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Legal Structure of Deals Places Municipalities


JULY 20, 2011 Investments Muddy Dirt-Bond Holders Legal Structure of Deals Places Municipalities' Special Tax Districts Ahead of Other Creditors; 'We Don't Have a Vote' By ROBBIE WHELAN

During the boom years, as big housing developments mushroomed throughout the country, developers worked with local governments to raise billions of dollars for roads, sewers and sidewalks through a municipal-debt security known as "dirt bonds."

In the Fiddler's Creek development in Naples, Fla., only about 1,700 of the planned 6,000 homes were built.

Now, as those bonds get tested by the worst housing downturn since the Great Depression, dirt-bond investors are getting a few nasty surprises. Take a case playing out in U.S. Bankruptcy Court in Florida involving an ill-fated 6,000-home project in Naples, Fla., known as Fiddler's Creek. The investors who bought some $100 million in dirt bonds backed by the project have been hamstrung because of the unusual structure of the dirt-bond deals.

Other dirt-bond investors throughout the country are paying attention. Some observers estimate that about $35 billion of dirt bonds were issued, mainly concentrated in about 10 states, during the real-estate boom.? "We don't have a vote, even though we have the most money on the table," said Daniel Carter, of ITG Holdings LLC, a Florida investment firm that runs a $40 million distressed-debt fund that invested in Fiddler's Creek dirt bonds.

ITG Holdings bought about $23 million of the Fiddler's Creek debt at a steep discount, starting in 2009, joining several other large investors, including Oppenheimer & Co., MuniMae LLC and AllianceBernstein. They are among the project's most senior creditors.

"All we're being told is, sit on your hands, and we'll pay you in a couple of years," Mr. Carter said.

A representative for Oppenheimer declined to comment on the details of its investment. A spokesman for AllianceBernstein said the company holds $16 million of the Fiddler's Creek dirt bonds and expects no material financial impact to its portfolios.

If a precedent is set in the Fiddler's Creek case that is bad for bondholders, it could hurt investors throughout the country who have snapped up discounted dirt bonds backed by ailing projects. Longer term, some said the viability of dirt bonds for use in future projects may be undermined if debt investors get dragged through the mud in the current round of bankruptcies and restructurings.

"Will a Wall Street firm buy bonds on a new issue, for a new development in Florida down the line?" said Bill Eshenbaugh, a Tampa, Fla., land broker.

A research firm said about 170 of Florida's approximately 300 special districts have defaulted on dirt bonds, meaning they have either missed a debt-service payment or drawn on reserve funds to pay creditors.

The story of some dirt-bond investors in some ways mirrors what happened to buyers of many of the new debt products that Wall Street rolled out in the boom years. When the markets were sizzling, they all performed nicely. But in the downturn many investors have been forced to write down the value of these investments or sell them in distressed situations.

Dirt bonds also have faced scrutiny this year from the Internal Revenue Service and the Securities and Exchange Commission over their tax-exempt status and whether or not they were valued properly by investors, which are mostly high-yield mutual funds, but no enforcement actions have been announced.

In typical dirt-bond deals, quasigovernmental districts are established that collect taxes from the new homeowners and use those proceeds to pay off bondholders. California housing developers for decades have been financing infrastructure with dirt bonds, which are typically tax free and unrated by the large credit-ratings firms.

During the boom years, they also became popular in other states, including Florida, Texas, Colorado and Louisiana.

Bond defaults began accelerating as the global economy tanked. An estimated more than $5 billion in dirt bonds are in default, according to Matt Fabian, managing director at research firm Municipal Market Advisors. In California, about 4.3% of the $6 billion in bonds issued by municipalities in California from 2005 to 2009 are in default, according to investment bank Stone & Youngberg LLC.

In Florida, the outlook is much bleaker: The default rate is 27%, according to Stone & Youngberg. Interactive Data Corp., a research firm, said about 170 of the state's approximately 300 special districts have defaulted on dirt bonds, meaning they have either missed a debt-service payment or drawn on reserve funds to pay creditors.

Typically, in distressed real-estate situations, the most senior creditors have an enormous amount of power. But some bondholders said they don't have as much clout when dirt-bond deals go into bankruptcy because technically the special tax districts are the developer's creditors, and they don't always listen to bondholders.

Take the case of Fiddler's Creek, where about only 1,700 of the planned 6,000 homes were built. Facing foreclosure last February, the legal entity that controls the project filed for Chapter 11 bankruptcy protection. Naples, Fla., condo builder Aubrey Ferrao, the developer, has filed a reorganization plan that would allow him to hang onto the project and pay off creditors over time, partly through the proceeds from future home sales. The dirt-bond holders, some of whom won't be paid for at least two years under the plan, have opposed it and favor bringing in a new developer. Last year, they supported a plan by Starwood Land Ventures LLC, a division of private-equity fund Starwood Capital Group, to pay off creditors immediately and finish developing the project. But the special taxing districts involved in Fiddler's Creek have voted to support the developer over the objections of the bondholders. A bankruptcy judge, who has refused to terminate Mr. Ferrao's exclusivity agreement on the project, is expected to rule on Mr. Ferrao's reorganization plan in the next few weeks.

A lawyer for Mr. Ferrao, Paul J. Battista, of Genovese Joblove & Battista PA, said the developer's plan to eventually repay bondholders in full was a favorable outcome for them and said the situation is due to the legal structure of the bonds.

Phil Brougham, chairman of one of Fiddler's Creek's special taxing districts, said the board members voted for Mr. Ferrao's plan over the objections of bondholders because there was no other immediate option. The "Board of Supervisors is not merely a conduit for bondholders' interests. We must and will consider all factors, including those of the residents of Fiddler's Creek who elected us," he said.

Bondholders, however, still have doubts. "The problem is that nobody is willing to bite the bullet, write these things off, sell them, and find somebody else to continue the project," said Mr. Carter, the dirt-bond investor. "Most developers are living in a fantasy land where they think everything is somehow going to be paid off."