Default Case Studies in the Municipal Market
Default Case Studies in the Municipal Market
Municipal bond defaults remain rare events (Moody's reports a 0.0420% ten-year cumulative default rate for rated issues), but when they occur, the lessons reverberate for decades. The point is: understanding how defaults unfold teaches more about credit analysis than any rating methodology ever could.
Detroit (2013): The Myth of GO Bond Safety
Detroit's bankruptcy stands as the largest municipal bankruptcy in U.S. history by debt ($18-20 billion). Filed July 18, 2013, it shattered a long-held assumption that general obligation bonds were inherently safer than revenue bonds.
The Recovery Disparity:
- ULTGO (Unlimited Tax General Obligation) bondholders: ~75 cents on the dollar
- General fund paper holders: as little as 14 cents on the dollar
- Water and sewer revenue bonds: 100% of payments continued throughout bankruptcy
Why this matters: The city's water and sewer system (backed by approximately $6 billion in specific revenue pledges) maintained full payments even while GO holders faced significant haircuts. The legal pledge on revenue bonds provided leverage that taxing authority alone could not match.
The durable lesson: Credit fundamentals matter more than bond pledge type. Detroit's GO bonds failed not because of structural weakness in the GO form, but because the city's tax base had collapsed. The spread between GO and revenue bonds narrowed industry-wide after Detroit (investors realized they had been overpaying for a false sense of security).
Puerto Rico (2015-2022): When Triple-Tax-Exempt Becomes Triple Trouble
Puerto Rico's restructuring represents the largest public sector bankruptcy in U.S. history at $33 billion restructured. The Plan of Adjustment, confirmed January 18, 2022 by Judge Laura Taylor Swain, reshaped territorial bond investing permanently.
By the Numbers:
- March 2022: Issued $7.4 billion in new bonds replacing $34.3 billion outstanding (78% reduction)
- Debt service payments reduced by over 60%: from $90.4 billion to $34.1 billion
- Debt service cost dropped from 25% of revenue to 6.1% in 2022
- Puerto Rico currently has no credit rating from major agencies
The test: Why did sophisticated investors hold Puerto Rican debt despite obvious distress signals for years? The answer: triple-tax-exempt status (federal, state, and local) created artificial demand. Investors chasing after-tax yield ignored deteriorating fundamentals.
A → B → C chain: Triple-tax-exempt status attracted yield-hungry investors → Demand compressed spreads despite rising credit risk → When PROMESA restructuring triggered, recovery rates varied wildly by creditor class.
Jefferson County, Alabama (2011): Complexity Kills
At the time of filing (November 9, 2011), Jefferson County was the largest municipal bankruptcy in U.S. history at $4.2-4.3 billion total debt.
Root Causes:
- EPA consent decree requiring sewer system expansion
- Interest rate swaps that backfired during the 2008 financial crisis
- Auction rate securities that failed
- Corruption among officials, contractors, and bankers (two dozen people jailed for bribery and fraud)
Resolution Timeline:
- Technical default began March 7, 2008 (failed to post $184 million collateral)
- Bankruptcy emerged December 2013
- Creditors wrote off more than $1.4 billion
- Sewer rates rose 7.41% per year for first four years
- 2024 refinancing: $2.24 billion drew $26 billion in orders (saving $1.17 billion over life of debt)
The point is: Jefferson County's sewer debt ($3.14 billion) became toxic not because sewers are inherently risky (essential service bonds typically perform well), but because derivatives layered complexity onto already-leveraged capital projects. When auction rate markets froze, the house of cards collapsed.
California Cities (2012-2017): Pension Politics Meet Bondholder Reality
Stockton and San Bernardino filed for bankruptcy within weeks of each other in 2012 (Stockton: largest U.S. city bankruptcy in 50+ years; San Bernardino: second-largest).
Common Causes:
- Property values fell 70% in San Bernardino
- Unemployment reached 22% in San Bernardino
- Poor cost control during property boom
- Tax revenue collapse as bubble burst
Recovery Rates (Source: Moody's Default Studies):
| Case | Pension Obligation Bonds | Overall Recovery |
|---|---|---|
| San Bernardino | 1% (worst in any municipal bankruptcy) | N/A |
| Stockton | ~51% | ~60% |
| Detroit | 12% | ~65% |
Why this matters: In every California case, pensioners were favored over bondholders. A federal judge ruled that CalPERS was "just another creditor," but political reality ensured pension obligations received priority. Pension obligation bonds (POBs) have consistently received the worst treatment in municipal bankruptcies.
Harrisburg, Pennsylvania (2009-2014): State Intervention as Backstop
Harrisburg's incinerator debt crisis demonstrates how state law shapes municipal credit risk.
Timeline:
- Incinerator opened 1972, closed 2003 due to environmental issues ($100 million debt accumulated)
- $360 million in bonds issued 2003-2007 for retrofit
- Contractor Barlow Projects went bankrupt
- City started missing payments in 2009
- City Council voted for Chapter 9 on October 11, 2011
- State legislature prohibited Harrisburg from Chapter 9
- Bankruptcy petition dismissed November 23, 2011
- State receiver appointed 2012; Harrisburg Strong Plan approved September 2013
The durable lesson: State law can prevent municipal bankruptcy filings. Pennsylvania's intervention protected bondholders (at the cost of local autonomy). When analyzing GO bonds, the state's willingness and legal framework for intervention becomes part of the credit calculus.
COVID-19 (2020): The Crisis That Didn't Cascade
The pandemic presented the most severe municipal revenue shock since the Depression (90% of municipalities experienced revenue decrease; cities experienced average 21% revenue decline). Yet widespread defaults never materialized.
Why Federal Intervention Worked:
- Municipal Liquidity Facility (MLF) lowered yields by approximately 72 basis points
- CARES Act passage lowered liquidity premiums 28-68 basis points
- Rating agencies looked "through the crisis" (no methodology changes)
Hardest Hit Sectors:
- Healthcare (hospitals facing elective procedure shutdowns)
- Higher Education (enrollment uncertainty)
- Airports (passenger traffic collapsed 60%+)
- Mass Transit (ridership fell 70%+)
- Special Tax-backed debt with narrow revenue pledges
The test: Why didn't 2020 produce a wave of defaults? Federal backstops created liquidity when markets froze. The lesson for future crises: municipal credit risk correlates heavily with federal policy response.
Practitioner's Checklist: Learning from Defaults
Essential Due Diligence (Before Every Purchase):
- Verify whether state law permits Chapter 9 filing (and under what conditions)
- Check pension funding ratio and OPEB liabilities relative to operating budget
- Assess revenue concentration (single employer, single industry, single tax source)
- Review derivative exposure and counterparty risk in Official Statement
High-Impact Questions:
- Has this issuer experienced rating agency negative outlook in past 24 months?
- What percentage of budget goes to fixed costs (pensions, debt service, mandated programs)?
- For revenue bonds: what is the debt service coverage ratio trend over 5 years?
The Bottom Line
Moody's data shows municipal defaults remain rare (senior living and local government special districts accounted for 60% of 191 missed payments in 2022). But rare does not mean impossible. The patterns from Detroit, Puerto Rico, Jefferson County, and California cities repeat: overleveraged capital structures, political constraints on adjustment, and complexity that masks underlying weakness.
The durable lesson from every major municipal default: the bonds that failed typically showed warning signs years before technical default. The investors who got hurt were those who assumed ratings told the whole story.
Source: Moody's Municipal Default Studies; MSRB EMMA filings; Federal Reserve research on Municipal Liquidity Facility