Detroit Bankruptcy Bodes Ill for Market

WASHINGTON — While Detroit's bankruptcy filing on Thursday was not unexpected, market participants say it's the largest of its kind and unique in other ways as well, making its impact hard to gauge. But so far, the implications for the muni market appear potentially ominous.

"This is the first time the largest city in a state has filed for Chapter 9 bankruptcy," said Ira Hammerman, senior managing director and general counsel at the Securities Industry and Financial Markets Association. "We are concerned that this development could raise borrowing costs for Detroit and other municipalities in Michigan over a long period because investors could perceive Michigan local government bonds as considerably less secure going forward."

Hammerman said SIFMA is also particularly concerned about how Detroit's general obligation bonds will fare in bankruptcy proceedings.

"Generally, unlimited tax general obligations bonds are the most senior of a city's obligations, backed the by full faith and credit of the taxing power. Investors expect that, as usually provided in bond contracts, principal and interest on general obligation bonds will be paid before other expenses and that taxes will be increased to pay debt service if necessary," he said. "The treatment of those bonds by the bankruptcy court could affect how investors' view those types of securities issued by all Michigan municipalities and potentially could have nationwide implications."

Matt Fabian, managing director of Concord, Mass.-based Municipal Market Advisors voiced similar concerns.

"I don't think anyone is as distressed as Detroit is. Detroit has been headed down for 50 years. It is the basket case of America. It's really hard to say that Detroit sets a precedent just by filing. This was very likely an inevitable development. There is such a massive mismatch between what they spend and what they receive," he said. "What is unexpected from the market is how Detroit will treat bondholders: wipe them out."

"In this bankruptcy story, bondholders may indeed get very little recovery," Fabian said. But he added, "The main story is less about bondholders but more about pension benefits ... its insufficiency of its revenues to pay pensions. They have lost more than half of their revenues due to the loss of their citizenry."

Detroit's population fell to just over 700,000 in 2011, the last year for which Census data was available, from a peak of 1.85 million 1950. During the decade ending in 2010, population fell 25% to 713, 777, the city's lowest population since the 1910 census.

Chris Mier, managing director of analytical services at Loop Capital Markets, said, "I think it's a completely unique situation and not comparable to any other bankruptcy we've had or ever will have. It's completely unprecedented to have a city as large as it was, one of the biggest cities in the country to lose so much population. I don't think its necessarily precedent setting and we won't see more of them."

"Pensions are certainly not the only reason they are in bankruptcy," said Mier. "It is one of a constellation of extremely large problems that make this case so difficult. These include Detroit's loss of over 50% of its population, its very large vacancy rate, its collapsing per capita income, falling personal income tax from nonresidents and failing property tax values and revenue, he said.

Dick Larkin, senior vice president and director of credit analysis at HJ Sims & Co., said the bankruptcy filing is no surprise.

"This bankruptcy isn't pre-packaged; it's premeditated. I think bankruptcy was the original goal of emergency manager Kevyn Orr from before the day he was hired, Larkin said.

"I have been projecting that Detroit would go in bankruptcy since January." he said. "But I am surprised by the lack of participation by the state of Michigan in trying to solve the city's problems and I think I am not the only one to say that. In the past Michigan had a good reputation of a state helping out its localities when they were in difficulties -- not just Detroit, but other cities as well. But this time it seems they are washing their hands out of Detroit and investors will remember that."

Larkin said there will be muni market ramifications for the city and the state.

"Do I expect a major impact sending shockwaves and seeing prices falling and yields spiking? Larkin asked, "No I do not because most people had expected it and [a bankruptcy] is already priced in the market, but I could be wrong. I firmly believe, however, that investors will begin exacting a premium from any borrower that has Michigan's name on it, and from this point, Detroit's name in the muni market is probably mud."

Pauline Schneider, special counsel at Ballard Spahr LLP, said that while it's hard to speculate on what the bankruptcy filing fully means at this point, ""I think this is going to be difficult and painful for the residents of Detroit."

Susan Collet, vice president for government relations for Bond Dealers of America pointed out that muni defaults are still rare.

"The historic default rate for the municipal sector is less than 1/3 of 1%, so this culmination of a decades long, difficult struggle on numerous fronts for Detroit should be put into proper perspective," she said, but she added that, " Defaulting on municipal bonds, even in the face of a bankruptcy, is the rare exception, and the scope of Detroit's situation is unique."

Tom Weyl, director of municipal research at Barclays, said, "We expect that this will be a long contentious bankruptcy."

"I think aspects of this bankruptcy will be contested," Weyl said. "The key to what will make a change in the market is what is adjudicated in the final plan of restructuring. Everything is impaired and everything is not getting paid. It really comes down to a question of bond insurance. Most bondholders are saying they have [bond insurance]. The people who are worried are the ones with the pension obligations. What will be precedent setting is how the judge looks at this and determines what is fair and equitable."




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