Bankruptcy: When The Can No Longer Can Be Kicked

As the financial crisis enters its sixth year we find municipalities and their bonds increasingly in the news.  Municipal woes appear to be on the rise.  Therefore it is important to realize how unique each municipality is as well as how unique all of their municipal bonds can truly be.  There is no such thing as a generic municipality nor is there any such thing as a generic municipal bond.  Every municipality is different.  Every municipal bond is different and therein lies the opportunity for you, the municipal bond investor.

Think about your city.   You may see some municipal projects that work as well as other areas that do not.  Municipal bonds may be involved in the financings for these individual projects, some that look successful while others seem to be closer to failure.  Harris County and the surrounding area of greater Houston have provided numerous examples of municipal bonds on one side of a street being successful while a failed municipal bond project may exist on the other side of the street.

One of the first questions in municipal credit analysis would of course be: “Did the project work?”  Generally one could easily answer that question.  Either the development attracted growth in assessed values sufficient to pay debt service or it did not.  Either the project was built and performing at or near expectations sufficient to pay debt service or it did not.  These questions are also traditionally linked to the bulk of past municipal bankruptcies.  Projects that do not perform usually eventually go bankrupt; projects that do perform usually do not go bankrupt.

In an era of seemingly rising wealth and credit expansion, one would expect municipal bond bankruptcies to be quite low, perhaps at even historic record lows.  This describes our pre-financial crisis past quite well but it is our future that we are most concerned.

Municipal credit quality is no longer an easy worked/didn’t work proposition.  As the financial crisis enters year six we find municipal credit is often declining in quality and we are discovering the extent of this decline as time goes on.  Six years is a long time of robbing Peter to pay Paul, shifting cash from flush funds to those running deficits, keeping up with rising costs and declining revenues.  After six years more and more municipalities are finding themselves (suddenly) out of cash.

Our cities and our citizens are under financial assault.  Successful cities, like successful citizens, are under assault because this is where the (needed) money is.  In California, successful cities, as determined by excess cash flow (taxes less debt service) generated by their redevelopment agencies, were sent invoices to share this cash with the state government in Sacramento to help shore up the state’s finances.  Such a system helped the state so much that the state decided to end the invoicing system, end redevelopment agencies ties to their local government and simply keep ALL the extra money for the state.

Obviously the state legislature failed to realize that all municipalities are unique.  Some redevelopment agencies were cash cows for their municipality generating millions (collectively billions) of dollars in excess of the agencies debt service requirements. Other redevelopment agencies were leveraged to the hilt by their local municipality and after five years of financial crisis do not generate excess funds for their municipality (or now the state) but instead need cash to prevent them from defaulting on their debt.

Currently the concern, our concern, is not with poorly performing redevelopment districts.  We are used to poorly performing projects and their consequences: the can is kicked down the road ala Jefferson County, Harrisburg and countless other poor performing municipal bonds that get less press ink.  This situation describes our previous milepost.  We are now entering a new phase.

We are now concerned with cities filing bankruptcy.  Cities do not file for bankruptcy because of pension or healthcare costs down the road.  Cities file for bankruptcy because they no longer have cash and thanks to Credit Expansion Finished, they no longer have the ability to borrow to kick the can any farther.  Year six of a financial crisis will do this to weak municipal credits.

The end of the can kicking phase is bankruptcy and once again we see California’s leadership in the process.  For those of you looking for catalysts in the marketplace, we nominate the California legislature’s decision to end the redevelopment districts, cutting off cash flow to municipalities, ending can kicking for weak municipalities and moving us into a new phase featuring bankruptcies.

Shortly after San Bernardino said it would seek bankruptcy Warren Buffet was asked if the stigma for municipalities to file for bankruptcy is now reduced.  This was a poor question to ask an oracle.  The question should have been “do you see more municipalities running out of cash and filing bankruptcy in the future?”

Along similar lines of thought, the ratings service Moody’s released a report last week that they expected bankruptcy filings to “remain few in number but (earlier filings) may indicate a new trend in fiscally troubled cities unwilling to pay their debt obligations.”  Willingness or stigma has nothing to do with Stockton, Mammoth Lakes or San Bernardino filing for bankruptcy; lack of cash did!  Also, experience tells us that there are significantly more municipalities in California that lack the cash needed to continue to kick the can down the road and therefore we are prepared for significantly more bankruptcies.

As we enter year six of the financial crisis we will find more and more circumstances of the can no longer being kicked down the road.  Cash and credit does not grow on trees.  Stockton, Mammoth Lakes and San Bernardino may have been able to borrow more money in the early years of the crisis, but obviously they cannot or will not now.  This is the reality of the crisis.  As the years pass, anger is becoming greater.  Citizens are fed up with stories of municipal employees retiring with ridiculously large retirement pensions.  The willingness of municipalities to raise taxes or borrow more money is also decreasing.  Municipalities that spend more than they bring in are losing more and more cash over time, not less.  This is all progress for us because we know kicking the can down the road is not a solution.  Unfortunately when government is involved, solutions only seem to happen once the can kicking no longer works.

We believe the municipal bankruptcy phase of the crisis is a turning point for the municipal market similar to the demise of municipal bond insurance.  Leading up to the financial crisis in 2007, municipal bond insurance had lulled the market into a complacency that municipal bonds were safe, generic, insured.  As we enter the sixth year of the financial crisis, the municipal bond market is lulled into a similar complacency, this time by the mistaken belief that Federal Reserve Chairman Ben Bernanke’s near zero interest rate policy will keep all municipal bond prices high.

Municipal bonds are not a generic asset class but instead a collection of hundreds of thousands of unique municipal bonds.  As municipalities begin to file for bankruptcy at an increasing rate, we look for investors to sell municipal bonds at an increasing rate providing us with continued opportunies for the coming months.

Our strategy has been to remain in Cash and quality municipal bonds that will shortly turn to Cash.  This is because we believed can kicking would eventually give way to bankruptcies.  Almost all municipalities must cut back their expenses and this means people and their costs (salary, healthcare and pensions).  Such cuts will continue to negatively affect property values, primarily residential properties, and this will continue to put downward pressure on the greatest can kick of them all: residential mortgages including FNMA, FHLMC and the balance sheet of the biggest banks.

If you were a true believer that the crisis was just a big(ger) recession, then I suggest you rethink your position.  Six years continues to take its toll as a financial crisis.  Every day more and more citizens are coming to the realization that things are not getting better next quarter.  Bernanke possesses no magic formula.  Government is not the solution but is instead the problem.  Banks will continue to act like, well, banks until the day they are closed.  These, and other ugly truths, are the realizations that citizens are coming to realize.

Others would have you believe that your long-term investments should be those that have gotten you here.  We believe it is best to be in Cash or in municipal bonds that will shortly turn to Cash.  The events of the past few weeks in California and elsewhere reinforce to us that we are on the right track.  Like we experienced in the municipal bond price swoon of 2008, selection is and will be the key in the municipal market going forward.  This is the time we have prepared for.

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