Will your city go bankrupt?

Joel Levy, Senior Municipal Analyst, TIAA-CREF Fixed Income Research

August 7, 2013

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The recent announcement that the city of Detroit had filed for bankruptcy caused significant concern among both investors and government employees. Whether you have investments in municipal bonds or a pension with a state or city government, you may be worried as pundits warn that any municipality could be on the brink of financial disaster.

If you read the headlines and grew concerned, you’re certainly not alone. The week after Detroit announced its historic bankruptcy filing, Lipper reported that municipal bond market outflows nearly doubled from the prior week to $2.2 billion (although some of these outflows may be attributed to concerns about rising interest rates).

Article Highlights

  • Detroit’s recent bankruptcy filing has left a lot of investors worried about financial disasters in other cities.
  • However, because there are many legal prohibitions against municipal bankruptcy, it is relatively rare.
  • Even in cases where municipalities do go bankrupt, many investors who hold municipal bonds get some portion of their principal back.
  • If you invest directly in municipal bonds, do your research and understand state municipal bankruptcy laws.

The good news is that there are many legal prohibitions against municipal bankruptcy, and it is relatively rare. And even in cases where municipalities do go bankrupt, most investors do get some portion of their principal back. Why, then, are the headlines so ominous? In an effort to simplify a complex topic, commentators often meld municipal and corporate bankruptcy experiences into a single monolithic entity, leading to inaccurate generalizations. Let’s look at the facts around municipal bankruptcy.

1. It is legally difficult for a municipality to go bankrupt

Some investors may be surprised by the rigidity of Title 11 of the United States Code (USC), which governs municipal bankruptcy. First, states are prohibited from declaring bankruptcy. Second, in order to file, the municipality must be “specifically authorized, in its capacity as a municipality or by name, to be a debtor under such chapter by State law, or by a governmental officer or organization empowered by State law to authorize such entity to be a debtor under such chapter.” In other words, federal law allows states to decide if a municipality will be given the legal option to file. If the state says, “No,” then the municipality cannot file—and nearly half of the 50 states do not allow their municipalities to file bankruptcy (see chart below). Sixteen states put conditions on filing, such as the appointment of an Emergency Manger, while just 12 allow municipalities blanket authority to file of their own free will. It is important to research the laws of the state in which you are investing.

State Bankruptcy Authorizations

Source: Source: State policy classifications obtained from "Primer on Municipal Debt Adjustment," Chapman and Cutler LLP. Number of Governments measured in 2012 Census of Governments

Those who fear that the Code could be altered to allow for state bankruptcies can look to the United States Constitution and “The Contracts Clause,” which prohibits states from “impairing the obligations of contacts.” A 1977 Supreme Court ruling (United States Trust Co. v. New Jersey) found that states may not retroactively change the covenants of its bondholders. Historically, a heightened standard of law is applied to state debt to ensure that state obligations are honored and that states are discouraged from creating debts that can easily be discharged by legislative fiat.

2. Municipal bankruptcies are relatively rare

In order to declare bankruptcy under Title 11, a municipality must offer proof of insolvency. Essentially, it must prove that it cannot raise taxes to meet its obligations. This is a high standard of proof. In 2011, Boise County, ID, was dismissed from bankruptcy court after the judge ruled that it had not met the test of insolvency. In other words, if a municipality can legally raise taxes to pay its debts, courts may force the entity to do so.

Thanks to this high bar, municipal bankruptcies are rare, despite what some sensational headlines may suggest. According to the United States Federal Court system, there have been fewer than 500 municipal bankruptcy petitions filed in the past 60 years. For comparison, there were 37,552 business bankruptcy filings in the 12-month period ending in March 2013 alone.

The rarity of municipal bankruptcy is driven by many factors—not least that most municipalities are fiscally well-managed. Negative news gets headlines, but when you consider that there are more than 89,000 municipal entities, it should be noted that a relatively scant few face crushing fiscal distress.

Lastly, bankruptcy is rare because it makes it extremely difficult for a municipality to function. Bankruptcy essentially freezes a municipality’s access to the capital markets. A municipality that cannot access the capital markets cannot borrow the funds necessary to provide essential public services. This is a strong incentive to pay debts. Municipalities have immediate capital needs that can only be met with free-flowing access to the capital markets.

3. Many investors recover their investments after a municipal bankruptcy

No investor wants to experience a bankruptcy hearing. However, if you ever find yourself in such a situation, an optimist would note that recovery rates tend to be high for municipal defaults. Moody’s Investor Services1 measured the recovery rates for every Moody’s rated municipal bond default between 1970 and 2012. They found that ultimate recovery rates averaged 62%. Senior unsecured bonds for corporate issuers averaged 49% over the same time period.

What people may also not know is that according to Moody’s research, municipal bondholders received 100% of their original principal in many cases. The recovery rate increases with the seniority of the debt: On average, general-obligation or asset-backed bonds had more favorable recovery rates than junior lien-unsecured debt. Doing the research upfront to ensure you fully understand the type of security granted will pay great dividends should you ever find yourself staring down the barrel of bankruptcy judge’s gavel.

Know your debt
Ongoing research is an integral part of portfolio management. Many investors erroneously stop researching their holdings after their initial purchase decision, thereby exposing themselves to readily foreseeable market and investment risks. Understanding state municipal bankruptcy laws, and the types of credit and security provisions offered, can help investors make an informed decision.

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