How Jefferson County trips up national reporters
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.”).