9% year-over-year in December 2015, well above the 2% national rate. Employment gains are widespread, particularly in key service sectors, and construction employment is expanding (+7.2% in December) as the housing sector recovers.

California's unemployment rate has fallen considerably, to 5.5% in February 2016 vs. 6.7% one year earlier, although it remains elevated relative to the nation's 4.9% unemployment rate; this is consistent with historical trends. Personal income growth has generally matched the national and regional averages over the past year and California ranks 11th among the states in terms of per capita personal income at 108.6% of the national average.

The State's latest economic outlook, released with Governor Brown's budget proposal, foresees continued moderate improvement in the economy; unemployment declining but still higher than the national rate; and continued recovery in the housing market. Personal income is forecast to grow 5.2% in 2016.

In California's most-desirable areas, gas, housing, food and other essentials can bring sticker shock. While the median price of homes sold in the State is about $400,000, a fixer-upper in San Francisco or parts of Los Angeles can easily top $1 million.

Most economists are saying that projecting what would happen in California is difficult because the proposed minimum wage increase is significantly larger than those in the past and may have unintended consequences. One leading economist on minimum wage issues said an increase from $10 to $15 would reduce employment among the least-skilled workers by at least 5 to 10%. But the impact on employment might be even bigger because employers would have to absorb significantly higher costs.

Effects would also vary by geography: in high-wage counties such as San Francisco and Santa Clara, about 22% of workers would get a raise. In places such as Fresno and Merced counties, about half the workers would see more money. San Francisco voters approved a measure two years ago to increase the minimum wage of $10.74 an hour to $15 in 2018. It is currently $12.25.

Business groups opposed the increase, warning it would force some employers to lay off workers or cut employee hours to compensate for higher wages. They also said it would affect more than those getting minimum wage because those earning slightly more would also now expect their pay to go up.

But advocates for low-wage workers countered that several academic studies show that raising the minimum wage has only minor effects on employment, and provides stimulus to the economy by putting more money in the hands of people most likely to spend it. Nonetheless, small businesses have already begun looking for ways to offset the increase in labor costs, including raising prices.

Conclusion

When the government sets the minimum wage at a higher rate than what businesses can afford to pay for unskilled laborers, the end result is likely to be higher unemployment and less opportunity. The largest number of people earning the minimum wage are not the heads of households. Most are in fact young people living at home looking to gain work experience and build their resumes. In fact, over 80% of minimum wage workers are teenagers, single adults living alone, or dual-earner married couples, according to an analysis of U.S. Census data the Employment Policy Institute (EPI) performed as part of its own study. Here's another key finding that should give voters pause. For every 10% increase in the minimum wage, teen employment at small businesses is estimated to decrease by 4.6 to 9.0%, EPI concluded.

In California, the proposal has resulted in an avalanche of special-interest spending, amplifying a long-running debate: Does a mandated wage hike help low-wage employees and spur economic activity or does it hurt business owners, taxpayers, and even those workers it purports to benefit?

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Flint (Michigan) and the Credit Implications

Tuesday, February 23, 2016

President Obama signed an emergency declaration last month for Flint (MI) that clears the way for federal aid for the City, which is undergoing a drinking water crisis. The White House issued a release calling for the Federal Emergency Management Agency to coordinate all disaster relief efforts to "alleviate the hardship and suffering" on residents. Flint switched water supplies in 2014, and the corrosive water from the Flint River leached lead from old pipes.

FEMA has been authorized to provide water, filters, cartridges and other items for 90 days. Direct federal funding also will be made available. Republican Governor Snyder requested the declaration, saying needs "far exceed the State's capability," and added that emergency measures could cost $41 million. His letter to Obama painted a bleak picture of the troubled City, describing Flint as an "impoverished area" that has been overwhelmed by the release of lead from old pipes.

The tap water in Flint, population 99,000, became contaminated after the City switched its water supply from the Detroit water system to the Flint River while a pipeline to Lake Huron is under construction. The corrosive water lacked adequate treatment and caused lead to leach from old pipes in homes and schools.

Flint returned to the Detroit system in October after elevated lead levels were discovered in children, and could tap into the new pipeline by summer. But officials remain concerned that damaged pipes could continue to leach lead, to which exposure can cause behavior problems and learning disabilities in children as well as kidney ailments in adults. The National Guard has been distributing free water, filters and other supplies.

Governor Snyder has proposed spending hundreds of millions more dollars to address Flint's water crisis and to update infrastructure, including lead water pipes, in the City and across the State.

The $195 million for Flint and $165 million for statewide infrastructure needs were detailed in the Republican governor's annual $54.9 billion budget presentation to the GOP-led Legislature. Snyder, who has apologized for his administration's role in the disaster and an inadequate initial response, said $25 million of the funding designated for Flint could help replace an unspecified number of old lead lines running from city streets to houses.

The governor and legislators have already directed more than $37 million toward the disaster, including funds for bottled water, filters, testing, health care and other services.

Flint will remain under a state of emergency until government authorities and independent experts declare the water safe to drink again without filters, which officials have said could happen in the spring. The additional money for Flint also includes $30 million to help residents with two years of water bills, dating to when the water source was switched to the Flint River in 2014 and improperly treated without anti-corrosion chemicals.

Democrats say Snyder's plan is short of what is needed to fully reimburse the water portion of people's water/sewer bills, and city officials want more to replace old pipes. A Snyder spokesman said his recommended amount for pipe replacement is a starting point and could grow once a full analysis is done and all the underground service lines are found in the City.

The Flint water crisis could contribute to a reversal of the State's recent measures to build reserves. Snyder has called for shifting $165 million he had planned for the rainy day fund to a new Michigan Infrastructure Fund. A commission he announced in his recent State of the State address would recommend how to prioritize the money, which could replace high-risk lead and copper water service lines around the State, assess infrastructure needs, and provide incentives for upgrades so they are done in conjunction with repairing roads.

The governor said the fund is a first step toward addressing other infrastructure issues months after the approval of a transportation-spending plan. Higher fuel taxes and vehicles registration fees will begin in 2017, boosting dedicated revenue by more than $500 million in the fiscal year that will start in October.

Cost estimates to replace Flint's water infrastructure alone have ranged between $700 million to $1.5 billion. With a 40% poverty rate for the City, issuance of substantial additional debt would be a large burden on residents. Given the local tax base limitations, coupled with the fact that the drinking water was contaminated with lead starting when the City was under the control of a state-appointed emergency manager, we expect that there will be a state role in financing the cost of fixing the City's water infrastructure. On top of waterline replacement costs, Flint is facing rising health and social service needs tied to the lead contamination that will likely persist for years, and political pressure for the State to contribute to these costs is mounting. Various class action lawsuits have been filed alleging that the State is responsible in part for the water crisis, and related legal costs to the State are uncertain. Federal financial support thus far has been limited, and we expect that the State and local governments will be responsible for financing the majority of the costs. Currently, the U.S. Senate is considering legislation that would provide up to $400 million in emergency federal funding, but with the caveat that it must be matched by the State.

Conclusion

MTAM believes it is too early to determine the magnitude of the Flint water crisis' credit implications for the State. We do not expect the solution to the water crisis will play out in the fiscal 2016-2017 budgets alone, and anticipate that the economic and social costs, on top of the financial responsibility, will unfold over an extended period. Spillover from the crisis could impact the area's general economic reputation including that of the surrounding local governments. While it is difficult to quantify the financial impacts, the reputational damage with negative economic implications to other communities in the region could also persist for some time. For those Michigan municipalities with declining manufacturing bases, even if they do not confront the type of immediate crisis that Flint does, may face legacy costs not easily supported by their currently contracting economic bases.

It is important to note that this is by no means solely a Michigan-municipality problem. U.S. public-water systems, about 85 percent-owned by municipalities, may face credit risks as costs rise from a failure to invest in infrastructure, and as demand outpaces supply. The U.S. currently has 52,873 community systems, according to the Environmental Protection Agency. Many municipalities have not initiated financing for the upkeep of their facilities because of burgeoning deficits and weakening balance sheets.

Water and sewer utilities are expected to continue to struggle with financing capital projects into the near future. The sector needs infrastructure investment due to outdated systems, regulatory issues, and migrating populations to the South and West, stressing existing water supplies in those regions. Over the past decade, several large systems have violated the U.S. Clean Water Act with sewer overflows into rivers, lakes or oceans. The main overflow culprits have been aging infrastructure, growth-related bottlenecks, and inflow and infiltration into the sewer system.

Environmental regulations have been and will continue to be an important defining element to the operations and capital requirements for water and sewer systems. The EPA estimates that aging systems require at least $335 billion in investment over the next 20 years to keep pace with current regulatory requirements. The nonprofit American Water Works Association estimates that U.S. systems may have to spend at least $1 trillion over the next 25 years to replace aging pipes and expand to meet demand.

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Credit Comment on California's Latest Budget Proposal

Tuesday, January 19, 2016

Last week, California Governor Jerry Brown released his proposed budget for the fiscal year 2016-2017, which will begin July 1, 2016. The budget proposal is based on robust revenue growth that reflects the continued expansion of the California economy. The governor continues his policy of restraining growth in on-going spending, while paying down long-term liabilities and funding the all-important rainy-day fund. MTAM believes the approach taken in the budget proposal is prudent and bodes well for continued fiscal stability taking into account the State's volatile revenue stream and the possibility of a future economic downturn.

Governor Brown proposed a $123 billion general-fund spending plan for the next fiscal year, a 6 percent increase over the current budget and the largest ever as state coffers overflow with surging tax revenues. The overall $171 billion budget plan for the fiscal year that begins July 1 includes $45 billion in special funds and $3.1 billion from bonds, according to the State Department of Finance.

Brown, a Democrat, has slashed state spending and used taxes on the wealthy to steer the world's 8th-largest economy from persistent budget deficits to surpluses. He has shored up reserves and paid down debt, resisting calls from fellow Democrats in the legislature to significantly boost funding for social programs.

In June, Brown and lawmakers agreed to a $115.4 billion general-fund budget that put $1.9 billion into a new rainy-day fund and paid off an outstanding balance left from $15 billion in bonds sold under former Governor Arnold Schwarzenegger to cover its once chronic deficits.

Debate over the budget will be shaped by proposals to extend temporary income tax increases voters approved in 2012 at Brown's behest. At the time, California faced a $9 billion budget shortfall, one in a run of deficits that exceeded $100 billion combined since 2007. The measure has added $15.2 billion to state coffers in the two budget years ending in June, according to data from Brown's finance department.

Teacher and state-worker unions have launched campaigns to qualify statewide ballot initiatives to either extend the taxes through the next decade or make some permanent while raising the levy on the wealthy even more. They want to spend the money on schools and programs for the poor.

The governor is proposing to set aside $3.6 billion in the State's rainy-day fund, $2 billion above what would be required by law. This would bring the balance to $8 billion by the end of fiscal 2017, approximately 2/3 of the target 10 percent of tax revenues detailed in Proposition 2. Budgetary borrowing would also be reduced from $3.9 billion to $2.5 billion by the end of fiscal 2017, as the State repays special funds, uses one-time funds to 'settle-up' prior year Proposition 98 obligations, and repays transportation loans.

The budget proposal for the State's general fund assumes 3 percent growth in revenues over the current fiscal year to $125.1 billion, before transfers including to the rainy-day fund. The State is also now estimating that current year fiscal 2016 revenues will exceed budget forecast by $3.5 billion (3 percent) and total $121.5 billion, also prior to transfers including to the rainy-day fund. Much of the increase in revenue will be automatically allocated to K-14 education under Proposition 98 but will also support increased spending for Medicaid and higher education. Rather than expanding on-going programs, the governor is proposing an allocation of $2 billion to non-recurring spending for deferred maintenance and State facilities renovations and replacement, in addition to the $2 billion allocated to the rainy day fund. California is estimating that its share of the optional expansion of Medicaid under the Affordable Care Act will total $740 million in fiscal 2017, as a small portion of costs that were fully covered by the federal government for the first three years of implementation are partially shifted to the State. The governor's proposed revisions to the managed health care tax, which is estimated to generate $1 billion, would compensate for this growing expense.

The budget proposal appears prudent in terms of restraining spending growth in favor of retaining flexibility for future economic weakness. The budget assumes solid economic growth in both fiscal 2016 and 2017, but notes the potential for a future downturn as well as risks associated with slower global growth or a stock market correction. As is the case in the current fiscal year, the State does not anticipate the need to issue cash flow notes in fiscal 2017.

California bonds have rallied as budget improvements have boosted the State's credit rating (Aa3/AA-/A+), once the lowest in the nation.

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Municipal Bond Market – Credit Outlook for 2016

Thursday, January 7, 2016

Municipal bond issuers will continue to face several credit challenges in 2016, but MTAM expects that the vast majority of municipalities will successfully manage through most difficulties with a combination of spending cuts and revenue enhancement plans.

Despite the challenges facing municipal bond issuers, there are always good opportunities, even for the very conservative investor. Given our expectations for low levels of economic growth, we would expect defensive credits like water and sewer bonds, special tax bonds, and public power bonds to perform better from a fundamental perspective. These types of bonds tend to have revenue streams that are less subject to economic volatility, have strong covenants, or are tied to an "essential service", making debt service payment more certain. In addition, there is legal precedence that bonds backed by a dedicated revenue stream may be protected in the case of a municipal bankruptcy. We prefer bonds that have a clean flow of funds, broad revenue streams, and high debt service coverage tests.

State Governments

The 2016 outlook for U.S. states remains stable as the continuing recovery of the U.S. economy drives moderate tax revenue growth, though the sector will not be without its ongoing challenges.

Risks to state revenue growth include anti-tax sentiment prevailing and the volatility of the stock market. With personal income taxes making up about 40% of state revenues, and with taxes from high wealth individuals contributing a disproportionately large share, revenues tend to rise and fall with the stock market.

Regional challenges will cause economic and revenue performance to vary across the country. Oil and gas producing states, particularly those with budgets heavily reliant on the sector, could be forced to reduce their budgets and lower their forward revenue assumptions.

Budget negotiations in some states became increasingly contentious in 2015. Budget managers face ongoing demands for additional spending on one side and tax relief on the other, and the pace of revenue growth is insufficient to satisfy all. Pressures on the budget side include Medicaid, pensions, K-12 education, and deferred infrastructure improvements and maintenance. Expected increases in Medicaid costs and growing pension expenses have constrained the ability of states to increase other areas of spending.

Discussions around the Affordable Care Act will shift from increased enrollment towards absorbing the new expenses that expansion states are scheduled to take on from the federal government in the next fiscal year. Another pressure point for state ratings in 2016 revolves around transportation. States will increasingly turn towards the public private partnership (P3) model for larger, more complex projects. Pension contributions will also continue to rise next year due to past investment losses and contribution practices, use of more conservative assumptions, and demographic trends.

State tax revenue should rise 4% - 5% in 2016. While this is slightly below last year's forecast, it is consistent with the post-recession average. Even with slower revenue growth and headwinds from rising spending costs, we expect most states will successfully keep their financial positions in balance with prudent budgeting.

Local Governments

The 2016 outlook for U.S. local governments remains stable as property tax revenues slowly recover. Property taxes, which are the primary source of most local government revenues, are expected to improve by 2% - 3% amid local tax base growth. Though still below prerecession growth of 4% - 5%, some local governments are limited by tax caps and slower-than-expected recoveries.

In addition, the stable outlook for local governments is supported by an increase in median fund balances. Fund balance levels indicate the financial resources a local government has available to meet future contingencies, and currently median fund balances are higher now than in 2008.

Unfunded pension liabilities and other fixed costs remain a long-term challenge for some local governments, however. Net pension liabilities will continue to grow in 2016, particularly given weaker June 30, 2015 investment returns and because local governments' annual pension contributions are often below actuarial requirements.

Fixed costs such as pensions and retiree health benefits are likely to consume an increasing share of budgets, presenting dilemmas about whether to cut costs, increase property tax revenue, or tap into reserves.

MTAM believes that few local governments are still struggling to reduce spending to compensate for a combination of weak revenue performance and pension payment increases. Now the challenge is long-been-postponed spending, including wage increases, service restoration, and infrastructure and facility maintenance needs. We believe this will continue in 2016, but is a much more manageable challenge than the heavy cuts required during the downturn. There will likely be instances of spending growth overtaking revenue increases, but we expect structural balance to prevail. Most local governments have been able to preserve or restore reserves to prudent levels that would provide a cushion if an unexpected downturn occurred.

We anticipate a moderate increase in local government debt issuance to address capital needs. While the increase is not anticipated to be significant, the debt instruments used may continue the recent shift to products with less transparency. The increased use of direct loans rather than public debt offerings may be advantageous to issuers, but can potentially reduce the level of information available to an entity's other creditors.

Not-for-Profit Hospitals

MTAM had assigned a negative outlook for the not-for-profit healthcare industry in January 2015. However, growing clarity on the fate of the Patient Protection and Affordable Care Act has since provided more stable expectations as hospital issuers execute strategic plans. The sector is seeing improvements in operating results and stronger clinical volumes as management teams have done a better-than-expected job of improving operating efficiencies. Clinical volumes saw an increase in fiscal 2015 due largely to the increase in insurance coverage from the Affordable Care Act. We believe the positive momentum will continue for the remainder of this year before tapering in 2017 as reimbursement pressures and supplemental funding cuts begin to accelerate.

The median operating profitability for U.S. not-for-profit hospitals showed strong gains over the past year, although growth in operating cash flows show the credit gap widening between higher- and lower-rated borrowers.

Strong cash flows and investment returns coupled with lower capital spending and diligent revenue cycle management helped precipitate the improvement in key median liquidity metrics. Further revenue cycle challenges lie ahead, although most investment-grade not-for-profit hospitals have planned adequately and have sufficient financial cushion to endure potential revenue cycle disruptions.

Capital spending by not-for-profit hospitals fell to its lowest point in six years in 2015 as hospitals continued to pull back from building new, costly inpatient facilities. Hospitals across all ratings categories restrained their capital spending last year, bringing the median down to the lowest level since 2008. We expect capital spending to rise modestly going forward, with a focus on the IT side and in outpatient facilities for a greater presence in the community, which is a much lower cost.

One credit concern, however, is the recent spate of proposed health insurer mega-mergers, as the consolidation shrinks the pool of insurers and intensifies control on an increasing source of hospital revenue. Over half of hospital revenue is subject to negotiations with insurers over reimbursement for individuals covered under both commercial and government-funded plans. Control over reimbursement rates will rest with fewer insurers, constraining hospital profitability.

The Anthem, Inc./Cigna Corp. merger poses the greatest risk to hospitals as the merged company will represent almost a quarter of the commercial insurance business, which typically accounts for roughly 33% of hospitals' gross revenues. The Anthem/Cigna combination will have 48 million individual members.

In addition to employer-provided plans, hospital revenue subject to insurer negotiation include those on the public exchanges created by the Affordable Care Act, and federal or state-funded plans administered by Medicare Advantage and Medicaid managed care plans.

Hospital revenue derived from Medicare Advantage and Medicaid managed care insurance plans are growing as the population ages, and states that expanded Medicaid move individuals into managed care plans to control expenses. However, the impact on individual hospitals will vary, even within the same region and state owing to a combination of factors affecting leverage, including the amount of members an insurer has in the hospital's immediate market.

Among providers, negotiating leverage will be greater for hospitals and health systems with dominant or leading market share. Many with a competitive edge have multiple sites covering a broad geographic region and a strong brand. Leverage will be less for smaller, single-site hospitals with limited service differentiation in competitive markets.

MTAM anticipates the insurer mergers will not impact hospitals until at least mid-2017 as they circumnavigate various regulatory approvals.

In general, MTAM sees the not-for-profit healthcare sector as containing risks that are unsuitable for most conservative investors. However, we are noting that 2015 rating upgrades outpaced downgrades, driven by strong financial results across the rating spectrum, aided by improved payer mix and utilization from Patient Protection and Affordable Care Act. We expect the positive trend to continue through 2016 as the payer mix continues to improve and management teams continue to make operational improvements. Higher-rated, larger systems enjoyed more of a volume boost than the stand-alone providers. The credit gap between larger, higher-rated hospitals and smaller, lower-rated providers widened in 2015, as it has over the past several years, and is expected to continue to widen in 2016. Diverging operating profitability levels were particularly notable, with higher-rated borrowers posting solid improvements across all key financial metrics, whereas lower-rated borrowers mostly continued to trend downward. While median operating profitability measures showed strong gains in 2015 in the A and AA categories, the same measures for BBB-rated issuers declined in 2015 compared with 2014. That trend is expected to continue in 2016, as new industry trends continue to favor larger systems. Consolidation is also expected to continue over the next few years.

Transportation

U.S. airports will hold stable in 2016, with MTAM projecting over 3% passenger growth mostly from major market airports. Low fuel prices will also continue to be an ancillary benefit for airports. The same stable outlook is in place for U.S. ports even as shippers and ports pursue increasing consolidation. Managing congestion and increasing freight volumes remains a focus as vessel size and cargo loads continue to grow. Our outlook for U.S. toll roads is positive thanks largely to the broadening U.S. economic recovery, traffic growth, and still low fuel costs. We anticipate a median traffic growth of 3% through 2016. Facilities nearing the end of extensive capital plans may see positive rating actions if strong performance continues. The outlook for grant anticipation revenue vehicles (GARVEEs) is stable. The five-year funding bill recently passed by Congress provides longer-term planning certainty for state governments, though a self-sustaining funding source for the Highway Trust Fund remains elusive.

In 2016, MTAM expects median toll revenue to increase between 5% and 6%, owing to traffic growth and annual toll rate increases. Of a sample of 45 toll roads, 30% have put annual toll increases or inflation-indexed toll increases into effect. However, increasing leverage remains a credit risk due to a widening funding gap for transportation infrastructure. State and local governments continue to tap into the excess cash flows of toll roads to subsidize their own capital and operating needs, or have shifted some of their transportation financing responsibilities to existing toll roads. Ultimately states could increasingly turn to public-private partnerships (P3s) to alleviate some of the financing pressures, if they authorize the use of P3s for transportation projects.

Water and Sewer

U.S. water and sewer utilities are facing increased pressure to the bottom line from rising costs and lower sales. Despite the challenge, our outlook for municipal water and sewer utilities remains stable. The sector's strong fundamentals, supported by the essential services it provides, monopolistic business nature, and local rate-setting ability, insulate it from potentially challenging operating environments or economic cycles.

Water supply variability will continue to be an issue to watch in 2016, particularly for utilities in far western states like California, which are still contending with a 25% state-wide mandatory conservation requirement. As a result, development of alternative water sources will continue to garner attention and action. Drinking water projects like saltwater desalination and recycled water that would have been inconceivable a decade or so ago are starting to become a reality as traditional sources have come under severe pressure.

Municipal water and sewer utilities also can expect more clarity about upcoming environmental regulations in 2016. The EPA is expected to release the final versions of its regulatory determination on strontium, the contaminant candidate list, and proposed changes to the lead and copper rule. New national drinking water standards are not anticipated until 2017 or later. However, wastewater providers will face additional regulations given the EPA's focus on nutrient pollution as the most significant threat to U.S. surface waters.

Financially, the sector continues to post healthy debt service coverage margins and cash balances are exceptional. But generally the sector has not charged enough for its services to pay for upkeep of its pipes and treatment facilities. Recovering these costs from customers is a growing concern given numerous studies pointing to significant investment needs to maintain existing service levels in the coming years. Recent legislation signed by the President will provide utilities with a new tool to help finance replacement costs, but MTAM believes borrowings will remain modest in 2016.

Public Power

The outlook for U.S. public power electric utilities will remain stable as measures of debt service coverage and liquidity in 2016 should be similar to those in 2015. The main reason for our stable outlook is public power electric utilities' unregulated ability to establish electricity rates.

Improvement in the U.S. economy in 2016 should also help utilities maintain their credit metrics because any required changes in rates are likely to meet more tolerance. We expect the median fixed-charge coverage ratio for rated U.S. public power electricity generators will hold steady at about 1.6x and that median days cash on hand will remain at 174 days, roughly in line what they have been in 2015.

As for levels of debt, projected lower demand for electricity implies that utilities will be borrowing less in order to build new capacity, so leverage is unlikely to significantly increase in 2016. Environmental compliance and systems reliability projects will remain a major focus of new capital improvement programs.

Uncertainty over the ability of public power electric utilities to comply with proposed federal carbon rules are an evolving, long-term risk to the outlook.

Colleges and Universities

The outlook for four-year public and private U.S. colleges and universities in 2016 is stable, reflecting the expectation that aggregate operating revenue will grow at or above 3% over the next 12-18 months.

All revenue streams are expected to rise modestly, and growth will be driven by at least inflationary increases in net tuition revenue and state funding, as well as expanded investment income and steady philanthropy. Tuition revenue growth is expected to be 2% - 3%. State funding for public universities is expected to grow 2% - 4%.

On an aggregated sector basis, student charges remain the largest component of revenue for both public and private universities, and therefore our projections for net tuition revenue is a key component of our outlook. Sector-wide, our tuition projection indicates most universities will be able to grow tuition at or above inflationary levels.

Universities will continue to face the challenge to contain expenses, while attempting to invest sufficiently to remain to remain competitive. Most universities have already addressed expense reductions and will be more fundamentally examining their programs and organizational structures. Some of these reductions are likely to be contentious. This is particularly true for the portion of the sector that is challenged to grow net tuition revenue.

The sector's stability has also been buttressed by favorable investment returns in the past five years, which, combined with strong philanthropy have bolstered reserves and endowments. During the 12 to 18 month outlook period, reserves are expected to remain stable with some tolerance for potential volatility in the global financial markets.

Smaller colleges with limited scale and low revenue growth will remain fiscally challenged for the outlook period. We have previously stated there will be a small increase in private college closures and mergers over the next few years.

Additionally, defined pension liabilities are a growing credit challenge for many public universities as the contribution requirements for many are increasing faster than inflation.

Housing

In 2016, state housing finance authorities (SHFA) should expect sound financial ratios, deleveraging bond programs, equity building, and improved delinquencies. The main drivers for the 2016 stable outlook include the sound financial ratios driven by the deleveraging of bond programs causing increased equity and the utilization of alternative funding tools for new loan production to allow for continuous lending. We anticipate that this sound financial performance will continue through fiscal 2016.

SHFAs use flexible approaches to maintain continuous lending contributing to the bottom line, including a combination of alternative funding tools. SHFAs have also used savings from bond refundings to subsidize new loan origination.

With SHFAs no longer using mortgage revenue bond programs as their primary funding source, debt issuance has declined, balance sheets have shrunk, and equity has increased. SHFAs have also grown their equity positions by generating cash up-front through the sale of mortgage backed securities. Overall, increased equity creates flexibility within bond programs.

SHFAs are challenged by the failure of first time homebuyers to return to normal, historical levels of homeownership. This may impact the SHFA's ability to originate new long term assets to ensure SHFA growth, profitability, and sustainability.

Default Outlook

First time municipal defaults totaled $2.6 billion in 2015 YTD through 11/18/2015; however, the total for payment defaults exclusive of late payments and cases where the bond insurer is expected to pay was $1.9 billion. Notably, the significant increase in top line defaults was driven by the $1.6 billion Puerto Rico Public Finance Corporation default in Q3, of which $1.56 billion (97.5%) is uninsured. Excluding Puerto Rico PFC, first time municipal defaults in 2015, YTD totaled just $292 million exclusive of late payments and cases where the bond insurer is expected to pay.

True payment defaults YTD in 2015, excluding late payments and insurer pays, of $1.9 billion were well above the similar periods in 2014 ($230 million) and 2013 ($694 million). Excluding Puerto Rico PFC, YTD defaults through 11/18/2015 of $292 million were 27% above the similar period in 2014 ($230 million) and 58% below 2013 ($694 million). The last time the municipal market experienced defaults of similar size was for the full year 2013, when total defaults, excluding administrative errors reached $2.7 billion as a result of the Detroit default ($1.9 billion), although a much larger share of the outstanding defaulted securities were insured, with total defaults of only $781 million when excluding insurer pays.

Looking at the default distribution by sector, bonds backed by Appropriations and Special Assessments have the highest frequency of true payment defaults. Risky sectors such as CCRC/Retirement Facilities and Charter Schools also rank among the top sectors based on true payment defaults. In 2016, we expect that the broader municipal market will experience few defaults. We expect that the highest potential for missed payments are in non-rated debt, Puerto Rico-based credits, special care facilities, and appropriation-backed credits in weaker geographic regions. We note there remains select cases of severe stress where high unemployment, high personnel costs, weak demographics, struggling housing markets, or massive debt or legacy costs can lead to outsized problems for local issuers. We also note that Puerto Rico-based issuers could move the needle on defaults, but continue to expect that this pattern of distress will remain relatively rare in the broader market, and do not anticipate more than a cluster of local bankruptcies/defaults as we move into 2016.

Puerto Rico defaulted on over $37 million in bond payments due January 1. This included $35.9 million of Puerto Rico Infrastructure Financing Authority debt and $1.4 million of Public Finance Corporation bonds. The $357 million of interest due on Puerto Rico's general obligation debt was paid. Puerto Rico's highway and convention-center agencies may default on bonds after July as the island uses their revenue to repay general obligation debt.

Conclusion

MTAM continues to recommend that investors select high quality municipal issuers that understand the new financial reality and have made or are making budget adjustments. Essential service revenue bonds without the budgetary concerns of state and local governments and limited payrolls can be attractive, but we stress that an essential service issuer cannot flourish if the underlying governmental entity is in dire economic circumstances. A healthy outlook holds for most infrastructure issuers due to fundamental strengths reflected in the provision of essential public services, adequate balance sheets, and generally sound governance and fiscal management practices. In the case of the enterprise sectors comprised of higher education, health, and housing, credit quality will be maintained primarily as a function of their ability to increase fees, control costs, and improve overall operating margins. Sound debt and fiscal management practices, preservation of adequate liquidity, and strong governance oversight will be significant determinants of credit quality for issuers during the coming period of financial adjustment.

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4th Quarter 2015 Review and Outlook

Wednesday, December 30, 2015

Tax-free bond investors experienced positive returns during the fourth quarter as the first tightening of monetary policy in many years failed to dent the demand for the asset class. Better still, the municipal bond market distinguished itself within the fixed-income space as the best performer overall in 2015. This outperformance relative to taxable bonds should come as no surprise as rising rate environments generally mean less tax-free bond supply as potential issuer refinancing opportunities dry up. The municipal bond market also surprised many naysayers who expected significant financial difficulties of a handful of high visibility issuers to bleed into negative sentiment (and negative returns) for the entire market. In fact, the municipal bond market did an admirable job of punishing those issuers with weakening finances while at the same time rewarding those whose economic fortunes were improving.

As we turn the page as investors to 2016, it may be more prudent to consider the economy and its potential trajectory. If the United States economy could be compared with a television show, it would be "Room 222" with the number "2" as the star.

  • Gross domestic product - about "2%"
  • Inflation - roughly "2%"
  • Wages - maybe "2%"

These numbers are not indicative of a recession, but in the same respect they are far from healthy. Monetary policy works with a lag, and certainly a tightening by the Federal Reserve just a few weeks ago should be no cause for alarm. However, it has been the tightening of financial conditions all year in the corporate bond market that has us concerned about economic vitality in 2016. The "cleansing" (bankruptcies, defaults, etc.) that should have occurred on a grander scale after the economic crisis of 2008 may have just been delayed by the printing press of the Federal Reserve. Now that Janet Yellen and company have ventured into the realm of tighter monetary policy, some mean reversion could be in store for risk assets and the U.S. economy. The true nature of how "mean" this reversion will be depends on whether foreign economies can rescue the eventual U.S. slowdown (or worse). Let's travel around the world economies in a few words to see what the prospects of that "rescue" are:

  • China - descending fast without a seat belt
  • Europe - completely hooked on "QE" to stay above water
  • Japan - like watching "Saturday Night Live" (the show is still alive, but the laughs died years ago)
  • Brazil - political dysfunction largely keeping talk of economic depression off the front pages
  • Russia - commodity price carnage still to be felt
  • Canada - our neighbor to the north may already be in recession

Based on the above "anecdotes," you can see that Miller Tabak Asset Management has a rather dim view on the prospects for growth in the coming months. Sometimes classic scenes in movies can best describe future conditions in the financial markets. So we give you a scene from "The Departed," as Frank Costello (played by Jack Nicholson) walks through his bar and stops to ask a patron:

          Frank Costello: "How's your mother?"
          Man in bar: "I'm afraid she's on her way out."
          Frank Costello: "We all are. Act accordingly."

While many on Wall Street find it fashionable to be optimistic as we enter into a new year, it remains difficult for Miller Tabak Asset Management to join the crowd. Our third quarter 2015 review and outlook made a hard turn into the "dark" side, and we have yet to find valid reasons to change our investment viewpoint given what we know. To recap our concerns:

  • We worry about issuers' "willingness to pay."
  • We remain quite concerned about the signal the corporate bond market is sending.
  • The Federal Reserve's "longer run central tendency" of the federal funds rate is comically way too high.

Given our rather uninspiring outlook for the economy, we would make one suggestion to our readers when considering asset allocation decisions for the coming year:

          "Act accordingly."

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
www.millertabakam.com

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Are Some U.S. Universities' Endowments 'Too Large'?

Thursday, November 19, 2015

When it comes to managing large endowments, U.S. colleges and universities are expected to balance the needs of both current and future students, deciding how much to spend today and how much to save and grow for tomorrow.

Some elite universities, however, may be getting that balance wrong. The wealthiest college endowments in the U.S. are attracting the interest of Congress as tuition costs rise and the funds' coffers grow to record highs unhindered by taxes. Endowments are exempt from corporate income tax because universities support the advancement and dissemination of knowledge. But instead of holding down tuition or expanding faculty research, endowments are being accused of hoarding money.

Endowments exist to serve students in the present and in the future. But if the endowment accumulates too much, is it really just serving the people who manage the money? This is not consistent with why endowments are allowed to be tax-exempt.

One proposal legally obligates universities with endowments in excess of $100 million to spend at least 8% of the endowment each year. If adopted, this policy would be a radical shift. While private American philanthropies are required to spend at least 5% of their assets annually to maintain their tax-exempt status, colleges and universities are not obligated to spend a cent.

And the way universities allocate their endowment spending can be troubling. One study found that private equity fund managers received more endowment money than students did at those institutions. For example, Yale University, a school that allocated nearly $480 million to compensate private equity fund managers — then spent just $170 million of its $24 billion endowment on tuition assistance, fellowships, and prizes.

Representative Tom Reed, a New York Republican, said last month in a hearing of the House Ways and Means subcommittee that he was drafting legislation that would "deal with what I believe is a crisis when it comes to higher education costs in America."

The cost of college has been rising faster than inflation for decades, and members of Congress are scrutinizing endowments as positive returns have enabled the wealthiest universities to return to pre-financial crisis levels. Taxing investment returns or requiring annual outlays, which have been repeatedly suggested by Congress, is an especially costly and complicated proposition for the almost 100 universities with endowments of at least $1 billion.

Reed's proposed legislation would mandate that colleges allocate investment earnings to tuition relief as a condition of tax-free status for the endowments. He suggested that wealthy universities such as Yale University and Harvard University, whose investment management firms can earn billions in returns annually, also distribute the unused excess to other institutions.

Georgetown University law professor Brian Galle, whose specialty includes taxation and nonprofit organizations, proposed in his testimony that Congress should consider tax rules that offer incentives to donors rather than mandating a spend rate or taxing investment returns. Currently, donors can reduce income and estate taxes by making a restricted gift while they are alive and they do not have to pay taxes on any appreciation.

Last month's hearing was not the first time that large college endowments have attracted the attention of Congress. Last year, David Camp, the former chairman of the House Ways and Means Committee, proposed a 1% excise tax on the net investment income of universities with endowments that have at least $100,000 per student. Camp has since retired.

Before the financial crisis, Charles Grassley, the Republican senator from Iowa, in a Senate finance committee hearing in September 2007, said he was concerned about endowment growth as college tuition continued to rise. Grassley later raised the idea that college endowments should pay out 5% of their value each year, using the same rule as foundations.

Several of the wealthiest U.S. colleges in 2007 and 2008 changed their financial aid policies, awarding grants that do not need to be repaid instead of loans. Among the schools that adopted the so-called "no-loan" polices were all of the Ivy League, Swarthmore College, and Pomona College. Princeton University had the policy years before.

Some analysts believe, however, that requiring universities to spend a portion of their endowments on a specific area can be tricky, as donations to endowments can be restricted by the giver, and endowment officials have fiduciary and legal obligations to adhere to those restrictions. In addition, schools would be concerned about fundraising if Congress began to restrict how money could be spent.

