Friday, June 21, 2013

Detroit Defaults on Pension COP Debt, Kevyn Orr's Restructuring Proposal (Unsecured GO Bonds = Employment Liabilities in Restructuring, GO Bonds Downgraded on Bankruptcy Risk)

Part of the reason why I started this blog was because municipal tax bases were about to get destroyed by the housing crash, financial crisis and unemployment. One of my first blog posts in July 2008 was on Detroit's comprehensive annual financial report, which at that time was the FY 2006 CAFR (the most recent audited financial statements available). So an already distressed municipal tax base with unfunded liabilities was about to experience a housing bust, financial crisis, auto bankruptcies and great depression 2.0 head on (the government and Federal Reserve bailouts of course lightened the blow). Ever since that post I've been waiting for a bankruptcy filing or restructuring event to occur so the city could finally turn around outside of its core.

Detroit Riverfront (source: @dvolatility on Twitpic)

According to MLive (1, 2), Detroit billionaire Dan Gilbert, founder of Quicken Loans and owner of the Cavs, now owns 7.6 million square feet of real estate in downtown Detroit through his company Rock Ventures. He's probably the biggest activist investor in downtown Detroit right now. Here's what he told The Detroit News a few days ago about Detroit's financial crisis:

Bankruptcy “is a tsunami we all think is going to come,” he told The Detroit News. “But I think it will be over relatively quickly. The faster we get there, the better. This is good news.” And if it isn’t so quick, as bankruptcy experts predict? “Obviously, that wouldn't be good,” he said. “That would be an overhang for us.”

According to FBI data, Detroit is still the second most dangerous city in America with a poverty rate of 40.9%. And according to Detroit's restructuring proposal, "there are approximately 78,000 vacant structures in the City. Approximately 38,000 structures are considered dangerous buildings. The number of dangerous structures is constantly increasing due to vacancy (particularly foreclosures) and house fires."

Dave Bing, Detroit's Mayor, kept saying that the city was running out of cash, so a restructuring was inevitable. Finally, on June 14, Detroit proved it was insolvent by defaulting on some of its debt. They missed a $39.7 million interest payment on its pension COP debt (certificates of participation). According to Bloomberg News, "Detroit becomes the most populous U.S. city to default since Cleveland in 1978." Kevyn Orr, Detroit's Emergency Manager, held a press conference after meeting with creditors last week (watch it below courtesy of the Detroit Free Press). His team is trying to restructure Detroit's debt and its unfunded liabilities (pension and other post-employment benefits (OPEBs)) to avoid a Chapter 9 bankruptcy filing. During his press conference, Kevyn Orr said there's still a 50% chance that Detroit will file for bankruptcy (he's "still at 50/50").

Detroit's emergency management team released their full "Proposal For Creditors" on Detroit's website. I put up snapshots of important info below. Not only will unsecured debt get a huge haircut, the city also wants to create a new public authority, the Metropolitan Area Water and Sewer Authority or MAWSA, which will operate the Detroit Water and Sewerage Department (DWSD) and lease it from the city. According to Orr (via Crain's Detroit), MAWSA would save Detroit $70 million annually.

Since the city is issuing $2 billion of notes to restructure $11.4 billion of unsecured debt, which includes the unfunded pension and OPEB liabilities, articles are saying that unsecured debt holders will end up getting 10 cents on the dollar in the restructuring (Bond Buyer, Bloomberg, Detroit Free Press, New York Times, Reuters). But the final numbers on the unfunded liability side still need to be hashed out and negotiations are still taking place (bond insurers are involved in this as well). Speaking of bond insurers, remember when Berkshire Hathaway was actively involved in municipal bond insurance? Here's what Warren Buffet said about insuring munis in his 2008 letter to shareholders. Berkshire Hathaway Assurance Co. is currently a second-to-pay insurer of Detroit Water and Sewer revenue bonds (related post).

"Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belt-tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Local governments are going to face far tougher fiscal problems in the future than they have to date. The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at year end 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering.

When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?

Insuring tax-exempts, therefore, has the look today of a dangerous business – one with similarities, in fact, to the insuring of natural catastrophes. In both cases, a string of loss-free years can be followed by a devastating experience that more than wipes out all earlier profits. We will try, therefore, to proceed carefully in this business, eschewing many classes of bonds that other monolines regularly embrace."

According to the restructuring proposal, Detroit currently has a projected accumulated deficit of $375 million for FY 2013. But, "If not for the City's recent debt issuances, the accumulated deficit for FY 2013 would have been approximately $700 million." And "Absent Structural Changes, the City’s Accumulated Deficit is Expected to Grow to Unprecedented Levels. At the City’s current run rate, its accumulated deficit could grow to 3-4 times its current level of $326.6 million to over $1.35 billion by FY 2017."

