Posts Tagged ‘municipal bond default’

The Grand Jury of San Diego issued a report of this title yesterday.  Also, at yesterday’s GFOA (Government Finance Officers Association) business meeting, the group voted  that the Government Accounting Standards Board should stay away from the topic of sustainability.  The only conclusion one can draw from the Grand Jury report is: the city of San Diego’s current trajectory is UNSUSTAINABLE.  Here, are a few choice passages (please read as if these too, were fully capitalized):

The City has yet to articulate structural solution to close the multi-million dollar budget deficit in fiscal year 2010.  More than 50% of this gap in financing was filled by using one-time solutions, such as skipping reserve payments and deferring projects.

In summary, this investigation is presented to the City and its citizens because the status quo is not going to resolve the crisis of financial instability, unbalanced budgets and reduction of the city’s obligations, liabilities and debts.

One of the underlying causes of the current structural budget imbalance is the underfunding of the City’s pension obligation by previous City administrations.

Ok, we know this.  This is true among states and municipalities across the country.  But what to do?  In some (not all) places the pitch of the problem has reached a scream – CONTINUING GOVERNMENT OPERATIONS ARE UNSUSTAINABLE.  Amazingly, the choice to cut critical services has become the lesser of two evils – the other being pension and benefit reform.  Elected officials, charged with managing cities like San Diego would rather have fewer cops, less trash pick-up, deteriorating infrastructure and higher taxes, than deal with runaway benefit spending.  Even if you believe that the benefits are deserved, earned and righteous, the city simply does not have the resources to pay these costs and also maintain a livable city.  So what’s the decision?  Give up the livable city?  The City’s Independent Budget Analyst stated:

Structural deficits require structural solutions.

The report suggests using the federal bankruptcy courts to determine what can and cannot be restructured.  Investors, along with public employee unions (strange bedfellows) hate this solution and prefer to stay in one-shot-land, or stand by while the deterioration mounts (see stories on Vallejo’s increasing crime.)  The courts could also decide to trim back debt obligations in the same restructuring process.  This has happened in Vallejo, where there is a moratorium on debt service payments (at least with the current intent of re-paying in full at the end of the moratorium period).  Vallejo’s bankruptcy tackled the city’s ability to reject union contracts, a key step, but they did not touch the pension issue.  The San Diego Grand Jury suggests a bankruptcy court could help sort out this benefits conundrum.

Finding 26: A proactive dialogue as to the efficacy of a Chapter 9 reorganization cannot be removed from any discourse as to the City’s financial health

Finding 27:  A Chapter 9 filing would result in a federal determination of which fringe benefits and collective bargaining agreements could be restructured.  The fringe benefit total is $423.7 million, according to the FY 2011 Proposed Budget.

RECOMMENDATION

The 2009/2010 San Diego County Grand Jury recommends that the Mayor of the City of San Diego and the San Diego City Council:Convene a panel of bankruptcy experts to discuss the legal and financial ramifications of a Chapter 9 declaration of bankruptcy, in the context of a publicly noticed City Council or Council Committee meeting. 

In this context, the municipal credit analyst, the investor and the taxpayer, need a new tack on fiscal review.  Unfunded pension liabilities must be included as a long term debt in debt ratios.  The rating agencies discuss these burdens but they are not included in the numbers. Medians that include all long term and contractually obligated costs should be developed to correctly compare cities and identify outliers like San Diego Vallejo.  The long term cost of these obligations should clearly be disclosed so that ratios may be calculated.  For example, red flags of fiscal trouble are waving fervently in San Diego’s case and the Grand Jury mentions Vallejo as well:

In 1994, the city’s budget for pension expense was 6% of payroll cost.  Today, sixteen years later, the cost is 28% of payroll, and growing.

For FY2009, the City’s fringe benefits rate was 52.5% of budgeted salaries of $728 million (IBA Report #09-10 issued February 24, 2009, p.2).  On average, privately operated companies spend 35% of budgeted salaries on fringe benefits. 

Some 76% of Vallejo’s operating budget went to salaries and benefits.  The norm is 50%.  Pensions were not an immediate issue since Vallejo had funded its pension obligation.  Vallejo’s most significant liability was $135 million of unfunded health care.  Vallejo officials brought the unions back to the bargaining table after the federal bankruptcy judge ruled collective bargaining agreements can be voided. 

