Welcome to Scribd. Sign in or start your free trial to enjoy unlimited e-books, audiobooks & documents.Find out more
Download
Standard view
Full view
of .
Look up keyword
Like this
2Activity
0 of .
Results for:
No results containing your search query
P. 1
cflnovember2013_316

cflnovember2013_316

Ratings: (0)|Views: 4,773|Likes:
Published by caitlynharvey
pdf
pdf

More info:

Published by: caitlynharvey on Oct 10, 2013
Copyright:Attribution Non-commercial

Availability:

Read on Scribd mobile: iPhone, iPad and Android.
download as PDF, TXT or read online from Scribd
See more
See less

12/03/2013

pdf

text

original

 
Detroit’s bankruptcy: The uncharted waters of Chapter 9
by Gene Amromin, senior fnancial economist, and Ben Chabot, fnancial economist 
On July 18, 2013, Detroit became the largest municipality to seek protection underChapter 9 of the U.S. Bankruptcy Code. This article describes several ways in whichDetroit’s bankruptcy filing has the potential to alter some of the key assumptions ofmunicipal bond (muni) finance, and examines the market reaction to date.
Chicago Fed Letter
ESSAYS ON ISSUES THE FEDERAL RESERVE BANK NOVEMBER 2013OF CHICAGO NUMBER 316
To date, Detroit’s bankruptcyfiling has had little impact onthe cost of municipal financingoutside of Michigan, but ithas the potential to set anumber of precedents withfar-reaching consequences.
Chapter 9
provides nancially distressedlocal governments, such as the City o Detroit, protection rom creditor claimsin the ederal bankruptcy courts, subject to a number o state-level restrictions.
 Michigan is one o 4 states that allow their municipalities to seek Chapter 9protection. Although the ederal require-ments or bankruptcy are explicit,
thepaucity o Chapter 9 lings and the variability in state legal environmentseectively make every new case a com-plex and protracted matter. This holdsparticularly true or Detroit’s ling, whichis notable or its sheer size, the multi-tude o competing claims, and the his-torical and economic contexts in whichthe bankruptcy is playing out. Indeed, theintensity o media coverage surround-ing Detroit indicates the extent to whichthe bankruptcy ling o the once-thrivingindustrial icon has resonated with the American public. In this
Chicago Fed Letter 
, we describe how municipal bankruptcy unolds in Michigan, how Detroit’s linghas the potential to change some o the key assumptions o municipal bondnance, and what the market reactionhas been thus ar.
Municipal bankruptcy in Michigan
 A unique eature o Michigan law is theability o the governor to appoint anemergency manager (EM) to take overoperations o nancially distressed unitso local governments, ranging rom schooldistricts to entire municipalities. Shortly ater the state’s February declaration that the City o Detroit was in a nancial emer-gency, Governor Rick Snyder appointedKevyn Orr as Detroit’s EM. Under new legislation that went into eect onMarch 8, 0, governor-appointedEMs are allowed to take extraordinary measures, including modiying or termi-nating collective bargaining agreementsand recommending that the municipality enter Chapter 9 bankruptcy.
WhenChapter 9 protection is sought, the EMhas the sole power to propose a restruc-turing plan to the bankruptcy court.Obtaining bankruptcy protection is arrom straightorward, however. AlthoughMichigan permitted Detroit to seek bank-ruptcy protection, the bankruptcy judgemust determine whether the city is in-solvent and can adjust its debts. The judgemust also determine whether Detroit,as represented by the EM, had negotiatedin good aith with its creditors and hadailed to obtain an agreement outside o court. Moreover, the court must rule ona number o legal objections to Detroit’sChapter 9 eligibility—which range rom whether Chapter 9 is itsel constitutionalto whether the state authorization orthe city’s bankruptcy ling is invalid inlight o Michigan’s state constitutionalprotection o pensions.I the bankruptcy court upholds Detroit’seligibility or Chapter 9 protection, the
 
