Morgan Stanley analysts point to rapidly increasing leverage, unusually high unemployment, shocks to revenue streams, and high pension and other post-employment benefit burdens as factors that can lead to municipal bankruptcies.
In “Muni Bankruptcy: More Lessons,” head of municipal strategy Michael Zezas and a member of his teamwrite that they expect local bankruptcies in the near future to rise but remain “modest and idiosyncratic.”
In the report released Tuesday, the authors examined the factors that led to the bankruptcies of Stockton and San Bernardino, Calif., and the recent near bankruptcy of Detroit.
They write that “red flags” for investors are both obvious and not-so-obvious.
Increased leverage was a factor shared by all three of those municipalities, the authors note. They determined the median percent increase in leverage for municipalities from the lowest point between 2001 and now, and the current value was 70%. They looked at municipalities with general fund revenues of $100 million or more. By comparison Detroit had a 105% leverage increase, San Bernardino had a 108% increase, and Stockton a 275% increase.
All three municipalities have also suffered unusually high unemployment. Joblessness peaked at 18.6% for Stockton in January 2011, 19.6% for San Bernardino in July 2010 and a whopping 27.8% in Detroit in July 2009.
By comparison the United States as a whole had a peak unemployment rate in the recent downturn of 10.0% in October 2009.
The current unemployment rate is 2.1 times the national rate for Detroit, 1.79 times the national rate for Stockton and 1.96 times the national rate for San Bernardino.
“Lower employment translates to lower income, lower property values, and, accordingly, less revenue-raising flexibility,” the authors wrote.
The three municipalities also share a history of shocks to their tax bases. Detroit lost 25% of its population from 2000 to 2010. Stockton had the highest foreclosure rate in the country, the second highest rate of home loans “underwater,” and the third-highest home value reduction percentage. San Bernardino was also severely affected by the housing bust.
In all three municipalities these shifts hammered their revenue stream and that, in turn, pushed their reserve funds down. Both California cities had reserves that declined as a percent of total revenues from 2006 to 2012 and both had essentially no reserves by 2011.
Detroit’s general fund reserves were negative and became more so from 2008 to 2010.
For outstanding muni debt from issuers with a minimum of $100 million in revenue and rated by Moody’s Investors Service, only 0.9% had a similar or worse reserve position than Stockton, whose last audited data was the best of the three Chapter 9 municipalities.
All three municipalities had escalating costs of servicing debt, pension and OPEBs.
As a percent their revenues, the costs for San Bernardino rose from about 12% to about 18% in 2010, for Stockton they rose from 18% in 2005 to 31% in 2010, for Detroit they went from 19% in 2004 to about 32% in 2011.
Unfortunately, determining the burden of pensions and OPEBs on municipalities from financial statements can be difficult, the authors wrote.
This “suggests substantial value to single-name credit analysis when picking within the local sector,” they said.
The analysts noted that general obligation yields remain low compared to those of other muni sectors, even while there is a “murky” credit picture of the sector.
They recommended investing in enterprise revenue sectors, which they say have low leverage, healthy operating margins, and benefit from the current slow growth.
