Municipal bonds are enjoying a renaissance.
|Forbes magazine article on Florida CDDs
Nervous investors craving tax-free income and the safety normally associated with state and local governments are gobbling up bonds. Municipal bond funds enjoyed $47 billion in net inflows in the first eight months of 2009. But not all municipals are created equal. A quiet epidemic of municipal bond defaults is already under way, another victim of the housing bust fed by eager builders and Wall Street. The defaults are hitting what's known as community development districts. Developers, using so-called dirt bonds, join with investment bankers and consultants to create these districts as quasi-governmental entities. They assess homeowners for the costs of roads, sewers, electric lines, clubhouses and tennis courts. These "municipalities" enjoy tax-free funding the same way cities, states, schools and hospitals do. They're supposed to be self-sustaining, but when homes don't get built, the whole scheme collapses. The biggest concentration is in Florida. At least 109 issues of Florida community development bonds, worth $2.8 billion when issued from 2004 through 2008, have defaulted. So says Distressed Debt Securities, a newsletter published in Miami Lakes by FORBES contributor Richard Lehmann. Some have stopped paying interest, and others have been paying interest and principal from reserve accounts, which aren't supposed to be tapped when projects are completed and homeowner fees kick in. Many investors have yet to feel the brunt of the damage, but the day of reckoning is coming. Standing behind the IOUs: tracts of land with pipes ending in empty, weed-strewn lots. The Tern Bay Golf Community consists of 1,780 acres a few miles south of Punta Gorda, Fla. in Charlotte County. In September 2005 this self-proclaimed municipality issued $58 million in tax-exempt bonds yielding from 5% to 5.4%. Home builder Lennar Corp. planned to build a luxurious golf, tennis and spa country club community with 1,800 houses, townhomes and condos to be priced as high as $450,000. Also planned were a 250-room hotel, eight tennis courts and 140,000 square feet of commercial space. The proceeds of the bonds were to go toward roads, water and sewer pipes and other amenities, including wetland preservation and a golf course. Two years ago Lennar stopped building homes, and today all that is left are partially built roads, some two dozen homes and 18 of 27 holes of a golf course designed by Chip Powell. The developer's telephone number has been disconnected. The bond trustee began dipping into debt service reserves in 2008. The trustee was unable to scare up the cash for a May 2009 coupon payment. The Tern Bay bonds are trading at 35 cents on the dollar.
Multiply this scenario by 100 and you get a picture of recently issued community development bonds in Florida. "I have visited these sites, and they are like infrastructure graveyards," says Andrew Sanford, analyst at Naples workout firm itg Holdings. He cites the hundreds of water and sewer pipes sticking up from another ill-fated project, a $47 million community called Six Mile Creek, 30 miles south of Jacksonville. The cast of characters feeding off the boom in community development bonds includes Pulte Homes and its recently acquired Centex operation (see story, "A Home for Every Buyer"), Beazer Homes and D.R. Horton. Banc of America Securities underwrote at least 28 troubled Florida community development issues. (By "troubled" we mean either not making interest payments or paying bondholders from reserve funds rather than from tax assessments.) Prager, Sealy & Co., a San Francisco firm specializing in municipal bonds, underwrote 70 issues totaling $2 billion in face value that are currently in default. Tampa real estate consulting firm Rizzetta & Co. is listed as district manager and financial advisor for over 100 troubled issues. "In my 24 years doing this I have never seen the market this bad," says William Rizzetta. The Tern Bay bond issue was mostly bought up by Oppenheimer mutual funds, but other buyers of community dev bonds included funds managed by Goldman Sachs, Alliance Bernstein and Nuveen. Oppenheimer's Rochester National Municipals fund and its amt Free Municipals between them own $1.4 billion of troubled Florida subdivision bonds. In its July 31, 2008 annual report Oppenheimer's Rochester National fund assured its shareholders that all was well. "We are seeing little evidence of credit quality fundamentally changing," the fund declared. Six months later the report, which disclosed that 18.6% of Rochester's $5.9 billion of munis were dirt bonds, reiterated management's confidence: "Default rates on municipal bonds in general continue to be extremely low relative to default rates on corporate fixed income investments."
Rochester National, which carries a 4.75% load and is sold mostly by brokers, has an enticing 9.5% yield. The open-end fund reports a total return (dividends plus gain in net asset value) of 40% since January, making it the number one fund in its Morningstar category. Instead of unloading its sick community development issues, Oppenheimer has been doubling down, buying up more in the open market. One issue that it has been adding to is South Fork East Community Development District. In March it bought bonds from Goldman Sachs (itself another buyer of busted CDDs) at 65 cents on the dollar. They now trade at 51 cents. Says Rochester portfolio manager Scott Cottier: "I can't speak to individual trades. If I let out my secrets, I wouldn't be the number one fund manager in my group." There is some method in this seeming madness. Owners of defaulted development bonds can effectively seize unfinished lots from the landowner if he doesn't make assessment payments. (Homeowners who have moved in are not at risk, provided they keep up with assessments representing their pro rata share of costs for building sewers, roads and utilities.) So, Oppenheimer could do well for its fund investors. But maybe it should change the fund's name to Rochester National Muni & Subdivision Spec Fund.Dirt Bond Disasters
Below are some of the biggest defaults among Florida's community development districts. As the tracts of land and bonds languish, speculators are circling. CDD LOCATION AMOUNT ($MIL) ISSUE DATE UNDERWRITER SHINGLE CREEK Osceola $159 8/2006 Prager, Sealy ARBORWOOD Fort Myers 131 6/2005 Prager, Sealy DURBIN CROSSING St. Johns 90 10/2005 Prager, Sealy LANDMARK AT DORAL Miami 72 10/2006 Banc of America SARASOTA NATIONAL Sarasota 61 3/2007 Prager, Sealy Source: http://www.floridacddreport.com