This Just In: Thousands of Secret Municipal Bond Defaults

The Washington Post, New York Times and other media are reporting on a Federal Reserve blog post revealing the existence of over 2500 municipal bond defaults not previously reported by the major rating agencies. Before municipal bond investors panic, we need to consider several points.

First, this large number of defaults should be considered in the context of the number of issuers and the length of time examined. There are approximately 60,000 municipal bond issuers and this number has not changed that much in recent decades. The Fed data contains 2521 defaulting issuers for the 42 year period ending 2011. That represents an average of about 60 defaults annually and an average annual default rate of roughly 0.1%.

Second, similar default statistics have been reported before. Anyone who subscribes to Richard Lehmann's Distressed Debt newsletter and database knows that he has cataloged about 3500 municipal bond defaults since 1980 (this number refers to the number of defaulting bonds rather than bond issuers - which is one reason that it is higher than the Fed's number). Lehmann's data was summarized in a 2011 Kroll Bond Rating Agency Municipal Default study that I co-authored. So the Fed's findings really aren't news.

Third, as mentioned in the Fed blog post and elsewhere, the vast majority of the defaults are not General Obligation or tax supported issues of states, cities, counties, towns or villages. Instead, they are mostly revenue bonds financing specific projects or facilities. So these situations should not be conflated with the cases of Stockton or San Bernadino.

Finally, most of the defaulting issuers are quite small. For example, as Bloomberg reported recently, a large concentration of municipal bankruptcy filings occurred in Nebraska.

Almost all of these filings were by Sanitary and Improvement Districts (or SIDs). Approximately 45 of these districts have filed municipal bankruptcy petitions since 1982. The bulk of these bankruptcies have occurred in Douglas and Sarpy counties. Douglas County includes the City of Omaha, while Sarpy County includes most of Omaha’s southern suburbs.

SIDs finance sewer, lighting, paving and other improvements in unincorporated areas selected by developers for the creation of new subdivisions. Costs for these improvements are financed by special property tax assessments on lots within the subdivisions. Bonds are often financed by the SID with special assessment revenues, typically collected over a period of ten years, generating funds to redeem the bonds. SIDs are typically quite small, encompassing one subdivision or a small number of subdivisions. Most of the bankrupt SIDs I examined had fewer than 200 lots. Their size is thus similar to that of a Home Owners Association, although the range of services provided differs.

So the conclusion is that a lot of small revenue bond issuers have defaulted over the years. This is not news and should not fundamentally alter the perception that municipal bonds in general - and tax supported bonds issued by states and larger cities - have relatively low default risk.

Agency Shortcuts and Shortfalls

Investors in certain "AAA" resecuritizations won't be happy. Late last night, Moody's downgraded a bunch of securities, even though they are supported by Agency-guaranteed RMBS.

Many of these were downgraded from Aaa to junk (some at Ba1, others all the way to B1) in one fell swoop, while others went only to A1.  (It looks like S&P still carries most of these securities at AA+, which is lower than Moody's Aaa as S&P has downgraded the United States to AA+.)

What's most interesting here is the reason.  It's not the case that either Fannie or Freddie hasn't paid up on their guarantees, but it looks like the deals may not have been modeled (possibly ever!) - or at least may not have been modeled correctly.  According to their press release, the resecuritization vehicles seem not to have the necessary protections in place to support the bonds issued, or the ratings provided.  Some of these deals were structured in 2007 and even late 2008.  Many of these deals are already suffering shortfalls.

From Moody's press release:

"The downgrade rating actions on the bonds are a result of continual interest shortfalls or lack of adequate structural mechanisms to prevent future interest shortfalls should the deals incur any extraordinary expenses."

... and ...

"Interest due on the resecuritization bonds is not subject to any net weighted average coupon (WAC) cap whereas interest due on some of the underlying bonds backing these deals is subject to a net WAC cap."

... and ...

"Since the coupon on the resecuritization bonds is currently higher than that of the underlying bonds, the resecuritization bonds are experiencing interest shortfalls which on a deal basis are accruing steadily."

Total issuance of $483mm affected, according to Moody's. Deals are of Structured Asset Securities Corp. and Structured Asset Mortgage Investments shelves.

