In Detroit's Wake: A Review Of The Muni Bond Landscape, Part 2

 |  Includes: MUB, MUNI, PVI, PZA, SUB
by: Stephen Percoco, CFA

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Individual Municipal Bankruptcies and Other Distressed Municipal Credits (Prior to Detroit)

Vallejo, Calif.

Vallejo, a city of 116,000, 30 miles northeast of San Francisco, began its long slide in 1996, with the closing of the Mare Island Naval Shipyard. The Shipyard was the city's largest employer. Its closing forced the city to drawdown its reserve fund to meet a modest budget shortfall.

A strong housing market helped limit the city's fiscal problems until the bubble burst in 2006. Then, Vallejo's modest budget deficit turned into a gaping hole: Revenues from property and sales taxes fell double-digits and the city's annual budget deficit ballooned to $16 million.

Compounding the problem were overly generous policies on city workers' pensions and healthcare benefits. According to the Huffington Post, police and fire officials could retire at 50 at 90% of their salary. The city tried to negotiate with public employees in a last ditch attempt to reduce its budget deficit but was unsuccessful. Vallejo filed for bankruptcy in 2008, listing debts of $175 million. The city's pension underfunding was pegged at $125 million. Police and fire fighters sued to block the bankruptcy filing, but ultimately were unsuccessful.

The filing forced sharp cutbacks in city services. Road maintenance was cut by 90%. Staffing at police and fire departments was halved. Grants for arts and recreation programs were nearly eliminated. Costs for retiree healthcare were slashed by an estimated $100 million, as the city cut monthly benefits by as much as 80%. Yet, residents helped to fill the gap in city services, for example, by increasing neighborhood patrols.

House prices in Vallejo fell 67% from the peak to just $140,000 on average. Real estate agents were required to disclose the city's financial condition to potential buyers. The city exited bankruptcy in 2011, but its financial problems have not been eliminated. Under its restructuring plan, Vallejo reduced debt by over $30 million. Some creditors were paid as little as 5 cents on the dollar. But professional fees totaled $12 million and the city was unable to reduce its pension liability, due to state mandates.

In 2013, a projected $5 million budget deficit was expected to be eliminated by more staffing cuts. Yet, there are some tentative signs of improvement. House prices have begun to rise. A few businesses have relocated to the area. While optimism is slowly returning, many residents view Vallejo's bankruptcy experience as a painful and expensive lesson.

Stockton, Calif.

Stockton filed for bankruptcy on June 29, 2012, after failing to reach a resolution with its creditors in a state-mandated negotiating period that had begun in March. Creditors refused to negotiate with the city unless it cut its pension payments to CalPERS, the state pension fund manager. After an arduous and costly nine-month process, Stockton was finally declared eligible for a Chapter 9 bankruptcy filing on April 1, 2013.

Located 80 miles east of San Francisco, Stockton is at heart an agricultural community that grew rapidly during the housing boom, attracting new residents who were willing to make the 90-minute commute in order to obtain housing at a more affordable price. The city sought to attract more residents by dressing itself up. It incurred $1.1 billion in debt to fund a variety of development projects, including a new city hall, events center and arena.

When the housing bubble burst, however, Stockton got hit pretty hard. It had one of the worst foreclosure rates in the nation and ranked third out of 306 cities in home value reduction. Its unemployment rate was 15.4% at the time of the bankruptcy filing. Falling tax revenues opened up a $26 million hole in its annual budget. (To put the deficit in perspective, the city's total annual operating expenses were about $180 million.)

In response, the city cut its overall staffing by 43%. Its police force was reduced by 25%, firefighters by 30%. Most recreational services, including senior centers and library programs, were either cut sharply or eliminated. The city also eliminated retiree healthcare benefits for its existing (i.e. non-retired) workers. It reportedly will seek to eliminate healthcare benefits for current retirees.

Stockton will also seek to raise additional tax revenues by raising its sales tax by ¾ of 1%. Its citizens will vote on the proposed increase on the November ballot. Most of the money raised by the tax hike will be directed toward restoring part of the police department's budget. The rest may help to cover the costs of the city's bankruptcy.

Like Vallejo, Stockton apparently will not seek to challenge its obligations to CalPERS. Under state law, the city is not allowed to change its contract with CalPERS. Like most cities and towns in California, Stockton provides its workers with very generous pensions. Under a formula that is fairly standard across the state, Stockton gives its retirees a pension equal to 3% of their final year's salary multiplied by the number of years of service. City workers who have retired over the past 15 years receive an annual pension of $50,400. Nearly 100 retirees receive annual pension of more than $100,000. Stockton's pension costs are especially burdensome because the city has more pensioners than full-time employees (1,683 vs. 1,370).

