By Wayne Lusvardi

In 1901, Frank Norris wrote a novel, “The Octopus: A Story of California.” The book became famous for its description of the monopolistic Southern and Pacific Railroad that dominated California a century ago.

Fast-forward to 2012 and the bankrupt city of San Bernardino, where the California Public Employees Retirement Fund is trying to become a new Octopus.

CalPERS asserts in bankruptcy court that it is a sovereign government agency that has police powers, the power of eminent domain and the power of taxation.  Police powers are the right of governments to enforce laws and regulations to protect public safety, health and welfare.  Eminent domain is the power to seize property for public use, while paying just compensation to the owners. The power of taxation means the constitutionally granted power of government to use coercive powers to impose and collect taxes.

CalPERS contends it is “an arm of the state” that is immune from the jurisdiction of the bankruptcy court. Thus, it asserts that the bankruptcy court cannot halt CalPERS from exerting its supreme right to the general funds of the city to meet its public-pension fund payments.  When the City of San Bernardino filed for bankruptcy, it stopped making pension payments to CalPERS. But CalPERS believes that it has police powers to protect government pensions as a new entitlement above even the duty of local government to protect its citizens from crime, fires and emergencies.

The Wall Street Journal reported: “If CalPERS has police power and sovereign rights, it could also seize private property or assess a special pension fee on taxpayers” — no matter that Proposition 13 requires a vote for any increase in taxes.  The Wall Street Journal cites the Fifth Circuit Court of Appeals, which ruled in 1940 that there is no preferential treatment for the state as a creditor. CalPERS asserts it can seize assets and leave the cash-strapped city of San Bernardino without money for essential public services such as police and fire protection.

CalPERS and underwater mortgage eminent domain

CalPERS often throws its weight around by using what is called “the CalPERS effect” to influence investment markets. It may not have monopoly power, but it has market power. This was described in a 2009 paper by Wilshire Associates Inc.:

“The California Public Employees’ Retirement System … has been a leading activist in the modern corporate governance movement since its beginnings in the mid-1980s. Over time, CalPERS gradually shifted its focus from more technical issues related to corporate control to fundamental issues of long-term corporate performance.”

The County of San Bernardino has recently retained Mortgage Resolution Partners to explore using eminent domain to condemn “underwater mortgages” as a way to bail out to several cash-strapped cities in the county. If over-mortgaged properties can be purged from lenders’ books, then CalPERS hopes the housing market will recover and tax coffers will refill and bail out the city and county pension funds.

Legal experts are doubtful that eminent domain can be used to take mortgages from lenders at less than full value, then pass the expected savings on to property owners with over-mortgaged properties.  Nonetheless, CalPERS believes it can trump even the courts, despite the checks and balances of the three branches of government: executive, legislative and judicial.

Executive agency

In reality, CalPERS is an agency under the executive branch of California government, with an unelected board that is not directly accountable to the public. Its board of directors is partly elected by CalPERS retirees. Other board members are appointed by the governor and the Legislature.  Also on the board are the state treasurer, controller, director of the Department of Personnel Administration and a delegate from the state Personnel Board.

There is no representation on its board to assure taxation with proportional representation or representation by taxpayer watchdog organizations.

What success CalPERS’ claims to sovereignty may have with a cash-strapped state court system that has a vested interest in any bailout of the state pension fund remains to be seen.

The Wall Street Journal calls CalPERS’ assertion of unlimited powers a “ploy.” Real octopus animals squirt an “ink” that serves to keep themselves hidden or as a decoy from predators. Expect some of the same from CalPERS.

By Wayne Lusvardi

What a ripoff. San Bernardino County wants to use eminent domain to let a private mortgage lender cherry pick “underwater” mortgages without paying damages to the lenders. Doing so supposedly would stimulate the resale market for homes.

