October 5, 2022

Local Governments Join The Strategic Default Movement

As if creditors didn’t have enough worries with nonperforming consumer debt and defaulting  real estate mortgages, it now appears that another wave of debt defaults has started – this time by municipal borrowers.

Consider the City of Buena Vista, Virginia, that recently defaulted on a bond payment due July 15th:

WSJ– Buena Vista, Va., borrowed $9.2 million through a bond offering in 2005 to refinance a municipal golf course. It pledged as collateral, of all things, its City Hall and police station.

Now, amid financial difficulties, the city says it can’t pay its debt, triggering a showdown over these public buildings.

On the other side of the battle is a big New York insurance company, ACA Financial Guaranty Corp., which is obligated to pay bondholders if the city defaults.

Municipalities across the U.S. are struggling with huge debts and shrinking revenue, making them vulnerable to similar situations. Harrisburg, the capital of Pennsylvania, is publicly flirting with bankruptcy. And when Central Falls, R.I., couldn’t pay its debt recently, it handed its finances to a receiver.

ACA Financial  insured the $9.2 million “moral obligation” bond offering, under which Buena Vista promised to pay the debt if revenues from the golf course were inadequate.  The golf course turned out to be a bust, and the City has been losing money every year just to keep it open. 

In 2005, at the peak of the lending/real estate bubble, ACA Financial did not foresee a problem with insuring a loan not backed by the full faith and credit of the issuing municipality.  This overly optimistic underwriting decision is likely to result in a 90% loss for ACA since the collateral backing the $9.2 million loan is only worth about $1.1 million and the borrower is under no legal obligation to pay (only a “moral obligation”).

The insurer has much to lose. The collateral is worth just a fraction of the debt. The bonds are secured by the golf course itself, but it is valued at just about $950,000, Mr. Kearney says.

The City Hall, part of the collateral, is a small two-story building constructed in the 1960s. Like the newer police station, it is worth just a few hundred thousand dollars, Mr. Kearney guesses, though nobody has bothered to appraise it.

Defaulting on debt has become a rational choice for many debtors.  Many defaults are forced due to unemployment, income loss or depleted savings.  More challenging for lenders are “strategic defaults” by borrowers who have ability to pay but chose not to, due to loss of collateral value backing the loan. 

In the case of Buena Vista, the mayor stated that “No one has been able to give us any solution short of a dramatic tax increase”.  Exactly how “dramatic” a tax increase would be required was unmentioned but here are some numbers to consider:

-Under the circumstances, Buena Vista could probably negotiate a reduction in the interest rate to 3% from the current 7.2% and extend the term to 25 years

-Buena Vista has approximately 2,300 families (total population 6,222) and the median household income is $41,900

-The monthly payment on a $9.2 million loan over 25 years at 3% is $43,627

-The payment due from each household to pay off the bond issue would be $18.96 per month, equivalent to foregoing around 3 cups of coffee per month at Starbucks

Is default Buena Vista’s only viable option or have they joined the Strategic Default Club?

Why The Biggest Risk To The Economy Is A Strong Recovery

Concerns about the current economic mess turning into another Great Depression seem to have faded.  The consensus view of  government officials and private economists seems to be that the economy, although still fragile,  is well on its way to a robust recovery.  According to Bloomberg,

Companies in the U.S. expanded in December at the fastest pace in almost four years, signaling the economic recovery is gaining speed heading into 2010.

The Institute for Supply Management-Chicago Inc. said today its barometer rose to 60, exceeding the most optimistic estimate of economists surveyed byBloomberg News and the highest level since January 2006. The gauge, in which readings greater than 50 signal expansion, showed companies boosted production and employment as orders climbed.

Stimulus programs and discounting have propelled a rebound in global sales that is reducing stockpiles, which may spur manufacturers to further increase production in coming months.

The world’s largest economy expanded at a 2.2 percent pace from July through September after a yearlong contraction that was the worst since the 1930s, figures from the Commerce Department showed last week. Economists surveyed byBloomberg forecast growth to pick up to a 3 percent pace in the fourth quarter and average 2.6 percent for all of 2010.

Predictions for a strong economic recovery seem to grow by the hour.   Recent articles in the press lead one to believe that  –  unemployment has bottomed, the growth of  foreign economies will result in greater demand for U.S. goods and services, inflation will remain subdued, the dollar has stabilized, a recovery in the housing market has started, mortgage rates will remain low, the bailed out banks are in full recovery mode, the Fed will gradually remove excess liquidity from the system, the politicians will get the deficit under control and the stock market will continue to post impressive gains.

