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ESSAYS ON ISSUES

THE FEDERAL RESERVE BANK
OF CHICAGO

NOVEMBER 2013
NUMBER 316

Chicag­o Fed Letter
Detroit’s bankruptcy: The uncharted waters of Chapter 9
by Gene Amromin, senior financial economist, and Ben Chabot, financial economist

On July 18, 2013, Detroit became the largest municipality to seek protection under
Chapter 9 of the U.S. Bankruptcy Code. This article describes several ways in which
Detroit’s bankruptcy filing has the potential to alter some of the key assumptions of
municipal bond (muni) finance, and examines the market reaction to date.

Chapter 9 provides financially distressed

To date, Detroit’s bankruptcy
filing has had little impact on
the cost of municipal financing
outside of Michigan, but it
has the potential to set a
number of precedents with
far-reaching consequences.

local governments, such as the City of
Detroit, protection from creditor claims
in the federal bankruptcy courts, subject
to a number of state-level restrictions.1
Michigan is one of 24 states that allow
their municipalities to seek Chapter 9
protection. Although the federal requirements for bankruptcy are explicit,2 the
paucity of Chapter 9 filings and the
variability in state legal environments
effectively make every new case a complex and protracted matter. This holds
particularly true for Detroit’s filing, which
is notable for its sheer size, the multitude of competing claims, and the historical and economic contexts in which
the bankruptcy is playing out. Indeed, the
intensity of media coverage surrounding Detroit indicates the extent to which
the bankruptcy filing of the once-thriving
industrial icon has resonated with the
American public. In this Chicago Fed Letter,
we describe how municipal bankruptcy
unfolds in Michigan, how Detroit’s filing
has the potential to change some of
the key assumptions of municipal bond
finance, and what the market reaction
has been thus far.
Municipal bankruptcy in Michigan

A unique feature of Michigan law is the
ability of the governor to appoint an
emergency manager (EM) to take over
operations of financially distressed units
of local governments, ranging from school

districts to entire municipalities. Shortly
after the state’s February declaration that
the City of Detroit was in a financial emergency, Governor Rick Snyder appointed
Kevyn Orr as Detroit’s EM. Under new
legislation that went into effect on
March 28, 2013, governor-appointed
EMs are allowed to take extraordinary
measures, including modifying or terminating collective bargaining agreements
and recommending that the municipality
enter Chapter 9 bankruptcy.3 When
Chapter 9 protection is sought, the EM
has the sole power to propose a restructuring plan to the bankruptcy court.
Obtaining bankruptcy protection is far
from straightforward, however. Although
Michigan permitted Detroit to seek bankruptcy protection, the bankruptcy judge
must determine whether the city is insolvent and can adjust its debts. The judge
must also determine whether Detroit,
as represented by the EM, had negotiated
in good faith with its creditors and had
failed to obtain an agreement outside of
court. Moreover, the court must rule on
a number of legal objections to Detroit’s
Chapter 9 eligibility—which range from
whether Chapter 9 is itself constitutional
to whether the state authorization for
the city’s bankruptcy filing is invalid in
light of Michigan’s state constitutional
protection of pensions.
If the bankruptcy court upholds Detroit’s
eligibility for Chapter 9 protection, the

