Municipal bankruptcies are less taboo than they once were now that cities across the country have emerged more financially sound after filing Chapter 9, according to a Moody’s Investors Service report released Thursday.

The report, “Municipal Bankruptcy Still Rare, but no Longer Taboo,” notes that the bankruptcies of Jefferson County, Ala., Stockton, Calif., and Detroit have laid out a blueprint that some distressed local governments could see as an option to reduce their debt and pension liabilities.

The instance of local government bankruptcies, though still a rarity, had increased shortly after the recession compared to the extreme infrequency since World War II, according to a Moody’s news release. The rise occurred due to the slow economic recovery and the rise in many governments’ fixed costs, i.e. pension costs, according to the report.

Generally, the risks to bondholders and, in turn, the severity of rating downgrades generally accelerate when bankruptcy is seriously considered as an option, according to the Moody’s report.

“Emergence from bankruptcy can restore credit quality going forward, but the process itself is radical and often unpredictable,” says Moody’s Senior Vice President Al Medioli. “There appears to be a dynamic at play that elevates retirees as a group above other creditors, and that further places pensions on a higher plane above all other liabilities, regardless of bond security or legal revenue pledge.”

Moody’s median municipal rating is Aa3, and less than .5 percent of all its rated cities, counties and school districts have speculative grade credit ratings. The lowest-rated issuers that could consider pursuing bankruptcy would have no impact on the overall distribution of Moody’s municipal ratings.

“A more frequent use of bankruptcy by distressed credits does not in and of itself alter our overall stable outlook on the state and local government sectors, but it does underscore how the recent recession has left in its wake significant pockets of financial pressure and a tighter budgetary ‘new normal’ that is less resistant to new shocks,” says Medioli.

For more information on municipal bankruptcy, check out this month's Issues & Trends section of American City & County's print addition.

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