Tweet
http://www.teamthronson.com/docs/Mun...Bankruptcy.doc
Municipal Corps didn't fail in full swing until 1932, how long before we see that kind of action in this present credit contraction?
Municipal Bankruptcy:
A Study of the Unique Characteristics and
Discussion of Common Causes
Eric Jerome Thronson
Advanced Financial Management
Professor Granof
May 2, 2007
Laws addressing both personal and private-business bankruptcy in the United States have many of the same attributes and objectives. Although similar to the other chapters of bankruptcy code in some respects, chapter 9 (municipal bankruptcy law) is significantly different in many ways. For example, unlike personal and business bankruptcies, municipal bankruptcy is an entirely voluntary action; creditors cannot force a municipality into bankruptcy. It is also a much rarer event than private bankruptcies.
The very idea of a municipality being unable to pay its debts is slightly incongruous. With its ability to tax, access to revenue is only limited by the wealth of the population within its jurisdiction, and services can be discontinued, bringing expenditures on anything but debt service to zero. In reality, however, there are practical limits to both taxing authority and the extent to which municipalities can eliminate services. Local governments need to be able to provide demanded services and balance their budgets against constrained resources. In fact, budgetary balance is a concise metaphor and symbol of fiscal integrity and prudence; a simple summary measure of overall capacity to govern.
These and other aspects of municipal default or bankruptcy make this topic both under-addressed and misunderstood. Municipal bankruptcy has received little attention in the legal literature, apparently of too little practical importance to legal professionals due to the small number of cases historically. And when local governments are in a situation where bankruptcy may be the most prudent option, officials often choose to ignore it for fear of the political repercussions that may result, such as recently in San Diego. Mr. Shea, appointed by a federal court to represent the small municipalities involved in the default of Orange County, California, believes that if Chapter 9 proceedings were called “a generous adjustment” instead of “bankruptcy”, his home city, San Diego, would be on its way back to financial health much more quickly than it currently finds itself. Hopefully, with some history, background, and better-defined characteristics, we can avoid the fear of municipal bankruptcy and recognize it as a necessary component of the free market, while seriously considering some of the causes in order to minimize threat of default in the future.
HISTORY
Historically, there was no recourse for investors to recoup losses when a municipality chose to default on debt.
In the absence of federal statutory law, the question of municipal default was governed by state statute and the state and federal common law. During this period, the law of municipal bankruptcy was the law of creditors’ remedies. Cities could not declare bankruptcy, but they could – and frequently did – fail to pay their debts. Thus, the legal question was: what could the courts do to compel cities to meet their financial obligations? Among the remedies creditors of a municipality might seek were: 1) seizure of city property; 2) judicial oversight of city affairs, including limitations on expenditures that would divert funds away from debt service; 3) seizure of private property within the city; 4) state assumption of municipal indebtedness; 5) obtaining a lien on future tax revenues; and 6) imposition of new taxes earmarked for debt service.
What is interesting is that each of these options, except the last, was taken from recourses available to private bankruptcy. Seizure of assets and judicial supervision of financial affairs help ensure that the debtor does not make unnecessary or unreasonable expenditures that reduce its ability to pay its debts. Seizing private property is analogous to piercing the corporate veil; this forces the real owners of the corporation to assume its obligations. Requiring the state to assume municipal obligations is analogous to requiring a parent corporation to assume the debts of its subsidiary. A lien on future taxes is similar to garnishing the wages or obtaining a lien on future income. However, the final alternative, requiring an imposition of new taxes for strictly debt service, while unlike anything in the private bankruptcy world, was usually the only one available in practice for creditors before federal action was taken in the early twentieth century.
According to a Time Magazine article from Monday, June 12, 1933, “To Washington a fortnight ago trooped two score mayors of two score debt-ridden cities all looking for Federal loans. All they got was sympathy.” President Roosevelt was hesitant to loan funds to municipalities for fear of overwhelming demand and also worried that local governments would have to surrender their independence by accepting the money. However Congress enacted the first municipal bankruptcy legislation in 1934 during the Great Depression, which was revised in 1937 and upheld by the Supreme Court. Finally there was recourse for fiscally-failing municipalities. In the 60 years since Congress established a federal mechanism for the resolution of municipal debts, there have been fewer than 500 municipal bankruptcy petitions filed.
BACKGROUND
The perennial problem of bankruptcy is two-fold. On one hand, those lacking resources need the ability to borrow money in a credible, legally-binding way – otherwise those with resources would be unwilling to lend. On the other hand, at times it becomes impossible to repay a debt, and it is in the best interest of both creditors and debtors to have a system in place to renegotiate or accommodate the restructuring of debt in order to allow the debtor to fulfill contractual promises. From this accommodation comes bankruptcy law and the necessity for such action to be possible – it is in the creditors’ interest to receive some or all returns in a longer timeframe than receive nothing at all, and the assistance granted can enable the debtor to escape a bad situation and continue with life.
