Bankruptcy series: The Road Ahead
Editor’s Note: This is the 11th in a CalWatchDog.com Special Series of in-depth articles on municipal bankruptcy.
Nov. 14, 2012
By Chriss Street
Up through September 2011, Wall Street underwriters, bond counsels and other assorted securities industry camp followers were gloating over the supposed failure of predictions in late 2010 by Meredith Whitney and me that there would be a coming surge of state and local bond defaults. These camp followers had been hitting the public airways to crow there were only 24 municipal defaults in the first half of 2011. That was down from 60 defaults in the first half of 2010. And it was down substantially from the 144 defaults in the first half of 2009.
But all the giddy glee state and local government were exempt from the Great Recession came crashing down on Oct. 12, 2011 when the city of Harrisburg, the state capital of Pennsylvania, filed the second largest bankruptcy in U.S. history with more than $500 million in liabilities. And on Nov. 8, 2011 when Jefferson County, Ala., filed the largest bankruptcy inU.S. history with more than $3.1 billion in liabilities.
Most Americans cannot fathom that state and local (“municipal”) governments in 2011 spent $2.89 trillion and commanded 20 percent of the American economy. To fund this muscular economic intervention, municipalities collected $2.62 trillion in revenue and borrowed hundreds of billions of dollars by selling municipal bonds to the public. Over the last 10 years, the outstanding amount of municipal bonds more than doubled from $1.197 to $2.8 trillion.
Then there’s debt. According to a June 25, 2011 report by James E. Spiotto, “The debt of state and local governments has more than doubled in the last 10 years, from $1.197 trillion in 2000 to $2.8 trillion at the end of 2010. (Some [Citicorp] contend that the market is actually $3.7 trillion with individual holders being $1.8 trillion [rather than $1 trillion] or 50 percent of the market but hard to verify.)
“This does not include over $1 trillion of unfunded pension liabilities and in addition OPEB liabilities over $200-300 or more billion plus the needed debt financing over the next five years to bring infrastructure up to acceptable standards of $2.5 trillion.”
Add it all up, and municipalities look like subprime borrowers.
Since the Great Recession began in 2007, Americans have personally cut spending, reduced debt and increased savings, while their local governments have increased borrowing to increase spending. With municipal government revenues now falling fast and economizing voters mostly opposed to higher taxes, thousands of over-leveraged municipalities appear doomed to default on their debt and be forced into bankruptcy.
About 71 percent of municipal bonds are purchased by wealthy individuals who often loathe the government cronyism and inefficiency, but have been willing to invest huge amounts of their net worth in “tax free” municipal bonds. Armed with a tax-advantaged ability to borrow for 20 percent to 30 percent cheaper than taxable borrowers, municipalities went on a borrowing binge and have increased their bond debt from $1.2 trillion to $2.62 trillion over the last 10 years. This red hot 8.9 percent compounded growth rate for debt far out-distanced the American economy’s annual growth rate of 4 percent.
U.S. Treasury Loses $40 Billion
According to Congressional Joint Committee on Taxation, this rapid growth of tax exempt municipal bonds now costs the U.S. Treasury $40 billion per year in lost taxes. Although the U.S. Supreme Court ruled in 1895 that there is no constitutional prohibition against taxing municipal bond interest, Congress authorized an exemption with the Revenue Act of 1913. But with the U.S. credit rating recently downgraded, President Obama is trying to reduce or eliminate the exemption.
Unlike the U.S.equity and corporate bond markets that are tightly policed by the U.S. Securities and Exchange Commission, the municipal bond markets have been collegially self-regulated by the brokers that sit on the Securities Industry and Financial Markets Association and have dominated the Municipal Securities Rulemaking Board. But the Dodd-Frank Wall Street Reform and Consumer Protection Act on Oct. 1, 2010 required the MSRB to be independent of SIFMA. Furthermore, MSRB was given expanded jurisdiction and enforcement authority to protect the interest of municipal entities and “obligated persons” — better known as taxpayers.
To review the potential impacts Dodd-Frank would have on investors, Bloomberg Television held a seminar in lower Manhattan in early October 2010. As the treasurer of Orange County, Calif., and the whistleblower who helped expose the county’s $2 billion investment loss that forced the county to file for bankruptcy in 1994, I was invited as the token speaker to warn about the risks to the economy from potential municipal bond defaults.
