ESSAYS ON ISSUES THE FEDERAL RESERVE BANK NOVEMBER 2013 OF CHICAGO NUMBER 316

Chicag­o Fed Letter

Detroit’s bankruptcy: The uncharted waters of Chapter 9 by Gene Amromin, senior financial economist, and Ben Chabot, financial economist

On July 18, 2013, Detroit became the largest municipality to seek protection under Chapter 9 of the U.S. Bankruptcy Code. This article describes several ways in which Detroit’s bankruptcy filing has the potential to alter some of the key assumptions of municipal bond (muni) finance, and examines the market reaction to date.

Chapter 9 provides financially distressed districts to entire municipalities. Shortly local governments, such as the City of after the state’s February declaration that Detroit, protection from creditor claims the City of Detroit was in a financial emer- in the federal bankruptcy courts, subject gency, Governor Rick Snyder appointed to a number of state-level restrictions.1 Kevyn Orr as Detroit’s EM. Under new Michigan is one of 24 states that allow legislation that went into effect on their municipalities to seek Chapter 9 March 28, 2013, governor-appointed protection. Although the federal require- EMs are allowed to take extraordinary ments for bankruptcy are explicit,2 the measures, including modifying or termi- paucity of Chapter 9 filings and the nating collective bargaining agreements variability in state legal environments and recommending that the municipality 3 To date, Detroit’s bankruptcy effectively make every new case a com- enter Chapter 9 bankruptcy. When plex and protracted matter. This holds Chapter 9 protection is sought, the EM filing has had little impact on particularly true for Detroit’s filing, which has the sole power to propose a restruc- the cost of municipal financing is notable for its sheer size, the multi- turing plan to the bankruptcy court. tude of competing claims, and the his- outside of Michigan, but it Obtaining bankruptcy protection is far torical and economic contexts in which has the potential to set a from straightforward, however. Although the bankruptcy is playing out. Indeed, the Michigan permitted Detroit to seek bank- number of precedents with intensity of media coverage surround- ruptcy protection, the bankruptcy judge far-reaching consequences. ing Detroit indicates the extent to which must determine whether the city is in- the bankruptcy filing of the once-thriving solvent and can adjust its debts. The judge industrial icon has resonated with the must also determine whether Detroit, American public. In this Chicago Fed Letter, as represented by the EM, had negotiated we describe how municipal bankruptcy in good faith with its creditors and had unfolds in Michigan, how Detroit’s filing failed to obtain an agreement outside of has the potential to change some of court. Moreover, the court must rule on the key assumptions of municipal bond a number of legal objections to Detroit’s finance, and what the market reaction Chapter 9 eligibility—which range from has been thus far. whether Chapter 9 is itself constitutional Municipal bankruptcy in Michigan to whether the state authorization for the city’s bankruptcy filing is invalid in A unique feature of Michigan law is the light of Michigan’s state constitutional ability of the governor to appoint an protection of pensions. emergency manager (EM) to take over operations of financially distressed units If the bankruptcy court upholds Detroit’s of local governments, ranging from school eligibility for Chapter 9 protection, the Detroit’s liabilities into payments on POCs into fixed-rate obli- 1. Yield spreads of S&P municipal bond GO indexes, 2013 specific categories. gations. The POCs and associated swaps percent Detroit’s largest single have been valued in the EM plan at 1.1 obligation is the ap- $1.5 billion and $0.8 billion, respectively. proximately $6 billion Chapter 9 bankruptcy grants senior status in water and sewer to debts secured by the pledge of spe- 0.9 bonds that are backed cific revenues (e.g., the water and sewer by the specific pledge system bonds secured by utility bill pay- of revenues from the 0.7 ments). All other debts are treated as city’s utility system. equally unsecured under the law. As se- Detroit also has about nior debt is repaid first, all other debts $1 billion in outstand- 0.5 can be repaid only from the revenues ing general obligation that are left over. Put differently, every (GO) debt. GO debt dollar of debt that is regarded as being 0.3 is typically paid out of Feb. Mar. Apr. May Jun. Jul. Aug. Sep. secured diminishes the pool of money the overall tax reve- available for repaying unsecured claims. SAPIGO−US10Y SAPIILG−SAPIGO nues and does not Theoretically, this suggests that all un- SAPIMIG−SAPIGO SAPICAG−SAPIGO have a dedicated re- secured debt is impaired (i.e., repaid payment source. How- Notes: The plots are the spreads between the yields of Standard & Poor’s (S&P) less than fully) in bankruptcy. The ex- municipal bond general obligation (GO) indexes (or those of an S&P index and ten-year ever, Detroit’s