Municipalities need the ability to borrow from capital markets for two principle reasons. First, borrowing capital to build long-lived assets, such as roads or power plants, enables the municipality to establish inter-period equity and give those that are benefiting from the asset the ability to pay for it. Second, many public needs require massive undertakings that would be virtually impossible to build in a timely manner without the ability to borrow. Dr. Hildreth explains the municipal capital market as follows:
Regardless of the debt structures used, a hallmark of infrastructure financing in the United States is its decentralized, market-based approach, especially with the withering of intergovernmental grants. There is no federal oversight of state or local bond transactions, either before or after the transaction, save for that very rare occasion where the Internal Revenue Service determines that the bond does not qualify for tax-exempt status. Moreover, very few states impose any comprehensive oversight over local debt creation and repayment. Instead, state and local governments must subject themselves to the demanding requirements of the capital markets, and the penetrating analysts at independent credit rating firms.
Municipal and state governments are able to benefit from efficiencies of the market-based system while taking advantage of the tax-exempt status of their debt, which gives them a competitive edge for capital.
However, by participating in the free market, municipalities become vulnerable to the natural circumstances that have the potential to lead to default. Because municipalities are very different entities from corporations or private businesses, defaulting or filing for bankruptcy is a very unique event. Understnading the unique character of municipal bankruptcy affords a better understanding of the financial life of the city itself.
UNIQUE CHARACTERISTICS
There are many significant differences between the municipal and private bankruptcy codes beyond the aforementioned inability of creditors to force municipalities into bankruptcy; one of the most interesting considerations addresses a basic understanding of bankruptcy protection itself. Bankruptcy law accomplishes more than merely to adjust the debts of entities unable to pay. In the private context, bankruptcy law also serves as a mechanism for reorganization so as to maximize value and minimize the recurrence of financial difficulties. It is the rare corporation that emerges from bankruptcy unchanged, its operations intact and going on as before. Federal municipal bankruptcy law, by contrast, is designed to perform the debt adjustment function without serving the reorganization function. Indeed, the premise of municipal bankruptcy law is that the city will emerge from bankruptcy in the same form – with the same boundaries, resources, functions, and governing structure – with which it entered bankruptcy.
Another interesting aspect of municipal bankruptcy in the United States is the legal limitations of defining insolvency. According to the federal bankruptcy code, 11 U.S.C. Section 101 (32)(C), insolvency is defined “with reference to a municipality, a financial condition such that the municipality is – (i) generally not paying its debts as they become due unless such debts are the subject of a bona fide dispute; or (ii) unable to pay its debts as they become due…”. However, as the Bridgeport, Connecticut case illustrates, insolvency rests in terms of cash flow, not budgetary balance. Bridgeport’s attempt to file bankruptcy was foiled by its failing, but still measurable, fiscal health; because it was able to pay its debts it was unable to seek bankruptcy protection. However, services had dwindled far below acceptable levels, and without being able to increase expenditures toward these services, revenues were virtually guaranteed to continue diminishing. This narrow definition of insolvency forces municipalities to actually fail before filing for bankruptcy instead of using it as a means of protecting themselves as failure inevitably approaches.
An interesting finding was included in a 2003 report, where Fitch Inc. sought to determine if municipal defaults increased during economic slumps. The report found that, in fact, there does seem to be a moderate correlation between the percentage change in gross domestic product (GDP) and the dollar volume of defaults that occur in a given year; a one-year lag produces a somewhat higher correlation.
Fitch Inc. 2003
As can be seen in the chart above, defaults did in fact spike in relation to GDP decreases. This is a significant component to consider when projecting future trends.
A final unique aspect of municipal bankruptcy, discussed in McConnell’s article, stems from two different ways of conceptualizing a city: as a political subdivision of the state or some larger entity, or as the agent of the citizens who reside within its bounds. The former view of the city, as an arm of the state, suggests that municipal bankruptcy should be treated as an opportunity to dissolve a “subsidiary” of the larger corporation and allow the presumably greater resources of the state cover the needs of the local residents and creditors more efficiently than the municipality was evidently able. The latter view suggests that bankruptcy should allow the dissolution of the municipal corporation into its constituent parts, followed by voluntary reorganization into more efficient and effective units. Either way, bankruptcy law could accomplish more than mere debt adjustment if the traditional definition of a city became less important.
FREQUENCY
From 1990 to 2002, there have been 135 Chapter 9 filings, with the bulk of the filings from land-secured special districts, not general governments, in California, Colorado, Nebraska, and Texas. The 13- to 20- year cumulative default rate on municipal bonds issued from 1979-1986 was 1.49% and low relative to other fixed-income sectors.
