Third of a three-part series.
As municipalities confront unprecedented budget shortfalls in the aftermath of the Great Recession, some analysts are questioning whether the history of prioritizing bondholders during bankruptcy proceedings will be of much help in gauging future outcomes.
As positive as that history has been, critics say, the data set of municipal bankruptcies is too small to have any meaning relative to the vast variety of issuers in the muni marketplace.
Just three major issuers and 250 municipalities in total have filed for Chapter 9 protection in the last 30 years, according to data compiled by bankruptcy expert James Spiotto of Chapman & Cutler. The majority of cases were for small special-tax districts and entities that did not issue municipal bonds.
Of those that did, most borrowed for nonessential services, like railroad stations without an accompanying railroad. Or they went bankrupt as a result of mismanagement, financial calamity or fraud.
The atypical nature of these cases underscores that history isn’t necessarily full of useful examples to cite and be comforted by.
PAST CAN’T FORECAST FUTURE
Peter Kaufman, head of restructuring and distressed mergers and acquisitions at New York-based Gordian Group, is one expert who won’t be surprised if municipalities start compromising on their debt in greater numbers.
“If we see one, two, or three prominent or semi-prominent Chapter 9 filings, you may then see a lot more say, 'This is a powerful tool and the stigma is lessening,’ ” he said. “Just being willing to credibly threaten Chapter 9 may result in consensual restructurings outside of it.”
Kaufman said it doesn’t make economic sense to trim bond interest payments because they are usually a tiny percentage of a municipality’s budget. But that could matter less in the coming years if there’s a populist backlash resulting from cuts to public employee pensions while a select few bondholders are paid in full.
“How does a municipality force its unions to take haircuts, and not its bondholders, who the public perceives as wealthy investors?” he asked. “You need an equitable sharing of the pain.”
Kaufman concedes there is little precedent of municipal bond payments being forced to take a haircut. But having worked on the Chapter 11 case for General Motors — where unions got protected and bondholders took a hit — he believes similar outcomes are possible in Muni Land.
Jon Schotz, chief investment officer at Los Angeles-based Saybrook Capital, added that it would be foolish to base investment decisions merely on a few historical examples.
“Just because history says, 'This is what’s happened in the past with defaults or Chapter 9s,’ does not mean that that’s what is going to happen in the future, and you shouldn’t base your decision on that,” Schotz said.
Each bond needs to be carefully reviewed on its own to determine how strong the pledge is, he said, adding that he is skeptical of generalizations for a market with more than 60,000 issuers of varying quality.
“You really have to look at the facts and circumstances around the particular bankruptcy or particular issue that you’re talking about,” Schotz said.
IS A G.O. THE BEST WAY TO GO?
Justin Hoogendoorn, managing director at BMO Capital Markets, suggests the 4.7% decline in general obligation issuance last year is a reflection of investor anxiety about the full-faith-and-credit pledge that backs such bonds.
“Investors have found comfort in knowing specific revenues are backing deals, as the bankruptcy topic has eroded some confidence around the typically higher-credit-perceived GO bond,” he said.
Revenue bonds, whose volume jumped 12.1% last year, have the advantage of being backed by a dedicated revenue stream which cannot be disrupted by the municipality, the bankruptcy court, or anyone else.
GO debt, however, is treated as a general unsecured credit in a Chapter 9 proceeding. As such, an automatic stay is imposed during the protection period, allowing the municipality to restructure such debt.
Municipalities have traditionally opted to keep bondholders happy to ensure access to capital markets, but legally there is nothing binding them to make that decision.
That can make essential-service or special revenue bonds a safer bet than a GO during the Chapter 9 protection period, depending on the particular health and wealth of the issues being compared.
Often the official statement will include a rate covenant that requires taxes or utility rates to be raised so that revenue shortfalls aren’t passed onto investors. But for GO bonds lacking a defined revenue stream, pessimists forecasting more defaults are correct to point out that when push comes to shove in bankruptcy court, some GO credits are little more than a voluntary payment.
For that reason, Richard Ryffel, managing director at Edward Jones, recommends sticking only to the top credits.
“An ounce of prevention is worth a pound of cure,” he said, “so our ounce of prevention is to recommend securities that are GOs of highly rated issuers or essential-service revenue bonds.”
Muni market participants can’t stress highly enough how important the motivation among issuers is to retain market access.
“The last thing they want to do is mess around with their credit ratings,” said Bill Mason, vice president of fixed-income trading at David Lerner Associates. “The stronger they are, the more they can come to the marketplace.”
And while in theory it could be compelling for a distressed municipality to seek to restructure its bond debt in a Chapter 9 bankruptcy, there are no significant examples of such an accomplishment so far.
“The reason there have been so few Chapter 9 filings is because the solution is to address the problem rather than throw everything up in the air,” Spiotto said. “That matters to municipalities because they need access to the market, they need credibility, and they need to be efficient in solving their problems.”
Those incentives don’t change much from municipality to municipality, said Duane McAllister, investment manager at M&I Investment Management.
He noted that in the years leading up to the global financial crisis, investors were over-reliant on rating agencies and market data relating to home prices.
A STURDY HISTORY
The shock of the meltdown has caused all investors to double-check the premises of history-based arguments. But in the case of public finance, the history is unusually sturdy.
“Here we are looking at the soundness of the legal structure,” McAllister said. “We’re a land governed by laws, and if you can’t rely on those, what’s the sense of having a Constitution, a Supreme Court?”
Moreover, a third of Chapter 9 filings in the past three decades weren’t even accepted by the courts. To file, municipalities need to prove insolvency, show that previous efforts to renegotiate debts have failed, and display a willingness to pay creditors. More than half of states — 26 — even prohibit their municipalities from filing unless specific authorization is granted.
Jefferson County, Ala., has been threatening to file for Chapter 9 as it struggles to pay $3.2 billion of sewer debt. But the threat is an empty one, Spiotto said, because the sewer debt is backed by revenues that the court can’t interfere with.
“Many people mention bankruptcy not because they want to do it, but strictly as a positioning to tell people, 'We have a problem, we need help, you ought to be listening to me,’ ” Spiotto said.
An alternative, such as refunding the outstanding debt, is more attractive because it would offer a surgical solution to the problem.
This high threshold for eligibility means that if there is an increase in filings this year, it won’t represent a greater risk to bondholders, according to Richard Lehmann, president of Income Securities Advisor.
In fact, filings can be viewed positively in some cases because it gives investors a forum to voice their disputes, he said. Otherwise, a municipality can just default, leaving bondholders with little leverage.
“These are governmental entities,” he said. “You can’t take them into court and put them into bankruptcy, the way you can [with] a private company.”
Ryffel, of Edward Jones, added: “Unless there are legal changes, I don’t know why anyone would assume that anything different is going to happen. There would have to be some legal change. Otherwise, the law is the law. It will be carried out the way it’s prescribed.”