municipal bond defaults (l): general

I’m finally trying seriously to formulate a detailed strategy statement for 2011.  As usual, I’ve waited to the absolute last minute.  In thinking about what might go wrong on a macro level, two issues stand out:

–possible EU sovereign debt problems and

–potential municipal financing difficulties in the US.

So I started doing research on municipal bankruptcies.

the slapstick

I learned there’s been a media firestorm over this topic during the past week, with real slapstick comedy overtones.  Putative municipal credit rater Meredith Whitney appeared on Sixty Minutes last week to predict that 50-100 cities in the US will declare bankruptcy next year, defaulting on “hundreds of billions of dollars” in debt.  This compares with the current record default year of 2008, during which cities stopped paying on about $8 billion of their obligations.  Muni experts were not amused.  They point out that the figure mentioned would imply just about every large city in the US going belly up.

Ms. Whitney is probably best known for being the spouse of former professional wrestling “champion,” John Layfield,  who performed under the nommes de guerre of “Hawk”  (a member of the Undertaker’s “Ministry of Darkness”), “Bradshaw,”  and “JBL.”  He is now a seller of herbal potions, as well as a financial commentator for Fox.  Whitney, also a financial commentator for Fox, gained fame while a bank analyst at Oppenheimer for her well-publicized (and correct) opinion that the financial crisis would be far worse than the consensus expected.

Though widely criticized for her non-consensus views on municipal finance, Whitney has found defenders, including Henry Blodget, a former Oppenheimer analyst himself, who is now barred from the securities industry as part of his agreement to settle securities fraud charges brought against him by the SEC.

the rationale

It’s not clear that Ms. Whitney has any deep knowledge of the municipal markets.  She does “get” the value of publicity, however.  And she has already been a big winner from understanding and exploiting two aspects of the traditional for-sale information business on Wall Street:

1.  Industry analysts depend for their livelihood on the viability and importance of the industry they cover.  As a result, they tend to gradually become like home-town sports announcers, that is, industry apologists.  They screen out any negative information.  That allows someone like Ms. Whitney to play the role of the boy who shouted out that the emperor wasn’t wearing any clothes.

2.  Sell-side analysts get noticed by staking out positions that are unusual and controversial, not by clinging to the consensus.  If radical positions prove wrong, customers quickly forget.  If the ideas are right, they’re the ticket to fame and fortune.  So a junior analyst has nothing to lose by getting as far away from the consensus as possible.

So not only is there a good chance that long-time observers of a section of the capital markets like municipals will ignore seemly obvious problems, but trying to point them out is a no-lose proposition.  So Ms. Whitney’s strategy of going out on a limb makes a lot of business sense.

the facts about municipals

two types of bonds

Municipal bonds are generally classified either as:

general obligation bonds, which means that the full faith and credit of the issuing government stands behind the issue, or

project bonds, or revenue bonds, which is basically everything else.  These bonds are backed by the revenue-generating power of some specific government-related endeavor.  They can range from a power plant or a road, to a nursing home or some more dubious private enterprise that uses municipal finance as a “conduit” or wrapper.

default rates are extremely low

According to data complied by Moody’s about issues rated by the agency, defaults on municipal bonds have been relatively rare.  Moody’s latest study covers the forty years from 1970-2009.  Of the 18,400 issues considered, 47% were GO issues, 53% project bonds.

Over that time period, 54 issues, or .3% of the total, defaulted.  Three of them were GOs, implying a default rate of .03% for GOs.  The project bond default rate was about .5%.

There has been some acceleration in the default rate, though.  36 issues, including all three GOs, have defaulted since the turn of the century.

In the defaults, investors’ recoveries have averaged 67% of principal.  The median recovery has been 85%.  The difference is caused by a few real clunkers of project financings where investors lost 95% of their money.

municipal bankruptcy isn’t easy to do

States can’t go into bankruptcy, period.

Cities and towns can go into Chapter 9 of the bankruptcy code, but require the permission of their states to file.  In a little fewer than half the states municipalities are simply prohibited from doing so.  In others, the process may be a lot more complicated–and time-consuming–than simply throwing a switch.

Chapter 9

Chapter 9 differs from the corporate Chapter 7 (liquidation) or Chapter 11 (reorganization), in that:

–the municipality must elect to enter Chapter 9.  Creditors can’t compel them to, as they can with corporate debtors

–Chapter 9 provides only for renegotiation of debt terms, not for liquidation

–the municipality continues to be in charge of operations, not a bankruptcy judge

–the municipality can’t enter Chapter 9 in anticipation of running out of money or even if it has decided to default on loans by simply not paying.  It has to be actually unable to pay.

In the case of a GO, if a municipality stops paying creditors can get a court order telling the municipality to raise taxes or do whatever else is necessary to raise the money need to cure the default.

Some commentators have observed that in the case of states, even those in the worst financial conditions, raising taxes by 2% would wipe out the budget deficits.  I don’t know if this is true or not.  I do think that matters are not that simple.  Higher taxes may increase non-compliance.  They may also hasten migration to areas (in the South or West) that don’t have income taxes.  As a practical matter, it’s entirely possible that raising taxes may result in a government getting in less revenue than before.

I’ve read, but been unable to confirm from the agency website, that the federal Government Accountability Office has recommended that municipalities use Chapter 9 as a vehicle for renegotiating employee pension obligations that they have previously agreed to but now find they aren’t able to afford.  In the few cases where this has been tried, however, the process is–as you might imagine–protracted and very contentious.

(In all this, remember that I’m an investor, not a lawyer.  My main point is that this area is much, much more complicated than it might seem at first.)

That’s it for today.  Tomorrow:  the scope of the problem and what effect it might have on the stock market.

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