Based on a study of defaults in the United States from 1980 to 2002, Fitch Inc. concluded that all municipal debt holders fit broadly into three classifications of default risk. The lowest risk class, consisting of general obligation (GO), tax-backed, and most appropriation-backed debt of state and local governments, suffer extremely few defaults. According to Fitch’s default studies, from 1987–2002, the five- to 15-year cumulative default rates within this class averaged 0.24%, which was less than the 10-year cumulative default rate of 0.43% for ‘AAA’ rated global corporate bonds. The second risk class consists of enterprises that serve essential purposes but are not fully insulated from competition or fluctuations in demand; these have been known to default occasionally but with far less frequency than other fixed-income securities. The five to 15-year cumulative default rates within these sectors averaged approximately 0.70% versus the 10-year cumulative default rate of 0.76% for ‘AA’ rated corporate bonds. The third risk class includes enterprises that must compete against private-sector entities or securities with volatile revenue streams. This class has default risk characteristics similar to corporations, and their five- to 15-year cumulative default rates averaged 3.65% versus the 10-year cumulative default rate of 3.97% for ‘BBB+’ rated corporate securities.
RESULTS OF MUNICIPAL BANKRUPTCY
Resumption of debt service payments is likely the means provided in the bond indenture to cure defaults on tax-backed debt, as well as revenue bonds for projects such as water/sewer facilities or toll roads issued through a trust estate; recoveries are often 100%. Similar to default risk, Fitch, Inc. defines the recovery prospects of municipal bonds in four broad classes. The following are the different classes within which all default risk can typically be included.
The first class, State GO and sales tax-backed debt, is considered the safest in terms of recovery. In the extremely unlikely event a state ever defaulted on its GO or tax-backed debt, it is believed the state would call upon its considerable resources to cure the default in short order. The second recovery class includes local government GO and tax-backed bonds. Recoveries from defaults on these securities are also assumed to be at or near 100%, with the only losses stemming from the time value of money on the delayed payments.
The third recovery class includes state and local leases and certificates of participation (COPs), as well as airports and public power distribution revenue bonds. As in the first two classes, recovery is assumed from resumption in debt service payments, albeit after a longer potential delay. In the case of a COP or lease-backed security, the issuer always has the legal right not to appropriate funds to pay the obligation; however, this would often result in the loss of the issuer’s right to use the asset. Even in cases where the certificate holder has no legal or practical ability to take possession of an asset, it is believed that most lease or COP issuers will ultimately repay their obligations, with few exceptions, to ensure continued access to the capital markets.
The last class consists of securities where enterprises may cease to operate but the bondholder can expect various levels of recovery from the resale value of the assets, as well as securities where bondholders do not have a lien on assets but resumption in debt service may be expected after an extended delay. These can include bonds backed by nursing homes and CCRCs, private higher education institutions, multifamily housing, public power generating facilities, and toll roads. The riskiest debt includes hospital, private prison, stadium, student housing, and tribal gaming bonds.
CONTRIBUTING FACTORS
As with most things, municipal bankruptcy is complicated by numerous factors. However, history points to four typical contributing factors that have traditionally led to default and/or municipalities seeking Chapter 9 protection.
The most common factor attributed to declining fiscal health for municipalities is the changing demographics of the resident population. “Declining tax revenues, matched by rising mandated payments like welfare, and expensive labor contracts have put cities and the politicians who run them into a nutcracker,” said Robert Lamb, the debt advisor to New York City in 1991 while they were struggling to close a $3.5 billion budget gap. Mr. Lamb, though speaking from personal experience, was responding to the unexpected bankruptcy filing of Bridgeport, the largest city in Connecticut. Bridgeport, like scores of others in the Northeast and Midwest, was declining for decades as basic industries moved to cheaper regions and the middle class moved to the suburbs. The Connecticut city became the poster-child for all struggling cities in the US suffering from affluent resident flight, increasing demand on social services and failing infrastructure. This factor will remain one of the most important causes of municipal default, and must be considered in every situation first and foremost.
A second, more recently developing factor leading to threats of municipal default are “creative” solutions to escaping legal borrowing limitations. In the late 1970s and early 1980s state and local governments faced mounting capital needs and limited resources because of high interest rates, inflation and a slowing economy. Managers and officials had to address these increasing needs and shrinking resources by finding alternative ways to finance capital expenditures. As Dr. Hildreth points out, over the past 25 years, issuers have steadily moved toward finding custom solutions to a specific financing need rather than relying solely on long-term, fixed-coupon general obligation (GO) bonds. Lately revenue bonds predominate, not GO bonds. “Creative” ways to avoid debt limits and procedural hurdles have propelled the growth of lease financing, and Certificates of Participation (COPs), the increased use of tax increment financing (TIF), bond banks, and revolving loan funds.
Another increasing contributor to municipal default lies with shifting underlying assumptions, generally resulting from overly-optimistic or even misleading future projections. An example of this can be found in the default of the Washington Public Power Supply System (WPPSS), which, in 1982, defaulted on $2.25 billion worth of revenue bonds. A state court decision allowed local governments to escape their contractual responsibilities to WPPSS, ruling that these municipalities did not have the legal authority to enter into take-or-pay contracts. This led to default on the bonds used to build the plants and infrastructure the utility planned to use to supply these local governments. What prompted the municipalities to seek legal relief was a change in circumstances brought on by unrealistic original energy demand estimates, extended project delays, escalating project costs in a high interest rate environment, and growing political pressures to maintain low power rates. These unrealistic forecasts and estimates gave the utility access to capital it never really had a chance to repay.
