Are States The Next Greece?

Recent Events
The recent downturn in our economy has created severe budgetary stress for states, as their revenues have fallen precipitously and the demand for services has increased. The State of California with it’s politically charged budgetary process, high foreclosure rate, and high unemployment rate has received much negative attention in the media. Some are saying “California is the next Greece”. While there is little doubt California is under financial stress we believe these concerns are overblown.

A Sovereign: Greece
Greece is an independent political and financial entity and enjoys “self rule”. It is responsible for it’s budget and has the ability to issue debt and print money. Much of their debt is sold to foreigners and foreign banks. Greece is part of the European Union (EU), and their currency is the euro. The EU requires certain fiscal disciplines for member nations, such as balanced budgets, in order to use the euro as their unit of currency. Recently, it was discovered that Greece created fictitious budgets in order to become part of the EU and their financial circumstances are much weaker than previously thought. The revelation of Greece’s weakened financial state has led to a lack of confidence in their ability to re-pay their debt which has created a “debt crisis” for the country and the EU. The EU has demonstrated a willingness to bail out Greece if certain austerity programs are implemented. Resistance to these austerity measures and violent demonstrations in Greece by it’s citizens have been shown on television. Other EU countries such as Portugal, Spain, and Italy are also experiencing financial problems. Many are questioning the viability of the euro as a currency, and it has been under severe pressure as holders of euro’s look to sell and trade into more secure currencies.

A State: California
The State of California is a political sub-division of the United States. It is responsible for it’s budget, but is required by law to have a balanced budget. It is not able to print money. The U.S. government has helped the States, including California, through various stimulus packages during the last 1.5 years. Most of the debt of the State is held domestically, and is not subject to additional volatility caused by currency risk, which makes them much less volatile than Greek bonds during the last couple of years. Though
the budgetary process is cumbersome and outdated, the financial reports issued by the State comply with legal reporting standards and offer a fair representation of the State’s financial circumstances. The State has the ability to cut expenses and raise revenues to balance the budget. The rapid decline in tax revenues for the last 2 years has caused a great deal of budgetary stress for the State. The ability to make difficult decisions shows the resiliency of the State. These decisions have been made without fiscal discipline being imposed from foreigners, and without rioting in the streets like Greece. The issue of unfunded pension liabilities and healthcare benefits for public employees has not been adequately resolved, and will likely become a major issue during the next 10 years.

Differences
One of the most important differences between Greece and the State of California is the legal framework and rules for reporting. California has had fiscal discipline imposed on it by existing state and federal statutes. These statutes require a balanced budget, and set priorities for paying bills. For example, the highest priority for the State when paying expenses is to first pay those for education, next is debt service on bonds. All other expenses are subordinate to these and are paid after these expenses have been paid. Since Greece is a sovereign, it has been easier for them to avoid fiscal discipline through false reporting and false promises to their citizens. However, this has come to an end as the EU and IMF are dictating austerity measures for Greece.

Another difference is that there is a closer relationship between a State and the U.S. government, than there is between a member nation and the rest of the EU. Imagine being a German citizen and watching reports on television of the rioting in the streets of Greece, while they are expecting you to bail them out. How would you feel when you aren’t even part of the same country?

Sovereigns are also responsible for the banking system and credit conditions within their borders. Many sovereign nations are still reeling from the extensive bailout programs which were required to bail out the banks during the last credit crisis, and to stimulate their economies. In the U.S. the Federal government is responsible for the banking system. This allows the States to focus on other issues, such as education.

Conclusion
There is little doubt that many Sovereigns are riskier credits than States in the U.S. During the last 10 years, the default rate for all Muni bonds has been only 0.1%. There has not been an instance of a State default for over 75 years. The default rate for all Sovereigns during the same time period was 6.0%, which is 60 times greater than the default rate for all Munis.

(Please see chart below for Muni vs. Sovereign comparison.)

Lessons From Vallejo

2008: Vallejo Under Financial Stress

In 2008 the City of Vallejo, CA was suffering from severe financial stress caused by recurring budget deficits in it's general fund. The city found it difficult to bring it's budget into balance because 74% of the budget consisted of expenses for police and firefighter salaries and pension obligations which had been growing out of control. City officials attempted to renegotiate labor contracts and benefits, but were unable to generate enough cuts to balance their budget. The deficit for 2008 was $4.3 million, with a projected deficit for 2009 of $16 million. According to a recent Wall St. Journal article which appeared on March 26, 2010 "salaries for police captains were over $300,000 per year, and firefighters averaged $171,000 a year. These same workers could retire at age 50 with a pension that guaranteed them 90% of their final year's pay."