Each panel session consisted of strident reassurances by underwriters, bond counsels and other assorted securities industry camp-followers that the municipal bond market was financially strong. Then I would reiterate why a combination of collapsing property tax collections, huge debt leverage and unfunded pension obligations would doom the muni bond market to years of defaults. After the sessions, we would gather for coffee and conversation. The same panelists who had vociferously argued in public the muni bond markets were safe, fretted in private about their firm’s professional liability for future defaults. Several stated, “I hope it doesn’t blow up too soon. I still have to pay for kids in college.”
Two months later, the CBS “60 Minutes” television show aired a 14-minute piece about U.S. state and local finances. Correspondent Steve Kroft interviewed Wall Street banking analyst Meredith Whitney, who in 2007 correctly warned that losses from sub-prime mortgage bonds would devastate the solvency of the U.S. banking industry. Whitney pessimistically noted that state and local governments were minimally facing collective annual operating deficits of $500 billion per year and a least $1 trillion more in un-funded pension obligations. The show closed with Whitney projecting a wave of defaults by counties and cities: “You could see 50 to a hundred sizable defaults, [maybe] more.”
A rattled Steve Kroft asked her when people should start worrying about local finances. Whitney answered: “It’ll be something to worry about within the next 12 months.”
The next morning all hell broke loose on Wall Street as municipal bond prices plunged by 10 percent. Over the next two months, prices fell another 10 percent to 15 percent as the shock and awe of the market disruption fueled panic among bondholders and froze out all but the highest rated municipalities from borrowing money in the public markets.
Fortunately for muni bondholders, the U.S. Federal Reserve Board took action in spring 2011 to force down long-term interest rates. The higher rate of interest on depressed municipal bonds attracted high-yield investors who drove the prices of municipal bonds back to just below when prices collapsed. But tax-exempt municipal bonds that once yielded 20 percent to 30 percent less than U.S. Treasury bonds now yield a whopping 20 percent to 30 percent more.
Threats to Bondholders
The higher yield for municipal bonds represents the level of risk bondholders are taking. If the economy improves, interest rates will rise rapidly and the price of municipal bonds will crash again. If the economy contracts, tax collections will continue to shrink and municipal bond prices will be crushed over fears of potential defaults. Under either economic scenario of good or bad times, municipal bond prices seem precariously doomed to fall. Add in the probability that Congress takes back the $40 billion tax exemption and bondholders face huge threats.
For Harrisburg, Chapter 9 bankruptcy filing is the only strategy that might allow the city to escape from being a permanent debt slave. The city was once a mixed use community of heavy manufacturing, food processing and state government. But after the private-sector industries pulled out, the property tax base collapsed, because all the state government property is tax exempt. To subsidize operating deficits and generate revenue, the Harrisburg city council sold $463 million in municipal bonds to invest in upgrading a huge trash incinerator, constructed parking lots and built a Wild West Museum.
For a working class city of 49,000 with a near poverty line median household income of $26,920, Harrisburg has a bloated municipal bond debt per household of $23,734.Harrisburg residents also pay some of the highest fees in the country to support what’s called The Incinerator, rather than hauling trash to a lower cost landfill. To fully service the city’s debt burden, each household would have to pay another $1,104 in taxes. With The Incinerator running negative cash flow, parking lots featherbedded and the museum defunct, residents of Harrisburg are now debt slaves.
Given this ludicrous indebtedness, Harrisburg would have seemed an excellent candidate to file under 11 USC § 904 of the U.S. Bankruptcy Code (“Chapter 9”) when the city announced in September 2010 it would miss a payment on its general obligation bonds and incinerator bonds. In bankruptcy, the city would have turned The Incinerator over to the bondholders, restructured city operations and negotiated down its debt burden to a manageable level.
But the Harrisburg mayor had fought against a filing for bankruptcy to protect her own political future. And the state of Pennsylvania was adamantly opposed to a Chapter 9 bankruptcy for fear of a daisy-chain of defaults across Pennsylvania as other municipalities and their taxpayers tried to escape similar debt-slavery.
Pennsylvania’s Act 47
To stave off an immediate bankruptcy in 2010, Pennsylvania’s then-Gov. Ed Rendell advanced $3.3 million in future state grants to pay bondholders. In July 2011, new Gov. Tom Corbett offered another grant advance of $3.6 million if the city would enter Pennsylvania’s Act 47 municipal recovery program by turning control of the city over to the state. Essentially, the state’s plan would have raised taxes, then sold off The Incinerator, city garages, parking meters and any other city property to pay bondholders in full.
After racking up millions of dollars in consultants and legal bills, a taxpayer-supported coalition elected to the Harrisburg city council voted 4-3 to file for bankruptcy on Oct. 12, 2011. The state Legislature screamed foul and voted to put Harrisburg into receivership. The city remained in federal Chapter 9 bankruptcy until a bankruptcy judge on Nov. 23 voided the bankruptcy, but decided the state had the right to take over the city and appoint a receiver.
