Sunday, March 30, 2008

The cautionary tale of Jefferson County Alabama

Jefferson County Alabama's sewer authority was once considered among the most sophisticated issuers in municipal finance. Now they are on the brink of Chapter 9. What happened, and can it happen to other municipal issuers?

It all started when investment bankers cooked up a clever way to use derivatives to lower interest expense for municipal issuers. The municipality would sell auction-rate debt, then enter into a pay fixed, receive floating interest rate swap. For tax-exempt issuers, the floating end of the swap is either based on a percentage of LIBOR or the SIFMA Index, which is an index of floating rate municipal debt rates.

The result of these transactions was a synthetic fixed-rate bond. The initial floating liability had been turned into a fixed liability via the derivative transaction. Bankers were able to show that through these machinations, even after hefty fees to the investment bank, the issuer would realize a interest rate savings.

For Jefferson County, those savings were important. They had been ordered by a federal court to make significant upgrades to their sewer system to comply with environmental standards. As a result, there has been a 3-fold increase in sewer rates over the last 10 years. In fact, the sewer system became highly leveraged in an attempt to spread out construction costs over time, which in turn would prevent the pain (and political embarrassment) of even larger rate increases.

Historically, auction rate municipal debt had consistently reset at or very near the SIFMA rate, which in turn was always highly correlated with LIBOR. But the recent liquidity crisis changed all that. Starting in January, auction rate municipals began routinely failing, or at best, resetting at rates considerably higher than the SIFMA or LIBOR indices. In other words, the pay-floating side of the interest rate swap was substantially lower than the actual amount being paid by the sewer system.

Because the sewer system was so leveraged, the extra interest expense was more than their budget could bear. Had they been a stronger credit, the sewer system probably could have refinanced their auction-rate debt with variable rate put bonds. That structure offers investors a weekly put option, and therefore has not suffered the liquidity problems of auction-rate bonds. Or they might have been able to cancel the swap arrangements and refinance their debt as fixed rate. But because of the extreme leverage employed and the rapid deterioration of what balance sheet they had, these options were not viable.

S&P has lowered the Jefferson County Sewer bond rating to CCC, with Moody's currently rating the system at B3. The rating had been A with both agencies as recently as mid-February.

Is bankruptcy in the cards? Probably not. The County, which isn't legally responsible for the sewer bonds, has proposed to redirect sales tax revenue to the extent it is not needed for school construction. It is not clear whether this would be enough to satisfy the sewer systems debt service needs, primarily because of uncertainty surrounding their outstanding swap arrangements.

The sewer system's swap agreements require it to post collateral in the event of a credit rating downgrade. According to the Bond Buyer, that figure is currently $184 million, which the County has yet to post, and is now past due. The swaps counter-parties are unlikely to push the collateral issue too hard, as the bond documents indicate that the swap providers are subordinate to bond investors.

So it seems the most likely outcome will be that banks and the County will work out some sort of restructuring. It would likely involve the County pledging certain revenues, a refinancing of their $869 million in auction rate debt, and some sort of restructuring of their swap arrangements. So bankruptcy cannot be ruled out, but it does seem there are too many interested parties who would rather see another solution.

Could the same thing happen to other issuers? Absolutely. Fortunately for general market municipal investors, the confluence of events leading to Jefferson County's problems are indeed rare. Most of the biggest issuers of ARS are either student loan-related, where max rates are very low, or relatively strong issuers, such as the City of New York, who will be able to refinance without trouble. The problems are most likely to crop up with small issuers, particularly private non-profits (e.g. a hospital or private college), who have entered into onerous swaps. These are issuers with limited resources, and also lack the political support that a sewer system enjoys.

It is a bit worrisome for many municipal investors that an issuer can go from A to CCC in less than 30 days. Gee, maybe bond insurance isn't dead after all.

12 comments:

Anonymous said...

I assume the Jefferson Cty issues were insured by one of the monolines? Would this problem have been avoided if they had an LC from a highly-rated bank?

That-Will-Never-Happen said...

AI: Fortunately for general market municipal investors, the confluence of events leading to Jefferson County's problems are indeed rare.

Financing long term liabilities with short term revolving debt is NOT "indeed rare" ... it is very common. And it has tripped up far more sophisticated players than municipals including the S&Ls, LTCM and Bear Stearns.

The long term neglect of critical infrastructure (like roads, sewers, bridges, etc) is what required a large "catch up" expenditure in the first place -- this problem is far from "rare"; its epidemic all over the country.

