The erroneous predictions by some pundits of impending disaster in the municipal securities market can be given two responses:
1. The disaster will not happen — the answer of most municipal market participants. Yet, there is a more dismissive answer that also is accurate.
2. It cannot happen.
This commentary is a brief summary why that is so.
First, however, one must make a distinction that few have made among the types of securities available in the municipal market. That is the distinction between general obligation securities and general fund securities. While these two types of municipal securities each contain the word "general," they are in fact quite different. They incorporate significantly different risks and structures.
It must be recognized that true local general obligation bonds, as that term is used generally across the market, have nothing to do with issuer general funds. At the state level, "general obligations" are payable from general funds, but those have considerably greater diversity of revenues, and many states offer constitutional or statutory preferences to investors. (Of course, there are many categories of revenue securities and special tax/assessment bonds that also are unrelated to general funds. This commentary is too brief to delve into those.)
At the local level, general obligation bonds are secured by issuer pledges to increase ad valorem property taxes as needed to pay debt service. At the time the bonds are issued, bond counsel opine that the pledges are enforceable under state law. This is playing out in Harrisburg. Most general obligation bonds are "unlimited tax" bonds, meaning there is no limit on how far taxes can be raised. Some are "limited," but the obligation to raise taxes up to the cap nevertheless applies. There is a good argument that, when general obligation bonds are secured by statutory liens under state law, which Pennsylvania lacks, the bonds should receive protection in Chapter 9 bankruptcies. That may make the presence or absence of statutory liens a disclosure point. Similarly, if state law does not authorize localities to enter Chapter 9, then there is no bankruptcy opportunity to avoid the pledge to raise taxes. Thus, the availability or nonavailability of Chapter 9 under state law may be another disclosure point. According to Municipal Market Advisors, at the end of February, only .01% of the outstanding general obligation bonds had defaulted (.06% counting insured bonds).
Local general fund securities, in contrast, are payable from whatever happens to be in issuer general funds, not from tax pledges. These commonly (but not always) are in the form of lease-purchase obligations. In most states, the obligation to pay lease payments must be appropriated annually in order to avoid voter approval requirements for debt creation. (In California and Indiana, abatement leases may be used pursuant to which issuers must pay lease payments if leased property is available for use.) Key issues include the leased property's essentiality for governmental use and its adaptability for private use (e.g., Stockton's leases of parking facilities, which now are operated for the benefit of investors). "Naked" general fund securities are uncollateralized.
Some notable securities payable from general funds have defaulted over the years. Until recently, they tended not to be collateralized. Those include New York City's notes (eventually repaid), Cleveland's bank loans (repaid), and Orange County's notes (repaid). More recently, we have Jefferson County's purported "general obligation" warrants (not payable at all from a tax pledge, but solely from the general fund) and Stockton's, Mammoth Lake's and San Bernardino's lease obligations and uncollateralized pension obligation bonds.
Although default reports often lump the general fund securities identified above into the GO category, not a single one of those securities was a true "general obligation" bond in the common usage of that term in the market (and the California issuers made no such claim). Many researchers and rating agencies routinely combine and confuse general obligation bonds and general fund securities. This practice makes accurate observation of the market very difficult.
Moreover, some general fund obligation issuers have placed the "general obligation" label on their obligations. This has the effect of confusing the market and corrupting default data. To that practice, I say, "You can call an ostrich a canary, but you can't make it sing!"
So, general fund securities (especially if uncollateralized) can, and sometimes do, default as a result of general fund stress. The difficulty for the naysaying pundits and media is that there are not a large quantity of general fund securities outstanding. Even if all of them defaulted, there would not be hundreds of billions of municipal securities in default.
The predictions of doom cannot be fulfilled.
Robert Doty is the author of The Bloomberg Visual Guide to Municipal Bonds (John Wiley & Sons and Bloomberg Press, 2012), which discusses the diversity and complexity of municipal securities and the municipal market. He is an officer of a municipal advisory firm. He also is President and proprietor of AGFS, his private consulting firm.
