Download pdf - Barclays Municipal Research Detroit - Chapter 9 Begins

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 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 EM’s 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

average.

• 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

of debt.

• 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 [email protected] Sarah Xue +1 212 526 0790 [email protected] Ming Zhang +1 212 528 7055 [email protected] 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 Detroit’s eligibility be set for late October; this is ahead of the EM’s 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.


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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 Detroit’s Bankruptcy

Borrower Our Sector

Designation Amt O/S ($mn) Insured Amt

($mn) EM’s Proposed

Status

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

9,213 6,833

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 EM’s plan, with distributable state aid enhancement. 2) Standalone without distributable aid enhancement. Designated as unsecured under the EM’s 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

Figure 2 shows the spread movements in selected Detroit credits year-to-date. For the majority of this period, the unlimited tax general obligation (UTGO) bonds appear to have traded 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 restructuring

FIGURE 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

50

100

150

200

250

Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-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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proposal that claims that the UTGO bonds are unsecured obligations in a bankruptcy. In June, spreads on the water revenue bonds widened as well. Arguably, there would have been no widening in the latter if not for the proposed forced exchange into a weaker credit structure, as the EM’s restructuring proposal treats this special revenue debt as unimpaired.

The following sections explore each particular debt or liability line item in more detail. With the exception of the POCs and the POC swap contracts, the order of the following sections indicates our belief of the capital structure and relative rankings of the various liabilities in a bankruptcy.

Pension Obligation Certificates Figure 3 provides a breakdown of the various series of pension obligation certificates.

FIGURE 3 POC Breakdown

Pension Obligation Certificates Amt O/S ($mn) Interest Rate Maturity Date Insurer

Series 2005-A 503 4.503 - 4.948 6/15/13-25 FGIC/Syncora

Series 2006-A 149 5.989 6/15/35 FGIC

Series 2006-B 800 Variable 6/15/29-34 FGIC/Syncora

1,452

Source: 2005 and 2006 POC Official Statements, City of Detroit June 14 Proposal for Creditors, Bloomberg, Barclays Research

POC Security The POCs are unsecured. There has been some market discussion that perhaps there is a stronger legal pledge backing the POCs than the statement found on Page 7 of the 2005 Official Statement, which says, “The city’s obligation to make COP Service Payments are unsecured contractual obligations of the City, enforceable in the same manner as any other contractual obligation of the City.” However, our analysis of the lien status does not seem to provide any additional argument that POC holders (or insurers) may use to attempt to enhance their claim.

Risk Factors to Treatment Investors may believe that the POC debt may have statutory lien status in bankruptcy, as the Official Statements for the 2005 and 2006 certificates state that “Article 9, Section 24 of the State Constitution obligates the City to contribute sufficient funds to the GRS and PFRS to maintain their actuarial integrity.” However, this statutory obligation applies only to the unfunded liabilities, rather than to the debt itself. Thus, we believe that the connection between the statutory obligation and the POC debt is tenuous, and we have not found evidence of an enabling statute that would convey statutory lien status to the debt itself.

Additionally, various creditor constituencies may challenge the validity of the POC debt, particularly as the EM’s proposal “has identified certain issues related to the validity and/or enforceability of the COPs that may warrant further investigation.” We believe that the identified issues relate to whether a Michigan municipality is authorized to issue bonds to fund pension payments and whether the specific structure of the Service Corporations issuing debt for a municipal obligation was or is valid under Michigan law.

As discussed in prior publications, the lack of proposed return to unsecured creditors provides an incentive for unsecured creditors to challenge other creditors’ status. In this case, there are additional potential benefits of successfully challenging the validity of the COPs. In addition to the obvious opportunity to eliminate a large share of the unsecured


7 August 2013 5

pool, there is the added benefit of potentially eliminating the POC swaps. This action could add roughly $50mn per year in excess cash flow available for unsecured creditors.

Relative Value The dollar price on POCs (those insured by FGIC) declined sharply around the time of the EM’s June 14 Proposal for Creditors. For example, just before the release of the proposal, the POC 2025s traded at $65; following its release, prices declined meaningfully, to $30-40 (Figure 4). We believe that these bonds will likely not return to the $60-70 context, in light of their relative ranking on the capital structure and payments designated under FGIC’s plan of rehabilitation.

Floating rate Syncora POCs are not eligible for the Barclays Municipal Index or the Barclays High Yield Municipal Index. We also were unable to locate trades of any size pertaining to Syncora POCs in the past year.

FIGURE 4 POC 2025s and 2035s, Dollar Price

Source: Barclays Research

Pension Obligation Certificate Swaps Figure 5 shows characteristics of the pension obligation certificate swaps.

FIGURE 5 POC Swaps

Amt O/S

($mn) Fixed Rate

Paid Rate

Received Maturity Date

of Bonds

POC Swaps 800 6.32-6.36 Variable 6/15/29-34

Source: 2005 and 2006 POC Official Statements, City of Detroit June 14 Proposal for Creditors, Bloomberg, Barclays Research

POC Swap Security Initially, the POC swaps were unsecured obligations. Following a termination event in 2009, the city negotiated a forbearance agreement with its swap counterparties, adding security (a pledge of casino tax revenues) to the swaps in return for the swaps remaining outstanding. In his Proposal for Creditors, the EM states that “although this proposal reflects treating the swap obligations as special revenue debt secured by the wagering tax revenues, that treatment is still being reviewed by the Emergency Manager.”

