Archive for May, 2010

June 1st marks the beginning of hurricane season.  It’s been quiet for a few years but forecasters are predicting a more active 2010 season.  Here are a few thoughts for analyzing the links to municipal bonds.  Gray and Klotzbacher of Colorado State University operate the Tropical Meteorology Project believe that 2010 will be a “significantly more” active year, relative to historical averages. 

Information obtained through March 2010 indicates that the 2010 Atlantic hurricane season will have significantly more activity than the average 1950-2000 season. We estimate that 2010 will have about 8 hurricanes (average is 5.9), 15 named storms (average is 9.6), 75 named storm days (average is 49.1), 35 hurricane days (average is 24.5), 4 major (Category 3-4-5) hurricanes (average is 2.3) and 10 major hurricane days (average is 5.0). The probability of U.S. major hurricane landfall is estimated to be about 130 percent of the long-period average. We expect Atlantic basin Net Tropical Cyclone (NTC) activity in 2010 to be approximately 160 percent of the long-term average. We have increased our seasonal forecast from the mid-point of our early December forecast.

The Tropical Meteorology Project has a detailed the probability of landfall of major hurricanes for each of the counties from the tip of Texas, along the Gulf Coast and up the Atlantic coastline to Maine.  There are pockets of high probability and pockets where hurricanes rarely hit.  The data is downloadable into a spreadsheet — if you navigate to the “landfall probability table”.  The project’s website also has background on their methodology and the full analysis of their predictions for the inquiring mind.  From this you can develop a methodology for analyzing hurricane risk in coastal communities. 

Citizens Property Insurance Corporation, a state insurer in Florida, was set up to be a “last resort” coverage for wind damage when private insurance fell apart.  The CPIC has grown to become the major insurance provider in the state and is controversial among property-owners.  The St. Petersburg Times recently commented:

Citizens, the state’s largest insurer with about 1 million policyholders, and the state’s Hurricane Catastrophe Fund, which sells reinsurance to insurers, are in better financial shape than they have been entering some previous hurricane seasons. But they are far from being able to handle the worst hurricanes, and after a large storm Floridians would be paying huge assessments and begging for help from the federal government. There has to be a better way.

We agree.  Single-state catastrophe insurance makes little sense.   Concentration of risk is a classic red flag in credit analysis, and a this program is rife with concentration.  A “cat” insurance product would balance locations that draw on capital at times when other places have lower risk, producing on-going premium and steady capital.     Unfortunately, political boundaries and the lack of inter-state collaboration makes such a program difficult.  A multi-state program  (best would be international) would balance the risks of earthquake, hurricane, flood and tornado (not to mention man-made disasters).  The Insurance Company Institute has an excellent discussion of the issues and current proposals for covering mega-disasters.    
 
Many are linking the oil spill in the Gulf with the coming hurricane season.  See the New York Times article on this.  John Mousseau of Cumberland Advisors recently wrote a chilling commentary about potential problems along Gulf Coast communities from the oil spill. 
 
The long-range consequences of the spill and how a serious hurricane would interact are not clear.  While the spill in Valdez, Alaska and Hurricane Andrew in Homestead, Florida actually created a surge in economic activity, we are less optimistic this time around. 

See this post on Reuters for discussion about Antioch, latest city in California to talk bankruptcy.  There is a bill, sponsored by state senator Mendoza, AB155, that would require cities to go through the state (via the California Debt and Investment Advisory Commission, CDIAC).  The bill was referred last week by the Senate appropriations committee — but now appears there will be some further review.  The pros and cons line up as follows;  cities strongly against state involvement in order to preserve local autonomy; unions and bondholders in favor in order to prevent reduction of obligations, whether they are union contracts or debt obligations.  Interesting line-up.  Many states have had oversight programs for their distressed communities for years.  Distressed designation may trigger  grants or aid to distressed municipalities that would not be present in a federal bankruptcy.  Some states map out a “receivership” process that gives the state certain intervention rights to reorganize the municipal government and bring finances back into balance.  Cities oppose any additional intervention by the state that encroaches on their powers.  Pro-union forces in the legislature want to prevent the cities from filing bankruptcy since it may result in reduction of  contract provisions (which was determined to be possible in the Vallejo case).  So far the pension albatross has yet to be tested.  According to Antioch’s 2009 audit the city is obligor on about $27 million certificates of participation, paid through lease agreements, current underlying ratings are Standard and Poor’s “A” and there is MBIA insurance on at least some (maybe all, we didn’t check each series) of the certificates.

