Bonds & Bankruptcy

Lesson from Detroit: Municipal Debt Isn’t Risk-Free

A ‘grand bargain’… but for whom?

by James Frischling, President & Ron D’Vari, CEO, NewOak

NewOak is an independent financial services advisory firm built for today’s global markets, providing a broad range of services across multiple asset classes, complex securities and structured products for banks, insurers, asset managers, law firms and regulators, including financial advisory and dispute resolution, valuation, credit and compliance, risk management, stress testing, model validation and financial technology solutions. We have analyzed or advised on more than $4.5 trillion in assets to date.

Judge Steven Rhodes, of the U.S. District Court for the Eastern District of Michigan, approved Detroit’s complex restructuring plan of the city’s $18 billion debt last Friday. Detroit, the largest city in the United States to ever file for bankruptcy, was able to reach this milestone in less than 16 months. Given the size and complexity of financial obligations, such an accomplishment is nothing short of remarkable. To be sure, Detroit has its work cut out for it. Eliminating debt is a beginning, while creating a viable recovery plan can be a potential solution.

Much has and will continue to be written about Detroit’s bankruptcy and the ”grand bargain” reached in order to save this city, but the lesson learned by municipal bond investors is simple and straightforward – municipal debt is not risk free.

From the very beginning, Judge Rhodes made it clear he was less concerned about the treatment of bondholders and other financial creditors. Fitch Ratings called the proposals in Detroit an “us-versus-them” mentality, which favored retired workers over bondholders.

If pension obligations trump bondholders, then the debt of Michigan is going to get penalized and municipal bond spreads may widen in the long run. Detroit’s record bankruptcy may be precedent setting for how priorities are set when municipalities fall into trouble.

Another lesson learned from Detroit is that corporate bankruptcies are very different from municipal bankruptcies. The difference is that one is far more political than the other, and as a result, a municipality has greater latitude in how creditors are treated.

From the very beginning, Judge Rhodes made it clear he was less concerned about the treatment of bondholders and other financial creditors. Fitch Ratings called the proposals in Detroit an “us-versus-them” mentality, which favored retired workers over bondholders

The bond market can conclude from the approval of the Detroit restructuring plan that municipal general obligation bonds are subordinate to pension liabilities. That will result in municipal bond investors demanding greater protections, yields or both. The municipal market may have just shed its reputation as a sheltered place to invest and has earned its place among a myriad of other asset classes where sophisticated analytical tools are a prerequisite.

Banks Operational Risk Management: Best Practice Standards Lacking?

Sound operational risk management (ORM) should be a core element of any institution’s overall governance and an integral part of its enterprise risk management. This entails disciplined and continuously monitored operational risk identification and mitigation efforts. The objective is to avoid errors and occurrence of events capable of causing material financial or reputational losses and any adverse impact on clients and counterparties. Banks and other financial institutions are no exception.

However, the Basel Committee on Banking Supervision’s (BCBS) survey of 60 significantly important banks in 20 jurisdictions has found that most banks are behind in implementing the “Principles for the Sound Management of Operational Risk” that it published in June 2011. The “Principles” address governance, the overall risk management environment and the role of disclosure, and identify three lines of operational risk defense: 1) business line management, 2) an independent corporate operational risk management function, and 3) an independent review.

The BCBS survey concluded that many banks showed some weakness in most areas but more egregiously in four key areas: 1) operational risk identification and assessment, 2) change management, 3) operational risk appetite and tolerance, and 4) and operational risk disclosure.

While banks have come a long way in establishing best practices for managing market, credit and liquidity risks, standards of practice for ORM have been far less uniform, with a range of approaches to the three lines of defense identified by BCBS.

A well-defined and articulate ORM framework needs to be part of the entire bank culture. We expect regulators to continue elevating standards for banks’ ORM, mandating banks to be much more proactive in identifying, measuring, managing and disclosing operational risks.