A few other red flags that can be identified with a bit of extra work:

Is the municipality/state postponing annually required benefit contributions?  Is the government making its “annually required contribution” or ARC?  If not, this will catch up quickly as evidenced in San Diego (see separate post on the state of Illinois)

Are judgments and claims high and increasing?  This points to the government’s poor risk management practices and sloppiness.  This is a low-hanging fruit that cities should tackle with gusto.  The Grand Jury found in San Diego’s case:

Funding of the City’s (self-insured) public liability fund against lawsuits that could drain the General Fund for years to come.  As of June 30, 2009, the City faces $129 million in claims.

Funding the city (self-insured) worker’s compensation fund against outstanding claims, currently estimated at $161 million.

As the press and blogosphere keep telling us, there will be more municipal defaults and bankruptcies.  But there is a difference between painting all securities with the same brush and rigorous analysis.  We believe the flags are identifiable. 

We are coming out of a period when investors bought municipal bonds with their eyes closed.  The mantra that municipals don’t default and the once widespread presence of bond insurance convinced the investing community that analysis was irrelevant.  No more.  On the other hand, Congress has pressured newly contrite rating agencies to upgrade municipals at perhaps the worst time in history. 

San Diego’s GO ratings?  Moody’s: Aa3; Fitch: AA- and Standard and Poor’s: A 

There is a table at the end of the Grand Jury report with a September 6, 2010 deadline for city officials to respond to the specific recommendations.  The Mayor, the City Council, the Retirement System’s administration, the Audit Committee and Independent Auditor are required under the state of California Penal Code to do so. Looks like a busy summer.

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.

We have two opposing camps in the muni-market at the moment: those who say it is the next systemic shoe to drop and the rating agencies that are systemically raising ratings.

Which is right?

We have moved from a market that has had heavy intermediation from the bond insurance companies to one where investors are on their own. Bond insurers historically performed heavy analysis and monitoring of the credits they insure and actively affect the legal protections embedded in a security. Bank credit enhancers have done the same, although in some cases their agreements allow them out of the risk under certain circumstances. Rating agencies assign their rating on sale and their business model has never been designed to provide robust monitoring of issuers in the secondary market. The Moodys and other agency default studies covered this time period – a relatively prosperous period from 1970 – 2007 when pending defaults on the investment grade level were mostly managed by bond insurers. Further, the default studies did not include insured bonds.

Municipal bonds do default and have throughout this period –not at all in large numbers by any comparison to the corporate world. Knowledgeable high yield investors are aware the risks in hospital, senior care, land development, and corporate-style tax exempts such as industrial revenue bonds. Project finance, such as the Harrisburg incinerator, Las Vegas monorail and Connector 2000 also carry high risk. (I should add WPPSS and other nuclear power projects to this list.)  These should not be lumped together with the other 30,000 or so municipal bond issuers. Like the stock market, there are many, many nuances among borrowers. Only now the investor is left to grapple with his own resources – and the loss of granularity among this diverse and deep market from ratings “re-calibration”.

(Concerning re-calibration of ratings:  As I have said before, lowering corporate ratings to their appropriate probability of default relative to municipals – would achieve the same effect, and be truer to their own research. Instead, the agencies are compressing ratings into fewer categories and eliminating much granularity for investors. But of course the other approach would have been business suicide and harmed many corporate portfolios.)

Within this, market prophets are now generalizing greatly, mostly those who have not spent their careers in this non-standard, messy, sometimes corrupt and poorly understood state and local financial world.

This brings me to some comments on Rick Bookstaber’s recent post. Many of his points are strong and need to be actively debated, but others generalize to the detriment of this very varied marketplace.

Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.

Agreed. The Tower Amendment should be abolished and municipalities that want to participate in public capital markets and be rated like corporates should be held to the same reporting standard. Period. Would you buy a corporate bond whose disclosure was two years old?

The argument that it’s too expensive and too burdensome for smaller municipalities to achieve transparency can and must be resolved. Technology and know-how exist to achieve this in a cost effective manner. Those municipalities that cannot produce timely and accurate reporting – should borrow locally and not expect to participate in national markets. Or they should not be given (potentially misleading) ratings. Borrowing locally will likely end up costing more than paying the auditor to get the report done in a timely manner.  Hiding behind the “municipals don’t default, so what difference does it make?” argument is so yesterday.

The rating agencies still do not fully incorporate pension and other benefits into the debt statement that produces their debt ratios and medians. Taxpayers certainly do consider these factors. All obligations that are paid from the public purse should be clearly disclosed. Understandably, rating agencies argue that they serve investors not taxpayers. But political risk – unwillingness to pay – clearly reaches back into the investor’s pocket.

