August 24, 2012 / 3:05 PM / 6 years ago

Column: Scranton turns to hedge funds

(The views expressed are the author’s own and not those of Reuters.)

The Times-Tribune of Scranton, Pennsylvania, is reporting that the city government, having recently missed a municipal bond payment, is courting hedge funds for a loan to bolster the city’s rotten finances. A city borrowing from hedge funds is the equivalent of an individual taking out a high-interest payday loan or transacting with a pawnshop. It’s basically the end of the road for a borrower.

Scranton made headlines a few weeks ago, when the mayor reduced the pay of all city employees to minimum wage to be able to meet the payroll. Here is how the Times-Tribune describes the current situation:

“Shunned by conventional banks and the municipal bond market, Scranton City Council is looking toward lenders of last resort — hedge funds — for $18.5 million needed to close a budget gap.

“With a loan default, dubious recovery plan and festering pension crisis staining its credit history, the city is radioactive to most conventional lenders. With few available options, city council plans to court hedge funds.

“For municipalities, borrowing from a hedge fund is so rare that Jeff Esser, executive director of the Chicago-based Government Financial Officers Association, said he’s not aware of any case of it.”

Making a bond payment late, which in most cases constitutes a default unless cured in 30 days, is not the same as an issuer refusing to repay a bond. But it is a red flag to the municipal bond market that a city is not in control of its finances. It’s the sort of event that causes bond investors to move away from the issuer or demand significantly higher borrowing rates.

The extreme fiscal problems of Scranton really should be read as a warning to all municipalities who think that punishing municipal bondholders is a painless way to reduce their liabilities. I’m specifically referring to Stockton, California, which has filed Chapter 9 bankruptcy and intends to haircut bondholders by 83 percent of the value of the debt. In the meantime Stockton has shown no willingness to reduce its liability to the state’s pension system, CalPERS, which under most interpretations of the law is a creditor on par with bondholders. Bondholders have every reason to believe that they are being treated unfairly by Stockton.

The Financial Times has an excellent quote from the spokesman of the California state treasurer about the dangers of stiffing bond investors through the bankruptcy process:

“Bankruptcy leaves a reputational stain that doesn’t go away for a long, long time,” said Tom Dresslar, the spokesman for the California state treasurer. “Worse, it makes it extremely costly, if not impossible, to finance public works and conduct other types of borrowing. No city is going to blithely skip into bankruptcy court to avoid its obligations.”

Scranton has not yet declared municipal bankruptcy but its attempt to borrow from hedge funds means it’s only a few steps away from that. Markets will extract a lot of pain if financial commitments have not been met. Stiffing bondholders could mean no access to the bond market or substantially higher borrowing costs.

Cate Long is the Muniland blogger at Reuters. Follow her on Twitter at @cate_long.

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