June 9th, 2017
One of our major beefs with the traditional municipal credit research approach is the over-reliance on legal covenant analysis versus an assessment of the true fundamental credit risk imbedded in any bond issue. As a young analyst, a few decades ago, I still remember being taught the “checklist method” for credit analysis. You all know what I mean: is there a 1.25x rate covenant? Check. 1.50x MADS additional bonds test? Check…and so on and so forth. What was lacking was the answer to the real question: do the economics of whatever is being financed make sense? Are the key players properly incentivized and are their interests aligned with the bondholders? In other words, will that rate covenant be breached, and under what conditions? Legal protection is nice to have in a worst case scenario, particularly with regard to recovery scenarios, but isn’t the whole point of good credit analysis to avoid ever resorting to it?
Although the municipal industry’s analytical sophistication has grown by leaps and bounds in recent years, some of that legalistic thought process still persists to this day, in our view. Take for instance the industry’s dismay over the fact that Congress “changed the rules” regarding Puerto Rico’s ability to file for a form of bankruptcy, i.e. Title 3 under the Promesa law. First of all, “bankruptcy risk” is not the same as “default risk”. Just because a state or local entity cannot file for bankruptcy doesn’t mean it can’t default on its debt. In fact, Puerto Rico showed that it was able to go into monetary default well before it had formal access to a formal debt restructuring process. In the same vein, the absence of a local government bankruptcy option in Illinois doesn’t mean that Chicago Public Schools (CPS) can’t incur liquidity problems and miss a coupon payment. At this year’s NFMA Conference, which we reported on recently, one of the panelists, who hailed from outside the muni mainstream, wondered aloud if muni investors are putting too much faith in the Chapter 9 process as part of their due diligence process.
The only certainty about the legal environment is that it can change at any time. As I recall, corporate bond investors don’t belly ache whenever Congress tinkers with Chapter 11, or when a new court case sets a new legal precedent. They just take it as a fact of life that statutes can change and the legal landscape can be significantly altered with the stroke of a pen.
Creditors of the State of Illinois, which is teetering on the edge of junk status, also appears to take solace in the strong constitutional protection bestowed on the State’s general obligation (GO) debt and in the fact that no U.S. state can file for Chapter 9 protection. Here again, just because the Prairie State, like all states, cannot file for Chapter 9 doesn’t mean it can’t default on its debt. Strong legal covenants may help you in bankruptcy court but they can’t keep an issuer from running out of money and defaulting.
Perhaps the legalistic approach was appropriate for the more genteel periods in the history of municipal finance, when resources were still bountiful and the full faith and credit GO pledge was the gold standard for bondholder security. Post-Detroit, that genteel environment no longer exists. Even the GO pledge has been turned on its head and relegated to the bottom of a municipality’s capital stack as an “unsecured obligation”.
Nary a day goes by when bonded GO debt service doesn’t find itself further subordinated to yet another “essential service” obligation. By now, it’s quite clear that pension obligations (and sometimes OPEB obligations) are, at least for the time being, treated by the courts as an obligation senior to debt service. Direct bank loans, which have proliferated in recent years, may be viewed as another de facto senior obligation due to their collateralized nature and inherently shorter maturity.
We may have to add Medicaid payments to the list of obligations that may be paid on parity with GO debt service, in the event of cash flow shortfalls. Just yesterday (June 7th), a federal judge ruled that Illinois is not in compliance with court orders to pay Medicaid recipients and instructed the State to work out a payment plan with all Medicaid stakeholders. State Comptroller Susana Mendoza, who had been giving priority to payments such as State payrolls and debt service prior to this ruling, now has to include Medicaid payments in the so-called “core priority” list.
Although Illinois’ cash flow problems are arguably self-inflicted due to the State politicians’ inability to reach a budget agreement, other municipal issuers who face “service insolvency” will have to make similar hard choices as to which payment to prioritize in a cash flow deficiency scenario. If a municipality’s essential services, however defined, are not being paid, constitutional protection and lockbox mechanisms may fall by the wayside. Just ask the holders of Puerto Rico GO and Cofina debt, currently locked in a legal battle that may have profound implications for the rest of the tax-exempt market. One can argue that, the sooner both parties can find ways to grow the overall “pie” instead of sticking to a narrow view of their own legal rights, the better the recovery values will be for all involved.
Truly, credit fundamentals always win out in the end.