$-

$10

$20

$30

$40

$50

$60

$70

$80

Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13

Pension Obligation (FGIC) 2025s Pension Obligation (FGIC) 2035s


7 August 2013 6

The statement that the treatment is still being reviewed is intriguing in a similar manner to the comment regarding the validity of the POCs. In the Proposal for Creditors, it appears as if the EM is trying to create negotiating leverage with certain creditors, including the holders of POCs and the POC swap counterparties. In the process, he is also leaving a roadmap for other unsecured creditors in their attempt to increase returns by knocking out other claims.

Risk Factors We see three basic risk factors regarding the security for the POC swaps:

• Potential invalidity of the POCs themselves

• Risk that the security is not special revenue

• Risk that the security, if not special revenue, is not properly perfected

Potential Infirmities Regarding the POC Swaps In this case, there are potential infirmities regarding the POC swaps, including the validity of the POCs themselves and the lien status of the casino tax revenues pledged to the swap counterparties. If it is determined that the POCs were not validly issued, then it is possible that the swaps might be voided as an obligation. As far as lien status is concerned, it is possible that the proper lien status is not special revenue; if the lien is judged to be that of a standard revenue bond transaction, then there is a chance that the lien is not properly perfected.

To evaluate the claim of special revenue status for the swaps, we consult the same reference material quoted in earlier sections, Municipalities in Distress. The definition of special revenues appears to support this argument. Definition (B) reads as follows: “special excise taxes imposed on particular activities or transactions.” The accompanying text expands this definition as follows: “An excise tax on hotel and motel rooms or the sale of alcoholic beverages would be a special excise tax under Clause (B). ‘Special Excise Taxes’ are taxes specifically identified and pledged in the bond financing documents and are not generally available to all creditors under state law.” The case for special revenue treatment appears strong until the last phrase. Here, the casino taxes are generally available to all creditors, making it at least questionable whether the swaps are special revenue.

If the swap security is deemed to be a standard revenue bond security, then the value of the pledge security will be substantially reduced. Special revenue bond treatment is thought to mean that the bondholders are fully secured because the lien is a replacement lien that continues in place until the bonds are paid in full. In contrast, the security for a standard revenue bond transaction in bankruptcy is valued as of the filing of the bankruptcy and may be at a level considerably less than par on the bonds. The revenue pledge essentially means that the value of the security equals the value of receivables at the time of the filing plus any cash on hand in a creditor-controlled bank account. In this case, there is a collateral or custody arrangement, in which daily casino tax receipts flow to the custody account in the control of the creditors. Thus, the value of the security will effectively be the amount of cash on hand in this account on the date of filing.

Actions Taken by EM and Swap Counterparties Indicate Differing Views on Whether the POC Swaps Should Be Treated as Special Revenue Days before filing for Chapter 9, the city entered into a settlement with its swap counterparties. Under this, the city may choose to terminate the swaps and pay 75% of the value of the swap termination payment through October 31, 2013; 77% between November 1 and November 15; and 82% between November 16, 2013, and March 13, 2014.

We find this settlement (and developments leading up to it) revealing. While fighting the special revenue argument with the UTGO, the EM appears to have conceded the special


7 August 2013 7

revenue argument to the swap counterparties by offering them at least 75 cents on the dollar. We believe there are several actions taken by the swap counterparties that actually indicate a lack of comfort with the strength of the special revenue argument. The first is the specific treatment of the revenue under that 2009 transaction, based on the July 2013 Forbearance Agreement; the second is the fact that a supposedly fully secured creditor group would choose to enter into a settlement agreement with the EM that could lead to a loss of up to 25% of potential claims.

The swap counterparties indicated a level of concern about this special revenue bond treatment when they structured the enhancement in 2009. The documents recently filed with the bankruptcy court to approve the new forbearance agreement do not claim special revenue bond status. Instead, the 2009 enhancement indicates a standard commercial security transaction. There is a material difference in value of the security between special revenue and standard revenue bond treatment. Special revenue bond treatment means payment in full, as the automatic stay is not in force and the creditor lien continues. In a standard commercial revenue transaction, the value of the security is determined at the time of filing. The difference here is very large, as the secured position as of the date of filing is potentially as low as $14mn, versus a swap termination fee of $296.5mn and a notional amount of $800mn.

The Settlement Appears to Be in Favor of the Swap Counterparties The EM claims that the settlement is in the best interest of the city because it provides access to the casino tax revenues. Undoubtedly, the casino revenues are important for the city. However, as either a special revenue pledge or a standard revenue pledge, the city would still have access to these revenues during the bankruptcy. Casino tax revenues are $170-180mn per year, while the swap interest payments are about $50mn. Thus, after swap payments, there would still be a significant amount of excess revenues available to the city. Additionally, we believe that the city had already effectively obtained access to these revenues, subject to adequate protection, through a state court injunction combined with the automatic stay.