Fourth, and most consequentially, the increasing pressure for alternative revenue streams, other than tax revenues, has become a significant contributing factor leading to municipal default concerns – Orange County, California, being the best example of this when, on December 6th, 1994, it became the largest municipality in US history to declare bankruptcy. Though, by itself, Orange County was the 30th largest economic power in the world at the time, the municipal investment pool the county operated on behalf of the hundreds of smaller and neighboring municipalities announced a $1.7 billion loss and incited a virtual “run on the bank”. Many factors led to the Orange County default, but risk-prone investment strategies intended to maximize revenue enabled it to become the crisis that it did.
Much has been made about the individual characters that have lead to some of the largest municipal bankruptcies, principally the Orange County collapse and its infamous villain, Bob Citron. It is well-known that Mr. Citron had problems. Without dwelling on it, the famous quote from Chriss Street, a Republican activist in Orange County, claiming that “there’s nothing worse than a gambler who goes to Vegas and wins the first time,” aptly and succinctly covers Mr. Citron’s issues. However, there are underlying themes to the California crisis that created the opportunity for this to happen in the first place, and these themes are found increasingly often across the country.
The fact is that in many locales, citizen demand for services has outstripped the willingness of citizens to pay. In the face of a constrained public budget environment, public officials and their finance managers have to be creative to achieve desired fiscal goals. Proposition 13, passed in California in 1978, so limited the local governments from raising taxes to pay for expanding services that alternative revenue streams became increasingly important. This pressure has a direct effect on the amount of risk a municipality is willing to absorb. With increased risk comes higher incidence of default; it is the very definition of risk. And with more and more conservative-led state governments threatening the restriction of local taxing revenues, the opportunity for municipal bankruptcy appears likely to increase into the future.
FUTURE CONSIDERATIONS
Changes in the sophistication of municipal capital markets have had many positive effects. Increased accountability, both internal and external to the government, has wedded with enhanced professionalism among municipal finance staff, which increases the capital market appetite for these governments. However, two concerns must be acknowledged by the financial community as we progress in municipal market sophistication.
First, the contributing factors mentioned earlier need to be tracked and well-communicated to both financial directors and potential investors. In particular, the two related factors of creative solutions to debt limitations and growing need for alternative revenue streams are especially significant. Both result from pressure to reduce taxes and spending, but both lead to increasingly riskier alternatives. Increased risk can lead to increased default rates, and if the relative safety and security of public debt is undermined, everyone will ultimately suffer.
Second, the real and increasing possibility of a significant disaster resulting in a reduced population either localized or widespread could undermine the integrity of any “full faith and credit” pledge. In isolated cases, such as the recent disaster of Hurricane Katrina in New Orleans and along the Gulf Coast, the state and federal governments can step in and back debt obligations local governments no longer have the population to repay. But state- or nation-wide catastrophes, such as the impending flu pandemic that experts predict will affect up to half the US population, cannot be so easily remedied. What then? There would be significant financial losses, and, while understandable, the sanctity with which investors typically hold public debt may forever be eroded.
These are but two interesting considerations for the future of public debt. The future of municipal finances and bankruptcy will become increasingly sophisticated and interesting, and hopefully people will begin to realize the intricate nature of the publicly-funded infrastructure they currently enjoy and take for granted, and appreciate it for the miracle that it is.
Bibliography
Granof, Michael H, Government and Not-for-Profit Accounting: Concepts and Practices, John Wiley & Sons, Inc. 2007.
Hildreth, W. Bartley and C. Kurt Zorn, “The Evolution of the State and Local Government Municipal Debt Market over the Past Quarter Century”, Public Budgeting and Finance 25 (4s), pp. 127-153, 2005.
Jorion, Philippe, Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County, Academic Press, 1995.
Judson, George, “New Bridgeport Mayor, Same Old Quagmire”, The New York Times, February 2, 1992.
Lanchner, David C., “New Risk in Municipals After Bridgeport’s Bankruptcy”, International Herald Tribune, July 6, 1991.
Lewis, Carol W, “Budgetary Balance: The Norm, Concept, and Practice in Large U.S. Cities”, Public Administrative Review, Vol. 54, No. 6 (Nov. – Dec. 1994), pp. 515-524.
Litvack, David T, Thomas J. Abruzzo and Mia Koo, Special Report: Default Risk and Recovery Rates on U.S. Municipal Bonds, Fitch Ratings, 2006.
Litvack, David T and Mike McDermott, Special Report: Municipal Default Risk Revisited, Fitch Ratings, 2003.
McConnell, Michael W. and Randal C. Picker, “When Cities Go Broke: A Conceptual Introduction to Municipal Bankruptcy”, The University of Chicago Law Review, Vol. 60, No. 2 (Spring 1993), pp. 425-495.
Shea, Patrick, “The Case for Municipal Bankruptcy”, The San Diego Tribune, February 18, 2005.
WEBSITES
“Municipal Bankruptcy”, Time Free Archive website, http://www.time.com/time/magazine/ar...745673,00.html,
last accessed April 30, 2007.
