The Precipitous Chapter 9 Road to Recovery

January 3, 2018

Good Morning! In this a.m.’s Blog, we consider the fiscal, scholastic, and governing challenges of the city emerging from the largest chapter 9 municipal bankruptcy in U.S. history.

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The Steep Fiscal Road to Recovery.  After years of failed leadership, financial mismanagement, quasi-chapter 9 municipal bankruptcy which led to a state takeover; the state of Detroit’s Public Schools Community District remains vital to encouraging young families to move back into the city—especially in the wake, last month, of DPS failing to meet critical deadlines necessary to be eligible for vital state aid.  (In 2016, Michigan enacted a $617 million DPS bailout, as we have previously noted.) That action separated the district’s debt from a new district that could start fresh. Now, renewed state intervention would be a critical fiscal step backwards; thus it is fortunate that Superintendent Nikolai Vitti appears to be on top of the situation: he warns that disciplinary action will follow in the wake of DPS’ failure to meet these deadlines, making it critical the Superintendent can trust his staff. It is especially vital now in the wake of a second credit rating upgrade—with the report card having recorded, last month, that DPS that Detroit Public Schools had lost out on $6.5 million in fiscal assistance to whittle down its old debt, because DPS officials had failed to turn in paperwork homework on time, according to Superindent Vitti (Michigan reimburses its public school districts for debt loss under Public Act 86 if they met the Aug. 15 deadline; thus, Superindent Vitte, on Monday, reported: “At this point, Detroit Public Schools is not eligible for the $6.5 million-dollar reimbursement from the state…After speaking with state officials, the available funds have already been disbursed to other qualifying entities. However, we will continue to petition the state to receive the reimbursement.”

Under the agreement, Detroit’s old district is still obligated to pay down its past operating debt; thus, the system’s failure to meet two deadlines last year cost not $6.5 million in aid from the state to help pay down its debt, but also a loss of public trust and confidence. As Superintendent Vitte noted last month: “At this point, Detroit Public Schools is not eligible for the $6.5 million-dollar reimbursement from the state: After speaking with state officials, the available funds have already been disbursed to other qualifying entities.” According to Superintendent Vitti, former CFO Marios Demetriou received the documents, but never completed them or sent them to the state. Even though the missed payout from the state is not expected to harm the day-to-day operations of the new district, it appears to curry a D grade; more importantly, it delays repayment of DPS’ legacy debt—or, as Superintendent Vitti notes: it is “unacceptable….The inability to submit the reimbursement form on time is a vestige of the past that continues to haunt the district…This is directly associated with the need for stronger leaders, systems, and processes. The individuals who were closest to the responsibility to submit the form will no longer be with the district.”

The unscholarly missteps appear to have contributed to ongoing doubts about the city’s fiscal acumen: The Motor City’s credit ratings remain deep in junk-bond territory, even after S&P Global Ratings last month upgraded Detroit’s credit rating from B to B+, while Moody’s last October had lifted its to B1 in the wake of the city’s launch of a new web portal to improve investor access to its financial data and bond offerings, Stephen Winterstein, a Managing Director and chief municipal fixed income strategist at Wilmington Trust Investment Advisors, Inc. to note he was “really optimistic about what they have been doing in terms of disclosure and the investor website is definitely a move in the right direction: The road to recovery is a long one, and I think that Detroit is doing the right things.”

