News of yesterday’s bankruptcy filing by Jefferson County Alabama, less than a month after Harrisburg Pennsylvania filed for bankruptcy, is sure to send shock waves to investors in the tax-exempt municipal bond market. Combined, these two entities have over $3.3 billion of outstanding debt, which could be restructured and impaired by bankruptcy court decisions in the next year or so. Does this portend a rapid and outsized increase of more defaults and municipal bankruptcies for 2012?
No. But that doesn’t mean that there won’t be more defaults in 2012; in fact, I expect defaults in 2012 to significantly increase over the $1 billion of bond defaults expected for 2011, which ends in less than 8 weeks. But even if municipal bond defaults quintupled next year, they would still be far less than the $8.5 billion of defaults in 2008, and $7 billion of defaults in 2009. Even if defaults in 2012 totaled $20 billion, which would be my worst case estimate, municipal bond defaults would still be less than 1% of all outstanding tax-exempt bonds, and a far cry from the “hundreds of billions” of defaults predicted by some analysts.
Keep this in mind: the $3 billion of bonds issued by Jefferson County Alabama for its sewer system is not a new default. The County had already reneged on repayment terms with banks that had backed its debt as far back as 2008—yesterday’s bankruptcy does not add to the low $1 billion of defaults that will occur in 2011. And while Harrisburg was able to avoid payment defaults by extraordinary advances from state government in 2010 & 2011, its incinerator bonds were technically in default since 2009, when the City chose to invade debt reserves rather than appropriate funds under the city guaranty that backs the bonds.
For all of the rhetoric in 2011 about falling revenue, rising expenses, high unfunded pension liabilities and cutbacks in federal aid, the stories behind these two bankruptcies are about human error by the officials charged with managing Jefferson County’s Sewer System, and Harrisburg’s Incinerator Project. Jefferson County officials oversaw a large increase in debt, and compounded the problem by using an extreme amount of variable rate debt, whose interest rates could rise dramatically; with the advent of the national financial crisis in 2008, that’s exactly what happened. In Harrisburg’s case, officials kept adding more debt to a project that was plagued by cost-overruns and operating problems. Eventually user charges fell well short of covering operating costs and servicing the massive debt burden.
Since starting as a municipal bond analyst in July 1975, I have seen the largest municipal bond defaults and financial crises first-hand—NYC’s default on short-term debt and near-bankruptcy in the 1970’s, Washington Public Power’s multi-billion dollar default on nuclear power bonds in the 1980’s, and Orange County California’s 1994 bankruptcy. There is a common thread to these debacles: they were directly the result of mismanagement. Not natural or unexpected, but true man-made disasters.
The record of extremely low municipal bond default rates, even during this prolonged recession, is a testament to the overwhelming majority of local governments’ fiscal prudence, and budget austerity when economic times turn rough. The protracted slowdown and elusive economic recovery will continue to present budget-balancing challenges to state and local elected and appointed officials. But the man-made disasters of Jefferson County and Harrisburg are exceptions, and not the rule, in the traditionally credit-safe municipal bond market. And they are not a new wave—both debacles have been seething since 2008, and their eventual decisions to file bankruptcy were no surprise to municipal bond professionals.
What remains to be seen is how JeffCo and Harrisburg will fare without being able to borrow in a municipal bond market that is not very forgiving and which has a long memory. When investors’ trust in lending life-savings to municipalities is repudiated, it is a long hard road to be able to regain their confidence. The ramifications of bankruptcy will be felt for years, as Vallejo California has learned since its bankruptcy in 2008.
The material presented here is for information purposes only and is not to be considered an offer to buy or sell any security. This report was prepared from sources believed to be reliable but it is not guaranteed as to accuracy and it is not a complete summary of statement of all available data. Information and opinions are current up to the date of publication and are subject to change without notice. The purchase and sale of securities should be conducted on an individual basis considering the risk tolerance and investment objective of each investor and with the advice and counsel of a professional advisor.