When Detroit filed for bankruptcy last summer, it was clear that it would be a case like no other. Already the largest municipal bankruptcy in history, it also poked the bear in several ways. One was its proposed treatment of general obligation (GO) debt, a $900 billion segment of the $3.7 trillion municipal bond market generally seen as the most secure.
Last month, Detroit agreed to pay Unlimited-Tax General Obligation (UTGO) bondholders about 74% of the $388 million they are owed. This was up from Draconian proposals of as little as 15%, and it was received favorably by the market. But the deal, negotiated with three bond insurers, covers only UTGO debt. It does not cover the estimated $160 million in Limited-Tax General Obligation (LTGO) debt, and this is critically important, for several reasons:
- LTGO debt is the primary source of financing for hundreds of cities, towns and counties in Michigan.
- LTGO debt represents a roughly $5 billion market in Michigan.
- Because LTGO debt does not require voter approval, it is relatively easy for Michigan localities to obtain. And in a state where 12 municipalities (not to mention five school districts) are stressed and under some form of state oversight, access to borrowing is critical. LTGO debt is essential to keeping "all systems go" for taxpayers in a financially responsible fashion, by offering relatively low-cost financing within state-imposed debt limits.
If no agreement is reached in relation to LTGO debt, and a cram down at the end of the bankruptcy process leaves bondholders with the plan's estimate of 10-13 cents on the dollar (vs. the 74 cents afforded to UTGO debt), the implications for Michigan municipalities could be calamitous. It could engender a distrust of a popular and necessary form of financing -and one previously believed to be backed by a first-priority promise of repayment. An apprehensive market could demand higher (in fact, prohibitive) interest rates on the debt. Municipalities, unable to afford the borrowing costs, could struggle to support their systems and provide services, and could turn to more speculative sources of financing, increasing the risk of more costly bankruptcies. Market distrust of Michigan LTGO debt is an outcome that would not only hurt bondholders - it could harm residents.
Our questions: Will the State of Michigan step in to help broker a solution? Is $160 million in Detroit bonds worth roiling a $5 billion market and risking the health of other municipalities and the future of the state's municipal bond market?
Michigan has an estimated $1 billion budget surplus (an overage comparable in size to Detroit's entire budget). Its aid to Detroit has been halved. Annual debt service on the Detroit LTGO bonds is roughly $30 million per year, inconsequential in the context of the governor's proposed $52 billion 2015 budget. It seems the state has the financial wherewithal to right a wrong, but is failing to acknowledge the implications of mishandling a critical form of debt.
Let's be clear: Bankruptcies are never easy, and that's particularly true in the case of municipal bankruptcies. (They are also costly. It is estimated that Detroit's case could rack up a bill of $100 million.)
But Michigan has an opportunity, with a relatively small financial rescue in one city today, to spare greater hardship for all of its locals down the road - and send a positive message to municipal bond investors everywhere about the meaning of a "full faith and credit" pledge.
We urge the state to do all it can to protect the interests of other stressed municipalities and, ultimately, of its proud residents.
Sources: BlackRock, Bloomberg, Michigan Department of Treasury, City of Detroit.
The opinions expressed are those of Peter Hayes as of May 15, 2014 and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of any individual holdings or market sectors. BlackRock owns Detroit LTGO debt, and has been an active participant in Detroit's Chapter 9 process on behalf of the LTGO bonds.
Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. A portion of a municipal bond fund's income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.