Detroit In Chapter 9: A Day Of Reckoning For Investors

Includes: EMI, MIW, MIY, MUB, SMB
by: Carl Dincesen

It is when, not if, and the resulting bankruptcy court rulings could permanently devalue twenty-five percent of the municipal bond market.

The City proposes to treat holders of its certificates of participation ($1.4 billion outstanding) as general unsecured creditors, the same as general obligation bondholders ($430 million outstanding). Based on the proposed plan, these creditors might get 20 cents on the dollar, a shockingly small amount for defaulted general obligation bonds.

Payments to pension plans and other employee benefit plans deemed unaffordable by the court must be reduced as well. The unfunded long-term liabilities of these plans are $9.5 billion, bringing the total amount owed unsecured creditors to $11.3 billion. All subject to adjustment by the court.

Publically held bonds, including the certificates of participation (COPs), represent only 18% of the total. Unsecured general obligation (GO) bonds, less than 4%.

The problem is not the amount of debt but rather unaffordable contractual promises made to current and former employees. This may be the face of any future municipal bankruptcies.

For GO bondholders the biggest problem with Detroit's proposed settlement is that it is in direct contradiction to Federal law pertaining to Chapter 9 settlements.

Why does the City include COP's at all in its proposal since they do not constitute debt under the laws and Constitution of Michigan or the United States? Why would a Federal bankruptcy judge grant standing to holders of certificates containing no promise to pay?

Politics is the answer to the first question. I think the City would prefer federal judges pull the rug out from the COP holders, which consist largely of institutional investors versus retail investors who generally favor GO bonds.

The second answer is - a judge will not grant standing because there is no basis in law to do so. Certificates is just one of several labels used to describe a category of municipal securities known as "appropriation backed bonds, loans, and leases".

They were originally labeled moral obligation bonds and have been issued since 1977 by many states and localities to circumnavigate legal restrictions, including voter approval requirements for incurrence of debt, secured and unsecured.

State courts permit these financings, which now account for about 25% of the total municipal bond market, precisely because bond repayment is not a legally enforceable obligation. Payment is at the discretion of subsequent legislatures. A moral, not legal obligation to pay principal and interest.

New York and California are the largest purveyors of appropriation debt. Some states, among them Michigan and California, allow subdivisions to borrow in this manner as well. This uniquely municipal bond financing "technique" was used in 1977 to refinance New York City's $1.3 billion general obligation notes that defaulted in 1975.

This will be the first time appropriation debt is addressed in a Chapter 9 case.

The court may decide the certificates are worthless, which in my opinion is likely. As a result, prices will decline and yields increase on all appropriation backed bonds.

More on the locally issued paper then on state issues. Single state municipal bond funds with concentration of appropriation risk may not fare well.

The spread adjustments will be welcome and are likely permanent. Investors have not been adequately compensated for the credit risk taken. That will change for the better.

Detroit's unsecured general obligation bondholders will fare much better than suggested in the City's proposal with a chance of coming out whole. There is little to be gained against Detroit's financial problem, a judge may find the cost of reneging on full faith and credit public debt outweighs the savings realized from writing down it down.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.