In the Event of a Loss of Cabin Pressure…
Every flight attendant’s departure speech includes the line “in the event of a loss of cabin pressure, the oxygen masks will deploy — please secure your own mask first before assisting others.” Metaphorically, the same line exists in the playbook of state governments facing fiscal stress: shore up state finances first and then attend to the downstream implications. The states have managed the fiscal challenges of the recession in different ways across the country. Their responses have varied depending upon the severity of the economic weakness within each state and the sectors of the local economy most impacted. Responses to these state-specific conditions have also been guided by equally state-specific constitutional and political frameworks. Almost all state and local governments have been challenged with declines in revenue and the need for expense reduction, and many governmental entities also face difficult long-term liabilities in the form of underfunded pensions and other unfunded retiree benefits.
A little over two years ago, the early stages of the sovereign debt crisis sparked a heated debate about municipal credit quality that climaxed in the winter of 2010-2011 with apocalyptic default prognostications and public calls for states to be allowed to declare bankruptcy. Investors across the country were educated about municipal bonds during that tumultuous period. Previous assumptions about municipal bonds (which were viewed as homogenized credits, especially during the era of bond insurance) were replaced with a greater level of understanding about the diversity and nuances of state and local government finance. Armed with a better informed investor base, the municipal market on the whole performed well in the 18 months following the end of 2010, with the Barclays Municipal Index returning 14.76% for that period. Fundamental analysis and relative value decisions drove the pricing of individual issuers more than systemic considerations. An important component of this new level of understanding was the recognition that, while there are many strong issuers in the marketplace, there are also weak ones and those weaker issuers can represent real risk to client portfolios.
In our opinion, California is probably the most interesting and vexing submarket in municipal bonds. California has a constitution that is partly the result of the legislative process (representative government) and partly the result of referenda (direct government). This greatly impacts the State’s resource allocation, payment priorities and financial flexibility. California also has a highly charged political environment with high turnover in legislative seats (term limits) and significant public scrutiny and debate.
The oxygen mask analogy is a particularly interesting one for California. Local governments cannot raise revenue as easily as their counterparts in other states because of Proposition 13, enacted in 1978, which severely limited ad valorem property taxes. A decade later, in recognition that Proposition 13 restrictions were hurting local school districts, Proposition 98 was enacted, guaranteeing a minimum of 39% of the state budget be spent on funding for K-12 and community colleges. The State cannot reduce this percentage of the budget, but clearly as the state’s revenues fell in 2009, these payments declined also. In addition, the state constitution has a delineated priority of payments, with the first claim to Proposition 98 funding, then general obligation debt service, and then payments for other purposes. This results in local governments (cities and counties) facing a disproportionate amount of pressure when the state has fiscal constraints. Again, using the oxygen mask analogy and understanding the history of Proposition 13, in 2011 Governor Brown proposed abolishing more than 400 local redevelopment agencies so that monies that would have gone to the agencies could be used for schools and other local services. In a highly charged political environment, it appears that the state, schools and counties benefitted from the elimination of redevelopment agencies, and that cities have received less money than in prior years. Historically California has also not supported, or otherwise tried to remediate, failing local entities. This practice varies across the country; for example, New York and Michigan have been more aggressive and proactive in interceding when local governments are in financial distress. From Orange County in the 1990’s to Vallejo in 2009 and Stockton in 2012, California has elected to leave local governments to deal with their fiscal distress in bankruptcy court.
The California Legislature did take action (AB 506) to provide for a “cooling off period” that required local governments seeking to file Chapter 9 to delay the filing for 60 to 90 days in order to negotiate with stakeholders and possibly avert bankruptcy. AB 506 also allows a municipal entity to file for bankruptcy if they declare a fiscal emergency, which appears to be San Bernardino’s intention. Ironically, AB 506 may have had the effect of reducing some of the stigma of bankruptcy, insofar as it provides (validates maybe?) a path to something that was historically viewed as a very draconian, last resort choice. It is still too early to say for certain, but AB506 may result in the unintended consequence of actually making the bankruptcy decision an easier one for a struggling municipality.