Relevant CUSIPs Downgraded Last Night
86363TAA4
86363TAC0
86363TAD8
86363TAF3
86363TAG1
86363TAB2
86363TAH9
86363TAJ5
86365HAA8
86365HAB6
86365HAD2
86365HAG5
86365GAA0
863594AA5
86359LPA1
86359LPB9
86359LPC7

Marc Joffe Discusses Pros of Open Source Rating Models for Sovereigns / Munis

On Friday night, PF2 consultant Marc Joffe was profiled on The Lang and O’Leary Exchange, a popular Canadian business program.



http://www.cbc.ca/player/News/Business/ID/2258963934/

LIBOR and Transparency

Americans obsessing over last week’s healthcare decision or zoning out ahead of July 4th may have missed the latest episode in the financial industry corruption soap opera. Last week. Barclay’s agreed to pay a $453 million fine for misreporting the rates at which it borrowed funds to the British Bankers Association, thereby distorting the value of the London InterBank Offer Rate (LIBOR). The bank’s Chairman and COO have both stepped down.

This instance of financial industry malfeasance appears to lack the compelling narrative needed to upset the general public. For those advocating on behalf of the “little guy”, this scandal may lack appeal, since most of the LIBOR manipulation appears to have been downward -thereby lowering mortgage rates paid by ordinary borrowers. Financial industry critics seem less concerned by the fact that many “little guys” who directly or indirectly invest in LIBOR-based vehicles were cheated out of some income. Journalists and bloggers have thus focused their ire on the rich and powerful individuals who have been caught cooking the books. This is unfortunate, because chopping off a few heads is not the real solution. As we will see in the coming days and weeks, misreporting of bank borrowing rates was pervasive. It is simply too tempting for most of us mortals in the financial industry to resist.

Rather than focus on the people involved or expect bank executives to morph into Mother Theresa, we should instead direct our attention to fixing the institutional framework. The problem is with how LIBOR and many other financial market prices and rates are estimated and reported. The systems we have are too easy to game and the benefits of gaming them are simply too great to resist.

In the case of LIBOR - as with bank loan prices and CDS spreads - the mechanism involves dealers reporting their bids and offers to a data aggregator, like Thomson Reuters or MarkIt. The aggregator then averages the reported quotes, often dropping the highest and lowest marks from the composite. As we’ve now seen, these dealer quotes are subject to manipulation. In less liquid markets, they may not be updated regularly since the dealer does not see new bids or offers. In either case, the composite marks reported by the aggregator do not reflect actual value.

This should concern everyone (who pays taxes to bail out banks), because it means that we don’t really know what most bank assets are worth. A better alternative would be to require all bank transactions to be reported and made publicly available. Reporting should be real time, easily accessible on the internet and as detailed as possible. Specifically, consumers of the data should be able to identify inter-dealer trades that may be executed for the purpose of manipulating mark-to-market prices.

Comprehensive transaction reporting will not be welcome by many in the financial industry. Although the major complaint may revolve compliance costs, these should be minimal, since banks already have to collect all of the transaction data for their internal systems. The real concern will be the loss of income suffered by traders, who realize significant gains from the opaqueness of many markets. Of course, that issue is much less of a concern for the rest of us.

With a few spectacular exceptions, prices of equities and other exchange traded products have proven trustworthy because of their relative transparency. By making markets for bank funding, asset backed securities, derivatives and exotic fixed income instruments more transparent, we can restore trust in quoted prices, enhance liquidity and increase the stability of our financial system.

Rather than simply scapegoating those who were caught, let’s use the LIBOR scandal as an opportunity to provide more transparent and reliable pricing not only to the market for short term bank financing, but to all markets touched by our “too big to fail” financial institutions.

One Bond - Three Prices

The challenges of appropriately pricing illiquid assets have returned, with JPMorgan reportedly having valued the same trades at different prices in separate departments of the bank.  To be fair, the current pricing regime enables these types of discrepancies to occur, and it makes it difficult to catch them.

But this time, the problem was big enough to get some attention.  From Bloomberg's JPMorgan CIO Swaps Pricing Said To Differ From Bank:

The discrepancy between prices used by the chief investment office and JPMorgan’s credit-swaps dealer, the biggest in the U.S., may have obscured by hundreds of millions of dollars the magnitude of the loss before it was disclosed May 10, said one of the people, who asked not to be identified because they aren’t authorized to discuss the matter.