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For Financially-Strapped Municipalities, New Prisons May Not Be The Answer

Thursday, October 8, 2015

Privately operated detention centers are facing an uncertain future after a series of bond defaults and changes in incarceration policies. In addition, the IRS is going after some counties that issued tax-free bonds to build jails used by federal agencies. But debt for the risky projects is still coming to market.

The slowdown in border detentions is putting a fiscal strain on counties that rushed to build jails in anticipation that a two-decade boom in immigrant inmates would continue. Municipalities that banked on those facilities for revenue and jobs are desperate to keep them afloat as a glut of beds goes empty. While many cities and counties scrupulously avoid a tax pledge, some are forced to find a use for facilities abandoned by their for-profit operators.

In Texas, the heart of a jail-building boom over the past decade, nine of 21 counties that created agencies to issue $1.3 billion in municipal bonds to build privately run correctional facilities largely for migrants have defaulted on their debt. A dozen other facilities from Florida to Louisiana to Arizona, many that housed immigrants, have also defaulted.

Moody's downgraded Bowie and Polk counties' general obligation ratings in 2014 and 2015 after bonds for private detention centers went into default. The downgrades were attributed to revenue lost to the counties from the private facilities.

One of the more dramatic closures came February 22 in far south Texas, when an uprising of immigration detainees heavily damaged the 2,200-bed Willacy County Detention Center. After the Federal Bureau of Prisons cancelled its contract with private operator Management Training Corp., the facility defaulted on more than $78 million of debt. In Livingston (TX), a $45 million private detention center is less than half filled and in default. Conduit issuer IAH Public Facilities Corp. recently announced a settlement with the Internal Revenue Service on the tax status of its bonds.

The IRS has made a point of auditing tax-exempt debt issued for private prisons arguing that debt for lockups that house significant numbers amounts of federal inmates are taxable private-activity bonds.

In the town of Encinal (TX) near the Mexican border, Emerald Correctional Management of Shreveport (LA) abandoned a $23 million detention center that needed repairs 12 years after it opened. That forced LaSalle County to take over the vacant facility, and negotiate a forbearance agreement to finance repairs as bonds issued by a conduit issuer went into default. Under a recent offer, investors in the LaSalle County Detention Center have until the end of October to accept 40 cents on the dollar for their bonds. In the meantime, county commissioners who serve as the board of the public facility corporation must find a way to staff the 680-bed lockup and seek inmates to support debt service.

In Alvarado (TX), 25 miles south of Fort Worth, Emerald won the contract to operate a 707-bed federal detention center that broke ground in June. Bonds were issued under the conduit Prairielands Public Facilities Corp., on whose board Emerald CEO Steve Afeman served until 2011, according to board records. The $63.4 million of taxable bonds priced through Aegis Capital and Municipal Capital Markets Group. Rated BBB by S&P with a stable outlook, the bonds pay yields of 3% on 3.5% coupons in 2017 and 6.55% on coupons bearing the same rate at final maturity in 2027.

Alvarado City Manager Clint Davis said the city has been studying the Prairielands Detention Center for five years and is confident that no local tax dollars will be at risk. Construction of the Prairielands Detention Center coincides with Johnson County's plan to build a $22 million jail to replace the existing privately operated facility in Cleburne. Alvarado is in Johnson County. The privately operated county jail was previously the designated detention center for Immigration and Custom Enforcement. Alvarado's contract with ICE has a term of five years, but any contractor, including ICE, can cancel with 90 days' notice. That type of cancelation sent the Willacy County Detention Center's rating to junk bond status from investment grade. As a backup, the Alvarado detention center will be certified to house county jail prisoners, as well as federal inmates.

While the Texas population has grown, the number of inmates in state and county jails has held relatively steady. Like other states, Texas has developed new sentencing guidelines to keep more people out of jail. With fewer state and local inmates, federal immigration detainees have become the target of private operators.

While the Alvarado facility is expected to hold low-risk inmates, uprisings are a source of risk for bondholders, as the riots in Willacy County demonstrated. Another facility, the Reeves County Detention Center in Pecos in far West Texas, has seen multiple riots. A report from the Justice Department's Inspector General in April found that Geo Group facility was understaffed and failed to address persistent security problems. The 2,400-bed federal prison, 175 miles east of El Paso, houses mainly immigrants who have committed low-level crimes, including drug possession and entering the United States illegally more than once.

Adelanto (CA), a Mojave Desert community with more prisons than supermarkets, is poised to authorize two more detention facilities as city leaders try to stave off insolvency. The city of 31,300 residents 85 miles northeast of Los Angeles has faced boom-and-bust property markets. The residential foreclosure rate is four times the California average and five times the U.S. level.

Officials face a $2.6 million deficit on a $13.3 million spending plan for the year through June 2015 after the defeat of a ballot measure last month to raise rates at its utility. Adelanto leaders are set to consider proposals for a 1,000-bed, privately run prison and a city-owned facility to house as many as 3,264 overflow inmates from Los Angeles County. The City Council is scheduled to vote December 10 on the larger facility, and take up the smaller one January 28.

Adelanto bailed out its budget in 2010 by selling a city-owned jail to a Florida operator for $28 million. Adelanto stands to gain from the prisons because of fees it will receive from developers as well as business related to the jails. The facilities are not a sure bet. In November, California voters approved a measure to reduce sentences for some non-violent offenses, which the state's legislative analyst estimated could apply to 40,000 prisoners. Los Angeles County, the source of most of Adelanto's expected new inmates, is pushing offenders into treatment programs rather than jails.

Adelanto, home to the High Desert Mavericks, an affiliate of Major League Baseball's Texas Rangers, was founded in 1915 by E. H. Richardson, inventor of what became the Hotpoint Electric Iron. It has one full-service supermarket. It also boasts a private detention facility for immigrants awaiting deportation, a county jail and a federal correctional site on the border with neighboring Victorville.

Boca Raton, Florida-based GEO Group Inc. is expanding the Adelanto detention facility it bought from the city four years ago by 640 slots to accommodate 1,940 people by next year. San Bernardino County houses about 700 inmates in Adelanto. More than 4,700 federal prisoners occupy the Victorville correctional complex.

City Manager James Hart said prisons bring hundreds of jobs. Adelanto's median household income of about $41,100 compares with $61,400 statewide, according to U.S. Census data. Its poverty rate of 32 percent is more than double the state level. The city government gets $230,000 directly in prison-related fees a year, he said.

GEO is offering $300,000 in mitigation fees to compensate for costs related to its proposed 1,000-bed facility, while LCS Holdings, the developer proposing the 3,264-bed prison, would pay $1.2 million. Both fees are recurring and will vary depending on how many prisoners are housed.

The California Municipal Finance Authority would issue $327 million of tax-free debt on the city's behalf, provided that Los Angeles County agrees to send overflow inmates to Adelanto and pay the city to house them. Adelanto would use the proceeds to pay the developer of the 3,264-bed prison. Payments from the county would go toward repaying the debt.

The federal Bureau of Prisons operates 121 prisons and was responsible for 210,227 inmates as of last February, according to the Inspector General. The bureau began contracting with private operators to hold immigrants in 1999 and in February housed 26,801 inmates in 14 of the privately operated facilities. Two more centers are under solicitation.

According to research by the nonprofit Sentencing Project, private detainees in the United States grew by 259% between 2002 and 2010, due primarily to increased efforts to find, incarcerate, and deport people who violate immigration laws. Since then, however, as border apprehensions slow and the federal government orders the release of more migrants, jails built to profit from an illegal immigration boom are weighing down the finances of rural counties in the U.S. Sunbelt.

The drop-off in inmates follows an almost two-decade boom that saw the number of immigrant detainees mushroom, partly as a result of more people crossing into the U.S., and partly due to a get-tough attitude toward illegal border crossers. County jails grew overcrowded. Prison operators crisscrossed the South pitching rural towns on the purported economic salvation of detention facilities. Under the arrangement, local governments would typically receive daily fees from the federal government based on the number of beds or persons filling them, and private prison operators would get a portion, usually the lion's share.

For some of the nation's smallest and most impoverished communities, locking up immigrants seemed like a good bet. To finance their construction, counties issued debt through conduit borrowers, limiting the county's liability, while allowing projects to be built quickly. Some financing of county jails, however, did entail lease-revenue debt implicitly backed by the county. Winning public referendum support for a jail is almost unheard of, though Houston and Harris County, did accomplish the feat in 2013 when voters approved $70 million of bonds.

Conclusion

Last year, Texas counties had $709 million in scheduled debt service for so-called lease-purchase obligations, most of which are for jail facilities, up from $273 million in 2000, according to figures from the Texas Bond Review Board. The increased debt grew right before migration patterns and immigration policy began to shift. Last year, there were 487,000 apprehensions, about the same level as in 1973, compared with a peak of nearly 1.7 million in 2000, according to the U.S. Border Patrol. That is partly because an improving Mexican economy and drug cartel violence kept fewer people from venturing north.

At the same time, the trend of locking up migrants has eased. More local officials are refusing to detain migrants at the behest of federal immigration officials and the Obama administration recently narrowed the categories of migrants that should be detained. The number of immigration detainees last year was down 11% from 2012, when incarcerations were at an all-time high, according to figures from U.S. Immigration and Customs Enforcement. The average daily population in ICE detention was 31,164 in June, down 16% over the same time period a year earlier.

Detentions may continue their downward march. Last month, a federal court rebuked the administration for its policy that jailed a wave of women and children fleeing violence in Central America. And just this week, new broke that the U.S. Justice Department is set to release about 6,000 inmates early from prison — the largest one-time release of federal prisoners — in an effort to reduce overcrowding and provide relief to drug offenders who received harsh sentences over the past three decades, according to U.S. officials. The inmates from federal prisons nationwide will be set free by the department's Bureau of Prisons between October 30 and November 2.

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3rd Quarter 2015 Review and Outlook

Tuesday, September 29, 2015

Tax-free bond investors experienced positive returns during the third quarter as global growth concern lifted demand for high quality fixed-income assets. While volatility in many other asset classes spiked during the quarter, it can be said that the municipal bond market acted as an "island of tranquility" during a stormy past three months for the financial markets. Longer-maturity bonds had the best returns during the quarter, as inflationary pressures remained quite contained thanks in part to the stronger Dollar and muted wage growth here in the United States.

We left off our last quarterly commentary (dated 6/30/15) predicting that the market would be more "China focused" in the coming months. It is clear that the August 11th, 2015 devaluation of the China Yuan has become a "game changer" for many investors as they rightly concluded that the world's second longest economy was experiencing sharply declining economic growth. The deflationary force that a slowing Chinese economy will have (and already has!) on commodity prices will be seen for a much longer time than many central bankers around the world would be willing to admit publicly. With Japan and Europe barely growing, and the United States on the verge of an interest rate hike by the Federal Reserve, it can be reasoned that tough times lie ahead for the global economy. As such, here are some base assumptions the Miller Tabak Asset Management investment team is operating under when considering the trajectory of the financial markets moving forward:

  • "Willingness to pay" is the new inflation for bondholders. Investors can lose significant capital by choosing to lend to the wrong issuers. Inflation is dead as currently calculated by governments around the world.
  • Should the Federal Reserve actually go ahead and raise rates in 2015, the corporate bond market will significantly underperform both the municipal bond and U.S. Treasury market. "Forced selling" has the potential to get very ugly in the corporate bond market thanks to concern over counterparty risk and credit quality concerns. Liquidity in the corporate bond market could be as difficult to find as a pay phone.
  • The "longer run central tendency" of the federal funds rate as published in September by the Federal Reserve of 3.3%-3.8% is absurd. It may be 1% in our view (at best).
  • Upgrading overall levels of credit quality in municipal bond portfolios will be a winning strategy in the months and years ahead, as default levels are likely to rise (see our comment on "willingness to pay").
  • "Negative" interest rates are likely sometime in the next three to five years in the United States. The U.S. national debt is over eighteen trillion dollars and generic growth will continue to disappoint in our view. Savers will be punished some more.
  • Any significant move higher in the overall level of interest rates for high quality municipal bonds should be viewed as a buying opportunity (see our comment above on "negative" interest rates).

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
www.millertabakam.com

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Credit Update on the Not-for-Profit Healthcare Sector

Tuesday, August 25, 2015

The median operating profitability for U.S. not-for-profit hospitals showed strong gains over the past year, although growth in operating cash flows show the credit gap widening between higher- and lower-rated borrowers.

Strong cash flows and investment returns coupled with lower capital spending and diligent revenue cycle management helped precipitate the improvement in key median liquidity metrics. Further revenue cycle challenges lie ahead, although most investment-grade not-for-profit hospitals have planned adequately and have sufficient financial cushion to endure potential revenue cycle disruptions.

MTAM had assigned a negative outlook for the not-for-profit healthcare industry in January 2015. However, growing clarity on the fate of the Patient Protection and Affordable Care Act has since provided more stable expectations as hospital issuers execute strategic plans. The sector is seeing improvements in operating results and stronger clinical volumes as management teams have done a better-than-expected job of improving operating efficiencies. Clinical volumes saw an increase in fiscal 2014 due largely to the increase in insurance coverage from the Affordable Care Act. We believe the positive momentum will continue for the remainder of this year before tapering in 2016-2017 as reimbursement pressures and supplemental funding cuts begin to accelerate.

Capital spending by not-for-profit hospitals fell to its lowest point in six years in 2014 as hospitals continued to pull back from building new, costly inpatient facilities. Hospitals across all ratings categories restrained their capital spending last year, bringing the median down to the lowest level since 2008. We expect capital spending to rise modestly going forward, with a focus on the IT side and in outpatient facilities for a greater presence in the community, which is a much lower cost.

One credit concern, however, is the recent spate of proposed health insurer megamergers, as the consolidation shrinks the pool of insurers and intensifies control on an increasing source of hospital revenue. Over half of hospital revenue is subject to negotiations with insurers over reimbursement for individuals covered under both commercial and government-funded plans. Control over reimbursement rates will rest with fewer insurers, constraining hospital profitability.

The proposed Anthem, Inc./Cigna Corp. merger poses the greatest risk to hospitals as the merged company would represent almost a quarter of the commercial insurance business, which typically accounts for roughly 33% of hospitals' gross revenues. The proposed Anthem/Cigna combinations would have 48 million individual members.

In addition to employer-provided plans, hospital revenue subject to insurer negotiation include those on the public exchanges created by the Affordable Care Act, and federal or state-funded plans administered by Medicare Advantage and Medicaid managed care plans.

Hospital revenue derived from Medicare Advantage and Medicaid managed care insurance plans are growing as the population ages, and states that expanded Medicaid move individuals into managed care plans to control expenses. However, the impact on individual hospitals will vary, even within the same region and state owing to a combination of factors affecting leverage, including the amount of members an insurer has in the hospital's immediate market.

Among providers, negotiating leverage will be greater for hospitals and health systems with dominant or leading market share. Many with a competitive edge have multiple sites covering a broad geographic region and a strong brand. Leverage will be less for smaller, single-site hospitals with limited service differentiation in competitive markets.

MTAM anticipates the insurer mergers will not impact hospitals until at least mid-2017 as they circumnavigate various regulatory approvals.

In general, MTAM sees the not-for-profit healthcare sector as containing risks that are unsuitable for most conservative investors. However, we are noting that 2014 rating upgrades significantly outpaced downgrades, driven by strong financial results across the rating spectrum, aided by improved payer mix and utilization from Patient Protection and Affordable Care Act. We expect the positive trend to continue through 2015 as the payer mix continues to improve and management teams continue to make operational improvements. Higher-rated, larger systems enjoyed more of a volume boost than the stand-alone providers. The credit gap between larger, higher-rated hospitals and smaller, lower-rated providers widened in 2014, as it has over the past several years, and is expected to continue to widen in 2015. Diverging operating profitability levels were particularly notable, with higher-rated borrowers posting solid improvements across all key financial metrics, whereas lower-rated borrowers mostly continued to trend downward. While median operating profitability measures showed strong gains in 2014 in the A and AA categories, the same measures for BBB-rated issuers declined in 2014 compared with 2013. That trend is expected to continue in 2015, as new industry trends continue to favor larger systems. Consolidation is also expected to continue over the next few years.

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2nd Quarter 2015 Review and Outlook

Tuesday, June 30, 2015

For the three-month period ending June 30, 2015, most investors experienced slightly negative returns on their tax-free bond portfolios. Longer maturity bonds underperformed shorter maturities as investors shed duration in anticipation of the Federal Reserve beginning the process of "normalizing" interest rates. Adding to the pressure on the municipal market has been a steady stream of heavy new issue supply that has forced broker/dealers to cut prices to keep their inventory moving. Municipalities have engaged in a significant amount of refunding (refinancing) deals to lock in low interest rates prior to the first tightening of monetary policy by the Federal Reserve in many years.

In an interesting turn of events, the higher quality municipal issuers actually outperformed their lower-rated counterparts within the investment grade space during the quarter. Excess supply often widens credit spreads as investors demand extra yield compensation for buying perceived riskier issuers bonds. Watch for this trend to continue in the coming months as an issuer's ability to pay (and willingness to pay) debt service on their bonds becomes of greater importance to an already skittish tax-exempt bond investor base.

We concluded our last quarterly commentary (dated March 30, 2015) with the following: "Moving forward, it is our view that the coming months will be volatile and uncomfortable for many as bond evaluations begin to move." Well, bond evaluations have moved, and the overall attractiveness of the municipal bond market is measurably greater than it was months ago. Compensation in the form of higher yields (and lower dollar prices) should propel direct purchases of municipal bonds by individuals higher in the months ahead. This potential added demand, coupled with a marginal slowdown in new issue supply due to less refinancing activity by municipal issuers, should put the tax-exempt bond market on better footing, and as such, expected total-returns may be more favorable moving forward.

As always, the events occurring overseas seemingly play an outsized role in the performance of the U.S. Treasury market (which then bleeds into the psyche of municipal bond market participants). The cataclysmic ascent in German "Bund" yields of nearly one full percentage point during the last quarter had everyone's attention on trading desks, and let's not forget the daily concerns about Greece, which drove volatility in many markets as each meaningless quote from a European politician hit the "tape." In our view, the coming months may take a more "China focused" turn on the overseas front as that nation grapples with excess manufacturing capacity, excess local government debt, and excess enthusiasm for stocks listed on the Shanghai Composite Index. Should the U.S. Dollar explode higher (not out of the question we say) due to turmoil overseas, any thoughts of tightening monetary policy by the Federal Reserve will become a 2016 discussion. While the United States is finally emerging from the 2008 financial crisis, it appears to us that some overseas economies are just beginning their descent into an even nastier financial crisis vortex of their own making. The "takeaway" here is not to get too bearish on fixed-income as an asset class, as the world remains a complicated and intertwined machine that could require maintenance at a moment's notice.

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
www.millertabakam.com

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State of the States - Midyear 2015

Friday, June 19, 2015

The outlook for U.S. states through the remainder of 2015 remains stable as a slowly improving U.S. economy supports state revenue growth. MTAM expects state tax revenue growth in 2015 to rise faster than in 2014, but remain within a 5 percent - 6 percent range, which is moderate for the sector and consistent with the long-term average. There will be significant regional variations, however.

Risks to state revenue growth include anti-tax sentiment prevailing and the volatility of the stock market. With personal income taxes making up about 40 percent of state revenues, and with taxes from high wealth individuals contributing a disproportionately large share, revenues tend to rise and fall with the stock market.

Pressures on the budget side include Medicaid, pensions, K-12 education, and deferred infrastructure improvements and maintenance. Expected increases in Medicaid costs and growing pension expenses have constrained the ability of states to increase other areas of spending.

Revenue forecasting is increasingly challenging due to increased volatility in state revenue results, including from capital gains. One-time events make it difficult to identify baseline revenue growth levels, a problem exacerbated by unpredictability in stock market and commodity price performance. As revenues recover, state budget managers, who face demands for additional spending and tax relief, have remained cautious. With the majority of gubernatorial incumbents re-elected, this approach will likely continue despite persistent pressures.

Medicaid has been the area of state budgets most challenging to control. We expect Medicaid to continue to be the biggest area of focus for state budget managers through 2015 and into 2016. Given the dominance of Medicaid in federal funding flows to the states, any material reduction in federal support for the program could be negative for state credit, particularly in the absence of related mandate relief.

Thirty-two states face budget gaps in fiscal 2015 or 2016 or both. For all but four U.S. states, June is the final month of the fiscal year-which is another way of saying that most states are still working on their budgets for the 2016 fiscal year. While we expect most states will finalize their budgets before month-end, some, given their large projected budget gaps or unresolved policy issues, could be late. While late budget enactment is rarely a good sign, it is not necessarily an immediate threat to credit quality. The structure of most state bonds, as well as-in many cases-the states' authority for funding debt service, tends to insulate them from credit catastrophe in the event of late budget enactment.

Nelson A. Rockefeller Institute of Government

Six years after the recession ended, many U.S. states are hard pressed to balance budgets because of a sluggish recovery and their own policy decisions. The fiscal fragility raises questions about how they will weather the next economic downturn.

A majority of states are making cuts, tapping reserves, or facing shortfalls despite an improving national economy and stock markets at record levels, according to the Nelson A. Rockefeller Institute of Government. State revenue has not rebounded to a prerecession peak adjusted for inflation, and other factors are putting pressure on budgets.

Alaska, Oklahoma, and energy-producing states saw receipts fall with global oil prices. Kansas overestimated revenue after tax cuts, while New Jersey faces a shortfall thanks to unfunded pensions. Even some Republican governors have championed tax increases to avoid further diminishing services curtailed during the 18-month recession, the deepest downturn since the Great Depression.

Spending on education, roads repair and other services is threatened. Some Kansas schools are closing early, while Alaska Governor Bill Walker recently threatened furloughing as many as 15,000 workers if lawmakers do not act on a $3 billion gap. Alabama Governor Robert Bentley has warned of impending cuts, including the closing of 15 of 22 state parks.

While the shortfalls do not pose immediate risks to credit quality, having so many now is an early warning about vulnerability when the next downturn hits. State governments have about half the reserves that they had before the recession.

Not all states are struggling. California Governor Jerry Brown said that an expanding economy has allowed a boost in proposed spending next year to a record $115 billion. Others, including Arizona, Missouri, and North Carolina, saw an "April surprise" of higher-than-expected income taxes after federal and state levies were paid, according to the National Association of State Budget Officers. Most states can expect slow growth in the coming year.

Still, improvement in employment, consumer spending, and revenue has grown more slowly than in previous recoveries. A dozen states still have not recovered all jobs lost since the start of the downturn in December 2007. Aggregate general fund revenue and spending haven not rebounded to inflation-adjusted fiscal 2008 levels, according to a survey by the State Budget Officers released in December. Revenue of $748 billion for fiscal 2015 would have to be $15 billion higher to match real 2008 levels, the group said.

While revenue growth has been sluggish, states have had to spend more on things such as Medicaid. Mounting pension shortfalls are also squeezing states including Illinois, New Jersey, and Pennsylvania. The situation has become so bleak in some states that even Republican governors loath to raise taxes have proposed higher levies. In Nevada, two-term Republican Governor Brian Sandoval has proposed $1.1 billion in new or continued taxes to pay for education and initiatives such as expanding full-day kindergarten. He has said he has no choice with a shortfall caused by declining mining and gambling revenue, as well as a need to bolster an education system that has the worst high-school graduation rate in the U.S.

Bentley, a two-term Republican, has proposed raising $541 million through taxes on cigarettes, car sales, and other items to avoid deep cuts to essential services with a long-building budget funding shortfall of $700 million.

Fiscal Survey of the States

The Spring 2015 version of the Fiscal Survey of the States, released last week by the National Governors Association and the National Association of State Budget Officers shows state budgets continuing to grow at a moderate pace after several years of slow recovery in the national economy following the Great Recession. According to executive budget proposals, general fund spending is projected to grow 3.1 percent in fiscal 2016. This growth rate falls below the historical average, though the current inflation rate remains low as well. Forty-two governors recommended spending increases in fiscal 2016 compared with the current fiscal year, helping to bolster core services such as K-12 education and health care. Mid-year budget cuts in fiscal 2015 remain fairly minimal compared with the levels observed during and immediately following the Great Recession. However, progress is slow for a number of states and structural issues remain. States vary in their fiscal health due to a combination of economic, demographic and policy factors. Long-term spending pressures in areas such as health care, education, infrastructure, and pensions continue to pose challenges for many states that will require difficult budgetary decisions. Meanwhile, state tax revenue growth remains limited, as employment continues to grow slowly, wages remain relatively stagnant, and labor force participation is low. States' spending proposals continue to be cautious as they plan for modest revenue growth and seek structural balance.

In fiscal 2016, general fund expenditures are projected to increase by 3.1 percent, a slower rate of growth than the estimated 4.6 percent increase in fiscal 2015. Executive budgets show general fund spending increasing to $779.6 billion in fiscal 2016, compared with $756.2 billion in fiscal 2015. General fund spending in fiscal 2014 reached $722.8 billion, a 4.1 percent increase over general fund spending in fiscal 2013.

Executive budgets in 42 states call for higher general fund spending levels in fiscal 2016 compared with fiscal 2015. However, new spending is expected to be limited, with few additional budget dollars available to address competing spending demands. Eight states project negative growth, while a majority of states (28) recommended positive spending growth of less than five percent in fiscal 2016. Meanwhile, 10 states project growth between five and ten percent and four states project growth of ten percent or more.

Despite five consecutive years of budget growth and the low inflation environment, state general fund spending for fiscal 2015 for the 50 states combined remains below the fiscal 2008 pre-recession peak after accounting for inflation. Aggregate spending levels would need to be at $780.5 billion, or 3.2 percent higher than the $756.2 billion estimated for fiscal 2015, to be equivalent with real 2008 spending levels.

Governors recommended that additional budget dollars most heavily target K-12 education and Medicaid in fiscal 2016, the two largest areas of state general fund expenditures. Governors recommended that additional funds be directed to K-12 education in 42 states and to Medicaid in 38 states, for net increases of $10.2 billion and $9.2 billion, respectively. K-12 education and Medicaid together comprise a majority of state general fund spending. Spending increases were recommended for all other areas of the budget in fiscal 2016 with the exception of transportation. However, since most states primarily rely on other fund sources to finance transportation spending, general fund spending adjustments are not necessarily indicative of overall recommended state spending changes for transportation in fiscal 2016. In fact, some states that reported a net decrease in recommended general fund spending on transportation indicated that additional funding from dedicated fund sources are recommended for infrastructure investments for the upcoming fiscal year.

State budget gaps that arise during the fiscal year are primarily solved through a reduction in previously appropriated spending. Mid-year budget cuts have subsided compared with the years immediately following the recession when states had to make substantial cuts and take other actions, such as expend rainy day funds, to balance their budgets. Similar to recent years, mid-year budget cuts have been minimal in fiscal 2015, though they did exceed the previous year's level. At the time of data collection, 11 states enacted net mid-year budget cuts totaling $2.0 billion in fiscal 2015. This compares with eight states enacting $1.0 billion in net mid-year budget cuts by this time in fiscal 2014, and 11 states enacting $1.3 billion in net mid-year budget cuts in fiscal 2013. Meanwhile, 16 states enacted net mid-year spending increases in fiscal 2015 totaling $2.3 billion. Additionally, four states enacted mid-year tax decreases, and one state enacted a mid-year tax increase resulting in a net revenue reduction of $1.3 billion in fiscal 2015.

Aggregate general fund revenues are projected to modestly increase in fiscal 2016. Governors' recommended budgets show revenue collections are projected to increase by 3.0 percent in fiscal 2016, a slightly slower growth rate than the estimated 3.7 percent gain in fiscal 2015. However, the growth rate is higher than observed in fiscal 2014, when revenues increased by only 1.6 percent. The revenue slowdown in fiscal 2014 can be largely attributed to the volatility caused by individuals shifting capital gains, dividends and personal income to the 2012 calendar year to avoid higher federal tax rates that were set to take effect on January 1, 2013. This one-time shift led to a substantial acceleration of revenue growth in fiscal 2013, followed by the slowdown in fiscal 2014. With more distance now from the impact of the socalled "federal fiscal cliff," most states appear to be returning to more stable patterns of modest annual revenue growth. However, the steep decline in oil prices recently has placed significant downward pressure on revenues in certain energy-producing states.

Governors' budget proposals forecast total general fund tax revenues of $777.6 billion in fiscal 2016, compared with the estimated $755.1 billion collected in fiscal 2015. Total general fund revenues in fiscal 2014 reached $728.1 billion. Despite five years of consecutive growth, aggregate revenues are still 2.3 percent below fiscal 2008 levels after accounting for inflation. Fiscal 2015 revenues would have needed to reach $772.5 billion, rather than the estimated $755.1 billion, to be equivalent with inflation adjusted 2008 levels. The data for this report were collected prior to April tax collections coming in. Many states had a positive "April surprise" this year after taxpayers filed their income tax returns, due to the strong stock market performance in calendar year 2014, which will likely help more states stabilize their budgets.

Governors in 16 states proposed net tax and fee increases, while governors in 12 states proposed net decreases in fiscal 2016, resulting in an aggregate net increase of $3.0 billion. For the most part, increases were proposed for general sales taxes and cigarette taxes – ten states recommended a sales tax increase and nine states recommended increased taxes on cigarettes and tobacco products. Meanwhile, a dozen states proposed decreases for personal income taxes. Pennsylvania was the largest driver of the net increase, recommending $4.6 billion in tax and fee increases for fiscal 2016, followed by Connecticut and Alabama. Texas recommended the largest decrease, followed by Florida and Ohio. Governors have also proposed $1.7 billion in new revenue measures in fiscal 2016.

Total balances include both ending balances and the amounts in states' budget stabilization funds (rainy day funds and reserves). In fiscal 2014, total balances amounted to $71.2 billion, or 9.9 percent of general fund expenditures. This marks a slight decline compared with fiscal 2013, when strong budget surpluses due to increased revenue collections helped to bolster states' balance levels, reaching $72.2 billion (10.4 percent), an all-time high for states in terms of actual dollars, though not as a percentage of expenditures. Total balances are estimated to have declined again in fiscal 2015 to $60.3 billion or 8.0 percent of expenditures, though this decrease is mostly attributable to an $8.9 billion drop in Alaska's balance levels as the state has tapped its reserves to respond to the revenue impacts of declining oil prices. Governors recommended reducing total balance levels in fiscal 2016 to $55.2 billion or 7.1 percent of general fund expenditures.

In recent years, two states – Alaska and Texas – have held a disproportionate share of states' budget reserves. In fiscal 2014, the balance levels of Alaska and Texas made up 39 percent of total state balance levels. However, Alaska's share has declined substantially according to estimated balance levels in fiscal 2015 and recommended levels in fiscal 2016. Texas's reserves, meanwhile, are expected to continue growing, and by fiscal 2016, are projected to comprise 34 percent of states' total balances. The remaining 48 states – excluding Oklahoma – are projected to have total balance levels representing 5.0 percent of general fund expenditures in fiscal 2016.

In fiscal 2015, total Medicaid spending is estimated to grow by 18.2 percent, with state funds increasing by 5.2 percent and federal funds increasing by 24.2 percent. The substantial increase in Medicaid spending in fiscal 2015 is largely attributable to the fact that this is the first full fiscal year reflecting the impact of Medicaid expansion under the Affordable Care Act (ACA) for almost all of the expansion states. Fiscal 2014 reflected a partial year impact of the optional Medicaid expansion under the ACA for those states that began expansion on January 1, 2014. Total Medicaid spending increased by 8.6 percent in fiscal 2014, with state funds growing by 5.9 percent and federal funds growing by 11.9 percent. The rate of growth in federal funds significantly exceeds the state fund growth rate since costs for those newly eligible for coverage are fully federally funded in calendar years 2014, 2015, and 2016, with federal financing phasing down to 90 percent by 2020. Medicaid spending growth in fiscal 2016 is expected to slow significantly according to governors' proposed budgets. Fiscal 2016 spending on Medicaid from all funds is projected to increase by 5.2 percent, with federal funds increasing by 6.9 percent and state funds increasing by 3.1 percent (roughly equivalent to recommended overall state budget growth).

Medicaid enrollment is estimated to increase by 13.4 percent in fiscal 2015, after having increased 9.5 percent in fiscal 2014. This reflects both the impact from the Affordable Care Act including increased enrollment in states that have implemented the Medicaid expansion that began on January 1, 2014, as well as increased participation among those currently eligible in both states that did and did not implement the expansion. In governors' recommended budgets for fiscal 2016, Medicaid enrollment growth is expected to slow, increasing by 4.6 percent.

State budgets are projected to grow again in fiscal 2016 for a sixth consecutive year, extending the period of fiscal rebuilding for states. Most states continue on a path of stable, moderate spending and revenue growth, though some states face structural budget challenges that will need to be addressed going forward. Long-term spending pressures on K-12 education, health care, pensions and other critical areas continue to grow, often faster than state revenue growth. Overall, state finances continue to improve, but growth is modest and governors' spending proposals for fiscal 2016 remain cautious.

State Public Pensions

While most public pension plans' funded ratios are stabilizing after multiple years of decline, they are doing so at lower levels, leaving states exposed to higher pension costs. While market gains and pension reforms may be helping some plans, pension challenges remain. Overall, actuarial liabilities rose without pause over the past five years.

The seemingly inexorable growth in actuarial liabilities during a period in which more than 40 states implemented numerous pension reforms underscores the difficulty of implementing benefit changes as wide-ranging as the reforms in Montana, New Mexico and Ohio. Funded ratios for Montana, New Mexico and Ohio's pensions have jumped significantly post-reform and included changes to the plan cost of living assets or shifting a portion of the contribution requirements from employers to employees.

Governments in general continue to contribute less to their pensions than the level calculated by their actuaries, the annual required contribution (ARC). Since the downturn, the ARC has risen significantly for most plans as they work to recoup past investment losses.

Numerous plans continue to calculate an ARC assuming a rolling, 30-year amortization of the unfunded liability. The repeated reamortization of the unfunded liability over a new, 30-year periods means that little meaningful progress is possible toward full funding, without investment gains exceeding the plan's investment return assumption.

Demographic profiles continue to weaken, with flat or declining government employment, rising retirements, and longer lifespans in retirement, trends that raise plan liabilities, pressure cash flows, and shift risk for plan performance to participating governments.

States' median debt burden totals 2.6 percent of personal income, while unfunded pensions attributable to the states total 3.3 percent of personal income. The range of state debt burdens is relatively narrow, from zero percent to 9.2 percent. By contrast, the range of pension burdens is much broader, ranging from 0.2 percent to 19.3 percent.

Conclusion

State budgets are expected to continue their trend of moderate improvement through fiscal 2015, after several years of recovery in the national economy. Since the recession, states have transitioned to a sustained period of fiscal rebuilding. However, progress is slow and structural challenges remain. Spending challenges persist in areas such as health care and higher education, and governors' recommended budgets indicate that revenue growth may not be sufficient to meet all the competing demands for state resources. As states shift some of their focus from immediate budgetary pressures, long-term challenges are likely to persist in fiscal 2016 as revenue growth remains modest.

In general, the gap between states' public pension funded levels looks likely to grow as some states have seen reform enacted, while others have seen proposals deemed unconstitutional or stuck in legal limbo. Pension funding status varies widely among states, and funding outcomes continue to play a significant role in relative creditworthiness over time. The gap is growing between well-funded and poorly funded state pension plans. Despite six years of economic expansion, many states face budget gaps in either fiscal 2015 or fiscal 2016, or both years, and lean budget margins could lead to a greater reluctance for struggling states to fund actuarially determined contributions.

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U.S. Transportation: State Highway Funding Crisis

Thursday, April 30, 2015

As U.S. states collect record tolls from drivers, political opposition to fee-based highways and bridges is threatening efforts to rebuild crumbling infrastructure. The resistance is hampering the ability of states to pay for roads, which has been hurt by eroding gas taxes, a lack of federal funding, and a tax-wary electorate that has given Republicans the most power in the nation's capitals in almost a century.

A group that includes FedEx and McDonald's has been working to keep Congress from lifting barriers to tolls on interstate highways, a proposal included in the $478 billion transportation bill the Obama administration sent to Congress. It would give states the power to add tolls on roads that must be rebuilt or are congested, as long as the federal government approves.

The anti-toll fervor comes as more money is needed for roads than ever. The nation should be spending $79 billion more per year on improvements, according to the Federal Highway Administration. Advocates say new toll roads help relieve congestion that cost motorists $121 billion in wasted time and fuel in 2011, or $818 per commuter, according to the Texas A&M Transportation Institute.

