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Moody's: Detroit Bankruptcy May Set Tone for Distressed Munis

CHICAGO -- Detroit's bankruptcy may be "profoundly meaningful" for other distressed local governments, setting a precedent for how to deal with liabilities, litigating key questions about pension versus bond debt, and clarifying the strength of various bond securities, Moody's Investors Service said in a report Friday.

"Detroit's bankruptcy could set a standard, if not a legal precedent, for how other distressed cities approach their long-term liabilities, especially the relative seniority of pension versus debt obligations," Moody's said.

The case could influence "market expectations and issuer behavior" for distressed or junk-rated municipalities, Moody's said, adding it rates only 34 local governments below investment grade, out of 7,500 rated governments.

If Detroit is able to restructure or shed most of its debt, the case could prompt other troubled issuers to seek federal bankruptcy protection, Moody's said.

"Bankruptcy may become more appealing to other stressed local governments if Detroit succeeds in reducing pension benefits and discharges most of its general obligation debt," Moody's analyst Anne Van Praagh said in the report, "Detroit Bankruptcy May Change How Other Distressed Cities Approach Their Pension and Debt Obligations."

Despite the potential precedent-setting nature of the Motor City's filing, which, if approved, will be the largest in the U.S., the case will likely have a much more limited impact on healthy governments who are not grappling with the same scale of problems, the ratings agency said.

If the city's petition is granted, the bankruptcy judge overseeing the case will have to two key questions to answer, Moody's said: the relative seniority of pension liabilities versus general obligation debt and whether GO bonds are secured or unsecured.

Both answers will depend on state law, but could still set a tone or even a legal precedent for how governments nationally treat their debt.

Only five states -- California, Colorado, Florida, Louisiana, and Rhode Island -- have rendered their GO bonds secured with statutory liens, the report said.

"Outside of these states, whether a GO pledge is considered 'secured' would need to be resolved through the courts," Moody's said.

If the city is successful in its attempt to treat general obligation debt as unsecured, "we could change the rank ordering of various debt security types, including GO bonds," Moody's added.

Recent municipal bankruptcy cases in California and Rhode Island have centered on the tension between worker benefits and bond debt. Detroit's bankruptcy case may provide more clarity on the issue, Moody's said.

"Most states have left unclear in state law which creditor class takes primacy over the other when resources are too scarce to satisfy both," Moody's said. "The answers to these questions could influence the municipal bond market's expectations for pension and debt recoveries, even if they don't set direct legal precedent outside of Michigan."

Still, Moody's said it considers Detroit an outlier, and said for healthy governments, which make up the bulk of the U.S. public finance market, the impact of the bankruptcy will be limited.

"We do not foresee the Detroit bankruptcy presaging a large volume of defaults and bankruptcies," the report said. "Most local governments are managing through the current environment, and defaulters like Harrisburg and Jefferson County will remain anomalies with unique stories to tell."

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