THE MONEY PIT: The Real Reason Harrisburg Pennsylvania Went Bankrupt

I have received a number of emails from people (mostly those familiar with my thesis that, generally speaking, state and local governments are experiencing policy crises, and not debt crises) requesting that I explain Harrisburg, Pennsylvania’s Chapter 9 bankruptcy filing. 

I do not think anyone would dispute that Harrisburg is involved in a bona fide debt crisis.  Harrisburg’s situation, however, is not typical of government borrowers in the municipal bond market.  Of course, the only way to make this point clear is to go into detail about how Harrisburg landed itself in financial distress.  So let me tell you a story.  (My fascination with project finance is endless, so you might want to get comfortable.)

The vast majority of Harrisburg’s bonded indebtedness stems from improvements made to the city’s trash incinerator plant.  According to the Patriot-News, Harrisburg’s local newspaper (a lot of the information in this post is derived from their excellent coverage), the incinerator plant has been a major source of financial trouble for the city since it opened in the early 1970s, yet city officials have demonstrated an inexplicable devotion to throwing money at the project.  (This story is, in fact, one long lesson in not allowing sunk costs to influence decision-making.  Not everyone pays attention in economics, apparently.) 

The plant was originally constructed to burn garbage and produce steam – some of which was piped to the nearby Bethlehem Steel Corporation plant, but most of which was just vented into the air.  In 1985, the city built a turbine at the plant to begin generating electricity from the steam that would otherwise be lost.  The plant was profitable until 1990, when Dauphin County (of which Harrisburg is the county seat) adopted a solid waste disposal plan that rerouted garbage produced outside of Harrisburg to various other landfills, which was less expensive than paying the incinerator plant to take the waste.  The plant lost millions of dollars of business virtually overnight.

In 1993, the city sold the incinerator to the Harrisburg Authority, the city’s public utility, for $40.7 million.  (Officials suggest that this sale was specifically encouraged by the bond rating agencies, but I find this difficult to believe.  Rating agency methodologies typically assume that governments will financially support enterprises that serve an essential government function.)  In 1995, Dauphin County was legally forced to send waste back to the plant, but the plant was already lost for other reasons.  The plant, which was more or less at the end of its useful life, was continually breaking down and was in violation of federal Clean Air Act regulations.  Some improvements were made to bring the plant back into compliance, but it was ultimately closed in 2003.  At this point, the incinerator was tied to $104 million of outstanding debt.  Officials should have just demolished the plant and eaten the expenses, but they decided to bankrupt the city instead.

City officials decided that they would gut and rebuild the plant – a problem that they approached with a truly Pennsylvanian penchant for gambling.  Rather than go with one of the large corporations that handle projects like this (like Waste Management or Covanta Energy, which is now running the incinerator), the city decided to go with Barlow Projects, a small start-up incinerator technology company based in Fort Collins, Colorado, and founded by engineer / ordained minister James Barlow. 

There were two reasons city officials preferred Barlow over his competition.  The first reason was his technology.  Barlow had patented an incinerator design that used high-pressure air to circulate burning garbage, not mechanical grates.  Jammed grates were one of the main reasons the Harrisburg plant frequently failed.

The second reason, naturally, was price.  Barlow’s final estimate for the construction work was $77 million.  Other estimates were at least $40 million higher, and one estimate was $178 million.  The difference in price should have been a red flag for city officials, but they were mostly concerned with the amount they could finance.  The authority would need to pay off the existing debt associated with the incinerator and the new debt associated with the retrofit.  At Barlow’s competitors’ prices, the plant would not produce enough revenue to be self-supporting – something the city would have to demonstrate to be able to sell the bonds to finance the project.  (Keep in mind that the city ended up guaranteeing the bonds, as did the county and Assured Guaranty. The city also received substantial reimbursements from the bond issues.)

All but one member of the Harrisburg City Council were fine rubberstamping the project.  Linda Thompson, the current mayor, was on the council and voted for the project (because God told her to), but she became an early critic of the project when it became publicly apparent it was a boondoggle. The council member that voted against the project was not reelected. 

One of the largest sources of risk in project finance is construction risk.  Construction risk refers to the risk that unforeseen problems would occur in the process of constructing a project that would throw the project off schedule or radically alter the project’s scope.  When bonds are primarily backed by the revenues generated by a facility, it is important that the project actually be producing revenues by the time the first payment is due.  (Projects such as this usually involve capitalised interest, where the borrower borrows more money than is actually needed to construct the project in order to be able to make interest payments during the construction phase.  The city issued $125 million of bonds in 2003 to pay for the project.)  I mention construction risk because the Harrisburg project was several times larger than any project Barlow had previously undertaken.  When asked whether his technology could be applied to a much larger project, Barlow did what most entrepreneurs about to land a major contract would do: he said he would make it work.  Barlow also stipulated that his company be the project manager, giving him complete control over the project’s execution.

