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Detroit Bankruptcy: U Turn by Michael Comes

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Below is a comment written by Michael Comes, a Portfolio Manager & Vice President Research of Cumberland Advisors.  His bio is found at Cumberland’s home page, www.cumber.com. His email is michael.comes@cumber.com.

Of note, last week, the NYT reported that Judge Steven W. Rhodes of United States Bankruptcy Court for the Eastern District of Michigan ruled that Detroit could proceed with a plan to pay $85 million to UBS and Bank of America over several months to terminate interest-rate swaps, roughly half the amount originally proposed. The city entered into the swaps in 2005 as part of a duplicitous series of transactions that evaded the state debt limit and was supposed to help finance pensions. -- Chris

U-Turn

April 12, 2014

It turns out there is a strong possibility that the Detroit bankruptcy’s losses to bondholders won’t be as painful as had originally been thought. Emergency Manager Kevyn Orr has made a U-turn on how General Obligation Unlimited Tax (GO ULT) bondholders are going to be treated in this bankruptcy. Given the magnitude of insolvency, the irony is that Detroit’s bondholders may fare better than other creditors in post-2008 vintage bankruptcies—and roughly in line with historical norms.

On Thursday, Judge Jerald Rosen, who is presiding over mediation between the city and bond insurers National Public Finance Guarantee, Ambac, and Assured Guaranty, announced a negotiated settlement whereby bond insurers would have their claims reinstated in the amount of $287.5 million of their $388 million original claim (a recovery of 74%) and exchanged for obligations of the Michigan Finance Authority. This new claim would be secured by an unlimited tax general obligation of the city, which is further secured by distributable state aid payments from the state of Michigan. The balance of the claim, 26%, will go to an income stabilization fund for vulnerable pension retirees. In layman’s terms, general-obligation unlimited tax bondholders in the Detroit bankruptcy, most of whom are insurers, will recover 74% of principal value, up from an offer of 20% in February and 15% as of March 31. This is a very fluid situation. 

So why the drastic increase in recovery from 15-20% to 74%? It appears as though Emergency Manager Kevyn Orr has had a change of heart.

Orr’s original plan of adjustment classified GO ULT debt as unsecured, or not having a lien on the city’s ability to raise taxes by the amount needed to pay debt service. We have written extensively in previous commentaries on the subject, arguing that GO ULT debt is in fact secured and that his degradation of this security structure impacts how local general-obligation debt is treated relative to other types of securities in a typical local issuer’s capital structure, namely to revenue debt like water and sewer bonds, which continue to be paid during bankruptcy and are not subject to automatic stay.

The new agreement states that UTGOs do in fact have a lien and that the UTGOs millage constitutes special revenue under Section 902 of the bankruptcy code.

In a Bloomberg Brief interview dated 4.11.12, Kevyn Orr states that if the millage weren’t enforced to repay bondholders, that it might not have been collectible by the city in the first place, forcing Detroit to forgo a key revenue stream into its general fund. The change in treatment has been prompted by the willingness of bond insurers to give up 26% of their dedicated revenue stream to pension beneficiaries, an arrangement which Orr supports. His interpretation of the bankruptcy law has changed based on his ability to extract concessions from bondholders in the form of distributable state aid payments.

The implications for this U-turn are vast. First, if in fact payments to general-obligation unlimited tax bondholders do constitute a special revenue because they have an actual lien on taxing power, this solidifies the seniority of the GO ULT pledge versus other general fund pledges, a contentious issue prior to the announcement of this settlement agreement. Also, pursuant to Section 902 of the Bankruptcy Code, since special revenue indebtedness is not subject to automatic stay provisions, what would be the purpose of filing for Chapter 9 if the creditor could not seek relief from such obligations? Would unlimited tax general obligations be left intact while all other obligations not considered as having special liens, such as lease-backed, limited tax, and miscellaneous revenue bonds, be restructured?

