Chapter 9 – words that are going to be on a lot of lips for some time to come. Last week, Detroit filed for bankruptcy protection under Chapter 9 of the United States Bankruptcy Code, and the Motor City became the largest municipal bankruptcy in history – definitely a dubious distinction. The financial press has focused most attention on the immediate impact to investors in Detroit’s debt, but in our opinion, there will be effects felt by municipal bond investors more broadly, as well as by Detroit’s citizens and workers.
A good deal of ink was spilled last week about how some municipal bond market participants were “concerned” about how some of the city’s general-obligation bonds (those are municipal bonds backed by the full faith and credit of a municipality) were classified as “unsecured” by the Detroit’s emergency manager. This shouldn’t have been surprising since general obligations usually are not secured by dedicated revenues or the projects they finance. So while general obligation bonds (or GO bonds, as they’re often known) may be considered by many to be the “safest” of municipal investments because of the strength of the pledge– they are most certainly not “secured” debt. Under Chapter 9, it is clear that, unless proven otherwise, general obligation debt is subject to an automatic stay of payment. Bonds that are backed by specific or dedicated revenue streams (for example, by sewer charges) don’t fall under this stay.
What’s important to remember is that filing for Chapter 9 protection is really only the beginning of the process. It’s now all up to the bankruptcy judge (the Honorable Steven Rhodes) and the litigation process. The various groups of creditors (and their lawyers) will now begin the process of negotiating settlements. The outcome is uncertain. What we do know is that the city must show throughout the process that they’re dealing in good faith, and that they must have an approved recovery plan in place before they can emerge from bankruptcy. It’s the uncertainty of the end result that’s the worst for the muni market.
Regardless of the outcome of Detroit’s bankruptcy process, muni investors will still continue to lend to municipalities. However, they will require stronger bond covenants (those formal agreements that protect bondholder interests), as well as higher yields as payment for any perceived additional risks. This likely means that borrowing costs will go up for municipalities.
The ones who will probably lose the most in the Detroit bankruptcy deal will be the employees and citizens of the Motor City. Of the city’s nearly $11.5 billion in unsecured debt, about $3 billion of that is due to Detroit’s unfunded pension obligations. Another $5.7 billion is from outstanding retiree health benefits. The pension benefits are ostensibly protected by federal law – federal protection’s good, but no guarantee. Those retiree health benefits, however, are not afforded the same protection. This is bad news for those who depend on those health benefits – Wayne Country (where Detroit lies) already ranks dead last in a survey of the healthiness of Michigan’s 82 counties.
Detroit’s fiscal situation is the result of poor governance, a declining tax base, and a lack of economic innovation that supports its dependence on a single industry. Detroit’s bankruptcy filing is the beginning of a new era for the Motor City. Hopefully, it will be the clarion call to other municipalities to get their houses in order so they and their citizens don’t have to suffer the same fate.
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