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Will States, such as California, File Chapter 9?

Posted by Larry Doyle on December 3, 2010 6:38 AM |

Are those large waves roiling the world of municipal finance–and centered on California–to be feared?

Are they an indication of an oncoming tsunami? Or are they to be discounted and taken as just another  “Hey, dude, don’t worry. Surf’s up!!”

Well, perhaps those less concerned about what is just ‘off the coast’ may care to ‘break out their boards’ but prudence dictates we take a harder look at what is causing the recent waves in the world of municipal finance. These factors include:

1. The Deficit Commission proposal includes language that may eliminate the tax-exempt status of this sector which many Americans have come ‘to know and love.’

2. The muni sector itself has just suffered the worst month’s returns (-2.29%) this year. Bloomberg highlights this performance in writing, Tax-Exempts Suffer Biggest Monthly Drop This Year.

3. What is behind the recent selloff? Is it a crush of supply? Yes. During October and November, in excess of $100 billion in municipal supply hit the market. Anything else? Yes. Reports indicate that outflows from municipal mutual funds exceeded $5 billion during the middle of November. These outflows were the greatest since the early 1990s. These waves within the market are not small but they seem manageable. Might there be something else concerning investors? Are you sitting down?

4. Given the enormous deficits facing selected states (can you say California and Illinois?…we will leave the editorial comments as to how and why these two states are running the largest deficits, but let’s just say you wouldn’t run your business like this), and with municipal financings getting increasingly challenging, how will states handle these deficits? Devalue? Well, they do not have their own currency so we will leave that option to Ben Bernanke and Tim Geithner at the federal level. But what about default and restructure? Could this ever happen? No way, right? Never happen in America? These states would never be able to reenter the credit markets if they defaulted, right?

“Come on, dude, relax!! Why worry about it? Surf’s up!!”

While some within the industry may care to issue the carefree “Surf’s Up” call, the mission of Sense on Cents is to help you manage the waves not get overwhelmed by them. On that note, let’s navigate.

How might the little used municipal option of entering a Chapter 9 Bankruptcy be used at a state level? The highly regarded Strategas Research Partners has many positive outlooks on the world of municipal finance at large but in the midst of those views, they also address the potential for state bankruptcy filings. In a recently released research piece, Strategas writes:

Central to our economic call that state and local governments will not be a large drag for GDP, and that job losses will be less than expected, is that states are set to increase spending in FY ’11. We estimated a 4.2 pct increase – a report released today shows the increase will be 5.3 pct.

Tax revenue growth is slowly gaining steam and should pick up with jobs and spending gaining steam (another reason extension of the tax cuts is needed now).

Let the States Go Bankrupt
University of Pennsylvania law professor David Skeel, writing in The Weekly Standard, suggests that Congress pass a law allowing states to go bankrupt. Skeel, a bankruptcy expert, notes that a Depression-era statute allows local governments to go into bankruptcy. A state bankruptcy law would not let creditors thrust a state into bankruptcy — that would violate state sovereignty. But it would allow a state government going into bankruptcy to force a “cram down,” imposing a haircut on bondholders, and to rewrite its union contracts. The threat of bankruptcy would put a powerful weapon in the hands of governors and legislatures: They can tell their unions that they have to accept cuts now or face a much more dire fate in bankruptcy court. National Review, 11/29/10

We would not be surprised if federal legislation is introduced that allows states to enter Chapter 9 bankruptcy. This would obviously have a major impact on the muni market and we don’t believe the intention is to hurt the muni market. Rather the purpose would be for states to better deal with their unfunded liabilities since states cannot cut pensions for current employees and unions have no reason to take a haircut. But if states can restructure their debts, thus sparking a threat of workers losing their pensions entirely, unions will have an incentive to negotiate. We don’t expect this to pass into law.

Maybe the Federal Reserve might bail out the bankrupt states, you think? Hell, the Fed bailed out foreign banks and provided emergency funding to the European Central Bank, so why not our brethren in California, Illinois and elsewhere who have proven themselves incapable of managing their own finances?

While Strategas may not expect legislation allowing states to enter Chapter 9 to pass, how much do you trust the crowd in Washington, Sacramento, and elsewhere these days? Not much? I thought so. Neither do I.

“This would obviously have a major impact on the muni market and we don’t believe the intention is to hurt the muni market.”

The world may be filled with the best of intentions, BUT the economic landscape is also filled with all sorts of unintended consequences.

Navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

  • Dude

    In today’s Financial Times,
    Nervous US ‘Muni’ Market Eyes Vallejo

    Like sovereigns in Europe, states cannot file for bankruptcy.

    A big concern in the bond markets is whether other cash-strapped local entities will turn to the courts for relief and force bondholders to accept concessions that have, at least in the recent past, been reserved for citizens, workers and vendors. In the past two weeks, investors have withdrawn more than $5bn from so-called “muni” funds, which buy municipal bonds, in part because of nervousness over local finances.

    “Vallejo is significant because it is part of a process of redefining the extent of the [bankruptcy] statute,” said Christopher Mier, a managing director at Loop Capital Markets, who served on the creditors’ committee for Orange County, California, whose 1994 bankruptcy was the US’s largest in 30 years.

    “Because Chapter 9 has been used so infrequently, any one case can set new precedents.”

    US state deficits

    Explore the US state fiscal crisis and examine each state’s 2011 budget gap and credit ratings
    Since 1980, there have been 248 Chapter 9 filings.

  • LD-

    My business is based in CA and a major part of what we do is work with distressed companies. Business is good! Most companies can not afford the exorbitant costs associated with a Chapter 11 and it is still the case that most lower middle market companies who enter into Chapter 11 end up in a Chapter 7 liquidation. We pride ourselves in being efficient and effective in dealing amicably and objectively with large numbers of creditors. Our assistance in implementing out-of-court restructuring plans has resulted in significant reduction in costs and delay, allowing clients that could not have afforded the administrative costs of a Chapter 11 to restructure and continue to operate. In representing our clients in an out of court restructuring we more often than not play the bankruptcy card in order to get concessions with our clients creditors. We present the facts and expedite the out of court restructuring process. We have a high level of success by being empathetic listeners to creditors and acting as an objective 3rd party. After creditors emotions have been separated by objectivity, most get it and a reasonable conclusion is realized. This is not the case when we deal with Unions. They believe and negotiate as if they are Sr. Secured creditors, and in my experience, I have seen their tactics torch good companies who would have been able to move forward if only the Unions were reasonable. The state of California is essentially insolvent and it is time the State starts operating as a business, lawyer up and start the cram down process with the Unions and other creditors or file Chapter 9.


    • LD

      Chuckie D.,

      Good to see there is some ‘sense on cents’ on the left coast…!!

  • Jeffers

    Regardless of other sentiment, I say no freaking way. If a state is bankrupt than why isn’t the federal government. The hypocrisy is too obvious and the loss to bond holders too great. The solution is more printing via the fed. QE2(3?) will be for those who need it most this next round. They will keep the game going. Do not worry.

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