BREAKINGVIEWS-Detroit bankruptcy is doing bondholders a favor

Tue Jul 23, 2013 2:19am IST

By Agnes T. Crane

NEW YORK, July 22 (Reuters Breakingviews) - Detroit's bankruptcy is doing bondholders a favor. The failed city wants to include debt in its restructuring that the $3.7 trillion municipal bond market considers sacrosanct. It's another example of investors ignoring the limited options governments have to honor their debts.

At issue are Detroit's general obligation (GO) bonds. This type of commitment is most akin to sovereign debt, since the government pledges to use its taxing power to pay back lenders in full and on time. Many assumed that such a promise gave GO bonds a stronger claim on assets than run-of-the-mill unsecured debt, including pension and other retirement obligations.

Detroit begs to differ. Its emergency manager, Kevyn Orr, who is charged with cleaning up the Motor City's fiscal mess, proposes to lump GO bondholders in with retired civil servants who are owed 17 times more.

Understandably, investors aren't happy about being thrust into a Battle Royale with retirees. The bonds aren't actively traded, but they took a hit when Detroit filed. The GO bonds that don't come with insurance have now plummeted 55 percent since May, according to Markit, the month before Orr presented creditors with his restructuring proposal.

The matter is far from settled. It’s not even certain Detroit can legally file for bankruptcy. But in light of Greece's default, the downgrade of America's credit rating and the disappearance of top-rated AAA sovereign issuers overall, the controversy surrounding what are supposed to be the muni market's most revered bonds should serve as another wake-up call to investors. Previous notions of safety no longer apply.

Still, it’s never easy to cast aside assumptions before they have been shattered. Just ask investors who bought subprime mortgages confident that U.S. home prices would never go down, or holders of Greek debt convinced that no euro zone member would ever be permitted to default.

A pledge by a government to raise taxes to honor its debts may seem like a safe bet. Often, it is. But Detroit's finances have been suffering for years – and its tax rates are already at or near statutory limits. Moreover, other cities and municipalities are still struggling in the aftermath of the 2008 crisis. The sooner bondholders focus on the underlying credit risk, and ignore outmoded notions of safety, the better.

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CONTEXT NEWS

- On July 19, Fitch Ratings warned that investors in Detroit's general obligation bonds may not be paid back on time or in full despite the government's pledge to use tax revenue to service the debt. The city, which filed for bankruptcy on July 18, is due to make an interest payment on the bonds on Oct. 1. All in, Detroit has $18.5 billion in liabilities, including pensions.

- Detroit's emergency manager, Kevyn Orr, considers $530 million of Detroit's $1 billion of general obligation bonds as well as pension and other retirement obligations to be unsecured debt.

- Fitch press release: link.reuters.com/fev79t

- Federal judge sets first hearing in Detroit bankruptcy case [ID:nL1N0FS0SK]

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(The author is a Reuters Breakingviews columnist. The opinions expressed are her own.)

- For previous columns by the author, Reuters customers can click on [CRANE/]

(Editing by Antony Currie and Martin Langfield)

((agnes.crane@thomsonreuters.com)(Reuters messaging agnes.crane.thomsonreuters.com@reuters.net)) Keywords: BREAKINGVIEWS DETROIT/BONDS

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