Detroit’s liabilities into
specific categories.
Detroit’s largest single
percent
obligation is the ap1.1
proximately $6 billion
in water and sewer
0.9
bonds that are backed
by the specific pledge
of revenues from the
0.7
city’s utility system.
Detroit also has about
$1 billion in outstand0.5
ing general obligation
(GO) debt. GO debt
0.3
is typically paid out of
Feb.
Mar.
Apr.
May
Jun.
Jul.
Aug. Sep.
the overall tax reveSAPIILG−SAPIGO
SAPIGO−US10Y
nues and does not
SAPIMIG−SAPIGO
SAPICAG−SAPIGO
have a dedicated repayment source. HowNotes: The plots are the spreads between the yields of Standard & Poor’s (S&P)
municipal bond general obligation (GO) indexes (or those of an S&P index and ten-year
ever, Detroit’s GO debt
U.S. Treasury bonds). SAPIGO indicates the nationwide S&P Municipal Bond General
Obligation Index. US10Y indicates ten-year U.S. Treasury bonds. SAPIMIG indicates
comes in a number of
the S&P Municipal Bond Michigan General Obligation Index. SAPIILG indicates the
S&P Municipal Bond Illinois General Obligation Index. SAPICAG indicates the S&P
different flavors. Some
Municipal Bond California General Obligation Index. The solid vertical line indicates
GO debt, known as
the first trading day (June 17) after the Detroit emergency manager’s proposal
to creditors. The dashed vertical line indicates the first trading day (July 19) after
unlimited tax general
Detroit’s bankruptcy filing.
Source: Authors’ calculations based on data from Standard & Poor’s.
obligation (UTGO)
bonds, was issued with
city will file its restructuring plan (i.e.,
explicit voter approval that commits the
its “plan for adjustment of debts”), which
city to levy unlimited taxes for repayment.
will outline proposed payments to difOther GO debt, known as limited tax
ferent types of creditors. Unlike corpo- general obligation (LTGO) bonds, was
rate bankruptcy, there is no provision in
issued directly by the city and can only
Chapter 9 allowing creditors to file their be paid from general funds. Moreover,
own plan. Moreover, the court can force some of the UTGO and LTGO bonds
the acceptance of the city plan as long
have separate streams of committed
as a majority of any class of the impaired
revenues coming from the state and
creditors accepts the proposal. As a reare, therefore, referred to as “doublesult, creditors have few opportunities to barreled” bonds. These distinctions
challenge restructuring in Chapter 9.
highlight the fact that various GO bonds
can enjoy different forms of legal proMuch of the market commentary and
tection and can count on different
news coverage to date has centered on
sources of revenues for their repayment.
the EM restructuring proposal, presented to creditors on June 14, 2013.4
In addition to bonded debt, Detroit’s
Although the EM proposal is in no way liabilities comprise outstanding pension
binding and may end up being quite
and other post-employment benefit
different from the final plan for adjust- (OPEB) obligations, mainly for medical
ment of debts, it provides a basis for the insurance coverage, to both current and
expected treatment of various types of
retired city workers, police, and firedebt. As such, the proposal created confighters. The pension and OPEB oblisiderable controversy, since it ignored
gations have been valued in the EM plan
several conventional approaches to
at $3.5 billion and $5.7 billion, respecprioritizing and valuing liabilities of a
tively. The remaining components of
bankrupt municipality.
Detroit’s liabilities are two sets of financial
securities closely related to its pension
Unique aspects of the EM proposal
obligations—pension obligation certifiTo understand the unorthodox nature cates (POCs) and the associated swap
of the EM plan, one needs to decompose contracts that convert variable-interest
1. Yield spreads of S&P municipal bond GO indexes, 2013

payments on POCs into fixed-rate obligations. The POCs and associated swaps
have been valued in the EM plan at
$1.5 billion and $0.8 billion, respectively.
Chapter 9 bankruptcy grants senior status
to debts secured by the pledge of specific revenues (e.g., the water and sewer
system bonds secured by utility bill payments). All other debts are treated as
equally unsecured under the law. As senior debt is repaid first, all other debts
can be repaid only from the revenues
that are left over. Put differently, every
dollar of debt that is regarded as being
secured diminishes the pool of money
available for repaying unsecured claims.
Theoretically, this suggests that all unsecured debt is impaired (i.e., repaid
less than fully) in bankruptcy. The exact degree of impairment of each type
of unsecured debt is determined during the bankruptcy process.
In practice, however, municipalities
seeking Chapter 9 protection have previously treated GO debt as senior to
other unsecured claims such as pensions
in their debt adjustment plans. This
meant that GO bondholders were typically repaid in full, even as some pension
and OPEB obligations were diminished.
In fact, between 1970 and 2011 (when
Jefferson County, Alabama, filed for
bankruptcy), no GO bond in the Moody’s
credit rating universe was impaired in a
Chapter 9 bankruptcy.
Yet, the EM proposal called for steep
cuts in payments to most bondholders,
as well as to pensions being received by
retirees, pension and OPEB obligations
owed to current employees, and POCs
held by pension creditors. Only the water
and sewer system bonds and doublebarreled UTGO and LTGO bonds were
regarded as secured and thus subject to
repayment in full. On average, the unsecured creditors were offered about ten
cents on each dollar in claims they held.
The EM’s proposed placement of some
GO bonds on the same footing as retirement and employment obligations surprised market participants. It triggered
extensive commentary on the need for
investors to rethink their assumptions
about recovery values of GO debt in bankruptcy. Although Detroit’s combination

2. Yield spreads of municipal bond portfolios, 2013
percent
0.6

0.4

0.2

0.0

−0.2
−0.4
Jan.

Feb.

Mar.

Apr.

May

Jun.

Jul.

Aug. Sep.

