Bankruptcy filings from California cities such as Stockton, San Bernardino and Mammoth Lakes are “disturbing” and may foreshadow major changes in the $3.7 trillion tax-exempt market, said Jon Schotz, managing partner at Saybrook Capital in Santa Monica, California.
Schotz, whose company oversees $400 million of munis, also discussed why investors aren’t getting compensated for the increased risk for today’s Bloomberg Brief: Municipal Market newsletter.
Q: What does it say about the overall municipal market that actual cities and counties are seeking Chapter 9 protection?
A: You have general municipal credit risk at a much higher level than we’ve had before. I don’t mean like Meredith Whitney -- light your hair on fire and the world is ending -- but I do mean that you’ve got very significant stress on cities.
I don’t know exactly what’s going to happen, but previously people wanted market access, so they wouldn’t stiff their bondholders. And the history of recoveries on general municipal defaults is usually fairly good. But you’re in a zone right now where there’s not a lot to recover in some of these situations.
We’re going to have a few bankruptcies and people are going to watch the precedents get set and use them as a template.
Q: You invest in distressed and defaulted municipal bonds. Do you buy land-secured deals?
A: We’ve bought land-secured financings. It’s been real- estate oriented, just because that’s what the downturn gave us.
I don’t like the Florida land-secured deals. There have been a couple cases that have gone the wrong way. When you have a new law that hasn’t been adjudicated, or you haven’t had a set of cases go to court to define the boundaries, you can have some unintended consequences.
There’s a case there called Fiddler’s Creek, and in that bankruptcy, the key was the court took the view that the district was the creditor in the developer’s bankruptcy, not the bondholders. So the bondholders didn’t get to vote on their security interest.
Q: Are the problems faced by local governments in California a disturbing trend or an investment opportunity?
A: It’s a very disturbing trend. Cities big and small are very much at risk, because they have a very strained ability to raise any source of money. You have San Jose, you have San Diego, and you have the bankruptcies.
In California, you can file for bankruptcy. You may have to go through six months of mediation with your creditors that was put into place by the unions when Vallejo filed, but that doesn’t matter that much at the end of the day. It’s a lot of posturing. Maybe things get worked out, maybe they don’t.
The bigger issue to me is the fact that the cities don’t have ways to raise money and they have these huge pension costs and health-care costs coming at them, with no way to pay for them. It’s simply not sustainable. Look at the percent of the budget that goes to those costs -- it’s absurd.
Q: What’s your strategy in this environment of record-low yields and constant money flowing into muni mutual funds?
A: We’re in an environment where we’ve had record flows in, and also something we’ve never had in the muni market, which is a storm cloud for defaults in the general muni area.
When you start getting to general muni problems like the city of San Jose or Stockton, not the idiosyncratic, out-of- balance budgets that need to be adjusted, you’re going to see wholesale change. There’s a lot more credit risk in the general municipal world than there ever has been, because the ability to raise revenue around the country is severely constrained.
Q: Are you joining other investors in moving down in average credit quality to capture additional yield?
A: You’re not getting paid for the risk you’re taking on some credits. I don’t know what’s going to change that. But yields are so compressed and credit spreads are so compressed, you’re not getting paid to take the risk on some of these credits. I don’t know when that changes, but hold onto your hat.
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