Nov. 14 (Bloomberg) -- A coffin maker in West Virginia and a Colorado massage school have something in common: They were financed by unrated U.S. municipal debt that defaulted and lost investors money.
Even as tax-exempt bonds with speculative grades are logging their best returns since 2009, unrated borrowings have proven to be a trap. Bonds, including those for the Boulder College of Massage Therapy, sold through an issuer such as a local government or development agency and lacking ratings, account for almost half of new local-debt defaults this year, Municipal Market Advisors data show.
What’s more, if Congress seeks to cut the U.S. deficit by curbing tax-free issuance, such debt is a likely target, said Michael Bailey, who drafted a report for the Internal Revenue Service that criticized the lack of oversight in bond deals for private companies through local agencies known as conduits.
“The industry is going to have to defend why the exemption for conduit borrowing makes sense,” Bailey, a partner with Foley & Lardner LLP in Chicago, said in a phone interview.
The debate over access to tax-exempt financing may intensify as President Barack Obama and lawmakers focus on the so-called fiscal cliff, $607 billion in spending cuts and tax boosts that will start in January unless Congress acts. Yields in the $3.7 trillion muni market set 45-year lows last week as traders bet taxes will rise as part of trimming the deficit.
Obama has proposed capping the muni tax break for top earners. Matt Posner, an MMA analyst in Washington, said it would be better to limit tax-exempt issuance to securities such as general-obligations and essential-service revenue bonds.
Those issuers are among the safest in the local-debt market, where defaults are on pace to be the lowest in at least three years, according to data from Concord, Massachusetts-based MMA, a research firm specializing in munis. Unrated conduit bonds tell a different story, racking up 29 of this year’s 67 first-time muni failures, MMA data show.
Nonrated conduit bonds to default this year include a Colorado hockey rink, the massage school, two privately run county jails in Texas and a soup factory in Louisiana.
Buyers of such debt include high-yield funds and insurers, as well as some individual investors, said Matt Fabian, managing director of MMA and Richard Lehmann, publisher of the Distressed Debt Securities Newsletter in Miami Lakes, Florida.
Investors have been more willing to stomach extra risk this year as yields sank. High-yield munis have earned 16.6 percent in 2012, the best since 2009, Standard & Poor’s data show.
Bonds for the Boulder school, which MMA’s Fabian added to his default list last month, are held by Colorado BondShares. Fred Kelly, who manages the $830 million mutual fund in Denver, didn’t return calls.
Boulder County issued the bonds in September 2006 for the 37-year-old school, which used the money to buy its campus. The securities, due in 2031, traded in October 2006 at a yield of 5.93 percent, at a time when benchmark debt yielded about 4.3 percent.
School President Dirk McCuistion, who took his post this year, said in an interview that he could turn the business around if he can work out a deal with Colorado BondShares to restructure the obligations.
While larger issuers like statewide development agencies often require ratings, unrated bonds from smaller conduits are the riskiest.
The issue for Aiken Continental LLC in West Virginia’s Raleigh County is an example. The county sold a combined $2.96 million in unrated bonds in October 2006 and in 2007 to help Charles Aiken, a casket salesman and consultant, buy Continental Casket, a family-owned manufacturer, according to the U.S. Securities and Exchange Commission.
In October 2006, Aiken was under indictment in Georgia on federal fraud and conspiracy charges related to a scheme to defraud payroll companies through false billings.
Continental sold to funeral homes in the Southeast. It had 15 employees and was producing about 2,500 caskets a year when Aiken bought it, former owner Doff Huffman, 67, said in a phone interview.
Aiken, 39, turned to bonds because he couldn’t get a loan and lacked financial resources, according to both him and SEC documents. Raleigh County issued the tax-exempt bonds with no government backing.
Nine days after the bond closing, Aiken reached a plea deal in the Georgia case, according to SEC documents. He pleaded guilty to misprision, or knowing of the fraud and not reporting it, the documents said.
After six months of prison and house arrest, he returned to West Virginia by 2008 to run his company. Aiken says the venture failed because he expanded too quickly. Huffman said Aiken didn’t know the business and drove off employees who did. Aiken stopped paying on the debt in 2009, bond documents show.
“Everyone should have looked more closely,” Huffman said. “The county knows that now, too.”
County Commissioners Pat Reed, John Aliff and David Tolliver and county attorney Carl Roop didn’t return calls. Court-appointed receiver David Abrams said in an e-mail that the factory buildings have been sold, that he has no information about the status of bondholders and that the county has no responsibility for payment on the bonds.
The SEC sued Aiken in December 2011, accusing him of fraud in the offer and sale of municipal bonds. The suit in U.S. District Court in Beckley, West Virginia, was based on his failure to disclose his indictment and the origin of a loan he used to make his financial contribution to the deal. The loan was from a firm partly owned by his lawyer.
Aiken said he followed his lawyer’s disclosure advice. The attorney, Chalmer Detling II, in Marietta, Georgia, said he couldn’t comment because his communications with Aiken remain private.
Aiken represented himself against the SEC and stopped responding to court communications in May. U.S. District Judge Irene Berger entered a default judgment against him in July, ordering him to pay $4.7 million in compensation and fines.
Florence Harmon, an SEC spokeswoman in Washington, declined to comment on what spurred the agency’s case.
A bank trustee is in the process of liquidating the casket company, as bondholders wait to see how much they lost. Aiken says he has no way to pay the judgment.
“I guess they think I’m lying when I say I have no money,” he said in an interview in Atlanta last month.
The case is SEC v. Charles A. Aiken and Aiken Continental LLC, 5:11-cv-1018, U.S. District Court, Southern District of West Virginia (Beckley)
The case is U.S. v. Niblack et al, 4:05-cr-00331, U.S. District Court, Southern District of Georgia (Savannah).
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