GO debt U.S. Treasury bonds). SAPIGO indicates the nationwide S&P Municipal Bond General act degree of impairment of each type Obligation Index. US10Y indicates ten-year U.S. Treasury bonds. SAPIMIG indicates comes in a number of the S&P Municipal Bond Michigan General Obligation Index. SAPIILG indicates the of unsecured debt is determined dur- S&P Municipal Bond Illinois General Obligation Index. SAPICAG indicates the S&P different flavors. Some Municipal Bond California General Obligation Index. The solid vertical line indicates ing the bankruptcy process. the first trading day (June 17) after the Detroit emergency manager’s proposal GO debt, known as to creditors. The dashed vertical line indicates the first trading day (July 19) after Detroit’s bankruptcy filing. unlimited tax general In practice, however, municipalities Source: Authors’ calculations based on data from Standard & Poor’s. obligation (UTGO) seeking Chapter 9 protection have pre- bonds, was issued with viously treated GO debt as senior to city will file its restructuring plan (i.e., explicit voter approval that commits the other unsecured claims such as pensions its “plan for adjustment of debts”), which city to levy unlimited taxes for repayment. in their debt adjustment plans. This will outline proposed payments to dif- Other GO debt, known as limited tax meant that GO bondholders were typi- ferent types of creditors. Unlike corpo- general obligation (LTGO) bonds, was cally repaid in full, even as some pension rate bankruptcy, there is no provision in issued directly by the city and can only and OPEB obligations were diminished. Chapter 9 allowing creditors to file their be paid from general funds. Moreover, In fact, between 1970 and 2011 (when own plan. Moreover, the court can force some of the UTGO and LTGO bonds Jefferson County, Alabama, filed for the acceptance of the city plan as long have separate streams of committed bankruptcy), no GO bond in the Moody’s as a majority of any class of the impaired revenues coming from the state and credit rating universe was impaired in a creditors accepts the proposal. As a re- are, therefore, referred to as “double- Chapter 9 bankruptcy. sult, creditors have few opportunities to barreled” bonds. These distinctions Yet, the EM proposal called for steep challenge restructuring in Chapter 9. highlight the fact that various GO bonds cuts in payments to most bondholders, can enjoy different forms of legal pro- Much of the market commentary and as well as to pensions being received by tection and can count on different news coverage to date has centered on retirees, pension and OPEB obligations sources of revenues for their repayment. the EM restructuring proposal, pre- owed to current employees, and POCs sented to creditors on June 14, 2013.4 In addition to bonded debt, Detroit’s held by pension creditors. Only the water Although the EM proposal is in no way liabilities comprise outstanding pension and sewer system bonds and double- binding and may end up being quite and other post-employment benefit barreled UTGO and LTGO bonds were different from the final plan for adjust- (OPEB) obligations, mainly for medical regarded as secured and thus subject to ment of debts, it provides a basis for the insurance coverage, to both current and repayment in full. On average, the un- expected treatment of various types of retired city workers, police, and fire- secured creditors were offered about ten debt. As such, the proposal created con- fighters. The pension and OPEB obli- cents on each dollar in claims they held. siderable controversy, since it ignored gations have been valued in the EM plan The EM’s proposed placement of some several conventional approaches to at $3.5 billion and $5.7 billion, respec- GO bonds on the same footing as retire- prioritizing and valuing liabilities of a tively. The remaining components of ment and employment obligations sur- bankrupt municipality. Detroit’s liabilities are two sets of financial prised market participants. It triggered securities closely related to its pension extensive commentary on the need for Unique aspects of the EM proposal obligations—pension obligation certifi- investors to rethink their assumptions To understand the unorthodox nature cates (POCs) and the associated swap about recovery values of GO debt in bank- of the EM plan, one needs to decompose contracts that convert variable-interest ruptcy. Although Detroit’s combination legal rulings with re- municipal debt for any city with large 2. Yield spreads of municipal bond portfolios, 2013 spect to the treatment underfunded pension obligations. percent of pension and OPEB 0.6 obligations, as well as How have the markets reacted thus far? GO debt backed by Apart from Michigan municipalities, the 0.4 unlimited tax pledges. market reaction to the Detroit bank- The standing of pen- ruptcy filing has been negligible. In the sion obligations relative week following the EM’s June 14, 2013, 0.2 to other municipal proposal to subordinate GO bonds, liabilities is particu- the difference (spread) between the 0.0 larly important to yield on the nationwide Standard & bondholders and the Poor’s (S&P) Municipal Bond General −0.2 broader public given Obligation Index (SAPIGO) and the the multitude of well- yield on ten-year U.S. Treasury bonds −0.4 publicized funding declined 8 basis points (figure 1). The Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. shortfalls in a great SAPIGO–ten-year U.S. Treasury bond H9−L9 Hno9−Lno9 number of American yield spread did increase by 9 basis points H9−Hno9 L9−Lno9 cities. For example, the day after Detroit’s Chapter 9 filing

