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Municipal Distress

This article originally appeared in Business Insider

Eventually we all have to accept full and total responsibility for our actions, everything we have done, and have not done.

― Hubert Selby Jr., Requiem for a Dream

A noteworthy facet of the evolving municipal distress story in the U.S. has been the slow moving, inexorable nature of the challenge.  Sadly, when a crisis of the magnitude that we are facing develops along these lines it is difficult to appreciate the true scope of the challenge.  This is doubly so when the inevitable change that is coming will upset so many entrenched interests.  And of course the opaque nature of municipal finance has not helped matters.

Stepping back to review the lessons learned in recent years, a few themes become evident:

1) The Story We Told Ourselves Was Flawed

We may very well look back on the smug claims that “local governments have taxing authority and so can always raise more revenue” and “XYZ bond issue is backed by a dedicated revenue stream, which makes it safer” as we now look at Wall Street’s over-reliance on structured finance to mitigate risk, and the simple yet profoundly wrong thesis that was spread in the middle of the last decade that real estate prices could never go down nationwide.  The simple fact is that for a great many municipalities, and for a troubling number of states and territories as well, the cost of honoring liabilities is severely restricting the ability of local governments to govern effectively (i.e. provide services).

2) Municipal Risk Has Been Mispriced

The dirty secret of the municipal finance world is that risk has been massively underpriced for too long.  But at the right yield investors will take on the risk of lending to a local government that has gone through a restructuring, and it may not be very long before forward-thinking creditors start to wonder if those local governments who acknowledged their problems and acted accordingly might not in fact offer a superior risk profile, having addressed their issues.

Highlighting the fact, which we have often repeated, that governments do not exist solely to service their debts, Moody’s has indicated that prior recovery rate assumptions for distressed municipal issues were flawed, and is therefore lowering its recovery rate assumptions for these issues going forward.

3) The Market is Forgiving

When the conversation around municipal distress first attracted wide attention in 2011, many commentators argued that local governments would do everything in their power to avoid a chapter 9 bankruptcy filing or related restructuring in order to stay in the good graces of the capital markets.  It appears that the markets are actually far more understanding than the commentators, with Vallejo, CA, which filed for chapter 9 bankruptcy protection in 2008 having recently sold $19 million in water-revenue bonds.

4) Delaying the Inevitable Will Only Force More Pain

  • Puerto Rico is facing a financial catastrophe, and the longer it seeks to paper over its challenges with additional borrowings from enabling lenders, the more distract the ultimate remedy will have to be.
  • The approval of the Jefferson County, AL plan of adjustment highlights the scope of losses that are possible going forward.  The revised plan will impose a 47 percent haircut on the holders of $3.1 billion in sewer bonds.
  • Vallejo, CA is facing the prospect of a slow slide to another bankruptcy filing due to an overly aggressive set of assumptions underlying its first emergence.

Conclusion

We are still in the early stages of a seismic shift in the municipal finance sector.  Liabilities have grown to such a point that they will not be paid in full.  This is a painful reality for all stakeholders, but that pain makes it no less true.  Hopefully the lessons of our first tentative steps toward comprehensive municipal restructuring will enable us all to act with clearer eyes and firmer convictions as we seek to position local governments to meet the needs of citizens in the years to come.

About the Author

David Johnson (@TurnaroundDavid) is Founder and Managing Partner of Abraxas Group, a boutique advisory firm focused on providing transformational leadership to middle market companies in transition.  Over the course of his career David has served as financial advisor and interim executive to dozens of middle market companies.  David is also a recognized thought leader on the topics of business transformation, change management, interim leadership, restructuring, turnaround, and value creation.  He can be contacted at: david@abraxasgp.com.

New Paradigm of Government Distress

This article originally appeared in Business Insider

A Slow-Moving Disaster

The state of Illinois is broke, and if it were a company it would at this moment be in the midst of a chapter 11 bankruptcy process.  A recent Bloomberg Businessweek article highlights just how bad things are in the Land of Lincoln:

  • The state is $4 billion behind on bills to 8,000 businesses, charities and state agencies.  Of that number, 114 are owed over $1 million.
  • This mountain of overdue bills exceeds the entire annual budget of the state of Delaware and is more than 10 percent of Illinois’ general budget for the upcoming year.
  • Banks are refusing to lend against these receivables, a sure sign that a state default is no longer a fringe idea.
  • Tax increases raised $7 billion for the state, which was insufficient to cover a $13 billion deficit.  The partisan fight over more borrowing continues.

State budget cuts are getting progressively deeper, and municipalities, faced with an end to federal stimulus money, the financial struggles of states, and declining property tax assessments, are being pressed to find new and ingenious methods to keep expenses down.

Painful Changes Needed

Sadly, cost reduction is not an area of expertise in most governments.  In the turnaround and restructuring community a shakeout is viewed as inevitable.  At the most basic level a restructuring of state and municipal debt as well as pension and healthcare obligations is essential.  Shared services and joint purchasing proposals will need to be moved from the drawing board to implementation.  We can expect vicious fighting between bondholders, government employees (current and former), voters and the unlucky politicians caught in the middle.

The policy implications of an age of local government financial distress must be considered as well.  California’s Proposition 13 was enacted in opposition to rising property taxes at a time (1978) when only half of the Baby Boomer generation was in the midst of their childbearing years.  We are a very different society with different demographic and social trends now, and more property tax fights might be expected, with long-term impacts on the resources placed at the disposal of local governments.

