Tuesday, June 18, 2013

Detroit Challenges the Municipal Bond Market


It's not often that a dispute on municipal debt hierarchy makes the front page of the  New York Times - and "above the fold", no less.


But there it was, in today's paper:

 "In Embattled Detroit, No Talk of Sharing Pain".

Detroit, of course, is on the brink of bankruptcy.  Years of profligate spending, and a rapidly declining industrial base, has pushed this once-vibrate city to ruin.

Months ago a special emergency manager named Kevyn Orr was named by Michigan's governor to try to sort out the huge problems the city faces.

Today's article describes the battle between Detroit's bond holders and the city's pensioners.

It has long been assumed that municipal bond holders had the highest claim on the assets of a creditor, particularly if the municipal bond is a "general obligation" of the issuer.  However, several groups in Detroit are challenging this long-held assumption:

With talks on labor issues scheduled for Thursday, municipal bond market participants say one of their main concerns is that the city’s proposal would flatten the traditional hierarchy of creditors, putting say, a retired librarian on par with an investor holding a general obligation bond. That does not square with the laws and conventions of the municipal bond market, where for decades small investors have been told that such bonds are among the safest investments and that for “general obligation” bonds cities could even be compelled to raise taxes, if that’s what it took to make good. The “full faith and credit” pledge was supposed to make such bonds stronger than the other main type of muni — revenue bonds, which promised to pay investors out of project revenue. 

http://www.nytimes.com/2013/06/18/business/in-embattled-detroit-no-talk-of-sharing-pain.html?hp

What happens in Detroit may have far-reaching consequences for the municipal bond market in the future. In prior municipal credit rulings (e.g. Rhode Island last decade, and New York City in the 1970's), bond holders were repaid before any other obligations.

Today, however, public sentiment has turned.

Another part of the article illustrates part of why Detroit is in such a mess:

Municipal market participants are also rattled by a big, sudden increase in Mr. Orr’s measurement of Detroit’s pension shortfall, which he is also classifying as unsecured, leaving workers and bondholders to compete for whatever pool of money is left over. As of June 30, 2011, the city’s most recent actuarial snapshot showed that its two big pension funds were in pretty good shape — short by just $644 million, because the city had issued securities called “certificates of participation” in 2005 and 2006, and put the proceeds into the pension funds. 

But Mr. Orr’s report said that estimated shortfall had been “substantially understated” through aggressive assumptions and other distortions. After correcting those, the two funds’ shortfall was closer to $3.5 billion. 

While Detroit's story warrants a close watch for municipal bond investors, I think it is also worth noting that the credit woes of Detroit have been known for some time.  Municipal bond investors who did not want to fight this battle could have sold their bonds long ago, albeit at a loss.

Detroit municipal bonds are trading at pennies on the dollar.  The holders of the bonds are hoping for the city to declare bankruptcy, with the hope that the courts will rule that the bond holders need to be mostly repaid before any other creditors, including the city's pensioners.