States have traditionally relied on gasoline taxes to pay for road construction, a funding source that has been diminished by more fuel-efficient cars. The federal gas tax has not been increased since 1993. Toll roads have helped make up the gap. There were 5,695 miles of roads, bridges and tunnels tolled in 2013, up from 4,918 five years earlier, according to the Federal Highway Administration. That generated $13 billion of revenue in 2013, compared with $10 billion five years earlier, according to the Bridge, Tunnel and Turnpike Association. The toll miles and revenue were the most ever, the Association said.

Republican and Tea Party-aligned groups have pushed back against the shift, arguing that new tolls on existing public roads -- or on those built with the help of taxpayer money -- are an unnecessary tax. Few states have seen as much pushback as Texas, where toll road mileage has grown faster than almost any other state over the past decade, according to federal statistics. Since 2007, Texas and its authorities have sold $27 billion worth of bonds for toll roads, bridges and tunnels, 62% more than California, the second-biggest borrower, according to Bloomberg data.

Tolls proliferated under former Texas governor Rick Perry, who unsuccessfully sought to use them to finance his proposed "Trans-Texas Corridor," a 4,000-mile network of roads, railways and utility lines through the state. Governor Greg Abbott, a Republican who replaced Perry in January, campaigned against relying on tolls to meet the state's infrastructure needs. His plan, a version of which has already cleared the Senate, would funnel a portion of the state's motor vehicle-sales taxes toward building and maintaining roads and bridges. He also wants to require that the state highway fund be used primarily for road work, instead of related activities such as policing.

Abbott's plan will test the feasibility of financing large-scale road investments without resorting to tolls. Texas currently needs to spend an additional $5 billion a year to maintain existing roads and add new capacity. That would swell to $7 billion a year if the use of tolling on new road construction was foregone.

U.S. Highway Trust Fund

U.S. states are taking more financial responsibility for roads and bridges as the expiration of federal transportation funding approaches, straining a partnership that dates to the administration of President Dwight D. Eisenhower in the 1950s.

At least six states have delayed $2 billion in construction projects because of the uncertainty, and others are making contingency plans to pay contractors. Five states, all with Republican governors, increased fuel taxes this year, while Minnesota and Michigan are pursuing legislation or ballot measures to raise additional money.

The Congressional Budget Office projects that the U.S. Highway Trust Fund, which provides federal dollars for roads and transit, will become insolvent after the current funding bill, itself only a 10-month fix, ends May 31. There has been no long-term funding plan since 2009, and Congress has failed to address an estimated $58 billion annual shortfall for surface transportation. States are charting their own courses.

States accounted for 40% of the average $213 billion in annual highway and transit spending from 2008 to 2012, with local entities paying 35% and the federal government 25%, according to the Pew Charitable Trusts. Yet in some states, federal funding accounts for more than half the transportation budget.

While U.S. infrastructure deteriorated, spending declined as cars became more fuel efficient and collections from state and federal gasoline taxes declined. Expenditures at all levels fell $27 billion, or 12%, between 2002 and 2011, and revenue for the Highway Trust Fund, created under Eisenhower in 1956 to pay for the interstate system, has fallen short of expenditures for more than a decade.

About $163 billion is needed annually over a six-year period for highways, bridges and transit systems, yet only $105 billion is being invested, according to a December report from the American Association of State Highway and Transportation Officials and the American Public Transportation Association.

The needs are pressing enough that even when states raise revenue, they cannot afford to lose dollars from Washington. The federal funding is still foundational. The Obama administration has proposed a six-year, $478 billion plan, and there have been proposals that include raising the federal gasoline levy or taxing U.S. companies' offshore profits brought home. None have advanced.

The roles of federal and state governments are changing by default as Congress fails to act. States will slowly provide a greater percentage of spending as long as funding from Congress remains stagnant.

The Highway Trust Fund's main purpose was to pay for interstates. After the system was completed in the 1990s, the fund's role and that of the federal government in paying for infrastructure became less clear. Congress had passed long-term funding bills sending money to state and local governments until 2009, when it started enacting a series of short-term extensions. The federal gas tax, the major source of revenue for the fund, has not been increased since 1993.

Some members of Congress, including senators Ted Cruz and Marco Rubio, both Republican presidential candidates, have advocated maintaining federal responsibility for interstates while shifting more authority to the states. U.S. Senator Rand Paul, another Republican candidate, and Democratic U.S. Senator Barbara Boxer introduced legislation April 16 to extend the Highway Trust Fund by letting companies voluntarily return overseas profits at a tax rate of 6.5%.

With needs mounting, states are moving to bolster their own funding. After no legislature increased gasoline taxes from 2010 to 2012, six states and the District of Columbia did in 2013, according to the National Conference of State Legislatures. Three others followed suit last year, and Georgia, Idaho, Iowa, South Dakota and Utah acted this year.

States are also borrowing more and turning to private sector. Ohio sold private-activity bonds this month for a $430 million highway bypass project, the state's largest, and its first public-private partnership. Michigan voters will consider in May whether to raise money for transportation, and the Republican-led Minnesota House of Representatives approved a bill April 22 to generate $7 billion for roads and bridges during the next decade.

Higher Gasoline Taxes

Governors and state lawmakers searching for ways to reinvigorate their transportation funding in 2015 are also focusing on the gasoline tax, with a flurry of new highway revenue proposals aimed at increasing collections from the long-time main source of highway spending.

Every state and the District of Columbia have a motor fuels tax on gasoline and diesel fuel, a trend that began with the first gas tax in Oregon in 1919. The first federal gasoline tax was levied in the early 1930s at 1 cent per gallon, and revenues from it helped build the Interstate Highway system in the 1950s and 1960s. But gasoline taxes have faltered in the past 10 years as more fuel-efficient cars hit the roads at the same time that motorists cut back on their mileage and construction costs rose steadily.

Between 2002 and 2012, annual revenues from the federal gas tax fell by $15 billion, or 31% in real terms when accounting for construction cost inflation, Pew Charitable Trusts said. At the same time, state fuel tax revenue dropped by $10 billion, or 19%. States sales taxes on new and used vehicles, which are a major source of transportation funding in many jurisdictions, also sagged by $8 billion a year, or 21%, between 2002 and 2012 after adjusting for inflation.

Gasoline tax hikes are one of the biggest trends we are seeing this year. Gasoline tax proposals are on a three-year roll after no state gasoline tax increases in 2010 through 2012. Six states and and the District of Columbia raised their gasoline taxes in 2013 and three more states did so in 2014.

Higher state gasoline taxes are among the more than 90 measures relating to transportation funding on the table in 26 states, according to a recent report by the American Road & Transportation Builders Association's Transportation Investment Advocacy Center. Governors and state legislators recognize the negative impacts of deteriorating road and bridge conditions on the local economy, safety, and mobility.

The structural imbalance in the federal Highway Trust Fund created by the faltering gasoline tax and the numerous short-term extensions of federal funding is putting pressure on state transportation spending. There was no need to increase federal or state gasoline taxes, or link them to inflation, while gasoline tax revenues rose steadily for almost three decades.

States can raise the gas tax rate, find some other source of revenue, or cut back on transportation spending to the level supportable by the gasoline tax. Cut backs are not going to happen, other revenue sources such as vehicle miles traveled are at least a decade away, so that leaves gasoline tax increases as the preferred option.

If the federal tax had been linked to inflation with regular increases, the Highway Trust Fund would not be in such a dire situation. The federal tax has remained at 18.4 cents per gallon since October 1, 1993. Since then, 22 states have raised their gasoline tax rate by more than 5 cents per gallon, including 11 of more than 10 cents per gallon. However, 16 states have not raised the tax in more than 20 years, and Alaska has not increased its 8 cents per gallon tax in 45 years.

Conclusion

Federal reimbursements for state road, bridge, and transit projects are being reduced and delayed as Congress fails to move toward extending the Highway Trust Fund solvency's beyond the May 31 expiration of the latest funding extension. Last month, Senators voted 45 to 52 against a budget amendment offered by Senator Bernie Sanders, I-Vermont, the ranking minority member of the Senate Budget Committee, which would have provided $478 billion of federal transportation funding over the next six years by closing a loophole that allows corporations to keep offshore earnings in overseas tax havens.

The Transportation Department said it will begin limiting disbursements to states from the Highway Trust Fund when the cash balance in the highway portion of it hits $3 billion and the transit account's balance falls to $1 billion. The Fund is structurally insolvent, with expenditures from it exceeding dedicated revenues from federal gasoline and diesel taxes by $13 billion a year. Extending the Fund's solvency through May required a general fund transfer of $11 billion last year, and another $10 billion will be needed to keep it solvent through the end of fiscal 2015. Since 2008, $65 billion has been transferred into the Fund from the general fund and other sources.

The Senate Republican fiscal 2016 budget resolution introduced by Budget Committee chairman Mike Enzi, R-Wyoming, directs Senate Finance Committee chairman Orrin Hatch, R-Utah, to develop a plan for restoring the Fund's solvency, but does not include any specific instructions. The House Republican budget resolution recommends Congress reduce Fund expenditures to match revenues from gasoline and diesel taxes. That would reduce federal transportation spending from $53.7 billion in fiscal 2015 to $39.6 billion in fiscal 2016.

State and local officials told House committee members last month that they see chaos ahead if Congress does not quickly pass a long-term transportation bill. Major highway and transit projects are sitting on the shelves in many states and others are being pushed back past the 2015 construction season because of questions over federal funding. State highway departments need a fully funded, long-term transportation bill by the end of May. The lack of a long-term surface transportation bill that provides a predictable stream of federal funding makes it nearly impossible for states to plan for large projects that need funding over multiple years.

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MTAM Recommendation: Remain Cautious with Small, Private Universities

Friday, April 24, 2015

The credit outlook for four-year U.S. colleges and universities through 2015 and 2016 remains negative.

For colleges and universities, net tuition revenue growth in 2015 will be the weakest in over a decade. The low revenue growth coupled with mounting expenses will contribute to weaker operating performance. However, against the backdrop of challenging business conditions, there are signs of emerging stability, including overall strong student demand and balance-sheet strengthening. But because most colleges rely heavily on student charges, net tuition growth matching the pace of industry inflation would be necessary for a stable outlook.

Despite revenue diversity, the financial performance of public universities is expected to moderate as state governments reduce operating appropriations while placing constraints on tuition growth.

Heavily tuition-dependent private colleges and universities with weaker market positions and regional draws will be increasingly challenged because of the restricted revenue growth. In contrast, the elite and wealthy private colleges and universities will outperform the rest of the higher education sector over the next 12-18 months, given business models linked to philanthropic support. As well, these financially strong universities benefit from diverse revenue sources, which underpin greater operating stability and cash flow generation.

Sweet Briar College

Sweet Briar College, a 114-year old women's private college in Virginia, said it would shut down at the end of this academic year. Sweet Briar's problems are an example of the challenges being experienced by small, rural colleges.

At least 22 colleges with fewer than 4,500 students and rated at best three steps above junk have seen trading in their bonds jump since March 3rd, when Sweet Briar said it would shutter in August, data compiled by Bloomberg show. The list includes Bridgewater College in Virginia (1,800 students) and Mills College in California (1,600 students). Both schools are facing continued deficit operations, which will be increasingly difficult to balance given the fundamentally challenged student market (with volatile enrollment, stagnant net tuition per student, and weak matriculation).

Sweet Briar's fate is far from certain: A county attorney sued the college last month seeking a court order removing its president and trustees and blocking it from closing. Regardless of the outcome, the plan puts a spotlight on schools buffeted by forces such as diminished ability to boost tuition in the face of mounting student loans.

The school embodies the financial pressures confronting smaller institutions. Ten private four-year colleges closed or were acquired on average annually from 2008 to 2011, about double the historic rate, according to a 2013 Vanderbilt University study.

Sweet Briar's specialization constrained how it could cut expenses and draw students, leading to an unsustainable business model. Although the college said it will help students enroll elsewhere, an alumnae group hired a law firm to fight the decision and raise funds to keep the school open. Its officials have said the school currently plans to meet its obligations on bank loans and bonds.

Mergers

Mergers of small colleges can be a credit positive for some colleges. Recently, six schools have announced mergers with six other schools (Thunderbird School of Global Management with Arizona State University; Union Graduate College with Clarkson University; William Mitchell College of Law with Hamline University College of Law; Montserrat College of Art with Salem State University; AIB College of Business with State University of Iowa; and Piedmont International University with Tennessee Temple University). Merged entities can benefit from increased enrollment, size, and programmatic diversity. We expect the pace of mergers to increase.

The Great Divide

The rich are getting richer in the U.S. higher education sector. The assets of the 40 wealthiest institutions, led by Harvard University, have increased 50% over the past five years. This is more than twice as fast as colleges with the lowest credit ratings, many of which have been struggling to fill their seats. This growing gap will pose increasing competitive challenges for less-endowed institutions that do not have the resources to invest in facilities, financial aid, and strategic initiatives.

U.S. universities with the greatest total wealth, based on cash and investments for fiscal 2014, are positioned to expand their financial advantage relative to the remainder of the sector. Within the largest 503 public and private institutions, the 10 wealthiest (as measured by total cash and investments) hold nearly one-third of the wealth, while the top 40 hold almost two-thirds of the total wealth.

The wealthiest public and private universities include Harvard University, Yale University, Duke University, Stanford University, and the University of Texas System. This group of financially leading universities is differentiated from the rest of the sector by long-term highly-diversified investment strategies, exceptionally strong philanthropic support, and healthy cash flows. Combined, these will contribute to ongoing wealth concentration in the higher education sector.

The favored few raise more money from alumni and earn more on their investments. The 40 richest schools collected 60% of total gifts in higher education in the year ended June 30. They also kept less cash on hand and more of their money invested in stocks and other high-return investments. Because of this riskier strategy, schools with large endowments posted some of the steepest investment losses in 2009 due to the credit crisis. They were also among the quickest to recover. Their diverse investment strategies and access to the best performing managers have played a pivotal role in the quick recovery since the financial crisis. By investing in less-liquid, higher-yielding assets, the group has stronger long-term investment returns. With very strong financial reserves relative to debt and operations, these universities can manage the volatility associated with these strategies.

Based on fiscal 2014, the top 40 universities had a median cash and investments of $6.3 billion compared with $272 million for the remainder of the sector. The majority of these financially leading universities attract a disproportionate share of philanthropic support, contributing to their ongoing outperformance. Gift revenue can be used to further their strong brand recognition by funding investments in academics, research, and facilities - widening their competitive gains.

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Pension Obligation Bonds - A Credit Neutral At Best

Monday, April 13, 2015

The topic of unfunded pension liabilities has garnered growing attention from a public confronting headlines warning of the staggering size of unfunded obligations, and lawmakers looking to pension funding amid ongoing budget stress. State and local unfunded pension liabilities stood at $1.3 trillion in 2014 according to the Federal Reserve. We believe that state and local pensions and the challenges they pose for the municipal asset class are highly individualized and should be viewed by investors on an issuer-by-issuer basis. MTAM looks past the headlines and conducts fundamental credit research on individual issuers. We analyze an issuer's pension funding status by reviewing its plan assumptions, annual pension contributions, and funded ratios as they relate to the actuarially based annual required contribution, or ARC, and the amount it represents in an issuer's overall budget. We also look at whether the issuer is making the full ARC payment and consider the size of the unfunded liability on a per-capita basis, as a percentage of an issuer's tax base, and as a percentage of personal income.

Pensions are a growing source of credit pressure as liabilities and costs continue to climb across the public sector. We have witnessed credit rating downgrades of several states and local governments attributable mainly or partly to pension pressures.

Pensions are one of many credit rating factors, but they affect three of the four key areas of our credit analysis. Debt burden - pensions are exceeding bonded debt in many jurisdictions, with escalating payments, and may be on legal parity with general obligation bonds; Financial performance - in terms of whether the budget is truly balanced; and Management - key assumptions used, strategies to control costs, and degree of local control.

Pension obligation bonds (POBs) have reemerged as a funding strategy in the current very low interest rate environment. The primary motivations include interest rate arbitrage, short-term budget relief, and funding closed plans. We view POBs as a credit neutral at best, as the hardened liability reduces flexibility; budget risk arises from uncertain asset performance after debt issuance; and failure to keep up with contribution requirements turns POBs into deficit financing.

The rating on a POB issuer incorporates these varying--and often offsetting--contextual factors to assess the extent to which issuing POBs results in a net change to the issuer's risk profile. When POB proceeds add to a system's assets, they effectively replace one long-term liability with another and, thus, have no net impact on the total liability burden. However, if proceeds are used to offset actuarial contributions made from budget resources, or not made at all, we view the POB to be a deficit financing. MTAM also assesses the repayment profile of the POBs compared with the pension contributions being replaced, and the issuer's track record of making full actuarial contributions.

In our view, unsustainable pension commitments pose a much greater risk to credit quality than issuing POBs given the nature of the benefit obligation as an annuity with a high fixed rate of return. Whether issuers fund their pension liabilities through cash contributions or POB proceeds is less relevant to credit quality than whether those issuers are willing and able to correct underlying pension sustainability challenges through reform.

Conclusion

Pension obligation bonds, which some issuers have pursued in response to weak funded ratios, are likely to have a neutral to negative impact on the issuer's credit quality. Issuing POBs may affect the issuer's overall liability burden and financial flexibility, and always adds investment risk. Likewise, the issuer's underlying pension situation before and after POB issuance are important considerations when assessing the credit impact of POBs.

There are some good reasons a government might choose to issue pension obligation bonds, but perhaps the best one is to create a visible and fixed repayment plan to tackle the unfunded pension liability dilemma that is stealthily growing underneath the budget table of many state and local governments.

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1st Quarter 2015 Review and Outlook

Monday, March 30, 2015

For the three-month period ending March 31, 2015, most investors experienced positive returns on their tax-free bond portfolios. These returns should be viewed in an even more positive light given the unexpected surge in municipal bond supply during the same period. The bulk of the surge in issuance came from issuers refinancing their outstanding debt (much like a homeowner would a mortgage) as global economic weakness emerged, and interest rates generally were biased lower around the world with a few exceptions.

Fissures emerged during the quarter in "quality" spreads of various municipal issuers faced with substantial pension deficits. Rating agencies seemingly caught napping when it came to problems in Puerto Rico and Detroit have in some cases overcompensated and punished other high profile issuers with rapid downgrades of their bond ratings. While it is clear to us that some of the punishing downgrades were justified, it is our view that some were not. Opportunities in the investing world only become apparent to many in retrospect. The municipal bond market is a much more complicated beast today, and as such should only be ventured into with qualified professional assistance.

The almost daily commentary from various Federal Reserve officials about "normalization" and the appropriate time for "lift off" has seemingly fallen on deaf ears in the bond market. While it is undeniable that employment gains have been strong in the United States, just about every other measure of economic strength has consistently fallen short of expectations. Look no further than the outsized appreciation of the U.S. dollar as reason for the economic softness, and one could clearly see why the bond market does not fear the Federal Reserve. America is clearly losing the "currency war" that just about every major central bank in the world is engaged in. Should the Federal Reserve actually tighten monetary policy in the coming months, be prepared for a very unexpected result in the bond market. Specifically, you may witness key areas of the yield curve rally (higher prices and lower yields).

The true value of owning a separately managed tax-free bond portfolio should emerge in the months ahead as volatility is likely to pick up as "normalization" approaches. This particular vehicle puts the owner in control of the overall portfolio, unlike a bond fund or ETF, which will get whipped around as investors redeem shares (often at the lows of the market). A well-diversified "SMA" can act as a vehicle for intelligent investors to deploy cash opportunistically into the municipal market as others are searching for the exits. The coming months will reward those investors who have "strong hands" not "weak knees."

Moving forward, it is our view that the coming months will be volatile and uncomfortable for many as bond evaluations begin to move. We think the best plan of action would be to add cash to your tax-free bond portfolios as prices decline. We strongly suspect that, given economic weakness both here and abroad, investors should be prepared for a "boomerang" bond market.

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
www.millertabakam.com

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The Impact of the Supreme Court's Decision on Obamacare

Friday, March 6, 2015

U.S. states and hospitals face high stakes as the Supreme Court hears arguments to decide the fate of Obamacare's subsidies that help people buy health coverage. The case, King v. Burwell, challenges federal subsidies in states that did not create their own health insurance marketplaces. The justices may not issue a decision until late June.

The subsidies provided to individuals are a key part of the Obamacare framework to increase health insurance coverage across the U.S. State governments have unevenly embraced Obamacare to date. Many have opted not to expand Medicaid to extend coverage to low income residents as allowed under the law, and many turned the health insurance exchange creation over to the federal government.

The Affordable Care Act will hand out $22 billion in credits to help people buy insurance this year, according to the Congressional Budget Office. So far, 11.4 million Americans have signed up for 2015 coverage, giving insurers and hospitals more paying customers, and cutting the number who show up in the emergency room to get care without paying.

A Supreme Court ruling stopping Obamacare subsidies in three-quarters of the U.S. would place immediate pressure on governors who have kept the health law at arm's length. Only 16 states built the online and telephone services called exchanges; the rest use the federal healthcare.gov system. As many as 87 percent of Obamacare customers get the subsidies. A ruling that ends them in 34 states would dramatically raise insurance premiums for an estimated 7.5 million Americans. Many would drop their insurance plans, and when they got sick, they would still go to the hospital, bringing back charity care. Without insurance subsidies, adjusted earnings growth across the hospital sector would slow in 2016, to 4 percent from 7 percent. A group of Republican senators has proposed providing subsidies for a transitional period, which could limit the initial impact on hospitals.

Congress is torn by dissent over the health law, making it unlikely to come up with a fix. The Obama administration says it can do little. That leaves governors and legislatures as the most equipped to solve the problem, either by working with the president or with other states. Since many are Republican, they will have to weigh the consequences of letting constituents lose healthcare coverage or finding a way to keep them insured under a program their party has opposed.

While governors and legislatures could build their own exchanges, that seems unlikely, given the timing: a court decision in late June would leave little more than three months before consumers begin signing up for 2016 coverage. Instead, two shortcuts are possible. The Obama administration could vastly simplify its rules for state-run exchanges. In the most permissive scenario, one that would test the boundaries of the law, states might be allowed to pass legislation or issue an executive order declaring that they have established their own insurance marketplace -- and that the healthcare.gov system runs it for them.

The Health and Human Services Department already allows Oregon, Nevada, and New Mexico to use healthcare.gov while designating the exchange as "state-based," because all three passed laws establishing one. New Mexico never built its own marketplace, while the other two states shut down theirs after technical difficulties in 2014.

Another option, one that may be more palatable to Republican leaders, is to join with states that already run their own exchanges. The Affordable Care Act authorized regional exchanges, although none have been formed. For any state run by Republicans, the greatest hurdle will be politics. In Georgia, for example, almost half a million people likely face premium increases if the court eliminates subsidies. Yet the legislature last year forbade the state from creating its own exchange. This could change if large numbers of people start to lose their health insurance.

Conclusion

As the Supreme Court of the United States hears oral arguments on King v. Burwell, the U.S. state sector confronts yet another uncertainty that has economic, public policy, and most importantly from a credit standpoint, possible budget implications. Given that economic and revenue recovery have been uneven, and reserve funds have not been restored in many states, potential economic and budget implications of this ruling could prove challenging.

A state's willingness and ability to change policy direction, as well as the administrative and cost issues associated with transitioning to a state exchange, would be the immediate issue at hand for states to consider. The magnitude of the issue is highlighted by the Kaiser Family Foundation, which indicates that with the subsidies eliminated, those who had been receiving them would face an increase in their out-of-pocket premiums averaging 256 percent. The outcome of this ruling has the potential to reverse the declining trend we have observed in the rates of the uninsured across the U.S., and may have broad implications for future health policy.

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After the Labor Slowdown: West Coast Ports are Challenged, but Remain Very Competitive

Tuesday, March 3, 2015

The West Coast ports of the U.S. returned to full operations last weekend after the Pacific Maritime Association, which represents management, and the 20,000-member International Longshore and Warehouse Union reached a tentative deal last Friday on a five-year contract, ending nine months of negotiations. It will take six to eight weeks to relieve cargo congestion at the 29 ports from San Diego to Bellingham, Washington, where productivity had been reduced by as much as half since November.

U.S. Labor Secretary Tom Perez brokered a compromise on the issue of whether the union could fire arbitrators in workplace disputes, which had held up settlement on a contract after the sides agreed on other terms. Instead of a single arbitrator, a panel now will hear grievances. This follows months of work slowdowns by dockworkers, as well as evening and weekend lockouts by terminal operators, resulting in considerable congestion and delays for shippers utilizing west coast ports for import and export cargo. The agreement must still be approved by ILWU rank and file members, a process which may take several weeks; the cargo backlog has yet to be cleared. Retailers are trying to get merchandise to stores. The labor dispute may cost retailers an estimated $7 billion, mostly because of lost sales and higher shipping cost.

West Coast ports are responsible for more than 43% of U.S. trade, according to the Pacific Maritime Association, and 12.5% of the U.S. gross domestic product. A closing would have cost the U.S. economy as much as $2 billion a day, the association said, citing figures from a 2002 lockout that lasted 10 days and cost $1 billion a day.

MTAM views the resolution and five-year labor agreement as removing a potentially negative development for port credits, as recent slowdowns and cargo diversions at many west coast ports have underscored the importance of stable working conditions and dependable scheduling for shippers. In recent months, many shippers had diverted cargo to Canada, Mexico, or the East Coast; shippers also added whole vessels coming through the Suez Canal, and loaded additional containers on existing ships transiting the Panama Canal, in a move to avoid costly delays moving goods through the west coast.

The protracted delays began to make their way into the operating results for several west coast ports, many of which rely on the container segment of cargo. The three most dominant ports by volume, the Port of Los Angeles, Port of Long Beach, and Port of Seattle/Tacoma, are reporting measurable year-over-year drops in total volumes of 29%, 18% and 13% respectively. It is expected to take months for the backlog to be fully cleared and operations to return to normal levels. As a result, and given the duration of the slowdown, MTAM expects to see some negative impact to fiscal 2015 throughput levels even while national GDP is trending positive.

The major west coast ports are amongst the highest rated in the sector. In our view, the leading west coast ports are collectively critical to maritime trade, and their strong market position protects them sufficiently to be relatively resilient to the interruptions from a financial/credit perspective in the near-to-medium term.

Should the slowdown drive volume decreases at secondary or smaller, niche ports, rating maintenance may be more at risk. However, we note that smaller secondary ports may also see upsides, as during past slowdowns some shippers who diverted services to such ports to avoid delays affecting larger west coast ports have ultimately stayed on and established regular service with the port.

Longer term, the question becomes one of ports' ability to guarantee reliability to shippers as well as the inherent risk of labor peace when contract renewals are coming due. As many in industry have noted, reliability is the 'currency' of the shipping business. Continued and frequent labor troubles (such as the recent backlogs; slowdowns in LA and Long Beach during clerical worker contract negotiations in 2012; and the 10-day lockout that occurred during the general ILWU contract negotiation in 2002) all serve to devalue this currency, eroding shippers' confidence in port reliability.

With each labor event, some diverted cargo has not returned, and this seems to be the case for some west coast ports coming out of this most recent contract negotiation. Discretionary cargo is the most at risk for permanent diversion. We expect cargos destined for and shipped out of local markets to continue to use their local west coast port, as is the case with 50% of cargo in the ports of Los Angeles and Long Beach.

Even before backups snarled cargo and ships in Los Angeles, Long Beach, Oakland, Seattle and Tacoma, the West Coast ports were losing market share. The facilities handled 43.5% of U.S. imports in 2013, down from 48.6% five years earlier, according to the Pacific Maritime Association. Larger cargo ships, a shortage of truck chassis used to transport containers from vessels, and limited rail capacity all strained the ports last year. Cargo shipments to and from Long Beach dropped 7.4% in December from the corresponding month at the end of 2013, while Los Angeles lost 1.2%. A rival port, in Savannah, Georgia, gained 19% while Houston rose 7.8%.

The labor battle accelerated a slide in market share for the ports of Los Angeles and Long Beach, and was endangering their plans to issue bonds to finance $5 billion in improvements. The two largest U.S. ports by container volume, with $2.1 billion in bonds, planned to issue a combined $315 million this year. If labor slowdowns and bottlenecks continued to send cargo elsewhere, they would have had to scale back their capital projects -- and with that, their borrowing.

With congestion leaving as many as 33 cargo ships waiting in the harbor and cargo containers stacked on docks, customers were turning to air deliveries or rerouting ships to the U.S. East and Gulf coasts and Canada. A project to widen the Panama Canal is intensifying the competition; this widening of the Western Hemisphere's busiest ship channel by 2016 to create a new lane of traffic, would help the world's largest cargo ships bypass the West Coast. The Southern California ports rely on rising volumes to finance measures such as dredging harbors, automating ship terminals, and replacing a 47-year-old bridge.

Conclusion

For West Coast ports, the risk is that the temporary measures to bypass congested shipping hubs may become permanent. When that happens, investors may reevaluate their holdings in the ports. MTAM is not recommending selling bonds issued by West Coast ports, although we are monitoring the long-term situation with the expansion of the Panama Canal and the potential for East Coast ports to be more viable as a result.

The two busiest U.S. seaports are facing their largest backlog of ships in more than a decade, even with hundreds of dock employees returning to work after their union reached a tentative labor contract. Cargo backups and delays continue to challenge the neighboring ports of Los Angeles and Long Beach, which together handle 43% of U.S. imports and 27% of exports. The backlogs may take as long as three months to untangle at the Los Angeles port. The mayors of Los Angeles and Long Beach expressed concern about losing business to other ports over the long term because of congestion and the possibility of another labor flare-up.

West Coast ports might continue to lose market share to rivals in Canada and on the East and Gulf coasts, though they have built-in advantages. The Southern California ports rarely experience bad weather of the magnitude of snowstorms on the East Coast and hurricanes in the Gulf, and Eastern ports have their own labor issues. The infrastructure that the West Coast ports have relative to the East Coast ports still provide a strong vehicle for them to remain competitive. Also, Los Angeles and Long Beach are deepening harbors and taking other measures to accommodate the largest container ships, which many ports cannot handle.

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Qualified Public Infrastructure Bonds: A Public-Private Partnership Proposal

Friday, January 23, 2015

President Obama is proposing a new class of municipal bonds to spur public-private partnerships in U.S. infrastructure projects. The program, called Qualified Public Infrastructure Bonds, would not expire, and there would be no cap on issuance. The debt also would not be subject to the Alternative Minimum Tax, which limits the tax benefits and exemptions that high-earning individuals can claim to reduce their levies.

"QPIBs will extend the benefits of municipal bonds to public-private partnerships, like partnerships that involve long-term leasing and management contracts, lowering the cost of borrowing and attracting new capital," the administration said in a statement released last week. The bonds will serve "as a permanent lower cost financing tool to increase private participation in building our nation's public infrastructure."

The proposal for a new type of security in the $3.7 trillion municipal market is part of a broader White House plan calling for more investment in roads, bridges, and other infrastructure in advance of the administration's budget proposal that will be released February 2nd.

The market contracted in 2014 for an unprecedented fourth straight year as local officials refrained from borrowing even as tax-exempt interest rates were close to generational lows. The last time the market expanded was in 2010, the final year of the federal Build America Bonds program. That program provided municipalities a subsidy on interest costs for issuing taxable debt to finance infrastructure work.

America's federal, state and local governments need to spend $3.6 trillion through 2020 to put the nation's critical systems in adequate condition, according to a 2013 report from the American Society of Civil Engineers. Without higher spending, the group projects the costs of travel delays, power and water outages will reach $1.8 trillion by 2020.

MTAM believes QPIBs could benefit capital financing of infrastructure projects by providing a cost-effective vehicle to move a diverse range of projects forward. But there is a cost associated with it, and as a result extensive deliberation in Congress is likely. In addition, a rise in debt issuance would increase the leverage of some issuers. Issuers could face downward rating pressure if they are unable or unwilling to maintain margins and liquidity levels. QPIBs would definitely provide a spark to start-up projects, advancing projects that might not have gotten off the ground otherwise. For these projects the rating outcome will ultimately be determined by an assessment of the project's construction risk and the financial resources and contingencies available to the project in case it deviates unfavorably from forecast.

But for now, the big question is: will it be approved? We have previously noted that interest in the public-private ("P3") approach is growing, and many states are developing programs that combine public ownership with private sector management and operations expertise. The financing structures can be complex and generally have not benefited from tax-exemption, but states and other municipal market issuers have found them to be an attractive alternative to deliver large-scale infrastructure projects. If the financing becomes more cost-effective, we expect that interest could grow. Currently, 33 states have authorized P3s and many projects have been financed or are in the planning stages. The projects have primarily focused on transportation, such as roads, toll lanes, and transit projects. However, the Long Beach Courthouse in California is an example of a social infrastructure P3 project, and other states with active transportation P3 projects are also considering approving legislation allowing social infrastructure P3s. We have also started to see interest at the local level.

There are currently Private Activity Bonds (PABs) (a $10 billion market) available to augment private investment projects, but their scope has been limited in terms of eligible projects and the amount available is capped. Under the White House proposal, QPIBs will expand the scope of PABs to include financing for airports, ports, mass transit, solid waste disposal, sewer, and water, as well as for more surface transportation projects. Unlike PABs, the QPIB bond program will have no expiration date, no issuance caps, and interest on these bonds will not be subject to the Alternative Minimum Tax. The QPIBs are not expected to be available for privately-owned facilities or privatizations of public facilities. As a result, they would be particularly beneficial for governmentally-owned projects that have long-term leases or concessions with private parties.

Infrastructure needs in the U.S. are very high, and a failure to meet those needs could limit a government's economic competitiveness. Investment has been restrained at the state level and for other municipal issuers, as evidenced by lower debt issuance over the past several years. In addition, pay-as-you-go contributions have been restrained by a wide range of other cost pressures and because less revenue was available following the Great Recession and the slower than average recovery.

President Obama also introduced other proposals, such as the creation of a new Water Finance Center to help state and local governments leverage federal grants to attract private investors in water and sewer projects, in a package of infrastructure initiatives. The new Water Finance Center would be created within the Environmental Protection Agency. The Center will increase innovative financing support for communities to sustain their water, wastewater, and stormwater infrastructure. This Center is part of the President's Build America Investment Initiative - a government-wide effort to increase infrastructure investment and promote economic growth by creating opportunities for state and local governments and the private sector to collaborate, expand public-private partnerships, and increase the use of federal credit programs.

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Municipal Bond Market – Credit Outlook for 2015

Monday, January 5, 2015

Municipal bond issuers will continue to face several credit challenges in 2015, but MTAM expects that the vast majority of municipalities will successfully manage through most difficulties with a combination of spending cuts and revenue enhancement plans.

Despite the challenges facing municipal bond issuers, there are always good opportunities, even for the very conservative investor. Given our expectations for steady levels of economic growth, we would expect defensive credits like water and sewer bonds, special tax bonds, and public power bonds to perform better from a fundamental perspective. These types of bonds tend to have revenue streams that are less subject to economic volatility, have strong covenants, or are tied to an "essential service", making debt service payment more certain. In addition, there is legal precedence that bonds backed by a dedicated revenue stream may be protected in the case of a municipal bankruptcy. We prefer bonds that have a clean flow of funds, broad revenue streams, and high debt service coverage tests.

State Governments

The 2015 outlook for U.S. states remains stable as a strengthening U.S. economy supports state revenue growth. MTAM expects state tax revenue growth in 2015 to rise faster than in 2014, but remain within a 5 percent - 6 percent range, which is moderate for the sector and consistent with the long-term average. There will be significant regional variations, however.

Risks to state revenue growth include anti-tax sentiment prevailing and the volatility of the stock market. With personal income taxes making up about 40 percent of state revenues, and with taxes from high wealth individuals contributing a disproportionately large share, revenues tend to rise and fall with the stock market.

Pressures on the budget side include Medicaid, pensions, K-12 education, and deferred infrastructure improvements and maintenance. Expected increases in Medicaid costs and growing pension expenses have constrained the ability of states to increase other areas of spending.

After experiencing 17 consecutive quarters of tax revenue growth, state revenues were essentially flat in the first half of 2014, reflecting the reversal of the 2012 income acceleration effect. For the current fiscal year, most states are assuming growth in line with baseline trends.

Revenue forecasting is increasingly challenging due to increased volatility in state revenue results, including from capital gains. One-time events make it difficult to identify baseline revenue growth levels, a problem exacerbated by unpredictability in stock market and commodity price performance.

As revenues recover, state budget managers, who face demands for additional spending and tax relief, have remained cautious. With the majority of gubernatorial incumbents re-elected, this approach will likely continue despite persistent pressures.

