How much will Detroit bondholders suffer?
The stream of analysts blasting Detroit’s proposed treatment of creditors summarized in 3 words: This is unprecedented! Yes. But is it fair?
— Nathan Bomey (@NathanBomey) February 24, 2014
Detroit’s proposed treatment of general obligation bondholders has turned muniland upside down. Here is what Fitch Ratings says:
Fitch Ratings believes the recent Detroit plan of adjustment filed with the Bankruptcy Court on Friday, Feb. 21, 2013, if confirmed, would set a troubling precedent in the municipal market. The plan not only classifies unlimited tax general obligation (ULTGO) bonds as ‘unsecured,’ but further degrades ULTGO value by giving other similarly classed ‘unsecured’ creditors preferential treatment, including unfunded pension and retiree health care liabilities.
The treatment of ULTGO bonds was argued last Wednesday. The city argued that the bonds were unsecured and that “there is no lien, there is no property interest, these creditors are like all others.” In other words, the bonds were unsecured. The city followed this court argument with a radical proposal to cut repayment for these bonds to 20 percent. Fitch goes on to say:
The city’s choice to treat ULTGO bonds as unsecured is particularly concerning, as they are backed by a separate property tax approved by the voters for the sole purpose of paying debt service on the bonds.
The backing of the ULTGO bonds by a separate property tax means that bond insurers that insured these bonds will likely appeal whatever decision is made in the final plan of adjustment. These are gray areas of the law (Here is an excellent argument why these bonds are secured). Without waiting for a court ruling from Judge Stephen Rhodes on whether these bonds are secured, the plan of adjustment proposes to treat them as unsecured.
Fitch then addressed the proposed treatment of pensions:
The judge in the case ruled last month that nothing distinguishes pensions from other debts, but the city and state are taking a different tack. The plan calls for pension creditors to receive a higher recovery, based upon approximately $830 million of contributions from private foundations, the Detroit Institute of Art (DIA) and the state. These contributions are proposed in order to avoid the liquidation of a particular city asset, the DIA art. These payments, however, are restricted for the benefit of only one class of unsecured creditor, the pension creditors, rather than for all creditors, as might have been expected.
Fitch is right, but during the bankruptcy eligibility hearing last December, Judge Rhodes specifically cautioned the city against harsh treatment of retirees. From the December 3rd eligibility hearing:
Judge Rhodes on constitutional challenges on grounds of pension impairment. “The court finds now that these issues are ripe for decision.”
— Chad Livengood (@ChadLivengood) December 3, 2013
Judge Rhodes on arguments that pensions have state protection: “These prohibitions, however, do not apply in federal bankruptcy court.” — Chad Livengood (@ChadLivengood) December 3, 2013
Rhodes: “No one should interpret this…to mean that this court necessarily will confirm any plan of adjustment that impairs pensions” — Sarah Cwiek (@sarahcwiek) December 3, 2013
Recap: Rhodes says pensions CAN be impaired or diminished under Chapter 9, which is constitutional. BUT he won’t necessarily approve cuts.
— Amy Haimerl (@haimerlad) December 3, 2013
What about the $1.4 billion of pension bonds (certificate of participation (COP) debt) that helped fund the city’s two pension funds? More from Fitch:
Fitch also finds troubling the city’s legal attempt to invalidate the certificate of participation (COP) debt, which would further skew the equitableness of the plan away from debt holders’ interests. The plan includes reducing COPs recovery to zero while remaining silent on whether or not the pension system, which benefited from the sale of the COPs, would return any of the borrowed assets.
Every element of Detroit’s plan of adjustment attempts to draw assets away from unsecured bondholders. But I think the plan of adjustment is merely a negotiating tool to get the city enough creditor classes to affect a cramdown on the remaining ones:
Ch 9 Cram-down Req: approval from creditor class comprising 2/3rds of debt & >50% by number. THEN Rhodes must rule fair&equitable & feasible
— MuniCredit (@MuniCredit) February 24, 2014
Fitch for the close:
Fitch considers Detroit’s plan of adjustment to be hostile to GO bondholders. If this priority of creditors is upheld, Fitch expects that this disregard for the rights of bondholders will factor into higher borrowing costs for local issuers, and ultimately for local property taxpayers, in Michigan.
I wouldn’t extrapolate what is happening in Detroit to the treatment of bondholders in future municipal bankruptcies. Ahead of the bankruptcy of Central Falls, Rhode Island, for example, we saw the state assembly pass a specific law to protect local general obligation bondholders who were repaid 100 cents on the dollar, while retirees took a 50 percent haircut on their pensions.
The decisions in the Detroit case are momentous, but they are part of a bigger puzzle for municipal bankruptcies.
Moody’s on the Detroit Plan of Adjustment:
Moody’s has reviewed the Plan of Adjustment filed last Friday by the Emergency Manager for the City of Detroit (GOULTs rated Caa3/negative outlook) and has written a short comment about its details. The highlights are:
- General Obligation (GO) creditors are treated as unsecured and face far lower recoveries, estimated at 20% of principal and interest, than most other creditors. Creditors have already challenged the city’s controversial designation in court. Certificates of Participation (COP) holders are one of the few creditor groups worse off than GO creditors as the city continues its attempt to completely repudiate these obligations, which could lead to 0% recovery.
- The most significant difference between the plan and last June’s proposal to creditors is that a distinction now exists between GO Unlimited Tax and GO Limited Tax bonds, with the city now proposing a slightly different approach to funding recoveries for these two classes of creditors. Unlimited Tax creditors have been offered a payment stream that would equal an estimated 20% of the allowed bond claim, funded by a separate Unlimited Tax General Obligation (UTGO) Note that would bear the same maturity schedule as current bonds. Limited Tax creditors would also realize an estimated recovery rate of 20%, but recovery would be funded via shares of two different notes, New B Notes and New C Notes. The June proposal made no distinction between these two classes.
- Water and sewer revenue creditors fare much better than general obligation creditors, with possible recovery rates as high as 100%. However, their standing is clouded by the city’s discussion with surrounding counties that could lead to a new authority to oversee water and sewer operations and other decisions which may lead to new debt repayment under less favorable terms.
- The city’s workers and retirees are treated far better than GO and COP creditors. Pension recoveries range widely, from 66%-96% for already accrued benefits, but future benefits are cut much more substantially. Retiree health care benefits (OPEB) face much lower recoveries, but appear to be treated slightly better than GO creditors.
- Litigation from GO creditors and other creditor groups is likely and the final court-approved plan could end looking much different from the city’s proposal. The possibility of cram down of the plan on creditors is possible.