Monday, July 20, 2009

Municipal Credit: They never even asked me any questions

California's budget woes are getting all the attention, but as reader In Debt We Trust pointed out, Philadelphia is also halting payments to vendors. In fact, because the current recession is hitting property taxes so directly (which is most local governments' best revenue source), I'd expect municipalities to struggle mightily with their budgets for the next couple years.

Now I expect very few actual defaults among municipal governments. But there will be some. And there will be even more close calls. Situations where municipal governments do things that they wouldn't normally contemplate.

Things brings us to some interesting legal questions that might shake the foundation upon which much of the muni market is based. Consider the use of lease-backed transactions. Here is a sample of language from a municipal official statement. Its for a lease by the City of Tulsa for a city government administration building. For full disclosure, I don't currently own this issue, but once did:

"Notwithstanding anything to the contrary contained in the Lease, if the City does not appropriate funds paid to the Authority pursuant to the Lease for any fiscal year... during the term of the Lease, the City shall not be obliged to make payments for such non-appropriated fiscal year. In such event, the Lease shall automatically terminate and become null and void as of the end of the preceding fiscal year."

So you ask yourself, who the hell would buy such a security? Basically Tulsa can get out of this lease by... not paying it! Imagine if an apartment lease was written this way: "The Tenant owes the Owner the rent, except if he doesn't pay the rent."

The answer is, of course, because if the City doesn't pay its rent, then in theory, bondholders can evict them from the administrative building. Obviously the city would still have to fill an administrative function, and if they reneged on one lease, they'd have a hard time getting another one. On top of that, depending on the situation, bond holders may not have the right to foreclose on the building.

Classically, munis guys have considered the essential service nature of any lease back transaction. So for example, this Tulsa deal, bond buyers can take some comfort that the City has a strong incentive to honor their obligation. In fact, in a typical lease-back deal, the ratings agencies will rate the lease 1 notch below the issuer's general obligation rating. So the City of Tulsa is rating Aa2/AA, this deal would be rated Aa3/AA-.

Now let's look at a different deal, this one for a new toll road being built in the Research Triangle area of North Carolina. This one was just sold last week.

"In July 2008, the General Assembly of North Carolina enacted legislation that included a provision creating a continuing annual appropriation to the Authority of $25,000,000 for the Triangle Expressway System to service debt and fund required reserves in connection with bonds issued to finance the Triangle Expressway System... The legislation states that it is the intention of the General Assembly that the enactment of the annual appropriation ... shall not in any manner constitute a pledge of the faith and credit and taxing power of the State of North Carolina, and nothing contained therein shall prohibit the General Assembly from amending the appropriations to decrease or eliminate the amount annually appropriated to the Authority." (Emphasis is in the original.)

So the state is giving you what? Literally just promise. Bond holders do not have a mortgage on the toll road (which isn't even constructed yet). The beneficial rights to that road (tolls) are 100% the State's. Bond holders cannot get to those funds. So in theory, the State could build the road, start collecting tolls, and then repeal the legislation allowing for payment to bond holders!

Now, I don't think this is very likely, since as I said, if the state reneged on its appropriations pledge, then it would be effectively shut out of the capital markets. But its amazing to think that bond holders actually bought up this Triangle Expressway deal without even demanding the proceeds from eventual toll revenue. At least that would give the state some real economic incentive to keep bond holders whole. Needless to say, I passed on these bonds.

But it brings up an array of legal questions, many of which have rarely been tested in court, if ever. For example, as I said before, bond investors have always valued more "essential service" leases over those designed for economic development. But could a municipality legally choose which lease payments to make? For example, (and I'm just making this up) say Tulsa has this lease for an important admin building, but it also built a conference center which it leased back to itself. Maybe the conference center can't get anything other that some dorky Star Wars convention every year and the City's budget is strained enough. They just want to close the place and walk away.

In a normal corporate setting, a corporation can't just choose not to pay subordinate bond holders in favor of senior holders outside of bankruptcy. Sometimes they can defer payments, depending on how the deal was structured, but even there, the obligation doesn't erase.

As I said above, ratings agencies treat these lease deals very much like a subordinate general obligation. But is it really? Getting back to my Tulsa example, if both leases were structured as subordinate GO bonds, then Tulsa would have to treat both the same. They couldn't choose to walk away from the money losing convention center but keep current on the admin building. The only way to restructure their indebtedness, without bond holder approval, would be in bankruptcy court.

But the leases aren't really subordinate GOs, not in a legal sense. But could someone go to court and argue that all Tulsa's leases are pari passu? I don't know that its been tested, and it probably depends very much on how exactly the indenture language is written as well as each state's constitution.

And what about something like the North Carolina highway, where its just a straight state appropriation. Say the state can't afford to make the appropriation in 2016, but the highway is still in use. Then let's say their fiscal situation improves in 2017. Would the state still be obligated to make its appropriation pledge? If they completely walked away, could a court rule that the State can no longer use the road? Again, I don't think this kind of thing has been tested all that much.

And it probably won't be tested with state-wide revenue issues. North Carolina's reputation is worth a lot to them in terms of lower cost of funds. So it would take a pretty bad situation for them to trash their credit rating. But I'm betting there are some local governments who try some aggressive maneuvering to improve their budget situation. And there will be lawsuits. Oh yes, there will be lawsuits.


Gringcorp said...

Two quick things. I don't think the Triangle Expressway bonds are closed yet, at least not all of them, and the appropriations-based bonds are not all the financing. There's a pretty decent-sized slug of bonds based on traffic revenues and which are set to be wrapped by our friends at Assured Guaranty. Could there be a cross-default provision between the two? I don't know, and the monoline might not want to do it that way.

But your examination of appropriations risk is a timely one. States and municipalities are starting to do deals where they pay a private party to build a road or hospital or courthouse of whatever over a number of years. It's a little like leasing the facility, though the private guys tend to do more of the maintenance and so forth. The contracts are 20 years, and the banks (mostly European) that are lending the private guys the money to do this have no idea whether the appropriations will be there down the line. Their assumption is that lack of access to capital markets is a sufficient deterrent. Ask them hoow that worked out with the Ecuadorian government's sovereign default.

Lou Polur said...

I remember growing up reading Moody's red-cover bond ratings book with my father every month. He would ask me about ratings, security & collateral, etc.

How can these get investment ratings?

Is this the same as AAA ratings on mortgage pools of sub & alt-A?

Lou Polur