Assessing Willingness-to-Pay in the Post-Great Recession Muni Market
Recent Events Suggest a Weakening in Issuers' Desire to Repay Certain Debts
It is an axiom of municipal finance that credit risk is a function of an issuer’s ability and willingness to repay bondholders.1
Over the past two years, much has been written about “ability-to-pay.” Among other things, market observers have worried that declining property tax revenue and rising pension costs may impair issuers’ ability to meet principal and interest payments.2
However, less thought has been given to “willingness-to-pay.” This is surprising. Issuers have demonstrated a strong desire to repay debt since the onset of the Great Recession,3 but recent events suggest a weakening in issuers’ resolve.4 In the last two months, Stockton and San Bernardino, California have sought to shortchange bondholders through the bankruptcy code. Detroit has delayed payment on a note owed to Bank of America, and Scranton, Pennsylvania has attempted to avoid paying a parking authority guarantee.
In this Special Commentary, we explore the present-day dynamics of municipal issuers’ “willingness to pay.” We begin by defining “willingness” and explaining how legal security and project essentiality shape it in the municipal market. We next discuss how external factors often contribute to municipalities’ unwillingness to pay debt and highlight how parent government guarantees and bond insurance have injected a dose of moral hazard into municipalities’ decision to repay debts.
Today’s modest debt levels strongly suggest that high quality issuers will remain devoted to repaying debt, but some distressed issuers may grow less willing to meet their obligations. Poorly secured bonds issued for non-essential purposes – especially those wrapped with bond insurance – seem most vulnerable.
“Willingness to Pay”: A (Loose) Definition
In the bond market, “willingness to pay” describes the inclination of a borrower to sacrifice cash flow or assets to repay bondholders.5
“Willingness” is an amorphous and hard-to-quantify credit trait. It is inherently linked to other characteristics of a bond deal, including: the type and number of lenders, an issuer’s debt load, its cash flow, other fixed costs, the use of proceeds, and the legal covenants that back the debt, among other factors.
“Willingness” plays different roles in the corporate, sovereign, and municipal markets.
For example, corporate investors place a limited emphasis on an issuer’s willingness to repay debt. Banks can often seize the assets of delinquent corporate borrowers, and unsecured bondholders can force defaulters into bankruptcy. As a consequence, corporate lenders generally worry about an issuers’ ability to service debts, not their willingness to pay them.6
In contrast, sovereign bond investors are highly attentive to issuers’ willingness-to-pay. Sovereign bondholders cannot liquidate a nation, attach its assets, or force bankruptcy on it, so credit risk is arguably solely a function of a sovereign’s willingness to pay investors.7 Sovereign issuers sometimes repudiate debts despite ample ability-to-pay.8
Municipal investors emphasize an issuer’s willingness-to-pay depending on the investment. In the municipal market, “willingness” is uniquely correlated with bond covenants and the use of bond proceeds. Well secured bonds issued for highly essential public projects are associated with a strong willingness to pay. Bonds secured by weak covenants and issued for less essential projects are associated with diminished willingness.
Legal Security, Project Essentiality, and “Willingness”
Municipal issuers almost always repay well secured bonds issued for highly essential public projects. The penalty for defaulting on well secured, essential bonds is extremely high. Municipalities have a consistent need to finance vital public infrastructure, and laws require payment on these bonds except in extreme financial emergencies.9 Default in the absence of inability-to-pay risks severe and permanent damage to an issuer’s credit reputation and a costly legal battle.