We've been writing about this problem for while - that in some cases hedge funds, banks and insurance companies can all carry the same asset at a different price. In illiquid markets, the price differential between two price providers can be extraordinary, creating an opportunity for lesser-regulated financial institutions to profit handsomely from the regulatory arbitrage available, at the expense of their more heavily-regulated counterparts.

The problem here is the same as with “ratings shopping,” where market participants seek the highest ratings on their securities.  Here, investors are financially incentivized to seek out the highest value they can find for each security: funds’ performance (and often their managers' bonuses) is directly determined from the valuations of their assets. Stronger performance, whether real or artificial, can even help a fund or company raise new capital.

In yesterday's Financial Times, Michael Mauboussin and Alfred Rappaport added to the conversation on pricing transparency. A solution they put forward is to add more meaningful disclosure around the asset pricing, rather than reporting a single estimate. Their approach isn't novel, but it's worth consideration.  They suggest a three-pronged approach: 

This type of controversy vanishes when there are three estimates. Fire-sale prices are appropriate for the pessimistic estimate if it is likely that creditors or regulators will force the bank to sell assets to stay afloat. The optimistic scenario reflects the present value of holding the securities until market prices recover. The most-likely estimate lies in between. This disclosure acknowledges that there is no right answer, only a range of possibilities.

We're interested to hear what you think.

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For a list of problematic asset pricings, click here.
For our suggestion of one solution to the problem, click here.
For more on this, including Citi CEO's Vikram Pandit's proposal and that of Barclays' Group Finance Director Chris Lucas, click here.

The Safety of State Bonds: A Historical Perspective

By Marc Joffe

The last state general obligation bond default occurred in 1933. Yet many state GOs yield significantly more than US Treasury bonds, reflecting investor fears of future defaults. While past results are no guarantee of future performance, history does offer investors valuable insights into our present situation.

As Table 1 shows, state and territorial bond defaults were relatively frequent during the 19th century.

Table 1. List of State Bond Defaults.

State	Default	Cure	Source	Notes
Alabama	c. 1870		New York Times (1930)
Arkansas	1/1841	7/1869	English (1996)	Some bonds repudiated in 1884
Arkansas	3/1/1933	1941	KBRA (2011)
Florida	1/1841	2/1842	English (1996)	Territory; Debt repudiated
Florida	c. 1870		Ratchford (1941)
Georgia	c. 1870		New York Times (1930)
Illiniois	1/1842	7/1846	English (1996)
Indiana	7/1841	7/1847	English (1996)
Louisana	2/1843	1844	English (1996)	Some bonds repudiated
Louisiana	3/1/1933	5/20/1933	KBRA (2011)	Due to failure of Hibernia Bank
Maryland	1/1842	1/1848	English (1996)
Michigan	7/1841	7/1849	English (1996)	Some bonds redeemed at 30%
Minnesota	1860		Ratchford (1941)
Mississippi	3/1841	11/1852	English (1996)	Mostly repudiated
Missouri	c. 1870		Smythe (1904)
North Carolina	c. 1870		New York Times (1930)
Pennsylvania	8/1842	2/1845	English (1996)
South Carolina	c. 1870		New York Times (1930)
South Carolina	7/15/1932		KBRA (2011)	No loss of principal or interest; maturing bonds were redeemed with new bonds rather than cash.
Tennessee	c. 1870		Ratchford (1941)
Texas	c. 1930		KBRA (2011)	Interest and principal not remitted to certain state-controlled funds; individual investors do not appear to have been impacted.
Virginia	c. 1870		Ratchford (1941)
West Virginia	c. 1870		New York Times (1930)

Sources:

English, W. B. (1996). Understanding the Costs of Sovereign Default: American State Debts in the 1840's. The American Economic Review, 86, 259-275.

Kroll Bond Rating Agency (2011). An Analysis of Historical Municipal Bond Defaults Lessons Learned – The Past as Prologue.

New York Times. Old Repudiated Debts that Stir the British. August 10, 1930. Page X12.

