CHICAGO -- A year after Detroit's record bankruptcy filing, lawyers and analysts said they have learned to throw out many long-standing beliefs about municipal debt and its treatment in Chapter 9.
"Nothing should be taken for granted," said Richard Ciccarone, president of Merritt Research Services. "We're breaking new ground on setting precedents in Chapter 9. We've had the presence of Chapter 11-style bankruptcy lawyers who have made great inroads into the muni market and are rewriting laws and expectations as we speak."
Detroit filed for protection on July 18, 2013, listing $18 billion in liabilities, dwarfing the previous high of $4.1 billion by Jefferson County, Ala.
It's too soon to assess the lasting legacy of the bankruptcy and whether it will achieve bankruptcy boosters' promise of a long-term recovery for the Motor City.
But events of the past 12 months have shown that pledges that had been seen as a bulwark for bondholders are only as strong as the underlying credit, and that politics are likely to trump legal protections.
Lesson number one: the pledge behind a bond is only as strong as the credit's underlying economic condition.
After Detroit, analysts and investors realize that traditional expectations and legal protections do not always mean a bond will survive distress. That includes debt structures designed to withstand bankruptcy and restructuring, such as special revenue bonds.
Lesson number two: politics is key. Many muni experts say the Detroit case is driven largely by politics, in everything from the city's push to exit Chapter 9 before the November elections to a public relations campaign that has pitted investors against Detroiters.
Also, a state's support for its distressed cities may have a limit. In Michigan's case, Detroit's problems simply grew too large to handle, say some experts.
Finally, a long-term recovery plan is crucial, particularly one that preserves some market access with a new or rehabbed credit.
The people driving the Detroit bankruptcy process, who are promising a turnaround, have made such a recovery harder, said Richard Sigal, partner at McKenna Long & Aldridge LLP, a restructuring veteran who has worked with distressed governments as far back as the New York City crisis of the mid-70s.
"Detroit will be a precedent for how not to manage a major city distress workout," Sigal said.
"The cram down and divisiveness is not a legitimate tool in a large-scale municipal bankruptcy and in the long run bringing the city together is the best solution, as was done in New York City and other places," he said. "It has been very expensive, as probably in excess of $100 million has been spent on lawyering with no long-term values achieved," he said. "There's enough precedents of success out there without using cramdowns," he said.
"It was inappropriate when the city had the kind of assets that it had," Sigal said.
REBUILDING THE CREDIT
Detroit Emergency Manager Kevyn Orr, a corporate bankruptcy attorney hired by Gov. Rick Snyder, took the city into bankruptcy four weeks after ordering the city to stop making payments on most of its debt and launching negotiations with creditors. The city's plan treated its general obligation bonds as unsecured, on par with the lowest-secured debt like retiree health care costs, a move that startled the muni market.
Orr and the city's top investment banker, Ken Buckfire of Miller Buckfire & Co., argue that a post-bankrupt Detroit will regain market access despite its defaults. With roughly 70% of its debt off the books and revenue projections that show a growing tax base, investors will be willing to lend money, Orr and his team say.
A recent court filing outlining Buckfire's expected testimony at an August trial on the city's plan for confirmation highlights the banker's belief that the city will be an attractive credit.
"The elimination and treatment of the city's significant pre-petition liabilities will, in Mr. Buckfire's opinion, improve the city's attractiveness as a borrower on a post-emergence basis," the brief says.
THE COST OF DEFAULT
Muni market participants, however, warn the city will likely need to craft a new credit or put together another kind of creative financing to be able to borrow going forward, despite the market's well-known short memory and its pursuit of yield.
"We've shaken the ground of the general obligation market for this distressed credit," said Ciccarone. "We're going to have to firm up the foundation with some newfangled creations to get market confidence back to do the larger financings that Detroit will need," he said. "They've lost trust in the marketplace and they will need crutches to give confidence. Even with alternative lenders, those parties are going to ask for covenants that are stronger than what they currently have."
Chapter 9 expert James Spiotto, managing director of Chapman Strategic Advisors, noted that the bump in the interest rate likely needed to attract investors may end up costing the city for years.
"We know the spread between an acceptable credit and one that there are questions about can easily be 150 to 200 basis points," he said, noting that such spreads add up over the 30-year life of a typical bond. "Detroit has proven not only that they'll go into bankruptcy but that they'll impair debt, and they need to work hard on that," said Spiotto. "That could be a significant issue."
THE WATER AND SEWER BONDS
Detroit has roughly $5.3 billion of water and sewer revenue bonds that muni market participants are watching closely.
The actions of Orr and his team have also challenged long-held tenets about revenue bonds. Water and sewer bondholders are being asked to sacrifice even though the system can support its revenue debt.
They are among only a handful of creditors who have not yet settled.
