Tuesday, July 23, 2013

Detroit and Pandora's Box Part II

In my last blog post, Detroit and Pandora's Box, I posited that various stakeholders in the Detroit Article 9 bankruptcy were in for some unexpected consequences.  I have since received some well-considered feedback, and push-back, on this blog post, so I thought I would elaborate on my thinking just a bit more in this follow up post.

1.  Detroit Pensioners and Impairment.

I argued that notwithstanding the provision contained in the Michigan constitution prohibiting reduction of vested pension fund obligations, Detroit would be authorized to confirm a plan in Chapter 9 in which these pension fund obligations will be impaired.

Generally, when federal and state law conflict, the Supremacy Clause of the US Constitution states that federal law prevails.  The only limitation to this principle is to found where the federal law itself defers to and recognizes that provisions of state law are controlling.  

The most obvious example of the deference of federal bankruptcy law to state municipal law is with respect to the eligibility of municipalities to file under Chapter 9.  Chapter 9 makes clear that it is state law that specifies whether a municipality is eligible to file and under what terms.  In the case of Detroit, special legislation was enacted authorizing Detroit's filing, provided the governor signed off on the filing and Detroit had made a prior good faith effort at negotiating an out of court reorganization.

The state pension fund interests will argue, just as Calpers has argued in Stockton, that Article 9 by its terms defers to the inviolability of state pension fund obligations where state law so provides.  The argument is that Article 9 , Section 903, states that Chapter 9 

"does not limit or impair the power of a State to control, by legislation or otherwise, a municipality of or in such State in the exercise of the political or governmental powers of such municipality, including expenditures for such exercise."

This argument goes on to hold that where the State has prescribed that vested pensions may not be impaired, the State has made this prescription in the exercise of its political/governmental power, and Chapter 9 may not contravene this political/governmental decision by impairing obligations incurred in connection with the political/governmental power.

I am not buying it, and I don't think any federal bankruptcy court judge will either.  This argument proves too much, because it is the exception that swallows the entire federal bankruptcy law as it applies to municipalities.  Indeed, a municipality could argue that all of its outstanding debts were incurred in connection with the exercise of its political/governmental authority.  If true, then all federal bankruptcy judges would be powerless to exercise federal bankruptcy jurisdiction in the case of municipal obligations which, all reasonable minds might agree, was not what Section 903 intended.

The reservation of political/governmental decision making authority to the municipality in a Chapter 9 proceeding relates to those governmental functions in the ordinary course of municipal governance, such as whether to spend $X for police and $Y for fire fighting, and so on.  This reservation keeps the federal bankruptcy judge out of those decisions relating to the provision of municipal services that should be responsive to democratic oversight, inasmuch as municipal residents can vote in municipal elections for municipal officers but not for federal judges.  

In my view, this deference to municipal political/governmental decision was intended to keep a judge out of the micro-budgeting for municipalities on an ongoing basis within the Chapter 9 case itself, and was not intended to render inviolable pension fund obligations that are outstanding, unsecured obligations of the municipality, or any other outstanding municipal obligations for that matter.  These obligations are the typical sort of debt that may be rearranged by the municipality in bankruptcy. 

2.  General Municipal Obligations and Impairment.

Detroit Emergency Manager Kevyn Orr has categorized unlimited general municipal obligations of Detroit as unsecured obligations, parri passu with pension fund obligations.  This has caused consternation within the municipal finance market, as it was thought that these general municipal obligations were secured insofar as they are backed by a pledge of tax revenues unlimited in rate and amount sufficient to pay off the general municipal obligations.  If unsecured, the general municipal obligations will not pay interest while in bankruptcy, and will rank in priority below the rank they would have had they been if classified as secured.  Moreover, the likelihood of impairment for general municipal obligation bondholders and monoline insurers that issued insurance in respect of these obligations will be much greater if they are classified as unsecured than if classified as secured.

In my view, you have to separate in your mind security for purposes of financial analysis and security for purposes of federal bankruptcy law.  Municipal obligations backed by an unlimited pledge of tax revenues are secured outside of bankruptcy by an enforceable obligation of the municipality to collect tax revenues, and increase those revenues if necessary in order to pay off the bonds.  If the municipality doesn't raise sufficient tax revenues, this obligation may be enforced by a bondholder in state court.  