Vallejo Enters Bankruptcy

On May 23, 2008 the City of Vallejo filed a petition for protection under Chapter 9 of the U.S. Bankruptcy Code. According to the law firm which represented Vallejo, Orrick, Herrington, & Sutcliffe, in order to file bankruptcy a municipality must meet the following criteria:

1. It must be a political subdivision of the state. A state is not allowed to file for bankruptcy.


2. State law must allow a municipality to file for bankruptcy. About half of the states in the U.S. do not allow municipalities to file bankruptcy.


3. The municipality must be insolvent which means they are not able to meet their current obligations or won't be able to meet them in the next year.


4. The municipality must desire to effect a plan to adjust it's debts.


5. The municipality must show it has tried to negotiate unsuccessfully with creditors.

In September 2008 the Bankruptcy Judge Michael McManus determined the City of Vallejo met these conditions, and the Bankruptcy Appellate Panel affirmed his decision on June 26, 2009.

Collective Bargaining Agreement Is Rejected

On March 13, 2009 the judge ruled the City could reject the Collective Bargaining Agreements it had with various city unions, and the City of Vallejo began to renegotiate it’s contracts with public employees including firefighter and police.

Vallejo’s Bankruptcy Workout Plan Affects Bondholders

On December 22, 2009 the City came up with a Bankruptcy Workout Plan which called for no principal or interest payments to be made for three full years beginning January 15, 2011 through January 15, 2014 on outstanding debt. This affects all bonds that are secured by the General Fund. Bonds with dedicated revenue streams are not affected by the moratorium on debt service payments. The bonds that are still paying interest are secured by water revenues, special assessments, and special taxes. Bonds for related entities are also not affected by the Workout Plan. These include Vallejo Sanitation and Flood Control District, Vallejo Redevelopment Agency, and Vallejo Housing Authority. These are all separate legal entities from the City of Vallejo.

Why Vallejo Is Important To Bondholders

During the last 40 years most Muni bond defaults have been for housing and healthcare bonds. There have only been 3 general obligation bonds which were rated by Moody’s that have defaulted during this period. Perhaps the best known case is for Orange Co., CA which defaulted on it’s debt, because of excessive exposure to derivative trades in it’s investment pools by rogue trading by the county treasurer. Bondholders were eventually able to recover 100% of both principal and interest. Jefferson Co., AL defaulted on it’s bonds in April 2008, because of excessive exposure to variable and auction rate securities swaps which caused a large liquidity deficiency for the county when their swaps didn’t work out.

The bankruptcy filing for Vallejo is quite different. It is the result of poor governmental planning with the City lacking the political will to negotiate affordable contracts with public workers, and also making them promises they are not able to keep. Public employees and bondholders alike are watching this case with interest. Numerous municipalities across the country have significant unfunded liabilities for both pensions and healthcare benefits. This case is, thus, important to see if bankruptcy for a municipality is a way to make these liabilities more affordable for it’s taxpayers.

Vallejo: Has Bankruptcy Paid Off?

It is clear bankruptcy has not been a silver bullet for Vallejo, and the costs have been significant. Since filing for bankruptcy, Vallejo’s tax revenues have fallen 20% with further expected declines likely in 2011-2012. The City has not had the political will to reduce existing pension costs. These costs will leave the City
facing projected annual deficits of $23-$27 million once retirement costs are fully recognized. There has been a stigma for residents which makes Vallejo a less desirable place to live. This is reflected in falling property values, reduced services, and a higher crime rate. The City has also been shut out of the credit markets, and will be unable to raise funds for an extended period. The City has made progress in renegotiating labor contracts, but the cost has been high.

We believe other municipalities will look at this case with mixed feelings, and will realize bankruptcy is an option of last resort. It is not a panacea for getting rid of unfunded pension liabilities. Most municipalities are not in the dire straits which Vallejo is in, which means they are not eligible to file for bankruptcy. Fears of widespread use of bankruptcy by municipalities to lower unfunded liabilities are overblown. On a positive note for taxpayers, this case sends a clear message to organized public workers. In a bankruptcy situation their existing contracts are all up for renegotiation. This should make them more willing to negotiate on more favorable terms with municipalities in the future.