Medicaid has been the area of state budgets most challenging to control. We expect Medicaid to continue to be the biggest area of focus for state budget managers in 2015. Given the dominance of Medicaid in federal funding flows to the states, any material reduction in federal support for the program could be negative for state credit, particularly in the absence of related mandate relief.

Local Governments

The 2015 outlook for U.S. local governments remains stable as property tax revenues slowly recover. Property taxes, the majority of local government revenues, have returned to a slow but steady growth trajectory as housing markets stabilize and governments are generally willing to use their property tax authority.

MTAM expects property taxes to grow at 2 percent - 3 percent for the next several years. Property tax caps, anti-tax sentiment, and the unevenness of the housing recovery are checks on this growth, which is significantly below the 6 percent range that it was before the economic downturn. In general, impending cost pressures will make it difficult for some local governments to balance their budgets.

Fixed costs such as pensions and retiree health benefits are likely to consume an increasing share of budgets, presenting dilemmas about whether to cut costs, increase property tax revenue, or tap into reserves.

MTAM believes that few local governments are still struggling to reduce spending to compensate for a combination of weak revenue performance and pension payment increases. Now the challenge is long-been-postponed spending, including wage increases, service restoration, and infrastructure and facility maintenance needs. We believe this will continue in 2015, but is a much more manageable challenge than the heavy cuts required during the downturn. There will likely be instances of spending growth overtaking revenue increases, but we expect structural balance to prevail. Most local governments have been able to preserve or restore reserves to prudent levels that would provide a cushion if an unexpected downturn occurred.

We believe there is a shifting focus by management and the public to the total cost of labor, including benefits and post-employment compensation. Momentum to curb increases in these aggregate costs appears to be continuing slowly even though the economic picture is no longer stressed.

We anticipate a moderate increase in local government debt issuance to address capital needs. While the increase is not anticipated to be significant, the debt instruments used may continue the recent shift to products with less transparency. The increased use of direct loans rather than public debt offerings may be advantageous to issuers, but can potentially reduce the level of information available to an entity's other creditors.

Both the Detroit and Stockton bankruptcy plans were deemed fair and equitable by the judges despite disparate treatment of creditors. Most notably, existing pension plan participants received little, in Detroit, or no, in Stockton, impairment. Both judges ruled that pension payments could be impaired in bankruptcy, but agreed with the importance of attracting and retaining qualified employees. Both concluded that providing pension benefits at current or near-current levels is essential to this goal. MTAM believes this may have ramifications for the priority of payments to creditors in other distressed municipalities. A plan of adjustment for San Bernardino is expected by mid-2015.

Not-for-Profit Hospitals

The outlook for the U.S. not-for-profit healthcare industry in 2015 remains negative as financial and business fundamentals will remain weak over the next 12-18 months. Growth in operating cash flow will be weak, operating margins will continue to narrow, and revenue growth will remain limited. The negative outlook also reflects the on-going uncertainties surrounding the continued implementation and legality of the Affordable Care Act (ACA) and the movement towards value-based payment models.

MTAM projects revenue growth for the industry will be low, but steady, at 3.5 percent - 4.5 percent over the next several years. We are forecasting median operating cash flow growth will range from -0.5 percent to +1.5 percent. We expect the largest hospital systems -- those with annual revenues above $2 billion -- to achieve growth of 3 percent - 4 percent, while most hospitals with revenues under $1 billion will likely generate negative operating cash flow growth.

The largest hospitals are getting stronger, while the smaller hospitals get weaker. The largest hospitals have long generated stronger operating margins and revenue growth owing to factors such as their economies of scale and ability to drive revenue growth through expanded services.

In all, MTAM expects the operating cash flows of a majority of hospitals to decline year over year, but for cash flow for the industry in aggregate to grow slightly. The industry should settle into a period of very low, but stable growth that ultimately could lead us to change our outlook to stable.

Operating margins will weaken further in 2015, as hospitals run out of ways to protect their margins and grapple with operating under two very different reimbursement models--the traditional fee-for-service model versus emerging models that emphasize preventive care and avoiding hospital stays, such as those that are part of the ACA. Further movement into high deductible health plans by employers, and better clinical outcomes is likely to further pressure inpatient volumes and profitability in 2015.

To date the impact of the ACA on hospital financial performance has been uneven, with differences slowly emerging between states that expanded Medicaid eligibility under the ACA and those that did not. In those states that expanded eligibility, the ACA's primary impact has been to reduce the level of uncompensated care provided by hospitals and increase their Medicaid exposure. We note that bad debt has declined significantly among the states that expanded Medicaid, with median bad debt down 5.6 percent through 2014. For states that did not expand Medicaid eligibility, bad debt grew 6.8 percent.

Despite challenges the sector faces, 2015 ratings are expected to be stable reflecting the ability of hospital and health systems to maintain adequate profitability despite continued pressure on reimbursement, softening inpatient volumes, and on-going challenges to the validity and legality of key provisions of the ACA.

The results of the November 2014 mid-term elections which gave control of both the houses of Congress to Republican majorities is likely to raise the level of uncertainty about continued implementation of ACA. While Republican attempts to repeal or defund key parts of the legislation are likely to meet a Presidential veto, it will further complicate raise the level of uncertainty and making strategic planning more difficult for hospitals and health systems.

A Supreme Court ruling against the federally created state exchanges in 'King vs. Burwell' would further challenge hospital and health systems, particularly in the states that did not expand Medicaid.

The hospital sector has navigated many challenging environments in the recent past, but the upcoming years represent a true transition as the core model of healthcare delivery and reimbursement is undergoing redesign. With a multitude of changes that require strategic navigation, management strategy, oversight and decision making capabilities will more highly influence individual facility/system financial performance.

Overall spending on healthcare should rise in the coming years as the overall economy has become more robust, Medicaid spending increases, and certain procedures delayed due to costs are addressed. We believe the impact of this growth will be beneficial to the nonprofit hospital sector. However, continued migration toward high-deductible health plans is likely to inhibit the rate of spending growth and increase bad debt expense.

The Centers for Medicare and Medicaid Services (CMS) reported that total healthcare spending rose by 3.6 percent in 2013. This marked the fifth straight year of increases below 5 percent. The rate of health spending grew by 3.9 percent annually from 2009 to 2011, compared with an annual growth rate of between 4.7 percent and 6.6 percent the prior three years.

One of the main drivers of this year's increased healthcare spending is the expansion of Medicaid coverage. The Congressional Budget Office projects total Medicaid payments will rise from approximately $300 billion in 2014 to $368 billion in 2016. This benefit will accrue to hospitals and healthcare systems operating in states that expanded Medicaid coverage under the Patient Protection and ACA, while providers in states that did not will not benefit.

Transportation

The 2015 outlook for airports, ports, and toll roads is positive. A solid rate of economic growth as well as recent decline in oil prices may spur traffic and volume growth in 2015.

In the past, fuel volatility was a credit concern, resulting in volume performance deviating from normal expectations. With lower fuel prices, airlines and shippers may see cost structure benefits allowing for more services on a system-wide basis. For toll roads, sustained lower gas prices may support a change in driver behavior leading to additional trips.

MTAM expects 2.5 percent - 3.0 percent passenger growth at U.S. airports in 2015 with international traffic growth leading. Major market airports are expected to continue to lead, with performance at smaller airports and secondary hubs likely to again lag. In recent years, the airlines have been concentrating service in the larger, more profitable markets at the expense of small- and medium-sized markets.

More seat capacity on U.S. airlines, combined with growth in the U.S. economy, will push growth in enplanements in 2015. Enplanements, or the number of passengers using an airport to depart on a flight, is a key driver of the airport sector because growth in this number usually translates into more parking and concession fees, approximately half of airport revenue. We expect there will be moderate growth at the large U.S. carriers, while smaller airlines like JetBlue, Alaska Airlines, and Spirit Airlines will be adding significant capacity. Overall, seat capacity on U.S. airlines is expected to rise 3 percent - 4 percent next year.

Growth in the U.S. economy will support demand for U.S. travel. However, foreign travel to the U.S. faces pressure because of a stronger dollar and slower economic growth in Europe and Latin America. For example, enplanement growth at Miami International Airport, a major hub for Latin America, stalled in 2014.

For most airports, the higher-than-expected enplanement growth and resulting stronger-than-expected financial performance in 2014 should provide a financial cushion against downside risks.

We expect modest improvements in U.S. port throughput and revenues, in line with U.S. GDP growth expectations of at least 3.0 percent in 2015. Labor relations and congestion at U.S. ports have caused disruption during the second half of 2014. Though unlikely given operational implications, sustained unpredictability may result in permanent shifts in volumes.

Our positive outlook is based on the view that the continuing recovery in U.S. container-volume growth is sustainable and that business conditions for global shipping lines, which drive cargo volume, have stabilized. We expect U.S. container volumes to rise 2 percent - 3 percent in 2015, tracking growth in the U.S. economy. The slow but steady recovery in container volumes will enter its fifth consecutive year in 2015, after declines during the recession. Container growth supports port credit strength by increasing the revenues from the volume-based fees the ports charge shipping lines.

Meanwhile, business conditions for the global shipping lines, the ports' largest customers, have stabilized, and growth in shipping capacity will drop in 2016, which will help support prices. Cost reductions will help drive EBITDA growth for shipping lines in 2015. Since the shipping lines ultimately drive port cargo and revenues, we expect less pressure on shipping lines will translate into less pressure on the ports.

Beyond 2015, MTAM expects the gap between winners and losers among the U.S. ports to widen and for the cargo competition to accelerate. Shipping container volumes will shift away from ports unable to accept larger vessels or that are disadvantaged in their locations. We do not expect the expanded Panama Canal, scheduled to open in 2015, to cause a major shift in cargo routes. Manufacturers will continue to ship higher-value, time sensitive cargo from Asia destined for the U.S. using the current, faster route through the West Coast ports.

Continued traffic growth, rising toll revenue, and lower gasoline prices extends our positive outlook in 2015 for the U.S. toll road industry.

The recovery in traffic growth will continue in 2015, growing 1 percent - 2 percent on a median basis. The strengthening U.S. economy is also a factor in our outlook, as traffic growth largely parallels economic gains. Growing traffic translates to higher toll road revenues and financial metrics.

Lower gasoline prices will also contribute to the recovery, increasing leisure travel. The drop in gas prices could also lead drivers to use less-congested toll roads that provide faster and more predictable trip times, especially in urban areas.

In addition to lower gas prices, increases in toll rates will also support growth, leading to a 3 percent - 5 percent increase in median toll revenue in 2015. Moreover, many toll roads have recently implemented inflation-indexed or multi-year toll increases, which smooths out revenue growth and makes it more predictable.

However, increasing leverage remains a risk in the sector as some state and local governments subsidize their capital and operating needs with excess cash flow from toll roads. States also have used debt to finance and maintain toll roads. Ultimately states could increasingly turn to public-private partnerships (P3s) to alleviate some of the financing pressures, if they authorize the use of P3s for transportation projects.

Although the outlook is stable, the lack of a long-term federal transportation solution remains a concern for grant anticipation revenue vehicles (GARVEEs). Continued imbalance between federal highway trust fund outlays and receipts goes unaddressed.

Water and Sewer

Drought, tightening regulations, and deferred maintenance pose some concern, but our outlook for the water and sewer sector is stable based on the sector's essential services and monopolistic business nature. While some utilities in drought-affected regions, particularly California, may see revenues squeezed from lower sales, the improving U.S. economic climate should bolster overall demand and help offset rate hikes for customers. In addition, concerns over local government support have waned, with many municipalities seeing improvements in property, sales, and income tax receipts.

More stringent environmental regulations may increase costs, albeit incrementally, for water utilities and contribute to an expected rise in their debt ratios by 3.0 percent - 4.0 percent as the EPA phases in new requirements. In particular, the EPA's focus on nutrient pollution will influence utility capital budgets along with the need to fix infrastructure that is near or past its useful life.

While many utilities in California and the southwest U.S. will continue to grapple with the effects of severe drought, which has been a major focus over the past four years, significant renewal and replacement needs is the biggest challenge facing the sector over the immediate horizon.

Utility charges will likely have to escalate at a faster pace than currently forecast to fix aging facilities. The sector's near-term financial results continue to be positive but medium- and longer-term capital needs may ultimately erode utility bottom lines.

Public Power

The outlook for U.S. public power electric utilities will remain stable as measures of debt service coverage and liquidity in 2015 should be similar to those in 2014. The main reason for our stable outlook is public power electric utilities' unregulated ability to establish electricity rates.

Improvement in the U.S. economy in 2015 will also help utilities maintain their credit metrics because any required changes in rates are likely to meet more tolerance. We expect the median fixed-charge coverage ratio for rated U.S. public power electricity generators will hold steady at about 1.6x and that median days cash on hand will remain at 174 days, roughly in line what they have been in 2014.

As for levels of debt, projected lower demand for electricity implies that utilities will be borrowing less in order to build new capacity, so leverage is unlikely to significantly increase in 2015. Environmental compliance and systems reliability projects will remain a major focus of new capital improvement programs.

Uncertainty over the ability of public power electric utilities to comply with proposed federal carbon rules are an evolving, long-term risk to the outlook.

Colleges and Universities

The outlook for four-year U.S. colleges and universities in 2015 remains negative, as is it is for community colleges that issue revenue bonds. Among the four-year colleges, a major pressure will be slow growth in tuition revenue, while declining enrollment is driving the negative outlook among community colleges.

For the four-year colleges, net tuition revenue growth in 2015 will be the weakest in over a decade. The low revenue growth coupled with mounting expenses will contribute to weaker operating performance. However, against the backdrop of challenging business conditions, there are signs of emerging stability, including overall strong student demand and balance-sheet strengthening. But because most colleges rely heavily on student charges, net tuition growth matching the pace of industry inflation would be necessary for a stable outlook.

Heavily tuition-dependent private colleges and universities with weaker market positions and regional draws will be increasingly challenged because of the restricted revenue growth. In contrast, the elite and wealthy private colleges and universities will outperform the rest of the higher education sector over the next 12--18 months, given more diverse revenues and business models linked to philanthropic support.

Research funding for universities will decline on an inflation-adjusted basis as a result of federal budget pressures. At the same time, most universities with academic medical centers are benefiting from the relationships with their hospitals as their performance shows sustained improvement.

In 2015, we expect state funding for public universities to grow, based on initial state budget proposals. However, state appropriations per student will remain below what they have been historically, and higher education funding will continue to compete against other state priorities.

Among the community colleges that issue revenue bonds, net tuition per student will grow at less than 3 percent in 2015 and 2016. State funding, on the other hand, will grow moderately, given political support for these institutions that match important state policy objectives.

Attempts to grow tuition revenue in the higher education sector may be hampered by the continued scrutiny of growing student loan debt. The Treasury Borrowing Advisory Committee looked at the student loan market and noted that student loan balances have increased from $1.0 trillion at year-end 2011 to $1.3 trillion in the second quarter of 2014. With over 85 percent of student debt backed by the Federal government, there will likely be greater Federal focus on this topic in 2015.

Private student loan (PSL) defaults dropped below 2.5 percent for the first time since 2006 and are expected to remain at pre-recession levels. The default index fell to 2.4 percent in third-quarter 2014, continuing a two-and-a-half year decline. The 90-plus delinquency rate index remained at its historic low of 1.9 percent.

The improving economy and declining unemployment will be factors of the lower default rate, which should continue to decline to the pre-recession range of 2.0 percent - 2.5 percent year over year. The loans backing 2010-14 securitizations are to borrowers with considerably higher credit quality than those in prior deals. In addition, loans from the 2001-07 securitizations, which made up 64 percent of the securitizations in indices in third-quarter 2014, will continue to season past their peak default periods.

The increasing use of federal income-driven and PSL interest-only repayment plans has also contributed to the lower level of defaults. These plans have eased borrowers' monthly loan obligations and helped some of them avoid default.

Although the improving economy has led to a drop in unemployment, underemployment, higher student loan debt, and lower earnings than pre-recession among new graduates and high debt levels will continue to challenge borrowers.

Housing

In 2015, state housing finance authorities (SHFA) should expect sound financial ratios, deleveraging bond programs, equity building, and improved delinquencies. The main drivers for the 2015 stable outlook include the sound financial ratios driven by the deleveraging of bond programs causing increased equity and the utilization of alternative funding tools for new loan production to allow for continuous lending. We anticipate that this sound financial performance will continue through fiscal 2015.

SHFAs use flexible approaches to maintain continuous lending contributing to the bottom line, including a combination of alternative funding tools. SHFAs have also used savings from bond refundings to subsidize new loan origination.

With SHFAs no longer using mortgage revenue bond programs as their primary funding source, debt issuance has declined, balance sheets have shrunk, and equity has increased. SHFAs have also grown their equity positions by generating cash up-front through the sale of mortgage backed securities. Overall, increased equity creates flexibility within bond programs.

SHFAs are challenged by the failure of first time homebuyers to return to normal, historical levels of homeownership. This may impact the SHFA's ability to originate new long term assets to ensure SHFA growth, profitability, and sustainability.

Default Outlook

Municipal issuers are defaulting at the slowest pace since at least 2010 as a strengthening economy boosts local government finances. With the U.S. economy expanding the most in more than a decade, improved balance sheets for cities and counties are easing concerns of widespread failures and supporting an unprecedented rally in their debt.

Fifty-seven issuers defaulted for the first time this year as of December 30, compared with 69 in 2013 and 140 in 2010, according to Municipal Market Advisors. The number will probably remain in a similar range in 2015 as cost-cutting municipalities in the $3.7 trillion municipal market have proven resilient. For the vast majority of municipal credits, even a slow recovery is good enough.

Outliers include Detroit, which emerged from a record $18 billion bankruptcy this year, and Puerto Rico, whose electric utility is expected to restructure its debt. Most defaults are occurring in bonds issued for projects sensitive to the housing bust and recession, such as land deals and retirement homes. The municipal market may be nearing a baseline level of defaults as issuers skip payments thanks to intrinsically flawed projects rather than the economy.

Municipal issuers also took advantage of rates close to generational lows to refinance and improve their balance sheets. They slowed borrowing for capital expenses except for only the most important projects. As a result, the U.S. municipal bond market shrank by $30.3 billion during the third quarter, cutting debt to the least in five years, according to the Federal Reserve Board. While the U.S. economy has improved, municipalities still must adjust costs to account for lower revenue.

Conclusion

MTAM continues to recommend that investors select high quality municipal issuers that understand the new financial reality and have made or are making budget adjustments. Essential service revenue bonds without the budgetary concerns of state and local governments and limited payrolls can be attractive, but we stress that an essential service issuer cannot flourish if the underlying governmental entity is in dire economic circumstances. A healthy outlook holds for most infrastructure issuers due to fundamental strengths reflected in the provision of essential public services, adequate balance sheets, and generally sound governance and fiscal management practices. In the case of the enterprise sectors comprised of higher education, health, and housing, credit quality will be maintained primarily as a function of their ability to increase fees, control costs, and improve overall operating margins. Sound debt and fiscal management practices, preservation of adequate liquidity, and strong governance oversight will be significant determinants of credit quality for issuers during the coming period of financial adjustment.

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4th Quarter 2014 Review and Outlook

Tuesday, December 30, 2014

For the three-month period ending December 31, 2014, most investors in tax-free bonds experienced positive returns on their portfolios. As has been the case all year, investors who have focused their portfolios with municipal bonds maturing ten years or longer fared much better than those who purchased shorter maturity bonds. Generally speaking, quality spreads continued to tighten during the quarter as "A" rated bonds once again outperformed "AAA" rated debt. MTAM expects this particular trend to remain in place until economic activity in the United States turns negative—more on that topic later.

The municipal market matured in 2014, as it was able to isolate the negative headlines from Detroit and Puerto Rico from the rest of the market, which on balance improved in credit quality in 2014. While the market as a whole benefitted from "crossover" investors providing liquidity on distressed debt, it cannot be assumed that this will continue into 2015, especially if smaller issuers run into financial difficulty. The municipal bond market has thousands of distinctly different issuers that need constant monitoring by qualified professionals. We strongly encourage investors to ensure that their individual holdings of municipal bonds are actively monitored for financial stress that might be in the early stages of "bubbling up" to the surface.

The Global Bond Market is Beginning to Resemble a Checking Account

Anybody who has a checking account in this country knows just how awful these have become in terms of interest earned and hidden fees. The global bond market with its paltry yields (see Japanese government bonds or German Bunds) or the negative interest rates on some shorter-dated European sovereign debt has turned this trillion dollar market into nothing more than a checking account—money is moved with a fee and no real return is earned. The weak economic growth abroad is structural in nature, and as such, investors in U.S. debt need to adjust their expectations for income accordingly. The Federal Reserve is likely to continue down the road to "normalizing" interest rates in 2015. In our view, investors should not assume that negative returns in 2015 are a given, due to the prospect of an eventual tightening by the Federal Reserve. The combination of falling inflation globally and a tighter monetary policy here in the U.S. could "pancake" the domestic yield curve in a way that Aunt Jemima would be proud. Shorter-dated bond yields will likely inch higher in anticipation of a move higher in the Federal Funds Rate, while longer maturity debt will react in a much more muted way—if at all. By virtue of their public "jawboning," the Federal Reserve has now painted themselves into a corner, and therefore, they need to tighten—or their credibility within the financial markets will be lost. We remain concerned that the stronger U.S. Dollar will act as a catalyst to substantially weigh on domestic growth as 2015 progresses. Therefore, MTAM will be interested in deploying cash more aggressively as yields adjust higher, as we see a high probability that "what goes up must come down." The global bond market senses that the war on inflation has been won, while the Fed is still preparing for battle. A policy mistake is coming folks.

Moving forward, we will continue to focus on upgrading credit quality when possible, as we anticipate a "recession-like" environment to be prevalent in the United States by the end of 2015. Investors, in our view, should prepare for this environment in the coming weeks by focusing more on high-quality fixed-income and less on "risk" assets. Keep in mind what a tightening by the Federal Reserve sets out to accomplish—slower growth and lower inflation. Does the global economy need more of this?

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management

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Investor Lessons from the Detroit Bankruptcy Exit Plan

Wednesday, November 12, 2014

Detroit won approval of a debt-cutting plan that backers say will allow the one-time hub of the U.S. auto industry to exit its record $18 billion municipal bankruptcy and rebuild after decades of population decline and industrial decay. Saying the bankruptcy process is designed to help cities solve problems they "cannot solve by themselves," U.S. Bankruptcy Judge Steven Rhodes on November 7th approved the plan which does away with $7 billion in debt. In a ruling widely expected to inform future municipal bankruptcies, Rhodes praised the city's debt adjustment plan as reasonable, fair, and equitable, key benchmarks under federal bankruptcy law.

Detroit filed for creditor protection in July 2013, after Michigan passed laws permitting the appointment of an emergency financial manager to tackle its financial woes. The city has since looked for ways to pay for everything from new streetlights to ambulances, while cleaning up blighted neighborhoods in a community whose population has dropped to less than 700,000 from a peak of 1.85 million in the 1950s. Detroit has enlisted charities, creditors, and billionaires such as Quicken Loans Inc. founder Dan Gilbert to help rebuild the blighted city and sustain a beleaguered pension system.

In a 90-minute oral ruling last Friday, Judge Rhodes said Detroit's plan to shed $7 billion of debt and reinvest $1.7 billion into the city was fair and reasonable to creditors and feasible for the city to implement. Rhodes ruled after a two-month trial during which he heard from investment bankers, a court-appointed financial expert, the mayor, and city workers. Detroit's bankruptcy exit plan sets the city on a path to fiscal recovery. For the $3.7 trillion municipal bond market, its legacy may be the tarnishing of a pledge that bond investors have held sacrosanct for decades.

Investors have monitored the proceedings for signs of how different classes of bonds would fare in bankruptcy. Money managers say that with general obligation holders recouping 74 cents on the dollar or less, the agreement undermines a bedrock assumption: that even distressed cities will make good on debt backed by their full faith and credit. The shift means greater scrutiny of legal protections, particularly as a locality's finances deteriorate.

In Detroit, G.O.s took a haircut, and it was bigger than other parts of their cost structure, so they were effectively subordinated. Holders of unlimited-tax general obligations will get 74 percent of the $388 million they are owed, while limited-tax debt recovers 34 percent of $164 million. The losses overturn investors' assumption that issuers would raise taxes as high as needed to pay the unlimited general obligation debt.

However, the levels may not set a precedent for recovery in future cases because the figures emerged from settlements rather than a judge's ruling. The city's success in getting holders of debt tied to property taxes to agree to take less than they were due still alters the repayment equation for investors in lower-rated general obligations. The recovery values are not as high as they once were; that should factor into wider trading levels for general obligation bonds if they are at risk of any type of restructuring. Issuers tied to struggling cities may have to lure investors with stronger pledges, such as an additional dedicated revenue stream, to keep borrowing costs down.

The other threat to bondholders from Detroit's exit plan is how investors are treated relative to retirees. The judge found that protections state lawmakers had given to public worker pensions do not apply in bankruptcy because federal law trumps state law. Yet local leaders still fought for plans that favored employees over debt investors. A key settlement will bring in as much as $816 million from charitable foundations and the state to prop up retirement plans, including police and firefighters. The deal preserved all or most of city workers' pensions.

By contrast, some investors who settled hold $1 billion in debt issued by the city in 2006 to bolster its retirement system. Those securities will be canceled, and investors and the insurers that guaranteed the borrowing will get $141 million in new notes and land instead. The pension-debt holders, including hedge fund managers Aurelius Capital Management LP and and BlueMountain Capital Management LLC, had argued that because they are being paid less than retired city workers, the plan is unfair. As part of the settlements, they have withdrawn those objections.

The outcome of Detroit's high-profile bankruptcy highlights the growing tension between pension obligations and bond debt for distressed governments, while leaving a lack of legal clarity on the treatment of general obligation bonds. By reaching settlements with all of its major creditors, Detroit avoided any court battles and subsequent appeals, as well as setting any legal precedents. But for municipal bond investors, key lessons will be the city's successful move - supported by the State of Michigan and driven largely by political considerations - to elevate pension debt over bond debt. Bondholders clearly have to take away that in a case such as this, where there is municipal bond debt and pension liabilities both at stake, that bondholders in many cases are going to be junior to pensioners. The lesson is that politics trump law.

Two of the major ratings agencies offered divergent views of the ruling, with Moody's saying the debt plan is negative for holders of Michigan general obligation bonds, and Standard & Poor's saying the lack of legal precedent means the case will not affect its G.O. bond ratings.

Moody's claimed approval of the plan was negative for municipal investors because it reinforces favorable treatment of pension claims over other unsecured claims. Moody's said the Detroit case raised more questions than answers for investors, especially those who hold Michigan debt, and revealed their vulnerability in a bankruptcy court setting.

While acknowledging the favorable treatment of pension obligations over bond debt in Detroit, S&P claimed the lack of legal precedents and the small number of municipal bankruptcies make it difficult to generalize about the treatment of G.O. bonds in a Chapter 9. S&P said the most important outcome from Detroit's creditor settlements is the wide gap in treatment of pensions versus bonds, as well as the very different settlements for LTGO, ULTGO, and pension obligation bondholders.

Given the nature of a Chapter 9 bankruptcy, we expect that most municipal creditors will continue to settle, as was the case in Detroit, rather than risk a bankruptcy court decision. While a trend could be developing where local governments in bankruptcy favor bondholder haircuts rather than pension reductions, we believe that recent municipal bankruptcies remain too small a sample size on which to base widespread ratings changes.

Despite Rhodes' ruling that the plan presents a feasible path to long-term recovery, some experts warn that the depth of Detroit's challenges and the uncertainty of future population growth threaten the recovery. Although the roadmap is set out in the plan of adjustment, it will still likely be difficult for the city to continue making the kinds of changes that will lead to the cost savings it needs to be operationally balanced. We believe that achieving this is the only way that Detroit will be able to stay out of bankruptcy in the future. We note that Detroit's treatment of its G.O. holders could end up costing the city millions in increased borrowing costs over the years.

Conclusion

Generally, unlimited tax general obligations bonds are the most senior of a city's obligations, backed by the full faith and credit of the taxing power. Investors expect that, as usually provided in bond indentures, principal and interest on general obligation bonds will be paid before other expenses and that taxes will be increased to pay debt service if necessary. The treatment of those bonds by Judge Rhodes will impact how investors' view those types of securities issued by all Michigan municipalities and may have nationwide implications.

While Detroit raises important questions about the sanctity of the G.O. pledge, we recognize that G.O. bonds represent 35 percent of the municipal bonds issued over the past 10 years, so will be an important part of any diversified municipal portfolio.

By comparison, sales tax and water and sewer bonds together represent 11 percent of all issuance within the past 10 years. With this in mind, we would allocate G.O. exposure to credits in areas with strong fundamentals and growing tax receipts, while avoiding utility and special tax credits in weaker geographic areas.

MTAM considers this to be a landmark bankruptcy case given the paucity of such cases and the city's size and historical prominence in the U.S. economy. While MTAM believes that bankruptcies in the municipal sector will remain an uncommon event, we continue to take a very cautious view toward the riskier municipal sectors and smaller, weaker municipal issuers, and any issuers where the budgetary pressure become extreme. The professional investment team at MTAM, which is directly charged by our valued clients to preserve assets, employs continuous surveillance to ensure we avoid deteriorating credit situations.

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Lower Oil Prices and the Impact on the Top Energy-Producing States

Thursday, November 6, 2014

Oil has historically been a volatile commodity, with prices tied to the world economy. This led to a drastic decline in spot prices during the recent recession from $136 a barrel in early July 2008 to $40 a barrel in January 2009. Since then, prices have generally rebounded although they remain volatile with multiple peaks and troughs. Oil prices have fallen again in Q3 2014, although not nearly to the degree seen in the second half of 2008. After peaking at $105 in June, the price has since declined 24% to a low of $80 in October.

MTAM expects that lower oil prices will bring new fiscal pressures to the top energy-producing states, with Alaska registering the greatest exposure. As of last Friday, oil prices have been below $83 per barrel for three weeks. A significant drop in oil prices from last Friday's $81.12 per barrel of West Texas Intermediate would be a credit negative for some of the top oil-producing U.S. states, especially Alaska, which depends on oil tax revenues to fund virtually all of its operating budget.

Of the five states with budgets reliant on oil and gas revenues, Texas is by far the largest producer, with 3.1 million barrels per day of production in July. However, the state's reliance on those revenues is only 8% compared with Alaska's 89%. The Texas budget also has a more conservative projection of the price of benchmark crude at $82.18 per barrel, virtually on target as of the past two weeks. For 2015, the Texas budget assumes oil prices at $80.33 per barrel. Alaska, on the other hand, produces 422,000 barrels per day with prices forecast in its budget this year at $106.61 and $105.06 in 2015.

The budget of North Dakota, the second-largest producer behind Texas at 1.1 million barrels per day, brings in 6% of its revenue from oil and gas revenue, and uses an even more conservative price projection than Texas. North Dakota based its revenue projections on oil at $75 per barrel this year and $80 in 2015. Oklahoma's budget is 4% reliant on oil and gas tax revenue, while New Mexico has a 19% exposure.

Alaska and New Mexico both forecasted higher oil prices for their fiscal years ended June 30, 2014 and may need to make budgetary adjustments.

Lower oil prices over an extended period could derail efforts to explore and drill new wells in Alaska, which enacted tax incentives that took effect in January 2014 to spur output. The low prices also risk decreasing the allure of tight oil deposits, which require more costly extraction, in states such as North Dakota and Oklahoma. Some unconventional drilling operations require oil prices of $80 per barrel to break even.

If the energy market does continue to weaken, energy-dependent states do appear well- positioned for a soft landing. Many oil-producing states built large fiscal reserves in recent years as elevated oil prices (and growing production in some states) increased tax collections. Their reserves mitigate a near-term oil revenue decline.

Though Alaska is the most reliant on oil tax revenues, its reserves of $26 billion exceed three years' of fiscal 2013 operating revenues. Other states with large reserves include North Dakota, with $2.5 billion, or 78% of revenues, and Texas, with $8 billion, or 16% of revenues. New Mexico's reserve levels are slightly lower at $671 million, or 12% of revenues.

Several other states have become significant energy producers through the technology of hydraulic fracturing, or "fracking", of shale formations using horizontal wells. Colorado produced nearly 63.2 million barrels of crude oil in 2013, a new state record and a 28% increase from 2012, when the state's oil and gas wells produced nearly 49.3 million barrels of oil.

Oil prices have dropped sharply since June's peak of $104 per barrel as supply growth has outpaced demand. Participants in the global market are waiting to see whether the OPEC, led by Saudi Arabia, will reduce production to raise prices at its November 27th meeting.

The United States exported 401,000 barrels per day of crude oil in July 2014, the highest level of exports in 57 years and the second highest monthly export volume since 1920, according to the U.S. Energy Information Administration. Alaska has begun shipping North Slope crude to South Korea, the first export of that oil in more than 10 years. A shipment of oil from Texas to South Korea in July was the first unrestricted sale of unrefined oil since 2007. Texas is also building facilities to export liquefied natural gas to other nations in hopes of expanding the market for natural gas. While oil is a global market, natural gas tends to be more regional in scope, dependent largely on pipelines for transmission. Amid record production this year, the November price for natural gas fell from $3.80 per million British Thermal Units last Wednesday to $3.659 per million BTUs last Friday.

While falling oil prices have an impact on the national economy, certain U.S. states are particularly reliant on the industry. The top five oil producing states accounted for over 60% of total national production in 2013. Oil companies contribute various combinations of direct and indirect revenues to the states, including production taxes, sales taxes, and corporate income taxes, depending on the state, while their employees pay applicable income, property, and sales taxes as well. The oil industry, especially in the top producing states, can create jobs, lift employment levels, and lead to population growth, when the industry is performing well.

National crude oil production has trended up in recent years. This increase in production has offset a portion of revenue declines during times of price declines. However, significant growth in production has been concentrated in select areas. In other areas of the country, notably Alaska, production has fallen, making them even more vulnerable to a price decline.

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Municipal Bond Market - Tax Reform Forecast Post-2014 Election

Monday, November 3, 2014

The Senate has been controlled by the Democrats since 2007 and the House by the Republicans since 2011. In the Senate, 53 members are Democrats, 45 are Republicans, and two are Independents that caucus with the Democrats. In order to take control of the Senate, the GOP would have to have a net gain of six seats from the midterm elections. In the House, 233 are Republicans, 199 are Democrats, and there are three vacancies. To gain a majority in the House, Democrats would need a net gain of 17 seats.

Republicans are highly likely to maintain control of the House, but the Senate could go either way, according to congressional observers. The midterm elections are next week, but the fate of the Senate may not be known until later because there could be runoffs in two states with competitive elections: Louisiana and Georgia.

Corporate tax reform is expected to be a priority for Congress and the Obama administration no matter which party has control of the Senate after the midterm elections, said tax experts and congressional observers who, nevertheless, differ on how this might impact municipal bonds.

Members of Congress and the Obama administration have been particularly interested in making changes to the corporate tax system because of recent concerns about corporate "inversions." An inversion is when a U.S. company merges with a foreign business and then reincorporates in that business' country, primarily to lower their taxes. The Treasury Department recently released guidance designed to slow inversions. However, Treasury Secretary Jack Lew, the top Democrats and Republicans on tax-writing committees have said that the best way to curb inversions is through legislation.

Key members of Congress such as House Speaker John Boehner and the leaders of the tax-writing committees continue to express a commitment to comprehensive tax reform. However, corporate tax reform may be more politically attractive initially, several sources said.

Democrats and Republicans agree on the need to look at the corporate tax system to improve the United States' ability to compete with other countries. Corporate tax reform is less politically volatile and may be easier for Congress to vote on than individual tax reform since there is a smaller range of issues that Congress and the White House have to address. The range of deductions and credits that have to be touched in individual tax reform are more Main Street issues.

Some members of Congress and the Obama administration have proposed capping the value of tax-exemption, which market participants contend would be equivalent to taxing municipal bonds. The president's recent budget requests have proposed capping the value of the exemption at 28%.

During the past few years a divided Congress has gotten little accomplished due to major differences of opinion between Senate Democrats and House Republicans. If there are Republican majorities in both houses of Congress, the House and the Senate could work more closely together on tax reform. If Republicans view tax reform as a major issue going into the 2016 election cycle, they may use the power of controlling both houses to bring tax reform front and center as part of the national debate.

But if a Republican-led Congress undertakes tax reform, it will want to lower rates and will have to figure out how to pay for doing so. The tax-exemption for municipals could be an offset to pay for reform. Curbs to municipals could include a cap on the value of the exemption or the elimination of the exemption for private-activity bonds.

