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 [14]. His email is michael.comes@cumber.com [15].
Of note, last week, the NYT reported [16]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
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