A municipal bankruptcy does not ruin a state

January 17, 2012

Chart source: Bonddesk

State politicians in Alabama, Pennsylvania and Rhode Island have lambasted municipalities within their borders that have either declared, or attempted to declare, bankruptcy. The politicians gripe that when a municipality in their state goes into Chapter 9 bankruptcy, it affects the cost of borrowing for the state and other issuers located there. But this rests on the false assumption that markets do not discriminate between different borrowers. Municipal bond issuers, like public companies, are looked at individually because every entity has its own story. After all, when American Airlines went bankrupt, it was not as if all airlines suffered.

Alabama Governor Robert Bentley explicitly used the increased cost of borrowing for other Alabama towns as a bludgeon against Jefferson County officials who declared bankruptcy last November. The Birmingham News wrote:

He [Governor Robert Bentley] said the county’s situation already has affected borrowing throughout the state and he expects the bankruptcy to increase the cost of borrowing even more. “The credit rating of Jefferson County is terrible already so it can’t get much worse, but certainly filing bankruptcy does not help,” he said. “I know they were frustrated but at some point, you have to step up and have to be a leader and have to be a statesman and you have to do what’s right. Bankruptcy is not right.”

I remember thinking at the time that the governor seemed to be exaggerating the effect Jefferson County’s bankruptcy filing would have on the state. In discussions with Chris Shayne, the senior market strategist at Bonddesk, the leading alternative trading platform, I asked if it would be possible to compare the yields of a bankrupt municipality with those of  its state. Chris and his team were able to pull six years of trade data and construct the chart above. Some amount of Jefferson County bonds and warrants are floating rate, so they have been excluded from the analysis. But you can still see that yields for the bankrupt county spiked way over the state’s borrowing cost. In his analysis Bonddesk’s Shayne said:

The main reason that the JeffCo bankruptcy was a non-event outside of Alabama is that it was not a surprise. The county has had well-documented financial troubles going back to the Great Recession of 2008. They were afflicted with a combination of serious problems, including heavy exposure to derivatives, fraudulent city officials, and difficulty raising new taxes. By the time they finally filed for bankruptcy protection last month, most observers were expecting the announcement. (It is also worth pointing out that neither JeffCo nor Harrisburg is large enough to roil the markets by themselves.)

The chart [above] shows that JeffCo yields increased substantially as soon as the trouble began to leak into the market. You can also see that prior to the distress in 2008 Jefferson County actually had lower bond yields than both the national median and the statewide median. Following the first sign of trouble, however, yields crossed over and remained elevated till they declared bankruptcy.

The same logic that Alabama’s governor used was also used in Rhode Island to pass a state law giving municipal bondholders superior rights in bankruptcy over pension holders. The argument was that if bondholders suffered in bankruptcy, then borrowing costs for all Rhode Island communities would increase. Using the Alabama data we can see that this is not true and that pension holders basically got shafted, while bondholders received 100 cents on the dollar.

There will be more municipal bankruptcies before this economic cycle turns. Let’s hope that the decision to file will be made on the basis of what is best for a community and not by fallacies about how the bond markets will react.

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