Never before in the US have we experienced a natural disaster of the magnitude of Harvey. The damage is of such a degree that we find it nearly impossible to comprehend. Yet Harvey does not stand alone. Climate events that preceded it give us much-needed insight into how municipalities recover, and whether disasters precipitate credit defaults.
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Like the people devastated by such storms, the affected municipalities are surprisingly resilient. In the case of municipalities, we’ve identified three factors that generally influence resilience: the underlying strength of the local economy, ample cash reserves at both state and local levels to meet immediate demands, and access to federal assistance.
The Life Cycle of a Disaster
At first, natural disasters disrupt economic activity through property damage and a decline in business activity. Soon after the event, however, economic activity typically spikes as rebuilding efforts lead to a surge in purchases and the hiring of temporary workers. As things return to normal, the local economy usually resumes its pre-disaster trajectory.
How do we know this? From analyses of Superstorm Sandy, which struck parts of coastal New Jersey, New York City and Long Island in 2012; the October 2015 North American Storm Complex, which caused 500-year flooding in parts of South Carolina; and the 2016 Louisiana Floods, which submerged Baton Rouge and 21 of its surrounding parishes.
New Orleans, on the other hand, has never properly recovered from Hurricane Katrina, in which the death toll exceeded a staggering 1,800. It’s a notable exception to the pattern described above, and one worth exploring.
New Orleans was heavily dependent on tourism, and it also had exposure to the petrochemical industry. It was already losing many jobs in petrochemicals leading up to 2005, when the storm hit. The flooding and devastation hit tourism hard and exacerbated an existing trend in the petrochemical industry. To make matters worse, many who were marginally attached to the city’s economy found better economic opportunities after being evacuated—mostly to Houston—and never returned. As a result, New Orleans’s population declined, shrinking the city’s tax base.
Yet even New Orleans never defaulted on its debt.
Harvey’s Investment Impact Could Be Modest
A Solid Local Economy. In contrast with New Orleans, Houston—the fourth-largest US city—has a strong and growing economy, driven by its position as the nation’s energy hub and the second-largest US port. It boasts one of the largest medical centers in the world, Texas Medical Center, which includes numerous hospitals, research institutions, medical and nursing schools, and the largest cancer hospital in the world, MD Anderson. And while the city didn’t escape the oil downturn unscathed, its population growth has continued at a healthy clip, with job losses that were tied to the oil and gas industries mitigated by gains in healthcare and a boom in petrochemicals and refining capacity. This year, job growth in the metro area has jumped as drilling activity has picked back up and as gains in other industries have continued. While it will take time to rebuild infrastructure and housing stock, we expect the city’s economy will continue to draw an increasing population, bolstering the tax base.
Ample Cash Reserves. Although federal aid has been a key factor in state and local governments’ strong track record after natural disasters, any delay in receiving those funds is a risk. Because FEMA does not carry a sufficient balance to fund recovery efforts as large as the one that will be required in Houston, Congress will need to make an appropriation. Even after an appropriation is made, the bureaucratic process of allocating funds will cause delays. In the interim, local governments with access to their own liquidity will be best situated to bridge the gap until federal funds are received.
Fortunately, many local governments in Texas are still flush with cash following the energy boom of the last several years. The City of Houston has cash reserves equal to 17% of its annual operating revenues; its combined water and sewer utility has 748 days of cash on hand; Harris County has cash equal to an astonishing 62% of revenues; Harris Country Toll Road Authority has nearly 1,500 days of cash on hand; and the University of Houston has total cash and investments of $1.3 billion. The State of Texas also has ample liquidity, with an available cash balance of 18% of its annual operating revenues; recently completed short-term financing of $5.4 billion further bolsters its liquidity.
Flowing Federal Aid. Local governments will be eligible for aid from FEMA. FEMA reimburses at least 75% of emergency costs for disaster areas and as much as 75% of infrastructure projects to increase resiliency against future climate events. So far, federal aid for designated counties has been approved at that 75% level. We expect additional federal aid will be forthcoming and that insurance payments, state support and private charitable donations will also aid the rebuilding process.
Without question, there are challenges ahead. But the city, county and state are well-positioned as municipal credits to survive the impact of Harvey, without much risk of default.
Smaller Municipal Credits Could Fare Worse
Harvey and storms like it do bring investment risks along with real human catastrophe. As was the case with Katrina, the hardest hit municipalities will be those that had thin liquidity heading into the storm. Governments that were already facing tough credit conditions may see their situations worsen in the storm’s wake. In the case of Harvey, that means smaller, more remote municipalities.
In addition, bonds issued by municipal utility districts to fund roads, plumbing and other infrastructure necessary for new development may find themselves challenged. These bonds carry the risks associated with filling these new developments, because repayment comes from a portion of property taxes eventually received. The problem isn’t a decline in demand for new development in and around Houston. Rather, it’s construction delays that may result from resources getting prioritized for the rebuilding effort.
One solution is for investors to maintain a well-diversified portfolio. And given the increasing frequency of climate events such as Harvey, it’s also important to consider the three factors that affect a credit’s resilience to natural disasters—among other features—when selecting municipal bonds.
As Hurricane Irma, currently rated a Category 5, races toward Florida’s shores, our thoughts are with those bracing for landfall, with the survivors of Harvey, and with those assisting in recovery and rebuilding efforts in southeast Texas.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Article by Daryl Clements, Richard Schwam - Alliance Bernstein
