Threat to State and Local Credit Ratings. Fitch Ratings announced yesterday it has placed the U.S.’s AAA credit rating on negative rating watch. The U.S. Treasury expects to exhaust extraordinary measures to finance government spending without raising the $16.7 trillion debt limit tomorrow. The negative rating watch means there is a higher likelihood of a downgrade within a shorter time frame, and it applies to long-term foreign and local currency issuer default ratings and outstanding debt. If Treasury exhausts its extraordinary measures and Congress continues to fail to act, the federal government will have only $30 billion, a level insufficient to meet its obligations using cash on hand and incoming revenues—or, from the perspective of chapter 9 municipal bankruptcy, insolvent. According to Fitch, after tomorrow, the federal government would have a limited ability to make payments and would be “exposed to volatile revenue and expenditure flows,” with its legal authority unclear with regard to whether the Treasury would be able to prioritize debt service on Treasuries over paying other obligations. Fitch warned “the U.S. risks being forced to incur widespread delays of payments to suppliers and employees, as well as social security payments to citizens — all of which would damage the perception of U.S. sovereign creditworthiness and the economy.” Fitch said it would only recognize a sovereign default if the federal government did not pay interest and/or principal on Treasuries on time. If that happened, Fitch said it would lower the issuer rating for the U.S. to “restricted default.” If the U.S. defaulted, it is unlikely that Fitch would return its rating to triple-A in the short-to-medium run once the default was cured: “Even a short-lived default, that did not impair the long-term capacity of the U.S. government to service its obligations, would call into question the effectiveness of the country’s political institutions in ensuring that sovereign debt obligations are honored in a timely manner.” Under a default, Fitch warned that U.S. Treasuries that were specifically affected would be lowered from triple-A to B+ (the highest rating Fitch gives for bonds in default when a full or near-full recovery is expected), and entities whose ratings are underpinned by U.S. sovereign support could see negative rating consequences. For state and local leaders, the credit rating agency noted that state and local credit ratings would not be directly affected; however, some municipal obligations with direct links to the U.S. rating would be, including bonds secured by the federal government and U.S. guaranteed debt obligations. Those bonds would be placed on a negative rating watch that would not be adjusted until the U. S.’ default was resolved.

Confronting Motor City’s Legacy Costs. Former Michigan State Treasurer Andy Dillon, in his deposition before his surprise resignation Friday, was questioned by union attorneys about his role and the emergency law he helped write to respond to an increasing number of fiscally challenged cities, counties, and public school systems. The deposition, taken along with similar depositions of Gov. Rick Snyder and his key aide Richard Baird, were completed in advance of the hearings that commenced before U.S. Bankruptcy Judge Steven Rhodes yesterday to determine if Detroit is eligible to enter into bankruptcy. Throughout the three depositions, the attorneys were seeking to determine if Mr. Dillon and Detroit Emergency Manager Kevyn Orr were seeking to use a chapter 9 federal bankruptcy filing as a means to overcome Michigan’s constitutional protections for pensions—and whether the city negotiated in good faith with unions and retirees. In retracing the beginning of the fiscal crisis for the Motor City, Mr. Dillon noted: “We understood that there could be a lot of troubled cities and school districts in the cue, so it was on our radar before we started…”We understood that we would be inheriting some financial crises throughout the state and we thought there was more to come.”

State Role. Union attorneys questioned Mr. Dillon closely about discussions surrounding new legislation to broaden the state’s power to intervene in troubled local governments, to which the former state Treasurer responded that when he first took over, Michigan Governor Rick Snyder had pushed for a new emergency management law to replace the existing law, which the state thought lacked the key power to cut labor costs: “What we found, typically for a governmental unit, 75% give or take of your costs are wages and benefits…We spent a lot of time on this issue about, you know, the constitutionality of can you modify a collectively bargained agreement. But the thought was we had two conflicting constitutional provisions here. One is the prohibition against impairing of contracts and then the other is the duty of the state to provide for the public health, safety, and welfare.” The state determined it was constitutional to temporarily modify an agreement until the financial crisis was over, and Public Act 4 was signed into law in March 2011—a law that led to so much opposition that it was rejected by the voters last November (the law was replaced with the current Wolverine law, Public Act 436, which became law last March—which has the same powers as the former Act 4, but also increases choices for local officials who face a takeover). In response to a question in the deposition about how he (former Treasurer Dillon) responds to critics who said the law was dictatorial, he replied: “I think it’s just a harsh reality that when you have a, whether it be a school district or a city in the severe financial crisis, that you’ve got to have someone that can make decisions and oftentimes what you’ll find is the governance, more in cities than in many school districts, makes it very difficult to navigate through a financial crisis.” The union attorney questioned why the credit markets — specifically credit firms like Moody’s Investors Service — believed that Public Act 4 was good for the state, to which Mr. Dillon responded: “Detroit is a good example…The health of your biggest city has an impact on the health of the state, right, and if you have a city of 700,000 folks that don’t have access to public safety, kids can’t walk safety to school, there’s no lights on, that’s going to have a negative impact on the state’s economy.”

