Independent Thinking^®

Howard Cure: California in Context: Head West, Young Bond Investor

California has made significant progress over the past three years on its path to fiscal stability, including balancing its budget while projecting to reduce its backlog of obligations to local governments and agencies by 84.5%. The state is not entirely out of the woods, as its history of undisciplined spending has undermined many a prudent fiscal plan, and its local municipalities remain at risk. However, investors in California debt have many viable bond choices. Of these, the coastal cities and their essential service enterprise systems are far more attractive bets than those inland.

Increasing Stability at the State Level

In stark contrast to states reliant on a few dominant economic sectors (i.e., manufacturing, mineral extraction, agriculture, etc.), California boasts a deep and diverse economy, capable of above-average growth rates. Its prominent higher-education institutions and businesses in innovative sectors position California as a leading venture capital recipient state. California has over two times more venture capital investments than the other top four venture capital states combined¹.
 
Of course, wealth brings its own burdens. California’s volatile revenue base and its increasingly highly progressive income tax structure make budgetary projections difficult to forecast. For instance, taxing capital gains as ordinary income can result in huge fluctuations in revenues that need to be addressed quickly. But the Golden State is better living up to its promise these days with a new and, from an investor’s point of view, very welcome commitment to aligning recurring revenues and expenses while paying down budgetary debts. The “Wall of Debt” as described by Governor Brown and estimated at $27.8 billion at the end of fiscal year 2013 is now expected to be reduced to $4.3 billion by fiscal year 2017.
 
There is a real likelihood now of regular enactment of timely budgets and of substantially less exposure to liquidity shortfalls following a constitutional change requiring only majority legislative approval for budget passage. In addition, a more objective method of drawing district electoral lines may make it possible for a more cooperative and centrist legislative body. This would be in stark contrast to legislative bodies in many states, as well as on the federal level.
 
So far, so good, as the governor and legislature have exhibited fiscal restraint, agreeing to a budget with general fund spending equal to just 5.45% of total state personal income, the third-lowest percentage since 1973. (So often, states are judged to be unfriendly to business based solely on absolute tax rates that fail to take into account the taxes collected as a percentage of the total economic base.) This self-control is particularly important in California, as the government has significantly less flexibility than in other states when it comes to budgeting and raising revenue. In a year when revenues are underperforming, the governor does not have the power to unilaterally order significant spending cuts. Raising revenues requires the consent of two-thirds of the legislature. California revises its revenue forecasts less frequently than many states, giving it less time to catch up to a downturn, and its system of voter initiatives and referenda has resulted in expenditure mandates.

California St Go’s 10-Yr Spread to MMD (BPS)*

Uninsured, no calls shorter than 8 years
Source: MSRB, MMD, Loop Capital

As indicated above, the municipal market appears to recognize the progress made by the state based on trading values for 10-year California general obligation debt compared to the AAA scale. It should be noted, however, that part of this narrowing also reflects less debt issuance than average during the last few years. At its widest in 2009, the state was in abysmal financial shape. A voter initiative to raise taxes, similar to the one passed recently, failed miserably. California was also running record deficits and had to resort to delaying payments to local governments, state employees and vendors to manage its cash flow crisis during one of the worst recessionary periods in the state’s history.

Head Further West

We believe many California cities have hit a low point in the municipal economic cycle and that a turnaround may be coming for those that are beginning to see revenue improvement. Given the recent recession’s impact on economies and local government finances, as well as some constitutional limitations on tax-raising flexibility for California local governments, it is not surprising that many local governments’ budgets have been hit hard, notably in the interior. There has been a widening gap in credit quality in the local government sector, with a bifurcation in credit quality between governments that had permanently transformed their budgets with long-term solutions and those that made short-term adjustments and one-time fixes. This corresponds with changes in California’s property tax base that highlight the state’s uneven recovery.
 
Local governments in California rely on property taxes for roughly one-quarter of their general revenues.
 
With limited abilities to increase tax rates due to Proposition 13, meaningful property tax growth for local governments will require not only stabilization in home prices, but also sustained improvements in new and existing home sales. California’s property tax base lost $172 billion in value between fiscal years 2009 and 2012 (a 3.8% decline), but state totals obscure regional differences in tax base performance. Assessed values for California’s inland counties fell by 10% over this period, while coastal counties experienced losses of less than 2%. Zillow’s Home Value Index shows an August 2012-13 California gain in home market value of 25%, which, because of Proposition 13 limitations, cannot be fully realized in assessments.
 
