Regional News

Study of California Defaults Finds Little Chance of Tsunami

SAN FRANCISCO — No flood of bond defaults will spread through California cities in the near future; just possibly a smattering, according to a new academic study.

The project, commissioned by state Treasurer Bill Lockyer, used its own methodology and found the vast majority of cities have less than a 2% probability of default.

The default probabilities, which equate to municipal creditor scores, estimate the likelihood of whether 261 cities in California with populations of more than 25,000 will fail to pay debt service over the course of a year.

“We are not going to be having a tsunami of bankruptcies. Not every city is going to turn out like Stockton and San Bernardino,” said Marc Joffe, a consultant with Public Sector Credit Solutions, who created the study along with Dr. Matthew Holian, a professor of economics at San Jose State University. “There are certainly differences. Some cities did perform quite badly and had high default probabilities above 2%.”

The study still needs to be vetted by peer review, and Lockyer’s office will not comment on the project until that process is finished, according to his spokesman Tom Dresslar.

Previously, Lockyer said the project would contribute to an early warning system to help determine whether cities are in financial distress, raising “red flags.”

The treasurer’s office discussed the warning system following the bankruptcies last year of three California cities —  Stockton, Mammoth Lakes and San Bernardino.

“With the collapse of municipal bond insurance business and questions concerning the credibility of bond ratings, new methods of credit risk assessment are required,” the report said.

A website has also been set up for the public so they can view and compare the city statistics, at http://www.publicsectorcredit.org/ca.

The study doesn’t consider technical defaults or the differences between bond issues, meaning general obligation bonds would have less risk than default estimates suggest, while less secure obligations — such as certificates of participation — would have more, according to the report.

Prior to declaring bankruptcy, the study said Stockton had a 1.724% chance of default, the 10th riskiest city out of 261, and San Bernardino had a probability of 2.085%, number four, based on 2011 financials.

For cities that filed 2012 audited financial reports — around 40 had not reported in time for the study — the study found that 15 California cities had higher chances of defaulting than Stockton.

The city in the most dire straits, according to the report, is Compton, Calif., which had only reported 2011 financials when the study was conducted. It had a 6.52% chance of defaulting, more than four percentage points higher than the next city on the list.

According to the 2012 data, the city of Ridgecrest with a 4.576% chance of default, Atwater with a 4.278% chance, and Monrovia with a probability ratio of 3.75% topped the list.

That probability may not have yet translated into higher interest rates since some of the riskier cities are less known, such as Ridgecrest, a city of 28,000 in Kern County. Atwater, which took second, has had its fiscal problems well documented.

Ridgecrest’s COPs issued in 2005 and maturing in 2023 that initially sold with an interest rate of 4.5% last traded on the secondary market in July 2012 in a block of $130,000 with a yield of 3.5%.

What all three cities also have in common in the study is a very high general fund over general fund expenditure ratio, which the study authors say is an indicator of major distress.

“I was surprised that we were able to find a single ratio that had so much predictive power,” Joffe said. “Stockton and San Bernardino were in the bottom 10% of that ratio.”

Joffe said that municipal analysts should start looking closely at those ratios, if they don’t already.

He also said that several cities didn’t report their financials in 2011 or 2012, including Bell, Calif., which could also be an indicator of fiscal problems. Joffe said most cities made their financial information easily accessible.

The model developed through the study uses case study evidence and logistic regression analysis of major city financial statistics from the Great Depression and more recent financial statistics.

Independent variables used in the model, based on procedures applied to corporate borrowers, include the ratio of interest and pension expenses to total revenue, annual change in total revenue, the ratio of general fund surplus or deficit to general fund revenues, and the ratio of general fund balance to general fund expenditures.

Joffe said ratings agencies may see the study as simplistic, and he said this is something that may be needed to better evaluate risk.

The report notes ratings agencies have little incentive to evaluate cities they are not paid to rate and rely on bond issuers for their revenue.

The study also points out that the three rating agencies were sued by the Connecticut Attorney General in 2008 for assigning overly harsh ratings to municipal bond issuers relative to corporate structured finance issuers, and two of the three agencies recalibrated their ratings in response to the suit that was settled in 2011.

“We believe that the informational vacuum created by the rating agency problem can be filled by academic research,” the study said. “This study represents our initial contribution to this academic project, and we hope that it will motivate others to add their insights.”

The study also goes after the “politically charged predications yet to be borne out by the facts on the ground,” specifically Meredith Whitney’s 2010 prediction of as many as 100 sizeable defaults, that fed into discussions of skyrocketing public employee pension costs.

Concerns about pension underfunding is not new, the study said. The topic was also a serious concern in the 1970s, when financial emergencies were highly publicized but there was no “spate” of municipal bond defaults.

It also noted author Michael Lewis’ story in Vanity Fair that quoted Whitney saying “who cares about the stinking muni bond market,” as part of an attempt to turn attention to fiscal problems in California cities, public employee pensions and the risk of “cultural” rather than financial bankruptcy.

“For those who do care about the ‘stinking’ municipal bond market, the discussion left much to be desired,” the report said.




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