As people work through the wreckage of Hurricane Harvey, more damage may be on the way, and it won't come in the form of more rain. Investors in municipal bonds may be in for a surprise if they see credit ratings begin to downgrade and the potential for default appear in their portfolios. It's too early to know the extent of the damage and how far the tentacles will reach, but investors should be aware of how these vehicles operate and the possible implications.
The Texas municipal market in general will not feel the effects of Harvey. It is specific municipal utility district bonds and water control and improvement district bonds (MUDs & WCIDs) that are likely at greatest risk. These bonds provide financing for new subdivisions to install roads and various underground utilities. The principal is repaid over time with interest as part of MUD taxes levied against the home and shown on the owner's annual property tax statement.
Homes with outstanding mortgages that are in special flood hazard areas are generally required to carry flood insurance, which helps soften some of the risk. However, homes that are already paid off may not have been carrying insurance when Harvey hit and most families don't have the resources just sitting around to completely rebuild their home. Under extreme circumstances, this could lead to mass abandonment and unfulfilled obligations on property tax payments. This could also lead to rising tax payments required of other homeowners within the district who did not flood or who carried adequate insurance. This gets particularly risky when homes sit with water in them for weeks on end. Several builders have told us that a home is usually not salvageable after it sits flooded for two weeks or more. Remember also that flood insurance reimbursement is capped by FEMA at $250,000. It is quite conceivable that some homeowners could be better off by walking away from their homes rather than rebuilding. When a homeowner "walks" on his mortgage, he loses his equity first. But homeowners are also legally responsible for the damages their lender incurs in selling the property in foreclosure. However, past experience has shown little effort on the part of lenders to pursue such damages. Nevertheless, this could clearly be problematic for some municipal bondholders.
We are surely early in the process, and maybe we're overthinking it. But we get paid to think about how the chess pieces might get moved around. This same evaluation allowed my firm to liquidate all uninsured Puerto Rico bonds at full face value years before the problems due to the country's bankruptcy came to full fruition.
My firm has taken a preliminary look at the flooding statistics to begin evaluating risks. We first looked at which districts have the largest percentage of flooded homes. We were looking for districts with more than half the homes and businesses flooded. We then looked to see if the MUD district bought insurance for its own debt obligation. This is a separate issue from flood insurance. Many MUD districts issue both insured and uninsured debt, so it's tricky to evaluate. Each MUD district had the option of purchasing insurance on its own ability to pay principal and interest when it issued the bonds. That insurance is generally pretty solid, so we're not too concerned about the bond issues that carry insurance. Yet, the interactive map for heavily flooded districts cannot distinguish between insured and uninsured. If you own bonds in these districts, it may be worth a call to us or your own financial advisor so we can check your bond by the CUSIP number. Here is a listing of the districts that fit our "at risk" parameters, and where they are located: