Municipal bonds are issued by a city, county or state to raise funds for highway construction, schools, hospitals or other public works projects. Many investors like to allocate a portion of their portfolio to bonds due to their low risk, and favorable tax implications. However, municipal bonds are not always risk-free; below we highlight the biggest municipal disasters of all time [for more municipal bond news and analysis create a free account today]:
1930s: The Great Depression
During the Great Depression, 4,770 municipals defaulted on their bond obligations, but the 1933 Arkansas bond default was the most famous.
In the 1920s, Arkansas began to increase their construction on roads as the automobile industry started to take off. In order to finance these projects, the state issued bonds to investors.
In 1927, the Mississippi River flooded, resulting in the destruction of a large amount of infrastructure, including some of the newly constructed roads in the state. The critical part of the flood was not so much the damage of the roads, but the loss of cotton fields, which were an essential product in the state.
By the 1930s, following the greatest stock market crash in history, the state was required to pay back its debt to the bondholders. However, that led to financial problems in the state since Arkansas spent an enormous amount of money to work on roadways and to fix the state after the flood. Adding to the state's financial burden, the loss of so many cotton fields caused the state to lose a large portion of its income.
Arkansas had $160 million in bond obligations by 1933, without the funds to pay for them. Eventually, the state was able to pay its investors back for the purchased bonds.
1983: Washington Public Power Supply System ("Whoops")
The Washington Public Power Supply System (WPPSS), which was nicknamed Whoops, was the largest municipal bond default in history.
In the 1970s and 1980s, WPPSS sold bonds to finance the construction of five nuclear plants needed to accommodate increased demand. In 1983, poor management and unsatisfactory safety conditions caused the construction of the plants to cost four times as much as originally estimated. At the same time, demand for nuclear energy began to decline, and construction on some plants was forced to terminate.
There was still an obligation of $2.25 billion to pay back to bondholders in 1983. To offset the cost, the price of electricity was increased for customers, which caused a major uproar. The uproar led to legal troubles, causing the utility's plan to raise money from customers to backfire.
The $2.25 billion debt was defaulted, and WPPSS was unable to pay their the full amount to their bondholders, recovering by only 40% from their municipal bond disaster.
1994: Orange County, California
In 1994, the Orange County, CA default and bankruptcy was a result of bad investment decisions, where The Orange County Investment Pool (OCIP) reported losses of $1.5 billion out of a total investment of $7.5 billion. The investment included high-risk, rate-sensitive securities, and leveraging to maximize returns.
This strategy worked well for OCIP in the beginning when interest rates were low, but once they started to increase, the OCIP began to see losses.
OCIP had a loan of $1.2 billion with a Wall Street creditor that it was unable pay back. As a result, the creditor began to sell the securities that OCIP used as collateral on their loan. To avoid obligations to the creditor, the county filed for bankruptcy in 1994. Luckily for the pension bondholders, the county was able to repay all of the debts owed to its investors by 1996.
2008: Vallejo, California
In 2008, Vallejo, CA was faced with financial insecurity caused by an ongoing budget deficit. The city could not balance its budget due to pension obligations which had been rising for years. Vallejo officials issued bonds in attempt to raise money to help pay for their pension obligations. When that failed, the city attempted to negotiate their obligations, but were unsuccessful. In 2008, the city filed for bankruptcy. Although investors were not paid immediately, bondholders were eventually able to receive 100% of their original investment as well as the interest.
2011: Jefferson County, Alabama
In the late 1990s, the county was forced to rebuild their sewer systems when it encountered a lawsuit resulting from their sewage being dumped in nearby rivers. The federal court mandated that the county correct sewage issues and make necessary improvements. In order to obey by The Clean Water Act, the county has no choice but to rebuild. To pay for this expenditure, the county issued bonds, raising $555 million.
By the 2000s, the county was faced with excessive debt, and the sewer project turned out to cost much more than originally expected. Up to 95% of the sewer bonds were traditional fixed cost securities and, as the market fluctuated, so did the interest rates. To avoid excessive expenses, the county entered into interest rate swaps, 18 of which were with JPMorgan. It was later discovered that JPMorgan had overcharged the county, which lead to big scandals for the company.
The county filed for bankruptcy and defaulted on $15 million in bonds.
2011: Harrisburg, Pennsylvania
In September 2010, the city of Harrisburg announced that they would be missing a $3.3 million bond obligation payment. This news came just over a year after the city failed to pay debt obligations to the Harrisburg Authority. Financial trouble was nothing new for the city, which had been missing payments for years.
Although the city was unable to pay its debts, none of these defaults resulted in monetary loss for investors due to reserve funds, Dauphin County guarantee programs and bond insurance.
The highly publicized financial issues in the city resulted in the state of Pennsylvania giving the city $350,000 in grants, as well as a $500,000 loan so that the city could hire a financial consultant. Despite the state s help, the city still attempted to file for bankruptcy in 2011, but was denied due to the state's prohibition against cities filing for bankruptcy.