Municipal-bond investors face their greatest challenge since the Great Depression. The devastation caused by Hurricane Katrina in Louisiana...
Municipal-bond investors face their greatest challenge since the Great Depression.
The devastation caused by Hurricane Katrina in Louisiana and Mississippi will result in tax delinquencies and bond defaults, bankruptcies and mortgage foreclosures.
For all those who have long wondered about just how solid and solvent the nation’s municipal-bond insurers are, the coming months will be the test.
In the long term, of course, everything will work out. Hysteria and hyperbole are strictly short-term, because property owners tend not to abandon their property.
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For the short term, even the medium, put aside all the things that tell you not to worry about the muni market.
Forget that prices on Gulf Coast bonds haven’t collapsed or that some institutional investors say they are confident about the big picture. Katrina is a serious problem for the municipal-bond market.
This market is not used to seeing natural disasters produce bond defaults, primarily because such disasters tend to be short term, with residents returning to their homes or what’s left of them relatively quickly to rebuild.
What makes this disaster so different is that it may take months before people are allowed to return home.
The municipal market has faced challenges in the past, but none of this magnitude.
Consider the Orange County bankruptcy in December 1994. The Southern California county, which had been a triple-A credit just months earlier, was done in because of losses in the investment pool it ran for itself and its municipalities.
The problem was compounded because the county borrowed money to pursue its investment strategy, and because the pool guaranteed participants their money back on demand.
Once the details came out about how much Orange County was losing, the county couldn’t meet those demands and entered Chapter 9 municipal bankruptcy.
Another example was the Washington Public Power Supply System (WPPSS), which in 1983 defaulted on $2.25 billion in bonds used to build its nuclear power plants, the biggest municipal-bond default ever.
It occurred after a court ruled the communities on the hook for the bonds didn’t have to honor their debts.
These were very specific cases. Orange County didn’t lead to a wave of municipal bankruptcies. The WPPSS default was the result of a rogue court decision that legitimized debt repudiation.
Nobody thought all municipalities would sue to get out of their obligations as a result. Nobody stopped buying tax-exempt debt.
Katrina is a much bigger problem because it affected a much bigger area. But it also threatens the fabric of the market, the pledge by municipalities to repay their debts with taxes and fees as long as they are able.
No people, no money
The affected municipalities are all willing to repay their debts. What they are certain to lack, the longer their populations are gone, is the ability to do so.
Nobody is confident in predicting how long this will go on.
The problem goes beyond New Orleans. It extends to the tiniest municipalities in the affected areas, places that sell small amounts of bonds every year, places that may not even carry credit ratings and operate well under the radar scope. Until now, that is.
Then there are the bond insurers. The four major bond insurers recently announced they had almost $13 billion in exposure to credits in Katrina’s path, almost $4 billion in New Orleans alone.
There are going to be interesting days ahead for these insurers, who since they began doing business in 1971 have said they underwrote business to a zero-loss standard. That is, they collected premiums with the expectation they would never have to pay claims.
They are going to have to pay claims, perhaps lots of them.
Those looking for good cheer may take some heart in that 4,770 issuers defaulted during the Depression on $2.85 billion in debt. Almost all of them paid it back.
Pessimists may observe the numbers are so much larger today, the bond issues much more complicated, those ultimately responsible for repayment so much more difficult to determine.