“US Courts: Bankruptcy Basics” website, http://www.uscourts.gov/bankruptcyco.../chapter9.html,
last accessed April 30, 2007.
A Study of the Unique Characteristics and
Discussion of Common Causes
Eric Jerome Thronson
Advanced Financial Management
Professor Granof
May 2, 2007
Laws addressing both personal and private-business bankruptcy in the United States have many of the same attributes and objectives. Although similar to the other chapters of bankruptcy code in some respects, chapter 9 (municipal bankruptcy law) is significantly different in many ways. For example, unlike personal and business bankruptcies, municipal bankruptcy is an entirely voluntary action; creditors cannot force a municipality into bankruptcy. It is also a much rarer event than private bankruptcies.
The very idea of a municipality being unable to pay its debts is slightly incongruous. With its ability to tax, access to revenue is only limited by the wealth of the population within its jurisdiction, and services can be discontinued, bringing expenditures on anything but debt service to zero. In reality, however, there are practical limits to both taxing authority and the extent to which municipalities can eliminate services. Local governments need to be able to provide demanded services and balance their budgets against constrained resources. In fact, budgetary balance is a concise metaphor and symbol of fiscal integrity and prudence; a simple summary measure of overall capacity to govern.
These and other aspects of municipal default or bankruptcy make this topic both under-addressed and misunderstood. Municipal bankruptcy has received little attention in the legal literature, apparently of too little practical importance to legal professionals due to the small number of cases historically. And when local governments are in a situation where bankruptcy may be the most prudent option, officials often choose to ignore it for fear of the political repercussions that may result, such as recently in San Diego. Mr. Shea, appointed by a federal court to represent the small municipalities involved in the default of Orange County, California, believes that if Chapter 9 proceedings were called “a generous adjustment” instead of “bankruptcy”, his home city, San Diego, would be on its way back to financial health much more quickly than it currently finds itself. Hopefully, with some history, background, and better-defined characteristics, we can avoid the fear of municipal bankruptcy and recognize it as a necessary component of the free market, while seriously considering some of the causes in order to minimize threat of default in the future.
HISTORY
Historically, there was no recourse for investors to recoup losses when a municipality chose to default on debt.
In the absence of federal statutory law, the question of municipal default was governed by state statute and the state and federal common law. During this period, the law of municipal bankruptcy was the law of creditors’ remedies. Cities could not declare bankruptcy, but they could – and frequently did – fail to pay their debts. Thus, the legal question was: what could the courts do to compel cities to meet their financial obligations? Among the remedies creditors of a municipality might seek were: 1) seizure of city property; 2) judicial oversight of city affairs, including limitations on expenditures that would divert funds away from debt service; 3) seizure of private property within the city; 4) state assumption of municipal indebtedness; 5) obtaining a lien on future tax revenues; and 6) imposition of new taxes earmarked for debt service.
What is interesting is that each of these options, except the last, was taken from recourses available to private bankruptcy. Seizure of assets and judicial supervision of financial affairs help ensure that the debtor does not make unnecessary or unreasonable expenditures that reduce its ability to pay its debts. Seizing private property is analogous to piercing the corporate veil; this forces the real owners of the corporation to assume its obligations. Requiring the state to assume municipal obligations is analogous to requiring a parent corporation to assume the debts of its subsidiary. A lien on future taxes is similar to garnishing the wages or obtaining a lien on future income. However, the final alternative, requiring an imposition of new taxes for strictly debt service, while unlike anything in the private bankruptcy world, was usually the only one available in practice for creditors before federal action was taken in the early twentieth century.
According to a Time Magazine article from Monday, June 12, 1933, “To Washington a fortnight ago trooped two score mayors of two score debt-ridden cities all looking for Federal loans. All they got was sympathy.” President Roosevelt was hesitant to loan funds to municipalities for fear of overwhelming demand and also worried that local governments would have to surrender their independence by accepting the money. However Congress enacted the first municipal bankruptcy legislation in 1934 during the Great Depression, which was revised in 1937 and upheld by the Supreme Court. Finally there was recourse for fiscally-failing municipalities. In the 60 years since Congress established a federal mechanism for the resolution of municipal debts, there have been fewer than 500 municipal bankruptcy petitions filed.
BACKGROUND
The perennial problem of bankruptcy is two-fold. On one hand, those lacking resources need the ability to borrow money in a credible, legally-binding way – otherwise those with resources would be unwilling to lend. On the other hand, at times it becomes impossible to repay a debt, and it is in the best interest of both creditors and debtors to have a system in place to renegotiate or accommodate the restructuring of debt in order to allow the debtor to fulfill contractual promises. From this accommodation comes bankruptcy law and the necessity for such action to be possible – it is in the creditors’ interest to receive some or all returns in a longer timeframe than receive nothing at all, and the assistance granted can enable the debtor to escape a bad situation and continue with life.