Why is the municipal market selling at such a premium?  I have been asked this question several times in the last few weeks — not by career municipal analysts at mutual funds or rating agencies, but sophisticated investors who are trying to make sense of the asset class.  The counterpoint is coming from writers forecasting the collapse of municipal bonds.  How do we reconcile this disconnect?  For one, the supply/demand dynamics have changed significantly since a year ago.  Aside from fear of tax increases propelling more buyers into the tax exempt shelter, there is another factor: BABs.  The Build America Bond program has grown to $97 billion, as of the end of April, according to Treasury’s May 12 release — or 20% of the municipal market since the program’s inception in April 2009.  (BABs are taxable municipal bonds; the borrower receives a 35% reimbursement from the federal government – on the theory that this creates a neutral rate compared with tax exempt bonds.)  But this 20% understates the recent trend.   A closer look shows that BABs issuance in recent months hovered around 25% of the new issue market.  All taxable municipal bonds issued in 2010 through April amounted to a whopping 33% of the market according to the Bond Buyer market statistics.  These changes have expanded the buyer base for municipals to those wanting long term public sector debt, but not affected by the US tax code, such as foreign buyers, pension funds and certain corporate investors — limiting supply of paper for the traditional  tax exempt investor.  This is not to mention that most BABs are structured at the long end of the curve, squeezing tax exempts into the shorter end — since most issuers will structure both into a single offering.  (Except of course for Illinois, which prohibits a mixed structure –hunh?)   The pattern is likely to continue in the foreseeable future as Congress extends the taxable BAB structure, although market dynamics may shift modestly when the subsidy is reduced to a more logical 28%.

———————

So how’s the economy?  The recent Bureau of Labor Statistics jobs report was encouraging.  We created 290,000 jobs last month.   Unemployment notched up to 9.9%, but this is to be expected at the early stages of recovery.  As signs of recovery emerge, more people enter the job market, and if that’s proportionately more than new job creation, the unemployment rate will go up.  (The unemployment rate expresses the ratio between the number of jobs and number of people counted as part of the labor market.  So if everyone stopped looking for work, unemployment would go down.)  In fact, 805,000 people entered the labor market last month far more than the number of jobs created. 

Not to be a downer, but many of the new jobs are temporary hires for the decennial Census count.  According to the BLS, the federal government employed 154,000 people for the census count as of April, an increase of 66,000 over the prior month.  This increase followed hiring of 48,000 in February.  Don’t get me wrong, these jobs will infuse spending into the economy, ease unemployment for many and get an important count accomplished.  But they are temporary jobs that will peel off around the same time that other federal stimulus programs wind down. 

Another factor slowing down the recovery is the lack of migration.  The housing mess is a contributing factor.  We noted in a previous post the first-time reversal of migration patterns since those statistics were collected.  We have always been a nation of restless movers – opportunity seekers since the founding of the U.S.     In large part this has contributed to the active municipal bond market for infrastructure growth and development.  As jobs moved from north to south, east to west, city to suburb, people and development followed.   In the current economy, this trend has reversed in many places. 

William Frey, the noted demographer, stated in a recent report for the Brookings Institution:

The detailed 2010 census results won’t be available for another year. But this week (back in March, ed.) the Census Bureau unveiled its latest population estimates for metropolitan areas and counties for the year ending last July. What they show is a country that is demographically standing still.

Last week, the Census bureau reported an uptick in the migration rate in 2009, from 11.9% to 12.5%.  But the majority of movers went from one county to another within the same state while job moves are typically inter-state.  Further, renters moved at five times the rate of homeowners.   Homeowners, already battered by the housing downturn are finding it difficult to move to better jobs (or jobs at all) when they cannot sell their homes.

See today’s op ed by Dan Miller, Harrisburg’s controller.

