WASHINGTON — Municipal bond analysts worry that issuers increasingly are drawing on bond insurance to temporarily pay for debt service without disclosing the action to investors.
“Any time an issuer responsible for paying debt service doesn’t pay and an enhancer ends up paying, it seems to me that would be a disclosure item,” said Mark Stockwell, chairman of the National Federation of Municipal Analysts and director of municipal research at PNC Capital Advisors LLC in Philadelphia.
But the Securities and Exchange Commission’s Rule 15c2-12 only requires such disclosures be made when “material.” Issuers contend such drawdowns are not materially important and that drawing on insurance is a cost-effective means of resolving short-term liquidity problems.
Other market participants, like Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management, say that even if insurance was not originally intended to function as a short-term loan, these drawdowns demonstrate the usefulness of it.
Analysts concerned about the undisclosed drawdowns point to actions taken late last year by four small localities located within Cook County, Ill., and Jefferson County, Ala.
Blue Island and Rolling Meadows Park District in Cook County made unscheduled draws on credit enhancement after the county was late in remitting property taxes to them. Fairfield and Adamsville in Jefferson County also made unscheduled draws on their enhancement, sources said, though it is unclear what caused the two cities to draw on their policies.
The bonds issued by all four cities were enhanced by MBIA Insurance, now known as National Public Finance Guarantee Corp., which stepped in to make principal and interest payments on the debt after they were contacted by the paying agents on the bonds — Amalgamated Bank of Chicago for the Cook County issuers and Bank of New York Mellon for the Jefferson County cities.
A spokesman for Amalgamated could not be reached and a spokesman for Bank of New York Mellon declined to comment, but sources confirmed the drawdowns. Officials from National briefed several analysts about the issue at the NFMA’s annual conference in May.
National declined to comment for this story beyond a statement from Thomas McLoughlin, the outgoing chief executive officer of the insurer, who said: “We thoroughly analyzed each issuer’s ability to meet its obligations on a timely basis under a variety of circumstances before agreeing to provide insurance. Regardless of the reason, if the issuer should subsequently fail to meet those obligations, National guarantees that insured bondholders will receive their scheduled payment when due.”
For their part, the cities paid back National within a matter of weeks, though it took Blue Island at least 60 days before it received all of the tax money it was owed from the county and could fully pay back the insurer, according to city finance director Michael Anastasia.
The county was late because a record number of appeals of assessed property values delayed the county assessor for more than two months in transmitting property tax data to the county treasurer, who then had to review, print, and mail property tax bills, according to county officials. Property tax bills that the county aims to mail in August were not distributed until late October. They were not due to the county until Dec. 1.
“This was uncharted territory for us; we never had a situation like this before,” Anastasia said. “But once the taxes came in, we were able to quickly pay the insurer.”
Asked why Blue Island did not disclose the unscheduled draw to pay for debt service on tax-increment bonds issued in 1998 as part of a $6.25 million transaction, Anastasia said the city was not aware it had to report anything to the market.
Meanwhile, an adviser for Rolling Meadows Park District said that the district had accumulated enough cash to make a semiannual $74,104 interest payment due on Nov. 15 for general obligation bonds sold in 2004 in a $4.46 million transaction, but needed to divert for operational expenses additional cash reserves that it had originally planned to use for its annual principal payment, which was also due on Nov. 15.
The district tapped MBIA for the approximately $300,000 principal payment because it was much cheaper to pay the insurer’s roughly $1,000 fee than pay about $3,000 in attorneys’ fees and interest costs to issue short-term tax anticipation notes, according to the adviser, who did not want to be identified. In any case, there was not sufficient time for a note sale, he said.
Though the district considered filing a material event notice, by the time it had settled on language the county had remitted the tax money to the district and the district had repaid National. The district has taken several additional budgeting steps to alleviate potential difficulties paying debt service at the end of the year if the county is again late in remitting tax payments, the adviser said.
Though industry officials confirmed the two Jefferson County issuers drew on their insurance policies, city officials were unaware of delayed tax remittances or drawdowns on credit enhancement.
However, a spokesman for the Jefferson County Board of Equalization and Adjustments said that assessed values throughout the county, which are largely based on real estate sales, decreased significantly last year and that it is possible that local governments did not anticipate such a huge drop when they prepared their budgets.
Adamsville city clerk Susan Gilmore said that the issuer advanced refunded bonds but never drew on the insurance wrapping the $4.41 million of GO warrants it issued in 2004.
Otis Smith, who handles finances for Fairfield, said the City Council would have had to approve of any drawdowns of its insurance for warrants it issued in 1998 as part of a $6.725 million deal, and it did not.
