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Detroit: the exception or the rule?

If Detroit files for bankruptcy it will be the largest in municipal bond market history, but analysts are divided as to how serious the impact on the market will be.

Around 78,000 abandoned buildings, 66,000 vacant lots, 40% of streetlights non-functional, a 63% decline in population from its peak, a violent crime rate five times the national average, and an unemployment rate that has almost tripled since 2000. It’s hard to believe this is the condition of 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.

In March, Michigan governor Rick Snyder appointed bankruptcy lawyer Kevyn Orr as emergency manager for Detroit, tasking him with the challenge of overseeing the recession-ravaged city’s finances. Filing for Chapter 9 bankruptcy has always been on the table, but Orr made clear from the offset he hoped to avoid it.

To this end, he met with creditors on Friday to introduce a proposal for rehabilitating Detroit’s finances, during which he also announced a moratorium on unsecured debt payments.

How creditors will respond is uncertain, and Orr still puts the odds of filing for bankruptcy at 50/50. Further meetings will ensue, with an important one occurring on Thursday with union and pension officials.

Yet while Detroit’s situation might be getting bleaker, the question still remains as to whether Chapter 9 would prove to be contagious if the city files – and what the implications will be for the muni market.

When asked whether a potential bankruptcy in Detroit might trigger filings in other heavily indebted cities, Morgan Stanley’s head muni strategist Michael Zezas said he didn’t think this would be the case.

“While many localities are experiencing similar stresses to Detroit, it is to a much lesser magnitude,” he says. “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 offer a different view, cautioning that if Detroit files, this could spark more municipalities to consider following suit, largely because of the attention such a filing would attract.

Nevertheless, bankruptcy isn’t exactly a get-out-of-jail-free card for indebted municipalities. As S&P states in a report on municipal bankruptcy, a filing would “carry a stigma” and “is far from a simple ‘reset’ button”. It’s also lengthy and legal fees can potentially be costly.

“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 CreditSights 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 is if it allows municipalities a back-door exit from the underfunding crisis in public pensions. The Pew Centre on the States has found that in key US cities – defined as the most populous in each state plus any others above 500,000 – the cumulative underfunding of pensions exceeds $217 billion.

However, 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 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, CA and possibly also San Bernardino, CA – becomes hugely important. 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 would increase – depending on whether the precedent would apply at a national level.

This is particularly relevant for those institutions who will be footing the bill if it comes to bankruptcy, namely the bond insurers.

In the case of Detroit, several insurers who are on the hook have said they will fully reimburse bondholders according to their contracts, including National Public Finance Guarantee Corporation (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 Inc, which holds $329 million-worth of outstanding pension debt.

The insurers will in turn have to stomach any haircuts: Orr’s initial proposal amounted to less than 10 cents on the dollar for some of the unsecured debt, including pension liabilities.

The pain of a bankruptcy filing would no doubt be acutely felt by those implicated in Detroit, but typically these filings do not create broader market stress, according to Zezas.

This is because of their small size compared to the market at large, their idiosyncratic nature – which does not inform new developments of systemic risk – and their advance warning through ratings downgrades and price deterioration.

Nonetheless, if Detroit files, it could still have some negative impact given market conditions.

“Distressed cases like these can negatively impact investor psychology when market liquidity is weak, incrementally increasing market liquidity risks,” says Zezas. “Thus, there is some concern that given the recent sell-off in the market and string of outflows from muni funds that the Detroit news could mean the market will take longer to recover from its recent negative performance.”

It’s uncertain how the situation will play out in Detroit – Orr has reiterated that the document provided to creditors was a “proposal” and thus open to negotiations, but that given the situation, there is not much leeway. Further complicating negotiations is the potential for a conflict of interests between different groups of creditors.

Ultimately, the question is whether all the creditors will manage to meet Orr halfway. If they don’t, they will be testing the waters of bankruptcy – and who knows how that will play out for Detroit.

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