1. Yield spreads of S&P municipal bond GO indexes, 2013
N
otes
:
The plots are the spreads between the yields of Standard & Poor’s (S&P)municipal bond general obligation (GO) indexes (or those of an S&P index and ten-yearU.S. Treasury bonds). SAPIGO indicates the nationwide S&P Municipal Bond GeneralObligation Index. US10Y indicates ten-year U.S. Treasury bonds. SAPIMIG indicatesthe S&P Municipal Bond Michigan General Obligation Index. SAPIILG indicates theS&P Municipal Bond Illinois General Obligation Index. SAPICAG indicates the S&PMunicipal Bond California General Obligation Index. The solid vertical line indicatesthe first trading day (June 17) after the Detroit emergency manager’s proposalto creditors. The dashed vertical line indicates the first trading day (July 19) afterDetroit’s bankruptcy filing.
s
ource
:
Authors’ calculations based on data from Standard & Poor’s.
percent
city will le its restructuring plan (i.e.,its “plan or adjustment o debts”), which will outline proposed payments to di-erent types o creditors. Unlike corpo-rate bankruptcy, there is no provision inChapter 9 allowing creditors to le theirown plan. Moreover, the court can orcethe acceptance o the city plan as longas a majority o 
any 
class o the impairedcreditors accepts the proposal. As a re-sult, creditors have ew opportunities tochallenge restructuring in Chapter 9.Much o the market commentary andnews coverage to date has centered onthe EM restructuring proposal, pre-sented to creditors on June 4, 0.
4
  Although the EM proposal is in no way binding and may end up being quitedierent rom the nal plan or adjust-ment o debts, it provides a basis or theexpected treatment o various types o debt. As such, the proposal created con-siderable controversy, since it ignoredseveral conventional approaches toprioritizing and valuing liabilities o abankrupt municipality.
Unique aspects of the EM proposal
To understand the unorthodox natureo the EM plan, one needs to decomposeDetroit’s liabilities intospecic categories.Detroit’s largest singleobligation is the ap-proximately $6 billionin water and sewerbonds that are backedby the specic pledgeo revenues rom thecity’s utility system.Detroit also has about $ billion in outstand-ing general obligation(GO) debt. GO debt is typically paid out o the overall tax reve-nues and does not have a dedicated re-payment source. How-ever, Detroit’s GO debt comes in a number o dierent favors. SomeGO debt, known asunlimited tax generalobligation (UTGO)bonds, was issued withexplicit voter approval that commits thecity to levy unlimited taxes or repayment.Other GO debt, known as limited taxgeneral obligation (LTGO) bonds, wasissued directly by the city and can only be paid rom general unds. Moreover,some o the UTGO and LTGO bondshave separate streams o committedrevenues coming rom the state andare, thereore, reerred to as “double-barreled” bonds. These distinctionshighlight the act that various GO bondscan enjoy dierent orms o legal pro-tection and can count on dierent sources o revenues or their repayment.In addition to bonded debt, Detroit’sliabilities comprise outstanding pensionand other post-employment benet (OPEB) obligations, mainly or medicalinsurance coverage, to both current andretired city workers, police, and re-ghters. The pension and OPEB obli-gations have been valued in the EM planat $.5 billion and $5.7 billion, respec-tively. The remaining components o Detroit’s liabilities are two sets o nancialsecurities closely related to its pensionobligations—pension obligation certi-cates (POCs) and the associated swapcontracts that convert variable-interest payments on POCs into xed-rate obli-gations. The POCs and associated swapshave been valued in the EM plan at $.5 billion and $0.8 billion, respectively.Chapter 9 bankruptcy grants senior statusto debts secured by the pledge o spe-cic revenues (e.g., the water and sewersystem bonds secured by utility bill pay-ments). All other debts are treated asequally unsecured under the law. As se-nior debt is repaid rst, all other debtscan be repaid only rom the revenuesthat are let over. Put dierently, every dollar o debt that is regarded as beingsecured diminishes the pool o money available or repaying unsecured claims.Theoretically, this suggests that all un-secured debt is impaired (i.e., repaidless than ully) in bankruptcy. The ex-act degree o impairment o each typeo unsecured debt is determined dur-ing the bankruptcy process.In practice, however, municipalitiesseeking Chapter 9 protection have pre- viously treated GO debt as senior toother unsecured claims such as pensionsin their debt adjustment plans. Thismeant that GO bondholders were typi-cally repaid in ull, even as some pensionand OPEB obligations were diminished.In act, between 970 and 0 (when Jeerson County, Alabama, led orbankruptcy), no GO bond in the Moody’scredit rating universe was impaired in aChapter 9 bankruptcy. Yet, the EM proposal called or steepcuts in payments to most bondholders,as well as to pensions being received by retirees, pension and OPEB obligationsowed to current employees, and POCsheld by pension creditors. Only the waterand sewer system bonds and double-barreled UTGO and LTGO bonds wereregarded as secured and thus subject torepayment in ull. On average, the un-secured creditors were oered about tencents on each dollar in claims they held.The EM’s proposed placement o someGO bonds on the same ooting as retire-ment and employment obligations sur-prised market participants. It triggeredextensive commentary on the need orinvestors to rethink their assumptionsabout recovery values o GO debt in bank-ruptcy. Although Detroit’s combination
Feb. Mar. Apr. May Jun. Jul. Aug. Sep.0.30.50.70.91.1SAPICAG−SAPIGOSAPIMIG−SAPIGOSAPIILG−SAPIGOSAPIGO−US10Y
 
