Detroit creditors ponder bankruptcy as preferred option
Now Detroit appears to be on the brink of filing for bankruptcy, but there is little talk of sharing the pain. Instead, the crisis in Michigan is building as a gigantic clash between bondholders and city retirees.
The city's proposals, which could give some bondholders as little as 10¢ on the dollar, are making some creditors think they would be better off in bankruptcy.
"The haircut is so severe," said Matt Fabian, a managing director of Municipal Market Advisors, "I think it's scaring them into bankruptcy, rather than away from bankruptcy."
But city retirees, facing the prospect of sharply reduced benefits whether in bankruptcy or under Detroit's restructuring proposal, think they stand squarely on the moral high ground because despite the poverty of many current and retired members, they have already offered big concessions.
With talks on labour issues scheduled for Thursday, municipal bond market participants say one of their main concerns is the city's proposal would flatten the traditional hierarchy of creditors, putting say, a retired librarian on par with an investor holding a general obligation bond. That does not square with the laws and conventions of the municipal bond market, where for decades small investors have been told such bonds are among the safest investments and that for "general obligation" bonds cities could even be compelled to raise taxes, if that was required. The "full faith and credit" pledge was supposed to make such bonds stronger than the other main type of muni - revenue bonds, which promised to pay investors out of road tolls or other project revenue.
Public finance experts have warned that broad societal problems could follow a loss of faith in municipalities' commitments to honour their pledges. Last year, the Securities and Exchange Commission warned communities would find it increasingly costly to raise money, threatening the time-honoured practices of building and financing public works locally.
Frequently Asked Questions about this Article…
Detroit appears to be on the brink of filing for bankruptcy, and investors are watching because the crisis has set up a major clash between municipal bondholders and city retirees over who will absorb losses.
Some bondholders think bankruptcy might leave them better off because Detroit’s restructuring proposals could impose very severe haircuts — the article notes offers that could give some bondholders as little as 10¢ on the dollar — so creditors are considering bankruptcy as an alternative.
The city’s proposals could sharply reduce benefits for retirees and reduce payments to some bondholders dramatically — potentially as low as 10¢ on the dollar for certain creditors, according to the article.
The proposal might flatten the traditional hierarchy of creditors by treating retirees and holders of general obligation bonds more equally, which undermines long-standing legal and market conventions that ranked some municipal claims (like general obligation bonds) above others.
General obligation (GO) bonds carry a "full faith and credit" pledge and historically were viewed as stronger — sometimes even backed by a city’s power to raise taxes — while revenue bonds are paid from specific project revenues (like tolls); the article highlights that this distinction has been central to how small investors were told muni risk differs.
Public finance experts warn that if faith in municipalities’ commitments erodes, it could make it more expensive for cities to borrow, which may reduce local governments’ ability to finance public works and could affect yields and prices for municipal bond investors.
The Securities and Exchange Commission warned that communities could find it increasingly costly to raise money if confidence in municipal commitments weakens, threatening traditional practices of building and financing public projects locally.
The Detroit case shows that muni bonds — even those historically labeled among the safest, like GO bonds — can face significant restructuring risk, so everyday investors should reassess credit risk, understand bond seniority rules, and be mindful that severe haircuts and legal fights can occur.
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