Public Finance

Special Report
The Perils of Considering Municipal
Bankruptcy
Analysts Overview
Richard J. Raphael Over the past year, some fiscally distressed municipal governments have publicly
+1 212 908-0506 considered filing for bankruptcy protection under Chapter 9 of the U.S. Bankruptcy
richard.raphael@fitchratings.com
Code. As the pain of the recession continues to be felt, some municipalities may
Eric Friedland contemplate bankruptcy as a last resort, and others may use it as a threat to seek relief
+1 212 908-0632 from onerous labor contracts and other obligations. While some have asserted that a
eric.friedland@fitchratings.com municipality’s statements about bankruptcy are not a credit concern, Fitch Ratings
Amy R. Laskey believes such statements should be taken seriously.
+1 212 908-0568
amy.laskeyl@fitchratings.com Although it is reasonable to assume that elected officials will from time to time make
informational inquiries about the bankruptcy code, such discussions will trigger an
Amy S. Doppelt inquiry by Fitch. If bankruptcy is being actively considered, Fitch will assess whether
+1 415 732-5612
amy.doppelt@fitchratings.com the entity’s current rating should be maintained, as consideration of bankruptcy not
only indicates severe financial stress but also a willingness to compromise the credit
standing of bondholders through a bankruptcy filing.
The hallmark of the municipal market has been the strong security structures afforded
to bondholders and the issuers’ demonstrated willingness to pay. Bankruptcy has rarely
been used by full-service municipal entities. In nearly all cases, municipalities have
taken the difficult measures required to maintain fiscal solvency, avoid bankruptcy,
and preserve bondholders’ credit standing. In certain cases, bankruptcy filing has been
averted when the state stepped in to provide assistance and oversight, often through
fiscal control boards. Furthermore, bankruptcy filings have generally been avoided
because of the significant political, legislative, and expense hurdles and severe market
access implications. The historically low municipal bankruptcy and default rate has
generally enabled broad and relatively inexpensive market access, despite the large
number of local government borrowers, ranging from small towns to large cities.
Bankruptcy compromises bondholder security. Therefore, the consideration of
bankruptcy as a viable option for relief in itself calls into question the issuer’s
willingness to pay commitment. Fitch believes that the more bankruptcy is publicly
discussed as an option for financial relief, the more its tarnish wears off, increasing the
likelihood of its actual use. With the near evaporation of bond insurance, which had
provided credit support to about one-half of the municipal market, actions by market
participants would be expected to nurture investor confidence and reinforce credit
protections, rather than erode them. Particularly, as local governments continue to
wrestle with fiscal pressures over the next few years, market access at affordable
interest rates for both short- and long-term needs is crucial to recovery.
Municipalities may intend to use the threat of bankruptcy as the ultimate tool to gain
concessions from labor and other strong constituencies, rather than to harm
bondholders. Fitch believes this type of brinksmanship can escalate, forcing follow-
through and resulting in outcomes that were perhaps not originally intended. A
bankruptcy filing is a blunt instrument that is used to prioritize and evaluate a large set
of obligations, with labor agreements and bond payments in the mix. In other words, in
bankruptcy, Fitch questions whether a local government’s labor contracts would be
surgically undone with bondholders’ rights left intact.

www.fitchratings.com January 27, 2010

 Public Finance
In two previous large bankruptcies  Orange County, CA in 1994 and San Jose School
District in 1983  debt service on long-term bonds was not affected, although Orange
County negotiated with noteholders a one-year delay in principal repayment that
included a negotiated and high-penalty interest rate. In contrast, last month, the
Vallejo, CA City Council approved a bankruptcy workout plan that includes reductions in
debt service payments on general fund obligations. The workout plan appears to align
with the bankruptcy judge’s earlier ruling in favor of rejecting Vallejo’s labor contract
with the International Brotherhood of Electrical Workers. The judge’s basis for the
contract rejection was that it met three criteria, one of which was that all creditors
shared equitably in losses, including bondholders, to whom payments had previously
been delayed or reduced.
If the Vallejo bankruptcy plan is approved by the court and ultimately upheld, it could
set a precedent for future municipal bankruptcies  at least some classes of
bondholders must share in losses along with other creditors. This further highlights the
perils to bondholders when bankruptcy is pursued.

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2 The Perils of Considering Municipal Bankruptcy January 27, 2010