CHICAGO — Fears expressed by some municipal market participants that cuts in state aid will spawn a wave of local government defaults are overblown, according to a new report by Nuveen Asset Management that examines 12 Cleveland-area issuers.
Using Cleveland and its neighboring and related issuers as case studies, the report examines the relationship between state aid, assessed valuation, and the risk of default.
It finds that for several issuers, defaults would not cure budget deficits.
For those issuers, such as Cleveland, where a default would cure a shortfall, the revenue lost from state aid cuts total less than 5% of their budgets — making it more likely that they would rely on a traditional mix of cuts and tax increases to offset the loss rather than invite the wrath of the capital markets.
Many local governments are fiscally stressed and more defaults could loom on the horizon, Nuveen acknowledges. But warnings that state aid cuts will lead to a spike in defaults paint the diverse and fractured municipal bond market with too broad a brush, the report concludes.
“You have so much diversity in the market that you can’t make a widespread pronouncement,” said Nuveen vice president and senior research analyst Shawn O’Leary, author of the report, “Municipal Credit Stress: Macro Prognostications and Micro Analysis.”
“You have to do it from the bottom, and that’s where the fundamentals of credit research come in,” he said.
Ohio Gov. John Kasich’s new budget enacts record-high cuts in local aid, and Cleveland so far has reacted by laying off up to 400 employees.
It hasn’t been easy, but the city has suffered the stigma of default before, in 1978, and isn’t about to go there again, its debt manager said.
Predictions of a wave of defaults have riled the municipal market since late 2010, sparked in part by warnings from high-profile analyst Meredith Whitney, who warned of investors losing “hundreds of billions.”
Such predictions so far have failed to pan out. Recent figures show that issuers have defaulted on $509 million so far this year, about 0.018% of all outstanding municipal bond debt, according to a recent Bank of America Merrill Lynch Global Research report.
About 98% of the defaults have been revenue bonds, led by special-assessment paper, followed by transportation and health care, the firm said.
Many states relied in part on cuts to local government aid to balance their fiscal 2012 budgets.
Ohio’s new two-year budget, for example, cuts state aid to local governments by about 25% the first year and 50% the second year. Some warn that politicians torn between constituents and bondholders — between cutting essential services and defaulting on debt payments — will tend to satisfy the former.
That argument is flawed, according to O’Leary.
“We certainly don’t believe that to be the case, and we wanted to put statistical validity behind our view, and demonstrate that our opinion is backed by actual research,” he said.
The report analyzes how a theoretical 50% cut in state aid would affect Cleveland and 11 overlapping issuers.
“What it shows is, even at that level, which is a healthy cut to be sure, it doesn’t create the kind of budget gap that would imperil debt service,” O’Leary said.
For five of the issuers — including the Cleveland Water District, the Northeast Ohio Regional Sewer District, the Cleveland Museum of Art and the Cleveland Clinic Health System — state aid cuts would have no impact at all because they receive no state aid in the first place.
Of the seven remaining issuers, four would face a revenue loss of 12% or more if their state aid were cut in half, according to the report.
Defaulting on their bonds, however, would not overcome the revenue loss, because state aid exceeds debt service costs for those issuers. It’s unlikely an issuer would risk the stigma of default if the move would still fail to cure its deficit, the report noted.
For the remaining three issuers, including Cleveland, a debt service default would offset their state aid loss.
But for these issuers, the revenue lost from state aid cuts makes up less than 5% of their total budgets -—a figure that is more easily managed with cuts and tax hikes than with a default, which brings with it stigma and years-long lack of access to capital markets.
“If history — and logic — is any guide, a revenue loss of less than 5% will be recovered through revenue increases and cuts, not default on debt service,” O’Leary said in the report.
If Cleveland, for example, saw a 50% cut in its state aid — which it might in Ohio’s new two-year budget, though the city is still determining the final numbers — that would translate into a 3.2% loss of its total governmental revenues, according to Nuveen.
Defaulting on its debt payments, which total 12.4% of its revenues, could cure its budget gap.
In fact, the city has already laid off hundreds of employees this year in a move that the city’s mayor has dubbed “state-imposed layoffs” to deal with Ohio aid cuts in the new budget.
Failing to make debt payments has never been an option, according to the city’s debt manager, Elizabeth Hruby.
“Certainly it’s not an easy decision to make all of these service cuts,” Hruby said in an interview Monday. “But there’s no chance we would default on our debt. We feel it’s our duty that bondholders have to be paid, and any responsible finance director would do the same thing.”
Hruby noted that Cleveland’s general obligation and subordinate-lien bonds are supported by a restricted income tax, not annual appropriations.
Default is “something you would think long and hard about before choosing it as your preferable route,” she added.
Cleveland has first-hand experience with the problems tied to a debt default. In 1978, the city failed to make payments on $15 million of short-term notes when local banks refused to roll over the debt for another year.
The city’s debt rating dropped to junk status for more than two years and the default prompted state officials to declare Cleveland the first Ohio city to be in fiscal emergency.
It took the city more than 15 years to regain its A rating.
“It was a stigma that you have a long time,” Hruby said. “There are a few people still around from that time. Having gone through that, we definitely would want to prevent it again and hopefully any other city’s finance people would understand the implications of not paying on their debt.”
The Nuveen report also pokes a hole in the theory that state aid cuts will depress assessed valuations, leading to a spiral of falling revenue for local issuers.
The report analyzes 20 years of data and finds no correlation between state aid and assessed valuations.
For Hruby, predictions of widespread defaults throughout the market are unfair to cities like Cleveland that are cutting services and laying off workers to deal with shortfalls like state aid cuts.
“These comments are irresponsible because they paint all of us in the same light, and you can’t do that anymore,” the debt manager said. “You have to look at each individual entity and their indentures and how they collect the money and their financial management. These statements are unfair to those of us who are adapting and dealing with it. We aren’t getting credit for it in the market the way we should.”