The recent increase in bankruptcy filings in California has root causes in the following:

• boom-bust real estate economy,
• state’s hands-off “home rule” policy,
• ability of public sector unions to obtain generous settlements and benefits during the good times – and,
• the state’s inability to raise taxes without voter approval.

California cities have been especially vulnerable to these risks, particularly those cities in the Inland Empire and Central Valley regions, where cheap financing and speculative and commercial development during the boom years resulted in high foreclosure rates and depressed prices. Communities in these areas are likely to experience continued fiscal stress, including further service reductions and pressure to reconsider existing labor agreements and provide significantly less generous terms for future agreements. While this could result in unprecedented shifts in local government programs, we expect general obligation debt to remain well secured based on strong legal features within California as a whole, owing to voter approval and payment mechanisms. While generally untested in bankruptcy, it seems likely that voter-approved property tax revenues levied in California for cities, counties and school districts, and pledged to general obligation bonds would be viewed as special revenues and outside the bankruptcy estate for purposes of a Chapter 9 federal bankruptcy plan of adjustment.
 
As noted in “A Brighter Bond Outlook in California,” published by Evercore Wealth Management on April 8, 2013, many sectors that were dependent upon the state for funding, particularly public education, should see a stabilization in their credit outlook as a result of Proposition 30, as additional revenues will be dedicated to reverse appropriation cuts endured over the last several years. As a result of this change, we are more favorably disposed toward this sector for the time being. Cities in California, for better or worse, are not nearly as dependent upon the state as educational entities and counties for its revenue base, and have not directly benefited by the statewide tax increase. There are, however, opportunities to invest in cities that have proven resilient in the face of cyclical economic events. In particular, we look for entities that did not suffer from fluctuations in the property tax base and dramatic declines in revenues, most of which are in the coastal areas.

A Tale of Four Cities

We focus here on four California cities. San Bernardino and Stockton, which are in the bankruptcy process, and San Diego and San Jose, which have successfully relied on voter-approved changes to deal with one of the most intractable and significant expenses facing cities – employee benefits and pensions.

The tremendous amount of attention paid in the media to municipal pension costs gives the impression that this expense drives California cities, and cities around the country, into insolvency. While the growth of pension costs and programs for the long term is a legitimate concern for credit quality, these costs are not the items tipping cities into insolvency. Instead, pension costs are a proportionately modest but fast-growing expenditure element that has pushed already financially struggling cities further into trouble. (These same cities were also grappling with bigger problems, such as continued deficits because of overall compensation, debt burden for lease obligations that do not benefit from additional property tax revenues, and a declining tax base.)

The mean and median annual pension cost (annual required contribution, or ARC) of California cities, according to their recent audits, was 6.7% and 6.5% of total governmental funds expenditures, respectively, which is considered by rating agencies as not overly burdensome². Ultimately, unaltered pension programs could cause problems for municipalities that are seeing the costs consume an increasing portion of their revenue allocation, as investment returns have fluctuated and the number of retirees increases without always replacing employees. However, most municipalities are aware of this anticipated expenditure growth and many have taken steps to alter this trajectory.
 

 
Both Stockton and San Bernardino are part of the state-run California Public Employee Retirement System (CalPERS). CalPERS has argued that the pension benefits promised to employees and retirees represent a legal obligation guaranteed by state law. San Bernardino temporarily halted payments to the pension fund after filing for Chapter 9 bankruptcy protection in August 2012. The city resumed payments in July 2013 but still owes CalPERS about $14 million from the previous year and has indicated it wants to restructure its relationship with CalPERS to reduce payments going forward. San Bernardino is supposed to pay the pension fund $24 million a year. Stockton has taken a different tack, making its regular contributions to CalPERS. This has triggered a court fight with bond creditors who question why the city can default on its bond obligations while still making payments to current employee and retiree pension plans.
 
