Buy Side

Bankruptcy Fears Are Hard to Ease

While the speculative hysteria about across-the-board municipal debt defaults has calmed, many investors are still wondering what bonds remain at risk and how many municipalities will end up in bankruptcy.

While the financial woes of Harrisburg, Pa., and Jefferson County, Ala., have been splashed on the front pages, actual defaults in 2011 are so far lower than in 2010 and 2009.

For the first half of this year, 24 issuers were in default, representing $746 million of bonds, putting 2011 defaults on pace to come in significantly lower than the past two years.

Last year, 89 issuers were in default on $3.2 billion of debt, and in 2009, 218 issuers defaulted on $8.2 billion, according to Janney Capital Markets. Barring a major change in the second half, analyst Meredith Whitney’s prediction of “hundreds of billions” in municipal defaults this year will be proven woefully incorrect.

None of the 2011 defaults have been for state or local government general obligation bonds.

“Defaults continue to be concentrated among the most speculative of issuers, with 72% of defaulted issuers coming from the housing sector and 83% of all defaulted issuers nonrated,” wrote Anthony Valeri, a market strategist at LPL Financial, wrote in a July 19 research note.

Municipal analysts caution that the low number of defaults does not mean municipalities are off the hook. Along with Harrisburg and Jefferson County — which is in default— Bell, Calif., and Central Falls, R.I., are high-profile examples of struggling local governments.

Market consensus says that while struggling is one thing, bankruptcy is another. Mark DeMitry, senior portfolio manager at OppenheimerFunds’ Rochester municipal group, said while Harrisburg and Jefferson County are in trouble, they learned lessons from the 2008 Chapter 9 filing of Vallejo, Calif., which just emerged from three-plus years of bankruptcy last week.

“Investors realized that bankruptcy is no silver bullet, and that everyone shares the pain, including spending $10 million to find a solution,” DeMitry said, referring to legal fees.

Others agree avoiding bankruptcy is key. “With the experience of Vallejo, more market participants are pointing out that expense and time associated with discussion of bankruptcy is very disruptive and that may not be the easy way out,” said Kathy Evers, head of municipal credit analytics at BMO Capital Markets.

John Knox, partner at Orrick, Herrington & Sutcliffe LLP, who was involved in the Vallejo bankruptcy, said the process certainly took longer and cost more than anyone thought at the time.

“Of course, the city didn’t have any choice but to file, but obviously we all hoped it would be [over] a lot sooner,” Knox said. He added that the bankruptcy took an especially long time because it was a precedent-setting case and that the city’s collective bargaining units fought hard to retain benefits.

And the fact that we are seeing fewer defaults and more negotiations taking place “may be in part that the negotiating climate is more favorable to a compromised solution given that Vallejo filed for bankruptcy and got a ruling rejecting the collective bargaining agreements,” Knox said. “So that precedent eventually contributed to the willingness of parties to come to the table and compromise rather than forcing the issue all the way to bankruptcy.”

Jefferson County — which is struggling to pay $3 billion in water and sewer debt it backs due to soured derivatives transactions — is working on staving off bankruptcy. County commissioners and Alabama officials are meeting behind closed doors to discuss how to avoid what would be the largest municipal bankruptcy in history. The county could file Thursday if no agreement with creditors is reached.

“Why would a state intervene in a county? Because bankruptcy will leave a stain on the entire state,” DeMitry said. He added that counties and states realize they will eventually need to come to market again and it will be more expensive to continue to operate if they file for Chapter 9.

Harrisburg, struggling to pay $300 million of debt for an incinerator project gone bad, hired a consultant through Pennsylvania’s Act 47 to come up with ideas on how to raise money to pay off the debt. Pennsylvania lawmakers also voted to suspend all state funds provided to the city if it files for Chapter 9.

“This is another lesson learned that distressed municipalities are working hard to find ways to solve problems even when a situation looks dire,” DeMitry said.

Tom Dalpiaz, portfolio manager at AAM, said the lesson learned from Harrisburg “is to be careful where you’re putting your GO pledge, particularly if you put your GO pledge on a complicated project such as a resource recovery project whose economics may not work out.”

Dalpiaz said Bell’s financial problems involve corrupt officials and ridiculously high government executive salaries.

“Vallejo is an example of a local smaller credit that lost control of employee costs somewhere along the line,” he said. “They made deals with unions that eventually choked their budgets.”

Many participants say the market should not put these troubled municipalities into the same category as the general muni market. “People have tried to make blanket statements in the municipal market, but the municipal market is not systemic but more idiosyncratic,” said Jamie Iselin, head of muni fixed income at Neuberger Berman.

“Harrisburg’s troubles are really event- driven. They got involved with an incinerator project that was clearly outside their level of expertise,” Iselin said. “In turn they guaranteed an amount of debt that was disproportionate relative to the size of their budget.”

“It’s a one-off situation because they guaranteed a big incinerator project and maybe the city should not have been in the business of running an incinerator,” said Alan Schankel, managing director at Janney Capital Markets. “This is not a trend.”

Dalpiaz also said Jefferson County is in trouble for specific reasons that are not necessarily widespread in the market. “It is usually not wise to structure debt in a way that uses an extremely high level of variable-rate debt and interest rate swaps,” he said. “They used those structures to an extent that no one else did and it came back to bite them.”

Central Falls filed for bankruptcy Monday, citing overwhelming pension and benefit obligations as one of the main reasons. The GO bondholders get some protection due to a Rhode Island law passed last year establishing a statutory lien that protects bond and note holders and gives GO bonds priority over all municipal obligations. Despite that, Moody’s Investors Service put the Caa1-rated GOs on review for possible downgrade Tuesday.

“Under the legislation, cities, towns, and districts are required to dedicate property taxes and other general revenues to pay debt service before any other claims or payments,” Moody’s analysts wrote. “It is unclear how the federal court will treat the tenets of this new law in a bankruptcy proceeding.”

On Thursday: Analysts are cautious about the housing and health care sectors of the muni market, where there have been defaults. But are there buying opportunities?


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