The municipal market doesn’t like surprises.
That’s why words such as transparency and disclosure are used so often by municipal analysts, investors and regulators. Tell us, they have been saying for most of the past three decades. Is something wrong? Taxes falling short? Swaps blowing apart? Attendance flagging? Mill not working? People moving out? Tell us. Tell us.
So if you are a municipal issuer and you want to make the market happy, it’s not a good idea to keep a secret for a couple of years only to have one of the rating companies discover that something seems to be amiss, and then to reward your furtiveness with a superdowngrade.
A superdowngrade is one that takes an issuer down three, four, five levels or more, sometimes from investment grade to non-investment grade. Even in a market that rarely trades, like munis, such actions have consequences, like falling prices or evaluations.
Consider the Newark Housing Authority in New Jersey. In December, Standard & Poor’s cut the rating on the authority’s $376 million in 2004 and 2007 bonds to a non-investment grade BB from AA-, an eight-notch downgrade. Prices on some of the bonds fell to as little as 89 cents on the dollar. The authority is now being sued by bondholders for negligence.
Follow the Money
What happened? In 2007, the authority sold $176 million in bonds to refund $200 million in debt sold in 2004. The bonds were backed by annual $12.5 million lease payments by the Port Authority of New York and New Jersey and earnings generated by the $3.125 million debt-service reserve fund, which was invested in an MBIA Inc. guaranteed-investment contract paying 5 percent.
Fast forward to the fall of 2011. Standard & Poor’s noticed that the bond’s construction fund had been drawn down, and asked trustee U.S. Bancorp why.
S&P continues the story in December’s downgrade.
“In 2009, in accordance with the bond’s supplemental indenture, the investment contract’s cancellation was triggered following the downgrade of MBIA and the funds were subsequently moved to a money-market fund to be reinvested in U.S. Treasuries,” according to the rating company. “Investment earnings on the debt service reserve under the GIC were 5%. In fiscal 2010, the investment earnings from the money market fund yielded a return lower than the 5 percent needed” to meet debt service.
The authority needed just a little bit more to pay the bondholders. It instructed the trustee to transfer $82,000 from the construction fund of one of the bond issues to cover the shortfall, rather than dip into the debt-service reserve fund.
Back in 1994, in connection with an amendment to its Exchange Act Rule 15c2-12, the Securities and Exchange Commission said there were 11 material events that must be disclosed to municipal-bond buyers as soon as possible.
Among these were unscheduled draws on reserves, substitution of credit or liquidity providers, and anything affecting collateral.
These were called the “11 deadly sins,” by people in the market and by SEC officials making speeches. The SEC later added to the list. The theme was simple: If there’s anything going on behind the scenes in a bond issue, issuers must let investors know about it by sending out material-event disclosures.
I asked Richard Marino, the primary credit analyst at S&P who gave the superdowngrade to the Newark Housing Authority, why the downgrade occurred in December 2011 if the GIC was canceled in 2009 and the transfer from the reserve fund took place in 2010. He told me that the authority never said anything about them.
Shouldn’t these have been disclosed, I asked him, in a material-events notice? “Under normal conditions, yes,” he said. “We went back, and we couldn’t find any disclosure.”
S&P downgraded the authority to below investment grade because pledged revenue for the bonds -- the Port Authority payments and the money-market fund earnings -- would not equal debt service.
I called Marvin Walton, deputy executive director of the authority, and asked him about it. He said the situation with MBIA was widely known at the time, and if the authority hadn’t canceled the GIC, it would have been “in worse condition than we already are.”
The collapse of MBIA, and most of the bond-insurance industry, was so well-known that it didn’t need to be disclosed.
I found this a novel interpretation of the rules. The authority did disclose the Dec. 5 superdowngrade of its bonds in a “Notice of Reportable Event for Continuing Disclosure,” posting the rating company’s report on the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access website on Dec. 20.
Walton also told me that S&P would soon be contacted because the authority, on Feb. 17, replaced the GIC, although he wouldn’t say with what. That hasn’t been publicly disclosed, either.
(Joe Mysak is editor of Bloomberg Brief’s daily Municipal Market and author of the Encyclopedia of Municipal Bonds, just published by Bloomberg/Wiley. The opinions expressed are his own.)
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