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Detroit's Fallout: Muni Illiquidity And Full-Faith-And-Credit Failure
08-17-2013, 10:02 AM,
#1
Detroit's Fallout: Muni Illiquidity And Full-Faith-And-Credit Failure
Detroit's Fallout: Muni Illiquidity And Full-Faith-And-Credit Failure

Municipal finance is in sharp focus after Detroit filed the largest municipal
bankruptcy in history. Detroit’s filing is arguably an isolated case and its
fiscal problems are not indicative of the broader municipal credit landscape;
but, the outcome of the bankruptcy process will dictate whether the
value of the full faith and credit pledge backing GO bonds will be diminished
going forward. The global hunt for yield has probably chased new
investors into the Muni market who may not fully understand that in recent years
it has become an ‘ownership not rental’ market.  In other
words, it is unlikely holders of Munis
can sell what they own, as liquidity in the secondarymarket is almost
non-existent.




Via Guy Haselmann (ScotiaBank),

Municipal finance is in sharp focus after Detroit filed the largest municipal
bankruptcy in history and with analyst Whitney warning of more to come.  At the
moment, Detroit’s (relatively small) $18 billion in GO (general obligation)
bonds have had few ripple effects on the $3.7 trillion US municipal market, or
on the $100 trillion of global fixed income securities.  However, this
bankruptcy could eventually lead to significant reappraisals of credit risk,
higher funding costs, and legal precedents pertaining to debt creditors and
pension ‘guarantees’.



Many fiscal stresses have roots originating from the duplicitous
incentive system of elected officials who over the past several decades promised
future perks to state and local public employees, but who leave the fulfillment
of those promises to successor governors or mayors.  In New Jersey for
instance, Governor Chris Christie inherited an underfunded pension, mostly
caused by 22 years in a row of preceding Governors not paying into the pension
system the full amount allocated in the State’s annual budget.  Part of
Christie’s high popularity in NJ and across the US is due to his plan to save
the pension system – a plan that passed the state legislature with bi-partisan
support.



Most US cities and states have not made much progress in addressing
the legacies of those future promises.  Making matters worse is the
fact that municipal finances (in recent years) have run deficits despite
constitutions that require balanced budgets.  Reduced federal subsidies and low
economic growth rates after the 2008 financial crisis have further impaired
budgets.  To bridge the gap, spending cuts are often made to basic social
services such as education, road and park maintenance, infrastructure projects,
or police and fire.  Cuts to pensions or bond creditors are typically skirted
due to legal protections.



Michigan’s governor appointed an emergency manager who proposes
paying Detroit’s GO bondholders less than 20 cents on the dollar.  As
for the pensioners, the state constitution refers to accrued pension benefits as
“contractual obligations which shall not be diminished or impaired”; yet, with a
$9 billion underfunded gap, pensioners expect cuts.  At some
point, a judge is likely to make a ruling on the legality of cuts to creditors
or pensions which could have an impact on market premiums and other public
pensions. (The PEW Research Center estimates US pension underfunding as high
as $3 trillion).



GO bonds are viewed as relatively safe securities because they are
seen as being in the first lean position and ‘guaranteed’ by the taxing
authority of the municipality.  When problems develop, cuts in services
happen, even as taxes rise.  The combination drives out residents and
businesses.  The erosion to basic social services often leads to drops in home
values and rising crime, further setting off a negative feedback loop. 
Therefore, the ability to tax or cut service has its limitations and should not
be seen as a solution to ‘guarantee’ creditors, because they destructively
undermine the sustainability of the city or state.



The global hunt for yield
has probably chased new investors into the Muni market who may not fully
understand that in recent years it has become an ‘ownership not rental’ market. 
In other words, it is unlikely holders of Munis can sell what they own, as
liquidity in the secondary market is almost
non-existent.
Via George Friedlander (Citi),

The Detroit bankruptcy filing is no surprise, given that its
financial distress can be traced as far back as 1992, when Moody’s
downgraded the City’s debt to junk. While ratings did bounce back to IG levels
for brief periods, the City has essentially faced worsening budget deficits and
liquidity challenges over the last decade.



The Detroit Emergency Manager’s proposal for creditors was unprecedented, at
least as far as municipals are concerned, as it essentially tried to
flatten the debt priority structure by attempting to impose the same treatment
for GO bonds as other forms of debt which are deemed unsecured, including
pension obligations, OPEBs, leases and COPs.



The Emergency Manager’s restructuring plan was unlikely to succeed
via bilateral agreements and just on the face of it, the Chapter 9 filing could
be viewed as mild positive for GO bond holders (especially unlimited GO
bondholders) as now more control rests with the bankruptcy judge and standard
Chapter 9 rules could apply.



However, the Emergency Manager retains the exclusive rights to file an
adjustment plan (unlike Chapter 11, there is no provision in Chapter 9 for
creditors to end this exclusivity or propose a competing plan). Thus, the
original restructuring plan could serve a baseline for the ultimate settlement
and recovery process.



It is still early in the process to predict recovery rates but the
unlimited tax GO bond structure provides creditors with a stronger lien on the
issuer’s resources and thus recovery rates on this class of debt could be
somewhat higher vs. limited tax GOs and other forms of debt which are deemed
unsecured. Again, it’s early in the process and there is no precedent
for a large city with this level of financial distress.



Detroit’s filing is an isolated case and its fiscal problems are not
indicative of the broader municipal credit landscape, in our view. But,
the outcome of the bankruptcy process will dictate whether the value of the full
faith and credit pledge backing GO bonds will be diminished going
forward.
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