STUMP » Articles » Buyers of Distressed Munis: BEWARE! GET OUT! » 18 May 2015, 01:57

In yesterday’s post, I mentioned that yield-hungry muni investors might want to hang fire when Chicago issues bonds in the coming weeks.

Why did I say that?

Whle the Illinois Supreme Court ruling on Illinois pension reform has been drawing all eyes, there was another court ruling going down across the country.

San Bernardino bondholders were being told that pensions come before them:

May 11 (Reuters) – An attempt by holders of bonds issued by bankrupt San Bernardino to win the same treatment accorded the city’s biggest creditor, state pension giant Calpers, was thrown out by a federal judge on Monday.

The ruling comes three days before the southern California city of San Bernardino is to produce a bankruptcy exit plan and would appear to clear the way for the city to slash its bondholder debt. The city has already said that it intends to make full payment to Calpers, which has assets of $300 billion.

The ruling mirrors what happened in two other recent city bankruptcies – in Detroit Michigan, and Stockton, California – where bondholders were paid little of what they were owed, while pensioners and pension funds emerged relatively untouched.

San Bernardino, a city of 205,000 that is 65 miles east of Los Angeles, declared bankruptcy in July 2012 with a $45 million deficit. Along with Detroit and Stockton, its bankruptcy is one of a handful that have been closely watched by the $3.6 trillion U.S. municipal bond market.
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In the San Bernardino case, Luxembourg-based Erste Europäische Pfandbrief-und Kommunalkreditbank AG (EEPK), which holds $50 million of pension obligation bonds issued by the city in 2005, sued the city in January.

EEPK, along with co-plaintiff Ambac Assurance Corp, which insures a portion of the pension debt, argued that their debt was part of the same debt owed by the city to Calpers.

EEPK based its argument on the fact its $50 million pension bond debt was used by the city in 2005 to pay down its obligation to Calpers.

EEPK argued that the two debts are part of the same “indivisible” obligation, and thus EEPK and Calpers have to be treated equally.

U.S. Bankruptcy Judge Meredith Jury rejected that argument. She said there was no evidence that the city ever intended to treat its pension bond debt the same as its obligations to Calpers.

Guys shouldn’t have been fooled by the name.

They may be called “pension obligation bonds”, but that’s just marketing. They’re not being treated the same as pension obligations. They are, simply put, a trick.

Anybody foolish enough to lend money to someone to play in the stock market (or hedge funds or private equity…) — well, well, well.

People have been paying attention to the fact that pensions did get cut in the Detroit bankruptcy. What they didn’t pay attention to was the fact that those haircuts were minor compared to what happened to the bondholders.

WON’T ANYBODY THINK OF THE LITTLE OLD LADY BONDHOLDERS?!

Anyway, in no surprise, Calpers wins again.

The Southern California city of San Bernardino wants to repay its pension bondholders just a penny on the dollar while paying the state pension fund Calpers in full under its long-awaited bankruptcy exit plan released on Thursday.

Under the bankruptcy plan, called a plan of adjustment, San Bernardino also intends to virtually eliminate retiree health insurance costs, and outsource its fire, emergency response and trash services.

San Bernardino proposes paying the Luxembourg-based bank EEPK, holder of $50 million in pension obligation bonds and the city’s second largest creditor, a fraction of its original debt, according to the plan, posted on the city’s website.

EEPK, along with Ambac Assurance Corp, which insures a portion of the pension bonds, and Wells Fargo, the bond trustee, have the $50 million principal amount of their debt slashed to just $500,000, or a penny on the dollar, under the bankruptcy plan.

On the bright side, I guess a 99% cut is better than a 100% cut.

Am I right?

So here is a warning to anybody buying Chicago (or Illinois or New Jersey) bonds: you’d better think long and hard about the possibility of losing almost all of the principal, and if the extra yield you’ll be getting for a while will be worth that possibility.

There have always been players willing to play in the junk bond (oh, sorry, high yield bond) space, but it seems that playing for a distressed company assets (and where, after all, the company is really allowed to fail) is very different when you’ve got a government entity on the other side.

And as for Calpers, they need to think through these short-term wins and their long-term effects. Both San Bernardino and Stockton have been allowed to leave pensions untouched in these current bankruptcies. But the ruling in the Stockton case gives later openings, and at some point, even if politicians don’t want to cut pensions, they may find they have to, just because of the cashflows involved.

Government debtors are being allowed to prioritize creditors in a way that is not allowed in private bankruptcies (usually… but then, the GM bankruptcy was not exactly private, now was it). But if one wipes out all the non-pension debt, and the pension debt is too much….

…guess what’s going to get cut.