Lessons To Be Learned For Bondholders

This case provides several lessons for investors. First, Muni bondholders should realize security selection has never been more important than it is now. Improper security selection can be very punishing to investors. Next, bond investors cannot assume general obligation bonds are more safe than revenue bonds. When a municipality experiences extreme stress and enters bankruptcy, bonds with dedicated revenue streams are superior to claims on the general fund. Also, some municipal entities may lack the political will to make sound financial decisions. Even though municipalities are required to balance their budgets, there may be some situations which make it extremely difficult for them to do so. Many budgetary problems need long term solutions, but politicians are only willing to provide short term fixes. In addition, since states are not able to declare bankruptcy, it is difficult for investors to know which type of bonds have priority over other general fund obligations such as payroll and vendors. Laws will vary from state to state. For example, in California payments for schools have priority over debt service, which has priority over all other general fund expenses. Finally, the Muni market is a fragmented market of over 50,000 different issuers. It is not possible to make general statements re
garding the creditworthiness of all Munis. Pundits which make generalizations about the Muni markets should be treated as suspect. Instead, investors should be more like loan officers who realize that each borrower has different abilities to service their debt. They should consider off balance sheet obligations, wealth levels, and debt per capita before purchasing the issuer’s general obligation securities.

Conclusion

The Muni market is not a good do-it-yourself market. Proper security selection is beyond the scope of most individual investors. We also believe the financial situation of the City of Vallejo shows the danger of blind reliance on default studies, which is not a good policy in today’s environment. These studies cover a time period where most municipalities did not experience the amount of financial stress which they will be facing during the next couple of years. This stress may be caused by declining tax revenues, higher costs of providing healthcare, or unfunded liabilities associated with public employees. Instead, we plan to place more emphasis on revenue bonds with secure revenue streams and less emphasis on some general obligation bonds. This strategy is similar to the one we have used for California Muni bond investors. We will continue to seek out general obligation bonds of high wealth areas, and issuers with low debt per capita levels, and a willingness to make difficult budget decisions. But, we will also place increasing emphasis on essential service revenue bonds where the issuer has a monopoly on the services they provide.

Shared Sacrifice

Turmoil In The Credit Markets
During the last 2 years there has been considerable turmoil in the credit markets due to the rapid decline in the credit quality of borrowers in the corporate, mortgage, and agency markets. The sub-prime mortgage crisis, collapse of Fannie and Freddie, banking and investment banking crises, stress on insurers and guarantors of debt, and collapse of 2 of the 3 largest auto makers are all examples of the deterioration in the credit quality which has taken place. Even the credit quality of the U.S. Government (the heretofore standard for a riskless borrower) has been called into question.

Fixed Income Credit Analysis and Risk
This decline in credit quality has made credit analysis more important than ever. Fixed Income money managers who were able to avoid major problems with credit issues have achieved superior performance to those who were unable to foresee potential credit problems. The penalty for being “wrong” on the credit of an issuer has been harsh as credit spreads blew out to very wide levels. A good credit analyst is able to identify and understand the risks in any given security. Most investors lose money because they grossly underestimate the amount of risk they are taking. The other mistake they make is “reaching for yield”. This leads to creating portfolios that consist of all the weakest credits, because they are the ones that yield the most. These portfolios do not perform well in stressful times for the markets. A good credit analyst is also able to determine what the “worst case” is for any security he owns. This is extremely important when things “go bad” for a credit. There are different layers of security for a bondholder. These include debt service coverage, the issuers ability to pay, and where the bondholder stands as a creditor in bankruptcy. In bankruptcy, there are long established rules that apply to secured and unsecured creditors, as well as to equity holders. These rules provide comfort to secured bondholders when things “go bad” for one of their borrowers. The current economic cycle has allowed the government to become involved in the economy to an unprecedented extent, which has revealed a new level of risk a good credit analyst needs to consider. We will call this ‘political risk”, which is the risk of confiscation of secured creditor assets for the benefit of a junior class of creditors. This is a risk that is more prevalent in unstable less developed countries, and was unthinkable in the U.S. until Chrysler.



The Chrysler Bankruptcy
The auto industry was particularly hard hit in the recent economic slide with both Chrysler and GM going into bankruptcy. The actions taken by the government in the Chrysler bankruptcy were unprecedented. The President introduced the concept of “Shared Sacrifice” in the media as he called upon secured creditors to take less than they were entitled to legally so that one of his political supporters, the UAW (a junior creditor), could get a larger share of the new firm. TARP participants who represented the majority of senior secured creditors were then coerced into voting for a government sponsored cram down which gave the secured creditors only 30% of the company while the junior class of creditors (UAW) received 50% of the firm. The secured creditors who did not vote for the plan were labeled as speculators and were portrayed as all around bad guys to the public. This creates an enormous amount of uncertainty for investors in fixed income securities in the U.S., because laws which were deemed sacrosanct have been rendered meaningless as assets are confiscated from one class of creditor and given to another class of creditor based on political whim instead of rule of law.

