In 2008, as the financial markets began to deteriorate, many banks and leasing companies in the tax-exempt municipal leasing business began to curtail or just plain bale out of that business. Many determined that corporate losses would render the returns on their tax-exempt investments substantially less attractive. Some just found it easier to jettison a smaller niche business when capital got tight. Looming in the background, however, was a growing storm of bad news regarding the financial stability of state and local governments around the country. As the economy deteriorated in 2009, we began to hear more and more suggestions (read that warnings) that municipal governments were in trouble due to rapidly diminishing tax revenues and bloated budgets. The seemingly logical conclusion, we were told, was an oncoming tide of municipal defaults and non-appropriations. This foreboding cloud started small. In 2009, The Wall Street Journal published an article wherein the author warned of the potential for substantial municipal default. He listed and described three such recent occurrences as proof of the impending disaster. By late 2010 the noise had reached cataclysmic proportions with Meredith Whitney’s televised prediction that there would be 50 to 100 major defaults, totaling hundreds of billions of dollars. (By the way, that’s more than we have ever had before, including the Great Depression.)
Fortunately, virtually none of this was founded in fact, nor has it been true. What comes to mind is Mark Twain’s wonderful comment about the reports of his death being greatly exaggerated.
Of the three default examples given in The Wall Street Journal article predicting increased municipal defaults, two were not even municipal government debt. They were revenue-based issues for nonessential projects not payable from tax revenues. The third was a legitimate municipal default. Which prompts me to acknowledge that there have been and will continue to be municipal defaults as long as we have municipal debt. That is and will always be an underwriting event - not a holocaust. As for the Whitney prediction, overall municipal defaults have gone up somewhat nominally. However, the incidence of government defaults remains literally anecdotal compared to the commercial and corporate lending business. Spend a few minutes in an online search for Ms. Whitney, and you will see that she has not been able to pedal backward fast enough to repair her mistaken forecast.
More specifically, take a look at the municipal leasing market. Lenders and lessors have been fairly slow to reenter the municipal leasing business. I have heard more than one commercial leasing executive suggest that municipal governments are in trouble and the first thing to go will be annually appropriated leases. Actually, the opposite is true and there is good reason. Over the past three years the Association for Governmental Leasing & Finance Survey of Industry Activity has reported municipal non-appropriations and losses as follows.
Losses for the same periods were all .01 percent or less.
Overall, Bloomberg has reported that municipal defaults declined by 60 percent in the first half of 2011.
In other words, we have just come through one of the worst economic periods in our lives and municipal leasing losses have remained at numbers near zero. In the overall municipal bond market, 2010’s $2.8 billion in defaults amounted to about .09 percent of the total outstanding. Meanwhile corporate bond defaults range from about 3 percent in good times to as high as 12 percent in bad times.
Certainly, municipal budgets are not out of the woods. Pressure will continue on these budgets until the economy improves enough to increase tax revenues and governments make additional cuts in their operating costs. Meanwhile, there are some real good reasons why this budget pressure will not result in a substantial increase in defaults. Generally, municipal governments do have the flexibility to raise taxes and to cut costs by cutting services. Most are using judicious amounts of each option to manage their operations efficiently.
Focusing more specifically on municipal lease purchase obligations, there is additional protection that adds strength to these transactions. Much of the misdiagnosed concern about municipal credit stems from a lack of understanding of how and why municipalities acquire, finance and pay for assets. Generally, governments don’t buy assets they don’t need. The assets they buy are necessary to provide essential services, services that the public will not do without. From the outset and for years the municipal leasing business has preached the value of financing only “essential use” assets. When that term is applied with the benefit of in-depth due diligence and underwriting, you can achieve the kind of loss experience referenced above. When it is abused for the sake of volume or yield you will most likely lose, just as in any lending business. A community water park or trash-to-energy project cannot be considered essential. They should be underwritten as any normal commercial business. Conversely, fire engines are more likely essential to the safety and well-being of the community. I have always looked at the essential use analysis as one of determining a pain factor. How much true pain will you cause lessees if you actually take their asset away and deprive them of its use? Notice I said the fire engine is more likely to be essential. Consider, however, financing the tenth fire engine for a town that only needs nine. If times are tough, they may be able to give up that one without suffering any pain. There are ways to mitigate that risk. Nonetheless, it is a risk component that should be explored with due diligence.
The essential use and pain from loss concept also makes it easier to understand that the market value or resale value of an asset is not as important in evaluating the municipal lease transaction. In a recent transaction, a state government official decided he could save some money in his department by not appropriating payments for several hundred printers used throughout the state. Imagine his surprise when he was asked to prepare them all for return to the lessor. He didn’t know he had to give them back. The state promptly decided to keep the printers and make the payments. The printers’ functions were to print out tag receipts for all taxes and fees paid for license tags throughout the state. It was not something they could do without. This deterrent holds equally true in the case of soft collateral. For example, my own hometown can’t function without the software used to compute and collect taxes. Consequently, I would be comfortable financing that asset.
Another deterrent to non-appropriation and default is the realization and understanding by the borrowers that non-appropriation or default will result in their inability to use this type of financing in the future. It is likely to have a negative effect on their ability to borrow from other sources, and could have a detrimental effect on their credit rating if they have one. A very large county in Florida, under public pressure from activist groups for spending too much on a new county office complex, decided to non-appropriate on the $40 million project. After substantial discussions with rating agencies and credit enhancement companies, it became clear that their rating would be downgraded and their cost to borrow on all of the county debt would be substantially increased for years to come. The additional borrowing costs would have amounted to several times the entire cost of the office complex. They changed their minds and did not cease payments.
Ultimately, the real protection against municipal non-appropriation and default is superior due diligence and underwriting. Understanding why non-appropriation occurs is the leading deterrent. The primary causes for non-appropriation by municipalities are as follows:
• Non-performance of the asset or vendor in support of the asset. This occurs most often with smaller ticket items such as copiers and other office products. It can also occur with the installation of more complex and unproven technologies.
• Fraud, by vendor or municipality. This can range from city officials absconding with city funds to a vendor-perpetrated pyramid scheme which pays for the last transaction with funds from the next one.
• Vendor sales tactics. From time to time sales people will sell the financing by telling customers that they can simply give it back if they don’t like it later. A rather broad definition of the right to non-appropriate.
All of the examples above are based on true cases. Fortunately, they are very few and far between. Granted, you can’t totally eliminate greed, avarice, ignorance or arrogance in the lending business. You can, however, eliminate most of the risk of non-appropriation and default in the municipal leasing business by having experienced and knowledgeable people engaged in a thorough underwriting and due diligence process. Our advice:
• Know your vendors and know their sales process
• Investigate the essentiality of the asset, its useful life and its actual anticipated use cycle
• Assess the municipality’s understanding of the asset being acquired, the financing process and the financing terms
• Evaluate the ability to pay
Due to the contraction of market participants, the companies that stayed active in the municipal leasing business during 2009 and 2010 were essentially able to pick and choose their transactions at attractive rates. Those companies that are wise enough to enter or gear up the business now will find it a very attractive and safe way to book additional, very low risk portfolio in an economy where volume is currently harder to come by. For all the reasons mentioned above, losses in the business will continue to be a small fraction of those experienced in all other commercial finance sectors. Thanks to a myriad of protective laws and regulations coupled with the substantial tools municipalities have available to manage their budgets, nothing short of a major economic collapse is going to cause significant municipal defaults.