Fitch Ratings said it maintains the Rating Watch Negative on Detroit Water and Sewerage Department's (DWSD) $1.1 billion BBB-plus senior lien water revenue bonds and $565 million BBB second lien water revenue bonds.
Senior lien bonds are secured by a first lien on net revenues of the city's water system (the system). Second lien bonds are secured by a second lien on net system revenues after payment of senior lien bonds.
The Negative Rating Watch continues to reflect uncertainty regarding the intention of the city's emergency manager to seek a negotiated debt exchange discussed in the June 14 "Proposal for Creditors" and the response of creditors to that proposal.
Despite the city's Chapter 9 bankruptcy filing on July 18, 2013, Fitch believes that there is substantial protection provided to the system's debt as special revenue bonds. In addition, all system funds and accounts are maintained separate and distinct from other city funds including the city's general fund. The city's water and sewerage department's (DWSD) timely repayment of its outstanding subordinate lien state revolving fund (SRF) loans, which was made as expected, five days prior to Oct. 1, reiterates Fitch's position that the debt of the system constitutes special revenue obligations under the city's Chapter 9 bankruptcy proceedings.
The system's marginal all-in debt service coverage (DSC) and low liquidity levels continue to pressure operations.
Debt levels remain high and payout of principal is slow. As an offset, minimal capital needs alleviate future borrowing pressures.
The system provides an essential service to a broad area that includes roughly 43% of Michigan's population, with over 70% of operating revenues coming from wealthier suburban customers.
The governing body has instituted virtually annual rate hikes in support of financial and capital needs. While recent changes in the city's governance structure could make it more difficult to achieve rate hikes in the future, Fitch does not view this change as a concern at this time.
A change in the dynamics, whereby bondholders are impaired, could lead Fitch to downgrade the rating on the water debt to C upon agreement and D upon execution.
Failure to maintain financial performance at a level commensurate with projections, including the ability to sustain over 1.0x DSC, would likely result in a one-notch downgrade for each security.
The EM's proposal, which included an outline for the creation of a new regional authority, the Metropolitan Area Water and Sewer Authority (MAWSA), and subsequent conveyance of city water and sewer utility assets to MAWSA. The asset transfer could benefit the city through a new "Transaction Payment" - likely a new lease payment from MAWSA of cumulatively $50 million per year or more - with the payment made prior to bonded debt service. Fitch believes the currently outstanding bonds of the individual water and sewer systems must be legally extinguished to successfully accomplish the asset transfer to MAWSA.
Repayment of outstanding water and sewer bondholder claims are segregated into two classes under the EM's proposal: Class A and Class B claims. Class A bondholder claims are not expected to result in 'material premium or penalty' when defeased, likely referring to bondholders whose bonds are callable at par at the time of the restructuring. Class B bondholders are all other claimants, most likely investors whose bonds are not immediately callable at par at the time of restructuring. Fitch estimates Class B bondholders hold the majority of outstanding water and sewer bonds.
Based on the EM's proposal, Class A bondholders will be paid a value of par plus accrued interest on the effective transfer date or receive 'such treatment as may be agreed upon by the parties'. A current refunding transaction relating to Class A bondholders would not necessarily have credit implications in and of itself. However, for Class B bondholders, the EM proposes to issue MAWSA bonds in exchange for the outstanding water and sewer bonds. This exchange could negatively affect the city's existing system credit ratings.
Fitch would view any such exchange based on bond holder (or bond insurer) consent as a distressed debt exchange and an infringement of the original contractual terms between the city and bondholders resulting in an immediate downgrade to 'C' upon agreement and 'D' upon execution. Similarly, Fitch could view an agreement by bondholders accepting an impairment of the call protection outside of Chapter 9 bankruptcy as done under duress, making such action consistent with a distressed debt exchange.
There is also an ancillary issue that Class B bondholders would receive a weaker revenue pledge from MAWSA than currently enjoyed. Currently, the water and sewer utilities make no direct payment to any city fund apart from reimbursements for what should be deemed customary operating expenses or for certain payments on city obligations that are paid on a basis subordinate to the water and sewer bonds payments. However, under the EM's proposal, bondholder claims would be subordinate in payment not only to operating expenses - as they currently are - but also to a "Transaction Payment" as described above. Fitch believes the city charter, as well as the current water and sewer indentures, preclude any such "Transaction Payment" absent the creation of a MAWSA-type structure.
Consequently, Fitch views any diminishment of bondholders' existing revenue pledge as a material breach of bondholders' existing rights and would contribute to significant downward rating pressure.
