Wednesday, August 14, 2013

After NoMotown, What Does It Take for GO's to be Secured in Bankruptcy?

Now that Motown has become NoMotown with Detroit's Chapter 9 filing, the question has been framed as to whether the current structure for municipal general obligation bonds (GOs) is sufficient to require their classification as secured for bankruptcy purposes.

The question has huge financial consequences for bondholders and municipal insurers.   If GOs are secured, they will continue to be paid during the pendency of the bankruptcy, and they are more likely to be unimpaired in connection with the rearrangement of debts confirmed in the bankruptcy plan.

It is safe to say that the general expectation among municipal finance practitioners was that GOs should be classified as secured in bankruptcy.  Detroit's bankruptcy filing classifying its GOs as unsecured has caused a cris de coeur within the municipal finance market and, while it is by no means assured that the federal bankruptcy judge in the Detroit case will concur with Detroit's classification of its GOs as unsecured for bankruptcy purposes, I have commented that I thought such treatment was quite plausible.

In essence, there is a difference between security for municipal finance and bankruptcy purposes.  The pledge by a municipality of its full faith and credit to pay principal of and interest on GOs, dedicating tax revenues unlimited in rate and amount to back that pledge, identifies for bondholders what is the municipality's source of funds to make these GO payments, and bondholders can assess, from a financial point of view, the security of such repayment.  This pledge is clearly enforceable outside of bankruptcy.

This pledge, from a bankruptcy point of view, is likely to be characterized as an executory contract that may be rejected as unenforceable by a municipality in bankruptcy.  As I have commented in Detroit and Pandora's Box Part II, there are serious repercussions to a municipality's decision to accord its GOs such unsecured treatment, but bankruptcy has a way of focusing the municipality's mind on the short term as opposed to its ability to sell its bonds in the longer term.

So what is a GO bond investor and municipal finance insurer to do?

I would be shocked if future GOs are not structured in a fashion that provides greater security in bankruptcy, at least in those jurisdictions where municipal bankruptcy filings are not prohibited by state law.  This can be easily done.  One of my suggestions is to require in the GO enabling authorization that tax receipts be deposited in a lockbox, and a security interest be granted GO investors in that lockbox.  The lockbox is controlled by a bank that is required to pay, first, required principal of and interest on the GOs, and, second, disburse to the municipality remaining funds for disbursement as the municipality sees fit.  In this way, as long as the municipality levies taxes, the priority (and hence security in bankruptcy) of GO investors and municipal finance insurers will be clear.

To a surprising degree, finance follows trends, much as hemlines rise and fall in the fashion world.  The taboo of a large municipal bankruptcy has been broken and while it would be wrong to expect many NoMotown copycat bankruptcy filings (because municipalities must prove insolvency on a paying its obligations as they come due basis, as opposed to a balance sheet basis, and this is a point of extremis that few municipalities other than Detroit can claim), it is not wrong to expect that those municipalities that can make a bona fide bankruptcy filing will be more likely to do so in the future.

If I am right in this regard, then municipal finance insurers in particular need to insist on a revised GO structure to deal with the moral hazard bomb that NoMotown has just dropped.

Disclosure:  Long MBI; AGO.
NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.