Municipalities need the ability to borrow from capital markets for two principle reasons. First, borrowing capital to build long-lived assets, such as roads or power plants, enables the municipality to establish inter-period equity and give those that are benefiting from the asset the ability to pay for it. Second, many public needs require massive undertakings that would be virtually impossible to build in a timely manner without the ability to borrow. Dr. Hildreth explains the municipal capital market as follows:
Regardless of the debt structures used, a hallmark of infrastructure financing in the United States is its decentralized, market-based approach, especially with the withering of intergovernmental grants. There is no federal oversight of state or local bond transactions, either before or after the transaction, save for that very rare occasion where the Internal Revenue Service determines that the bond does not qualify for tax-exempt status. Moreover, very few states impose any comprehensive oversight over local debt creation and repayment. Instead, state and local governments must subject themselves to the demanding requirements of the capital markets, and the penetrating analysts at independent credit rating firms.
Municipal and state governments are able to benefit from efficiencies of the market-based system while taking advantage of the tax-exempt status of their debt, which gives them a competitive edge for capital.
However, by participating in the free market, municipalities become vulnerable to the natural circumstances that have the potential to lead to default. Because municipalities are very different entities from corporations or private businesses, defaulting or filing for bankruptcy is a very unique event. Understnading the unique character of municipal bankruptcy affords a better understanding of the financial life of the city itself.
UNIQUE CHARACTERISTICS
There are many significant differences between the municipal and private bankruptcy codes beyond the aforementioned inability of creditors to force municipalities into bankruptcy; one of the most interesting considerations addresses a basic understanding of bankruptcy protection itself. Bankruptcy law accomplishes more than merely to adjust the debts of entities unable to pay. In the private context, bankruptcy law also serves as a mechanism for reorganization so as to maximize value and minimize the recurrence of financial difficulties. It is the rare corporation that emerges from bankruptcy unchanged, its operations intact and going on as before. Federal municipal bankruptcy law, by contrast, is designed to perform the debt adjustment function without serving the reorganization function. Indeed, the premise of municipal bankruptcy law is that the city will emerge from bankruptcy in the same form – with the same boundaries, resources, functions, and governing structure – with which it entered bankruptcy.
Another interesting aspect of municipal bankruptcy in the United States is the legal limitations of defining insolvency. According to the federal bankruptcy code, 11 U.S.C. Section 101 (32)(C), insolvency is defined “with reference to a municipality, a financial condition such that the municipality is – (i) generally not paying its debts as they become due unless such debts are the subject of a bona fide dispute; or (ii) unable to pay its debts as they become due…”. However, as the Bridgeport, Connecticut case illustrates, insolvency rests in terms of cash flow, not budgetary balance. Bridgeport’s attempt to file bankruptcy was foiled by its failing, but still measurable, fiscal health; because it was able to pay its debts it was unable to seek bankruptcy protection. However, services had dwindled far below acceptable levels, and without being able to increase expenditures toward these services, revenues were virtually guaranteed to continue diminishing. This narrow definition of insolvency forces municipalities to actually fail before filing for bankruptcy instead of using it as a means of protecting themselves as failure inevitably approaches.
An interesting finding was included in a 2003 report, where Fitch Inc. sought to determine if municipal defaults increased during economic slumps. The report found that, in fact, there does seem to be a moderate correlation between the percentage change in gross domestic product (GDP) and the dollar volume of defaults that occur in a given year; a one-year lag produces a somewhat higher correlation.
Fitch Inc. 2003
As can be seen in the chart above, defaults did in fact spike in relation to GDP decreases. This is a significant component to consider when projecting future trends.
A final unique aspect of municipal bankruptcy, discussed in McConnell’s article, stems from two different ways of conceptualizing a city: as a political subdivision of the state or some larger entity, or as the agent of the citizens who reside within its bounds. The former view of the city, as an arm of the state, suggests that municipal bankruptcy should be treated as an opportunity to dissolve a “subsidiary” of the larger corporation and allow the presumably greater resources of the state cover the needs of the local residents and creditors more efficiently than the municipality was evidently able. The latter view suggests that bankruptcy should allow the dissolution of the municipal corporation into its constituent parts, followed by voluntary reorganization into more efficient and effective units. Either way, bankruptcy law could accomplish more than mere debt adjustment if the traditional definition of a city became less important.
FREQUENCY
From 1990 to 2002, there have been 135 Chapter 9 filings, with the bulk of the filings from land-secured special districts, not general governments, in California, Colorado, Nebraska, and Texas. The 13- to 20- year cumulative default rate on municipal bonds issued from 1979-1986 was 1.49% and low relative to other fixed-income sectors.
Based on a study of defaults in the United States from 1980 to 2002, Fitch Inc. concluded that all municipal debt holders fit broadly into three classifications of default risk. The lowest risk class, consisting of general obligation (GO), tax-backed, and most appropriation-backed debt of state and local governments, suffer extremely few defaults. According to Fitch’s default studies, from 1987–2002, the five- to 15-year cumulative default rates within this class averaged 0.24%, which was less than the 10-year cumulative default rate of 0.43% for ‘AAA’ rated global corporate bonds. The second risk class consists of enterprises that serve essential purposes but are not fully insulated from competition or fluctuations in demand; these have been known to default occasionally but with far less frequency than other fixed-income securities. The five to 15-year cumulative default rates within these sectors averaged approximately 0.70% versus the 10-year cumulative default rate of 0.76% for ‘AA’ rated corporate bonds. The third risk class includes enterprises that must compete against private-sector entities or securities with volatile revenue streams. This class has default risk characteristics similar to corporations, and their five- to 15-year cumulative default rates averaged 3.65% versus the 10-year cumulative default rate of 3.97% for ‘BBB+’ rated corporate securities.
