When a business falls into financial distress, it has two options: to either issue corporate bonds or file for bankruptcy. When a government is in need of cash flow, it really only has one option: Chapter 9 bankruptcy. This bankruptcy code is a rare but applicable alternative for municipalities that investors should be aware of. It often affects their current investments, while swinging the door open to future opportunities. (To learn more about bankruptcy, be sure to read our related article What You Need To Know About Bankruptcy.)

About Chapter 9
Chapter 9 bankruptcy, first enacted in 1934, is designed to provide the reorganization of municipalities - which include towns, cities, villages, counties, school districts and taxing districts. This is reorganization - not liquidation, which many presume in bankruptcy cases.

The purpose of the legislation is to give a struggling municipality protection from its creditors. This protection allows the government to create a plan to adjust debts, most often by:

  • Lowering interest rates;
  • Obtaining new loans; or
  • Extending current loan agreements.

Chapter 9 offers a local government the benefit of time, which is needed to pay bills. However, it comes with a pair of substantial drawbacks:

  • Investors tend to lose trust in the municipality, especially if they had previous bonds default due to the bankruptcy.
  • Future lenders will be reluctant to offer money in the future.

Historically, Chapter 9 is a rarely used code. Fewer than 500 municipalities have filed, with only 141 going through the full legal process.

Case Study: New York City, 1975
In 1975, New York City was facing one of the largest municipal breakdowns in modern history. According to Felix G. Rohatyn, former chair of New York's Municipal Corporation, the city had no access to credit, and "bankruptcy to (Governor) Hugh Carey was plainly unacceptable."

The fiscal crisis developed through numerous avenues, said Rohatyn. "The banks had lent too much and checked too little; the unions took more than the city could afford; the city cooked the books, and borrowed; and the state encouraged this whole exercise," he added. (To learn how to spot earnings manipulation, read Cooking The Books 101.)

To get out of the financial mess, the city turned to the newly created classification of Chapter 9.

The Municipal Assistance Corporation (MAC) was a recommendation of Governor Carey. It was federally funded (with the help of a $2.3 billion lifeline from the Treasury), as well as state issued (through New York state). The Corporation was designed to reorganize New York City's debts and empowered to issue new bonds for the city. (Learn more about the Treasury and why it issues debt in What Fuels The National Debt?)

However, what made MAC a success was the bondholders. On Feb. 11, 1975, New York City sold an incredible $141.4 million in municipal bonds - all with an 'A' rating, according to Moody's and Standard & Poor's. The bonds also came with a 10% return (significantly higher than the current 8% for a comparable maturity). (For further reading on debt ratings, be sure to read The Debt Ratings Debate.)

Organizations such as the Teacher's Association of New York agreed to use their pension funds to support the municipal securities. This support helped pull the city from the threat of disaster and showed how investors can make a positive impact in the financial situation of a local government.

How Cities Pull Themselves out of Bankruptcy
After Chapter 9 is filed, a municipality has to make two tough decisions: Which services to cut and which to preserve?

  • Services to cut: Earmark programs - those that are for recreation and research - are the first services local municipalities cut. Governments dig through their budget in other areas to cut costs as well. Some programs that may see budget restrictions include prison funding, public service and city renovations.
  • Services to preserve: Essential programs that are necessary for the well-being of the community are preserved. These services include trash removal, water and sewage and education. (Learn about investing in these and similar services in Build Your Portfolio With Infrastructure Investments.)

After the initial filing, the municipality must make a plan of action, as described in the Bankruptcy Code. The plan is known as the "Plan for Adjustment of Debts" and is a court-ordered document that lays out, in detail, a plan to accomplish the following:

  • Pay back creditors
  • Cut back spending
  • Handle outstanding debts
  • Dismiss or honor investor bonds
  • Issue new municipal bonds

Municipal Bonds
Municipal bonds also play a significant role during the Chapter 9 process. The bonds, known as munis, were used heavily during the 1975 New York bankruptcy case. They typically carry higher returns than Treasury notes (due to slightly higher risk), and they allow individuals to play a part in the recovery of the municipality. Investors like munis because of their higher interest, general safety and strong aide to the community. (Read Basics of Municipal Bonds for more on munis.)

Cash-strapped municipalities turn to munis as a way to gain liquidity without raising taxes or asking for a government bailout. (Read about government bailouts through the years in Top 6 U.S. Government Financial Bailouts and about a recent example in Liquidity And Toxicity: Will TARP Fix The Financial System?)

In the rare case of Chapter 9, municipalities and investors alike have to pull together. If the fiscal crisis of 1975 taught us anything, it is that with a strong community effort and a little financial responsibility both sides can end up winners.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.