Tempestuous Municipal Debt Markets: Oxymoron or New Reality?
Amromin, Gene, Paulson, Anna, Chicago Fed Letter
Municipal bonds (munis) are issued by states, cities, or other local government agencies. They may be general obligations of the issuer or secured by specified revenues, like fees paid by tollway users. The interest on municipal bonds is usually exempt from federal income taxes. Investors have long regarded these bonds as a relatively safe investment. Not coincidentally, holdings of municipal securities (or munis) have been heavily concentrated among household investors, who own about two-thirds of the $2.9 trillion market.
In the fall of 2010, the sense of complacency that had surrounded diese investments was shaken by deteriorating fiscal conditions of state and local bond issuers. The concerns about issuers' ability to honor their existing debts were amplified by high-profile media interviews that, for the first time, raised the specter of "hundreds of billions of dollars in defaults."2 Investors headed for the exits en masse. In just five weeks, a record $16.5 billion was withdrawn from muni mutual funds. By late January of this year, the yields on the highest-rated (AAA) issues of 20year municipal debt had jumped by nearly 100 basis points (figure 1) and new bond issuance had slowed to a trickle.
In recent months, municipal bond markets have calmed considerably. Still, this episode provides a number of useful insights into their structure, as well as highlighting some of their potential fault lines. In this Chicago Fed Letter, we describe how municipal markets are responding to changing conditions and new investor concerns.3
What happens when local governments go bankrupt?
This, in essence, was the question asked by retail and professional investors alike in the wake of dramatic statements about the impending tide of state and municipal issuer defaults. Within days, the popular and financial press carried numerous stories on this subject. In late January, the U.S. Senate reportedly considered introducing legislation to allow states to declare bankruptcy. This action only increased investor unease as bankruptcy is not typically an option for sovereign borrowers like states. The states, in turn, registered their strong opposition to this legislative idea, for fear of further undermining investor confidence.4
The bankruptcy process for municipalities is governed by Chapter 9 of the U.S. Bankruptcy Code, which allows local governments to voluntarily seek bankruptcy protection in the federal courts.5 However, since municipalities are instrumentalities of states that retain certain sovereign rights under the Tenth Amendment, their eligibility for Chapter 9
protection is controlled exclusively by each state. Presently, Chapter 9 filings are either prohibited or not expressly permitted in 26 states (see figure 2). Many of the remaining states further restrict eligibility by requiring explicit authorization by various elected or appointed bodies. For instance, Louisiana requires the governor and the attorney general to pre-approve a bankruptcy petition, while in New Jersey such approval must be granted by a municipal finance commission.
Chapter 9 filings are also substantially different from the more familiar corporate bankruptcy proceedings. The municipality cannot be forced to declare bankruptcy by its creditors. While the municipality is able to restructure its contracts, its assets cannot be liquidated. Furthermore, only the municipality, and not its creditors, can propose an exit plan. The bankruptcy court has very limited authority to force any specific restructuring changes. In fact, unlike with corporate bankruptcies, the court for the most part is a passive observer of the Chapter 9 process. After the initial determination of eligibility to file is made, the main remaining function of the court is to confirm an exit plan. Municipal bankruptcies do not generally result in any losses for bond investors. In each of the approximately 300 Chapter 9 filings over the past 40 years, bond investors were repaid in full, if sometimes late. …