The Illinois Comptroller’s April report  is scary reading.  The state is $4.5 billion in arrears on payments to vendors and others (like school districts and service providers) with no end in sight.  The Comptroller expects 2011 to be worse.  The following chart from the report looks to me like a deteriorating structural imbalance moving towards a delicate liquidity position.   

click for larger image

As long as markets are willing to provide liquidity, the state will be able to continue on this trajectory.  As we learned from the New York City fiscal crisis in the mid 1970’s, not to mention the banking liquidity issues beginning August 2007 and later, those institutions that depend on short term market access for viability will freeze up (seize up?) when the markets don’t cooperate.  

The Civic Federation prepared a detailed analysis  and critique of the proposed 2011 budget.  In the report they graphically present the state’s roll-over of short term debt from 2009 to 2010.   In 2011 the state expects to issue $4.7 billion notes for “voucher payments.”  Where will the re-payments come from?  

So here’s some simple math.  The state’s debt service payments for 2011 jump from $1.6 billion to $2.8 billion.  Short term debt will be $4.7 billion.  The budget assumes $27.4 billion General Fund revenues in 2011, so it looks to me like debt service consumes a hefty 27.4% of that total.  Red flag.  Maybe there will be some roll-overs, some additional budget cuts, maybe some tax increases, maybe the economy will be good to the state and they will make it into 2012.  But the long-term problem here is huge.  

 Bondholders are feeling sanguine since, like California, payments go to debt service before other services.  As tax increases loom on the horizon, investors want that tax exempt paper.  As the Civic Federation described:  

As the State continues to issue more G.O. debt than it retires on an annual basis, the amount of General Funds committed to debt service payments will continue to rise. To make these payments the State pledges its full faith and credit to its bondholders and legally commits itself to transfer the debt service payment into the General Obligation Bond Retirement and Interest Fund (GOBRI) prior to paying any other bills or transferring funds for any other appropriations.

  

  

 

  
 
 

 

I’m putting on my public policy hat now (as opposed to financial analyst).  There’s no mechanism for bankruptcy or receivership at the state level in the U.S. which may be comforting from an investor’s perspective, but lousy public policy.   There’s no IMF and no process at the federal level to re-structure state finances other than handing out bailout grants or loans — which usually require increased borrowing or matching spending.   There’s no Board of Directors as in the private sector whose charge is to protect shareholders (substitute “taxpayers” for shareholders) even when painful actions are necessary.   So we are left with random taxpayer uprisings and the occasional vote for elected officials and the analysis of think tanks.  Maybe there will be a lawsuit by vendors or school districts to get the state to meet its obligations.  Maybe vendors and residents will vote with their feet.   The preferred approach would be an objective mechanism with authority and mettle to resolve the fiscal mess.   Someone please tell me that I am wrong …

I read this news story with a “ho hum” since their debt is to the county until I saw that they have $10 million utility debt that they are trying to reduce with a Chapter 9 filing?  Iowa is one of those states that explicitly prohibits Chapter 9, so I am not sure where these city officials are coming from.  I am posting this for general consumption since it is symptomatic of municipal governments throwing the bankruptcy word around willy-nilly.  This particular story is more troubling than the Flint, Michigans or Toledo, Ohios that are wrestling hard to balance a budget in an environment with economic decline, high unemployment and strapped taxpayers.  In this case there’s no cry of budget cuts, fiscal stress, troubled pension costs, or workout efforts, etc.  — and the community is near Des Moines, a healthy economy.  They look like they bit off more than they could chew and  just simply want to reduce debt obligations with a bankruptcy filing.

Add Xenia Rural Water District’s to the short but growing list of over-leveraged municipal borrowers.  With $143 million in debt and about 9,000 customers, the unfolding socio-gram includes bondholders, bond insurers CIFG and Assured Guaranty, the US Department of Agriculture, Bank of America, and last, but not least, the ratepayers.  A $5.2 million note to Bank of America comes due June 1 and the district is already in arrears to the USDA.  The BofA notes were sold on the assumption they would be taken out with permanent financing from the USDA.  Will that happen?  USDA has called in its auditors and expects to complete a financial review during May.  Having the federal lender as a creditor on this workout should make things interesting. The State of Iowa is also auditing, with results for 2009 to come out in a month.   As of the district’s 2008 audit there was 64% coverage of debt service from available revenues. 

