Why muni investors shouldn’t worry about Jefferson County

By Felix Salmon
December 26, 2011
Mary Williams Walsh's article about the fate of Jefferson County's general-obligation bonds:

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There’s a distinct whiff of the faux-naive coming off Mary Williams Walsh’s article about the fate of Jefferson County’s general-obligation bonds:

People who own what is considered the safest type of municipal bond may be in for a surprise.

This safe debt, called a general-obligation bond, is said to be the next strongest thing to Treasuries because it is backed by a “full faith and credit” pledge. That means the government that issued it will pay it on time, no matter what.

But now Jefferson County, Ala., has stopped paying such debt, breaking with convention and setting up a fundamental test of what full faith and credit truly means.

While we’re repeatedly told what “conventional wisdom” has to say on such matters, or what certain fund managers might once have been taught, not once is any authority actually cited saying that GO bonds are “the next strongest thing to Treasuries”.

Which is hardly surprising, since the muni market hasn’t been considered particularly strong for some time now. Back in February I blogged Michael Corkery’s article on how individual investors were abandoning the market, precisely because they had become aware that it was anything but safe. When 60 Minutes is running alarmist pieces on how hundreds of billions of dollars of muni bonds could default, no one’s sitting back with a smug expression and saying “well, your muni bonds, backed by actual cashflows, might default, but my muni bonds, backed by some amorphous ‘full faith and credit’, are perfectly safe”.

And in truth no one ever said that — it’s hardly been a closely-held secret that Jefferson County has no tax-raising abilities. In fact, that’s one reason why revenue bonds came into being: as in most other markets, there’s a strong case to be made that secured bonds are safer instruments than unsecured bonds.

Indeed, if you carry on reading through the end of the NYT piece, you’re eventually told that Jefferson County’s MBIA bonds were wrapped (that is, insured) by MBIA. Obviously, if everybody thought they were perfectly safe, then no one would have demanded them to be insured.

But the biggest problem with the NYT article is its deep premise: that Jefferson County is some kind of harbinger, and that if it can default on its GO bonds, then lots of other municipalities can as well. This meme is both very pervasive, and very dangerous, as Bond Girl explained in a long blog entry in October:

Some people mistakenly characterize Jefferson County’s financial problems as a canary in the coalmine for the municipal bond market, which suggests that they still have no idea what transpired there (or how long Jefferson County has been in financial distress). Portraying Jefferson County as a typical municipal credit is akin to portraying Enron as a typical corporate credit. With Jefferson County, various financial firms – but primarily JP Morgan – exploited an existing culture of corruption and made taxpayers the victims of one of the largest frauds in the history of the financial markets.

I’ve been saying at least since at least April 2009 that munis are one of those asset classes which is safe until it isn’t — that once you get some unknowable number of municipal bond defaults, suddenly no one will have access to the market any more, and the whole market could implode:

If five or six munis default, things get much, much worse. At that point, the cost of default for a wrapped muni issuer plunges, and possibly even goes negative. Once a few munis default, no one’s going to lend to any muni, even the ones which are current on their debt. So why bother staying current? Why not just default and let the insurer, rather than your local taxpayers, take most of the pain?

In other words, there’s a very serious, and pretty much impossible to hedge, risk of snowballing muni defaults.

But the point here is that Jefferson Country is sui generis and emphatically not one of those five or six munis. It’s a case unto itself, cut through with corruption and fraud, and is in no sense an example for any other municipality to follow. Jefferson County’s GO bonds are not an example of the safety of GO bonds more generally: as Bond Girl says, they’re more akin to the way that people lost their money with Enron or Madoff. The germane risk in Jefferson County is fraud risk, not GO-bonds-defaulting risk.

And remember that no one knows what the recovery value is likely to be even on Jefferson County’s bonds: it could yet turn out to be quite high.

Now I’m no great believer that bondholders should be senior to everybody else, to the point at which bond coupons are more important than vital municipal services. But let’s not look to Jefferson County to blaze a trail on that particular front. What’s going on in Jefferson County is an interesting datapoint, but it’s in no sense the beginning of some kind of muni-default snowball.


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It seems to me that the important point here is not the Enron issue. It’s that this is a GO from a county. Even a non-corrupt county’s GO is risky, because the the tax base is relatively small. OTOH, a GO from California, Va or Md may be even safer than a T-Bill. Large states have vast tax bases. Plus, when they run into trouble, they can’t print money the way the Fed can, which means they can’t de facto default via inflation. GO by itself doesn’t mean much. Which entity’s full faith and credit is pledged to protect the GO most certainly does.

Posted by maynardGkeynes | Report as abusive

Points out some great reasons why municipal bond holders should be senior to other payments – otherwise default can look too attractive in the short-run, particularly for a politician focused just on the next election, and the spillover effect impairs capital-raising by other government entities – right before expressing doubt that bondholders should be senior to other payments.

Posted by realist50 | Report as abusive

Reading your “speech” from 2009 suggests to me you think Meredith Whitney could right (there could be untold billions of defaults), except of course when she is wrong (all last year)? My read of Bond Girl is that Ms. Whitney is unequivocally wrong, wrong, wrong — but you seem to suggest that Whitney could be right, hypothesizing that a mere trickle of defaults could at some point become a flood. You also seem to hedge your warning that Jefferson County is indeed a default but not a really significant default, so that you disagree with neither Whitney nor Bond Girl.

Posted by mlnberger | Report as abusive

Anyone who’s been paying attention to Jefferson County has spent two years surprised that they hadn’t defaulted yet. Asking (primarily high-income) bond holders to do a little bit of due diligence doesn’t seem too much.

