Thursday, 20 January 2011 02:13

Here Come Those Municipal Defaults That Everyone Said Couldn't Happen

Three years ago, I ran a series of posts that declared the housing crisis will lead to municipal defaults (Municipal bond market and the securitization crisis – part I and Municipal bond market and the securitization crisis – part 2) and even worse, miserable recoveries. I caught a lot of flack on this proclamation from the "expert"Muni investors and analysts. The Muni default record blah, blah, blah... Historically, Munis have rarely defaulted... Yakety yak! Well, somebody better explain that to the unsecured investors of bankrupt Vallejo, CA. From the Bond Buyer:

SAN FRANCISCO — Unsecured creditors will receive 5 cents to 20 cents on the dollar for their claims under a reorganization plan Vallejo, Calif., filed Tuesday in federal court.

The plan to exit bankruptcy outlines the reorganization of debt the city owes its largest creditors, Union Bank and National Public Finance Guarantee. It also sets aside a pool of $6 million to pay unsecured creditors about 5% to 20% of their claims over two years, according to court documents filed in U.S. Bankruptcy Court for the Eastern District in Sacramento.

“The city regrets that it cannot pay a higher percentage,” Vallejo officials said in the court filings. “The city lacks the revenues to do so while maintaining an adequate level of municipal services, such as the provision of fire and police protection and the repairing of the city’s streets.”

The city has also settled with NPFG over fees that backed insured certificates of participation, according to court documents.

The formal legal plan is based on a five-year road map City Council members approved at the end of November, tackling $195 million in unfunded city pension obligations, cutting payments for retiree health care, reducing pension benefits for new employees, raising pension contributions for current workers, and creating a rainy-day fund.

Union Bank, the largest creditor, is owed $50 million after holding letters of credit on four series of defaulted COPs. The filing indicates Union Bank will get a new “lease-leaseback” obligation in exchange for canceling the COP series. It will also get $6 million of unspent proceeds from the COPs held under trust agreements.

Union Bank is slated to get 40% less than what it would have received from the original COP scheduled payments, according to the Vallejo filing.

Big cities and small cities alike will be facing this problem. As excerpted from NYC Goes Out “Euro-Style” As It Experiences The Results Of “Applied, Stealth Austerity” And Its Citizens Suffer Like Never Before! Wednesday, December 29th, 2010

It is not inconceivable to fantasize about crucial city services that save lives getting more of that multi-trillion federal assistance than bondholders behind failed and fraudulent banking practices, no? As for the anticipation that this will resolve itself by next year…


So, where does this leave us? Well, if it is clear that European states will probably default, why wouldn’t the same apply to US municipalities? Three years ago (in 2007) I warned of an extreme spike in muni defaults. Here is an annotated excerpt of a more detailed warning written in 2008 when everyone thought I was being a “bear” (actually, it should be called a realist with a spreadsheet and objective perspective)…

From the Municipal bond market and the securitization crisis – part 2

Further building on the Municipal bond market and the securitization crisis – part I, we have calculated the likely default amount on the municipal bonds issued in the last four years (2004 to 2007). We have assigned default rates on the municipal bonds for various states on the basis of property price decline and the decline in the building permits witnessed in each state. In this analysis, we have also considered defaults on the general obligation bonds (GO bonds) as the macroeconomic conditions have deteriorated and could result in increased stress on municipalities. Although historically, the GO bonds have defaulted rarely (the contribution to total default by Municipal bonds is 3.54% for GO bonds and the remaining 96.46% defaults is on Revenue bonds), declining property prices and rising foreclosures are likely to have a negative impact on municipalities’ revenues in the form of taxes.

Since we have maintained from the beginning that this crisis is far worse than any crisis that the US economy has witnessed for close to half a century, our underlying assumption while calculating the default probabilities by GO and Revenue bonds has been a premium over historical default rates on the munis for the period 1979-97. This premium is dependent on the degree of decline in housing prices, building permits and the broader infrastructure investment. In the case of Revenue bonds, the multiple has been considered higher as compared to GO bonds since historically; Revenue bonds have defaulted more than the GO bonds.

House price decline

Building permits decline

Premium over historical defaults for Revenue bonds

Premium over historical defaults for GO bonds













> -15%

> -30%



We have calculated the likely defaults on municipal bonds issued since the year 2004 since this is the period where most US state and local governments had prepared budgets based on the existing real estate boom. In addition, the prevailing low interest rate environment was very conducive for muni bond issuance. However, with the collapse of the housing market, property values went down and increasing numbers of homeowners applied for the property revaluation to reduce their property tax burdens. This increased the burden on the respective municipalities, as homeowners, in an attempt to mitigate the increase of their financial obligations obtained during the housing boom equity spending spree, cut corners by any means necessary. Construction permits and the associated fee income dropped precipitously, further constricting the bloated budgets of municipalities who, like the fabled subprime refinancing, SUV driving 1st time homeowner binged on easy equity-sourced cash.