In return for “access” to the casino tax revenues, the EM pledges not to challenge the validity of the POC transaction. In this settlement, the city gained access to revenues to which it already had access, while the swap counterparties received a large return via special revenue treatment, plus a covenant not to challenge the validity of POC debt. This is one-sided treatment in favor of the swap counterparties.

Ultimately, we expect the judge to approve the swap settlement or rule that his approval is not needed under Chapter 9 legal doctrine. However, should the UTGO ultimately be treated as unsecured while the swaps receive a more favorable settlement of at least 75% of claims, then one could argue that the swaps received special treatment. Thus, the settlement might become a confirmation issue, as the plan may not be confirmable if the swap settlement evidences preferential status to a group of creditors. The preferential treatment here may represent a plan infirmity.

Returns on the $2bn Note Figure 6 shows three hypothetical cases involving the unsecured claims pool. In claims pool 1, we take the unsecured claims pool as designated by the EM but remove the UTGO claim. While the secured special revenue status of UTGO will need to be adjudicated, the argument is very similar to the evidence backing the status of revenues pledged to the swaps; thus, we are treating this debt as secured. In claims pool 2, in addition to the removal of the UTGO claim from the unsecured pool, we reduce the size of the pension and OPEB claim to $1bn each. In this case, we use the $1bn amount as a placeholder for pension and OPEB claims, rather than the EM’s designated amounts, because claims should be valued as the change in benefit given


7 August 2013 8

to a pension/OPEB recipient. This $1bn placeholder for pension claim is considerably closer to the true unfunded pension liability, which is estimated to be in the range of $900mn-$1bn. The $1bn in OPEB claim represents our estimate of the unfunded liability arising from the proposed change in insurance. Finally, claims pool 3 removes the OPEB claim altogether, because of “double-dip” issues previously discussed in A Chapter 9 in the Making? Most Frequently Asked Questions (July 2013).

FIGURE 6 Unsecured Claims Pool Hypothetical Scenarios

Amounts in $mn Claims Pool 1 Claims Pool 2 Claims Pool 3

UTGO 0.0 0.0 0.0

LTGO 161.0 161.0 161.0

POC Principal 1,428.8 1,428.8 1,428.8

Pension 3,474.0 1,000.0 1,000.0

OPEB 5,718.3 1,000.0 0.0

Other 298.2 298.2 298.2

11,080.3 3,888.0 2,888.0

Source: Emergency Manager June 14 Proposal for Creditors, Barclays Research

Recall that the EM proposes to provide a $2bn note to unsecured creditors. We now explore the sensitivity of returns for that $2bn note should UTGO debt receive secured special revenue treatment. Figure 7 builds on Figure 6 and shows a range of potential returns (in PV terms) on that $2bn note as a percentage of the hypothetical unsecured claims pools 1-3. Case A of Figure 7 shows the present value of the note assuming that it is paid down according to the EM’s formula, without blight grants or asset sale adjustments. Case B shows the present value of the note assuming pay-down according to the EM’s formula, with blight grants and asset sale adjustments built in. Case C shows a cash flow sweep scenario, including blight grants and asset sale adjustments. We use a 10% discount rate in discounting projected cash flows.

FIGURE 7 Sensitivity of Returns on $2bn Note using Different Assumptions and Claims Pool Sizes

Claims Pool

PV on $2bn Note: Claims Pool 1 Claims Pool 2 Claims Pool 3

Case A 2% 7% 9%

Case B 5% 13% 17%

Case C 8% 22% 29%


Using these assumptions, we arrive at returns of 2-29 cents on the dollar on the $2bn note as a percentage of claims. In claims pool 1 and case A, returns are minimal because we follow the EM’s restrictive pay-down formula and assume no asset sales or blight grants; the unsecured claims pool remains similar to the EM’s proposal, though UTGO creditors are treated as secured. In claims pool 3 and case C, the 29 cent PV assumes that unsecured creditors are able to negotiate a cash flow sweep for the claim and the size of the pension claim is significantly reduced, while OPEB claims are eliminated altogether. We caveat that these scenarios are not meant to forecast actual recoveries on the $2bn note. Instead, we intend to provide a sense of how:

• A reduced claims pool meaningfully enhances returns, particularly as pension/OPEB claims are lowered. The status of the UTGO claim is ultimately subject to judicial determination.

https://live.barcap.com/go/publications/content?contentPubID=FC1944826



7 August 2013 9

• A negotiated change in the payment methodology on the $2bn note also improves returns, with a cash flow sweep particularly beneficial to noteholders.

We emphasize that any return above that shown in Case A/Claims Pool 1 is highly dependent on unsecured claimants’ securing litigation and negotiation victories; these results are highly uncertain.

