By Joe Mysak
Dec. 23 (Bloomberg) -- The accountant who predicted the nation’s largest municipal bankruptcy says as many as 10 insolvencies will roil the $2.7 trillion U.S. market for state, county and city debt next year as public finances worsen amid calls for federal aid to state and local governments.
John Moorlach said in 1994 that Orange County, California’s leveraged investing strategy could wreck its finances. The county went bankrupt about six months later after losing $1.6 billion.
As many as four cities in the Golden State and six others nationwide may seek court protection from creditors next year under Chapter 9 of the bankruptcy code, the section devoted to municipal governments, Moorlach said in an interview.
“The total could be higher,” said Moorlach, 53, now chairman of the Orange County Board of Supervisors. He didn’t name any cities outside California, which has seen the cost of insuring state debt against default more than quadruple since September. He said his estimate was based on general economic conditions.
States project a $97 billion shortfall over the next two years, according to theNational Conference of State Legislatures. This mounting pressure on public finances gives President-elect Barack Obama’s administration “strong incentives” to provide federal aid, wrote George Friedlander, a municipal strategist at Citigroup Inc., the largest U.S. underwriter for tax-exempt bonds, in the firm’s Dec. 12 Municipal Market Comment.
Three Considering
“In an environment where the federal government needs to stimulate the economy, keeping states from being forced to take steps that are rapidly and severely restraining will become absolutely essential,” Friedlander wrote. He could not be reached for comment yesterday.
Two California cities, Rio Vista, with a population of 8,000, and Isleton, a 10th as large, have said budget gaps and debt loads may force them into insolvency. Likewise, Jefferson County, Alabama, which is trying to restructure $3.2 billion in sewer debt, has considered what would be the largest U.S. municipal bankruptcy.
The most such filings in a year is 104 in 1940 at the end of the Great Depression, according to a 1964 study, “The Postwar Quality of Municipal Bonds.” Since 1980, the record is 18 in 1987, the year of the Oct. 19 stock-market crash.
There may be 36 bankruptcies over the next two years, said Richard Ciccarone, chief research officer of McDonnell Investment Management LLC of Oak Brook, Illinois.
Borrowing Cost
Ciccarone predicts a dozen defaults in 2009 “and at least double that number in 2010.” He didn’t identify cities or counties and said his forecast is based on studying how municipalities respond to economic crises.
If well-known localities turn up among the insolvent, he said, borrowers’ costs will increase at least 50 basis points. A basis point is 0.01 percentage point. If the interest rate on 10- year bonds worth $1 million increases to 5.5 percent from 5 percent, borrowers pay an additional $50,000 over the bonds’ life. Tax-exempt yields on the Bond Buyer 20-bond index were at 5.46 percent on Dec. 19.
Orange County sought court protection on Dec. 6, 1994, about six months after Moorlach, a Republican, predicted the bankruptcy while running for the treasurer’s office. Incumbent Robert Citron, a Democrat whose investment strategy required heavy borrowing to increase bets, resigned. Moorlach, a Republican, replaced him and held the office through 2006.
California Insolvencies
Now, he says, three or four of next year’s insolvencies will be in California, the biggest borrower in the municipal bond market. State lawmakers are grappling with a $14 billion shortfall in the fiscal year that ends June 30. A $42 billion hole is projected for the year that begins July 1. The state this year has sold $21.6 billion in tax-exempt bonds while localities have sold $31.1 billion, according to data from Thomson Reuters.
Standard & Poor’s downgraded California’s short-term note rating to SP-2 from SP-1 on Dec. 10. The state has “some vulnerability to adverse financial and economic changes over the term of the notes,” the New York-based company said. Notes rated SP-3 are deemed to be speculative.
Spreads on credit-default swaps against 10-year California debt rose to 507 basis points on Dec. 12, more than double their value of 213 on Dec. 2, according to data compiled by Bloomberg. They declined to 400 yesterday, meaning investors would pay $400,000 annually to protect $10 million of California debt. California swaps are the most expensive of any state, followed by Michigan, at 365 basis points.
‘Gone Haywire’
The swap contracts, conceived to protect bondholders, pay a buyer face value in exchange for the underlying securities or the cash equivalent should an issuer fail to adhere to debt agreements. They increase in value as perceptions of credit quality deteriorate.
The market for municipal credit protection has “quite literally, gone haywire,” Citigroup’s Friedlander wrote Dec. 12, noting that the cost for California debt was higher than for Turkey’s. “These prices bear no relationship to real risks whatsoever,” he said in the report.
More Chapter 9 filings are not inevitable, said Bruce Bennett, a partner at Hennigan, Bennett & Dorman law firm in Los Angeles who designed Orange County’s 1994 bankruptcy strategy.
“Municipalities are unbelievably artistic at deferring liquidity problems,” by tapping reserves and cutting expenses, he said.
Vallejo Impact
Moorlach said many California cities are watching Vallejo, a city of 117,000 on San Francisco Bay that filed under Chapter 9 in May. The city hopes to rewrite its labor contracts with police and firefighters.
“If Vallejo is successful in unwinding pension agreements, you could see Chapter 9 become a whole new industry,” Moorlach said.
Orange County needs to close a projected $84 million gap in next year’s $700 million general fund. On Dec. 11, after the state cut funding for social services, county leaders said they would lay off 210 workers. Nick Berardino, general manager of the Orange County Employees Association, the county’s largest union, said politicians have been slow to respond to suggestions on how to prevent layoffs.
Berardino said he thought most municipalities would avoid bankruptcy and mass job cuts by slashing services this fiscal year.
“After July of 2009, though, it’s a whole new ballgame,” he said.
To contact the reporter on this story: Joe Mysak in New York atjmysakjr@bloomberg.net.
