BRADENTON, Fla. — It turns out all general obligation debt is not created equal.
The way such bond deals are structured for repayment is becoming more critical to investors as local governments continue to struggle with a slow recovery from the recession and deal with the financial realities of paying debt with fewer revenues.
The recent bankruptcy of Jefferson County, Ala., is a case in point.
The county filed the largest municipal bankruptcy in U.S. history in November with $4.2 billion of debt.
Of the debt outstanding, the county lists $200.5 million of GO warrants as unsecured claims in bankruptcy court documents.
The county stopped paying debt service on fixed-rate GO warrants this week, shining a spotlight on inherent structural risks of certain GO credits, not only in Alabama but across the country, according to market experts.
In some cases, the risks for investors may have been obscured by credit enhancement or buried in convoluted print in official statements, experts said.
In other cases, a bond or warrant with a “full faith and credit pledge” can be nothing more than an obligation secured by an issuer’s general fund revenue, which is the case in Jefferson County.
All of the county’s GO warrants are secured by an “irrevocable full faith and credit” pledge, according to bond documents.
“We’re going to find out what full faith and credit in Alabama really means,” said Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management LLC.
“It seems like whatever is done in Jefferson County on the full faith and credit warrants will have historical significance for investors, in one way or another, whether through their willingness to pay through the courts or later,” he said.
Some experts said a troubling aspect of Jefferson County’s GO warrants, which may be found in other bonds sold around the country, is that they are not classic GO bonds as defined by the Municipal Securities Rulemaking Board.
A GO bond typically is secured by the “full faith, credit, and taxing power of an issuer,” the MSRB definition said.
These are known as general obligation unlimited-tax bonds.
A full faith and credit bond is backed by all legally available funds of the issuer, “paid from the issuer’s general fund but … not necessarily backed by ad valorem taxes,” the MSRB definition said.
The Jefferson County GO warrants, in contrast, are limited-tax GO debt.
“On the security question, there are many different types of GO pledges, varying state by state and sometimes issuer by issuer,” said Matt Fabian, managing director at Municipal Market Advisors. “In general, investors don’t have a great appreciation for this, but structure counts very much when projecting default risk.”
Some investors may not have even been concerned with different GO structures, if the bonds were insured.
“Since the GO and full faith and credit security structure has been so reliable for so many years, the market hasn’t significantly distinguished bonds on a state-by-state or even issue-to-issue basis for some time,” Ciccarone said. “Bond insurance provided a further cover that shielded these credits from fine-comb scrutiny.”
Jefferson County’s GO warrants are insured by National Public Finance Guarantee; the county says many holders of the fixed-rate warrants are small mom-and-pop investors. NPFG has publicly stated that it will fulfill its insurance obligation.
The county defaulted on $105 million of outstanding variable-rate GO warrants some time ago. They are now held by banks.
The remaining outstanding GOs are fixed rate in the amounts of $46.2 million of 2003A warrants, and $49.3 million of 2004A warrants. The county had been current on these payments until this week.
Though the cover of official statements for all of the GO warrants states that they are backed by the full faith and credit of the county, more than 10 pages into the documents the county reveals the security structure.
The warrants are secured by “ad valorem taxes, sales, business license and occupational taxes, and other general fund revenues,” though “none of such legally available revenues are, however, specially pledged for the payment of debt service.”
The county explains well into the bond documents, and in technical terms, the complex structure in Alabama that requires counties to obtain permission from the Legislature to increase taxes.
Jefferson County has been unable to secure legislation allowing it to replace an occupational tax that was struck down in court.
Some investors may not have looked beyond insurance coverage and understood the security structure, said a financial advisor who thought the language was not clear.
In a press release last week after deciding to default on the fixed-rate warrants, the county said it “takes seriously its responsibility to honor its general obligation warrants.”
Because of dwindling general fund revenues, and inaction by the Legislature, the county said it was opting to pay essential government services instead of debt service.
The county said it expects that payments on the GOs will not resume until they are restructured or reinstated under the plan of adjustment in the Chapter 9 case, and any restructuring or reinstatement is dependent on legislative action to provide a “stable, long-term source of general fund revenues to the county.”
Ciccarone said the county could ultimately pay off all its GO debt, albeit on a later amortization basis, as was done following the Great Depression when many issuers defaulted on their general obligations.
If the county tries to repudiate some or all of the debt, he believes it will reflect the county’s ability and willingness to pay, and influence market access as well as prices in the future.
“What they do here, and how they handle it in the future, will have significance for investors in the future,” he said.
GOs have been considered the “gold standard” because investors believe them to be more secure than revenue bonds secured by a limited source of revenue.
However, in a Chapter 9 proceeding, holders of GO bonds and notes are considered unsecured creditors whose payments can be stayed or stopped in a bankruptcy, unless a statutory lien is in place. That lien is the taxing pledge most often associated with traditional general obligation bonds, though not all GOs.
“I believe that these distinctions on the GO and full faith and credit pledge concepts are being put to the test,” Ciccarone said.
In the bankruptcy case this week, JPMorgan and Jefferson County objected to requests by two insurers for relief from the Chapter 9 case.
Assured Guaranty Municipal Corp. and Syncora Guarantee Inc. have asked federal Judge Thomas Bennett to allow their suits filed in New York State Supreme Court several years ago to move forward.
Both suits are against JPMorgan, though Jefferson County was brought in as a third party in Assured’s complaint.
The suits claim that the investment bank fraudulently induced them to provide coverage for the county’s failed variable- and auction-rate sewer warrants by concealing bribes that JPMorgan paid to county officials to obtain underwriting and swap business.
In its objection Monday, Jefferson County said that Assured is attempting to continue a “nonstop litigation campaign that the sewer creditors have waged against the county since the County filed its Chapter 9 case.”
“This campaign advances a war of attrition against the county whereby the creditors seek to consume the attention and resources of the county and its counsel with litigation, rather than allowing the county a breathing spell to focus on formulation of a Chapter 9 plan,” the county filing said in part.
The county said it has spent more than $2.5 million from its general fund defending the New York complaints.
JPMorgan said that if the cases proceeded, they would be detrimental to the county’s restructuring efforts.