Detroit Recovery Plan Threatens Muni-Market Underpinnings
Emergency Manager Kevyn Orr’s plan to suspend payments on $2 billion of Detroit’s debt threatens a basic tenet of the $3.7 trillion municipal market: that states and cities will raise taxes as high as needed to avoid default.
Orr, appointed by Republican Governor Rick Snyder to oversee Michigan’s largest city, proposed a deal last week that included skipping a $39.7 million payment on pension-obligation debt. The city is also set to default on unsecured unlimited-tax and limited-tax general-obligation bonds as it grapples with $17 billion in liabilities to avoid a record bankruptcy.
By calling into question the safety of any security backed by a government’s general obligation to pay what it owes, Orr, 55, imperils similar debt across Michigan, the eighth-most-populous state. As local governments strive to rebound from the longest recession since the 1930s, they may confront higher borrowing costs.
“It definitely sets a precedent, and there’s definitely going to be a penalty going forward for the city and the state,” said Dan Solender, director of munis at Lord Abbett & Co. in Jersey City, New Jersey. The company oversees $19.5 billion of local debt.
Detroit, where officials struggle to provide public safety and even street lighting, joins California cities Stockton and San Bernardino in trying to stick bondholders with a loss. With about 700,000 residents, it’s the most-populous city in at least 35 years to default on debt.
The biggest surprise is Orr’s willingness to skip payments on interest and principal owed on unlimited-tax general-obligation bonds, said Matt Fabian, a managing director at Concord, Massachusetts-based Municipal Market Advisors.
Paying less than 100 cents on the dollar would “rock the market,” said Tamara Lowin, director of research for Belle Haven Investments in White Plains, New York.
Orr, a Washington bankruptcy lawyer, lacks a nuanced understanding of the security behind Detroit’s two classes of general-obligation debt, Lowin said.
Unlimited-tax bonds must be approved by voters and repaid from a special property levy that has no limit as to rate or amount, Lowin said. The revenue is entirely separate from that used to cover general-fund operations. By contrast, she said, limited bonds are unsecured.
“You could make the case for downgrading every G.O. bond in Michigan,” Fabian said. “Bondholders need to assume that they’re substantially weaker.”
After Orr aired his plan with creditors June 14, Standard & Poor’s lowered its rating on the city’s general-obligation debt a step to CC from CCC- with a negative outlook. That’s 10 steps below investment grade.
Terry Stanton, a spokesman for Michigan Treasurer Andy Dillon, said by e-mail that “nearly all of the local units of government in Michigan carrying G.O. debt are in a significantly better financial position than the City of Detroit.”
Investors demand 0.71 percentage point more in yield than top-rated municipal bonds to own general-obligation securities issued by Michigan and its localities, the third-highest spread among 19 states tracked by Bloomberg Fair Value indexes. Only issuers in Illinois, the lowest-rated U.S. state, and Pennsylvania face higher borrowing costs.
Orr is asking unsecured creditors owed at least $5.85 billion to trade their debt for $2 billion in new, 20-year notes that carry an interest rate of 1.5 percent.
Bondholders shouldn’t panic, because suspended payments don’t necessarily mean they will be forced to take principal reductions, said James Spiotto, a partner with Chapman & Cutler LLP, a law firm in Chicago.
In 1975, New York City suspended payments on debt. After a lawsuit, negotiations and state and federal aid, creditors were fully repaid, he said.
“The devil is in the dialogue,” Spiotto said, referring to coming negotiations between Orr and Detroit creditors.
Investors holding insured debt may also be paid in full. Assured Guaranty Ltd. (AGO) is “committed to honoring its unconditional and irrevocable guaranty,” Ashweeta Durani, a spokeswoman for the insurer, said in a statement. National Public Finance Guarantee Corp. will ensure that policyholders get timely principal and interest payments, Kevin Brown, a spokesman, said in a statement.
Investors are selling the city’s insured securities anyway. A Detroit unlimited-tax general-obligation bond maturing in April 2028 traded June 14 at an average of 96 cents on the dollar, the lowest since March 2012, data compiled by Bloomberg show. The bonds are backed by a unit of Assured Guaranty.
Bart Mosley, co-president of Trident Municipal Research in New York, said an issuer’s “full faith and credit” pledge must give way to facts.
“Economic reality, such as Detroit’s shrinking population and tax base, does impose a limit: Once all the blood is squeezed from the stone, you are unsecured.”
Cutting Detroit income and property taxes so that they’re competitive with surrounding areas is critical to reversing crippling population and job losses, Orr said in his report.
Detroit isn’t the only Michigan municipality facing fiscal distress. This month, Snyder said a fiscal emergency existed in Hamtramck, a city of 22,000 encompassed by Detroit.
Hamtramck, along with other Michigan communities under an emergency manager, such as Pontiac and Flint, will face even higher penalties as investors anticipate a similar treatment of general-obligation debt, Solender said.
Richard Larkin at Herbert J. Sims & Co. said there’ll be “hell to pay” for local bond issuers because of the default.
“It will certainly affect all the debt of struggling governments in Michigan, if not nationally,” Belle Haven’s Lowin said.
To contact the editor responsible for this story: Stephen Merelman at email@example.com