Muni Bonds: Tax Free Doesn't Mean Worry Free

Prior to the 1930s, it was not legally possible for a U.S. municipality to declare bankruptcy as no legislation existed covering this event. The growing number of insolvent towns during the 1930s depression necessitated a change in the Bankruptcy Act.

The act was amended by Congress in 1934 to cover municipalities. However, the Supreme Court ruled the 1934 legislation as unconstitutional on the grounds that it improperly interfered with the sovereign powers of the state under the Tenth Amendment. Congress enacted a revised Municipal Bankruptcy Act in 1937 that was upheld by the Supreme Court the following year. The consequence of this decision will be seen in a minute.

The law has undergone several amendments since 1937, and today it includes a federal mechanism for the resolution of municipal debts. Known as Chapter 9 cases, quoting the section of the bankruptcy code that covers this type of filing, they are rare but not unusual. There have been 591 municipal bankruptcies since 1938:

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Source: Prof. K. Deal, Auburn University

As shown in the table, the 181 filings in the 20 years since 1990 are twice the 89 filings during the 40-year period from 1950 to 1989. An explanation for the recent tapering off in the numbers is given below.

A “municipality” is defined in the bankruptcy code to include: city, town, village, county, special taxing districts, municipal utility, and authority. The inability to service the debts accrued or bonds issued by any of these political units are grounds for a municipal bankruptcy. A good example of this is Harrisburg, PA, where a failed incinerator project, financed with bonds issued through the Harrisburg Authority, is going to take down the whole city.

The majority of municipal bankruptcies are the result of two things, 1) economic problems, and 2) financial mismanagement by elected and/or appointed officials. No surprise here. It is also worth noting that the majority of municipal bankruptcies since 1980 involved a utility or special district and not a city, per se. But over the last few years, the pressure on city budgets across the country to meet collective bargaining agreements covering wages, benefits, and pensions has been severe, pushing many to the brink of insolvency. These pressures are long-term commitments that will intensify over time, as opposed to one-off, isolated incidents of mismanagement.

Chapter 9 bankruptcies are not designed to forgive debt. Rather, their intent is to aid a municipality through reorganization – for example, by renegotiating contractual obligations and seeking more favorable financing – while the municipality continues to operate. A municipality cannot be forced to file, and it must meet five federal statutory requirements prior to a filing:

- It must qualify as a municipality (per above definition)

- State law includes authority to file (explored further below)

- Meet an insolvency test based on cash flow

- Demonstrate a desire to put a plan into action

- Negotiate with creditors

Recalling the Supreme Court’s ruling mentioned above, the final authority to grant or deny a municipality’s desire to file bankruptcy, and the degree to which the process is regulated, resides with the state. And this is where it gets interesting.

Today, 26 states prohibit a municipal bankruptcy, up from 21 states in 2007. Here they are:

AlaskaNew Hampshire
DelawareNew Mexico
GeorgiaNorth Dakota
IllinoisRhode Island
IndianaSouth Dakota
MassachusettsWest Virginia

Of the 24 states that allow it, 11 do not require any formal notification to the state prior to filing. But recent actions by state governments where laws do not explicitly prohibit municipal bankruptcy suggest that the trend toward state prohibition is likely to continue. Consider:

  • In reaction to the city of Central Falls revealing that it might seek the path of bankruptcy, the state of Rhode Island passed legislation prohibiting Chapter 9 filings. They are one of the newest members to the above list.
  • When Harrisburg leaders signaled that a bankruptcy filing looked imminent, the governor stepped in to offer alternative assistance from the state. A final decision by the city council is still pending.
  • Georgetown, Indiana, was considering bankruptcy until it was put on notice that city leaders lack the authority. From the Georgetown Courier-Journal, “Georgetown’s leaders ‘have no authority’ to declare the town bankrupt, said Brian Bailey, general counsel for the Indiana Department of Local Government Finance. Bailey cited a 1994 update to the federal bankruptcy code that says a municipality ‘must be specifically authorized’ by state law to be a debtor, and no Indiana law does that.”
  • The city of Hamtramck, Michigan, was recently forbidden by the state from filing bankruptcy. From Dow Jones Newswire, “A spokesman for the Michigan state treasury said that municipal bankruptcy isn't an option for Hamtramck, the small city near Detroit that earlier this month asked the state for permission to file for the process.” In line with the universal government mindset – “Hey, buddy, too much debt got you down? How about a loan?” – the state offered the city three alternatives: borrow, borrow, or sell its future tax revenue stream, a maneuver called a Tax Anticipation Note. Brilliant!

A state that remains in play on this issue is California. In 2009, Assembly Bill 155 (AB 155) was introduced and, if passed, would require municipalities to obtain state permission to file bankruptcy and be placed under the supervision of a new state commission that would then be formed. The bill died in committee as the December 2010 session of the Legislature came to a close.

The fate of this California bill seems to be a special situation and more the outcome of election year politics than anything else. With anti-incumbent fever infecting the voters during this year’s midterm election, and candidates looking to not incite the electorate any more than they already were, sticking with the status quo was the default choice of many state legislators. The bankruptcy of the city of Vallejo, California, and its expected resolution early next year will keep this a hot issue in the state, and AB 155, or some variant, will likely appear once again on the legislative agenda in 2011. Stay tuned.

There are two trends that I see underway here. The first concerns contagion; state governors are increasingly paranoid that a default by a municipality in their state will cause borrowing costs to rise for other cities as well as the state itself. With just about every state in the union battling a budget deficit, an increase in borrowing costs is an unwelcome visitor. I would expect the trend where states outlaw, or intervene in, the ability of municipalities to choose bankruptcy to continue. And as the fiscal health of cities deteriorates, this trend should accelerate. This development is responsible for the truncated 2010 number of filings in the table above.

The second trend I see underway is speculative but seems highly probable when considered in the context of today’s bailouts and money giveaways by federal governments and central banks. The states just might be hedging a bet that they can afford to help out or bail out their cities, banking on Uncle Sam and Uncle Ben to take pity on them and cast a benevolent eye, and a sack full of money, their way. I will take it further and suggest that the states have no other choice. To prevent spooking the bond market with a municipal default and sending interest rates saw-toothing ever higher like they have lately, the states will be forced to act. Any financial assistance offered will simply compound their already seemingly unclosable budget gaps. The endgame creeps closer.

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