I have received a number of emails from people (mostly from people familiar with my thesis that state and local governments in general are going through political crises rather than debt crises) asking me to please Harrisburg, Pennsylvania, To explain the bankruptcy petition in accordance with Chapter 9.
I don't think anyone would deny that Harrisburg is in a real debt crisis. However, the situation in Harrisburg is not typical of government borrowers in the municipal bond market. The only way to get this point clear, of course, is to go into detail about how Harrisburg got into financial hardship. Let me tell you a story. (My fascination with project finance is endless. You might want to make yourself comfortable.)
The vast majority of Harrisburg's debt securities result from improvements to the city's waste incinerator. According to the Patriot-News, the local Harrisburg newspaper (much of the information in this post comes from their excellent coverage), the incinerator has been a major source of financial troubles in the city since it opened in the early 1970s City officials have shown an inexplicable devotion to To throw money into the project. (That story is indeed a long lesson in not letting sunk costs affect decision-making. Apparently, not everyone in business pays attention to it.)
The facility was originally built to incinerate garbage and generate steam. Some of this was diverted to the nearby Bethlehem Steel Corporation plant, but most of it was only vented into the air. In 1985, the city built a turbine at the plant to generate electricity from the steam that would otherwise be lost. The facility was viable until 1990 when Dauphin County (Harrisburg county seat) passed a solid waste management plan that diverted waste produced outside of Harrisburg to various other landfills. This was cheaper than paying the incinerator to dispose of it. The plant lost millions of dollars in business practically overnight.
In 1993, the city sold the incinerator to the Harrisburg Authority, the city's public utility, for $ 40.7 million. (Officials suggest that this sale was specifically promoted by the bond rating agencies, but I find that hard to believe. The rating agencies' methods usually assume that governments fund companies that perform an essential government function.) In 1995, Dauphin became County was legally forced to return waste to the facility, but the facility was already lost for other reasons. The facility, which was more or less at the end of its useful life, constantly collapsed and violated the provisions of the federal law on clean air. Some improvements were made to bring the facility back in line, but it eventually closed in 2003. At that time, the incinerator was tied to outstanding debt of $ 104 million. Officials should have just demolished the facility and eaten up the cost, but decided instead to bankrupt the city.
City officials decided to core and rebuild the facility – an issue they had approached with a real penchant for gambling in Pennsylvania. Instead of working with one of the big companies that handle projects like this (like Waste Management or Covanta Energy, which now runs the incinerator), the city chose Barlow Projects, a small incineration technology start-up based in Fort Collins , Colorado, and founded by engineer / ordained minister James Barlow.
There were two reasons city officials preferred Barlow to his competition. The first reason was its technology. Barlow had patented an incinerator that used high pressure air to circulate burning garbage rather than mechanical grids. Jammed grids were one of the main reasons the Harrisburg plant failed to operate frequently.
The second reason, of course, was the price. Barlow's final estimate for the construction was $ 77 million. Other estimates were at least $ 40 million higher and one estimate was $ 178 million. The price difference should have been a red flag for city officials, but they were mostly concerned about the amount they could fund. The agency would have to pay off the existing debts associated with the incinerator and the new debts associated with retrofitting. At the prices of Barlow's competitors, the plant would not generate enough revenue to support itself – something the city would need to prove in order to sell the bonds to fund the project. (Remember, the city ultimately guaranteed the bonds, as did the county and the insured guarantee. The city also received substantial reimbursements from the bond issues.)
All but one of the Harrisburg City Council members finely stamped the project. Linda Thompson, the current mayor, was on the council and voted for the project (because God told her to), but became an early critic of the project when it became public that it was a boondoggle. The councilor who voted against the project was not re-elected.
One of the biggest sources of risk in project finance is construction risk. Construction risk refers to the risk that unforeseen problems arise during the construction of a project that throw the project off schedule or radically change the scope of the project. If bonds are primarily backed by the revenue of a facility, it is important that the project is actually generating revenue by the time the first payment is due. (Projects like this usually involve capitalized interest, where the borrower borrows more money than is actually needed to build the project in order to make interest payments during construction. The city issued bonds worth $ 125 million in 2003, to pay for this the project.) I mention the construction risk because the Harrisburg project was many times larger than any project Barlow had done before. When asked if his technology could be applied to a much larger project, Barlow did what most entrepreneurs would do to get a big deal: he said he would make it work. Barlow also envisaged that his company should be the project manager, which gave him complete control over the execution of the project.
