Over the last two years, we’ve noticed a shift in thinking on the part of distressed municipalities tinkering with the idea of filing for bankruptcy. With Harrisburg’s attempted bankruptcy filing and Jefferson County’s filing, both in late 2011, we saw municipalities default due to exposure to enterprises such as leveraged sewer systems, convention centers, and other projects backed by the government, where the related obligations were left to fail (source: Moody’s). In these cases the ability (or, rather, inability) of these municipalities to pay debt service was the deciding factor in pursuing bankruptcy or some other type of remediation (source: Moody’s).
In contrast to the filings of 2011, the recent decisions by the California cities of Stockton and San Bernardino may indicate a paradigm shift that we consider to be quite disturbing. This is the use of bankruptcy to get concessions from labor unions, suppliers, and bondholders. This has created a shift in how we think about defaults in the municipal market, placing emphasis on an issuer’s willingness to pay versus its ability to pay. This raises questions for both Cumberland Advisors and municipalities in their treatment of debt: is debt service a discretionary item? Is walking away from debt “OK,” similar to walking away from a mortgage? And is bankruptcy no longer an anathema? (source: Municipal Market Advisors) Never before, especially in the current “anti-Wall Street” era in which we find ourselves, has it been more important for us to assess an issuer’s willingness, in addition to its ability, to pay.
In this commentary, we will examine the city of San Bernardino as a case study of an issuer’s lack of willingness to pay debt service. The natural question to ask would be, under what circumstances does a reduced willingness to pay hurt bondholders? We believe that the political sentiment of the subject municipality and, by extension, its management, is a deciding factor. Given strong anti-Wall Street sentiment and a dislike of tax increases, the city of Stockton decided to force the majority of the burden onto bondholders. Structurally imbalanced operations and poor fiscal management over decades were what caused San Bernardino to authorize a bankruptcy in early July of this year: this was a political decision. Political sentiment was such that unsustainable budget deficits required a bankruptcy process to be put into place to reduce political strains involved with personnel, spending cuts, and debt service. However, with debt service only a small fraction of expenses, this is an example of unwillingness to pay, where clearly, over the past decade, it would have been possible for the municipality to reverse its course and reduce expenditures.
San Bernardino stunned municipal market participants and other stakeholders two weeks ago with its authorization to forego California-mandated mediation with creditors and vote to file for Chapter 9 bankruptcy protection (yes, authorization for a vote, and not an actual filing). As bond investors, we find there are common forces at work impacting the credit quality of San Bernardino and other non-coastal credits in California: lack of multi-year budgetary planning; poor disclosure and, in some cases, fraud; structurally imbalanced operations; and lack of reasonable plans (for bondholders, at least) to alleviate stress.
Compounding these problems, in the coming years, these cities will have to deal with poor demographics and weakened local economies, weakened housing markets, and burdensome personnel costs, which will detract from their ability to manage through the difficult post-recession environment. Given the current deflationary climate, San Bernardino will struggle to generate the funds needed to service its expenditures, 85% of which are personnel costs and are rapidly increasing faster than revenues. The likelihood of immediate improvement is low.
These problems sound unmanageable, insofar as municipalities are victim to their immediate surroundings and recessionary cyclicality has increased their credit stresses to the point that they are unable to pay debt service. A closer look at the problem, however, leads us to conclude that San Bernardino’s ability to pay remains intact. In reality, the city’s political motivations are the root cause of the unsustainable budgets over the past decade. The city’s economic and demographic issues have obviously not helped, but bankruptcy is seen as a way to break these tensions, a way of punting the issues. California’s AB 506 creditor mediation process can be bypassed upon declaration that the city cannot pay its obligations within the span of the required 60-day process. It does not seem likely the city council realized on July 10th they would be unable to make early August payroll, after a decade when pension costs quintupled.
The motivations of San Bernardino are clear, and asking bondholders to participate is not necessary, given the small size of debt service payments in relation to other expenditures. Bankruptcy may seem most palatable to municipalities at first, but we’re reminded of the bankruptcy of the city of Vallejo that lasted three years, left the city with little in the way of services, higher crime, $12 million in legal fees, and the likelihood of no bond market access for years to come.
The question from a portfolio manager’s perspective is whether this emerging trend will create a domino effect among the more stressed-out municipalities in California. In other words, does the existence of more municipalities filing (or contemplating filing) for Chapter 9 bankruptcy remove the stigma of bankruptcy and make it more likely for other issuers to file, or to at least seek mediation?
At this point, we do not believe this will become a “beggar thy neighbor” series of filings, but we will be watching closely. The penalty for municipalities is that future access to the capital markets will carry with it much higher-than-market yields, affecting not only the bankrupt communities but others that are close by, as well. That is why states such as Pennsylvania and Rhode Island have been proactive in trying to prevent municipalities from filing or, if they do, encouraging them to continue to pay debt service (as in the case of Rhode Island, with Central Falls).
As property taxes are the largest source of revenue for local governments, and are used to finance local services and pay debt service (source: Rockefeller Institute), we have maintained a bias toward stronger credits and revenue-backed, essential-service credits in the G.O. space. Historically, property taxes have been very stable but the housing bubble and Great Recession have hurt local government tax collections (source: Rockefeller Institute). Based on conclusions reached from a piece by the Rockefeller Institute of Government, dated July 2012, “prolonged weakness in the property tax” and possible spending cuts in Washington are expected to create budget problems in many parts of the country for local governments.
Luckily, as our friend John Dillon points out in his “Municipal Market Monthly,” dated July 24, 2012, during the past year the municipal market has done well in “compartmentalizing distressed issuers while enabling the rest of the marketplace to function properly and efficiently,” which contrasts with investor anxiety about 18 months ago during the Meredith Whitney faux-crisis. We have seen a lower systematic risk element in munis relative to Treasury rates and believe there to be considerable increase in return per unit of risk through investing in munis versus taxable spread product, with the added benefit of additional upside, should ratios snap back to historical norms. The long end looks most attractive to us (MMA/Treasury = 1.62), given the Fed’s promise to stay on hold until 2013.
We will keep readers informed of developments.