Last week, we predicted that, in the absence of fresh news from Puerto Rico, the market would shift its attention to the two weakest State GO credits, Illinois and New Jersey. With regard to the Garden State, that already seems to be happening.
The rating agencies, for once, appear eager to get in front of this incipient credit crisis. Last Friday (September 5), Fitch downgraded New Jersey GOs from A+ to A, citing “the absence of long-term, fiscally sustainable solutions to close identified budget gaps in fiscal year 2014 and 2015, (…), the resurgence of sizable one-time measures to balance its operating budgets (…) and maintenance of extremely narrow financial reserves.” Fitch also pointed out that “New Jersey’s economic performance continues to lag that of the nation.” Yesterday, S&P also lowered its GO rating for New Jersey, from A+ to A. Unlike Fitch, S&P chose to focus more on the State’s structural deficit and its growing pension and OPEB liabilities. Which goes to show that the Garden State is in trouble on many, many fronts. You just have to take your pick.
An astute market observer on Twitter pointed out that New Jersey’s appropriation debt rating is now, at A-, only one notch above Illinois’ GO debt rating, by both Fitch and S&P. The case can certainly be made that the two State credits are on a path toward convergence. As far as we’re concerned, the current spread of about 115 basis points between Illinois and New Jersey just seems too wide. Although New Jersey’s specialty state appeal will always keep the two credits from trading on top of each other, that spread should narrow significantly over time, in our opinion.
The fiscal plight of a high profile local issuer such as Atlantic City has also served to draw attention to New Jersey’s deteriorating credit picture. This oceanside resort, as it were, lends itself quite readily to muni credit analysis 101: it is a classic tale of a one-industry town whose sole industry happens to be in a tailspin.
The declining fortunes of Atlantic City’s gaming industry have been well documented in the media. Under intense competition from existing and soon-to-be-opened casinos from neighboring states in the Northeast corridor, particularly in New York State, the city’s gambling revenues have reportedly declined by more than half since they peaked in 2006. Three out of the city’s 12 casinos have already shut down this year, leading to a potential loss of 8,000 jobs. As the latest casualty, Trump Entertainment Resorts Inc., which owns two Atlantic City casinos (Trump Plaza and Trump Taj Mahal), filed for Chapter 11 on Tuesday.
In an ironic twist, New Jersey legislators are considering ending Atlantic City’s 40 year-old monopoly on in-state gambling and allowing another casino to open in the northern part of the state. As the reasoning goes, expanding gambling to other towns is crucial to recapturing revenues lost to facilities in New York and Philadelphia. It will also allow the State to funnel more state aid to Atlantic City. Whether this will turn out to be more of an opportunity or a risk to the city remains to be seen. If directed toward economic diversification efforts, the additional state aid could potentially lay the foundation for Atlantic City’s recovery. On the other hand, more in-state competition may well sound the death knell for this once bustling city’s gambling industry.
Socio-economic data on the city, courtesy of Merritt Research Services, paint a Detroit-like picture: Atlantic City’s population has declined by an average annual rate of -0.2% over the past 5 years, compared to the average annual growth rate for the surrounding County, the State and the U.S. of 0.2%, 0.4% and 0.8%, respectively.
Let’s face it, there’s a bigger question on everyone’s mind: is Atlantic City heading for default on its outstanding $245 million in GO debt?
Since 2006, the local employment base has also been shrinking by an average annual rate of -1.9%, versus -0.1% for NJ and +0.3% for the U.S. The local unemployment rate as of July 2014 stood at 13.9%, just about double the rate for the State. Per capita income for local residents has been shrinking at a 3.2% compound annual rate, in sharp contrast to the 1.3% annual growth rate for the State as a whole.
Most tellingly, the so-called “Accommodations & Food Services” sector for more than 22% of the county’s total income, is second only to the Government sector at 23.6%. Indeed, the top 10 property taxpayers, consisting entirely of gambling institutions, account for fully 69% of the city’s assessed valuation.
This concentrated tax base has another downside: all these large casinos employ very good tax lawyers and they have been quite successful in appealing their tax assessments. So much so that the city has been, and will be again, forced to issue GO debt to fund tax refunds to these establishments. Needless to say, this kind of deficit financing will only add to the city’s future fiscal problems.
Let’s face it, there’s a bigger question on everyone’s mind: is Atlantic City heading for default on its outstanding $245 million in GO debt? While this is certainly not intended to be a full credit analysis, we did some quick back-of-the-envelope calculations based on the FY2013 “audit.” Based on total General Fund expenditures of $240 million (net of expenditures for overlapping entities), the City apparently spent $37 million for debt service and another $23 million for pension contributions (however determined). Together, these fixed charges accounted for fully 25% of expenditures. In our experience, 25% is usually the threshold beyond which fixed charges will start to “crowd out” other operating expenses, leading to severe fiscal stress. So, the warning signs are there.
For now, there remains the perception, warranted or not, that Governor Christie won’t let the city default under his watch. After all, the City has been operating under supervision from the Director of the New Jersey Local Finance Board since 2010. A state aid intercept mechanism is also available on certain of the City’s bond issues to insure debt service will be paid.
One last but critical point: like many other New Jersey local governmental entities, Atlantic City does not report its financial results on a GAAP basis, only on the so-called “regulatory basis,” thus forcing its auditors to issue a “qualified” opinion every single year. So, as bad as the numbers currently look, the real numbers based on GAAP accrual accounting might be even worse, and there’s no way for us to tell at this point.
Despite the relentlessly negative media coverage, the City’s GO bonds have actually held up well, although the current split rating of Ba1 by Moody’s and A- by S&P may have helped support market value. For example, the GO 5.00% of 2033 (cusip 048339ud5) just traded on September 9 right around par. Still, at +226 to the AAA curve, the current spread is certainly more reflective of a junk credit than of an investment grade name.
Governor Christie, ever mindful that a high profile fiscal disaster at the local level could hurt his chances for national office, convened a meeting of state and local leaders in Atlantic City earlier this week. Not surprisingly, the meeting resulted in the appointment of yet another committee. This committee, to be headed by real estate developer Jon Hanson, is expected to report back to the Governor with new ideas to rejuvenate the city in 45 days. Great political theater but no real concrete assistance to this beleaguered town in the short-term.
In the meantime, the hard-charging Governor has said he would exploit a potential loophole in a 2013 federal court ruling and allow sports betting at the state’s local gambling institutions. Given the relatively small size of the sports betting industry and its uncertain legal status, gaming experts don’t believe this will provide a lifeline to Atlantic City.
Undeterred by all the negative headlines, the city has announced plans to sell another $140 million issue in the fourth quarter to cover the cost of successful tax appeals. This new financing is expected to be done under the New Jersey Qualified Bond Act to take advantage of the State’s higher debt rating. Ironically, as we’ve discussed above, riding on the State’s credit coattails may turn out not to be such a panacea at this time.
“Boardwalk Empire,” the HBO TV show set in Atlantic City during the Prohibition era, just started its final season. Will the real Atlantic City also see its finale as the Las Vegas of the East? We will soon find out.
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