Size and potential systemic effects. That this is a big market in the credit space goes without saying.

This is a big market, but is not uniformly systemic like housing.

Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?

In some cases. Given our federal system, each state has its own set of rules for local municipal finance. For example financing infrastructure for housing and economic development is vastly different in structure and credit quality in California (Mello Roos for example) vs. Florida (community development districts) vs. Texas (municipal utility districts).

Bookstaber’s point does apply to the municipal market in several ways. Investment portfolios and cash management are prey to marketers of the security “du jour”. As one of his commenters suggests, Fannies and Freddies could put municipal investments systemically at risk of a federal policy change — affecting many municipal government investors at one time. I would add to this list: securities lending practices among pension plans and other large public funds  (which some practice but others do not).

Ratings triggers on counterparties that create terminations, unwinds and a change in interest rates, basically legal provisions that automatically change the terms of the deal — also create across the board risk for those borrowers involved. Examples include variable rate securities, swap transactions, LOCs and GICs. These structures effectively embed corporate and market risk into municipal credit.

At the traditional fixed income municipal debt level however, there is significant diversification among security types and legal structures – given the 10th amendment and individual state peculiarities.

Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky — the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.

Agreed. Analysts and investors should incorporate a haircut for unfunded pension and benefit liabilities that use overly ambitious earnings as a discount rate. The debate about “risk free” vs. a historical earnings rates is an important one. Stated another way, this debate points to the fact that public pensions (defined benefit) are irrevocable, guaranteed and must be paid.  How would you invest funds when you could not afford to lose a penny vs. money you are willing to take on more risk? Since pension obligations are long-lived, the counter-argument that earnings over time should be used has some merit as well.   But the inequities between public retirees and the rest have piqued the taxpayer whose 401K and life savings have been subject to market losses.  Also, the “defined benefit” retirees are facing off against the “defined contribution” beneficiaries.  Fairness is an important public good, as difficult as this debate may be.   

Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the underfunded portion of the portfolio.

Absolutely. Maybe they don’t have to do a site visit on each review, but they should disclose the date of their latest full review for each rating, no question. How many of the re-calibrated ratings have been freshly reviewed?

Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.

Disagree. See my comments above and other blog posts on this site. Municipalities do not behave the same as homeowners. Clearly there are scoundrels and irresponsible politicians who just want out of obligations they did not understand or were misled from the get-go.

Even with debt repudiation talk in the air, it is difficult to file bankruptcy in most states, and default is not a good option for a municipality that needs capital markets access. Plus, as covered elsewhere, given the 10th amendment, bankruptcy does not give the federal courts the same kinds of control over a municipality as a corporate entity.

Keep in mind that the majority of municipal borrowers (like the majority of homeowners) want to do the right thing.

Neither are taxpayers irrational. Protests are explainable. There are only certain states where initiatives and referenda are permissible (and this too has historical roots). There are correlations between rapid growth in taxable assets, public spending increases and taxpayer protest. (I have written about this on my blog and elsewhere.) 

Taxpayers are right to be angry at politicians who are spending their money mainly to buy votes and for poor policy reasons. We need to look at the spending patterns in government and have this debate. How many say, “It’s a pre-election year, of course nothing will get done.” In the private sector, someone with that approach would be fired.

Two important worries Bookstaber hasn’t addressed directly:

Liquidity: There are major liquidity issues at some of the states, quickly filtering down to the local level. At least three states have held back making payments to localities and vendors – California, New York and New Jersey. At some point liquidity markets may stop lending – or the cost will become prohibitive — which will have immediate impact on the economy in those states. Where enough taxes roll in the next month to cover payments, these states will limp along until they are able to cure their structural imbalance or they will hit the wall. While some look for a federal bailout in this situation, a failure to tackle the cure for structural deficits is bad policy. As we learned in recent banking crisis, institutions that require regular market funding for survival will fail in a liquidity freeze.

State solvency: tied to the first point, there is no mechanism in our society to address state insolvency. States, as sovereign entities, do not go bankrupt. There simply does not exist any legal or political institution with the authority to facilitate an orderly reorganization of state obligations. We need to think up objective, non-political structures that put the brakes on spending increases when times are good and that facilitate reorganization when times are bad.

Looks like the city is making its best effort to try to resolve budget imbalance.  Ohio is one of the states that has a strong oversight/receivership program and municipalities may not file bankruptcy without approval of the state.  Local governments there do rely on income taxes, which is tough in the current economy, especially in auto and manufacturing which dominates the landscape.

