Governance in Municipal Bankruptcy. The process of exiting municipal bankruptcy has to be one of the most extraordinary challenges there can be: it involves a federal judge, legal authority defined by state law, a receiver or emergency manager, elected officials of the city or county in question, conflicts between all three levels of government, and—as we have noted in Detroit, the conflicting claims of 100,000 creditors—each of whom expects to be made whole. In San Bernardino and Detroit, the situations are further challenged by the transitions underway―mayors in each city are changing, as are councils. Not only—from governance perspective—is it hard to imagine a greater challenge, but also the challenge in governing is beset by both the incessant drain of resources the process imposes and by the fundamental conflicts between different stakeholders. For instance, yesterday, one of our readers asked: “Why doesn’t federal law hold a bond insurer responsible for fulfilling its insurance obligation?  What’s the point of an agency paying for (municipal) bond insurance if a bond insurer is allowed to negotiate its way out of paying? Allowing bond insurers to shift their business losses to retirees, when the pension system under which those retirees are being paid was already in place when the bond insurer did its financial evaluation, not only makes bond insurance utterly meaningless but it eliminates the bond insurers’ incentive to say no and prevent an agency from issuing dangerous debt in the first place.”

The complexities involved in adjudicating between bond insurers and public pensions are significant—especially in San Bernardino and Detroit, where the respective state constitutional protections for public pension contracts could mean final resolutions of these municipal bankruptcies could end up in the U.S. Supreme Court. But decisions with regard to which creditors might be impaired could have impacts far beyond the respective city boundaries too. Were the law to be amended to subject insurers to impairment, but not pensions, it could have the effect of subjecting other cities, towns, counties, and states—and their taxpayers and pension retirees to greater credit uncertainty—and costs.

While there appears to be little chance the insurers will come out of Detroit without taking deeper impairments than retirees, by the same token, as you can imagine, Judge Rhodes will have many difficult claims to balance in considering whatever Plan of Adjustment is proposed by the City. Just try, in an environment of changeover of elected officials with a state-appointed emergency manager, to try and think how you would create an efficient process to weigh, balance, and determine how to meet the demands of 100,000 creditors. Moreover, there appear to be discrepancies between pension plans in Detroit—so it also seems likely that not all beneficiaries will come out equally if the Judge determines that one plan has greater integrity than the other. So how these respective cities with their transforming governments in different courtrooms proceed over the coming months could affect every city, county, and state in the country. It will surely prove to be one of the most extraordinary challenges in governing the nation has ever experienced.

While there is a perception that Detroit’s bankruptcy is unique, the Federal Reserve, after the financial crisis, established financial monitoring teams to keep an eye on areas that might be sources of systemic risk. One of those areas is municipal finance.  The Federal Reserve is concerned that if municipalities stopped paying their debts, there could be ripple effects that spread through bond insurers or the banking system.[1] The concern is that if municipal bond insurers were to come under stress from taking over payments for the municipalities, that could lead to downgrades of other bonds they insure. About $7 billion of Detroit’s debt is insured, but the list of companies insuring municipal debt is pretty small. When viewed in context of coinciding municipal bankruptcies, there is enough insured debt to raise the question whether insurers could cover all current and future losses. The Fed is also concerned the nation’s banking system could be another transmission channel. The banking system might be vulnerable if distressed municipalities ceased making loan or bond payments. While the municipal debt market is small relative to the banking system, it is not necessarily evenly distributed: some banks may have large exposures to specific states or municipalities. Finally, the Federal Reserve notes that one issue common to nearly all of the current municipal bankruptcies is growing public pension and healthcare obligations.

Economist Thomas Fitzpatrick of the Cleveland Federal Reserve Notes: “Generally there are three areas of potential focus: funding, investing, and benefit adjustments. Most states that protect public pension benefits do not have a law requiring that the pensions be funded in a way that ensures sufficient funds will be there to pay the benefits when they are due. When they do have laws that seem to require funding, courts can be reluctant to enforce them. Most state laws also allow actuarial assumptions about expected rates of return that may not reflect market rates. Creating credible funding mechanisms could help solve this problem in the future.

“Similarly, in the past, courts have been reluctant to enforce laws requiring that funds for public pensions be invested prudently. Sometimes investment cases can be very difficult to decide, because the line between prudent and imprudent investments is not always clear. Other times it is a bit more obvious. Federal pensions solve this problem by investing only in US Treasuries. Such a strategy would increase the required annual funding of public pensions, but would also largely immunize them against large market fluctuations.”

[1] “Hot Topic: What’s at Stake in the Detroit Bankruptcy?” Federal Reserve Bank of Cleveland, November 7, 2013.


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