Bankruptcy Law
Existing bankruptcy law is designed to protect debtors from creditors seizing their assets without giving them time to come up with a plan to pay creditors in a fair and equitable manner. When bankruptcy is declared an estate is created, similar to when a person dies. The assets of the estate are then valued, and creditor claims are processed and organized into order of their priority. Some claims are secured, and have a priority over junior claims. A first mortgage claim is entitled to receive full payment before the second mortgage holder receives any funds. Priority of claims is a well established principle of bankruptcy law. Debtors are not allowed to pay some creditors to the detriment of others immediately prior to or during bankruptcy. The debtor in possession of the assets is allowed to form a plan which is equitable to it’s creditors, and the creditors can then vote on the plan. If a majority of the creditors vote for the plan, the dissenters will suffer what is caused a cram down, as the plan is approved over their objections. In the Chrysler case there are problems with the asset valuation process, priority of claims issues, and the nature of the government’s cram down. The concept of “shared sacrifice” violates bankruptcy law and discourages lending, particularly to weaker credits.


Conclusion
We believe the government has now re-written bankruptcy law in this country. Since the Chrysler case, GM has been put into bankruptcy. A similar approach to a rushed asset valuation process has been taken in GM as well. Virtually every secured creditor in the country has now found their position in bankruptcy lowered, as the government ignores the established rules of bankruptcy law. We were fortunate that we did not own any bonds for the auto companies, because our credit analysis deemed them too risky. We also avoid high yield bonds, because they are very highly correlated to equities, and don’t offer enough diversification to the investor’s overall portfolio. However, even though we dodged the Chrysler bullet, we are still very concerned by the government’s actions and our level of “trust” for our system has been shaken. Why would any investor want to invest in high yield fixed income with the additional risk of confiscation in bankruptcy? Without the established priority of claims in bankruptcy there is now no such thing as a secured or priority claim. “Shared sacrifice” does considerable harm to encouraging lending during these difficult times, because it makes it nearly impossible to determine the lender’s worse case. It makes more sense for the lender to avoid lending to riskier firms, because a secured loan to a struggling creditor suddenly has become much riskier.

Ambac Insured Auction Rate Securities

What Do I Own?
Some investors have become concerned because they own securities that are AMBAC insured and Fitch recently downgraded the insurer to AA from AAA. We are not particularly concerned about munis that are strong credits on their own. However, there may be instances when an investor should be concerned.

The example below is for Arizona Public Service Company and is in a weekly Auction Rate mode. It is important for the investor to understand what this security is in order to determine if it is a suitable investment for him/her. A weekly Auction Rate security has a rate that resets weekly. This rate is determined by an “auction” process. The stated maturity is shown to be 6/1/2034. This security is not deemed to be Money Market Fund eligible because a money fund can normally only invest in maturities out to a little over 1 year. It is possible, but highly unlikely, in the event of a failed auction that the investor would end up owning a security with a maturity in 2034, instead of a money market alternative. The underlying credit quality of APS is BBB-. This is shown in the Bloomberg screen shot below. While it is normally unlikely for an auction to fail, the current stress on the guarantors (in this case AMBAC) and the weak underlying credit quality of APS increase the possibility of this unlikely event occurring.

We have avoided these securities and invest in Variable Rate Demand Notes instead. These securities are money market eligible because the liquidity to put them back to the dealer on 7 days notice is guaranteed.

Conclusion
We would caution investors to be aware of the risk of a failed auction on a weak underlying security that is guaranteed by an insurance company that cannot maintain their AAA rating.

The Guarantors

The Insurers

There has been considerable attention devoted to the Sub-Prime Mortgage crisis and the exposure of insurers such as MBIA, AMBAC, FGIC, and XLCA to this sector. The stocks of these companies have been hit particularly hard during the recent flight to quality rally in the treasury market. The chart below shows the price activity for MBIA during the last year.

Click on the picture for a larger view.

The stock is down roughly 50% during the last month. The stocks of AMBAC and XLCA are down even more during this same time period. The negative news surrounding these firms due to the large losses they have taken and their large Sub-Prime exposure are causing investors to question the value of insurance and the ability of these firms to cover potential losses.

Muni Bond Insurance

The insurers play a major role in the Muni market. Over 50% of all financings come with credit enhancement such as insurance. Most retail investors have come to rely upon insurance when investing in tax-free bonds. The large scale deterioration in the credits of the insurers is causing investor anxiety and raising questions as to the quality of each insurer and their ability to pay. This problem is exacerbated by falling confidence in the rating agencies to properly rate these firms.