As our friend Natalie Cohen of Wells Fargo has pointed out in her writings, the question of use of proceeds is also of interest. If Detroit used proceeds from GO ULT or GO LT indebtedness for specific projects, instead of just “general purposes,” the revenues may be considered “special revenues.” If not, this argument is less valid. Because the city of Detroit does issue GO ULT bonds for specific projects and not general purposes, they may be classified as special revenues. 

Although this mediation agreement is just that, and not part of a court-approved plan, these terms could change; however, Emergency Manager Kevyn Orr, who during the course of this bankruptcy has had significant negotiating leverage over creditors, was party to this agreement. Given his desire to fast-track this process, we believe this agreement has a high probability of approval and incorporation into the plan of adjustment.

Analysis of post-2008 vintage bankruptcies shows that Detroit’s GO ULT creditors will fare relatively well in this process, contrary to the market’s prior perception. Harrisburg’s general obligation bondholders recovered 75% while Jefferson County’s holders of sewer warrants recovered 55-60%. Vallejo’s creditors recovered 50%. If this agreement goes through, it will help cement the seniority of GO ULT creditors over other classes of debt in Chapter 9 municipal bankruptcy. This is a welcome event for a chapter in the bankruptcy code with little case law to guide its interpretation, a reflection of its lack of usage (annual Chapter 9 filings in the mid single digits versus roughly 11,000 annual Chapter 11 filings). This begs the question: “Was a Chapter 9 filing really necessary?” Kevyn Orr sought to classify GO ULT debt as unsecured, when in fact it was widely believed that it was secured. After tens of millions in legal fees, a river of negative press, and ripple effects to other local municipalities, we have U-turned and are back to where we started.

Michael Comes, CFA, Portfolio Manager & Vice President Research

Resources:

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Twitter: @CumberlandADV

 

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Sun, 04/13/2014 - 12:35 | 4654163 Iam_Silverman
Iam_Silverman's picture

Apparently the only winner so far has been the legal counsel for each "side".  The bond insurers hopefully have reserves allotted for payout in this bankruptcy, otherwise who backstops them?

It also important how the bankruptcy judge sets priority for recovery in this case.  With the wrong decision, that muni bond collapse predicted years ago may suddenly become a reality - overnight.

Sun, 04/13/2014 - 14:47 | 4654490 shovelhead
shovelhead's picture

I think AIG has this covered.

No Problem.

Sun, 04/13/2014 - 12:21 | 4654125 HardlyZero
HardlyZero's picture

Flint, Detroit, Chicago...aren't they all just different sizes of the same ?

When Chicago goes down they will grab all the resources and the rest will fall off the map.

 

The only thing going for Detroit is its proximity to Canada and Toronto.  Buffalo NY is also similarly close to Canada.

So Detroit may survive on the cross-border business with Canada (which may one day pick up).

Sun, 04/13/2014 - 12:13 | 4654108 Fred Hayek
Fred Hayek's picture

First of all, Chris, why go to the extra work to make the acronym GO-ULT. It's GOUT. And doesn't GOUT fit the image of the fat cat bond buyer, be it an institution or an investor? What kind of idiot was buying City of Detroit bonds anyway? The whole world has known for years that this default was going to happen. I'm very much against the big banks who consciously participated and abetted a fraud getting a single dime out of this. I also think that the pension holders should take some haircut seeing as they knew they were accepting promises that could never be kept. They knew it. And a 74% payout to bond holders who knowingly bought excrement is ridiculous. One can't help but suspect that Kevyn Orr didn't have a change of heart. He had a change of tax bracket.

Sun, 04/13/2014 - 12:21 | 4654128 whidbey-2
whidbey-2's picture

Your picture is but one path to ruin. Each involves the key plays who trusted a contract too air tight to work.  NO....you loose becasue you knew everything and did nothing.  Drop the virtue and get in line.

