Is a higher muniland default rate Congress’ fault?

August 23, 2012

Last week the New York Fed put out a controversial report claiming that the default rate for municipal bonds is 36 times higher than one cited by credit rating agencies. Using data sets from S&P Capital IQ and Mergent that tracked defaults for unrated bonds, the New York Fed report created a big stir among muniland commentators and probably a small amount of concern among retail investors. The data cited by the New York Fed is well known among market professionals and has been thoroughly dissected, but so far the discussion hasn’t focused on why these unrated bonds default at higher rates. Specifically, no one has linked the high default likelihood of this sector, private activity bonds, to the fact that Congress has exempted them from rigorous disclosure since 1968.

Randall Forsyth at Barron’s pulled the right information from JPMorgan municipal bond research to explain what this unrated sector of high defaulting bonds is. Take special note of that last section:

“The vast majority of defaults came from revenue bonds, which are backed by the cash flows from a specific authority or entity, such as a municipal hospital, or an industrial-revenue bond issued on behalf of a private entity. In other words, by far the diciest niche of the muni market.

Indeed, defaults were concentrated in a relatively small, high-risk subsector of the muni market, according to data collected by Priscilla C. Hancock, managing director at J.P. Morgan Asset Management. Moreover, the data also show that even in default, bondholders recover a substantial percentage of their investment.

In recent years, the defaults in the muni market have been centered in just a few areas, according to J.P. Morgan’s numbers. From 2000 to 2011, corporate-related bonds, such as industrial-revenue bonds, accounted for 34 percent of defaults. Within that sector, American Airlines’ bankruptcy was responsible for a whopping 84 percent of those defaults. The AMR unit was responsible for debt for airport facilities; but that is representative of a corporate-credit risk, not that of municipalities.

Land-based “dirt bonds” comprised 26 percent of the defaults. These debts were to fund “build it and they will come” projects that went bust with the housing collapse. Health-care related issues accounted for 19 percent of the defaults, 92 percent of which were for nursing homes. In other words, the vast majority of municipal defaults in the past decade were the result of the private sector’s use — some might say abuse — of the tax-exempt bond market.”

Note that the vast majority of defaulted bonds were issued under the cover of the municipal tax exemption to fund private, for-profit activity — essentially a corporate municipal bond. Airport facilities dedicated and controlled by one airline, the bankrupt American Airlines in this case, and privately run nursing homes are infiltrating muniland to take advantage of lower borrowing costs and significantly lower disclosure requirements, thanks to Congress.

Jonathan Hemmerdinger of the Bond Buyer wrote an excellent piece detailing the 40-year effort of the Securities and Exchange Commission to push Congress to require corporate-like disclosure for these high-defaulting private activity securities. Hemmerdinger detailed the two most recent SEC efforts:

“In 2007, then-SEC chairman Christopher Cox asked Congress in a white paper to enact legislation that would require corporate conduit borrowers in the muni market to meet the same registration and disclosure standards they would be subject to if they were not borrowing through a municipal issuer.

The SEC fired the latest volley on July 31, when it recommended in its report on the municipal market that Congress eliminate the exemption in the Securities Act of 1933 for conduit borrowers. If Congress acts on the SEC’s recommendation, borrowers of many private activity bonds would be required to register with the SEC, and would be subject to periodic reporting requirements. Nonprofit borrowers and privately-placed securities would continue to be exempt.”

Personally I think private activity bonds should have their tax-exempt status removed. Allowing that exemption is an abuse that costs the U.S. Treasury tax revenues. The New York Fed study detailing the higher default rate gives weight to the argument that the SEC has been making for 40 years: that this bond sector needs more rigorous disclosure standards. Investors need protection from defaults, and the first line of defense is high-quality disclosure. For some reason Congress is shielding issuers of private activity bonds. Maybe it’s time for Congress to shift its focus to protecting investors.

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