Bond Insurance Considerations One key factor to returns to bondholders in the Detroit bankruptcy will be bond insurance. We partition the discussion of insurers into groups based on rating and payment status: we are not concerned about the payment status of bonds insured by Assured, MBIA/NPFG and the general account of Ambac, based on the combination of their investment grade ratings, claims-paying status and relatively strong capital base. We differentiate FGIC and Syncora based on their history of payment moratoriums, thin capital base and partial payment status (in the case of FGIC). Some may question the categorization of Syncora with FGIC. However, Syncora has exposure to Detroit twice the amount of its capital base (roughly $800mn in POCs, POC swaps and UTGO, versus capital of $400mn). Although Syncora made the recent payment on the defaulted POCs, we remain concerned about payment in full from Syncora. One insurer that we did not mention is BHAC, or Berkshire Hathaway. However, its exposure to Detroit is through either reinsurance or wraps on sewer bonds that are not impaired. Therefore, we see no meaningful role for BHAC in this case.

Overall, Detroit provides an opportunity for bond insurers to remind the market of the value proposition of credit enhancement in a muni bond insurance contract. Of those firms involved in Detroit, this benefit will mostly accrue to the active insurers and NPFG, which is attempting a comeback. Interestingly, while not involved in Detroit, Build America Mutual (BAM) and Municipal Assurance Corp (MAC) also stand to benefit from the other firms’ promotion of the aforementioned value proposition.

FIGURE 8 Uninsured versus Insured Debt in Detroit

Debt Uninsured ($mn) Insured ($mn)

Water Revenue Bonds 501 2,056

Sewer Revenue Bonds 0 2,864

UTGO State Aid 100 0

UTGO Standalone 0 369

LTGO State Aid 379 0

LTGO Standalone 68 93

POC 0 1,452

1,048 6,833

* 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

Per the EM’s classification of debt as secured or unsecured, there is roughly $630mn of GO debt at risk as unsecured. Of this amount, only $68mn is not insured and, therefore, truly at risk. However, when we drill down in the insured categories, we find $34mn in UTGO insured by Syncora. We expect current payments to be made by Syncora, but questions regarding full coverage remain.


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A significant area of concern is the POCs, as 100% of these are insured by FGIC and Syncora, with FGIC responsible for $1.1bn, or roughly 75%. We focus on FGIC because its payment status is relatively certain, given its rehabilitation plan.

The FGIC Plan Under FGIC’s plan of rehabilitation, holders of permitted claims receive recovery in the form of an upfront cash payment based on a cash payment percentage (CPP) of the claim. The remaining portion of the claim is designated as a deferred payment obligation (DPO) meant to capture excess cash flow over time. Overall, the plan is designed to ensure that policyholders receive the same recovery on their permitted claims, regardless of when that claim arises. FGIC’s plan of rehabilitation includes base and stress scenarios valuing the recoveries on the claims.

Based on expected payments through 2052, estimated recoveries under FGIC’s base case scenario are 22 cents on the dollar in present value terms (based on a 10% discount rate) or 34 cents in gross terms. The stress scenario values the recoveries at 15 cents on the dollar in present value terms or 19 cents in gross terms. Figure 9 shows estimated recoveries under FGIC’s plan at different discount rates under various scenarios.

FIGURE 9 Estimates of Gross Recovery under FGIC Plan of Rehabilitation

Discount Rate Base Scenario Recovery Stress Scenario Recovery

0% 34.2% 19.1%

10% 21.6% 15.1%

15% 20.4% 15.0%

20% 19.7% 15.0%

Note: Recoveries shown are our approximations only. Source: FGIC Plan of Rehabilitation, Barclays Research

There are several key questions that holders of FGIC-insured POCs may wish to consider:

What are the potential legal outcomes, and how do they affect recovery for holders of FGIC-insured POCs? Figure 10 shows four basic potential legal outcomes to holders of FGIC-insured POCs. In Outcome 1, they are deemed invalid and receive no return, as FGIC also deems the claim invalid. In Outcomes 2a and 2b, holders receive recovery from FGIC, and FGIC retains the pro rata share of recovery on the $2bn note, as the insurer successfully argues for subrogation rights to recoveries. In Outcome 2a, recovery from the FGIC claim exceeds recovery from the $2bn note; bondholder recovery is equal to the value of the FGIC claim. In Outcome 2b, recovery on the $2bn note exceeds recovery from the FGIC claim; bondholder recovery is equal to the value of the note itself, as the FGIC Plan of Rehabilitation states that any recovery above that which FGIC pays out will be paid back to bondholders. Finally, in Outcome 3, holders of POCs receive recovery from the FGIC claim and retain their pro rata share of the $2bn note, as the judge rules that FGIC does not to have subrogation rights to own the note.


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FIGURE 10 Potential Outcomes to FGIC-insured POC holders

(1) Nullification (2a) FGIC Gets the Note (2b) FGIC Gets the Note (3) FGIC + Note

Ownership of $2bn note is immaterial

Value of FGIC claim > Value of $2bn note.

Value of FGIC claim < Value of $2bn note.

Ownership of $2bn goes to bondholders.

Return = 0% PV return of 15-22% of claims based on FGIC's projection in its rehabilitation plan. FGIC will likely argue that the unsecured claim return is its property.

Return: Current estimate of 2-29% of claims as shown in Figure 8. We believe this may be enhanced (i.e., by continuing the water & sewer fund pro rata share payments).

