By: Mark Glennon*
Most readers’ eyes surely glazed over when they read last week about the cat fight between two of the agencies that rate credit for Chicago Public Schools. What’s far more important than that dispute is what it illustrated: The municipal bond community is way ahead in putting itself before everybody else with a stake in the financial crises gripping CPS, Chicago, other muncipalities and the State of Illinois. They’ve been hard at work securing positions to ensure they’ll get paid first, ahead of other creditors and ahead of taxpayers hoping to see government cash used for services and a fresh start.
Here’s what this is really about:
Insolvency proceedings of some kind are coming, and the municipal bond folks know it. Maybe those proceedings will be formal and orderly under the U.S. Bankruptcy Code. Or maybe some newfangled proceeding like Congress created for Puerto Rico. Or maybe a “bankruptcy-lite” federal proceeding as some have proposed. Or maybe it will be disorderly without any formal proceeding — a chaotic free-for-all where creditors sue and secured creditors foreclose, which is what it seems we are headed toward.
Whatever. It doesn’t matter. Bond folks know how this game is played no matter what, as does everybody with experience in workouts, insolvency and bankruptcy. You get every lien you can to secure what’s owed to you. Liens (mortgages and security interests) can be placed not just on tangible assets like buildings and cars but on every intangible thing imaginable. In the case of municipal bonds, a critical part of their collateral is money that flows in various forms from the state to cities, towns and school districts.
In other words, you “collaber up” everything you can. That’s the phrase we used in Texas when I practiced insolvency law there. It means you collateralize the debtor’s assets to make sure you get paid.
The dispute between between Moody’s and Fitch was just one example of how smartly the bond crowd is focused. That dispute was about how certain collateral positions would hold up legally under different circumstances. Details, if you are interested, are linked here, but the details aren’t really the point.
Another example of the bond community’s focus is SB10, a little noticed bill that’s part of the “grand bargain” now being debated in Springfield. Under that legislation, “a home rule municipality could enter into an agreement assigning a set amount of revenue it receives from the state to a special entity such as a public corporation or trust-like fund established for the ‘limited purpose of issuing obligations’ for the municipality, wrote Yvette Shields in The Bond Buyer today (reprinted by Fidelity Investments linked here). “The dedicated revenue would bypass a municipality’s general fund.”
That will help municipalities by lowering their borrowing costs, the thinking goes, and that’s no doubt true. But it’s a mixed blessing. It will also allow municipalities to borrow more and it will ensure that, when things collapse, state money goes to bondholders and not to services the municipality needs to provide.
I swapped emails today with a municipal investment banker who candidly said that’s the real point of SB10 — to get municipalities to borrow more. Is that really what we need? As an example of a place that’s already too far in hock he mentioned the Village of Bridgeview. Just the borrowing Bridgeview did for a soccer stadium, he wrote, means bondholders “might as well own that town because it outsizes the debt levels so much.”
A further example would be provisions popping up in various bills that would retroactively grant blanket liens even to secure bonds already issued. That would mean a windfall for existing bondholders that they didn’t bargain for and would do nothing to lower future borrowing costs. In fact, it would increase those costs.
Finally, you can easily find many stories (like this one) of ever more creative and aggressive structures used by CPS and Chicago to try to insulate the collateral they pledge from other uses and from bankruptcy.
How does does all this hurt taxpayers? If you’re “all collabered up” there’s nothing to work with. Everything of value is owned by the bank. Even a formal bankruptcy proceeding won’t help. A fresh start isn’t feasible. That’s when, in the private sector, a Chapter 11 bankruptcy reorganization gets converted to a Chapter 7 liquidation. The issue is particularly important for towns, cities and school districts that rely on money that flows from the state.
If we had sensible leadership, the state and its municipalities would be working in concert to, well, stiff existing bondholders. That may sound harsh but it isn’t. That’s what you have to do in insolvencies. It’s a hardball game. The whole point is to protect those you want to protect, which in this case should be citizens who need services and unsecured creditors like social service organizations and, yes, pensioners — up to a point. Unfunded pension liabilities are general unsecured debt. Many retirees desperately need some reasonable amount of their pensions protected. The excess, which is abundant, is a different story.
Bondholders are big boys. Nobody is talking about taking their legal rights away. They bought bonds knowing the rules of bankruptcy and insolvency and that those rules can be changed.
And please don’t bring up the usual red herring that this kind of talk means nobody would be willing to lend in Illinois. I’m talking about how to deal with bonds already issued. If they get deprioritized, that helps with future borrowing. Lenders always threaten would-be bankrupts about future borrowing, but they’ll line up eager to lend after a successful reorganization cleans up the balance sheet.
Here’s the most depressing part: Nobody, and I mean nobody, in the General Assembly is thinking in these terms. And if there’s anybody there who knows how to play this game, I don’t know who it is.
But rest assured the municipal bond community knows how to play the game, and that they are running circles around everybody else. With every day that passes the difficulty of turning things around in Illinois worsens. We’re gradually getting “all collabered up” in Texas-speak, or just “owned” by the bondholders, as that investment banker put it.
UPDATE 2/10/17 Further analysis of SB10 indicates it’s far worse than indicated in this article. The bill must be stopped at all costs. I will write further about it specifically soon.
UPDATE 2/9/17 For a wonderful illustration of the point of this article, see a recent interview linked here in Crain’s Detroit with Gerald Rosen, one of the key architects of Detroit’s bankruptcy plan.
The only thing that made the “Grand Bargain” work there was the luck of discovering huge value in a city-owned art museum. Rosen says he remembers thinking, “What the hell have I gotten myself into?” My job is to get deals. To get deals, you have to have revenue or assets that can be monetized into revenue, and the cupboard was pretty much bare. There didn’t seem to be much to work with for deals, other than the art.”
Illinois, its towns, cities and school districts don’t happen to have multi billion dollar unencumbered art collections sitting around, so they will be looking at what Rosen calls an “assetless bankruptcy.” He says, “overwhelmingly, the most challenging issue for me was an assetless bankruptcy — other than the art. I’ll never forget…realizing that there really weren’t any assets other than the art.”
“This was a time when Detroit was cannibalizing its heritage to mortgage its future,” says Rosen.
Remember that phrase. “Cannibalizing to mortgage the future.” That’s what we are doing now.
*Mark Glennon is founder of Wirepoints. Opinions expressed are his own.