MuniLand

The market reaction to Detroit’s bankruptcy ruling

By Cate Long
December 4, 2013

Fitch Ratings managing director Amy Laskey talked to Fox Business about how Detroit is a unique story in muniland. Fitch published a research note on the bankruptcy ruling and concluded that Detroit’s ruling would not lead to a “spate” of local bankruptcies in Michigan:

Although the judge ruled that pensions could be adjusted, Fitch does not believe the ruling grants Detroit’s emergency manager unlimited freedom to adjust these obligations. The city must submit a plan of adjustment to the bankruptcy court, which must be deemed ‘fair and equitable’ by the presiding judge. The emergency manager expects to submit the plan to the court by year-end. Fitch does not believe that the judge’s decision on pensions will lead to a spate of additional bankruptcy filings in Michigan.

The New York Times, on the other hand, suggested that the Detroit’s ruling could impact other cities:

The judge, Steven W. Rhodes, dealt a major blow to the widely held belief that state laws preserve public pensions, and his ruling is likely to resonate in Chicago, Los Angeles, Philadelphia and many other American cities where the rising cost of pensions has been crowding out spending for public schools, police departments and other services…

…James E. Spiotto, a lawyer with the firm Chapman & Cutler in Chicago who specializes in municipal bankruptcy and was not involved in the case, said: ‘No bankruptcy court had ruled that before. It will be instructive.’

In a Reuters MuniLand video, S&P’s Managing Director Jeff Previdi suggests that the ruling will encourage unions to negotiate pension changes:

Previdi: We don’t think the Detroit pension ruling will necessarily make Chapter 9 more appealing to municipalities. It is very expensive and difficult to go through bankruptcy. We do think it might encourage unions to negotiate sooner in the process. If this happens it may lead to fewer bankruptcies than more.

In a research note, Wells Fargo’s Managing Director Natalie Cohen discusses the pension ruling and long term fiscal sustainability:

The unions and retirees have argued that the filing was unconstitutional because the city seeks to cut pensions and other benefits — which are guaranteed by the state constitution. Judge Rhodes was quite clear in stating that pensions have protections under the Michigan constitution but do not have the protection in federal bankruptcy court.

Judge Klein, presiding over the Stockton, California bankruptcy case has made the same assertions — that federal bankruptcy is all about changing contracts…but states may not. Judge Rhodes also asserted that the court would not lightly exercise federal bankruptcy law to impair pensions and that a plan of adjustment must be ‘fair and equitable’.

Furthermore, a plan should offer the municipality the ability for long-term financial sustainability. In this, we are not convinced the criterion is fully defined. Does it mean three years? Five years? More? We hope this issue will be addressed in Detroit, as well as Stockton and San Bernardino. However, we point out that the city of Vallejo emerged from bankruptcy only a few years ago but is again suffering significant fiscal distress. In part, Vallejo’s problems (and those of other California cities) are due to significant hikes in required pension contributions to improve the funding level of CalPERS — costs that were not visible in the city’s bankruptcy proceeding.

Moody’s issued a short comment that highlighted the possible benefits and risks for bondholders from the Detroit ruling:

The judge opined the state’s constitutional protections for pension contracts may be trumped by federal bankruptcy court under Chapter 9. This could indirectly lead to higher recoveries for bondholders if the solution to the city’s fiscal woes are spread among more creditor groups, but it is too early to determine this.

The ruling sets an important judicial precedent establishing pension benefits are unsecured contractual claims in Michigan and could be cited as precedent in other jurisdictions. This is similar to what occurred in the bankruptcy of Central Falls, RI.

While the ruling may indirectly benefit bondholders with a larger asset pool for recovery, there are bondholder risks implicit in the ruling, which arguably lays the foundation for a similar contractual treatment for the city’s general obligation pledges.

In my radio appearance on Detroit’s public radio WDET, I highlighted the proposed financing for the interest-rate swap termination payments and its impact on the creditor hierarchy.

There are many pieces to the ruling, and we await Judge Rhodes’ written ruling (it will be posted here). Meanwhile Christie’s filed a confusing lowball estimate on the value of the art holdings of the Detroit Institute of the Arts. Detroit’s eligibility ruling hearing has set an important benchmark for muniland.

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