Public Finance. New Zealand Local Government Funding Agency Limited (LGFA) New Zealand. Full Rating Report. Key Rating Drivers. Rating Sensitivities

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1 New Zealand New Zealand Local Government Funding Agency Limited (LGFA) Full Rating Report Ratings Foreign Currency Long-Term IDR AA Short-Term IDR F1+ Local Currency Long-Term IDR AA+ Short-Term IDR F1+ Outlooks Long-Term Foreign-Currency IDR Long-Term Local-Currency IDR Financial Data Stable Stable New Zealand Local Government Funding Agency Limited (LGFA) 30 Jun Jun 16 Interest revenue (NZDm) Net profit (NZDm) Debt (NZDm) 8, ,043.6 Equity and reserves (NZDm) Interest revenue on loans/total loans (%) Net interest income/ earning assets (%) Equity and reserves/ total assets (%) Net profit/total equity and reserves (%) Key Rating Drivers Close Links to Sovereign: New Zealand Local Government Funding Agency Limited s (LGFA) ratings are based on its strong links to the sovereign (AA/AA+/Stable), which owns 20% of LGFA, and the liquidity support available through the New Zealand Debt Management Office (DMO). Fitch Ratings classifies LGFA as a credit-linked public-sector entity and equalises its ratings with those of the sovereign. Strong Local Governments: The credit quality of New Zealand s local governments is robust, supported by a strong institutional framework that includes significant disclosure and monitoring by the central government. LGFA s loan pool is concentrated among New Zealand s larger councils, in particular, Auckland Council, which accounted for around 30% of LGFA s total exposure at end-september 2017 (with a maximum of 40%). The concentration is a reflection of New Zealand s most populous and prosperous regions. Guarantee on Default: All principal shareholders and borrowers with more than NZD20 million in loans must sign a Joint and Several Liability Guarantee (JSLG). This guarantee is on demand and can be called by LGFA without a board or court order following a payment default. Should a guaranteeing council not pay its share, the shortfall is recoverable from the other guarantors on a pro-rata basis. The guarantee does provide strong incentive for councils to be current on their obligations to LGFA even though it is enforced only after a default. Robust Creditor Protection: LGFA s lending to councils is secured via a charge over the councils' rates, which strengthens creditor protection. The Local Government Act 2002 allows councils to secure borrowing with their assets. Rate revenue is predictable and is the main source of operating revenue for New Zealand s local authorities totalling NZD5.4 billion in 2016 (around 60% of total operating revenue). Important Lender to Sector: Total loans outstanding to the local authority sector increased by 21% yoy to NZD7.8 billion for the year ended June 2017 (FYE17), with LGFA providing 83% of the sector s long-term borrowing requirements in FY17 (91% if Auckland is excluded). All loans are performing. Related Research Institutional Framework for New Zealand Subnationals (May 2014) Analysts Samuel Kwok samuel.kwok@fitchratings.com Fernando Mayorga fernando.mayorga@fitchratings.com Sound Liquidity: LGFA manages liquidity risk through a mix of cash, a portfolio of highly rated fixed-income securities and an undrawn NZD800 million liquidity facility with the DMO. Onbalance-sheet liquidity improved, with cash and fixed-income securities totalling NZD327 million at FYE17, compared with NZD266 million at FYE16. Liquidity requirements increased following the introduction of bespoke and short-term lending. Rating Sensitivities Credit Linked: LGFA s ratings are credit-linked to those of the New Zealand sovereign; positive or negative rating action would stem from a similar move on the sovereign. Downward Pressure: Weaker integration with the sovereign, such as the removal of liquidity support, a deterioration in the credit quality of local governments or a decrease in strategic importance could result in wider notching from the sovereign s ratings. 16