Rating Agency Review

Fitch released a special report on 9/2/2007 which outlined the current state of the insurers. In early November, they announced a further review of the guarantors’ ability to withstand the stress of continued deterioration in the Sub-Prime market. This study should be completed in about a month. The September study showed the Capital Adequacy Ratio for each of the major insurers. These ratios need to be met to maintain the AAA rating. The chart below shows these ratios. The only company that does not meet the minimum in this chart is Radian, which is already rated AA. Fitch and Moody’s are both doing additional reviews which will

Click on the picture for a larger view.

include further analysis of the insurers’ exposure to the weakening Sub-Prime market. The table below shows their preliminary findings of the likelihood that an insurer will need to raise additional capital or use reinsurance to reduce their exposure. CIFG and FGIC show a high likelihood of needing more capital to maintain their AAA rating. If it is determined that an insurer needs more capital, Fitch will give them 30 days to comply before downgrading them to AA.

Click on the picture for a larger view.

Click here for a PDF of this article

Bond Insurance:MBIA

Insurance Risk
Last year, over 60% of all Muni Bond issuance was credit enhanced by either insurance or bank LOC’s. Since a guarantee is only as good as the one who guarantees it, the credit-worthiness of an insurer is very important. Last month, Barron’s ran an article about MBIA insurance. In the article, Pershing Square Capital Management justified their short stock position in MBIA by saying the insurer has significant exposure to the sub-prime mortgage market, delinquencies are on the rise for these loans, and MBIA’s insurance exposure is much greater than the rating agencies would like for you to believe. As fixed income money managers, we are less concerned about how well the firm’s stock does. What matters to us is the company’s ability to pay claims as well as the likelihood they would be required to pay these claims.

Breakdown of Insurance In Force

Insurance exposure can be broken down into the following categories:

U.S. and Non-U.S. Public Finance
U.S. and Non-U.S. Structured Finance

The chart below shows the amount and the relationship of this exposure. Default studies would suggest that the exposure to Public Finance is quite manageable. Total Public Finance insurance in force was $706.3 billion at the end of 2006.

The insurance in force for Structured Finance was $254.5 billion for the same period. This includes:

Collateralized Debt Obligations (CDO's)
Mortgage-backed Home Equity
Mortgage-backed Other
Mortgage-backed First Mortgage

The next chart shows the breakdown percentages for Structured Finance. According to a recent S&P report, MBIA has $5.78 billion of sub-prime exposure in Mortgage-backed securities, and about $431 million is speculative.

The chart shows 62% of their Net Insurance for Structured Finance is in CDO’s. The same S&P report said MBIA has $16.605 billion of Insurance Exposure to CDO’s with sub-prime exposure, and $2.059 billion of this is for sub-prime mortgages. If we combine this total with the $431 million of speculative Mortgage-backed, the total is $2.49 billion of sub-prime insurance written by MBIA.

Ability to Pay

S&P calculates the ability to pay this insurance exposure by looking at the following:

$13.3 billion in claims paying resources
$6.6 billion in qualified statutory capital
$819 million in earnings last year

S&P argues that any future claims are likely to be less than 1 year’s earnings. Their reasoning is that the firm’s exposure to $431 million of speculative grade sub-prime mortgages is about 6.6% of total statutory capital ($6.6 billion), and less than half of 2006 earnings. We find some problems with this analysis because:

1. None of the $2.059 billion in CDO sub-prime exposure is included in their analysis
2. Default rates for higher quality sub-prime Alt A mortgages are also rising. Currently, 2.9% of these mortgages in CDO’s are 60+ days delinquent and 1.08% are foreclosed.

Conclusion
It is easy to see how MBIA’s earnings may be negatively affected in the future due to increasing default rates in the sub-prime area. However, as bond holders we are more concerned about the firm’s ability to pay and maintain their AAA rating. We still have confidence in MBIA’s ability to pay, but feel deteriorating credit conditions are much worse than S&P’s report would suggest. The rating does not appear to be in danger at this point, but we would rather invest in underlying securities unlikely to ever need the insurance. We feel bond insurance is good when there is a localized event, such as Hurricane Katrina. Investing in junk and relying on insurance to bail you out if something goes wrong is not a formula for success. Insurance is no substitute for research if global credit conditions worsen.

How to Decipher the Cover Sheet of an OS

Introduction

In the previous post, we discussed how to obtain an official statement on a municipal bond issue. Now, we will explore various areas of relative importance on the cover sheet of an OS. The particular Official Statement used in this analysis is the Glendale Arizona Industrial Development Authority Hospital Revenue and Refunding Issue dated in 2007 (The file can be downloaded here). On this document, there are numbers next to the highlighted information that can be used as a guide. Throughout this post, we will explain various parts on the cover page of this Official Statement.