The county’s policy would socialize the losses and privatize the gains of the underwater mortgages.  This would be done by acquiring underwater mortgages by eminent domain and re-selling them in the mortgage market for a discount.  Essentially, all taxpayers in the county pay would pay off the difference between the full acquisition price and the re-sell price through a municipal bond. The private mortgage company working for the county would make a fee from each sale.

Phil Angelides Previously Headed Mortgage Company

Mortgage Resolution Partners is the mortgage company selected by San Bernardino County to resell underwater home mortgages.  This company was recently headed by Democrat Phil Angelides, the former state treasurer lost a bid for governor in 2006. Angelides also was the chairman of the national Financial Crisis Inquiry Commission that mainly blamed banks, not government, for the 2007-09 economic crisis.

Angelides was also the co-developer of a residential subdivision called Laguna West in Elk Grove outside of Sacramento. Trulia.com reports there are 24 foreclosures and pre-foreclosures for re-sale in Laguna West today.

I’m no lawyer. But as an eminent domain appraiser for over 20 years, I would find the county’s proposal to condemn only “underwater mortgages” where the homeowner is still making payments as a likely violation of the legal rules for appraising just compensation in California.

The Entire Loan Portfolio Needs to be Valued

The mortgages to be acquired by eminent domain would have to be valued by appraisers for their “Fair Market Value.”  What would be appraised would not be the physical, tangible real estate of each home.  What would be appraised would be the intangible value of the underwater mortgages. An underwater mortgage is where the unpaid portion of the loan on the property exceeds the current open market value of the home.

The loans would have to be acquired for their remaining loan balance in order to make the lenders whole. Mortgage brokers or experts, not real estate appraisers, would subsequently be asked to value the mortgages for re-sale.  The mortgages would be valued not on the basis of the “comparable sales price” of actual homes, but the discount rate paid by mortgage brokers in the mortgage market.

According to securities expert and commercial real estate appraiser Steve Body of Eagle Rock, the discount is likely to be in the 50 to 60 percent range. This discount would have to be paid for by all county property taxpayers through a bond. Only the intangible loan value of the mortgages would be taken, not the physical real estate of each home with an underwater mortgage.

To comply with accepted “before and after” valuation methodology under eminent domain law in California, a condemning agency must retain an independent appraiser to value the “larger parcel” of the property to be taken.

For example, an agency may only want to acquire the farmer’s field. This is what is called a “part taking.”  But what has to be valued is the entire farm, including farm buildings, water wells, water rights, crops in place, chattels, any vertically integrated “ongoing” businesses, etc.

The same rule would likely apply in San Bernardino’s situation.  The “underwater” mortgages are part of a larger portfolio of loans.  Whole loan portfolios are valued in the private sector by discounting the cash flow from loan payments to their present value.  Loan portfolios likely have a mix of loans that are “not performing” (loan payments are in arrears) and loans that are “performing” (owner is current on payments).

As I understand it, what San Bernardino wants to do is cherry pick the best performing loans and leave the lenders with the loans that have been given Notices of Default and are in the process of foreclosure.  In short, they want to cherry pick the top of competitive lenders mortgage portfolios — all in the name of the “public interest.”

As many legal experts have stated, there is likely no doubt that the county has the right to define what is in the “public interest.”  The county can likely establish that it can take mortgages and allow a private lender to make a profit on them by reselling them.  This would be like taking someone’s home and allowing a private developer to upzone the land and make a profit on the higher use of the property for redevelopment.

But the county would have to re-write the Code of Civil Procedure and case law in California if it thinks it just wants to value those mortgages that are underwater and not the entire loan portfolio of the lenders.  This would be a gargantuan task because the county would have to appraise the entire loan portfolio of every lender, not just the 5,000 underwater mortgages it plans to take. We’re talking about countless thousands of loans valued as of a specific date. And the holders of the loans would have to be tracked down and identified, which may be an impossible task.