MUNI FISCAL WOES
For analysts, the draws on the insurance bring the issue of disclosure to the forefront as states and local governments face the largest strains on their finances in recent memory.
“The issue of the adequacy of disclosure is heightened given the credit pressure caused by the recession, and the need analysts have to anticipate credit problems,” said Christopher Mier, managing director in the analytical services division of Loop Capital Markets LLC in Chicago.
Matt Fabian, managing director at Municipal Market Advisors, said the draws by these issuers show the stresses on states and localities is more pronounced than default figures suggest, as few so-called safe-sector issuers have actually defaulted on their bonds. Aside from Harrisburg, Pa., and Vallejo, Calif., most of the issuers that have defaulted on their debt in recent months have been nongovernmental borrowers.
Fabian said also that the actions of these municipalities appear to give credence to some of the concerns raised by Berkshire Hathaway’s Warren Buffett about the muni market.
In his annual letter to shareholders last year, Buffett wrote that his muni insurer, Berkshire Hathaway Assurance Corp., was reluctant to underwrite new insurance policies largely because a troubled municipality is more likely to default on its obligations if there is a bond insurer sitting between it and the bond holder.
“When faced with large revenue shortfalls,” he wrote, ”communities that have all of their bonds insured will be more prone to develop 'solutions’ less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents.”
Last month, Buffett warned a federal panel investigating the financial crisis about a “terrible problem” for state and local finance within the next five to 10 years that could lead some governments to seek federal bailouts.
Fabian noted that in addition to the Cook and Jefferson county issuer draws, Buena Vista, Va., has failed to budget debt-service payments on bonds backed by ACA Financial Guaranty Corp. it sold in 2005 to finance a golf course. Chowchilla, Calif., relied on trustee-held reserves to cover both interest and principal due on lease revenue bonds it sold in 2005 for a civic center, he said.
Though Chowchilla’s bonds are insured by Syncora Guarantee Inc., formerly known as XL Capital, the firm is not currently paying claims.
Fabian cautioned, however, that while it is unfortunate more issuers apparently see insurance as a source of liquidity, which “is not what insurance is for,” bond insurance “has been sold to a lot of communities in a lot of different ways and we can’t rely on everyone in the industry having the same definition of what bond insurance is.”
“You have to treat the issuer as if it did default, but you also have to understand the issuer’s motivation,” he added. “Since the issuer doesn’t believe it is defaulting, the systemic implications are far less.”
Richard Lehmann, publisher of Distressed Debt Securities Newsletter in Miami Lakes, which tracks muni defaults, said it is hard to rhetorically challenge issuers that use insurance as a form of liquidity.
Though insurers claim they are merely selling credit enhancement and write their policies to a zero-loss standard — meaning that if they think there is a chance of default, they won’t insure the issue — the issuers can convincingly argue that they are turning to a service for which they have paid good money, he said.
But Tom Weyl, director of municipal research at Eaton Vance Management in Boston, said that even though bondholders were paid on time, the draws on insurance should be considered defaults against the borrowers.
“No matter how it’s written [in the offering documents], the fact of the matter is that the payment was not made by the borrower by the required date,” Weyl said. He added that because all bonds now trade based on the strength of the underlying credit, “material information about the underlying issuer needs to be known.”
“There’s a fraud in the market if the market doesn’t know there’s a default,” he said.
Weyl acknowledged that these draws were made by small, lightly traded issuers, but said: “The fact that that’s the case here when there’s 50,000 issuers in the market doesn’t mean we can ignore it. What if those bonds traded retail, and the retail holder then found out there was an underlying default? What if the default wasn’t made up? When does the borrower or the trustee or the paying agent or whomever decide to give notice to the market?”
In late May, the SEC approved changes to its Rule 15c2-12 on disclosure that would require issuers to disclose in material event notice filings all “unscheduled draws on credit enhancement reflecting financial difficulties.” The changes, which take effect Dec. 1, differ from the current rule, which allows issuers to determine whether unscheduled draws are material before disclosing them.
But some market participants warn that the rule change language is so broad many issuers may still elect not to disclose such draws. One attorney who asked not to be named noted that an issuer could reasonably argue that its action does not reflect “financial difficulties,” but rather a simple matter of “timing.”
Stockwell, who cautioned that he has not analyzed these issuers, argued that if a borrower is not paying debt service out of its own resources, there must be some kind of financial difficulty, unless there is some administrative glitch that can be cured in a day or two.
Asked about this issue, Martha Mahan Haines, the SEC’s muni chief, said she could not comment without knowing more facts.
Shelly Sigo contributed to this story.