Governments typically finance their capital projects with general obligation debt, secured by the “full faith and credit” of the government. A full faith and credit pledge implies that, unless specifically limited, the government will use its full taxing power to ensure that lenders receive timely repayment of principal and interest.

When New York City faced a financial crisis in the mid-1970s, city and state leaders concluded that bankruptcy was out of the question. A combination of belt-tightening and selling secured long-term debt to redeem outstanding short-term debt enabled the city to muddle through. Although it declared a temporary moratorium on repayment, the city ultimately paid all its general obligation debt. But what if a government files for bankruptcy because of legal, financial or economic constraints on its ability to raise taxes? Unfortunately, when a municipality files for bankruptcy, all bets are off; faith in getting repaid isn’t enough.

            When the city of Detroit filed for bankruptcy in 2013, it had approximately $1 billion of outstanding general obligation bonds. Detroit had two types of full faith and credit debt. Its Unlimited Tax General Obligation (UTGO) debt had been approved by the citizenry and was secured by a separate property tax levy, as required by state law. Its Limited Tax General Obligation (LTGO) debt was not approved by the citizenry, but was secure by a requirement that the first collection of regular property taxes be set aside each year to pay the debt service.

            In his initial “proposal for creditors,” Detroit’s emergency financial manager declared all outstanding general obligation debt to be “unsecured claims,” lumping them together with Detroit’s unfunded obligations for pensions, retiree health insurance, and certain other liabilities. He proposed that all creditors receive a settlement amounting to a few pennies per dollar of debt. Municipal bond insurers, having guaranteed payment of the debt service, argued that the legal requirements and related procedures—Detroit’s pledge, the separate property tax levy that could be used only to repay the UTGO bonds, the set-aside of the first tax collections—were such that all the general obligation debt should have priority over other claims. Several knowledgeable observers believed that the pledge behind the UTGO debt was particularly strong.

            The federal bankruptcy judge urged Detroit and its creditors to negotiate a settlement, holding over their heads the potential that, if he had to make a decision, individual parties might be hurt more than they would under a negotiated agreement. After negotiation, Detroit offered its bondholders (and bond insurers) 74 cents per dollar owed on the UTGO debt, and 34 cents per dollar owed on the LTGO debt. And that’s how the bankruptcy judge finally ruled. The final settlement is better than the original proposal, but it’s much less than the amount owed.

Required:

You live in an Ohio municipality and always wanted to buy its bonds. Most of the municipality’s tax revenues are obtained from real property taxes and sales taxes. Describe three significant factors about the municipality (covering financial, economic or demographic factors) that you would like to know before you make the investment and state why each will enhance your faith in the city’s ability to pay you back