H9−L9

Hno9−Lno9

H9−Hno9

L9−Lno9

Notes: The sample of 92 bonds was selected by choosing at most two bonds from
each issuer from the set of uninsured fixed-rate general obligation bonds issued by
the cities included in Pew Charitable Trusts (2013). When multiple bonds from the
same issuer met these criteria, the two with a maturity closest to ten years were
selected. H9 is a portfolio of bonds issued by cities with high per capita pension
and other post-employment benefit (OPEB) obligations located in Chapter 9 states.
L9 is a portfolio of bonds issued by cities with low per capita pension and OPEB
obligations located in Chapter 9 states. Hno9 is a portfolio of bonds issued by
cities with high per capita pension and OPEB obligations located in non-Chapter 9
states. Lno9 is a portfolio of bonds issued by cities with low per capita pension and
OPEB obligations located in non-Chapter 9 states. “High” and “low” obligations are
defined as above and below the median, respectively. The plots are the spreads
between the weighted average yields of the portfolios. The solid vertical line indicates
the first trading day (June 17) after the Detroit emergency manager’s proposal to
creditors. The dashed vertical line indicates the first trading day (July 19) after
Detroit’s bankruptcy filing.
Sources: Authors’ calculations based on data from Bloomberg and Pew Charitable
Trusts (2013).

of financial woes and structural economic
problems is unique, a substantial number of local governments nationwide face
large pension and OPEB obligations. For
these governments and their creditors,
Detroit’s case is a potential bellwether.
Another surprising aspect of the EM
proposal was its failure to differentiate
between debt backed by the unlimited
tax pledge and debt lacking such a pledge.
UTGO debt is typically repaid from a
special property levy that has no limit and,
as such, relies on revenues that are entirely
separate from those used to cover generalfund operations.5 This feature of UTGO
debt makes it quite similar to other secured debt, contrary to the EM’s statements implying that none of the GO
bonds have legal security. This issue will
be ultimately settled by the court, and it
might have wide-reaching consequences
for the pricing of voter-approved GO debt.
Implications for municipal bonds

In the preceding section, we touched on
the potential market ramifications of

legal rulings with respect to the treatment
of pension and OPEB
obligations, as well as
GO debt backed by
unlimited tax pledges.
The standing of pension obligations relative
to other municipal
liabilities is particularly important to
bondholders and the
broader public given
the multitude of wellpublicized funding
shortfalls in a great
number of American
cities. For example,
data from a recent
Pew Charitable Trusts
study of large cities
indicate that they
have funded only
57.5% of the $511.2 billion of retirement
benefits promised to
their employees.6

There is a conflict
between state and
federal laws as to
whether pension obligations can be
impaired by a federal bankruptcy court.
Michigan’s state constitution prohibits
reductions of promised pension benefits,
but Detroit’s EM argues that Michigan
law allows for pension cuts in federal
bankruptcy court. Pension funds have
challenged the EM’s interpretation on
the grounds that it violates both the Tenth
Amendment to the U.S. Constitution
and state law. To date there is no jurisprudence addressing the question of
whether a municipality can diminish
pension obligations protected by a state
constitution. If the court agrees with
pension creditors that state protections
hold supreme, this could change market
expectations with respect to the relative
standing of municipal debt issued by
cities located in states with such protections (e.g., Chicago, Los Angeles, and
New York City). Furthermore, any precedent that makes pension obligations
senior to municipal bonds on broad
Tenth Amendment grounds could
have a material effect on the pricing of

municipal debt for any city with large
underfunded pension obligations.
How have the markets reacted thus far?

Apart from Michigan municipalities, the
market reaction to the Detroit bankruptcy filing has been negligible. In the
week following the EM’s June 14, 2013,
proposal to subordinate GO bonds,
the difference (spread) between the
yield on the nationwide Standard &
Poor’s (S&P) Municipal Bond General
Obligation Index (SAPIGO) and the
yield on ten-year U.S. Treasury bonds
declined 8 basis points (figure 1). The
SAPIGO–ten-year U.S. Treasury bond
yield spread did increase by 9 basis points
the day after Detroit’s Chapter 9 filing
on July 18 but quickly returned to its
pre-bankruptcy level. In contrast, the
spread between the yield on the S&P
Municipal Bond Michigan General
Obligation Index (SAPIMIG) and the
yield on SAPIGO increased 14 basis
points following the EM proposal. The
spread further jumped by 29 basis points
on the day after Detroit’s bankruptcy
filing and has remained elevated since,
suggesting that the filing has had a
material impact on borrowing costs of
Michigan municipal issuers.
Charles L. Evans, President ; Daniel G. Sullivan,
Executive Vice President and Director of Research;
Spencer Krane, Senior Vice President and Economic
Advisor ; David Marshall, Senior Vice President, financial
markets group ; Daniel Aaronson, Vice President,
microeconomic policy research; Jonas D. M. Fisher,
Vice President, macroeconomic policy research; Richard
Heckinger,Vice President, markets team; Anna L.
Paulson, Vice President, finance team; William A. Testa,
Vice President, regional programs, and Economics Editor ;
Helen O’D. Koshy and Han Y. Choi, Editors  ;
Rita Molloy and Julia Baker, Production Editors;
Sheila A. Mangler, Editorial Assistant.
Chicago Fed Letter is published by the Economic
Research Department of the Federal Reserve Bank
of Chicago. The views expressed are the authors’
and do not necessarily reflect the views of the
Federal Reserve Bank of Chicago or the Federal
Reserve System.
© 2013 Federal Reserve Bank of Chicago
Chicago Fed Letter articles may be reproduced in
whole or in part, provided the articles are not
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Prior written permission must be obtained for
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ISSN 0895-0164

