Earlier this month, our state’s capital, Harrisburg, voted to file for bankruptcy protection. This puts the city in a perilous position and sends reverberations throughout the municipal markets.
Harrisburg is the first state capital to seek bankruptcy protection in the last 40 years. Does this mean Meredith Whitney’s dire predictions from last year may be coming true?
At the end of 2010, a woman named Meredith Whitney predicted significant municipal bond defaults totaling in the hundreds of billions of dollars. This statement sent the municipal market (usually a poster-child of stability with very low default rates — typically .01%) into a tailspin.
So, who is Meredith Whitney and why do we care what she thinks? Fortune magazine ranks Meredith Whitney as No. 48 on the 50 Most Powerful Women in Business for 2011 list. She owns Meredith Whitney Advisory Group and was a banking analyst for Oppenheimer and Co. before starting her own firm in early 2009.
Her claim to fame is her bearish call on banks, most notably a scathing report on Citigroup, before the financial crisis in 2008, and was named CNBC’s ‘Power Player of the Year’ in 2008, quite a feat for a woman in the financial industry. However, being a bank analyst and calling the financial disaster caused by banks are much different from making a call on the municipal bond market.
While the muni bond market has since staged a recovery, Ms. Whitney’s call on its imminent collapse and the subsequent media blitz she received (starting with a segment on ’60 Minutes’) swiftly hammered the municipal bond market.
Given the recent Harrisburg filing, could she still be right? Let me clarify: Even if she is not right on this call, she is still willing to call it like she sees it and go against the grain. That is something special on Wall Street.
Harrisburg is the largest municipality to file for bankruptcy since 2008. The capital city has a population of approximately 47,000 and has a poverty rate of 29 percent, thus one reason for its financial problems. If the bankruptcy is permitted to go through, it will hurt the city’s ability to finance projects through bond offerings.
Pennsylvania passed legislation earlier this year specifically to deter Harrisburg from filing for bankruptcy. In reality, the bankruptcy filing may be a bargaining chip with both the state and its bondholders. The city faces a heavy debt-load of $450 million, which is five times Harrisburg’s annual budget. The issues that steered Harrisburg to bankruptcy were spearheaded by the Harrisburg Resource Recovery Facility, or ‘the incinerator.’
The story goes back to 1972, when the incinerator was built for $15 million and sold to the city under the projections that the incinerator would provide enough steam power to cover its costs and debt service. The projections were wrong, and in 2003 the EPA discovered the incinerator needed to be retrofitted due to its emissions of dangerous chemicals and shut it down.
Incredibly and unfortunately, Harrisburg doubled-down on its bad decision and spent an additional $125 million in bonds to upgrade. This was in addition to the $94 million already owed on the facility. The incinerator has not broken even and is essentially Harrisburg’s money pit. The Chapter 9 bankruptcy filing occurred when the city could not afford to pay on the incinerator’s $242 million debt outstanding and had a $65 million payment past due.
Many pundits agree that cities may begin to use bankruptcy as a way to seek concessions from states and their bondholders. While filing used to be frowned upon, more cities are discussing the option. Chapter 9 bankruptcy is available to many municipalities (unless outlawed by their state) and excludes states (states are not permitted to file Chapter 9) and it is different from corporate and personal bankruptcy proceedings. It gives power to re-write collective bargaining agreements, which is very difficult in corporate bankruptcies. General Obligation bonds are treated as general debt and payment may be withheld for these during the bankruptcy process. GO Bonds are typically restructured in Chapter 9 to regain solvency for the municipality.
Since Nestlerode and Co. Inc. (now Nestlerode and Loy Inc.) was founded in 1937, there have been only 629 municipal bankruptcies. As of September 27, 2011, the default rate for municipals in 2011 was only .03 percent, which is higher than the average but not untenable.
My belief is that we will not see a rash of municipal defaults. Defaults leave a black eye, are difficult to do (it usually takes two-three years just to file) and lead to higher borrowing costs. However, the threat of bankruptcy may be used to obtain concessions and lessen the debt load of many municipalities.
For high-income individuals, the tax-adjusted interest rates and perceived security are still attractive, and a downturn can be used to add to positions in the right places.
