Bloomberg has a nice piece here that partially explains this phenomenon. Many financially strapped municipalities cannot borrow on the "full faith and security" of their future tax revenues. Cities always have the power (not necessarily the right) not to pay a creditor, even if that creditor holds a general obligation (GO) bond.
Cities are tempted to stop paying their general obligation bond creditors when the immediate needs of their current residents overwhelm the political will to pay earlier contracted debts. As Bloomberg puts it, "Debt payments are typically subject to appropriation, meaning officials could divert the funds in a cash crunch to preserve services or make payroll." And there's not much the GO bondholders can do outside bankruptcy and even less in the event the defaulting city files for relief under Chapter 9.
Bond buyers are thus more and more likely to lend to troubled cities by "buying" certificates of participation (COPs). An example of COP financing would have a city enter into a long-term lease of a public golf course to a private entity and then sell COPs in the stream of anticipated lease payments.
This works fine unless, however, the lessee of the golf course stops paying. The city would then have the right like any lessor to take back the leased property but whence will it get the money for the payments promised to the buyers of the COPs? In short, it will probably stop paying and the COP buyers like general obligation lenders will find themselves holding the short end of the stick.
And here's where the Bloomberg article leaves me wanting more. While Bloomberg reports that some institutional bond (and COP) buyers "may" pull out of the market, why aren't the credit reporting agencies doing a better job of evaluation each GO bond and COP issue on a city-by-city and lease-by-lease basis? Perhaps the lackadaisical approach could be excused in the first decade of this millennium but no longer, right?
As Bloomberg reports, "Michael Ginestro, director of municipal research at Bel Air Investment Advisors, which manages $2.7 billion of munis, said he focuses on the collateral for lease bonds, rather than credit ratings." I can understand Ginestro's efforts if ratings aren't of any value. Yet, if this is generally the case, then what's the point of paying rating agencies a boatload of money to rate bonds?
For those who want more detail on municipal finance and bankruptcy, download my published article Municipal Bankruptcy: When Doing Less Is Doing Best (here) and working drafts of my very soon-to-be-published papers Who Bears the Cost? The Necessity of Taxpayer Participation in Chapter 9 (here), and Who Bears the Burden: The Place for Participation of Municipal Residents in Chapter 9 (here).