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Detroit Not Indicative of Widespread Muni Malaise

Even with the extraordinary events occurring in Detroit, the credit quality of the muni market remains high, says Morningstar's Beth Foos.

The City of Detroit filed for protection under Chapter 9 of the U.S. Bankruptcy Code on Thursday afternoon, marking the largest Chapter 9 filing in U.S. history and the first in the State of Michigan. The move came after weeks of negotiations between the city's state-appointed emergency manager, Kevyn Orr, and the city's creditors, which resulted in a failure to produce a compromise on the restructuring of Detroit's massive $19 billion of liabilities. 

As required by state statute, the city's petition comes with approval from Gov. Rick Snyder. In his authorization letter, Snyder stated that "it is clear that the financial emergency in Detroit cannot be successfully addressed outside of such a filing, and it is the only reasonable alternative that is available." He went on to explain that the decision comes "in the wake of 60 years of decline for the city" resulting in the city's inability to meet its obligations to its citizens and creditors. "The only feasible path to a stable and solid Detroit is to file for bankruptcy protection," the governor concluded.

The city filed its bankruptcy petition in the U.S. Eastern District Court of Michigan and will be appointed a bankruptcy judge to oversee the case. Whereas the city will continue to offer services to its residents and customers including police, fire, water, sewer, and public works, an automatic stay would be placed on any lawsuits against the city and most of its bills, including its unsecured debt such as certain bonds and contractual agreements. It is expected that Detroit will continue to pay what it considers secured debt, such as water and sewer bonds, as those creditors have the ability to seize assets if they are not paid in a timely manner. 

For approval of its petition, the city will need to prove that it's insolvent, that it can't pay its bills, and that it has negotiated "in good faith" with creditors. In response, those creditors will likely challenge the city's eligibility for bankruptcy in court. Ultimately, the federal judge will hear arguments for both sides with a ruling coming in the following weeks or months. If Chapter 9 protection is authorized, Orr will be required to produce a plan of reorganization, which will likely resemble what has already been proposed. Then negotiations with creditors will continue with oversight of the federal court. 

Chapter 9 filings are rare, which makes searching for precedent to guide this very complicated case an almost futile task. With that, the unfolding events in Detroit of the next several months and possibly years will force investors to confront some fundamental questions of the municipal market. Questions regarding the risk associated with general-obligation debt, especially in the state of Michigan, as well as how unfunded pension liabilities are treated in stressed conditions, will undoubtedly be explored. The answers to these questions will only come with time, and court rulings and will likely set precedents themselves. 

It's important to note that a significant portion of Detroit's outstanding bonds and pension-obligation certificates are also secured by municipal-bond insurance. Although these bonds no longer carry AAA ratings from the major bond-rating agencies, their policies are still in place, and it's expected that related bondholders will be paid accordingly. Shortly after Orr released his debt-restructuring plan, several of the city's insurers, including Syncora Capital Assurance and Ambac Assurance, issued public statements confirming their commitments to honor the relevant policies. At the same time they reaffirmed their commitment to pay, Ambac stated it believes Orr's proposal and the failure of the state of Michigan to protect the status of general-obligation bonds are harmful to the city and to Michigan taxpayers, and the firm hired additional advisors to deal with the case. Syncora recently engaged in contentious negotiations in and out of court with the city, as it was forced to cover a nearly $40 million payment due on pension-obligation certificates that Detroit officials failed to pay. 

Even with the extraordinary events occurring in Detroit, overall Morningstar believes that the credit quality of the muni market remains high. Rather than assuming that the situation in Detroit is indicative of a widespread malaise, investors instead need to analyze each credit on its own merit. This case, as well as others currently ongoing in the municipal market, reinforces the importance of thorough credit analysis when making investment decisions.