Is a higher muniland default rate Congress’ fault?
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.
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. Join DiscussionUnions are crushing Yonkers and San Bernardino
The progressive website Media Matters for America disputed the thrust of a recent Fox TV special called Cities Going Broke because the show laid much of the blame for fiscal stress on union presssures. Media Matters argues that the financial crisis is the real culprit here, as it devastated state and local taxes. Though the crisis did cause tax revenues to fall, Media Matters never looks more deeply at the wages of municipal workers in stressed communities to see how they affect municipal finances. Two examples now in the media show that public-sector wages and unions bear part of the blame.
First, take a look at Yonkers, NY, where Michael Spano, the city’s Democratic mayor, is waging a public fight with the firefighters’ union in advance of their upcoming contract negotiations:
Mayor Mike Spano upped the ante in his fight with the firefighters union Sunday, calling for givebacks on pay, hours and sick leave before the city considers hiring a new class.
In a news release, [Mayor Mike] Spano said his concerns about Yonkers firefighters’ high starting salaries, fewer average work hours and “generous” sick leave must first be addressed at the bargaining table…
…Spano said Sunday the starting salary for Yonkers firefighters, at $70,996, is at least 30 percent higher than what their peers earn in other departments.
The starting base salary for a New York City firefighter is about $39,400, plus $3,700 in benefits.
At the same time, Spano said, Yonkers firefighters work fewer hours annually than firefighters in other cities, creating a “low-availability baseline” that sets the stage for excessive overtime.
Spano also said about 20 percent of the total firefighters required to work on any given day in Yonkers are out on non-line-of-duty sick leave.
McGoey, the union chief, acknowledged that the starting firefighter salary in Yonkers is higher than in other cities. But he said the regular work week of Yonkers firefighters, at 37.5 hours, is longer than city police officers, at 36 hours, and many public works employees, at 35.
Firefighting is a tough and dangerous job, but the per capita income for Yonkers residents is $29,191 (in 2010 dollars), according to the U.S. Census, or over $40,000 less than the starting salary for local firefighters.
Then of course there is the bankrupt city of San Bernardino, CA, which is suffocating from the high wages and benefits paid to their union workers, especially fire and police:
San Bernardino Mayor Patrick J. Morris said on Southern California Public Radio yesterday that the city’s public employee wages were especially “lucrative.” Although city employees agreed in 2010 to a 10 percent wage reduction for two years, the firemen’s union had told him to “pound sand” and sued the city to restore the previous wage level. It’s clear from this episode that even though San Bernardino firefighters were paid an average salary of $146,359 in 2010, they are entirely unwilling to help the city escape its fiscal black hole.
San Bernardino is even poorer than Yonkers. The average annual per capita income was $15,616, according to the U.S. Census, and 27 percent of local residents live below the poverty level.
Why is the pay of public union members so out of line with their local communities? Regardless of the impact of the financial crisis, how can communities afford these wages and pensions for the retired public workers? Join DiscussionUnions is unions. Getting the pay of public union members out of line with their local communities is the goal of each and every one.
MuniLand Snaps: August 13
Here is Brian Uhler of the California Legislative Analyst Office addressing questions about the use of Chapter 9 bankruptcy by municipalities in California. Read more here.
Also, starting tomorrow, MuniLand will be on holiday until August 22. See you then!
Good Reads
Governing: Pension plan changes pose challenges for lawmakers
Bond Buyer: California’s $10 billion Ran sale tied as largest ever
Morgan Stanley: Muni bankruptcy: More lessons
MuniLand Snaps Join DiscussionWhat is happening with Puerto Rico employment?
Some odd employment data is coming out of Puerto Rico. Although the population of the island has increased (see chart above), labor participation and the number of people employed have declined steadily, as seen below.
Meanwhile the government reports that the unemployment rate keeps declining (see below). Is this because they are contracting the size of the labor pool, or are there really new jobs coming online?
A Spanish-language publication says that employment gains this year are coming from government hiring (Google Translation from Spanish):
In the first 11 months of this fiscal year, election year, government employment has increased while still falling in the private sector. The data show that employment growth occurs in the central government agencies rather than municipalities. Why does this increase occur when the government is cutting spending?
Data from the Department of Labor and Human Resources indicate that employment in the public sector increased 2.8% in the first 11 months of fiscal 2012. The government has created about 7,400 more jobs than in the same period last fiscal year. The increase occurred among central government agencies (an increase of 4.2%, about 7,800 additional employees), while in the municipalities, employment fell 1.4%.
Is the Puerto Rico economy actually contracting without the addition of central government hiring?
Further:
Is Puerto Rico's economy actually contracting without the addition of central government hiring? Join DiscussionMuniLand Snaps: August 10
The story of the federal government in one simple chart. Bloomberg’s Scarlet Fu shows how government spending on entitlements rose as the level of government investment decreased.
