(Reuters) - A growing number of U.S. cities are choosing to fund essential services like public safety and garbage collection over making payments on their outstanding debt, as rising costs and falling revenue deplete their budgets.
So far, the bond defaults are not roiling the $3.7-trillion municipal market because insurance companies are stepping in to make payments to bond holders in some cases. But defaults on insured bonds are putting pressure on these insurers, which never fully recovered from the last decade's financial crisis.
The California cities of Stockton and Hercules, as well as Pennsylvania's capital, Harrisburg, have opted to default on some of their insured debt in recent months.
"Municipalities are saying this is what bond insurance is for - bond holders get paid," said Richard Lehmann, publisher of Distressed Debt Securities Newsletter.
So far in 2012, there have been 21 muni defaults totaling $978 million, versus 28 defaults totaling $522 million for the same period in 2011, said Lehmann, who sees the number rising. A breakdown of defaults on insured munis was not available.
Although issuers contend they are not singling out insured munis for defaults, some believe that municipalities are strategically protecting bond buyers by relying on insurers to pay the debt service.
"Such a default may signal changing attitudes by distressed municipalities to contemplate a strategic default or bankruptcy on insured debt, knowing that bond holders will not suffer losses," Moody's Investors Service said in a report this week.
The credit rating agency added that municipal issuers "may be willing to damage their relationship" with insurers, which in turn could potentially be exposed to large losses.
CITY SERVICES TRUMP BOND-HOLDERS
Harrisburg's state-appointed receiver said earlier this month that $5.3 million of payments due on general obligation bonds insured by Ambac Assurance Corp will be skipped.
"I was aware they were insured bonds when we made the decision," David Unkovic, the receiver, told Reuters, adding that the city's financial condition was more important than bond-holders.
"My first concern as receiver is to maintain vital and necessary service in the city," he said. "In order to do that I need sufficient cash flows."
The city of Stockton, nestled among the farms of California's Central Valley, is defaulting on about $2 million in bond payments for debt sold in 2004, 2007 and 2009. Wells Fargo & Co is the trustee on each of the debt issues and has filed a lawsuit against Stockton for missing its February 28 payment on its $32.8 million of 2004 parking facilities debt, said bank spokeswoman Elise Wilkinson.
Hercules, which had considered bankruptcy, reached a settlement this month with Ambac after defaulting on a $2.4 million bond payment due in February.
Some of the companies are starting to feel the pressure. Syncora Guarantee Inc last month told a federal judge in Alabama that the prospect of it having to make good on millions of dollars a month in debt payments owed by bankrupt Jefferson County might sink the company.
In addition, the once-widespread use of insurance on new issuance has shrunk to a sliver of the muni market. After the financial crisis, so-called monoline insurers left the business, and the largest remaining insurer, Assured Guaranty, is scaling back, depending on states' bankruptcy laws.
Insured bonds, which accounted for 57.3 percent of muni issuance in 2005, sank to only 5.5 percent of issuance in 2011, according to Thomson Reuters data.
Insurers do not appear to perceive an immediate risk.
"We don't feel picked on," said a senior executive at a bond insurer. "I'm not sure it's correct to say issuers are deciding to default on insured bonds over uninsured ones. The market does not care whether a bond's insured or not. The fact they defaulted is what the market remembers."
The executive, who spoke on condition of anonymity, said struggling issuers get no tangible benefit from skipping payments on an insured obligation over an uninsured one since any money must eventually be repaid to the insurer.
"It's not a get-out-of-jail card," the executive said.
THE FINANCIAL CRISIS LEGACY
There was a time when bond insurers confined themselves to the dull but steady business of underwriting municipal debt, effectively lending their superior credit ratings to cities and towns for a fee.
The insurers branched out into structured financial products, which resulted in huge payouts when the credit crisis hit.
One-time market leader MBIA was compelled to restructure, and its municipal National Public Finance business is no longer writing new policies, pending the outcome of a lawsuit filed by a number of banks challenging the restructuring.
Ambac, once the second-largest U.S. bond insurer, went bankrupt in 2010, as did the parent of bond insurer FGIC. Syncora went through a major restructuring in 2009 and stopped writing new business as well.
The carnage left one bond insurer standing, Assured Guaranty. Though the company long ago lost its AAA credit rating, it has argued it can still effectively underwrite smaller municipalities with lower-tier ratings. Even so, it is also threatening to pull out of some states without tight bankruptcy controls.
"This is weighing more heavily in our underwriting as we examine the legal framework for bankruptcy in every state that we insure municipal securities," Assured said in a written reply to Reuters. "While some defaults have occurred on insured transactions, most have been on uninsured transactions."
Assured Guaranty said it believes defaults will remain infrequent, saying its municipal portfolio has experienced "only modest loss development on a few isolated transactions."
As of the end of 2011, Assured Guaranty enhanced $15.2 billion of munis - a drop of 45.1 percent from 2010, when it was also the market's sole active guarantor.
Assured listed exposure to $3.9 billion of debt sold by non-investment grade issuers on its 2011 financial statements. It includes notorious names like Alabama's Jefferson County sewer system, Harrisburg, Detroit, and Detroit Public Schools.
Radian Group, which wrote bond insurance until 2008, said last September it was considering starting a new unit with dormant bond insurance assets it purchased from Macquarie Group. The Financial Times reported this week that Goldman, Sachs & Co has also been hiring for a bond insurance specialist.
(Reporting By Karen Pierog, additional reporting by Jim Christie in San Francisco, Michael Connor in Miami, Lisa Lambert in Washington and Ben Berkowitz in New York. Editing by Tiziana Barghini and Dan Grebler)
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