Wednesday, April 9, 2014

The Detroit GO Settlement, and My Halls of Fame and Shame

The monoline insurers MBIA, Assured Guaranty and Ambac ("monolines") scored a major victory when they settled with the City of Detroit with respect to the Chapter 9 treatment of the insured Detroit unlimited tax general obligation bonds (GOs).

The term sheet for the settlement provides, among other things, the following:
  • the entire $388 million claim in respect of the GOs will be allowed in the Chapter 9, and the existing ad valorem taxes securing the GOs will be treated as "special revenues" for purposes of the Chapter 9, thereby rendering the GOs as secured for purposes of the Detroit plan of confirmation.
  • 74% of the GOs will be reinstated for the benefit of the holders (Reinstated GOs), and 24% of the GOs (Stub GOs) will be reinstated and assigned to a fund for the benefit of the poorest Detroit pensioners.
  • ad valorem taxes securing the GOs will continue to be levied in an amount sufficient to pay off all of the GOs, but such tax revenues will be applied first to pay the Reinstated GOs, and any excess will be applied thereafter to pay the Stub GOs.
  • upon plan confirmation, the Reinstated GOs will be exchanged for GOs issued by the Michigan Financing Authority, which will be secured by both the existing Detroit ad valorem taxes as well as a 4th lien on state aid provided by the State of Michigan. There are further bond protections provided.
This is a significant victory for the monolines since the Detroit Emergency Manager (EM) had proposed an allowable claim of just 15%, or $58 million, in the proposed plan of adjustment.  This settlement constitutes an incremental $229 million win for the monolines.

Readers of this blog will not find this settlement win for the monolines to be surprising.  I have previously stated in this blog and in an online debate on the Public Sector Inc. website that I thought the monolines would win this fight with the EM.  It was clear to me that the GOs were secured by ad valorem taxes which were created and levied in connection with the authorization of the GOs, such that these taxes would be treated as "special revenues" and the GOs treated as secured obligations in Chapter 9.

Why the 26% discount if it was so clear that the monolines would prevail?  There are several possible theories.  One is that the monolines perceived some risk that given the weakening of property values in Detroit, the ad valorem taxes would not be sufficient to pay the GOs in full, even if the GO claim was allowed in full. This would explain why the monolines obtained in the settlement further security for the Reinstated GOs in the form of the state aid lien.  

Additionally, remember that the GOs were double barrel bonds, secured by (i) a full faith and credit pledge, as well as (ii) a pledge of specially levied ad valorem taxes in connection with the authorization of the bonds.  The monolines might have been concerned that while Judge Rhodes would find for the monolines on the ad valorem pledge, and therefore provide the monolines an allowable claim in full, Judge Rhodes might have found against the monolines on the full faith and credit pledge, thereby creating an undesirable precedent for monolines to deal with down the road.

Moreover, let's remember, that no matter how certain a litigant may believe it will prevail, one must discount one's chances by at least 10%, given the nasty vagaries of judicial whim.  If one starts with a 90% certainty that the monolines would prevail, settling for a 74% recovery is a meager settlement discount, especially in the face of a 15% offer.

Hall of Fame

My hall of fame award goes to the monolines.  They have proven to all municpal issuers and bondholders the practical value of bond insurance.

Consider this:  suppose you were a bondholder without the benefit of insurance, and the EM just told you that he was going to shaft you by offering $.15 on the dollar, even under circumstances where you rightly believe that on the merits you are entitled to par.  Would you have have been able to contest successfully the EM's proposal in an adversary Chapter 9 proceeding?  Would you have preferred to form a committee of bondholders and commenced litigation against the EM? You would have faced a collective action problem that likely would have prevented you from mounting an effective challenge.

If there was ever a perfect illustration of the value of bond insurance, this is it.  The monolines are keeping the bondholders whole and are obtaining a recovery that is $229 million better than what the EM offered.  Bond insurers provide financing benefits to issuers in the form of reduced interest rates, but they also provide benefits to holders after issuance by assuming the risks and costs of asserting creditors remedies.

Hall of Shame

My hall of shame award goes to the EM.  This is just another example of how the EM has screwed the pooch in the Detroit Chapter 9 proceeding.
  • The EM failed to understand municipal bankruptcy law and recognize the lien underlying the GOs in respect of the pledged ad valorem taxes, and therefore failed to make the monolines a fair offer in the proposed plan of adjustment.  The EM had a good faith obligation to classify Detroit's claims in Chapter 9 properly, and the EM both failed in this regard, and then wasted Detroit resources in trying to defend its failure.  
  • The EM failed to understand municipal bankruptcy law and recognize the absence of any lien securing the swap obligations, which has led the EM to make overly generous offers to the swap banks on two occasions, with the result that each settlement has been rejected by Judge Rhodes.  A third swap settlement between the EM and the swap banks has been teed up for a possible strike three later this week. 
  • The EM stated that it was central to its plan of adjustment that Detroit lease its water and sewer facilities to the surrounding counties, and apply any lease payments in excess of payments on the bonds secured by these facilities towards Detroit's rehabilitation.  The EM has not been able to even begin to implement this proposal, because the EM has not been able to provide the counties sufficient financial information for the counties to even understand the EM proposal, much less negotiate it.
  • The EM failed to find a way to maximize proceeds from the Detroit Institute of Art fine art collection while still maintaining the cultural viability of the DIA.  Here is a meaningful DIA solution offered up by a monoline insurer.  The EM ignored the huge collateral value of the DIA art and has made Detroit pensioners suffer losses because of this EM failure. 
Of course, the EM is good at making public appearances and giving press interviews, and is now busy trying to save face.  Notice this specious explanation from the EM spokesman regarding the GO settlement with the monolines given to a columnist in today's Detroit News:

"Orr spokesman Bill Nowling said bondholders are getting a better deal now because the city previously didn't include revenue from voter-approved property taxes in its iniital offer to investors of Detroit's debt."

This makes it seem like the EM has suddenly become magnanimous in reaching settlement, as opposed to the reality of the situation, which was that the EM was abjectly wrong in excluding such tax revenues as security in the first place in making the GO offer!

One simply hopes that this buffoonery on the part of the EM doesn't dissipate Detroit resources for too much longer.

Disclosure:  Long MBI; AGO.
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.


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