Although the market penalized Michigan
municipal issuers, there was little immediate price impact in municipalities
with large unfunded pension obligations
located in other states. Figure 1 graphs
the yield spread between S&P municipal bond GO indexes for California
(SAPICAG), Illinois (SAPIILG), and
Michigan and the nationwide SAPIGO.
Illinois debt issuers, in particular, have
faced recent credit downgrades because
of unfunded pension obligations and
legislative stalemate in addressing this
issue, so the SAPIILG–SAPIGO yield
spread increased noticeably in August.
Did the muni market start demanding
a larger risk premium for issuers with
large pension and OPEB liabilities in
the wake of Detroit’s bankruptcy filing?
To answer this question, we selected 92
bonds issued by cities in Pew Charitable
Trusts (2013) and sorted these bonds
into four equal-duration portfolios based
on issuers’ per capita pension and

OPEB obligations and whether the issuer
was located in a Chapter 9-eligible state.
The yield spreads between these bond
portfolios are graphed in figure 2. The
baseline series labeled (H9–L9) depicts
the difference in yields on bonds issued
by cities with high obligations located
in Chapter 9 states and bonds issued
by cities with low obligations located in
Chapter 9 states. The H9–L9 yield spread
is remarkably stable around the dates of
the EM proposal (June 14) and Detroit’s
bankruptcy filing (July 18). Market participants appear to require no more
compensation to hold bonds issued by
cities with obligations that are subject
to Chapter 9. In fact, the yield spread
between bonds from high-obligation
issuers located in Chapter 9 states (H9)
and those from similar issuers located in
non-Chapter 9 states (Hno9) declined
approximately 20 basis points in the
month after Detroit’s bankruptcy filing.
Over the same period, the yield spread
between bonds issued by high- and

low-obligation cities located in nonChapter 9 states (Hno9–Lno9) increased.
This evidence suggests the absence of
any systematic discrimination against
issuers located in Chapter 9 states or
issuers with high per capita pension and
OPEB obligations following Detroit’s
bankruptcy filing.

previous version of the law (Public Act 4)
in a November 2012 referendum. Both of
the EM laws are subject to several lawsuits
challenging their constitutionality.

Charter tax rate limitations for payment of
such obligations,” quoted on p. 15 of
www.scribd.com/doc/159347508/
Barclays-Municipal-Research-DetroitChapter-9-Begins.

1 For details, see Gene Amromin and Anna

Paulson, 2011, “Tempestuous municipal
debt markets: Oxymoron or new reality?,”
Chicago Fed Letter, Federal Reserve Bank of
Chicago, No. 291, October.

4

2 Section 109(c) of the U.S. Bankruptcy Code
sets forth the eligibility requirements for
Chapter 9.

3 The new EM law (Public Act 436) was passed
after Michigan voters had repealed the

5

The EM plan is available at www.freep.com/
assets/freep/pdf/C4206913614.PDF.
The official statement for 2008 UTGO bonds
states: “In accordance with State law, the City
is obligated to levy and collect taxes without
regard to any constitutional, statutory or

Conclusion

As of this point, Detroit’s bankruptcy
filing has had little impact on the cost of
municipal financing outside of Michigan.
Nonetheless, Detroit’s case has the potential to set a number of precedents
with far-reaching consequences, such
as the treatment of pension and OPEB
obligations vis-à-vis bonded debt, the
degree of protection afforded by state
constitutions, and the value of the unlimited tax pledges approved by the
electorate. The resolution of these issues
in court will change the shape of municipal financial markets for years to come.

6

Authors’ calculations based on data from
Pew Charitable Trusts, 2013, “A widening
gap in cities: Shortfalls in funding for pensions and retiree health care,” report,
Washington, DC, January, exhibit 1, p. 3.