Yesterday the City of Detroit applied for Chapter 9 bankruptcy protection. It is the largest municipal bankruptcy in United States history. SNW Asset Management clients do not own any City of Detroit obligations as we have never been buyers, and we proactively sold out of inherited positions well in advance of any announcement of payment default or bankruptcy. To provide a sense of scale, the City of Detroit’s bankruptcy, at $18.0 billion in secured and unsecured debt is almost four and half times larger than that of the Jefferson County, AL bankruptcy, which was the second largest U.S. municipal bankruptcy. The next step in the process is an automatic stay which will freeze any debt payments. The city doesn’t need approval to continue public services. For example, the police, fire, water, sewer and public works are completely unaffected by the bankruptcy filing for now, and will operate as usual. The bankruptcy filing is likely to be a long drawn out process. If the federal bankruptcy judge authorizes the City to move forward with a bankruptcy case, then a reorganization plan will emerge. This could take weeks, months or potentially years. Bankruptcy court allows the city to restructure its operations and its balance sheet, which could involve budget cuts, layoffs, consolidation, slashing union contracts, selling assets and dramatically reducing city debts, including outstanding bonds. This will result in a likely impairment to the City’s unsecured bonds, but it is unknown how the secured debt will be impacted.
What does this mean for the municipal bond market? Low-investment grade rated general obligation (A3/A- or lower) bond spreads will likely widen, which may create opportunities for us to use our credit expertise to find value among the cast-offs and specifically low rated Michigan State credits. Whether this announcement pushes more retail investors out of the municipal market (creating a larger market sell-off) is yet to be seen. Systematic market risk could be benign due to the fact that Detroit's debt represents a small portion of the $3.7 trillion municipal market. However, a broad sell-off like we saw in 2010 in concert with rising interest rates could create an opportunity to marginally increase duration in tax-free bonds at mispriced valuations. SNWAM will continue to monitor the situation for its impact on the municipal market landscape and keep you apprised of any material information.