Can a bankruptcy court remove a co-signer from its obligation? If one party agrees to back the debt of another, shouldn’t it pay up if the debtor defaults? A major government bond insurer and an analyst’s organization are not waiting to find out.
The National Public Finance Guarantee Corp., an indirect subsidiary of MBIA, has filed a motion to counter an automatic stay in the Chapter 9 proceedings of the City of Vallejo, California, which owes payments to its bondholders. Attorneys for the city argue that the bondholders have no right to monies in a fund that the city used initially as a credit enhancement to make it look more reliable to lenders when it wanted to borrow nearly $5 million in 1999. This September, smelling a possible court-ordered precedent, the 1,000-member National Federation of Municipal Analysts, whose members advise mutual funds, insurance companies, broker-dealers, bond insurers, rating agencies and financial advisory firms, rallied to the insurer’s side by filing a friend of the court brief.
The NPFG and the NFMA are objecting to the stay, a routine element of bankruptcy filings that halts the outflow of funds to creditors. “We wanted to make sure that there was not a precedent set that revenue from state credit enhancement programs would flow to municipalities instead of the bondholders. The intent of the legislators [in setting up the programs] was that the money was meant to flow to the bondholders,” explains Mark Stockwell, chairman of the NFMA and director of municipal research at PNC Capital Advisors, which advises PNC’s municipal bond funds and separately managed bond accounts.
The concern is understandable. The U.S. Bankruptcy Court judge in this matter, Michael McManus, ruled in March that Vallejo could wipe out its contracts with firefighters’ and electrical workers’ unions. Seeing a creditor walk away from signed commitments could unnerve any lender.
The NFMA is also worried that the outcome of this case could affect 22 other states. That is the number that have some kind of credit enhancement or state aid intercept program in place, according to Standard & Poor’s, which rates their as well as the related governments’ creditworthiness. The program ratings are usually a notch below those given to the government entities.
The presence of a credit enhancement program — in Vallejo’s case fed by motor vehicle fees — figures significantly into what interest rate investors are willing to accept on loans, in this instance the $4.8 million in notes that Vallejo floated to build one fire station and improve others. With better ratings, governments may pay less interest, allowing them to operate without spiking taxes. Ironically, the cost of maintaining the fire department is contributing to the city’s collapse, according to court records. Calls to the mayor and the city manager of Vallejo were not returned. This spring, S&P lowered the city’s rating from B to C.
“This is not about one municipality,” says Stockwell. “This is a problem that is vital to the operation of the U.S. municipal bond market. If there are any questions as to the viability of tapping into state intercept programs, this could seriously impact other issuers, especially smaller governments with lower ratings, such as A and triple-B areas of debt.”
Chapter 9 filings, intended to provide financially distressed municipalities with protection from creditors while they negotiate and adjust their debts, are fairly rare, with as few as four in 2008, followed by 12 in 2009, the most in any year since 1980, according to the American Bankruptcy Institute.
Stockwell, who leads a team of five municipal bond analysts, says the situation is exacerbated by a loss of insurers. “Three years ago there were seven triple-A-rated bond insurers that insured 50 percent of bonds in the municipal market. Now, with downgrades and consolidations of the bond insurers, the remaining companies only insure about 10 percent of new issuance.” While the NPFG is paying the debt service on Vallejo’s borrowings, the intercept, in this case known as the Vehicle Licensing Fee Enhancement Program, is required to pay the city’s bondholders unless the court determines otherwise. The motion has been continued until October 4.
The other states with credit enhancement programs are Colorado, Georgia, Indiana, Kentucky, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Nevada, New Jersey, New York, Ohio, Pennsylvania, South Carolina, South Dakota, Texas, Utah, Virginia, Washington, West Virginia and Wyoming.