Harrisburg, Pennsylvania can’t really afford to pay for the Resource Recovery bonds that it guaranteed.  Their recently adopted 2010 budget does not include debt service for this guarantee (see prior post with link).  It is accepted practice for rating agencies to rate municipally (or state) guaranteed debt off the credit of the guarantor.  Unlike bond insurance or any insurance for that matter there are no capital set-asides for guarantees by municipal governments.  Market analysts assume that the city or county would raise its taxes to the point of covering the debt.  Harrisburg is now testing that assumption. 

There has been some disagreement on the underwriting floors (at least in bond insurance, if not at the rating agencies) whether one should take into account the credit quality of the project being financed or simply “look through” to the guarantor’s quality.  I suggest a middle ground.  Assume that the Resource Recovery project was rated on its own merits as a project finance — what category would that be?  Then assume a contingent liability on the balance sheet of the guarantor of that lower credit quality.  If it is clear that the guarantor cannot afford the contingency the rating should embed this risk.  This thinking extends to “moral obligation” bonds whose ratings are automatically notched down from the state (or infrequently, local) rating.  Should a “white elephant” project backed by a moral obligation bear the same rating as one that is performing and essential?  (We don’t think so)   Affordability of obligations (add pensions, opeb, debt service to the list) is going to become an increasingly important risk factor as government wrestles with raising taxes, reducing expenditures and satisfying multiple constituencies — unions, taxpayers, retirees and service beneficiaries.

In a recent report about Mello-Roos Community Facility Districts (CFD’s) the California Debt and Investment Advisory Commission (CDIAC) stated:

Despite the potential impacts of evolving mortgage conditions, CFD’s have not reported higher default rates, at least through 2007-2008, but have reported a recent rise in the number of their draws on reserves.

(Mello-Roos bonds are post-proposition 13 financings that are secured by “special taxes” rather than more typical ad valorem taxes.  They are mostly issued by school districts, cities and towns and are a popular version of California’s land secured tax exempt finance.) 

To date CFD’s have held their own on the default scene, certainly doing better relative to Florida community development districts which are defaulting in droves.  We believe the lag in defaults is too lightly appreciated and there will be an elevated default pattern in the next two years. 

Like other corners of the real estate markets, Mello-Roos borrowings soared in the 2000-2007 time period.  We show CDIAC’s summary for Mello-Roos activity.   Nearly 60% of all issuance from 1992-93 was sold during this time period.

CLICK TWICE TO OPEN LARGER

CLICK TWICE TO OPEN LARGER

A look at the 1990’s downturn in the California real estate market compared with Mello-Roos defaults is instructive.  The Calculated Risk blog posted the following chart in 2005:

CLICK TWICE TO OPEN LARGER

CLICK TWICE TO OPEN LARGER

Calculated Risk shows the early 1990’s real estate boom had positive growth until 1991 then went negative until finally turning positive 1996. 

Now look at the default chart from the CDIAC report.

CLICK TWICE TO MAKE LARGER

CLICK TWICE TO MAKE LARGER

Two observations: first, as expected, draws on reserves peaked ahead of defaults.  Draws hit their high in 1995-96, just when real estate was beginning to climb out of the trough.  Second, defaults didn’t peak until 1997-1998 and remained elevated until the 2001-2002 year.

 

Bill Huck, CEO of S&Y Capital Group points out that building permits are a better indicator of trouble.  Building permits began their steady and steep decline in 1985-86 and didn’t trough until 1993. 

CLICK TWICE TO MAKE LARGER

CLICK TWICE TO MAKE LARGER

Baked into this relationship is the assumption that land development must continue for the districts to remain solvent – underscoring the “speculative” nature of this type of finance.  So a drop off in building permits correlates with a prediction of future defaults – with a longer lag period than the asset value decline that is grabbing so many headlines today.  Once a home is sold, even if it has lost value or is in foreclosure you are most likely to get the Mello-Roos tax payments, Huck commented. 

