MuniLand

Inflationumberitis

As the Detroit bankruptcy is prepared to begin in the courtroom of Federal Bankruptcy Judge Steven Rhodes, a lot of debate is taking place in muniland. Many of these arguments are over whether secured bondholders will take haircuts, where the money will come from to pay off the swaps termination fees that are currently being negotiated and whether Detroit Emergency Manager Kevyn Orr has authority to cut the earned pensions of the city’s retirees. Orr has been making the media rounds to bolster his case for why these well-funded pensions should be cut. Of course, the more he cuts retiree benefits, the more he can force cuts on bondholders. Let’s shed a little light on Orr’s pension voodoo. Here is how the Detroit pension funds are represented in the 2012  annual financial report (CAFR) (page 145):

 

We don’t know Detroit’s pension returns for 2012, but it was a good year overall for public pension funds, with an average return of 12.69 percent, according to Wilshire Trust Universe Comparison Service. In 2012, according to the CAFR, Detroit contributed $64 million to the General Retirement System and $50 million to the Police and Fire System (page 146). That is $114 million, or about 10.3 percent of the $1.1 billion of general fund revenues in 2012. The voodoo comes in when Orr projects pension contributions jumping to $285 million in 2017 from $114 million. That is an increase by a factor of about three (June 14 Creditor Proposal page 91):

 

Why is Orr doing this? Does he believe that the pension funds are not adequately counting their future liabilities? I don’t think so. Ken Klee, one of the smartest municipal bankruptcy attorneys in the nation, who lead Orange County, California out of bankruptcy, lead the Jefferson County, Alabama bankruptcy case. Did attorney Klee go after Jefferson County’s pension fund, which was funded at almost the same level as Detroit’s Police Retirement System? I knew the answer was no, but I wanted to confirm with the Birmingham News reporter who covered their bankruptcy trial since the start:

 

Here is Jefferson County’s pension fund (Jefferson County CAFR page 155):

Orr is also trying to make the argument that the pension bonds (COPs) and related swaps are liabilities of the pension funds and retirees. They are not. They are liabilities of the city, just like bonds that were issued to build a bridge or a school. I dare say that Emergency Manager Orr has inflationumberitis.

Who is representing Detroit?

Since Kevyn Orr was appointed Detroit’s emergency manager on March 18, his approach always seemed a little off, especially when bankruptcy is concerned. For a Chapter 9 municipal bankruptcy to work, most of the parties must come to a mutual agreement about what each will sacrifice. Federal bankruptcy judges only have the authority to “cram down” a minority of creditors in a specific class when the majority agrees. Federal bankruptcy judge Steven Rhodes, for example, can’t force all bondholders in a class to take a 50 percent haircut. Absent that power, municipal bankruptcy usually lasts much longer than others, as parties come to an agreement.

This balancing act is no easy task for a bankruptcy leader (city official, receiver, emergency manager or lead attorney). But when Orr laid out his creditor proposal on June 14, his aggressive treatment of retirees and bondholders seemed to me like he was wielding a chainsaw where a paring knife would have been the best tool to begin the work. The law firm Jones Day, the firm Orr left before becoming emergency manager, had been involved in the corporate bankruptcy fight of Chrysler. Orr’s opening punch felt like a move from corporate bankruptcy.

We get a peek into Orr’s thinking through a series of emails between him, while he was still a lawyer at Jones Day, and state officials. The emails were made public by a FOIA request by a Detroit labor activist. A January 31, 2013 email from associate Dan Moss to Orr is a suggestion to “nationalize” Detroit’s bankruptcy issue and provide “cover” for state politicians:

The fight begins in Detroit

 

As Detroit’s bankruptcy filing this week brings on understandable lamentations about the city’s dwindling population and derelict building, a murky legal challenge is under way. There are many places where state and federal law cross over in municipal bankruptcy proceedings. There are few court rulings about the subject, so it is hard to know which law books to reach for when understanding the ones that will prevail.

The Tenth Amendment, which reserves to the state all powers that are not directly granted to the federal government, is at play when the U.S. Constitution says nothing on a matter. In Detroit’s case, pension rights are enshrined in the Michigan Constitution. It is an unknown if these will be considered a “contract” that Detroit Emergency Manager Kevyn Orr can break or a “constitutional right,” which would be harder to adjust.

Bankruptcy in Detroit, and new precedents may be set

The emergency manager of Detroit, Kevyn Orr, with the blessing of the Governor of Michigan Rick Snyder, has gone to the federal courthouse and filed a petition for Chapter 9 municipal bankruptcy. The most important dimension of this filing is that it shields the city from lawsuits that are being filed against it. Already Detroit’s public pension funds and workers have filed state-level lawsuits against Orr and Snyder to halt them from filing for bankruptcy. Undoubtedly a legal judgment was made about the validity of those suits and whether seeking the protection of the federal bankruptcy court was necessary.

It took the municipal market and public by surprise when the filing happened today. The publisher of the Bond Buyer, Mike Stanton, said:

Free speech or securities fraud?