Notes: The sample of 92 bonds was selected by choosing at most two bonds from data from a recent on July 18 but quickly returned to its each issuer from the set of uninsured fixed-rate general obligation bonds issued by the cities included in Pew Charitable Trusts (2013). When multiple bonds from the Pew Charitable Trusts pre-bankruptcy level. In contrast, the same issuer met these criteria, the two with a maturity closest to ten years were study of large cities spread between the yield on the S&P selected. H9 is a portfolio of bonds issued by cities with high per capita pension and other post-employment benefit (OPEB) obligations located in Chapter 9 states. indicate that they Municipal Bond Michigan General L9 is a portfolio of bonds issued by cities with low per capita pension and OPEB obligations located in Chapter 9 states. Hno9 is a portfolio of bonds issued by have funded only Obligation Index (SAPIMIG) and the cities with high per capita pension and OPEB obligations located in non-Chapter 9 states. Lno9 is a portfolio of bonds issued by cities with low per capita pension and 57.5% of the $511.2 bil- yield on SAPIGO increased 14 basis OPEB obligations located in non-Chapter 9 states. “High” and “low” obligations are defined as above and below the median, respectively. The plots are the spreads lion of retirement points following the EM proposal. The between the weighted average yields of the portfolios. The solid vertical line indicates the first trading day (June 17) after the Detroit emergency manager’s proposal to benefits promised to spread further jumped by 29 basis points creditors. The dashed vertical line indicates the first trading day (July 19) after their employees.6 on the day after Detroit’s bankruptcy Detroit’s bankruptcy filing. Sources: Authors’ calculations based on data from Bloomberg and Pew Charitable filing and has remained elevated since, There is a conflict Trusts (2013). suggesting that the filing has had a between state and material impact on borrowing costs of federal laws as to Michigan municipal issuers. of financial woes and structural economic whether pension obligations can be problems is unique, a substantial num- impaired by a federal bankruptcy court. ber of local governments nationwide face Michigan’s state constitution prohibits Charles L. Evans, President ; Daniel G. Sullivan, large pension and OPEB obligations. For reductions of promised pension benefits, Executive Vice President and Director of Research; Spencer Krane, Senior Vice President and Economic these governments and their creditors, but Detroit’s EM argues that Michigan Advisor ; David Marshall, Senior Vice President, financial Detroit’s case is a potential bellwether. law allows for pension cuts in federal markets group ; Daniel Aaronson, Vice President, bankruptcy court. Pension funds have microeconomic policy research; Jonas D. M. Fisher, Another surprising aspect of the EM Vice President, macroeconomic policy research; Richard challenged the EM’s interpretation on proposal was its failure to differentiate Heckinger,Vice President, markets team; Anna L. the grounds that it violates both the Tenth Paulson, Vice President, finance team; William A. Testa, between debt backed by the unlimited Vice President, regional programs, and Economics Editor ; Amendment to the U.S. Constitution tax pledge and debt lacking such a pledge. Helen O’D. Koshy and Han Y. Choi, Editors ; and state law. To date there is no juris- Rita Molloy and Julia Baker, Production Editors ; UTGO debt is typically repaid from a prudence addressing the question of Sheila A. Mangler, Editorial Assistant. special property levy that has no limit and, whether a municipality can diminish Chicago Fed Letter is published by the Economic as such, relies on revenues that are entirely Research Department of the Federal Reserve Bank pension obligations protected by a state separate from those used to cover general- of Chicago. The views expressed are the authors’ constitution. If the court agrees with and do not necessarily reflect the views of the fund operations.5 This feature of UTGO Federal Reserve Bank of Chicago or the Federal pension creditors that state protections debt makes it quite similar to other se- Reserve System. hold supreme, this could change market cured debt, contrary to the EM’s state- © 2013 Federal Reserve Bank of Chicago expectations with respect to the relative Chicago Fed Letter articles may be reproduced in