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City Responds to Moody's Downgrade of Covington Credit Rating in Wake of Embezzlement

Moody's, the national credit rating agency, has downgraded the City of Covington's credit rating from from A2 to Baa1.

The agency placed the City's credit rating under review in late December, three months after former finance director Bob Due was arrested on suspicion that he embezzled hundreds of thousands of dollars over a period of a dozen years.

Due pleaded guilty to fifteen charges in Kenton County Circuit Court two weeks ago and faces fifteen years in prison. An examination of Due's embezzlement and of operations within the City's finance department by Kentucky Auditor Adam Edelen's office revealed that Due pocketed $793,000 by writing fraudulent checks to himself, family members, and fake vendors.

Due is scheduled to be sentenced on April 17.

"Please note that the City's new rating is still considered "investment grade"," said City Manager Larry Klein on Monday. "I would further add that Moody's and other investor rating services have been looking hard at municipal finances for the past several years due to general economic conditions in the US but also because of growing pension liabilities we have in our state pension systems."

Moody's rating system is used to provide investors with a way to grade the credit-worthiness of securities. Covington's previous rating of A1 signified an upper-medium grade and a high ability to repay debt. The new rating of Baa1 denotes a medium grade and a moderate credit risk.

According to a news release from Moody's, the rating on Covington's general obligation bonds, affecting $2.7 million of outstanding rated debt, was downgraded with a negative outlook. "The City has an additional $43.9 million in debt outstanding that is not rated by Moody's but was considered in our analysis," the news release said.

"The downgrade to Baa1 reflects a history of deficit spending that has led to an extremely limited financial position with no near-term plans to rebuild reserves, which is compounded by the city's reliance on economically sensitive revenue streams. The rating also considers the recent administrative and personnel changes that were implemented to help prevent future theft of city resources. Also considered is the city's large tax base favorably located in the Cincinnati metro area; below average socioeconomic indices; variable rate debt exposure and elevated pension burdens."

"The negative outlook reflects our view that the limited liquidity of the city could continue to pressure the rating, given the city's exposure to variable rate demand obligations and reliance on market access for short-term borrowing to meet cash-flow needs."

Moody's cited a large tax base located in the Cincinnati metro area and recent administrative changes and a tightening of internal financial controls as strengths for the city while noting a history of general fund deficits, extremely limited financial reserves with no near term plans for an increase (compounded by a reliance on economically sensitive revenues), the use of short-term tax and revenue anticipation notes to meet cash-flow needs, and a variable rate debt exposure and elevated pension burdens as challenges.

"The negative outlook reflects our view that the limited liquidity of the city could continue to pressure the rating, given the city's exposure to variable rate demand obligations and reliance on market access for short-term borrowing to meet cash-flow needs," the news release said.

Covington could improve its rating with a history of operating surpluses and a strengthening of financial reserves as well as with a diversification of revenue streams. The rating could go down further with a continued deterioration of reserves or the contraction of the local economy.

Klein noted that 83% of Moody's rating changes were downgrades in 2013 after the agency tightened its criteria. He also pointed out that Newport has a lower credit rating at Baa2.

"I was happy to see in the Moody’s report that they noted as one of our “Strengths” the recent administrative and personnel changes we are making to strengthen internal controls and improve segregation of duties. They continue on the following page, last paragraph noting the “…City’s commitment to preventing future occurrences and ensuring that public funds are properly managed going forward” and that embezzled funds that are recovered will add to our General Fund balance," Klein said.
 
"I also appreciate Moody’s recognition of the City Commission’s aggressive commitment to capital spending and reinvestment in the City’s infrastructure, riverfront development, and neighborhood revitalization."
 
Additional notes:
 
On the City's historically low amount of reserve funds:
Larry Klein: (Moody's was) concerned about this even when City had the 5% fund balance reserve requirement, when our fund balance reached a high of $2.5 million in 2008, right before national housing and mortgage collapse, and general nationwide economic decline. When this decline occurred in late 2008 beginning with reduction of staff at Fidelity campus, and for following years the City had to rely on this fund balance as it made changes/reductions in staffing, health care and other changes in the City’s budget and organizational structure.
 
On the City's exposure to variable rate debt:
Larry Klein: Some of the City’s debt issues in past have been for variable interest rates. Our two old City pension fund debt issues are variable rate debt, which accounts for about 25% of total City debt. Moody’s concern is those rates could increase since not fixed rate.
 
On the City's use of tax anticipation notes to bridge budget years based on low cash flow:
Larry Klein: The City historically does short term borrowing of about $3.5 million at beginning of each new budget to ensure adequate cash flow to meet payroll and other 
financial obligations. This is because of City’s historically low cash reserve position. The City then pays back this short term TAN sometime during budget year when cash is higher. Our revenue streams are cyclical. Property taxes come in around end of September ($6 million). Net profits taxes, ($2.4 million) about 90% comes in around April 15th monthly for larger payers and quarterly for smaller payers. Waste fee collections ($2.2 million comes in around March and April after billed). Payroll taxes ($22 million) come in monthly for larger payers and quarterly for smaller payers. Waste fee collections ($2.2 million comes in around March and April after billed).
 
How the City plans to improve its rating:
Larry Klein: Using proceeds of sale of former City building for Hotel Covington to shore up our fund balance reserve; This should also help us reduce the annual amount of TAN we must do at beginning of each new budget year; We are currently looking at options to refinance some of our variable rate debt to fixed rate debt. When we do this, if it is refinanced through the Kentucky League of Cities, we will no longer have a Moody’s rating, or more simply put, it won’t be applicable, as our bonds will be rated AA- based on KLC bond pool rating. In addition, an expensive interest rate swap on our two old City pension funds (currently at 4.56%) expires at end of December. We would have to pay a prepayment penalty to change that right now. We believe this can be refinanced at end of year and reduce interest costs.
 
Written by Michael Monks, editor & publisher of The River City News
 
Photo: Covington City Hall/RCN file