Since exiting from the largest chapter 9 municipal bankruptcy in American history just three years ago last month, Detroit has issued debt twice: in August 2015 with $245 million of local government loan program revenue bonds, and in August 2016 with a $615 million general obligation/distributable state aid backed bond sale—albeit both issuances were via the Michigan Finance Authority, with the first enhanced with a statutory lien and intercept feature on the city’s income taxes. CFO John Naglick said that Detroit is also close to deciding on the underwriting team for a request for proposals it launched in October to find banks to lead a tender offer and refunding of its unsecured financial recovery municipal bonds with the aim of lowering its costs and easing a future escalation of debt service. For its part, S&P, in its upgrade, cited positive momentum the city is building with regard to stabilizing its operations and being better prepared to address future significant increases in pension contributions—or, as the agency noted: “We believe the city’s financial position is now more transparent compared with recent years, as is Detroit’s long-term financial strategy, which relies on fairly conservative growth assumptions…We also believe that the city has a stronger capacity to service its debt obligations than in years past.” Indeed, Detroit’s credit ratings are the highest since March of 2012, just over a year before Kevin Orr filed for chapter 9 bankruptcy in July of 2013. Nevertheless, Detroit’s credit rating remains deep in junk territory and vulnerable to another recession, say market participants. Or, as Michigan Attorney General and gubernatorial Bill Scheutte notes: “We still believe Detroit faces a long path that will require years of prudent decision-making from management and the avoidance of major economic shocks before its debt makes sense for investors looking for high-quality municipal exposure…The city still has an abundance of extremely high-risk characteristics and speculative-grade qualities that investors should be very cognizant of and understand what they are taking on.” Notwithstanding, Detroit appears to be on course to exit state oversight this year: it has presented deficit-free budgets for two consecutive years, enabling it to exit from oversight by the Financial Review Commission oversight; it ended FY2016 with a $63 million surplus; Detroit’s four-year forecast predicts an anemic annual growth rate of only about 1%; thus, any adverse public school news could have repercussions.


The Potential Consequences of a State Takeover of a Municipality


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eBlog, 2/03/17

Good Morning! In this a.m.’s eBlog, we consider the long-term costs and consequences of state takeovers of a municipality, and of a broken state financial system.

The Fiscal Costs of Incompetence. Michigan taxpayers, including those in Flint, will be paying litigation and legal defense expenses for two former officials implicated in contributing to Flint’s lead-contaminated water crisis. Governor Rick Snyder’s Office confirmed that the Michigan Treasury Department will reimburse the city of Flint for legal and defense fees for former state-imposed Flint Emergency Managers Darnell Earley and Gerald Ambrose—officials appointed by the Governor who have now been charged by Michigan Attorney General Bill Schuette with committing false pretenses and conspiracy to commit false pretenses, 20-year felonies. The duo also face a charge of misconduct in office, a five-year felony, and a one-year misdemeanor count of willful neglect of duty. Gov. Rick Snyder’s spokeswoman notes that state officials do not have any estimates on costs to state taxpayers for their defense—or if there is any ceiling with regard to what state taxpayers will be chipping in.

The Fiscal Costs of a Broken State Financial System. Dan Gilmartin, the Executive Director of the Michigan Municipal League, this week noted that “A lot of people feel as if we’ve turned the corner here in Michigan, you know, we’ve got more people employed, and the big three are doing better, and there’s some good things happening in the tourist economy and all kinds of different areas, so they think things are getting better…they might be getting better for state coffers; but they’re actually getting worse at the local level because of the system that we’re in right now.” Noting that, despite the state’s strong economic recovery, that recovery has not filtered down to its cities—which, in the wake of some $7 billion in state cuts to general revenue sharing since 2002—has left the state’s municipalities confronting an increasingly harder time to finance public infrastructure and public safety. The League’s report also recommends the state help cities come up with more modern health care plans which would allow them to control costs and stay competitive with other employers. Perhaps most intriguing, Mr. Gilmartin recommended that state aid for public infrastructure be allocated on a regional basis, rather than jurisdiction by jurisdiction. Finally, he urged the Michigan legislature to make up for the steep cuts made to revenue sharing in the last 15 years.