Insurance companies were less swayed by Barlow’s ambitions than city officials, however.  Barlow could not obtain a performance bond for the project.  A performance bond (not to be confused with the revenue bonds used to finance the project) is a type of insurance given to a customer (in this case, the City of Harrisburg) by a contractor (in this case, Barlow), usually covering the full contract price, ensuring that the customer would be reimbursed in the event that the contractor does not finish the project as stipulated in the contract.  This should have been the second red flag for city officials, but they decided to work around the performance bond issue.  The fact that the city would not demand a performance bond for a multimillion-dollar project absolutely defies standard public procurement procedures, but remember that officials were quite committed to getting the project done as cheaply as possible.

Officials demanded two alternative forms of security from Barlow, both of which they willingly forfeited during the course of construction.  The city did not advance the typical 50% of the amount required for equipment purchases for the project and retained 20% of all other money due to Barlow.  The only traditional form of security for the project was the performance bond produced by one of Barlow’s subcontractors, which was nullified when that subcontractor walked off the project.

After the construction began, basically anything that could go wrong did go wrong, and a relatively inexperienced contractor was left trying to pick up the pieces.  A year after the contract was finalised, Barlow discovered that the company that was supposed to build the steel boilers for the plant (the most significant element of the project) had not even begun their work and had failed to hedge against a spike in the price of steel.  Barlow asked the city to increase the contract price.  Without the boilers, there wasn’t anything that could be done at the construction site.  This set the project back six months.  Once construction could resume, making up for lost time became very expensive.  Barlow asked the city for more money.  They released the money they had been withholding, thus giving the city no security for Barlow’s performance.

By the end of 2005, city officials were becoming desperate – the bond payments were coming due and the city had budgeted revenues from the plant – so they tried to locate a contractor that could replace Barlow.  No one would touch the project.  But city officials were not out of idiotic maneuvers just yet.  They took out a short-term loan from CIT against the rights to the plant’s technology.  (Hey, it was 2005.)  The idea behind that loan was that the city would make payments to CIT, which were supposed to be passed on to Barlow.  The city, of course, found itself on the hook for making these payments.  Since CIT now owned the plant’s technology, the company had the right to shut down the plant in the event of non-payment.    

Barlow “finished” the project by April 2006, four months late.  After the plant opened, the city discovered that there were major problems with the plant’s ash-handling systems and that the third boiler was not entirely finished.  Without the third boiler, the plant could not generate enough revenue to make the required debt service payments and offset operating expenses.  (As far as I can tell, it would cost the city another $50 million for the plant to be fully functional.)  The plant’s deficits became a burden to the city, which cut staff, increased property taxes, and increased waste bills.  Even still, the city was unable to make its promised payments on the bonds and the county and Assured have had to make payments instead.  (The city has avoided defaulting on its general obligation bonds, however, due to the up-front payment it received on a parking lease.)  Last I read, the city had paid for a forensic audit of the authority’s finances in order to have a better understanding of how the project’s costs escalated so rapidly.  They have also sued Barlow.  Both of these actions are moot, of course, because Barlow filed for bankruptcy.

As massive as the city’s financial woes were at the conclusion of this project, the city council turned down a number of opportunities to fix the city’s problems.  In 2008, the city council voted down a $215 million-dollar proposed lease with a developer for its parking system.  That lease would have paid down a substantial portion of the incinerator debt.  The council has also turned down a number of other proposals to sell assets.

In October 2010, the city entered Pennsylvania’s Act 47 program for distressed municipalities.  As part of that program, the state crafted a 422-page recovery plan for the city [pdf].  That plan made some specific recommendations to reform the city’s operations and to improve its financial situation.  Unsurprisingly, the plan also suggested that the city sell assets, among other things.  The city council has rejected the state’s recovery plan three times this year.  The same four council members (out of seven total) that voted down the recovery plan also voted for the city to file for bankruptcy. 

(I have had a number of people ask me why the city should have to sell assets in order to pay the “speculators” who invested in or guaranteed the city’s debt.  If this is your reaction to the city’s bankruptcy filing, I would submit to you that city officials – and by extension, the people who elected them – have also been true speculators in this project all along.  City officials bet that they could get some nobody to construct a large project for less than far more sophisticated corporations, demanded no insurance in the event of his failure, and put their taxing authority behind that bet.  Were they born yesterday?  Was this the first project the city had ever undertaken?  No, they were greedy and reckless, plain and simple.  If the city had chosen a more honest and traditional arrangement, the project would not have been feasible on paper, and the bonds could never have been sold.  I’m not sure where the moral outrage toward the county or the bond insurance company comes from, but it is not based on anything approximating sound logic.)