Low default rates on general obligation bonds issued for schools and on revenue bonds issued for sewer utilities testify to the correlation between strong covenants, high essentiality, and resolute willingness-to-pay. Among Moody’s rated municipal bonds, there have been only three school district defaults and two utility defaults since 1971.10
Recent court decisions in the Jefferson County bankruptcy case suggest that properly secured, essential service bonds will remain insulated from any degradation in issuers’ willingness to pay debt. Rulings in January and June conform bankruptcy law to the traditional rule that municipalities default on highly secured revenue bonds only when there is an inability-to-pay. Jefferson County must continue to make sewer debt payments throughout its bankruptcy and cannot divert pledged sewer revenues to its general fund.11 It is also prohibited from ratcheting-down its obligations by refusing to raise sewer rates or inflating sewer operations and maintenance costs.12 In short, Chapter 9 forbids Jefferson County from repudiating its revenue bonds. This is consistent with Alabama law and the federal constitution’s contracts clause.13
In contrast, poorly secured municipal bonds issued for non-essential purposes are vulnerable to issuers’ unwillingness to pay. The penalty for defaulting on these bonds is high – but modest – relative to other defaults. Municipalities do not need consistent market access to finance assets like sports stadiums or to incubate speculative businesses, and the law sometimes sanctions municipal defaults on these bonds even in the absence of financial distress.14
The comparatively high default rate for weakly secured municipal bonds underscores the link between weak covenants and unwillingness to pay. Between 1970 and 2011, the default rate on Ba-rated non-general obligation bonds was 6.36%. Over the same time period, the default rate on Ba-rated general obligation bonds was only 0.08%.15
Events in Stockton, California suggest that some highly distressed issuers are becoming more comfortable with defaulting on poorly secured, non-essential debts. Stockton’s “pendency plan” for emerging from Chapter 9 includes skipping FY 13 principal and interest payments on several types of poorly secured, non-essential debt,16 but the City plans to make payments on highly secured special revenue bonds.
Stockton also plans to subordinate its weakly secured bonds to its burgeoning pension payments and lucrative employment contracts. Stockton’s payroll has declined by 29% since FY 08 but payroll costs have declined by only 10%. Per collective bargaining agreements, the city let go junior employees with lower base pay but continued to grant pay increases for its remaining employees.17 The average salary for a Stockton employee is now $102,260.18 The bankruptcy court may not sanction subordination of Stockton’s weakly secured bonds to healthy employee salaries.19 However, Stockton is plainly less willing to honor these bonds compared to others.
External Factors that Contribute to an Unwillingness to Pay
Alone, legal security and project essentiality are insufficient to help predict when an issuer will become unwilling to meet debt obligations. For example, Jefferson County sought to reduce its sewer obligations despite strong bond covenants and its sewer system’s vital public role, and Stockton officials continued paying debt service on poorly secured, non-essential bonds until very recently, despite rapidly deteriorating finances.
Typically, external pressures transform a burdensome financial obligation into something more: a perception that the commitment is morally abhorrent. Debts that taxpayers regard as unjust and debts that diminish local sovereignty are particularly vulnerable.
Municipal investors have long known that taxpayers sometimes become unwilling to pay “unjust” debts. Unjust debts surface in a variety of situations. Examples include when public works projects go unfinished, officials perpetrate a fraud on the public, or debt is unauthorized.
The 1982 Washington Public Power Supply default illustrates what can happen when a project goes unfinished. That default ensued when utility customers realized that not-yet-completed power plants would never deliver energy to residents.20
Jefferson County’s recent bankruptcy filing stems from fraud. Twenty-two former county employees, contractors, and advisors have been criminally convicted in a bribery scandal, which has left the county with nearly $4 billion in debt.21 County Commissioners are understandably slow to pay the county’s sewer debt.22
The notorious 1842 Mississippi debt repudiation exemplifies unauthorized debt. In that case, Mississippi’s Governor justified default on the grounds that the debt was illegally issued.23
Local Sovereignty Impaired
Taxpayers are also sensitive about paying debts that infringe on their democratic “right” to self governance. For example, a significant proportion of Detroit’s residents appear to prefer local autonomy to bond market access. In early July, Detroit officials successfully won a two-week repayment extension (read: default) on privately placed Bank of America debt by entangling the State of Michigan in an unwanted lawsuit.24 The extension endangers Detroit and Michigan’s future access to credit insofar as it suggests that Michigan cannot ensure the creditworthiness of its largest city. Detroit’s intransigence and unwillingness to repay its lenders stems from public distaste for the state’s takeover of city operations. One School Board member characterized the takeover as placing the city “into slavery.”25
Detroit (and Michigan’s) behavior is atypical in the municipal market. Infringement-of-local-sovereignty-by-overwhelming-debt is traditionally less of a credit concern in the municipal market than in the sovereign bond market. Municipalities are not sovereign, and most arguments for debt relief grounded in the language of “sovereignty” or “local democratic rights” go unheeded. States delegate to local residents the authority to govern their communities. If pushed, states can completely control municipal governments. They can dissolve entire cities, if they so choose.26
Parent Government Guarantees, Bond Insurance, and Moral Hazard
In today’s market, parent government guarantees and bond insurance also appear to be affecting issuers’ willingness to repay debt. Implicit and explicit government guarantees and bond insurance have injected moral hazard into the marketplace. Distressed issuers, in particular, seem less inclined to meet debt obligations because they anticipate a financial rescue.