The ratings consider Fitch's view that there is substantial protection provided to the DWSD's system debt as it constitutes special revenue obligations under the city's Chapter 9 bankruptcy proceedings. The rating also considers factors that historically have separated system operations from those of the city. These factors include a separation of system funds from other city funds as required under city charter and the bond ordinance; billing and collection of rates and charges by DWSD; relative autonomy by the department's governing structure to oversee the affairs of the system without undue influence by the city; and retention of surplus funds by the system.
Fitch expects the separation of system operations from those of the city to continue, but notes that DWSD is a component unit of the city and therefore is not entirely free from potential city influence. Specifically, the EM may act for and in the place of the governing body, including the DWSD Board of Water Commissioners (the board). Consequently, any actions taken that directly or indirectly change the historical paradigm could exert immediate and significant credit pressure on system bonds, particularly given the city's very weak credit quality.
The system's fiscal 2013 unaudited results are not available. However, management estimates that all-in DSC (including senior, subordinate and junior lien state revolving fund debt [SRF]) for 11 months through May 2013 totaled 1.23x. The narrow coverage reflects retail and wholesale revenues that were 12% and 3% below budget, respectively, during the 11-month period. Lower than budgeted retail estimates were due to lower water sales than projected for fiscal 2013. Management anticipates that the negative variance for retail and wholesale will grow to 15% and 5% below budget, respectively, based on preliminary June 2013 data. Yet, operations and maintenance (O&M) expenses were approximately 6% below target, somewhat offsetting the revenue decline. The estimated decrease in expenses is due primarily to reduced contractual services and supply costs.
Given the department's 11-month estimated actuals, the system's fiscal 2013 results may fall below its original all-in DSC projection of 1.25x. Furthermore, audited results may be somewhat weaker than projections because DWSD bases its coverage calculation on cash flows and excludes other post-employment benefit (OPEB) accruals, which are included on the income statement of the audited financials. Fitch's calculation of DSC is based on operating activity contained in the financial statements and includes OPEB accruals for the year. - The system's all-in DSC for fiscal 2012 was just over 1.0x, although improved from the prior year.
Other key metrics, while improved for fiscal 2012, also were low. Days cash rose to 183 days and system free cash for fiscal 2012 equaled just 5% of depreciation expenses. In fiscal 2013, DWSD gave notice of termination for selling water to the City of Flint (Flint), the system's largest wholesale customer. The termination notice of the 35-year old contract was a response to Flint no longer wanting to receive water services from the system. Flint accounted for $22 million (or 6%) of the system's total billed revenue for fiscal 2013. Flint's departure from the system, which is expected to happen sometime over the next three to five years, may add pressure to DWSD's already narrow finances. Management maintains that there are few viable options other than DWSD for most wholesale customers to purchase treated water. Therefore, it is not anticipated that other major wholesale customers will leave. The system's ability to absorb the $22 million loss of its largest borrower is important to the rating. Fitch would consider lowering the ratings if all-in DSC based on the financial statements are inconsistent with projections and drop below 1.0x.
The system's debt burden is relatively high with long-term debt per customer totaling $2,079. Also, principal payout is slow with only 26% of the debt maturing in 10 years. Medium-term capital costs are expected to remain manageable as there are no regulatory compliance issues for the system.
The system's 2015-2019 final draft capital improvement plan (CIP) total's approximately $504 million, virtually unchanged from the previously published plan. DWSD anticipates only one debt issuance of approximately $150 million in fiscal 2015. Given the system's excess treatment capacity, management is in the process of strategically aligning certain system flow with system demand, thereby reducing future plant replacement and renovation costs in the CIP. In addition, management added no new projects to the plan in order to preserve cash and allow itself time to complete and to implement an asset management program (AMP) by early 2014. The AMP will help DWSD determine where future capital investments should be made.
The system is a regional provider serving around 4.2 million people or nearly 43% of Michigan's population, including the city's population of over 700,000. The system serves the city on a retail basis and 124 communities through 84 wholesale contracts. The service territory consists of an area of 138 square miles in Detroit and 981 square miles in eight counties. Population and customer growth have experienced modest annual declines for a number of years. Detroit's population in particular has experienced continuous decline, but suburban areas have picked up most of the migration.
The governing body has consistently raised rates to meet financial and capital needs, although unfavorable operating conditions and rising fixed costs have eroded the revenue impact. For fiscal 2013, the board raised charges 9.9% and 6.7% for city retail and suburban wholesale customers, respectively. For fiscal 2014, DWSD implemented approved 4% increases on July 1. Annual increases of 4% are preliminarily forecasted for fiscals 2015-2017. Retail city rates remain among the lowest of most major U.S. metropolitan areas despite recent rate increases but are around Fitch's median household income (MHI) affordability benchmark given the weak MHI within the city. On the suburban side, rates remain very affordable.