A Tale of Two Cities and a County in Muniland

A Tale of Two Cities and a County in Muniland
November 29, 2010
David Kotok

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What do Menasha WI, Harrisburg PA, and Cumberland County NJ have in common? All have issued municipal bonds for infrastructure projects. All have projects that failed to meet expectations. All stressed about what action to take.

Where are they different? Two engaged in financial misbehavior. One, Cumberland County, demonstrated quality governance and acted correctly.

In Menasha, a steam plant financing payment was due in September, 2009. Instead of paying, the city allegedly reneged on its pledge to make deficiency payments. Therefore, they are now spending taxpayer money on legal fees instead of doing a debt workout. (Source WSJ archives)

Harrisburg, the capital of the State of Pennsylvania, made national news with its attempt to use bankruptcy as a means of avoiding payments that were promised. Harrisburg is a scandal and an embarrassment for PA and its Governor Rendell, who has tried to find workable alternatives and must deal with uncooperative and irresponsible local officials.

No one has heard about Cumberland County NJ. Why not? The board of the Cumberland County Improvement Authority (CCIA) made a difficult governance decision. They determined not to build a landfill expansion because the economics that drove the original decision had changed. They had lost a large customer of a landfill facility after it redirected its flows. The customers were forced to do so because of particularities under NJ’s flow-control laws. So, CCIA found itself with project financing that was no longer the most cost-effective alternative.

Here is a case of “good governance.” CCIA stopped the project. It is using the unexpended proceeds provision in its bond resolution to call the bonds that were originally issued to pay for the project. It is also defeasing that resolution so that it may operate the smaller facility under less financially stressful conditions during this period of national economic uncertainty.

Investors did not read headlines about CCIA. It didn’t make national news. It will not default. It won’t delay payment. Moreover, it will honor its obligations and therefore not injure the other county entities and the cities that are impacted.

The point of this commentary is that governance must be part of the investor’s credit ranking system. State and local infrastructure projects are most often viable from an economic viewpoint. In theory, they shouldn’t be built without passing that test. However, they are also subjected to political models. If local politicians choose to avoid payment responsibility, they injure their constituents for years. It is up to the constituents to throw them out of office, ridicule their decisions and, perhaps, impeach them. We get the government we deserve and sometimes we fail to act to change it.

At Cumberland Advisors, we do not and did not own Menasha or Harrisburg debt. It failed the governance test. CCIA is a consulting client and we are proud to serve them.

There are about 90,000 separate issues of state and local government securities that are traded with some frequency. They each have a governing structure and a well-defined legal framework under which they conduct business. They have many diverse and complex terms that cover their borrowing and repayment obligations. Serious investors need to understand, examine and dissect them. What is clear to us is that the information is mostly available. It may be complex but it is there. In addition, it is very transparent to any skilled analyst who will take the time to do the work. BTW, nearly all of them will make their timely interest and principal payments on their bonds.

In the old days we used to be asked: “Why do you need to do any of this work? We can just buy AAA-insured bonds and forget about it.” The world has changed. Lethargy & complacency-inducing AAA insurance is dead. However, that does not mean state and local government securities are all bad and are all going to default.

There are some great bargains available right now in the tax-free and taxable Muniland space. Investors are getting well paid for participating. The case for Munis is now classic by market standards. Buy something when no one wants it; sell it when it is very popular.

Lazy investors or those who are scared by the headlines are running from Munis in droves. That selling is why they are very cheap. Investment Company Institute reports that a record-setting $4.78 billion was pulled out of Muni mutual funds in the week ending Nov. 17. Lipper FMI says another $2.3 billion was withdrawn in the week ending November 24. This is evidence of huge panic selling; it suggests a selling climax in Muniland.

So we argue the contrary case. It is time to do the homework. Read the bond indentures. Examine the governance structure. And buy the good ones. We do.

As for Harrisburg and Menasha, they may be nice places to visit, but I wonder what communal life will be like when the governing body wants to hide behind the courts in order to avoid confronting a bad financial decision. Menasha and Harrisburg each need to determine a work-out plan and stop the bleeding. Time will reveal the true costs of their poor governance to date. Markets and vendors will punish defaulting debtors without mercy.

Note that there were 54 cases of Moody’s-rated municipal debt default during the 40 years from 1970 to 2009. Of them, 78% were in stand-alone housing and health-care projects (source: WSJ, November 11). Considering that there were thousands of bond issues, that is a pretty good record. Also, note that a disciplined governance structural review and an examination of the credits would have likely kept a high-grade bond buyer from purchasing most, if not all, of the 54 issues. It did for us.

Happy holidays.

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David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors