On January 31, the City of Detroit, MI (Caa3 negative) filed a motion with the bankruptcy court to invalidate $1.45 billion of pension obligation Certificates of Participation (COPs). The attempted repudiation of municipal debt is an extremely rare and unusual act. A successful repudiation is still subject to court approval and would be credit negative for holders of the city’s COPs and potentially for pensioners and other bondholders if the city were also required to return the proceeds of the certificate sale. The return of proceeds is a possibility since they were used to fund the city’s previously unfunded pension liabilities and are part of the assets of the pension system. Ultimately, the city’s repudiation attempt is unlikely to impact the broader municipal market because it is so rare. Should the city prevail, the case is still likely to have limited implications for COPs holders elsewhere.
While repudiation is radical, some creditors may actually benefit if the court invalidates Detroit’s COPs, simply by making more funds available for unsecured creditor recovery. The city would no longer need to include repayment for $1.45 billion in COPs principal in its reorganization plan, including a projected $676.3 million in cumulative COP debt through 2023 and $498 million of forecasted expenditures for swaps related to the COPs, according to analysis presented in the city’s Proposal to Creditors in June 2013. Because COP proceeds funded pension liabilities, the funded status of the pensions could be severely weakened, however, if the court disgorges those proceeds following the repudiation. The ultimate disposition of the proceeds, should disgorgement occur, is unknown.
It is rare for a US municipal issuer to repudiate debt. The most recent example of a successful repudiation occurred in 1983, when a state court ruled that the Washington Public Power Supply System’s (WPPSS) Projects 4 and 5 take-or pay contracts were illegally executed. The municipal participants challenged the contracts after the projects were cancelled due to cost overruns and other complications. After the court invalidated the contracts, WPPSS defaulted on $2.25 billion of revenue bonds secured by the contracts. In contrast, Richmond Unified School District, CA failed in its attempt to repudiate its COPs lease obligation after defaulting on a COP lease payment in August 1991. While the district argued that the COPs were invalid because the underlying lease created debt in violation of the state’s constitutional debt limit, the court ultimately ruled that the lease was valid and enforceable. The district settled with the trustee for repayment. Neither of these examples involved an entity in bankruptcy.
Detroit similarly alleges that it issued pension obligation COPs illegally by violating the city’s statutory debt limit, despite the legal disclosure at the time of issuance to the contrary. Setting aside the legal merits of the city’s claim, the broader market impact of a favorable ruling for the city would likely be limited. COPs and instruments of this type are extremely rare in Michigan. Only one other Moody’s rated issuer has used a similar structure, and there is little precedent or case law in other jurisdictions where financings of this type are more common. In many states, the law recognizes lease-backed obligations as valid structures. Moreover, in the context of Detroit, debt repudiation is not completely surprising, given the depth of Detroit’s credit challenges. We do not expect debt repudiation to become a frequently used tactic for local governments given the very strong credit fundamentals of the vast majority of COPs issuers.
VOD: The reports above from the Bond Buyer and Moody’s belie Wall Street’s role in pushing the COPS loan, and profiting from it. They also show alarm at the lawsuit filed against it, and threaten Detroit’s pension systems with having to repay the loan, instead of UBS AG, Bank of America Merrill Lynch, and Siebert, Brandford and Shank, the lenders who profited from it.
It was predatory mortgage lending by these banks and others that was largely responsible for the 2008 global economic collapse, and for the devastation of Detroit’s neighborhoods and tax base. Wall Street reps shown at top pushed this loan KNOWING that danger lay ahead, but assuring the City Council it was safe.