Detroit bankruptcy could change muni market, Chicago Fed says


CHICAGO, Oct 4 (Reuters) - Detroit's historic bankruptcyfiling could upend long-established market views on the highstanding of general obligation bonds, the form of debt sold mostfrequently in the U.S. municipal bond market, Chicago FederalReserve Bank researchers said Friday.

The city's move in July to seek protection from creditors sofar has had only a modest effect on the overall muni market,apart from driving up borrowing costs for issuers in Michigan.

But how the bankruptcy court rules on the treatment ofdifferent debt classes could profoundly alter market perceptionsof their risk, particularly for issuers with mushrooming pensionobligations like Detroit's, two of the bank's economists wrotein a monthly research note, the "Chicago Fed Letter."

A key issue in the city's pending Chapter 9 bankruptcy iswhether Detroit's state-appointed emergency manager, Kevyn Orr,may treat certain general obligation bonds as unsecured debt ona par with its pension obligations, and repay them at justpennies on the dollar.

General obligation, or GO, bonds have long been viewed asthe muni market's gold standard, and none of the handful ofmunicipal bankruptcies since 1970 has resulted in a writedown ofGO debt. Since 2003, GO bonds accounted for nearly 60 percent ofnew debt deals in the $3.7 trillion muni bond market, wherecities, states, hospitals, school districts and others raisecash for capital projects and other needs.

Orr's proposed cuts to retirement benefits, which are beingchallenged in the bankruptcy case by labor unions, retirees andpension funds, conflict with strong protections in the MichiganConstitution against impairing those benefits.

The judge in the Detroit case has not yet determined ifDetroit is eligible to formally enter bankruptcy protection, ashearings in that phase begin later this month.

A successful challenge by unions and retirees, on the basisof the U.S. Constitution's Tenth Amendment regarding states'rights, could impact the pricing of bonds issued by cities withlarge unfunded pension liabilities, according to the Fed report.

"If the court agrees with pension creditors that stateprotections hold supreme, this could change market expectationswith respect to the relative standing of municipal debt issuedby cities located in states with such protections," the Fedreport said, pointing to Chicago, Los Angeles, and New YorkCity.

Overall, large U.S. cities in a recent Pew study have fundedonly 57.5 percent of the $511.2 billion of retirement benefitsthey promised.

Orr has lumped about $411 million of unlimited tax GO bondsinto the unsecured debt pile even though Detroit voters approveda special property tax levy to pay off the debt.

That pile also includes limited tax GO debt, secured only byDetroit's general fund revenue, and pension debt - neither ofwhich was approved by voters.

"This issue will be ultimately settled by the court, and itmight have wide-reaching consequences for the pricing ofvoter-approved GO debt," the report said.

Detroit defaulted on its "unsecured" GO bonds this week byskipping debt service payments due on Tuesday.

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