Exiting Receivership. The Michigan Department of Treasury has announced that the small municipality of Allen Park—a city of about 28,000 in Wayne County, where the annual per capita income is $27,000 and the estimated median assessed property value is $91,000, is no longer under receivership—meaning the city’s elected leaders have effectively had their authority to govern restored. The small city, which had also been charged in 2014 by the Securities and Exchange Commission with fraud, with the SEC charging public officials as “control persons,” came in the wake of a recommendation from members of the Allen Park Receivership Transition Advisory Board, which was state-appointed in 2014 in the wake of Gov. Rick Snyder’s announcement that the city’s 2012 financial emergency had been resolved after its structural and cumulative deficits had been eliminated. Gov. Snyder had imposed an Emergency Manager from March 2013 to September 2014, the same month in which the Michigan Receivership Transition Advisory Board was appointed. According to the Treasury, Allen Park “has made significant financial and operational progress,” including increasing its general fund balance; passing 10-year public safety and road millages; and saving $1.1 million by tendering 62 percent of Allen Park’s outstanding municipal bonds issued through the Michigan Finance Authority. In addition, the municipality made its required contributions into the pension and retiree healthcare systems, including an additional $500,000 annual payment toward other OPEB liabilities. Allen Park Mayor William Matakas responded: “On behalf of the city, I express my gratitude to the members of the Receivership Transition Advisory Board for their professionalism during Allen Park’s transition from emergency management to local control…I look forward to working with local and state officials to ensure we continue down a path of financial success.” Michigan Treasurer Nick Khouri, in the wake of the release of the municipality under Michigan’s Local Financial Stability and Choice Act, said Allen Park leaders are thus authorized to regain control and proceed with tasks such as approving ordinances, noting: “This is an important day for the residents of Allen Park, the city, and all who worked diligently to move the city back to fiscal stability…The cooperation of state and city officials to problem-solve complex debt issues now provides the community an opportunity to succeed independently. I am pleased to say that the city is released from receivership and look forward to working with our local partners in the future…The cooperation of state and city officials to problem-solve complex debt issues now provides the community an opportunity to succeed independently.” According to Mr. Khouri, since the state intervention, Allen Park has increased the city’s general fund balance in the wake of adopting a 10-year public safety millage and a 10-year road millage; in addition, the city completed a successful tendering of 62% of the outstanding municipal bonds issued via the Michigan Finance Authority used to fund a failed movie studio project for a savings of $1.1 million in 2015. An additional remarketing of the remaining amount was finalized in 2016, saving the city another $900,000. It makes one wonder whether New Jersey Governor Chris Christie might benefit from observing the constructive relationship between the state and Allen Park as a means to help an insolvent city regain its fiscal feet.

Post Chapter 9: Returning to the Municipal Market & Avoiding a State Takeover

In this morning’s eBlog, we consider the critical, first effort by the City of Detroit to issue full faith and credit municipal debt–an effort complicated by the  still unsettled fiscal  situation of Detroit’s public school system, and we examine Atlantic City’s efforts to—once again—avoid a state takeover.

To Market, to market…& the Ties that Bind. In the wake of last month’s unanimous approval by the Detroit City Council of the issuance of up to $660 million of refunding bonds to save an estimated $37 million and help pave the Motor City’s return to the municipal bond market after emerging from the largest municipal bankruptcy in American history (a successful sale is projected to generate savings of about $40 million that the city would use to provide budgetary and property tax relief)—and the Council’s further actions to put aside $30 million from a budget surplus to deal with a possible public pension funding shortfall of nearly $500 million; the city is set to issue full faith and credit municipal bonds today to refund up to $275 million of unlimited tax general obligation (utgo) bonds sold in 2014 and up to $385 million of limited tax GO bonds sold in 2010 and 2012—municipal bonds backed by state revenue earmarked for Detroit, which are to be issued through the Michigan Finance Authority (MFA) in an agreement led by underwriter Barclays—marking Detroit’s first GO bond issuance in the market since it exited the largest municipal bankruptcy in the nation’s history two and a half years ago. The $615 million refunding, which is expected to price as early as today, will test not only the implicit benefit of the value of the MFA authority, but, at the same time, the uncertainty created by the ongoing disruption to the security of similarly structured Detroit Public Schools (DPS) state-aid backed or so-called DSA (distributable state aid bonds) municipal bonds due in the wake of the DPS state takeover as it became insolvent—indeed, as our respected friends at Municipal Market Analytics (MMA) warned, these Motor City municipal bonds may incur “a larger-than-anticipated” penalty, even as Detroit CFO John Naglick attempted to make clear the significant distinctions between Detroit and DPS with regard to governing structures—and the fact that the city’s DSA bonds were protected during the city’s historic municipal bankruptcy. Moody’s and S&P affirmed the single-A to double-A ratings on Detroit DSA-backed bonds sold under the MFA’s local government loan program: S&P noted: “Given the double-barrel pledge, we rate the bonds to the stronger of the two pledges, which is the DSA revenue stream.” Nevertheless, MMA has noted that Detroit’s short-term progress since emerging from its historic municipal bankruptcy is insufficient to offset longer-term municipal investor risks, with fabulous Matt Fabian of MMA noting: “It’s clear that the state can’t be trusted with respect to its willingness to pay municipal bond holders, especially when it comes to (municipal) bonds held by Detroit…Remember that the city’s economic and financial future remains far from secure, and Detroit is at serious risk of relapsing into bankruptcy within the next 10 years: Buyers of the new bond series are thus betting directly that the state will change its tack and develop a willingness to pay city of Detroit bondholders in the future…[but] this is not an unreasonable speculation by risk-aggressive managers who have clearly communicated their plans to their own investors. However, this bond series should not be the province of traditional retail.” Ergo, the state aid statutory lien is central to the investment-grade ratings on the $615 million proposed sale—one which will unroll in four series:

