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CREDIT FOCUS
RATINGS
Jefferson County
Issuer Rating GO Limited Tax School Warrants Sewer Warrants Caa3 Negative Caa3 Negative B3 Negative Ca Negative
KEY INDICATORS
FY2010 FY2011 FY2012
All figures in thousand USD except where noted Jefferson County Annual Audits
Analyst Contacts:
NEW YORK +1.212.553.1653
Christopher Coviello +1.212.553.0575 Vice President - Senior Analyst christopher.coviello@moodys.com Dan Seymour +1.212.553.4871 Analyst dan.seymour@moodys.com Julie Beglin +1.212.553.4648 Vice President - Senior Analyst julie.beglin@moodys.com Naomi Richman +1.212.553.0014 Managing Director - Public Finance naomi.richman@moodys.com
The countys outstanding sewer warrants are rated Ca negative, consistent with recovery prospects in the 35%-65% range upon issuance of the new debt and confirmation of the bankruptcy plan. We also rate the countys defaulted General Obligation Limited Tax (GOLT) debt at Caa3 negative, with an expected recovery in the 65%-80% range upon conclusion of the bankruptcy, based on our approach for calculating recovery. (See the Appendix for a chart of our outstanding ratings on the county.)
Our opinion is based on the underlying credit quality of the debt, without regard to credit enhancement provided by bond insurance. The credit opinions in this article are based on information from Jefferson Countys Preliminary Official Statement dated Nov. 4, 2013, and on Moodys data.
New Higher Sewer Rates Critical to Debt Repayment Face Financial and Governance Risks
Financial Risk
Jefferson County faces a steep challenge in adhering to its plan, which projects raising sewer rates each year for 40 consecutive years in order to meet its projected debt service, while leaving funding for long term capital needs unaddressed. The approved rate plan increases user charges by 7.89% each year from 2014 to 2018 and by 3.49% each year from October 1, 2018 through maturity in 2053. Although the county intends for these rate increases to cover repayment of the new warrants and 10 years worth of projected capital and operating expenses, there is a clear risk that current projections will not play out. While the countys 10-year financial projections appear reasonable based on available information, long-term financial projections are inherently tenuous. The projected level of rate increases may be insufficient if actual revenues, operating expenses or capital expenditures turn out less favorably than assumed. If this occurs, user rates would need to be raised beyond the already approved increases. Additional rate increases will also be necessary to cover capital expenditures beginning in 2024. Uncertainty surrounding the county commissions ability and willingness to accept additional increases, especially given its history of resistance to rate increases, will remain a sizeable risk.
Governance Risk
Most publicly run US sewer systems set their rates through approvals from appointed, quasiindependent bodies that are established to reduce the unpredictable influences of electoral politics. However, in Jefferson Countys case, the responsibility for rate-setting rests with its five commissioners, who must face election every four years. The current 40-year schedule of rate increases recently passed by a narrow 3-2 vote and can be revisited by future boards, whose members may well change far more often than an appointed board would. The affordability of the rate increases for residential users of the system remains a contentious topic of political debate. Current user rates are already among some of the highest in the nation, and arguments have begun in the county about whether or not the approved rates meet the state constitutions standard of reasonable and nondiscriminatory rules and regulations fixing rates and charges. The new rates will be incorporated into the countys final plan for resolving its bankruptcy, and approval of the plan by the bankruptcy court is a condition of closing for the warrants. Following issuance of the new warrants, current or future commissioners could vote to roll back or rescind the rate increases. While the bond trustee could then ask the court to compel the county to enforce its bankruptcy plan, we are not aware of a precedent for a federal court to compel public utility rates of this nature, given the federalism issues involved in this bankruptcy. It is also possible that a future commission could even re-enter bankruptcy, in which case the county would start the bankruptcy process over. Jefferson County is one of only two rated US local government water and sewer issuers to default on water and sewer revenue bonds since 1970. It is the only one to impose material losses on creditors. Our forward-looking opinions about credit quality do not impose an automatic penalty box on past defaulters, but willingness to pay is a key element of our analysis, and past performance is often an important indicator of future actions. We recognize that the countys past debt issuance was motivated in part by criminal acts on the part of multiple individuals, and that previous risky debt structure included variable rate modes and many layers of derivative contracts. However, we are mindful that this structure was motivated in part by a
2 NOVEMBER 13, 2013 CREDIT FOCUS: JEFFERSON COUNTY, ALABAMAS DEBT OFFERING HAS NON-INVESTMENT GRADE CHARACTERISTICS
desire to minimize debt service payments in order to keep sewer rates low. We also know that the county did not raise sewer rates for five years from 2008 to 2013 despite insufficient net revenues to cover debt service. This history separates Jefferson County from the overwhelming majority of sewer revenue bond issuers who routinely demonstrate willingness to pay debts by implementing single-digit, annual rate increases to cover their operating and capital expenses. The current commissioners have demonstrated a change from past governance practices, including not only the implementation of 40 years of rate increases but also the appointment of a professional, experienced management team.
