Nearly Half Of All Municipal Bonds Are Bankruptcy Proof - For The Unlucky, Technicalities Become Important In Court

Includes: MUB
by: Carl Dincesen

During the 1930's Depression, a wave of more than 2,000 municipal insolvencies spread across the country. In response, Congress passed a temporary bankruptcy law. A subsequent permanent municipal bankruptcy statute was ruled unconstitutional. It came back for good in 1941 and has been amended many times since then.

The amount of government-backed municipal bonds that are exempt from the debt adjustment provisions of the U.S. Bankruptcy Code approximates 45%. That is not to say exempt from monetary default, i.e., funds insufficient to pay principal and interest. Since at least 1950, almost all municipal bond defaults have been resolved outside of bankruptcy.

That may be changing. The backing for local government bonds is increasingly made up of unsecured promises to pay and debt payable from non-mandatory appropriations. From the investor's point of view, these are the fodder for municipal bankruptcies because the debt is unsecured.

This will not significantly change the number of defaults but will increase the number that end in bankruptcy because they are a growing percent of municipal debt issuance.

No property tax secured or enterprise revenue bond default has been settled in federal court since at least 1950. There have been only a handful of municipal bankruptcies, almost all in the last twenty tears.

There have been four bankruptcies in California and counting. I attribute the concentration in that state to a convergence of factors. The most important is the state's share of personal income, measured on a per capita basis, has fallen from above average to the national average in the past twenty years. Add to that generous, as compared to average public employee compensation and the extensive use of appropriation-backed bonds to finance of pension plan contributions, for both state and local governments.

Court imposed adjustments to outstanding loan amounts, and/or interest rates, have applied solely to unsecured general obligation bonds and appropriation backed obligations. Whether appropriation "backed" bondholders would have standing in a bankruptcy proceeding i.e., be recognized as a creditor, is open to question. This lending format does not exist in the corporate bond market. It was born out of the NYC financial crisis in the 1970's.

Unlike corporations, U.S. municipalities and states cannot back their debt with a security interest in property or capital improvements. Notwithstanding the sale lease back of government buildings that are in each case financed on an unsecured or appropriation basis.

The bankruptcy code recognizes a municipality's right to issue secured debt as well as unsecured or general obligations. In the corporate world, "unsecured" and general obligation means the same. Only in the U.S. municipal market are there two kinds of general obligations, unsecured and secured.

To be secured municipal debt, the federal bankruptcy law requires municipalities grant a lien on and security interest in "Special Revenues". These revenues are not part of the local governments' general revenues. Further, they must be the sole source of payment for debt issued to fund and maintain essential public infrastructure.

Examples of special revenues include electric, water, sewer, transportation revenues, special assessments and property taxes levied for the sole purpose of repaying capital improvement bonds. Bonds must have a lien on and security interest in the special revenue.

About half of municipal general obligations are secured as defined. In turn, they comprise an estimated 20% to 25% of all municipal bonds outstanding. The aforementioned essential service enterprise revenue bonds account for another 25%.

The catch is that not all states authorize their localities to grant a security interest in "special revenues". Thirty-three states do.

Last year Rhode Island became the thirty-third when it passed legislation to create and perfect the security interest in property taxes levied by of the city of Providence for outstanding general obligation bonds, thus qualifying them as Special Revenue protected. This was done in response to concern the city could be forced to file for Chapter 9 bankruptcy protection. It did not.

It may turn out that Jefferson County, Alabama, sewer revenue warrant holders end up being treated as unsecured creditors because the lien on sewer revenues is not secured under Alabama law.

What kind of backing a bond issue has can be found at the MSRB repository website. Read the cover page of the offering statement.

Phrasing similar to the following indicates: secured bonds.

Secured by and payable solely from a lien on and security interest in the operating revenue of ABC essential service enterprise.

Alternatively, secured by and payable from property taxes levied for the sole purpose of repaying debt issued to fund essential service capital improvements. For example, roads, schools, and firehouses. They are typically voter approved with a tax rate unlimited with respect to generating funds sufficient for debt service.

Phrasing similar to the following indicates: general obligation (un-secured) bonds.

Unconditional promise to pay backed by full faith, credit and taxing power (or authority) is pledged to the repayment ABC general obligation bonds. There is no mention of any lien or security interest in any property tax or enterprise revenue.

Phrasing similar to the following indicates: appropriation bonds

The bonds do not constitute debt under the constitution and laws of ABC's' state. Repayment of the ABC bonds is subject to annual appropriation. They are payable solely from voluntary appropriations by the borrowing entity.

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.

About this article:

Author payment: Seeking Alpha pays for exclusive articles. Payment calculations are based on a combination of coverage area, popularity and quality.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here