Second of a three-part series
Vallejo has been mired in a messy, prolonged and expensive bankruptcy proceeding since May 2008. But if the California city is “the poster boy of a new era,” as some have suggested, that doesn’t look too bad for bondholders.
Vallejo bonds backed by non-general fund revenues amount to $62 million of debt. They have been paid in full and on time throughout the bankruptcy proceeding. They include securities with dedicated income streams including water revenue bonds, tax allocation bonds, and assessment and improvement district bonds.
The city’s general fund, responsible for paying $52 million of outstanding certificates of participation, has serviced the debt at less than contractual rates since July 1, 2008. Payments were even suspended between July 2008 and April 2009, and when they resumed, the interest payments were 2% — less than the variable or fixed rates due on the issues.
However, retail investors have been insulated from any damage. Owners of the COPs have either continued to receive full payments on time because the debt was wrapped by bond insurance, or they redeemed it at par because of a letter of credit issued by Union Bank. It is the bond guarantor and the LOC provider that have, so far at least, lost money on the transaction.
“I’m actually surprised that Vallejo is paying as much as they are,” said Duane McAllister, investment manager at M&I Investment Management. “These are unsecured credits — there’s no legal obligation to do that.”
The city’s thinking, he said, appears to be motivated by the need for market access in the future.
Vallejo filed for Chapter 9 bankruptcy, claiming it could no longer afford to pay wages and benefits promised to its employees.
Indeed some city workers and retirees are set to receive as little as 5% to 20% of their claims, according to a plan submitted by the city last month.
PRIORITIZING BONDHOLDERS
The top priority bondholders receive in the Chapter 9 proceeding is well established but not always well known, even among municipal experts. One veteran investment manager recently charged with evaluating cases where bondholders lost money during a bankruptcy had to give up after finding no examples.
The reason Chapter 9 hasn’t proved onerous for bondholders is that issuers simply don’t use it to mitigate bond debt, according to Richard Lehmann, president of Income Securities Advisor.
“Normally, the Chapter 9 bankruptcy is not filed because of an inability to pay bondholders,” he said. “They are just an incidental player in a bigger situation.”
For a run-of-the-mill government in the wake of the Great Recession, that bigger situation involves declining revenue mixed with locked-in labor contracts and promised pension benefits.
Ceasing interest payments on bonds does little or nothing to address either problem.
According to the Census Bureau, state and local governments brought in $2.66 trillion of revenue in 2008, the most recent year available. Interest payments that year totaled $112 billion, or 4.2% of revenue. For Vallejo, debt-service costs are 6% of the budget.
Skipping out on bondholders to save such a small percentage of annual revenue is a sure way to guarantee higher borrowing costs in the future, said Matt Dalton, chief executive at Belle Haven Investments.
“It’s really foolish to think that defaulting on the bonds is going to fix the problem — it makes for a bigger problem,” he said. “It’s not the debt that’s pulling them under, and municipal authorities know they need access to the markets.”
There is one major example where bondholders got stiffed, but the case didn’t involve a Chapter 9 bankruptcy filing.
In the early 1980s, the Washington State Supreme Court ruled against bondholders contesting a massive default by the Washington Public Power Supply System — known as WPPSS and pronounced “Whoops.”
The system borrowed more than $8 billion in separate issues to construct five nuclear power plants beginning in 1976. Only one plant was ever completed, and bonds for two of the plants defaulted when the projected costs for them shot up to $24 billion.
When bondholders fought in state court to receive their payments, the court came to the conclusion that WPPSS did not have the legal right to sign the original contracts. The contracts were declared void and resulted in a $2.25 billion default — the largest ever in Muni Land.
After the default, bonds issued by WPPSS — including court-tested, secured debt from the other projects that never experienced payment problems — traded with a severe penalty. Moreover, settlements took more than 12 years to finalize, which cost the system millions of dollars of legal fees on top of the market penalty.
According to former Washington Treasurer Mike Murphy, even the state’s credit rating suffered a two-notch downgrade despite having no direct link to the failed project.
Because WPPSS never declared bankruptcy the final court decision voiding the debt was not handed down in a Chapter 9 forum. Such a forum would likely have produced a better outcome for bondholders.
MUNI V. CORPORATE BANKRUPTCY
The need for market access alone largely explains why there have been so few Chapter 9 filings in history, according to James Spiotto, partner at Chapman & Cutler.
He calculates that there have been roughly eight municipal bankruptcies per year in the past four decades, and 620 in total. That total is less than one-tenth the number of Chapter 11 corporate reorganizations recorded in 2009 alone.
Another key reason for municipalities to avoid bankruptcy: Chapter 9 doesn’t provide any financing.
“If you can’t pay for your municipal services because of illiquidity, Chapter 9 doesn’t provide any more money to you,” Spiotto said.
Of the many differences between Chapter 9 protection and a corporate bankruptcy, two are crucial.
One, the municipal filing has to be voluntary, so no liquidation is possible. And two, the bankruptcy court has limited or even no authority to force the municipality into making changes.
The 10th Amendment limits the authority of federal courts to meddle in local governments’ affairs.
The court cannot force the municipality to fire people, discontinue services, pay its debts, or even stop it from incurring more debt.
The purpose of Chapter 9 protection is to provide the municipality some temporary reprieve from creditors while it continues to operate. Whereas a corporation will dismantle itself the moment it becomes economical to, a municipality needs to continue picking up garbage and locking up bad guys, even while it’s in bankruptcy court.
The creditors have a right to negotiate, but they cannot propose a competing reorganization plan to the court, and the judge has “cram-down” powers to make the plan binding on dissenting parties — provided some creditors have accepted it.
The municipality has one clear advantage. During a bankruptcy proceeding, it can freeze lawsuits and creditors’ claims, giving it leverage to negotiate contracts and restructure debt.
Lourdes German, a vice president at Fidelity Capital Markets, said that legally allows the municipality to eliminate some debt in the proceeding, but the market penalty is simply too high to seriously consider reneging on bondholders.
“That has to be in the forefront of their minds — the higher borrowing costs, the downward pressure on the value of their bonds,” German said.
In today’s climate, the headline risk alone could be enough for a municipality to find a solution before heading to court, she added.
So far that appears to be the lesson from Vallejo. Its ongoing fight with creditors has already cost the city of 118,000 people more than $9 million in legal fees.
“As the people in Vallejo can testify to, it’s a lot of time and effort,” Spiotto said. “It’s not a short process, and it’s very painful.”
But while some look at Vallejo and see a big deterrent for municipalities to follow suit, others believe the challenges facing municipalities today are so unprecedented that forecasting outcomes in the coming years by using examples from the last few decades is simply foolish.
