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Katrina Spells Armageddon for Muni Bond Investors: Joe Mysak

Sept. 7 (Bloomberg) -- U.S. municipal bond investors now face their greatest challenge since the Great Depression.

The devastation caused by Hurricane Katrina in Louisiana and Mississippi will result in tax delinquencies and bond defaults, bankruptcies and mortgage foreclosures.

For all those who have long wondered about just how solid and solvent the nation's municipal bond insurers are, the coming months will be the test.

In the long term, of course, everything will work out just fine. Hysteria and hyperbole are strictly short-term, because property owners tend not to abandon their property.

For the short term, and even for the medium term, put aside all the things that tell you not to worry about the municipal market. Forget that prices on Gulf Coast bonds haven't collapsed, or that some institutional investors say they are confident about the big picture. Katrina is a serious problem for the municipal bond market.

The market is not used to seeing natural disasters produce bond defaults, primarily because natural disasters tend to be very short-term events, with residents returning to their homes or what's left of them relatively quickly to rebuild. What makes this natural disaster so different is that it may take months before people are allowed to return to their homes.

Past Challenges

The municipal market has faced challenges in the past, but none of this magnitude.

Consider the Orange County bankruptcy in December 1994. The county, which had been a triple-A credit just months before, was done in because of losses in the investment pool it ran for itself and its municipalities.

The problem was compounded because the county borrowed money to pursue its investment strategy, and because the pool guaranteed its participants their money back on demand. Once the details of just how much the county was losing came out, the county couldn't satisfy those demands and entered Chapter 9 municipal bankruptcy.

Or take the Washington Public Power Supply System, which in 1983 defaulted on $2.25 billion in bonds used to build its nuclear power plants, the biggest municipal bond default ever, after a court ruled that the communities on the hook for the bonds didn't have to honor their debts.

These were very specific cases. Orange County didn't lead to a wave of municipal bankruptcies. The WPPSS default was the result of a rogue court decision that legitimized debt repudiation. Nobody thought all municipalities would sue to get out of their obligations as a result. Nobody stopped buying tax-exempt debt.

Ability to Pay

Katrina is a much bigger problem because it affected a much bigger area, first of all; but it also threatens the fabric of the market, the pledge by municipalities to repay their debts with taxes and fees as long as they are able.

The affected municipalities are all willing to repay their debts; what they are certain to lack, the longer their populations are gone, is the ability to do so. Nobody is confident in predicting how long this will go on.

The problem goes beyond New Orleans, obviously; it extends to the tiniest municipalities in the affected areas, places that sell small amounts of bonds every year, places that may not even carry credit ratings and so operate well under the radar scope. Until now, that is.

Paying Claims

Then there are the bond insurers. Last week the four major bond insurers announced they had almost $13 billion in exposure to credits that were in Katrina's path, almost $4 billion in New Orleans alone. There are going to be some interesting days ahead for these insurers, who since they began doing business in 1971 have said they underwrote business to a zero-loss standard. That is, these insurers collected premiums with the expectation that they would never have to pay claims.

They are going to have to pay claims, perhaps lots of them.

Those looking for good cheer may take some heart in the fact that during the Depression, 4,770 issuers defaulted on $2.85 billion in debt. Almost all of them paid it back.

Those with a grimmer frame of mind may observe that the numbers are so much larger today, the bond issues so much more complicated, those ultimately responsible for repayment so much more difficult to determine.

To contact the writer of this column:
Joe Mysak in New York at jmysakjr@bloomberg.net.