CHICAGO -- Fitch Ratings has offered one of its first detailed looks at how the largest municipal bankruptcy in the U.S. may prompt a change in its ratings methodologies.
In the report, "Rating to Bondholder Security After Detroit," Fitch says Detroit's proposed plan of adjustment "strains boundaries" of creditor expectations, and that if the plan is approved by the bankruptcy court, it will "challenge traditional rating distinctions linked to bondholder security."
All three major ratings firms have closely monitored the Chapter 9 case since Detroit filed it in July. But they have largely refrained from speculating on how the city's proposed treatment of its debt could change ratings.
Detroit has reached a tentative settlement with its unlimited-tax general obligation bondholders that calls for a 74% recovery. It has not settled yet with its limited-tax GO holders, however, and is proposing repaying them roughly 10 cents on the dollar. The city also wants to impair its water and sewer bonds, though repaying 100% of its principal, and invalidate entirely $1.4 billion of certificates of participation issued to boost its pensions. The proposed treatment show how "operations trump security" for distressed credits, Fitch said.
"Maintaining or restoring essential services should be expected to trump attention to security distinctions when a municipality is distressed to the point of bankruptcy," analyst Amy Laskey wrote in the report. "Rating distinct security structures at levels without any direct linkage to the [unlimited-tax general obligation] debt will make sense only when that security reflects impregnable legal protection. It remains to be seen whether special revenue status, which could include a statutory lien on dedicated tax revenues, affords that kind of protection. The proposed impairment of the utility debt in the [city's plan of adjustment] suggests it may not."
Detroit emergency manager Kevyn Orr has proposed paying holders of $5.9 billion of water and sewer bonds 100% of principal, but eliminating call protection and refinancing the debt in a way that would, among other changes, make debt-service subordinate to an annual lease payment to the city.
If pushed through without bondholder consent, the plan would mean special revenue bonds may be "less special than assumed," Fitch said.
"If the lien or the call protection on the utility on the utility bonds is ultimately impaired, Fitch will reevaluate its current assumption that utility revenue bond ratings are so well protected as special revenue debt under Chapter 9 that such bonds can be assigned ratings on a stand-alone basis without a link to related municipal ULTGO rating," Laskey wrote. "Consideration of general government credit quality may become a more important factor in rating utility bonds."
A utility bond impairment could also hurt non-utility debt secured by a statutory lien on a dedicated tax, she said. "The desire to limit the lien to a sum-sufficient coverage level of the secured debt to free up excess revenues for operations could be irresistible."
Detroit's effort to overturn its $1.4 billion of pension COPs, issued in 2005, could create a limited legal strategy for other distressed issuers. But state law or state-based court actions will likely play a larger role in examining such debt issuances in the future if Detroit is successful, Fitch said.
Issuance of COPs or lease revenue bonds through a conduit, as Detroit did, is common, especially in states like California, which requires voter approval for GO debt, and Florida, noted Fitch.
"In contrast, Detroit's structure was described at the time as novel and does not benefit from either statutory authorization or judicial review of a similar structure in a Michigan court," Laskey said.
The strength of the issuer will remain one of Fitch's most important ratings considerations in the future.
"Whether or not [the plan of adjustment's] novel approach to bondholder security stands, the underlying operational strength of the obligor will remain paramount," Laskey wrote. "No matter how much legal fortification there is for the GO pledge, we believe bondholder payments will always be vulnerable where there is extreme financial distress and a desire to reduce fixed costs or divert spending to operations."
Laskey added that Fitch expects such situations -- as well as Chapter 9s themselves - to continue to be rare events.