Detroit was ruled to be eligible for Chapter 9 bankruptcy protection on Tuesday, and Judge Steven Rhodes took the unexpected step of ruling that pension rights are contractual and “not entitled to heightened protection in bankruptcy,” meaning that pensions will likely take a cut just like the city’s bondholders and other creditors. Some analysts have suggested that this ruling could set of a rash of municipal bankruptcies as cities struggle to get out from under their pensions, but Mark Palmer at BTIG says the argument is based on a misunderstanding of Chapter 9 bankruptcy.
In order for a city to file for Chapter 9, it has to demonstrate that it is either unable to pay its bills now, or that it will be unable within the next fiscal year. “The solvency test applied by U.S. bankruptcy courts is not a balance-sheet test. And Chapter 9 cannot be used by a municipality as a means of averting future financial problems,” Palmer wrote back in August, the first time such fears were floated by analysts. Even if a city can prove that its unfunded pension is a time bomb, they can’t file unless it’s going to explode next year.
Muni bankruptcy fears ignore the real trend
He also argues that muni bankruptcy fears ignore the real trend – more and more cities are reforming their pension systems and negotiating with unions to get costs under control so that bankruptcy doesn’t become necessary. Knowing that pensions are no longer sacrosanct should even give cities a bit more leverage during difficult negotiations. And if another city does ultimately have to file Chapter 9, putting pensions on the table along with other forms of debt means that bondholders won’t have to lose quite as much on the deal. From Palmer’s point of view, this is the most important development, and it’s actually quite good for muni bondholders.
Pensions are now on the table
“The real takeaway from Judge Rhodes’ ruling, we believe, is that pensions can no longer count on getting 100 cents on the dollar in every municipal bankruptcy,” Palmer wrote following the ruling. “This new state of affairs could translate into significantly improved recoveries for MBI, AGO and AMBC going forward.”