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Alabama Raises a Question: When Is a GO Not a GO?

MAY 23, 2012 9:42pm ET
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BRADENTON, Fla. — General obligation bonds, long considered the gold standard for safety, have become increasingly tarnished as the nation’s largest municipal bankruptcy plays out in Alabama.

After the state Legislature ended its regular session refusing to provide fiscal relief to Jefferson County, commissioners Tuesday redirected money that might have paid GO warrants to the general fund for operations. The county lacks authority to impose taxes without state approval.

In muni shops across the country, Alabama’s political unwillingness to pay what many used to covet as a secure investment is a hot topic centered on different types of GOs and proper disclosure of risks.

“I’ve certainly heard discussion that going forward bond counsel and issuers will need to be more careful to explain what the security pledge is,” said Peter Bianchini, managing director and senior municipal strategist of institutional sales and trading at Chicago-based Mesirow Financial Inc.

“It’s leading to more scrutiny by investors about the exact security behind the GO bonds they are buying,” he said.

Without financial help from lawmakers to pay for essential public services, Alabama’s most populous county is poised to pursue a rare repudiation of some, or all, of its $200.5 million of outstanding GOs through its bankruptcy restructuring plan.

Some $105 million of the GOs sold in 2001 are in variable-rate mode and owned by liquidity banks Bayerische Landesbank and JPMorgan.

The remaining 2003 and 2004 fixed-rate GOs were originally insured by then triple-A rated MBIA Insurance Corp.; the exposure has since been ceded by MBIA to a sister company, National Public Finance Guarantee. NPFG is rated Baa2 by Moody’s Investors Service and BBB by Standard & Poor’s.

“National is disappointed by the failure of Jefferson County’s state legislative delegation to reach a consensus on a solution to the county’s budget shortfall and remains concerned that the gridlock in the Legislature will have negative repercussions for other municipalities throughout Alabama as well as for the state itself,” said chief risk officer Adam Bergonzi.

National will ensure that policyholders receive all principal and interest payments, Bergonzi said.

Market experts said investors now, more than ever, should understand what they are buying since the insurance sector has contracted and many entities are working through financial problems.

Jefferson County sold its GO warrants with an “irrevocable” full-faith-and-credit pledge, and that has focused attention on the security, its structure, and the appropriate disclosure of risk.

“If you are pledging full faith and credit, what is that?” said Tim Schaefer, president of Magis Advisors Inc., an independent financial advisory firm in California. The pledge can be meaningless, he noted.

“State laws are peculiar,” Schaefer said. “There are terms of art that have crept into the business over the years, and I think we need to define our terms.”

Does a full-faith pledge mean a debtor would sell city hall to make a bond payment? “The answer almost always is no,” he said.

Schaefer pointed to the Municipal Securities Rulemaking Board for industry definitions. A GO bond is secured by the full faith, credit and taxing power of an issuer.

The ad valorem taxing power can be unlimited or limited. Limited GOs are secured by a pledge of ad valorem tax that has a set rate or amount.

There are also full-faith-and-credit bonds backed by all legally available funds of the issuer’s general fund, but not necessarily backed by ad valorem taxes.

According to Interactive Data Corp., $991.4 billion of unlimited GOs are currently outstanding. Another $90.8 billion of limited GOs are also outstanding.

It is not known how much of the limited GOs actually has no ad valorem tax pledge.

It is nearly a dozen pages into bond documents that Jefferson County describes — in what some call legalese — the ad valorem taxes, sales, business license and occupational taxes and other general fund revenues available to pay debt service.

The caveat: none of the taxes are specifically pledged to pay debt service.

Several pages later, the county reveals that only the state Legislature can approve ad valorem property tax increases, which then must be approved by local voters.

While some experts believe the language is too complex, and the tax structure is disclosed far too late in bond documents, they believe the bigger issue is whether or not Jefferson County truly issued general obligation bonds.

“If the bondholder says, 'You told me this is a GO, and you haven’t executed on that GO,’ don’t you think it is arguable that calling it a GO is misleading?” Schaefer said. “The way I understand it in Alabama is if you didn’t have the authority to follow through on that pledge, then I think arguably you did mislead me.”

Schaefer pointed to guidance from the Securities and Exchange Commission that issuers should disclose material and relevant issues, even if those possibilities are remote.

“If you are dealing with a pledge that says it’s a GO, but it’s not really a GO because I can’t pay you, there may be a broader disclosure issue there,” he said.

Schaefer and Bianchini said investors need to ascertain a bond’s key underlying fundamentals, and evaluate the state laws where the issuer is based.

Both cited California for stronger credit fundamentals because local GOs must be approved by voters. Once an unlimited tax is passed, there are automatic tax increases to support debt payments.

While local governments in Alabama can also issue GO bonds with voter approval, the state Legislature also authorizes issuers to sell GO warrants that do not require voter approval.

“I think Alabama local government GOs have among the weaker security pledges behind their GOs,” said Bianchini, citing the political reliance on legislators for permission to raise taxes. “The Alabama GO warrant is more of a general fund pledge than a general obligation.”

Another complication that threatens nonpayment on GOs is bankruptcy.

Alabama is among 14 states that authorize local governments to file for bankruptcy, but do not grant GOs a statutory lien that protects or secures the rights of bondholders, according to a report earlier this year by Moody’s Investors Service analyst Gregory Lipitz.

Jefferson County’s GOs are unsecured claims.

That means how much warrant holders or the insurer are ultimately paid depends on the revenues available when the plan of restructuring is finalized.

“In about half the states in the country, counties don’t have home rule to raise taxes,” said Kenneth Klee, one of several bankruptcy attorneys representing Jefferson County. “The problem is when a county is authorized to issue [GO] debt and has no taxing power.”

When revenues run short, the county must provide services, he said.

Klee suggested Jefferson County warrant holders consider pursuing payment from the Alabama Legislature, since it retains the ultimate authority over the county’s ability to pay the debt.

“If that’s not the case, then it means nothing to have a county issue a full-faith-and-credit obligation other than an empty hope and a prayer,” he said.

Schaefer said he hoped Jefferson County’s case would be a catalyst for discussing better and clearer disclosure practices about different kinds of general obligation bonds and warrants.

“If we call it something we all know because it existed in the market for long time, and presume people know about it and know it has an infirmity, we have a greater obligation to disclose that,” Schaefer said.

“I’d like to see plain English risk factors included in virtually every bond offering we do,” he added.

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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