A More Secure Investment?

Stockton

At its housing peak, Stockton home pricing had grown nearly 200% over six years, resulting in an influx of property tax revenue for the city; from 2006-2009, prices dropped 70% (Bloomberg, June 27, 2012). Unable to meet its revenue needs, Stockton filed for bankruptcy in 2012 with outstanding insured general obligation bonds totaling $240 million. Under the settlement terms reached in early November 2013, bond insurers have taken up to a 50% loss on some general obligation bonds (Reuters, Nov. 4, 2013). The Stockton situation is being called “precedent-setting” as the courts determine what is owed to bondholders under municipal bankruptcy law.

Detroit

While Stockton provides a cautionary tale for general obligation bondholders, Detroit's bankruptcy may prove to be even worse. Once the United States' third largest city, Detroit issued $233.2 million in insured bonds to two companies between 1999 and 2006, which the city defaulted on and left the companies to pay bondholders (Bloomberg, Nov. 8, 2013). The city officially filed for bankruptcy in July 2013, causing concern for general obligation bondholder and bond insurers. The city's current debt liabilities are estimated at $17 to $18 billion, of which $2.9 billion is unsecured (Michigan National Public Radio, Oct. 28, 2013). Detroit's Chapter 9 filing is the largest municipal bankruptcy filing by debt owed in U.S. history. The second largest, Jefferson County, AL, hardly comes close to Detroit, with $4 billion in debts owed.

Detroit's state-appointed emergency manager previously noted the possibility of offering as low as 10 cents on the dollar to some of the city's creditors. According to an expert with the Citizens Research Council of Michigan, emergency manager Kevyn Orr's proposal to creditors marks the first time general obligation debt and pension obligations are treated in the same way (The Economist, June 22, 2013). This is a departure from Stockton's bankruptcy proceedings, which prioritized pension obligations over obligations to bondholders. The end game for Detroit's general obligation bondholders is still unclear as the city is in very early stages of the bankruptcy process. What is certain is that bondholders are guaranteed to lose out on their investments long-term regardless.

Other Cities

Detroit and Stockton are not the only cities in America that have and possibly will enter into municipal bankruptcy. Recently, Merritt Research Services examined the financial health of 250 of America's cities. More than half still have reserves below their 2007, or pre-recession, levels (The Wall Street Journal, Oct. 27, 2013). Pew Charitable Trusts found that 30 cities, which in combination with their metropolitan areas make up 49% of U.S. gross domestic product, still have an unstable outlook for their recovery (The Wall Street Journal, Nov. 11, 2013). Because property-tax collections lag behind housing recovery, Pew predicts that collection rates could continue to plague many municipalities. With continued uncertainty around municipal financial stability, which investment type can best weather the storm?

GO Bonds Versus Municipal Leases

The table on page'below lays out several distinct differences between these two types of obligations. Attractiveness of each investment type for a lower investment grade municipal entity is dependent on the economic and socioeconomic conditions at the time of investment and expected trends in the future. Next, we examine GO bonds and municipal leases for essential equipment outstanding with investors under three separate conditions.

For each situation, the GO bonds were used for capital improvements to the municipality's school district buildings and computer systems. Likewise, in all three situations, the municipal lease funded the replacement of the municipality 911 systems and its police car fleet.

First, under average conditions with no stress on the municipal entity, both investments behave normally with full payment of principal and interest as expected by investors holding the bonds and leases. Investors are happy with both GO bonds and municipal leases. GO Bonds have a slight advantage with the municipal bond market trading bonds at par.

In our second scenario, the municipality begins to enter a stress period with potential decline in rating by the rating agencies. Real estate assessments are stagnant and tax collection rates are less than expected historically. The GO bond market has been affected and is trading slightly less than par due to an expected downgrade. Trading will continue at the downgraded rate until real estate tax assessments improve and tax collection increases. With a slightly stressed municipality, both investor communities are happy with their investments; however, in response to the changing conditions, some GO bond investors will liquidate their position at a slight loss of principal.