The district had great dreams of expansion, aggressive you might say.  One of the problem projects was a 16 mile pipeline designed to reach about 20-30 homes, according to the Ames Tribune.  The former Executive Director Dan Miller (separated at birth from Harrisburg, PA’s comptroller, Dan Miller?) had a penchant for expansions, even when they no longer made sense.  The district expected to double the number of connections and revenues by 2011 when maximum debt payments kick in according to a read of the official statement.  For a rural, agricultural region, even in the best of times, this is ambitious.

Then there were the line extensions to several ethanol projects within the district.  According to the Guthrie Center Times, at least one of these projects

may have contributed to Xenia’s dire situation.. The company extended a pipeline from Clive to the western edge of Waukee and from DeSoto to Menlo at a cost of $15 million to provide water to the Hawkeye Renewables ethanol plant at Menlo.  The work was done by Xenia’s construction crew and the cost overrun of $3.5 million had to be born by the company.  Xenia charged Hawkeye Renewables $1 million for the connection fee to the pipeline.

The district has been in discussions to have Des Moines Water Works acquire Xenia.  They’ve raised rates by 22% and are asking forgiveness of $45 million of debt. 

The plot thickens.  CIFG, the now defunct bond insurer, guaranteed the $83.6 million 2006 bonds when they were issued (and when they were rated “AAA”).  The underlying rating on the bonds was then “BBB” by Standard and Poor’s, lowered to “BB” in August, 2009 following disclosure of the district’s difficulties.  CIFG is now in runoff and as part of the bond insurer’s workout, Assured Guaranty entered into a reinsurance agreement for the troubled company’s $13 billion municipal portfolio.  Assured Guaranty, as agent for CIFG said “no” to the district’s workout plan.  They would like to see rates go up enough to cover their obligations, without debt forgiveness.

BTW, Iowa is one of those states that do not permit municipalities to file bankruptcy.  So what happens now? 

For bondholders to claim an Assured Guaranty payment on default, the reinsured CIFG bonds have to be “novated” which is an insurance term for extinguishing the original CIFG policy and issuing a new Assured Guaranty policy. 

The process began on an optimistic note.  Assured Ltd’s president and CEO, Dominic Federico said in October 2008, announcing the deal:

Public finance investors will benefit from an upgrade of the rating on their investment if they agree to the novation of their current policy with CIFG NA, and we look forward to helping them make the novation process as quick and efficient as possible. 

Three months later, Assured sounded a far less confident and far more measured:

The novation process for each covered policy will be determined in conjunction with representatives for each underlying insured credit based on the applicable legal requirements and the particular facts and circumstances of each such insured credit.  There can be no assurance as to the timing of the novation process or whether an insured credit will be successfully novated. 

Then New York State Insurance Commissioner Eric Dinallo was more upbeat.  He stated in January 2009:

We expect that the municipal bonds currently insured by CIFG will go from junk to the highest investment grade.  This will result because the bonds will be reinsured by and are intended to be novated to Assured Guaranty Corp, meaning that Assured will replace CIFG as the insurer…

But the novation process is taking far longer than expected.  According to last week’s Bond Buyer the “vast majority” of bonds have yet to be novated.   One has to assume the bondholders have every reason to be cooperative in this process.  As of this morning the Xenia bonds were still rated “BB” by Standard and Poor’s. S&P rates Assured “AAA” so these bonds have not been re-branded.  Maybe Assured has an out on the novation, given Xenia’s now non-investment grade rating. 

If the bonds are just reinsured and not novated, any payment that CIFG recoups from Assured via the reinsurance agreement could just go into the big, black CIFG pot and not to bondholders. 

Meanwhile, back on the farm, customers are none too happy with the prospect of 63% higher water rates.  Ratepayers, who include rural residents as well as numerous franchise communities, are busily looking into ways to get off the system. Heavy attrition would make achieving revenue targets only that much more difficult.