Severance Damages Also Need to Be Valued

Even if the entire loan portfolio could be valued, any “severance damages” to the remainder of the loans would also have to be appraised. The intent of just compensation is to “make the property owner whole,” not only for the property taken but also for any damages.

To use a farm example again, any damages to the remainder of farmland would have to also be appraised in addition to the value of the land taken.

As commenter Michael Baldridge appropriately wrote in the Wall Street Journal online:

“They want to seize the note. The note is worth what the note says. It’s the underlying collateral that is worth less. If they want to ‘seize’ the mortgage, they’ll have to pay the owner market value of the note, which is whatever is left on the mortgage. The underlying collateral is irrelevant. Using Mortgage Resolution Partner’s logic, the government could seize the note on a new car the second it drove off the lot, and the car is now worth 10% less. Then sell the car back to the owner for a 10% lower price (and lower payments), taking all the future payments while sticking the car dealer with the loss.” 

If the county cherry picked the best loans, then it would have to pay any damages to the remainder of the lender’s loan portfolio.

According to Body, if the county’s action results in leaving a greater proportion of non-performing mortgages in the lender’s loan portfolio, this would likely alter the portfolio to a status of “junk” (B-minus or lower credit rating).  The overall loan-to-value ratio, the percentage of under-performing loans, and the default rate would also have to be considered.

Uneconomic Remnant

If the remainder of a lender’s loan portfolio became unmarketable or worthless due to the county’s actions, the remainder of the portfolio could be deemed an “uneconomic remnant.” 

The term uneconomic remnant means: “a parcel of real property in which the owner is left with an interest after the partial acquisition of the owner’s property”; and which the government agency “has determined has little or no value or utility to the owner.”

In such an event — where the portfolio remainder has no value — the county could be legally compelled to acquire the whole portfolio.

Inverse Condemnation?

There are many other flaws in the notion to use eminent domain to acquire underwater mortgages to re-stimulate the housing market in San Bernardino.  Another of them is that such an effort is likely to impair the market value of properties for sale with no mortgages on them — where the homes are owned “free and clear” of any mortgage.  Bailing out the figurative water from “underwater” mortgages would flood the market with too much of a supply of homes, resulting in a decline in value.  Fire-sale prices would likely result as the pent up demand to sell previously over-mortgaged homes would flood the market and depress prices further.  The value of non-mortgaged homes would likely be dragged down along with the value of previously over-mortgaged homes.

This could give rise to what is called an “inverse condemnation” or “regulatory taking” lawsuit, where the property owner sues the government for a loss in value.

Fatal Flaw in County Proposal

Having to pay “severance damages” could be a fatal flaw that would likely make San Bernardino County’s proposal to acquire “underwater mortgages” economically infeasible and politically unacceptable.

If damages also had to be paid, the private loan reseller for the county would be unlikely to be able to make a profit.  Another option would be to have all property taxpayers in the county additionally pay for any damages to the remainder of the lender’s loan portfolio, as well as the underwater mortgages. Taxpayers might be outraged to have to pay damages as well as having to pay for what constitutes a gift to homeowners with underwater mortgages.

And if any homeowners file an additional lawsuit for “inverse condemnation” damages for impairing the market value and marketability of their homes, this could result in the county having to pay double damages to both the mortgage lender and third-party homeowners who couldn’t sell their homes.

San Bernardino County would be wise to ask the office of Attorney General Kamala Harris to issue a preliminary ruling of whether such a use of eminent domain is legal. And if so, the attorney general’s office should indicate whether the county would have to comply with the State Eminent Domain Code and the State Rule of Appraising Partial Acquisitions of property.

Advice also should be asked of eminent domain legal experts such as Gideon Kanner.

With San Bernardino city just declaring bankruptcy, and even faces a criminal probe, San Bernardino county shouldn’t compound the area’s economic problems.

By Dave Roberts

In California, there are three certainties: death, taxes and the re-election of Sen. Dianne Feinstein. In 2006, she shellacked Dick Mountjoy by 24 points. In 2000, she trounced Tom Campbell by 19 points.

