In a Detroit bankruptcy, who is first in line?

May 24, 2013

The state-appointed emergency manager for Detroit, Kevyn Orr, has been given a year of legal authority to address Detroit’s insolvency problem. It is a herculean task to right decades of complex problems. Muniland observers believe that the city will end up filing for Chapter 9 bankruptcy.

The rationale for this relates to certain limitations of the emergency manager’s authority. Outside of Chapter 9, the emergency manager cannot legally cut debt or pension liabilities, and the likelihood that bond market creditors and the city’s 48 unions will voluntarily make concessions seems slim.

Orr has authority to cut public employee wages. He possibly could obtain pension concessions as part of wage negotiations. Detroit Mayor Dave Bing already reduced public employee wages by 10 percent last July, when he used his new authority under the state’s Consent Agreement to cut the pay of city workers in 40 unions and make other changes to labor agreements.

Lots of estimates of the city’s debt liabilities have been floating around, but here is what the emergency manager’s report says (page 20):

The City has liabilities of approximately $9.4 billion in special revenue bonds, state revolving loans, pension certificates of participation (i.e., POCs), mark-to-market swap liabilities, unlimited and limited tax general obligation bonds and various other funded City debts.

According to the report of the Detroit Financial Review Team in February, 2013, city officials have projected that over the next five years, the cash needed to fund these long-term liabilities will total approximately $1.9 billion. This is cash that the city does not have, and it is effectively locked out of bond markets until it achieves some fiscal stability and soundness. That could take years.

Over $5 billion of Detroit’s debt load is in revenue bonds related to its sewer and water systems and the airport. These are properties that Orr has discussed selling so that debt could possibly be retired with asset sales. The need for cash to service that debt would be eliminated, but the city would lose valuable assets.

The city has certain liabilities that cannot undergo haircuts in a bankruptcy filing. These are the city’s $800 million of interest rate swaps associated with their pension certificates of participation (POCs),  which were $439 million out of the money as of June 30, 2012 (page 118):

The city is paying its swap counterparties a fixed interest rate of approximately 6 percent and receiving payments back of approximately 0.57 percent (current three month Libor ~0.27 percent + 0.30 percent = 0.57 percent for the floating rate). The city’s swap counterparties cannot take haircuts if bankruptcy is filed, according to a creditor attorney that I spoke to. In fact, they move to the head of the creditor line. The same part of the bankruptcy code that was used in the Lehman bankruptcy (Chapter 11) applies to Detroit (Chapter 9). Swaps are settled (netted and paid) when the entity enters the bankruptcy process. From the Stanford Law Review:

Under the Bankruptcy Code, creditors of a failed entity are stayed or prohibited from seizing that entity’s assets. Since 1978, however, Congress has exempted derivatives counterparties from the automatic stay and permitted the termination of the derivatives contracts.

Clearly Detroit’s derivative counterparties will siphon precious cash away from the insolvent city if it were to enter bankruptcy. This cash payment to swap counterparties could likely be in the $400 million range. Bondholders are not on par with derivatives counterparties, and will likely have less recovery. Public pensions and retiree healthcare benefits will also likely take haircuts through this process. It’s a long, hard road ahead for Detroit’s stakeholders and creditors.

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