2 Rating History Date Long-Term Foreign IDR 6 Dec 11 AA AA+ Long-Term Local IDR Credit Profile Activities LGFA began operating as an optional borrowing vehicle for New Zealand s councils in February 2012, following the enactment of the Local Borrowing Act Its main objective is to optimise debt funding terms and conditions for participating local authorities (PLAs). This includes reducing interest costs, offering flexible terms and allowing long-term borrowing. LGFA had 18 foundation council shareholders on incorporation, of which nine were considered the Tight Nine as they were founding members, as well as the New Zealand government. The number of shareholders was increased in 2012 by another 12 councils. A further 14 councils are borrowers and guarantors, while nine are only borrowers. In all, 53 local authorities are eligible LGFA borrowers, with 50 being borrowers at FYE17 (three councils joined LGFA in FY17). PLAs represent around 97% of New Zealand s local government sector debt. LGFA aims to provide at least half of the PLAs' aggregate long-term debt funding. The aim of LGFA is to provide savings in the cost of funds for participating councils through economies of scale and to make longer-term and flexible borrowing available. New Zealand Local Government Sector New Zealand is divided into 11 regional councils and 67 territorial authorities, comprising 12 city councils (territorial authorities with more than 50,000 inhabitants), 54 district councils and one Unitary Territorial Authority (Chatham Islands Council). Six of the territorial authorities Auckland Council, Nelson City Council, Gisborne District Council, Marlborough District Council, Tasman District Council and the Chatham Islands Council also have the powers of a regional council see the Institutional Framework for New Zealand Subnationals report under Related Research. Around 60% of local government revenue is sourced from rates, including property rates, targeted rates, such as water usage, and uniform annual general charges. Local councils, with the exception of Auckland Council, cannot borrow in foreign currency, although LGFA can. They can charge any asset, including rates, to secure borrowings, but in every borrowing prospectus they must explicitly state that the New Zealand government does not guarantee and is not liable for the local authority s debt. Council Borrowing Per annum (NZDm) From LGFA From Other Sources 3,000 2,500 2,000 1,500 1, Related Criteria Rating of Public-Sector Entities Outside the United States (February 2016) International Local and Regional Governments Rating Criteria Outside the United States (April 2016) 2

3 Public-Sector Entity Support Factors Summary Legal status Strategic importance Control and oversight Integration/ financial Rating factor Stronger Stronger Midrange Stronger Source: Fitch Legal Status LGFA is a council-controlled organisation under the Local Government Act Ownership by shareholder councils is via principal shares (PS) in the entity. Defined as ordinary shares, they give the holders voting rights and discretionary dividend payments. If shareholders want to dispose of their PS or default, they are required to sell their PS to another council or the New Zealand government. LGFA had 45 million ordinary shares on issue at FYE16, of which 20 million were uncalled. All ordinary shares rank equally, with one vote attached to each. Our Stronger assessment of this factor reflects the fact that while the sovereign holds 20% of the paid-up PS, the remainder is held by 30 local and regional councils and, therefore, the general government sector holds 100% of the share capital. The council shareholders have subscribed for uncalled capital of NZD20 million that has been issued on a 1:1 basis with their paid-up capital. The government s holding will be diluted to 11.1% if this capital is called. Non-shareholding councils can borrow from LGFA. However, borrowing councils must contribute subordinated capital in the form of borrowing notes (BNs) to the equivalent of 1.6% of their outstanding debt. The BNs are temporary capital without voting rights, senior only to PS and convertible into redeemable shares at LGFA s discretion, for instance, if there is an imminent default. Legislation has been enacted requiring all principal shareholders, excluding the New Zealand government, and any council borrowing more than NZD20 million to be signatories to the JSLG. The guarantee constitutes an on-demand direct obligation on each guarantor, guaranteeing LGFA s obligations, including its issued bonds and the DMO liquidity facility. Each guarantor is jointly and severally liable, with the proportion of its liability calculated on a pro-rata basis according to the prior year s rate revenue. If a guarantor fails to pay its pro-rata share, the shortfall has to be covered pro-rata by the other guarantors. The guarantee is supported by lending security over the council borrowers rates. Strategic Importance LGFA was established with the support of the central government as a means of providing an alternative and cost-effective borrowing option for local governments in New Zealand. LGFA is the second-largest bond issuer in the country after the sovereign and the 53 eligible borrowers include the largest local councils in the country. In addition to lowering funding costs, LGFA has enabled councils to lengthen their debt profiles through longer-dated debt maturities. The longer durations reduce refinancing risk and provide funding more in line with the longer life of mainly debt-funded infrastructure assets. Fitch has assessed this attribute as Stronger given LGFA s important role as an issuing vehicle for the local governments in New Zealand and the fact that over 92% of the borrowing of this sector is through LGFA. Control and Oversight LGFA s board consists of six members, of whom five are independent and one represents the local government sector. The New Zealand government does not have a representative on LGFA s board but appoints a representative on the shareholder council. Mark Butcher was appointed CEO in August 2014; he was previously the treasurer of Auckland Council and a 3

