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Municipal Bankruptcy: Standard &Poor's Approach And Viewpoint

Primary Credit Analyst:

Gabriel J Petek, CFA, San Francisco (1) 415-371-5042; gabriel_petek@standardandpoors.com

Secondary Contacts:

Jeffrey J Previdi, New York (1) 212-438-1796; [email protected]Steve J Murphy, New York (1) 212-438-2066; steve_murphy@standardandpoors.comBill Montrone, New York (1) 212-438-2062; bill_montrone@standardandpoors.com

Table Of Contents

Indirect Costs Of BankruptcyFuture Costs Of BankruptcyDefaulting On Debt Without Pursuing BankruptcyBankruptcy Is The Start Of A "Negative Campaign"The Stigma Of Bankruptcy RemainsRelated Criteria And Research

WWW.STANDARDANDPOORS.COM/RATINGSDIRECTOCTOBER 4, 2012 1

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Municipal Bankruptcy: Standard & Poor'sApproach And Viewpoint

When a municipality files a Chapter 9 petition under the U.S. Bankruptcy Code, Standard & Poor's Ratings Services believes the municipality is raising the issue of its willingness to fund some or all of its financial obligations.In our view, there are few actions that should carry greater stigma in the municipal credit markets than a bankruptcyfiling. We believe any potential weakening of an obligor's willingness to pay its obligations may reflect degraded creditquality. Moreover, once a bankruptcy occurs, we anticipate the credit implications will remain after the municipalitytechnically emerges from bankruptcy. Restoration of market access could be many years into the future.

Overview

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Bankruptcy should, and does, carry a great stigma in the credit markets.

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Credit implications will remain after a municipality technically emerges from bankruptcy.

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It could take years to restore market access, at least with a Standard & Poor's bond rating.If we learn that a municipal obligor is actively and publicly considering filing a Chapter 9 bankruptcy petition, we mayplace the credit ratings of all of the municipality's rated debt on CreditWatch with negative implications in accordancewith our criteria. Such consideration of bankruptcy will trigger a review that will focus on the factors included in ourpublished ratings criteria relevant for the obligor, including key financial metrics and managerial performance. As partof that review, we will request information about the municipality's bankruptcy plans. We will publish the results of ourreview, including any related ratings actions.In our view, municipal bankruptcy continues to carry a substantial stigma inasmuch as it amounts to an abdication of a borrower's authority to manage its own operations. We also believe a bankruptcy filing is not a discrete event butrather part of a process, as it is likely to be only the beginning of a costly and possibly economically debilitatingepisode in the broader arc of a municipality's history. Once it has filed a Chapter 9 petition, it is less important whethera municipality managed itself into genuine insolvency or chose to use bankruptcy as a fiscal tool. In short, filing aChapter 9 petition—no matter the reason—sets in motion a process with damaging consequences to a municipality'sfiscal and economic prospects. And, technically emerging from bankruptcy, while necessary, could also be a long andcostly process. Furthermore, emerging from bankruptcy alone is unlikely to be sufficient to reverse the direct andindirect costs to a municipality of having gone down this path.In hindsight, we believe the factors precipitating a municipal bankruptcy can be years in the making. Budget gimmicksmay be a feature of these situations, helping delay but not precluding the eventual day of reckoning. In fact, while useof accounting maneuvers can be expedient and may defer the need to make difficult policy choices they do not offersustainable solutions to underlying fiscal imbalance. Fiscal erosion can occur rapidly, in the span of one year, or it can be gradual, taking several years before coming to a head. Sometimes, because it is being papered-over by accountingshifts, fiscal decline is difficult to detect as it is happening. Regardless of how quickly or slowly the process evolves,


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however, when it culminates in a bankruptcy filing, management has ultimately relinquished its role as steward of acommunity's financial resources just the same.Once a municipality's officials decide to file a Chapter 9 petition, we believe its prospects for future economic growth,and its credit standing, will likely be much weaker. In exchange, the municipality may obtain temporary cash flowrelief and, potentially, the court's backing for a stronger negotiating position with some of its creditors. However, ourreview suggests to us that these benefits are likely to dissipate within a few years. They are also typically offset by thepotential residue a bankruptcy can leave on the municipality's reputation that results in longer-term financial andmorale damage to its residents. We believe the fallout from bankruptcy often includes reduced prospects for economicinvestment of all types. Measured against these more permanent costs, municipal officials may want to discount thevalue of any temporary benefits that they may obtain by filing bankruptcy.

Bankruptcies Are Likely To Remain Rare

Due in part to the characteristics of municipal governments but also owing to the fact that municipal bankruptcyis unlikely to actually be beneficial, we continue to believe bankruptcies are unlikely to occur outside a very smallminority of the obligors we rate (see "In 2012, U.S. State And Local Governments Confront FundamentalQuestions To Balance Long-Term Budgets," published Jan. 25, 2012).Our view remains that credit quality across the sector is generally stable and resilient. Furthermore, the recent bankruptcies are consistent with another point we have made: We expect there to be pockets of outright creditdistress. But as our existing rating distribution implies, we believe the vast majority of obligors we rate arecommitted to meeting their financial obligations.

Indirect Costs Of Bankruptcy

While a municipality is in bankruptcy, instead of funding services and investing in infrastructure maintenance andimprovement, based on our review, a considerable share of the municipality's tax revenue typically goes to pay for theunavoidable legal and advisory costs of bankruptcy proceedings. Large indirect costs also occur when a municipalitymust divert its human resources to administer the bankruptcy process itself instead of fulfilling the municipality'smission.Moreover, the burden of this cost is magnified in bankruptcy when, as is typically the case, the municipality isdownsizing significantly. Redirecting the time and attention of remaining staff members to bankruptcy-related tasksonly adds to the filing's overall costs and impacts, including foregone services to residents and the effect this may haveon the city's image and desirability as a place to live or do business. Large opportunity costs are also associated with amunicipal bankruptcy, which can contribute to the weakening of an obligor's future ability to pay.

Future Costs Of Bankruptcy

Assessing an obligor's ability and willingness to pay its obligations lays at the heart of our credit analysis. And it


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Municipal Bankruptcy: Standard & Poor's Approach And Viewpoint