Insurance companies, however, were less influenced by Barlow's ambitions than city officials. Barlow was unable to get a performance guarantee for the project. A performance guarantee (not to be confused with the yield guarantees used to fund the project) is a type of insurance that a customer (in this case the City of Harrisburg) from a contractor (in this case Barlow) usually covers the full contract price, which ensures that the customer receives a refund in the event that the contractor fails to complete the project as stipulated in the contract. This should have been the second red flag for city officials, but they decided to bypass the issue of performance bonds. The fact that the city would not require a performance guarantee for a multimillion-dollar project is absolutely contrary to standard public procurement practices. However, keep in mind that the officials went out of their way to make the project as cheap as possible.
Officials asked Barlow to provide two alternative forms of security, both of which willingly expired during construction. The city has not brought forward the typical 50% of the amount required to purchase equipment for the project and has withheld 20% of all other monies due to Barlow. The only traditional form of security for the project was a Barlow subcontractor's performance guarantee, which was lifted when that subcontractor left the project.
After construction began, basically anything that could go wrong went wrong and a relatively inexperienced contractor tried to pick up the parts. A year after the deal was signed, Barlow found that the company that was supposed to build the steel boilers for the plant (the most important element of the project) hadn't even started work and couldn't hedge against a surge in steel prices. Barlow asked the city to raise the contract price. Without the boilers, there would be nothing to be done on the construction site. This put the project back six months. Once construction could resume, it became very expensive to make up for lost time. Barlow asked the city for more money. They released the money they had withheld, thus giving the city no security for Barlow's performance.
In late 2005, city officials became desperate – the loan payments were due and the city had budgeted the revenue from the plant – and tried to find a contractor who could replace Barlow. Nobody would touch the project. But the city officials haven't had any idiotic maneuvers yet. You took out a short term loan from CIT in exchange for the rights to the technology in the facility. (Hey, it was 2005.) The idea behind this loan was that the city would make payments to CIT that were to be passed on to Barlow. The city, of course, was on the hook to make these payments. Now that CIT owned the technology for the facility, the company had the right to shut down the facility in the event of non-payment.
Barlow "finished" the project by April 2006, four months late. After the facility opened, the city found that there were major problems with the facility's ash treatment systems and that the third boiler was not fully completed. Without the third boiler, the facility could not generate enough revenue to make the necessary debt servicing payments and offset operating costs. (As far as I can tell, it would cost the city an additional $ 50 million if the facility were fully functional.) The facility's deficits put a strain on the city, downgrading staff, raising property taxes, and increasing waste costs . Even so, the city could not make its promised payments on the bonds, and the county and Assured had to make payments instead. (However, the city avoided defaulting its general notes due to prepayment on a parking contract.) The last time I read was that the city paid for a forensic audit of the agency's finances to get a better understanding how quickly the project costs have increased. You also sued Barlow. Both lawsuits are, of course, controversial as Barlow has filed for bankruptcy.
As massive as the city's financial problems were at the end of this project, the city council turned down a number of ways to resolve the city's problems. In 2008, the city council agreed a proposed $ 215 million lease with a developer for its parking system. This lease would have paid off a significant portion of the incinerator's debt. The council has also rejected a number of other asset sale proposals.
In October 2010, the city joined the Pennsylvania Act 47 program for communities in need. As part of this program, the state prepared a 422-page restoration plan for the city (pdf). This plan contained some specific recommendations to reform the city's operations and improve its financial situation. Unsurprisingly, the plan also suggested that the city sell assets, among other things. The city council has rejected the state's redevelopment plan three times this year. The same four council members (out of a total of seven) who rejected the recovery plan also voted for the city to file for bankruptcy.
(I've been asked by some people why the city needs to sell assets to pay the “speculators” who invested in or guaranteed the city's debt. If this is your reaction to the city's bankruptcy filing, I would submit that city officials – and by extension the people they voted for – have been real speculators on this project all along. City officials bet they couldn't get anyone to build a big project for less than far more demanding companies, demanded no insure in case of failure and put their tax authorities behind this bet. Were they born yesterday? Was this the first project the city had ever undertaken? No, they were greedy and ruthless, plain and simple. If the city had chosen A more honest and traditional arrangement, the project would not have been feasible on paper and the bonds would never have can be sold. I'm not sure where the moral outrage against the county or bond insurance company is coming from, but it's not based on anything that approaches sound logic.)