Sun, 04/13/2014 - 12:05 | 4654086 ZeroFreedom
ZeroFreedom's picture

Both the Bankers and Pensioners need to get less otherwise it will not work. BK is suppose to clean up and give a fresh start not just put in a box the legacy practices which are not sunstainable. 

In any case go lone Detroit Muni's. 

Sun, 04/13/2014 - 12:14 | 4654051 whidbey-2
whidbey-2's picture

The whole question of municipal bankruptcy, or Chater 9 in the USBC, has been corrupted by hard bargains affecting the voters who think "they would not screw the children". This is especially dangerous when the current voters are the beneficiaries of the bankruptcy . Debt the next generation ! The only thing that keeps California from a debt collapse is that the debt solution disposses of the debt means "no further credit to the entity.... or a third party lockbox" to keep the legislature from intereving.  As things stand now debted states are running on TANs and are years ahead on tax receipts borrowing. Calif has borrowed against 2050 taxes in many cases. The problem with" Dumping tax anticipation bond holders"is that they never come back, instead they haggle with the legislatse about who gets paid first, not a court. The effect is to stop credit to cities, counties and states. But Wait? These entities run civilization and if they stop the civil government,  the economy stops?? The Dog chasing his tail in script.

 

  Boeing has stripped Everett, WA. and forces the WA leglisture to keep giving back taxes to BA. BA wants to keep cutting the corporation's state taxes, OR, they move away from its plants and jobs in Wa State to CA, Or, KS, NC and overseas.  The corporations and the legisture conspire to keep business taxes low, but the consumer in WA. is left  attempting to keep a job, while the state builds its debt.  How can it end?  Why.... we grow out of the debt, because Alice there is a Santa Claus.  The magic is growth.   Like hell Alice, you pay. OH my dear,  you are too young and dumb to know that Mom and Dad did it to you. Final scene is where all hell has broken loose and you keeping callingout to your parents - but they are now dead, laughting in paradise. You screw up... you trusted your parents!! Grow up schumks...............................

 Has the undertones of a Decline and Fall of something.

Sun, 04/13/2014 - 11:31 | 4653997 espirit
espirit's picture

Bottom Line:

Pensioners will go tits-up when the bail-in occurs.

No Change You Can Believe In.

Sun, 04/13/2014 - 11:27 | 4653991 joego1
joego1's picture

dog shit with cherry on top- There, all fixed.

Sun, 04/13/2014 - 11:25 | 4653985 NoTTD
NoTTD's picture
What a load of shit.   If BK can't discharge these fuckers, what's the point?  Just to screw the pensioners?   Not that I'm against screwing the pension leeches, but should't they go last as compared to morons who loaned Detroit money knowing it was bankrupt?  You don't have to look far to see the hand of Obama Cronyism in this.
Sun, 04/13/2014 - 10:56 | 4653921 Seasmoke
Seasmoke's picture

I really like Jamie Dimon. - Chris Whalen. 

Sun, 04/13/2014 - 10:57 | 4653919 AdvancingTime
AdvancingTime's picture

Bottom-ine may people will not get their money or far less than they origanly expected. If in the future Detroit has to pay more of the debts it owes recovery will be very slow.

Nations and governments around the world are up to their eyeballs  in debt. Prepare for our Government and others across the world to break promises and rewrite the rules. More about this subject in the article below.

http://brucewilds.blogspot.com/2012/06/fantasy-world-of-debt-and-more-li...

Sun, 04/13/2014 - 10:58 | 4653927 Seasmoke
Seasmoke's picture

Written almost 2 years ago. And yet here we are. Nothings changed. SSDD. 

Sun, 04/13/2014 - 10:40 | 4653875 Cloud9.5
Cloud9.5's picture

The reason to file bankruptcy is to get out from under unsustainable debt.  If that debt gets reinstated then it must be funded from general revenue.  Less money for school teachers, cops, judges court officials and whoever would attempt to collect this dept.   The last three remaining taxpayers in the city need to recognize their plight and go Galt.

