The Detroit Bankruptcy
The City of Detroit filed for Chapter 9 bankruptcy on July 18th. This is the largest municipal bankruptcy in history and the most prominent American city ever to file for protection. The filing came a little over a month after the state-appointed Emergency Manager, Kevyn Orr, presented a reorganization plan for the city. His proposal was to issue $2 billion in notes in exchange for the $11.4 billion of “unsecured” debt. Mr. Orr had been meeting with the pension funds and creditors (primarily bond insurers, as most of the City’s debt is insured) to convince them to accept his plan, before resorting to a bankruptcy filing.
Observations Specific to Detroit
- As expected, the bondholders and the pension funds were not willing to accede to the terms that were initially offered and this filing is an admission that the proffered plan did not work.
- There are dozens of unions in the city and the largest creditors are the retirees, in the form of over $9 billion in unfunded pension and other post employment benefits (OPEBs).
- Pension obligation certificates, limited tax general obligation bonds and unlimited tax general obligation bonds account for another $2 billion. Most of these obligations are insured.
City of Detroit Total Liabilities (Approx. $18 billion)
- Lawsuits filed by retirees and pension funds in the past few days have tried to stop the bankruptcy filing, on the grounds that pension benefits are constitutionally protected in Michigan. Today, Ingham County Circuit Court Judge Rosemarie Aquilina ruled that the governor lacks the power “to diminish or impair pension benefits,” and that the bankruptcy filing was unconstitutional. However, the Michigan State Attorney General, Bill Schuette, has already appealed Aquilina’s decision, highlighting the fact that the situation remains in flux.
- The bankruptcy court will now be in control of the process, and the City still needs to prove that it is eligible to file for bankruptcy, which can take time.
Broader municipal market points
- The largest question for the municipal market is where the General Obligation pledge stands in relation to pension obligations and retiree healthcare benefits and the precedents set here over the next year or years will be critically important.
- Kevyn Orr’s unprecedented claim that general obligation bondholders are “unsecured creditors” is the most directly damaging to the municipal market. Local general obligation bonds have historically been the most secure credit.
- Citizens, bond holders, bond insurers, two pension funds and around dozens of unions are all stakeholders in this process.
- The role of the bond insurers and of bond insurance will be tested heavily in this case.
- What is the potential impact on spreads, not just in Detroit but in the market in general? MMD reports this morning that yields on longer-dated maturities of AAA-rated bonds rose 5 to 9 basis points.
Samson clients have no Detroit exposure, and we have not invested in Detroit credits since 2010. Prior to that date, we had utilized secured Detroit Water and Sewer issues. In 2010, we became concerned about the proximity of the water and sewer system to the City’s weakening financial position.
While the situation in Detroit is unfortunate, the bankruptcy filing was essentially unavoidable. This event is the culmination of a 60-year decline in the city’s population and economic viability, as its core industries moved out of the city and out of the country. Hopefully, Detroit can emerge resized and more viable as a smaller economy, although we expect that it will be a turbulent process with an uncertain timeframe for resolution. While many state and local governments face challenges of the same type, the magnitude and urgency of Detroit’s problems are unique, and the city’s situation should not be extrapolated to the rest of the municipal market. Over the longer term, this process should energize the discussion about the broad problem with unfunded municipal pension liabilities and OPEBs. While Detroit did not have the time or economic capacity to fix this problem, other states and local governments with significant unfunded liabilities still have time to solve these problems. The math is inarguable though, so that window will not stay open indefinitely.
Managing Principal and Chief Executive Officer
Director of Credit Research
Credit Research Associate
July 19, 2013
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