Orr wants bondholders to either take a lower interest rate or waive their call protection. Despite the pledge to repay 100% of principal, the restructuring would represent an impairment of the special revenue bonds, typically considered the best-protected in a bankruptcy. The proposal led ratings agencies to dump the debt into junk territory.
"The water and sewer bond was a terrific bond; it was bankruptcy secure," said Sigal, who worked on the credit in the 1980s. "The fact that it got destroyed in this bankruptcy is just outrageous."
Spiotto too, notes the danger of setting an impairment precedent for special revenue bonds, which were created to ensure that municipalities, even if distressed, had access to capital if they could pledge a reliable revenue stream.
"It's these types of situations that create some real issues to our ability to do the things we need to," he said, adding that Detroit's long decline also shows the importance of sufficiently funding infrastructure and enterprise projects.
BACK TO CREDIT BASICS
As with the 2008 recession and the decline of bond insurance, Detroit's case has proven again the importance of examining the underlying credit as well as a bond's covenants, experts said.
The settlements the city has reached with bondholders -- 74% for unlimited-tax GOs and 34% for limited-tax GOs -- prove the importance of independent credit work, Ciccarone said.
"The settlements themselves are a de facto warning shot for all analysts and investors who in the past over-relied on a general obligation or a special revenue pledge," he said. "When a city is in free-fall, or experiencing economic decline, you don't know where the bottom is, and you never want to pit worker claims against bondholder claims," he said. "Even if you've got the legal protection, there may not be the money there to pay the bills."
THE ROLE OF POLITICS
In Detroit's bankruptcy, politics has driven everything from the fast-paced schedule to anti-bondholder rhetoric from city and state officials.
Syncora Guarantee Inc., the bond insurer that emerged as the city's most vocal challenger, has repeatedly complained that the city, and the federal bankruptcy court itself, have engaged in an anti-Wall Street campaign that includes the mediators who crafted the so-called "grand bargain" at the center of the city's bankruptcy exit plan.
"In the future, investors may want to charge more for taking on the political risk of distressed credits," said James Sprayregen, an attorney with Kirkland & Ellis LLP, which represents Syncora.
"You have mediators holding press conferences, going to Lansing to lobby a Legislature. You have statements made by the city calling my client and others the Huns of Wall Street, when it's creditors just trying to get as much recovery as they can," he said.
"This is unfortunate for cities in the muni bond world," he said. "The idea that you could treat retirees at par and give us almost zero is almost a war on Wall Street, and that's not a good fight for cities to be fighting."
Syncora insures just under $390 million of the $1.4 billion of pension certificates of participation that the city is suing to invalidate, arguing the original 2005 borrowing was illegal. Syncora also insures the interest-rate swaps that hedge $800 million of the certificates.
"The beauty of New York, the beauty of the cities in Pennsylvania, even in [Washington] D.C., is that they've all been feel-good situations," Sigal said. "Everyone came out of that saying, 'Okay, the city went through a tough time, but we've got a new bond we can go forward on now'," he said. "I don't see that in place here, and I don't see any real effort to get that done."
Ratings agencies have also warned that the political nature of the case has impacted expected recoveries. Moody's Investors Service put out a report July 17 noting that pensioners' recovery may reach 82% compared to 74% for unlimited-tax GO holders.
"The city's proposal provides evidence that, even where a bankruptcy judge has indicated that pension benefits are subject to contractual impairment and a city is willing to impose cuts, pensioners are more likely to receive politically favorable treatment," Moody's said.
A trial on the city's plan of confirmation is set to begin August 14. Holdout creditors like the water and sewer bondholders, the certificate holders, and insurers may still settle. Sprayregen said there's still "plenty of time and room" for a settlement with the city.
If Detroit reaches deals with all of its creditors, and no one objects to the confirmation plan, U.S. Bankruptcy Judge Steven Rhodes will find it easier to rule on the 'fair and equitable' creditor treatment test. But he will still need to rule on whether the confirmation plan is feasible over the long term.
Detroit's recovery plan assumes $1.4 billion of capital investment over the next 10 years, with expectations of modest revenue and population growth.
"The judge will separate dreams from reality," Spiotto said.
Some observers, like Municipal Market Advisors, note that the "generous" nature of some of the retiree settlements raises the question of whether the bankruptcy was necessary in the first place. More ominously, said MMA, it raises the possibility of the city re-entering Chapter 9 in the future.
"People are realizing now that to confirm a plan of debt adjustment, the issue is broader than just the best interest of creditors," Spiotto said.
"You have to show that the city is going to address the systemic problems that brought it there in the first place, and that you're going to reinvest in the community and have a real recovery plan," he said.
The verdict on those questions will be rendered over the years to come, not in the months remaining for the bankruptcy case.