Please note: Not all OS’s are created the same. These sections are not necessarily in the same order as other Official Statements. The goal is to showcase the wide array of information on the cover of an OS.

Details

1. The upper right corner of this Official Statement is the rating(s) on the bond. Some issues may be non-rated (NR). The three largest rating agencies are:

a. Moody’s

b. S&P

c. Fitch

2. There is an opinion from bond counsel on the exemption status for several areas of taxes:

a. Federal

b. State

c. Alternative Minimum Tax (AMT)

d. Corporations

3. This section contains:

a. the Size of the Deal

b. the Issuer

c. the Type of Issue (Revenue, General Obligation, Certificate of Participation, etc.)

d. the Particular Series

4. A few key points in this area are:

a. the quantity and increments in which the bonds can be purchased

b. the dates of the year in which interest is paid to the bondholder

5. A subject to redemption prior to maturity is noted in this section. More information about the provision can be found inside the OS.

6. This division consists of descriptions of the obligator, the trustee, and agreement specifications.

7. The Maturity Schedule for the various series of bonds is displayed which includes:

a. Due Date

b. Principal Amount

c. Interest Rate

d. Yield

e. CUSIP

8. This piece includes the specifics of who are not the obligators.

9. Investing in the municipal bonds involves various risks. These risks are disclosed within the Official Statement. The table of contents in the OS allows the reader to efficiently search for a variety of topics such as the risks involved in the municipal bond deal.

10. Appendices are mentioned in this section, which are located towards the conclusion of the OS and can include items such as:

a. General Information

b. Financial Statements

c. Certain Provisions

d. Opinion of Bond Counsel

11. This section notes various counsel involved in the municipal deal such as:

a. Bond Counsel

b. Disclosure Counsel

c. Financial Advisor(s)

12. The manager of the deal and co-managers (if applicable) are located in this segment. If an investor is interested in buying this deal, he/she should give their order to one of the managers.

13. The date the OS was created for distribution is included for recordkeeping purposes.

Conclusion

It is important to navigate through research material in an effective and efficient manner when evaluating potential investment opportunities. The cover page of an Official Statement includes valuable information on the bond issue, but is meant to be a supplement to the entire statement as opposed to a substitution when performing due diligence.

How to Obtain an Official Statement

Introduction

There is a wealth of information available to research municipal bonds. One resource with a plethora of information about a municipal bond issue is the Official Statement (OS). This can be used to become more familiar with the credit of a municipality (issuer). The OS includes such items as the purpose of the deal, the maturity schedule, the status of tax-exemption, sources of payment, debt service requirements, financial statements, and any other pertinent data. The underwriter / senior manager puts together the Official Statement for distribution to dealers, advisors, and investors. The OS is the disclosure notice for a municipal bond issue.

How-To

One might ask, "Where do I find Official Statements?" This brief process will explain the steps needed to retrieve an OS.

1. Go to the website http://www.investinginbonds.com (A picture of the webpage is shown below).

2. Under the Markets in Depth section, there is a subsection titled Municipal Markets. Click on the hyperlink: See Municipal Market At-A-Glance (The section of interest is highlighted in the picture below).

3. Next is a page where you can either select the bonds traded today category, the bonds traded yesterday category, or the bond history category. If you choose bonds traded today or bonds traded yesterday, go to 3A. If you want to enter a CUSIP into bond history, go to 3B.

a. By clicking on bonds traded today or bonds traded yesterday, the page following will show the history of municipal bond trades. In the example below, the State of Arizona was chosen to view bond trade history. You can select a particular bond in the history. On the right side of the page, there is a column labeled More Info. One of the links in this column is Statements (See 4A for further instructions).

b. If you know the CUSIP for the bond you are interested in, you can type it into the bond history box. The following page should show the actual bond and it's description. Click on the hyperlink below the column titled # of Trades.

This will take you to a screen shown below (See 4B for next step).


4. a. By clicking on the Statements link, the site will take you to a page where you can download the Official Statement for this particular issue. The user has an option t0 download the cover page, the entire OS, E-mail the document, or download part of the document. The picture below shows an example of what this page looks like.


b. If you click on the link for Search Munistatements.com, you will come to a page that allows you to download the Official Statement. The user has an option t0 download the cover page, the entire OS, E-mail the document, or download part of the document. The picture below shows an example of what this page looks like.


Conclusion

After the Official Statement is available for viewing, the next step is to research the particular issue. The following post will begin discussion of how to go about performing due diligence on a municipal bond issue beginning with deciphering the cover page of an OS.