Return comes from FGIC claim and $2bn note, minus the return on the note that is owed to FGIC, as indicated by the Plan of Rehab. This result is achieved if the unsecured claim return is the property of current bondholders.

Source: FGIC Plan of Rehabilitation, City of Detroit Proposal for Creditors, Barclays Research

In our view, outcomes 2a and 2b are higher probability, while outcomes 1 and 3 are lower probability. FGIC would receive its pro rata share of the $2bn note if the outcome in the Las Vegas Monorail case (discussed below) repeats here and based on the subrogation rights contained in the FGIC Plan of Rehabilitation. These outcomes would occur if there is not a settlement.

Who gets the proposed recovery note from the bankruptcy? While it may seem obvious that the note will belong to bondholders, it is not so simple. In general, bond insurers will likely argue that as long as they are paying claims, they have subrogation rights to recoveries. This argument is relatively straightforward in the case of an insurer such as Assured and the UTGOs (if they remain unsecured). Assured is making payments in full. By the time that the bankruptcy is concluded and the notes are distributed, Assured will have made several years worth of payments and accrued substantial subrogation rights. Under the restated policies from the rehabilitation procedure confirmed by a New York State court, FGIC also has subrogation rights and is in full compliance with its policy obligations even though it is paying only a portion of claims. We expect FGIC to argue that it owns the note under its policy. In a comparable case (the Las Vegas Monorail, which we discuss below), the recovery rights were not assigned to bondholders.

What is the timing of claims, insurance payments and recoveries? The timing of claims, insurance payments, and recoveries may become an important consideration for POC holders at some point. We know of only one similar municipal bond distressed transaction that included a bond insurer in regulatory rehabilitation proceedings: the Las Vegas Monorail. In that case, Ambac offered to commute the policy. The trade-off faced by bondholders in the Monorail case was one of taking significantly less in current dollars (settling bondholders) or waiting to receive a much higher payout (NPV) over a considerable time (non-settling bondholders). Settling bondholders in the transaction were given the right to receive the underlying recoveries. Non-settling bondholders receive their payout over roughly 40 years (from Ambac), though realistically the run-off of the Ambac book will likely be accelerated. Figure 11 provides a summary of expected recoveries to bondholder in the case, settling and non-settling.

This case highlights an important consideration for FGIC-insured Detroit POC holders. Setting aside the four legal outcomes discussed earlier, investors may encounter a situation in which they may be presented with a settlement. In the Las Vegas Monorail case, investors with a longer-term focus preferred to take the non-settling option, as returns were maximized even without investors obtaining recovery rights to the note. Those with a shorter-term focus opted to settle, receiving a much lower recovery despite retaining rights to the note. In the case of this settlement, retaining rights to the note actually did not result in maximum return to the bondholder. Ultimately, it is difficult to forecast what may occur with the FGIC-insured POCs, and investors are encouraged to consult counsel and perform their own analyses with any new developments.


7 August 2013 12

FIGURE 11 Summary of Recoveries in the Ambac-insured Monorail Case

Non-settling Bondholder Settling Bondholder

Ambac Rehab Monorail Commutation

Current Claim Payments 25% 22 - 24%

Deferred 75% 0%

Recovery on Underlying Obligation 0% 3% gross

Valuation 40-60 cents NPV initially 24-26% NPV

Current Status Valuation trending higher as commutations are done at levels that are additive to Ambac. Surplus Notes,

representing deferred claim against Ambac, are currently quoted at 92 ½ - 93 ½.

Valuation of monorail trailing lower as payments from the monorail are being made through issuance

of additional notes


Water and Sewer Bonds Figures 12-13 provide a breakdown of Detroit water and sewer revenue debt.

FIGURE 12 Water Revenue Debt Breakdown by Insurer

Insurer Amt O/S ($mn) Interest Rate Maturity Date

Water Revenue Bonds

FGIC 685 3.40 - 6.50 7/1/12-35

MBIA 623 Variable/4.00-6.00 7/1/12-33

Assured Guaranty/FSA 748 3.00 - 7.00 7/1/12-36

NA 501 2.496 - 5.75 7/1/12-41

2,556

State Revolving Loans 23

Total 2,579 Note: As of June 30, 2012, and not adjusted for issuance/pay-downs thereafter. Source: City of Detroit June 14

Proposal for Creditors, Bloomberg, Barclays Research

FIGURE 13 Sewage Disposal Revenue Debt Breakdown by Insurer


Sewage Disposal Revenue Bonds

Assured Guaranty/FSA 1,540 Variable/3.30 - 7.50 7/1/12-39

FGIC/Berkshire Hathaway 382 3.50 - 5.75 7/1/12-36

FGIC 453 0 - 5.50 7/1/12-36

MBIA 489 Variable/3.40 - 5.50 7/1/12-35

2,864

State Revolving Loans 508

Total 3,372 Note: As of June 30, 2012 and not adjusted for issuance/pay-downs thereafter. Source: City of Detroit June 14

Proposal for Creditors, Bloomberg, Barclays Research

Description The debt issues for the water and sewer systems have initially been described as secured special revenue debt of the utility systems by the EM and are expected to be unimpaired in terms of principal repayment. This treatment is consistent with market expectations over legal status of the lien of this debt. However, the city has not as yet published its formal


7 August 2013 13

bankruptcy restructuring plan; thus, our analysis is based on the Proposal for Creditors issued pre-bankruptcy negotiations.

