The Hard School Odds against Recovering from Municipal Bankruptcy


April 29, 2015
Visit the project blog: The Municipal Sustainability Project

Going to School on Municipal Bankruptcy. Detroit’s road to recovery from the largest bankruptcy in U.S. history was never projected to be easy, but actions by the Michigan House yesterday and the desperate fiscal status of the city’s Detroit Public Schools (DPS) have added significant obstacles. Yesterday, the Michigan House passed and sent to the Senate a $37.8 billion general government spending plan that slashes state revenue sharing for Detroit by $4.1 million. In its 59-51 vote, House Republicans rejected a Democratic amendment to adopt Gov. Rick Snyder’s recommended $1.7 million increase in funding for Detroit’s municipal operations. The rejection of the Governor’s funding request came as the Governor is poised to release a plan tomorrow to address the teetering fiscal situation of the Detroit Public Schools—a plan to overhaul the troubled district, which has been under state control since 2009, yet still faces a $160 million deficit. Absent a fix for the city’s troubled school system, Detroit’s ability to attract families to move to the city appears dim. Thus, in the wake of months of work by Michigan local and state officials, Gov. Snyder is expected to announce his legislative package―a package that is already drawing opposition from the Detroit Federation of Teachers, who yesterday protested what they anticipate to be a plan to expand charters and the Education Achievement Authority in Detroit, and against what the union termed “all the destruction that 15 years of state mismanagement has brought Detroit Public Schools.” Last week, the Detroit News reported the Gov. was considering splitting DPS into two districts: one which would educate 47,000 students under a new structure, and one which would use DPS’s 18-mill non-homestead levy to pay off the district’s debt. The “new district” would have a board named by Gov. Snyder and Detroit Mayor Mike Duggan. Under such a revised structure, one would take on legacy debt and the other educational responsibilities. Adding to the already severe fiscal challenge confronting the city, however, Municipal Market Analytics, in its weekly “Municipal Issuer Brief,” on Monday suggested that holders of municipal debt issued by DPS would “likely [realize] more to gain from selling than holding [DPS debt] at this point,” noting that schools in Michigan and Illinois, so far this year, have accounted for 13% of all super downgrades—in large part because of state level fiscal challenges: “[A]ll Michigan local school bondholders are effectively long the risk that the governor of Michigan will not look to impair bondholders in a hypothetical DPS Chapter 9. That is not a good bet,” noting that the school system’s emergency manager is positioned to recommend a filing for municipal bankruptcy “if no reasonable alternative exists to repair the existing financial emergency,” and adding that [Gov.] “Snyder’s demonstrated ‘contempt’ for bondholders in Detroit’s bankruptcy, where the city’s unlimited-tax general obligation bonds were treated as unsecured, was hardly reassuring.” In its warning to holder of DPS municipal debt, the firm noted that no Michigan school district has ever filed for federal bankruptcy protection, the fate of enhanced municipal bonds would be most uncertain. According to DPS’s official statement: “In the absence of a legal precedent addressing the obligation of the State Treasurer to make an Act 92 payment in the context of a Chapter 9 proceeding, no assurance can be given that if the school district were to become a debtor under a Chapter 9 proceeding, the obligation of the state Treasurer to pay principal and interest on the municipal obligations post-bankruptcy filing would not be impaired”―a statement which the firm notes marks a “dramatic shift,” adding that “Michigan’s recent actions vis-a-vis bondholders give us little reason not to assume the worst.”

Superdowngrades. Municipal Market Analytics this week also provided a fiscal storm alert for Illinois municipalities, where Gov. Bruce Rauner has proposed a 50 percent cut in state income tax revenues provided as aid to local governments—a cut, which MMA notes, if agreed to by the legislature, “would be the kind of event to trigger superdowngrades.” While MMA considers such an event as “unlikely,” because there is no precedent for such action in the state and rarely have such actions occurred in other states; nevertheless, it is a fiscal warning.

Fiddling in Congress While Puerto Rico Squirms. Presidential candidate and former Florida Governor Jeb Bush, in a visit to Puerto Rico yesterday stated that Puerto Rico’s public agencies should be able to seek bankruptcy, during a visit to the U.S. territory. His visit came as yields on Puerto Rico’s newest general obligation bonds are setting record highs as lawmakers struggle to resolve a debate on tax changes that might pave the way for a $2.9 billion bond sale needed to ease a cash crunch. With about two months left in the fiscal year, the U.S. territory’s House of Representatives is not ready to vote on a plan to revamp its levy on goods and services, even as yields on tax-exempt Puerto Rico general obligation bonds maturing in July 2035 traded early this week with an average yield of 10.36 percent, according to data compiled by Bloomberg. The yield reached 10.42 percent last week, the highest since the bonds’ sale in March 2014. Mr. Bush’s visit came as the Government Development Bank, which warned last week that the government risks shutting down within three months, warned that tax overhaul is essential to attract investors to the planned bond sale. Without cash from the new bonds, Puerto Rico may fail to shield its general obligations and sales-tax debt, dubbed Cofinas, from restructuring. Philip Fischer at Bank of America Merrill Lynch, in not an understatement, said: “They’ve run out of many of their options…The administration has indicated very strongly that it would like to preserve the integrity of Cofina and the general obligations. When you’re in a situation of a possible insolvency, it’s not clear how much you can control it.” The territory and its state agencies have amassed $73 billion of debt―more than any U.S. state except California and New York, even as it is losing population; its public power utility, PREPA, is negotiating with creditors and may ask them to take a loss, which would be the biggest restructuring ever in the U.S. municipal-bond market. Gov. Bush’s visit came as the Puerto Rico House may vote as early as this week on a plan to boost the island’s sales and use tax by nearly 40% in June to 10 percent from 7 percent; then a new 14 percent levy, to be called a goods-and-services tax, would expand the sales-tax base beginning in January―the proposed tax plan would also include tax breaks for lower-income individuals as soon as July 2015. The projected changes could reap as much as $900 million of new revenue in the fiscal year beginning July 1, and would go toward paying debt service and retirement costs for public workers; the proposed $2.9 billion in new borrowing, to be backed by oil taxes, would repay loans the highway agency owes the Government Development Bank. The bank’s net liquidity fell to $1.1 billion as of March 31, from $2 billion in October. In his visit, Mr. Bush told Puerto Rican leaders: “Puerto Rico should be given the same rights as the states…In order for Puerto Rico to eventually become a state, it must begin by being treated as a state.” Like U.S. states, Puerto Rico, a self-governing island of 3.5 million, cannot file for bankruptcy, but, unlike states, Puerto Rico cannot authorize its municipalities to file for bankruptcy—and, to date, as Mr. Bush noted, Congress has demonstrated no willingness to consider amending the law to provide for such protections for Puerto Rico’s municipalities.