Waiting for an implicit parent-government “bailout” is a time-tested strategy for struggling municipal issuers. However, in today’s market, parent governments are battling their own budget problems and are increasingly stingy with cash. As events in Jefferson County and Harrisburg, Pennsylvania illustrate, local issuers’ can mistakenly cling to a state lifeline.27 Neither Jefferson County nor Harrisburg has yet won state assistance, and in both situations, bondholders have been harmed by a drawn out intergovernmental stalemate.
Explicit parent government guarantees are also diminishing issuers’ willingness to pay.28 Guarantees made by local governments in New Jersey, Michigan, and Pennsylvania are proving unexpectedly cumbersome. In May, Sylvan Township, Michigan defaulted on a $12.5 million bond payment guaranteed by Washtenaw County.29 In June, Scranton, PA sought to avoid paying $54 million in guarantees for a failed parking authority.30
Bond insurance may also be contributing to erosion in issuers’ willingness to pay. Several municipalities drew on insurance policies in late 2011 to meet debt obligations,31 and insurance was present in at least five of the eight most significant defaults since 2009.32
Defaulting on insured bonds makes financial sense for certain issuers. Struggling issuers have an incentive to default on insured bonds knowing that bondholders will be paid and insurance companies have limited practical recourse against defaulters. Bond insurance contracts require municipalities to repay policy draws plus interest and penalties. However, today’s struggling issuers may seek to repay insurers only a fraction of what they are owed. There is presently only a modest penalty for losing access to such insurance because most issuers now access the market without it.33 Moreover, some of today’s insurers are less likely to protest draws on policies because they lack the resources to challenge questionable claims.
Conclusion: Risks for Non-Essential Appropriation-backed Bonds Wrapped With Insurance but a Wave of Defaults Remains Unlikely
Current market dynamics suggest that non-essential, appropriation-backed, insured debts are most vulnerable to the growing wane in municipalities’ willingness-to-pay. Defaulting on these bonds is painful, but unlikely to permanently threaten a municipality’s future market access or to trigger costly lawsuits on par with defaults on better secured bonds. Moreover, in the near-term, most insurers should be able to pay bondholders, if necessary.34
Widespread deterioration in municipal issuers’ willingness to repay debt remains unlikely. Bonded debt levels remain manageable for most state and local governments, and even vulnerable bonds are likely to be paid when there is an ability to make debt service payments.35 The vast majority of issuers continue to have little strategic reason to default on bonds of any sort in the near- or long-term.36
DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Factual material is believed to be accurate, taken directly from sources believed to be reliable, including but not limited to, Federal and various state & local government documents, official financial reports, academic articles, and other public materials. However, none of the information should be relied on without independent verification.
1. As we explain below, “willingness” is a function of legal covenants and essentiality of the public project being financed. Other municipal investors refer to a “tripod” of credit factors: ability, willingness, and essentiality. See Cochran, Pellegrini, Stevens, Torkelson, and White. The Handbook of Municipal Bonds, Ch. 10, p. 191 (2008). Also note that Breckinridge believes that some issuers, as entities, can be understood to be “essential,” and by virtue of their public purpose, are more likely to repay investors regardless of the use of bond proceeds. The public generally supports the endeavors of essential service providers regardless of the purposes for which they issue debt. For example, state governments and other third parties often help local governments, utilities, nonprofit hospitals, universities, and other key service providers to pay debt and remain solvent.
