How safe are GO bonds?

August 14, 2013

Detroit’s Emergency Manager Kevyn Orr and Michigan Governor Rick Snyder have told some bondholders that they will not be repaid at 100 cents on the dollar in Detroit’s bankruptcy plan. Lamentations ring out across the nation. This treatment of general obligation (GO) bonds – the gold standard for municipal securities – has rocked the market.

Here is the formal description of GO’s from the MSRB (emphasis mine):

[General obligation] typically refers to a bond issued by a state or local government that is payable from general funds of the issuer, although the precise source and priority of payment for general obligation bonds may vary considerably from issuer to issuer depending on applicable state or local law.

Most general obligation bonds are said to entail the full faith and credit (and in many cases the taxing power) of the issuer, depending on applicable state or local law. General obligation bonds issued by local units of government often are payable from (and in some cases solely from) the issuer’s ad valorem taxes [property taxes], while general obligation bonds issued by states often are payable from appropriations made by the state legislature.

The former receiver of Harrisburg, Pennsylvania, David Unkovic, sent me a column he wrote for the Bond Buyer that explains the available remedies bondholders have if an issuer decides that it doesn’t want to pay GO bondholders (not including bankruptcy):

Some in the public finance world are arguing that the Detroit bankruptcy and similar situations call into question the efficacy of general obligation debt, thereby undermining the market for and pricing of general obligation debt for all governmental borrowers. I don’t buy it.

In Pennsylvania, where I practice, and in many other states, GO debt really means that a lender (whether you are talking about bondholders, trustees or credit enhancers) has three ultimate remedies.

First, if the government has not budgeted or appropriated or paid the debt service on the GO bonds, the lender can go into court and have the judge order the government to do so.

Second, the lender can go into court and have the judge divert the first dollars coming into the government’s treasury to be applied to pay debt service on the GO bonds.

Third, the lender can go into court and have the judge force the government to raise real estate taxes in order to raise additional money sufficient to pay the debt service on the GO bonds. These three remedies are essentially the “security” for GO debt.

Detroit doesn’t collect all due property taxes, according to a study by the Detroit News, and the city seems uninterested in trying to improve tax collection so bondholders can be repaid in full. Detroit is not demonstrating “full faith” in this sense. But when the city filed for Chapter 9 federal bankruptcy on July 18th, it stopped, or “stayed,” any lawsuits from bondholders that would have forced more property taxes to be collected.

Of course no bondholder wants to have to sue to get paid. They would rather rely on the “full faith and credit” that bond payments will be made on time and in full. Confidence is the fuel of bond markets.

But bondholders do have remedies, if necessary, to get repaid. It’s not a black and white issue. General obligation bondholders have reliable security; until a municipality enters Chapter 9 bankruptcy.

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