Motor City Finally Hits Bankruptcy

Yesterday, December 3, 2013, a federal judge ruled that the city of Detroit met the legal criteria to file for relief under chapter 9 of the Bankruptcy Code and win protection from its creditors. The city filed for bankruptcy this past July.

United States bankruptcy judge Steven Rhodes effectively ruled that the city had demonstrated enough evidence to meet the test of insolvency. As a recap, remember that this is a city that has seen its population shrink from 1.8 million to 700,000 people in 35 years. The pension costs of earlier generations are being supported by a diminishing work force; there are ballooning annual deficits, a tax base that is decreasing substantially, and borrowing on top of borrowing. Detroit is by far the largest US city to declare bankruptcy. It is struggling with approximately $18 billion in debt and long-term obligations.

Among the judge’s findings were that (1) the city is, for all purposes, insolvent and has filed bankruptcy in good faith (this is important, as it means that cities cannot resort to bankruptcy on a whim) and (2) that pensions can be impaired (like other contracts) during a bankruptcy proceeding.

Clearly, the key in the bankruptcy language is that creditors will be treated fairly and equitably. When the city comes back with a further plan of adjustment, the negotiations will start. For most of the time period since the city filed in July, municipal unions have argued that pensions are protected under Michigan law. In this case, it would seem that the judge is saying that federal law supersedes state law.

What does this federal ruling mean, going forward?

Our first-glance opinion is that the city will continue to enjoy the protection afforded by chapter 9 of the Bankruptcy Code without being impeded by creditors. It also means that all unsecured creditors – pensioners, unsecured (read: general-obligation) bondholders, and vendors – are subject to haircuts. The judge did go out of his way to say that the court will be very careful in exercising the power to impair pensions. This is an important point since, in some other states (notably California), some cities in bankruptcy proposed paying pensions even though they were cutting other debt.

The idea is for the city to be able to provide basic services – fire, police, and emergency services, as well as basic municipal services – and to be able to get back on a more solid financial footing and begin rebuilding. The kind of investments in the infrastructure that Detroit will need – from businesses, universities, and the state itself – will remain problematic. But to the extent it can happen, that investment will take place in an environment that is less financially crushing than the current one.

Bondholders, at first glance, would seem marginally better off as a result of the ruling. In other words, it doesn’t appear they are being put behind other classes of creditors (read: unions). There has been very little trading in Detroit’s general-obligation bonds since the city filed in July. Five-year general-obligation bonds (unsecured) are trading in the 6.90-7% range, compared to 1.25-1.50% for high-grade tax-exempt bonds. The general trend over the past two months has been a slight decrease in yields and a pickup in prices from the low levels going into bankruptcy. At the margin the ruling would also appear to benefit municipal bond insurers who have insured some of the city’s debt. They now have another partner (unions) to help craft a solution.

The ruling does reinforce the benefit of having liens on essential services such as water, sewer, and transportation. General-obligation bonds of all sorts have for years been considered among the safest classes of debt. But as we see with Detroit, in the case of the unthinkable – bankruptcy – the general-obligation bondholder becomes essentially an unsecured creditor. However, water and sewer bonds, secured by revenue streams, continue to be paid (although, as we have often mentioned, this provision doesn’t forestall a drop in the value of bonds due to headline risk).

We will be watching developments closely. It would appear that this decision will reinforce some discipline among all parties involved in trying to craft a solution for Detroit, and will also affect other municipal entities grappling with problems such as pensions and other post-employment benefits. The State of Illinois passed a $160 billion pension rescue bill yesterday. The bill includes a number of measures, including limiting cost-of-living adjustments (COLA) in pensions and raising the retirement age for workers. In our opinion, the best aspect of the Illinois plan is that the legislature actually passed it. It was their sixth attempt in 16 months to approve some sort of pension reform in the state with the worst problems. If a solution can begin to be crafted in Illinois – even if it will certainly be challenged in the courts – then there is reason for optimism going forward.

Cumberland Advisors has not owned Detroit general obligation municipal bonds in portfolios in many years because of the clear credit risks and headline risks. We recently started to own Illinois state general obligation bonds again this summer as it appeared that progress was being made and that bonds were priced appropriately given the risks.

We will keep readers informed.

BY John Mousseau