Why US States Don't Adopt a Bondholder Friendly Bankruptcy Law

US States that reformed municipal bankruptcy law in a bondholder-friendly direction experienced lower borrowing costs and increased investment in public goods, according to new research by Stefano Rossi (Bocconi University's Department of Finance).

Prof. Rossi and Prof. Hayong Yun (Michigan State University) studied the effects, and causes, of the adoption of municipal bankruptcy legislation in their new paper "Financial Reform and Public Good Provision: Municipal Bankruptcy Law and the Financing of Hospitals," published online ahead of print in Management Science.

The US municipal bond market is a rather big one, currently worth around $4tln. Municipal bonds (munis) can be classified in two categories, General Obligation (GO) and Revenue bonds. GO bonds are backed by the tax cash flows of the municipality and are usually senior. Revenue bonds are backed by the cash flows of the specific project they finance, such as the tolls from a highway or the profits of a hospital. While Revenue bonds do often have a residual claim on the tax revenues of the municipality, they are junior to GO bonds.

Enter Chapter 9. Chapter 9 (of the US Bankruptcy code) regulates municipal bankruptcies, much like the better-known Chapter 11 does for firms. From its first drafting in 1933 (it was not named Chapter 9, yet), only twenty-seven out of fifty States have, in several waves, authorized it. The law is generally considered to be particularly favorable for bondholders.

Chapter 9 is indeed a game-changer for municipal bonds. In fact, when a municipality enters bankruptcy proceeding under Chapter 9, all its GO bonds are subject to an "automatic stay," meaning all payments are frozen until the bankruptcy proceeding is over. Revenue bonds' payments, instead, are not suspended. Thus, Revenue bonds become effectively senior to GO bonds during bankruptcy.

Exploiting the staggered adoption of Chapter 9, the authors found an 8.5 basis points decrease in municipal bonds spreads after Chapter 9 authorization. The decrease is almost entirely driven by a decrease in Revenue bonds spreads, suggesting that investors are willing to pay more for bonds that are safer in a bankruptcy scenario. Revenue bonds issuance is considerably higher after the authorization.

Since hospitals are often financed through municipal debt issuance, one would expect an increase in investment towards the construction (and operation) of hospitals in States that introduce Chapter 9. Indeed, this hypothesis was corroborated by the data, which revealed a 24.5% increase in hospitals' capital expenditures after Chapter 9 authorization. But the effect was not limited to hospitals, with positive spillovers on the construction industry and, although of smaller magnitude, on real estate, wholesale and healthcare.

After assessing the effects, the authors turned their attention to the drivers of authorization of Chapter 9 at the State level. The hypothesis is that social and interest groups that are negatively affected by the reform politically oppose it and therefore that the authorization depends on such groups' relative power. One natural candidate for the Chapter 9 not-so-fan club is labor unions. Indeed, one of the bondholder-friendly provisions of the law is the possibility to unilaterally restructure public employment contracts, including sometimes firing workers. The authors found that States with stronger labor unions were less likely to adopt Chapter 9, as well as States with a less efficient judiciary (measured by the average caseload per judge).

Municipal bankruptcies, in fact, are large and complex cases, which only an efficient judiciary is fully equipped to handle.

"The paper's most important result is showing how Chapter 9 authorization affects munis spreads and States' investment," Professor Rossi said, "but our findings about the influence of certain interest groups are perhaps the most extendable, as they could help explain a wide range of financial reforms."

Stefano Rossi, Hayong Yun, paper "Financial Reform and Public Good Provision: Municipal Bankruptcy Law and the Financing of Hospitals" published online ahead of print in Management Science.