Editor's Note: Detroit is more than a sideshow. What's at stake here is bigger than most investors realize. It could take a Supreme Court decision to determine the viability of many municipal bonds. Regardless of whether you are a muni bond investor or not, what happens in Detroit will affect you. Shah Gilani has the whole story.
Detroit went bankrupt, but so what?
Its own decades-long gross political mismanagement, corruption and incompetence pushed the city over the cliff into bankruptcy.
Why should we care?
It could change the way investors look at muni bonds. And not for the better.
The largest Chapter 9 filing in U.S. history will reverberate well beyond this once- bustling city and its creditors.
What's most threatening to muni bond investors, and in fact all investors, is whether the city's general obligation bonds are secured or unsecured issues.
General obligation bonds, backed by a city's ability to levy taxes to pay interest and principal, are thought to be the safest of all munis.
Detroit is putting this to the test.
Without the ability to levy taxes on account of a dwindling population, and raise revenues sufficient to backstop its general obligation bonds, Detroit raises the crucial question that could affect muni bond investors around the country:
Are general obligation bonds unsecured and what are investors' rights?
The Supreme Court may be hearing this issue. And muni bond investing may be shaken to its core.
Detroit's Chapter 9 bankruptcy filing is what could hammer muni bond markets, because it gives the city the ability to possibly purge what everybody thought were its secured muni bond obligations.
And this could set a terrible precedent for investors everywhere as cities, counties and municipalities in financial straits around the country consider this form of bankruptcy.
Detroit's Sneaky Move
Everyone is mad at Kevyn Orr, the "emergency manager" of Detroit appointed earlier this year under a revamped state law designed to "alleviate the financial problems of Michigan's municipalities and school districts."
Creditors claim they were negotiating in good faith with the emergency manager instead of suing and pursuing their collateral rights when Orr blindsided them with the bankruptcy filing.
Detroit's ability to file for bankruptcy under Chapter 9 has been challenged in Michigan state court by the city's pension funds, bondholders, and other creditors who claim that in spite of the city being more than $18 billion in debt, it is not insolvent.
Last Wednesday U.S. Bankruptcy Judge Steven Rhodes, the federal judge overseeing Detroit's Chapter 9 filing from his Chicago bench, halted all lawsuits related to the city's bankruptcy filing, handing Detroit an early victory and clearing the way for it to proceed with its bankruptcy filing.
Detroit's pension plans alone have unfunded claims amounting to $9.2 billion, which breaks down into $5.7 billion of unfunded retiree health insurance obligations and $3.5 billion in unfunded pension payment obligations. While the pension fund plan managers speak for the plans, the city's 23,500 retirees have no formal legal representation.
Is Filing Chapter 9 A New Fad?
The Chapter 9 filing differs from a Chapter 11 bankruptcy filing for a corporation, which allows outside parties to make counter-proposals, or from a Chapter 7 filing that would require a liquidation of the city's assets.
Also, the Chapter 9 filing makes the city less vulnerable to any other parties controlling its much- needed restructuring.
"In a Chapter 9, which means the city holds more cards than they do in a private sector filing, the judge can't impose a plan on the city and no one else decides what they can do," said Michael Sweet, a noted authority on financial restructuring and bankruptcy.
What actually happens under Chapter 9 is:
- The city gets an automatic stay against commencing or continuing collection efforts and foreclosures by creditors, but it doesn't prohibit payment of certain obligations if the city can and wants to make payments.
- It's business as usual for Detroit. Section 904 of the Code prohibits the bankruptcy court from interfering in the political or government powers of the city or from use and enjoyment of income- producing properties.
- Section 109(c) of the Code imposes eligibility on entities filing for relief under Chapter 9. Court hearings on a filing entity's eligibility are at the heart of the actions brought against the city's Chapter 9 filing in state court. There is no easy or quick answer to the eligibility question.
California's San Bernardino County, which filed for Chapter 9 protection, took almost a year to be declared eligible. The eligibility status of Stockton, California is still being argued in court more than 16 months after it filed for Chapter 9 protection from its creditors.
Ultimately, the eligibility issue could make its way to the Supreme Court, which may have to decide on Chapter 9 issues if more cities, counties, or municipalities threaten to restructure under court protection.
That's why the bankruptcy of Detroit will change government financing methods, investor appetite for government bonds, and how other American cities, municipalities and counties face the music from the Great Recession and their borrowing binges.
For more on what Detroit's bankruptcy means for muni bond investments, read here.
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Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
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Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
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Here is where the free market will torpedo Bernanke's attempts to keep interest rates down. If municipalities and states try to raise money through bond offerings, they are going to have to pay a premium to attract bond buyers. Potential bond buyers will see muni bonds as a greater risk and will therefore, rightly expect a higher rate of return for that risk. As interest rates move up on municipal bonds, the Fed will have a tough time competing for the same money that could be going into their T-Bills. They will have no choice but to increase the rates on T-Bills. The bankruptcy of Detroit is the straw that broke the camel's back. Watch for interest rates to increase dramatically over the next 6 months to a year. Does anyone remember the high interest rates of the 1980s? It's deja vu all over again.
Muni bonds are bought because they were secure and paid a bit more than T's. If they are not secure, they will not be purchased. These fund managers will lose their jobs if they gamble. So it is back to T's. The second problem is that many cities have gone from judicious debt on key infrastructure projects to borrowing to pay the light bill. If they can't borrow, the collapse will be dramatic and quick. You can forget your pensions and potholes. Even your hockey arena will have to pay its own way. Do your own survey and see if your city has any competent managers and politicians.
Like much of Southern Europe, there will be a period of 'adjustment'. Muni bonds will be sold with large discounts and then, not at all. So where will all the money go? A bit into safe T's and the rest? The stock market is already flooded with outside M&A money. Can the emerging markets take any more? Maybe it will just pay down debt and disappear to the Caymans. Maybe investing in a yacht builder would be a good idea!
The Fed /US Government bailed out AIG/Goldman/ BOA/ etc and continues to buy mortgages at $45B / month. What if they were to provide a guarantee of Muni bonds up to a certain amount the same as bank deposits? Whats another trillion or so in contingent liabilities?
So the creditors claim they were negotiating in good faith then Orr came out of left field and filed Chapter 9.
Good for Orr! He is a hero to all tax-payers.
The creditors (mostly government unions) deserve losing some of their ill-gotten sweet-heart deal benefits.
If the unions lose their pensions and health benefits, maybe it will be a harsh reality check for other greedy government unions around the world to be less greedy in the future.
There is a HUGE crash coming in stocks, and I don't REALLY CARE how much the Fed will
or will NOT guarantee, the FED itself is a MORONIC ponzi scheme that is ready for collapse.
Stephen >>>>>>>>>>>>>
The bankruptcy of Detroit is a good thing not a bad one. It is an admission that the government of Detroit and the State of Michigan can not escape financial reality any longer. It is a giant signal far superior to any bond rating that these supposedly safe investments are actually full of default risk in addition to interest rate risk. Furthermore, it is an admission that there is no bond contract that is free of political chicanery and that bond investors must this political risk into current and future bond investments.
Detroit is just the first domino…. look at some of the ciies in California and the great lakes region. Although there may wind up being some great investments in munis, some will be disasterous and many investors are going to avoid them like a plague. I would advise people become very familiar with their city's finances and leadership. Some of you may soon need to be prepared to haul your own trash to the dump once a week, send your children to other schools, or protect your own property should police or fire force become too scaled back. The next series of default/bankruptcy dominoes… cities then states, then….. oh well.
Lots of pessimism…investing wisely is maybe the only solution.