The city of Detroit's record bankruptcy filing has cast a cloud over the US municipal bond market as creditors face potential steep losses on the typically safe investment.
Bond holders are nervously awaiting a federal judge's decision on Detroit's request Thursday for bankruptcy protection as it seeks relief from a staggering $18.5 billion debt.
The biggest US city bankruptcy in the nation's history was not unexpected, given decades of decaying finances in the once-mighty automotive capital known as Motor City.
"Are we about to enter a new era of municipal finance? The debts of many municipal entities are large enough to make the current state of affairs more compelling for bankruptcy. It all depends on how much debt you can erase," said Robert Brusca of FAO Economics.
"Detroit bears watching very closely. It is both a special case and a paradigm," he said.
The Detroit bankruptcy reorganization filing, if approved, is expected to make it harder for municipalities in Michigan and other US states to borrow money by undermining confidence in what used to be among the most trusted bonds available.
The White House says it was monitoring the situation but the Obama administration has not signaled it would throw the city a lifeline.
On Friday, ratings firm Standard & Poor's cut its rating on Detroit's general obligation (GO) debt from "CC" to "C", just one notch above default, and said the outlook was "negative."
"The negative outlook reflects our expectation that, given the Emergency Manager's statements regarding debt restructuring, actions taken to date, and negotiations currently underway with bondholders, we could lower the rating in the one-year time horizon of the outlook," S&P credit analyst Jane Ridley said in a statement.
But, Ridley said: "We view Detroit's default and subsequent bankruptcy filing as idiosyncratic, and not as a symptom of a wider issue in the municipal market."
About half of Detroit's debt is owed to the pension funds and retiree health care benefits of the city's 10,000 workers and 20,000 retirees.
Detroit Emergency Manager Kevyn Orr said the city has about $2 billion to repay $12 billion in "unsecured" debt, which includes the pension obligations.
In mid-June, Orr proposed negotiations for writedowns to creditors as the insolvent city was forced to defer payments on some obligations.
It was not known how long the federal judge would take to make a decision on whether Detroit is eligible for Chapter 9 protection.
Leon LaBrecque, head of LJPR, a Troy, Michigan-based wealth management firm, said the filing has cast Detroit into "uncharted waters."
The restructuring proposal classifies Detroit's unlimited-tax general obligation bonds as unsecured, meaning returns are not guaranteed, whereas municipal bond investors generally view them as being backed by a pledge of tax revenue.
"If Mr. Orr's classification is upheld by a court of law, it will have far-reaching effects, not just for other troubled municipalities, but the municipal market in general."
Pension benefits are protected by the state of Michigan's constitution, but the bankruptcy process could drastically diminish those obligations. Public employees across the country are watching the case, fearful that they too may see their retirement benefits slashed.
The bankruptcy filing put in limbo a lawsuit filed earlier in the week by the city's two pension funds over $9.2 billion in unfunded obligations, seeking to prevent Orr from slashing retirement benefits.
Douglas McIntyre of 24/7Wall St. blamed Detroit government officials and unions, not bond holders, for the crisis, saying they had tried to hang on to as much money and privilege as they could.
"Detroit's elected officials have lost all of their power. Orr has it, and soon a court will. Unions and their members can only wait to see how badly they will be gored as part of the Chapter 9 process."