Good Reads
WaPo: A Golden State train wreck
Assured Guaranty: Preliminary objection to Stockton bankruptcy filing
The Record: Bankruptcy challenge cites CalPERS bias
Reuters: Bond insurer contests Stockton bankruptcy over pensions
Press Enterprise: San Bernardino: Rifts erupt at city level
MuniLand Snaps Join DiscussionWhy doesn’t Stockton challenge CalPERS in bankruptcy?
The public pension fund crisis is dire across most of America. Some states and local governments have well funded pension plans, but on a national basis pension plan shortfalls are estimated to be in the trillions of dollars. Public resources are increasingly being diverted to pay for pensions. Cities with large public pension plans had median contribution rates of 12.7 percent of payroll in 2009, up from 10.3 percent in 2002 (GAO page 15). This is projected to climb as more public workers retire. As pension costs rise, state and local governments either have fewer resources to spend or must raise taxes to maintain a steady level of services.
California has bestowed some of the most generous pensions in the country, and cities there are looking for ways to lower their contributions. Recent ballot initiatives passed in San Diego and San Jose will create modest reforms to those cities’ pension benefits. The San Francisco Chronicle reported that State Senate President Pro Tempore Darrell Steinberg (D-Sacramento) suggested there might be some “constitutional issues” at play since the San Diego and San Jose reforms affected the benefits of current public workers. The reforms are being challenged in court.
But there is one place, clearly within the law, that cities can make substantial and fiscally stabilizing changes to their workers’ pension benefits: Within the Chapter 9 municipal bankruptcy process. Cities like Stockton, Mammoth Lakes and San Bernardino have the opportunity to adjust their pension liability as they seek to adjust their other unsecured creditors.
The federal judge in the Vallejo bankruptcy made a very explicit ruling that a city in Chapter 9 is given authority under federal law to reject contracts. Pension benefits are a “contract” under California law. The Vallejo judge, Michael S. McManus, Jr., specifically said in his ruling (page 73, clause 3102.1):
Debtors’ authority to reject executory contracts, as set forth in the Bankruptcy Code, preempts state law by virtue of the supremacy clause, the bankruptcy clause, and the contracts clause. U.S.C.A. Const. Art. 1, § 8, cl. 4; U.S.C.A. Const. Art. 4, § 1 et seq.; U.S.C.A. Const. Art. 6, cl. 2.
Translation: Public pensions benefits are construed as a “contract” under California state law, but bankruptcy law is federal and preempts state contract law. A city in Chapter 9 bankruptcy has the ability to lower pension benefits by rejecting their pension contract.
So why didn’t Vallejo adjust pension benefits in bankruptcy if the judge said that it could? From a blog post I cited yesterday, it appears that CalPERS lawyers threatened Vallejo with endless litigation:
The federal judge in the Vallejo bankruptcy made a very explicit ruling that a city in Chapter 9 is given authority under federal law to reject contracts. Yet CalPERS appears to have Stockton cowed. Join DiscussionGood question.
I wonder if we are headed to a condition where legislation will no longer be effective, and all financial issues surrounding our years of “irrational exuberance” will have to be settled in the courts.
If our state and national politicians themselves hadn’t become so corrupt, and opted out of their responsibilities to We the People, we wouldn’t be dealing with these terrible conflicts all across this nation.
Someone needs to remind all elected officials that they are public servants of We the People – nothing more, and nothing less – and that politics is the art of reasonable compromise.
I think it’s a sure bet that the American people won’t be electing any more Presidents from California – or from Texas any time soon . . if ever.
We the People simply can’t afford any more Ronald Reagans or George Bushes.
And we definitely don’t need a politician as President whose only qualifications are as a corporate turnaround artist, and whose first loyalties are to his religious cult beliefs and to his low tax rates.
MuniLand Snaps: August 9
The current U.S. drought monitor. To view regional drought conditions, click through the map. State maps can be accessed from regional maps.
Good Links
CBPP: Deficit-reduction package without new revenues would shift costs to states and localities
Reuters: Connecticut’s pension fund assets slip 0.9 percent in FY 12
NJ.com: Four major pro sports leagues sue to stop New Jersey from allowing betting
Bloomberg: Murders rival jobs in Emanuel’s battle to right Chicago
MuniLand Snaps Join DiscussionCalifornia publishes a municipal bankruptcy guide
In the wake of three cities’ recent bankruptcy filings, California’s Legislative Analysts Office has published a municipal bankruptcy guide. Authored by Brian Uhler, the report gets down into the nitty-gritty of Chapter 9 municipal bankruptcy proceedings. To my knowledge California is the first state to detail the mechanics of federal bankruptcy law as it applies to its own municipalities.
