Default From Grace : California Sees Big Increase in Failing Muni Bond Issues, Most of Which Are Land-Backed Deals

Just as irrational exuberance may be a dangerous thing for the nation’s stock market, irrational pessimism could be worrisome in the California municipal bond market.

But pessimism may become the widespread feeling among safety-craving muni bond investors once they discover that a record amount of California municipal bond issues went into default in 1996--and that even more are expected to default this year.

Eleven California bond issues worth a total of $88.1 million defaulted in 1996, the highest dollar total in at least 12 years, according to the California Municipal Bond Advisor, a Palm Springs-based newsletter that tracks muni bonds.

Defaults in 1996 increased dramatically from 1995, when $46.8 million worth of bonds defaulted.

Considered one of the safest investments around, municipal bonds are issued by local governments, school districts and other agencies, generally to finance long-term projects. Interest paid on the bonds is exempt from state and federal income taxes.

The muni market nationwide is worth about $1.3 trillion. And in California alone, the value of outstanding muni bonds is estimated at $130 billion. Which means that last year’s defaults, while historically high, are a very tiny portion of the bonds outstanding.

“California bonds are still very good investments for those in high tax brackets,” said Zane Mann, publisher of the California Municipal Bond Advisor. “Most of the defaults were in one sector.”

Most of the disasters were in land-backed bond deals, some of which collapsed because of problems stemming from the lingering California real estate downturn that began in 1990.

Many of the bonds were issued to pay for sewers, lighting, streets or other infrastructure for development projects that did not materialize or were downsized due to sagging real estate prices. In some cases, the land securing the deals dropped in value by half or even more.

Default occurs when developers or property owners are unable to make scheduled payments to bondholders. Often, the land carries so little value that even a foreclosure sale can’t pay off the bonds.

“These defaults in the land-backed deals are really a lagging indicator, reflecting the downturn in the economy that began in 1990,” said William Huck, a principal with Stone & Youngberg, a San Francisco investment banking firm that underwrites many such deals. “Because of that, I think we’ll see even more defaults this year.”

Huck, who specializes in devising plans to fix many of the troubled deals, said that the firm has more than 20 additional land-backed bond deals throughout the state that are currently on a “watch” list because of a high rate of delinquent payments.

While even one delinquent payment causes a “technical default” in a bond issue, a formal default occurs only after a series of interest and principal payments are missed and the bond issuer indicates it has no ability to pay as scheduled.

Still, Huck said, it is important for investors to remember that the upturn in the state economy and rising land prices will help many of these bonds.

“The worst thing an investor could do right now is to panic and decide they aren’t going to be in these bonds,” said Tom Lockhard, also a principal with Stone & Youngberg. But “the trend ought to tell you to be careful and study each individual issue.”

In general, the muni bonds most vulnerable to cycles in the real estate market include Mello-Roos community facilities districts, assessment district deals and other bonds that are ultimately secured by property.

Specifically, some of the land-backed bonds that went into default in 1996 included $10.3 million of 1991 Long Beach assessment bonds for a seismic retrofitting project; $24 million of specialty tax bonds for a Riverside County Mello-Roos district; and $2.6 million of 1990 assessment bonds for the Andreas Hills project in Palm Springs.

“California’s default rate was high last year, and Long Beach just added to the confusion,” said Dick Hilde, treasurer of Long Beach.

That city’s defaulted bonds were a special type of taxable muni bond sold to help private property owners pay for fire sprinkler upgrades for buildings built before 1934, so the structures would meet city building codes.

The buildings were brought up to code, but about 25 property owners have failed to make their payments, due to bankruptcies and other problems caused by the real estate downturn, Hilde said. Bondholders and city officials are meeting this week to discuss potential repayment strategies. “There may be ways to restructure the bonds, and we’re looking at that,” Hilde said.

California’s muni bond default rate is outpacing that of the nation as whole, where defaults are down, according to figures from the Bond Investors Assn., in Miami Lakes, Fla., which focuses on issues important to individual bondholders.

Nationwide, defaults last year totaled 64 issues worth $809 million, compared with 97 issues totaling $2.3 billion the previous year, the group found. Still, the group cautioned that the number of 1996 defaults could increase, as some won’t be counted for another month.

“If California was up, it’s contrary to the nation as a whole,” said Richard Lehmann, president of the group. “But investors need to remember that California’s issuance always outpaces that of the nation. So it’s not extraordinary.”

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To calm investors’ fears, local governments in California are increasingly opting to buy private insurance for their newly issued bonds. More than half of all new bonds issued in California last year were sold with insurance, an increase from previous years.

None of the 1996 defaulted issues were insured.

For investors who own land-backed munis or are considering buying them, experts advise looking carefully at the bond documents and the quality of the ultimate security for such deals.

Many of the muni issues that are secured by land, especially those that aren’t rated by major bond-rating services, are really just as risky or even riskier than as corporate junk bonds, even though they are munis, noted Mann. “Investors need to remember to look very closely at the credit quality of the bonds they buy,” he said.

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In Default

Eleven California municipal bond issues totaling $88.2 million defaulted in 1996:

Riverside County Community Facilities District 88-8

$24 million in special tax bonds

A Street North

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Los Angeles Housing Authority

$13.5 million in multifamily taxable bonds Series 1992 A

Hayward Manor Apartments

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Long Beach Assessment District 90-3

$10.3 million in 1991 taxable assessment bonds

Seismic Retrofitting

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Hesperia Community Facilities District 91-3

$10 million in special tax bonds, 1992 Series A

Belgate Development Project

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Calaveras County Water District A.D. 604

$9.68 million in 1991 assessment bonds

New Hogan/La Contenta

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Atwater Community Facilities District 1-90

$6.9 million in Series B subordinate bonds, 1995 refunding

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Colton Redevelopment Agency

$6.41 million in multifamily housing bonds Series 1986 A and B

Casa del Rio Project

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Palm Springs Assessment District 158

$2.6 million in 1990 assessment bonds

Andreas Hills

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Wheatland Community Facilities District 1

$2.1 million in special tax bonds

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East Niles Community Services District A.D. 4 and 6

$2 million (combined total) in 1990 assessment bonds

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Tehachapi Community Facilities District 89-1

$670,000 in Series B subordinate bonds, 1995 refunding

Capital Hills

Muni Defaults

The dollar volume of California muni bond defaults each year since 1984:

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Defaults Year (millions) 1984 $15.3 1985 9.6 1986 31.5 1987 34.4 1988 16.7 1989 0.0 1990 20.6 1991 42.2 1992 60.8 1993 51.2 1994 74.2 1995 46.8 1996 88.2

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Source: California Municipal Bond Advisor