( August 1st, 2012) The fiscal plight of local governments has been well publicized in the wake of the Great Recession, with notable bankruptcy filings in California fueling the most recent spate of headlines. This has investors in the municipal market questioning the fiscal integrity of issuers and trying to discern whether events in the most populous state represent the beginning or the end, an anomaly or the mean. BlackRock has said for some time that outside of the higher-risk high yield sectors, local governments are most susceptible to distress. As such, recent happenings come as little surprise to us, and it is important that they are viewed in context. In the following pages, we offer some perspective on local bankruptcies and the implications
for municipal bond market participants.
Locals: Sizing Up the Issue
The local government sector consists of more than 89,000 units including municipal governments, townships, counties, school districts and special districts. All told, locals account for 12% of national gross domestic product (GDP) and 11% of the US labor force. Local government debt represents 13% of outstanding debt in the municipal bond market—not insignificant, but not a market-moving proportion.* Since the start of the recession, it has been clear to us that local governments would be more exposed to bankruptcies and defaults than states and other portions of the
municipal market, for several reasons:
- Locals, unlike states, have the legal ability to file for Chapter 9 bankruptcy protection. With bankruptcy as an option, some will obviously use it to alleviate financial pressure.
- Declining house prices mean declining property tax collections, a major source of revenue for locals. This has posed significant financial strain.
- At the same time, local governments have substantial fixed costs, including contractual obligations that are difficult to renegotiate and can be particularly burdensome against a backdrop of declining revenue.
- States have balanced their budgets by cutting spending and offloading costs to municipalities, putting additional pressure on already stressed locals. While state revenues have started to recover, locals’ continue to decline.
Outside of event risk, such as natural disasters or legal judgments, a number of signs point to local distress. For that reason, we believe most local bankruptcies to date have been foreseeable, and this has allowed us to avoid exposure to these distressed cases in our portfolios. Among the signposts we look for in assessing local hardship are high levels of foreclosure, unemployment and poverty, as well as out-migration population trends and, most importantly, fiscal mismanagement.
States: Help or Hindrance?
States, by cutting aid and downloading costs, have had some part to play in the fiscal struggle of local governments. That said, several states have been proactive in aiding their locals in times of stress. State intervention measures may include financial assistance, direct lending or the authorization of deficit bond issuance, among others. More commonly, state intervention involves the appointment of a controller to monitor a municipality’s budget, facilitate negotiations with creditors and influence political will to increase taxes or reduce spending.
States that have been active in aiding local governments include Michigan, Pennsylvania, New York and Rhode Island. The impetus, particularly in the recent case of Rhode Island, has been to ensure market access to capital for local governments, and the result has been the orderly restructuring of debt or, in some cases, the avoidance of bankruptcy. Other states, most notably California, have turned their backs to locals’ problems—with headline-making results.
California: Big State, Bigger Problems?
According to Municipal Market Advisors, nearly 40% of the 45 Chapter 9 filings since 2007 have occurred in either California (8) or Nebraska (11). Notably, most of these filings are not cities. In Nebraska, the bankruptcy cases are primarily very small development districts that were typically non-rated and, as such, speculative in nature. Outside of California and Nebraska, no other state approaches these numbers. This tells us that the vast majority of the country has been able to manage its debt and presents opportunity for investors.
The recent California bankruptcy headlines, featuring three cities in as many weeks (Stockton, Mammoth Lakes and San Bernardino), were by no means bombshells, nor was the Vallejo filing in 2008. Each represents a culmination of factors, over the course of many years, and a lack of state support mechanisms.
The State of California does not provide any formal fiscal oversight for cities and counties in distress. California locals are also more vulnerable to fiscal pressure due to limited revenue flexibility and restrictions imposed by the state via Proposition 13, which caps the property tax rate at 1% of the assessed value of a home and holds annual tax increases to no more than 2%. While assessed valuations in California overall turned positive in 2012 (after declining in 2010 and 2011), certain locales still face negative growth, which continues to inhibit revenues. Locals in California also are more dependent on voters’ support for taxes to provide services to residents. Given these constraints on revenue generation, many locals are left to maintain fiscal integrity through expenditure management, but have been unwilling to accept spending concessions, in some cases leading to or exacerbating fiscal stress.
All of this said, investors need not count California out. State oversight of school districts is quite strong and, as such, we find ample investment opportunity among school districts, as well as community colleges, essential-service providers and dedicated- tax bonds. Notably, while the headlines have been alarming in their frequency and scope, the eight California bankruptcies since 2007 are within the context of more than 4,000 California local governments. While we continue to find opportunities, we would caution that California’s lack of pro-bondholder policy could eventually sour investor sentiment toward the state.
What (or Who’s) Next?
While declining or stalled housing prices are a national phenomenon, foreclosures are most acute in areas that saw soaring home prices (southern CA, AZ, NV and FL) as well as older industrial areas (OH and MI). As such, it is fairly easy to identify areas that are more susceptible to fiscal stress. In modern-day ghost towns (former booming areas struck by high foreclosures), there are undoubtedly certain municipal credits that should be avoided. There are also many strong credits that we believe will continue to perform relatively well. The map below illustrates areas we believe are vulnerable to fiscal distress (and potential bankruptcy/default), as well as those areas representing greatest opportunity. Notably, our short list of favorable locals has not changed since 2008, a testament to the fact that many distress cases have been long in coming and well telegraphed to the marketplace, whereas areas of financial fortitude have prevailed even amid recession.
Navigating Local “Gridlock”
While headlines surrounding bankruptcy can certainly unnerve investors, we would stress the point that none of the cases since 2007 have taken the market by surprise and the vast majority have had less to do with the recession and more to do with fiscal mismanagement and unfortunate decisions over the course of time. As such, while bankruptcy rates among locals may continue to trend modestly higher versus historic norms, we do not foresee systemic or widespread risk and believe distress cases will continue to be isolated to the periphery rather than the core of the municipal market. Of note, Chapter 9 municipal bankruptcy is authorized in only 26 states, meaning a large subset of the United States is precluded from filing. In addition, while negative headlines may continue and the number of local names declaring bankruptcy could inch up from historically low levels, the total dollar amount of defaulted debt is likely to remain modest. This is an important distinction, as it speaks to the fact that many of the local filings represent very small issuers with minimal debt outstanding and, as such, have little to no impact on the broader municipal marketplace.
We have long said that credit research is the key to success in municipal investing. The current environment only reinforces that view. Choosing high-quality, high-potential investments requires a deep understanding of individual credits, issuers and the economic, social and political environment in which they exist. At BlackRock, our finely tuned credit analysis process is among the strongest in the industry and boasts a long-term track record of translating that research into investment results. We are keenly aware of state and local issues affecting credit fundamentals in all municipal sectors. Importantly, this has not only allowed us to select the strongest credits for our portfolios, but also to avoid negative surprises. For more on BlackRock Municipal Credit Research, see “BlackRock Municipal Credit Research: Making a Difference One Bond at a Time.”