Bond Default Is About Too Much Debt, Too Little Time: Joe Mysak

By Joe Mysak - Jul 20, 2010 9:00 PM ET

Bloomberg Opinion

 

The last time a state defaulted on its bonds, it took eight years and the federal government’s help to come up with a remedy.
When Arkansas defaulted on its bonds in 1933, the politicians and investors talked about the same things we would talk about today. The state blamed underwriters for allowing it to sell too many bonds. Investors compared the willingness to repay debt with the ability to pay, and weighed the advantages of bonds backed by a pledge of taxing powers to those secured by specific revenue.
Unlike today, nobody thought the federal government should come to the rescue.
To be sure, the municipal market was a much different place in the 1920s and 1930s. States and localities borrowed about $1 billion in long-term debt each year (compared with $400 billion now), credit research was in its infancy, and the practice of bond law was only about 50 years old. The 10-year bond call wasn’t as common as it is today, and there were no prohibitions on the number of times issuers could refund their bonds. The market was less codified and more contentious.
The framework of the story is eternal: too much debt, too little time.
“We have a state ranking 46th in per-capita wealth in 1929, ranking first in per-capita indebtedness,” was how state Senator Lee Reaves summed up the matter in a 1943 article for the Arkansas Historical Quarterly. “Under the best of circumstances it would have been difficult to meet payments on the mounting debt.”

Good Intentions

The story began, as so many do, with the best of intentions. In 1927, the state of Arkansas took responsibility for $54.8 million in debt sold by hundreds of road districts to prevent its default.
Combined with the state’s own $84 million in highway-system bonds and $7.2 million in toll-bridge securities, the assumption of district bonds pushed Arkansas’ debt to $146 million. Coupons on the bonds were as much as 5 percent.
Fast forward to March 1933 in the depths of the Great Depression -- not Senator Reaves’s best of circumstances. The Arkansas General Assembly passed the Ellis Refunding Act, which sought to exchange all outstanding highway debt for state bonds carrying a 3 percent coupon, maturing in 25 years.
“Interest on highway and toll-bridge bonds, amounting to $770,500, due March 1, is in default, and this fact spurred the Governor in his demand for a refunding program that would yield revenue sufficient to meet any emergency and insure stability to outstanding obligations,” the New York Times reported.

Loaded Word

Bondholders were having none of it. They went to Governor J.M. Futrell, and protested that the new refunding violated the state’s contract with bondholders, in that it replaced their first lien on automobile and gasoline taxes with the state’s own full faith and credit pledge.
Modern readers may pause. There is nothing safer than a general obligation bond, secured by a state’s full faith and credit taxing powers, right? Yet the bondholders in 1933 preferred their portion of a specific, dedicated revenue stream rather than the state’s promise.
The bondholders -- mainly Northern and Eastern banks and insurance companies -- also said reducing the interest rate amounted to partial “repudiation.”
That was a loaded word in those days. Bond investors were still smarting from the repudiation of bonds used to build railroads, the Confederacy, and carpetbagger governments. This was the catalyst for the creation of the bond counsel business: Underwriters paid lawyers to certify an issuer’s bonds.

‘Vast Difference’

“There is a vast difference between repudiation and inability to pay,” Governor Futrell told the New York Times. “Repudiation is refusal to pay when you are able to do so.”
The governor then took a shot at bond underwriters: “Arkansas has been oversold through a wrecking crew with the assistance of the bond buyers, despite their knowledge that the State highway issues were excessive. Although Arkansas has not received full benefit from its highway bonds, the state owes the debt, and will pay in time, but our peoples are struggling for existence and cannot pay additional taxes, nor meet present requirements.”
The bondholders headed to Little Rock to negotiate. The state failed to make $10.5 million in bond payments on Aug. 1.
In January 1934, the bondholders got a permanent injunction against the state, blocking the use of automobile and gasoline taxes for anything other than highway maintenance and debt service.

Refunding Agreement

Now “at the mercy of the bondholders,” in the words of Senator Reaves, the state in 1934 agreed to a refunding that extended some maturities and required an increase in both those automobile and gasoline taxes.
That cured the 1933 default.
But that’s not the end of the story. State officials said default was again possible in 1944 -- when $12 million in principal and interest had to be repaid -- and probable in 1949, when $41.3 million would come due. So in 1937, and again in 1939, the state tried to refund its $140 million in highway bonds. It was rebuffed both times.
On April 1, 1941, $90.8 million of the outstanding highway bonds was callable; an additional $45 million was callable on July 1. The state made plans for another, this time uncontested, refunding.
A syndicate of 250 banks said it would bid on the new Arkansas refunding bonds, in conjunction with the Reconstruction Finance Corporation, a new entrant in the municipal market and a creation of Herbert Hoover’s administration.

RFC Steps In

On Feb. 27, 1941, to Wall Street’s shock, the RFC bought the entire issue single-handed.
“In our several conferences with the bankers, they indicated to us they would not bid for as much as $90 million and that the interest rate would have to be 3.5 percent,” RFC Chairman Jesse Jones said. “We thought this rate too high for a tax-exempt bond of a sovereign state,” he told the New York Times.
The RFC bid, which averaged 3.2 percent, saved Arkansas $28 million over the life of the bonds. The corporation later sold the securities to Wall Street banks at a profit of $4 million.
Arkansas never looked back. Today, the state ranks 46th in tax-supported debt per capita, at $312, according to Moody’s Investors Service.
In 1933, nobody thought Washington should get involved in a state bond default. In 2010, that’s the first place we would look for help.