CHICAGO The resolution of Detroit’s proposed treatment of its pension, retiree healthcare, and bond obligations in its historic Chapter 9 bankruptcy stands to shape the municipal market for years, the Federal Reserve Bank of Chicago concludes in a new report.
Detroit emergency manager Kevyn Orr has proposed treating the city’s general obligation bonds as unsecured debt unless it carries a double-barreled revenue pledge. Such treatment puts it on par with pensions and retiree health care costs.
With the market rattled by Orr’s position, the Federal Reserve Bank of Chicago added its voice in a letter published Friday that assesses that market impact so far of Detroit’s July 18 filing and looks at how the outcome of the city’s proposals stands to jolt conventional market positions.
“As of this point, Detroit’s bankruptcy filing has had little impact on the cost of municipal financing outside of Michigan” but it has the “potential to set a number of precedents with far-reaching consequences,” reads the letter.
The potential precedents involve the treatment of pension and other post-employment benefit obligations, bonded debt, the degree of protection afforded by state constitutions, and the value of the unlimited tax pledges approved by the electorate.
“The resolution of these issues in court will change the shape of municipal financial markets for years to come,” says the letter authored by senior financial economist Gene Amromin and financial economist Ben Chabot.
The city’s first default on unlimited and limited tax GO bond payments came on Oct. 1. Orr has proposed issuing $2 billion of notes to pay off all $11.4 billion of unsecured creditors, including bondholders and retirees. Detroit’s only other default so far was a June payment for $39.7 million on the city’s pension certificates.
The Michigan constitution ascribes a guarantee of repayment for voter-assisted general obligation bonds such as the city’s unlimited tax GOs and in past Chapter 9 bankruptcies municipalities have afforded GO debt a more senior ranking to other debt such as those related to pensions. Michigan’s state constitution prohibits reductions of promised pension benefits, but Orr argues that Michigan law allows for pension cuts in federal bankruptcy court.
“In fact, between 1970 and 2011 (when Jefferson County, Alabama, filed for bankruptcy), no GO bond in the Moody’s credit rating universe was impaired in a Chapter 9 bankruptcy,” the report said.
Where the bankruptcy court lands in Orr’s attempt to strip unlimited and limited tax of their long-held market distinctions “might have wide-reaching consequences for the pricing of voter-approved GO debt,” the report warned.
UTGO debt is typically repaid from a special property levy that has no limit and, as such, relies on revenues that are entirely separate from those used to cover general fund operations. This feature of UTGO debt makes it quite similar to other secured debt, contrary to the EM’s statements implying that none of the GO bonds have legal security, the report asserts.
The ultimate treatment of Detroit’s pensions and other retiree costs also could guide future market perceptions especially given the breadth of struggles other municipalities across the country face on those fronts. The report cites a recent Pew Charitable Trust study of the largest cities that indicated they have funded only 57.5% of $511 billion in promised retirement benefits.
“The standing of pension obligations relative to other municipal liabilities is particularly important to bondholders and the broader public given the multitude of well publicized funding shortfalls in a great number of American cities,” the report reads.
A shift in market expectations as to the relative standing of municipal debt issued by other cities could occur if the bankruptcy court agrees with the pension funds that have challenged the city’s position on state and federal grounds that protect pension benefits.
“Furthermore, any precedent that makes pension obligations senior to municipal bonds on broad Tenth Amendment grounds could have a material effect on the pricing of municipal debt for any city with large underfunded pension obligations,” the report predicts.
Michigan is one of just 24 states that allow municipalities to file under Chapter 9 protection. While some in-state deals have been held up due to steep penalties demanded by investors, the authors found a negligible impact of the bankruptcy on pricing beyond Michigan’s borders.
A week before Orr unveiled his proposed restructuring in June, the spread between yields on the nationwide Standard & Poor’s Municipal Bond GO Index (SAPIGO) and the 10-year Treasury was eight basis points. The spread increased by nine points the day after Detroit’s filing but then quickly returned to pre-bankruptcy levels.
That wasn’t the case in Michigan, where the spread between the S&P Municipal Bond Michigan GO Index and the yield on SAPIGO increased 14 basis points following the EM proposal. The spread further jumped by 29 basis points on the day after Detroit’s bankruptcy filing and has remained elevated since.
The authors also saw no material impact for other municipalities with significant unfunded pension obligations in other states.
The report illustrates that point by looking at Illinois debt issuers including Chicago and Cook County -- which have faced recent credit downgrades because of unfunded pension obligations and legislative stalemate on reforms.
The S&P Municipal Bond Illinois General Obligation Index to SAPIGO yield spread increased noticeably in August so the authors sought to assess whether the market had begun to demand a larger risk premium for issuers with mammoth retiree liabilities in the wake of Detroit’s bankruptcy filing.
The authors looked at dozens of bond issues based on their retiree obligations and whether the issuer was located in a Chapter 9-eligible state and concluded: “Market participants appear to require no more compensation to hold bonds issued by cities with obligations that are subject to Chapter 9.”
Detroit obligations include $6 billion of water and sewer bonds backed by the specific pledge of revenues from the city’s utility system, giving it senior status among liabilities.
The city has another $1 billion of GO debt with its unlimited tax GOs issued with voter approval. Some pieces of both the unlimited tax and limited tax bonds are double-barrelled with revenue pledges.
The city’s pension and OPEB obligations have been valued by Orr at $3.5 billion and $5.7 billion, respectively. The city has another $1.5 billion pension obligation certificates and $800 million of swap contracts, as valued by Orr.