Meredith Whitney Was Right

When Meredith Whitney mad her bearish call predicting a wave of municipal defaults, scorn was heaped upon her.  In a follow up research report looking at the state finances, Whitney reiterated her bearish call, pointing out that the health of state finances is even more precarious than is generally acknowledged.  While many fixed income investors have argued technical points of her analysis, I believe that by taking a step back it is clear that Whitney is making the directionally correct call and those opposing her analyses are propounding a type of exceptionalism that has traditionally led to significant losses for investors.

True believers are difficult people.  Often the very traits that allow them to be ahead of the curve on issues make them poor proponents of those issues to the broader public.  This is exactly the problem with Whitney.  She is media savvy and, since her Citigroup call, seems to be hooked on making big predictions.  As another Business Insider piece pointed out, she could learn a great deal from economist Nouriel Roubini, whose firm also has a bearish view on the U.S. municipal bond market, but has been politic enough to couch their prediction in the soothing tones of economist-speak.

A New Paradigm

We are living in an exciting time, during which the role of state and local governments will be reshaped, with luck for the better.  The old paradigm had something for everyone: nearly risk-free returns for creditors, job security for government employees, pension and healthcare benefits that were both very generous (for employees) and underfunded (for taxpayers).  It was an imperfect system but it worked for a long time.  That time is now at an end.  Stakeholders can fight all they want (and they will), but change has come, and we expect that this change will be contentious but ultimately for the best.

About the Author

David Johnson (@TurnaroundDavid) is Founder and Managing Partner of Abraxas Group, a boutique advisory firm focused on providing transformational leadership to middle market companies in transition.  Over the course of his career David has served as financial advisor and interim executive to dozens of middle market companies.  David is also a recognized thought leader on the topics of business transformation, change management, interim leadership, restructuring, turnaround, and value creation.  He can be contacted at: david@abraxasgp.com.

A Good Story, But Untrue

This article originally appeared in Business Insider

Efficient markets are something of an absurdist joke to me.  Markets swing wildly based on supply and demand issues, in reaction to changes in unrelated asset classes or in search of safety during period of political turmoil.  And markets love a good story, even if that story is no longer true.

The municipal bond market has a fantastic story: tax-adjusted yields with a historically low rate of default.  And look, yields have been dropping, which must clearly indicate a vote of confidence from the market on the credit quality of municipal debtors.  Like all good stories there was once some truth to it, but things have changed.

A recap of the trouble spots in municipal finance:

Continued Economic Weakness: U.S. GDP growth in the last quarter for which QE2 was in effect was 1.0%. The August ISM numbers show the New Orders, Order Backlog and Production indexes all indicating contraction.

Credit Risk Transfer: Risk mitigation techniques are fantastic, but they only pass off losses to another party. If the risk of municipal default has been grossly underestimated, as I believe it has, the solvency of counter-parties must be considered.

Historical Default Rates: A discussion of the very low default rates municipal bond holders have enjoyed for the past few generations seems to conveniently ignore the last severe banking led downturn: the Great Depression. A historical analysis that conveniently ignores the last relevant financial contraction of the current type is useless.

Lagging Impact of the Downturn: A recent report by Ascent Investment Partners noted that: “financial performance of municipalities has typically lagged the national, state and/or regional economy by 18 to 24 months, resulting in cyclical lows for municipal finances approximately two years after the depths of an economic downturn.”  To date, municipal finances have been the beneficiaries of a delayed reaction to the full impact of the 2008-9 recession thanks to the lag of property tax assessments and federal stimulus spending. Both of those props have now been removed, and absent an economic recovery that remains much discussed but little seen, the budget woes of municipalities will only increase.

Limits of a Capital Markets Orientation: The danger of citing the capital markets in support of a thesis is that the capital markets are constantly providing feedback, but much of it is white noise. Efficient market theory states that all available information affecting a security is reflected in the price of that security. Of course, if this were true hedge funds and private equity firms would be impossible. Howard Marks of Oaktree Asset Management further sheds light on this issue by noting that markets are severely challenged in reacting to multiple stresses simultaneously. A flight to perceived safety resulting in depressed yield for a group of debtors whose mid-term financial outlook is bleak is a perfect example of just such a failure.

Pension Obligations: The Baby Boom generation is preparing to retire, and for municipal governments across the country that raises the specter of underfunded plans that will never catch up, and rising health care costs that cannot continue to be met.  These obligations need to be restructured, and they will be.

Taxing Authority: The ability of municipalities to raise revenue through taxes and fees has important practical limits. Local government officials and their elected leaders are likely to feel more accountable to voters and other constituencies over bondholders. Attempts to legislate around this bias (in Alabama and Rhode Island, for instance) have not yet been tested by the bankruptcy courts.

The credit worthiness of municipalities post Great Recession and post Boomer retirement wave will be lower throughout much of the country. Shockwaves in other corners of the debt markets may drive investors toward what they perceive as relative safety, and in the process drive down yields, but in the long-run the financial prospects of this class of debtor will only improve through a restructuring of bondholder and pension liabilities.  Luckily, the market has a wonderful mechanism for dealing with increased risk in an asset class: demanding higher returns.

For all the flaws associated with it, S&P’s downgrade of the U.S. should serve as a wake-up call to all classes of bondholders that there is no risk free return, and that we have entered into an economic environment sufficiently different from all other post-Depression downturns as to demand more due diligence and deeper thinking from all parties.

About the Author

David Johnson (@TurnaroundDavid) is Founder and Managing Partner of Abraxas Group, a boutique advisory firm focused on providing transformational leadership to middle market companies in transition.  Over the course of his career David has served as financial advisor and interim executive to dozens of middle market companies.  David is also a recognized thought leader on the topics of business transformation, change management, interim leadership, restructuring, turnaround, and value creation.  He can be contacted at: david@abraxasgp.com.