Politicians diverting repair funds (which have only a long term benefit, probably after the politician leaves office) in favor of short term "quick fixes" (which benefit the current politician) is hardly "rare" -- its everywhere.

Politicians attempting to avoid embarrassment of massive tax/fee increases using fancy accounting "structures" is also rather commonplace.

The first off-balance sheet financing was not Enron -- it was New York State forming the NY Turnpike Authority and issuing bonds, all to sidestep voter imposed debt limits.

And completely missing from all AI's missives about the mortgage market is the history behind FNMA and FHLMC being quasi public companies... Back in the late 1960s, both companies were government owned. They were "sold" to the public (kind of) to create the illusion of a balanced budget.


Muni bonds have had low default rates for the past 50 years -- so financiers like to say they are very low risk... Of course, many of the same financiers spent the last few years telling us to buy CDOs and subprimes, because historically home prices do not decline.

Caveat Emptor

Anonymous said...

This is not about the muni market. It is a garden variety municipal corruption case. They are in trouble because they were ripped off. This story has almost no relevance to the general muni market.

gramps said...

That-will-Never...

Good points; and I would add two more:

Many municipalities have planned future spending based on continued revenue from the housing boom (both from property taxes and from transfer taxes). The revenue is obviously not going to materialize -- so politicians are already forced to lower voter expectations on spending and/or increase taxes... In essence, this is the problem facing California

Second, almost every state and major city has a MASSIVE underfunding of municipal pensions and OPEB. This will require either very significant tax increases and/or reneging on benefits to retired municipal workers. Both these outcomes are political hot potatoes, but a choice cannot be avoided in the next few years.

Most muni investors, like mortgage bankers, have very short term memories and are basing their belief of "safety" on only the recent past. A lot of problems have been swept under the rug for many years now. We all see that big bump in the rug, we all see its getting bigger each year, and we won't be able to ignore it indefinitely.

Also, the historical default rates do not reflect the more recent (and poorly disclosed) financing structures like the swaps in the Jefferson County example. If you are going to draw inferences from historical defaults, you need to find historical data that is similar to the present. We don't much history of municipalities using swaps; the limited history we have isn't good.

Like it or not, politicians (with our consent if not at our behest) have spent a lot money that we don't have-- the same as the rest of the economy. You don't need an MBA to figure this out; plenty of newspaper reporters have been saying so for years.

Someone is going to take a loss: taxpayers, municipal workers or muni investors... or all three.

Back in the 1970s when New York City was on the verge of default, the Federal government (of all people!) refused to help NYC unless it enacted massive spending cuts (the headline of the Daily News: "Ford to City: Drop Dead").

Even though AI has suggested (in the past) that muni's "rarely" default -- there is actually a long history of muni defaults.

Overall, the default rate is about 0.25% -- but this includes ALL muni bonds including general obligation bonds. If you look at just revenue bonds (like the AL sewer example AI gave) -- the historical default rates are much higher, on the order of 10% or more (see this link for an overview or google muni defaults).

Recovery rates (what an investor gets following bankruptcy) are high with some caveats... The recovery rate is supposedly about 69%; however the great statisticians that compile these numbers consider a new bond as "payment". If you were counting on cashing out a bond at maturity to pay your own expenses, you were screwed.

There is nothing wrong with buying muni bonds per se... but go in with your eyes open and know all the facts. Like the mortgage market, do not assume that credit rating agencies have done your homework for you.

Eventhorizon said...

How do these people manage to get ripped off? If they wanted to pay a fixed rate why did they not simply issue a plain vanilla Munipal bond?

Fixed rate debt always makes sense from a borrower's point of view since the lender takes most of the risk: if rates drop re-fi to a lower fixed rate, if rates rise, continue paying your, now, low fixed rate.

If someone said to me "we're going to issue a variable rate bond where the rate is set each week in an auction then we're going to sell you a floating for fixed swap and you are essentially going to pay a fixed rate". I would have said "Why don't we just issue fixd rate debt?"

The term "sell you" should trigger all kinds of alarms. For god's sake didn't they notice the pointy nose and big triangular teeth?

Never, never, never buy a financial product you don't understand.

Anonymous said...

Gramps,
You are too good.

DougM said...

@event...

The coupon rate on a 30 year fixed rate bond was probably higher than a comparable swap rate, which provided the opportunity for this "arbitrage."

