Municipal Bondholders 1, Jefferson County Newspeak 0

Score one for bondholders. 

A federal judge ruled in June that Jefferson County, Alabama could not reduce debt payments while in bankruptcy in order to spend more of the system’s net operating revenues on its aging sewage system. 

County’s Orwellian claim at odds with municipal market

In its losing argument, the county claimed future capital expenditures were, in fact, “necessary operating expenses” and it was entitled to hold back significant portions of its net operating income for these operating expenses rather than apply them to current debt service payments as called for in the bond indenture. The county’s claim is at odds with most municipal bond lawyers’, investors’ and market participants’ understanding of the law and contrary to decades of historical precedence.

The federal judge ruled: “operating expenses as determined under the indenture do not include (1) a reserve for depreciation, amortization, or future expenditures, or (2) an estimate for professional fees and expenses.” In other words, the Judge ruled any available income after covering the system’s current operating expenses (i.e. salaries, electric bill, etc.) must be applied to debt service payments. That is how the indenture (bond contract) reads – this is not a complex issue.

From the outset, the county’s claim seemed to be Orwellian in nature with an Alabama twist. It was nonsensical – an attempt to redefine basic words, terms and concepts municipal bond market participants have relied on for decades. Fortunately, it was thwarted by the decision of U.S. Bankruptcy Court Judge Thomas B. Bennett and, temporarily, returns a modicum of sanity to the ongoing financial and political fiasco that has engulfed Alabama municipal finance for the last several years. We are hopeful officials in Jefferson County, Alabama will take note of the Court’s decision and begin to deal with their problem in a responsible manner.

We applaud Judge Bennett for his decision relying on Orwellian newspeak to write, “the judge’s decision prevented an ungood (bad) situation from becoming double plus bad (worse)” . 

Follow the leader – Stockton files 

Stockton, California filed for Chapter 9 bankruptcy protection in June becoming the largest U.S. city to seek court protection from its creditors. The current year budget (July 1st) defaults on approximately $10 million in bond payments and $11 million in employee pay and benefits. Salaries and benefits for employees coupled with retiree benefit costs account for approximately 70% of its general fund. Additionally, two bond issues for non-essential, non-traditional public purposes (ice hockey arena and waterfront development projects) increased its outstanding debt approximately $200 million. The city stated its largest unsecured creditor is the California Public Employees’ Retirement System. Debt holders represent the second largest creditor group and mostly, but not universally, enjoy a secured creditor status. 

Let the newspeak, California style, begin.

Three pillars of municipal credit research stand

How do we react to and interpret the evolving events in Jefferson County, Alabama and Stockton, California? How do these events affect our clients’ managed bond portfolios even though none own any Stockton, California or Jefferson County, Alabama bonds?

The first thought that comes to mind is that there will be more situations similar to Stockton and Jefferson County so diligence remains primary.

Secondly, we remind our readers of a municipal bond market truism we believe and have recited many times over many years – municipal finance is mostly a local phenomenon. 

Stockton and Jefferson County face serious financial problems – greatly of their own making – resulting from a series of very bad decisions over many years. That was apparent to anyone paying attention to details years ago. Now, each one of these communities will spend years struggling to right itself financially so that it can progress and prosper in the years ahead. The future success or failure each will experience will depend greatly on decisions made locally and at the state level in the months ahead as these communities move through the Chapter 9 process.

As an example, the Rhode Island state legislature enacted legislation clearly stating the long recognized, priority interest of SECURED BONDHOLDERS in any Chapter 9 filings occurring in its state. This action positively impacts and lowers borrowing costs for local governments across Rhode Island and serves to encourage investors to invest capital in Rhode Island.

California and Alabama, to date, have not taken similar actions. Will they? Until we see some clarity, we remain wary of credits in these states. These will be interesting case studies to follow.

Thirdly, not all communities have behaved like Stockton and Jefferson County – and most, we would argue, have behaved more rationally and responsibly. There are hundreds of well-run municipal governments. There are hundreds of desirable, solid credit public purpose municipal bonds available to investors.

We know this because when we review a municipal issue to determine if it is credit worthy we seek the three pillars of municipal credit research:

1. Essential and public service deal purpose

2. Strong deal structure

3. Solid underlying credit quality metrics

Understand the presence of all three elements does not necessarily guarantee deal solvency, but it is a very good start in our experience. The three elements work in tandem. Weaker underlying credit quality demands heightened deal purpose and deal structure, in our view. 

The municipal bond market is highly diverse. This is one of its greatest strengths. As tragic as the Stockton and Jefferson County stories are, they do not represent the prevailing market narrative. The market’s diversity creates challenges and complications at times. And this creates opportunities for knowledgeable investors.

Please call us if you have any questions or would like a portfolio review.

I wish you and your family a happy and safe Fourth of July holiday.

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
July 2, 2012