“New Jersey won’t approve Chapter 9 bankruptcy filings by distressed municipalities, according to Thomas Neff, director of the state Division of Local Government Services. New Jersey law requires state approval of all municipal bankruptcies, Neff said in an interview at a conference of mayors in Atlantic City. His division would look to use state aid and possible takeovers of city finances to avert such filings, he said. “It’s more likely to snow in July than for us to approve a bankruptcy,’’ Neff said. “I can’t even see myself posting it for consideration.’’

Many readers have asked for a perspective on the Chapter 9 Municipal Bankruptcy of Jefferson County, Alabama. Others have e-mailed us concerning Harrisburg, Pennsylvania. Over the course of the year we have written about these situations. Our view remains that these are one-off events brought about by failures of the local political systems and disappointing governance. Sometimes corruption is added to that toxic combination.

We argue that most Munis are mostly safe most of the time. The key is to research them and understand the construction of each of these idiosyncratic credits.

Specific bankruptcies, like Jeffco and Harrisburg, are the final actions of a process that began several years previously. They were the result of poor decision making on the part of elected public officials. However, not every bad Muni deal ends in a bankruptcy. Many can be worked out. In those cases the political officials realize that avoidance of bankruptcy is “less worse” than choosing what appears politically to be an easy way out; they are mistakes that were made either by the elected officials or others involved in the process.

Portions reprinted from our friends at Cumberland Advisors

The municipal bond market has been expecting this for some time. For the past three years this situation has been deteriorating. Its roots involve a sewer system grossly expanded under federal mandate, and corruption among county officials. It also involves the downgrade of municipal bond insurers in 2008, which caused the county’s many ill-advised swaps to skyrocket in interest costs.

Through much of the summer and fall, Jefferson County has been trying, to no avail, to negotiate a haircut on the principal of their bonds. With $3 billion involved, there will be some effects, mainly on lower-rated debt, but the market has been prepared for this. Most market participants were hoping that something could be worked out. The Governor of Alabama, Robert Bentley, had been trying to forge a solution between bondholders and the county. This solution would have included bonds backed by the state, but would also have resulted in much higher sewer fees in the county. The bankruptcy action may be an impetus toward crafting a solution.

Where have Jefferson County bonds been trading?

We expect to see little market impact on trading in Jefferson County bonds. The county has refunded most of its fixed-rate sewer debt with VRDBs and ARS in 2002 and 2003. The trades we have seen and local dealer quotes have been at high interest-rate levels. Participants most affected are the Letter of Credit banks that hold the failed remarketed debt and bond insurers, not bondholders. And with the Chapter 9 filing, we would expect to see more trading in the bonds.

What does Jefferson County do next?

They need to demonstrate to the bankruptcy judge that they cannot pay their bills. The judge will then determine what obligations they must fulfill, and at what level. JPMorgan, as well as the bond insurers FGIC and Syncora (formerly XLCA), face the largest losses.

Does this morph into a Meredith Whitney-like falloff?

We think not. Jefferson County has been developing for over three years. This is a result that almost happened in September. It was staved off by tentative settlements with creditors that did not get legislative approvals. Municipal bankruptcies are running at about 30% of last year’s totals. Problems such as Harrisburg, PA and Central Falls, RI have been known for a while; they represent specific mismanagement. Furthermore, the improvement in municipal credit this year has been very good.

Through the courtesy of our friends at Raymond James, we show two graphs:

State Taxes Grow

Property Tax Weakness

The first shows year-over-year changes in state and local taxes. The other shows specific tax revenue changes. You can see the strong rebound in state taxes, which are now back to pre-financial-crisis levels after seven quarters of gains (following five quarters of declines). Growth in local taxes – specifically property taxes – has been falling but held up better than other types of taxes when the recession hit, as it does in most recessions. The overall municipal market has rebounded smartly in the past nine months.

We will stay abreast of the next developments.

The right thing to do is for bondholders and the county to work this out. The wrong thing to do is for the county commissioners to in effect to approve a “walk out”. To imply the entire county has no assets to sell off now or in the future is plain silly. How about selling off or privatizing local government assets like city hall, office buildings, vacant land? Or what about securitizing future revenues from parking garage revenue and sales taxes?

