Bloomberg News

Detroit Bankruptcy Exit Plan Threatens Munis as Pensions Favored

February 01, 2014

"The Wedding Dance" by Pieter Bruegel the Elder

To protect the city’s collection of art masterworks, including "The Wedding Dance" (c. 1566) by Pieter Bruegel the Elder, foundations and the Detroit Institute of Arts have pledged $470 million. Source: Detroit Institute of Arts via Bloomberg

Detroit’s proposal to restructure its $18 billion of debt by paying pensioners at more than twice the rate of some municipal bondholders threatens to increase borrowing costs for localities throughout Michigan.

The draft plan given to creditors this week by Emergency Manager Kevyn Orr offers different recovery rates for classes of unsecured creditors. Pensions would get 45 to 50 cents on the dollar, though retiree health-care liabilities would recoup just 13 cents, according to the plan. By comparison, those who loaned $1.4 billion to shore up the two pension funds would receive 20 percent of their claims. Holders of $369 million in unlimited-tax general obligations would recover 46 percent.

Detroit’s latest proposal reinforces concerns in the $3.7 trillion municipal market about what Fitch Ratings called an “us versus them” mentality, favoring retired state workers over bondholders. Republican Governor Rick Snyder proposed the state pay $350 million over 20 years specifically for pensioners in its most populous city.

“If you’re a bondholder in the state of Michigan, every pledge should be viewed as a subordinate pledge going forward,” said Adam Mackey, head of munis at PNC Capital Advisors LLC in Philadelphia. “Ultimately you’re going to see Michigan debt be penalized.”

Faith Questioned

Detroit’s record municipal bankruptcy may set precedents for how retirees and bondholders are prioritized when a locality falls into distress. It’s poised to test the assumption in the municipal-debt market that states and cities will raise taxes as high as necessary to make full payments on bonds backed by their full faith and credit.

Detroit imposes all taxes allowed by state law, according to the Citizens Research Council of Michigan, which analyzes public policy.

Demand for bonds from Michigan municipalities dried up in the month after Detroit’s filing. At least three governments -- Genesee County, Battle Creek and Saginaw County -- postponed a combined $131 million of issuance in the face of higher borrowing costs.

State municipalities have found ample demand for their debt this year, selling at more than twice the pace of 2013. They’ve borrowed $426 million through Jan. 24, compared with $175 million over the same period last year, data compiled by Bloomberg show.

Michigan still pays the second-highest yield relative to benchmark AAA munis among the 17 states tracked by Bloomberg. Orr’s latest proposal will serve as a reminder of the state’s unwillingness to repay bondholders, Mackey said.

Long-Term Risk

“Detroit’s proposal would not be good for the municipal bond market in the long run,” said Chris Ryon, who helps oversee about $10 billion in local debt at Thornburg Investment Management in Santa Fe, New Mexico. If accepted, the plan would “probably cause credit spreads to widen,” he said.

Orr’s plan makes clear that unsecured creditors, with $9.2 billion in claims, would be treated differently in the bankruptcy, which came after the one-time industrial giant was unable to pay bills or provide adequate services. The proposal was given this week to creditors for feedback, as Orr prepares to submit a restructuring plan to federal bankruptcy court.

Payments would rise slightly if the city leases its water-and-sewer system to a new operator, netting $1.5 billion over 40 years. Orr is negotiating with suburban leaders to create a new regional water authority that would pay the city to operate a system that serves 40 percent of Michigan’s residents.

Opposing Creditors

While paying a better rate to pension claims, Orr’s plan would result in “painful cuts” to retirees which average $19,000 for those in the general employee system, said Jordan Marks, executive director of the Washington, D.C.-based National Public Pension Coalition.

“While Detroit’s communities would fall further behind, big banks will feel little pain as Wall Street posted record profits in 2013,” Marks said in an e-mailed statement.

The plan assumes an infusion of $700 million for the two pension systems from equal contributions by the state and private foundations. To protect the city’s collection of art masterworks, foundations and the Detroit Institute of Arts have pledged $470 million. Snyder proposed $350 million that the legislature must approve.

The deal to protect pensions and the art works without considering bondholders was panned by Fitch Ratings, which this week said it created a mentality in Michigan that pits citizens against those who loaned to the city.

BofA, UBS

The city has also proposed paying nothing to Bank of America Corp. (BAC:US) and UBS AG (UBS:US), who hold secured, interest-rate swaps that have cost taxpayers $202 million since 2009. The city says it disputes the legitimacy of the swaps but may set aside about $4.2 million a month in reserve in case a court finds them legal.

Bondholders would be repaid in the form of 30-year notes with a 5 percent interest rate.

Under the U.S. Bankruptcy Code, similar creditors are normally treated the same, which means that giving the pension funds more money than unsecured bondholders may be difficult to justify to a judge.

Orr’s latest plan increases money going to unsecured creditors compared with an offer he made in June, before the city filed for bankruptcy protection. That proposed treating pension funds and bonds the same, both getting pennies on the dollar.

Orr’s proposal also would create an independent trust for retiree health care. The trust would receive the $524 million to be paid under the settlement with unsecured creditors.

To contact the reporters on this story: Chris Christoff in Lansing at cchristoff@bloomberg.net; Brian Chappatta in New York at bchappatta1@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net


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