MuniLand

Detroit’s embedded time bomb

There are a lot of moving parts in the Detroit story as it goes through the largest municipal bankruptcy in U.S. history. The strangest part of the story has been the interest rate swaps that were layered onto the city’s 2005 and 2006 pension obligation bonds.

The purpose of the swaps was to lower the city’s borrowing costs by using interest-rate arbitrage. Theoretically, if financial conditions had remained “normal,” the swaps would have been beneficial for the city. Instead, Detroit’s credit rating was downgraded and the financial crisis upended the delicate conditions that underpinned the swaps.

On July 18th, when Detroit’s Emergency Manager Kevyn Orr filed for municipal bankruptcy, he also filed a proposed settlement with the swaps counterparties. Orr’s proposal would pay the counterparties – UBS and Bank of America Merrill Lynch – between 75 and 82 cents on the dollar to terminate the swaps and move them out of the picture. This action insulates UBS and Bank of America from the hatchet job that Orr plans to give to other creditors in the course of the bankruptcy process. Those unprotected creditors include bond insurer Syncora, which insured the interest-rate swaps and the underlying pension obligation bonds.

In the end it comes down to who has legal control of the city’s $15 million per month of casino tax revenues. About $4 million per month has been used since 2009 to pay UBS and Bank of America on their swaps deals. Federal bankruptcy judge Steven Rhodes ruled that the city has control of the excess $11 million. Reuters reports:

Syncora had tried to block Detroit from accessing an estimated $11 million in monthly tax revenue from the city’s three casinos, claiming it had a lien on the money, which had been used as collateral since 2009 to secure the city’s interest-rate swap agreements. Detroit’s emergency manager, Kevyn Orr, and one of his top consultants said in sworn depositions that the casino revenue is key to city’s survival.

Detroit’s forsaken leaders

Being the emergency manager for bankrupt Detroit is no picnic. Coordinating the largest municipal bankruptcy in American history while simultaneously trying to restructure city operations, even with a posse of high-priced consultants, is a huge job. The current emergency manager, Kevyn Orr, wants to complete the bankruptcy and his term in 18 months. This is a recipe for inappropriate appointments, rich living and major mistakes.

Now the mayor of Detroit, Dave Bing, has weighed in with scathing comments about Orr’s performance. From The Detroit News:

Mayor Dave Bing reiterated Wednesday his growing frustration with how consultants and Emergency Manager Kevyn Orr have taken over City Hall and sidelined his team.

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.

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):

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