Look at the trend of Detroit's accumulated deficit since FY 2007 (click the pic for a clearer view).




Here's more info on Detroit's eroding tax base from the report.





And why Detroit is insolvent.





Finally, Detroit's emergency management team plans to realize the value of Detroit's assets and restructure its debt. Due to budget constraints, the city wants to spin-off the Detroit Water and Sewerage Department's (DWSD's) operations to a "standalone public authority" called the Metropolitan Area Water and Sewer Authority (MAWSA), which would "collect water and sewer fees," be able to "issue taxable and tax exempt revenue bonds or incur other indebtedness," and would lease the water and sewer assets from the City of Detroit (as noted above).










Speaking of the Joe Louis arena, according to the Detroit Free Press, Mike Illitch's Olympia Development (the Illitch family owns the Red Wings) and Detroit's Downtown Development Authority (part of the Detroit Economic Growth Corporation) are planning to build a new "$650-million Red Wings arena near Woodward and I-75." According to Crain's Detroit, "No general fund tax monies from the city or county will be used for the project." "The property taxes earmarked for the arena are already collected by the DDA on properties within its defined geographical district, and by law must be reinvested on improvements within that district." Interesting.

Here is the debt restructuring proposal for Detroit's secured debt (Detroit Water and Sewerage revenue bonds, general obligation bonds, COP-related Interest Rate Swaps, and more). According to Kevyn Orr in his news conference and Bloomberg News below, the interest rate swaps have a lien on casino tax revenues.

"Wall Street firms that sold interest-rate swaps to Detroit as part of $1.4 billion of pension-bond issues stand to get paid before investors and the retirees the borrowings were supposed to help.

In 2009, the companies -- UBS AG (UBSN) and SBS Financial Products Co. -- could have forced the city to pay a fee to end the agreements, which were designed to cut the cost of the debt. Instead, the firms struck a deal giving them a claim on Detroit’s gambling-tax revenue, guaranteeing they’ll get paid $50 million a year."

Have you seen the fair value of these interest rate swaps? The total notional value is $800 million and fair value is now negative $439 million (what Detroit would pay the banks to terminate the swap contracts). The city is paying a 6.3% fixed rate and collecting 3-month LIBOR + 30 to 34 basis points. The city would have benefited from these swaps if interest rates bottomed out in 2006 and the world didn't end (and rates weren't manipulated downward). Ouch... (Read more about Detroit's interest rate swaps at DealBreaker and Bloomberg.)







Here's the unsecured debt portion that has the muni market and retirees in a tizzy. It includes unsecured general obligation bonds and notes, pension certificates of participation (COPs), unfunded OPEB liabilities (other post employment benefits) and unfunded pension liabilities. The fact that unsecured GO bonds, which are backed by the "full faith and credit and tax authority of the city" (secured GO bonds are backed by the State), are being treated the same as OPEB liabilities and pension COPs is now a big deal for GO bond holders across the state of Michigan. It's funny that pension liabilities weren't even reported on government balance sheets until 2012 (1, 2). Retirees are not happy about this and plan to fight the cuts (video).







As a result of the default, credit rating agencies Moody's and Fitch downgraded Detroit's GO bonds on heightened bankruptcy risk.

"Fitch Downgrades Detroit, MI COPs & ULTGO's to 'C'; Water & Sewer Rev Bnds on Rating Watch Negative

14 Jun 2013 4:26 PM (EDT)

Fitch Ratings-New York-14 June 2013: Fitch Ratings has downgraded the following Detroit, Michigan ratings, citing imminent default:

--Approximately $411 million unlimited tax general obligation (ULTGO) bonds to 'C' from 'CCC';
--Approximately $202.8 million limited tax general obligation (LTGO) bonds to 'C' from 'CC';
--Approximately $1.5 billion pension obligation certificates of participation (COPs) series 2005-A, 2006-A, and 2006-B issued through the Detroit Retirement Systems Funding Trust, Michigan to 'C' from 'CC'.

Fitch has placed the following Detroit, MI revenue bond ratings on Rating Watch Negative:

--The 'BBB+' rating on approximately $1.9 billion senior lien water revenue bonds;
--The 'BBB' rating on approximately $1.1 billion second lien water revenue bonds.
--The 'BBB+' rating on approximately $1.9 billion senior lien sewer revenue bonds;
--The 'BBB' rating on approximately $974 million second lien sewer revenue bonds.