  • a $247 million of taxable first lien limited tax GOs in a mix of term and serial maturities;
  • a $125 million taxable third-lien limited tax GO in a mix of serials and terms;
  • a $225 million fourth-lien tax-exempt unlimited tax GOs tranche with serial maturities; and
  • a final $18.1 million taxable fourth lien unlimited tax GO tranche in serial maturities.

Nevertheless, the sale is beset by apprehension with regard to the complex and unresolved fiscal status of the Detroit Public Schools (DPS) restructuring and the fate of the school systems’ municipal bonds—bonds secured by a state pledge, but under which the state funds now will go to a newly created district free of debt, even as the old DPS remains intact to continue collecting tax revenues to retire its debts. Indeed, S&P, in a quasi—scholarly action, recently downgraded DPS’s state aid bonds from 2011 and 2012 issuances, noting apprehensions about the potential fiscal impacts with regard to the new state legislation and potential disruptions of pledged state aid. Restructuring could disrupt pledged aid. (The MFA recently approved a $235 million financing to restructure the bonds.) , but final details have not been made available. Mr. Fabian notes it is clear the MFA will take action to restructure the bonds, adding, however, that absent more specifics, municipal bondholders holding the DPS bonds “are being presented with more anxiety than they probably bargained for when they bought those.” For his part, CFO John Naglick does not agree there is a correlation between Detroit’s refunding and the outstanding DPS bonds: “The distributable state aid pledged by the city is appropriated to the city under a different statute from the one under which state aid is appropriated to and pledged by school districts…Additionally, a significant portion of the DSA is allocated to the city by the Michigan constitution, not by [a state] statute. The bonds of the city and DPS are also issued under different statutes. Finally, in its [municipal] bankruptcy proceedings, the city did not impair, did not attempt to impair, and throughout that process treated as secured its DSA-backed debt.” Nevertheless, in its offering, the proposed sale lists nearly four pages of “risk factors” municipal bond investors might be advised to consider, including the warning that were Detroit to file again in the future for municipal bankruptcy protection, such a filing could have “significant adverse consequences affecting bondholders,” including “immediately delaying for an indefinite period of time payment on the bonds, modifying the maturity date, interest and payment terms and conceivably modifying the security for the principal amount.” Nevertheless, Moody’s and S&P last week affirmed the single-A to double-A ratings on Detroit municipal bonds backed by distributable state aid and sold under the MFA’s local government loan program; in addition, Detroit’s distributable state aid includes a portion of the 6% retail sales tax revenues collected across the state—of which the constitutional component is mandated by the Michigan state constitution and distributed on a per capita basis to townships, cities, and villages: it is not subject to reduction by the state legislature; in contrast, the statutory component of state aid is authorized by legislative action and distribution is subject to annual state appropriation by the state legislature.

Tempus Fugit. St. Francis, long ago, warned: “Time is round, and it rolls quickly.” So too for those gambling on Atlantic City’s future—and who cannot, like Donald Trump, simply declare bankruptcy and walk away from the famed boardwalk city—the time here with which to reckon is five days: that is, the city must come up with the means to meet a $3.4 million debt service payment by then or default—with the consequent urgency to reach agreement with the state on a bridge loan—a loan upon which the state last May agreed, as part of a recovery package to avoid an immediate default, but upon which the state has been characteristically slow to follow-up: it has only recently begun proposing terms to the city, according to Moody’s, where crack analyst Douglas Goldmacher noted a sign of how much Atlantic City need the loan occurred when the state had to step in to make an $8.5 million payment owed to the Atlantic City School District last week—a payment to be deducted from its final loan amount—with Mr. Goldmacher writing: “The city has requested, and the state has agreed, to a $74 million loan, but the terms have not been publicly announced and no formal agreement has been reached…The legislation did not outline the terms for the loan, leaving it to the state’s Division of Local Government Services to negotiate with Atlantic City management.” He added that negotiations with the state are underway, and, if the loan can be executed this week, it would help Atlantic City to avoid default next Monday and to make payments on an additional $18.6 million owed in municipal debt service for the rest of this year; he noted the funds could also help the city devise a five-year financial plan required by early November as part of the state rescue legislation, warning: “Absent any receipt of state support, we believe a default would likely set off a series of missed debt payments and revive the prospect of Atlantic City filing for municipal bankruptcy, or pursuing debt restructuring outside chapter 9 bankruptcy, which we would consider a distressed exchange.”