4 member of LGFA s board of directors. LGFA operates a lean management structure of seven employees, including the CEO. This exposes the entity to key-person operational risk, although operational processes are clearly defined and documented. The Department of Internal Affairs monitors LGFA as well as oversees local councils. LGFA must comply with securities laws as if it were a New Zealand local council, even though it is not regulated by the Reserve Bank of New Zealand. LGFA maintains private internal credit ratings on all councils it lends to. LGFA must report to its board, bond trustee with the frequency determined by the trustee or the terms of the relevant bonds local councils (shareholders), treasury and the Department of Internal Affairs. It publishes half-yearly accounts. The Office of the Auditor General has appointed KPMG LLP as LGFA s auditor. However, LGFA can act independently and does not need to obtain the approval of the government to borrow. As a result, this attribute has been assessed as Mid-range. Integration Although LGFA does not require or receive subsidies or transfers from the sovereign to support its operations, the Local Government Borrowing Act 2011 allows the central government to grant a tax exemption for LGFA and authorises the crown to lend to LGFA if it is in the public interest, but on commercial terms. This led to the establishment of the DMO committed liquidity facility, which was increased to NZD800 million in February 2017 from NZD400 million. The DMO also provides support by acting as the sole counterparty for derivative transactions. The liquidity facility is considered an important element in this attribute and it has been assessed as Stronger. Overall Assessment Fitch classifies LGFA as a credit-linked public-sector entity under its criteria. This is due to the entity s strong strategic importance to the local government sector; legal status supported by legislation to allow councils to enter into JSLGs; its central government shareholding; and the support and strong ability of the sovereign to provide extraordinary support. LGFA s ratings are equalised with the New Zealand sovereign s ratings. Fitch believes the sovereign has demonstrated intrinsic support by amending the local government law to allow councils to enter into JSLGs a crucial mechanism for LGFA s establishment as well as providing other types of support, such as a 20% shareholding in the entity, a tax exemption, the DMO liquidity facility and by the DMO acting as sole counterparty for derivative transactions. The sovereign has a strong record of supporting its local councils and state-owned entities, the financial system and other large companies important to New Zealand s economy; for example, it paid or committed about NZD14.3 billion to help Christchurch s recovery after the 2011 earthquake, guaranteed retail deposits of up to NZD1 million in 2008 and bailed out Air New Zealand in The sovereign has intervened on some occasions in local councils and appointed a commissioner to maintain confidence; no council has ever had to appoint a receiver. Fitch believes that if the sovereign needs to support LGFA, it will do so first using liquidity. In the event of a local council not paying under its obligations, liquidity support would be required from the time of non-payment until finalisation of the recovery, which could take up to 18 months. Fitch believes full recoveries are probable due to underlying asset strength, extremely strong incentive for councils to pay in view of collateral over rate revenues and the joint and several guarantees. 4

5 F 2019F 2020F F 2019F 2020F Public Finance Profit and Loss (NZDm) Financial Performance Profitability LGFA is a non-profit-maximising entity that aims to assist participating local borrowing authorities by providing lower funding costs, rather than benefitting shareholders through dividends. The entity recorded a profit of NZD11 million in FY17, up from NZD9.5 million in FY16 and was higher than its initial projections under the statement of intent. LGFA s statement of intent shows net profit staying relatively flat at NZD10.9 million in FY18 but declining to NZD7.4 million in FY20 from tighter margins. Operating expenditure was in line with the entity s expectations and has increased as some services were brought back in-house and it developed and is operating a treasury system that was previously outsourced to the DMO. 0 LGFA s main operating income source is net interest revenue from loans to local councils. Its target is to achieve an average base-margin above its cost-of-funds (to its highest-rated participating local authorities) of 0.10%. This is in line with its non-profit-maximising strategy. Profitability is supported by LGFA s tax-exempt status and well-managed operating expenses, which consist mainly of personnel expenses and the development and operating costs of its treasury system. Lending Total loans to the local authority sector amounted to around NZD8 billion at end-august 2017 and LGFA provided 83% of the sector's long-term borrowing requirements in FYE17. We estimate that eligible borrowing councils comprise more than 90% of all New Zealand ratepayers. In addition to lowering funding costs, LGFA has enabled councils to strengthen their debt profiles through longer-dated debt maturities and reduce potential refinancing risk. Top Ten Borrowers with LGFA Debt* (NZDm) % sector Rates (NZDm) Population 2017 % NZ Council June 2016 debt June 2016 (Stats NZ) population Auckland council 7, ,564 1,657, Christchurch city council 1, , Tauranga city council , Hamilton city council , Greater Wellington regional , council Wellington city council , Kapiti coast district council , Taupo district council , Rotorua district council , Whangarei district council , Total 11, ,933 3,313,100 Sector total 13,852 5,429 4,793,700 * Includes non-lgfa borrowing Total Asset Growth (NZDm) 9,000 6,000 Risk Management Risk Policies LGFA s lending and investment policies are outlined in its shareholder agreement and treasury policies. LGFA can only lend to local councils and not to council-controlled organisations, council-controlled trading organisations, council joint ventures or partially owned entities. 3,000 0 Treasury policies cover LGFA s credit, liquidity and market risk. Credit risk is managed by LGFA directly via financial covenants, including net debt/total revenue, net interest/total revenue, net interest/annual rates income and liquidity, and concentration risk. If councils are rated by an external credit rating agency, their covenant limits are increased. Borrowers credit risk is reviewed at least annually. In certain circumstances, the board or shareholders can 5

