Implications of Detroit Bankruptcy
Board: Macro Economics
Sometimes the inevitable occurs. Detroit declared Chapter 9 bankruptcy today. While it was pretty much agreed to be inevitable, the timing was surprising. Most observers thought it would not occur until ~ September. What moved the timing up to today was that several of the employee unions filed a pre-emptive lawsuit seeking to prevent Detroit from filling BK. The grounds were that a BK filing would irreparably harm the employee pensions. This is precisely what the Detroit Emergency Manager Kevyn Orr was proposing in BK. If the unions had been successful in court, it is possible that the judge would have placed an injunction on Detroit, forbidding them from filing BK. So the unions got the unintended consequence of FORCING the BK filing immediately.
Without a doubt, Detroit is a financial disaster. Steve has documented the poor, shall we say incompetent, city management for at least one decade. Steve has also kept us up to date on the crime blotter. Several former mayors have served jail time and it flows downhill from there. It is a tragic outcome for both the citizens of Detroit and the employees/former employees. Separate from those issues, there a few big picture items that might have implications beyond Detroit.
1) Will the city be able to push through a fast track, pre-packaged BK like GM and Chrysler did? Kevyn claims that they can complete the BK in ~ 12 months. Most outside BK lawyers expect 3 to 5 years. If it is done in 12 months, it will pretty much mean that creditors will get little say so, just like occurred in the GM/Chrysler cases. The lawyers claim there is no precedent for a fast track Chapter 9 BK, so we will see.
2) Are pensions or bondholders higher up in the priority for payouts? Both sides claim that should have the upper hand. This is exactly like the Stockton BK case in that regard. My best guess is that Stockton will set the precedent well before Detroit gets to answer that question.
3) Pension payouts both in Detroit and Stockton rely on state law. State law essentially says that pension payouts are sacred and cannot be cut after the fact. BK law is all federal. The question is which law prevails: state or federal in essence.
4) How sacred are General Obligation bonds? Some of the Detroit bond are GO’s. The bond indenture promises in writing that Detroit will raise taxes if necessary to make the bond payments on time. Kevyn has proposed these GO’s be classified as “unsecured creditors” and must stand in line with all of the other unsecured creditors. Bondholder claim they should be at the front of the line.
5) Will Detroit resort to selling valuable works of art from the museum and antique cars? In personal and corporate bankruptcies, the judge can order all property to be used to pay claims. Chapter 9 BK law does NOT give the judge this power, so if someone attempts to “attach” the valuable art, it is not clear they have any legal standing.
6) Will this seriously damage the last strong municipal bond insurer, Assured Guaranty? Detroit in and of itself will NOT cause this. The issue is whether their BK filing leads the way to other municipalities, which COULD swamp out AG’s insurance reserves.
7) Will this prompt Federal legislative action to either bail out Detroit pensioners and/or setup a larger country wide backstop for municipal pensions. Private pensions are insured by the Pension Benefit Guaranty Corp, which is a federal creation. Public pensions do NOT have any such insurance. You might be able to argue that Stockton could pay their pension obligations if they stiff the bondholders. I don’t see that for Detroit. IMO, Detroit will NOT be able to meet their pension obligations, even if they forced 100% losses on the bond holders. Somebody will have to ride to the rescue if these pensions are to be honored. Maybe the state will do it, but I am guessing there will be political pressure to install some kind of federal insurance.
8) Muni bond investors are going to re-address the whole market if they end up getting shortchanged either in Detroit and/or Stockton. I have NOT seen any wide scale panic of any sort in the muni bond markets to date. Quite the contrary: I have been seeing sellers pricing Detroit bonds like all is well. I am seeing a few buyers paying close to full price, for god only knows reasons. IF and it is a BIG if, bond holders end up with major haircuts, it will have far reaching implications for the muni markets. It will change from a “one-off” event to a systematic, system wide risk that must be priced in. This decision is months to years away IMO. Please note that many of the Detroit bonds are insured. The problem is that other than Assured Guaranty, the other insurance companies are deemed very weak, bordering on insolvent. It is not clear whether the insurance companies can/will absorb the haircuts, yet pay the bondholders in full.
9) Meredith Whitney is MORE right today about the magnitude of municipal bond defaults. She has been widely criticized for the timing and quantity of defaults. Detroit makes her story more credible. Personally I think she was too early, but will end up correct on the quantity.
BOTTOM LINE is that there are a lot of precedents likely to be set in Detroit and/or Stockton regarding municipal bankruptcies. It is beyond Yoda to forecast how all of these items will be decided.