A Republican-led Congress could have incentive to take action on tax reform. When the party that does not control the White House controls Congress, it wants to prove that it can win the presidency, and to do so it actually has to accomplish things in Congress. If a Republican-controlled Congress focuses on infrastructure financing, the municipal market could benefit. However, if it instead tries to do whatever is necessary to lower taxes, the municipal exemption could be harmed.

In February, House Ways and Means Chairman Dave Camp released a draft comprehensive tax reform legislation that included a 10% surtax on municipal interest for high earners and eliminating the ability to issue tax-exempt private-activity bonds or advance refunding bonds after 2014.

No matter what type of tax reform Congress tries to undertake, it will be a challenge to get it enacted before the next presidential election. Regardless of which party wins control of the Senate, President Obama will still be in office and will have the power to veto legislation. Vetoes can only be overridden by two-thirds of both the House and the Senate, and Republicans are highly unlikely to have large enough majorities in these chambers.

If reconciliation instructions for tax reform were included in an enacted budget resolution, only 51 Senate votes would be needed to approve the tax bill based on the instructions. But Obama would still need to sign the tax bill.

If Republicans take control of the Senate, Sen. Orrin Hatch of Utah would almost certainly become chairman of the Senate Finance Committee, congressional observers said. If Democrats prevail, Sen. Ron Wyden of Oregon would likely continue to lead

the committee. Wyden has spooked the municipal market in the past because he has introduced comprehensive tax reform legislation that replaced the exemption for municipal bonds with traditional tax-credit bonds. Hatch is from a Western state with substantial infrastructure needs, but those needs are harder to finance because the state has a relatively sparse population and a small tax base. As a result, Hatch recognizes a critical federal role in infrastructure, including tax-exempt bonds.

Wyden has expressed more of an interest in taxable but tax-credit or direct-pay bonds, though right now he seems more interested in them as a supplement to municipals, rather than a substitute. Hatch, on the other hand, is more conservative and interested in preserving the status-quo.

Hatch and many other Republicans have generally opposed Build America Bonds. The senator has long viewed the bonds as a disguised bailout for states. Sen. Chuck Grassley, R-Iowa, has complained that BABs provided lucrative fees for underwriting firms and are used by states with lower credits, which get higher subsidies because they have to sell at higher interest rates. But some tax experts believe the Republican opposition stems primarily from the fact that BABs were part of Obama's economic stimulus legislation, the American Recovery and Reinvestment Act. Most observers believe efforts to revive the program would not be able to pass a Republican-led Congress. However, Republicans could take a different view of BABs once they are in power.

The House will have a new chairman of its Ways and Means Committee in January, no matter the outcome of the midterm elections, because Camp is not running for reelection and was term-limited as chairman. The leading two contenders to succeed Camp are Reps. Paul Ryan, R-Wis., and Kevin Brady, R-Texas.

Brady has been a strong inside the committee player. Ryan is currently the chairman of the House Budget Committee and has released budgets that include principles for tax reform, such as lowering individual and corporate tax rates, which could hurt bonds. If marginal tax rates are lower, they lose some of their advantage over taxable bonds and become less valuable. Also, Camp's plan showed that it is difficult to lower rates without going after tax preferences like the tax-exemption for municipals.

But there is always a question about how much flexibility committee chairmen have over the direction of tax legislation, and how much control congressional leadership has. While Wyden may be more committed to tax reform than Hatch is, the committee chairman does not control the debate. The key question is whether there is support in Congress for the difficult decisions that have to be made in tax reform.

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Ebola and the Not-for-Profit Healthcare Sector

Thursday, October 30, 2014

There is a moderate degree of uncertainty about Texas Health Resources' financial performance after the Ebola-related situations at one of the System's flagship hospitals, Texas Health Presbyterian Hospital Dallas (17% of system net patient revenues in fiscal 2013). These events may result in operational and reputational impairment, which may be either short- or long-term.

A longer-term disruption in financial performance or significant financial stress, including a permanent reduction in volumes, damage to the brand, or liabilities in excess of insurance may result in negative rating pressure. This event is also a material distraction for management and will consume resources that would otherwise be devoted to growing the enterprise.

MTAM does not currently expect any other near-term rating actions in the not-for-profit healthcare sector as a result of the Ebola situation. However, we recognize that preparedness will be an added financial expense for many providers, and it is already impacting senior management time and energy.

We expect the current spread of Ebola will be contained, and the healthcare sector--and the nation as a whole--will come to terms with the U.S. being exposed to this disease. We currently believe that the financial and credit impact will likely be modest.

Hospitals may face additional costs for equipment, training, and hazardous waste disposal for patients who have Ebola or are suspected of having Ebola. In addition, hospitals could face a stigma from treating Ebola patients, potentially driving other patients away from the facility. Similarly, the Ebola stigma could create personnel shortages of nurses and other healthcare professionals if they choose not to be present if Ebola patients show up at their facility. Hospitals may also face the questions of lawsuits for deaths and the potential spread of the disease; and thus, malpractice costs could rise.

The Dallas hospital that treated the first patient in the U.S. diagnosed with Ebola saw its patient count and revenue drop by more than 20% in October compared with the first nine months of the year. The average daily patient count for Texas Health Presbyterian Hospital Dallas declined 21% to 337 and emergency room visits fell by more than half, according to a regulatory filing by its parent company, Texas Health Resources. Revenue fell by 25%.

The negative financial impact is primarily the result of the emergency department being placed on diversionary status from October 12th to October 20th after one of the nurses who treated the first patient, Thomas Eric Duncan, was found to be infected. Duncan was admitted to the hospital on September 28th and diagnosed with the disease. Two nurses, Nina Pham and Amber Vinson, were later diagnosed with the disease. Duncan died October 8th at the hospital.

The hospital's handling of Duncan has led to congressional hearings, new protocols for healthcare workers nationally, and renewed efforts to prepare the country for future Ebola-infected patients.

Presbyterian Hospital remains open, the emergency department is again accepting ambulances, and while inpatient volumes are down 20% compared with before the Ebola cases, patient volumes are beginning to pick back up, particularly with the emergency department off of diversion status. Management has quantified an initial negative revenue impact of about $8.1 million. About $145 million of Texas Health's variable rate bonds were tendered and all have been successfully remarketed. In addition, Texas Health Resources reports that this event will not trigger any material adverse event clauses with its various liquidity providers on its variable rate debt.

MTAM will continue to monitor healthcare providers for any immediate and longer term financial impact caused by the Ebola disease. However, we expect the incremental costs related to Ebola preparedness will be but one more cost pressure on U.S. providers, and one more factor contributing to our view on the overall credit quality of healthcare providers.

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What are Green Bonds?

Thursday, October 23, 2014

The State of California's $2.3 billion municipal bond deal that came to market last month included $200 million of green bonds. All of the bonds are secured by the State's general obligation pledge (Aa3/A/A). While the green bonds are dedicated to environmental projects, they are otherwise structured identically to the other general obligation bonds sold by the State.

Green bonds are a relatively new segment of the bond market, with the first municipal issuance sold last year by the Commonwealth of Massachusetts, but one that investors are sure to hear more about in the years ahead. Issuance has surged in 2014. Green bond sales in the first half alone, including municipal and other green bonds, has surged to $20 billion, matching the total for the past 7 years, according to Bank of America.

Green bonds are devoted to funding sustainable and environmentally beneficial projects. Revenues from green bonds usually fund projects ranging from clean water and drinking water, conservation, habitat restoration, improving energy efficiency in state buildings, and protecting open spaces.

Green bonds attract investors who are motivated by a desire to promote conservation or help offset global warming. Investors who are interested in green bonds tend to be socially responsible people who are concerned about climate change, who have concerns about quality of life, and who have concerns about having value in their portfolio, other than those just looking out for the best return.

In general, the market tends to look at the security of bonds, and not the use of proceeds. However, selling green bonds does offer certain benefits to issuers. In theory, a green bond finances environmentally efficient government services, which should garner savings and reduce the overall cost of government operations. It can also help increase demand for municipal debt.

Green bonds have been offered in other areas of the market, including corporate and asset-backed funds, but there have only been a handful of green bonds in the municipal sector. In 2013, Massachusetts sold its first issuance of green bond debt. The Commonwealth sold $100 million as part of a $670 million GO bond sale. Proceeds went toward financing projects to support open spaces as well as environmental clean-up efforts at various sites. Massachusetts was inspired by a similar program from the World Bank, which has issued more than $3.5 billion in green bonds since 2008.

Other municipal green bond issuances include a $213 million issuance from the New York Environmental Facilities Corp. and a $300 million issuance from the DC Water and Sewer Authority, both issued in June.

Connecticut will become the latest state to issue green bonds, state Treasurer Denise Nappier announced this week. Nappier said her office plans to issue environmentally-themed bonds next month for up to $60 million of "critical" wastewater infrastructure projects statewide through the State's clean water program. The green bonds will be part of a $300 million general obligation offering. "We are developing the new green bonds product to meet the needs of the growing group of investors who have mandates to invest in sustainable projects that will help preserve our environment for future generations," said Nappier.

In New York City, Mayor Bill de Blasio and Comptroller Scott Stringer have each proposed environmentally themed financings. De Blasio last month called for 24 solar power installations at city schools, with the City to fund all but $5 million of the $28 million cost. Stringer called for mainstreaming green bonds into GO offerings as part of the City's next major capital plan, in early 2015.

Conclusion

MTAM would approve green bonds that carry the issuer's general obligation pledge (if the issuer's credit fundamentals are strong overall). Green bonds typically carry the same credit rating as the issuers' other debt obligations, and are deemed essential purpose by the people who are making the investment. MTAM believes that if a green bond deal is attractively priced, it will see significant demand due to the overall shortage of bonds available in 2014.

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3rd Quarter 2014 Review and Outlook

Wednesday, October 1, 2014

For the three-month period ending September 30, 2014, investors in tax-free municipal bonds earned positive returns. Demand for municipal bonds has remained steady throughout the quarter, even as indications of stronger domestic economic growth have emerged. As has been the case all year, it has been more rewarding to have ventured further out the yield curve. Longer-maturity municipals continue to substantially outperform the short-end of the market, primarily due to falling inflation expectations, courtesy of the stronger U.S. Dollar. New issue supply of municipals has recently become healthier, and has been met with outstanding demand. It seems from our perspective to be an indication of significant "crossover" demand emerging from other markets that may be deemed "overvalued" by some. If you are of the belief that interest rates will be rising over the coming quarters, this is the fixed-income asset class to be invested in, as supply contracts as yields move higher. This usually leads to good "relative" performance versus many taxable bonds.

Lower quality bonds ("BBB") continue to significantly outperform higher quality debt ("AAA," "AA," "A"), as investors stretch for yield as defaults in tax-free bonds have been ebbing since the worst of the "Detroit" news has seemingly passed. As we move closer to 2015, we are skeptical that this trend will remain, as something always seems to "break" when tightening cycles begin. A "stealth" tightening of economic activity is already underway, thanks to the strengthening U.S. Dollar. States that have a heavy reliance on the manufacturing sector for growth are at the top of our list to watch, as "King Dollar" can slam the brakes on growth quickly. States that normally prosper from overseas tourism also bears watching as a stronger Dollar tends to cancel hotel reservations on the margin. We think 2015 will be a difficult year for risk assets in general, and "high yield" bonds in particular, due to the confluence of both a stronger currency and a less accommodative Federal Reserve. MTAM will continue to invest in only the sturdiest municipal issuers to ensure your capital is well protected.

Can the path to "normalization" have a Derek Jeter ending?

Whether you are a baseball fan or not, it was hard not to be impressed by New York Yankee shortstop Derek Jeter's last at-bat at Yankee Stadium after twenty years. A "walk-off" hit to end a career has all the hallmarks of a Hollywood script where the hero walks triumphantly into the sunset as the credits roll onscreen. As bond investors, we are naturally curious as to how the markets will react as the Federal Reserve attempts to "normalize" interest rates after a long period of suppressing them. As calm and stoic as Mr. Jeter appeared in the batters box before knocking in the winning run with millions watching, we could not help but wonder how Janet Yellen might perform when it comes time to end the easy money. Here is what we expect to be happening in the economy as Janet Yellen steps into the batters box in 2015:

  • Housing will be notably slowing well before the first "hike"
  • Global equity markets will be under "pressure"
  • The United States bond market will be "pancaking," as short rates begin to resemble long-term rates
  • Economic activity in the United States will be somewhat "softer" than expected

Can Janet Yellen and her colleagues at the Federal Reserve avoid "whiffing" when the eyes of the world are watching? Perhaps Mr. Jeter would admit they are under a tad more pressure than he was in his last at-bat.

Our goal at MTAM in the coming months is to continue to focus on quality and capital preservation. While Detroit and Puerto Rico continue to receive most of the media's attention, we sense there is more "trouble under the hood" of the municipal market than just those two issuers. Given the path to "normalization" is moving closer, we will continue to avoid issuers who could "stall" your portfolio on the side of the road at precisely the wrong time.

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management

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Impact of Climate Change on Municipal Credits

Tuesday, September 30, 2014

Climate-related disasters have the potential to erode some U.S. state and local governments' credit quality. While credit ratings have not been impacted to a large extent by climate-related issues, primarily because the federal government has provided aid for those hit by disasters, that assistance may not always be available.

The major threats to municipalities are depressed economic growth, increased costs for recovery and infrastructure at a time of lower revenues, and federal support not keeping up with changing risks. MTAM recommends that municipal governments should be planning and setting aside funds, namely rainy-day funds and catastrophe funds with analytic metrics.

The costs associated with inaction, or not preparing for the possibility of weather-related events, will continue to grow. So far, most local governments have been able to withstand and recover from previous weather-related disasters. As for those taking action to prepare for future impacts of climate change, such mitigating efforts do not affect credit quality. Certainly, it is positive to be prepared, but it is very difficult to assess specifically where the impacts will be. Such mitigation projects taken on by local governments could enhance credit, but they are not always effective.

Whether state and local governments are reacting to an event or they are taking steps to mitigate the damage that future disasters will cause, they will have to pay expenses. MTAM assumes that governments may have to issue debt to finance disaster-relief projects, which could put pressure on their credit ratings.

It is not always a catastrophic event, but sometimes an accumulation of pressures that may put financial stress on governments. MTAM looks at prolonged issues like the drought in California, which is pressuring water authorities to spend more. We view states' passing severe weather-related costs onto taxpayers or ratepayers as favorable, but we do not assume that states have an unlimited capacity to do so.

We have seen climate-related events have some impact on certain municipalities, but overall, at least in the local government sector, they have been able to handle that risk — particularly with federal and state support. The most significant credit risks of climate change are for local governments that are not able to quickly recover from weather disasters. We do not focus so much on the immediate aftermath, but we look for the extent to which there are any signs of lingering effects on the tax base, the overall economy, and the financial position of the government.

Most local governments have been able to bounce back from natural disasters, though there are two exceptions that did not, and as a result, received lower credit ratings. Louisiana, for example, was hard hit in 2005 by Hurricane Katrina, where a number of local communities were financially under-prepared to deal with the damage from the natural disaster. As a result, the rating agencies took several negative rating actions on local governments and school districts affected by the hurricane.

In 2008, Galveston (TX) was hit by Hurricane Ike — the third costliest hurricane to make landfall in the United States — which led to downgrades on the City's general obligation and water and sewer ratings. The hurricane wiped out a significant part of the tax base and also caused uncertainty about whether the City's largest employer would relocate.

Other natural disasters generally have not had a significant impact on credit ratings because they tend to be short-lived. Generally, reconstruction and repopulation takes place shortly afterwards and actually sometimes generates a boost in revenues due to reconstruction, revitalization, and repopulation, so there is an increase in economic activity shortly after.

Although Superstorm Sandy lowered national growth during the fourth quarter of 2012, the recovery effort, which led to increased construction and rebuilding activity, quickly boosted output once again. This was a different outcome from Hurricane Katrina, which spurred limits on reconstruction and development in high-risk areas in the Gulf Coast.

MTAM notes the substantial efforts to understand and mitigate weather-related vulnerability. We expect continued focus on this area given the pattern of natural disaster activity over the past decade. However, we expect the pace and progress of actual investments will likely be slow due to funding constraints at all levels of government.

New York State has created a Sea Level Rise Task Force that identifies and addresses climate change, and recommends actions for state and local governments to undertake to address these risks. Elsewhere in the region, other communities impacted by Hurricane Sandy are also making preparations for future weather-related events. Communities in New Jersey will receive funding for projects that will provide flood protection, including the Meadowlands, the Hoboken waterfront, and parts of Weehawken and Jersey City. The money comes from a "Rebuild by Design" program created by the U.S. Department of Housing and Urban Development to make the region more environmentally and economically resilient. Under the program, New York, New Jersey, and New York City are receiving $920 million from HUD in HUD's recent allocation of $2.5 billion in Community Development Blocks Grants - Disaster Recovery for the region hit by Hurricane Sandy.

The latest estimates from the government's National Climate Assessment warn of temperature changes of more than eight degrees Fahrenheit and sea level increases of one to four feet by 2100 if the current path of global emissions increases continues. California is joining federal and local governments to finance levee improvements designed to achieve 200-year flood protection. A rise in sea level could lead to increases in runoff and flooding, which can reduce the quality of water, according to the U.S. Environmental Protection Agency.

In June, the EPA proposed updated carbon emissions standards for existing power plants. The proposal would cut carbon emissions at existing power plants by 30% from 2005 levels by 2030. It would establish targets for states to meet, but each state would have a good deal of flexibility as to how to meet the them. Under the proposal, states would submit to the EPA their initial plans about how they plan to meet the targets by June 2016. If they need more time, they can have until 2017, and if they work together to take regional approaches to meeting the standards, they have until 2018.

The EPA proposal would be a credit negative for coal-producing regions of the United States because they would compound tax revenue and economic pressures that local governments in the regions already face. The EPA estimates that utilities will raise their rates by 6.2% in 2020 to pay for investments to meet the proposed standards, and critics of the proposal claim that increasing manufacturers' electricity costs will cause them to move production overseas. However, supporters of the standards argue that they are a necessary response to costs of the severe weather caused by climate change.

Conclusion

Some states and localities are developing plans to mitigate the impact of weather-related disasters, which could be costly and potentially divert resources from other capital spending projects, particularly if shared revenues are insufficient and limitations on tax-supported debt come into play. If federal support falls short in the future, the costs of not preparing for climate change could also mount and affect credit quality over time, especially in disaster-prone areas.

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New Jersey's Financial Challenges Continue

Friday, September 12, 2014

The State of New Jersey's internal MTAM credit rating of 'A2' reflects high wealth levels, and a broad and diverse economy. These economic strengths have been offset by a high debt burden and a multitude of spending pressures, including continuing capital needs, as well as significant unfunded pension and employee benefits obligations. The State's revenue performance amid the economic recession weakened sharply; however, despite the reduced operating flexibility, a 'stable' credit trend assumes that the State will promptly address revenue shortfalls with actions necessary to restore budgetary balance, thus protecting bondholders.

Recently, Standard & Poor's and Fitch lowered their ratings on the State of New Jersey's general obligation debt to the mid A-range (A1/A/A). Among the reasons cited were the State's economic weakness, unbalanced operations, overly optimistic revenue assumptions, high debt levels, and large unfunded liabilities. These rating downgrades place New Jersey as the second-lowest rated state overall, behind only Illinois (A3/A-/A-)

New Jersey's budgets have been structurally unbalanced for years, including fiscal 2014. The State has resorted to various one-time solutions, such as tobacco securitization, shortchanging annual pension contributions, or debt restructuring to plug these gaps. This inability to generate sufficient recurring revenues to meet recurring expenses (known as structural balance) has taken a financial toll on the State. New Jersey's 'rainy day fund' was depleted in 2002 and has not been replenished. The General Fund's unassigned fund balance is very low at 0.9% of revenues, providing little cushion for financial uncertainties. The State's cash position is very weak. Relying on overly optimistic revenue projections in the State budget, projections that failed to materialize, has added to the strain. New Jersey's tax revenues have yet to recover to pre-recession levels, which is concerning as both debt service and retirement obligations are slated to escalate in the coming years, adding to the financial pressures. The State has indicated its intent to increase its ending fund balance to $388.5 million at the close of fiscal 2015; up from $300 million ending fund balance in fiscal 2014. This level of fund balance (1.2% of revenue) would provide only limited operating flexibility in the event of future negative fiscal developments.

New Jersey's unfunded pension and OPEB (other post-employment benefits) liabilities are quite large on both an absolute and per capita basis, and are among the worst of the 50 states. New Jersey routinely contributed much less to its pension plans than was due in each year from 2000 through 2013. The Annual Pension Cost over that same period grew by 480%, likely due to the pension underfunding and other possible factors such as investment performance and benefit modifications. Not surprisingly, New Jersey's pension funding is low, standing at 62.8% on a combined basis in fiscal 2013.

In response, the pension system was revised in 2010 and 2011, with laws that increased the retirement age for public workers, eliminated cost-of-living adjustments, and required public workers to pay more toward their pensions. In exchange for those revisions, the State was required to fully fund its APC, as calculated by an actuary, to each pension plan operated by the State. However, this latter requirement is to be phased in over seven years beginning in fiscal 2012. The State had been increasing its pension contributions as called for under the legislation; however, a revenue shortfall in fiscal 2014 prompted the Governor to call for a scaling back of pension contributions in fiscal 2014 and fiscal 2015. Various union groups are challenging this in court.

The Governor has recently convened a special pension task force to propose options for additional pension reform. The Governor acknowledged the sizable and increasing burden of pension contributions and recommended that additional, as yet unspecified, reform measures be considered in the current legislative session.

The State's somewhat steep income tax structure concentrates the personal income tax on the highest earners, making it more vulnerable to swings in asset prices and capital gains tax receipts:

-- New Jersey's top individual income tax bracket is currently 8.97%, placing it sixth-highest among the 50 states.

-- In fiscal 2011, the latest year available, the top 5.9% of tax filers accounted for 52.5% of the State's income tax receipts, and the top 1.7% accounted for 36.8%.

-- Personal income taxes accounted for 39% of Budgeted Funds' revenues in fiscal 2013. This concentration can set the stage for wide swings in the State's fiscal picture.

-- New Jersey's state sales tax rate is 7.0%, second-highest among the 50 states.

-- New Jersey has the highest property taxes in the nation and the highest overall tax burden of the 50 states, according to the Tax Foundation.

New Jersey is a wealthy state, with 2013 per capita income at 126% of the national average, which places it fourth-highest among the 50 states. New Jersey's statewide poverty rate of 9.9% is well below the national average of 14.9%. New Jersey's diverse economy is closely tied to New York City's and has benefited from an influx of jobs from the City. New Jersey ranks third in financial services jobs, behind New York and Massachusetts. The Port of Elizabeth/Newark is the East Coast's largest seaport and handles about one third of the nation's ocean-going trade. However, New Jersey's recovery from the recession has been uneven, and currently lags the nation. According to the U.S. Bureau of Labor Statistics, through April 2014, New Jersey has recovered only 38% of the non-farm payrolls it lost during the recession, compared with a 99% recovery for the U.S. New Jersey now leads the nation in home foreclosures, surpassing Florida in the first quarter of 2014. Moody's Analytics is projecting that the State's economic recovery will continue to trail the region and nation. The State's fiscal problems, its high cost nature, and slow population growth are cited as long-term impediments to higher economic growth. This economic weakness is a key reason for the State's soft tax collections.

According to The Bond Buyer, issuance of new municipal debt in New Jersey, including state and local issues, registered $13.4 billion in 2013. That represented 4.1% of 2013 issuance nation-wide and made New Jersey the fourth-largest issuer of municipal debt in the nation in 2013. With such a dependence on the capital markets, it is highly unlikely that New Jersey would risk losing access by defaulting on any of its debt. Additional rating reductions would be much more probable than an outright default.

New Jersey itself issues debt under a variety of programs, including general obligation, annual appropriation and dedicated revenue obligations. The State's general obligation bonds carry the State's strongest security pledge. Prior to issuance, State general obligation debt must be approved by the citizens of New Jersey in a general election. Under Article VIII, Section II, paragraph 3a of the New Jersey State Constitution, an ordinance authorizing general obligation debt cannot be repealed until the debt is paid in full. In addition, under provisions of the Refunding Bond Act of 1985, if State tax revenues are insufficient to provide for payment of debt service, a tax shall be levied on all taxable property within the State, in an amount sufficient to meet that year's debt service requirements.

However, most debt issued by the State of New Jersey is not general obligation debt. The majority of the State's debt is secured by annual appropriations made by the New Jersey State Legislature. These bonds were issued under various state agencies such as the Transportation Trust Fund or the New Jersey Economic Development Authority. Prior to 2008, appropriation debt did not require voter approval and was widely seen as a way around the voter approval process. A constitutional amendment approved by the electorate in November 2008 now subjects appropriation debt to voter approval, which is likely to curtail its use in the future. The State also issues debt secured by various sales and excise taxes such as the New Jersey Economic Development Authority's Cigarette Tax Revenue Bonds, or the Garden State Preservation Trust.

In relation to other states, New Jersey is considered heavily indebted. According to Moody's, New Jersey has the third-highest amount of tax-supported debt among the 50 states, standing at $36 billion in 2013. On a per capita basis, the State's debt burden is fourth-highest among the 50 states at $3,989 compared with the Moody's median of $1,054. Net tax-supported debt as a percentage of personal income was fourth-highest in the nation, at 7.3%, compared with the Moody's median of 2.6%. Net tax-supported debt as a percentage of Gross State Domestic Product was also fourth-highest in the nation, at 7.0%, compared with the Moody's median of 2.4%. Despite being more heavily indebted than most states, principal and interest on New Jersey's bonded debt comprised only 3.6% of the State's Governmental Funds' revenues in fiscal 2013.

The State's debt levels have increased substantially since 1998. A driving force behind this increase has been debt issued for school construction to comply with a 1998 NJ Supreme Court ruling (Abbott v. Burke) that requires the State to fund the full cost of renovating or replacing schools in the State's poorest districts.

Conclusion

Restoring fiscal balance at the state level will be a challenge for New Jersey in light of the growing pension liabilities, increasing debt, and an economic recovery that is expected to continue to lag the nation. As a sovereign entity, New Jersey has an array of tools at its disposal to maintain fiscal stability. Solutions may involve, among other things, tax hikes, expenditure reductions, or a combination of the two. While outright default is exceedingly unlikely, additional downgrades of the State's bond ratings are possible should the State not execute a sustainable long-term solution to these challenges. Our 'stable' outlook reflects an expectation that the State will ultimately retain a strong ability to fund its debt obligations as they come due despite a likelihood, in our view, that its budget will continue to be structurally imbalanced and that reliance on one-time measures will remain at or close to current levels.

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Atlantic City (NJ): A Lesson in the Merits of Economic Diversification

Tuesday, August 19, 2014

Atlantic City, New Jersey, the gambling hub that has been hammered by regional competition in the U.S. Northeast, recently had its credit rating cut two levels to speculative grade by Moody's. The reduction to Ba1 from Baa2 on the City's $245 million of general obligation debt reflects a weakened tax base resulting from anticipated casino closings. The outlook remains negative.

Moody's downgrade to Ba1 reflects the City's significantly weakened tax base, revenue-raising ability, and broader economic outlook. These result from ongoing casino revenue declines, expected near-term casino closures, and the impact of sizable casino tax appeals, all of which has stemmed from increased competition from casinos in neighboring states.

Revel, the $2.4 billion casino and resort that opened on Atlantic City's boardwalk just two years ago, will close its doors next month. The company had said that it would close if it could not find a buyer for the ailing facility. In a statement last Tuesday, Revel's parent company announced that it would close by September 10th.

Revel had more than 3,100 employees as of last month, according to the New Jersey Division of Gaming Enforcement. And this closure comes amid the news that Trump Plaza is expected to close mid-September. All told, Atlantic City could see four casinos closing this year, costing more than 7,800 people their jobs. These closures come as Atlantic City's casino revenues have plummeted since 2006, illustrating the dramatic decline facing the onetime gambling mecca.

Atlantic City was a decaying resort until New Jersey legalized casino gambling in 1976 and limited it to that location. The first casino, Resorts International, opened in 1978. Revenue rose steadily, reaching a peak of $5.22 billion in 2006. It has dropped for seven years, falling to $2.86 billion in 2013. Atlantic City lost its regional monopoly as states including Pennsylvania, Maryland, and New York legalized casinos or expanded betting to increase tax revenue.

Atlantic City's 12 gambling houses account for almost half its jobs: 5,883 positions in a workforce of 13,500. The Atlantic Club closed in January, putting a total of 1,600 people out of work. The closing of Caesars Entertainment Corp.'s Showboat on August 31st will wipe out 2,133 jobs. Trump Plaza Hotel & Casino's closure will take away another 1,009.

About one-fifth of the 30,000 people registered as casino workers with the State Division of Gaming Enforcement live in Atlantic City, the most in a single zip code. Thousands more live in the suburbs such as Egg Harbor Township, Galloway, and Pleasantville. Atlantic City's jobless rate stood at 14.9 percent in May, more than double the statewide figure of 6.8 percent, according to State Labor Department figures. The number of City residents deemed in the workforce and unemployed was 2,400. Based on the fifth of casino jobs held by residents, additional cuts would swell the number of unemployed in the City by about 1,500, or two-thirds.

Besides competition from other markets, Atlantic City's casino business has suffered from the recession, a lack of non-gambling attractions, and real-estate taxes that cost more on its four properties there than on all its others combined.

City officials are hoping that reducing casino capacity will lead to a healthier industry in Atlantic City, or at least stabilize it. However, after the closures, gamblers may not shift from the closed casinos to the remaining ones. With fewer casinos to choose from, gamblers may stay away from the City altogether. Mayor Don Guardian has sought to turn around Atlantic City's slump by championing business conventions, the arts, and gay tourists. Governor Chris Christie announced a five-year turnaround plan in 2010 that included a marketing push to increase non-gambling tourism. The State in November also began letting casinos offer online betting. Revenue has not met forecasts.

The closure of four of Atlantic City's 12 casinos will pressure the City's already tenuous finances. Short-term, there could be a cash flow problem in meeting Atlantic City government's expenses. Longer-term, the City could struggle in its ability to service its debt given that there is additional competition in the area.

City officials are more optimistic about its short-term prospects. The City has reached settlement agreements on tax appeals with the owners of three of the four closing casinos for them to make payments in 2014 and 2015, said Atlantic City director of revenue and finance Michael Stinson. He said he expected the owners to stick to these agreements even if the casinos close. The owners of Showboat only reached a tax agreement for 2014. Its closure will lead to lower City revenues in 2015, he said.

However, MTAM believes that the casino owners may appeal the property taxes on the closed buildings in court. Over the long-term, the closures will cut away at the City's primary source of revenue. The closures will also hit the City's already weak socioeconomic profile. The City's median family income is just above 50 percent of the U.S. value.

Comparison to Las Vegas

In comparison, Las Vegas is emerging from the collapse of the housing market and slowdown in gaming with far better credit quality (Aa2/AA/AA) than Atlantic City (Ba1/A-/NR). A substantially larger, more diverse economy and healthier demographics are the primary reasons for the better performance.

Both cities watched their property values drop by 50 percent after the peak of the real estate boom in 2007, but in Las Vegas property values have begun to recover. Las Vegas' gaming industry has also begun growing again, while Atlantic City's gaming revenues continue contracting because of competition from new casinos in neighboring states and online gambling.

Although casino gaming is the dominant industry in both cities, Las Vegas relies on it less, contributing to its stronger fundamental credit quality. Even within the casinos, gaming revenue only generated 34 percent of Las Vegas' 2012 casino revenues, compared with 78 percent for Atlantic City casinos, as Las Vegas casinos generate substantial sums from rooms, entertainment, and retail offerings.

Las Vegas is a more diverse tourist destination, offering a wide array of conventions, restaurants, and attractions. Further, the City's healthcare and technology sectors are making headway. The cities are also experiencing very different demographic trends. Las Vegas' demographic profile is an overwhelmingly positive credit factor with strong population growth, healthy income levels, and a recovering employment picture. In contrast, demographics are weak in Atlantic City, with no population growth, high levels of poverty, and persistently elevated unemployment.

Atlantic City's tax base is also extraordinarily concentrated in its casinos, with 12 of them constituting 70 percent of its assessed value. In Las Vegas, the 10 largest taxpayers make up just 6.2 percent of the tax base, a result of the Las Vegas Strip casinos being part of the Clark County tax base and located in Clark County outside the City's boundaries.

Casino industry analysts say the four casino closures are a dramatic correction, but a necessary correction as there were too many casinos in Atlantic City for the market of gamblers. They expect there will be no more Atlantic City casino closure announcements in the next several months. Also, there may be various possibilities for the four closing casinos. Revel may be picked up soon because it is a stunning building. Showboat and Revel may be closed and rebranded or may be sold before closure. Atlantic Club will hopefully reopen as a hotel.

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Credit Update on the Higher Education Sector

Tuesday, July 29, 2014

Colleges and universities operate in a highly competitive business environment and do not enjoy a sole franchise for students in a geographic region or academic field. They compete against one another for student enrollment. The successful ones are those that have established either a solid financial or academic advantage, or both.

The general outlook for the U.S. higher education sector continues to be negative, with prospects for revenue growth and also for controlling expenses limited. Despite these strains, trends are emerging that may point to credit conditions stabilizing over the next two years.

In the overall U.S. economy, the recent uptick in employment should lead to an increase demand for educated workers. In addition, the well-performing equity market is aiding gift revenue and fueling increased endowment support. Also, improved household balance sheets should create more willingness to invest in education. Longer-term demand for higher education is strong, and the earnings premium for having a college degree over a high school diploma continues to rise.

We will change our outlook to stable when indicators suggest broad parts of the sector will be able to sustain revenue growth while controlling expenses. Currently, tuition revenue growth remains meager because of lingering affordability concerns, political limits on tuition pricing, and the highly competitive environment for students.

Achieving stability will be particularly difficult for lower-rated private colleges and smaller, regional public universities. In fall 2013, over half of all public universities reported either no growth or declines in enrollment. Meanwhile, total net tuition revenue declined for 25 percent of regional public institutions, compared with only 4 percent of flagships and systems.

On the private side, total revenue fell for 20 percent of all universities, with those universities most reliant on tuition revenue feeling the greatest strain. However, we note that due to increases in the equity market, cash and investments exceeded pre-recession levels at nearly three quarters of all private universities.

Online Courses

MTAM sees the increasing use of online courses as a credit positive for the higher education sector. A quarter of students at U.S. universities currently use online courses toward their degree, signaling an adaptation to technology and student preferences. Online courses remove geographic barriers to education, expanding the potential applicant pool and can help colleges that have capacity constraints.

Although educational outcomes for online education are closely scrutinized, advancements in technology, online curriculum, and quality controls have made online education a more accepted and marketable tool for educational delivery. Still, schools must balance enrollment gains with increased competition, investment costs, and reputational risks. More than 60 percent of students at four-year for-profit colleges exclusively use online courses, the highest rate in the industry. At large public universities with enrollments of more than 20,000, more than 30 percent of students use some online courses, compared with 10 percent at small liberal arts colleges with student bodies of less than 1,000.

Capacity concerns, greater economies of scale, and a higher proportion of students requiring flexible schedules contribute to the higher use at large schools. The entry of elite universities into distance learning, albeit primarily through non-credit granting courses, should help legitimize this form of delivery and reduce the stigma that has historically been associated with distance education.

Impact of Performance-Funding

Spurred by a renewed focus on affordability and accountability, performance-based funding models are creating trade-offs for some public higher education institutions. Depending on how institutions respond to performance metrics prescribed by their respective state, performance-based funding may reshape the competitive landscape and incentivize increased innovations in areas that support student success. At the same time, it may also challenge some access-oriented institutions, while schools with strong academic profiles may have to choose between preserving their profile and conforming to new requirements linked to state funding.

Significant variability in the framework, scale and application of performance-based funding models exists. A number of states are either in the process of reconceptualizing existing performance-based funding structures, attempting to introduce performance-based funding for the first time, or taking a wait-and-see approach until the outcome of the federal rating system has been determined.

The Obama administration's recent efforts to tie federal financial aid to measures of access, affordability and outcomes introduce an additional layer of uncertainty. In MTAM's view, a material change in federal financial aid policy will have a significant impact on the sector given the considerable student reliance on federal financial aid in the U.S. However, it is not expected to significantly change the landscape in the near term. The impact may be felt further out as institutions make adjustments they deem necessary to accomplish their goals.

Public Institutions

Despite easing state appropriation cuts, tuition and fee increases continue to fill the revenue gap for public universities. MTAM anticipates moderate tuition increases going forward even as state operating appropriations stabilize. Operating results, for the portfolio medians, remained slim but positive across the public university sector in fiscal 2013 due to pressures limiting tuition rate increases, expense pressures following years of cost-containment efforts, and a still-constrained appropriation environment.