6 approve an exception to these criteria. LGFA has an internal rating review and a watch list that is continuously monitored. The investment policies determine LGFA s liquidity investments in terms of asset quality and concentration. The main market risk is interest-rate risk, as exposure to foreign-exchange risk is minimal, since all borrowing and lending are in New Zealand dollars. Credit Risk and Enforcement Internal Review Process LGFA s internal rating process reviews a council s financial position, strengths and weaknesses, financial ratios, regional profile and size, debt profile, budgetary performance, rates revenue, capital expenditure, contingent liabilities and performance against financial covenants set by LGFA. LGFA can refuse entry to a borrower and lending to a council if the council does not meet minimum credit standards. Additional oversight is gained through the review of published long-term plans (currently ), which are audited by the Office of the Auditor-General and provide insight into where potential covenant breaches could occur. Single-name lending concentrations exist, with Auckland Council being the largest LGFA borrower, accounting for 30% of long-term lending at FYE17 (LGFA s exposure limit is 40% of its total lending), followed by Christchurch City Council, which accounts for around 20.4%. The two councils represent 42% of New Zealand s population but have higher capex and funding requirements. Auckland has experienced strong population growth and Christchurch has been rebuilding after the 2011 earthquake. The 10-largest borrowers within LGFA accounted for around 76% of outstanding long-term loans at FYE17 (similar as the previous year). Enforcement Guarantor local authorities issue security stock certificates in favour of LGFA and the security trustee. The security provided is a charge over the local authorities rates. The obligation to LGFA and the security trustee ranks equally with other rate-secured creditors of the local authorities and allows LGFA and other stockholders to appoint a receiver through the debenture trustee. Rates revenue is the main source of operating revenue for New Zealand s local authorities totalling NZD5.4 billion in 2016 (60% of total operating revenue). Debt and Liquidity Risk Management The front, middle and back office services previously undertaken by the DMO were transitioned to LGFA in 2015, although the DMO continues to act as sole swap counterparty. Borrowing LGFA issued NZD1.3 billion in bonds in FY17 and outstanding debt totalled NZD8.1 billion at end-august 2017 across eight bond maturities from December 2017 to April LGFA also introduced short-term bills in FY16 with an outstanding amount of NZD350 million at FYE17 across one-month to six-month maturities. LGFA issues bullet bonds and historically matched lending maturities. The introduction of bespoke lending in FY16 (the amount of bespoke lending issued in FY17 was NZD707 million) and short-term issuance have increased maturity mismatches, so LGFA has updated and strengthened liquidity policies. LGFA s aim is to issue bonds to match existing New Zealand government bond (NZGB) maturities where possible to attract NZGB investors and achieve an average cost-of-funds above NZGBs of no more than 50bp. 6