The grande doyenne of California Democrats has been in the Senate for 20 years and will turn 79 next month. She’s up for re-election and, short of serious illness or death, it’s likely she’ll still be in the Senate when she’s 85 and 91 if she wants.

So it’s not exactly a shock that prominent Republican congressmen like Darrell Issa, David Dreier and Dan Lungren have chosen to sit this one out. That has left the field of challengers to 14 Republicans, five Democrats and four minor party candidates — all of whom have zero to little electoral experience or name recognition. In a crowded field of nobodies, getting their party’s endorsement provides an advantage in winning the second spot in the new top-two primary system and its ticket to the general election in November.

The top two system was instituted by Proposition 14 in 2010.  Under it, the top two winners of June 5 primary will face off in November. No other candidates for U.S. Senate will be on the ballot. Assuming Feinstein is the top vote getter, that means just one other person will face her on the ballot, likely a Republican. Third party candidates will be shut out.

The function of the political parties has been reduced to official endorsements.

In March, the California Republican Party endorsed more than 100 candidates for a variety of offices, including for the U.S. Senate. “As the party prepares to be a vigorous contender in California’s first top two primary, we seek to promote the most competitive candidates in the field this primary season,” said Party Chairman Tom Del Beccaro in the press release announcing the endorsed candidates.

Elizabeth Emken won the GOP nod as the most competitive candidate to face Feinstein. However, the Danville autism advocate’s only electoral experience is finishing fourth out of four candidates in the 2010 Republican primary in Democratic Rep. Jerry McNerney’s district. Emken received 16.7 percent of the vote. In a district that winds through four counties, Emken didn’t even win her own Contra Costa County, finishing second, just 270 votes ahead of the third-place finisher.

Such a poor showing might be understandable if a candidate were running a token campaign, placing her name in contention for publicity’s sake but doing little campaigning. But Emken ran full out in 2010, spending $456,404 — more than $200,000 of it from her own pocket. That equates to $40 per vote. At that rate Emken would need to raise more than $200 million to best the more than 5 million votes Feinstein gathered in 2006. As of March 31, Emken had raised just more than $300,000. Feinstein’s campaign treasury had more than $7 million on hand.

‘Most competitive candidate’?

So what makes Emken the “most competitive candidate” in the eyes of state GOP officials? One factor is that her senior communications advisor is Mark Standriff, who in January left his position after two years as communications director for the California Republican Party. “Mark has been a tireless member of our senior staff and dedicated himself to improving the CRP’s communications efforts by helping me reach more voters in more corners of our state,” California GOP Chairman Tom Del Beccaro said in a statement upon Standriff’s departure.

In an email interview, I asked Jennifer Kerns, who replaced Standriff as the California GOP communications director, whether it was helpful for Emken in getting the endorsement to have Standriff on her staff. Kerns did not address the question, saying simply, “He was free to consult with any campaign once he departed the CRP.”

Said Standriff in a phone interview, “The only thing it helped is that I am a professional communications director and somebody who has worked on campaigns for years and was able to put together a comprehensive package. I contacted no board members. Frankly, I wish I had that kind of power.”

Standriff said Emken’s experience two years ago in one district’s partisan Republican primary is not relevant to today’s statewide, top-two primary.

“You have to take everything that happened pre-Prop. 14 and throw it out the window,” he said. “All of these other candidates seem to think this is still a partisan primary, and it’s not. It’s open to everybody. That’s why you will see 24 different names on the ballot. So the Republican Party said, ‘Who do we think is the most electable, who has the best chance to get through June 5th and take on Dianne Feinstein?’ Everybody had the chance to present their financial package and show how much money they will be able to raise and present their positions. She’s the only one who has ever gone to Washington D.C. and stood up and said, ‘Enough is enough.’ And that’s a big thing.”