RESULTS OF MUNICIPAL BANKRUPTCY
Resumption of debt service payments is likely the means provided in the bond indenture to cure defaults on tax-backed debt, as well as revenue bonds for projects such as water/sewer facilities or toll roads issued through a trust estate; recoveries are often 100%. Similar to default risk, Fitch, Inc. defines the recovery prospects of municipal bonds in four broad classes. The following are the different classes within which all default risk can typically be included.
The first class, State GO and sales tax-backed debt, is considered the safest in terms of recovery. In the extremely unlikely event a state ever defaulted on its GO or tax-backed debt, it is believed the state would call upon its considerable resources to cure the default in short order. The second recovery class includes local government GO and tax-backed bonds. Recoveries from defaults on these securities are also assumed to be at or near 100%, with the only losses stemming from the time value of money on the delayed payments.
The third recovery class includes state and local leases and certificates of participation (COPs), as well as airports and public power distribution revenue bonds. As in the first two classes, recovery is assumed from resumption in debt service payments, albeit after a longer potential delay. In the case of a COP or lease-backed security, the issuer always has the legal right not to appropriate funds to pay the obligation; however, this would often result in the loss of the issuer’s right to use the asset. Even in cases where the certificate holder has no legal or practical ability to take possession of an asset, it is believed that most lease or COP issuers will ultimately repay their obligations, with few exceptions, to ensure continued access to the capital markets.
The last class consists of securities where enterprises may cease to operate but the bondholder can expect various levels of recovery from the resale value of the assets, as well as securities where bondholders do not have a lien on assets but resumption in debt service may be expected after an extended delay. These can include bonds backed by nursing homes and CCRCs, private higher education institutions, multifamily housing, public power generating facilities, and toll roads. The riskiest debt includes hospital, private prison, stadium, student housing, and tribal gaming bonds.
CONTRIBUTING FACTORS
As with most things, municipal bankruptcy is complicated by numerous factors. However, history points to four typical contributing factors that have traditionally led to default and/or municipalities seeking Chapter 9 protection.
The most common factor attributed to declining fiscal health for municipalities is the changing demographics of the resident population. “Declining tax revenues, matched by rising mandated payments like welfare, and expensive labor contracts have put cities and the politicians who run them into a nutcracker,” said Robert Lamb, the debt advisor to New York City in 1991 while they were struggling to close a $3.5 billion budget gap. Mr. Lamb, though speaking from personal experience, was responding to the unexpected bankruptcy filing of Bridgeport, the largest city in Connecticut. Bridgeport, like scores of others in the Northeast and Midwest, was declining for decades as basic industries moved to cheaper regions and the middle class moved to the suburbs. The Connecticut city became the poster-child for all struggling cities in the US suffering from affluent resident flight, increasing demand on social services and failing infrastructure. This factor will remain one of the most important causes of municipal default, and must be considered in every situation first and foremost.
A second, more recently developing factor leading to threats of municipal default are “creative” solutions to escaping legal borrowing limitations. In the late 1970s and early 1980s state and local governments faced mounting capital needs and limited resources because of high interest rates, inflation and a slowing economy. Managers and officials had to address these increasing needs and shrinking resources by finding alternative ways to finance capital expenditures. As Dr. Hildreth points out, over the past 25 years, issuers have steadily moved toward finding custom solutions to a specific financing need rather than relying solely on long-term, fixed-coupon general obligation (GO) bonds. Lately revenue bonds predominate, not GO bonds. “Creative” ways to avoid debt limits and procedural hurdles have propelled the growth of lease financing, and Certificates of Participation (COPs), the increased use of tax increment financing (TIF), bond banks, and revolving loan funds.
Another increasing contributor to municipal default lies with shifting underlying assumptions, generally resulting from overly-optimistic or even misleading future projections. An example of this can be found in the default of the Washington Public Power Supply System (WPPSS), which, in 1982, defaulted on $2.25 billion worth of revenue bonds. A state court decision allowed local governments to escape their contractual responsibilities to WPPSS, ruling that these municipalities did not have the legal authority to enter into take-or-pay contracts. This led to default on the bonds used to build the plants and infrastructure the utility planned to use to supply these local governments. What prompted the municipalities to seek legal relief was a change in circumstances brought on by unrealistic original energy demand estimates, extended project delays, escalating project costs in a high interest rate environment, and growing political pressures to maintain low power rates. These unrealistic forecasts and estimates gave the utility access to capital it never really had a chance to repay.