With a High Debt Load and Deferral of Principal Repayment, Comparative Financial Metrics Are Weak
High Debt Load
Despite the expected large haircuts for existing bondholders, Jefferson Countys sewer system is expected to remain highly leveraged for the foreseeable future. The system will be far more leveraged and offer significantly weaker coverage of future maximum annual debt service (MADS) than is typical of investment grade sewer systems. Despite the significant reduction in debt as a result of the bankruptcy process, the system will continue to bear a heavy debt load. Jefferson Countys debt ratios are outliers compared to rated sewer revenue bonds. The sewer systems ratio of total debt to current year (2013) operating revenues will be roughly 11 times. This is far above the median of about three times for all rated sewer systems and four times for the largest systems with more than $100 million of operating revenues. Among rated sewer systems, the median MADS coverage by current year revenues is 1.62 times for all systems, and 1.58 times for the largest systems. In contrast, Jefferson Countys revenues provide MADS coverage of only 0.4 times. 2
The MADS calculation incorporates unaudited fiscal 2013 net revenues of $106 million and $254 million MADS in 2053.
CREDIT FOCUS: JEFFERSON COUNTY, ALABAMAS DEBT OFFERING HAS NON-INVESTMENT GRADE CHARACTERISTICS
Debt Service Coverage Will Decline Precipitously When Principal Payments Spike After 10 Years
We expect the county to face increasing risk that it will fail to achieve adequate debt service coverage in the later years of these warrants. The enacted rate increases would boost net revenues to amply cover debt service in the early years, but the back-loaded debt structure will lead to tighter coverage in the future. The countys POS only offers financial projections through 2023, or one-quarter of the total life of the new debt. The lowest projected debt service coverage through 2023 is a robust 5.2 times for senior warrants and a solid 1.6 times for junior warrants for the next 10 years. However, debt service jumps sharply by 67% from 2023 to 2024. At that point, debt service coverage will tighten dramatically. We calculate that projected 2023 net revenues inflated at 3% would cover debt service by only 1.2 times in 2024.
Significant Future Capital Needs Loom; Will Require Further Rate Increases
One of the material risks that the new warrants face is that the back-loaded debt structure and corresponding rate increases may not leave capacity for future capital investment. Beyond regular system renewal and replacement, significant investments could be necessary to meet stricter environmental standards. Jefferson Countys extensive capital plan addresses various environmental issues related to its 1996 Consent Decree, as well as system efficiency upgrades that will meet both specific utility needs and provide operational reliability going forward. However, the feasibility study states that the strict phosphorus limit requirements that the countys sewer system will be accountable for in the future are approaching the limits of currently available phosphorus treatment technology. 3 The necessary upgrades would require sizeable future capital expenses. If these standards are not relaxed, or if other environmental standards tighten in the coming years, it is likely that significant debt issuance would be needed in fiscal 2024 and beyond, requiring even greater rate increases than have already been approved.