Kerns said Emken’s experience as an autism lobbyist was a major factor in her endorsement.

That was echoed by Jeff Corless, Emken’s campaign manager. He said, “She, unlike the rest of the candidates, not only has business experience and experience helping those truly in need, but also understands the legislative process from day one when she goes back to the Senate, because of her experience in advocacy for autism.”

Endorsement process

Perhaps it’s a case of sour grapes, but several Republican candidates who did not get the endorsement or chose not to participate in the endorsement process, with its $500 buy-in for consideration, have harsh words for the way things went down.

“I believe the Republican Party has committed fraud in its endorsement of Elizabeth Emken by doing so without providing an opportunity for all candidates to be heard,” said Dennis Jackson, an aerospace general manager from Rancho Cucamonga. “Due to the open primary, there were no party debates or any type of debate that was televised.

“I have been a voting Republican since 1968 and would destroy Elizabeth Emken in a debate or in a comparison of backgrounds that would best serve this nation. However, I was never contacted by the Republican Party about any meeting to review my candidacy, policies or background. In making the endorsement in such a manner, the party is playing king-maker and insulting the intelligence of the voters as well as attempting to silence the voice of the candidates that they never even took the time to meet. The party politics seem more in line with the Bolsheviks than the Founding Fathers.”

Disappointment

Also ticked off in Rancho Cucamonga is MBA student Dirk Allen Konopik, who said, “The California Republican Party’s leadership, to include Chairman Tom Del Beccaro, has been a constant disappointment; from their continuous failure to support viable candidates, to the unethical decision to charge U.S. Senate candidates $500 just to consider them for the CRP endorsement. I chose not to pay. It is now very clear to me, after ramping up our U.S. Senate campaign since January 2011, why the Democratic Party controls California. It’s because the CRP is inefficient, ineffective and corrupt. In my opinion, I would rather have the California Federation of Republican Women lead the CRP.”

Also critical is Orly Taitz, the Laguna Niguel attorney who has become known for challenging President Obama’s citizenship.

“The nomination process was a complete fraud, and a number of the candidates are considering suing the corrupt 24 board members,” said Taitz. “Two candidates … talked to the Chair of the Board Tom Del Beccarro and another board member, who told them that the meeting and discussion was just a formality, the decision was already made. So, the Board has collected several thousand dollars from candidates under false pretenses. They used this money to have a nice weekend at a nice hotel and announced the predetermined decision. They defrauded the candidates and the voters.”

Another unhappy candidate is Rick Williams, a Los Angeles attorney.

“I believe the California Republican Party acted improperly by engaging in a process to endorse one candidate in the United States Senate race from a field of 14 good Republicans running for the seat,” he said. “I declined to participate in their disgraceful process. I realized it was a sham and wanted nothing to do with it. The decision as to which candidate should represent the Republican Party against Dianne Feinstein is for voters to make — not a tiny group of insider political operatives at the state party who were trying to tilt the playing field.”

Nachum Shifren, a Santa Monica rabbi, believes the state party snub of his campaign may be an asset: “My chances are helped, since the GOP mafia and good ol’ boys club will never nominate or support a true conservative that threatens the status quo,” he said. “I am having success in precisely distinguishing myself from the other RINO candidates and those that simply won’t take on the difficult issues.”

Kerns dismissed the criticism of the endorsement process, saying, “We provided every candidate the opportunity to be heard, in writing, by phone, and in person. This was to ensure the fairest process.”

If party officials had decided to base their endorsement on the candidate with the best electoral experience, they would have chosen Greg Conlon, a Burlingame CPA.

“I probably have the best chance because I ran statewide in 2002 for state treasurer and received over one million votes in the primary and three million votes in the general election against Phil Angelides, an incumbent,” said Conlon. “Therefore, even though it was 10 years ago, some will remember the name and vote for me now.”