There is plenty of time to make annual payouts over the next 30 years. As the economy improves so will Jefferson Country. But to just take the money and run is just plain wrong. Oh and by the way, its illegal.

“I am disappointed by the commission’s decision… as bankruptcy will negatively impact not only the Birmingham region, but also the entire state,” Gov. Robert Bentley said in a statement moments after the County Commission voted. “By filing for bankruptcy, the county commission now relinquishes control of its affairs into the hands of a federal bankruptcy judge,” Bentley said.

Despite a tentative deal with creditors reached in September to settle $3.14 billion of debt, county commissioners this week resurrected the threat of a Chapter 9 bankruptcy filing largely because the estimated savings from the September agreement had shrunk by about $140 million. The filing could add to heightened concerns in the $3.7 trillion U.S. municipal bond market, which has recently been hit hard by the high-profile debt crisis in Pennsylvania’s capital of Harrisburg. Creditors such as JPMorgan Chase & Co and the county in September reached a tentative deal calling for Jefferson County’s sewer-system debt to be substantially reduced, but final terms were not reached.

A sticking point discussed in a commissioners’ meeting on Monday was adjustment of a $140 million difference between the originally agreed-upon $2.05 billion the county must repay the creditors. That figure recently crept up to $2.19 billion. The September agreement was seen as a turning point for Jefferson County, which since 2008 has teetered on the edge of a bankruptcy that would have surpassed that filed by Orange County, California, in 1994. Jefferson County’s debt escalated in the mid-2000s with interest and auction rate bond deals as it sought to refinance an upgrade of its sewer system. Should Jefferson file Chapter 9 bankruptcy, at over $5 billion for the county’s total indebtedness, it will be the largest municipal filing in U.S. history.

The story – often reported by our friends at Cumberland Advisors – is that of an incinerator that was not needed, but built as a boondoggle. After failing to attract enough business, the city decided to spend much more money retrofitting the incinerator, putting the city’s pledge behind the bonds used to finance and retrofit. This turned into a disaster. The city stopped making payments on the incinerator debt last year. With much consternation and discussion, they have continued to pay debt service on their general-obligation bonds.

Last week the city council voted to declare Chapter 9 bankruptcy for Harrisburg, even though the Mayor of Harrisburg was against it and the Commonwealth of Pennsylvania itself had passed a law declaring that it would be illegal for Harrisburg to declare bankruptcy.

There is now a court-mandated delay of a month to sort this out. On Monday, a judge for the US Bankruptcy Court in Pennsylvania set a November 23 court date to settle the legality of the bankruptcy declaration by the council.

Why is the state moving as if the matter has already been settled in its favor? It’s not just the politics, it’s the state not wanting Harrisburg’s woes to result in much higher borrowing costs for towns and cities in the rest of central Pennsylvania.

What do we see reflected in the municipal bond market, given the current state of affairs?

Most of the Harrisburg general-obligation debt is insured. Ratings on Harrisburg itself have been withdrawn by the rating agencies. Bonds backed by Assured Guaranty, the healthiest of the bond insurers (AA3 Moody’s and AA+ Standard and Poor’s) are trading at 5.5% to 6%. Bonds from downgraded insurer MBIA (now National RE), rated Baa1/BBB, are trading in the 6.25-6.50% range, and bonds with other insurers who are below investment-grade and have no rating are all over the lot, with trades in the 7%-plus range (levels courtesy of Oppenheimer). This is in a world where longer-maturity, high-grade Pennsylvania debt is trading in the 4.5% range.

The one thing we know for sure is that the bond insurers come down squarely of the opinion that Harrisburg has NOT taken the necessary steps to avoid bankruptcy: raising taxes, selling assets, and using their full faith and credit to pay their bonds.

So far, this has not carried over to the state’s own bonds, as far as any patina of higher yields associated with the problems of Harrisburg. The state sold bonds this week at their normal high-grade level.

Stay tuned as this develops.

