Detroit Schools In Dire Straits

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CHICAGO - Detroit Public Schools, currently in a financial crisis so severe it is considering becoming the first major public school district to file for bankruptcy, hopes to issue up to $1.1 billion of new debt over the next six years to finance the rebuilding of nearly all of its schools.

Voters will weigh in on the bond proposal in November. The district's underlying rating is currently in junk-bond territory.

The capital improvement plan would include spending roughly $250 million in fiscal 2010 to build three new schools and would also include $148 million of Build America Bonds, school officials said.

Proceeds from the bonds would also finance rebuilding the district's 60 schools, which have an average age of more than 50 years.

More immediately, DPS plans to enter the market in the next few weeks with $243 million of notes as part of its annual cash-flow issuance. JPMorgan is the underwriter on the transaction. Public Financial Management Inc. is the district's financial manager and Miller, Canfield, Paddock and Stone PLC is bond counsel.

In addition to the bond proposal, the November ballot will ask voters to decide whether Detroit's mayor should run the district rather than the school board.

Michigan took control of the district's finances from the board earlier this year after a fiscal review found DPS to be in a state of emergency. As part of the takeover, Gov. Jennifer Granholm appointed school administrative veteran Robert Bobb as emergency financial manager.

The $1.1 billion capital improvement plan is part of DPS' effort to attract new students to the cash-strapped district and stem the tide of falling enrollment.

Driven in part by Detroit's own declining population, the school district's enrollment fell to under 100,000 this year. The decline triggered a state law that allows community colleges to establish new charter schools within the district's boundaries, which could mean fresh threats to DPS' ability to attract new students and increase badly needed state aid tied to enrollment levels.

"We haven't had a major capital improvement program since the 1990s," said Ricardo Kisner, the district's chief financial officer. "We're in the process of developing the full CIP now as well as communicating that initiative to the community over the next couple months."

Officials are working with a marketing firm to hold a series of public meetings and media appearances over the next few months to promote the capital improvement plan.

Along with declining enrollment, the school system suffers from an erosion of its property tax base in Detroit. Its top taxpayer is Chrysler LLC and its fourth-largest is General Motors Corp., both of which filed for bankruptcy this year. Detroit also has one of the highest housing foreclosure rates in the country.

These problems as well as state budget cuts and seven years of chronic overspending have led to a structural deficit of $276 million, according to officials.

While DPS hasn't entered the market with general obligation bonds since 2005 and is faced with aging facilities, taking on significant amount of debt could pressure the already-strained balance sheet, Moody's analysts warned.

The district currently has a relatively high debt burden of 11.4% and a slow amortization of 42% in 10 years, said Moody's Investors Service, which recently downgraded its underlying rating on the district to B1 from Ba2.

"The district will be challenged to address their capital needs at a time of operating pressure," Moody's analyst Elizabeth Foos wrote in a recent report on the downgrade. A significant change in the district's debt profile could lead to a downgrade, she said.

DPS has $1.47 billion of outstanding debt. Of that, $1.3 billion is in GO school bonds issued as part of the last capital improvement plan from 1993 through 2005, according to Almon Turner, the district's director of cash management. Those bonds are paid from property tax levies approved by voters and are not paid from the district's general purpose fund.

The district also has roughly $181 million of special purpose bonds, which are backed by state aid, Turner said. In 2005, it refinanced $210 million of short-term debt into 15-year bonds as a way to cover the current-year deficit.

The roughly $22 million in annual debt service on that debt is paid from the general purpose fund, and is often cited by the new financial team as one of the top "cost drivers" over the next five years.

The new finance team has spent the last several months developing a fiscal 2010 budget that closes an estimated $131 million current-year deficit, as well as a longer-term deficit elimination plan that proposes ways to close the accumulated $276 million deficit.

The $1.2 billion all-funds budget includes $227 million in cuts, including closing 29 schools. About 2,451 employees would be laid off - from a total of 13,880 - and DPS officials hope to save $87 million through renegotiating union contracts. If implemented, the budget would eliminate the current deficit and leave a $17.4 million surplus that would bring down the accumulated deficit to just under $260 million, officials said.

"We're going to reduce costs until we have a surplus cash flow and can eat into the deficit," said Delores Brown, deputy CFO and chief accounting officer for the district.

The district can't refinance most of its debt until 2015 but will consider refinancing "as soon as the market is right" to achieve savings, Brown said.

Officials last week submitted a final deficit elimination plan to the state for approval. A draft long-term plan outlined by Bobb last month included the option of filing for Chapter 9 bankruptcy.

But Kisner last week downplayed the likelihood and said the option was not included in the final plan.

"Bankruptcy is one of the options among several options that the district is looking at, but we have finalized a deficit elimination plan where Chapter 9 bankruptcy is not part of that plan, nor part of the five-year financial forecast we're looking at," the CFO said.

"At this point we have not decided. More than likely it would be the very last resort," he said, adding that district officials raised the possibility in part so that the unions would be aware of it.

As DPS would be the first large public school district to file for bankruptcy, it is unclear what the move would mean for bondholders. While Kisner declined to speculate, public finance experts warned the move could choke off the district's ability to access the market and threaten its ability to make debt service payments.

"The critical question for the school district is to keep its market access open," said one public finance professional who asked to remain anonymous. "If you can't do cash-flow borrowing, it's like cutting off air."

While debt service on the portion of DPS debt that is backed by state aid would continue to be paid even in the case of bankruptcy, it's uncertain what would happen to the district's GOs. Under Michigan law, the school district must secure a state loan if it can't meet its debt service obligations - and the state is required to give the loan to the district.

"It's an interesting legal question: what happens when bankruptcy and state law intersect?" the expert said.

Moody's Foos cited the "heightened risk that the district will avail itself of federal bankruptcy protection" in the agency's recent downgrade, and noted that the move could endanger debt payments.

"Given the lack of history of municipal bankruptcy, it is unclear which district revenues, assets, and debt obligations could be affected by bankruptcy proceedings and that a bankruptcy filing could weaken the district's ability to meet debt obligations," Foos wrote.

DPS officials are expected to make a decision on whether to file for bankruptcy by the end of August.

Standard & Poor's does not have an underlying rating on the district. It maintains an A-plus rating on a chunk of 2005 state intercept aid debt and a AA-minus rating on the district's school loan fund program debt. Both ratings are based on the programs and not the district's credit.

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