The median available funds ratio relative to debt weakened somewhat for 'Aaa' public universities. It was stable for the 'Aa' rated institutions, which are the largest and most representative group of rated public universities. MTAM attributes both trends to strategic debt issuance as the economy, investment markets, and fundraising environments improve. Median available funds ratios relative to operating expenses strengthened slightly, indicating continued cost containment efforts in a still-pressured appropriation environment, as well as some endowment and balance sheet support from fundraising and stronger investment markets.

Private Institutions

Despite most private colleges and universities seeing higher net tuition income and slower growth in scholarship discount rates, fiscal 2013 operating margins were weaker across the board. Weakened operating margins indicate expense pressures including net student revenue and increased general operating expenses. Net tuition revenue is pressured by tuition discounting, competition, and in some regions fewer high school graduates.

While net tuition revenue increased between fiscal 2009 through 2013, expense pressures constrained operating margins in fiscal 2013. MTAM considers an institution with declining net student revenue as challenged and likely to be operating in a competitive market requiring high institutional aid, which could trigger rating actions.

Fiscal 2013 financial medians for private colleges and universities maintain a strong relationship between revenue diversity and rating quality. Institutions rated in the 'Aaa' and 'Aa' categories typically have more diverse revenue streams and less reliance on net student fee revenue. Private colleges and universities in the 'A' and lower rating categories typically have higher net student fee dependence.

The enrollment growth rate slowed between fiscal 2012 and 2013 for all private university rating categories, and was slightly negative for 'A' and lower rated institutions. MTAM attributes this fluctuation in part to competition for students, affordability concerns from families, and in some regions fewer high school graduates.

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2nd Quarter 2014 Review and Outlook

Tuesday, July 1, 2014

For the three-month period ending June 30, 2014, investors in tax-free municipal bonds earned positive returns. As was the case in the prior quarter, investors who embraced "duration" were rewarded with greater overall returns as interest rates nudged lower once again. While there was some hint in June that municipal bond issuance might be picking up, it still remains a very challenging environment overall for investors with cash to deploy in the asset class. It is our view that the second half of 2014 will see more tax-free issuance, which is certainly comforting since we also see demand rising as signs emerge of a possible sustained slowdown beyond the disastrous first quarter for the United States economy.

Credit spreads on municipal bonds continued to grind tighter during the quarter as investors stretched for yield in this painfully low interest rate environment. While some of this collapse in credit spreads can be attributed to somewhat better fundamentals (California comes to mind), a greater cause is likely the European Central Bank's policy of charging banks for the privilege of parking cash with them. This policy of setting a "negative" interest rate will continue to have a profound influence on the overall level of interest rates globally, which should keep a "buy the dip" strategy—a winning one when it comes to fixed-income portfolios in the months ahead.

"Bond Funds Versus Separately Managed Accounts"

We do not normally comment on individual media articles, but this one was worth a few sentences by your favorite municipal bond manager. A story recently appeared in the "Financial Times" that dealt with the topic of installing "exit fees" on bond funds to prevent a potential "run" when interest rates rise. The Federal Reserve reportedly was discussing this subject. While the probability of this ever becoming policy is very remote, we caution investors that in an environment where governmental overreach is prevalent globally, one must pay close attention to "trial balloons" such as these. Perhaps a few bullet points from MTAM on why we consider separately managed portfolios superior to bond funds in this environment is warranted.

  • Individual investors can hold bonds to maturity in separately managed portfolios, ensuring no capital loss. Bond fund investors cannot make this claim.
  • Should rates begin to rise, bond fund investors will likely redeem their shares, causing the fund manager to sell into a declining market. Investors who have their own individual portfolios can utilize excess cash to buy into weakness and lock in higher yields.
  • Managing capital gains and losses is far easier to accomplish in an individual portfolio. Simply put, one need not be concerned which way the "herd" is headed.

While we remain skeptical of the case for much higher interest rates (please refer to last quarter's commentary on our website — "Whether the Weather" and "Is the Federal Reserve the Staten Island Clown"), we do sense too much complacency in the financial markets these days. MTAM's goal has always been about capital preservation, and as such, we will continue to keep an eye out for "potholes" in the coming months as the Federal Reserve continues to look for ways out of this "roach motel" called "quantitative easing."

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management

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State of the States - Midyear 2014

Monday, June 23, 2014

State general fund spending is increasing, although it continues to lag behind historical averages, and revenue growth remains small in some states, according to a report the National Association of State Budget Officers released last week.

State executive budgets reveal that general fund spending is projected to increase by 3% in fiscal 2015, below the decades-long average of 5.5%. Fiscal 2015 revenues are projected to grow by 3.2%, a rate the report characterizes as "not overly robust." General fund spending is projected to reach $751 billion in fiscal 2015, up $21.4 billion over fiscal 2014. General fund tax revenues are estimated to reach $749 billion in fiscal 2015, $24 billion over the projected amount collected the previous fiscal year.

Increased revenue collections have boosted the short-term outlook for U.S. states, but the slow economic recovery and persistent high unemployment have many states concerned that the fiscal improvements may be temporary.

Nelson A. Rockefeller Institute of Government

States are set to increase spending at the slowest pace since the recession ended five years ago, reflecting wariness about the recovery. Even with many states projecting general fund surpluses, officials are hesitant to cut taxes, hire workers, or restore all cuts made after the 18-month recession ended in 2009. The growth of tax collections slowed this year, following a jump in 2013 after taxpayers sold stocks and collected bonus income early to avoid federal rate increases set to kick in that year. During the first four months of this year, income-tax collections slipped by 7.1 percent, or $8.4 billion, declining in 38 of the 41 states that impose a broad-based levy on wages, according to a report by the Nelson A. Rockefeller Institute of Government. New Jersey, Connecticut and Virginia are among states that were caught off guard by the magnitude of the drop. After deep budget cuts stemming from the recession, some states are hesitant to spend surpluses that emerged during the recovery. In California, for example, Governor Jerry Brown, a Democrat, is pressing lawmakers to pay off debt and bolster savings.

Fiscal Survey of the States

The Spring 2014 version of the Fiscal Survey of the States, released last week by the National Governors Association and the National Association of State Budget Officers shows slow growth, but increased stability for state budgets.

State budgets are expected to continue their trend of moderate growth in fiscal 2015 according to governors' spending proposals. Consistent year-over-year growth has helped states achieve relative budget stability, but progress remains slow for many states. With each passing year of slow improvement, more and more states are moving beyond recession induced declines and returning to spending and revenue growth. According to executive budgets, general fund spending is projected to increase by 3 percent in fiscal 2015. This growth rate is less than the historical average, although inflation is also currently low. This means budget growth will likely outpace inflation in many states, presenting an opportunity to accelerate fiscal progress. Governors in most states have recommended additional spending for core services such as K-12 education. However, spending continues to be impacted by limited gains in revenue. Budgetary challenges also linger from a long recovery in the national economy, unemployment rates higher than policy makers want, and stagnant wages. As the economy continues along a trajectory of relatively slow growth, many states will continue to face difficult budgetary choices in fiscal 2015 and beyond.

Executive budgets in 42 states call for higher general fund spending levels in fiscal 2015 compared with fiscal 2014. However, additional spending is likely to be limited, with few budget dollars available to cover increasing demands in areas such as Medicaid and higher education. In addition, state spending for fiscal 2014 for the 50 states combined is still below the fiscal 2008 pre-recession peak after accounting for inflation. Aggregate spending levels would need to be at $761 billion, or 4.4 percent higher than the $729.1 billion estimated for fiscal 2014, to be equivalent with real 2008 spending levels.

Governors recommended that additional budget dollars most heavily target K-12 education and Medicaid in fiscal 2015. Executive budget proposals in 39 states recommend increasing general fund spending for K-12 education by $10.9 billion. Governors also recommended that additional funds be directed to Medicaid in 34 states and to higher education in 37 states, for net increases of $4.9 billion and $3.5 billion respectively. All areas of the budget received recommended spending increases in fiscal 2015 with the exception of public assistance, although much of the net decrease was due to a shift in spending from funds outside the general fund in California.

State budget gaps that arise during the fiscal year are primarily solved through a reduction in previously appropriated spending. Mid-year budget cuts have subsided compared with the years immediately following the recession when states had to make substantial cuts and take other actions, such as expend rainy day funds, to balance their budgets. Similar to fiscal 2012 and 2013, mid-year budget cuts have been minimal in fiscal 2014. At the time of data collection, February through April, eight states enacted net mid-year budget cuts totaling $1.0 billion in fiscal 2014. This compares with 11 states enacting $1.3 billion in net mid-year budget cuts in fiscal 2013, and eight states enacting $1.7 billion in net mid-year budget cuts in fiscal 2012. In contrast, 18 states enacted mid-year spending increases in fiscal 2014 totaling $2.3 billion. Additionally, six states enacted mid-year tax decreases, and one state enacted a mid-year tax increase resulting in a net revenue reduction of $184 million in fiscal 2014. Improved revenue collections and spending controls have significantly reduced the number of states needing to make budget cuts in fiscal 2014.

Aggregate general fund revenues are projected to modestly increase in fiscal 2015. Governors' recommended budgets show collections are projected to increase by 3.2 percent in fiscal 2015, a faster rate of growth than the estimated 1.2 percent gain in fiscal 2014. However, the growth rate is much slower than fiscal 2013, in which revenues increased by 7.1 percent. Substantial revenue increases in fiscal 2013 were attributable in large part to a one-time gain for states as high income taxpayers shifted capital gains, dividends and personal income to calendar year 2012 to avoid higher federal tax rates that were set to begin on January 1, 2013. States planned for the revenue slowdown in fiscal 2014 accordingly, but collections may not meet expectations in some states. Revenue shortfalls in fiscal 2014 are more likely a consequence of unanticipated volatility tied to tax law changes that were part of the federal "fiscal cliff" and individual taxpayer behavior, rather than underlying changes in the economy.

Governors' budget proposals forecast total general fund tax revenues of $749.2 billion in fiscal 2015, compared to the estimated $725.6 billion collected in fiscal 2014. Total general fund revenues in fiscal 2013 reached $716.9 billion and surpassed the pre-recession highs of fiscal 2008 by $41.2 billion or 6.1 percent. Yet, aggregate revenues in fiscal 2014 are still 3.8 percent below fiscal 2008 levels after accounting for inflation. Fiscal 2014 revenues would have needed to reach $753 billion, rather than the estimated $725.6 billion, to be equivalent with inflation adjusted 2008 levels.

Executive budgets recommended reducing net taxes and fees by $2.5 billion in fiscal 2015, although most tax change proposals are modest. Eight governors proposed tax increases and 15 proposed tax decreases. Governors in 32 states either proposed no tax changes or changes resulting in less than $5 million. States with the largest proposed tax decreases include Florida, Minnesota, New York, and Ohio. States with governors proposing the largest tax increases include Delaware, Massachusetts, and New Jersey, which took efforts to close corporate tax loopholes. Governors have also proposed $440 million in new revenue measures in fiscal 2015. State legislatures enacted net tax cuts in fiscal 2014; however, fiscal 2015 is the first time since the onset of the recession that governors put forth recommendations to reduce rather than increase net taxes and fees. In fiscal 2014, states cut taxes and fees by $2.1 billion, after raising taxes and fees by $6.9 billion in fiscal 2013.

In fiscal 2013, total balances, which include ending balances and rainy day funds, reached $73.5 billion, or 10.6 percent of general fund expenditures. This marked an all-time high for states in terms of actual dollars, though not as a percent of expenditures. Budget reserves increased substantially in fiscal 2013 as one-time revenues attributable to the federal fiscal cliff resulted in collections higher than projections. This led to budget surpluses in many states and greater than anticipated ending balances by the close of fiscal 2013. However, total balances declined in fiscal 2014 as states utilized ending balances from fiscal 2013 to acclimate budgets to the slowdown in revenue collections. Total balances are estimated to be $63 billion or 8.6 percent of expenditures in fiscal 2014. And governors recommended decreasing total balance levels in fiscal 2015 to $55.4 billion or 7.4 percent of general fund expenditures. In addition, two states have a disproportionate share of states' budget reserves. The balance levels of Alaska and Texas are estimated to make up 37 percent of total state balance levels in fiscal 2014 and 37.7 percent in fiscal 2015. The remaining 48 states have balance levels that represent only 3.5 percent of general fund expenditures for fiscal 2014 and 3.0 percent for fiscal 2015.

For fiscal 2014, total Medicaid spending is estimated to grow by 13.0 percent with state funds increasing by 5.9 percent and federal funds increasing by 18.3 percent. Executive budgets for fiscal 2015 assume an increase in Medicaid spending of 7.6 percent in total funds with state funds increasing by 5.8 percent and federal funds increasing by 10.2 percent. The projected growth rates in fiscal 2014 and in fiscal 2015 reflect both the Affordable Care Act's Medicaid expansion option that began on January 1, 2014, in addition to ongoing program spending. The rate of growth in federal funds exceeds the state fund growth rate since costs for those newly eligible for coverage are fully federally funded in calendar years 2014, 2015, and 2016, with federal financing phasing down to 90 percent by 2020.

Medicaid enrollment is estimated to increase by 6.9 percent in fiscal 2014. In governors' recommended budgets for fiscal 2015, Medicaid enrollment would rise by an additional 8.9 percent. This reflects both the impact from the Affordable Care Act including increased enrollment in states that have implemented the Medicaid expansion that began in January 1, 2014, as well as increased participation among those currently eligible in both states that did and did not implement the expansion.

State Public Pensions

While most public pension plans' funded ratios are stabilizing after multiple years of decline, they are doing so at lower levels, leaving states exposed to higher pension costs. While market gains and pension reforms may be helping some plans, pension challenges remain. Overall, actuarial liabilities rose without pause over the past five years.

The seemingly inexorable growth in actuarial liabilities during a period in which more than 40 states implemented numerous pension reforms underscores the difficulty of implementing benefit changes as wide-ranging as the reforms in Montana, New Mexico and Ohio. Funded ratios for Montana, New Mexico and Ohio's pensions have jumped significantly post-reform and included changes to the plan cost of living assets or shifting a portion of the contribution requirements from employers to employees.

Governments in general continue to contribute less to their pensions than the level calculated by their actuaries, the annual required contribution (ARC). Since the downturn, the ARC has risen significantly for most plans as they work to recoup past investment losses.

Numerous plans continue to calculate an ARC assuming a rolling, 30-year amortization of the unfunded liability. The repeated reamortization of the unfunded liability over a new, 30-year periods means that little meaningful progress is possible toward full funding, without investment gains exceeding the plan's investment return assumption.

Demographic profiles continue to weaken, with flat or declining government employment, rising retirements, and longer lifespans in retirement, trends that raise plan liabilities, pressure cash flows, and shift risk for plan performance to participating governments.

States' median debt burden totals 2.6% of personal income, while unfunded pensions attributable to the states total 3.3% of personal income. The range of state debt burdens is relatively narrow, from zero% to 9.2%. By contrast, the range of pension burdens is much broader, ranging from 0.2% to 19.3%.

Conclusion

State budgets are expected to continue their trend of moderate improvement in fiscal 2015, after several years of recovery in the national economy. Since the recession, states have transitioned to a sustained period of fiscal rebuilding. However, progress is slow and structural challenges remain. Spending challenges persist in areas such as health care and higher education, and governors' recommended budgets indicate that revenue growth may not be sufficient to meet all the competing demands for state resources. As states shift some of their focus from immediate budgetary pressures, long-term challenges are likely to persist in fiscal 2015 as revenue growth remains modest.

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Credit Comment on California's 'Rainy-Day' Reserve Fund Bill

Tuesday, May 27, 2014

California, the most-indebted U.S. state, is perhaps set for higher credit ratings as lawmakers follow Governor Jerry Brown's plan for a multibillion-dollar rainy-day reserve fund to cushion against economic downturns.

Legislators in the most-populous U.S. state unanimously passed a bill last week that will ask voters in November to approve a constitutional amendment requiring the State to set aside 1.5 percent of general-fund revenue each year as well as capital-gains taxes that exceed 8 percent of the general fund. That is a higher threshold than the 6.5 percent Brown had sought. If approved, the bill would also limit government discretion when to add or withdraw from the fund.

The reserve is a cornerstone of the $107.8 billion spending plan Brown proposed for the fiscal year starting July 1. His budget seeks to pay down half of the remaining $24 billion of loans and deferrals of health care, payroll and school costs used to cover deficits in the past decade, and leave $1.6 billion in reserves, developments that would have long-term positive credit implications.

The governor projects that the rainy-day fund would increase to $4.6 billion in fiscal 2018, or 3.8 percent of projected 2018 expenditures, from $1.6 billion at fiscal year-end 2015, or 1.5 percent of proposed 2015 expenditures. If voters pass it, the new requirement could eventually lift the maximum size of the rainy-day fund to 10 percent of revenues -- amounting to about $10 billion based on the current budget -- well above the 6.2 percent nationwide average, according to the National Association of State Budget Officers. As part of the rainy-day fund agreement with the legislature, the State would also pay down $3 billion of additional debt in three years. California's use of excess revenue for a one-time debt payment would be prudent in light of the temporary nature of Proposition 30 increases in sales and income tax rates.

California's credit ratings are currently ranked the second-lowest in the U.S. California's general obligation bonds have an 'A1' rating from Moody's. Standard & Poor's and Fitch grade it 'A', one level lower than Moody's. S&P is alone in giving it a positive outlook -- usually a precursor to an upgrade.

The rating agencies have long criticized California for its failure to set aside money when the economy is booming and for relying on capital gains, which vary with the performance of the stock market, to pay for two-thirds of the State's general spending. S&P said that failing to enact a rainy-day fund now would "be a missed opportunity." The rating agency said the 6.5 percent Brown proposed was low enough to require deposits in most years. Capital gains tax receipts have cleared that level in seven of the last 10 years.

Two-thirds of the legislature was needed to approve sending the measure to voters. Until last month, Brown had enough Democratic votes in both chambers to meet the requirement. Then three Democratic senators were suspended after being charged in unrelated corruption cases. That meant Brown also had to negotiate with Republicans to win support for his plan. Republicans were demanding that the money be deposited into the fund more regularly than Brown proposed, and sought stricter rules governing when and how the money is spent.

California already has a rainy-day provision known as the budget stabilization fund, approved by voters in 2004. That law requires depositing 3 percent of annual revenues into the reserve each year. However, payments are easily suspended, something that has happened every year since 2007. There are few restrictions on when and how the reserve money can be spent.

In 2010, lawmakers and then-Governor Arnold Schwarzenegger, a Republican, agreed to ask voters to set restrictions on suspending deposits and make it harder to spend the money. A vote on that plan was delayed until this year. Under the current deal, the constitutional amendment would take the place of that proposition on the ballot.

The State could withdraw funds only for a disaster or if spending remains at or below the highest level of spending from the past three years. The maximum amount it could withdraw in the first year of a recession would be limited to one half of the fund's balance. Other requirements include a separate Proposition 98 K-14 school spending reserve, a requirement that California use half of each year's deposits for the next 15 years for supplemental debt payments (or other long-term liabilities), and a requirement for a multiyear budget forecast.

Brown, who is already California's longest-serving governor, is running for an unprecedented fourth term. The rainy-day fund would add to his fiscal victories in leading the State from a $26 billion deficit to the biggest surplus in more than a decade.

A recent poll finds that California's likely voters prefer using the projected budget surplus to repay debt and build reserves, rather than restore funds to social-service programs. With an excess $3.9 billion predicted for the fiscal year beginning July 1, 57 percent of likely voters would rather pay down debt and build a rainy-day fund, while 39 percent favor restoring some social-service money, the nonpartisan Public Policy Institute of California said. The poll found a political divide on the surplus, with 59 percent of Democrats backing restored services, while 76 percent of Republicans preferred debt payment.

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Municipal Bond Market - Default Outlook Improves

Sunday, May 4, 2014

Municipal bonds are defaulting at the slowest pace in at least five years as a modestly growing economy lifts the most speculative corners of the $3.7 trillion market.

First time payment defaults have totaled $137 million year-to-date 2014, but only totaled $48 million excluding those defaults caused by administrative errors and cases where the insurers are expected to pay. The majority of true payment defaults continue to be in unrated securities, with only one of the three issues that experienced a true payment default in 2014 having both a rating and bond insurance. In YTD 2014, the healthcare sector accounted for 51 percent of all true payment defaults, retirement facility/CCRC debt accounted for 32 percent, and general obligation bonds accounted for the other 17 percent of true payment defaults.

Nine borrowers missed payments for the first time so far in 2014, down from 25 at the same point in 2013, according to Municipal Market Advisors. It is the fewest failures in the research firm's database, which goes back to 2009.

A rebound in property taxes and real estate values after the recession that ended almost five years ago is filtering down to the riskiest parts of the municipal market, where governments sell bonds backed by revenue from projects such as museums and housing developments. The decline in defaults tracks a broader improvement in municipal finances. State tax collections have risen in every quarter since the start of 2010, according to the Nelson A. Rockefeller Institute of Government. That is fostering a recovery for communities still contending with pressures from the 18-month recession that ended in June 2009.

The fiscal strains pushed three California cities, Detroit, and Central Falls, Rhode Island, into bankruptcy since 2008. Faced with a struggling economy and mounting debt, junkrated Puerto Rico borrowed $3.5 billion last month, giving it enough cash through mid-2015.

Among those defaulting were the owner of North Adams Regional Hospital, a money-losing medical center in northwestern Massachusetts that filed for bankruptcy this month. Others included bonds issued by government agencies that financed the Lewistown Commerce Center, a shopping complex outside Richmond, Virginia; and a privately operated detention center in Arizona for undocumented immigrants. Last week's bankruptcy filing by Energy Future Holdings Corp., the Texas power company that was taken private in 2007 in the biggest-ever leveraged buyout, may add to the default tally because of related municipals.

In general, municipal defaults have been rare, and remained so even as they increased following the recession. Moody's Investors Service said last year that there was an average of 4.6 defaults annually from 2008 through 2012 on bonds it rated, up from 1.3 from 1970 through 2007. Typically, about 70 percent of such cases are related to healthcare providers and housing developers that sell tax-exempt bonds through government agencies.

Pension deficits at the local level, as well as financial pressure on hospitals from President Obama's health-care overhaul, remain a source of strain. However, the modestly improving economy is propping up bond-funded projects and borrowers' ability to raise money to keep developments operating as they try to turn a profit.

More than half of U.S. states have larger 2014 general fund balances than anticipated at the start of the year because of the strengthening economy. Thirty-six of the governments expect to end this fiscal period, which lasts through June for most states, with a higher balance than the year's beginning, showing progress in bringing their fiscal structures into ongoing alignment. However, states should be wary of increasing spending given the potential for volatility in equities and tax receipts. The governments' revenue rose in fiscal 2013 for a third straight year, pushing collections to a record $846 billion, according to the Census Bureau. State sector credit quality through at least the next 12 to 18 months may be linked to whether the states maintain a restrained fiscal posture. Some states' finances have yet to rebound from the recession that ended in June 2009. Less than half -- 24 states -- have 2014 reserves bigger than in 2008. Also, 27 states do not regularly fund annual pension contributions.

Conclusion

There are a multitude of reasons that state and local government defaults will remain rare. Chief among the reasons municipalities will continue repaying their debt is that they have to. Governments know they need to borrow regularly and cannot afford to repulse investors by defaulting on bonds. Aside from losing access to the capital markets, filing for Chapter 9 bankruptcy is not an easy way out, anyway. It can be a difficult process that does not ease the debt burden after all. Moreover, repaying debt normally does not impose a big cost on municipalities; paying off debt represented only 8% of revenue at the state level.

We expect any credit problems, as they occur, to be more localized and mostly among smaller, less traditional issuers and rarely from government bodies. We look for more defaults in land-backed deals and special-purpose districts (hotels, casinos, etc.). Many of the default filings have been from community development districts in Florida. Governments with unlimited taxing power are in a different category.

MTAM continues to take a very cautious view toward the riskier municipal sectors and smaller, weaker municipal issuers, and any issuers where the budgetary pressure becomes extreme.

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Puerto Rico: Is Statehood the Answer?

Friday, April 4, 2014

Last month, Puerto Rico took a small step in the direction of becoming the 51st U.S. state. U.S. Senator Martin Heinrich (D-N.M.) submitted legislation that would mandate a referendum asking Puerto Rican residents if the island should become a U.S. state in an up-or-down vote. The Senate resolution, called the Puerto Rico Status Resolution Act, is an identical companion version to legislation already filed in the House by the island's non-voting representative, Resident Commissioner Pedro Pierluisi.

"In 2012, 54 percent of Puerto Ricans rejected their current relationship with the United States," Heinrich said in a press release. "We have a responsibility to act on that referendum, and this step is critical in that effort. My home state of New Mexico spent 66 years as a territory before gaining statehood in 1912 -- the longest of any state. Puerto Rico has spent nearly 116 years as an American territory. That's long enough."

Pierluisi, of the pro-statehood New Progressive Party, has been pushing hard for statehood since the non-binding plebiscite in 2012 showed that most Puerto Ricans were dissatisfied with their position as a U.S. commonwealth. The two-part referendum went on to ask whether voters wanted to become a U.S. state, an independent country, or a freely associated state -- a type of voluntarily limited sovereignty. Remaining a commonwealth was not an option. Statehood won the largest number of votes, but because commonwealth supporters cast blank ballots on the second question in protest, statehood failed to win a majority of the votes cast.

While some statehood supporters tried to argue that the blank ballots should be discarded from the final tally, their case failed to convince Congress or the White House that the referendum amounted to a statehood mandate.

Whether or not the statehood resolution passes, Puerto Rico's status will remain a major issue for the near future. The Obama administration included $2.5 million in the Omnibus Spending Bill to conduct a plebiscite aimed at resolving the status conflict.

Juan Carlos Hidalgo, a policy analyst on Latin America at the Center for Global Liberty and Prosperity at the Cato Institute, said Puerto Rico's governor, Alejandro García-Padilla, who does not support statehood, has to approve another referendum. And even if the referendum shows an overwhelming majority in favor of statehood, it must then be approved by a simple majority in Congress. "That's not going to happen," Hidalgo said. "That is something that hardly happens because of the political consequences." Making Puerto Rico the 51st state would add two senators and six to eight representatives. "These representatives are almost always Democrats and it would change the balance of power," he said. "For the same reason Republicans don't want to give away their power in Washington, they are opposed to Puerto Rico becoming a state."

Hidalgo believes Puerto Rico's status as a U.S. territory puts it at a disadvantage. "I think many of the current economic problems are because of the status," he said. Puerto Rico's minimum wage is set by the U.S. government, for example, and Hidalgo said this has translated into a tremendous unemployment problem for the tiny nation. He points to that law as the reason 40 percent of Puerto Ricans are on welfare. "The labor participation rate is among the lowest in the world. Only 41 percent of the people who are of working age work," he said. Statehood could also give business start-ups pause because "companies would have to start paying federal taxes, which is what attracts them to set up shop here."

The GAO Report

The Government Accountability Office is projecting in a just-released report that federal spending on many programs would increase by hundreds of millions or billions of dollars if Puerto Rico became the 51st state. That would potentially allow the commonwealth's government to use its revenues to address its mounting debt problem, spurred by the popularity of its bonds, which are tax-exempt at the federal, state, and local levels.

The bonds were downgraded to speculative grade by all three major rating agencies earlier this year. The study did not produce specific figures, but projects possible spending ranges for various categories.

Many of the most significant changes would likely involve social welfare spending. The GAO said Medicare spending could increase by as much as $1.5 billion annually under statehood, while Medicaid spending could increase from about $400 million to about $1.5 billion per year. However, the report also said spending on Medicare could remain almost flat, depending on the number people eligible to receive it. Supplemental security income spending on the island could increase very much to between $1.5 billion and $1.8 billion from roughly $24 million on a similar federal program in 2011, according to the report.

The report estimated a $115 million annual increase in federal highway spending. Puerto Ricans, who are American citizens, would also pay the U.S. government about another $2 billion annually in federal income taxes, the report states. Corporate income tax from companies operating in Puerto Rico might increase between $700 million and $5 billion according to the GAO, but some businesses might leave Puerto Rico if they lose the favorable corporate tax climate they currently enjoy there. Under special multi-year agreements with Puerto Rico, some of these corporations pay corporate income tax rates far below the commonwealth's maximum rate of 39 percent. Instead they pay a special excise tax, the legality of which has been questioned by some observers and even the Internal Revenue Service.

Conclusion

The statehood issue is divisive in Puerto Rico, which has held four internal votes on the issue since the late 1960s. Resident Commissioner Pierluisi seized on the GAO report as evidence of statehood's benefit to the commonwealth's economy. "As GAO expressly observes, 'statehood could eliminate any risk associated with Puerto Rico's uncertain political status and any related deterrent to business investment,' Pierluisi said in a statement. "It must be emphasized that investment in Alaska and Hawaii increased substantially once they became states." Pierluisi claims that statehood will be "mutually beneficial for Puerto Rico and the U.S. and that "equal treatment" will improve quality of life for the people of Puerto Rico and strengthen the economy while the U.S. gets more tax revenue.

Governor García-Padilla takes the opposite view. "The GAO's findings are very concerning for Puerto Rico, our economy and jobs," he said. "The enormous tax burden that Puerto Ricans would be forced to shoulder as a state would be incredibly damaging to our economy, our businesses, and the workers on the island. This report also clearly states that statehood will make it very difficult for the commonwealth to move its economy forward. Ultimately, statehood is a losing proposition for both Puerto Rico and the U.S."

The GAO report contains some major gaps, including the billions of dollars of Obamacare funding Puerto Rico would be eligible for as a state. The report also does not take into account some political factors, such as how tax reform might affect the numbers before any statehood question could be resolved, and what changes two new senators and multiple voting congressmen might be able to get enacted once the commonwealth gained statehood. Although the report provides no clear comprehensive view of how statehood would affect the territory, pro-state and anti-state elements on the island will try to spin it in the coming weeks.

MTAM believes that there are many variables when it comes to outcomes regarding Puerto Rico under statehood. Consequently, statehood's aggregate fiscal impact would be influenced greatly by the terms of admission, strategies to promote economic development, and decisions regarding Puerto Rico's government revenue structure.

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1st Quarter 2014 Review and Outlook

Tuesday, April 1, 2014

For the three-month period ending March 31st, 2014, investors in tax-free municipal bonds earned positive returns. "Duration" was the story in the first quarter, as investors who took on interest rate risk were the biggest winners as longer-maturity bonds exploded higher in price as tax-exempt supply fell in tandem with economic activity. New-found demand appeared to enter the tax-free bond asset class during the quarter from investors looking to "lock in" their outsized equity market gains from the previous year. We sense this may be a recurring theme throughout 2014.

While longer-maturity bonds were rallying in muniland, credit spreads tightened significantly during the quarter as a desire to maximize yield drove investors into the high-yield segment of the market, which took a beating in 2013 primarily due to the troubled finances of Puerto Rico and Detroit. As the quarter progressed, we found ourselves more inspired when looking to invest in higher quality bonds as they were discarded in the search for yield. Our clients should expect more of that bias from MTAM in the coming months, as we believe the best long-term results will benefit from investing in high quality municipals when they go "on sale."

"Whether the Weather?"

Much has been written about the cold and snowy weather being the primary reason for the soft economic data as of late, and we will give a tiny nod to that theory. However, it generally is cold in the winter and hot in the summer, and yet the economy generally moves forward. The housing market began weakening around eight months ago, and this may be more of a result of poor wage gains and rising uncertainty on the overall costs of health care moving forward. To be clear, it is our view that some "bounce back" of economic activity will emerge as we move through springtime. Most likely, this will concern the bond market once again about the possibility of higher interest rates. However, it will not be long before the economists will be blaming the warm weather for the additional slowdown we see coming over the summer months.

"Is the Federal Reserve the Staten Island Clown?"

So the Federal Reserve has made it pretty clear to investors their intent to continue to wind down the quantitative easing policies they embarked on to stimulate the economy, and this has rattled some nerves of bond investors who fear higher rates will be the eventual outcome of this reversal. Recently, Janet Yellen remarked (stumbled, misspoke, etc.) that the Federal Reserve might begin raising short-term rates sooner than many investors had anticipated. All of this would be quite bearish for bonds, except we are experiencing slower economic growth and falling inflation around the globe. MTAM believes the Fed has realized "QE" has been a failure and they are intent on reversing this policy, while economic output remains "positive." By signaling to the markets their desire to normalize interest rates, it may be perceived as an indication that the economy is on the precipice of "taking off" (are you listening corporations and small business owners?). In this day and age, "nothing" can be turned into "something" just by creating a perception in the media. Recently, in this part of the country, a man walking around in a clown costume at night has become a media sensation for no apparent reason. He has been described as "creepy," "frightening," and "bizarre" by terrorized residents of Staten Island, yet all he did was walk around at night with balloons in his hand. Of course this turned out to be a publicity stunt by a production company looking to make a name (and money) for themselves. Investors need to pay close attention that this economic recovery the Federal Reserve sees coming does not leave them looking like clown costume-wearing cheerleaders without a circus.

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management

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Chicago is Not Detroit

Thursday, March 6, 2014

Moody's downgraded the City of Chicago's general obligation debt rating three levels on July 17th, 2013. A cut of that magnitude is unprecedented for a U.S. city as populous as Chicago, according to Moody's data since 1990. Detroit, about 280 miles to the east, filed the nation's largest municipal bankruptcy the next day as $18 billion of debt compromised its ability to protect its citizens. And then, just this past week, Moody's downgraded Chicago's credit rating another level, to 'Baa1' from 'A3'. (S&P and Fitch currently rate the City's general obligation bonds A+/A-, respectively).

The timing of Chicago's previous rating cut and Detroit's bankruptcy highlighted similarities between the localities. Like Detroit, Chicago faces sharply rising pension contributions. To meet higher funding levels, Chicago may have to hike pension contributions from the current $480 million to $1.1 billion in 2016.

However, Chicago has significant advantages that insulate it from following Detroit's path. Its economic base is broader and its citizens are wealthier, allowing the City to collect revenue to offset budget shortfalls. The median household income in Chicago from 2007 to 2011 was $47,371, compared with Detroit's $27,862, Census data show. The median home value in Chicago over the period was $260,800, more than triple Detroit's $71,100. In short, Chicago has a spending problem, but has the revenue to pay their bills if cuts are made. Even if Detroit made cuts, they still would have no way to raise revenue. That is why the cuts have to be so severe.

Although Chicago has mounting budget difficulties -- including large pension obligations and budget deficits -- it is widely expected to avoid a Chapter 9 bankruptcy. Chicago has had relatively strong local management, versus Detroit's weak management. The City produces long-term financial and capital plans, which officials update annually. It has a formal debt management policy and has adopted ordinances that limit the use of non-general fund reserves for budget-balancing purposes.

With a sizable tax base and taxing flexibility given its broad home-rule powers, Chicago has the ability to meet all of its obligations. Its willingness (or lack thereof) to raise taxes -- in contrast to Detroit's inability to do so -- will have a significant impact on the City's rating trajectory.

We view Chicago's home-rule status as a credit positive, fostering revenue independence and flexibility. The general fund derives support from utility taxes, state sales taxes, transaction taxes, and recreation taxes among others. The general fund does not rely upon property taxes for operations, as they are earmarked for pensions, library expenses, and debt service. The City's home-rule status also exempts it from the state's Property Tax Extension Limitation Act. A self-imposed limit matches that of the state, limiting increases in the levy to the lesser of 5 percent or the CPI. In recent years, the City has kept its levy flat, without accessing the allowable growth. We believe the self-imposed levy limit is relatively flexible and that increased property taxes may provide an important source of funding for potential future increases in pension payments.

MTAM believes Chicago can largely control its own fate, whereas Detroit cannot, nor will it be able to for some time. In our view, this may be the key difference between the two cities, and may be what will allow Chicago to work through its problems rather than follow Detroit's path on the road to bankruptcy.

Demographics

Both cities have seen populations shrink, but Detroit has fallen much faster. Chicago's population peaked at 3.62 million in 1950 and had dropped 26 percent to 2.7 million in 2010, leaving it as the third-largest city in the nation. Detroit's population topped out at 1.85 million in 1950 and fell 61 percent to 713,777 in the 2010 Census, making it the 18th-largest U.S. city.

Citywide data reflect significant outmigration in Detroit, which differs from Chicago, which continues to attract younger 'Millennials'. By attracting this generation, Chicago stands to benefit from increased consumer activity and demand for education, as well as a larger pool of talent from which to select its future community leaders. With a younger population base, Chicago is also likely to have broader support of local school district levies and a greater population of future taxpayers to pay for legacy pension and other postemployment benefit (OPEB) liability costs.

