How Detroit bankruptcy could alter the key assumptions of municipal bond finance…

Sometimes a 100 pager paper fails to make sense and sometimes just a 4 pager does the job,

Gene Amromin and Ben Chabot of Chicago Fed write this must read note on Detroit bankruptcy. It not only explains the economics of bankruptcy of cities in US but the politics as well:

Chapter 9 provides financially distressed local governments, such as the City of Detroit, protection from creditor claims in the federal bankruptcy courts, subject to a number of state-level restrictions.1 Michigan is one of 24 states that allow their municipalities to seek Chapter 9 protection. Although the federal requirements for bankruptcy are explicit,2 the paucity of Chapter 9 filings and the variability in state legal environments effectively make every new case a complex and protracted matter.

This holds particularly true for Detroit’s filing, which is notable for its sheer size, the multitude of competing claims, and the historical and economic contexts in which the bankruptcy is playing out. Indeed, the intensity of media coverage surrounding Detroit indicates the extent to which the bankruptcy filing of the once-thriving industrial icon has resonated with the American public. In this Chicago Fed Letter, we describe how municipal bankruptcy unfolds in Michigan, how Detroit’s filing has the potential to change some of the key assumptions of municipal bond finance, and what the market reaction has been thus far.

In Michigan, one gets to appoint an emergency manager as the guardian:

A unique feature of Michigan law is the ability of the governor to appoint an emergency manager (EM) to take over operations of financially distressed units of local governments, ranging from school districts to entire municipalities. Shortly after the state’s February declaration that the City of Detroit was in a financial emergency, Governor Rick Snyder appointed Kevyn Orr as Detroit’s EM. Under new legislation that went into effect on March 28, 2013, governor-appointed EMs are allowed to take extraordinary measures, including modifying or terminating collective bargaining agreements and recommending that the municipality enter Chapter 9 bankruptcy.3 When Chapter 9 protection is sought, the EM has the sole power to propose a restructuring plan to the bankruptcy court.

Obtaining bankruptcy protection is far from straightforward, however. Although Michigan permitted Detroit to seek bankruptcy protection, the bankruptcy judge must determine whether the city is insolvent and can adjust its debts. The judge must also determine whether Detroit, as represented by the EM, had negotiated in good faith with its creditors and had failed to obtain an agreement outside of court. Moreover, the court must rule on a number of legal objections to Detroit’s Chapter 9 eligibility—which range from whether Chapter 9 is itself constitutional to whether the state authorization for the city’s bankruptcy filing is invalid in light of Michigan’s state constitutional protection of pensions.

One the court upholds Detroit’s appeal to file comes the issue of settling claims. This is really interesting as you have both state laws and federal laws for pension cuts:

There is a conflict between state and federal laws as to whether pension obligations can be impaired by a federal bankruptcy court. Michigan’s state constitution prohibits reductions of promised pension benefits, but Detroit’s EM argues that Michigan law allows for pension cuts in federal bankruptcy court. Pension funds have challenged the EM’s interpretation on the grounds that it violates both the Tenth Amendment to the U.S. Constitution and state law. To date there is no jurisprudence addressing the question of whether a municipality can diminish pension obligations protected by a state constitution. If the court agrees with pension creditors that state protections hold supreme, this could change market expectations with respect to the relative standing of municipal debt issued by cities located in states with such protections (e.g., Chicago, Los Angeles, and New York City). 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 bonds..

Plenty of other issues as there are multiple kinds of bonds with differing views on seniority etc..

Useful reading..

2 Responses to “How Detroit bankruptcy could alter the key assumptions of municipal bond finance…”

  1. bankrupt Says:

    Now a days the “bankruptcy” word is the common term of common or extraordinary people. Though still I do not have any experience but before facing the same problem I want to update myself regarding this cause no one one whats happens in life . Thanks a lot for sharing this very important information.

  2. Southbay Law firm » Blog Archive » Recent Insolvency and Bankruptcy Headlines – June 6, 2014 Says:

    […] How Detroit bankruptcy could alter the key assumptions of municipal bond finance… […]

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