Mayor Don Guardian Tuesday evening noted the city is close to finalizing the loan, and City Council President Marty Small vowed Atlantic City will have a plan to close a $100 million shortfall in next year’s budget in time for a state-imposed Nov. 3rd deadline, albeit the city still may seek an extension. The state has said it will similarly step in and cover the city’s payroll or the pending $3.2 million bond payment, Atlantic City Mayor Don Guardian said on Tuesday. If Atlantic City fails to submit a plan by Nov. 3rd, or if the plan is rejected, the state can sell city assets, break union contracts and assume major decision-making powers from the city’s government for five years. Brian Murray, a spokesman for Governor Christie, said that there is nothing in the bill that would allow an extension. “The statute signed by the Governor is very clear that city officials had 150 days to develop a plan…There is nothing in the legislation or otherwise that provides for any waiting period regarding the city’s request for a bridge loan.” Similarly, a spokesman for Senate President Steve Sweeney also dismissed any notion of an extension: “It appears the government of Atlantic City is not concerned about its residents or its responsibility to govern…If the city was serious, they would have submitted a plan already. This financial crisis was well-known for years prior to the signing of the legislation. It’s time for action, not delays.”

Council President Small said the city will be ready with a plan within the state-imposed 150-day timeline, but blamed the state for a six-week delay in providing vital loan documents. She added Atlantic City did not receive bridge loan documents until two weeks ago, which hampered the process of working on the plan, noting: “The Governor signed the document of Memorial Day weekend…We’re just getting those documents.” Said documents relate to an agreement on a $74 million bridge loan which would allow Atlantic City to cover its expenses as it completes its plan to prevent the state takeover.

If the loan is not approved this week, the city could default on a $3.4 million debt service payment, according to a report by Moody’s Investors Service issued yesterday: “Absent any receipt of state support, we believe a default would likely set off a series of missed debt payments and revive the prospect of Atlantic City filing for bankruptcy, or pursuing debt restructuring outside bankruptcy, which we would consider a distressed exchange…A sign of how much the city needs the bridge loan came July 15th when the state stepped in to make an $8.5 million payment to the Atlantic City School District on behalf of the city. The payment will be deducted from the city’s final loan amount.”

Council President Small also expressed other frustrations with the state, noting that all of the ideas the city has come up with to balance the budget, such as adding a hotel room tax of $10 and a wage tax, have fallen on deaf ears in the state government: “The City of Atlantic City, as they say, is the golden goose…We’re responsible for a lot of projects and programs throughout the state…Well, the golden goose has a little paint chipping away. Now it’s time for them to help us out.” Nevertheless, and notwithstanding his frustrations, Councilman Small said that he is not giving up on the city that he was born and raised in: “Some people think that we’re wasting our time and that the state is going disapprove anything we give them…Well guess what, we’re going to die trying.”

In his assessment, Mr. Goldmacher also wrote that Atlantic City is also looking to tackle other municipal debt challenges including $228 million in bonds issued to cover tax appeal refunds incurred between 2010 and 2015, as well as an additional $165 million in refunds to Borgata Hotel Casino and MGM Mirage. Borgata and MGM Mirage have taken a combined $17 million credit against their 2016 year-to-date property taxes as partial payment for the owed refunds, according to Mr. Goldmacher, who notes: Atlantic City is responsible for any refunds owed on taxes paid to the city, the county and school district: Both the city and state are negotiating with the casinos to adjust future payments and make payment arrangements.”