Reprinted by permission from our friends at Cumberland Advisors

A Messy Situation

Harrisburg’s financial woes stem from an incinerator originally built in 1972. Plagued with operating problems from the start, the city nevertheless decided to expand and retrofit the plant in 2003, taking on $125 million in debt. The initial contractor on the job went belly up, which led to more borrowing and debt that mushroomed to $310 million – a daunting sum for a city of 49,000 residents and a total municipal budget of less than $60 million. Ultimately, the city filed for bankruptcy, which the state is currently challenging in court.

Bonds Are Insured

Although Harrisburg’s move was unusual, the market hardly took notice. Harrisburg is not a significant issuer of bonds, and its financial plight has been well documented. A good portion of Harrisburg’s overall debt is insured, and many of the bonds associated with the incinerator are secured by Assured Guaranty, which made some payments the city previously missed. However, Assured credit rating has been lowered several times from AAA to where it is today.

While there are other cities and municipalities face strained finances, few are confronted with challenges similar to Harrisburg’s. Defaults continue to be extremely rare. Last year, municipal defaults totaled $2.65 billion, an 8.6% decline from 2009. So far this year, defaults total $1.1 billion, a small fraction of the $2.93 trillion in outstanding municipal bonds.

In the meantime, a judge placed Harrisburg’s bankruptcy on hold for a month, enabling bond insurers to file briefs in the case while state lawmakers are pushing to take over the city’s finances. Soon after Harrisburg filed for bankruptcy, the state sued, concurring with the mayor’s opposition to the filing. Harrisburg’s City Council voted three times over the summer to reject a financial recovery plan under the state’s program for distressed communities. All the decisions were carried by a 4-3 margin. The measure on October 12th to file bankruptcy was approved by the same 4-3 margin.

This is important on two counts. First, it blunts the Meredith Whitney arguments that led to the bond-fund sell-off last winter. But also, it reinforces the argument about the quality of municipal credits. Many state and local municipal entities enjoy captive audiences – for water, sewer, transportation, etc. They performed in this recession like they have in others, by tightening belts, cutting costs, and raising fees where necessary. And this has been a big contributor to the curing of the muni market since last winter.

The White House proposals are keeping muni rates high. The Obama administration’s Jobs Bill has proposed imposing a tax on individuals or couples above certain income thresholds, to essentially eliminate the tax advantage enjoyed between the 28% and 35% tax bracket. This 7% tax would translate into roughly a 35-basis-point tax on muni yields (4-4.5% range). We do not think there is much chance of this proposal being enacted – certainly not to include existing municipal bonds. However, the uncertainty is helping to contribute to tax-exempt bond yields which are much higher than they would be without it. In some cases, taxable BABs (Build America Bonds) yields are only marginally higher than the tax-exempt form of the very same credit. The market has started to see cross-over buyers respond to this anomaly.

As we head into the last quarter of the year we expect to see municipal supply pick up. It downshifted greatly early in the year, due to the high interest rates fostered by the Whitney meltdown. With lower nominal rates, visible supply is starting to pick up. But the December/January reinvestment period should also be vigorous – especially given the volatility of the equity market. That should mean most of the reinvestment goes back into the muni market.

And after much consternation on all sides, we do not expect the Administration proposals with regard to tax-free bonds to pass. This should also mean that the muni market will return to more normalized pricing levels relative to Treasuries.

Thanks to our friends at Cumberland Advisors.

While no agencies were named in the report, at one of the larger agencies the SEC said “the procedures for disseminating a pending rating action appeared to allow for limited dissemination of a pending rating action in some instances prior to public dissemination.” While they didnt name the agency there has been much speculation that Standard & Poors was the prime target of the probe.

We find this very troubling for the municipal bond ratings industry and another reason for investors to use market implied ratings which are disseminated to all investors immediately.

The 23-page document is the latest report released by the SEC on the major ratings agencies — Fitch, Moody’s, and Standard & Poor’s — and seven others of lesser stature which are recognized in the United States.

Annual checks of the agencies were introduced under a financial reform law that came into effect in July last year. Up until then, the checks were carried out every two years. This latest report covers the 2009-2010 period. No agencies were named throughout the report.

The powerful “big three” raters have been accused of contributing to the global financial crisis by helping propel the sale of risky investments such as mortgage-backed securities just to net more business.

