The great recession continues to test the creditworthiness of issuers of municipal bonds. The stress has not yet reached its peak. When it does, in the next 18 months or so, the vast majority will have demonstrated their ability to pay principal and interest on their bonds in full and on time. But, a large increase in defaults from a very small historical base appears inevitable.
The stress level today is the worst since the Depression. That has exposed the consequences of bad financial management decisions more quickly than what would otherwise have been the case.
From the bondholders' perspective those decisions come in two basic flavors: 1) too much debt and 2) excessive growth in benefits for public employees and other spending categories.
When a particular state or locality borrows too much or does not control spending or does both, the odds for monetary default can be as high as ten or even twenty five percent.
Circumnavigation of constitutional debt limits and a willingness to employ non-standard financing techniques to excess has increased credit risk. But for most government borrows, excessive debt is not the problem.
Much of today’s financial stress is the result of failure to control spending and commitments to spend. California and Illinois are headline cases in point. Too much debt includes Jefferson County, Alabama and Harrisburg, Pennsylvania.
The financial capacity or protection margin afforded state and local government (and their bondholders) has been reduced to levels not seen in 50 years.
But, pegging municipal bond credit risk is as much about avoiding the bad ones than picking good ones. A few rotten apples do not spoil the barrel, but the barrel has more of them today. Naturally, accompanied by an increase in the less than fresh.
Bond defaults are rarely associated with local government bankruptcies and that will probably not change.
Today, in those States where it is allowed, bankruptcy is being used by localities to threaten public employee union leaders at the bargaining table. But, in the odd and spectacular circumstances surrounding Jefferson County, Alabama, they are using it to threaten bondholders. That is highly unusual in muni bond land.
In this case, very large financial institutions mostly located in New York underwrote and now hold most of the bonds; totaling more than $3 billion dollars face amount of auction rate sewer revenue bonds.
The auction rate structure turns long-term bonds into very short-term securities. Interest payments are assumed to be lower because buyers believe the effective maturity date is the next scheduled auction. In this case, accomplished using interest rate swaps and liquidity agreements.
The structure works as long as the various parties perform on their obligations and are not downgraded by the rating agencies. Participants were downgraded and the structure fell apart because nobody would buy the sewer bonds at auction at any interest rate.
On May 9, 2009, the County’s sewer enterprise defaulted in the payment of scheduled interest and principal due on $3.1 billion in outstanding sewer revenue bonds. The default remains unresolved. There is a massive difference between what the sewer system can generate, charging about $70 a month for residential service, and annual debt service.
The County’s default is the largest in modern history in nominal terms, exceeding the $2.3 Washington Public Power Supply System revenue bond default in the 1980’s and $1.3 billion New York City general obligation note default in the 1970’s. For more on these defaults and evaluating local and state credit risk, see “Municipal Bonds – Time for a second look, published here on March 26, 2009. An up dated version can be found on Municipal-Credit-Insights.Com.
These particular revenue bonds are secured by a first lien on net sewer system revenues after payment of reasonable costs of operation and maintenance. The County did not guarantee payment of the bonds or make any commitment to provide funds to make up any shortfall should net enterprise fund revenue prove insufficient.
It is important to note that four County Commissioners were sentenced to jail for their part in this fiasco. The current Commissioners appear to be playing hardball with the “big” investors by threatening to file for bankruptcy. Neither the State of Alabama nor investors want that.
The fact is bankruptcy is not applicable in this situation due to the aforementioned limited pledge of revenue. The discussion of bankruptcy so upset Moody’s Investors Service (NYSE:MCO) that they slashed the county’s general obligation bond rating, a distinctly separate risk.
The County’s barging position is quite strong without the empty legal threat of bankruptcy. The County needs only to take one last step to end their dispute with bondholders. Institute the 7% rate increase recommended by the independent rate consultant retained by the bond trustee as required under the bond indenture. That increase would cover only a small amount of the shortfall.
Should the County comply with the law on this point, it will not have to worry about constant annual sewer rate increases from people hired by the bond trustee to maximize revenue. In Alabama, a judge can block any rate increase found excessive and not in the public interest. This is disclosed in the documents used to sell the bonds.
That kind of proviso is relatively rare. It undermines the main remedy available to bondholders. My guess is that the Jefferson County revenue bond default will be settled with a swap of new fixed rate bonds for the existing at a discount acceptable to both parties.
Disclosure: Long MCO