CHICAGO — The outcome of Detroit's high-profile bankruptcy highlights the growing tension between pension obligations and bond debt for distressed governments while leaving a lack of legal clarity on the treatment of general obligation bonds.
Detroit's ability to recover from its historic Chapter 9 remains in doubt despite the federal court's approval of its high-profile plan of debt adjustment, some experts warn.
In a 90-minute oral ruling Friday that sometimes bordered on effusive, U.S. Bankruptcy Judge Steven Rhodes said Detroit's plan to shed $7 billion of debt and reinvest $1.7 billion into the city was fair and reasonable to creditors and feasible for the city to implement.
Two of major ratings agencies offered divergent views of the ruling, with Moody's Investors Service saying the debt plan is negative for holders of Michigan general obligation bonds, and Standard & Poor's saying the lack of legal precedent means the case won't affect its GO bond ratings.
Detroit won approval of its confirmation plan just weeks after a federal court gave the green light to Stockton, Calif. to exit its bankruptcy case. In both cases, the struggling cities chose to elevate pension claims over bond claims.
In both cases, judges tantalized investors by affirming the theoretical ability to impair pension benefits while in practice leaving them largely untouched while approving huge haircuts to many bonds.
"Detroit clearly indicates the sympathy the courts and the public will have to provide a fair deal for retirees and from that standpoint, it means that for bondholders to think they're at the top of the heap and that's all that matters is a dangerous way to think," said Richard Ciccarone, president and chief executive officer of Merritt Research Services LLC. "There's a natural tension there, but that tension is not really a clear and present danger until there's a significant dose of fiscal stress," he said.
Moody's released a report saying approval of the plan was negative for municipal investors because it reinforces favorable treatment of pension claims over other unsecured claims.
Moody's analysts said the Detroit case raised more questions than answers for investors, especially those who hold Michigan debt, and revealed their vulnerability in a bankruptcy court setting.
"Confirmation of the plan is a credit negative for investors of Michigan general obligation bonds, not only because the pledges were impaired, but also owing to the lack of a ruling on the strength of the pledges," analyst Genevieve Nolan wrote in the comment. The ULTGO settlement with the city, which calls for a 74% recovery, "weakens the market's perceived strength of the pledge," Nolan said.
While acknowledging the favorable treatment of pension obligations over bond debt in Stockton and Detroit, Standard & Poor's said the lack of legal precedents and the small number of municipal bankruptcies make it difficult to generalize about the treatment of GO bonds in a Chapter 9.
"In our view, the Detroit and Stockton situations will likely not set a precedent - however high profile and attention-grabbing they may be - and we shouldn't universally apply the lessons learned to all GO-bond debt ratings," S&P analyst Jane Ridley wrote.
By reaching settlements with all of its major creditors, Detroit avoided any court battles and subsequent appeals, as well as setting any legal precedents. The chief mediator in the case, U.S. Chief District Judge Gerald Rosen, said in a press conference following the ruling that one of the goals of mediation was to avoid any legal precedents.
Detroit's settlement with its pensioners calls for no cuts to public safety monthly checks and 4.5% cuts for general employees. Their cost-of-living increases were reduced or eliminated, and retiree health-care benefits cut by nearly 90%.
Unlimited-tax general obligation bondholders agreed to a 26% cut - with the money going to pensioners - and limited-tax GO holders settled for 34% for a 66% cut. Holders of $1.5 billion of certificates of participation will see a 14% cash recovery as well as a groundbreaking package of vacant land, asset leases, and development deals.
Standard & Poor's said "the most important outcome" from Detroit's creditor settlements is the wide gap in treatment of pensions versus bonds, as well as the "very different" settlements for LTGO, ULTGO and pension obligation bondholders.
"Given the nature of a Chapter 9 bankruptcy, we expect that most municipal creditors will continue to settle, as was the case in Detroit, rather than risk a bankruptcy court decision," Ridley wrote, adding that it remains unclear whether any trial court decisions would be binding in other courts.
"While a trend could be developing where local governments in bankruptcy favor bondholder haircuts rather than pension reductions, we believe that Detroit's and Stockton's bankruptcies remain too small a sample size on which to base widespread ratings changes," she wrote.
"I do not see any strong precedents from Detroit," said Alan Schankel of Janney Capital markets.
The "grand bargain," in which state and foundation money came in to fund Detroit's pensions in return for keeping the city's art collection intact, was a unique factor.
"As was the case in Stockton, the pensioner versus bondholder dynamic remains uncertain given the foundation and state assist on the pensions," Schankel said.
Like ratings agencies and other muni bond experts, Schankel added that Detroit's water and sewer bonds escaped the bankruptcy relatively unscathed, showing the underlying strength of the revenue pledge.
"In Chapter 9, the court can only do so much," Schankel said. "In both Detroit and Stockton, the city plan largely prevailed, though Judge Rhodes certainly used his bully pulpit to force parties to reach agreement."
From the beginning, many market participants have downplayed the argument that the Detroit case would spark a wave of bankruptcies from other distressed governments. But one Michigan-based restructuring expert said Chapter 9 could remain one of the only options for stressed Michigan governments.
"They all should be looking at it," said Pat O'Keefe, chief financial officer of restructuring firm O'Keefe and Associates.
"The big issue is always the retirement benefits, and a shrinking population of retirees that are supporting it," he said. "I'm not a big fan of bankruptcy because it's costly and uncertain, and for businesses it's uncertain, but when you're dealing with residents who aren't going anywhere, you've got to take a close look at it.
"Arguably there's a certain cleansing that takes place in the bankruptcy process in terms of legacy liabilities," O'Keefe said. "One could argue that Detroit is in a much better position to attract muni bond financing, which is the lifeblood of every communities."
Despite Rhodes' ruling that the plan presents a feasible path to long-term recovery, some experts warn that the depth of Detroit's challenges and the uncertainty of future population growth threaten the recovery.
"They've still got a heavy load of legacy costs and it's still going to be expensive to run the government," Ciccarone said. "I think it's really hard when you look at the numbers to say they've done enough to be on the path to recovery."
Standard & Poor's, in its report, also cautioned that the city could have a hard road ahead.
"Although the roadmap is set out in the plan of adjustment, it will still likely be difficult for the city to continue making the kinds of changes that will lead to the cost savings it needs to be operationally balanced," Ridley wrote. "We believe that achieving this is the only way that Detroit will be able to stay out of bankruptcy in the future."
Detroit's treatment of its GO holders and, to a lesser extent, its revenue bond holders, could end up costing the city millions in increased borrowing costs over the years, said James Spiotto, managing director of Chapman Strategic Advisors.
"As the judge said from the beginning, it's the long-term survival and reinvestment in Detroit that's the most important thing," Spiotto said. "He wants to make sure that you've got that survivability; make sure that there is a not a repeat, which is extremely important because another bankruptcy for Detroit could be significantly more difficult and painful."
Referring to the possibility of Detroit filing for another Chapter 9, which some observers have dubbed Chapter 18, Spiotto joked: "No one wants to count that high."