WASHINGTON - The amount of tax-exempt debt that went into default in 2008 spiked to record levels equaling about 2% of the year's total dollar amount of new issuance, and 2009 is on track for another high level of defaults, according to market participants who track them.
Though the bulk of the debt was issued on behalf of corporations that sell debt in the municipal market through conduit issuers or special taxing districts, the trend has not escaped the notice of Securities and Exchange Commission chairman Mary Schapiro, who highlighted it in a speech last week in which she said improvements to the muni market are a high priority for the SEC.
"Despite their reputation for safety, municipal securities can and do default," she said, noting that in 2008, 140 municipal issuers defaulted on $7.6 billion of bonds.
Schapiro added that she expects the five-member commission to take steps "to help ensure that investors in municipal securities receive improved quality, quantity, and timeliness of information about those investments."
Sources said that the SEC may propose regulatory or legislative changes for the muni market next month.
However, issuer officials strongly dispute Schapiro's reference to defaults, which they say are inaccurate because state and local governments do not comprise the bulk of the borrowers that have defaulted.
Frank Hoadley, Wisconsin's capital finance director and the chairman of the Government Finance Officers Associations' debt committee, said Schapiro's remarks unfairly suggest that states and localities aren't making debt service payments on their bonds.
"I find it very distressing that this kind of information gets used in a way that casts shadows across the municipal bond market," Hoadley said. "You'd have to assume then that these securities that wind up in default are not insured bonds and reflect nothing more than a credit default by a private-activity entity. It's not a governmental entity that's failing here, and I don't know of any amount of disclosure rules or accounting rules that are going to change that fact."
Speaking for himself and not the GFOA, Hoadley added that he hopes the SEC will distinguish between the two types of borrowers.
But SEC officials said yesterday that their concerns about the municipal market are not limited to conduit bonds. States and localities are facing challenging fiscal pressures and every muni bond, whether conduit or not, has been issued by a governmental issuer or it would not be a municipal bond, they noted.
In addition, they said that default is not the only risk material to investors, who need information to assess the value of a municipal bond throughout its life. They added that Schapiro's default figures came from data provided by Richard Lehmann, who publishes the Distressed Debt Securities Newsletter.
In an interview, Lehmann said that the number of defaults last year is actually somewhat higher than the figures cited by Schapiro. He estimated that last year there were some 150 municipal defaults tied to about $7.8 billion of debt, representing the highest level of defaults since 1983 when the Washington Public Power Supply System defaulted on $2.25 billion of debt.
The 2008 figure compares to about 113 issues totaling $3.3 billion of tax-exempt debt that have gone into default so far this year, Lehmann said. Of those defaults, 79 issues worth a total of $2.3 billion had been sold by Florida community development districts.
In CDDs, a housing developer works with a local government and an underwriter to issue tax-exempt debt to construct new housing developments in special taxing districts. The developments are failing because of the sharp real estate downturn nationally and in the state, Lehmann said.
For Lehmann, a default generally occurs when an issuer stops paying the trustee, who then starts making payments from reserves. "We draw the line at that point because that's when you want to let a prospective buyer know that he's buying into a troubled situation," he said.
Though defaults by state and local governmental issuers are rare, about half, or $3.8 billion, of the volume of 2008 defaults is tied to sewer and some general obligation debt issued by Jefferson County, Ala.
The county, mired in a financial scandal for years, failed to make principal payments last year, though it has entered into forbearance agreements that effectively delay such payments. The county is still is in negotiations with creditors in an attempt to restructure its debt and avoid filing what would be the largest municipal bankruptcy in the U.S.
The 2008 figures also include about $280 million of debt issued by Vallejo, Calif., which automatically defaulted when the city filed for bankruptcy in May 2008, saying it couldn't afford its contracts with public employee unions.
Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management LLC, said the amount of muni bond defaults represents 2% of the dollar amount of new issuance last year.
The muni defaults appear small compared to the defaults in the corporate bond market. Lehmann said that in 2008 about $159.8 billion of corporate debt defaulted, although $127 billion of that figure was tied to the collapse of Lehman Brothers. So far this year, $23.6 billion of corporate debt has defaulted, according to Lehmann.
But he predicts that muni defaults will likely grow and said Vallejo is indicative "of what's coming down the road" over the next decade for municipal governments. He said governments will struggle with similar cash-flow problems, in addition to large unfunded pension and health care benefits for retiring baby boomers.
"That's going to be a national problem because years ago, politicians promised big retirement expenses to keep their budgets low," he said. "Over the next decade, the demographics of the country are going to be working tremendously against municipal governments because of these retirements."
In April, Moody's Investors Service assigned a negative outlook to the entire tax-backed local government sector.
Ciccarone also warns about the future. "No one should take any credit for granted. Going forward, economic growth [and any slowdown of it] is going to correlate with default propensity," he said.
Lehmann said that he agrees with Schapiro about the need for more transparency in the muni market, especially in situations similar to the Florida CCD deals, where payments to the bondholders have not yet been stopped.
Because little information about the bonds is widely disseminated, "these bonds still trade at very high levels, when in fact they should probably be trading at the 30% range, because they have a lot of grief ahead of them," he said.
Lehmann said it is difficult to find the material event notices that have been filed about these bonds with the existing four nationally recognized municipal securities information repositories. Sometimes the notices, which say that reserve funds are being drawn down, are misfiled, and the only way to find them is by searching by the name of each issuer, he said.
Beginning July 1, the Municipal Securities Rulemaking Board will become the sole NRMSIR, a move that is designed to improve transparency in the muni market because it will be easier to check whether issuers are complying with the secondary market disclosure agreements they made with bondholders.