Is the bullish consensus getting out of hand or will there be a few surprises on the path to a booming economy?  One scenario that could shatter the dreams of the bulls is if private individuals and businesses are crowded out of the debt markets by a U.S. government that needs to borrow seemingly endless trillions of dollars.  The latest data on private and governmental borrowing from the St Louis Federal Reserve show that crowding out could slam the brakes on an economic recovery.  Businesses and individuals may be unable to borrow in strained capital markets or face much higher borrowing costs as they compete with the government for capital.

Lending by large commercial banks has plunged, a combination of tougher lending standards and reduced loan demand.  Any economic recovery would result in increased loan demand by the private sector which strained capital markets may not be able to supply.   Competition for funds could lead to a spike in interest rates.

comm-lending-wk-change

As lending to the private sector has collapsed, government borrowing has exploded.

fedgov-debt-explodes

With no end in sight to new trillion dollar programs being passed by Congress, the financing needs of the U.S. Government are not likely to be reduced any time soon.  The recovery of the U.S. economy that many foresee may come to a grinding halt if private sector borrowers are crowded out of the capital markets.

Depression In Commercial Real Estate Results In Bargains For Some

Depression Pricing As Empty Hotels Slash Rates

The recent era of easy lending was not confined to residential real estate.  Commercial real estate lending is the next big worry for a banking industry already beset by an avalanche of non performing loans.  The banking industry has $1.8 trillion dollars of commercial real estate loans and many analysts believe that banks have reserved for only a small fraction of current and future losses.  Recent examples of losses on commercial hotel loans  in major travel destinations such as Hawaii and Las Vegas indicate the severity of the problem.

Hawaii Hotel Industry Downturn Worse Than Great Depression

Hawaii Hotels Face Fewer Visitors – For the hotel industry in the continental U.S., this downturn is the worst since the Great Depression. But the Hawaiian resort industry is taking a beating that’s even more severe.

Meanwhile, revenue per available room has fallen nearly 25% in the past two years and now averages $150.75.

Major renovations of existing hotels are common in Hawaii because construction of new resorts has been limited since the 1980s because of steep land prices and local governments’ opposition to expansion. “So the name of the game is to buy, renovate and reposition,” says Joseph Toy, president and CEO of the hotel-consulting company Hospitality Advisors, based in Honolulu. Many of the resorts that changed hands in recent years were built by Japanese owners in the 1980s.

But practitioners of that pricey repositioning strategy now find themselves in a bind due to the recession, the capital crisis and Hawaii’s tourism downturn. “The operating numbers have cratered, the underlying fundamentals aren’t very good, and you have a whole bunch of problem loans,” says David Carey, president and chief executive of Outrigger Enterprises Group, which owns 30 Hawaiian hotels, none in foreclosure.

Las Vegas Hotel Worth 41% Of Construction Cost – Cheaper to Tear Down Than Finish

Doubts Are Cast On Value of Las Vegas’s  Fontainebleau – LAS VEGAS—The Fontainebleau the luxury hotel and casino development at the northern end of the Las Vegas Strip, sits more than half-finished after falling into bankruptcy in June.

But as potential suitors consider rescuing the project, they are facing a grim reality: It may not be worth the money it would cost to complete it. More than $2 billion has already been poured into construction.

“It is going to take $1.2 billion to $2 billion to finish Fontainebleau, and it’s not worth that much,” Penn National Gaming Chief Operating Officer Tim Wilmott said. Penn is currently negotiating to take it over from the project’s creditors.

When the 4,000-room Fontainebleau project was first mapped out four years ago, gambling revenues were soaring and Las Vegas barely had enough hotel rooms to accommodate a flood of visitors.

Now, Las Vegas has a surfeit of luxury rooms. Occupancy rates in August fell to 83% from 94.9% two years earlier, and room rates have fallen sharply.

An outside analysis contracted by some of the Fontainebleau lenders last spring found that Fontainebleau would be worth $1.76 billion if it were completed in May 2010, according to a court filing, far less than its $3 billion total cost.

Depression Pricing For Hotels

Overwhelming supply and weak demand have resulted in hotels slashing room rates to keep the cash flow going.  In many cases, the cost of lodging at major hotels and resorts has dropped as much as 50% from two years ago and vacancy rates still remain high.  For newer resorts that were built during the boom years, the picture is even bleaker, resulting in bargain rates that were previously unimaginable.  On a recent trip to Mexico in September, I had the occasion to visit the newly completed and mostly vacant multi billion dollar resort, La Amada Hotel, Playa Mujeres, Cancun.  The La Amada website describes the property, which opened in May 2009,  as follows:

La Amada Hotel is a 5-star luxury hotel. Here you’ll have a comfortable home base of contemporary luxury. Stylish hotel architecture and decor, generous suites, spotless service, deluxe facilities, and of course, our secluded beachfront setting, all enable you to let your days here happen naturally. Situated just 25 minutes from Cancun International Airport, Playa Mujeres is the newest luxury resort destination in greater Cancun.

