24 June 2014

Yet More on "Municipal Bankruptcy"

My earlier posts about my article, Municipal Bankruptcy: When Doing Less Is Doing Best (download here) can be found here and here. In the first, I gave away my conclusion: the triple-threat of confirmation requirements--fair and equitable, no unfair discrimination, and best interests--make it virtually impossible without the consent of all creditor classes to confirm a plan treating retirees and bondholders differently or treating them the same (in states that give public employment retirees special protection). The court's threat of dismissal coupled with the return to the pre-bankruptcy mess should drive all parties to consensus. In other words, the Bankruptcy Code creates a game of Chicken.

In the second post, I described one set of reasons why the California city of Stockton got in its financial mess. Extravagant and irreducible public employee benefits played a substantial part.

In this post I want to address the other side of the coin--the dark arts of public finance. Quoting myself:

In 2012 the United States Securities and Exchange Commission issued a substantial report addressing several areas of concern with the municipal securities market. The SEC Report made a number of background statements about the parlous state of municipal finance in America. ... Since 2008, however, private credit enhancement in the form of bank-issued letters of credit and traditional bond insurance has fallen substantially.  Instead of private insurance, credit enhancement currently takes the form of guaranties by other governmental entities of the debt of a lower-level or affiliated issuer.

Summarizing matters, until 2008, private insurers guaranteed local government borrowing, which allowed bonds to be issued at lower rates of interest. Thus, buyers of bonds felt insulated from credit risk. Since then, however, local governments can still borrow at very low rates of interest rates because in at least some cases their states guarantee their debts! Thus, buyers still feel insulated from risk because states cannot file bankruptcy. Talk about a house of cards!

But there's more due to ...

the opaque nature of the secondary market in municipal securities. According to the SEC Report, “information about the prices at which market participants may be willing to buy or sell a municipal security, and who might be interested, is not broadly available. . . .” Thus, while the secondary market in municipal securities is active, matching small transactions is not straightforward and current pricing information is often lacking. The prevalence of many relatively small retail investors attracted by tax subsidies for municipal securities exacerbates this problem.

Summary #2: buyers of municipal bonds don't know what they're buying. They operate on blind faith that all municipal bond issuers will pay all the time. Welcome to Stockton and Detroit. 

The bottom line: For many years cities have been able to borrow at low rates of interest from folks who thought there was no risk. Any wonder many municipalities have borrowed and spent money like drunken sailors? And no wonder some believe that insouciant buyers of municipal bonds should bear more of the burden of municipal insolvency than aged retirees.

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