Muni Bonds: Moody's Maps Muni Ratings To Corporate Bond Ratings

Moody’s Default Report

Last month, Moody’s issued a report entitled: “The U.S. Municipal Bond Rating Scale: Mapping to the Global Rating Scale and Assigning Global Scale Ratings to Municipal Obligations.” The purpose of the report is to map muni ratings to the corporate rating system.

We have felt that one of the in-efficiencies in the taxable bond market is taxable muni bonds trade too cheaply for their quality. Recent experience shows that a Aaa-rated taxable muni trades at about the same spread to U.S. Treasuries as an A-rated corporate bond. This makes no sense, because the munis are less likely to default and are not subject to the same event risk as a corporate bond. This report confirms our position on taxable munis. Moody’s shows default rates for the last 36 years on all bonds they rate. During this time period, there were a total of 41 defaults by municipal issuers considered to be investment grade (Baa or higher). Of these, only 1 default was backed by either a General Obligation pledge or Water & Sewer Revenues. These types of bonds have a very low risk of default. The chart below shows that an investment grade corporate bond has a 2.1% chance of defaulting during the next 10 years, while an investment grade muni has only a .1% chance of default, according to the study.

Moody’s separates munis into different categories and then maps them to corporate ratings.

Here are some of their conclusions:
1. An A-1 rated state GO is equivalent to a Aaa-rated Corporate Bond.
2. A Baa-2 rated local GO is equivalent to a Aa-3 rated Corporate Bond.
3. A Aaa-rated Corporate Bond is 5 times more likely to default during the next 10 years as an investment grade muni bond.
4. The risk of default by a State GO, local GO, or Water & Sewer revenue bond is much lower than other categories of muni bonds.
5. Local lease obligations and special tax, electric & gas for transmission, mass transit, public higher education, general airport revenues, and existing toll roads have all shown superior risk profiles.

Conclusions

There is less credit risk in certain types of muni bonds than the ratings imply because of their superior risk profiles. Moody's recognizes in this report that State and local GO's may be under-rated by their existing rating system compared to their Global Ratings for Corporate Bonds. Some Muni investors may wish to buy lower rated investment grade GO's and Water & Sewer bonds if they are over-compensated for the additional credit risk taken. Moody's estimates that about 50% of the Muni bonds they currently rate as Baa will be upgraded to A-rated in the near future. This may create opportunities for "spread tightening" trades. Unfortunately, credit spreads in the Muni market are currently relatively tight by historical standards. So, it may be difficult to take advantage of these potential upgrades by Moody's. The better opportunity for spread tightening may be in the Taxable Muni market where quality spreads still have plenty of room to compress.

So You Think You Want To Be A Credit Analyst: Unfunded Pension Liabilities

Recently, S&P released a report entitled "Improved U.S. State Pension Funding Levels Could Be On The Horizon." This report is based on 2005 year-end data, which is the most recent data available for all states. S&P made the case that most state pension funds use 5 Yr smoothed returns, and the returns from 2001-2002 have been acting as a drag on the actuarial value of fund assets. If the equity market behaves itself, the 5 Yr smoothed value of these assets will increase as the returns from 2001-2002 fall off the 5 Yr averages. This increase in asset values will increase the funding of these state pension systems, which will help alleviate the current levels of underfunding. We are in agreement with this conclusion; however, there are some states that are grossly underfunded. Let's take a look at these state retirement plans and see how municipal credits are analyzed.

The chart below shows the 10 states with the largest Unfunded Actuarial Accrued Liabilities (UAAL). California, at $47 billion, has the largest unfunded liability, Illinois is next with $31 billion, and Ohio is right behind with $30 billion. The rest of the top 10 are all under $15 billion.

While it is interesting to know the magnitude of the funding gap, it is beneficial to look at the percentage that is funded to determine the progress the state has made in providing money for these obligations. The chart below is based on data from the same S&P report as above. This chart ranks states by the percentage of the funding. West Virginia has the lowest value at only 47% funded, next is Oklahoma at 57%, and Connecticut at 58%.

