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December 15, 2013 7:52 am
Detroit’s bankruptcy has long roiled the US’s municipal bond market, but December’s federal court decision declaring the city eligible for bankruptcy protection seems to leave investors in a stronger position than before.
The $18.5bn restructuring, the largest municipal bankruptcy in US history, has chilled the market for state and municipal fundraising since the city’s initial filing in the middle of the year, coinciding with $43.9bn in municipal bond fund outflows this year through October, according to data from Morningstar, the fund tracker.
Detroit’s preliminary restructuring plan overturns bankruptcy precedent by proposing to treat its general-obligation bondholders and public pension funds as unsecured creditors, exposing them to “haircuts”, or significant underpayment. In the ruling certifying Detroit’s eligibility for Chapter 9 protection, Judge Steven Rhodes accepted that the pension assets are not entitled to special protection and did not challenge the city’s treatment of the general-obligation debt.
The new vulnerability for general-obligation bonds, long considered among the safest forms of municipal debt, will force municipal bond investors to reassess their risks, according to Elizabeth Foos, a municipal credit analyst at Morningstar.
“With this ruling that they can move forward with the bankruptcy and there will be some adjustment, there has been a really big idea shift for the market as a whole, that some of these stressed municipalities might not be able to live up to the full potential of their pledge,” Ms Foos says.
At the same time, the judge’s finding that Detroit may legally reduce public pension benefits unlocks a deep reservoir of assets for creditors in the event of bankruptcies, bolstering issuers’ long-term credit quality, says Matt Fabian, a managing director at Municipal Market Advisors.
“Bondholders are not at a disadvantage versus pensions, and that is the big takeaway,” Mr Fabian says. “Pension assets provide more cash to fuel a restructuring.”
A related ruling in the US’s second-biggest municipal bankruptcy, in Alabama’s Jefferson County, similarly eased bondholders’ bankruptcy burden by holding that future ratepayers and future taxpayers could be forced to contribute to restructurings.
“These two cases in a row have taken some potential pressure off bondholders to pay for a restructuring themselves,” Mr Fabian says.
The potential reduction of pension assets also empowers states and municipalities in their negotiations with employees, probably accelerating long and contentious attempts to shore up public finances and consequently buttressing the related bonds.
Fitch Ratings, in a report on the Detroit ruling, acknowledges the possibility that pension asset impairment could encourage struggling municipalities to file for bankruptcy. However, it seems likelier that efforts to resolve fiscal impasses will be redoubled.
“While the judge’s ruling may lead other financially strained local governments to try to obtain relief through bankruptcy, it may instead provide incentive for employees and retirees to negotiate changes to pension obligations rather than risk the loss of control that accompanies a bankruptcy,” the report reads.
Mr Fabian points to legislation passed in Illinois, nearly simultaneously with this month’s Detroit bankruptcy ruling, to eliminate that state’s $100bn pension shortfall.
“It gives political leaders more cover to go after pensions, and we definitely saw this in Illinois,” he says. “There were members in the legislature talking specifically about how, after the ruling in Detroit, this is an easier target for them than otherwise.”
It may take years for such consequences to ripple through the markets, however, as inevitable court challenges play out. The more immediate market effect will be continued turmoil for exposed investments, and the cloud probably will not lift until a final court resolution, says Wilson White, a municipal bond expert witness in court cases and former analyst and trader.
“There are a whole bunch of Michigan [municipal bond] funds that have been hit rather hard already, even the ones that don’t have any Detroit [debt exposure] in them,” Mr White says. “My guess is that they will continue to be suspect until we get some sort of decision on how they are going to treat general-obligation bonds.”
Fund investors seem oddly indifferent to the fact that most of the Detroit bonds are covered by insurers that have promised to honour their coverage, Mr White notes.
Indeed, the municipal bond market has a tendency to overreact to bankruptcies, owing to its large contingent of individual investors, according to Municipal Market Advisors’ Mr Fabian.
“When bankruptcies happen, they have an outsize impact on investor confidence because the lion’s share of investors are individuals, not professional investors,” he says.
“There is not a lot of detailed subject knowledge on what municipal credit is and how bankruptcies work.”
Judge Rhodes’ ruling allows the city to proceed with negotiations with creditors on the restructuring plan. Kevyn Orr, Detroit’s emergency manager, has said he expects the city to unveil the plan in early January.
The American Federation of State, County and Municipal Employees has appealed the ruling, and the judge is scheduled to hear arguments on the challenge today.
Ultimately, the US Supreme Court will probably have to settle the status of public pension assets in municipal bankruptcies, says Mr Fabian.
“There is widespread expectation that the pension issue will go to the Supreme Court, and I think that the odds of getting that element of it overturned are pretty low,” he says. “The rulings have made a pretty good case for having them supported.”
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