WASHINGTON – Investors' willingness to lend to municipalities in crisis like Puerto Rico, and count on a bankruptcy process to sort out the mess, is ratcheting up risks in the muni market, according to panelists at an analyst conference here on Friday.
Market participants need “to be far more careful about permitting people to borrow money that they don’t have a genuine basis for repaying” because politicians are going to find ways to borrow money when they need it, said RIchard Ravitch, the former non-voting representative of Puerto Rico’s government on the Puerto Rico oversight board, who is known for helping New York City sidestep its 1970s fiscal crisis.
“As long as they have willing collaborators in the financial world, they will do what Puerto Rico did,” Ravitch said, referring to borrowing by the commonwealth that led to its roughly $70 billion in debt and $46 billion in unfunded pension liabilities. The panel discussion was part of the National Federation of Municipal Analysts’ annual conference in Washington.
Stephen Spencer, a managing director with Houlihan Lokey who has worked on financial restructurings including Puerto Rico and Detroit, said the muni market is going through “a quantum risk shift.” The “big three” of risks he sees in each of the distressed municipalities he has worked with are growing pension funding deficits, rising healthcare costs, and a lack of capital execution funding.
He said the capital execution funding issues tend to result from entities cutting back on their capital expenditures when finances get tight.
“That could go on for years before people really realize it,” Spencer said, pointing to the scandal in Flint, Mich., which has been dealing with a water crisis because of poor infrastructure.
Spencer also sees the application of a corporate restructuring model to government debt as another part of the looming risk shift for the market. Though he doesn’t see the risk as imminent, Spencer said it puts the market “on a path to the tipping point.” He said the narrative that usually accompanies the application of a corporate model is that investors and analysts like those in the audience for the panel “should have seen it coming” and “basically abetted” an entity’s fiscal trouble.
Spencer said that while it’s true that entities’ descents into fiscal trouble “are slow-motion trainwrecks,” it is unrealistic to expect that all analysts and investors will step back and require greater fiscal discipline before lending money. After all, it is their jobs to “put money to work,” he said.
Part of the problem is an improper and false reliance on there being a reasonable restructuring framework in place for distressed entities, according to Spencer.
“Chapter 9 is not that,” he said, contrasting the uneven creditor protections under Chapter 9 with the balance of debtor and creditor protections under the “gold standard” of Chapter 11. He added that members of the audience who underwrite debt should understand that they are “the least sympathetic constituents in a government restructuring.”
Restructuring also plays into the troublesome idea that if an entity cleanses its balance sheet, it will eventually return to something close to regular market access, Spencer said.
“I know the market right now is saying ‘Look, if you just clean that up, if you take the easy off ramp and just purge your debt obligations and don’t do any meaningful, politically unpopular fiscal reforms, we will not give you access to capital,’” Spencer said. “I’ve heard that many times in the corporate context too. Guess what, take them through chapter clean up the balance sheet, everybody stays in place and six months down the road, maybe the next time an offering is dinged 25 … basis points, but they get the money.”
He added that in his experience, when governments really need money, they’ll start to put fiscal reforms into effect and start to take steps that will entice lenders to make a commitment by investing. But that fact is complicated by “this false reliance” on Chapter 9.
“Frankly, if you just took away Chapter 9, if you took away any restructuring framework, you would get to I think folks issuing debt on a more responsible basis and the market exercising a more judicious upfront assessment of the risks that pertain to that government entity issuing the debt if there were no framework at all,” Spencer said.