The city received a similarly exhaustive and nuanced report from the law firm Cravath, Swaine & Moore.  The firm conducted its investigation and produced the report on a pro bono basis.  By the time the report was presented, state lawmakers had already introduced legislation to take over Harrisburg’s operations.  The city council hired Mark D. Schwartz somewhere around the time the takeover legislation was introduced.  Seeing as how Schwartz has been unequivocal in supporting the city’s bankruptcy filing (which he stands to make a lot of money off of, not to mention gain some level of notoriety), I imagine he had some influence over the council’s decision to vote down the recovery plan.

(Although Harrisburg appears to have an above-average concentration of assclowns per square mile, Schwartz is an interesting character in his own right.  According to his Wikipedia page – which is surely organic – his dream in life is to be an actor.  And he does seem to love a stage.  He and the city controller, who is running for mayor, have done rounds of interviews since the filing, which seems beyond unprofessional to me.  Apparently, Schwartz even invited himself over the local paper for an interview.)

I would be very surprised if Harrisburg’s bankruptcy case was not ultimately thrown out of court.    As I explained in my December post, Default and Bankruptcy in the Municipal Bond Market (part two), a petitioner has to meet several criteria to be eligible for Chapter 9: (1) the petitioner has to meet the definition of a municipality; (2) the state must specifically authorise Chapter 9 filings (and if such authorization is conditional, the municipality must have satisfied those conditions); (3) the petitioner must meet the definition of insolvency provided in the code, which means it cannot meet its obligations as they come due; (4) the petitioner must desire to have a plan to adjust its debts, and (5) the petitioner must demonstrate that it has attempted to negotiate with its creditors in good faith.

The biggest question hanging over the bankruptcy filing is whether the city has been authorised by the state to file for bankruptcy.  As I mentioned in the earlier post, Chapter 9 was crafted with the utmost respect for state sovereignty as provided by the 10th Amendment of the US Constitution.  Pennsylvania law authorised Chapter 9 filings through Act 47.  However, the legislature, watching events unfolding in Harrisburg, passed legislation this summer prohibiting the class of cities encompassing Harrisburg from filing for bankruptcy until mid-2012.  The House of Representatives has also overwhelmingly passed the takeover legislation, which is expected to be taken up by the Senate this week, and will likely be signed by the governor.  The objective of Chapter 9 is to provide a municipality with breathing room from creditors and the opportunity to bring all stakeholders in a municipality’s finances to the table to negotiate, rather than having the municipality work out its issues on an individual basis.  This is supposed to occur with the state’s blessing.  The objective of Chapter 9 is not to offer a municipality protection from a hostile state takeover.  The state is the sovereign and issues with its political subdivisions are the prerogative of those participating in the state’s political process.  I would expect the bankruptcy judge to take the state’s actions very seriously.

Further complicating the city’s eligibility is the fact that it is unclear who is even representing the city.  The filing was approved by four council members, who have retained their own attorney, and is opposed by the mayor’s office, which has retained a different attorney to contest the filing.  As a practical matter, if there is this level of political dysfunction and lack of cooperation among the people representing the city, how is the city supposed to negotiate with creditors during the bankruptcy process?  As I have said, all Chapter 9 does is give a municipality breathing room from creditor lawsuits.  It does not guarantee a resolution to political problems if the participants are unwilling to compromise.  In fact, it does not guarantee a resolution at all – there have been instances where municipalities have filed for Chapter 9 and not reached any resolution.  (This is one way in which municipal bankruptcy is different than corporate bankruptcies.)

The city may also have a difficult time demonstrating that it has negotiated with creditors in good faith, especially considering that the council has shrugged off the recommendations of state officials and independent consultants as to how it may resolve its debt crisis.

To me, a state takeover is clearly the most advantageous solution to the city’s problems.  The city will avoid potentially years of bickering (and spending millions of taxpayer dollars on legal fees) and the negative stigma associated with bankruptcy.  Harrisburg will also still be receiving state aid along the path to recovery.  All of these benefits are tremendous.  As Vallejo has demonstrated, the cost of filing for bankruptcy can quickly spiral out of control if parties are intent on challenging every aspect of the proceedings.  Given that several parties are already challenging the city’s eligibility, I think such conflicts are to be expected.

In the meantime, this filing is unlikely to have any effect on trading in the municipal bond market.  Harrisburg’s financial problems have been known for years and have been the subject of numerous articles in industry publications.  And most muni market professionals are able to recognise that Harrisburg, like Jefferson County, Alabama, is a highly unique credit.  I doubt the fact that Harrisburg’s financial problems predate the credit bubble by at least a decade will stop anyone from portraying this event as a harbinger of massive defaults, however.  I have come to accept that few people do actual research anymore.

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