2. Among other publications, see: “An Analysis of Historical Municiapl Bond Defaults,” Kroll Bond Ratings, November 14, 2011; “Why Fears about Municipal Credit Are Overblown,” Daniel Bergstreser and Randolph Cohen, Harvard Business School, available at: http://ssrn.com/abstract=1836678; “Presentation to the Treasury Borrowing Advisory Committee,” U.S. Department of the Treasury, Office of Debt Management, Aug. 3, 2010; “U.S. State and Local Governments Remain Inherently Resilient, Despite Growing Pressures,” Moody’s Investors Service, February 2010; “States of Despair,” Parts I and II, Roubini Global Economics, February 28, 2011 and April 14, 2011.
3. Presently, only 24 rated essential service and tax-backed bonds are in payment default. See Municipal Market Advisors, Default Trends report, June 5, 2012.
4. See Mary Williams Walsh, “With No Vote, Taxpayers Stuck with Tab on Bonds,” New York Times, June 25, 2012.
5. This is Breckinridge’s own definition of “willingness” based on our independent research. Others may have a slightly different formulation.
6. See Ananth Ramanarayanan, “Sovereign Debt: A Matter of Willingness, Not Ability, to Pay,” EconomicLetter, Vol. 5, N. 9 (September 2010). Federal Reserve Bank of Dallas. Available at: http://www.dallasfed.org/assets/documents/research/eclett/2010/el1009.pdf.
7. See Gersovitz and Stiglitz “A pure theory of country risk,” European Economic Journal (1986). In this article, the authors theorize that, in nearly all cases, a sovereign borrower will have sufficient net worth to liquidate its debts. However, because lenders to sovereigns cannot typically secure their lending with government assets (legally or in practice), repayment in the sovereign markets is almost solely a function of a borrower’s willingness-to-repay.
8. Despite market penalties imposed on defaulters, outright debt repudiation remains an unhappy feature of the sovereign debt market. See “Arturo Porzecanski, “A Modern Legal History of Sovereign Debt: When Bad Things Happen to Good Sovereign Debt Contracts: The Case of Ecuador,” 73 Law & Contemp. Prob. 251. (Fall 2010).
9. The conclusion that a municipal debtor can legally default on well secured bonds (like general obligation bonds) in an extreme financial emergency follows from the Supreme Court’s ruling in U.S. Trust v. New Jersey, 431 U.S. 1 (1977) and legal hurdles associated with filing for bankruptcy. In U.S. Trust, the court established that a state (or a political subdivision thereof) can impair it own contracts only “if it is reasonable and necessary to serve an important public purpose.” U.S. Trust, at 25. The term “reasonable” has been construed to mean there must be a “financial emergency” and the term “necessary” is, by definition, understood to describe a situation in which there is no alternative but to impair the contract. This framework prevents states and local governments from “walking away” from their debts but permits governments to restructure overwhelming debts when there is an honest-to-goodness inability to pay. The framework is codified in Chapter 9 of the bankruptcy code which permits filings only if, among other things, (a) the municipality is insolvent, (b) the filing is made in good faith, and (c) the municipality has state permission.
10. See Moody’s Investors Service, “U.S. Municipal Bond Defaults and Recoveries,” 1970-2011, p. 11 (March 2012).
11. See In Re: Jefferson County, Alabama, Case No. 11-05736-TBB, at 57. U.S. Bankruptcy Court Northern District of Alabama Southern Division, Ch. 9, January 6, 2012. The conclusion of the case is clear: “Lastly, the Net Revenues, the amount of which is subject to futher determination of this Court, are not subject to the automatic stays of 11 U.S.C. §362(a) or 11 U.S.C. §922(a).”
12. See In Re: Jefferson County, Alabama, Case No. 12-00016-TBB, at 41 and 42. U.S. Bankruptcy Court Northern District of Alabama Southern Division, Ch. 9, June 29, 2012. “[S]ome of the inability of the sewer system to meet its Indenture obligations is the result of not having revenue enhancements, be it by rate increases or otherwise. This is yet one more reason for why this Court should not go behind what was agreed to in the Indenture. To do otherwise would allow a special revenue financing borrower to use a default in a revenue enhancement obligation, i.e. a rate adjustment requirement, to justify imposition [of a bond default through the bankruptcy code].”
