California GOs Different – And Stronger – Than Detroit's

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LOS ANGELES - It's a long way from Detroit to California.

While the substantial haircut bankrupt Detroit wants to give its general obligation bondholders has caused municipal bond market ripples, the GO pledge should stay strong among California's municipalities, market experts say.

"What is obviously on everyone's mind in California right now is they're looking at Detroit and saying, well, could that happen to us?" said Robert Christmas, a financial restructuring and bankruptcy partner at Nixon Peabody LLP. "And I think the answer to that is no."

Detroit, which filed for bankruptcy protection in July, wants to give most GO bondholders an 80% haircut, with little differentiation between limited tax GOs and voter-approved unlimited-tax GOs.

While the term general obligation bond is widely used, its actual meaning varies from state to state.

One way to look at GO debt is to take into account whether a state's law establishes a clear statutory lien for GOs, and whether it allows local governments to file Chapter 9, when those liens might come into play, muni experts have said.

Michigan lacks a statutory lien and does allow for Chapter 9.

California also allows Chapter 9 filing. While the state's statute does not specifically refer to a "lien," it has unique language that "has had the practical effect of creating a lien on revenues," according to a Moody's Investors Service report.

The agency said only five states expressly endow some or all GO debt with statutory liens. Moody's includes California among those five states.

"I don't think bond market participants in the California general obligation bond market should be worried," Christmas said. "If you look at the structure and you look at the history, California has had very low borrowing costs historically due to the strong structure that they have."

In California, voters must approve local GO bonds and a specific tax levy to pay for them. Local GO bonds are secured by a promise to levy property taxes in an unlimited amount as necessary to pay debt service.

Voters approve the ad valorem tax to pay the debt service -- and it can't be used for any other purpose.

California cities must obtain two-thirds voter approval to authorize GO bonds, which is hard to get. There are no limited-tax GOs.

None of California's three big recent bankruptcies, in Vallejo, Stockton and San Bernardino, involved any GOs, though Stockton, in particular, has sought big haircuts on other classes of bonds.

School bonds, which can be authorized by 55% majorities, are much more common in California.

But the state government, which has a constitutional obligation to K-12 students, has for the last quarter-century stepped in to backstop insolvent school districts.

The debate over the security of GO bonds is relatively new for the municipal market.

Detroit's proposed haircut is dramatically larger than most historical GO defaults, according to Moody's. In the past 25 years, the recovery rates on GO bonds have been much higher than in other sectors — frequently close to par. In the overall muni sector, recovery rates were close to 60%.

"Before Detroit, I've never seen such an attack on GO debt with this kind of structure," Christmas said.

It's been the opposite, he said. For example, when California's San Jose Unified School District filed for bankruptcy in 1983, it specifically preserved its GO bond debt and continued to make payments.

The Sierra Kings Health Care District in Reedley, Calif., which filed for Chapter 9 bankruptcy protection in 2009, also made payments on all of its GO bond debt.

Central Falls, R.I. emerged from Chapter 9 in 2012 without defaulting on its GO debt.

Detroit's severe treatment of a class of debt that has typically been prized for its relative safety as an investment has prompted market participants to reconsider the meaning of the "GO pledge."

"Certainly what's going on in the bankruptcy cases now, including Detroit, San Bernardino, and Stockton, is going to have long-term implications on Wall Street because there's a clear indication that what the bond community thought may be different from reality," said Michael Sweet, a bankruptcy partner at Fox Rothschild LLP.

"As we see bonds get less than ideal treatment in these various bankruptcy cases, it's going to certainly send a message in terms of what people are going to do in future bond transactions where there's a risk of bankruptcy and presumably that risk will be priced into the bonds," he said.

Currently, local GOs make up a sizable portion of the muni market — close to 60%, according to data compiled by municipal analysts at Citi.

"Thus far, spreads of local GOs did not widen in response to the introduction of Detroit's plan, helped by strong and improving muni technicals in early 2014, as well as the belief that Detroit may be a unique case," Citi analysts said in a recent research report.

They added that if spread widening does occur, it would most likely show up on lower investment grade credits, such as triple-B and below, since stronger credits would be far less likely to transition into the condition of deep financial insolvency experienced in Detroit.

"It's definitely disconcerting to imagine that there's going to be a possible conclusion where GOs are held to be worth less than what people thought they were, but I'd be very careful to make allusions of contagion here," said Hector Negroni, co-founder, co-chief executive officer, and chief investment officer of Fundamental Credit Opportunities.

"First and foremost, there are not that many GOs facing imminent default in bankruptcy filing," he said. "So just the sheer mass of the number of likely incidences is very, very small."

Secondly, there's good reason to expect diverse outcomes among entities in default in different states, he said. Each entity has its own set of circumstances, including the factors causing bankruptcy, the different types of stakeholders, and the constitutional protections afforded to participants.

"Practically speaking, I don't think you'll find a lot of cities wanting to do what Detroit is attempting," Christmas said.

He believes states will put pressure on municipalities to honor their bond debt, as happened in Rhode Island, which passed legislation reaffirming the nature of bond pledges. That law was applied in the Central Falls bankruptcy, in which bondholders remained whole unlike other creditors such as pensioners.

"This state government pressure occurs because local bond defaults can have a contagion effect on the borrowing costs of other local issuers and, ultimately, also the state, all at the expense of taxpayers," Christmas said. "The market extracts a penalty."

In addition, going to war with bondholders would make it very difficult to manage and get out of Chapter 9.

"Detroit may not be the only city that will go through a massive contraction, but I think its strategy will be an outlier," Christmas said. "Extreme positions can be taken in litigation, and the briefs may be well-written, but that does not mean the arguments have merit."

Citi analysts said the Detroit bankruptcy case could prompt states to strengthen the local GO pledge and bring unions and local governments to the negotiating table to resolve underfunded pension issues.

Moody's also said that if Detroit's plan prevails, more states might consider laws that expressly classify GO pledges as statutory liens or not in order to clarify bondholder rights.

Whether or not Detroit is successful in its attempt to classify its GO bonds as unsecured debt remains to be seen.

"I don't think it will fly," Christmas said. "Bondholders might agree to a lesser payment treatment to avoid litigation, but there's too much protection around the taxes — first they're voter-approved, which is similar to California. Second, the law says where the money gets to go. And in California, there's actually additional protection because it's in the state constitution."

In confirming a Chapter 9 plan of adjustment, the bankruptcy court has to make a finding that actions contemplated in connection with the plan are not prohibited by state law, Christmas said.

If state law, as in California, says that the relevant tax revenues can only be used to pay off bond debt, a plan that provided for other uses of such taxes would be in violation of state law.

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