The agencies, suspected of multiple conflicts of interest, are the focus of several US probes. S&P’s decision in August 2011 to strip the United States of its sterling AAA credit rating was preceded by several media reports announcing the decision was imminent.

The SEC noted that each of the big three had “made changes to improve its operations since the 2007-08 examinations.”Commission staff made a series of recommendations to each agency for improvements, notably on how to handle conflicts of interest, the report said.

That said, while reviewing the tax exempt status afforded to muni bonds is a legitimate question for a democracy and all its people to consider, it should be addressed forthrightly, not by the back-door mechanisms being proposed by the administrative branch. If Washington wants to change the tax status on newly issued bonds by states and municipalities, thats reasonable as the success with the Build America Bond has already proved, a direct subsidy to issuers is more efficient than tax exemption.

Here is more below on this issue from Barron’s ever prescient columnist Randall Forsyth.

Under the jobs bill the President sent to Congress Monday, high-income individuals and families would no longer receive interest from state and municipal bonds free completely from federal income taxes, beginning in 2013. The legislation would also reduce the value of tax deductions for taxpayers in the highest bracket.

Specifically, individuals earning over $200,000 and families earning over $250,000 would effectively have the value of tax breaks against the top 35% bracket lowered to the 28% bracket.

The proposed change would help pay the $447 billion tab for the American Jobs Act of 2011. There have been previous attempts to enact a back-door tax hike on the upper brackets. Reformers have asserted that it is unfair that high-income taxpayers receive a greater benefit from deductions; a $1,000 deduction saves somebody in a 35% bracket $350, $70 more than the same deduction saves a taxpayer in the 28% bracket.

Never before have high-income investors in municipal bonds been so targeted, however. With the exception of so-called private-purpose bonds subject to the Alternative Minimum Tax, interest on munis generally was exempt from federal income taxes.

As with deductions, the tax-free feature on munis is more valuable to investors in the top income-tax brackets. For that reason, Internal Revenue Service data show that 58% of all tax-exempt income was earned by individuals earning over $200,000, according to The Bond Buyer, the muni-market trade paper.

For instance, a tax-free bond that yields 3.50% (about the going rate on a 30-year, triple-A muni) is equivalent to a taxable bond that yields 5.38% for an investor in the 35% tax bracket. But for an investor in the 28% bracket, that 3.50% muni is equivalent to a taxable yield of 4.86%.

All else being equal, the yield on muni bonds would have to rise to compensate for the lesser tax benefit, if the Obama jobs bill is enacted as proposed. For instance, a rise of 50 basis points (one-half percentage point) would result in a price decline of about 9% for a 30-year bond — equal to $90,000 for a $1 million holding.

As a result, upper-income investors would suffer the dual blow of lower after-tax income and capital losses from their muni-bond portfolios.

That could severe repercussions for the muni market, which only in recent months has recovered from the so-far errant prediction of hundreds of defaults totaling billions of dollars from analyst Meredith Whitney.

“In my opinion, this will have a negative effect on the muni market and could start another wave of heavy withdrawals from muni-bond funds, even though many investors in these funds will be minimally affected,” says Ken Woods, who head Asset Preservation Advisors, an Atlanta manager of bond portfolios specializing in high-net-worth individuals. “The muni investor’s thought process will be, ‘the government’s next step could be the complete elimination of the [tax] exemption.’”

One of the ironies of this proposal in the so-called jobs bill is that the measure contains infrastructure spending, some $38 billion worth. It would also create an infrastructure bank to fund such projects.

But reducing demand for bonds issued by state and regional authorities that build highways, bridges, airports, water and sewer systems and transportation projections would hamper the very sort of projects the legislation seeks to encourage.

Obviously, the proposal to reduce the appeal of muni bonds to high-income investors is aimed at sentiments such as voiced recently by Berkshire Hathaway’s Warren Buffett, who lamented his tax rate was lower than his secretary’s.

If the Obama Administration wants to raise taxes on high earners to reduce income and wealth inequality, that is a legitimate question in a democracy. But it should be addressed forthrightly, not by back-door mechanisms.