13. Well structured revenue bonds are secured with a “rate covenant” that compels an issuer to raise utility rates sufficient to pay debt service costs. States typically endow revenue bondholders with the right to appoint a receiver to raise rates in the event a utility becomes unable to service its debt. (For example, see laws in Washington, Georgia, and Oregon (RCW 7.60.025, O.C.G.A. 36-82-67, and ORS 224.210), among others. The rate covenant enforcement mechanism ensures that the utility will pay whenever it is able. As for the Federal Constitution, the contracts clause is designed to ensure that municipal bond obligations are paid unless it is both “reasonable” and “necessary” to abrogate the bond contract (see U.S. Trust v. New Jersey, 431 U.S. 1 (1977)).
14. For example, bonds issued with “non-appropriation” clauses are structured specifically to permit the issuer to refuse to appropriate annual debt service payments. See James Coniglio, State & Local Debt financing, 2d Edition, Vol. 1, Ch. 11:15. Thomson Reuters/West, 12/2011.
15. See Moody’s Investors Service, “U.S. Municipal Bond Defaults and Recoveries,” 1970-2011, p. 12 (March 2012)
16. Stockton’s pendency plan envisions $0 in appropriations for $10.2 million in debt service on several lease-appropriation bonds and the City’s pension obligation bonds. These bonds are not supported by a tax levy and are subject to “available funds” in the general fund. Stockton has no more “available funds.” See Stockton’s pendency plan, p. 169. Available at: http://www.stocktongov.com/files/CouncilAgenda_ProposedAnnualBudget_Item_16_03_2012_6_20.pdf
17. See “Stockton Files for Bankruptcy,” Barclay’s Municipal Research, p. 4, June 29, 2012.
18. See “Stockton Files for Bankruptcy,” Barclay’s Municipal Research, p. 4, June 29, 2012.
19. See “Statement from Assured Guaranty Regarding City of Stockton, California Filing for Bankruptcy,” available at: http://assuredguaranty.com/statement-regarding-city-of-stockton-california-filing-for-bankruptcy/. See also: “Stockton Files for Bankruptcy,” Barclay’s Municipal Research, p. 4, June 29, 2012.
20. See James Spiotto, The Handbook of Municipal Bonds, Ch. 44, p. 713 (2008) and Chemical Bank v. Washington Public Power Supply, 99 Wash. 2d 329 (1983).
21. See “Jefferson County Sewer Scandal: Gary White Sentenced to 10 Years in Prison for Bribes, July 30, 2010.” Available at: http://media.al.com/spotnews/photo/730corrupjpg-ea474d2178c19458.jpg
22. See Kent Faulk, “Birmingham group representing Jefferson County sewer customers file $1.6 billion claim in county bankruptcy case,” The Birmingham News, June 4, 2012. Available at: http://blog.al.com/spotnews/2012/06/birmingham_group_representing.html
23. See James Austin, An Account of the Origin of The Mississippi Doctrine of Repudiation, p. 4. Bradbury, Soden, and Company (1872). The author, Mr. Austin, was particularly irked by Mississippi’s behavior 30-years prior: “The situation… was communicated to the Mississippi legislature in the annual message of the governor, January 1841, and certain measures were suggested by him in relation to the bonds. In this message first appears the word [“repudiation”] at the head of this article, and [that word] has since been generally adopted in the United States as a synonym for extensive swindling; a word which, unless measures be taken to redeem the national honor so deeply implicated in the course of Mississippi, will be hereafter used abroad as characteristic of American faith; a word, in short, which, like the terrific cries of the French sansculottes, is filled with anarchy and revolution.” Austin, page 4.
24. See Caitlin Devitt, “Detroit Wins Extension on Payment Date on B of A Merrill Debt,” Bond Buyer, July 5, 2012. The City Attorney for Detroit refused to rescind a lawsuit against the state. Recission of the suit was necessary to enable the City to borrow to refinance $80 million in privately placed Bank of America notes. Under the July 5th agreement, Bank of America expected to be paid two weeks late. Available at: http://www.bondbuyer.com/issues/121_129/detroit-wins-extension-on-bank-america-merrill-payment-date-1041553-1.html
25. Detroit School Board member Wanda Akilah Redmond uttered the remarks after the City Council voted to support a consent agreement between the state and the City of Detroit. The consent agreement endows the state with powers tantamount to a state takeover. Redmond’s exact quote was “I’m asking this body not to vote us into slavery… If you do this, all your authority will be taken away from you.” See “Simone Landon, “Detroit Consent Agreement Approved by City Council,” Huffpost Detroit. Available at: http://www.huffingtonpost.com/2012/04/04/detroit-consent-agreement_n_1404140.html.
