Detroit’s Message to Investors
There will be blood.
When emergency financial manager Kevyn Orr filed his plans in late February to lift Detroit out of bankruptcy, his proposals drew fire from the municipal-finance industry. Investors, bond insurers, ratings analysts, and industry groups all balked at his terms. That’s not surprising, since Orr, a private-sector restructuring expert, has used the Detroit bankruptcy to try to overturn years’ worth of precedent in municipal finance.
Even before Detroit went bankrupt, Orr made it clear that he would attack sacrosanct practices. Last June, he castigated holders of Detroit’s general-obligation bonds—traditionally considered among the safest kinds of municipal borrowing—for investing in the city for a decade, even as it went broke “openly and notoriously,” in his words. Though the usual assumption is that general-obligation bonds have the “full faith and credit” backing of a city or state, Orr said, he would regard Detroit’s bonds as unsecured—and he warned investors that they’d see deep cuts in any structuring plan. “They understood the risk,” he said.
Orr used the unprecedented threat of treating general-obligation bonds like unsecured debt as a negotiating tool, which prompted the backers of those bonds to agree to significant concessions in the face of his threats to repay them just 15 cents on the dollar. They’re now going to let the city divert some $26 million in city revenues they are owed to help pay off other Detroit debts, including pension obligations. Orr’s successful negotiating ploy means buyers of general-obligation municipal bonds will never quite feel as secure as they once were, especially when it comes to purchasing the debt of struggling cities.
Orr’s approach to Detroit’s pension borrowing is even more radical. Just weeks before filing his debt-restructuring plan, he sued in bankruptcy court to overturn $1.44 billion the city borrowed in 2005 to support its pension funds. Orr claimed that the borrowing was illegal because city officials and their advisors structured it to circumvent Michigan’s debt-limitation law. Investors and municipal officials took notice because Orr’s criticism applies to lots of the debt that cities and states issue these days. The Detroit borrowing was orchestrated through two independent entities, which the city itself had created to skirt state borrowing limits. The city contracted with these creations, called service corporations, to make payments into the pension system from money the entities raised by issuing certificates of participation—financial instruments that provide investors with revenues from a contract or lease. Detroit officials then claimed that the money it paid to the service corporations was not to pay for the borrowing but just to fulfill a contract. Orr alleges, by contrast, that the corporations were basically “pass-through” shells, “without economic substance,” and that the money they raised was indeed Detroit debt. He’s asking the court to relieve the city of that debt. “City officials turned a blind eye to the requirements of state law,” Orr’s suit contends.
Orr’s gambit strikes at the heart of municipal finance. Though most states have laws or constitutional restrictions on borrowing, governments (and their financial advisors) have found ways to sidestep them. At least two-thirds of all municipal borrowing in the $3.5 trillion market now takes place outside the scope of debt limits, according to an estimate by Columbia University law professor Richard Briffault. He calls these transactions “non-debt debt.” In 2009, in one example, Arizona closed a budget gap by borrowing $1 billion, even though its constitution prohibits such debt. The state simply claimed that the transaction wasn’t borrowing but instead a sale of government-owned office buildings. Yet no real sale took place: the state retained control of the properties and instead sold certificates of participation for them. Arizona is repaying the certificate holders out of tax revenues but calling the payments “rent” (see “State Budget Bunk,” Winter 2011). The Goldwater Institute, a Phoenix-based think tank, estimated that Arizona will spend $1.6 billion to pay off the $1 billion sham sale.
Orr is challenging the Detroit debt maneuver in federal bankruptcy court, where Judge Steven Rhodes has had a unique window onto the destructive power of fiscal gimmicks, thanks to his work on the Detroit case. Rhodes’s ruling could send a chill through the finance world because this kind of debt is so common among municipalities.
The Detroit bankruptcy could also upend the financial transactions, known as swaps, between municipalities and financial institutions. After Detroit borrowed money for pensions in 2005, using bonds with variable interest rates, it then purchased contracts from several financial firms to protect itself against sharp rises in rates. Instead, rates plunged during the 2008 financial turmoil. The cost to the city to pay off the swaps reached a staggering $350 million. Orr considered suing the banks that engineered the deal for taking advantage of city officials, but he’s balked at further litigation. Nonetheless, Judge Rhodes has already rejected as too expensive two settlements between the banks and the city. Most recently, Orr has proposed settling the debt for $85 million.
Swaps between municipalities and banks became popular in the late 1990s, but the deals have often backfired for borrowers, burdening taxpayers. After Pennsylvania allowed these transactions, for example, dozens of small municipalities jumped into the game. The result: some $17 billion in debt, engineered by more than 200 school districts and towns and cities, including contracts that played a role in Harrisburg’s subsequent insolvency. Some states, such as Tennessee, have now restricted these deals. But the Detroit example is making financial institutions less likely to write new contracts.
Meanwhile, Orr is offering city workers and retirees greater rates of recovery than bondholders, even though retirees are traditionally considered unsecured creditors in bankruptcies. Orr would use several hundred million dollars pledged by private groups to reinforce Detroit’s pension funds—money that the groups would not allow the city to pay to bondholders. This plan is upsetting the municipal market, too. “While we understand that favoring pensioners and discriminating against bondholders might be politically popular, we believe this is contrary to bankruptcy law,” a spokesman for the city’s largest unsecured creditor, Financial Guaranty Insurance Co., told the press. But bondholders shouldn’t be so surprised that the landscape is changing. Warnings that growing state and city retirement obligations are a threat to municipal investors have started to circulate. Last October, for example, former New York lieutenant governor Richard Ravitch told investors at a municipal-finance conference in New York that no distinction existed between the obligation to pay bondholders and pensioners, and no process was yet in place for deciding who gets paid back in a bankruptcy involving such competing interests.
Detroit is already the largest municipal bankruptcy on record. Orr’s stance toward the city’s debt also makes the case one of the most troubling ones yet for municipal investors.next>>