Inside bankruptcy, not every obligation is enforceable.  In my view, the pledge of tax revenues is an example of an obligation that may be rejected in bankruptcy.

The promise to collect taxes sufficient to pay off the general municipal obligations is an executory contract of the municipality which may be rejected in bankruptcy court by Detroit, as debtor.  Moreover, if Detroit decides during its bankruptcy proceeding to increase its allocation of tax revenues towards police and other municipal services, this is a proper exercise of political/governmental authority that the federal bankruptcy judge, and therefore creditors, cannot countermand, as discussed above.  In this respect, bankruptcy law for municipalities is more lenient for the debtor than for corporations.

The best analogy that I can come up with is the example of a pledge of a security interest which is unperfected.  An unperfected security interest results in an obligation that is not secured.  Now, if the general municipal obligation was secured by a security interest in a lockbox into which all tax revenues were required to be deposited, and the terms of the instrument creating the general municipal obligation and governing the lockbox made it clear that the lockbox would be subject to a waterfall payment structure, whereby the payment of general municipal obligations came first and before payment of all other municipal services, then you might have a secured general municipal obligation for purposes of bankruptcy law.  It is not my understand that those are the terms of Detroit's general municipal obligations.  Perhaps going forward, that is how general municipal obligations should be structured.

3.  Detroit Institute of Arts Museum and the Mother of all Auctions.

The Detroit Institute of Arts Museum (DIA) is a magnificent museum that holds well over $1 billion of art that is owned by Detroit.  The DIA has stated its intent that its artwork is held in trust for the cultural benefit of future Detroit residents, and should not be subject to sale in connection with Detroit's bankruptcy.

Now, outside of bankruptcy, this is a fine statement of intent.  It makes clear that the museum is dedicated to cultural education, as opposed to investment gain.  DIA's art is not considered by Detroit to be some portfolio investment (which has probably done quite well, thank you), but rather a cultural legacy.

Inside bankruptcy, this expression of ownership intent matters not one whit.  The art held by DIA is an asset owned by Detroit, and creditors will argue that its value should be marshalled towards the payment of Detroit's obligations in connection with any rearrangement of Detroit's debts.

One wonders whether Detroit will argue that the decision to continue ownership of DIA's art, as opposed to its liquidation and application of the proceeds thereof towards payment of Detroit's obligations, is a valid exercise of Detroit's political/governmental decision making authority, which as discussed above is beyond the jurisdiction of the federal bankruptcy judge.  However, it is one thing to ask creditors, including municipal employee pensioners, to suffer a haircut, and quite another to ask these creditors to stand idly by while over $1 billion of artwork sits on walls that are only less frequently visited by a city population that has dwindled from over two million to about seven hundred thousand.

I expect that if Detroit tries to impose a significant haircut on municipal creditors, a bankruptcy judge will be inclined to order an auction of DIA's art at the request of creditors.  I think a more likely outcome will be some sort of global refinancing of Detroit's debts where a haircut might be nominal, where DIA's artwork might serve as collateral to secure the repayment of this refinancing.  There is no way to know how this will play out. 

4.  Monoline Insurers and the Path Forward

MBIA and Assured Guaranty have written insurance on several billion dollars of Detroit water and sewer bonds that Mr. Orr has proposed to refinance.  Moreover, it is likely that any bonds issued by Detroit coming out of bankruptcy to finance itself going forward will require insurance.  Mr. Orr, Detroit and the monolines may be strange bedfellows, but their interests are frankly more aligned
than opposed at this point.  Mr. Orr has to keep the monoline insurers onside as working partners if Detroit wants to exit bankruptcy with an acceptable financial outlook.

I see Detroit as an opportunity for the monolines to reestablish the utility of municipal financial guaranty insurance both to the marketplace and issuers alike.  As long term interest rates begin to climb, the monoline business opportunity will only expand.

Disclosure:  Long MBI.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Friday, July 19, 2013

Detroit and Pandora's Box

Detroit's filing for Chapter 9 bankruptcy protection was not only expected, it makes sense from Detroit's point of view.

Essentially, Detroit had nothing to lose--the services it provided Detroit residents were already so bad that there will likely be no discernible degradation in services provided by Detroit under Chapter 9, and something to gain--Detroit was unfinanceable before the filing, subsisting on a financial drip line from Michigan, whereas after filing, lenders can provide Detroit financing which will be treated as an administrative expense under bankruptcy law.  These lenders will get repaid on a priority, last in, first out basis.