(Note: Just this past week Stockton released a $167 million plan of adjustment which could be used to exit Chapter 9. The proposal calls for 35.9% of the cuts to come from employee compensation, with 25.7% coming from staffing and service cuts, 16.8% taken from new taxes (requiring voter approval), 12% sourced from cuts to retiree healthcare, and 9.6% coming from changes to debt service payments, among other sources. Stockton is proposing leaving pension payments intact while cutting retiree healthcare benefits).
 
Success by Stockton’s creditors and San Bernardino in subjecting CalPERS to accepting less than what is actuarially owed would have major ramifications for bondholders in these cases, as well as for California municipalities broadly. Bondholders may do better if CalPERS is forced to share in any reorganization of fixed cost payments, an outcome that could encourage other distressed California entities to bring CalPERS to the negotiating table. At stake is whether federal bankruptcy trumps state law. A plan of adjustment, like any bankruptcy reorganization plan, cannot favor one group of creditors over another.
 
The bankruptcy court’s decisions in San Bernardino and Stockton will have wide-ranging implications for cities around the state and country. Because there is so little experience with municipal bankruptcies, we believe the judges in these cases will be very deliberate, and we expect the process to take several months to resolve. Bankruptcy court is about debt relief, which prevents the debtor from treating certain creditors differently. Employees and retirees who expect pensions have to compete with other city creditors, particularly bondholders, while the city still provides basic services to its citizens. The hope is that the pain inflicted upon all parties will force other cities and their employees to the negotiating table before it is necessary to resort to a bankruptcy filing. Other cities are also waiting to see if bankruptcy is the only way to get out from under their pension obligations, which currently have the protection of state law.

San Diego and San Jose

In comparison to Stockton and San Bernardino, San Diego and San Jose are fairly healthy municipalities with solid ratings in the AA-range and regular access to the capital markets. San Diego and San Jose were proactive in dealing with their pension liabilities over the corresponding periods. They submitted propositions to the voters that would go a long way in changing pension and benefit obligations. Both ballots were overwhelmingly approved by the voters.
 
In San Diego, the proposition included several key changes designed to lower retirement costs over time: a nearly six-year freeze on the salary used to calculate employee pension benefits; requiring all new city employees other than public safety personnel to enroll in a defined contribution plan modeled after the 401(k) format; changing the salary calculation for pensionable pay for new police officers; and establishing a 9.2% and 11% maximum city contribution for non-sworn and sworn employee pension plans.
 
In San Jose, the voters approved a second tier benefit plan for new city employees that provided far lower pension and health benefits. The city will also alter pension benefits for existing workers, allowing them to choose either a similar plan or to pay significantly more out of their own pockets for the benefits they had come to expect.
 
Both initiatives are being challenged by various public-sector labor unions. The outcome of these court battles is expected to have a major impact on municipal budgets around the state and, perhaps, the country. The key will be if the court allows pension and benefit plans to be altered for existing employees. The unions contend that a pension deal in effect when government workers are hired cannot be lowered for the rest of their career. The cities contend that state law, backed by the voter changes, allows each city to cut future pensions as long as it does not touch the benefits that workers have already accrued. As noted earlier, cities in California are under particular pressure because it is so difficult to raise property taxes in the state, and because, during boom times, many cities voted for a huge benefit increase.

Research-Driven Investing in California Debt

Given the cash shortages the state was facing just a few years ago, California has made significant progress on the path to fiscal stability. We are increasingly optimistic about the state’s credit as a whole and hope there is now a will to maintain its structural balance without inflicting undue pain on underlying local entities.
 
We continue to favor bonds supported by essential service enterprise systems. There are many to choose from in California, given the number of water, wastewater and public power issuers. These entities do not face the same revenue-raising restrictions that confront cities as a result of Proposition 13 limitations. Further, they are more capital intensive and do not have the same proportion of labor costs. Careful research at the grassroots level enables us to identify what we believe are the best of these.
 
While there is reason for hope that California’s economic, fiscal and political improvements will become entrenched, history would suggest a more cautious optimism on the local level, where we remain very careful buyers. Many cities are still grappling with events both in and out of their control in a state that provides little guidance to local governments. And it remains to be decided in court whether pension obligations are sacrosanct or if employees are, at the end of the day, just another creditor.

¹ National Venture Capital Association, 2013 Year Book, p 26
² “Diving Under The Surface of California City Credit Quality Reveals A Diverse Picture,” December 19, 2012, Standard & Poor’s