The GOP endorsement may ultimately be irrelevant to the outcome of this year’s election. It’s likely that whoever wins the primary from among the 14 largely unknown and inexperienced Republican candidates will become a sacrificial lamb led to the Feinstein slaughter in November.

By WAYNE LUSVARDI

California’s convoluted finances, ironically, could preclude a split-roll property tax increase. Such a tax increase would alter Proposition 13 to keep property taxes on homes the same (allowing increases of just 2 percent a year), but permit unlimited tax increases on commercial property.

Involved are what are called “conduit bonds,” which are “marketed by public entities such as states, counties and cities on behalf of a private entity.” The “conduit bonds” could help a private company finance a new stadium or low-income housing.

Conduit bonds were involved in the recent controversy over the Sacramento Kings basketball team potentially moving to Anaheim.

Conduit bonds — to refine the definition — are “corporate bonds disguised as municipal bonds,” said Michael Lissack in an article in the Los Angeles Times.

Conduit bonds typically provide tax-exempt interest rate financing for large private profit-making corporations such as Apple or GM, or for a non-profit hospital chain, for economic development purposes. That would include such things as building a manufacturing plant, a non-profit hospital or affordable multi-family housing.

Conduit bonds should not be confused with municipal general obligation bonds that finance public works projects.  Conduit bonds are revenue bonds that are not backed by the taxpayers if the bonds are defaulted on. Conduit bonds must serve a public purpose such as the creation of jobs in an economically depressed area.

By overusing and possibly abusing industrial development “conduit bonds,” California has probably shot itself in the foot on the split-level tax issue. Commercial property prices are already down 40 percent in value from their peak, and a wave of conduit bond defaults will depress the market even further.  The chickens are just starting to come home to roost when it comes to industrial development conduit bonds in California.

Damage Control

As a result, California state legislators are scrambling for political damage control to the news of a wave of expected defaults of industrial development conduit bonds that would adversely affect holders of such bonds.

An advisory committee of the U.S. Congress today, June 15, is releasing a report to the Internal Revenue Service on alleged exorbitant bond issuance fees, conflicts of interest and questionable tax exempt status of conduit bonds issued by private bond firms on behalf of state economic development authorities. But the California legislators’ reaction to the expected congressional report thus far has been like convening a den of thieving foxes to talk about how to avoid henhouses.

To provide apparent political cover from the congressional report, California Sen. Gloria Negrete McLeod, D-Chino, is concurrently presiding over the California Senate Local Government Committee to conduct hearings regarding the transparency of bond fees and other problems of issuing conduit bonds.  In 2007, McLeod sponsored a failed bill, SB 188, which would have allowed the Statewide Communities Development Authority (CSCDA) to finance out-of-state bonds.

There are five major statewide development agencies that authorize the issuance of industrial development conduit bonds: the California Statewide Communities Development Authority, the Municipal Finance Authority, the California Health Facilities Financing Authority, the League of California Cities and the California Association of Counties.  The last two reportedly issue the most conduit bonds in the state, mostly through a private issuer BP Capital Resources, Ltd.   According to The Bond Buyer online, some of these bonding authorities have gotten the reputation for politicization of the bond issuance process.

As reported in The Bond Buyer online, one of the more notable cases was when a worker’s union at Sutter Health, a nonprofit hospital chain, influenced members of the California Health Facilities Financing Authority (CHFFA), headed by then-State Treasurer Phil Angelides, to hold off on a planned bond issue. The bond issue went through in 2007 after Angelides left state office and assumed the job of treasurer of the CHFFA.

A new book by Gretchen Morgenson of the New York Times, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, explains much of what has happened. The villain of the Bank Meltdown of 2008 was a cartel including: the Democratic Party, community organizing groups such as ACORN and La Raza and politicians such as Barney Frank, Nancy Pelosi, Henry Cisneros and ex-California Treasurer Phil Angelides.  Pelosi reportedly got a job and layoff protection for a son. Phil Angelides got subprime loans to fill up new California housing developments with unqualified buyers.

