Chairman Ben Bernanke’s finally got his intended message across during his two-day Humphrey-Hawkins testimony this week. This time, global markets took his remarks in stride. Equity investors in particular have grown comfortable with the Fed’s professed accommodative stance, sending both the Dow and the S&P 500 to fresh historical highs by Thursday’s close.
Following an initial rally alongside equities, 10- and 30-year Treasuries gave up much of the gains and closed yesterday at 2.54% and 3.63%, respectively.
For its part, the tax-exempt market has been trying to firm up throughout the week, particularly in the belly of the curve. The long-dated high grade scale has by-and-large remained unchanged, with buyers still leery about taking on duration risk. The outperformance of intermediate maturities versus longer term maturities has resulted in the steepest 10-30 year curve in at least a year, according to Municipal Market Data.
Institutional demand for municipals remains challenged as mutual fund outflows picked up again this week. Still the bearer of bad news, Lipper reported outflows of $1.56 billion for weekly reporting muni bond funds for the week ended July 17. That’s up from $1.20 billion investors withdrew the previous week. Long-term muni bond funds recorded heavy outflows $1.03 billion, compared with $857 million last week. High-yield muni funds also reported outflows of $246 million, versus $207 million a week ago.
Detroit’s Bankruptcy and the Royal Baby
Cate Long, one of the wittier members of the muni blogging community, recently compared the muni market’s anticipation of Detroit’s bankruptcy to the media frenzy surrounding the birth of Kate Middleton’s baby. Well, at least in Detroit’s case, the wait is now over. Late Thursday, to no one’s surprise, Emergency Manager Kevyn Orr went into federal court seeking the right to file for Chapter 9.
Of course, just because Motown wants to declare bankruptcy doesn’t mean it automatically can.
With this move, Detroit has replaced Jefferson County, Alabama as the largest muni bankruptcy in U.S. history to date. The filing follows a month of intense negotiations with various classes of creditors, with Mr. Orr displaying masterful, if not ruthless, legal gamesmanship. As best we can tell, the main thrust of his strategy has been to browbeat those creditors deemed most “secured” first, in order to gain maximum leverage with less-secured claimants. He came close to succeeding this week: after suing insurer Syncora for interfering with his negotiations, Mr. Orr was able to extract a reported 25% haircut from the city’s interest rate swap counterparties (Bank of America and UBS). Since swap counterparties are generally viewed as the most secured of all creditor classes, a significant concession on their part would not bode well for the rest of the creditors, particularly for the pension bonds which reside at the bottom of the city’s capital structure.
Ironically, because the swaps were designed to hedge against interest rate increases, the city’s potential liability vis-à-vis the banks should be declining as we move into a rising rate environment. So, the agreement with the banks would’ve had the effect of turning a “soft” liability into a hard liability.
With that agreement in hand, Kevyn Orr was going to turn his attention to other classes of creditors. However, on Wednesday, the city’s retirement systems threw a wrench in his plans by filing suit to block any potential bankruptcy filing, with a hearing scheduled for next Monday. This left the Emergency Manager with no other choice but to file Chapter 9 on Thursday to benefit from the immediate stay on all related litigation.
Of course, just because Motown wants to declare bankruptcy doesn’t mean it automatically can. This only marks the beginning of a 30-to-90 day process to determine whether or not the city is even eligible to file Chapter 9. Once the filing is approved, legal experts predict the entire process could take years to complete.
From a legal standpoint, the Detroit case will be rife with potentially precedent-setting outcomes … including the treatment of the “full faith and credit” General Obligation pledge.
In the short term, we wouldn’t expect the Detroit news to have much effect on the tax-exempt market at-large. Some investors may wish to steer clear of local credits within the State of Michigan, particularly many of the already troubled school districts. At the margin, however, the unprecedented media coverage for this event may just give those investors already anxious to chase equity returns another excuse to bail out of municipals.
From a legal standpoint, the Detroit case will be rife with potentially precedent-setting outcomes. The most important, as previously discussed in this column, may be the treatment of the “full faith and credit” General Obligation pledge.
The second legal precedent to watch would be the treatment of the water and sewer debt, traditionally assumed to be insulated from the financial plight of the underlying city.
Distressed investors will be paying close attention to the ultimate recovery rates among the various classes of creditors. Detroit has historically come to market with a wide variety of security structures, so this will be a unique opportunity for the market to observe how various components of the city’s capital structure will be treated by the bankruptcy court.
Because of its obvious connection to the auto industry, the Detroit situation has been compared to the General Motors (GM) bankruptcy back in 2009. Of course, as you may recall, the GM reorganization was orchestrated and funded by the Federal government. In Detroit’s case, recent efforts to solicit federal help have already been soundly rejected. One aspect of the GM case that still rankles bond investors was the way labor union and pension fund interests were protected at the expense of creditors. This time around, market participants will be watching closely to make sure all classes of creditors are treated with an even hand.
At the end of the day, this ultimate capitulation by one on America’s major cities has a cathartic feel to it. Assuming the city takes this opportunity to fundamentally restructure its operations to finally reflect its depleted socio-economic base, we believe this could be a new beginning for Detroit. After all, the American auto industry also came back from the brink and is now hitting the ball out of the park, almost in spite of itself. There’s no reason the Motor City couldn’t accomplish the same feat.
Getting back to more suspenseful matters, the due date for Kate’s royal baby is now reported to be July 23rd.
UPDATE (Friday July 19, 2013, 2:00pm cst): Shortly after we published our column, Ingham County Circuit Court Judge Rosemarie Aquilina ordered Governor Snyder and emergency manager Orr to withdraw the city’s bankruptcy filing on grounds that it violated the Michigan constitution by seeking to impair employee benefits. The dispute appears to be heading for the state Court of Appeals. So, hang on to your hat. This political circus is only getting started.
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