I think this is an excellent report, but I imagine it was intended for members of the California legislature as much as city officials coping with distressed finances. There are swarms of bankruptcy attorneys circling weak municipalities, willing and able to establish an hourly relationship and give advice. But California legislators have a lot of constituencies to placate, and every muni bankruptcy affects public unions and their retirees. Public unions have long been a powerful force in Sacramento. Bloomberg reported that public unions contributed $76 million to California politicians and ballot measures in 2010, the single largest interest group that year.
The report provides the mechanics for assessing whether a municipality qualifies as “insolvent;” how California’s mediation process, AB 506, works; and what happens after the bankruptcy paperwork is filed. For most municipalities the largest area of spending is wages and benefits for employees, and the report addresses both. Basically, wage contracts can be broken in Chapter 9 if the city can show:
(1) the agreement hinders its ability to achieve fiscal stability (2) the employee group otherwise would bear a disproportionately small burden of the locality’s bankruptcy (3) the locality negotiated in good faith with the employee group but no resolution was reached
As to the bigger, more complex issue of benefits for retirees (emphasis mine):
A local government’s agreements with retirees to provide pension or health benefits are generally considered contracts which may be subject to rejection under Chapter 9. However, Chapter 9 cases addressing retiree benefits have been rare. In its Chapter 9 case, Vallejo became the first and only California locality to use a plan of adjustment to significantly reduce health benefits for its retirees by decreasing its payments to a flat rate of $300 per month.
To date, no California local governments have used Chapter 9 to change pension benefits for current retirees; however, pension benefits were changed in at least one case in another state (Central Falls, Rhode Island). Due to the lack of case law regarding the treatment of retiree benefits in Chapter 9, it is not clear if and under what circumstances local governments would be permitted to reduce retiree benefits in future Chapter 9 filings. It is possible that differing benefit and contractual requirements in different states could result in Chapter 9 applying differently from one state to another.
I had a little back and forth with Uhler regarding the Vallejo bankruptcy judge’s decision that allowed the city to renegotiate pension benefits. This was a useful quote from the blog Calpensions.org:
To my knowledge California is the first state to detail the mechanics of federal bankruptcy law as it applies to its own municipalities. Join DiscussionMuniLand Snaps: August 8
New video from Cato on #sequestration, military spending. A primer for some; useful factoids and graphics for experts: youtu.be/s-nB6zQu9Mw
— Cato Foreign Policy (@CatoFP) August 7, 2012
Good Links
Tax Foundation: Governor Brown’s tax proposal and the folly of California’s income tax
Bloomberg: Brown redevelopment fund seizure drives increase in city taxes
The Record: Opinion: Christie’s rhetoric does not match reality
Reuters: Puerto Rico bonds were the most actively traded in 2nd quarter 2012
Montana Watchdog: Commentary: Tax exempt status for municipal bonds on endangered list?
MuniLand Snaps Join DiscussionCalifornia’s historic shift on prisons
California is undergoing an historic shift as it moves its incarcerated from state prisons to county jails. This comes in response to a U.S. Supreme Court decision that mandated a reduction in the state’s prison population, given the inadequate healthcare being provided. State legislation AB 109 and 111 were passed to implement this move:
AB 109 changes the law to realign certain responsibilities for lower level offenders, adult parolees and juvenile offenders from state to local jurisdictions. AB 109 will give local law enforcement the right and the ability to manage offenders in smarter and cost-effective ways.
The New York Times has a piece that includes reactions from current and former inmates on the shift:
Built for stays shorter than one year, the [county] jail does not offer the kind of activities, work programs and amenities found in most prisons. “You’re stuck in a little cell,” Mr. Diaz said, while prisons with outdoor space provide plenty of “yard time.” Soup costs $1 here, compared with 30 cents at the canteen at Coalinga, which Mr. Diaz said he left in 2005. “My homie just got out a couple of months ago,” he said, “and the canteen went up only, like, 3 cents, 4 cents.” …
…Violence among inmates has risen since the policy shift, Sgt. Terry Barnes said, attributing it to inmates’ realization that they might spend years in a place with few of the activities and amenities they enjoyed in prison.
“They’re very frustrated with the idea that this is it,” said Sergeant Barnes, a corrections officer who has worked at the jail for 24 years.
What the Times is suggesting might actually be a positive deterrent to crime if would-be felons fear having to spend time in a stripped-down jail with no activities.
California is also experimenting with a second, equally profound change in its treatment of certain classes of offenders by delegating some punishment to the communities where they committed crimes. The Public Policy Institute of California lays out the details:
California's correctional system is undergoing two unprecedented shifts as it moves its incarcerated from state prisons to county jails and as it delegates some decisions on punishment to the communities where felons committed their crimes. Join Discussion-
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