In the summer of 2013, Detroit filed the largest municipal bankruptcy in history. One year on, how has the filing played out and what insights can be gleaned?
- Ability is not the same as willingness to pay. Political pressures continue to influence the bankruptcy process, potentially to the detriment of bondholders and leaving politically-connected stakeholders more equal than others.
- Legal protections included in bond indentures may prove inadequate. The Unlimited-Tax G.O. (UTGO) bonds and the Limited-Tax G.O. (LTGO) bonds failed to deliver their expected resiliency and settlements are expected to leave G.O. bondholders, not only with a loss, but with a lower recovery than pensioners.
- Chapter 9 bankruptcy has proven to be an ineffective tool for reducing unfunded pension liabilities, despite the bankruptcy judgeâ€™s ruling that pension claims are considered unsecured obligations and subject to impairment within the confines of Chapter 9.
Detroitâ€™s bankruptcy has not had negative systemic effects on the broader municipal market, as we ventured in our Making sense of Detroitâ€™s bankruptcy filing piece last summer. We continue to maintain the view that Detroitâ€™s bankruptcy is not emblematic of what is to come for other local governments with underfunded pension liabilities. However, there has been a spillover effect to other, mostly lower-rated, Michigan local governments, as we outlined in Detroitâ€™s collateral damage.
While the direct implications of Detroit may be largely limited to other fiscally distressed Michigan local governments, the bankruptcy has yielded significant insights for municipal market participants. The first being a lesson in understanding exactly what a G.O. pledge is, and more importantly, what it is not. There are many variations of G.O. debt, which necessitates a thorough case-by-case assessment.
In Michigan, UTGO bondholders settled with the city for a recovery of 74% of par. While this outcome would not set precedent, as it is a settlement, not a court ruling, it is possible the bond insurers negotiating on behalf of the bondholders were not confident the bankruptcy court would rule in their favor. A common argument for why UTGO bondholders accepted less than 100% recovery is Detroitâ€™s tax base was deemed too dilapidated to carry through with the bond indenture pledge to â€œlevy ad valorem property taxes sufficient to meet debt service, without limit as to rate or amount.â€ There is no question Detroitâ€™s tax base has suffered significant erosion. However, that argument remains an open question when considering the full terms of the settlement. While 100% of the voter-approved property tax levy for UTGO debt service payments will remain in force, post-bankruptcy, bondholders will only receive 74% of their claim. The remaining 26% will be deposited into the pension trust funds. Therefore, this settlement will not ease the property tax burden on Detroit residents. We may never know the rationale for the settlement terms, as the agreement was negotiated behind closed doors under the bankruptcy judgeâ€™s order of mandatory mediation. Regardless, it leaves market participants with the unsettling notion that UTGO bonds may not be as resilient as once believed.
On the other hand, the LTGO bonds do not offer a pledge to increase taxes to meet debt service, but have a â€œfirst budget obligationâ€ pledge of the general fund. This means that the city pledged, upon receipt of tax collections, to pay LTGO debt service before any other operating expense. As we witnessed through the city defaulting on these bonds and an ultimate settlement of just 34% of par, the pledge did not hold up well under Chapter 9. This is a clear demonstration that, despite what legal protections bondholders are afforded per their indentures, a cityâ€™s desire to pay employees to continue providing essential services to residents/taxpayers will come before bondholders, regardless of legal language.
The need to understand the political environment has always been a staple in municipal bond credit analysis. However, Detroit has demonstrated how the intensity of political influence multiplies in a situation of fiscal distress and is likely to result in more beneficial terms to politically-favored classes of creditors at the expense of the less well-connected. This happened in Detroit where pensioners/retirees received much better settlements than bondholders.
The City of Detroit has taken significant steps and has communicated its intent to emerge in October from Chapter 9 protection. Although the city has reached settlements with most creditors, nothing is final until the federal judge determines the plan of adjustment to be fair and equitable, and deems the cityâ€™s plan feasible. Even if Detroit is successful in securing the judgeâ€™s approval and re-emerges from Chapter 9, it will likely be years before we can determine if Detroitâ€™s Chapter 9 bankruptcy was a success.
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