Bankruptcy Judge Rejects CaLPERs Seniority In Muni Bond Bankruptcies

U.S. Bankruptcy Judge Christopher Klein has surprised the bond market by ruling that the California Public Employee’s Retirement System (CalPERS) doesn’t have any special rights as a bond holder in the City of Stockton’s bankruptcy proceeding, even though California law explicitly says that it does.

The implication for municipal bondholders – and for bond insurers such as Assured Guaranty Ltd. (NYSE:AGO), MBIA Inc. (NYSE:MBI) and Ambac Financial Group, Inc. (NASDAQ:AMBC) by extension – is the prospect of enhanced recoveries in future restructurings,” writes BTIG analyst Mark Palmer. “Bondholders would no longer have to settle for carving up the value that remained after state pension funds with exposure to distressed municipalities were paid in full, but would be placed in the same claims pool as the pensions.”

California law invalid, says Judge Klein

During a municipal bankruptcy it has been taken for granted that state pensions will be the first to get reimbursed in full, leaving everyone else to fight over what’s left. From the state’s point of view this makes perfect sense, the California state government limits its own downside risk by giving CalPERS special rights, but Judge Klein is unimpressed.

“California public employee retirement law … is simply invalid in the face of the Supremacy Clause of the United States Constitution,” said Klein. Therefore, the federal bankruptcy code and contract law applies to pension funds just like everybody else.”

Stockton decision has major implications for the muni bond market

This has an immediate impact on Stockton muni bond holders who can now expect to recover more, but it also has broad implications for the muni bond market in general. If similar rulings in other cases follow Judge Klein’s lead, it would mean that the average recovery for everyone except state pension funds goes up and distressed muni bonds look a little bit better. Monoline insurers would also fare better in the short term since they would have to cover fewer losses (though it could even out in the long run if it puts pressure on their rates).

Pension funds, on the other hand, will have to reassess whether they can handle the risk that comes with those same bonds. As long as they had the first shot at recovery, pension funds were looking at a skewed risk/return compared to the rest of the market. This ruling has the potential to reshape the mix of muni bond investors, at least when bankruptcy is a serious concern, though we’ll have to wait and see how the changing position of investors impacts yields in the future.

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About the Author

Michael Ide
Michael has a Bachelor's Degree in mathematics and physics from Boston University and Master's Degree in physics from University of California, San Diego. He has worked as an editor and writer for several magazines. Prior to his career in journalism, Michael Worked in the Peace Corps teaching math and science in South Africa.

2 Comments on "Bankruptcy Judge Rejects CaLPERs Seniority In Muni Bond Bankruptcies"

  1. beadsunderfoot | Oct 2, 2014, 8:31 pm at 8:31 pm |

    The term “public servant” is defined in most state constitutions in the
    60s, union or not. Their deferred compensation due upon retirement, in
    the form of pensions/benefits, is part of the total compensation career
    “public servants” earn, as it has been since WWII. This is not
    something new, as our career public servants have been compensated this
    way for over 70 years. The public has always had a seat at the
    table…they elect their city councilperson, or Mayor, or whatever…and
    those folks each have to approve the contracts negotiated in a public
    forum/meeting. In each and every city or community there are more
    voters than career public servants…so any argument otherwise is simply invalid.
    But I agree that the way career public servants are compensated has to
    change, but more importantly so does the shear number of local governments…they must
    combine just like the private sector had to combine…to survive. We
    the taxpayer cannot afford all of these local governments/school
    districts and associated costs any more

  2. Why would anyone offer any government entity an unsecured loan?
    I wouldn’t give any city even sub-prime rates.

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