The city received a similarly comprehensive and nuanced report from the law firm Cravath, Swaine & Moore. The company conducted its investigation and produced the report free of charge. At the time of this report, lawmakers had already enacted laws to take over Harrisburg's operations. The city council hired Mark D. Schwartz somewhere when takeover legislation was introduced. Given that Schwartz clearly supported the city's bankruptcy filing (which he can make a ton of money on, not to mention notoriety), I can imagine he had some leverage in the council's decision against the Bankruptcy to agree recovery plan.
(Though Harrisburg appears to have an above average concentration of ass clowns per square mile, Schwartz is an interesting character himself. According to his Wikipedia page – which is certainly organic – his lifelong dream to be an actor. And he seems to love a stage. He and the city administrator who is running for mayor have conducted rounds of interviews since the submission, which seems unprofessional to me. Apparently Schwartz even invited himself to an interview through the local newspaper.)
I would be very surprised if Harrisburg's bankruptcy proceedings weren't finally out of court. As I explained in my December post, Default and Insolvency in the Municipal Bond Market (Part 2), a petitioner must meet several criteria to be eligible for Chapter 9: (1) The petitioner must meet the definition of a municipality . (2) The state must explicitly approve the filing of Chapter 9 (and if such approval is subject to a condition, the municipality must have met those conditions). (3) The petitioner must meet the definition of insolvency set out in the Code, which means that he will not be able to meet his obligations when they become due. (4) The petitioner must want a plan to adjust his debt; and (5) the petitioner must demonstrate that he has tried to negotiate in good faith with his creditors.
The biggest question when filing for bankruptcy is whether the city has been declared bankrupt by the state. As I mentioned in my earlier post, Chapter 9 was created with the utmost respect for state sovereignty, as provided for by the 10th Amendment to the US Constitution. Pennsylvania law cleared the filing of Chapter 9 through Law 47. However, the legislature that watched the events in Harrisburg passed law that summer prohibiting the class of cities in Harrisburg from filing for bankruptcy until mid-2012. The House of Representatives also overwhelmingly passed the Takeover Act, which is expected to be passed by the Senate this week and likely to be signed by the governor. The goal of Chapter 9 is to give a church the opportunity to ventilate its creditors and bring everyone involved in a church's finances to the table for negotiation, rather than letting the church work out their problems individually. This should be done with the blessing of the state. Chapter 9 does not aim to protect the community from a hostile takeover. The state is the sovereign, and problems with its political subdivisions are the prerogative of those who participate in the state's political process. I would expect the bankruptcy judge to take the actions of the state very seriously.
Another difficulty for the city's eligibility is the fact that it is unclear who actually represents the city. The filing was approved by four council members who kept their own attorney and is rejected by the mayor's office, which has hired another attorney to challenge the filing. In practice, how is the city supposed to negotiate with creditors during the bankruptcy process when there is such a level of political dysfunction and lack of cooperation between city officials? As I said earlier, Chapter 9 only gives a church room to breathe believers' suit. It does not guarantee a solution to political problems if the participants do not want to compromise. In fact, it doesn't guarantee a solution at all – there have been cases where municipalities applied for Chapter 9 and couldn't find a solution. (This is one way that municipal bankruptcy is different from corporate bankruptcy.)
It may also find it difficult for the city to demonstrate that it negotiated in good faith with creditors, especially given the council has rejected recommendations from state officials and independent advisers to resolve its debt crisis.
For me, a government takeover is clearly the most beneficial solution to the city's problems. The city will potentially avoid years of arguments (and spending millions of dollars in taxpayers' money on legal fees) and the negative stigma associated with bankruptcy. Harrisburg will continue to receive state aid on its way to recovery. All of these benefits are enormous. As Vallejo has shown, the cost of filing for bankruptcy can quickly get out of hand if the parties intend to question every aspect of the process. Given that several parties are already questioning the city's eligibility, I believe that such conflicts are to be expected.
In the meantime, this filing is unlikely to have any impact on trading in the municipal bond market. Harrisburg's financial problems have been known for years and have been the subject of numerous articles in specialist publications. And most muni market professionals are able to see that Harrisburg, like Jefferson County, Alabama, is a highly unique loan. I doubt Harrisburg's financial troubles are at least a decade before the credit bubble and will keep anyone from portraying this event as a harbinger of massive defaults. I have come to the conclusion that few people are actually doing research.