MuniLand

Detroit’s contentious swaps

The proposed settlement between Detroit’s emergency manager Kevyn Orr and the city’s swaps counterparties, UBS and Merrill Lynch, is on the docket this week in federal bankruptcy court where the case is being heard. The Bond Buyer reported:

Key hearings on #detroit‘s swap settlement originally set for this week may be delayed … parties in mediation. http://t.co/iyU2LuEoA9

— Caitlin Devitt (@Devitt_BB) September 23, 2013

Mediation could be a good alternative for the parties because this is a complex element of Detroit’s bankruptcy. Circling around the perimeter of this bankruptcy litigation and mediation is the bond insurer Syncora, which insured both the underlying pension obligation bonds and the interest rate swaps that are part of the negotiations between Orr, UBS and Merrill Lynch. Orr has worked to force Syncora, the bond insurer, out of the picture and essentially leave it responsible to pay off the pension obligation bonds without access to Detroit’s casino tax revenues. Syncora believes that it is legally entitled to access the casino revenues because it insured the pension obligation bonds, which have a cross-default covenant with the swaps.

The Detroit News does an excellent job of threading the story together:

[Orr’s] proposal to pay UBS AG and Bank of America [Merrill Lynch] at least $250 million to terminate an interest rate swap arrangement that went bad for the city during the recession is opposed by insurers of the debt who stand to lose millions of dollars and retirees owed billions of dollars in promised retirement benefits.

Some legal and financial experts also question why Orr is trying to settle with the two big banks so quickly in the bankruptcy process.

Detroit’s pension math

A lot of ink has been spilled over the assertions of Kevyn Orr, Detroit’s emergency manager, on the level of funding in Detroit’s pensions (Okay, I might be the leader of that pack). The issue has bearing on the benefits that Detroit’s retirees will receive, as well as how much cash-flow the city will have to service its bonds and other debts. The pension question is a major point in Detroit’s bankruptcy negotiations. Reuters described the situation like this:

Detroit’s largest unsecured creditors are its two pension funds, which have claims totaling nearly $3.5 billion in unfunded liabilities, according to a city estimate included in a bankruptcy filing. Pension funds and unions dispute the estimate, claiming Orr has overstated the underfunding.

Orr has said he based the city estimate on ‘more realistic assumptions’ than previously used. His figure is five times more than the $644 million gap the pension funds reported based on 2011 actuarial valuations.

How safe are GO bonds?

Detroit’s Emergency Manager Kevyn Orr and Michigan Governor Rick Snyder have told some bondholders that they will not be repaid at 100 cents on the dollar in Detroit’s bankruptcy plan. Lamentations ring out across the nation. This treatment of general obligation (GO) bonds – the gold standard for municipal securities – has rocked the market.

Here is the formal description of GO’s from the MSRB (emphasis mine):

[General obligation] typically refers to a bond issued by a state or local government that is payable from general funds of the issuer, although the precise source and priority of payment for general obligation bonds may vary considerably from issuer to issuer depending on applicable state or local law.

Most general obligation bonds are said to entail the full faith and credit (and in many cases the taxing power) of the issuer, depending on applicable state or local law. General obligation bonds issued by local units of government often are payable from (and in some cases solely from) the issuer’s ad valorem taxes [property taxes], while general obligation bonds issued by states often are payable from appropriations made by the state legislature.

Where is Detroit’s sales tax?

I have read about 5,000 stories about the collapse of Detroit. I keep searching for some useful or novel idea for fixing the city, and what I haven’t seen is any discussion of raising taxes.

I wrote yesterday about Stockton, California putting a 3/4 cent sales tax increase on the ballot. The city intends to use the new revenue to put more police on the streets. I thought about how little of Detroit’s revenues came from sales tax, and I wondered why a tax couldn’t be implemented to lift the city out of bankruptcy.

According to the Detroit News, Detroit has the highest property tax rate in the country:

Detroit’s emergency manager sure loves the media

#Detroit EM Orr was one of Miami's "most eligible men" in 1990, thank you @MaryellenTighe for the best fact of the day! #muniland

— Kate Smith (@laKateKate) August 8, 2013

I’ve closely watched five municipal bankruptcies, Jefferson County, Alabama, Central Falls, Rhode Island, Vallejo, Stockton and San Bernardino in California and two near bankruptcies in Mammoth Lakes, California and Harrisburg, Pennsylvania. Never have I seen the person managing a bankruptcy process seek media attention like Detroit’s Emergency Manager Kevyn Orr.