Sun, 04/13/2014 - 20:24 | 4655305 sethstorm
sethstorm's picture

Or in the case of ALEC, to use debt as a political weapon.  If it's not there (WI, OH, etc.), they create it out of nowhere; if it's there, they use it (Michigan).

Sun, 04/13/2014 - 12:28 | 4654150 caconhma
caconhma's picture

What a nonsense.

More money for school teachers, cops, judges court officials and whoever would attempt to collect this dept? What a shitty mentality: just print more money and pay more to government parasites?

Sun, 04/13/2014 - 09:45 | 4653738 Reaper
Reaper's picture

This is the problem with case law or precedents being used in US court battles. There should be absolute law, not modified law by prior judges. Other countries legal systems do not use case law or precedents. In our corrupt stupid system, the law is not what was written, but what some prior judge whimsically or corruptly altered. Our system feeds lawyers to argue over precedents, rather than only the facts and the law.

Ignorance of the precedents is no excuse is the US law.

Sun, 04/13/2014 - 12:39 | 4654166 caconhma
caconhma's picture

"Our system feeds lawyers to argue over precedents, rather than only the facts and the law. " Right on the money!

This is the best post on the topic. The Law of the Land is irrelevent!

As long as the US government can indiscriminately print money and buy social tranquility, nothing will change. The good news is that this is coming to the end.

 

Sun, 04/13/2014 - 13:31 | 4654285 Crisismode
Crisismode's picture

 

 

It is???

 

When?

 

Sun, 04/13/2014 - 09:26 | 4653702 chunga
chunga's picture

blah..blah...blah

Chris Whalen Goes Off the Deep End, Issues Error-Filled Screed in Defense of Mortgage Servicers

I once had a good opinion of bank analyst Chris Whalen, despite having some reservations about him. But his error-filled screed against mortgage servicing regulations means he can no longer be taken seriously on the subject of banking. Whalen has become a textbook illustration of the Upton Sinclair saying, “It is difficult to get a man to understand something when his salary depends on his not understanding it.”

"Yves Smith" - Naked Capitalism - 3/31/2014

Sun, 04/13/2014 - 09:26 | 4653701 farragut
farragut's picture

Anyone want to guess at which TBTF (UBS or BAC) Mr. Orr will be given a plush and lucrative consulting job in 1-2 years?   :)

Sun, 04/13/2014 - 12:20 | 4654126 Fred Hayek
Fred Hayek's picture

We have bingo.

There will be a suitable intervening period and then Mr. Orr will be paid more than he could ever have expected. I wouldn't be surprised if he just *happened* to walk in the door as a party selling a beach house on the Jersey shore suddenly made a whimsical choice to sell it for much less than market value.

Sun, 04/13/2014 - 09:25 | 4653696 MillionDollarBoner_
MillionDollarBoner_'s picture

Sooo...this is BULLISH for stocks, right?

Sun, 04/13/2014 - 10:39 | 4653873 disabledvet
disabledvet's picture

Yeah, exactly. "Detroit is still bankrupt"...and so is Puerto Rico I might add.

So you're at the head of the line to collect zero. Big whupp.

Sun, 04/13/2014 - 12:04 | 4654081 Emergency Ward
Emergency Ward's picture

Talking about Puerto Rico, here's who takes the knockout punch for PR Govt Bonds:  Boxer Felix Tito Trinidad, who earned $90 million over his career and lost it all investing in PR Govt Bonds.  The bankers and brokers went home with the trading fees in their pockets (after they assured Tito that the bonds were safe as milk)....

https://sports.yahoo.com/news/puerto-rico-bond-crisis-leaves-boxing-cham...

Now, my guess is that the same brokers and bankers who originally promoted the bonds will operate on insider knowledge (about a US Govt bailout) and buy Tito's bonds for pennies on the dollar and after a year or so reap some huge profits.

Sun, 04/13/2014 - 14:27 | 4654422 max2205
max2205's picture

Where but USSA when losing means winning

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