Charles L. Evans,
President 
;
 
Daniel G. Sullivan,
 Executive Vice President and Director o Research 
;
 
Spencer Krane,
Senior Vice President and Economic Advisor 
;
 
David Marshall,
Senior Vice President 
,
fnancial markets group 
;
 
Daniel Aaronson,
Vice President 
,
 microeconomic policy research 
;
 
 Jonas D. M. Fisher,
 Vice President 
,
macroeconomic policy research 
;
 
RichardHeckinger,
Vice President 
,
markets team 
;
 
 Anna L.Paulson,
Vice President 
,
fnance team 
;
 
 William A. Testa,
Vice President 
,
regional programs 
,
and Economics Editor 
;
 
Helen O’D. Koshy and Han Y. Choi,
Editors 
;
 
Rita Molloy and Julia Baker,
Production Editors 
;
 
Sheila A. Mangler,
Editorial Assistant.Chicago Fed Letter 
is published by the EconomicResearch Department o the Federal Reserve Banko Chicago. The views expressed are the authors’and do not necessarily refect the views o theFederal Reserve Bank o Chicago or the FederalReserve System.© 0 Federal Reserve Bank o Chicago
Chicago Fed Letter 
articles may be reproduced in whole or in part, provided the articles are not reproduced or distributed or commercial gainand provided the source is appropriately credited.Prior written permission must be obtained orany other reproduction, distribution, republica-tion, or creation o derivative works o 
Chicago Fed Letter 
articles. To request permission, please contact Helen Koshy, senior editor, at --580 oremail Helen.Koshy@chi.rb.org.
Chicago Fed Letter 
and other Bank publications are availableat www.chicagoed.org.
 