Posted by dWj | Report as abusive

Yes, local politics and politicians have been primary movers in the problems there from the start. And it’s worth noting that many Birminghamians believe these troubles would never had happened had the EPA not told them to stop dumping raw sewage into area waterways.

Posted by thisdave | Report as abusive

Read Cate Long in today Reuther’s for clarity:

http://blogs.reuters.com/muniland/2011/1 2/27/how-jefferson-county-trips-up-natio nal-reporters/

How Jefferson County trips up national reporters
By Cate Long

Dec 27, 2011 17:42 EST

The New York Times really needs to improve the quality of its reporting on the municipal bond market. Mary Williams Walsh makes such a terrible hash of the situation in Jefferson County, Alabama, that she is bound to set off another muniland hysteria in the mold of Meredith Whitney.

In the opening paragraphs, Walsh contends that general obligation bonds (GO) issued by state and local governments and with the pledge of their “full faith and credit” may not be as creditworthy as always assumed. About half of the $3.7 trillion municipal bond market is general obligation bonds. She dramatically states that investors who own GO bonds might be in for a “surprise:”

People who own what is considered the safest type of municipal bond may be in for a surprise.

This safe debt, called a general-obligation bond, is said to be the next strongest thing to Treasuries because it is backed by a “full faith and credit” pledge. That means the government that issued it will pay it on time, no matter what.

But now Jefferson County, Ala., has stopped paying such debt, breaking with convention and setting up a fundamental test of what full faith and credit truly means.

What goes unmentioned is that the halted debt repayment is happening in the context of an insolvent county in bankruptcy. More importantly, general obligations bonds can be very high-quality from a strong issuer with top credit ratings, or they could be very low-quality from a near-insolvent municipality with the lowest possible credit ratings. The type of the bond is no assurance of ability to repay bondholders.

The point of a municipality seeking bankruptcy court protection is to halt the legal actions of creditors, including GO bondholders. This gives debtors time and a safe space to reorganize their finances. It’s not in any way “breaking with convention” to halt paying GO bondholders in bankruptcy.

The U.S. Federal Court system’s bankruptcy guide (page 49) describes Chapter 9 municipal bankruptcy:

The purpose of chapter 9 is to provide a financially-distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting its debts. Reorganization of the debts of a municipality is typically accomplished either by extending debt maturities, reducing the amount of principal or interest, or refinancing the debt by obtaining a new loan.

There is substantial case law, some of which dates to the 1980s, about GO bondholders being repaid less than their full claims in municipal bankruptcy (see footnote below). Investors are aware that municipal debt may have risk if the issuer is weak. That is why we have credit ratings to signal the risk of specific bonds.

After waving this false flag, Walsh finally gets around to explaining in the 19th paragraph that most of the debt of Jefferson County is not general obligation bonds anyway. In fact only 5 percent of the approximately $4 billion of Jefferson County debt is GO debt; the other 95 percent is revenue debt, which has claim only to the revenues of the entity the debt was issued for (say, a hospital, school or sewer project).

2010 ended with Meredith Whitney making claims about the enormous default likelihood in the municipal market. Municipal market professionals spent all of 2011 refuting Whitney’s unfounded claims. I really hope we don’t have to spend 2012 refuting more of the same nonsense.

Footnote: Jones Day: An Overview of Chapter 9 of the Bankruptcy Code: Municipal Debt Adjustments, 23 August 2010

Similarly, in the context of unsecured debt obligations (such as general obligation bonds), significant impairment is possible. See, e.g., In re City of Columbus Falls, Montana, Special Improvement District No. 25, 26, 28, 143 B.R. 750 (D. Mont. 1992) (approving plan that provided for less than full payment of general obligation bonds, holding that municipal debtor is empowered to impair prepetition general obligation bonds as long as other requirements of chapter 9 were met); In re Sanitary & Improvement Dist. #7, 98 B.R. 970 (Bankr. D. Neb. 1989) (explaining that general obligation bonds are general unsecured claims, subject to impairment); In re City of Camp Wood, Texas, Case No. 05-54480 (Bankr. W. D. Tex. June 13, 2007) (approving plan of adjustment that impaired prepetition general obligation bond debt through (a) a principal reduction, funded through a sale of assets; (b) a new 20-year amortization schedule; and (c) a new interest rate of 5 percent). Moreover, impairment is a possibility, even if the municipality has the ability to pay the obligation in full, through additional taxation or other measures. See Sanitary & Improvement Dist. #7, 98 B.R. at 974 (explaining that “[i]f a municipality were required to pay prepetition bondholders the full amount of their claim with interest … and the [debtor] had no ability to impair the bondholder claims over objection, the whole purpose of Chapter 9 would be of little value.”).

Cate Long writes about the retail fixed income markets including municipal bonds. Her primary interest is creating tools and systems to help retail investors understand bond markets. She has worked for a number of years with industry standards organizations, regulators and Congress to help craft a more transparent and fair framework for investors to participate in the fixed income markets. She is a guest contributor to Reuters.com.

Posted by FPecar4525 | Report as abusive

Kudos to Cate Long for an informative posting. One of the major challanges in the Jeffco Chapter 9 is that the securities at issue are not Bonds, they are Warrants. There appears to be an important question under Alabama law whether a municipality (like Jefferson County) can unilaterally act to raise taxes in order to satisfy these Warrants (assuming Jefferson County even wanted to voluntarily do so)without State approval.

We are currently investigating possible legal claims against certain parties involved with the underwriting of these Warrants.


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