Municipal bonds: Muni market braced for fallout from Detroit
Potential bankruptcy would be largest in market’s history; Observers divided on contagion risk
The picture is grim: 78,000 abandoned buildings, 66,000 vacant lots, 40% of streetlights non-functional, a 63% decline in population from its peak, a rate of violent crime five times the national average and an unemployment rate that has almost tripled since 2000. It’s hard to believe that these statistics refer to one of the largest cities in the US, but Detroit’s situation has gone from bad to worse as it teeters on the brink of bankruptcy. According to CreditSights, as things stand the city will run out of cash before the end of this year.
Bankruptcy lawyer Kevyn Orr was made emergency manager for Detroit in March, tasked with overseeing the recession-ravaged city’s finances. Filing for Chapter 9 bankruptcy has always been on the table, but Orr has made clear from the offset that he hopes to avoid it.
To this end, he met with creditors on June 14 to introduce a proposal for rehabilitating Detroit’s finances, during which he also announced a moratorium on unsecured debt payments. A much-anticipated meeting with pension officials on June 20 proposed cutting off pension payments to city employees with less than 10 years’ service.
Question of contagion
The question weighing on the market’s mind is the contagion that a Chapter 9 filing by Detroit might trigger.
"While many localities are experiencing similar stresses to Detroit, it is to a much lesser magnitude," Morgan Stanley’s head muni strategist, Michael Zezas, tells Euromoney. "The degree of debt burden and operating leverage in Detroit is an outlier both in terms of absolute level and its growth over the past decade."
However, analysts at CreditSights caution that if Detroit files for bankruptcy, it might prompt more municipalities to consider such a move, largely because of the attention such a filing would attract. "The reality here is that cities and municipalities cannot be run effectively without access to bond markets, and a muni that defaults and impairs its creditors will have little market access for a sustained period of time," the analysts point out. "That in itself is the major deterrent to more widespread use of this part of the bankruptcy code."
What could make Chapter 9 desirable for municipalities is if it were to facilitate a back-door exit from the underfunding crisis in public pensions. The Pew Center on the States has found that in key US cities the cumulative underfunding of pensions exceeds $217 billion.
Conflict of law
The question of whether or not pension obligations can be impaired finds itself caught in a conflict between federal and state law.
Among the states that do allow for some sort of municipal bankruptcy filing, various restrictions can be found. And the question as to whether or not pension obligations can be treated as senior to other unsecured debt is a crucial one.
This is where Detroit’s potential filing – alongside the current filing for Stockton, California, and possibly also San Bernardino, California – becomes important. Currently, Orr is arguing that Michigan law allows pension obligations to be considered on a level playing field, while Stockton is claiming that California law protects pension obligations.
If a precedent is set that pension obligations can be impaired, it’s possible that filings will increase – depending on whether the precedent would apply at a national level.
This is particularly relevant for those institutions that will be footing the bill if it comes to bankruptcy: the bond insurers.
In the case of Detroit, these include National Public Finance Guarantee Corp (a unit of MBIA); Assured Guaranty, which holds $329 million of general obligation debt, $1 billion of sewer revenue bonds and $804 million of water revenue bonds; and Syncora Capital Assurance, which holds $329 million-worth of outstanding pension debt.
The outcome might be painful: Orr’s initial proposal amounted to less than 10 cents on the dollar for some of the unsecured debt, including pension liabilities.
Zezas reckons that any filing will not create broader market stress. This is because of the small size of any filing relative to the market at large, their idiosyncratic nature and advance warnings from ratings downgrades and price deterioration.
"Distressed cases like these can negatively impact investor psychology when market liquidity is weak, incrementally increasing market liquidity risks," he admits, however. "Thus, there is some concern that given the recent sell-off in the market and string of outflows from muni funds, the Detroit news could mean the market will take longer to recover from its recent negative performance."
The outcome for Detroit is uncertain – Orr has reiterated that the document provided to creditors was a "proposal" but that given the situation, there is not much room for negotiation.