This Could Shake Muni Bonds to the Core

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Detroit went bankrupt, but so what?

Its own decades-long gross political mismanagement, corruption and incompetence pushed the city over the cliff into bankruptcy.

Why should we care?

It could change the way investors look at muni bonds. And not for the better.

The largest Chapter 9 filing in U.S. history will reverberate well beyond this once- bustling city and its creditors.

What’s most threatening to muni bond investors, and in fact all investors, is whether the city’s general obligation bonds are secured or unsecured issues.

General obligation bonds, backed by a city’s ability to levy taxes to pay interest and principal, are thought to be the safest of all munis.

Detroit is putting this to the test.

Without the ability to levy taxes on account of a dwindling population, and raise revenues sufficient to backstop its general obligation bonds, Detroit raises the crucial question that could affect muni bond investors around the country:

Are general obligation bonds unsecured and what are investors’ rights?

The Supreme Court may be hearing this issue. And muni bond investing may be shaken to its core.

Detroit’s Chapter 9 bankruptcy filing is what could hammer muni bond markets, because it gives the city the ability to possibly purge what everybody thought were its secured muni bond obligations.

And this could set a terrible precedent for investors everywhere as cities, counties and municipalities in financial straits around the country consider this form of bankruptcy.

Detroit’s Sneaky Move

Everyone is mad at Kevyn Orr, the “emergency manager” of Detroit appointed earlier this year under a revamped state law designed to “alleviate the financial problems of Michigan’s municipalities and school districts.”

Creditors claim they were negotiating in good faith with the emergency manager instead of suing and pursuing their collateral rights when Orr blindsided them with the bankruptcy filing.

Detroit’s ability to file for bankruptcy under Chapter 9 has been challenged in Michigan state court by the city’s pension funds, bondholders, and other creditors who claim that in spite of the city being more than $18 billion in debt, it is not insolvent.

Last Wednesday U.S. Bankruptcy Judge Steven Rhodes, the federal judge overseeing Detroit’s Chapter 9 filing from his Chicago bench, halted all lawsuits related to the city’s bankruptcy filing, handing Detroit an early victory and clearing the way for it to proceed with its bankruptcy filing.

Detroit’s pension plans alone have unfunded claims amounting to $9.2 billion, which breaks down into $5.7 billion of unfunded retiree health insurance obligations and $3.5 billion in unfunded pension payment obligations. While the pension fund plan managers speak for the plans, the city’s 23,500 retirees have no formal legal representation.

Is Filing Chapter 9 A New Fad?

The Chapter 9 filing differs from a Chapter 11 bankruptcy filing for a corporation, which allows outside parties to make counter-proposals, or from a Chapter 7 filing that would require a liquidation of the city’s assets.

Also, the Chapter 9 filing makes the city less vulnerable to any other parties controlling its much- needed restructuring.

“In a Chapter 9, which means the city holds more cards than they do in a private sector filing, the judge can’t impose a plan on the city and no one else decides what they can do,” said Michael Sweet, a noted authority on financial restructuring and bankruptcy.

What actually happens under Chapter 9 is:

  • The city gets an automatic stay against commencing or continuing collection efforts and foreclosures by creditors, but it doesn’t prohibit payment of certain obligations if the city can and wants to make payments.
  • It’s business as usual for Detroit. Section 904 of the Code prohibits the bankruptcy court from interfering in the political or government powers of the city or from use and enjoyment of income- producing properties.
  • Section 109(c) of the Code imposes eligibility on entities filing for relief under Chapter 9. Court hearings on a filing entity’s eligibility are at the heart of the actions brought against the city’s Chapter 9 filing in state court. There is no easy or quick answer to the eligibility question.

California’s San Bernardino County, which filed for Chapter 9 protection, took almost a year to be declared eligible. The eligibility status of Stockton, California is still being argued in court more than 16 months after it filed for Chapter 9 protection from its creditors.

Ultimately, the eligibility issue could make its way to the Supreme Court, which may have to decide on Chapter 9 issues if more cities, counties, or municipalities threaten to restructure under court protection.

That’s why the bankruptcy of Detroit will change government financing methods, investor appetite for government bonds, and how other American cities, municipalities and counties face the music from the Great Recession and their borrowing binges.

Reprinted with permission from Money Morning.

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