Ratchford, B. U. (1941). American State Debts. Durham, NC: Duke University Press.

Smythe, R. M. (1904). Obsolete American Securities and Corporations. New York: R. M. Smythe.

Most of the 19th century defaults occurred in two waves: one that followed the Panic of 1837 and the other following the Civil War. The first wave of defaults happened after a number of states made heavy investments in canals and state-chartered banks. In the deflationary years that followed the 1837 financial collapse, eight states and the territory of Florida failed to service their obligations. A recent article by Jeff Hummel provides an excellent summary of this situation, along with references for further reading.

The post-Civil War defaults were concentrated in ravaged Southern states, many of which took on substantial loads of debt under “carpetbagger” controlled governments. The carpetbaggers – northerners who came down south with their possessions wrapped in old carpets – seized control of some state governments, issued bonds and then kept much of the proceeds. When local politicians regained control of state governments, they deemed the carpetbagger-incurred debt as illegitimate and repudiated it.

Since the 19th century, all states with the exception of Vermont have implemented balanced budget requirements and other restrictions on debt issuance. As a result, state bonded indebtedness as a percentage of GDP has remained relatively low, while the national debt has skyrocketed.

During the 20th century, there was only one case in which a state bond default resulted in losses for individual investors: the Arkansas default of 1933. Arkansas got into trouble after assuming a large volume of road bonds issued by local governments during the 1920s. This heavy debt load combined with sharply decreased property tax collections (the result of falling property values during the Depression) rendered the state insolvent.

Many readers will undoubtedly be skeptical of state balanced budget requirements given the many news reports of politicians circumventing these restrictions. While elected officials do employ many gimmicks, they also impose real spending cuts and revenue enhancements when closing budget gaps. The result is some growth in debt burdens, but not nearly enough to trigger a solvency crisis. Professors Daniel Bergstresser and Randolph Cohen provide a detailed discussion of constitutional balanced budget rules, methods used to circumvent them and their overall restraining influence in a recent Harvard Business School paper.

Evaluating a Government’s Debt Burden

A government’s debt burden is often stated in terms of a Debt-to-GDP ratio. This ratio scales debt to the size of the economy, thus providing a more consistent measure across political subdivisions with varying populations and wealth. The Bureau of Economic Analysis reports US GDP by State. This BEA measure is called Gross State Product (or GSP). The Census bureau collects state and local government financial data (including indebtedness) each year, with the most recent data being available for Fiscal 2009. By combining the BEA and Census data set, we can measure Debt/GSP by State, as we do in Table 2.

Table 2. Debt/GSP Ratio By State, 2009

State	Total Debt	Gross State Product	Debt/GSP Ratio
Alabama	8,155,943	166,819,000	4.89%
Alaska	6,589,698	45,861,000	14.37%
Arizona	12,324,879	249,711,000	4.94%
Arkansas	4,135,051	98,795,000	4.19%
California	134,571,934	1,847,048,000	7.29%
Colorado	17,202,374	250,664,000	6.86%
Connecticut	28,394,151	227,550,000	12.48%
Delaware	5,984,645	60,660,000	9.87%
Florida	38,885,422	732,782,000	5.31%
Georgia	13,455,164	394,117,000	3.41%
Hawaii	6,880,242	65,428,000	10.52%
Idaho	3,501,676	53,661,000	6.53%
Illinois	56,962,364	631,970,000	9.01%
Indiana	23,711,889	259,894,000	9.12%
Iowa	6,353,306	136,062,000	4.67%
Kansas	5,857,295	122,544,000	4.78%
Kentucky	13,364,138	155,789,000	8.58%
Louisiana	17,504,772	205,117,000	8.53%
Maine	5,297,276	50,039,000	10.59%
Maryland	23,472,579	285,116,000	8.23%
Massachusetts	74,597,901	360,538,000	20.69%
Michigan	29,591,278	369,671,000	8.00%
Minnesota	10,524,424	258,499,000	4.07%
Mississippi	6,208,639	94,406,000	6.58%
Missouri	19,217,206	237,955,000	8.08%
Montana	4,723,765	34,999,000	13.50%
Nebraska	2,516,775	86,411,000	2.91%
Nevada	4,444,804	125,037,000	3.55%
New Hampshire	8,411,660	59,086,000	14.24%
New Jersey	56,897,866	471,946,000	12.06%
New Mexico	8,001,721	76,871,000	10.41%
New York	122,651,630	1,094,104,000	11.21%
North Carolina	19,910,714	407,032,000	4.89%
North Dakota	1,888,148	31,626,000	5.97%
Ohio	27,949,184	462,015,000	6.05%
Oklahoma	9,855,393	142,388,000	6.92%
Oregon	12,678,820	167,481,000	7.57%
Pennsylvania	41,924,042	546,538,000	7.67%
Rhode Island	9,180,938	47,470,000	19.34%
South Carolina	15,313,021	158,786,000	9.64%
South Dakota	3,626,024	38,255,000	9.48%
Tennessee	4,847,786	243,849,000	1.99%
Texas	30,438,160	1,146,647,000	2.65%
Utah	6,267,888	111,301,000	5.63%
Vermont	3,426,670	24,625,000	13.92%
Virginia	24,301,179	409,732,000	5.93%
Washington	24,603,219	331,639,000	7.42%
West Virginia	6,501,995	61,043,000	10.65%
Wisconsin	20,913,355	239,613,000	8.73%
Wyoming	1,320,852	36,760,000	3.59%
50 State Total	1,045,339,855	13,915,950,000	7.51%

