Municipalities , Muni Bond Holders, and Chapter 9 Bankruptcy

Cumberland Advisors reports:

One of the unforeseen consequences of the financial crisis has been the phenomenon of municipal governments in distress. Prior to the financial crisis, Chapter 9 municipal bankruptcy was a topic hardly germane to municipal investors: it happened sometimes, usually for one-off reasons (e.g., a legal judgment or poor internal controls) but was not widespread. The infrequency of municipal distress made municipal bankruptcy an issue that was overlooked by investors, and untested. Annual Chapter 9 filings number in the single digits and are concentrated in small, nonrated issues; in contrast, there are roughly 10,000 Chapter 11 filings annually.



The biggest “credit” issue is the municipal capital structure, and the recent emergence of pension obligations and other post-employment benefits as long-term liabilities – the result of poor stock market performance and the graying of the population. Since this is a new problem, it raises unanswered questions. In the case of Detroit and California municipalities, which used bankruptcy as a tool to restructure, we’ve asked ourselves, “Who gets paid first in line in a bankruptcy?”



On Wednesday, Judge Christopher Klein, the federal judge overseeing Stockton’s bankruptcy, ruled that CalPERS and GO bondholders are both unsecured creditors. Payment of claims to CalPERS will not come prior to those of bondholders in a plan of adjustment; they will be equally secured on the same basis. This is a big deal for three reasons. First, it asserts the power of the federal government in the relationship between state and local governments. We take Klein’s decision to mean that state and local fiscal relationships fall within the jurisdiction of federal courts. This has been called into question by CalPERS who has argued that state law and constitutional protections cannot be altered by federal government. This is very much a 10th Amendment issue. Second, the ruling reinforces the government’s power to amend, modify, and break contracts, a power reserved solely to the federal government under the “Contracts Clause” of the US Constitution. Third, it is a positive for bondholders.



It does not solve a primary problem we’ve seen, and that is the principal-agent problem inherent in local government finance – namely, will Stockton’s elected officials do what is in the best interest of bondholders, or themselves? Stockton’s proposed plan of adjustment haircuts creditors but not pension payments to unions. The plan is much less likely to be confirmed now. Hearings on the city’s plan of adjustment start on October 30th.

It's not like we didn't warn you back in 2008.