 

A few factors slow down the default timeline.  First, some counties where Mello Roos predominates, such as Orange (but not Riverside) includes districts in the “Teeter” program.  Under Teeter the counties pay 100% of the property taxes to the local agencies and then receive penalty and interest payments.  The counties have the right to kick out an agency from the program in the next year, so this source of cash flow is not ironclad.   Most counties would rationally kick out delinquent payers rather than lose money on their Teeter programs.   Second, many CFD’s have debt service reserve funds, so reserve draws are an important early indicator of trouble.  Finally, many CFD’s are less leveraged than special districts in other states.  The awareness of payment problems has led financial managers to be pro-active, whether through bond refinancing or more aggressive foreclosure resolution.  Given that reserve draws are elevated again we expect to see defaults climb in the next few years – or sooner if covering counties exit the Teeter plan.

The check is not in the mail.  Prichard, Alabama, came out of Chapter 9 bankruptcy in 2002 and promised to make deposits into its public pension fund.  They didn’t and now they are simply out of money.  Retirees did not get their October 1 payment.    What’s next?  The retirees are suing.  The city is looking for investors in a bingo operation as a last ditch effort to raise cash.  The bankruptcy word is being raised again.  (see our post from June 20)

The city does not have general obligation bonds outstanding at this time but some are eyeing the cash in the water and sewer system. That system, which refinanced its bonds in May (insured by AGO) has had its disputes as well.  They were under a consent decree to clean up their system.  The Mobile Area Water and Sewer System (MAWSS) was willing to take them over, but the city refused.  The city purchases water from MAWSS and handles its own treatment, distribution, billing and collection services.  Standard and Poor’s rated the system BBB- in 2005 but rates the 2009 bonds A-.  Coverage has improved, disclosure of the multiple lawsuits that were in the 2005 official statement have been dropped from the current disclosure and the refunding will save the water and sewer Board a significant amount of money.    After the May 2009 issue, the Board signed a 10 year public-private-partnership contract for $78 million with Severn Trent to operate the system (the amount is according to WKRG).  The amount seems high for a 2008 budget of about $7.4 million (excluding depreciation and amortization) that also includes about $1.0 million fixed cost for water purchase from MAWSS. 

Is the city’s dilemma symbolic of a pattern across the U.S.?  We think so.  Small municipalities that manage their own pension and retiree benefit programs, poor fiscal management and maybe an external shock such as loss of a major employer or reduced tax revenues are symptoms of trouble.  Vallejo, California fits this pattern as does the Sierra Kings Health Care District, California that just filed Chapter 9 last week.  While the common belief in the market is that municipalities don’t default, we see trouble among these smaller, vulnerable communities.  Watch the balance sheet for these factors before you pass “go”.

Municipal bond defaults over the last two years occur in sectors that tie into the financial crisis: real estate.  Multi-family housing and land development projects that never took off are at the front line.  Special entities – usually a district of some kind, depending on the state – sell tax-exempt bonds to finance infrastructure for real estate development projects.  These are mostly non-rated securities.  Many of the securities were sold during the go-go development years of 2001-2007. 

A stark increase in defaults among Florida “community development districts” took place in 2008-2009.  These are primarily single family subdivisions across the state and many remain in their dirt stage of development.  “CDD’s” as they are called, rely on special assessments paid by the land-owners.  (The owner is assessed based on the “benefit” received from the infrastructure – rather than a property tax based on the value of the property.)  The land-owners in early stage districts are essentially the developers.  Some of them today are bankrupt and unable to pay the assessments. 

In Florida, defaulted properties become part of the tax lien market where individual investors who believed in the prospects of a project could pay off the tax liens and reap high returns on the investment.  With the bursting of the housing bubble, these markets have softened and a traditional source of liquidity that kept this market going has dried up. 

The other state where land development defaults are showing up is California.  There the defaults are in “Mello-Roos” districts, which may be part of a school district or city.  A special tax is charged to land owners located within a Community Facilities District.

Elsewhere, commercial real estate troubles are beginning to show up in debt service reserve withdrawals in sectors such as transportation development districts in Missouri and Arkansas.  These are sales taxes or tax increment bonds that funded infrastructure for a small retail, or commercial real estate development.  Some of these retail establishments never got off the ground.  Again, the common pattern is issuance of bonds during the last five years. 

For some reason, Texas, which has many special districts for land development (known as “MUDS”), are not appearing on the default screen at this time.  Rather, multi-family housing –defaults are clustered in Texas, while the special district (single family developments) are mostly clustered in Florida and in California.  (your thoughts?)

Notable other defaults include repeat headline grabbers: the Las Vegas Monorail, the Connector 2000 toll road in South Carolina and Jefferson County, Alabama sewer system. 

We break down the default data into the following general sectors.  (Note that debt service reserve draws are not included here.)

default sectors

Click twice to enlarge