Bond Holders versus Retirees. The union attorneys asked Mr. Dillon how it was that Detroit’s bondholders should have any protections in municipal bankruptcy compared to the “holders of vested pension and retirement benefits (who) have the protection of the (Michigan) constitution.” To which Mr. Dillon responded: “It’s still there in the constitution, but if the unit can’t pay the pension they can’t pay the pension.” The attorney followed up, asking: “Why doesn’t that logic also apply to the bondholder creditors of the city of Detroit?” Mr. Dillon replied: “I’m not certain that it doesn’t…If the unit doesn’t have the money to pay their bondholders, there’s a problem, and I guess that’s what Chapter 9 is for or some type of effort to resolve it in a different way.”

Is Detroit Insolvent? U.S. Bankruptcy Judge Steven Rhodes yesterday began the first of two days’ of hearings to determine if the Motor City is insolvent, whether there had been good faith negotiations with its creditors, and had secured state authorization, and, thereby, could be deemed eligible for federal municipal bankruptcy. Creditors argued that the U.S. Constitution and the Michigan Constitution should block the city’s Chapter 9 bankruptcy. Detroit attorneys must fend off more than 200 objections to the city’s July 18 bankruptcy filing from creditors and individuals who argued that the city does not meet the criteria outlined by Congress for municipalities to file for bankruptcy. Sharon Levine, an attorney for AFSCME, the city’s largest employee union, attacked the constitutionality of Chapter 9 bankruptcy. She said the law allows the U.S. government to infringe on state rights and gives “political cover” to Detroit emergency manager Kevyn Orr to pursue pension cuts: “I’d ask your honor to come back with me to elementary and high school when we first talked about what the Constitution means…By turning over Chapter 9 to the federal government and being able to hide behind the bankruptcy process, we lose that accountability that’s a cornerstone of what our constitution requires of us.” Claude Montgomery, an attorney for the Motor City’s retiree committee set up by Judge Rhodes, testified the bankruptcy must be rejected before Mr. Orr is allowed to enact pension cuts: “We think you don’t actually have to wait until the harm has befallen you if the threat is imminent.” To which Judge Rhodes responded: “Of course, if eligibility is denied, the city is also denied the right to deal with its other debt, isn’t it?” Counselor Montgomery testified, in response, that Detroit would be welcome to reapply for bankruptcy without violating the Michigan Constitution’s protection of public pensions. Mr. Montgomery and other creditors have argued that the city’s bankruptcy should not proceed, because of the Michigan Constitution, which protects public pensions as a “contractual obligation.” After this week’s legal hearings, Judge Rhodes next week will open an eligibility trial on October 23rd.

Key Questions:

· Is the city insolvent? In a document filed in court in September, the city said Detroit was “cash insolvent, budget insolvent and service delivery insolvent;” nevertheless, there are contrasting third-party actuarial reports on the health of the city’s two pension funds.

· Did the city negotiate in good faith with creditors? (Chapter 9 requires the municipality to prove it negotiated “in good faith” or is “unable to negotiate with creditors because such negotiation is impracticable.”

· How does Emergency manager Orr’s plan to cut pensions factor in bankruptcy eligibility? (Michigan’s Constitution protects public pensions as a “contractual obligation” that cannot be “diminished or impaired.” Chapter 9 of the federal bankruptcy code allows contracts to be diminished. Does federal law preempt the Michigan constitution?

· Did the state legally authorize the city’s Chapter 9 bankruptcy filing?

· Are Chapter 9 and the emergency manager law constitutional?

