In The News › Why Didn’t N.O. Declare Bankruptcy?

Jan 12, 2007

Source: The New Republic

Why Didn’t N.O. Declare Bankruptcy?

Held in Bondage
by Noam Scheiber
Only at TNR Online | Post date 01.12.07

Meetings of the Louisiana State Bond Commission are typically dreary affairs, even by the standards of local government. Once each
month, 14 commissioners shuffle into a windowless vault known evocatively as “Senate Committee Room A,” where they quiz local
bureaucrats about their most pressing credit needs. Agenda item 21 at a recent meeting was a request by DeSoto Parish to borrow
$70,000 for fire protection equipment. Item 35 involved a $5 million offering of sewer revenue bonds for the town of Kinder.

But, on September 15, 2005, with the state’s largest city recently evacuated and still mostly under water, the proceedings produced a
rare show-stopper: a wrenching monologue by State Treasurer John Kennedy. Kennedy told of emergency calls with senators and
Wall Street officials; a line of credit with “two of the largest financial institutions in the world”; and a massive effort to catalogue
every last dollar of public debt in Louisiana—some $8 billion in all. He confidently laid out a three-step plan for averting financial
meltdown. And, most heroically of all, Kennedy highlighted a promise he’d made to the state’s creditors: “We told them there would
be, under no circumstances, under no scenario, any bankruptcies in Louisiana.”

Kennedy says he made the promise because, appearances notwithstanding, he didn’t think bankruptcy would be necessary: He
believed some combination of state and federal aid would enable cities like New Orleans to avoid filing for Chapter 9. And, as it
happened, state and federal officials eventually made good on Kennedy’s prediction. While New Orleans is still a shell of its former
self, a recent round of favorably-termed loans has helped it step back from the edge of a precipice. At the time, however, there was no
way of knowing this would be the outcome —it was almost a year before the aforementioned funds materialized. Had the financing not
been forthcoming, Kennedy’s categorical refusal to consider bankruptcy could have made the situation hopeless.

Kennedy says it was worth the risk because the consequences of bankruptcy would have been even worse. “I felt like every political
subdivision, as well as the state, would bear that stain,” he told me this summer. “It would cost us … in the future. Not just for me, but
for my kids and their kids.” And he would seem to have a point. In theory, when a city burns its creditors by declaring bankruptcy,
investors will demand exorbitant interest rates before they’ll ever lend again.

The problem is that this is empirically untrue: There’s little evidence that seeking bankruptcy protection, at least when exercised as a
last resort, hurts a city’s ability to borrow over the long term. Indeed, the local entities behind two of the largest-ever municipal
defaults both managed to borrow at reasonable interest rates within a few years’ time. So where does the assumption come from? As it
happens, it comes largely from an obscure but enormously influential player in the field of municipal finance: the multi-billion-dollar
bond-insurance industry.

In the absence of a government bailout, bankruptcy (and possible debt default) may well have been New Orleans’s best bet. Indeed, as
the months went by with no aid package in sight, a rising chorus of local voices began urging its consideration. One respected New
Orleans group, the Bureau of Governmental Research, went so far as to issue a 30-page report implicitly chiding Kennedy for taking
bankruptcy off the table. The report argued that Chapter 9 protection represented a way for the city to lower its debt obligations to
more manageable levels. At that point, New Orleans would arguably have faced more, not less, favorable terms for borrowing. (Local
bonds have mostly been rated “junk” since Katrina, after all.)

One early precedent for this came in 1983, when the Washington Public Power Supply System (WPPSS) canceled construction on two
nuclear power plants whose economic rationale had faded in the decade since they were approved. The decision amounted to a $2.25
billion default, and investors were understandably irate. By 1989, however, WPPSS—which Wall Street had long since dubbed
“Whoops”—was back in the bond market. Investors demanded a slightly higher interest rate relative to similar bonds. But, by and
large, they eagerly snatched up Whoops’s $700 million offering. “WPPSS ISSUE IS GREETED WARMLY: INVESTORS SHRUG OFF EARLIER
HUGE DEFAULT,” read the headline in The Wall Street Journal.

Though municipal bankruptcies and defaults are rare, the few other known examples tend to reinforce this storyline. A bankrupt
school district in Contra Costa County, California, was back in the bond market only two years after an $8.5-million default in 1992.
Orange County, California, managed to borrow again within a year of its spectacular $1.6 -billion financial meltdown in 1994, which
forced it into bankruptcy and default. The reason for the quick turnaround, explains Bart Hildreth, an expert on municipal finance at
Wichita State University, is that the new bonds are usually a pretty good investment. As in the case of Whoops, recently bankrupt
entities tend to pay slightly higher interest rates than comparable entities but lower rates than they would have paid had they not
restructured or defaulted. Over the long term, they tend to regain their pre-default credit rating.

That’s not to say defaulting is costless or that the decision should be made lightly. Cities that defaulted regularly or casually would
have a tough time borrowing. (Though Orange County recovered its investment-grade status in 2001, it did so only after emerging
from bankruptcy and making its investors whole again.) But a New Orleans-style crisis represents the opposite end of this spectrum.

Jan 12, 2007

Source: The New Republic

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