What Are the Causes of Municipal Defaults and Bankruptcy?

by James Spiotto

A.  Traditionally causes of municipal bond defaults in the U.S.A. have been more linked to inability to pay rather than unwillingness to pay or political risks:

1. Economic depression.
2. Non-essential services.
3. Feasibility of projects and municipal enterprises.
4. Fraud.
5. Mismanagement.
6. Natural and man-made disasters.

B.  New causes of default:

1. Unaffordable and unsustainable personnel costs.
2. Deferred costs of capital improvements and infrastructure costs.
3. Decline of urban areas.
4. Proposition thirteen mentality – The popularity of tax caps and limitations.
5. Off balance sheet liabilities – Unforeseen judgments and derivatives problems.

The Big Question:

Willingness to pay vs. ability to pay – Willingness to pay traditionally has not been a problem but could be a growing problem.

C.  Causes of Chapter 9 and default to be noted and financial condition of issuers to be avoided:

1. Unaffordable and unsustainable personnel costs. (Vallejo, San Bernardino, Detroit)
2. Deferred costs of capital improvements and infrastructure costs. (Detroit and Central Falls)
3. The bursting of the local government debt bubble. (Jefferson County and Detroit)
4. Decline of urban areas. (Detroit and Central Falls)
5. Proposition thirteen mentality – The popularity of tax caps and limitations. (Stockton and San Bernardino)
6. Lingering legal issues and surprise court decisions. (Town of Mammoth Lakes and Boise County, Idaho)
7. Off balance sheet liabilities. (Underfunded pension obligations – Stockton, San Bernardino, Detroit)
8. Willingness to pay vs. ability to pay – Willingness to pay traditionally has not been a problem but could be a growing problem. (Jefferson County, Orange County, etc.)

D.  Analysis of the causes of municipal default. Generally, 75% of all municipal bond defaults have occurred in bonds issued by municipalities to finance revenue producing enterprises (i.e., highways, bridges, utilities, swimming pools, harbors, etc.).

There are many causes of municipal default. A number of factors, while they do not in and of themselves necessarily cause default, contribute to restricted cash flow which brings about an inability to meet scheduled debt service payments.

1. Personnel costs. One of the largest problems that municipalities face is the ability to deal with all the personnel related financial problems. Increasing number of employees, salary, benefit, and pension demands, create an increasing and significant problem for municipalities absent new sources of revenues, including taxation.

	NUMBER OF STATE EMPLOYEES	NUMBER OF LOCAL EMPLOYEES	PERCENTAGE OF STATE OF ALL GOVERNMENT EMPLOYEES	PERCENTAGE OF LOCAL OF ALL GOVERNMENT EMPLOYEES
1970	2,755,000	7,392,000	21.1	56.7
1997	4,732,608	12,000,608	24.2	61.4
2015 January	5,077,000	14,089,608	23.2	64.5
Percent Increase from 1970	84.2%	89.5%	9.9%	13.7%

Pension obligation for Municipal Workers do not have priority in Bankruptcy no protection for Deferred Compensation:

–    Demand for Funding Now.

–    Orange County Cut Thousands to Balance Budget.

State and Local Government Employees have grown between 1946 – 2008 by 12.7 million employees, faster than the rate of growth in population. In 1946, there were 2.3 State and Local Government Employees per 100 citizens. In 2008, that number was 6.5. Are we less effective? (Grandfather State and Local Government Spending Report by Michael Hodges).

2. Deferred capital improvement and infrastructure costs. The life cycle for capital improvements in a municipality may be 20, 30, 40 or even 100 years depending upon the quality and nature of the improvement. It is clear that municipalities need bridge financing to cover those years in which significant cash levies must be made for capital improvements. In addition, municipalities face increasing resistance by taxpayers for continuing assessments and taxation. This has caused increased problems for municipalities. Many times, municipalities forego capital expenditures for political expediency and popularity with the electorate, only to find that the cost of maintenance and repairs has increased, thereby decreasing funds available for other municipal services. Current estimate of the cost to keep the infrastructure in the U.S.A. up to an acceptable level as of 2014 over the next five years is $3.6 trillion according to the American Society of Civil Engineer (“ASCE”).
3. Natural disasters or manmade disasters.
   • The hurricanes of the early 1900’s caused Galveston, Texas to be virtually wiped out and so was its bond debt.
   • Acts of terror or present day disasters all have the potential of being a contributing cause to municipal defaults.

4. USA: state and local government debt bubble.
   • The debt of state and local government has also almost doubled in the between 2000 and 2009, from $1.197 trillion in 2000 to $2.362 in the fourth quarter of 2009.
   • This does not include over $1 trillion of Unfunded Pension Liabilities and OPEB of over $300-$700 billion plus the needed financing of debt funding over the next five years to bring infrastructure up to acceptable standards of $2.5 trillion.

5. Decline of urban areas.
   • Surfing the Internet.
   • Virtual office – Telecommuting probably less than 10% today (3.8% as of 2012) of workers in U.S.A. but what if it is 25% or more tomorrow. (Globally 20% of workers telecommute.)
   • Decrease intercity tax payer (head tax, income tax, parking, sales, gasoline taxes).

6. Flight from the rustbelt to the funbelt.
   • Movement from Industrial States. (the rustbelt, Illinois, Indiana, Michigan, New York, Ohio, Pennsylvania, West Virginia and Wisconsin went from 53% share of manufacturing jobs in the U.S.A. in 1950 to 35% in 2000.)
   • New office environments.
   • Effect on 30 year Bond and taxes.
   • Erosion of corporate and residential tax base.

7. Proposition thirteen mentality – the popularity of tax caps and limitations. Back in the mid-1800’s, certain municipalities recognized the necessity of keeping taxation within limits, and certain states established constitutional debt limitations to prevent extraordinary expenditures. By the 1960’s, the tax burden was imposed upon fewer and fewer citizens. With the increased pressure on individual personal budgets, the taxpayer revolt spawned by Proposition Thirteen in California became a reality. This reality limited the ability of many states and municipalities to solve problems by increasing taxes or issuing new bonds. In short, the absence of votes and legislative approval for increased taxes has significantly decreased municipal cash flow. The Tea Party is just beginning.
8. Lingering legal issues and surprise court decisions.
   • WPPSS – Participants obligations to pay.
   • Orange County – TRANS Statutory Lien and use of derivative investments.
   • Riverside County – Bondholders liability for revoking tax–exempt status.
   • Camden, NJ – Coordinating state and local government relationships.
   • Jefferson County, AL – Unwillingness to pay rates that were projected and disclosed to warrant holders and use of local government malfeasance as a defense to not paying.
   • Detroit, MI – Questioning the pledge of revenues of Unlimited Tax General Obligation Bonds (“ULTGOs”) and the validity questioning of certificates of participation which funded $1.4 billion pension funding.

9. Off balance sheet liabilities.  (Is the balance sheet the tip of the iceberg?)
   • Early Call / Redemptions: Tax and IRS problems, municipalities continuing disclosure cooperation.
   • Environmental clean up.
   • Unfunded mandates.
   • Pension fund liabilities (underfunded).
   • Deferred compensation.
   • Liabilities for IRS and SEC Investigations.
   • SWAPS and Derivative Contracts.
   • Auction Rate and Variable Rate Issues.
   • Deferred infrastructure cost of maintenance and improvements to essential services.

James E. Spiotto, Co-Publisher © James E. Spiotto. All rights reserved (2015).