We believe that Vallejo’s experience with bankruptcy should serve as an object lesson to dissuade other entities from pursuing the same course. Across the stakeholders in Vallejo, there really were no winners and the condition of the city today does not convey an inspiring message about returning from Chapter 9. But Stockton’s politicians and stakeholders chose not to make the hard concessions and avert Chapter 9 and now San Bernardino seems to be headed down the same path. Mammoth Lakes, California has also filed Chapter 9, but this small city’s distress is not the direct result of economic conditions and political choices, but relates to a large legal judgment so is unusual in its cause. When performing corporate credit analysis, the assessment of management is of paramount importance, since those individuals have a significant amount of influence over the success or failure of a business. In municipal credit analysis, it is more difficult to analyze this, as the players in local government — mayor, city manager, city council, etc. — may have different agendas.
The story is not all bad though.
Interestingly, while Vallejo, Stockton and San Bernardino all represent situations where the politicians and stakeholders perceived irreconcilable differences, other local California entities have tried to take different paths. While facing different challenges, San Diego and San Jose both confronted untenable long term liabilities in their pension systems and both cities took the issue directly to the voters for a solution. San Diego and San Jose demonstrated strong political management and roused their key stakeholders — to the extent that approximately 70% of votes went for pension reform and long-term fiscal sustainability. The ultimate outcomes will not be known until the legal challenges are addressed but investors should not underestimate how significant the developments in San Diego and San Jose are in the municipal market. Maybe it should not come as a surprise that the state that generates such remarkable technological innovation can be as revolutionary with governmental finance.
Analyze and diversify.
As we have discussed over the last three years, building a safe and diversified California portfolio is more challenging than in previous periods. In recognition of the unusual strains, we have de-emphasized local government general fund debt, with the exception of the major coastal cities, and have emphasized state-level debt, essential services, dedicated taxes and school district debt (where Prop 98 is a positive). We also consider opportunities to diversify risk further by utilizing non-California issuers, as well as taxable sectors such as Treasuries, Agencies, Corporates and GNMAs when they are attractive on a tax-adjusted basis. Unfortunately, across the country, and in an amplified way in California, local governments are bearing some of the greatest downstream pressure from state fiscal challenges. The good news is that far more responsible solutions are being implemented than irresponsible ones, but of course the extremely limited history of municipal bankruptcies among governmental entities makes those that choose the Chapter 9 path an important area of focus.
These developments in California are troubling, not only to municipal bond investors but also to citizens in California and in the rest of the country. We believe that, fortunately, the marketplace is benefitting from the participation of informed investors, who understand that Stockton and San Bernardino are not Los Angeles and San Francisco (figuratively speaking of course) and are certainly not Dallas and New York. If the Stockton and San Bernardino events had occurred in early 2010, it is highly likely they would have resulted in a systemic shock to the entire marketplace, replete with scathing headlines, panicked mutual fund redemptions and Congressional hearings on the safety of municipal bonds.
Vigilance is not optional.
Investing in bonds involves credit, interest rate and political risk. However, the political risks appear to be even more important in California and are now one of the more challenging components of the analysis. So far, today’s informed investors recognize that we live in a world where some governmental entities will inevitably fail, but that the number and size will likely be far less than the apocalyptic predictions of 2010. There is also a recognition that the factors that lead to those failures will be somewhat predictable in general — sadly, since predictability also implies preventability. Fundamental analysis is the lynchpin in assessing the risk and return tradeoff of any investment, and that remains as true as ever in what we believe is a still-high-quality municipal bond market since many economic challenges remain. The risk in California, especially at the local level, lies in the political decision making process. This could be construed as the systemic risk to the market; if a path-of-least-resistance attitude combines with less stigmatization around bankruptcy in California, then the risk in local government issues will increase further. The spillover effects to otherwise strong California issuers and the State itself could be quite punitive in that event, so not a desirable path by any measure.
We will closely follow what happens and communicate with you on a timely basis.
Benjamin S. Thompson Judy Wesalo Temel
Chief Executive Officer Director of Credit Research
July 13, 2012
Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements are now or will prove to be accurate or complete in any way. Certain information herein was obtained from third party sources which we believe to be reliable, but Samson cannot guarantee the veracity of the information.