Mark Funkhouser, the director of the Governing Institute and a former mayor and auditor of Kansas City, took a few swings at the SEC for its securities fraud prosecution of Harrisburg, Pennsylvania. Funkhouser has three concerns with the SEC’s case.

First, he correctly points out, as the SEC case contends, that the city of Harrisburg did not issue any financial statements between January 2009 and March 2011. The SEC says that because of this, investors had to seek out other statements made by public officials that included material misstatements. Funkhouser blames it on investors for poor diligence. He says:

You’d think it would be obvious to potential investors that if there’s not much current information available about a city’s finances they might want to think twice about buying its securities. But investors don’t always exercise proper diligence, and it wouldn’t have hurt for the SEC to have driven home that point.

When Detroit goes to bankruptcy court

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Detroit Emergency Manager Kevyn Orr predicts that the chances of Detroit entering bankruptcy are about 50/50. But if we consider what the major participants, bondholders, public employees and retirees are likely to do, it’s almost 100 percent certain that Mr. Orr will be entering the federal bankruptcy court house on West Fort Street in Detroit.

The bankruptcy case of Stockton, California provides an indication of how willing bond insurers will be to make upfront concessions. In Stockton, they were totally unwilling to give up anything. From the written ruling of the bankruptcy judge in Stockton, Christopher Klein: (page 17)

Bond insurers are the legal grinding stone of the municipal bond market. They don’t give anything away if litigating would gain them some advantage. They have stables of high-powered attorneys to fight their battles.

Detroit’s 10 cents-on-the-dollar meme

Detroit’s emergency manager, Kevyn Orr, held his big creditor meeting today and presented his Proposal For Creditors Powerpoint (PDF) for how he would like to treat the city’s liabilities. The mainstream media is running with the story that Orr’s proposal will give creditors 10 cents on the dollar, but the proposal is far from having those terms.

The Proposal calls for the following treatment of various classes of debt:

For secured debts:

For the $5.5 billion of secured water and sewer revenue bonds, Orr proposes to issue new bonds with the current full principal amount (with accrued interest) at a lower interest rate (i.e. no haircuts or reduction in principal). (page 101)

For the $411 million of Secured General Obligation Debt (unlimited property tax pledge) Orr says, “Treatment: Subject to negotiation with holders”. So no stated haircut there. (page 104)

Pain for Stockton taxpayers

After proving it was insolvent, the city of Stockton, California entered the municipal bankruptcy process last week. The judge hasn’t yet delivered his formal ruling, but here are some of the most relevant reasons for the city’s insolvency, according to Judge Christopher Klein (page 556 most of which you have read here at MuniLand over the past year):

Excessive public employee compensation levels:

Some of the problems were also the incrustation of a multi-decade, largely invisible or non-transparent pattern of above-market compensation for public employees. Among other things, the City offered generous health care benefits, to which employees did not contribute. Retirees had their entire health bills paid for by the City. The City permitted, to an unusual degree, so-called “Add Pays” for various jobs that allowed nominal salaries to be increased to totals greater than those prevailing for other municipalities.

The enormous explosion of retirement liabilities:

Some of the problems were also rooted in generous retirement practices. The pensions, of course, are themselves a form of implicit compensation. Pensions were allowed to be based on the final year of compensation, and only the final year of compensation, and that compensation could include essentially an unlimited accrued vacation and sick leave. So it was possible to engage in the phenomenon that’s become known as ‘pension spiking,’ in which a pension can wind up being substantially greater than the annual salary that the retiree ever had.

What Harrisburg learned while waiting to file for bankruptcy

Last year, muniland watched as the mayor, city council members and state legislature went through a tortuous period of fighting over filing municipal bankruptcy for Harrisburg, Pennsylvania. The city council filed a bankruptcy petition, but the mayor objected. Then the legislature passed a law that denied Harrisburg the right to file until November 30, 2012. The bankruptcy judge threw out the bankruptcy petition and the governor appointed a receiver to take control of the city’s finances.

The first-state appointed receiver, the seasoned bond attorney David Unkovic, worked for about six months and then resigned from his position because he felt he was being obstructed in his efforts. He testified to the state senate about the substantial problems with the city’s debt issuance. Roxbury News captured his testimony about the cronyism and his recommendations to legislators:

The delay that occurred last year gave Unkovic enough time to review the bond offerings that pushed the city into insolvency. Unkovic said in his testimony:

Mapping the saga of San Bernardino

Reuter’s reporters Tim Reid, Cezary Podkul and Ryan McNeill wrote a great analysis of the fiscal and political troubles of bankrupt San Bernardino, California. They zeroed in on the high cost of wages and pension benefits for fire and police safety workers:

In bankrupt San Bernardino, a third of the city’s 210,000 people live below the poverty line, making it the poorest city of its size in California. But a police lieutenant can retire in his 50s and take home $230,000 in one-time payouts on his last day, before settling in with a guaranteed $128,000-a-year pension. Forty-six retired city employees receive over $100,000 a year in pensions.

Almost 75 percent of the city’s general fund is now spent solely on the police and fire departments, according to a Reuters analysis of city bankruptcy documents – most of that on wages and pension costs.

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