Labor rights, animal rights, prisoners’ rights – all are considered sacrosanct these days. Not 
so investor rights; they are being trampled left and right. Given the animus towards the “one percenters” whipped up by President Obama, this comes as no surprise. However, it could come with a cost – to taxpayers.
Starting with the upsetting of age-old bankruptcy law in wiping out bondholders in the GM and Chrysler reorganizations, and moving onto the eminent domain fight now going on in California and the treatment of bondholders by Detroit’s emergency manager – investors’ rights have been upended. The fall-out from the authorities not “playing by the rules,” as Mr. Obama is so fond of saying, could be significant. The Detroit mess, especially, could have wide repercussions.
In Detroit’s bankruptcy, for the first time in the history of the $3.7 trillion muni market, general obligation bondholders are being treated like ordinary creditors. Normally, GO bonds rank at the top of the creditor pile, due to very specific guarantees. The issuing documents for the 2008 bonds, for instance, describe the securities as “secured by a pledge of the full faith and credit of the city.”
It goes in to note, “The City is authorized and required by law to levy and collect…property taxes without limitation” to pay off bondholders. That should mean that the city’s resources are first and foremost owed to investors who have funded the city’s operations. However, in trying to put the city back in working order, the authorities have decided to demote bondholders to “unsecured creditor” status, along with retirees and many others.
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Alexandra Lebenthal, CEO of muni bond firm Lebenthal & Company, says that the claims of GO bondholders have never been treated this way and thinks the judge in Detroit’s case will eventually reaffirm their rights. That doesn’t mean they won’t be hit with losses, as happened in the 1975 reorganization of New York City’s debt. In that case, though, the rights of bondholders were held up by the judge, who wrote that hardship is no defense. Investors agreed to swap their bonds for a new, less valuable security.
Given Detroit’s dire fiscal outlook, Emergency Manager Kevyn Orr has proposed paying off general obligation bonds to the tune of about 20 cents on the dollar. Recently, bondholders have offered to restructure the debt, lengthening the term of the bonds and making other concessions. Orr is unmoved, saying in an interview with Reuters that he doesn’t want to saddle the recovering city with decades of burdensome payments.
On the other hand, some think the decision to toss the city’s legal obligations overboard could sour Detroit’s future finances. Who will lend money to Motown if their rights can be so wantonly abandoned? As important, what will this mean to other municipalities whose finances are wobbly…like San Francisco or Chicago? Some 40 percent of the muni market is made up of GO bonds—this is not small potatoes.
The downgrade of bondholder rights has already had some impact, including driving an exodus from the muni market. Investors pulled nearly one billion dollars out of muni funds last week; it was the 11th consecutive week of losses. Local communities are especially impacted; three planned bond sales in Michigan have now been shelved, while yields have climbed. Most recently, a sale of $61 million in bonds for Saginaw County, to cover pension obligations has been postponed.
It could get worse. Lebenthal says that if the judge upholds Orr’s treatment of GO bondholders, there will be a serious backlash in the marketplace, with the “market exacting a stern penalty on weaker credits.” That could cost taxpayers in other cities with fiscal problems, like Oakland, Harrisburg, Pennsylvania or Providence.
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Admittedly, Detroit’s troubles are unusual. The city owes at least $18.5 billion and offers little prospect of a buoyant revival. Arguably, as Governor Rick Snyder has said, those who bought Detroit’s bonds should perhaps have seen this shipwreck coming. However, in other cities that have recently gone bankrupt, including Stockton and San Bernardino, “meaningful repudiations of both general obligation and specific revenue bonds are included in the solution set,” as one investor note puts it.
In an effort to reassure funders, Rhode Island passed a law last year affirming the senior status of GO bondholders over other creditors, including retirees. Legislators in Rhode Island may be ahead of the curve, seeing fiscal issues ahead – and political firestorms ignited by public employee unions. Absent that sort of legal guarantee, cities and counties elsewhere may have to pay higher rates to attract investors.
Earlier, the Obama administration threw GM bondholders under the bus when that company went through reorganization. Bondholders and unions each had claims of roughly $30 billion against the company – the latter in the form of unfunded pension and health care plans. Bondholders were paid about 10 cents on the dollar in GM’s bankruptcy, while union obligations were nearly kept whole, a political gift to President Obama who very much needed to keep Michigan blue. Union health care and pension funds ended up fully funded, an extraordinary outcome in bankruptcy. But, this was no ordinary bankruptcy proceeding.
Trampling on the rights of investors – whether they own municipal bonds, or mortgages, or GM or Chrysler bonds – is a risky business. Mitch Daniels, in a Wall Street Journal op-ed, slammed the Obama administration for its ill treatment of Indiana pensioners who owned Chrysler bonds. He celebrated a (minor) favorable ruling the Supreme Court handed that group, saying, “The greatest benefits will accrue not to lenders and borrowers but to all those whose jobs are created because investors once again can trust that the money they’ve risked is safe from seizure by the state.” Hear, hear.
