One of the most obvious values of municipal bond insurance is the protection it provides the investor in the event that an issuer files for bankruptcy. In the case of municipalities, this filing takes the form of Chapter 9. Chapter 9 was established to protect a municipality from its creditors while it figures out the correct plan for altering its debt and debt service structure.
It is important to remember that although Chapter 9 is similar to other bankruptcy laws, it does not include a provision for the liquidation of any assets of the municipality in order to pay back creditors as this would “undoubtedly violate the Tenth Amendment to the Constitution and the reservation to the states of sovereignty to their internal affairs.” This important distinction means that Chapter 9 filings often result in a reorganization of debts through principal or interest reduction, maturity extension or an entirely new set of debt issuance used to refinance the outstanding obligations.
The Bankruptcy Filing Process
Although historically, each case of a municipality filing for bankruptcy is unique, the process generally takes the same general form. First, the municipality must voluntarily seek protection under Chapter 9. If the municipality meets the eligibility criteria under federal law, the case is then assigned to a bankruptcy judge.
The bankruptcy code then requires that the notice of the beginning of the case must be made public and be published “at least once a week for three successive weeks in at least one newspaper of general circulation published within the district in which the case is commenced, and in such other newspaper having a general circulation among bond dealers and bondholders as the court designates.” 11 U.S.C. § 923. Once the case is assigned and announced, an automatic stay takes effect, essentially prohibiting collection actions against the municipality and its property.
Without getting too far into the intricacies of the bankruptcy code, in order for a municipality to emerge from Chapter 9, the debtor must file a plan of debt adjustment. There are seven general standards applicable to any debt reorganization plan, including the idea that the debtor is not explicitly prohibited by law from taking any action necessary to carry out the reorg. Most importantly, courts require that any plan to adjust the debt is both feasible and in the best interests of the creditors. If a plan is approved, the municipal debtor is generally discharged from Chapter 9 and may re-engage both creditors and the marketplace.
What Does a Municipal Bankruptcy Mean For a Bondholder?
For bondholders, there are a couple important details to keep in mind while a municipality remains in Chapter 9. First, bondholders are not the only creditors of a municipality, and they will likely be part of a working group alongside pensioners and local workers to negotiate a settlement. Any workout has to take into consideration the needs and demands of all creditors and not solely bondholders.
Secondly, a municipality retains a large amount of control over its ability to tax and spend throughout the bankruptcy process. Lastly, and most importantly to municipal bond holders, the type of municipal bond issued determines how it is treated under Chapter 9. General Obligation bonds (GOs) are considered general debt of the municipality and, unless secured by a “statutory lien,” will be treated as unsecured debt, but in all events payments on even statutory lien GOs will be subject to the automatic stay provisions. In contrast, bonds secured by specific revenues or contracts may be eligible for “special revenue” status with a continuing lien post the filing of the bankruptcy petition, and as such, the pledged revenues will flow to service the revenue bonds throughout the chapter 9 case.
The most common outcome for Chapter 9 filings is for existing bonds to be restructured either through maturity extensions, principal or interest reductions, or refunding. In all cases, bondholders of a bankrupt municipality may be forced to take a haircut on their initial investments. These haircuts can range significantly depending on the specific challenges and financial constraints facing a municipality on a go-forward basis.
Taking Cues From Recent Municipal Bankruptcies
Because the recovery rates for each bankruptcy can differ, it is useful to take a look at recent Chapter 9 filings and discuss what happened to the bonds of a municipality when they filed. The largest Chapter 9 bankruptcy in United States history was Detroit, Michigan. The city filed on July 18, 2013, for relief on approximately $18-20bn in debt outstanding. In this bankruptcy, pensioners of the city were paid around 82 cents on the dollar, and holders of unlimited tax general obligation (ULTGO) bonds around 75 cents on the dollar. Holders of Detroit general fund paper received as little as 14 cents on the dollar.
Another recent large Chapter 9 filing was Jefferson County, Alabama. The county ran into issues around its financing of a large sewer project coupled with an economic downturn and market pressures exacerbated by the financial crisis in 2008. In this example, average recovery rates for bondholders were around 58%, while the pension fund was not affected. Most of the losses were borne by a single large creditor, with significantly lower losses for bond insurers.
In both cases highlighted above, one must distinguish not only what happens to the different types of bonds issued by a municipality throughout a bankruptcy process, but also the difference between insured and uninsured bonds. In the case of Detroit, the bond insurers were highly involved in the negotiation and settlement process with the city and made up the balance of payments on insured bonds.
Those investors holding insured Detroit ULTGO bonds not only received the 75 cents on the dollar from the municipality but an additional 25 cents on the dollar from the insurance company that wrapped the bonds. This “make-whole” of the principal of the bonds came in addition to the insurance companies making timely payments on the current interest of the debt.
Insurance on bonds not only benefits the holders of such paper at debt service payment dates but also in the secondary market. In the instance of Detroit, during the Chapter 9 proceedings in September of 2014, the uninsured 5% coupon Detroit GOs traded with a dollar price in the mid $20s, while the same bonds with an insurance wrapper remained almost 70 points higher! The discrepancy in secondary market pricing for insured versus uninsured bonds is evident in the market today with Puerto Rico. As a Commonwealth, the island does not have the ability currently to file Chapter 9, but recent federal legislation has created an avenue for court-ordered restructuring, and most market participants are familiar with the financial stress facing Puerto Rico. Currently, insured Puerto Rico General Obligation bonds trade approximately 35 points higher than uninsured paper.
The Bottom Line
Bankruptcy can be a long and arduous process for a municipality and is certainly not something entered into casually. For municipal bondholders and investors, Chapter 9 filings are likely to continue to be a more common occurrence. Therefore, it is important not only to understand the structure and covenants of each bond purchase but whether the investment is insured or not. As evident throughout the details highlighted in this article, bond insurance is a useful tool for those investors who seek a greater level of protection or safety in their investments.
About the Authors
This article was written by Ben Seelaus and Robert Bertoni.
Ben Seelaus is COO at R.Seelaus & Co. He joined the firm as a Managing Director in October of 2014. Ben spent the first 10 years of his career as a market maker and trader of U.S. Government Bonds for several firms including JP Morgan and HSBC. Just prior to joining Seelaus, Ben was a Managing Director and Head of U.S. Government Bond trading for Morgan Stanley.
Robert Bertoni has been in the R. Seelaus & Co. muni trading department for two years. He began his career with HSBC in their middle office group. He currently holds his Series 7, Series 63 and is a Level 3 CFA candidate.
Learn more about Ben and Robert here.
Sponsored by Assured Guaranty Municipal Corp., Municipal Assurance Corp. and Assured Guaranty Corp., New York, NY. This article is for informational purposes only and does not constitute (a) an offer to sell or a solicitation of an offer to buy any security, insurance product or other product or service, (b) financial, tax, legal, investment or accounting advice, or © advice with respect to any municipal financial products, or the issuance of any municipal securities, including with respect to the structuring, timing or terms of any such financial products or issuances. None of the sponsors or any of their affiliates is acting as an advisor in connection with any municipal financial product or any offering of municipal securities.