And if Washington wants to change the tax status on newly issued bonds by states and municipalities, that also is legitimate. A direct subsidy to issuers is more efficient than tax exemption.

But to change the rules after the fact on an investment that has always been tax-free, as in the case of munis, isn’t just counterproductive; it’s not fair.

Whats the lesson here for credit raters? Investors vote thru their wallets. Assets are worth what the marketplace is willing to pay… No more no less. Its common knowledge that credit ratings can be easily derived from asset prices by using market implied credit ratings. These ratings are in place for all municipal bonds at bondview.

The even prescient Bart Chilton, commissioner on the U.S. Commodity Futures Trading Commission has some good comments about all this.

On Aug. 5, the Standard and Poor’s rating agency downgraded the United States from AAA to AA+. That news ran across front pages. Since the early 1900s, when ratings began, this was the first time the United States wasn’t rated AAA.

S & P’s downgrade was based upon its view that Washington politics remain unstable and therefore deficit-reduction measures will not be attainable. Additionally, their decision was fueled by a $2 trillion calculation “error.” The direct impact on markets was colossal. The Monday following the release of the rating, the Dow dropped 635 points!

Remember, some of these agencies (like S & P) are the ones who got ratings so very wrong a few years ago. Not only did they give favorable ratings to firms that ultimately went under during the economic fiasco, they maintained AAA ratings on pools of junk mortgages packaged by Wall Street banks, trading away credible ratings for the bottom line of the ratings agencies. Do we really want to continue to rely upon such agencies?

Now consider “Idol” judge Steven Tyler (the flamboyant Aerosmith front man). He provides insightful commentary based upon his music and performance experience. What he says colors contestant performances with a professional texture viewers might not otherwise notice. What he and the other judges do not do is render the final judgment. That’s up to the viewers.

Ratings agencies need to be more like “Idol”: providing information, but not making final judgments that drastically influence outcomes. They should be more informative and insightful, but not deterministic. They’ve become excessively powerful and create a self-fulfilling prophesy about what markets will do. As one member of Congress asked the heads of the ratings agencies, “How could you possibly make that kind of a decision based on an opinion when you have millions of people relying on that?”

Furthermore, smaller ratings agencies should be encouraged to compete, rather than relying upon three agencies comprising 97 percent of all ratings. Importantly, agencies should work for consumers, not deal makers – a business model that incentivizes agencies to provide favorable ratings.

As Tyler sings, it’s time to stop “Livin’ on the Edge” of the financial teeter totter subject to faulty ratings agencies. We need to change the way the raters operate. We have seen the damage they can create and we should accept the status quo “No more, no more.”

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The bonds that may be effected most include Housing bonds (bonds with the backing of federal agencies like GNMA and FNMA) will see their S&P ratings affected. Certain lease bonds with the federal government as a tenant may see their ratings downgraded, depending on the proportion that the federal government is responsible for on the leases

Pre refunded and escrowed municipal bonds, the gold standard for munis: These are generally older, higher-coupon bonds that have been defeased by their issuers. Proceeds of “refunding” issues are placed in Treasury securities to pay interest and call the older bonds at the first call date. This results in significant cost savings for the municipalities, and the older bonds are often (but not always) re-rated AAA based on the US Treasuries, which are now backing the older bonds. These bonds will see a downgrade.

What does this mean from a portfolio-management sense? In our view, it should not affect the muni market greatly. In our opinion, the United States is still the premier sovereign credit in the world. Investors will continue to own prerefunded bonds in the shorter-maturity end of a barbell strategy.

It is important to remember that both Moody’s and Fitch continue to rate the US as “AAA” including housing bonds backed by the federal government or prerefunded bonds or bonds backed by federal leases. As strange as it sounds, because state and local governments and their agencies are rated on different criteria than governments, some municipal issuers will have S&P credit ratings higher than the federal government.

The smart muni bond professionals who fly in our circle are saying the municipal marketplace will still react to the same forces it has in the past: high demand for tax free bonds propping up prices due to low supply, retail buy and hold investors ignoring much of the fray, bond fund redemptions of high quality bonds causing a pricing ripple effect on on all other muni bonds and the lack of clear insight into the why and how of credit ratings.