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.


  1. No future for a Detroit as it once was. Nothing positive will happen until jobs exist. If they can get adequate incentives, employers will locate there (easier said than done, of course). If jobs come, you institute an 'urban homestead' act for certain sections of Detroit. Transfer title to anyone willing to build a new house or rehab an existing structure while providing long-term low rate financing. Any sale of the property within a certain time period would require a portion of the equity to be paid to the city.

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