Choices come with consequences. When a municipality and its home state choose to file for Chapter 9 bankruptcy, the consequence is a loss of market access. And so it goes in Michigan.
Last week brought the news that yet another Michigan municipality has had to delay a large bond deal. Why? As expected, and as we warned the state of Michigan, Detroit’s Chapter 9 filing has inhibited market access for its local issuers. Investors are simply reluctant to provide funding to Michigan municipalities on favorable terms.
Two of the three recently pulled deals were to be general obligation (GO) issues — a subject of particular market angst after the Detroit emergency manager’s unprecedented suggestion that GOs be treated as unsecured debt.
Ironically, part of the emergency manager’s recovery plan for Detroit is to spend on infrastructure. Some of those projects will undoubtedly need to be funded with borrowed dollars, and the big questions are: Will there be any investors, and if so, what will they require of Detroit? It could be a very costly compromise — costs that will likely be borne by Detroit residents, who will be forced to repay the debt via higher taxes down the road.
Our key observations amid these most recent events are this:
- The public sector relies on the municipal market to fund its services, operations and facilities, and to make improvements that ensure safe and vibrant communities. There is no other credit source for these entities, and it’s important that its integrity is preserved.
- This need for market access remains an important deterrent to Chapter 9 filing. Unfettered and favorable market access simply will not exist in the face of Chapter 9. For the most part, states are aware of this and have generally taken steps to aid troubled municipalities and avoid bankruptcy. It’s a fairly easy choice to make. We believe the example now playing out in Michigan will only reinforce this position.
- Traditionally, muni issuers have been able to finance at favorable terms relative to the taxable market. The tax-exempt nature of muni income and the high-quality nature of the market have allowed for relatively lower borrowing costs. This is good for taxpayers, ultimately translating into lower taxes. But when quality erodes, lenders demand higher rates to support a deal — and taxpayers pay.
- In most municipalities, even in Detroit, debt represents a relatively low percentage of total liabilities. As such, cities and towns have the capacity to borrow in terms of their debt-to-revenue ratios — but it matters not if their market access is denied due to exogenous events.
The market will be tested in the next two weeks as some Michigan school districts are expected to access the market with bond sales. To some extent, the market is in “wait-and-see” mode, allowing time for the rating agencies to weigh in and adjust their assessments of Michigan credits in a post-Detroit world. Downgrades are inevitable; another consequence the state tacitly accepted when it allowed a Chapter 9 filing. Clearly investors are skittish and a Detroit penalty is being imposed on many Michigan issuers, particularly those attempting to enter the market under less-than-pristine conditions. This is not to say no deals will get done. Some have and still more will, but not necessarily on the most favorable terms.
We would remind investors that one city does not a muni market make. Michigan is feeling the consequences of its choice now. But I have to believe that more states and their municipalities will continue to choose the ongoing benefit of favorable market access over the costly and difficult process of bankruptcy.