Our third scenario reflects the economic conditions for some cities during and after The Great Recession. Under these conditions, the municipality moves into a high stress period with a strong downgrade in rating and significant cash flow issues. Bankruptcy is being considered and the entity is now expecting to miss a future scheduled GO bondholder payment. The investor communities have now reached two distinct levels of contentment. GO bondholders are feeling very insecure and are looking at a current loss in value of principal dollars. The municipal leaseholders will have to watch for the next appropriation of budget dollars for their lease payments. Municipal lease investments may be watch listed, but the municipality cannot do without their 911 system and police cars, so there is a certain security in holding a lease for municipal equipment.

Long-Term Investment Security

Clearly, the attractiveness of each investment type will vary with conditions. So, which is the better investment for the long-term investor? In order to answer this question, it may help to look at what happens if the city enters into a municipal Chapter 9 bankruptcy. The municipal lease has the upper hand, compared with an unsecured GO bond.

A municipal Chapter 9 bankruptcy is analogous to a Chapter 11 filing for a failing company. Although the municipality will be treated as a sovereign entity, the provisions of the Bankruptcy Code regarding matters like lessor protections and secured party protections still apply. The ultimate objective of a Chapter 9 bankruptcy is for the municipality to make an arrangement with its creditors in its bankruptcy proceedings, somewhat like a plan of reorganization for a Chapter 11.

Because GO bonds are not secured, the unpaid indebtedness on the bonds is categorized as part of general unsecured claims, making it the lowest priority claim to be paid in bankruptcy. While this is bad news for bondholders, they do have some leverage to negotiate for a better deal as the city's ultimate plan will be voted on by all impaired creditors.

Municipal leases have better protection in bankruptcy. They will be treated as a security interest, not a “true lease,” because, in a tax-exempt municipal lease, the lessee is the owner at the end of the lease (Cubic Corp. v. U.S., 541 F. 2d 829 (9th Cir. 1976)). Under bankruptcy law, the holder of a security interest is given protection to the extent of the value of the collateral (“the equipment”) covered by the lease.

In our scenario, the police cars and 911 system are essential to the municipality, so the municipal lease is not likely to be rejected in bankruptcy. In fact, if the equipment were not essential, the city would likely have terminated the lease under the standard nonappropriation clause in the lease prior to the bankruptcy. If the lease survived to the bankruptcy, it is because of the essential nature of the equipment. In the bankruptcy, the lessor is entitled to be paid to the extent of the value of the police cars and 911 system, and it has the right to seek an “adequate protection” order to ensure payment (11 U.S.C. ' 363). The police cars and 911 system would be valued in place and in use, so the lessor could expect the bankruptcy court to recognize significant value for the equipment and require the city to pay accordingly as part of an adequate protection order. Should the municipality cease paying rents under the lease, the lessor may also ask the court for an order to lift the bankruptcy stay and allow the lessor to remove the equipment from the municipality.

Although the municipal leaseholder has more leverage, each party has some negotiating power, including the municipality. The city might try to drive its payments lower, or even reject the municipal lease, by seeking similar, cheaper alternatives in the marketplace. When the equipment is considered essential, the municipality is unlikely to take such measures as embedded systems, like 911, would be very costly and time-consuming to replace.

Conclusion

There is a place for both municipal investment types. However, in the wake of the Great Recession, cities like Detroit and Stockton are proving that municipal lessors are in a much better position than GO bondholders and GO bond insurers. It appears that for investors, the changing times favor equipment-backed municipal leases.

Thomas B. Howard, Jr. is vice president and director of Government Finance for TD Bank. He has been in the equipment finance and specialty lending industry for more than 35 years. Michael Geltner of Geltner & Associates, P.C., Falls Church, VA, specializes in leasing law, public finance and government contract law and bankruptcy law.

For many decades, U.S. institutional investors and large bond insurers have viewed the general obligation (GO) municipal bonds from rated investment grade municipalities as a much higher value investment vehicle than an illiquid municipal lease subject to annual appropriation. Have the recent large municipal bankruptcies and the increasing recognition of underfunded pension funds improved the attractiveness of the less liquid municipal lease? In the current climate, with cities like Stockton, CA, and Detroit, MI, causing concern for municipal investors, are the municipal lease and its annual appropriation risk are now more secure because of the fully assigned security in the municipality's essential equipment?