But there can be many outcomes from the filing that will definitely be unexpected for various stakeholders, and we can pause to consider what may lie within Pandora's box.

1.  Impairment and Pension Obligations.

Michigan's state constitution contains a provision upholding the inviolability of pension obligations.  While this provision prevents Michigan legislatures from reducing Detroit's vested employee pension obligations, it does nothing to prevent a Chapter 9 bankruptcy proceeding from reducing Detroit's vested employee pension obligations.  Detroit pensioners have the Supremacy Clause of the US Constitution to thank (or should I say blame) for that.

2.  Impairment and the Taxing Pledge Underlying General Obligation Bonds.

General obligation bonds were considered extremely safe by the municipal finance market because they are backed by the municipality's pledge to raise and collect taxes in an unlimited amount sufficient to pay the bonds.  Outside bankruptcy, if the municipality did not stand behind its pledge, the bondholder could walk into state court and obtain a writ of mandamus ordering the municipality's elected officials to honor that pledge.

Inside bankruptcy, that pledge is just another executory promise which can be rendered unenforceable in connection with the municipality's rearrangement of debts. Bondholders could expect a municipality to refrain from filing for bankruptcy, it was thought, since by doing so, that municipality would know that it had just become unfinanceable in the public markets, and no municipality would dare do such a thing.

You can now file this market expectation as another quaint American myth.  MBIA, Assured Guaranty and Ambac can expect to take a haircut on their general obligation wraps.

3.  Has All of Michigan Just Become Unfinanceable?

Under the state legislation authorizing Detroit's Chapter 9 filing, Michigan Govenor Snyder had to sign off on the filing.  Mr. Snyder's and Michigan's fingerprints are all over this filing.  I would expect the municipal finance market to interpret Detroit's filing as a direct attack on the municipal finance market by Michigan itself because, after all, it was Michigan that was backstopping Detroit's ability to finance itself prior to the filing.

To put it bluntly, it has just become a very unwise career move for a municipal finance mutual fund advisor to buy not only Detroit obligations in the future, but frankly obligations of Michigan as well.  What does that advisor say to her superior's potential future admonition, fool me once, shame on you...This is a conversation you don't want to have.  Better to stay clear of Michigan!

4.  Is the Detroit Chapter 9 Filing a Blessing in Disguise for Monoline Insurers such as MBIA and Assured Guaranty?

Suppose you are a municipal finance mutual fund advisor and your boss walks in and asks you to show her the Detroit exposure.  You can either show her Detroit insured general obligation bonds and tell her, no sweat, we are going to get paid, or you can show her uninsured bonds, in which case you can start to sweat.

The insured municipal finance market goes through cycles of complacency and periods of being reawakened to the benefits of municipal finance insurance.  This is one of those periods.

The question is how badly will MBIA, Assured Guaranty and Ambac get burned in the short run in order to revalidate the need for their business?  Inasmuch as MBIA's and Assured Guaranty's exposure to Detroit is mostly in the form of secured sewer and water bonds, which will continue to be paid and which might even get refinanced in connection with the Chapter 9 proceeding, both MBIA and Assured Guaranty may be paying a small price to remind every municipal finance mutual fund advisor why it is good not to sweat.  Ambac will pay a little more.

Moreover, any refinancing of MBIA's and Assured Guaranty's insured water and sewer bonds is a double win for the insurers.  They not only get to wipe off the insurance exposure from their liabilities, but they get to accelerate into income the associated unearned premium.  Detroit's finance czar Orr has already outlined a plan whereby he envisions Detroit refinancing these sewer and water liabilities.

But, one wonders, in what financial world would Mr. Orr expect to sell the bonds that would refinance these outstanding water and sewer bonds.  Certainly not in the real world given this Chapter 9 filing, certainly not without MBIA's and Assured Guaranty's insurance.

So, it seems, MBIA and Assured Guaranty might be holding a trump card in what at first might look like a badly dealt hand.  This article indicates the monoline insurers were trying to act as part of the solution before Detroit's filing; there seems no way in which they won't have to be part of Detroit's solution emerging from bankruptcy.

