Stockton ‘cram-down’ would severely test muni market

Stockton, Calif., the latest and largest U.S. city to enter bankruptcy protection, has set the stage inadvertently for an ugly battle in the $4 trillion municipal bond market.

“Right now is not a time to panic, but it is a time to pay attention,” said Daniel Toboja, vice president of muni bond trading at Ziegler Capital Markets.

At issue for muni bond investors is whether the city of nearly 300,000 residents ultimately will be allowed to place municipal employee sal-ary and benefits through the California Public Employees’ Retirement System ahead of commitments made to bondholders.

“If the final bankruptcy plan comes through and CalPERS is made whole and the senior creditors get an 80% cram-down, that will be an issue,” Mr. Toboja said. “This is similar to the [2009] General Motors bankruptcy, when the federal government stepped in and gave unions priority over bondholders.”

Stockton, which was granted Chapter 9 bankruptcy protection last week, has a total debt issuance of more than $500 million.

CALPERS

The city already has defaulted on some of those bond payments. But it didn’t bring CalPERS to the negotiating table during the bankruptcy approval process, meaning that it plans to continue paying the pension provider about $30 million a year.

“The big question at this point is whether CalPERS will be deemed to be a creditor or not,” said Greg Lipitz, vice president and lead analyst for Stockton at Moody’s Investors Service.

As he pointed out, even though CalPERS serves primarily in a fiduciary capacity on behalf of city employees and retirees, it is identified as the city’s largest creditor. And CalPERS hasn’t suffered any losses to date in the Stockton bankruptcy.

“The contribution amounts are set, and the annual payments must be made in order to keep the pensions funded,” CalPERS spokeswoman Amy Norris said.

Stockton public information officer Connie Cochran insists that cutting payments to CalPERS is off the table and the city has already trimmed benefits to government employees and retirees.

“Nearly every city in the state participates in CalPERS, and if we don’t have a retirement benefit comparable to other municipalities’, we’re not able to attract and retain employees, particularly in public safety,” Ms. Cochran said.

Don’t tell that to the folks in San Bernardino, another bankrupt California town, which has stopped making payments to CalPERS, in addition to defaulting on its bonds.

The muni bond market wants benefit providers such as CalPERS to be part of the negotiations to spread the pain around, and they think that generous pay and benefit packages contribute to the budget problems.

“About 40% of Stockton’s outstanding liabilities are to CalPERS, so if Stockton is going to exist going forward, CalPERS will have to be at the negotiating table,” said Ronald Bernardi, president of Bernardi Securities Inc.

The muni bond market is quick to point out that defaults are rare and bankruptcies even rarer.

According to Moody’s, from 1970 through 2009, there were an average of fewer than two defaults per year. But the pace has picked up recently, with seven defaults in 2010, four in 2011 and five, including Stockton, last year.

And because municipalities operate under state regulations, the ultimate impact on bondholders from defaults and bankruptcies varies.

OTHER CASES

In 2011, for example, the tiny town of Central Falls, R.I., filed for bankruptcy protection but never missed a bond payment and didn’t default on its muni debt.

Harrisburg, Pa., was denied bankruptcy status in 2009 but continues to default on some of its debt obligations.

Vallejo, Calif., which entered bankruptcy protection in 2008 and has since emerged, did honor bondholder principal payments but made reduced interest payments.

In Jefferson County, Ala., a 2011 bankruptcy filing resulted in defaults.

And in the 1994 bankruptcy of Orange County, Calif., the municipality not only paid bondholders in full but also compensated some creditors with additional late-payment fees.

Municipal bankruptcies are usually costly ordeals, but a default today doesn’t always mean bond investors won’t eventually be made whole, Mr. Lipitz said.

Moody’s has downgraded Stockton’s credit rating to level 19, with 21 being the lowest rating.

“At this point, we anticipate an expected recovery on Stockton munis of between 65% and 85%,” Mr. Lipitz said.

That compares with a 65% average recovery rate from the more than 75 muni defaults since 1970.

The Stockton bankruptcy could say a lot about how certain states will treat muni investors when the chips are down.

“If bondholders are made to take a haircut at the expense of pensioners, that could have ramifications on other Chapter 9 filings and also on a municipality’s ability to issue debt in the future,” said Stephen Winterstein, chief strategist for fixed income at Wilmington Trust Corp.

There are more than 50,000 issuers of muni bonds in the United States because municipalities are heavily dependent on this type of debt to manage their budgets. But a default will either shut a municipality out of the debt market or make borrowing a lot more expensive.

“Whenever you shortchange bondholders, the bondholders remember that,” Mr. Winterstein said.

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