By international standards, these ratios are quite low – well below those of the US federal government and other major Western countries. They also compare favorably to large Canadian provinces such as Quebec and Ontario – which had bonded debt to gross product ratios of 44% and 30% respectively in 2009 (according to public accounts documents filed by each province).

Also, it is worth noting that the Census debt totals include much more than a state’s general obligation bonds. These totals also incorporate revenue bonds, industrial revenue bonds, pollution control bonds, special assessment bonds, certificates of participation (COPs), judgments, mortgages and construction loan notes (CLNs) – which are generally junior to general obligations.

When assessing states and national governments, rating agencies often consider the ratio of interest expense to revenue. This ratio is more useful that Debt/GDP because it also reflects the impact of interest rates and the government’s ability to derive revenue from the economy. Japan, for example, can sustain very high Debt/GDP ratios (above 200% by some measures) because it faces very low interest rates. Governments that have relatively limited ability to extract revenue like Greece (due to tax evasion) and the US federal government (due to difficulty of passing tax increases) may face crises at lower levels of Debt/GDP. American states also face lower ceilings on their Debt/GSP ratios because their ability to raise tax rates is limited by the relative ease of relocating to another state (as opposed to another country).

Table 3 shows Interest Expense to Revenue ratios based on Census data.

Table 3. Interest Expense to Total Revenue, 2009

State	Interest Expense	Revenue	Interest/Revenue Ratio
Alabama	340,732	20,504,479	1.66%
Alaska	310,326	9,001,893	3.45%
Arizona	508,006	23,232,724	2.19%
Arkansas	161,048	12,879,574	1.25%
California	6,220,851	113,389,307	5.49%
Colorado	805,668	10,336,795	7.79%
Connecticut	1,432,900	20,931,946	6.85%
Delaware	284,055	5,787,487	4.91%
Florida	1,480,969	45,602,974	3.25%
Georgia	660,288	33,614,408	1.96%
Hawaii	432,964	6,751,116	6.41%
Idaho	180,803	5,537,466	3.27%
Illinois	2,963,785	40,530,099	7.31%
Indiana	899,488	27,948,706	3.22%
Iowa	252,713	13,207,715	1.91%
Kansas	346,754	11,654,910	2.98%
Kentucky	525,344	18,993,131	2.77%
Louisiana	954,107	23,100,188	4.13%
Maine	268,987	6,468,113	4.16%
Maryland	1,044,928	24,071,623	4.34%
Massachusetts	3,736,377	37,260,774	10.03%
Michigan	1,147,573	47,714,878	2.41%
Minnesota	526,994	22,781,153	2.31%
Mississippi	218,614	14,375,357	1.52%
Missouri	847,712	17,937,884	4.73%
Montana	167,993	4,828,033	3.48%
Nebraska	108,050	7,380,731	1.46%
Nevada	212,010	7,531,884	2.81%
New Hampshire	391,573	5,639,852	6.94%
New Jersey	2,139,595	42,946,396	4.98%
New Mexico	324,507	9,643,066	3.37%
New York	5,505,131	92,112,356	5.98%
North Carolina	637,401	30,150,407	2.11%
North Dakota	146,457	4,372,683	3.35%
Ohio	1,445,927	24,961,252	5.79%
Oklahoma	490,185	17,428,959	2.81%
Oregon	456,106	7,507,145	6.08%
Pennsylvania	1,823,759	38,795,484	4.70%
Rhode Island	437,293	4,710,553	9.28%
South Carolina	780,304	19,897,729	3.92%
South Dakota	135,135	2,436,934	5.55%
Tennessee	236,118	18,750,827	1.26%
Texas	1,242,925	82,053,694	1.51%
Utah	243,708	8,783,428	2.77%
Vermont	164,354	4,559,365	3.60%
Virginia	919,732	26,224,905	3.51%
Washington	1,110,674	24,476,808	4.54%
West Virginia	246,458	11,112,547	2.22%
Wisconsin	1,262,365	8,518,436	14.82%
Wyoming	64,221	4,787,884	1.34%
50 State Total	47,243,967	1,123,226,058	4.21%