Angelides is also named as one of the central players in the national financial meltdown in 2008 in the book, “The Great American Bank Robbery: The Unauthorized Report About What Really Caused the Great Recession” by Paul Sperry, former Washington Bureau Chief for Investors Business Daily.

Angelides is a disinformation specialist who has chaired his own self-serving National Commission and issued a so-called blue ribbon panel report on the causes of the national financial meltdown, which was funded by a Democratic-controlled Congress.  Again, the fox convenes a self-serving committee to write a report on how subprime loans resulted in the foreclosure of proverbial henhouses.

California Treasurer Bill Lockyer

Not to be outdone is California State Treasurer Bill Lockyer. Reported Bond Buyer online:

“We have long believed that CSCDA (California Statewide Communities Development Authority) is a private business being run out of a government agency,” Lockyer spokesman Tom Dresslar said recently. “A thorough scrubbing of their books and their operations is long overdue.”

But this seems duplicitous when the Treasurer’s Office uses several conduit bond issuers, including the politicized California Health Facilities Financing Authority.  While Lockyer decries the lack of transparency and incestuous relationships of state bonding authorities, it would seem to be his job to mandate standards for bond issuers’ fees and relationships.

According to the Bond Buyer, the California Statewide Communities Development Authority and joint power bond authorities did not require bond issuers to file audited financial statements until the Legislature mandated it in 2009.  But the state now has a minimum disclosure format that doesn’t require the actual disclosure of bond issuer fees charged.

Los Angeles County has recently pulled out of using the California Statewide Communities Development Authority in order to bring bond issuance operations in house. But Gov. Jerry Brown’s efforts to close down local redevelopment agencies statewide will have no apparent impact on the state’s industrial development bonding authorities. Local redevelopment agencies may be disbanded, but the state, the California League of Cities, and the California Association of Counties have no intention of winding down their own statewide industrial development bonding authorities.

Private bond issuers are not the cause of bond defaults anyway, even if they charge exorbitant fees or issue questionable tax exempt bonds.  It is the economic development bonding authorities, whether local or state, which declare areas “blighted,” authorize the taking of private property for the use of private retailers, industrialists and developers, and authorize the issuance of tax-exempt development bonds for use by profit-making entities. Finding a fall guy in private bond issuers that exact exorbitant fees is only symbolic reform.

Defaults Coming

Legislators are in the process of enacting reforms before an expected wave of defaults of conduit bonds hits the markets. California is the largest conduit bond issuer and conduit bonds have a 70 percent default rate, even though they only reflect 20 percent of the entire municipal bond market.  Thus, 14 percent of all municipal bonds can be expected to default (20 percent X 70 percent).

But the credit markets are anticipating a 7 percent annual municipal bond default rate, and that 30 percent of such bonds will have defaulted through 2014.  This forecast is based on the MCDX Index of 50 municipal bond credit default swaps — or insurance for short. The MCDX 5-year index interest rate spread is up 100 percent since November 2009 to reflect the risk of defaults.

Two researchers at Harvard University have issued a report, “Why Fears About Municipal Credit Are Overblown,” which documents that the impacts of conduit bond defaults will be localized to each specific project, and that the bond market has already absorbed the losses in future higher bond interest and insurance rates.

In other words, due to self-correcting measures in the bond markets, there is no apparent need to take over the business of private issuers of such bonds other than to control fees. The market has already absorbed any default losses in advance and will be passing the cost of defaults on to new beneficiaries of revenue bonds.

This is not good news, however, to holders of defaulted conduit bonds that may lose their proverbial shirts. As Mark Twain once wrote: “You can put all your eggs in one basket, but watch that basket.”

Any conduit bond defaults will not affect taxpayers, but may force the sale of any commercial or industrial real estate serving as collateral for such bonds. However, bondholders probably won’t want the burden of managing facilities financed with conduit bonds.