Oil Slickonomics Part 10-Trouble in Muniland

David R. Kotok
Chairman and Chief Investment Officer
Oil Slickonomics Part 10-Trouble in Muniland
July 21, 2010

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Since the BP rig explosion, $450,000 of the Louisiana St. Trans Auth Toll Sr. Lien-LA 1 Project-Series A, 4.5% of 12/01/30 tax-free municipal bonds have traded. Prices have ranged from a low of 93.25 to a high of par (100). The average price was about 99, or $990 per thousand-dollar face amount.

The bonds were issued in 2005. At the time, S&P, Moody’s, and Fitch rated them AAA. The rating was achieved because Ambac insured the bonds. Today Ambac itself is rated at a low junk-bond status.

Fitch rated this Louisiana bond BBB in January 2009. S&P rerated the bond A+ in October 2009. Moody’s rerated it Aa3 under its new global scale. That rating occurred on April 16, 2010, four days before the Deepwater Horizon explosion. The rating agencies based these results on the bond’s underlying credit structure; Ambac is ignored because of its junk status.

In May 2010, Moody’s said that the Gulf Oil spill would have a major impact on the shoreline, but a minor impact on Louisiana and local credits. Six months before the BP explosion (October 2009), Moody’s awarded an A1 rating to Louisiana’s General Obligation bonds. Moody’s cited the oil industry as one of the strong factors in Louisiana’s economy.

Four years earlier, in 2005, Moody’s “assigned an Aa3 to the Louisiana Transportation Authority LA 1 Project Toll Revenue Senior Lien Bonds, series 2005A.” The reason given was that the bond has a “first lien on toll revenues, but the “security ultimately hinges on a Cooperative Endeavor Agreement between the State and the Authority in which the State agrees to replenish the Debt Service Reserve Fund if necessary, subject to appropriation.”

Let us be blunt. This is a toll revenue bond. It is dependent on the use of a 16.3-mile elevated highway and bridge system beginning at Port Fourchon, Louisiana. The major customers are the Louisiana-based oil industry and the Louisiana-based shrimp industry. The toll revenue projections are now in jeopardy. First because the fishery industry is decimated by the BP spill. Secondly because the Obama administration’s oil-drilling moratorium threatens oil-industry revenues.

If the tolls are insufficient, the credit support for this bond comes from a state guarantee. The underlying economic assumption for this bond, according to the consultants who prepared the revenue estimates, is that “oil and gas drilling in the Gulf of Mexico will continue unabated, as will the LOOP terminal, with Port Fourchon remaining as the principal service port for these platforms.”

However, the state’s obligation requires that the legislature appropriate money in order to fund any deficiency. They may face this issue if the Debt Service Reserve Fund runs out of money because the toll revenue is insufficient. Will that happen? We do not know. Could it happen? Absolutely, yes.

Will the legislature fund the debt service at the time their state budget is under pressure because of the aftermath of the BP spill and because of the federal government’s oil drilling moratorium? We do not know. However, the pressure to defer any payment will be intense and the legal obligation to fund it is uncertain.

The language in the documents suggests that the legislature’s obligation to pay in the future will remain if the legislature fails to fund any debt service deficiencies as they occur. That implies the legislature may be able to delay the funding while it litigates with the federal government.

We fear this issue may become one contested in a court. If so, the bondholders will be dependent on Ambac for the timely payment of their debt service. And Ambac has gone from a AAA credit to a weak junk bond status. Enough said.

No rating agency has downgraded this bond since the explosion. No rating agency has put it on credit watch. We cannot find any rating agency action that reflected any negative response for this bond because of the BP oil spill and its aftermath.

In June of 2010, someone bought a small piece of this bond at par (100), according to public records of trades. If that person checked the status of the bond, they would have observed the investment grade ratings we outlined above. No current credit report would have mentioned this payment intricacy.

Cumberland would not buy this bond. At the current prices we see in the transactions reports, the bond is trading as if there were nothing happening to elevate the risk. The market pricing assumes that the State of Louisiana has negligible negative credit impact due to the moratorium and the BP spill.

We do not understand the rationale behind this lethargic behavior by the rating agencies. We wonder why this bond, and others like it, is not on a credit watch for a possible downgrade.

Since the Deepwater Horizon explosion, Cumberland has sold about 40 different issues of municipal bonds because of possible exposure to the aftermath of the BP oil spill. The only reason we did not sell this one is that we never owned it to begin with.

Proactive Muni management means sell quickly when a contingent risk is evolving. Acting early means that most of the bonds sold will ultimately pay on time. The idea is to manage a rising risk by selling into market pricing that has yet to reflect that risk. This bond is an example of such a rising risk.

Nothing in the documents suggests that BP has any liability for any debt-service shortfall. BP did cause damage to the shrimp industry but BP did not create the drilling moratorium. There is no stated obligation of the federal government to pay for any debt-service shortage because of the moratorium. Ultimately, the Feds will either pay voluntarily or the State will have to prevail in court.

We wish the holders of these bonds good luck. They may need it.

Note: the GIC delegation will visit Port Fourchon by helicopter as part of its August 11-12 research seminar in Baton Rouge. There are four seats still available on the delegation’s helicopters. For details see: www.interdependence.org or call 215-898-9453.

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David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com