These ratios reflect each state’s total revenue – not just its general fund revenue – and its interest expense on all bonds – not just general obligations.

When Arkansas defaulted in 1933, its interest to revenue ratio was about 30% - well above the level in any other state at the time and well above present levels. The only two other defaults during the last century by governments similar to US states in comparable nations (New South Wales, Australia in 1931 and Alberta, Canada in 1936) also occurred after the interest to revenue ratio exceeded 30%.

Applicability to Today

Could a state default with an interest to revenue ratio significantly below 30%?  While any financial result is possible, it is highly unlikely. Default is a political decision in which elected officials balance two considerations: (1) inability to spend money on programs due to debt service expenses versus (2) embarrassment and loss of bond market access by defaulting.

When interest expenses are a relatively low proportion of revenue, defaulting does not make any political sense. Indeed, defaulting makes much less political sense now than it did in the 19th century or during the Great Depression.

Most state debt in the 19th century was held in Europe. In 1933, most Arkansas debt was held by investors in other states - in New York and elsewhere. With the inception of state income taxes and their exclusion of most in-state municipal bond interest, a very large proportion of state bonds are now owned by high income residents. Since the bonds are in the hands of voters and campaign contributors, the choice to default is even more politically suicidal than in was in the 1930s.

Pensions and Retiree Benefits

Fears about current state credit quality center around public employee pensions and other employee benefits.  The size of this problem – from a credit standpoint – is often exaggerated because the unfunded liability is juxtaposed with the state’s annual budget. Since the unfunded liability is payable over many years, this comparison is faulty. Further, unfunded liabilities quoted in the media often apply to an entire pension system, whose costs are only partially borne by the state. For example, the State of California is responsible for only about 36% of the beneficiaries in the CalPERS system (according to page 151 of the CalPERS 2011 Comprehensive Annual Financial Report.

Underfunded state employee pensions are nothing new. The problem was also common in the 1970s and early 1980s – the last period of extended poor stock market performance – and did not produce any general obligation defaults. Statistics published by Alicia Munnell and her colleagues at the Boston College Center for Retirement Research show that pension contributions as a proportion of state budgets have yet to return to the peaks reached thirty years ago.

Unfunded retiree health benefits have also been a constant. While it is true that health care costs have risen substantially in recent decades, much of this extra cost is borne by Medicare.

Conclusion

When considering the risk of a state G.O. bond default, investors should be careful to separate their political views from actionable investment information. Inadequately funded retirement plans and political evasions of balanced budget requirements are bad public policies – worthy of criticism in the court of political opinion. Whether these issues are serious enough to trigger an outright default on principal and interest payments, is a very different question, and one that is best answered through historical research and quantitative analysis.

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Marc Joffe is a consultant with PF2 Securities Evaluations, which recently published an open source Public Sector Credit Framework. In 2011, he researched and co-authored Kroll Bond Rating Agency’s municipal bond study. Prior to that, Marc was a Senior Director at Moody’s Analytics. Marc owns State of California bonds.