We now have charts that show the magnitude of the shortfall and the progress each state has made in achieving their goal of funding these pension obligations. It is also important to see how well these states can afford to meet these pension obligations. The amount of debt each state has outstanding can be calculated. If we divide this number by the population of the state, we arrive at a number for Debt Per Capita. Let's take the amount of the unfunded liability and divide it by the population to arrive at the Per Capita Unfunded Liability. When these 2 numbers are combined, we have a measure that is a better representation of the total obligation of the state. There are also Per Capita income numbers available for each state. These numbers show the earning power of the average person in the state. The combined Debt Per Capita numbers divided by the Per Capita income number gives us the percent of debt to income for each person. This number helps to show how significant the debt burden is for taxpayers in any given state. The chart below shows these numbers for the 10 states with the highest combined debt burden compared to their earning power. All 10 states have 10% or more ratios, with Alaska over 20%. This may be easier to understand if we use some actual numbers. Let's use Alaska as an example. The Debt Per Capita (PC) is $2,000 and the Unfunded Pension Liability is $6,212 PC. This is a total of $8,212 PC divided by the PC Income of $35,612 to give us a debt ratio of 23%. This is a big number and should cause concern in some investors. This measure gives us a better idea of Alaska's financial health than the $2,000 Debt Per Capita number.

These numbers do not include OPEB liabilities. OPEB is Other Post Employment Benefits and is primarily the actuarial accrued liability for health care costs. States will be coming out with these numbers over the next 3 years as required by GASB 45. This is another huge liability that municipalities have incurred. It should be important to each investor to look at not only traditional numbers such as Debt Per Capita, but also to include unfunded pension liabilites and OPEB obligations in their analysis to determine the creditworthiness of each security. So, do you still think you want to be a credit analyst?

Muni Bonds: Texas Says No To OPEB Rules

"Whoa!" says Texas to the new reporting guidelines for disclosing OPEB liabilities. The state treasurer, Susan Combs, recently stated that Texas was not planning to comply with the GASB 45 guidelines in disclosing unfunded Health Care liabilities for public workers. These guidelines, which are being phased in over the next 3 years, are designed to increase disclosure of unfunded liabilities so investors have a better understanding of the financial position of a municipality before investing in it's debt obligations.

The State of Texas is taking the following position relative to these disclosure requirements:

1. These are not "hard liabilities" of the State, because the legislature can change the amount it appropriates for the payment of these benefits.
2. It is impossible to know what this stream of benefits may be for the next 30 years.
3. Workers will suffer because municipalities will discontinue offering these benefits to their workers.

This is a very interesting approach to the OPEB disclosure requirements, because what the State is saying in plain English is this: "You can't make us do this because we don't really owe these workers these benefits, it's too much trouble to figure them out even if we did owe it to them, and how dare you jeopardize their future benefits (that we feel we don't owe them anyway)."

This is a unique response and has some serious consequences. First, it is a politically untenable position to take in regard to the employees of the State. After all, if you were an employee of the State of Texas, how secure would you feel your Health Care benefits were after you retired? Second, it is an attempt by the State to thumb it's nose at the GASB and investors. When Texas attempts to fund projects in the municipal bond market, it will receive an adverse determination letter for lack of proper disclosure. What investor will buy Texas' securities under those circumstances?

This position is indefensible and not reasoned properly. Estimates of the State's unfunded OPEB liability are around $50 billion. Can this be what is driving this decision by Susan Combs?

Finding A Way To Fund Pension Liabilities: Illinois

The Governor's Plan

Today's Bond Buyer, a trade publication, had an interesting article about the plans the governor of the State of Illinois has to fund it's $41 billion pension liability. This is his creative solution to this problem.

First, the State would sell it's state run Lottery for $10 billion by doing a Public Private Partnership (P3). This would probably be done with a long-term lease arrangement. Last year, the State of Indiana sold the Indiana Toll Road for $3.5 billion to a group of foreign investors using a 99 year lease.

Second, the State would issue $16 billion of taxable Municipal Bonds. These munis would be considered taxable because the proceeds of the bond issue would be invested in equities (a higher returning asset class). This creates an arbitrage situation which does not allow the munis to qualify for tax exemption. Illinois did what is still the largest taxable muni deal in 2003 ($10 billion) at an interest cost of 5.05%, and the pension funds have earned returns of over 14% from 2003 until now. Can they do the same with another $16 billion?

Finally, the State would raise taxes on corporations. This tax increase is expected to generate $6 billion a year beginning in 2009. The State will also enact a payroll fee on businesses that do not provide health care. This is expected to raise $1 billion a year. There are no plans to raise taxes on individuals in the Gov's plan.

Conclusion

The combination of these 3 actions is projected to get the State's pensions up to 83% funded from the current 60% funded level. Of course, this is just a trial balloon that is being floated by the governor of Illinois, Rod Blagojevich. But, in an era of unfunded pension and healthcare liabilities across the nation, it shows the general willingness to sell public assets and issue debt as a way of keeping tax increases down to as low as possible. Welcome to Public Funding 101 in America today.