“Frustrated as Hell.” In his deposition, this week, Detroit  Mayor Dave Bing testified that his department heads are “frustrated as hell” by the consultants who have taken over City Hall, so that he agreed with an assessment that Emergency Manager Kevyn Orr is “not doing a competent job” restructuring city operations: “My big concern there is at some point in time we will come out of bankruptcy, and if you don’t have the people internally that know the system and you have all these consultants doing the job that city employees ought to be doing, when Kevyn leaves… you haven’t developed anybody to run the city on a day-to-day basis.” “That’s my biggest concern. We don’t even have a line item in our budget for training. Somebody’s got to get trained to do these jobs on a long-going basis.” Mayor Bing stated that the Emergency Manager has a good grasp of Detroit’s long-term financial needs, but that he has failed to carry out key reforms to city operations. Anthony Ullman, an attorney representing a committee of Detroit retirees, asked Mayor Bing about a July 10 email from a city employee that gave Orr high marks for addressing Detroit’s long-term liabilities, but blasted the emergency manager for failing to change how the city operates: “Mr. Andrews’ conclusion is that the emergency manager, and I quote, threw away the head start we gave him, he frankly is not competent at all…In fact, he’s embarrassingly incompetent and only listened to his equally incompetent staff and (does) not well exercise the added powers he had. So Mr. Andrews gives him an A in long-term liabilities and an F in operations.” Mayor Bing responded: “I’m not going to give (Orr) a grade from A to F in either one of those areas, but I would agree that his strength was in dealing with the long-term liabilities and not operations.” Mr. Ullman followed: “Mr. Andrews’ view is that he’s (Mr. Orr) not doing a competent job in the restructuring aspect and the operational aspect. Did you agree with that?” Mayor Bing responded; “Yes, I would.” One of the issues that makes municipal bankruptcy so distinct from corporate bankruptcy is that, because it is specifically enacted to ensure continuity of operations and the provision of essential services, the federal law creates an awkward relationship between the existing elected leadership and the receiver or emergency manager. Thus, this week’s deposition appeared to underscore the awkward and difficult relationship that has developed between outgoing mayor Bing and Mr. Orr after the emergency manager was appointed in March.

At the deposition, Mayor Bing said he became aware that Kevyn Orr was the Governor’s choice for emergency manager in late January or early February. He testified that he was asked to fly to Washington to meet Mr. Orr in February. He testified he had hoped to retain his existing management team, but that didn’t happen: “I had no input at all” on Orr’s appointments…I didn’t want to see a lot of turnover, additional turnover…With an emergency manager coming in, if we started losing some of our key players that have been there with me to put a plan together and then try to execute the plan, relieving or dismissing any of those people I thought would be a negative, would take us backwards and not forward.”

Taking Stock in Stockton. Moody’s has downgraded Stockton’s credit rating to Ca from Caa3 for its series 2007 pension obligation bonds and changed the outlook to negative from developing; the action on the 2007 pension obligation bonds reflect the proposed treatment of these bonds’ creditors as outlined in the city’s chapter 9 plan of adjustment adopted earlier this month on October 3rd. Under Chapter 9 of the bankruptcy code, a municipality must issue and have confirmed a plan of adjustment before it can emerge from bankruptcy; ergo, Stockton’s plan serves as the its blueprint for reorganizing its debt and other aspects of its operations. For Stockton, a key determinant of whether it can successfully exit hinges on whether its voters agree to a ¾ cent sales tax, and the plan’s confirmation by the court. Stockton’s plan calls for the series 2006 lease revenue bonds to be paid in full, without interruption in debt service. For the series 2007 pension obligation bonds, the city is proposing significant losses to bondholders. Moody’s now estimates these losses to be in a range of 50%-65% of principal from the date the city first defaulted on the series 2007 bonds. While better than the city’s initial proposal of losses of around 80%, the projected losses are somewhat greater than had been implied at the former Caa3 rating level. For the series 2007 pension obligation bonds, the Ca rating assumes losses will be between 50% and 65%, although these losses will accrue to Assured Guaranty Municipal Corp (“Assured,” A2 stable) rather than to bondholders. Under the plan, beginning in June, 2014 Assured will receive annual payments from the city from various sources. The city has deemed these payments “non-contingent.” Assured may receive additional, “contingent” payments tied to the performance of the city’s future revenues, which would increase bondholder recovery.

Federal Shutdown’s Impact on Municipal Bankruptcy Proceedings. Bipartisan Senate leaders last night and this morning are nearing an agreement to reopen the federal government through the early part of next year; however, House leaders have indicated little to no support for the proposal, leaving unclear how much longer the shutdown might persist. The unending shutdown of the federal government, absent resolution this week, could impact the municipal bankruptcy proceedings in San Bernardino, Stockton, Jefferson County, and Detroit unless Congress acts soon. U.S. courts are trying to assess how much longer they can continue to operate, with a spokesperson for the U.S. District Court noting:  “After 10 days we’ll have to reassess and see where we go from there,” Rod Hansen, the media information officer for the U.S. District Court, said; “Judge Rhodes is determined to move this along without delay, and how persuasive he might be in being able to continue on, I don’t know.”

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