by guest contributor Michael J. Ross
While municipal bond market participants have been focused on distressed credits – Puerto Rico, Detroit, Jefferson County, Alabama, and others – a new reporting standard is garnering industry attention. The Governmental Accounting Standards Board (GASB) has issued two regulatory standards – GASB Statement 67 and GASB Statement 68, which will become effective for fiscal years ending on June 15, 2013 and June 15, 2014, respectively – that will dramatically restate state and local government pension liabilities.
Municipal bond industry welcomes increased transparency
Investors rely on timely and accurate financial information when considering their investment options. However, municipal bond disclosure has lagged that of its corporate counterparts in both the equity and bond markets. Securities and Exchange Commission (SEC) Rule 15c2-12, initially effective on July 3, 1995, dramatically improved disclosure for municipal bonds. The Rule was welcomed by municipal bond market participants because many issuers agreed to comply and provide annual filings. Some issuers even agreed to release unaudited information to national repositories (called Nationally Recognized Municipal Securities Information Repositories, or NRMSIR). In the mid-2000s, The Municipal Securities Rule-making Board stepped up its disclosure efforts with the launch of its Electronic Municipal Market Access (EMMA) system. Since then, EMMA has become the centralized source for continuing disclosure and information transparency for municipal bond market participants.
[GASB Statements 67 and 68] could have a significant impact on municipal bonds, likely impacting price discovery at a minimum, and perhaps even changing credit criteria standards.
Municipal securities disclosure will continue to evolve. The Governmental Accounting Standards Board (GASB) Statements 67 and 68 are the latest regulatory enhancements designed to provide increased consistency of reporting and greater transparency. These rules could have a significant impact on municipal bonds, likely impacting price discovery at a minimum, and perhaps even changing credit criteria standards.
The GO bond security pledge comes under greater scrutiny
Municipal bonds have enjoyed a solid reputation among investors based on the market’s historical resilience. But news of distressed credits – from Detroit to Jefferson County, Alabama – that crossed over from industry to mainstream headlines in 2013 have raised questions about the security pledge supporting general obligation (GO) municipal bonds.
Exactly what constitutes the security pledge behind GO bonds is not quite as crystal clear as many believed. Over the past year, the distinction between a general obligation bond backed by ad valorem property taxes and a general obligation bond backed by the general fund came under greater scrutiny among municipal bond market participants.
In the case of fiscally distressed municipalities, the priority status of unfunded pension liabilities also became a significant credit variable for municipal investors.
The higher degree of analysis required to determine what constitutes security and payment priorities added a layer of qualitative research that can only be revealed by fully understanding the true nature of the security pledge and related provisions. The qualitative review and scrutiny of security provisions do not replace the need or importance of quantitative measures in the credit assessment process. However, bond attorneys, issuers, and, in some instances, underwriters may be asked to provide greater clarity of the security features for some GO backed municipal bonds as enhanced disclosure information when the bonds are being marketed.
New GASB standards are designed to “level the disclosure playing field”
Distressed municipal credits will likely continue to garner municipal headlines in 2014 and rightly so, as many state and local government entities face fiscal challenges. GASB 67 and GASB 68 will likely have significant implications for the financial transparency of municipal bond issuers by providing information that levels the disclosure playing field. Possible implications of the new GASB standards include:
- States and local governments will recognize a “net pension liability,” which will make it easier to compare liabilities among issuers. The standardization of accounting methods for pension liabilities will reduce the need for analysts to make their own adjustments. Comparability of the net pension liability will become more meaningful.
- Prior fiscal year liabilities could prove to have been understated when viewed in the context of the newly implemented of the standards.
- The discount rate per the new GASB standards will be based on current market conditions rather than a historical assumed rate of return. If plan assets are projected to be insufficient to cover all projected benefit payments, then benefits past that crossover point will be required to use a discount rate based on the 20-year tax-exempt GO AA rate. The crossover point will highlight where the deficiency exists and the extent of the unfunded liability.
- As long as projected plan assets exceed projected benefits, governments will continue to use a discount based on their long-term expected rate of return on plan assets.
- Fiscal Sustainability, defined as a government’s ability and willingness to generate inflows of resources needed to meet current service commitments and to timely fund obligations as they become due, will be an increasingly important factor in credit analysis. Sustainability has always been a key credit factor and significantly unfunded pension liabilities can be indicative of fiscal stress.
The use of liberal accounting standards allowed states and local governments to underfund pension costs for many years, treating it almost as a discretionary expense. Pensions were categorized as long-term liabilities, and if revenues were lower than budget projections, the government’s pension contribution would be lower with the intent to make up the deficiency in the coming years. However, this approach resulted in substantial underfunding of pension plan assets.
Over a multitude of years revenues were uneven and other expenditures may have been funded with dollars that should have been allocated for contributions to the defined pension plan. In addition to underfunded pension systems, the assumed rate of return assumptions proved to be liberal. The result: negative realized returns in some periods, and significant increases in unfunded pension liabilities.
The use of liberal accounting standards allowed states and local governments to underfund pension costs for many years, treating it almost as a discretionary expense.
