Economists at the Chicago Federal Reserve said Friday Detroit’s record-setting Chapter 9 bankruptcy filing may dramatically reshape the U.S. municipal bond markets and pension financing.
The case already has increased the costs of borrowing by other Michigan cities and counties, the Chicago Fed noted.
“Detroit’s case has the potential to set a number of precedents with far-reaching consequences, such as the treatment of pension and (retiree health care) obligations vis-à-vis bonded debt, the degree of protection afforded by state constitutions and the value of the unlimited tax pledges approved by the electorate,” Fed economists Gene Amromin and Ben Chabot said in a report released Friday.
“The resolution of these issues in court will change the shape of municipal financial markets for years to come.”
The Chicago Fed’s report cited data on recent Michigan cities’ and counties’ borrowing, which in some cases showed a higher interest rate compared to other U.S. cities. That suggests “the filing has had a material impact on borrowing costs of Michigan municipal issuers.”
So far, the impact of Detroit’s bankruptcy on borrowing by cities outside of Michigan has been “negligible,” the report said. “Although the market penalized Michigan municipal issuers, there was little immediate price impact in municipalities with large, unfunded pension obligations located in other states.”
The report noted that between 1970 and 2011, all cities and municipalities that filed for Chapter 9 bankruptcy restructuring treated general obligation debt as secured debt, and fully repaid those obligations.
Detroit emergency financial manager Kevyn Orr opted to treat $1 billion in outstanding general obligation debt as unsecured. He has offered $2 billion for $11.5 billion in unsecured debts, including $3.5 billion pension obligations and $5.7 billion retiree health care liabilities, along with general obligation debt.
Some of the general obligation debt was issued with voter approval “that commits the city to levy unlimited taxes for repayment,” the report said. On average, those debt-holders are being offered 10 cents on the dollar, the report noted. The report said it was “surprising” that Orr opted to treat all general obligation debt the same – including the unlimited debt. “This issue will be ultimately settled by the court, and it might have wide-reaching consequences for the pricing of voter-approved (general obligation) debt.”
The report noted that a recent Pew Charitable Trust study showed that large cities have funded 57.5 percent of $511.2 billion in retirement benefits promised employees.
There’s no precedent for whether a city can avoid or reduce employee pension obligations that are protected by a state constitution -- as some argue in the Detroit case. If the bankruptcy court agrees with pensioners that state protections trump other claims, cities with underfunded pension systems could have to pay higher borrowing rates.
The report also noted that many other U.S. cities face financial problems similar to Detroit’s. “For these governments and their creditors, Detroit’s case is a potential bellwether,” the report said.
The Chicago Federal Reserve Bank is one of 12 regional banks and oversees Detroit.