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Municipal Bankruptcies Rare, and Should Continue to Be So

Despite Jefferson County's woes, we don't expect widespread defaults--but trouble spots do remain, says Morningstar muni credit analyst Rachel Barkley.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The Jefferson County, Ala., bankruptcy has been on the mind of a lot of municipal bond investors. I'm here today with Rachel Barkley, she is a municipal credit analyst at Morningstar, to take a closer look at that bankruptcy and what it could mean for muni investors.

Rachel, thanks for joining me.

Rachel Barkley: Thank you.

Glaser: So, let's first talk about Jefferson County itself. What kind of trouble have they gotten themselves into? What's happening there?

Barkley: Sure. Well, on Nov. 9, Jefferson County filed for bankruptcy. This was immediately proceeded by the deterioration of negotiations with its creditors on a little over $3 billion of debt. I will note that this marks the largest municipal bankruptcy in the United States history.

Glaser: So, what does this mean for bondholders of the county?

Barkley: Well, it depends. They will go through the bankruptcy process. I believe the first hearing is next week, and it partially depends on what the judge rules, and it also depends on a variety of factors, including what the security of the bonds is that each person would hold.

Glaser: So it sounds like it's a bit of a mess. How did they get into this situation?

Barkley: Well, it's a long story that actually dates back to the '90s, but more recently, there are two main causes. The most widely discussed relates to the sewer system. There was a combination of bad financial deals, unanticipated borrowing costs, as well as political corruption. That was all magnified by the fiscal crisis in 2008 and led to the county defaulting on its sewer debt. Since then, the county has been in negotiations with its creditors.

Then again on the general finance side, the general fund has been under pressure as well. What pushed it over the edge was a recent court ruling, which ruled that the occupational tax, which provides a significant portion of general fund operating revenue, was declared invalid, not allowing the county to collect the tax anymore, and [that] also contributed to the bankruptcy filing.

Glaser: You mentioned that this was the largest municipal bankruptcy in U.S. history. Is this really the start of a trend? Have we been seeing a lot more bankruptcies recently? Do you think it's something that is going to continue?

Barkley: No, we don't think so. Municipal bankruptcies are rare, and Morningstar believes that they will continue to be so. Municipal bankruptcies tend to ... the causes of the municipal bankruptcies tend to be specific to the actual entity. The  most widely discussed in addition to Jefferson County ... have been Harrisburg as well as Central Falls. In Harrisburg, you had a combination of politics as well as an unessential incinerator project, which hasn't performed as expected. With Central Falls, you largely had some unfunded pension obligations, which drove the filing for bankruptcy.

The takeaway is that municipal bankruptcies are very rare, and we expect them to remain so. On the other hand, what this does really highlight is that there is a wide disparity in credit quality amongst municipalities, and it highlights the need for municipal analysis.

Glaser: Since this bankruptcy, have you seen any major ripple effect through the muni market, or has the impact has been relatively limited?

Barkley: We haven't seen a major effect across the municipal market. What we do expect is a more concentrated effect within Alabama. What would be interesting to see is that the city of Birmingham, which is the county seat of Jefferson County, has said that they plan on going to voters for a bond referendum next year, which, if that passed, they would be able to issue bonds.

Since Birmingham is of strong credit quality, it's rated in the AA category by all three major rating agencies, it would be interesting to see if there were higher borrowing costs for them compared to other AA category entities, then if they weren't located in Alabama.

Glaser: Certainly it sounds like this bankruptcy has caused a lot of headlines, but it might not have a huge impact on most muni investors.

Barkley: I think that's the major takeaway.

Glaser: Rachel, I really appreciate you talking with me today.

Barkley: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.