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Municipal Bankruptcy Upheld

San Bernardino Sets Bankruptcy Precedent

Written by Marcelina Hardy
Posted August 30, 2013 at 7:10PM

Municipal bonds will never be the same again. With cities around the country filing for bankruptcy or considering it, people are losing money they thought they were going to receive because of their “secure” investment in municipal bonds.

bankruptWhat has happened that has further shaken municipal bonds? Where will investors put their faith next?

San Bernardino’s Bankruptcy

One year ago, San Bernardino, California filed for bankruptcy protection. The city found itself in a deficit of $46 million. It had run out of money to support its operations. To compound the problem, the city’s mayor said the pension debt was overwhelming.

When San Bernardino filed for bankruptcy, California Public Employees’ Retirement System (CalPERS) objected to it, of course. CalPERS is a pension fund providing retirement and health benefits. More than 1.6 million public employees, 3,000 employers, retirees and their families use the system.

The bankruptcy of San Bernadino is devastating to CalPERS because it will lose the money its investors have been counting on. Not only will the investors end up suffering, but so will the reputation of the company.

This is why the pension fund company had to do something. It argued that city officials didn’t do everything they could do avoid bankruptcy, failing take the time to come up with an agreement with creditors before filing for bankruptcy.

As required by bankruptcy law, a city must proceed with “good faith negotiations” before filing bankruptcy. What is meant by good faith is up for debate, and it is most likely what saved the city.

Judge Meredith Jury reviewed CalPERS's claim that the city officials didn’t negotiate before filing, but she found it wasn’t enough of a reason to throw the bankruptcy out of court. The judge stated that it wasn’t in anyone’s interest (even creditors) to throw the bankruptcy case out of court.

She also concluded that there wasn’t enough evidence to prove the city wasn’t trying to move forward. She believes there really is no other choice for the city – bankruptcy and dissolving is the only way for the government to survive its financial problems.

This ruling by Judge Jury has likely set a precedent for other cities filing or considering filing for bankruptcy. Public employees in Detroit have already considered trying to do the same thing as CalPERS, but seeing as the California pension fund didn’t make any leeway, Detroit's probably won't be successful either.

If the judge had allowed CalPERS to overturn the city’s bankruptcy filing to make it ineligible, this would have led to a lot of trouble for the city. Creditors would be coming from all directions – as many as 10,000 of them, according to CNNMoney – to sue the city for all of money they are owed. This would have surely blasted the city government out of the water, making it nearly impossible to ever recover.

What This Means for Investors

Municipal bonds used to be considered rather secure investments. Investors found them to be a great way to save for retirement. But they're not looking so secure now, and this may change the way investors look at municipal bonds forever.

For decades, investors never thought cities would file for bankruptcy because this could ruin the reputation of the city's bond market. This created a false sense of security because, as there is a stipulation that says that investors could lose their investments if the city government were unable to pay.

Investors don’t want to invest in something that may be pulled from them at any time. Even when cities recover financially, investors will likely now see as a reminder that municipal bonds aren’t always the most secure investment.

Alternatives to Municipal Bonds

Now that you see what has happened to San Bernardino and Detroit, it’s likely you’re shaken by municipal bonds as much as other investors. So now, it’s time to find somewhere else to invest your money.

Jim Grant, bond market expert, told Bloomberg that he does not favor municipal bonds. He is more of a REIT kind of guy.

REITs are mortgage-backed securities. Some of the REITs he has invested in are offering yields of as much as 10%.

Grant reports that the two REITs he recommends with positive pre-tax yields are:

  • Annaly (NYSE: NLY)

  • MFA Financial (NYSE: MFA)

There’s always an alternative in investing. Going with what makes you feel the most comfortable is what’s important.

Look more into REITs, as Grant recommends. It may just produce a return that won’t have the risk that many cities’ municipal bonds now face.


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