SECURITY

ULTGO bonds are supported by the city's unlimited property tax pledge. LTGO bonds are a first budget obligation. Pension COPs are unconditional contractual obligations of the city, not subject to appropriation. If the city fails to make a COP debt service payment, the contract administrator may file a lawsuit against the city to enforce the obligation, and a court can compel the city to raise the payment through the levy of taxes without limit as to rate or amount pursuant to Michigan law.

Senior lien water revenue bonds are secured by a first lien on net revenues of the city's water system. Second lien water revenue bonds are secured by a second lien on net system revenues after payment of senior lien bonds.

Senior lien sewer revenue bonds are secured by a first lien on net revenues of the city's sewer system. Second lien bonds are secured by a second lien on net system revenues after payment of senior lien bonds.

KEY RATING DRIVERS

DOWNGRADE REFLECTS IMMINENT DEFAULT: The downgrade to 'C' on the city's ULTGO, LTGO and COPs reflects the Emergency Manager's (EM) Proposal for Creditors (proposal), released today, stating that the city will not make the debt service payment on the pension COPs due today. The proposal further calls for a distressed debt exchange for ULTGO and LTGO bonds; Fitch would consider such an exchange to be a default.

RATING WATCH REFLECTS UNCERTAINTY: The Rating Watch Negative on senior and subordinate water and sewer revenue bonds reflects heightened uncertainty around water and sewer fund debt given its inclusion in the EM's proposal.

RATING SENSITIVITIES

ULTGO; LTGO AND COPS: The rating will be downgraded to 'D' upon payment default or upon the execution of a distressed debt exchange that does not result in full and timely payment according to the original terms promised.

REVENUE BONDS: Rating action will follow further clarification from the city and/or EM regarding their intentions for senior and subordinate water and sewer revenue bond debt service payments.
(Source: Fitch Ratings)

Moody's downgrades Detroit's GOULT bonds to Caa2 and GOLT and COPs to Caa3; Water and Sewage Revenue Senior and Second Lien Bonds downgraded to Ba1 and Ba2

Global Credit Research - 13 Jun 2013

All Ratings Are On Review for Possible Downgrade; Rating Changes affect $510 million in GOULT debt, $582 million in GOLT debt; $1.4 billion in COPs, $2.6 billion in water enterprise debt, and $3.3 billion in sewer enterprise debt

New York, June 13, 2013 -- Moody's Investors Service has downgraded the City of Detroit's (MI) General Obligation Unlimited Tax (GOULT) rating to Caa2 from Caa1 and its General Obligation Limited Tax (GOLT) rating to Caa3 from Caa2. Moody's also downgraded the city's Certificates of Participation (COPs) rating to Caa3 from Caa1. The GOULT, GOLT and COPs ratings have all been placed on review for possible downgrade.

Concurrently, Moody's has downgraded the ratings for Detroit's Water Supply System Revenue bonds and Sewage Disposal System Revenue bonds each one notch to Ba1 (Senior Lien) and Ba2 (Second Lien) as the growing probability of a city bankruptcy filing potentially increases bondholder risks. Ratings for Detroit's Water Supply and Sewage Disposal enterprise revenue debt have also been placed on review for possible downgrade.

SUMMARY RATING RATIONALE

The downgrades reflect the increased likelihood of a bankruptcy filing, a major general debt restructuring, or a combination of the two, following the appointment of the Emergency Manager (EM) in March 2013 and the EM's recent pronouncement that Detroit's current liabilities require significant restructuring to ensure the city's long-term financial health. Should default or bankruptcy occur, the recovery levels for bondholders could potentially be quite low based on recent municipal recovery rates for other distressed local governments. The EM and his staff are reportedly planning to meet with creditors and stakeholders to commence negotiations for restructuring the city's liabilities this week. The downgrade of the COPs two notches to Caa3 reflects the lack of a dedicated revenue stream that is currently being levied and the uncertainty of enforcement of a judgment lien going forward.

The review for downgrade for all securities will focus on the EM's restructuring plan with respect to both bondholder repayment and potential treatment of the water and sewer system assets. Prior to today's action, the outlook for all of the ratings was negative based, in part, on the possibility that the city could file for bankruptcy."
(Source: Moody's)

"Kevyn Orr speaks to the media after meeting with creditors at the Westin Hotel at Detroit Metropolitan Airport." (source: Detroit Free Press).



Here's an update with more videos (interviews): Kevyn Orr orders probe of worker benefits; unions vow court fight in plan to freeze pensions (Detroit Free Press).

 An article related to munis: New York state announces plan for board to help cash-strapped cities (Reuters).

 *And there should be a online media organization in the old abandoned Detroit Train Station (videos and more Twitpics).

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