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Judge Lets Stockton Go Bust: Should Muni Bondholders Worry?

5 April 2013 in Trading Ideas

A California bankruptcy judge’s decision earlier this week to let a Chapter 9 filing by the city of Stockton, Calif., proceed did little to illuminate the ultimate issue: When a city goes bust, how are the losses going to be divvied up among bondholders and its workers and retirees?

As the Wall Street Journal reported1, Judge Christopher Klein ruled that Stockton’s bankruptcy filing could not be dismissed, as bondholders had wanted, since without the powers of the bankruptcy law, the city would be unable to fulfill its obligations to its residents – namely, public safety.

Bondholders were arguing that the city was unfairly using bankruptcy proceedings to cut debt payments – but not touching its obligations to the California Public Employees’ Retirement System, or Calpers, which holds city workers’ retirement money.

Judge Klein disagreed, but also allowed that bondholders could continue their fight against Stockton’s debt-repayment plan.

The city’s woes are far from an isolated incident. Stockton’s move follows moves toward bankruptcies by California municipalities, including Vallejo, Mammoth Lakes, and San Bernardino – the latter of which is also trying to negotiate concessions from its bondholders.

Municipal experts and other struggling towns are watching the case to see whether a city’s pension-fund obligations are immune from cuts imposed by a bankruptcy judge. If they’re not, the thinking goes, more municipalities could be inclined to file for bankruptcy.

And that isn’t necessarily bad news for muni bond investors, since any agreement among cities, bondholders and Calpers that sustains debt obligations could benefit holders of that debt. In addition, if Calpers should happen to make any concessions with regard to its expectations (which hasn’t yet been signaled), a key precedent could be set for the future health of municipal governments.

1Katy Stech, “California City’s Bankruptcy Poses Risk to Pensions,” The Wall Street Journal, April 1, 2013.

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