For many governments, the process to fix the problems will take many years. It will also require tough choices and strain already limited resources. Certain ratios based on expenditures and fund balances could require certain adjustments to become more meaningful. For example the general fund balance could be positive yet the combined fund balance could be negative. The effectiveness of the plan to address the unfunded liability will be measurable once the new GASB standards are enacted. In its presentation to members, the Utah Retirement System recommended that employers review their debt covenants for possible violations after the accounting change. Others may follow suit.
Revenue receipts and expenditure outlays will likely become increasingly significant focal points
Some state and local government budgets may become strained if pension expenses are larger or accrue faster quickly than past reporting methods. In addition, local governments may receive less from state or federal revenue sources going forward. The costs of providing basic services, paying debt service, funding pension and OPEB costs will all compete for limited revenues. Property taxes are the only controllable local government revenue recourse, and it too has limitations.
For most local governments, property taxes – which tend to be relatively stable and respond to property value declines more slowly than income, sales, and corporate taxes respond to declines in the overall economy – remain the dominant revenue source. Property tax collections tend to lag fluctuations in the overall economy, and can be slow to rebound from influences such as declining assessed values, tax cap limitations that could push overall collections lower on both an absolute or inflationary adjustment basis.
In a special report released on December 19, 2013, the Nelson A. Rockefeller Institute of Government reported that local taxes grew in real year-over-year terms-by an average of 2.3 percent over the last four quarters, a significant improvement over the 2.2 percent decline from the prior year and a 3.0 percent average decline of two years ago.
Property taxes traditionally have constituted a substantial source of revenues for all local governments. While data compiled by Merritt Research Services using FY 2012 financial statements shows that nearly 40% of all general fund revenues for about 1,300 cities and over 1,600 school districts came from the property tax. Often for school districts, the percentage can be higher depending on state aid formulas.
Assessed value recovery will likely be uneven, and some local governments will experience negative changes in assessed values. For example, 52% of the 972 cities in Merritt Research Services’ database showed negative year-to-year changes in assessed values mostly between 2010 and 2011. Revenue sufficiency can become an issue for pension and OPEB funding requirements for municipalities that heavily rely on property tax levies and may be experiencing stagnant or declining real estate values. Banks have managed their real estate owned (REO) portfolios to minimize loss of value. The actions by the banks to manage their portfolios and extend foreclosure amnesty, whether voluntarily or statutorily, have positively influenced real estate values, and therefore assessed values. According to RealtyTrac, California, Nevada, Florida, Delaware, South Carolina, Illinois, Ohio, Connecticut, Iowa and Utah top the list of states with highest foreclosure rates in the country:
In a December 20, 2013 article, the Wall Street Journal reported several salient points regarding national real estate trends. The tone suggests that recent real estate transactions have occurred may not be reflective of a market that could stabilize assessed values. Short sales and cash sales may influence assessed values in communities and result in existing homeowners property value challenges.
- The median price of a distressed residential property–in foreclosure or bank-owned–last month was $110,500, which was 39% below the median price of $181,500 for a non-distressed residential property.
- The housing market recovery continued to be driven by investors and other cash purchasers in November. Lenders are taking advantage of the environment to unload more of their bank-owned inventory.
- All-cash purchases made up 42% of all residential sales in November, compared with 38.8% in October and also up from a year ago.
- Short sales accounted for 5.6% of all U.S. residential sales in November, down from 6.5% a year earlier and up from 5.4% in October. Sales of bank-owned homes made up 10% of all sales last month, compared with 9.4% a year earlier and 9.1% in October.
Real estate prices are influenced by local markets; therefore, despite nationally reported trends, a micro-market analytical approach is warranted. The price levels at which homes sales occur will impact the local assessed value trends. The question is how much of an impact can these lower prices have on assessed values of similar homes? In some cases, the recovery of assessed values could be hindered, or at the very least extended by local statutes such as property tax caps, or voter referendums requirements to increase taxes. These circumstances could constrain the financial flexibility of those local governments.
New reporting standards could impact perception of muni bond credit quality
The new GASB statements will reveal how well – or how poorly – a state or local government pension plan is funded as of the financial reporting dates. Local governments that are deemed insufficiently funded with limited financial flexibility could become flagged as credit concerns. Revenue sources could become limited and property tax revenues constrained by negative, stagnant, or low assessed residential assessed real estate values. The degree of distress will vary because of local market assessed value trends and statutorily limiting factors.
In some instances, timing for revenue receipts will be a critical issue. And, access to the capital markets for short-term borrowings such as RANs, TRANs, or BANs until property tax collections are received will be the solution to resolve the revenue problems. Some municipalities will not have this kind of alternative and will have tougher decisions to make to shore up their long-term sustainability.
Local governments that compare poorly to their peers under the new GASB disclosure standards could become subject to higher levels of scrutiny by some investors. Municipal market participants should remain concerned about distressed headlines, and also consider the implications the GASB Statements could have on municipal credits with limited financial flexibility caused by residential assessed value pressures.
The pool of distressed credits could become larger as an increasing number of local governments are forced to address unfunded pension liabilities. Long-term sustainability – a risk factor that will become easier to measure under the new GASB standards – will likely become an important consideration when assessing the credit quality of municipal bonds.
About the Author
Mike Ross is currently the Director at MJR Consulting, specializing in municipal research, credit risk analysis, and credit modeling and surveillance. Mr. Ross has many years of experience on the buy side of the municipal bond industry as a credit analyst and portfolio investment team member. He has been manager of municipal research groups at several major broker/dealers.
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