Additional strains in the revenue sourcing for municipalities are the rampant foreclosure rate increases and the actual volumes of foreclosures. Up until the event of actual foreclosure, property taxes are usually not paid, further hampering the cash flows of municipalities that relied on these funds. It gets worse. Even after foreclosure, and even on behalf of the municipality, the back taxes cannot be monetized and actually paid until the property is sold. Many auctions in high foreclosure areas are seeing properties with no bid at the upset price.

This is being exacerbated by the continual fall in prices (see ).

This portends very bad things for the banks, the municipalities and the insurers who wrote insurance to cover them! See

  1. What is the Fallout of the Ambac Bankruptcy on the Investment Banking Industry? Robo-signing Conspiracy Theory Grows Some Balls Monday, November 15th, 2010
  2. Banks, Monolines, and Ratings Agencies As The Three Card Monte (Wall)Street Hustlers! Its a Sucker’s Bet, Who’s Going to Fall for it in QE2? Tuesday, November 9th, 2010
  3. The Inevitable Has Come To Pass and Those That Insured Guaranteed Blowups Are Being Blown Up! Monday, November 1st, 2010


These developments are likely to have a severe negative impact on the tax inflow for the state and local governments which forms the basis of our underlying assumptions. According to our estimates, on the total municipal bond issuance of US$1.6 trillion in the year 2004-07, the potential losses due to defaults will be US$22.8 billion or a default rate of 1.44% with Revenue bonds contributing majority of the default amount of US$22.5 billion while GO bonds account for US$304 million. This indicates a default rate of 2.12% for the Revenue bonds and 0.06% for GO bonds.

In the multifamily housing segment, default rates increased significantly and were extremely high for the period 1987-90, i.e. at the time of the S&L crisis when real estate lending was reckless due to declining lending standards by banks and other financial institutions. The default rate peaked in 1988 in the eleven year period reviewed to 4.31%, followed by 3.41% in 1989.

See also Is Illinois Worse Off Than Greece with a Little LTCM and Bear Stearns Thrown In? In Case You Didn’t Know… Monday, August 23rd, 2010

As excerpted:

Illinois Municipal Debt Defies Gravity

As municipal debt issuance continues to drop alongside yields, Chicago and Illinois continue to issue debt despite their deteriorating credit ratings and negative outlooks.  Even as rates for AAA tax exempt borrowers have fallen, statewide issues from budget shortfalls, unemployment a full percent above the national average, and most importantly for the municipal bond market, declining state revenues have started to drive Illinois credit spreads wider than the poster child for state profligacy, California.  Recent headlines have made it clear that state services in this fifth largest of the US states are under pressure.

Illinois Budget Crisis Draining State Services: Bloomberg

  • State retirement liabilities are near $130 billion, Illinois holds the country’s largest pension and health care funding gaps
  • Pension debt is $90 billion, and programs are unfunded to the tune of $54 billion
  • The state’s unpaid bills have risen by $1 billion in the past year

Chicago Downgrade Raises Borrowing Costs Amid $164 Million Sale: Bloomberg

  • Chicago is planning a multibillion dollar education capital plan, which it will debt finance
  • Chicago has continued to thin out its cash reserves, and when faced with firing 1,200 public school employees, it instead chose to let the good times roll (party like its 2005)
  • Recent credit ratings downgrades may have raised the debt financing cost by 40%

Illinois Pension Continues to Borrow From Future: Sun Times

  • In January of this year, Illinois raised $3.5 billion in five year pension obligation notes at a tax free rate of 3.84%, most of the funds going to the Teachers Retirement System (TRS)
  • The pension fund usually reinvests the some of the proceeds from the bond sale into financial markets to try and beat the 3.84% interest rate, however, in 2009, the TRS fund lost 22%, even as the S&P 500 strengthened by 26%
  • The pension system has reached an endpoint where simply cutting future benefits will not be enough to get out of a fatal debt spiral

Those who are interested in reading more on my 3 year old muni sector analysis should read Municipal bond market and the securitization crisis – part I and Municipal bond market and the securitization crisis – part 2. Those interested in subscribing to our research services can do so by following this link.


Last modified on Thursday, 20 January 2011 02:13