Municipal Bond Bankruptcy. Why Its Different This Time.

Posted on July 11, 2012

Is there an Evolving View of Bankruptcy in the Municipal Market?

The traditional view of municipal bankruptcy, and the defaults leading up to them, was that it had to be avoided at all costs. Cities, such as New York City, Cleveland and Philadelphia that were under severe stress, would accept some element of state control and oversight in exchange for assistance to avoid a bankruptcy. While bankruptcy is a commonly-used tool for corporate issuers of debt, the widespread view in the municipal market was that it had to be avoided at all cost, primarily because once an issuer went into bankruptcy, it would not be able to access the market for years, if ever. But is that the case and will it continue to be?

In today’s difficult environment, many cities are threatened with defaulting on their bonds, or bonds that they had provided guarantees for. The issues with Vallejo, Stockton, Harrisburg and Scranton, among others, are well known in the municipal market. With high levels of debt, large unfunded pension obligations and sluggish economic growth, it is clear that something has to give as municipalities cannot meet all their obligations while providing expected services to their citizens.

These municipalities have made large cuts in social services, public safety spending and other discretionary spending items, yet their problems continue. They are at, or will reach a point, where they cannot cut further with resulting in a major deterioration of the quality of life in their city. Public officials may face a choice of paying bondholders or their police force. In such a case, will they be able to pay a portion of their debt service, such as 50 cents on the dollar, rather than make draconian spending cuts or tax increases that would decimate the local economy. Bondholders of Greek sovereign debt agreed to a large haircut, will the same be done with municipal debt? And if they do, will a municipality be able to access the market in the future when it is financially stable?