The problem was the basis risk between the "receive floating" benchmark of the swap and the auction rate.

Accrued Interest said...

Anon #1: They were insured by various insurers.

That Will: I stand by my statement that the confluence of events at Jefferson are rare. Obviously short-term funding isn't rare, but very few large governments were leveraged like Jeff County.

Gramps:

Where in this article does it indicate "Revenue" bonds default at a 10% rate? When muni people use the term "Revenue" they mean any bond that isn't backed by the full taxing power of a municipality. That's the majority of municipal bonds. I'm sorry but there is absolutely no evidence that revenue bonds default at this rate.

Anyway... here is Moody's default study... See for yourself.

http://tinyurl.com/3a5bke

As far as the problem of declining property taxes... that's a real problem that I'm sure as hell not going to try to sweep under the rug. I'm not buying any local CA credits right now. But its worth noting that the state of CA doesn't collect property taxes. Local governments do.

I think CA's decline in income taxes post dot-com bubble will turn out to be a bigger deal than this will. Remember that CA only re-assess homes after a sale. Therefore most assessments are going to be based on 3-5 year old data. I think in the normal course of the budget process local municipalities will be able to deal with this. I'd expect downgrades moreso than defaults. Again, I'm not buying up local CA credits, mind you, because I fear the downgrades.

Anonymous said...

Just FYI regarding California property taxes, it's slightly more nuanced but the gist is correct. Property taxes are permitted to increase a maximum of 2% each year, unless the property is sold, at which point it can be reassessed an arbitrary amount.

However, for local municipalities the reality is slightly worse, as it is of course permitted in a downward market to request a reduction in assessed value.

Anyway, there's no way we'll see an across-the-board 2% property tax increase fly, and in many cases tax revenue will be lower as people request reduced assessment and houses sell for less than they did a few years ago. Ouch!

gramps said...

AI -

The attachment goes through a pretty lengthy split out of default rates on revenue bonds. Actually, the 10% was even a bit conservative for industrial and non-hospital healthcare backed bonds.

The problem we will all have analysing default rates is that the rates were very high for bonds issued before 1986 (when the tax law governing munis was reformed). Before then, practically any foolish idea somehow got muni status. Arguably, this inflated default rates for older bonds, but without any "control" its hard to say by how much.

Bonds issued since then have not really gone through a recession.... Yes, I know you are going to hysterically yell that the sky is falling as we speak. It may yet fall, but right now the Fed and Wall Street look downright ridiculous slashing rates and carrying on like chicken little. GDP is showing anemic but positive growth.

In all probability, we are in a recession (or will be soon)... but 300bp easing including inter-meeting moves and special lending facilities-- you would think we were actually in the great depression. Excluding people who got over-leveraged (who were foolish and will suffer no matter what the Fed does) -- most of the country isn't panicking. You shouldnt be either.

Anyway, because the Fed over-reacts to even the possibility of a slight downturn -- recently issued munis have never really been stress tested.

And as stated earlier, the history of muni bond defaults is almost entirely limited to cashflow problems on whatever project being financed.

In today's muni market, you also need to worry about a bureaucrat mistaking himself for a rates trader and making massive interest rate bets with swaps, caps, etc.

Truly "old" muni default rates may suffer from negative selection. More recent bonds have never been stress tested, and I think its fair to say that few, if any, muni issuers understand the swap agreements they have entered.

Jon Corzine, now NJ governor and former Goldman Chair, was quoted last year as saying he could not understand some of the swap agreements municipalities had entered into.

"Modern" bonds carry new risks. Besides swaps, declining taxes, crumbling infrastructure and unfunded pensions- many municipalities have spent way beyond their means in recent years (much like the rest of the country). You cannot make a valid comparison between the relatively "conservative" local governments of yester-year and today's municipalities...

All I am saying is that using the last 10-15 years of default history is misleading for many reasons. Default rates before that were much higher (for revenue bonds).

Salesmanship (are you trying to sell munis on this site?) is all very well-- but full disclosure really requires you to say that default rates can and have been much higher than the recent past.

Not to long ago, salesman were telling us mortgages were a "sure thing" because home prices never go down... lets all try to learn from our mistakes

Anonymous said...

I am in the Engineered equipment biz (pumps). The comment about corruption is correct. FBI was on to these guys. People at Jeff County went to JAIL.

Anonymous said...

Two words explain how Jeff Co got into this mess: Larry Langford.