Detroit Files for Municipal Bankruptcy: Is this just the beginning?
Eric Kazatsky, Credit Analyst and Sean Simko, Managing Director, SEI Fixed Income Portfolio Management gave the following analysis:
Kevin Orr, the emergency manager for the city of Detroit, filed a 16-page petition with the U.S. Bankruptcy Court. Despite the headlines the filing has generated, it was not a surprise. Detroit’s situation has been slowly unfolding for some time. The move officially makes the city of Detroit the largest municipal bankruptcy case in United States history. The filing launches a 30-to-90-day process whereby the courts will have to determine whether the city is even eligible for Chapter 9 protection. (Chapter 9, Title 11 of the United States Code is a chapter of the United States Bankruptcy Code, available exclusively to municipalities to assist them with debt restructurings). The Chapter 9 move by Mr. Orr came after a tenuous month that saw him at odds with city creditors and other stakeholders, including pension funds and collective bargaining units.
Mr. Orr has stated repeatedly that his one goal was to restructure almost $20 billion of city liabilities, something that would require massive and shared sacrifice to achieve. He had proposed settling outstanding debt at close to 20 cents on the dollar and treating retirement benefits and general-obligation (G.O.) debt as unsecured obligations to creditors. During the past month of negotiations, Mr. Orr has only been able to reach a settlement with two creditors at seventy-five cents on the dollar. He has been fought along the way by unions and retirement funds, and was even sued this week in an attempt to block a Chapter 9 filing. (As we noted in our December commentary, Michigan’s emergency-manager statute throws up several impediments to effective fiscal restructurings.)
With so much at stake, this is going to be a long process. This is a city that has lost almost half of its population over the past 30 years and cannot even afford basic public services and simple maintenance on infrastructure. Instead of paying creditors in full, Orr would use $1.25 billion over the next decade to buy police cars and fire trucks, replace broken street lights, tear down burned-out homes, fight blight and improve city services, according to The Detroit News.1 Even Michigan Governor Snyder has conceded that the only way Detroit can begin to move forward is to shed some of the untenable debt that is strangling the city. What will happen next is truly anyone’s guess. However, it would seem appropriate for Mr. Orr to seek to implement his original debt-settlement plan in the forum offered by bankruptcy court.
1 Robert Snell et al, “Creditors to fight Detroit insolvency claim,” July 18, 2013, <http://www.detroitnews.com/article/20130718/METRO01/307180103#ixzz2ZS0yT5Iy> accessed on July 19, 2013.
The situation in Detroit is unique, because no other cities have seen such a brutal loss of both population and industry (and by extension, tax base). There are other cities struggling with legacy obligations—just this week, Moody’s sharply cut its rating on Chicago’s general-obligation debt, for example—but we do not see Detroit’s bankruptcy petition as a watershed moment that will spread across the municipal marketplace. While the filing sets a new precedent for municipal bankruptcies, we believe it is an isolated occurrence and not a harbinger or outbreak of a national problem. Detroit’s day of reckoning is the culmination of problems several decades in the making.
That said, we will continue to keep a close eye on how the city’s general-obligation debt and retiree benefits are treated and settled. Traditionally, the view around general-obligation bonds is that an issuer will step in and raise taxes as needed to ensure that creditors are made whole. In the 1970s, the federal government even stepped in to help New York City avoid bankruptcy. If Detroit’s general-obligation bonds are wiped out, it would be a notable departure from that precedent and could cast doubt on the sanctity of the tax pledge that helps underpin the municipal G.O. market. According to Moody’s Investor Services, historically, the ultimate recovery rate on defaulted U.S. municipal bonds was just under 65% for the period from 1970 through 2012.2 Mr. Orr’s plan would come in much lower than this figure. However, looking at the larger picture, even if the city were to raise taxes, the population of Detroit could not possibly afford it, given high poverty and unemployment levels and a long-eroding tax base. Either way, non-payment could be the end result, which would set an important and unsettling precedent for the G.O. market.