ments implying that none of the GO standing of municipal debt issued by whole or in part, provided the articles are not bonds have legal security. This issue will reproduced or distributed for commercial gain cities located in states with such protec- be ultimately settled by the court, and it and provided the source is appropriately credited. tions (e.g., Chicago, Los Angeles, and Prior written permission must be obtained for might have wide-reaching consequences any other reproduction, distribution, republica- New York City). Furthermore, any prec- for the pricing of voter-approved GO debt. tion, or creation of derivative works of Chicago Fed edent that makes pension obligations Letter articles. To request permission, please contact senior to municipal bonds on broad Helen Koshy, senior editor, at 312-322-5830 or Implications for municipal bonds email [email protected]. Chicago Fed Tenth Amendment grounds could Letter and other Bank publications are available In the preceding section, we touched on have a material effect on the pricing of at www.chicagofed.org. the potential market ramifications of ISSN 0895-0164 Although the market penalized Michigan OPEB obligations and whether the issuer low-obligation cities located in non- municipal issuers, there was little im- was located in a Chapter 9-eligible state. Chapter 9 states (Hno9–Lno9) increased. mediate price impact in municipalities The yield spreads between these bond This evidence suggests the absence of with large unfunded pension obligations portfolios are graphed in figure 2. The any systematic discrimination against located in other states. Figure 1 graphs baseline series labeled (H9–L9) depicts issuers located in Chapter 9 states or the yield spread between S&P munici- the difference in yields on bonds issued issuers with high per capita pension and pal bond GO indexes for California by cities with high obligations located OPEB obligations following Detroit’s (SAPICAG), Illinois (SAPIILG), and in Chapter 9 states and bonds issued bankruptcy filing. Michigan and the nationwide SAPIGO. by cities with low obligations located in Illinois debt issuers, in particular, have Chapter 9 states. The H9–L9 yield spread Conclusion faced recent credit downgrades because is remarkably stable around the dates of As of this point, Detroit’s bankruptcy of unfunded pension obligations and the EM proposal (June 14) and Detroit’s filing has had little impact on the cost of legislative stalemate in addressing this bankruptcy filing (July 18). Market par- municipal financing outside of Michigan. issue, so the SAPIILG–SAPIGO yield ticipants appear to require no more Nonetheless, Detroit’s case has the po- spread increased noticeably in August. compensation to hold bonds issued by tential to set a number of precedents cities with obligations that are subject with far-reaching consequences, such Did the muni market start demanding to Chapter 9. In fact, the yield spread as the treatment of pension and OPEB a larger risk premium for issuers with between bonds from high-obligation obligations vis-à-vis bonded debt, the large pension and OPEB liabilities in issuers located in Chapter 9 states (H9) degree of protection afforded by state the wake of Detroit’s bankruptcy filing? and those from similar issuers located in constitutions, and the value of the un- To answer this question, we selected 92 non-Chapter 9 states (Hno9) declined limited tax pledges approved by the bonds issued by cities in Pew Charitable approximately 20 basis points in the electorate. The resolution of these issues Trusts (2013) and sorted these bonds month after Detroit’s bankruptcy filing. in court will change the shape of munici- into four equal-duration portfolios based Over the same period, the yield spread pal financial markets for years to come. on issuers’ per capita pension and between bonds issued by high- and

1 For details, see Gene Amromin and Anna previous version of the law (Public Act 4) Charter tax rate limitations for payment of Paulson, 2011, “Tempestuous municipal in a November 2012 referendum. Both of such obligations,” quoted on p. 15 of debt markets: Oxymoron or new reality?,” the EM laws are subject to several lawsuits www.scribd.com/doc/159347508/ Chicago Fed Letter, Federal Reserve Bank of challenging their constitutionality. Barclays-Municipal-Research-Detroit- Chicago, No. 291, October. Chapter-9-Begins. 4 The EM plan is available at www.freep.com/ 2 Section 109(c) of the U.S. Bankruptcy Code assets/freep/pdf/C4206913614.PDF. 6 Authors’ calculations based on data from sets forth the eligibility requirements for Pew Charitable Trusts, 2013, “A widening 5 The official statement for 2008 UTGO bonds Chapter 9. gap in cities: Shortfalls in funding for pen- states: “In accordance with State law, the City sions and retiree health care,” report, 3 The new EM law (Public Act 436) was passed is obligated to levy and collect taxes without Washington, DC, January, exhibit 1, p. 3. after Michigan voters had repealed the regard to any constitutional, statutory or