Fourth, and most consequentially, the increasing pressure for alternative revenue streams, other than tax revenues, has become a significant contributing factor leading to municipal default concerns – Orange County, California, being the best example of this when, on December 6th, 1994, it became the largest municipality in US history to declare bankruptcy. Though, by itself, Orange County was the 30th largest economic power in the world at the time, the municipal investment pool the county operated on behalf of the hundreds of smaller and neighboring municipalities announced a $1.7 billion loss and incited a virtual “run on the bank”. Many factors led to the Orange County default, but risk-prone investment strategies intended to maximize revenue enabled it to become the crisis that it did.
Much has been made about the individual characters that have lead to some of the largest municipal bankruptcies, principally the Orange County collapse and its infamous villain, Bob Citron. It is well-known that Mr. Citron had problems. Without dwelling on it, the famous quote from Chriss Street, a Republican activist in Orange County, claiming that “there’s nothing worse than a gambler who goes to Vegas and wins the first time,” aptly and succinctly covers Mr. Citron’s issues. However, there are underlying themes to the California crisis that created the opportunity for this to happen in the first place, and these themes are found increasingly often across the country.
The fact is that in many locales, citizen demand for services has outstripped the willingness of citizens to pay. In the face of a constrained public budget environment, public officials and their finance managers have to be creative to achieve desired fiscal goals. Proposition 13, passed in California in 1978, so limited the local governments from raising taxes to pay for expanding services that alternative revenue streams became increasingly important. This pressure has a direct effect on the amount of risk a municipality is willing to absorb. With increased risk comes higher incidence of default; it is the very definition of risk. And with more and more conservative-led state governments threatening the restriction of local taxing revenues, the opportunity for municipal bankruptcy appears likely to increase into the future.
FUTURE CONSIDERATIONS
Changes in the sophistication of municipal capital markets have had many positive effects. Increased accountability, both internal and external to the government, has wedded with enhanced professionalism among municipal finance staff, which increases the capital market appetite for these governments. However, two concerns must be acknowledged by the financial community as we progress in municipal market sophistication.
First, the contributing factors mentioned earlier need to be tracked and well-communicated to both financial directors and potential investors. In particular, the two related factors of creative solutions to debt limitations and growing need for alternative revenue streams are especially significant. Both result from pressure to reduce taxes and spending, but both lead to increasingly riskier alternatives. Increased risk can lead to increased default rates, and if the relative safety and security of public debt is undermined, everyone will ultimately suffer.
Second, the real and increasing possibility of a significant disaster resulting in a reduced population either localized or widespread could undermine the integrity of any “full faith and credit” pledge. In isolated cases, such as the recent disaster of Hurricane Katrina in New Orleans and along the Gulf Coast, the state and federal governments can step in and back debt obligations local governments no longer have the population to repay. But state- or nation-wide catastrophes, such as the impending flu pandemic that experts predict will affect up to half the US population, cannot be so easily remedied. What then? There would be significant financial losses, and, while understandable, the sanctity with which investors typically hold public debt may forever be eroded.
These are but two interesting considerations for the future of public debt. The future of municipal finances and bankruptcy will become increasingly sophisticated and interesting, and hopefully people will begin to realize the intricate nature of the publicly-funded infrastructure they currently enjoy and take for granted, and appreciate it for the miracle that it is.
Bibliography
Granof, Michael H, Government and Not-for-Profit Accounting: Concepts and Practices, John Wiley & Sons, Inc. 2007.
Hildreth, W. Bartley and C. Kurt Zorn, “The Evolution of the State and Local Government Municipal Debt Market over the Past Quarter Century”, Public Budgeting and Finance 25 (4s), pp. 127-153, 2005.
Jorion, Philippe, Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County, Academic Press, 1995.
Judson, George, “New Bridgeport Mayor, Same Old Quagmire”, The New York Times, February 2, 1992.
Lanchner, David C., “New Risk in Municipals After Bridgeport’s Bankruptcy”, International Herald Tribune, July 6, 1991.
Lewis, Carol W, “Budgetary Balance: The Norm, Concept, and Practice in Large U.S. Cities”, Public Administrative Review, Vol. 54, No. 6 (Nov. – Dec. 1994), pp. 515-524.
Litvack, David T, Thomas J. Abruzzo and Mia Koo, Special Report: Default Risk and Recovery Rates on U.S. Municipal Bonds, Fitch Ratings, 2006.
Litvack, David T and Mike McDermott, Special Report: Municipal Default Risk Revisited, Fitch Ratings, 2003.
McConnell, Michael W. and Randal C. Picker, “When Cities Go Broke: A Conceptual Introduction to Municipal Bankruptcy”, The University of Chicago Law Review, Vol. 60, No. 2 (Spring 1993), pp. 425-495.
Shea, Patrick, “The Case for Municipal Bankruptcy”, The San Diego Tribune, February 18, 2005.
WEBSITES
“Municipal Bankruptcy”, Time Free Archive website, http://www.time.com/time/magazine/ar...745673,00.html,
last accessed April 30, 2007.
“US Courts: Bankruptcy Basics” website, http://www.uscourts.gov/bankruptcyco.../chapter9.html,
last accessed April 30, 2007.
Comment