The State of Michigan’s failure to preserve the integrity of the General Obligation (GO) pledge in Detroit has greatly undermined the market’s confidence in debt issued within Michigan. It has also resulted in increased borrowing costs for other Michigan entities.
The State communicated to investors the UTGO security pledge of local governments should not be considered any stronger than a basic appropriation or lease, raising significant concerns statewide.
In contrast, other states, such as Rhode Island, have offered varying levels of support to distressed municipalities. Demonstrated state-level support provides evidence of an additional layer of bondholder protection, one that is not always expressed in bond offering documents.
Michigan’s willingness to allow Detroit to impair GO bondholders has highlighted the importance of gauging an issuer’s ‘willingness to pay’, in addition to its underlying ability to pay.
It is becoming increasingly important to understand the level of oversight and intervention states are willing to take with distressed local governments.
On October 1, the City of Detroit defaulted on its Unlimited Tax General Obligation (UTGO) Bonds. While the default was widely anticipated, it presents a good opportunity to follow up on our initial response to Detroit’s bankruptcy filing, and review any fallout the filing has had on the municipal market.
Since Detroit filed for Chapter 9 bankruptcy on July 19, other local governments in Michigan have been hesitant to issue new bonds and paid a higher price when doing so. To date, the most prominent examples include Oakland County, Saginaw County, Genesee County and the City of Battle Creek. Genesee County and Battle Creek delayed their deals by a month and ultimately came to market with bond insurance. Oakland County opted for its first-ever private placement and Saginaw County has yet to price their deal in the market. The issuers that ultimately issued bonds paid higher yields than similarly-rated credits outside of Michigan. Distressed local governments in Michigan have effectively been shut out of the market or, at the very least, penalized for Detroit’s woes. The two distressed local governments that have priced deals are Ypsilanti Public Schools and Detroit Public Schools. However, both required state credit enhancement. Even with state aid payments deposited directly with the trustee, the Detroit Public School deal was priced at a well-above-market 4.5% yield for a one year maturity. Detroit remains a unique situation and is not representative of any broader distress trends in the national municipal market. Consistent with this thesis, the municipal market, outside of Michigan, has not seen any credit driven fallout from Detroit’s bankruptcy.
Regarding the State of Michigan signing off on Detroit’s restructuring proposal: the State not only failed to preserve the integrity of the GO pledge for its governments, it endorsed Detroit’s plan to impair GO bondholders. Trust and confidence remain vital to the creditworthiness of municipal issuers and Michigan’s decision to support Detroit’s attempt to impair GO debt has greatly undermined the market’s confidence in debt issued by Michigan governments. Even if UTGO bondholders were to prevail in federal bankruptcy court and establish standing as secured creditors, we feel the damage to the creditworthiness of Michigan local governments will be difficult to reverse.
While the fallout from Detroit on other Michigan local governments demonstrates the cost of inaction by a state, Rhode Island offers an excellent example of how a state willing to intervene and preserve the security of the GO pledge of its governments is able to bolster market confidence. In 2011, when Central Falls, Rhode Island was facing an inevitable bankruptcy filing, the State immediately recognized the risk of inaction to the state’s other governments and quickly passed legislation establishing all GO debt in Rhode Island as secured under Chapter 9 bankruptcy. This action cemented the municipal market’s confidence in Rhode Island’s leadership and GO pledge of its governments. To date, Rhode Island’s willingness to preserve the GO pledge has been held up as the gold standard for maintaining the market’s confidence in a state amidst a local government bankruptcy situation.
While Michigan and Rhode Island represent the far ends of the spectrum in States’ willingness, or lack thereof, to support local debt, most other states fall somewhere in between. Formally, seven states proactively monitor the financial position of their local governmental entities, including Florida, Maryland, New Hampshire, New Jersey, North Carolina, Ohio and Pennsylvania. These states have formal legislation and processes in place mandating additional levels of financial reporting and budget analysis, which have been instrumental in identifying and remediating financial distress before default. One of the strongest examples of state oversight is in North Carolina, where the Local Government Commission (LGC) analyzes the fiscal and accounting practices of all local governments, handles the sale of all debt, monitors repayment, offers ongoing technical assistance to local government managers and manages the audit process for all municipalities. Furthermore, a handful of additional states have reactively enacted direct oversight measures to ease distressed municipalities and retool management.
Further, running counter to Michigan’s inaction and in an effort to prevent distressed municipalities from filing for Chapter 9 bankruptcy protection, defaulting on debt service obligations or being forced to curtail the services provided to residents, several states have proactively intervened with a variety of support mechanisms. Such assistance may include bridge financing, transfer of costly services to other governmental agencies, loan or grant funds to cover budgetary gaps and/or an early release of state taxes payable to the municipality. For the state and municipality, the benefits of avoiding bankruptcy are multiple, while the consequences of a filing can be painful, wide-ranging and long-lasting. Importantly, avoiding bankruptcy will likely result in uninterrupted access to market capital at reasonable costs and allowing the municipality to continue operating day-to-day, while seeking to bring its budget into balance over the longer term. In our view, demonstrated and repeated state-level support provides evidence of an additional layer of bondholder protection, one that is not always expressed in bond offering documents.
As we have seen in Michigan, the municipal market will penalize local governments in a state that does not act to preserve the GO security pledge. As a result, it is becoming increasingly important for investors to understand the level of intervention and oversight states they invest in are willing to take with distressed local governments. The cost of bankruptcy and/or default is difficult to quantify, although for municipal issuers it can be very expensive and generally has very little upside. Furthermore, in several cases, an issuer’s ability to utilize Chapter 9 filing to renegotiate collective bargaining agreements or retirement benefits has been handicapped by state efforts to curb such practice, as is the case in Michigan.