Chicago's highly educated work force supports its status as a major financial and business services center. Educational attainment levels are strong, with 33 percent achieving a bachelor's degree and 13 percent an advanced degree, compared with the U.S. averages of 28.2 percent and 10.5 percent, respectively.

More Details on Pension Funding

The size of Chicago's unfunded pension liabilities makes it an extreme outlier, as indicated by the City's fiscal 2012 adjusted net pension liability of 8.0 times operating revenue, which is the highest of any rated U.S. local government. While the Illinois General Assembly's recent passage of pension reforms for the State of Illinois and the Chicago Park District suggests that reforms may soon be forthcoming for Chicago, we expect that any cost savings of such reforms will not alleviate the need for substantial new revenue and fiscal adjustments in order to meet the City's long-deferred pension funding needs.

MTAM believes a pension solution that enhances funding levels while preserving sustainable budgetary balance is necessary to stabilize the credit. Inaction, or affirmative steps to avoid actuarial-based funding of pensions, will have a negative impact on the rating.

Management has presented a plan to address the pension problem, but lacks the legal authority to implement it unilaterally. Direct negotiations with labor groups have failed to yield a solution, and attempts to lobby the legislature for benefit changes which would reduce the unfunded actuarially accrued liability (UAAL) have been unsuccessful thus far.

State law requires dramatically increased annual funding requirements for two of the City's four pension systems beginning in 2016, which would need to be addressed in the fiscal 2015 budget. The new formula requires a contribution that would be sufficient to bring both the police and fire systems to 90 percent funding level by 2040.

The City estimates the annual requirement will rise by $590 million as a result, an amount that will raise carrying costs to above-average levels. Legislation to delay the implementation and to require property tax increases to fund it has been introduced, but the legislature has not acted on it. We believe deferral of the increased actuarially-based requirement would exacerbate the problem absent a meaningful reduction in the UAAL.

More Details on Fiscal Results and Budget

We recognize the current administration's notably improved financial and budgetary management which has brought the City closer to structural balance, following the prior administration's long-term trend of reliance upon asset sales and other non-recurring items to fund operations.

Management has made significant progress toward matching ongoing revenues with non-pension annual expenditures. We view positively the City's stated commitment to ending the practice of using the corpus of its long-term reserves to balance the operating budget. Other recurring improvements over the past two years include a hiring freeze for non-essential positions, the elimination of 2,000 vacant positions, and a marked reduction in retiree health care costs, although the latter is subject to litigation.

Chicago's fiscal 2012 unrestricted general fund balance dropped to 6.8 percent from 10.2 percent of spending a year prior. We view the $625 million, or 20.1 percent of fiscal 2012 general fund spending, in the service concession and reserve fund as an important element of financial flexibility.

Published preliminary fiscal 2013 results show revenues outperforming budget by a larger margin than expenditures exceeded budget. Detail is not yet available, but early projections indicate a net positive budgetary variance of $45 million which if realized, may decrease further the amount of reliance on non-recurring sources. The preliminary fiscal 2014 budget seeks to appropriate $50 million of identified surplus from fiscal 2013, to be used toward increased police overtime expenses.

The $3.3 billion fiscal 2014 budget closed the previously identified budget gap of $338.7 million through a variety of recurring and one-time measures. Revenue measures include an assumed $101 million growth in economically sensitive revenues, $53 million of general fund and $35 million other fund balances, and $34 million of increased taxes, fees and fines. Expenditure measures include $66 million of savings, including $24 million of savings from the elimination of retiree health care for certain retirees, which is subject to litigation.

We believe that these identified measures are achievable given the City's recent history of budgetary adherence; however, we will not consider the City's financial operations to be structurally balanced until recurring revenues support recurring expenditures, including actuarially-based pension costs.

Conclusion

Since Detroit's filing under Chapter 9 of the U.S. bankruptcy code last summer, and in light of Chicago's mounting budget difficulties, some media commentators have drawn parallels between the future credit strength of the two cities. However, MTAM believes that although the cities are facing some of the same credit strains, such as large pension obligations and budget deficits, a review of Chicago's and Detroit's respective credit characteristics demonstrates more differences than similarities -- and ultimately underscores Chicago's long-term viability against the backdrop of Detroit's bankruptcy and default.

We believe that Chicago's growing economy and taxing flexibility provide it with the resources to avoid a fate similar to Detroit's should it capitalize on this flexibility and remain on course. Chicago's proactive management style, coupled with key financial and economic differences, places the City in a much stronger position, and provides a basis for our view that it will not suffer the same fate as Detroit.

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The High Cost of Winter Weather

Thursday, February 27, 2014

The winter of 2013-2014 has not been kind to state and local budgets. All around the country, lawmakers are being forced to tap into emergency funds or request more money to pay for round after round of snow removal and the salting of roads. In some cases, it is not clear where the money will come from, nor how this winter's budget-busting storms will impact municipal finances down the road. Officials around the country said the costs would be steep, but many said they would not worry about tabulating them until the crisis was over.

The exceptionally cold and stormy winter battering the Midwest, South, and Northeast has forced states and cities to put road crews on double shifts, and step up purchases of asphalt, trying to keep up with an epidemic of potholes. They have also bought and spread so much salt that there is a shortage in the Mid-Atlantic States, with more storms expected.

Cold weather is tough on municipal water systems because as the water chills, metal pipes contract. At the same time, frost and ice cause the ground to expand, adding pressure. And even light dustings of snow can be just as expensive as blizzards because of the amount of snowplows, sand trucks, and personnel that are deployed just in case a storm arrives. Northern regions tend to have older pipes and bridges, while areas farther south tend to be ill-equipped for snow drifts and subfreezing temperatures that can snarl traffic and buckle pavement.

The Michigan Legislature is considering allocating an additional $100 million to the transportation department, counties and cities for plowing and salting roads and fixing potholes. In New Jersey, officials say that major roads might have to be shut down -- not because of winter weather, but because of a shortage of salt needed to deal with winter weather. The State is in the process of seeking a special waiver from the federal government that would allow a barge carrying road salt to New Jersey from Maine.

South Carolina officials estimated that a single weather system last month drained $2 million from the State's budget. Pennsylvania has used road salt at a pace 24 percent ahead of normal, an additional cost of more than $8 million so far, and last month Governor Corbett deployed elements of the National Guard to help with an emergency response, which means another expense.

Chicago budgeted $20 million for 2014 to plow snow and salt roads, but it has already spent $25 million. City crews are filling potholes at double the rate of last year -- which means buying twice as much patching material for that purpose. In Baltimore, 353 water mains ruptured in January, about one-third as many as in all of 2013. A 137-year-old main that popped in Lower Manhattan turned some of the most stylish streets in Greenwich Village into a temporary Venice, and a break in Boston's Chinatown nearly swallowed a public works truck.

Detroit -- the largest American municipality ever to enter bankruptcy, and yet to exit it -- was already suffering from an aging, neglected infrastructure. After a wave of retirements at the City's Water and Sewerage Department, the remaining staff, like the budget for water main repair, was not up to the job. To those burdens, this winter added persistent subzero temperatures and heavy snow, contributing to about 500 water main breaks in January, compared with 300 a year earlier, forcing the City to hire outside crews to try to keep up.

In addition to the direct costs to governments, harsh weather can also mean lower tax revenue by slowing economic activity. Storms in January probably cost more than $3.5 billion in economic losses, including business interruption and property damage, insurance broker Aon Plc said this month. Burst pipes, falling trees, and roof collapses inflated costs to home insurers including Allstate Corp. and Chubb Corp.

Risks to auto insurers have been cushioned by a decrease in the number of motorists, some of whom are cowed by snow and ice. In some cases, where an entire city is shut down like Atlanta, people actually drive less.

The Dreaded Pothole

The combination of precipitation and rapidly changing temperatures experienced in much of the country over the past two months has made for an exceptionally bad pothole season in the Midwest and the East. In winter, water and road salt seep into cracks, then expand and contract, finally undermining the pavement. A pothole is born.

Most municipalities will be contending with an unprecedented road-repair season, straining work crews and budgets already depleted by plowing and salting. About three-fourths of U.S. states and many cities have outspent their maintenance budgets dealing with the extreme weather according to the American Association of State Highway and Transportation Officials in Washington.

In New York City, crews have filled a record 113,131 potholes this year, up from the 50,434 patched at this point in 2013. The American Automobile Association in New York has received more than 80,000 calls for flats from potholes among its 1.3 million members in the City and eight surrounding counties. Mayor Bill de Blasio is adding $7.3 million for street repairs to the City's $74 billion budget because of "unprecedented wear and tear."

The potholes are emblematic of a deeper chasm. The gap between the cost of improvements to U.S. transportation infrastructure and available revenue from both state and federal sources was as much as $147 billion, according to a 2009 National Transportation Infrastructure Financing Commission report. They also contribute to substandard conditions on more than a quarter of U.S. urban roads that cost the average driver using them $377 a year and $80 billion nationwide, according to TRIP, a nonprofit transportation research group in Washington.

Impact on U.S. Airports

Flights cancelled due to the severe winter weather could result in financial risk to airports to varying degrees. Flight disruptions have been widespread, with over 40,000 flights cancelled and 180,000 delayed during the 2013-2014 winter so far according to some estimates. Much of the disruption has occurred in the Midwest and Northeast, resulting in a ripple effect affecting every major airport across the U.S.

Airlines have limited flexibility when trying to reestablish flight patterns due to postrecession efforts to control seating capacity. With passenger loads consistently exceeding 80 percent over the past three years, accommodating passengers on delayed or cancelled flights is a significant challenge.

Passenger traffic is the lifeblood of airport revenue. Passenger-generated revenue from terminal concessions, on-airport parking, and car rental are most at risk to changing conditions. All together, these revenues can contribute 40 percent - 60 percent of total airport operating revenues, and quickly impact total non-aeronautical revenue generation. From the expense side, higher costs for snow and ice removal can impact net cashflow as well.

Most U.S. airports have strong cost recovery mechanisms and robust liquidity that provide ample flexibility to weather the conditions seen so far this winter. Credit implications are expected to be limited.

Conclusion

The meter for states and localities keeps ticking. We have more winter -- and potentially more brutal cold, snow, and ice -- to go through before the arrival of spring. The problem is many municipalities have already run through a season's worth of the money and supplies needed to cope with winter storms. With revenues and staffing still below pre-recession levels, many state and local governments face a new financial strain from storm-related increases in spending on overtime pay, contractors, and supplies. MTAM expects that most will be able to cope with the added expenses, although it could lead to increased taxes or expenditure cuts elsewhere.

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Credit Comment on California's Drought

Tuesday, February 4, 2014

MTAM does not expect California Governor Jerry Brown's drought proclamation to have any immediate credit impact on the State's water utilities. On January 17th, the governor issued a proclamation of a state of emergency as severe or extreme drought grips 90 percent of California. The most direct and tangible impacts of the drought declaration are that it facilitates water transfers throughout the State and eases certain restrictions on water diversions from the Sacramento-San Joaquin River Delta. Perhaps the most significant intangible impact of the declaration is the heightened public awareness it creates of the very dry conditions that California has been experiencing.

California just ended the driest calendar year on record, according to the California Department of Water Resources. The current wet season has also been extraordinarily dry, marking a third dry year for the most populous U.S. state. Governor Brown asked the State's residents to cut water use by 20 percent, and hinted that mandatory rationing may be required in the months ahead. The California State Water Project, which serves two-thirds of the State's population, late last year announced an initial allocation of water for 2014 at just 5 percent of contracted amounts; and then just last Friday it was announced that it now projects that it will not be able to deliver any of the 4 million acre-feet of water sought by local agencies. An acre-foot is the volume needed to cover an acre of land one foot deep with water. The reduction means that agencies will have to rely on existing supplies such as ground water or what is in storage behind dams. This allocation could rise, as it did in 2010, when a 5 percent allocation eventually rose to 50 percent after a series of winter storms. Winter is California's wet season, and there is still time for winter storms to change the supply outlook. But so far, there has been little precipitation, and the National Oceanic and Atmospheric Administration's outlook through April is for the drought to persist or intensify across the vast majority of the State.

MTAM believes that California water utilities should be able to manage the State's drought emergency in the near term. However, a more severe or longer-than-typical drought could pressure import and surface water-dependent utilities even as those with significant ground water supplies should maintain their financial stability.

In a prolonged drought, a simultaneous increase in water prices and reduction in usage would put import-dependent utilities under pressure, forcing large and difficult-to-impose rate increases. Water utilities with significant ground water supplies in basins that have not been over-pumped, utilities that have invested heavily in alternate supplies like water recycling, and surface water purveyors with very high priority water rights would have ample supplies to sell, outperforming peers.

We expect revenue reductions in 2014 and 2015 to be less severe than those in the 2007-2009 drought as sales are currently lower than when utilities experienced the dual impact of economic recession and drought conditions. Also, many utilities adopted drought rates following 2007-2009 or will have corresponding expenditure reductions in their purchased water costs.

Although the governor's declaration was made two weeks ago, the dry conditions are not news to California water utilities. A January snow survey by the State Department of Water Resources (DWR) showed statewide water content at 20 percent of average for this time of year. This survey and the January 2012 survey -- also at 20 percent -- are the two driest on record. Snowmelt provides about one-third of the water used by residents and farms within the State through streams, reservoirs, and major export projects, such as the State Water Project (SWP) and U.S. Bureau of Reclamation's (USBR) Central Valley Project (CVP).

In his declaration, the governor directed State agencies to take a series of actions to mitigate the drought impacts, and specifically for DWR and the State Water Resources Control Board (SWRCB) to expedite the processing of water transfers. Typically, water transfers are limited by "place of use" restrictions. To ease these restrictions, DWR can petition SWRCB to temporarily consolidate the SWP and CVP places of use by citing the declared emergency as the reason. The governor directed SWRCB to immediately consider such a petition, and if the petition is approved, DWR and USBR will be able to operate the SWP and CVP -- major parts of the State's water infrastructure -- as a single unit and utilize the combined infrastructure to more effectively and efficiently facilitate water transfers and exchanges. Water diversions from the Delta are restricted in part by the water needs of special status species, such as the delta smelt. We understand that some of these restrictions can be suspended pursuant to the governor's declaration, which may allow additional water diversions from the Delta that otherwise would not be permitted.

Importantly, the drought declaration will likely serve as an effective public awareness tool. We have seen water utilities' demand, as measured on a per capita per day basis, generally decline during the past five years. This change in demand has been driven primarily by water conservation messaging as various water utilities work toward their state-mandated water use reduction targets, as well as the tightening impact of the economic recession on household budgets. We anticipate that the drought declaration will lead to a heightened awareness by residents of the need to further curtail water usage. As earlier stated, the governor has called on residents to meet a 20 percent voluntary reduction in personal water usage, similar to the 25 percent reduction in personal water use that he requested during his previous tenure as governor, during the 1976-1977 drought. The drought declaration may also focus the attention of federal officials who could accelerate aid to the State.

The challenge to water entities is to ensure that water revenues meet operational and debt service costs during this period of constrained supply. Although financial assistance for drought projects was available from the State during the 2008 through 2011 drought, the source of funding for that assistance was from bond proceeds. With the State's last water bond measure passed in 2006, we understand that any remaining bond proceeds are already obligated and are not be available for drought assistance.

The response of water utilities to the dry conditions can be wide-ranging, depending on sources of supply, seniority of water rights, and level of water storage. For example, with storage in the Folsom Reservoir on the American River at 17 percent of capacity and 34 percent of normal, a number of water utilities in the Sacramento area, including Sacramento, Roseville, Folsom, and the San Juan Water District, have instituted mandatory or voluntary water use reductions. The Marin Municipal Water District, which relies on its local watershed for 75 percent of supplies, has begun tapping water in one of its reserve reservoirs due to dry conditions. It has also asked customers for voluntary conservation. Meanwhile, the Metropolitan Water District of Southern California (MWD), the large wholesale water supplier serving 18 million people in the south of the State, has publicly stated it does not plan to ration water this year. Although the SWP is one of MWD's two major water sources, it has been storing excess water in recent years, which has shored up overall stored supply. Water utilities relying mostly on groundwater may feel fewer effects of the drought, at least in the near term.

The State's two biggest population centers, Los Angeles and San Francisco, have built up water reserves and will not be as hard hit as places such as Sacramento and California's central valley farming region. Still, the drought could cause a drop in hydroelectric generation used by power companies such as PG&E Corp. as stream flows dwindle. That could force utilities to sell higher costing -- and higher polluting -- fossil fuel generated power, including natural gas. In 2012, hydro-power production in California decreased to 13.8 percent because of drier conditions. That led to an increase in natural gas-fired generation, which rose from 45.4 percent in 2011 to 61.1 percent in 2012.

The agricultural industry can withstand a short-term drought. In fact, when the last drought struck from 2007 until 2009, farm income actually rose to its highest ever at the time, in part because of high crop prices and strategies farmers and ranchers used, such as fallowing or idling fields, shifting cropping patterns, and temporary water transfers. California is the top U.S. agricultural producer at $44.7 billion. Farmers would have a difficult time lasting through a sustained drought like the one that struck between 1987 and 1992, when some communities were forced to cut water use by as much as half. Lost revenue in 2014 from farming and related businesses such as trucking and processing could reach $5 billion, according to estimates by the 300-member California Farm Water Coalition, an industry group.

The drought may influence voters' willingness to pay for water projects. Governor Brown is considering whether to submit a bond measure to voters to pay for tunnels and other infrastructure to increase supplies from the Delta region. In July 2012, the governor withdrew an $11 billion borrowing proposal from the November 2012 ballot, citing concerns that it would have jeopardized his plan for higher sales and income taxes. Renewed concern about water shortages may tilt public opinion in favor of a recently proposed $9.2 billion water-bond measure.

Conclusion

Regardless of the declared state of emergency, the State is experiencing a third year of drought conditions, which are expected to continue. Absent conservation or use restrictions, dry conditions can actually increase water demand as customers increase irrigation to maintain landscaping, which can lead to increased operating revenue. However, if users heed the governor's request for voluntary reductions, or if water utilities implement mandatory conservation measures, water sales revenue could decline. Most of the water utilities have at least adequate cash reserves to cover a period of reduced water use. In most cases, they also have debt service coverage above 1.0x, providing some cushion for fluctuations in revenues. If dry conditions persist, water use restrictions could tighten and constrain sales, which could impact debt service coverage and liquidity metrics.

Water rates are often structured with a flat base rate and a volume-based rate, providing some revenue stability even if sales fluctuate. We note that California government agencies that operate water utilities have autonomous rate-setting authority and can raise rates subject to State laws requiring public notice. Also, some water utilities may institute drought pricing to incentivize compliance. Over the longer term, the drought could spur additional investment in water supply projects, for which the costs and benefits must be weighed. Water utilities serving agriculture customers could be particularly impacted if they do not have an adequate water supply to sell; however, we note that some of these water utilities receive property taxes and assessments as fixed revenue, which lessen the effect of reduced water sales. MTAM's internal ratings incorporate each water utility's operations, including its water supply portfolio, supply reliability, and overall flexibility. We will continue to monitor the drought conditions in California and will assess the impact on individual water utilities.

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Credit Comment on California's Latest Budget Proposal

Wednesday, January 22, 2014

The State of California has made substantial progress in recent years in addressing its prior budgetary problems, progress boosted by a recovering economy, increased revenues from Proposition 30, a soaring stock market, and the legislature's decisions to make few new ongoing spending commitments. MTAM believes that Governor Jerry Brown's budget proposal for fiscal 2015 sets out a reasonable course to further strengthen California's financial position as it continues to repair the remaining damage from two fiscal crises over the past decade. Last week, the governor proposed a record $106.8 billion budget as the coffers of the most-populous U.S. state brimmed with the biggest surplus in more than a decade.

The 75-year-old Democrat, who may seek a fourth term this year, called for an 8.5 percent increase from the current spending level, increasing funds for schools, welfare and healthcare for the poor. The governor also said he will back a constitutional amendment to stockpile unpredictable capital-gains taxes, and deal with looming shortfalls in public pensions. The proposed early repayment of the State's economic recovery bonds, as the deficit bonds are called, would free up sales tax resources now dedicated to bond repayment to support the general fund beginning in 2015-16.

The governor's proposed budget is consistent with the last three adopted budgets, which also prioritized shoring up the State's finances, through prudent control of spending and budgetary debt repayment. Only three years ago, the State faced a cumulative operating gap of $26.6 billion, equivalent to 15.3% of baseline fiscal 2011 and 2012 general fund revenues. Since then, gradual economic and revenue gains, the State's disciplined approach to limiting spending growth, and voter approval in 2012 of temporary personal income and sales tax increases have enabled the State to move toward structural budget balance, while repaying billions in past budgetary borrowing. These factors contributed to Fitch's August 2013 upgrade of the State's general obligation rating to 'A' from 'A-'; and S&P's credit outlook revision to positive from stable just last week. The State still has the second-lowest rating among U.S. states at A1/A/A, ahead of only Illinois (A3/A-/A-).

The governor's budget proposal assumes continued slow economic recovery and steady revenue gains through fiscal 2015, while emphasizing the uncertainty that is inherent in California's volatile tax revenue system. Wisely, the proposal rejects restoring the deep spending cuts made since fiscal 2011, repays an additional $11.8 billion of budgetary debt, leaves a small, $1.6 billion cumulative general fund balance, and deposits $1.6 billion into the State's rainy day fund, the first deposit since fiscal 2008. Furthermore, a proposed change to the State's rainy day reserve mechanism could enable the State to set aside part of the temporary personal income tax revenue windfalls it receives during good economic times in order to cushion the inevitable revenue declines that have precipitated recent fiscal crises.

The budget plan includes retiring $6.2 billion in outstanding K-14 deferrals, which would eliminate the largest component of the school and community college wall of debt by the end of 2014-15. The governor has long emphasized the importance of eliminating the budgetary borrowing, mainly owed to schools, remaining from these fiscal crises. The State has made material strides to date, lowering the balance to $26.9 billion in fiscal 2013 from $34.7 billion in fiscal 2011. The State's forecast assumes budgetary borrowing will fall to $4.7 billion by fiscal 2017.

The California Legislative Analyst's Office released a mostly positive review of the governor's proposed budget for fiscal year 2014-15, saying it focuses on the right goals including debt repayment. The LAO views the governor's spending plan as a reasonable mix of one-time and ongoing spending. When the governor presents his revised budget plan to the legislature in May, the LAO said there is a significant possibility that 2013-14 and even 2014-15 revenue estimates will rise by a few billion dollars.

LAO's favorable outlook is the product of ongoing economic growth, recent temporary tax increases, and consistent state actions to maintain spending austerity at a time of rising revenues. Notwithstanding recent budgetary discipline, the State historically has had difficulty restraining spending growth during periods of strong fiscal performance, setting the stage for more severe fiscal weakness in the inevitable recession that follows.

The LAO report also notes the risk of another recession during the forecast period. The volatility of California's tax revenues, particularly capital gains taxes, has been a key factor in the State's recent fiscal crises. The temporary tax rates approved by voters last year are likely to increase this volatility. However, institutional changes made since the 2008-2009 recession would make timelier, more effective responses to future cash and budgetary weakness more likely, although the State has not yet begun rebuilding its rainy day fund as a cushion against revenue underperformance.

In our view, California has other budgetary challenges beyond repaying borrowing. The State has yet to correct the deep underfunding of teacher pension contributions, which CalSTRS estimated at $4.5 billion as of July 1, 2014. And annual interest payments to the federal government on the State's unemployment trust fund deficit, estimated to be $9.7 billion as of December 31, 2013, are ongoing. The State's October 2013 unemployment insurance fund forecast assumes benefit payments exceeding employer receipts through 2015, with only slow progress lowering the deficit in the near term.

Conclusion

Despite the considerable fiscal improvement made by the State to date, it has yet to fully recover from the effects of two fiscal crises in one decade. At the end of fiscal 2015, the State projects having $13.1 billion in unpaid budgetary borrowing, and multiple long-term fiscal challenges will still require the State's attention and resources, notably, addressing the underfunding of teacher pension contributions. Nonetheless, MTAM considers the State's budget proposal to be another step toward fiscal recovery.

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Municipal Bond Market – Tax Reform Forecast for 2014

Monday, January 13, 2014

MTAM sees comprehensive tax reform unlikely in 2014 given the current political environment. Congressional leaders in both chambers remain highly skeptical about moving forward with tax reform this Congress.

Despite the significant obstacles, Chairmen Max Baucus (Senate) and David Camp (House of Representatives) continue to push aggressively to move the process forward. Senator Baucus proposed several drafts in 2013, and Chairman Camp may release draft legislation early in 2014.

We believe the same political discord that derailed agreement on major tax change in 2013 will also be in play in 2014. We anticipate that the House and Senate's competing bills will garner some media attention, although it is not clear that any proposal will even come before the full House or Senate for a vote. Senate Democrats will likely couple tax reform and simplification with several revenue-raising proposals which will be unacceptable to the House, and House Republicans will likely propose significant revenue-neutral tax reforms.

Movement will be slowed not only by political gridlock, but also by changes in leadership in the House and Senate tax-writing committees. President Obama has recently nominated Senate Baucus to become ambassador to China. And House Ways and Means Committee Chairman Camp, R-Michigan, in his last year of his term as chair in 2014, is unlikely to receive a waiver from term limits to continue to hold the job. Rep. Paul Ryan, R-Wisconsin, chairman of the House Budget Committee, has already expressed interest in taking over leadership of the tax committee.

The timeline of Baucus' confirmation to the ambassador post is unclear. Baucus had previously announced that he was not going to seek re-election in 2014, and the impending ambassadorship means he will likely leave the Senate before the end of the year. Baucus released a few tax reform discussion drafts over the past several weeks that focused on non-municipal specific areas of the tax code. He may release a discussion draft about infrastructure tax reform in January, which could include bond-related provisions. Whenever he leaves, most sources think Sen. Ron Wyden, DOregon, is most likely to replace him as chairman of the Senate Finance Committee.

It is unclear whether Wyden would take the same approach to tax reform as Baucus. The likely early change in leadership may be a setback to tax reform in the Senate in the short run. However, Wyden has previously alarmed the municipal market by introducing bills that would change the exemption for interest on municipal bonds to a traditional tax credit.

Absent a shift on the part of the President and Congressional Democrats toward revenue-neutral tax reform before the mid-term elections, the ability to pass significant tax legislation would increase dramatically if the Democrats were able to take over leadership of the House of Representatives. Obviously, the 2014 mid-term elections are several months away and difficult to predict, but based on the results of the off-cycle 2013 elections, we do not expect the Republicans will relinquish control of the House.

Currently, there are 435 seats in the House of Representatives, and Republicans currently hold a comfortable advantage at 232 seats, to 200 Democratic and 3 vacant. Legislation can get passed with a simple majority vote.

Conclusion

While several market participants think there will be some movement on tax reform in 2014, the chances that reform will actually be enacted are slim. There will be hurdles with moving bills through the House and Senate, reconciling versions of the bills, and getting presidential approval. The fact that 2014 is a mid-term election year makes enacting tax reform legislation in the next 10 months more challenging. Most market participants believe President Obama will continue to include a 28% cap on the value of the tax-exemption for municipals in his fiscal 2015 budget, which is supposed to be released in February. There is a possibility the president could include in his budget something different that would raise greater complications, and maybe more restrictions than the 28% cap. The president has recently put an emphasis on addressing income inequality, and there has been a perception that municipals only benefit the wealthy.

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Municipal Bond Market – Credit Outlook for 2014

Friday, January 3, 2014

Municipal bond issuers will continue to face several credit challenges in 2014. In general, the specter of revenue shortfalls, ongoing budget pressures, decreased federal funding levels, increased demand for services, and rising healthcare and pension costs will continue for all sectors. MTAM expects that the majority of municipalities will successfully manage through this difficult period with a combination of spending cuts and revenue enhancement plans.

State Governments

U.S. states enter 2014 with a stable outlook after 14 consecutive quarters of revenue growth, bolstered by replenished reserves following a surprisingly strong fiscal 2013 due to taxpayer activity to avoid federal tax increases. Stock market gains and private sector expansion also continue to support state revenue growth. In general, state financial reserves are now at levels comfortably above their fiscal 2010 low, although still well below their pre-recession peak. States that are still feeling acute pressures are experiencing below-average economic recovery, have specific budget challenges such as rising pension funding demands, or suffer from management weaknesses.

The federal government remains the most significant threat to state budgets in 2014. State revenue systems quickly reflect economic conditions, and to the extent federal action or inaction hurts the economy, it hurts states.

Federal healthcare reform will affect all states in 2014, regardless of whether they are choosing to expand Medicaid. Enacted budgets for fiscal 2014 include an estimated impact of reform and, despite guesswork in the estimates, deviations from the forecast are expected to be modest in the context of overall healthcare spending.

Despite these challenges, we expect most states to maintain fiscal stability through tight budgeting and spending restraint – practices that became common in the recent recession.

Thirty-six states will hold elections for governor in 2014, with the incumbent governor running for re-election in the majority of cases. This will have a major influence on the political focus of state governments in 2014, which will be a mid-biennium year without need for a new budget in many states.

Local Governments

The outlook for local government credit is somewhat more negative than the outlook for states. Pressures on local governments, including slow revenue growth and increased spending, are not expected to abate in 2014, resulting in more downgrades than upgrades.

Revenue recovery is expected to remain uneven in 2014. While the moderately expanding economy should translate to increases in most local tax revenues, areas that have seen a strong housing rebound and are dependent on property taxes may see more robust growth.

Many local governments were able to achieve significant labor savings over the past few years, although signs of labor's unwillingness to negotiate further concessions are on the increase.

Even with financial market recovery, benefit spending growth will continue to put pressure on budgets in 2014. State and local pension plan reform efforts continue to be encouraging, although many will not have a meaningful impact on liabilities or annual payments for many years. The flexibility to reduce OPEB is not always clearcut, and varies by state. Litigation related to post-employment benefits, some as part of ongoing bankruptcy cases, will provide some insight into the ability of governments to make changes in these areas.

A willingness to repay debts has been a hallmark of the municipal credit market, but evidence of management's failure to prioritize debt service payments in a limited number of bankruptcy cases is troubling. MTAM expects the current bankruptcy cases to set important precedents for other distressed municipalities. If pending bankruptcy rulings demonstrate that pensions take priority over general obligation debt service, or require debt restructuring along with benefit adjustments, more cities may be encouraged to take this path. We would likely re-evaluate the strength of the general obligation pledge in states where benefits are clearly placed ahead of GO debt.

Not-for-Profit Hospitals

The 2014 outlook for the not-for-profit hospital sector remains negative, as MTAM expects margins to continue to tighten as expenses for hospitals grow faster than their revenues. As patient volumes shrink, the pace of revenue growth will continue to decline. Specifically, we expect median revenue growth in fiscal year 2013 fell to a range of 3 percent to 3.5 percent, which is much lower than fiscal year 2012's growth rate of 5.2 percent; we project revenue growth in 2014 to also remain low.

The sector as a whole will face weakening business conditions and contracting margins as not-for-profit hospitals adjust to changing dynamics brought on by the Affordable Care Act, and insurance companies, employers, and other industry participants seek to control healthcare costs.

Several factors will slow revenue growth, including an effective 1.3 percent Medicare payment reduction as well as the reduction in disproportionate share payments that began October 1st, 2013. Also contributing will be continuing declines in inpatient volumes and the ongoing shift in care toward outpatient settings, where reimbursements are lower. We expect commercial rate increases to be in the 0 percent to 5 percent range, far below their historical levels.

Meanwhile, expenses have been growing faster than revenues for the second year in the row. Big expenses include investments in information technology and in expanding physician practices, which generally operate at a loss, but are seen as important for drawing referrals.

The recent start-up of the provisions of the Affordable Care Act that most directly impact hospitals present large unknowns, as the insured population is growing unevenly. There are many unknown variables that make budgeting and strategic planning especially difficult over the near term, including how many people will gain insurance coverage through the public exchanges or with what frequency they will access healthcare services. It has been estimated that most insurance sold on the exchanges will reimburse hospitals at rates 20 percent to 30 percent lower than existing commercial rates, but at levels that are still above Medicare rates. At these reimbursement levels, exchange-sold products will still be profitable, but will contribute to tighter margins.

Transportation

The 2014 outlook for airports, ports, and toll roads is stable despite tepid growth.

The growing use of Public Private Partnership, or P3, transactions to construct new or expand existing projects is largely motivated by limited resources at the state and local level, combined with uncertainty on future federal funding levels. While not a panacea for all funding issues, governments are increasingly looking to P3s for transportation projects where the economics make sense. Two-thirds of states currently have P3 enabling legislation in place, and given the size of future capital needs, MTAM expects transportation P3s to continue to rise in 2014.

The outlook for airports is stable for 2014, supported by stable traffic trends, positive industry fundamentals, strong capital development program execution, and sound financial operations. Traffic performance across all U.S. airports should continue to move in a modestly positive direction in 2014, in the 1.5 percent to 2.5 percent range. The American/US Airways merger may lead to network realignments, though due to settlement terms protecting incumbent hubs this process may take some time. We will pay special attention to airports with higher leverage or committed to large capital programs as the merger comes into effect.

The first quarter of 2014 will see the first increase in the number of flights in almost three years. The enplanement growth in 2014 should support the additional debt airports have taken on in the past two years. The growth in enplanements, along with de-leveraging at midsize and small airports, will blunt the impact of higher debt service at the large hub airports. Numerous major hubs have taken on more debt to fund terminal renovation projects.

Possible but unlikely events that would probably shift the stable outlook back to negative include reductions in airline services should oil prices increase above $135 a barrel, and reductions in government operational or grant funding, which would lead to increased debt funding.

The outlook for ports remains stable for 2014, with flat to modest improvements in port throughput, and largely stable revenue profiles expected. Macroeconomic trends both in the U.S. and globally will affect throughputs and shifts in trade volumes, though contracts at the largest ports should insulate cash flows from volume volatility. Effects of shipping alliances on service frequency and cargo volumes, particularly the P3 alliance in 2014, continue to be monitored, as do expansionary capital expenditure programs at several ports. MTAM expects ongoing negative pressure on throughput as U.S. consumers continue to exercise caution.

The outlook for the toll roads sector is stable, reflecting continued slow growth in aggregate driving across the country. Even in a declining traffic scenario, mature assets and systems with a combination of pricing power, robust liquidity, and moderate leverage retain considerable resilience to sustain current rating levels. Forecasting risk remains high for recently constructed or green field standalone projects, which may be more vulnerable to a sustained weak economic environment.

We expect traffic growth of 1.5 percent for toll roads in 2014 as the U.S. economy strengthens. This growth rate marks a sustainable comeback from the nearly 3 percent decline in 2009. In 2014, the traffic growth will be less than the 2 percent to 3 percent GDP growth that is expected in the U.S. because of demographic shifts and the changing driving patterns of younger drivers. The rate of traffic growth is slowing down overall and so the slower, albeit more stable growth rates reflect a 'new normal'.

In all, we expect toll revenue will increase by a mid-single-digit percentage in both 2013 and 2014, driven mainly by continued widespread toll-rate increases and the modest traffic growth.

As for ongoing credit risks for the sector, we note increases in financial leverage as an important one. State and local governments continue to exert demand on the excess cash flows of toll roads to subsidize their own capital and operating needs, or have shifted some of their transportation financing responsibilities to existing toll roads.

The current outlook for Grant Anticipation Revenue Vehicle (GARVEE) bonds is stable. Uncertainty remains over the future of federal transportation funding with MAP-21 set to expire at the end of September 2014.

Water and Sewer

Water and sewer utilities continue to face ongoing capital and debt pressures despite the sector's overall financial strength. The sector outlook for 2014 is stable.

Water and sewer utilities have shown some financial improvement despite flat water usage and near-flat wastewater flows. However, many still face insufficient cash flows to fully cover annual depreciation expenses.

Many of the key financial metrics have improved, including a 6 percent increase in revenue due to rising user charges, while liquidity levels remain robust. However, this is offset by a 10 percent decrease in planned capital spending, which raises concerns about future deferred maintenance.

While debt ratios fell modestly due to a slowing of new issuance, debt burdens are forecasted to increase slightly over the next five years.

Public Power

The outlook for the public power sector remains stable, given the utilities' unregulated ability to set retail electricity rates at levels that maintain sound debt service coverage and liquidity, as well as their ability to adapt to changing customer demand. However, rising costs tied to environmental compliance and the transition to cleaner power sources continue to pose long-term risks.

