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THE DETROIT FALLOUT – PENSIONS AND BONDS – BONDS – (PART II)

August 20, 2013

THE DETROIT FALLOUT – PENSIONS AND BONDS – BONDS – (PART II)

The term “bond” has several meanings in Webster’s Dictionary. The one with which we will be concerned here is “5. an interest-bearing certificate of indebtedness of a corporation or government.” Detroit’s bonded debt is now in the hands of a federal bankruptcy court, and since the city is broke, the main question is not whether interest will be paid but rather what portion of the principal will be salvaged to holders of the bonds. Early signs for recovery at face value are not good, but however it works out, the issue is in the hands of the court and Detroit’s bonding problems will ultimately be decided by the court (or by Appeals courts).

Arguments about whether Detroit should have even filed its Chapter 9 petition are in our wake, so the governor and his appointed city czar are out of the loop. Jurisdiction (the power to decide) is now in the hands of the court in a little-used Chapter 9 filing (less than 700 filings ever), so now what?

Cities and other political subdivisions sell bonds to underwrite local projects such as sewers, upgrades of water projects etc. These typically are projects beyond the reach of current taxation to pay for and amount to borrowing. “Bonding out” costs on such public projects, supported by the collateral from revenues from such projects and as an alternative to a raise in taxes, are desirable exercises as they smooth over the costs of such large outlays. Taxes are not raised but the improvements are made anyway; bond interest is paid to bondholders from the city’s pledged revenues stemming from the improvements made and a fund is established on an appropriate schedule to retire the principal from revenue as well. Thus if a city, for instance, needed a new sewer plant at a cost of, say, 15 million dollars, it could issue bonds in that amount and pay interest on the bonds as they move along staggered maturity dates for repayment of principal. Sales of such “municipal bonds” are helped by exemptions from taxation of interest earned thereon (which is reflected in the lower interest the city must pay), so all is well unless. . . . unless what?

Unless half the people (as in Detroit) leave town and you have an inadequate customer base to pay the sewage or water or whatever fees necessary to keep bond interest and principal payments on track. The remaining customers, presented with increased utility bills and minimum wage jobs might decide to leave as well, thus exacerbating the problem. I think this is the fundamental problem which led to the Chapter 9 filing – the exodus of fee-payers. Whether it can be attributed to managerial incompetence or other mishandling of the city’s finances is for the politicians; that is not and will not be an issue before the court, which deals in realities rather than what might have been and who will be elected next time.

As a lawyer, I have never had a Chapter 9 filing either as counsel or in representing creditors. I have had one experience with bond counsel in representing a governmental unit in need of bonding to upgrade its phone system. The unit was an island in the Pacific where earthquakes and typhoons did not treat the island’s phone system kindly. Upgrades and repairs were necessary and common. I found bond counsel to be bright and knowledgeable, though single-minded on the question of collateral undergirding the proposed bond issue and how and when such bonds and interest thereon were to be retired. They did a good job, and the local government was the happy recipient of 28 million dollars.

So is the Detroit experience up for replication elsewhere? Cities across Michigan with bond sales for various improvements are fearful that interest rates they have to pay will go up because of the likely loss Detroit bondholders are likely to suffer. One newspaper account reports that “already three cities have withdrawn from the bond market because they feared they’d get whacked in the pocketbook because of the financial uncertainty in Motown.” The same paper reports that “A New York investor told the Detroit Free Press that for a while there’s been a Detroit penalty for bonds in the Detroit area, but now it’s really pronounced and impacting non-Detroit entities.” Ypsilanti (a Detroit area city) recently inquired about bonding for improvement of it schools, and “got slapped with a $112,000 higher interest rate.” It thus appears there is in fact “fallout,” like concentric circles on shore from a rock thrown into the middle of a goldfish pond. So your city or county is well-managed? Too bad; we’ve been burned in your area. Pony up a higher interest rate and tell me what other additional collateral other than revenue you can bring to the party, because I won’t sleep nights if people start leaving your town, Mr. Mayor.

The political subdivisions that have withdrawn to date from the bond market in Michigan are Saginaw County, Genesee County and the governor’s hometown of Battle Creek. All were poised to sell bonds but have backed off. It would be a shame if these few cases turned into a tidal wave, and for more reasons than one. A lack of bonding not only means that needed upgrades or new facilities are not built and the people are not better served; it is also bad for an already fragile economy. Bond sales create local jobs and stimulate local economies. New capital in town (without tax increases) improves the quality of life of its residents and provides jobs and increased demand in local communities. Not just the people building new sewers but also the merchants who share their paychecks are happy.  What’s not to like? It’s a win-win situation.

One of the ways those who issue “municipal bonds” save money is by constant refinancing of existing bond issues. When interest rates drop, mayors and other such local executives can save big money by refinancing such existing debt. It rightly leaves them in good political shape as they can brag to voters how they saved them money.

So has the “Detroit experience” created an uptick in interest rates for other Michigan entities in their quests for bond money to make public improvements? I think it is too early to tell. We’ll know more as this Chapter 9 saga continues, where such interesting questions as to whether the court will order Detroit to sell other assets (such as vehicles, paintings etc.) to satisfy the claims of bondholders and pensioners which may be presented. Chapter 9 is so little-used and such an unknown quantity that I hesitate to predict what the court will or can do – I await edification. Time will tell.  GERALD  E

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