No Cash for Clunkers

July 30th, 2013

by Eric Schaefer

In the past ten days there has been a flurry of activity in the Motor City. On July 18th, after months of speculation, Kevyn Orr, the emergency manager appointed by Governor Rick Snyder of Michigan, announced the city of Detroit would seek bankruptcy protection under Chapter 9 of the Federal Bankruptcy Code. One day later, pension fund officials obtained a ruling from Ingham County Judge Rosemarie Aquilina ordering the bankruptcy filing to be withdrawn. The grounds? Bankruptcy proceedings threatened to reduce pension benefits which are contractual obligations according to the Michigan state constitution. By the 23rd, the emergency manager reclaimed the initiative as Federal Bankruptcy Judge Steven Rhodes announced the appointment of a mediator for the proceedings.

As filings, injunctions, stays and opinions volleyed back and forth between the parties involved — ranging from pensioners, bond holders, city officials, the emergency manager and the state — prices for city of Detroit general obligations continued to slip and yields to rise. By the 23rd, yields on the city's 5.25% bonds maturing in 2022 were quoted at 9.35%. In comparison, at the start of 2013 yields stood at 7.08%. Yes, the general rise in interest rates is partially responsible for the increase; but, the looming bankruptcy is also to blame, inflating credit spreads as uncertainty confounds valuations.

The reaction to recent events is surprising and yet not. The vociferous opposition to the emergency manager is surprising because Michigan is no stranger to state fiscal oversight of its constituent municipalities. Emergency managers are currently responsible for nine cities and five school districts under Public Act (PA) 436 (and its predecessor, PA 72). While Detroit is the largest city so supervised, Flint (pop. 101,000) and Pontiac (pop. 60,000) are both sizeable municipalities and venerable industrial cities — like Detroit — fallen on hard times. Flint has been under emergency supervision since November 2011 and Pontiac since March 2009. Many readers may also be surprised to learn that the Detroit Public Schools (DPS) have been under emergency management since March 2009. Detroit's residents too are no stranger to a state appointed official serving as a financial czar when local elected officials are unable to take the actions necessary to bring budgets back into balance.

So much for why one can be forgiven for being surprised by the passions raised since Mr. Orr took the helm as Detroit's emergency manager. Now, the furor is not surprising because he has moved faster than his predecessors in seeking a resolution. He is also the first among his peers to seek the participation of the federal bankruptcy court. And, of course, there is the scale of the mess he is tasked with tidying up.

Mr. Orr's stated goal is to wrap up the proceedings by September 2014. Certainly, one would expect the parties involved to appreciate a rapid resolution for the better or for the worse. But, this infers a rational perspective lacking in certain quarters. We expect there are parties who believe that a delay serves their best interests. As proceedings drag on into 2014, we expect the issues raised by Detroit's bankruptcy proceeding to take center stage in the November mid-term Congressional elections. Once again more Democrats (20) than Republicans (14) will be defending seats in the Senate. A swing of five seats will suffice to pass control to the Republicans. One of the seats up for grabs is that of retiring Senator Carl Levin, the Democratic Chairperson of the Senate Armed Services Committee. Need we say more?

Washington's role will largely be that of the chorus in a Greek drama: politicians may voice opinions, but will play no active role. Politics favors a bailout or intervention; but the budgetary reality is there is no cash for Detroit's clunkers — either for its bonds or its pension obligations. Indeed, the moral hazard raised by any bailout — with cities, counties and states lining up for federal dollars — will keep Washington's purse strings tied.

Notes on Sources, Methods and Definitions:

Bond prices and yields obtained from the Municipal Securities Rulemaking Board (MSRB) Electronic Municipal Market Access (EMMA) website. Remember yields move inversely to a bond's price. As bond prices fall, yields rise; and, vice versa.

Yields are shown for City of Detroit General Obligation (GO) bonds maturing in at least 10 years. GOs are unsecured debt instruments backed by the issuing municipality's full faith and credit. Among the various species of municipal debt instruments, investors generally view GOs as being of higher quality.

Many factors affect the price (yield) quoted for a municipal debt instrument in the secondary market. Perceived credit quality, the security's credit rating (by S&P, Moody's or Fitch), its stated interest rate (or coupon rate), maturity, call features (the ability of an issuer to retire debt before its stated maturity), sinking fund provisions (a requirement for an issuer to set aside funds for the instrument's repayment), issue size and market liquidity are factors affecting the price paid or received for a particular issue at any time. This list is by no means exhaustive; other considerations can and will play a determining role.

Yields quoted are not indicative of levels investors can expect to receive.

(Sources: MSRB — EMMA; AIFS estimates.)

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