MTAM expects the liquidity and leverage ratios of the public power utilities to improve modestly in 2014. Relatively stable business conditions, a slowly improving economy, and low natural gas prices will continue to temper increases in electricity rates.

Customer demand for electricity has been tracking the slow improvement in the economy. Slower growth in customer demand will make it harder for utilities to spread costs over a large customer base. However, it will also delay the need to finance new energy and capacity in order to meet growth, moderating debt ratios.

The risks to the sector's stability are longer-term, and mainly tied to environmental compliance. Greater carbon regulation and advances in technology that threaten the monopoly utilities have on customers are long-term credit risks. The more the pace of change accelerates, the greater the credit pressure on public power utilities and the need for them to adapt.

We continue to view climate change policy as one of the most significant uncertainties because of the estimated cost it will impose on coal-fired generation and, in turn, be passed on to ratepayers. The Environmental Protection Agency, for instance, recently announced carbon emissions output standards for new coal-fired power plants that would likely lead to a halt in building new coal-fired generation units.

A lesser risk facing the industry arises from changes in the power markets, as regional energy and capacity markets continue to move toward integration. These add a layer of uncertainty about the cost recovery on the newest coal-fired generation assets.

Colleges and Universities

The outlook for the higher education sector remains negative. Revenue growth is expected to remain much lower than historical standards and to be eclipsed by expenses, due to pent-up institutional needs.

Heightened competition for government funds, donors, and students combined with pressure to increase compensation and invest in programs and facilities will result in continued deterioration of financial performance. Although higher education institutions have shown a willingness and ability to adapt to weak economic conditions, the uncertain funding and regulatory environments will overshadow the sector's strengths in the near term.

Macroeconomic pressures, including a relatively high unemployment rate, lagging labor force participation rate, and income stagnation, are undercutting the ability of universities to grow net tuition revenue. Affordability remains a key issue as the economic environment continues to affect families' ability to pay for higher education, and reduces institutions' discretionary spending capacity.

Governmental funding pressures will also challenge the industry in 2014. Federal budget pressures could affect Pell Grants and other federal financial aid. State funding will either be reduced, stagnant, or only slightly increased. Federal research funding will contract further in 2014 following a 5 percent cut through sequestration.

College affordability and job attainment remain a focus for students and families, while institutions grapple with the uneven economic recovery, demographic shifts, and technological advancements. Institutions are placing greater emphasis on performance metrics, including retention and graduate rates, which could influence which students are recruited, and how future academic programs are offered or configured.

Overall, MTAM expects moderate tuition and fee increases over the near term, which will help to maintain relatively stable enrollment at most colleges and universities, but still create budget pressures from constrained net tuition revenue growth. Liquidity levels, generally improved through 2013, remain a partial offset for potential demand and operating challenges.

Pressured by state and federal cost-cutting initiatives, and diminished funding levels in recent years, institutions are likely to remain fiscally conservative evidenced by expense containment, measured debt issuance, and focus on capital preservation.

Constrained family finances, a decrease in the number of high school graduates in certain regions of the country, and changing demographics are key factors influencing the competitive market environment for colleges and universities in 2014.

Housing

The 2014 outlook for state housing finance agencies (SHFA) is stable for the first time in five years due to housing program profitability and sound issuer financial ratios, as well as the combination of SHFAs building more equity while deleveraging bond programs.

While SHFAs are still realizing scarce investment income in the low rate environment, many have managed to find other ways to boost and/or maintain profitability. SHFAs have moved away from the traditional business model by diversifying out of mortgage revenue bonds to originating loans using other funding sources and selling them for securitization into mortgage-backed securities. This allows SHFAs to continue to remain in the business of originating loans, and generate revenue from the related sales.

Additional drivers of the sector outlook are improved housing market fundamentals, including home price appreciation and mortgage loan performance. SHFA portfolios are slowly showing signs of improvement in loan performance off of elevated delinquency levels.

A decline in job growth or increase in unemployment could stall, or reverse, home price appreciation and negatively impact mortgage loan performance. If these macroeconomic trends show decline, the sector outlook could revert back to negative.

Default Outlook

While we have seen some high profile credit issues surrounding Detroit and Puerto Rico this year, overall municipal credit quality remains strong. MTAM does not expect municipal credit quality to deteriorate in 2014, and anticipate only modest defaults. Through November 22nd, there have been $749 million of true payment defaults in 2013, and $3.2 billion of defaults if late payments due to administrative errors and cases where insurers have paid or are expected to pay are included. Total defaults were $1.4 billion and $1.2 billion, respectively through this period in 2012 and 2011. The Detroit Pension COP default in June accounts for $1.4 billion of 2013's $3.2 billion headline number. The Detroit GO default adds another $530 million to the total and $68 million to the true payment default figure, reflecting the portion of the limited tax unsecured GO bonds that are not insured.

Defaults have also been highly concentrated by sector in the past three years, a trend we expect will persist. Nursing home and continuing care retirement center defaults continue to comprise a significant percentage of aggregate defaults, although special assessment defaults have played a smaller role in 2013 than in the prior two years. More defensive sectors like water and sewer bonds have performed better, but GO bonds represent 28 percent of the headline default number in 2013 because of Detroit. Finally, we would expect the majority of defaults to continue to be in unrated securities. Although less than 10 percent of the outstanding market is unrated, YTD 2013 79 percent of true payment defaults have been in unrated bonds.

Conclusion

Despite the credit challenges facing municipal bond issuers in 2014, there are always good opportunities, even for the very conservative investor. Given our expectations for slow but steady levels of economic growth, we would expect defensive credits like water and sewer bonds, special tax bonds, and public power bonds to perform better from a fundamental perspective. These types of bonds tend to have revenue streams that are less subject to economic volatility, have strong covenants, or are tied to an "essential service", making debt service payment more certain. In addition, there is legal precedence that bonds backed by a dedicated revenue stream may be protected in the case of a municipal bankruptcy. We prefer bonds that have a clean flow of funds, broad revenue streams, and high debt service coverage tests.

Essential service revenue bonds without the budgetary concerns of state and local governments and limited payrolls can be attractive, but we stress that an essential service issuer cannot flourish if the underlying governmental entity is in dire economic circumstances. A healthy outlook holds for most infrastructure issuers due to fundamental strengths reflected in the provision of essential public services, adequate balance sheets, and generally sound governance and fiscal management practices. In the case of the enterprise sectors comprised of higher education, health, and housing, credit quality will be maintained primarily as a function of their ability to increase fees, control costs, and improve overall operating margins. Sound debt and fiscal management practices, preservation of adequate liquidity, and strong governance oversight will be significant determinants of credit quality for issuers during the coming period of financial adjustment.

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4th Quarter 2013 Review and Outlook

Tuesday, December 31, 2013

For the three-month period ending December 31, 2013, investors in tax-free municipal bonds earned a slightly positive overall total-return. This was not true for all of 2013 as individual bonds maturing longer than five years experienced negative totalreturns. Simply put, in 2013, the longer an investor ventured out along the yield curve, the greater the loss incurred. Generally speaking, higher quality municipal debt outperformed lower quality debt during the quarter as investor concerns over the fate of Puerto Rico's finances kept risk tolerance muted within the tax-free bond market.

We are keenly aware that as the calendar turns from 2013 to 2014, most readers are more interested in the "outlook" than the "review," so let's get right to it. Miller Tabak Asset Management believes 2014 will be a year where the bond market transitions from handicapping the "taper" to actually reading the "tape." Now that the Federal Reserve has begun the process of withdrawing stimulus (yes, tapering is tightening credit), we believe that the real economy and the economic data will reassert itself as the driver of financial market returns (and yes, even the stock market!). MTAM believes the "tape" will be a negative detractor to municipal bond performance in the early months of 2014, as the economy continues to show positive momentum in a multitude of different industries across the United States. We suspect that with this economic backdrop, investors should correctly continue liquidating their municipal bond mutual funds, and look to establish their own individual, separately-managed "muni" accounts to guard against capital losses.

Yes, Rates Will Continue to Rise—but Watch for the "Wall"

Miller Tabak Asset Management believes a sizeable portion of the rise in long-term interest rates has already occurred in 2013, and as such, we see excellent opportunities emerging for those who have short duration portfolios to incrementally invest cash into a generously steep tax-free municipal bond market yield curve. Our clients know that we move very selectively when deploying cash. This investing style will capture the higher yields the market will be offering in early 2014 to entice buyers. However, as previously mentioned, "tapering" is a "tightening" of financial conditions (think housing), so we will be on the lookout for signs that the U.S. economy has hit a wall. If generously low interest rates provided the impetus for the economic recovery, then any unwinding of that carries the risk of a slowdown at some point. The best analogy we can think of to illustrate our concern over the economy hitting the wall is a famous quote from former heavyweight boxing champ Mike Tyson: "Everyone has a plan until they get punched in the mouth." The bond market giveth (lower rates), and the bond market will taketh (higher rates). While it is impossible to time correctly, MTAM believes that tax-free municipal bonds will be outside the boxing ring enjoying popcorn and a soda in the first row when that first punch to the U.S. economy connects.

Happy New Year!

Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management

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Impact of the Detroit Bankruptcy on the Municipal Bond Market – Part 2

Wednesday, December 4, 2013

The City of Detroit filed the biggest U.S. municipal bankruptcy on July 18th, listing $18 billion in debt and saying it did not have the money to pay bondholders, retirees, and employees everything it owes them while still providing basic city services. While Detroit's bankruptcy filing was not unexpected, it is the largest of its kind and unique in other ways as well, making its impact difficult to gauge. The way the bankruptcy is handled could have a lasting effect on the municipal bond market.

MTAM is concerned about how Detroit's general obligation bonds will fare in bankruptcy proceedings. Generally, unlimited tax general obligations bonds are the most senior of a city's obligations, backed by the full faith and credit of the taxing power. Investors expect that, as usually provided in bond indentures, principal and interest on general obligation bonds will be paid before other expenses and that taxes will be increased to pay debt service if necessary. The treatment of those bonds by the bankruptcy court could impact how investors' view those types of securities issued by all Michigan municipalities and potentially could have nationwide implications.

Detroit's unlimited tax general obligation official statements declare that the City is "authorized and required by law to levy and collect ad valorem taxes upon all taxable property in the City, without limitation as to rate or amount" to pay debt service, but, go on to say a few paragraphs later that, "The rights and remedies of owners or holders of the Bonds and the enforceability of the Bonds, the Unlimited Tax Resolution and the Limited Tax Resolution, as the case may be, Act 279 and Act 34, may be subject to and limited by bankruptcy, insolvency, reorganization, moratorium, fraudulent conveyance, or similar laws affecting the enforcement of creditors' rights".

Update on Bankruptcy Status

Detroit can remain under bankruptcy court protection, where it is shielded from lawsuits or other actions that might interfere with its attempts to reduce debt and cut employee benefits. U.S. Bankruptcy Judge Steven Rhodes announced his decision on Tuesday in Detroit after holding a two-week trial to determine the City's eligibility to continue enjoying the protections of Chapter 9 of the U.S. Bankruptcy Code, which deals with cases filed by municipalities. In ruling, Rhodes said it would be lawful to cut city pension obligations as part of a debt-reduction plan.

With Rhodes's ruling, the City can now focus on writing a plan to cut the debt. That will mean spending time in court fighting with creditors and time in confidential mediation talking to them. For the plan to be approved, it must treat similar creditors equally, which means if unsecured bondholders take losses, retirees should lose by the same percentage.

Before the bankruptcy, Detroit's emergency manager, Kevyn Orr, proposed canceling $3.5 billion in future obligations to the pension system and $1.4 billion in unsecured bonds the City issued in 2005 and 2006 to fill a hole in its retirement system. Orr offered to replace those debts with a $2 billion note paying 1.5 percent interest, which would give bondholders, the pension system, and other unsecured creditors pennies on the dollar.

In a ruling with implications for other cities coping with obligations to retired workers, Rhodes said federal bankruptcy law allows Detroit to try to cut pensions, rejecting arguments that the reductions are barred by the U.S. and Michigan constitutions.

Detroit's Liability Profile

Tuesday's ruling did not specifically address bonded debt. Detroit's liability profile includes a variety of security pledges and promises for repayment, which traditionally carry different risk assumptions for investors. When doing credit analysis and assessing the likelihood of repayment, MTAM continues to stress that understanding the security pledge--how and when that entity has promised to make debt service payments--is very important for investors.

The general obligation unlimited tax pledge is generally considered one of the strongest security pledges offered for bond repayment in Michigan. General obligation limited tax bonds are first budget obligations of Detroit, but their levy rates are subject to limitations that introduce more risk of nonpayment. To strengthen certain bonds secured by the GOULT and GOLT pledges of the City and to enhance its access to the markets, Detroit issued GO bonds with an additional pledge of distributable state aid in 2010 and 2012. These DSA bonds provide statutory liens on certain state revenue sharing payments Detroit expects to receive from the State of Michigan under provisions of Act 140 in each city fiscal year to provide more security of payment for investors.

Like many municipalities nationally, Detroit has issued two types of general obligation debt, unlimited and limited tax. One of the most controversial proposals from the emergency manager is that both types are viewed as unsecured debt with no differentiation in creditor standing. This assessment runs directly counter to the long-held view of the municipal market--that the specific legal rights afforded by an unlimited tax pledge exceed significantly those afforded by a limited tax pledge.

In the proposal for creditors, Orr outlines Detroit's most pressing liabilities and the City's approach to restructuring them. Importantly for bondholders, under Orr's plan, all of the City's debt is treated as either "secured" or "unsecured". Orr purports that secured debt has a specific asset or revenue stream backing it, such as casino revenue, state aid revenue, or net revenue from an enterprise system. Substantially all of the City's water and sewer revenue bonds, parking revenue bonds, and the GOULT and GOLT DSA bonds that were issued with a backing of state aid are considered a part of the City's estimated $7.2 billion secured debt under the proposal. We expect that the payment of this debt will not be interrupted by the bankruptcy filing and found that the City did make its July 1st payments on certain water and sewer debt service payments. The full repayment of this debt is subject to negotiation with creditors in Orr's restructuring plan.

More concerning for some bondholders is what qualifies as unsecured debt in Orr's restructuring plan. Orr categorizes $11.4 billion of the City's general obligation unlimited tax bonds, limited tax bonds, unfunded pension liabilities, and retiree health-care obligations as unsecured liabilities. In using this term, he is indicating that none of the aforementioned have a lien on a specific asset or revenue stream. His proposal exchanges all unsecured debt for a total of $2.0 billion of limited recourse participation notes paid out on a pro rata basis. With this proposal, the City's GO debt is treated the same as pension and OPEB liabilities, which undermines the long-held assumptions about security risk in the municipal market. Traditionally, payments of general obligation debt were believed to take precedent over pension liability payments; however, this plan clearly defies that assumption.

How these issues are resolved could set precedent for how debt and long-term unfunded liabilities are fundamentally viewed by the market and treated by financially-stressed municipalities moving forward. Essentially, in this moment of fiscal stress, the stateappointed EM is suggesting that the strong legal security of the GOULT pledge of Michigan localities should not be fully recognized. Investors should take note that moving forward, when it is most likely to be relied upon (during times of financial stress), the strength of the general obligation pledge in this state may not be there.

Even if the EM files a plan of adjustment within weeks, as promised, factors outside the City's control are likely to slow the process, such as the distraction of related appeals, one of which was filed within minutes of the bankruptcy court's ruling. This is important, given that time and money are commodities Detroit can ill afford to lose. MTAM views Tuesday's court ruling as one step in the process. When a municipality argues against its own ability to operate--an odd position, given that municipalities cannot cease to exist--there is no choice but to move through the long and arduous process.

Conclusion

While Detroit raises important questions about the sanctity of the GO pledge, we recognize that GO bonds represent 35% of the municipal bonds issued over the past 10 years, so will be an important part of any diversified municipal portfolio. By comparison, sales tax and water and sewer bonds together represent 11% of all issuance within the past 10 years. With this in mind, we would allocate GO exposure to credits in areas with strong fundamentals and growing tax receipts, while focusing on utility and special tax credits in weaker geographic areas.

The proposal by the City of Detroit's emergency manager to group unlimited tax general obligation and limited tax general obligation bonds together, as well as with employee benefit payments, as a single class of creditor is at odds with market participants' prior expectations. If it is confirmed in bankruptcy, it will lead participants to rethink the distinctions made between tax-supported ratings within Michigan, and perhaps nationally. MTAM considers this to be a landmark bankruptcy case given the paucity of such cases and the City's size and historical prominence in the U.S. economy.

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New Jersey and the Minimum Wage Hike

Thursday, November 7, 2013

New Jersey voters overwhelmingly approved a constitutional amendment Tuesday to raise the minimum wage by $1, to $8.25 an hour, and add automatic cost-of-living increases each year. The vote was a victory for Democrats in the state Legislature, who put Public Question 2 on the ballot to achieve through referendum what they were blocked from doing by Governor Chris Christie. He vetoed a bill last year that would have raised the minimum wage to $8.50 an hour with annual inflation adjustments.

New Jersey is the fifth state to add a minimum wage to its constitution and the 11th to implement automatic hikes, according to data maintained by the National Conference of State Legislatures. The other four states with constitutional provisions on the minimum wage — all of which include automatic increases — are Florida, Colorado, Nevada and Ohio, according to the NCSL. In Florida and Nevada, it was added in 2004, while Ohio and Colorado added it in 2006. Arizona, Missouri, Montana, Oregon, Vermont, and Washington have nonconstitutional provisions to automatically increase the minimum wage.

The new minimum wage goes into effect January 1st. The cost-of-living adjustments will take place every September 1st. New Jersey will not have the highest minimum wage in the nation, though. Washington State has a $9.19 rate, and New York and Connecticut are phasing in $9-an-hour wages over the next two to three years. New Jersey's current minimum wage of $7.25 per hour is the same as the rate in 21 other states and the federal government's. Eighteen states and Washington, D.C., currently have a higher minimum wage. With the move to $8.25 an hour, New Jersey moves into the top 10.

Of the 1.8 million workers in New Jersey who are paid by the hour, an estimated 49,000 — nearly 3 percent — are paid the minimum wage, according to Bureau of Labor Statistics data. Another 54,000 are paid less than the minimum wage, which exempts some occupations like waiters and waitresses. New Jersey's minimum wage has been at the federal minimum since 2009.

Republican Governor Christie, who won easy re-election Tuesday evening, had opposed a minimum wage increase for months, saying the economy — already dismal due to Superstorm Sandy fallout — would take an even greater hit with the new mandate. Businesses are now scrambling, looking for ways to offset the mandated increase — which comes at the same time they are also struggling with costly Obamacare regulations. Some predict layoffs are on the way. The New Jersey Business and Industry Association says the minimum wage hike will lead to 31,000 lost jobs in the next decade.

But advocates for low-wage workers countered that several academic studies show that raising the minimum wage has only minor effects on employment, and provides stimulus to the economy by putting more money in the hands of people most likely to spend it. Nonetheless, small businesses have already begun looking for ways to offset the increase in labor costs, including raising prices.

When the government sets the minimum wage at a higher rate than what businesses can afford to pay for unskilled laborers, the end result is higher unemployment and less opportunity. This is what a steady chain of economic studies have concluded. Just last year, the Rhode Island Center for Freedom and Prosperity released a report that focused on how increasing the minimum wage exacerbated teenage unemployment. The study, which is based on findings of economists David Macpherson and William Even, also includes a national survey of minimum wage laws in 2011. Among the 24 states with unemployment over 8 percent that year, 11 had set their minimum wages above the federal $7.25 per hour, while only six of the 26 states with an unemployment rate of 8 percent or lower had set elevated minimums.

The National Federation of Independent Business Research Foundation analyzed the potential economic impact of implementing the changes to New Jersey minimum wage laws that would amend Article 1 of the New Jersey Constitution to include language stipulating an increase of the minimum wage in New Jersey to $8.25 per hour beginning the January 1 following the date of the amendment's passage (assumed to be January 1, 2014, for purposes of this analysis). The amendment also provides for future increases in the New Jersey minimum wage by tying it to the consumer price index for all urban wage earners and clerical workers as calculated by the federal government.

  • 0% inflation = 13,679 jobs lost by 2023; economic output lower by $1.5 billion
  • 2% inflation = 22,695 jobs lost by 2023; economic output lower by $2.8 billion
  • 4% inflation = 31,797 jobs lost by 2023; economic output lower by $4.2 billion

The largest number of people earning the minimum wage are not the heads of households. Most are in fact young people living at home looking to gain work experience and build their resumes. In fact, over 80 percent of minimum wage workers are teenagers, single adults living alone, or dual-earner married couples, according to an analysis of U.S. Census data the Employment Policy Institute (EPI) performed as part of its own study. Here's another key finding that should give voters pause. For every 10 percent increase in the minimum wage, teen employment at small businesses is estimated to decrease by 4.6 to 9.0 percent, EPI concluded.

Labor groups campaigned for the ballot measure, saying New Jersey's high cost of living means families cannot afford basics such as groceries and rent while earning $7.25 an hour. However, some say what has been slyly repackaged as "living wage" is in fact a political payback the Democratic Party is offering up to its union benefactors. A higher minimum wage makes it more expensive for businesses to higher low-skill workers and this translates into less competition for union members who are paid higher wages.

Business groups opposed the increase, warning it would force some employers to lay off workers or cut employee hours to compensate for higher wages. They also said it would affect more than those getting minimum wage because those earning slightly more would also now expect their pay to go up. They also said setting the minimum wage by changing the constitution makes it difficult to undo if there is another recession.

In New Jersey, the proposal resulted in an avalanche of special-interest spending, amplifying a long-running debate: Does a mandated wage hike help low-wage employees and spur economic activity or does it hurt business owners, taxpayers, and even those workers it purports to benefit? The idea was opposed by business organizations, in part due to the short-term economics, but perhaps more significantly because it would lock the increases into the state constitution. They say businesses will raise prices, reduce hours, or cut jobs to cope.

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Impact of the Federal Government Shutdown on Municipal Bond Credits

Friday, October 4, 2013

The federal government's shutdown due to an impasse in Washington over the fiscal 2014 budget, Obamacare, and the looming federal debt ceiling debate have generated many questions about what a closure might mean for municipal bonds. MTAM believes the direct credit impact on state, city, or municipal enterprises will not be immediate. We will continue to monitor the ongoing dialogue surrounding both the government shutdown and the debt ceiling debate, and will continue to assess the credit impact on U.S. public finance credits.

The Current Shutdown

The shutdown of U.S. government operations and services due to the political stalemate in Washington should have a minimal impact on municipal credits provided the shutdown is short lived, as expected. However, if extended, the impact of funding reductions would become more pronounced.

State and Local Governments

The shutdown's impact on the states should be muted. The largest federal aid program is Medicaid, whose funding is not expected to be curtailed. Furthermore, states have been rebuilding financial cushions and could carry temporary delays in aid program payments. Similarly, for local governments, it is unlikely to present significant challenges. Local governments do not generally receive significant amounts of direct federal aid (roughly 4% for local governments and 9% for school districts). Thus, any short-term disruptions in cash flow should be minimal. Delayed governments worker paychecks may produce a noticeable economic effect. This is likely to be most pronounced in the Washington D.C. region and other areas with sizable numbers of federal civilian workers, such as cities with large military bases.

Not-For-Profit Hospitals

The shutdown will have little, if any, impact on the operations and cash flow if resolved within a reasonable amount of time. Funding under both the Medicare and Medicaid programs are mandatory and are not subject to annual appropriations. However, payments to HHS employees and CMS's Medicare vendors for claims processing comes from the CMS operating budget (subject to congressional appropriation). HHS employees would likely be considered 'performing essential work', although reduced HHS staffing could slow the payment process. It is not clear if payments to the vendors processing claims are considered as payment for 'performing essential work'. During the 1995-1996 shutdown, for instance, claims vendors continued to process claims during the stalemate without any impact to providers. However, a longer term shut down could result in delayed claims processing of Medicare claims should vendors not get paid.

If the shutdown is more prolonged, however, most not-for-profit hospital and health care providers are adequately positioned to weather a more drawn out resolution due to their strong balance sheets. With a median days cash and investments on hand of 184 days, most hospitals have ample liquidity to sustain a period of delayed government reimbursement in the short-term. However, significant deviation exists, with some individual hospitals possessing less than 30 days cash on hand.

Universities

Should the shutdown be prolonged, higher education institutions may begin to see some effect due to the level of federal research funding available, in addition to the access to some financial aid programs.

Housing

The government shutdown will have no immediate impact on housing bonds. All Public Housing Capital Fund bonds and bonds backed by Section 8 contracts have debt service reserve funds in place and therefore we do not expect any disruption in bond payments.

Transportation

Municipal bonds backed by federal mass-transit aid are the most vulnerable to the U.S. government shutdown. Grant Anticipation Revenue Vehicles, known as Garvees, are sold by states or transit agencies and backed by federal highway or transportation aid. At least $10 billion of the bonds are outstanding in the $3.7 trillion municipal market. While money will continue to flow to pay debt service on highway Garvees, appropriations for the securities through the Federal Transit Administration would be affected by a shutdown. The transit debt will not face missed payments immediately, but in a very prolonged shutdown scenario, some of those bonds might need some type of intervention, such as using reserve funds or other state money.

The Looming Federal Debt Ceiling Debate

If the current stalemate carries over into inaction in lifting the debt ceiling mid-month, there could be broader disruptions in the financial markets and the pace of the economic recovery. These disruptions could negatively impact state and local governmental revenues, and cause volatility in the valuations of public pension funds and endowments of not-for-profit entities, such as college and universities.

While reserve levels and conditions are generally improved since the summer of 2011 debt ceiling crisis, full cyclical recovery has not been broadly achieved. For many public finance entities, continued recovery is a condition necessary to address longer term challenges, such as funding post retirement costs.

Other implications of a failure to raise the ceiling remain unclear. It could require a cut in government spending of up to 20%. The fervor of political posturing could even lead to lawmakers raising questions over how municipals are treated as tax-exempt products.

In the scenario of a binding debt ceiling limit, municipal issuers could have funding jeopardized as the federal government fails to provide federal transfers to states. States have relatively high dependence on federal revenues, and some have high economic reliance on federal procurement and healthcare spending. Lower funding to states could then trickle through to less aid to local governments.

One of the risks to the debt ceiling not being increased would be that the federal government would start to issue cash management actions so not to default on its own debt, and there would be effects on state and local governments. Cuts to Medicaid funding could delay reimbursements to healthcare providers, a credit negative for hospitals. Medicaid provides as much as 71% for some hospitals. The states would have to determine if they would use their own funds to send the reimbursements along to the providers.

Several municipal credits receive federal revenues necessary to make their principal and interest payments. This could be via grants, appropriations or quite simply the interest payments on treasury or agency debt that backs a municipal escrow. Any delay in these federal payments will impede the credit on the associated municipal bond. Federal revenue provides as much as 37% of total government revenue to some states. A lengthy shutdown that turns into a stalled debate over the debt ceiling could impair states. Mississippi, Louisiana, and Alabama are the most exposed to a cutoff of federal transfers, with 37.2%, 36.9% and 34.9%, respectively, of those states' revenue coming from the federal level.

Fortunately, a U.S. credit downgrade that roiled the tax-exempt market during the 2011 debate is considered unlikely to recur this time around. Worst-case scenarios should politicians fail to raise the debt ceiling range from reduced federal funding to states to credit cuts and changes to municipal tax-exemptions. They are largely being shrugged off by analysts and investors, because they assume the government will again sidestep the dire consequences by lifting its cap on borrowing.

The potential impact on municipals surrounding the debt debate should be much more limited this time. Less economic uncertainty and a strengthening recovery will also help brace the municipal market as the congressional stalemate continues.

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3rd Quarter 2013 Review and Outlook

Monday, September 30, 2013

Municipal bond portfolios, constructed with an intermediate-term maturity focus, realized positive total returns in the third quarter of 2013. A large portion of these positive returns came in September as the Federal Reserve surprised the market by not "tapering" the amount of bonds they are purchasing in their quantitative easing program. Interest rates had previously been moving up steadily in anticipation of the "taper," but seemingly the Federal Reserve got "cold feet" at the last minute as it appeared the economy in general—and housing in particular—were not as strong as they had hoped.

The municipal bond market has been anything but its normal, boring self as the bankruptcy of Detroit and the financial strain bearing down on Puerto Rico has worked to clobber sentiment amongst the broker-dealer community—which has been pounded by requests to bid on these two troubled issuers. Municipal bond fund complexes have been the most active sellers, as outflows of investor cash have been steady for many months. In "normal" times, the municipal market is illiquid and "choppy," which can present obstacles for investors looking for price discovery on the value of their portfolios. For sellers of municipal bonds, these past few months have been like trying to find a swimming pool in the Mojave Desert. "Reasonable" bids often show up on appointment-only, and it often requires multiple attempts to find a buyer willing to pay "fair value" before liquidity has been achieved. Our suspicion here at Miller Tabak Asset Management is that this illiquidity will remain a core feature of the municipal bond asset class as balance sheet reduction by the "sell side" continues in earnest.

For years, the market had been nervous that California's finances were unsustainable—which may ultimately be true—and, as such, spreads on many issuers had previously been penalized by virtue of higher borrowing costs. However, it is amazing what a state income tax hike combined with better-than-expected economic growth can do in the short-term. California's relative borrowing costs have improved notably, and just identifying "reasonable" offerings on the short end of the yield curve has been like trying to find Waldo. Rating agencies are beginning to warm to the state's general obligation bond again, which should keep investor demand constant in the months ahead (yes, some people actually still care about what they say). The takeaway from this change of sentiment on the Golden State is that investors should take a long look at opportunities that exist currently in the municipal marketplace. From our perspective, the constant negative media headlines have created opportunities within the "Rust Belt" of the United States that are, in some cases, quite compelling. While you will not be seeing Miller Tabak Asset Management buying any Detroit bonds, it is often the case in the municipal market that retail investors sell first and ask questions later when negative news hits. We are particularly fond of this dynamic, and as such, will continue to keep a keen eye on this area of the country, as we suspect value will continue to fall onto our laps—and into your portfolios. As always, only the most pristine issuers within that region will be considered for purchase.

Moving forward, it is likely that the Federal Reserve will, at some point, be able to muster the courage to begin "tapering" their bond purchases. This event will ultimately usher in a period of panic once again in the fixed-income markets, and yields will once again head higher. Our advice if and when this occurs? Traders should sell bonds and investors should add cash to their portfolios to lock in what will once again—in our opinion—prove to be unsustainably high yields. After countless stimulus, we now know:

  • inflation has remained very tame
  • economic growth remains challenged
  • 4% and higher tax-free bond yields are a steal if invested with the right issuers

Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management

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North Carolina and the Impact of Tax Reform

Monday, September 16, 2013

North Carolina residents will see dramatic changes to their taxes after the legislature approved a plan in July that lowers income tax rates, repeals the estate tax, and alters the sales tax. Governor Pat McCrory (R) signed this comprehensive tax reform into law last month implementing new flat personal and corporate income-tax structures while ending many state sales tax exemptions, such as the annual sales tax holiday on school supplies. The reforms cut individual income tax rates from the current three brackets of 6%, 7%, and 7.5% to a single flat rate of 5.8% in 2014 and 5.75% in 2015. Corporate income tax rates will be reduced from 6.9% to 6% in 2014 and 5% in 2015.

In signing the legislation, McCrory said he believed that it would "prove to be critically important to growing North Carolina's economy and getting people back to work. This tax reform package is fiscally responsible and provides reasonable revenue growth every year to meet the state's budget needs."

MTAM believes the new tax reform measures enacted by North Carolina are substantial, but the overall budgetary impact should be manageable. The income tax cuts are largely offset by broadening the sales tax base and eliminating several sales tax exemptions. The sales tax, the second-largest revenue source for the state, was expanded to include electricity, piped natural gas, and some service contracts. A number of refunds, credits, and exemptions were repealed.

The net effect of the tax reform is estimated by the state to reduce general fund revenue by 1% in the 2013-2015 biennium, and 3% in the fiscal 2015-2017 biennium. According to legislative forecasts, the enacted tax changes will cost the state $2.4 billion over a five-year period. Given the reform measures, overall revenues are still increasing and the state balanced the 2013-2015 biennium budget with a projected surplus in spite of the net revenue decrease from the tax change.

The package also will:

— eliminate personal exemptions but increase standard deductions for individual income tax filers.

— raise the $100-per-child tax credit for low-income families to $125.

— subject the combined state and local 6.75 percent sales tax to service contracts and extended warranties.

— cap the state gasoline tax at 37.5 cents per gallon through June 2015.

— repeal starting in 2014 sales tax holiday weekends in August for school supplies, computers, and clothing, and for Energy Star appliances in November.

The tax overhaul package will result in $524 million less in combined revenue through mid-2015 compared with if no tax changes were made, with the amount expanding to more than $600 million annually in the following years, according to General Assembly staff projections.

Senator Tom Apodaca, R-Henderson, said that Commerce Secretary Sharon Decker told him and colleagues that she received several calls from company executives saying they want to build in North Carolina because of the tax package. Democrats say the package will result in higher taxes for small business owners and low- and middle-class taxpayers, citing documents from advocates for the poor and the General Assembly's non-partisan staff. A $50,000 maximum individual tax deduction for business-related income approved just two years ago will be repealed.

Sixty percent of individual income tax returns with business income and qualified for the deduction will see an average tax increase of $1,190, according to the legislature's Fiscal Research Division. Republicans offered their own scenarios showing tax filers from $20,000 to $250,000 getting a tax reduction under the plan.

Grover Norquist, president of the fiscally conservative Americans for Tax Reform, praised North Carolina's tax legislation, claiming that it "will provide significant and muchneeded tax relief for individuals, families, and employers across North Carolina." The Tax Foundation says these changes will make North Carolina more business-friendly, catapulting the state from 44th to 17th in the Tax Foundation State Business Tax Climate Index. North Carolina's 25% reduction in the state income tax is the largest in the nation in 2013. The largest tax breaks will go to higher-income earners, particularly single taxpayers, who will see a larger proportional cut than a North Carolina household making the state's median income of $40,000 a year.

These changes lower individual and corporate tax rates while placing more emphasis on the sales tax as a revenue source. This is basically the same program that other states have tried to use to move away from reliance on income tax towards more sales tax revenue support. Some economists will argue that leveling taxes across sales, corporate, and income prevents unduly burdening any one segment of the populace. This system is generally referred to as one with "broad bases and low rates."

At the moment, seven states across the country do not levy a tax on income, and North Carolina Republicans want to make it eight, according to a powerful member of the state legislature. State Senator Bob Rucho, a Mecklenburg County Republican and chairman of the Senate Finance Committee, said that he hoped to use the 2015 legislative session to eliminate the state income tax, replacing it with a consumption-based sales tax to make up for the lost revenue. Florida and Texas, two states that do not levy a tax on income, (and both highly rated at Aa1/AAA/AAA and Aaa/AA+/AAA, respectively), are very attractive to retirees, and North Carolina could compete as a viable option; thus, enhancing long-term growth prospects for the state.

North Carolina's income tax accounts for 61 percent of state revenue. But the revenue stream has been volatile in recent years, given the impact of the recession. The uneven results on a year-over-year basis can play havoc with annual budget planning in a state that requires a balanced budget, and it is something Rucho said he wanted to avoid.

Expect to hear much more about the tax reform package in the months ahead, especially as House Speaker Thom Tillis (R) gears up to run against Sen. Kay Hagan (D) next year. Tillis, who helped broker a deal on taxes between the Senate and Gov. McCrory, said he will use his record in this year's legislative session to make his case to North Carolina voters. In an interview, Tillis pointed to Tax Foundation rankings that showed North Carolinians shouldering a much lower tax burden after the reform package passed the legislature than they had in previous years.

Since the current legislative session began in January 2013, North Carolina has passed a slate of legislation with significant impacts on the state's finances. North Carolina joins a growing list of states, including Indiana, Kansas, Oklahoma, Virginia, Idaho, Louisiana, and North Dakota that have attempted or succeeded in significantly altering their state tax structures. However, MTAM does not foresee North Carolina losing its gilt-edge, toptier triple-A status from the three major municipal rating agencies.

Conclusion – North Carolina's triple-A general obligation bond rating reflects its moderate debt burden, conservative financial operations, and long-term prospects for continued economic expansion and diversification. The state's $20.6 billion budget plan increases overall spending by 2.5% and includes the largest tax cut in state history. However, the budget fully funds the state's retirement system and health plan, bolstering it as one of the best-funded pension programs in the country. The budget also doubles North Carolina's "rainy day" fund to $819 million, providing budgetary stability in future economic downturns. MTAM will continue to closely monitor how well the modified revenue structure meets the state's budgeted requirements.

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