Risk Factors to Treatment Two risk factors come to mind. The first is that the debtor counsel in bankruptcy will likely challenge many structures, especially when a utility system such as the water and sewer system appears to be the most significant and monetizable asset. Therefore, an attempt to fashion a novel legal theory to attack the utility system debt cannot be ruled out, especially when it comes to developing negotiating leverage. A second risk factor is that while not subjecting the water and sewer debt to principal impairment, the EM has proposed an exchange of the non-callable debt that will likely cause market value impairment in the bonds. We do not believe such an exchange has been completed in a Chapter 9 bankruptcy and see impediments to its implementation as proposed. With regard to the second risk, in our view, the worst-case scenario is that bondholders receive new bonds in a weaker credit structure, with some material market value loss.

Given the separation of the utilities from city operations and the classification of the debt as secured special revenue debt, we see little opportunity for unsecured creditors to attempt to impair the debt and create additional revenues for distribution to unsecured claims.

Relative Value The underlying ratings on the Detroit water and sewer bonds came under pressure this year, reflecting the risk of a potential forced exchange into a weaker credit structure. On June 17, Moody’s downgraded the water and sewer systems’ senior lien rating to B1 from Ba1 and the second lien rating to B2 from Ba2. On July 19, S&P placed its BB- ratings on the issuer on CreditWatch negative. In terms of relative value, yields on this debt look attractive at current levels, compared with the Municipal Index and the HY Muni Index. The AGM-insured 2033s, for example, trade with a dollar price of $91 and YTW of more than 5.75%, with the yield differential between the CUSIP and broader muni indices near its wides since January 2012 (Figure 14). Since the water and sewer bonds could retain special revenue status in bankruptcy and the EM’s proposed debt exchange faces obstacles, we believe that current yield levels more than adequately compensate investors, given the level of risk.

FIGURE 14 YTW Differential between Water Revenue 2033s and Muni Index/Muni HY Index


90

92

94

96

98

100

102

104

106

108

-300

-200

-100

0

100

200

300

400

Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13

Dollar PricebpWater Revenue (AGM-insured, A2/AA-/BBB) minus Muni Index YTWWater Revenue (AGM-insured, A2/AA-/BBB) minus HY Muni Index YTWWater Revenue (AGM-insured, A2/AA-/BBB) Dollar Price


7 August 2013 14

UTGO bonds We separated the UTGO bonds into two groups based on security: UTGO bonds enhanced with the distributable state aid and standalone UTGO debt (Figure 15).

FIGURE 15 UTGO Debt Breakdown


With Distributable State Aid Enhancement

NA 100 5.129 - 8.369 11/1/14-35

Without Distributable State Aid Enhancement

Ambac 78 4.25 - 5.25 4/1/14-24

Assured 169 4.00 - 5.25 4/1/14-28

MBIA 88 5.00 - 5.50 4/1/14-22

Syncora 34 4.00 - 5.25 4/1/14-23

469

Source: UTGO Official Statements, City of Detroit June 14 Proposal for Creditors, Bloomberg, Barclays Research

State Aid Intercept UTGO Security This debt is double-barrel, secured by the unlimited tax pledge of the city and enhanced by state aid. According to the EM, the strength of the security in this transaction rests on the additional revenues pledged to the bonds, rather than the unlimited tax pledge. We believe the additional pledged revenues enhance the transaction as a statutory lien under Michigan state law.

Issued pursuant to Act 80, the 2010 distributable state aid enhanced UTGO bonds are backed by distributable state aid payments (state shared revenue payments), which are based on a state-wide sales tax. The Official Statement for the bonds states that the “Distributable State Aid received or to be received by the Trustee for the purpose of paying debt service on the Bonds is subject to a statutory lien and trust for the benefit of Bondowners that is perfected without delivery, recording or notice.” Act 80 contains similar language regarding the statutory lien on the bonds and holds that the distributable state aid payments shall not be used to pay down any obligations other than the bonds at hand.

Risk Factors to Treatment The bonds are backed by a security structure of revenues that appears to represent a statutory lien. If the statutory lien were challenged and abrogated, the bonds could receive special revenue treatment or standard revenue bond treatment with a valuation of the lien. Finally, the bonds are backed by the city’s UTGO pledge. While the EM has stated that UTGO bonds are unsecured obligations, this treatment is expected to be litigated by various constituents, including the bond insurers, so, this issue will be decided by ruling.

The most significant risk factor appears to be the timely payment of debt service, not the ultimate payment of it. Statutory lien status for the debt does not necessarily convey a waiver from the automatic stay of bankruptcy. We believe the arguments for relief from the stay are strong but relief is uncertain.

