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Thursday, August 16, 2012

This Just In: Thousands of Secret Municipal Bond Defaults

The Washington Post, New York Times and other media are reporting on a Federal Reserve blog post revealing the existence of over 2500 municipal bond defaults not previously reported by the major rating agencies. Before municipal bond investors panic, we need to consider several points.

First, this large number of defaults should be considered in the context of the number of issuers and the length of time examined. There are approximately 60,000 municipal bond issuers and this number has not changed that much in recent decades. The Fed data contains 2521 defaulting issuers for the 42 year period ending 2011. That represents an average of about 60 defaults annually and an average annual default rate of roughly 0.1%.

Second, similar default statistics have been reported before. Anyone who subscribes to Richard Lehmann's Distressed Debt newsletter and database knows that he has cataloged about 3500 municipal bond defaults since 1980 (this number refers to the number of defaulting bonds rather than bond issuers - which is one reason that it is higher than the Fed's number). Lehmann's data was summarized in a 2011 Kroll Bond Rating Agency Municipal Default study that I co-authored. So the Fed's findings really aren't news.

Third, as mentioned in the Fed blog post and elsewhere, the vast majority of the defaults are not General Obligation or tax supported issues of states, cities, counties, towns or villages. Instead, they are mostly revenue bonds financing specific projects or facilities. So these situations should not be conflated with the cases of Stockton or San Bernadino.

Finally, most of the defaulting issuers are quite small. For example, as Bloomberg reported recently, a large concentration of municipal bankruptcy filings occurred in Nebraska.

Almost all of these filings were by Sanitary and Improvement Districts (or SIDs). Approximately 45 of these districts have filed municipal bankruptcy petitions since 1982. The bulk of these bankruptcies have occurred in Douglas and Sarpy counties. Douglas County includes the City of Omaha, while Sarpy County includes most of Omaha’s southern suburbs.

SIDs finance sewer, lighting, paving and other improvements in unincorporated areas selected by developers for the creation of new subdivisions. Costs for these improvements are financed by special property tax assessments on lots within the subdivisions. Bonds are often financed by the SID with special assessment revenues, typically collected over a period of ten years, generating funds to redeem the bonds. SIDs are typically quite small, encompassing one subdivision or a small number of subdivisions. Most of the bankrupt SIDs I examined had fewer than 200 lots. Their size is thus similar to that of a Home Owners Association, although the range of services provided differs.

So the conclusion is that a lot of small revenue bond issuers have defaulted over the years. This is not news and should not fundamentally alter the perception that municipal bonds in general - and tax supported bonds issued by states and larger cities - have relatively low default risk.