In the wake of the recession, unprecedented large U.S. city bankruptcies are emerging, under significantly different circumstances than previous municipal bankruptcies. The Great Recession put more declining revenue pressure on most municipal entities due to generally lower property tax revenue and a reduction in grants and revenue sharing from U.S. federal and state sources, which had been relatively stable or increasing for decades. On a national scale, the 10 worst housing markets saw declines of at least 55% from their peak (NBC News, Sept. 26, 2012).

Two notable bankruptcy case studies from The Great Recession are Stockton and Detroit: the former having reached a settlement in 2013, while the latter is just beginning its hotly contested bankruptcy process.

Stockton

At its housing peak, Stockton home pricing had grown nearly 200% over six years, resulting in an influx of property tax revenue for the city; from 2006-2009, prices dropped 70% (Bloomberg, June 27, 2012). Unable to meet its revenue needs, Stockton filed for bankruptcy in 2012 with outstanding insured general obligation bonds totaling $240 million. Under the settlement terms reached in early November 2013, bond insurers have taken up to a 50% loss on some general obligation bonds (Reuters, Nov. 4, 2013). The Stockton situation is being called “precedent-setting” as the courts determine what is owed to bondholders under municipal bankruptcy law.

Detroit

While Stockton provides a cautionary tale for general obligation bondholders, Detroit's bankruptcy may prove to be even worse. Once the United States' third largest city, Detroit issued $233.2 million in insured bonds to two companies between 1999 and 2006, which the city defaulted on and left the companies to pay bondholders (Bloomberg, Nov. 8, 2013). The city officially filed for bankruptcy in July 2013, causing concern for general obligation bondholder and bond insurers. The city's current debt liabilities are estimated at $17 to $18 billion, of which $2.9 billion is unsecured (Michigan National Public Radio, Oct. 28, 2013). Detroit's Chapter 9 filing is the largest municipal bankruptcy filing by debt owed in U.S. history. The second largest, Jefferson County, AL, hardly comes close to Detroit, with $4 billion in debts owed.

Detroit's state-appointed emergency manager previously noted the possibility of offering as low as 10 cents on the dollar to some of the city's creditors. According to an expert with the Citizens Research Council of Michigan, emergency manager Kevyn Orr's proposal to creditors marks the first time general obligation debt and pension obligations are treated in the same way (The Economist, June 22, 2013). This is a departure from Stockton's bankruptcy proceedings, which prioritized pension obligations over obligations to bondholders. The end game for Detroit's general obligation bondholders is still unclear as the city is in very early stages of the bankruptcy process. What is certain is that bondholders are guaranteed to lose out on their investments long-term regardless.

Other Cities

Detroit and Stockton are not the only cities in America that have and possibly will enter into municipal bankruptcy. Recently, Merritt Research Services examined the financial health of 250 of America's cities. More than half still have reserves below their 2007, or pre-recession, levels (The Wall Street Journal, Oct. 27, 2013). Pew Charitable Trusts found that 30 cities, which in combination with their metropolitan areas make up 49% of U.S. gross domestic product, still have an unstable outlook for their recovery (The Wall Street Journal, Nov. 11, 2013). Because property-tax collections lag behind housing recovery, Pew predicts that collection rates could continue to plague many municipalities. With continued uncertainty around municipal financial stability, which investment type can best weather the storm?

GO Bonds Versus Municipal Leases

The table on page'below lays out several distinct differences between these two types of obligations. Attractiveness of each investment type for a lower investment grade municipal entity is dependent on the economic and socioeconomic conditions at the time of investment and expected trends in the future. Next, we examine GO bonds and municipal leases for essential equipment outstanding with investors under three separate conditions.

For each situation, the GO bonds were used for capital improvements to the municipality's school district buildings and computer systems. Likewise, in all three situations, the municipal lease funded the replacement of the municipality 911 systems and its police car fleet.

First, under average conditions with no stress on the municipal entity, both investments behave normally with full payment of principal and interest as expected by investors holding the bonds and leases. Investors are happy with both GO bonds and municipal leases. GO Bonds have a slight advantage with the municipal bond market trading bonds at par.