5. The Mother of all Art Auctions

Detroit's Institute of Arts (DIA) owns over 60,000 works of art, worth by its estimation well over $1 billion.  It has labeled itself one of the preeminent art museums in the country.  It also will sponsor one of the world's most prestigious auctions of art since, you see, Detroit owns all of this art and Detroit is now bankrupt.

In art auctions, provenance is key, and buying from a renown museum is nearly the best of all provenance, next to buying directly from the artist.  Buying from a museum rarely happens because arts museums eschew deaccessioning, since that indicates that blood is in the water for that museum with respect to all future donors.  However, DIA will have none of these concerns since whether it realizes it or not, the jig is up for the DIA.  Detroit has bills to pay.

Postscript:  Add this to the list of unexpected consequences.  This Michigan state court judge is going to find out what federalism and the Supremacy Clause is all about.

Disclosure:  Long MBI.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Tuesday, July 2, 2013

New York Supreme Court Commercial Division Line Up Welcomes Justice Friedman to MBS Litigation

On May 23, 2013, the chief administrative judge of the New York Supreme Court, Commercial Division, rendered an order that all mbs cases not otherwise assigned should be assigned to the newbie of the Commercial Division justice line up, Justice Friedman.  This order put into writing what the administrative judge determined was the division's assignment practice at the time.  It was curious, then, to see that Ambac v Nomura was initially assigned to Justice Sherwood in contravention of this assignment order.

Curious, and distressing to Ambac, as the line up of the Commercial Division justices can be assessed for sympathy to plaintiff mbs claimants in much the same manner as the Supreme Court justices can be assessed for "liberal' or "conservative" orientation.

While it is something of a generalization, just between you, me and the lamp post, Justice Bransten is most sympathetic to the claims and arguments presented by mbs plaintiffs, with Justices Kapnick and Kornreich lying somewhere in the middle ground, and Justices Ramos and Sherwood most antagonistic to plaintiff mbs arguments.  We will find out about Justice Friedman in the bye and bye.

So, one wonders why Ambac v Normua was initially assigned to Justice Sherwood, or perhaps rather how Nomura's counsel was able to persuade the assigning clerk to make this initial assignment.  In any event, Ambac was able to petition to vacate this assignment and oblige the Commercial Division to follow its own rules.  See here.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Monday, July 1, 2013

ResCap Examiner's Report Concludes It is Unlikely that (i) Piercing Corporate Veil and (ii) Substantive Consolidation of Ally and ResCap Claims Would Prevail

The Examiner's Report in the ResCap Bankruptcy Case has been unsealed and may be read in all of its War and Peace-length glory here.

There are a stunning number of creditor claims set forth in the report that the Examiner reviews and handicaps as to legal merit, after having conducted an exhaustive investigation.  These creditor claims, if they prevailed, would have served to increase the size of the bankruptcy estate of ResCap for the benefit of ResCap's creditors and to the detriment of ResCap's parent, Ally.  It was the threat posed by these creditor claims and the looming shadow cast by the Examiner's Report that led to the plan support agreement among Ally, ResCap and ResCap's principal creditors, in which Ally is to contribute $2.1 billion to the bankruptcy estate in exchange for a release of claims.  This plan support agreement was recently approved by the ResCap bankruptcy court.  A reorganization plan based upon this plan support agreement has yet to be filed.

But there are no bigger creditor claims considered in the Examiner's Report than the (i) piercing the corporate veil and (ii) substantive consolidation arguments alleged by ResCap's creditors.  These are doomsday claims, as they would have potentially put Ally on the hook for all of ResCap's liabilities.  It is hard to see how a plan could be confirmed based upon the plan support agreement that provides a $2.1 billion contribution by Ally if the Examiner had concluded that it was likely that these veil piercing or substantive consolidation creditor arguments would prevail.  Such a conclusion could have put Ally on the hook for as much as $25 billion of potential claims, according to published estimates.

No worries for plan support agreement proponents, at least with respect to these doomsday claims, as the Examiner concludes at pps. 45-47 that it is unlikely that these doomsday claims would prevail.  Moreover, a claims valuation scorecard is set forth by the Examiner, beginning at p. 51, which indicates that, on a present value basis, Ally's $2.1 billion consensual contribution is within the ballpark of what ResCap creditors might reasonably be expected to recoup by means of litigating its claims.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.