Municipal Credit Research
7 August 2013
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Detroit
Chapter 9 Begins
With Detroit’s Chapter 9 filing in late July, we look at the various liabilities involved in the bankruptcy,although it should be understood that this does not constitute legal advice. We begin with adiscussion of the pension obligation certificates (POC), which we believe could be subject to the mostvolatility over the course of the bankruptcy process. The FGIC-insured POC 2025s, for example,traded down meaningfully in dollar price after the release of the EM’s
Proposal for Creditors
(from$65 to $30-40). Absent an unforeseen development, we believe it is unlikely that the POCs willreturn to $60-70. We detail cases in which returns appear to be below 30 cents on the dollar.In our view, crucial determinants of recovery on the FGIC-insured POCs are recovery from the FGICclaim, recovery under the $2bn unsecured note, and subrogation rights on the note. As we believethat there is a high probability that FGIC may successfully argue for ownership of the $2bn note,returns to holders of FGIC-insured POCs are limited by the greater of the value of the FGIC claimand the value of the $2bn note. Setting aside outcomes adjudicated in court, we can also envisionan instance in which FGIC-insured POC holders are offered a settlement. Should this come tofruition, investors are faced with the decision of either a short-term goal of certainty of payment ora long-term goal of maximizing returns.We also discuss the following classes of liabilities and their treatment in bankruptcy:
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Water and Sewer
: We believe that water and sewer bonds will likely retain special revenuestatus in bankruptcy. Although the EM has proposed an exchange of the non-callable debt,which would result in market value impairment, we see impediments to its implementation.The AGM-insured water revenue 2033s offer value at current levels, with the YTW differentialversus comparable indices near wides since January 2012.
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State Aid Enhanced UTGO:
Arguably the most secure of the four classes of GO debt, the stateaid-enhanced UTGOs appear to have statutory lien status via the revenue sharingenhancement. Additionally, if this were abrogated, the bonds could have special revenuestatus in bankruptcy.
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Standalone UTGO:
We believe these bonds could have special revenue status in bankruptcy.Spreads on UTGO 2028s are trading 45bp off their YTD tights and 10bp away from theaverage.
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State Aid Enhanced LTGO:
The state aid enhanced LTGOs appear to have statutory lien statusvia the revenue sharing enhancement. Should the lien on the bonds be abrogated, these bondswould likely become unsecured.
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Standalone LTGO:
These are arguably the weakest of the four types of GOs available, with lowlikelihood of statutory lien or special revenue status. Additionally, as these appear to be moredifficult to source and certain issues are uninsured, investors may wish to consider other typesof debt.
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POC Swaps:
Risk factors regarding security for the POC swaps include potential invalidity of the POCs themselves, risk that the swap security is not special revenue, and risk that the swapsecurity (if judged to be a standard revenue bond transaction) is not properly perfected.
Thomas Weyl+1 212 526 0751thomas.weyl@barclays.comSarah Xue+1 212 526 0790sarah.xue@barclays.comMing Zhang+1 212 528 7055ming.zhang@barclays.comwww.barclays.com
Barclays | Detroit: Chapter 9 Begins7 August 2013 2
Overview
The first court hearing on the Detroit bankruptcy was held on July 24, 2013. Two specifictopics were covered: the status of conflicting state court objections to the bankruptcy filingand the extension of immunity to related parties such as the emergency manager (EM) andthe governor of Michigan. In both cases, US Bankruptcy Judge Rhodes provided preliminaryvictories for the city, granting an injunction against any related suits being heard in statecourts and extending the immunity from suits as requested.This decision means that the city parties (the city itself, the EM and the governor) will not bedistracted by the several suits filed or to be filed in State Court opposing the action. JudgeRhodes ruled that municipal unions and others seeking to litigate grievances against theproposed fiscal restructuring of the city must bring said grievances and litigation to the USbankruptcy court. This decision is consistent with general bankruptcy theory, which holdsthat the idea of bankruptcy is to provide a single forum to manage the many issues involvedin a financial restructuring. Current and potential litigants will have at least two mainopportunities to litigate their case: through the eligibility process and at plan confirmation.Initially, there will be some administrative or procedural hearings, with the first real issue tobe determined being eligibility. The EM has requested that Judge Rhodes require objectionsto the filing (eligibility issues) to be filed within 30 days, which he has granted. This is fairlyshort period from what has occurred in other Chapter 9 bankruptcies. For example, theeligibility process took over nine months in the case of Stockton, California, and was fairlylong and contentious in the Vallejo, California case. In Stockton, objections were filedseveral months after the commencement of bankruptcy.At an early August hearing, Judge Rhodes began to solicit comments regarding his proposedtimetable, which has Detroit moving through bankruptcy court fairly quickly. Specifically, hehas proposed that the trial over Detroit’s eligibility be set for late October; this is ahead of theEM’s proposal for a November deadline with regard to filing pre-trial briefs. Although JudgeRhodes is attempting to move the case along quickly, expectations of many issues of firstimpression are likely to result in several lengthy appeals and could prevent a speedybankruptcy (with a September 2014 emergence date, as proposed by the EM). The judge hasset a mid-March 2014 deadline for the city to file its plan of adjustment.Overall, we expect a vigorous fight over eligibility. There are eligibility hearings in mostcontested Chapter 9 cases, as this is one of the few opportunities for creditors to force atrial and judicial ruling. Unions will likely bring state court arguments to be heard in USbankruptcy court, which may state that these arguments are issues to be determined atconfirmation, rather than at an eligibility hearing. Bondholders, unions and otherconstituencies might object to eligibility on a good faith basis.
