The city of Detroit has moved in its bankruptcy hearing to declare certain of its general obligation bonds as unsecured debt. This will be, of course, challenged in the bankruptcy court. The decision will be a watershed moment and could set a course of action for other municipal bankruptcies to come.
The issue, which is being heard by bankruptcy judge Steven Rhodes, is whether the pledge of Detroit tax revenue to pay off the voter-approved bond (it’s important to note that this is a voter-approved bond) is considered a binding obligation under Michigan law. The bondholders are arguing for a binding obligation while the city is stating that this is just a promise to pay.
In legal terms, a promise to pay is not as binding as an actual obligation. Thus, if it’s only a promise to pay, this would mean that the bondholders would be reduced in the amounts that they could recover. That is, they would only receive pennies on the dollar.
The outcome is more than just the Detroit bankruptcy. Because general obligation bonds make up as much as 60% of the total bond market, this would fundamentally change how these bonds are viewed (and priced). Thus, investors would require much more to take on these bonds, which would further erode municipalities access to capital.