In our second scenario, the municipality begins to enter a stress period with potential decline in rating by the rating agencies. Real estate assessments are stagnant and tax collection rates are less than expected historically. The GO bond market has been affected and is trading slightly less than par due to an expected downgrade. Trading will continue at the downgraded rate until real estate tax assessments improve and tax collection increases. With a slightly stressed municipality, both investor communities are happy with their investments; however, in response to the changing conditions, some GO bond investors will liquidate their position at a slight loss of principal.

Our third scenario reflects the economic conditions for some cities during and after The Great Recession. Under these conditions, the municipality moves into a high stress period with a strong downgrade in rating and significant cash flow issues. Bankruptcy is being considered and the entity is now expecting to miss a future scheduled GO bondholder payment. The investor communities have now reached two distinct levels of contentment. GO bondholders are feeling very insecure and are looking at a current loss in value of principal dollars. The municipal leaseholders will have to watch for the next appropriation of budget dollars for their lease payments. Municipal lease investments may be watch listed, but the municipality cannot do without their 911 system and police cars, so there is a certain security in holding a lease for municipal equipment.

Long-Term Investment Security

Clearly, the attractiveness of each investment type will vary with conditions. So, which is the better investment for the long-term investor? In order to answer this question, it may help to look at what happens if the city enters into a municipal Chapter 9 bankruptcy. The municipal lease has the upper hand, compared with an unsecured GO bond.

A municipal Chapter 9 bankruptcy is analogous to a Chapter 11 filing for a failing company. Although the municipality will be treated as a sovereign entity, the provisions of the Bankruptcy Code regarding matters like lessor protections and secured party protections still apply. The ultimate objective of a Chapter 9 bankruptcy is for the municipality to make an arrangement with its creditors in its bankruptcy proceedings, somewhat like a plan of reorganization for a Chapter 11.

Because GO bonds are not secured, the unpaid indebtedness on the bonds is categorized as part of general unsecured claims, making it the lowest priority claim to be paid in bankruptcy. While this is bad news for bondholders, they do have some leverage to negotiate for a better deal as the city's ultimate plan will be voted on by all impaired creditors.

Municipal leases have better protection in bankruptcy. They will be treated as a security interest, not a “true lease,” because, in a tax-exempt municipal lease, the lessee is the owner at the end of the lease ( Cubic Corp. v. U.S. , 541 F. 2d 829 (9th Cir. 1976)). Under bankruptcy law, the holder of a security interest is given protection to the extent of the value of the collateral (“the equipment”) covered by the lease.

In our scenario, the police cars and 911 system are essential to the municipality, so the municipal lease is not likely to be rejected in bankruptcy. In fact, if the equipment were not essential, the city would likely have terminated the lease under the standard nonappropriation clause in the lease prior to the bankruptcy. If the lease survived to the bankruptcy, it is because of the essential nature of the equipment. In the bankruptcy, the lessor is entitled to be paid to the extent of the value of the police cars and 911 system, and it has the right to seek an “adequate protection” order to ensure payment (11 U.S.C. ' 363). The police cars and 911 system would be valued in place and in use, so the lessor could expect the bankruptcy court to recognize significant value for the equipment and require the city to pay accordingly as part of an adequate protection order. Should the municipality cease paying rents under the lease, the lessor may also ask the court for an order to lift the bankruptcy stay and allow the lessor to remove the equipment from the municipality.

Although the municipal leaseholder has more leverage, each party has some negotiating power, including the municipality. The city might try to drive its payments lower, or even reject the municipal lease, by seeking similar, cheaper alternatives in the marketplace. When the equipment is considered essential, the municipality is unlikely to take such measures as embedded systems, like 911, would be very costly and time-consuming to replace.

Conclusion

There is a place for both municipal investment types. However, in the wake of the Great Recession, cities like Detroit and Stockton are proving that municipal lessors are in a much better position than GO bondholders and GO bond insurers. It appears that for investors, the changing times favor equipment-backed municipal leases.

Thomas B. Howard, Jr. is vice president and director of Government Finance for TD Bank. He has been in the equipment finance and specialty lending industry for more than 35 years. Michael Geltner of Geltner & Associates, P.C., Falls Church, VA, specializes in leasing law, public finance and government contract law and bankruptcy law.