Pennsylvania

After Harrisburg, odds still favor muni bondholders

October 20, 2011: 8:51 AM ET

Alarmist predictions called for many major municipal defaults this year, but the opposite is true. In fact, the latest news from Harrisburg, PA, only underscores how rare they are.

By Cyrus Sanati, contributor

Harrisburg

The lights are on in downtown Harrisburg

FORTUNE -- Harrisburg, Pennsylvania's current muni mess shouldn't be viewed as a harbinger for an imminent meltdown in the $2.9 trillion municipal bond market. The tiny city probably would have found itself in the same situation even if the general economy was healthy, thanks to its past questionable business dealings and poor management. Muni bond failures are rare, but they do occur. Nevertheless, alarmist predictions from some Wall Street analysts, notably Meredith Whitney, that there would be several major defaults in the muni market this year, look to be increasingly off the mark.

The market has known about the troubles in Harrisburg for years. The city, which is the state capital of Pennsylvania, has been struggling to make ends meet following profligate spending in the years before the financial crisis erupted. The city's current problems stem from a waste-to-energy garbage incinerator project started back in the early 1970s. That project seems to have incinerated more cash than garbage over the years amid a myriad of reasons, ranging from environmental concerns to technical glitches.

As a borrower, Harrisburg looks pretty sketchy. Half of the city's nearly 50,000 residents live under the poverty line and its only main employer is the state of Pennsylvania.

To that end, one could infer that this city, in the heart of the Rustbelt, is like many in nearby states, including Ohio, Michigan, and Illinois. The city's demographics, along with its shrinking property tax base, are similar to nearby small towns, setting the scene for what could be a wave of defaults across the region.

But while fiscal hardships may be similar, Harrisburg is unique. Its city council seems to be playing a game of chicken with the state to try and push millions of dollars of its debt, which it accumulated from the incinerator project, from the city level up to the county level. The state did not go along with that plan and so last week the city council voted 4 to 3 to enter Chapter 9 bankruptcy protection.

Trouble is, Harrisburg is not allowed to seek bankruptcy protection according to state law as it has been designated as a distressed community. The city is supposed to work with the state and come up with some sort of plan to get back on track, not just wave the white flag. The recovery plan proposed by the state wouldn't have meant draconian cuts or super high taxes for Harrisburg residents. Instead, the plan called for the city's parking structures to be leased out to a private corporation for 75 years and the much maligned incinerator sold. Bond insurers would share in the pain by taking a $100 million haircut.

The state legislature, fearing that the bankruptcy of its capital city would reflect poorly on the state as a whole, has taken action. It voted in favor of putting the city in a quasi-receivership status, whereby a state-appointed council would eventually be able to overrule the city council and call the shots in Harrisburg.

The exceptional bankruptcy

The drama in Harrisburg is quite unique. Going bankrupt is usually considered fatal for most state and local governments, as it restricts their ability to borrow in the future. There are some instances where a municipality has been forced to default on its obligations, but it is very rare. When it does occur, investors usually see it coming from miles and miles away. The meltdowns of the three big muni problem children – Jefferson County, Alabama; the city of Vallejo, California; and Harrisburg – were widely anticipated and are now in various stages of resolution.

But it was believed that a wave of muni defaults would sweep over the U.S. this year. Many state and local governments have allowed their pension obligations to go unfunded for too long, while at the same time spending too much money on non-essential projects. With the property tax base shrinking due to depressed home values, rising defaults seemed inevitable. The situation reached critical mass last December when Meredith Whitney said on 60 Minutes that there would most likely be 50 to 100 "sizable" muni defaults in the wake of the financial crisis.

But so far this year there have been almost no major muni defaults. Actually, things are looking better this year. Muni defaults stood at $511 million in the first half of the year compared with $1.55 billion during the same time last year, according to S&P. The largest default so far wasn't a state or local government but a muni-backed retirement condo in Chicago, which went bust with $233 million in debt.

What Whitney failed to factor into her calculations was that unlike companies, states and municipalities dread going bankrupt. The 10-year average cumulative default rate for muni debt from 1970 to 2009 was just 0.09%, according to an analysis by Moody's (MCO). That compares to the corporate default rate of 11% during the same time period.  Even during the Great Depression from 1929 to 1937, muni defaults remained low at around 1.8% a year.

Ironically, the financial crisis has pushed governments into fiscal balance. This may seem counterintuitive, but when times are good, it is hard for elected officials to raise taxes and cut spending. When times are bad, elected officials are given far more leeway to balance the budget.

For example, Illinois, one of the most indebted states going into last year, approved the biggest tax increase in its history to bridge its massive funding gap. The state is slashing jobs and cutting spending quickly to generate enough cash to try and address its pension problem and keep its credit rating high enough so it could continue to borrow money for longer-term projects.

In Dekalb County, Georgia, which encompasses parts of Atlanta, a 20% decline in taxable property values since 2008 caused S&P in March to downgrade the county's credit rating five levels to BBB on fear that it could be facing a default. Dekalb immediately got its act together and in July passed a 26% property-tax increase and slashed services. And the Harrisburg situation shows that even if a city wants to go into bankruptcy, most states won't let them go easily.

Draconian austerity measures have been seen across the country as municipalities try to balance their budgets to avoid further downgrades to their credit rating. The long-term effects of such moves could lead to a decrease in economic activity, which could exacerbate an already hairy situation. But for now, it looks like the moves taken by most muni issuers have been balanced. Nevertheless, there are 90,000 muni bond issuers in the U.S., so there will be a few, like Harrisburg, that will be exceptions. The vast majority, though, seem committed to their bondholders.

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