CHICAGO - Detroit officials were working yesterday to stave off a demand from its interest rate swap counterparties for a termination payment following Standard & Poor's move a day earlier to strip the city's general obligation debt of its investment-grade rating.
Standard & Poor's attributed its decision to knock the city's $2.4 billion of limited and unlimited-tax GOs down to the junk ratings of BB, from BBB-minus and BBB, respectively, to Detroit's deteriorating financial position and expectation of a 2009 budget deficit.
"Economic challenges in the city have translated directly to the financial bottom line," analysts wrote, adding that the city's chronically late audits and failure to accurately assess year-end results make it difficult to assess the city's fiscal health.
Detroit in May lost its investment-grade rating from Moody's Investors Service on its limited-tax bonds - now at Ba1 - although the unlimited bonds still carry the lowest investment-grade credit of Baa3 and a stable outlook. Fitch Ratings assigns both sets of bonds its BBB with a negative outlook.
While the downgrade stands to affect Detroit's future borrowing costs and market access, officials were more concerned this week with the immediate impact on its books. That's because the downgrade triggers a termination event on an interest rate swap tied to a 2006 pension certificates of participation issue. The certificates carry the same Standard & Poor's rating as the city's limited-tax GOs, now at BB.
Mayor Ken Cockrel Jr. warned late Tuesday that Detroit's counterparties on the swap agreements could demand a termination payment that would cost the city $400 million, a crippling amount he said the city could not cover. The city's finance team, led by chief financial officer Joseph Harris, is working on a proposal to the counterparties that could include offering city assets as collateral to stave off the termination payment demand. City officials yesterday declined to provide additional information.
"I think the key is to renegotiate" the agreements "because there is no way the city can come up with $400 million," said City Council fiscal analyst Irving Corley Jr.
Detroit entered into the floating-to-fixed-rate insured swap agreements as part of the Detroit Retirement System Fund's $948.5 million taxable certificates of participation issue in 2006 that refunded previous certificates sold to fund its unfunded pension liabilities.
The city's counterparties on the transaction are UBS AG and SBS Financial Products Co., which is part of Siebert Brandford Shank & Co. UBS and Siebert also both served as co-senior managers on the transaction. The agreements are insured by XL Capital Assurance Inc. and Financial Guaranty Insurance Co., both of which have lost their investment-grade ratings.
Under the swap agreements, the counterparty can terminate the agreements in the event that the COPs' ratings are withdrawn, suspended, or stripped of their investment grade by one of two rating agencies, and at least one rating agency drops the insurers' ratings to below the low-single-A category.
In a mark-to-market evaluation of the swaps, Moody's reported that as of March 31, 2008, the city would face a roughly $151 million payment if the agreements were terminated. It is unclear how the city came up with the $400 million figure on the termination payment.
UBS spokesman Doug Morris did not have an immediate comment on the firm's position on the termination payment. Siebert officials did not return calls seeking comment.
While UBS no longer serves as a municipal underwriter, Siebert enjoys a long-standing underwriting relationship with Detroit, giving it more incentive to work with the city to avoid the hardship of an up-front payment.
The city's downgrade comes as the new administration is trying to eliminate a budget deficit amid a faltering economy and a struggling automobile industry.
Cockrel, the former City Council president, took over as mayor in September after Kwame Kilpatrick resigned as part of a plea deal on charges that he and his former chief of staff lied under oath during a 2007 police whistleblower trial.
Cockrel is expected later this month to release his plan to eliminate what he has said is a combined structural and operating budget deficit of $300 million. A fiscal 2010 budget is due to the City Council in April.
Standard & Poor's analyst Jane Hudson Ridley said no single event triggered the downgrade, but analysts had maintained regular contact with city officials, given the firm's internal policy requiring such contact when an issuer's audit is late. Under state law, certified financial statements are due six months after the close of a fiscal year.
Detroit is chronically late with its audits but has traditionally won state approval for extensions. It most recently faced a Dec. 31, 2008, deadline on its fiscal 2007 audit, but city officials had said they did not expect it to be ready until February. State officials did not return calls yesterday to say whether a further extension had been granted. The state has withhold $42 million in local aid sharing funds because of the late audits.
Standard & Poor's was particularly troubled of late by the city's warning that it expected a structural budget deficit in 2009. Officials have said they don't believe the 2007 results will show a deficit but are not sure about 2008. The deficit is separate from an ongoing, cumulative negative general fund balance of about $175 million, Ridley said. Standard & Poor's had lifted its two-year-old negative outlook on the credit last year.
"At that time, they indicated that they expected to be balanced," she said, adding that analysts meeting in committee this week looked at the city's overall credit characteristics and decided "that this is not currently an investment-grade credit."
Uncertainties over the city's future political leadership also raised some concerns, although Standard & Poor's favorably views the new administration pledge that the city's fiscal strength and stability are a primary goal. A special primary election is set for February and a general election for May to fill Kilpatrick's remaining term. A general election is set for November to chose the successor to Kilpatrick's replacement.
Fitch analyst Melanie Shaker said the agency "was reviewing the credit as part of ongoing credit analysis" and Moody's Elizabeth Foos echoed those comments. Both said they planned to talk with the city about its plans to address to potential termination payment.
Several traders and portfolio managers said yesterday the city's revenue and GO bonds had previously been trading cheaper in the secondary market, having lost some of their value due to the Kilpatrick scandal and the auto industry's woes.
"The revenue bonds and enterprise debt should be fine. It can't get much worse, as it's already been trading cheaper," said Thomas Spalding of Nuveen Investments.
