Municipal Distress: What to Consider When Working with Local Governments: Municipalities Today Face Many Challenges, but Profitable Opportunities Still Exist for Lenders Willing to Commit to Robust Due Diligence and Ongoing Monitoring
Johnson, David, The RMA Journal
LENDERS AND LOCAL governments are in many ways perfectly suited to each other.
For lenders accustomed to the volatility of private companies, the tax revenues of municipalities must appear pleasantly insulated from economic shocks. Additionally, lenders find local governments to be attractive prospects because they have a constant need for funding, as well as the ability to increase revenue at will via taxes.
Meanwhile, municipalities see in a lender a partner with whom they can form a relationship--an improvement over a capital markets funding approach, which relies on a diffuse universe of bondholders.
But even though the appeal on both sides is clear, lenders face significant challenges in their desire to begin, continue, or expand lending operations to municipalities. Successful lending in this arena requires an understanding of the challenges facing municipalities and how those challenges will likely resolve in coming years. Consider the following points:
1. Municipalities and private companies are very different. Municipalities' accounting, funding, governance, and reactions to distress all reflect a mix of economics and politics--a point that lenders need to appreciate to be successful in this arena. Lenders must know the underlying logic of the generally bearish case against municipalities in order to determine whether those challenges apply to a given municipality.
2. Government pension and health-care benefits pose significant challenges. Again, these issues must be well understood by the lender to see if they apply to a given situation.
3. Lenders must review recent cases of municipal distress in order to identify evolving trends.
4. Prudent risk management will allow lenders to manage profitable municipal lending operations. But as with all lending, understanding the borrower (and, in this case, the class of borrowers) is key.
In December 2010, analyst Meredith Whitney went public with her bearish call on municipalities, predicting a wave of municipal defaults. Throughout 2011, scorn was heaped upon her when these defaults failed to materialize.
Undeterred, Whitney reiterated her bearish call in a follow-up research report, which found that the health of state finances is even more precarious than is generally acknowledged. (1) Many have argued the technical points of her analysis, but Whitney is clearly making the directionally correct call, and those opposing her analyses are propounding a type of exceptionalism that traditionally has led to significant investor losses.
Despite the savage response to Whitney's analyses, the standing of those who share similar views would seem to lend credence to her arguments.
* In 2011 the noted economist Nouriel Roubini also released an analysis forecasting municipal defaults of as much as $100 billion, though this amount was spread over five years. Roubini, well versed in the perils of offering predictions, has been careful to couch his forecast with many qualifiers, but it is noteworthy that he came up with a number similar to Whitney's. (2)
* In January 2011, Jamie Dimon, CEO of JPMorgan Chase, predicted an increased level of municipal distress in coming years. (3)
* Large investors such as Berkshire Hathaway and Allstate (as well as JPMorgan) announced reductions in their holdings of municipal bonds in the first half of 2011, another bearish sign.
The crux of the bearish case for municipalities is that they are facing a perfect storm of conditions that will impose wrenching changes on local governments and potentially stunning losses on a group of creditors grown accustomed to a historically low default rate. The issues facing municipalities are as follows.
* Benefits: The baby boom generation is preparing to retire and, for municipal governments across the country, that raises the specter of underfunded plans that will never catch up and rising health-care costs that cannot continue to be met. …