Even the bearish and realistic thinking type guests on CNBC have been repeating often that muni bond defaults are "an extremely rare occurence"...unlike the greatest debt driven asset bubble in history I suppose -g-
some background:
TRENDS IN MUNICIPAL DEFAULTS
In 1988, a study by Enhance Reinsurance Co. looked at historical patterns of municipal defaults from the 1800s to the 1980s and concluded that municipal defaults usually follow downswings in business cycles and are also more likely to occur in high growth areas that borrow heavily. Following the 1873 Depression, when more than 24 percent of the outstanding municipal debt was in default, the greatest number of defaults occurred in the South, the fastest-growing region at the time. Factors that caused defaults included fluctuating regional land values, commodity booms and busts, cost overruns and financial mismanagement, unrealistic projections of the future, and private-purpose borrowing. The report also said that since World War II, revenue bonds have been a new source of default, largely a result of revenue overprojections.
The most infamous default cases involving general obligation bonds include New York City's default in 1975 and Cleveland in 1978. The largest default in the history of the municipal bond market was the Washington Public Power Supply System's (WPPSS) default on $2.25 billion in bonds. WPPSS launched a risky program to build five nuclear power plants in the 1970s to supply electricity to the Pacific Northwest. Only one of the five planned nuclear plants was ever completed. The WPPSS fiasco gave a lot more credibility to concerns that tax-exempt bonds were not a completely safe bet.
In 1999 Fitch Ratings published its first study of municipal defaults, which was updated in 2003.2 The latter study covered 2,339 cases of municipal defaults worth $32.8 billion between 1980 and 2002. It found that the cumulative default rate on bonds issued through 1986 (as they approached or reached maturity) was 1.5 percent, while the cumulative default rate on bonds issued between 1987 and 1994 was 0.63 percent. Municipal bonds issued on behalf of corporations or by municipal entities had a much higher overall default rate because of their exposure to corporate risks such as bankruptcy.
Cumulative default rates were found to be lower for bonds issued after 1986. Fitch attributed this to the Tax Reform Act of 1986 (which restricted the issuance of tax-exempt debt, particularly poor performing industrial development bonds), better disclosure, better financial management practices by issuers, greater scrutiny by different stakeholders, and improved economic conditions, including lower interest rates, which lowered the cost of borrowing.
Default rates, however, varied significantly across municipal sub-sectors, even though the overall rate was low compared to many fixed-income sectors. The study found that the 16 to 23 year cumulative default rates for tax-backed and traditional revenue bonds were less than 0.25 percent. Industrial revenue bonds had a cumulative default rate of 14.62 percent, multi-family housing 5.72 percent, and non-hospital related healthcare 17.03 percent. These three sectors accounted for 8 percent of all bonds issued but 56 percent of defaults. Education and general-purpose sector bonds accounted for 46 percent of issuance but only 13 percent of defaults.
One of the new findings in the 2003 study was that there was a moderate correlation of default risk with economic cycles, though a one-year lag produced a higher correlation. During the early 1980s and the early 1990s when economic growth was slow, default rates were the highest.
Another new finding was that defaulted municipal bonds have a fairly high recovery rate of 68.33 percent based on the number of defaults. Recovery can be made in a couple of ways. The borrower may get out of the default situation by making full debt service payments or collateral securing the bonds may be liquidated. Most issuers, particularly providers of essential services such as water and sewer, resume paying debt service. These types of securities are backed by physical assets that are public property. Thus they are never pledged to bondholders. In such cases, bondholders maintain a lien on revenues, which often enables full recovery. Industrial development bonds and multifamily housing bonds, the two sectors with the highest default rates, are often backed by collateral leading to higher than average recovery rates. |