Corbett then appointed attorney David Unkovic as the city’s receiver, setting off howls that Unkovic’s former law firm, Saul Ewing, actually represents the city’s largest creditor, Assured Guarantee Municipal Corp. Harrisburg listed $458 million in creditor claims when it filed its bankruptcy petition. City council attorney Mark Schwartz said the Chapter 9 filing was aimed at giving the city “bargaining power” with creditors and the state of Pennsylvania. In addition to its debt and state buildings not paying property taxes, the city also is also being battered by the state’s unfunded pension crisis.
Ten years ago the Pennsylvania State Employees’ Retirement System claimed its pension plan was “substantially over-funded” based on an assumption its investments would earn an 8 percent rate of return forever. State lawmakers then spiked public employee pension benefits and PSERS cut employers’ (including Harrisburg’s) contribution rate to just 5 percent of their payroll.
But with employees retiring early with lush benefits and the stock market losing 43.2 percent after inflation over the last 10 years, PSERS recently admitted it has a $30 billion unfunded liability. Today only 109,000 public sector workers are now supporting 111,000 retirees. To prevent the liability from jumping to $55 billion in six years, PSERS ordered Harrisburg to increase its employer contributions to 28.1 percent of payroll.
Muni bond advocates stress that there have only been 625 Chapter 9 municipal bankruptcies since 1937, versus 58,322 business bankruptcies in 2010 year alone. This conveniently avoids the fact that eight states and one territory defaulted in the 1840s. Thirteen states repudiated their debt entirely in the 1870s. And approximately 4,770 municipalities, or 18 percent of the entire municipal bond market, defaulted during the Great Depression.
Bankruptcy: Good or Bad?
The municipal bond industry has always screamed that a bankruptcy filing will deny municipalities any access to borrowing. But given that over-barrowing by state and local governments is the primary risk for default, this is just seen to be the cost of tough love.
Historically, the results of Chapter 9 bankruptcy filings seem beneficial to municipalities and their taxpayers. Orange County, Calif. filed in 1994 after losing $2 billion in speculative investing. After county supervisors tried and failed to convince voters to raise taxes, the county issued layoffs to 4,000 employees (20 percent of staff). And it collected $600 million in a legal settlements from Merrill Lynch, KPMG and others.
Surveys demonstrated that most residents could not identify any lower levels of service and today the county has a stellar AA credit rating. The city of Vallejof iled for bankruptcy after being overwhelmed by municipal bond debt, high wages and pension liabilities. After cutting police and fire by 50 percent, the city discounted $500 million in bond debt and other claims for $6 million.
Only municipalities in 11 states are specifically authorized to file for Chapter 9 bankruptcy. And another 13 states authorize Chapter 9 after approval by some state official or commission. But Harrisburg filed for bankruptcy without “permission” when it became clear the state’s plan was to take over the city, quickly sell the assets and raise taxes to pay off bondholders.
The day after Harrisburgfiled bankruptcy, the Jefferson County, Ala. sewer district board met to consider filing Chapter 9. After defaulting on $3.14 billion in municipal sewer district bonds, JP Morgan had already offered $647 million to settle bribery charges. But even after the settlement, the district would still need to permanently raise local sewer bills from $63 to $395 a month to pay off their municipal bond debt.
When the county’s bankruptcy lawyer, Ken Klee, was asked by Alabama lawmakers what would be the negative if the sewer district filed for bankruptcy, he could not see a negative for the sewer district, but he did believe it “would be like Chernobyl” for other districts’ bond ratings in Alabama. But since the bankruptcy filing, high credit quality issuers in Alabama have already sold billions of new municipal bonds to investors.
State and local governments have been living in a fantasy world where borrowing money was deemed a responsible way to operate huge organizations. Wealthy local individuals fed that fantasy by lending irresponsible amounts of money to bureaucrats. In a post-Lehman Brothers world, corporate bondholders of insolvent companies have had to suffer “cram-downs” of part of their debt to establish a more sound financial position for the company to survive.
The bottom line for over-indebted and over-taxed municipalities is they need to stop borrowing money. If they are insolvent and need to consider filing for Chapter 9 bankruptcy, the key question they ask is: “Are we better off continuing as debt slaves?” The answer will be usually be no.
Street was treasurer of Orange County, Calif. and blogs at Chriss Street And Company. His recent book is, “The Third Way: Public-Sector Excellence Through Leadership and Cooperation”
June 19, 2013