We note that there may be a legal issue with these intercepts in a bankruptcy. The bankruptcy status of the Michigan intercept programs was raised in relation to a 2009 Detroit Public Schools note issue. Standard & Poor’s requested a bankruptcy opinion regarding the intercept, and the city was unable to find counsel that could provide one


7 August 2013 15

acceptable to S&P. As a result, the notes were sold as unrated obligations at a much higher yield. Long-term investors purchased the high yielding notes on the legal analysis that the intercept may not provide timely payment during a bankruptcy, but the notes would eventually be repaid in full through the intercept. In subsequent issuances, the Detroit Public Schools provided an unenforceable covenant prohibiting the filing of bankruptcy in lieu of the bankruptcy opinion, and S&P restored its short-term rating.

Security for Standalone UTGOs The EM and spokesmen for Governor Snyder have previously stated that “general obligation bonds don’t have any legal security….Bondholders are relying on general revenues of the city.” In our view, this comment ignores the nuances of GO debt. We believe there is a strong case for UTGO bonds (unenhanced by state aid) to receive secured special revenue status in bankruptcy.

In Municipalities in Distress, Chapman and Cutler LLP states that sales and property tax levied to pay indebtedness for capital programs, rather than for general purpose, would qualify as special revenue. The Official Statement for 2008 UTGO Bonds describes the bonds as follows: “In accordance with the State Constitution, unlimited tax general obligation bonds must be voter-approved before issuance. General Fund departments have traditionally relied on unlimited tax general obligation bonds of the City for capital programs. In accordance with State law, the City is obligated to levy and collect taxes without regard to any constitutional, statutory or Charter tax rate limitations for payment of such obligations.” Thus, the Official Statement description of UTGO debt appears to match the definition for special revenue status presented by Chapman and Cutler.

Additionally, the voter-approved nature of the UTGO debt helps set the record regarding the project specific nature of the tax levy issued to repay the debt. Finally, Detroit’s Comprehensive Annual Financial Report suggests that there is an identifiable revenue stream for its UTGO bonds. Investors looking for a more in-depth discussion of the evidence that UTGO may be considered special revenue should review A Chapter 9 in the Making? Most Frequently Asked Questions (July 2013).

Risk Factors to Treatment While there is evidence that the standalone UTGO bonds (not enhanced with state aid) should receive special revenue status in bankruptcy, there is a risk that UTGO bondholders could lose such litigation. There is also an argument that the voter-approved nature of the bonds would result in a statutory lien status under the Michigan Constitution. Specifically, Article IX, Section 25 has a clause that states that “the repayment of voter approved bonded indebtedness is guaranteed.” However, this argument for statutory lien status appears to be weaker, as the voter-approved language does not actually appear in the enabling statutes. We view this constitutional protection in a similar manner to the constitutional protection of contracts and pensions: valid on a state-law basis, but subject to adjustment in federal bankruptcy court.

Investors have raised the concern that the judge may rule against the UTGO secured claim, not on legal merits but based on an “in the interests of Detroit” type of rationale. In our view, the secured status of the UTGO debt only affects returns to creditors and does not materially affect the city or its emergence from bankruptcy. If UTGO is found to be secured, then recovery or payment to the $2bn note for unsecured claimants will be lower. This is an issue for creditors, rather than the city.

A secondary reason for us to reject this rationale is the fact that there are likely to be many appeals of rulings in this case; a prudent judge will likely look to limit the appeals, given the need for the city to move quickly through this bankruptcy. We believe that a ruling against




7 August 2013 16

the UTGO holders would likely result in an appeal. Conversely, we believe that a ruling in favor of UTGO secured status may limit appeals. Since a swift completion of this bankruptcy is in the best interest of Detroit, the city has the incentive to settle arguments such as this lien status. If lien status goes to trial and one believes that the judge was likely to rule “in the interests of Detroit,” then the likely ruling is for the UTGO lien status rather than against.

Relative Value Investors with the appropriate risk appetite may wish to consider standalone UTGO bonds. As discussed above, such debt will likely have a strong argument for special revenue status in bankruptcy, though there is no guarantee such argument will prevail. Additionally, it is cushioned by an added layer of protection via bond insurance (non-FGIC). Figure 16 shows spreads on the standalone UTGO 2028s, which are trading 45bp off their year-to-date tights and 10bp away from the average.

FIGURE 16 Unlimited Tax GO (Standalone) 2028s, Spread above AAAs (bp) and Dollar Price


Limited Tax General Obligation Bonds (LTGO) As with the UTGO, we separated the LTGO bonds into two groups based on security: LTGO bonds enhanced with the distributable state aid and the standalone LTGO debt (Figure 17).

FIGURE 17 LTGO Breakdown


With Distributable State Aid Enhancement

NA 379 3.00 - 5.25 11/1/14-35

Without Distributable State Aid Enhancement

Ambac 93 4.00 - 5.15 4/1/14-25

NA 68 5.00 - 8.00 4/1/14-16

540

Source: UTGO Official Statements, City of Detroit June 14 Proposal for Creditors, Bloomberg, Barclays Research

86

88

90

92

94

96

98

100

102

104

150160170180190200210220230240250

Jan-13 Mar-13 May-13 Jul-13

Dollar PriceSpread (bp)

UTGO (standalone, A3/AA-/C, insured by Assured) 2028 Spd $ price


7 August 2013 17

State Aid Intercept LTGO Security Similar to the state aid intercept UTGO bonds, the state aid intercept LTGO bonds are double-barrel, secured by a limited tax pledge and enhanced by state aid payments. As in the case with the state aid intercept UTGOs, we believe the additional revenues in the form of state aid payments would enhance the transaction as a statutory lien. Act 80 and Act 227 contain language regarding the statutory lien on the bonds and hold that the distributable state aid payments shall not be used to pay down any obligations other than the bonds at hand.

