Why the troubled Los Angeles schools got an upgrade to triple-A
A review following the Puerto Rico special revenues court ruling led Kroll Bond Rating Agency to upgrade the Los Angeles Unified School District's general obligation bonds.
Kroll on Wednesday upgraded three series of LAUSD GOs issued in 2016 to AAA from AA-plus and maintained a stable outlook.
“As a result of the ruling, we reviewed the state laws that are relevant for the ratings where we relied on special revenue provisions,” said Kroll analyst William Cox. “In consultation with external counsel, we have concluded that the ruling’s language actually strengthened our view of the California law and the mechanics for protecting bondholders.”
The GO upgrades come even as the school district struggles with financial troubles, underscored by declining enrollment and a teachers' strike earlier this year.
“We are pleased with Kroll’s rating upgrade from AA-plus to AAA,” said Megan Reilly, deputy superintendent of business services and operations. “While we acknowledge that we still have work to do, we remain responsible stewards of taxpayers’ money.”
The extremely strong security features and the strength of the GO bonds' pledged revenue source are compensating considerations in assessing the credit risk of the bonds, irrespective of the district’s weakening financial profile, Kroll analysts wrote.
“Our analysis of the state statute and the legal protections of voter authorized GOs allows us to reach a conclusion that bondholders are protected, because of the county tax collection process, requiring that these property taxes be collected and used for only one purpose. And that is to pay the debt service on these specific bonds,” Cox said in an interview. “Neither the school district, nor any party, can use the funds for any other purpose. That is the crux of the matter.”
Kroll had said in a March 27 report that it was analyzing the credit implications for San Diego Unified School District, LAUSD and the Board of Education of the City of Chicago in light of the March 26 decision by the 1st Circuit Court of Appeals in the Puerto Rico debt restructuring that payment of special revenue bonds in municipal bankruptcies is voluntary, rather than mandatory. That case, brought by Assured Guaranty Corp. and three other insurers, involved Puerto Rico Highways and Transportation Authority’s special revenue bonds.
Despite the strength of the Los Angeles County economy, Kroll analysts said, the district is facing significant financial challenges due to a combination of escalating costs and modest revenue growth projections.
LAUSD, the nation’s second largest school district after New York City's, has been losing students at a rate of 14,000 per year and posted enrollment of 453,000 students this year. The district approved a balanced $7.8 billion general fund budget on June 14, but included plans to lay off employees and reduce hours for others.
At the same time, the district’s assessed value is approaching $700 billion in 2019, up 7.5% year-over-year, and the district has a diverse tax base in a county with favorable trends in employment, income per capita, commercial activities and property value, according to Kroll.
The district’s debt level of $10.2 billion in outstanding GOs and voter-approved capacity to issue another $5.54 billion weighs favorably against its robust assessed value, Cox said.
Though Kroll generally viewed the Puerto Rico special revenues ruling as unfavorable, the ruling has a caveat that says that the change applies “absent state law that specifically governs the use of special revenues,” Cox said.
“In this case, we examined state law again — and determined the state law is so explicit that it’s highly unlikely a bankruptcy court could rule in a way that contradicts the purpose and intent of the state legislature in protecting these revenues,” Cox said. “We believe this would be an encroachment and unconstitutional.”
On May 14, Kroll upgraded San Diego Unified School District GO bonds to AAA from AA-plus. It is still weighing the implications of state law on the Board of Education of the City of Chicago, Cox said.
Fitch Ratings had placed seven special revenue ratings on negative watch in March — including the Oakland, Sweetwater and Sacramento school districts in California — after the appeals court ruling in the Puerto Rico bankruptcy challenged the long-standing assumption that special revenue bonds would continue to be paid in Chapter 9 municipal bankruptcies.
Fitch noted in a June 10 report that LAUSD was anticipating stronger financial results for fiscal 2020 despite the failure of Measure EE, a June ballot measure that would have imposed a property parcel tax to support the district. Fitch said despite proposed cuts, the school district still had a structural imbalance, and it did not alter its rating or outlook at that time.
The district will end fiscal year 2019 with a $59,292 operating surplus in its general fund after transfers compared to the $24.7 million surplus forecasted in the superintendent’s final budget, which, Kroll said, is due to increased expenses associated with the new contract with United Teachers Los Angeles after the six-day strike in January. Kroll estimated the agreement including salary increases and additional staffing cost the district $95 million.
The district self-certified as “qualified” in fiscal year 2019, a state schools designation that means it may be unable to meet its financial obligations for the current school year and the two succeeding fiscal years.
The designation also means that the school district cannot issue certificates of participation, tax and revenue anticipation notes, revenue bonds, or any other debt that does not require voter approval in the current or next fiscal year, without a determination by the Los Angeles County Office of Education. The school district hasn’t issued TRANs since 2013.
LACOE appointed James Morris, who worked for decades in administrative positions at LAUSD including chief operating officer, as a fiscal adviser to the district in January.
“If greater intervention is required, LACOE could install a fiscal advisor with stay and rescind authority over school board actions,” Fitch analysts wrote. “Ultimately, after intervention by a fiscal advisor, if LACOE determines that the district's finances are becoming more severely impaired, it would assess whether the district should be overseen by an outside administrator, with financial support from a state loan.”
The action did not affect Fitch’s AAA underlying rating and stable outlook on the district’s unlimited tax general obligation bonds, which are based on a dedicated tax analysis without regard to the district’s financial operations.
Fitch downgraded LAUSD’s issuer rating to A from A-plus in September and revised the issuer rating outlook to negative from stable before the teachers' strike in January.
Fitch began drawing a distinction between issuer ratings and unlimited tax general obligation bond ratings for California school districts in 2015. It issues a rating based on its “special revenues” distinction and another based on operational risks.
Moody's Investors Service on June 20 downgraded LAUSD general obligation bonds to Aa3 from Aa2 after the failure of Measure EE, which was estimated to bring in $500 million annually. The downgrade affects $10.2 billion in outstanding debt.
Moody’s also lowered the rating on the district’s $180.5 million in outstanding certificates of participation to A2 from A1, while revising the outlook to stable from negative.
From 2012 to 2019, LAUSD’s K-12 enrollment declined by roughly 100,000 students, continuing a 16-year-long trend in which the district lost about 260,000 students, according to an S&P Global Ratings report published in connection with a March downgrade. S&P downgraded LAUSD to A-plus from AA-minus citing its structural imbalance, long term trend of declining enrollment and sizable unfunded other post-employment benefits liability. The district expects to lose another 15,000 students in 2020 and 12,000 students in 2021, according to the report.
In addition to being protected in the unlikely event of a bankruptcy, the school district’s GOs have several security features that ensure bond payments will be made, according to the Kroll report.
The rated bonds are secured by voter-approved ad valorem taxes, Los Angeles County is statutorily obligated to levy taxes at a level sufficient to pay debt service, the county has a key role in levying and collecting taxes for debt service on the bonds, the pledged revenues are deposited in a segregated interest and sinking fund maintained by the county treasurer, and the revenues can only be used to repay the bonds.
“The bonds protections on the GOs allowed them to be rated higher,” Cox said. “We continue to analyze the financial operations in case we are asked to rate bonds that are secured differently in the future.”
Kroll doesn’t rate any of the district’s shorter term debt, or anything that isn’t secured by the district’s dedicated unlimited ad valorem property tax.