7 Bond Maturity Profile as at 30 June 2017 (NZDm) 1,600 1,400 1,200 1, Projections based on the 10-year ( ) local council plan show absolute debt levels rising through to 2025, although revenue increases are forecast to match the increase in debt. Current forecasts show sector debt peaking at NZD20 billion by 2025 and debt with current guarantor councils reaching NZD19.4 billion. LGFA projections have outstanding borrowings growing from NZD6.5 billion at FYE16 to NZD7.9 billion by FYE20. LGFA has a wider investor base than each individual local council, especially in light of its ability to raise both domestic and foreign-currency debt in offshore capital markets. Liquidity rules introduced under Basel III make LGFA debt attractive for banks, which held 33% of outstanding bonds at end-september 2017, as local government debt is eligible for liquidity holdings and as collateral in repo transactions with the Reserve Bank of New Zealand. Other investors include insurance companies, pension funds, corporates and retail investors. LGFA embarked on its first major international investor roadshow in mid-2013 and at end-september % of bond holders resided outside of New Zealand. Demand for LGFA bonds remains strong with average bid coverage ratio in FY17 of 2.96x. LGFA has issued NZD50 million of each LGFA bond maturity to itself and holds the bonds as treasury stock to support secondary-market liquidity. These bonds are available to bank counterparties via a repo transaction for terms less than 30 days and secured against cash. Liquidity LGFA manages its liquidity risk by holding a mix of cash and highly rated fixed-income securities in its liquid asset portfolio and undrawn NZD800 million liquidity facility. On-balancesheet liquidity has improved, with cash and fixed-income securities totalling NZD327 million at FYE17. LGFA aims to maintain a liquid asset portfolio size of NZD250 million-300 million. Liquidity requirements have risen following the introduction of bespoke and short-term lending. The maximum amount of council debt that can mature within one year is the greater of NZD100 million or 33% of outstanding LGFA debt. LGFA sets liquidity targets based on one-, three- and 12-month funding cash flow commitments, defined as committed funding and refinancing, operating expenditure and interest owing. The entity targets a liquidity buffer where liquid assets after haircuts and the DMO facility cover 110% of the next 180 days of funding due for repayment, operating expenditure, interest owing and any other committed cash obligations. The standby DMO line provides liquidity although the facility commitment can be reduced to zero if LGFA s rating differs significantly from that of the sovereign. The DMO s standby facility is in place until December 2021 and is priced on commercial terms. Advances under the facility must mature no later than two years from the drawdown date. The last resort for addressing a liquidity issue is LGFA s uncalled capital of NZD20 million and the JSLG. Fitch believe these facilities provide limited liquidity support as council shareholders have limited spare liquid investments and rely heavily on LGFA for funding. 7

8 Liquidity Portfolio LGFA s investment policy requires it to hold liquidity in the form of fixed-income securities with highly rated issuers, such as the sovereign, supranationals and highly rated banks. LGFA is not allowed to hold any securities issued by local councils within its liquidity portfolio. Capitalisation LGFA s capital structure included NZD25 million in paid-up capital and NZD29 million in retained earnings at FYE17. Additional capital sources included NZD20 million of uncalled PS and NZD131 million of borrower notes. Non-risk-adjusted leverage ratios are low relative to commercial lending entities. However, as LGFA is not a registered bank and is not required to produce risk-adjusted capital ratios, the non-risk-adjusted ratios do not reflect the credit quality of the loan portfolio. At FYE17, 88% of lending was to councils with an internal rating of A+ or higher, with the remaining 12% unrated. LGFA s total equity/total assets ratio was 0.6% at FYE17, but rises to 2.4% when including the additional capital sources, which is above its self-imposed ratio requirement of 1.6%. Fitch sees this as adequate considering the concentration risk and underlying credit quality of the local councils. The requirement for local councils to subscribe to the bank notes, the amount of which is equivalent to 1.6% of their aggregate borrowings, ensures this ratio is maintained. 8

9 Appendix A (NZDm) Profit and loss Interest revenue Interest expenditure Net interest income Net fees and commissions Other operating income Personal expenses Other operating expenses Net gains and losses on securities and trading Net operating income/(loss) Provisions Operating profit (loss) after provisions Other non-operating revenues/expenses Contributions from state budgets Profit (loss) before tax Taxation Net profit (loss) Balance sheet Assets Cash and cash equivalents Liquid securities Deposits with banks Loans 2, , , , ,783.9 Other earning assets Long-term investments Fixed assets Intangible Other long-term assets Total assets 2, , , , ,491.3 Liabilities & equity Customer deposits Deposits from banks Short term borrowing Other short term liabilities Debt maturing after 1 year 2, , , , ,865.4 Other long-term funding Other provisions and reserves Other long term liabilities Equity Reserves Total liabilities and equity 2, , , , ,491.3 Memo Guarantees and other contingent liabilities Source: Issuer and Fitch calculations 9

10 Appendix B Ratios Performance Interest revenue on loans/loans (%) Interest expense/borrowings and deposits (%) Net interest income/earning assets (%) Net operating income/net interest income and other oper. revenue (%) Net operating income/equity and reserves (%) Net operating income/total assets (%) Credit Growth of total assets (%) Growth of loans (%) Impaired loans/total loans (%) Reserves for impaired loans/impaired loans (%) Loan impairment charges/loans (%) Liquidity and funding Long term debt/total equity and reserves (%) 11, , , , , Liquid assets/total assets (%) Total deposits and debt/total assets (%) Liquid assets/short term deposits and borrowing (%) Capitalization Equity and reserves/total assets (%) Net profit/total equity and reserves (%) Loans/equity and reserves (%) 10, , , , , Regulatory capital adequacy ratio (%) n.a.: Not available Source: Issuer and Fitch calculations 10

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