It is apparent that the state of California has put significant pressure on its cities to honor their CalPERS contracts. It fears that any successful efforts to cut contract obligations will open the floodgates. In places like Stockton, where pension costs are high in relation to the overall budget, maintaining the sanctity of pension contracts forces comparatively greater cuts everywhere else. It is easy to see why creditors would object to the state's pension policy.

Some legal experts have suggested that Stockton will have to impair CalPERS along with the rest of its creditors in order to gain approval for its bankruptcy plan. Indeed, bankruptcy judge Christopher Klein who approved the Stockton's bankruptcy petition over the objections of creditors also said that he would not approve a bankruptcy plan that was not fair to all creditors. On the surface, it appears that a showdown is set over this issue.

On the other hand, Stockton may still be able to keep CalPERS whole because of its decision to gut retiree healthcare benefits. The city could argue that employees and pensioner were willing to accept cuts in healthcare benefits because their generous pensions were kept intact. If so, a plan that avoids a CalPERS haircut could be judged as fair to all of the city's creditors.

In any case, it is inevitable that some California city or town will eventually force a showdown over the pension issue. When that happens, they and the rest of their creditors, excluding CalPERS will argue that California law conflicts with the rights of debtors under Chapter 9 to void executory contracts.

San Bernardino, Calif.

A potential challenge to the CalPERS contracts could come from the city of San Bernardino, which filed for bankruptcy on Aug. 1, 2012. Like many California municipalities, the city had suffered declining property and sales tax revenues and higher unemployment as a result of the housing bust and recession. In this case, fraud and mismanagement may have also played a role in the deterioration of the city's finances. It has been alleged that budget directors hid the city's financial problems from the mayor and city council for nearly a decade.

In July 2012, San Bernardino's finance director outlined the city's projected $46 million deficit and negative cash position in a presentation to city officials. The city then declared a financial emergency and directed its lawyers to prepare for a Chapter 9 filing. Because this was an emergency, San Bernardino would skip the three-month mediation period required by state law. The date of the filing was reportedly moved up when the families of three men who had been slain by city police threatened to sue to enforce a $1.4 million settlement.

Since its financial situation was dire, the city suspended payments on its pension debt and the employer's portion of amounts due to CalPERS, the state pension fund. It also took an ax to the city's budget. In the four years prior to the bankruptcy filing, the city had already reduced its workforce by 20% and negotiated $10 million of salary and benefit cuts with its labor groups. By the end of 2012, it had reduced its workforce by another 22% to 938 full-time equivalent positions and cut salary and benefit payments by an extra $26 million. Along with $35 million of cost deferrals, most of which was achieved by suspending payments to CalPERS, the city was able to turn its $46 million budget deficit into a projected $8 million surplus.

Despite the seriousness of San Bernardino's financial situation, CalPERS and the San Bernardino Public Employees Association petitioned the court to declare the city ineligible for bankruptcy protection. In its court filings, CalPERS would later call the bankruptcy a sham and accuse city officials of criminal behavior. After a one-year moratorium, San Bernardino was set to resume payments to CalPERS in July. It is unclear what the city proposed to do about the estimated $10.2 million in skipped payments. The city has also asked the court to rule on its eligibility for Chapter 9 protection on August 28.

Of all of the California municipal bankruptcy filings to date, San Bernardino's seems to be the one most likely to challenge the inviolability of its CalPERS obligations. Yet, the city's interim manager has publicly said that maintaining retirement benefits for city workers is a priority. Although she did not completely rule out a reduction in benefits, she referred to the suspension of payments as a "deferral" which indicates that the city intends to catch up on its payments at some time in the future. Once the city resumes its payments to CalPERS, it is unclear whether those skipped payments will be forgiven or simply added to amounts owed to CalPERS.

San Bernardino's bankruptcy is still a work in progress. It is still not clear how much of a haircut, if any, the city will try to impose on the $55.9 million of outstanding public debt; but it is probably reasonable to assume, however, that if CalPERS is impaired, the losses on San Bernardino outstanding bonds will be significant. Yet, the municipal bond market does not seem to be fearing the worst, perhaps assuming that the budget cuts already undertaken by the city will be sufficient to ensure the restoration of most of the interest and principal payments due on the bonds.

For example, Tax Allocation Bonds due 2030 that were issued by the San Bernardino Joint Powers Authority in 2010 recently traded at par to yield 9.25%. That's a hefty yield by muni bond standards, but their trading price is still much higher than investors would expect, if the bonds are likely to be impaired.

Jefferson County, Ala.

Jefferson County filed for bankruptcy in November 2011 under the weight of $3.1 billion of debt linked to its troubled sewer system. This marked the end game of a long period of waste, fraud, corruption and mismanagement on the part of politicians, contractors and city workers. More than 20 people have been convicted. JPMorgan Chase, the county's financial advisor was penalized by the SEC for bribing middlemen.