ISSN 0895-064
2. Yield spreads of municipal bond portfolios, 2013
N
otes
:
The sample of 92 bonds was selected by choosing at most two bonds fromeach issuer from the set of uninsured fixed-rate general obligation bonds issued bythe cities included in Pew Charitable Trusts (2013). When multiple bonds from thesame issuer met these criteria, the two with a maturity closest to ten years wereselected. H9 is a portfolio of bonds issued by cities with high per capita pensionand other post-employment benefit (OPEB) obligations located in Chapter 9 states.L9 is a portfolio of bonds issued by cities with low per capita pension and OPEBobligations located in Chapter 9 states. Hno9 is a portfolio of bonds issued bycities with high per capita pension and OPEB obligations located in non-Chapter 9states. Lno9 is a portfolio of bonds issued by cities with low per capita pension andOPEB obligations located in non-Chapter 9 states. “High” and “low” obligations aredefined as above and below the median, respectively. The plots are the spreadsbetween the weighted average yields of the portfolios. The solid vertical line indicatesthe first trading day (June 17) after the Detroit emergency manager’s proposal tocreditors. The dashed vertical line indicates the first trading day (July 19) afterDetroit’s bankruptcy filing.
s
ources
:
Authors’ calculations based on data from Bloomberg and Pew CharitableTrusts (2013).
percent
o nancial woes and structural economicproblems is unique, a substantial num-ber o local governments nationwide acelarge pension and OPEB obligations. Forthese governments and their creditors,Detroit’s case is a potential bellwether. Another surprising aspect o the EMproposal was its ailure to dierentiatebetween debt backed by the unlimitedtax pledge and debt lacking such a pledge.UTGO debt is typically repaid rom aspecial property levy that has no limit and,as such, relies on revenues that are entirely separate rom those used to cover general-und operations.
5
This eature o UTGOdebt makes it quite similar to other se-cured debt, contrary to the EM’s state-ments implying that none o the GObonds have legal security. This issue willbe ultimately settled by the court, and it might have wide-reaching consequencesor the pricing o voter-approved GO debt.
Implications for municipal bonds
In the preceding section, we touched onthe potential market ramications o legal rulings with re-spect to the treatment o pension and OPEBobligations, as well asGO debt backed by unlimited tax pledges.The standing o pen-sion obligations relativeto other municipalliabilities is particu-larly important tobondholders and thebroader public giventhe multitude o well-publicized undingshortalls in a great number o Americancities. For example,data rom a recent Pew Charitable Trustsstudy o large citiesindicate that they have unded only 57.5% o the $5. bil-lion o retirement benets promised totheir employees.
6
There is a confict between state andederal laws as to whether pension obligations can beimpaired by a ederal bankruptcy court.Michigan’s state constitution prohibitsreductions o promised pension benets,but Detroit’s EM argues that Michiganlaw allows or pension cuts in ederalbankruptcy court. Pension unds havechallenged the EM’s interpretation onthe grounds that it violates both the Tenth Amendment to the U.S. Constitutionand state law. To date there is no juris-prudence addressing the question o  whether a municipality can diminishpension obligations protected by a stateconstitution. I the court agrees withpension creditors that state protectionshold supreme, this could change market expectations with respect to the relativestanding o municipal debt issued by cities located in states with such protec-tions (e.g., Chicago, Los Angeles, andNew York City). Furthermore, any prec-edent that makes pension obligationssenior to municipal bonds on broadTenth Amendment grounds couldhave a material eect on the pricing o municipal debt or any city with largeunderunded pension obligations.
How have the markets reacted thus far?
 Apart rom Michigan municipalities, themarket reaction to the Detroit bank-ruptcy ling has been negligible. In the week ollowing the EM’s June 4, 0,proposal to subordinate GO bonds,the dierence (spread) between the yield on the nationwide Standard &Poor’s (S&P) Municipal Bond GeneralObligation Index (SAPIGO) and the yield on ten-year U.S. Treasury bondsdeclined 8 basis points (gure ). TheSAPIGO–ten-year U.S. Treasury bond yield spread did increase by 9 basis pointsthe day ater Detroit’s Chapter 9 lingon July 8 but quickly returned to itspre-bankruptcy level. In contrast, thespread between the yield on the S&PMunicipal Bond Michigan GeneralObligation Index (SAPIMIG) and the yield on SAPIGO increased 4 basispoints ollowing the EM proposal. Thespread urther jumped by 9 basis pointson the day ater Detroit’s bankruptcy ling and has remained elevated since,suggesting that the ling has had amaterial impact on borrowing costs o Michigan municipal issuers.
Jan. Feb. Mar. Apr. Jun. Jul. Aug. Sep.−0.4−0.20.00.20.40.6L9−Lno9H9−Hno9Hno9−Lno9H9−L9May

You're Reading a Free Preview

Download
scribd
/*********** DO NOT ALTER ANYTHING BELOW THIS LINE ! ************/ var s_code=s.t();if(s_code)document.write(s_code)//-->