Service Area, Anchored by a Large University Healthcare Complex, Has Average Wealth Levels
The sewer system serves most of Jefferson County and small portions of adjacent counties. Jefferson County benefits from a substantial property tax base of $43.7 billion. It has a sizeable healthcare, educational and financial presence located predominantly in the City of Birmingham (GOLT rated Aa2 stable). The University of Alabama at Birmingham (UAB) (Aa2 stable) is the sewer systems largest single customer, accounting for 2% of 2012 charges billed. It operates a substantial hospital and research program and generates nearly $3 billion in annual revenue. UAB is not only the largest employer in Jefferson County, but also one of the top employers in the entire state. Wealth levels within the county remain somewhat below national averages, with per capita income at 96.5% of the US and median family income at 90.5% of the US. 4 Unemployment levels, however, continue to trend below both state and national averages at 6% as of July 2013, compared to state unemployment of 6.6% and national unemployment of 7.7%.
3 4
POS Appendix E, Municipal Advisors Feasibility Study, Series 2013 Sewer Warrants, p. 4-6. 2006-2010 American Community Survey 5-Year Estimates
CREDIT FOCUS: JEFFERSON COUNTY, ALABAMAS DEBT OFFERING HAS NON-INVESTMENT GRADE CHARACTERISTICS
The county encompasses 1,124 square miles and as a result, the sewer system is extremely large. The need for sewer lines to traverse the areas hilly terrain contributes to the systems heavy capital needs. The system originally consisted of 21 individually operated collection facilities that eventually connected to the countys treatment system. Today, with $2.68 billion book value of net fixed assets, the system consists of nine treatment plants that treat an average of 104 million gallons per day (mgd), 177 pump/lift stations and 3,145 miles of sewer lines.
Senior Lien Current Interest Warrants Senior Lien Capital Appreciation Warrants Senior Lien Convertible Capital Appreciation Warrants Total Senior Lien Par Sub Lien Current Interest Warrants Sub Lien Capital Appreciation Warrants Sub Lien Convertible Capital Appreciation Warrants Total Subordinate Lien Par Total Senior and Subordinate Par
Source: Jefferson County Preliminary Official Statement dated November 4, 2013
Security for the new warrants will include a senior lien rate covenant of 125% of annual debt service and a subordinate lien rate covenant not less than 110% of annual debt service. The warrants will also have debt service reserve funds, which are funded with letters of credit from JP Morgan. Senior lien warrants will have an additional bonds test of 1.25 times senior lien debt service coverage. The additional bonds test is 1.10 times for subordinate lien. All of the senior and subordinate warrants are fixed rate. If there were a second bankruptcy filing, while priority of payment may be respected, there is still a great deal of uncertainty about ultimate recovery of senior and subordinate lien debt, given that municipal bankruptcies are so rare.
CREDIT FOCUS: JEFFERSON COUNTY, ALABAMAS DEBT OFFERING HAS NON-INVESTMENT GRADE CHARACTERISTICS
Jefferson County Sewer revenue* Jefferson County GOLT Jefferson County Lease Jefferson County Limited Obligation School City of Birmingham GOLT Birmingham Water Works Board Senior Lien Birmingham Water Works Board Subordinate Lien
*These are the current warrants in default, not the planned new issuance.
CREDIT FOCUS: JEFFERSON COUNTY, ALABAMAS DEBT OFFERING HAS NON-INVESTMENT GRADE CHARACTERISTICS
US Municipal Bond Defaults and Recoveries, 1970-2012, May 2013 (151936) Jefferson County Demands More Concessions from Creditors, October 2013 (159533) How Moodys Calculates 55-60% Proposed Recovery Rate for Jefferson County Sewer Warrants, August 2013 (157609) Moodys Affirms Ca on Jefferson County, ALs $3.1B sewer revenue warrants; outlook remains negative, August 2013 Moodys downgrades to Ca from Caa3 the rating on Jefferson Countys (AL) $3.14 billion in outstanding sewer revenue warrants; outlook remains negative, February 2013 Jefferson County Commission Settlement Plan is Broadly Consistent With Our Expectations For Sewer Debt, June 2013 (154973)
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CREDIT FOCUS: JEFFERSON COUNTY, ALABAMAS DEBT OFFERING HAS NON-INVESTMENT GRADE CHARACTERISTICS
CREDIT FOCUS: JEFFERSON COUNTY, ALABAMAS DEBT OFFERING HAS NON-INVESTMENT GRADE CHARACTERISTICS