This 922-acre (373 hectare) luxury development includes a boutique hotel, upscale residences, a golf, yacht, and beach club, and Cancun’s first marina situated on tranquil Playa Mujeres in the Mexican Caribbean. Envisioned as an exquisitely and carefully developed sustainable community, La Amada is a destination where culture, ecology, history and art are integrated in a stimulating style.

La Amada, located in the Marina section of the Playa Mujeres “master planned’ community, is a 552-unit project of one, two and three bedroom residences, a 110-room five star boutique hotel, and a top of the line spa. In addition, the developers have created a “marina village” with 150,000 square feet of commercial space for restaurants, bars, cafes and shops, creating an ambiance akin to top European resorts such as Puerto Banus and St Tropez. No expense was spared on this spectacular creation; residences can even fly in and land on the properties private helicopter pad.

La Amada is a spectacular luxury resort hotel.  Equally spectacular are the discounts  – luxury suites are being offered at $280 per night, marked down from $700.  Apparently, even at these discounted prices, income stressed consumers are saying no.  During three visits to the property, I saw only one couple on an otherwise deserted beach.  Finished units remain empty with no guests to be seen.   The planned bars, cafes and shops have not opened.   Virtually all of the 176 slips in the Marina remain empty.  La Amada was built during an era of easy money when it was assumed that prosperity, based on eternal asset appreciation, would never end.  There is little doubt that the investors in La Amada have created a truly fabulous resort – far less certain is whether or not they will ever see a return on their investment.

La Amada sign points to empty hotel

La Amada sign points to empty hotel

Deserted La Amada beach

Deserted La Amada beach

Beachfront La Amada

Beachfront La Amada

Empty boat slips at marina

Empty boat slips at marina

La Amada - where are the guests?

La Amada - where are the guests?

Discount prices fail to lure guests

Discount prices fail to lure guests

The Correlation Between Incomes And Default Rates

The Marginalization Of Risk

The massive number of loan defaults that has put the entire banking industry on the brink on insolvency did not happen by accident.   Banks recklessly extended credit, even to low income borrowers who obviously had the least ability to service their debts.   What may have seemed like a virtuous circle of increased consumer consumption and  higher banking profits has turned into a debt disaster for both borrower and lender – consider the Democratization of Credit.

WSJ -The recession has forced a financial reckoning for Americans across the income spectrum. The pressure is especially acute for the low-income Americans who relied on borrowing for daily expenses or to gain the trappings of middle-class life. Shifting credit practices over several decades had enabled them to live beyond their means by borrowing nearly as readily as the more affluent.

But the financial crisis and recession have reversed what some economists dubbed the “democratization of credit,” forcing a tough adjustment on both low-income families and the businesses that serve them.

“We saw an extension of credit to a much deeper socioeconomic level, and they got access to the same credit instruments as middle-class and mainstream Americans,”…

The financial crisis has forced lenders to be especially cautious with the riskiest borrowers, a category that low-income families often fall into because their debt tends to be higher relative to income and assets.

Some are turning to wherever they can for credit. A publicly traded pawnshop chain, EZCorp., reported a 37% rise in revenue in the second quarter. “With credit limited and other options disappearing, there are people looking for somewhere they can get emergency cash,” said David Crume, president of the National Pawnbrokers Association.

Cash-strapped workers have long obtained advances through “payday loans,” available at storefront lenders for fees that equate to high annual interest rates. Even that move is not so easy now.

“More customers are walking in the door, but turndowns are up,” said Steven Schlein, a spokesman for the payday-loan industry’s trade group, the Community Financial Services Association of America.

The Journal article also includes a chart showing that the combined delinquency and default rate for lower income groups dramatically exceeds that of higher income groups.  Are lower income groups inherently a poorer credit risk or did lenders create the conditions for default by recklessly granting credit in excess of a borrower’s ability to repay?

The Journal article perhaps should have more appropriately been titled “the marginalization of risk”.   Banks failed miserably in executing their basic mission – lending prudently based on a borrower’s ability to service the debt.   Regulators failed miserably by allowing banks to make inherently unsound loans.  Did the bankers really believe the income numbers supplied by borrowers who “stated” their income?  What were the regulators thinking when they allowed banks to lend money without considering a borrower’s income, such as with “no doc” loans?

The long term adverse economic consequences of reckless lending are now obvious – the bigger tragedy is that it was allowed to happen in the first place.