Risk Factors to Treatment The bonds are backed by a security structure of revenues that appears to represent a statutory lien. If the statutory lien were challenged and abrogated, the bondholders might not receive special revenue status.

Security for Standalone LTGOs These bonds are unsecured. The lack of a state aid intercept removes any argument for statutory lien status, and the fact that these bonds are not project specific, voter-approved UTGO’s likely precludes any argument for special revenue status.

The Official Statement for Detroit LTGO Bonds reads as follows: “The City may issue limited tax general obligation bonds or other obligations without the vote of the electors. However, taxes may not be levied in excess of constitutional, statutory or Charter limitations for the payment thereof. Such bonds are payable from general non-restricted moneys of the City.” As the language here indicates the tax levy is general purpose, the bonds do not meet the condition for special revenue as stated in Municipalities in Distress.

Risk Factors to Treatment Of the four general types of GO structure affected by the Detroit bankruptcy (UTGO enhanced by distributable state aid, standalone UTGO, LTGO enhanced by distributable state aid, standalone LTGO), standalone LTGOs are arguably the weakest in terms of security.

Relative Value State aid-enhanced LTGO 2035s currently trade with a spread of 120bp (Figure 18); spreads widened shortly after the EM’s proposal was filed, before tightening back to levels at the beginning of 2013. Investors looking for exposure to standalone LTGOs may wish to select CUSIPs that are insured, as two series are not enhanced by insurers. Standalone LTGO bonds tend to be of shorter maturities or smaller size; thus, it may be more difficult to find them.

FIGURE 18 LTGO (Distributable State Aid) 2035s, Spread above AAAs (bp)


90100110120130140150160170180190

Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13

LTGO (with distributable state aid, AA3/AA/NR) 2035s


7 August 2013 18

Other Security Interest Factors Note: The discussion below on first payment obligation applies to all GO debt. However, a determination in bankruptcy court on the issue has meaningful implications for recovery on standalone LTGO debt in particular, as (in our estimation) UTGO debt should receive special revenue treatment in bankruptcy.

Market participants have traditionally viewed GOs as first payment obligations in a normal flow of funds context. In a vacuum, many forms of GO debt are unsecured obligations. The question becomes, how does the concept of first payment obligation affect GOs statutorily and in bankruptcy court?

In bankruptcy, we believe there is a high chance that GOs could be judged to be unsecured. We look to pensions and contracts as an analogy: while these enjoy constitutional protections against diminishment, pensions and contracts can be impaired in bankruptcy. By the same logic, while GO debt may enjoy first payment priority in a normal context, they could be subject to impairment in bankruptcy.

Another question is how the concept of first payment budget obligation would affect the treatment of GOs versus other unsecured claims. This issue has never been addressed, and Detroit’s bankruptcy will serve as a testing ground for whether the first payment obligation would result in a priority status over other unsecured claims.

Please see the Appendix for a list of states and whether their governmental entities are permitted to file for Chapter 9 (states themselves may not file for bankruptcy). There is a higher chance of GO impairment in states that allow its entities to file Chapter 9. In those that do not allow its entities to file for Chapter 9, GOs would likely continue to have the privileges of first payment obligation.


7 August 2013 19

Appendix Figure 19 provides a breakdown of which states allow its governmental entities to file for Chapter 9.

FIGURE 19 State Authorization for its Governmental Entities to File for Chapter 9

States Bankruptcy Authorization States Bankruptcy Authorization

Alabama Yes (bonds only) Montana Yes

Alaska No Nebraska Yes

Arizona Yes Nevada No

Arkansas Yes New Hampshire No

California Conditional New Jersey Conditional

Colorado Limited New Mexico No

Connecticut Conditional New York Conditional

Delaware No North Carolina Conditional

District of Columbia No North Dakota No

Florida Conditional Ohio Conditional

Georgia No Oklahoma Yes

Hawaii No Oregon Limited

Idaho Yes Pennsylvania Conditional

Illinois Limited Puerto Rico No

Indiana No Rhode Island Conditional

Iowa No, with exception South Carolina Yes

Kansas No South Dakota No

Kentucky Conditional Tennessee No

Louisiana Conditional Texas Yes

Maine No Utah No

Maryland No Vermont No

Massachusetts No Virginia No

Michigan Conditional Washington Yes

Minnesota Yes West Virginia No

Mississippi No Wisconsin No

Missouri Yes Wyoming No

Source: Municipalities in Distress (Chapman and Cutler).

Analyst Certification We, Thomas Weyl, Sarah Xue and Ming Zhang, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report.

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