Detroit News Spotlights Municipal Bonds

As you have probably heard, the city of Detroit filed for bankruptcy last night in what would be the largest Chapter 9 filing of all time, if it stands. Worth noting that this is only the beginning of a very long process that may or may not actually wind up with Detroit going forward with a bankruptcy filing. Already a Michigan judge has declared the filing unconstitutional, but expect appeals. Anyway, you can read about the facts surrounding this case on other sites, but here on Real Money I wanted to give some insight into what this might mean for the broad municipal bond market.

 First, it is safe to say that Detroit's situation is simultaneously unique and yet common among other municipalities. The tremendous population and employment loss, occurring over many years, is more or less unique to Detroit. However their severe pension underfunding, which is a key reason why the city cannot afford its bills, is much more common. Just this week, Moody's downgraded two pretty vibrant cities (Chicago and Minneapolis) multiple notches over this same issue. Detroit's indebtedness matters of course, but without the pension situation, the workout being discussed would look much different.

Even so, there wouldn't be much real concern about Detroit roiling the muni market solely because they have defaulted. The troubling issue is what kind of precedent they might set. The media is not quite reporting it how many muni pros are looking at it.

In municipals there is something called an "Unlimited General Obligation" (ULGO) which means that a municipality has pledged all its taxing power to repay the debt. The media has reported this as "sacrosanct" which some have improperly interpreted as meaning that you can't lose money in an ULGO. The market hasn't quite viewed it that way. The more accurate way to think about it is that ULGOs were assumed to be senior to all other types of debt in terms of their claim on tax revenue.

Detroit's emergency manager, Kevyn Orr is trying to claim that all of the city's debt obligations are simply "unsecured" obligations, and therefore should be treated the same in bankruptcy (or in a non-bankruptcy workout). I personally think use of the term "unsecured", which legally meaningful, is confusing in reality.

Normally when you think of a certain debt holder as being "secured" you think of there being some asset pledged against that loan, i.e., a residential mortgage is "secured" by the house. Municipalities don't have a lot of hard assets. What they have is this nebulous asset of taxing power over its citizens.

But if we go back to my prior concept of seniority, Detroit has various kinds of debt. Some are ULGOs, but others are backed by appropriations. The latter is debt where the city promised to add the debt service to the city's annual budget, but they didn't promise to raise taxes in order to ensure that there would be enough money to appropriate.

To Orr, this is a distinction without meaning. If Detroit sold debt backed by the city's revenue, that constitutes a general creditor of the city. One is not necessarily senior to the other. Holders of ULGO's are arguing that they are senior, since the pledge of the city's full taxing power is stronger than a vague promise to make money available in the city's budget.

A tremendous amount is at stake. Many cities and states use various forms of appropriations backed debt, and this debt universally sells at higher yields than ULGO debt, under the view that it is slightly more risky. If Orr is successful, the GO debt would have to rise in yield and the appropriation debt would decline a little. Some states and municipalities use a lot more of this appropriations debt than others. Wisconsin and New Jersey for example. Their ULGO debt would be more at risk.

Equally importantly, Detroit has some other debts which are not actually backed by the city's revenue, but by other revenue streams collected by city agencies. Orr wants to put a haircut on debt for the city's profitable water and sewer system. Typically the municipal market has treated debt from separate city agencies as having nothing to do with the municipality itself, for better or for worse.

If Orr succeeds in haircutting the water and sewer debt, it could also set a bad precedent. Working in favor of the water and sewer debt in this specific case is that virtually all of this debt is insured, which means that Orr will be negotiating with a fairly small number of highly sophisticated investors. Look for any haircut to be very small.

The muni market traded weaker today on this news, which seems to be driven by some ETF flows. This case will take a long time to play out, but I will say it is the biggest threat to the basic functioning of the muni market since the demise of the muni insurers. Stay tuned.