Municipal Bonds — the next subprime crisis?

Are municipal bonds going the way of subprime loans?  Will the threat of municipal bankruptcies adversely impact real estate values?  Should real estate investors be concerned?  Recent articles suggest the answer to these questions is a qualified “Yes.”  But while it may be too early to tell for certain, the forecasting dynamics are like predicting earthquakes — the proof of your theory may be a disaster of unprecedented magnitude.

The WSJ reported on 2/18 that cities around the country were evaluting the potential benefits of filing bankruptcy under Chapter 9, a seldom-used section of the Bankruptcy Code that provides limited ability for municipalities to file for bankruptcy protection.  There have been only 600 Chapter 9 filings since the provision was enacted in 1934.  One of the largest in recent history was Orange County, CA in 1994, but the current situation in Vallejo, California is grabbing the headlines.  There, the City has moved to used Chapter 9 to get out from under its union contracts with municipal employees, including police and fire personnel, and the issue is under appeal.  The WSJ reported that the City of Harrisberg, PA, with a population of only 47,000 — is facing $288 Million in debt and a $2 M payment due March 1st.  The San Jose Mercury News reported on 2/19 that the City of San Jose is facing a $100 M deficit, and a 15% cut in payroll across 6,521 employees would be necessary to avoid 550 layoffs.  San Jose is considering asking for a 1/4-cent hike in Sales Tax, a proposal with lukewarm support, but it would only raise around $30 M.

Underlying these stories is another looming crisis — the potential of an unprecedented disaster in the muncipal bond market.  Long considered a “zero-loss underwriting” market, the municipal bond insurance industry is looking closely at the situation.  In the near term, the threat appears moderated by technical factors under Chapter 9 rules, which allows special revenue bondholders to continue to receive payments, unlike the automatic stay provisions of Chapter 11.  But bond insurers are starting to set aside reserves, and some issuers are seeing their ratings drop.  If nothing else, it will make it more difficult — and expensive — for cash-strapped municipalities to raise funds.

What impact will this have on real estate values?  Already severely depressed by the current and looming inventory of foreclosed properties, real estate values have plunged, and even the most optimistic predictions acknowledge the recovery path is long and shallow.  But virtually every “Top-10-Best City” list for areas to live, invest, raise families, etc., is based on statistics that are heavily influenced by the level and quality of municipal services:  police and fire protection; crime rates, public parks and libraries; education and cultural activities; public transportation; bustling downtowns; and other similar criteria.

Here is where the picture gets darker.  Several articles cite a recent rise in crime in Vallejo as evidence of the hidden cost of filing bankruptcy, and the City has called for assistance from the Highway Patrol and surrounding communities.  But the State and local entities are themselves strapped for cash and resources.  San Jose has already made drastic staffing cuts in its Redevelopment Agency staff, and it’s clear that park and street maintenance efforts are on life support.  In short, every muncipal government in the United States is facing a budget issue as a result of the downturn in the economy, and their need to cut back services will further diminish the quality of life of their residents — and adversely impact the quality-of-life rating criteria typically used to rank them.  There aren’t many Mayors who don’t appreciate the irony — cutting back muncipal services, although essential to save money — will adversely affect quality of life and deter investment.  But filing bankruptcy could have even more drastic impacts — both tangible and psychological — which why no one wants to be the first.

There was a time, not too long ago, when the typical homeowner scoffed at the plight of the subprime loan holder, often blaming them for foolishly taking out a loan too rich for their income.  Very few homeowners, especially in California, ever considered the possiblity that their home value would decrease, and most people used to view bankruptcy or foreclosure as an extreme, last-ditch measure.  Even fewer had ever heard of a loan mod, and fewer still knew what a “short sale” was.  In a similar manner, local government officials do not want to be on the bleeding edge of trends, which is why they currently are doing all they can to resist using Chapter 9, just as so many homeowners once resisted the temptation to walk away from upside-down properties.  But if Vallejo’s “experiment” is upheld, and cities are unable to find new sources of revenue, the psychological barriers may be overcome by sheer necessity.  Bond insurers, investors, and Mayors are all watching closely.