CHICAGO --In 2010, with Detroit struggling to access the bond market, Michigan amended a law to allow the city to sell debt enhanced by certain protections aimed at assuring bondholders that they would be repaid even if the city went bankrupt.
The move secured a chunk of the city’s limited-tax general obligation debt backed by state aid payments with a statutory lien and intercept feature that attorneys argued would likely protect the bonds in the case of a Chapter 9.
The relatively new statutory lien underpins about two-thirds of the city’s limited-tax GO bonds. The city’s unlimited-tax GO debt benefits from a special revenue pledge. Both pledges will likely boost protection in bankruptcy.
Some other Detroit GO bonds, however, are backed only by a pledge of general fund revenues, making them vulnerable in a bankruptcy scenario.
Meanwhile, the city’s $1.45 billion of pension debt features no pledge from the city, but the interest-rate swaps hedging that debt enjoy a lien on a special revenue that some experts say will likely make the debt undisturbed by a bankruptcy judge.
With Detroit on the edge of bankruptcy, holders of the city’s $1.1 billion of general obligation bonds are taking a closer look at the different pledges that underpin their investments.
“I think we have taken the GO term and we’ve become very loose with it over the years,” said Michael Ross, managing director at Raymond James. “They’re not all the same.”
The varying pledges among Detroit’s GO debt illustrates the importance of investor research into the securities supporting the debt, said market participants.
“There’s a lot of things happening in the industry now that are making people take a second look at what they believe to be true,” said Alessandra D’Imperio, senior director at Kroll Ratings. D’Imperio was one of two authors of “Not all G.O. Bonds are Created Equal,” a recent Kroll report.
“You really have to do your due diligence,” she said.
Detroit would be the largest U.S. city to file for Chapter 9 if its emergency manager, Kevyn Orr, takes the city down that route.
Municipal bankruptcy remains relatively rare, with current cases, particularly in California, just beginning to clarify issues such as the rights of pensioners versus bondholders. The lack of case precedent makes it uncertain how creditors and bond pledges will play out.
State law plays a key role in bankruptcy, and Michigan has never allowed a local government to file for Chapter 9. The scenario became more likely recently, with the takeover of Detroit, because the state passed a new law for distressed local governments that highlights a possible role for Chapter 9.
Like Gov. Rick Snyder, Orr has repeatedly said bringing down the city’s long-term debt is a top priority. Debt service on the bonds, even the $1.1 billion of general obligation bonds that make up a relatively small part of the city’s overall $15 billion in red ink, is too much of a strain on the city’s general fund, Orr has said. The GO debt, combined with $1.8 billion of pension debt and related derivatives, ate up 11% of the city’s general fund in 2012, according to Orr.
Orr will reportedly meet with creditors and unions over the next six weeks and should know within two months whether the city will be able to restructure outside of the bankruptcy court.
The different securities underpinning Detroit’s GO debt would likely lead to different treatment in a bankruptcy, with lawyers for all creditors making their best arguments for special revenues, liens and other protections.
Of the $1.1 billion of general obligation bond debt, $511 million is unlimited-tax bonds and $576 million is limited-tax GO debt.
Almost $400 million of the limited-tax bonds are distributable state aid bonds that benefit from a statutory lien and trust intercept feature.
The lien and the intercept were created specifically to help assure investors that they would be repaid in the case of a Detroit bankruptcy.
Bond documents outline the protections: “The city has been advised by bond counsel that, although the question is not free from doubt, in a case that is properly argued, the court having jurisdiction over the case should hold that the distributable state aid received or to be received by the trustee from the state treasurer, both before and after the city’s filing for protection under the bankruptcy code, remains subject to the statutory lien and trust,” the documents say.
Detroit entered the market three times using the statutory lien and intercept feature: a $250 million LTGO deal in March 2010, a $100 million ULGO deal in December 2010, and $129 million LTGO deal in August 2012.
The remaining roughly $200 million of LTGO bonds, issued over the years for various capital improvements and to pay self-insurance claims, have only a pledge of general fund revenue.
Nearly all of Detroit’s bonds carry insurance, though the LTGO state aid bonds issued in 2010 and 2012 do not.
All $511 million of Detroit’s unlimited-tax GOs are secured by a specific pledge of ad valorem taxes, one of the strongest pledges as it pledges a specific revenue source and requires the city to raise taxes to cover debt payments regardless of any other obligations.
The unlimited-tax GO debt includes $100 million of state aid bonds that benefit from the statutory lien. Another $100 million of ULGO bonds were sold to finance a renovation of a former casino into a public safety headquarters and other projects. The specificity of the projects could help protect those bonds in the case of a bankruptcy, said one source close to Detroit.
“There could be arguments made that if the unlimited tax pledge was for a specific project, then arguably those are special revenues under the bankruptcy code,” the source said. “We don’t have any court decisions in Michigan that have dealt with the issues. We don’t know what is going to have better protection.”
The $1.45 billion of pension certificates are not general obligations of the city and have no full faith and credit or first budget obligation pledge. The certificates are contractual agreements. If the city stops paying debt service, the investors or insurer can take Detroit to court, and if the city loses, then it can be forced to raise taxes to cover the debt service.
But the interest-rate swaps hedging the pension debt have a lien on casino revenue, one of Detroit’s few strong revenue streams.
That lien was part of a 2009 renegotiation of the swap agreements that allowed the city to avoid involuntary termination of the swaps.
Restructuring the city’s bonds, in or out of the court, is possible regardless of liens and securities, Ross points out.
“If the cash flow can’t meet the debt service, it could still be restructured, given a haircut in terms of the coupon,” Ross said. “The lien would remain in effect, but if there’s not enough revenues, they could restructure the payments.”
The importance of the underlying security behind a GO bond, particularly for a distressed issuer, makes it a disclosure issue, some experts said.
Detroit, which has faced the spectre of bankruptcy for years, has since at least 2010 featured detailed sections in its bond documents on how the bonds might be treated in the event of a Chapter 9.
“People are certainly asking more sophisticated questions,” said Robert Doty, a financial advisor at Government Financial Strategies in California who also owns his own consulting firm.
“I don’t know that we have all the answers,” he said, adding that two of the most important questions for investors is whether a state allows local governments to go into bankruptcy and if state law provides a statutory lien to secure the bonds. “These are the issues that have emerged over the last couple years that need to be considered for disclosure.”
James Spiotto, head of the special litigation, bankruptcy and workout group at Chapman and Cutler LLP, agreed.
“Sometimes when you take a detailed look, it’s different than what you first perceived,” Spiotto said. “Generally in disclosure there hasn’t been a lot of effort to spell out,” he said. “Going forward, that’s something that municipalities, in order to really fully disclose, are going to have to consider: making it clear that this is how this bond is going to be paid, even in a bankruptcy.”