By: Mark Glennon*
An interesting debate has arisen on one particular aspect of the proceeding now pending in an Illinois court to invalidate certain state bonds. However you come down on that debate, it illustrates the vast difference in how some of us view Illinois’ fiscal crisis and how courts and markets should be addressing it.
As widely reported, a pending petition seeks authority to proceed with a lawsuit claiming the State of Illinois unconstitutionally issued certain bonds. If successful, it would prevent the state from making any further payments thereon.
The particular debate is about the motives of one of the plaintiffs, Warlander Asset Management. They hope to stop the state from making any further payments on two particular sets of bonds, claiming issuance was unconstitutional. Specifically, $10 billion of general obligation bonds sold in 2003 and $6 billion in 2017 are being challenged. The 2003 bonds were pension obligation bonds, meaning the proceeds were to be used for pension funding. The 2017 bond proceeds were used to pay down some of the state’s backlog of ordinary accounts payable.
Based on published reports, Warlander reportedly will profit in two ways if it wins. First, they hold other Illinois general obligation bonds that would benefit because more cash would be freed up to ensure those other bonds get paid. Second, they hold credit default swaps against the bonds they want to invalidate. That’s basically a bet that they will win in court. If the court ordered the state to stop payments on the challenged bonds, a payment in some unknown amount would go to Warlander, owed by some counterparty, whose identity we don’t know, that took the opposite side of that bet.
It’s those credit default swaps that especially set some people off. Columnist Rich Miller, on his site, criticized my question on Twitter about whether Warlander did anything unusual and my suggestion that motives shouldn’t matter. WCIA reporter Mark Maxwell asked on Twitter, regarding the swaps, “How is this not criminal?”
Yikes! “Hedge fund” and “credit default swaps.” Few terms are more certain to trigger fears of sinister forces at work. And it’s just unseemly for somebody to try to profit from the state’s default. That seems to be enough reasoning for many.
But hold on. It’s not so simple. There’s another side to this.
On the one hand, there’s a risk of market manipulation. I am not suggesting this occurred, but conceivably a fund could make investments like Warlander and file a lawsuit not intending to win but merely to scare the market, then cash out before the lawsuit is fully decided. That’s an entirely fair concern.
On the other hand, if the facts are as simple as I’ve stated, there’s probably nothing unusual here and, unless other bad facts become known, nothing that should concern anybody. In fact, a reasonable case can be made that Warlander’s actions are healthy. Here’s why:
First, Warlander has put its money where its mouth is. While Miller, bond pundits and many others have said the lawsuit is frivolous, Warlander hasn’t only bet on its own legal position but has also hired a very expensive New York law firm to argue its case, White & Case.
Second, through the default swaps, Warlander has also allowed somebody who thinks the case is frivolous to bet accordingly. If that counterparty is right and the case is dismissed (as I, too, expect), Warlander handed them the opportunity to profit from their opinion.
Third, if Warlander’s case really has merit, it is doing a service for other holders of any bonds except those they are challenging. The muni bond business is a sleepy one, dominated by widows, orphans and other individual investors who lack the wherewithal to mount lawsuits defending their interests. Warlander is doing their work for them.
Fourth, in the world of insolvency, it’s routine for investors to take stakes in securities they think are undervalued then go to court to get the enforcement they think is right. That routine often includes attempts to invalidate or subordinate competing claims to free up cash for the position the investor holds, which is what Warlander seeks to do.
Fifth, do we really want courts judging cases on the basis of motive and not the law? Countless cases are filed every day because plaintiffs want bucks. Should courts judge claims differently if the plaintiffs say their motive is to save mankind? Shouldn’t they simply apply the law as best they can?
Sixth, the actual results for the state, if Warlander were to win, would be far different than some critics seem to think. The state would be destroyed and it’s credit slashed, some are saying.
Nonsense. The state would stop payment on the challenged bonds, indeed freeing up that cash to relieve the budget crunch and ensure that other bonds get paid. Taxpayers would be better off. Only the challenged bonds would be impaired, provided the court’s rationale were limited to those bonds. That’s an important proviso. If the court issued a sloppy or overly broad opinion, many other bonds could become suspect. Regardless, however, the credit rating for bonds to be issued in the future would improve, provided the they are made within the legal limits the court would have laid out in its decision. That point came up yesterday in court.
That’s the part that so many don’t seem to get. It’s the creditworthiness of bonds to be issued in the future that counts. Holders of old bonds are of less concern. They should get what the courts say they have a right to get, and nothing more.
Put it all together and you may see why some of us view our fiscal crisis through an entirely different lens. The only ones playing the insolvency game in Illinois the way it’s routinely played are bondholders and pensioners. Bondholders have been doing what all smart creditors do in the face of insolvency – they shore up their position by getting mortgages, liens and other priorities however they can, knocking down the other guys when possible. Pensioners likewise have played it smart by getting laws passed for intercepts and forced funding levels. The entrance of opportunistic, litigious investors was inevitable, but isn’t necessarily bad. It depends what they ultimately do.
And, now, bondholders are duping the public and the state into thinking that full payment of previously issued bonds is essential to the state’s future. That’s because nobody is thinking through what might be in taxpayers’ interests and playing the insolvency game smartly on their behalf.
None of this is to say that Warlander is likely to win. We’ve said from the outset that we’re very skeptical that any Illinois court would side with them, and the state has other defenses not discussed here. Instead, we said the lawsuit should make for a good education, and that’s what we’re getting.
UPDATE 9/19/19: It’s very odd to me that, as became apparent in this debate, so many people are so concerned about the rights of old bondholders instead of protecting future bond issues, other state creditors and taxpayers.
In response to this article, for example, Rich Miller wrote as follows:
That’s some truly wishful thinking. The state can’t just walk away from bond obligations. If the courts eventually do rule against Illinois (which I seriously doubt, but it’s the courts, so one never knows for sure), Illinois will have to make bondholders whole or undoubtedly face serious consequences with the credit ratings agencies. It can’t just walk away from billions in debt – even with a judicial ruling – and not expect a major downgrade into junk status. After all, most of the same institutions which now hold those old bonds are the ones who will be buying new bonds.
No, no, no. The whole point of the suit is to stop payment on just those certain bonds. That’s their specific request for relief. That’s the part that’s wishful thinking because I, like most, think they likely will lose. But if they win Miller apparently thinks the state would somehow pay those bondholders anyway. The state and some in the muni bond world have been saying something similar, to the effect of “we will take care of you anyway even if the state loses.”
No, the state would be barred from doing that, and the bar would apply only to the challenged bonds — if the plaintiffs won. Other bonds and future bonds would benefit, provided, as I said, that the ruling was limited to the challenged bonds. It would be as if a court said you no longer had to make payments on your mortgage because of some claim you had against that lender. Would your credit rating be impaired? No, of course not.
There’s something fundamental about insolvencies that lots of people don’t understand. Restoring solvency requires reducing old debts. Nobody should be obsessing about old bond issues.
*Mark Glennon is founder of Wirepoints.