As in the Stocktonbankruptcy, creditors may argue that the EM basically held forums for stating the case forhis restructuring proposal and that there were little real negotiations (let alone good faith)in the conduct of the forums. The EM has claimed that his efforts to negotiate in good faithwere interrupted by creditors filing for court injunctions against his plan. In recent casessuch as Stockton and Vallejo, the distressed fiscal condition of the city trumped creditors’arguments against eligibility.
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Section 109(c)(2) of the bankruptcy code establishes the following requirements for a debtor to file for Chapter 9:the entity 1) must be a municipality as defined under state law; 2) has specific authorization to file; 3) is insolvent; 4)wants to adjust its debts through a plan; and 5) has obtained the agreement of majority of creditors in each class withregard to the impairment under the plan, has failed to obtain the agreement of said creditors but has negotiated ingood faith, or fulfills some other conditions.
Barclays | Detroit: Chapter 9 Begins7 August 2013 3
What happens to the liabilities?
Given general interest in affected Detroit obligations, we detail debt and liabilities anddiscuss the relative strength or weakness of these structures in the bankruptcy. We caveatthat the discussion herein is limited by the fact that there are several issues of firstimpression that are expected to be ruled on by the bankruptcy judge. Our discussion of strengths and weaknesses is produced prior to the potential courtroom arguments of theseissues. Figure 1 provides a summary of these various classes of liabilities.FIGURE 1
Summary of Debt and Long-term Liabilities at Stake in Detroit’s Bankruptcy
BorrowerOur SectorDesignation Amt O/S ($mn)Insured Amt($mn)EM’s ProposedStatus
Detroit Water & Sewer * Special Revenue 5,951 4,920 SecuredCity of Detroit UTGO
1
100 0 SecuredCity of Detroit UTGO
2
369 369 ImpairedCity of Detroit LTGO
1
379 0 SecuredCity of Detroit LTGO
2
161 93 ImpairedPension Obligation Certificates Unsecured 1,452 1,452 ImpairedPOC Swaps Dedicated Tax? 800 NA Secured9,213 6,833Pension Claim (in EM plan) 3,474 NA Impaired?OPEB Claim (in EM plan) 5,718 NA Impaired?
Note: UTGO stands for unlimited tax general obligation; LTGO stands for limited tax general obligation. 1) Designatedas secured under the EM’s plan, with distributable state aid enhancement. 2) Standalone without distributable aidenhancement. Designated as unsecured under the EM’s plan. * The amount outstanding and enhanced amountsshown for Detroit Water & Sewer Bonds are as of June 30, 2012; all other amounts outstanding have been adjusted forissuance and principal payments through June 30, 2013. Source: City of Detroit June 14 Proposal for Creditors, OfficialStatements, Barclays Research
Figure 2 shows the spread movements in selected Detroit credits year-to-date. For themajority of this period, the unlimited tax general obligation (UTGO) bonds appear to havetraded with a combination of credit concern and standard market movement. In June,spreads on the UTGO bonds widened with the announcement of the EM’s restructuringFIGURE 2
UTGO (unenhanced) 2028s vs. LTGO (enhanced) 2035s and Water Revenue 2033s (bp),Spread above AAAs (bp)
Note: LTGO 2035s are enhanced with distributable state aid. Source: Barclays Research
50100150200250 Jan-13Feb-13Mar-13Apr-13May-13Jun-13Jul-13Aug-13UTGO (standalone, A3/AA-/C) 2028sLTGO (with distributable state aid, AA3/AA/NR) 2035sWater Revenue (AGM-insured, A2/AA-/BBB) 2033s
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