Commentary – General Obligation Debt: The Good, the Bad and the Ugly
August 31, 2013
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Commentary – General Obligation Debt: The Good, the Bad and the Ugly
Some in the public finance world are arguing that the Detroit bankruptcy and similar situations call into question the efficacy of general obligation debt, thereby undermining the market for and pricing of general obligation debt for all governmental borrowers. I don’t buy it.
In Pennsylvania, where I practice, and in many other states, GO debt really means that a lender (whether you are talking about bondholders, trustees or credit enhancers) has three ultimate remedies. First, if the government has not budgeted or appropriated or paid the debt service on the GO bonds, the lender can go into court and have the judge order the government to do so. Second, the lender can go into court and have the judge divert the first dollars coming into the government’s treasury to be applied to pay debt service on the GO bonds. Third, the lender can go into court and have the judge force the government to raise real estate taxes in order to raise additional money sufficient to pay the debt service on the GO bonds. These three remedies are essentially the “security” for GO debt.
I view this situation in the context of The Good, The Bad and the Ugly (Sergio Leone, 1966). If you have a government that is a good credit, a failure to budget, appropriate or pay GO debt service is caused either by some sort of irrational political brouhaha between elected officials or by an administrative mistake. In such a case, the three remedies will clearly be available and will be enforced by the court. The mere threat of going to court will clear up the problem.
If you have a government that is a bad credit, the failure to budget, appropriate or pay GO debt service is usually caused by bad management and a history of making bad decisions. The government could operate successfully with better management and better decision making. In such a situation, the GO remedies should work. The government needs to be forced to operate better, and the remedial process will force it to do so. Although the enforcement of the remedies may take longer than the lenders want it to, the remedies should in the end do the trick.
It is the ugly situations in which the remedies break down. An ugly situation is one in which there simply are insufficient revenues and cash flow to pay for both public safety (police and fire) and GO debt service, and in which the real estate market in the community is so bad that raising real estate taxes will in fact result in lower tax receipts (in other words, you are on the wrong side of the Laffer Curve).
If the immediate choice for the elected official, public administrator, judge or receiver is to pay either the public safety employees or the lenders, but not both, the money will go to the public safety employees every time, no matter what the law says. The first role of government is to protect its citizens from harm or death. That will trump GO debt remedies. And raising taxes to collect less money will simply not be done.
Does that mean that GO debt remedies are therefore worthless for all governments? No. All it does is reinforce some basic Darwinian concepts of capitalism. If you, as a lender, decide to lend into a situation that is already ugly or has the potential of becoming ugly very soon, then you cannot expect “normal” remedies to work well, or maybe work at all.
This is not unique to GO debt. It is just as true for the classic form of lender’s collateral: a mortgage on real estate. As was proven in the Great Recession meltdown, if a lender makes a mortgage loan to a borrower with ugly credit in a highly overvalued real estate market, the ability to collect on the mortgage when the ugly debtor defaults will be severely compromised.
This is not a bad thing. Bad results discipline the lending side as well as the borrowing side of the credit markets.
There are lenders who specialize in lending to ugly credits, and they approach such borrowers differently than the way a lender in the bond market approaches a “normal” GO debt situation. Lenders who approach an ugly or potentially ugly GO debtor the same way they approach a normal GO debtor should not be surprised if the GO remedies do not work well.
Published in The Bond Buyer on July 31, 2013