Under the terms of the settlement, holders of the country's $3.1 billion of sewer bonds have agreed to reduce principal by $1.2 billion. JPMorgan Chase, which holds $1.2 billion of debt, will bear the brunt of those losses, $842 million, or about 70 cents on the dollar. In addition, the bank has agreed to waive $647 million of fees associated with the termination of interest rate swaps, bringing its total cost for the bankruptcy to $1.5 billion.

The remaining bondholders, many of whom are hedge funds, will either take a 20 percent haircut (in exchange for foregoing all potential future claims) or a 35 percent cut (and keep their claims). They also stand to earn additional fees, if they participate in refinancing the old debt. County residents will also pay a hefty price. The county has agreed to raise their sewer rates by 7% annually for the next four years (and potentially by 3.9% annually thereafter).

This settlement was announced in June. The county filed its debt adjustment plan, which also covers an additional $1.2 billion of other debt at the end of June. An objection to the disclosure statement has been filed by the city of Bessemer and the Birmingham Water Works Board, who say that the plan may compromise the county's future growth. Others have questioned whether the financial data upon which the projections are based needs to be updated. Monthly financial statements are not current and the last audit was performed in December 2011.

Obviously, there will be discussions on the proposal, which could take some time to resolve. The tenor of the objections seems to argue that more debt forgiveness is needed and that the proposed increases in sewer rates should be reduced. Since one class of impaired creditors, the bondholders, has already effectively agreed to the plan (and take a $1.2 billion haircut), it would be surprising if the court rejects the current debt adjustment proposal. County officials hope to address these and any other concerns, get the plan confirmed by the court and exit bankruptcy by the end of the year.

Harrisburg, Pa.

Trouble for Harrisburg, the capital of Pennsylvania, began in 2007 when it raised $300 million in a debt offering that was insured by Assured Guaranty and Ambac to finance the overhaul and conversion of a city incinerator into a waste-to-energy facility. That facility never generated enough in revenue to cover its operating costs. By 2009, the city was having difficulty paying its bills, but investors did not become fully aware of the city's problems until 2011.

Harrisburg filed for bankruptcy protection in October 2011, under orders from the city council; but the petition was not approved by the mayor and city solicitor as required under city law. Council members objected to a resolution plan that would require salary cuts for city workers and the sale of some of the city's prime assets. In November, the bankruptcy court dismissed Harrisburg's petition because it violated state law.

In December 2011, Pennsylvania's governor declared a fiscal emergency in Harrisburg and appointed a receiver, William Lynch, to manage the problem. The city defaulted on a bond payment in March 2012 and has not made any payments on the bond issue since. Lynch has developed a plan to resolve the city's fiscal crisis. He plans to sell the incinerator to the Lancaster County Solid Waste Management Authority and lease the parking garages to an outside vendor. Assured Guaranty and Ambac will pass the proceeds from the asset sales on to bondholders, who will be paid in full. The insurers will then receive most of the lease revenue stream over 50 or 60 years, after which time the garages will revert back to the city.

In order to generate sufficient lease income to satisfy Assured Guaranty and Ambac, the deal assumes that the parking garages will be more profitable under this new vendor arrangement. The plan also assumes significant cuts in salaries and benefits for city workers; but not all of the unions have agreed to these concessions.

Despite the rejection of the bankruptcy petition, there is still a sentiment among many city officials that the plan is not workable. They believe that it puts too much of the burden on the city. They argue that bondholders should bear some of the losses here. Consequently, it remains to be seen whether Mr. Lynch's plan will close the book on Harrisburg's financial problems.

Puerto Rico

Bonds of the Commonwealth of Puerto Rico are exempt from federal taxes in all 50 states, so they are often included in the portfolios of many municipal bond funds. In recent years, Puerto Rican bonds have been a drag on portfolio performance, as the economy there has suffered first from a change in its Federal tax status, which made it less attractive for corporations to locate their operations there and then from the general decline in the economy that followed the 2008 financial crisis.

The government has been working hard to get its house in order. It has enacted a number of measures - principally tax increases and spending cuts -- designed to shore up its financial position. Although Moody's worries that the tax hikes may hurt businesses and may not, in the end, raise as much revenues as hoped, the municipal bond market has grown more comfortable with Puerto Rico over the past year. Spreads on Puerto Rico's debt have narrowed by nearly 30% from slightly less than 300 basis points at the beginning of 2013 to slightly more than 200 basis points recently. The decline in yields will pave the way for more than $3 billion in bond issuance starting with $600 million from the Puerto Rico Electric Power Authority in August followed by $600 million in general obligation bonds and then $2.2 billion for the Government Development Bank (replacing loans which finance local agencies and authorities).

With its belt tightening initiatives and help from an improving global economy, the Commonwealth should show steady progress in the months ahead. Still, debt levels remain high and with its dependence upon the tourism sector, Puerto Rico will need to direct any budget surplus toward further debt reduction to put its financial position on higher ground.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.