You can watch video interviews of Orr done with Detroit television stations and newspapers, national broadcast networks and national financial media like Reuters, the Wall Street Journal and the Financial Times. This media rush began before Orr dropped his Proposal to Creditors on June 14th. I was astonished at the time that Orr had pre-packaged and distributed how he wanted creditors treated. This step usually happens much later in a bankruptcy process. Although Orr claimed that he wanted to use his proposal as a template for negotiations with creditors he held no meetings with retirees, unions or bondholders other than marching these groups into city auditoriums and presenting Powerpoint presentations. Everyone of these groups say that Orr did not hold “good faith” negotiations; a requirement to be accepted into Chapter 9 bankruptcy.

The real history of public pensions in bankruptcy

There appears to be a frenzy of comments lately that public retirees receive excessive pensions in the current economy and that they need to be reduced. Many in the media have taken a brief look at Detroit and decided that costly pensions were the cause of the city’s bankruptcy. Nothing could be farther from the truth. Detroit pays a relatively modest median pension of $19,000 a year to general government retirees and $30,000 to police and fire retirees. Detroit’s pension system was funded at 82 percent in 2011 (and at 99 percent for its police and fire retirement system). That is higher than the national median of 74 percent. But public benefits make easy targets for critics. Let’s take a tour of pensions in bankruptcy through the years.

Attorneys Kenneth E. Noble and Kevin M. Baum describe Prichard, Alabama:

Prichard, Alabama, which experienced a population decline of approximately 50 percent over the past 50 years, filed for bankruptcy in 1999 after it was unable to pay approximately $3.9 million in delinquent bills. In addition to the unpaid bills, Prichard also admitted to not making payments to its employees’ pension funds and, even though the city had withheld taxes from employees’ paychecks, the city failed to submit such withholdings to the state and federal governments.

While in bankruptcy, the city successfully revised its budget so that it no longer operated at a deficit. However, Prichard was still unable to meet its pension obligations. In 2009, Prichard filed for bankruptcy for the second time in order to stay a pending suit brought by its pensioners after it failed to make pension payments for six months. In its chapter 9 petition, the city claimed that during the previous year it had operated a $600,000 deficit on its $10.7 million budget. Further, Prichard had failed to make a $16.5 million payment to its pension fund under its previous plan of adjustment.

How much federal money already goes to Detroit?

 

Members of the House of Representatives are trying to gather support from other members of Congress to hold hearings on a federal fund to help Detroit through its bankruptcy.

As I have been saying for months, the likelihood of a federal bailout for Detroit is miniscule. Federal spending, excluding transfer payments like Social Security, Medicare and Medicaid, has been shrinking as a percentage of the U.S. GDP. The federal government’s discretionary spending is contracting. Moreover, it is difficult to find the political will to rebuild Detroit. Federal money is spent on sudden, massive disasters like Hurricane Sandy, not on a slow crash like Detroit.

The likelihood of a federal bailout for Detroit is small to none, but there is a discussion about the funds that the federal government sends to Detroit on an annual basis. This has been a form of life support for the city. The question is how much Detroit already receives from the federal government.

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):

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:

Has Detroit over-inflated its pension liabilities?

Joshua Pugh, a writer and contributor to the Detroit News Politics Blog, has written about a topic that is a big one among muniland professionals. That is the question of whether Detroit’s Emergency Manager Kevyn Orr inflated pension liabilities to make the city’s debt appear larger, allowing for more aggressive haircuts for bondholders and pension holders. Pugh points out a Bloomberg Businessweek piece on his personal website:

How much does the city owe? Orr says Detroit has nearly $20 billion in debt and long-term obligations. Pension funds and bondholders have said in the past he’s inflating the numbers. Why would Orr do that? Because the more dire the city’s finances seem, the more aggressive he can be in pushing for concessions. Also, to be eligible for bankruptcy protection, the city must prove that it’s insolvent, meaning it has no way to pay its debts.

In 2004 and 2005, Detroit issued two sets of pension obligation bonds (Certificates of Participation) to fully fund the city’s pensions with an additional $1.5 billion. This is why, when I started looking at Detroit about 18 months ago, the pensions were surprisingly well-funded. Those pension bonds have now been lumped with general obligation bond debt, pension shortfalls (unfunded liabilities) and retiree health care as unsecured debt, which Orr intends to haircut.

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