Municipal Credit Research 7 August 2013
PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 19
Chapter 9 Begins With Detroits 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 a
discussion of the pension obligation certificates (POC), which we believe could be subject to the most
volatility 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 EMs Proposal for Creditors (from
$65 to $30-40). Absent an unforeseen development, we believe it is unlikely that the POCs will
return 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 FGIC
claim, recovery under the $2bn unsecured note, and subrogation rights on the note. As we believe
that 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 claim
and the value of the $2bn note. Setting aside outcomes adjudicated in court, we can also envision
an instance in which FGIC-insured POC holders are offered a settlement. Should this come to
fruition, investors are faced with the decision of either a short-term goal of certainty of payment or
a long-term goal of maximizing returns.
We also discuss the following classes of liabilities and their treatment in bankruptcy:
Water and Sewer: We believe that water and sewer bonds will likely retain special revenue status 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 differential
versus comparable indices near wides since January 2012.
State Aid Enhanced UTGO: Arguably the most secure of the four classes of GO debt, the state aid-enhanced UTGOs appear to have statutory lien status via the revenue sharing
enhancement. Additionally, if this were abrogated, the bonds could have special revenue
status in bankruptcy.
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 the
State Aid Enhanced LTGO: The state aid enhanced LTGOs appear to have statutory lien status via the revenue sharing enhancement. Should the lien on the bonds be abrogated, these bonds
would likely become unsecured.
Standalone LTGO: These are arguably the weakest of the four types of GOs available, with low likelihood of statutory lien or special revenue status. Additionally, as these appear to be more
difficult to source and certain issues are uninsured, investors may wish to consider other types
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 swap
security (if judged to be a standard revenue bond transaction) is not properly perfected.
Thomas Weyl +1 212 526 0751 firstname.lastname@example.org Sarah Xue +1 212 526 0790 email@example.com Ming Zhang +1 212 528 7055 firstname.lastname@example.org www.barclays.com
Barclays | Detroit: Chapter 9 Begins
7 August 2013 2
Overview The first court hearing on the Detroit bankruptcy was held on July 24, 2013. Two specific topics were covered: the status of conflicting state court objections to the bankruptcy filing and the extension of immunity to related parties such as the emergency manager (EM) and the governor of Michigan. In both cases, US Bankruptcy Judge Rhodes provided preliminary victories for the city, granting an injunction against any related suits being heard in state courts 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 be distracted by the several suits filed or to be filed in State Court opposing the action. Judge Rhodes ruled that municipal unions and others seeking to litigate grievances against the proposed fiscal restructuring of the city must bring said grievances and litigation to the US bankruptcy court. This decision is consistent with general bankruptcy theory, which holds that the idea of bankruptcy is to provide a single forum to manage the many issues involved in a financial restructuring. Current and potential litigants will have at least two main opportunities 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 to be determined being eligibility. The EM has requested that Judge Rhodes require objections to the filing (eligibility issues) to be filed within 30 days, which he has granted. This is fairly short period from what has occurred in other Chapter 9 bankruptcies. For example, the eligibility process took over nine months in the case of Stockton, California, and was fairly long and contentious in the Vallejo, California case. In Stockton, objections were filed several months after the commencement of bankruptcy.
At an early August hearing, Judge Rhodes began to solicit comments regarding his proposed timetable, which has Detroit moving through bankruptcy court fairly quickly. Specifically, he has proposed that the trial over Detroits eligibility be set for late October; this is ahead of the EMs proposal for a November deadline with regard to filing pre-trial briefs. Although Judge Rhodes is attempting to move the case along quickly, expectations of many issues of first impression are likely to result in several lengthy appeals and could prevent a speedy bankruptcy (with a September 2014 emergence date, as proposed by the EM). The judge has set 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 most contested Chapter 9 cases, as this is one of the few opportunities for creditors to force a trial and judicial ruling. Unions will likely bring state court arguments to be heard in US bankruptcy court, which may state that these arguments are issues to be determined at confirmation, rather than at an eligibility hearing. Bondholders, unions and other constituencies might object to eligibility on a good faith basis. 1 As in the Stockton bankruptcy, creditors may argue that the EM basically held forums for stating the case for his 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 faith were interrupted by creditors filing for court injunctions against his plan. In recent cases such as Stockton and Vallejo, the distressed fiscal condition of the city trumped creditors arguments against eligibility.
1 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 with regard to the impairment under the plan, has failed to obtain the agreement of said creditors but has negotiated in good faith, or fulfills some other conditions.
Barclays | Detroit: Chapter 9 Begins
7 August 2013 3
What happens to the liabilities? Given general interest in affected Detroit obligations, we detail debt and liabilities and discuss the relative strength or weakness of these structures in the bankruptcy. We caveat that the discussion herein is limited by the fact that there are several issues of first impression 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 these issues. Figure 1 provides a summary of these various classes of liabilities.
FIGURE 1 Summary of Debt and Long-term Liabilities at Stake in Detroits Bankruptcy
Borrower Our Sector
Designation Amt O/S ($mn) Insured Amt
($mn) EMs Proposed
Detroit Water & Sewer * Special Revenue 5,951 4,920 Secured
City of Detroit UTGO1 100 0 Secured
City of Detroit UTGO2 369 369 Impaired
City of Detroit LTGO1 379 0 Secured
City of Detroit LTGO2 161 93 Impaired
Pension Obligation Certificates Unsecured 1,452 1,452 Impaired
POC Swaps Dedicated Tax? 800 NA Secured
Pension 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) Designated as secured under the EMs plan, with distributable state aid enhancement. 2) Standalone without distributable aid enhancement. Designated as unsecured under the EMs plan. * The amount outstanding and enhanced amounts shown for Detroit Water & Sewer Bonds are as of June 30, 2012; all other amounts outstanding have been adjusted for issuance and principal payments through June 30, 2013. Source: City of Detroit June 14 Proposal for Creditors, Official Statements, Barclays Research