Municipal Bankruptcies and the Unintended Impact on Muni Bonds


By: Ramona Ortega

The municipal bond market is quickly becoming the latest entity to be impacted by the lingering housing and financial crisis.  In June, Stockton, California became the latest city to head to bankruptcy court to sort out its financial woes and is hoping to be the first city to impose losses on bondholders in its plan of reorganization.  As more cities, reeling from high foreclosure rates and a reduced tax base, file for Chapter 9 municipal bankruptcy protection, muni bondholders are becoming increasingly concerned that Stockton’s plan could create an unsettling precedent.

The automatic protections in the Bankruptcy Code will allow Stockton to postpone paying creditors until a deal with creditors has been struck, but the forecast is gloomy as California, Stockton’s home state, faces rising deficits that impact municipal budgets.  Before heading to court, city administrators and creditors were required to participate in an unsuccessful mandated mediation process that was passed into law after the 2008 Vallejo, California bankruptcy.

The impact of bankruptcy on bondholders depends upon several factors, in particular if the bond is considered a general obligation of the municipality or a special revenue bond.  General obligation bonds are considered to be unsecured creditors in a Chapter 9 case, while special revenue bonds for revenue producing projects, such as water and sewer plants, are collateralized by the revenue streams from these projects and therefore subject to the liens of bondholders under Section 928 of the Bankruptcy Code.

Municipal bankruptcies used to be a rare occurrence but as cities feel the squeeze from a shrinking tax base due to high unemployment and rampant foreclosures, reorganization provides a way for municipalities to deal with their diminished budgets by restructuring their debt with their biggest creditors-unions and bondholders.  Cities across the nation face an estimated $20 billion in combined shortfalls this year, according to the National League of Cities, a Washington-based lobbying group.

Muni bonds are an important financial instrument used by cities and states to fund infrastructure projects, like schools, city offices, prisons and sewage facilities.  The municipal bond market, which represents $2.9 trillion dollars, used to be a relatively safe long-term investment but the increasing number of Chapter 9 filings has bondholders worried about their long-term stability. Ratings downgrades, suspended debt payments and forced reductions in principal balance are among some of the events that worry the bond market.  Municipal bankruptcy is not the only threat to the bond market, a larger more intense debate between the muni bond market and unions has been stirring in Washington regarding the possibility of granting States the right to file for Bankruptcy.  Currently, under the Bankruptcy Code, states are not authorized to file for bankruptcy.  Municipal bonds have also been the focus of recent investigations by the Securities and Exchange Commission relating to the industry wide lack of disclosure, particularly as it relates to municipalities understating their pension obligations.

Last year, Jefferson County, Alabama, garnered the title as the largest municipal bankruptcy by debt, owing creditors about $4.2 billion.  Like Stockton, Jefferson County is also attempting to force bondholders to take less than face value.  Stockton now holds the title of the largest municipal bankruptcy in California, taking the dubious title from Vallejo, which exited bankruptcy in 2011.  Despite the gloomy news, some analysts point to the fact that no U.S. municipality has used bankruptcy to force bondholders to take less than the full principal due since at least 1981, and possibly as far back as the 1930s.

The combination of the financial crisis and the failure of cities and states to maintain sustainable budgets hurts residents and capital markets alike.  Let’s hope Stockton gets this right and that chapter 9 remains a rare exception—not the rule.


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Fordham Journal of Corporate & Financial Law