26. Unless prohibited by federal law or a state constitution, states have complete control over municipal governments. In legal parlance, this is known as “Dillon’s Rule,” which states that “municipal corporations owe their origin to, and derive their powers and rights wholly from, the [state] legislature. It breathes into them the breath of life, without which they cannot exist. As it creates, so may it destroy. If it may destroy, it may abridge and control.” See Clinton v. Cedar Rapids and the Missouri River Railroad, 24 Iowa 455 (1868). The rule has twice been affirmed by the Supreme Court of the United States, most recently in Hunter v. Pittsburgh, 207 U.S. 161 (1907).
27. In Jefferson County’s case, County Commissioners want state help to repay the county’s debts, but the state refuses to re-establish a county-wide occupational tax. The County and its creditors remain mired in bankruptcy court and are likely to stay there until the County and the State can reach an agreement. See also: “Dunstan McNochol, “Harrisburg, Pennsylvania, Bond Default Averted with State Aid,” Bloomberg, September 13, 2010. Available at: http://www.bloomberg.com/news/2010-09-12/harrisburg-pennyslvania-bond-default-is-averted-by-advance-on-state-aid.html
28. See “General Obligation Guarantees by New Jersey Local Governments Can Detract from Their Credit Quality,” Moody’s Investors Service, May 2, 2012.
29. Caitlin Devitt, “Michigan County Forced to Cover Debt Service for Ailing Township,” Bond Buyer, May 16, 2012.
30. See Mary Williams Walsh, “With No Vote, Taxpayers Stuck with Tab on Bonds,” New York Times, June 25, 2012.
31. See Distressed Debt Newsletter, November 2011.
32. This includes two general obligation bond defaults (Jefferson County, AL and Harrisburg, PA), and one default on appropriation-backed debt (Vallejo, CA). Several guarantees of non-essential revenue bonds have also defaulted (Menasha, WI, Wenatchee, WA, Moberly, MO, and Scranton, PA). In five of the eight defaults, bonds were insured. Per a review of filings on the MSRB’s Electronic Municipal Market Access database, defaults in Menasha, Moberly, and Wenatchee were likely uninsured.
33. See Moody’s Investors Service, “Financial Guaranty Insurance: Negative Outlook,” p. 11.April 26, 2012.
34. It is commonly believed that bond insurers are irreparably insolvent. In fact, most bond insurers have adequate capital to continue making principal and interest payments on municipal defaults. For example, Assured Guaranty has $3.1 billion in statutory capital which it can use to pay claims. Its municipal insurance contracts typically require it to pay debt service (principal and interest) as those payments become due. Other insurers, like struggling Ambac, also have better-than-expected capital cushions. Ambac’s qualified statutory capital was $520 million in Q1 2012. Its claims paying resources exceeded $7 billion. Granted, both Assured and Ambac have significant liabilities, but the likelihood they can meet municipal debt service payments when due over any six or twelve month period is relatively high. See Assured Guaranty Municipal Corporation, Financial Supplement, March 31, 2012, p. 5 and see Ambac Assurance Corporation, 2012 Quarterly Operating Supplement, Q1 2012.
35. See Federal Reserve Flow of Funds, Table Z. 211, June 7, 2012 and U.S. GDP figures from the Bureau of Economic Analysis . The table and GDP figures show that state and local debt has declined as a percentage of U.S. GDP in each of the last nine quarters. Overall state and local debt (less refundings) was 18.2% of U.S. GDP in Q1 2012, well within historical norms.
36. See National Association of State Budget Officers (NASBO) June 2012 Survey of the States. The report notes that state revenues are expected to climb by over 4% in FY 13 compared to FY 12 and concludes that “overall state fiscal improvement is occurring.”
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