Detroit - Analysis and...

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Detroit - Analysis and Clarification

Morningstar Municipal Research

Elizabeth Foos, Sr. Credit Analyst

Rachel Barkley, Sr. Credit Analyst

Jeff Westergaard, Dir. Municipal Analytics

Aug. 1, 2013

Agenda

× Timeline of events

× Liabilities and the Emergency Manager’s plan

× Concerns for bondholders- highlighting different security pledges

× Detroit and bond insurance

× Analyzing pension liabilities

× Mutual fund exposure to Detroit obligations

× Market reaction- observations of recent trades

× Conclusion

× Appendix

2

The Detroit Credit Crisis: A Brief Recap

× Detroit experienced decades of economic and fiscal stress and mismanagement

× March 14, 2013: State of Michigan assigns Emergency Manager to Detroit, Kevyn Orr

× June 14, 2013: Orr publishes Proposal For Creditors

× July 18, 2013: Detroit files for bankruptcy protection

3

Outstanding Liabilities ($ in millions)

4

$5,700

$3,500

$2,900

$2,400

$1,400

$879

$540

$473

$469

$265

$21

$8

Unfunded OPEB*

Pension Unfunded Liability

Sewer Revenue Bonds

Water Revenue Bonds

Pension Certificates

Pension Swaps

GO-LT

Sewer Revenue Loans

GO-ULT

Other**

Water Revenue Loans

Parking Revenue Bonds

Estimated Liabilities from Emergency Manager Report

*Other post employment benefits; **Miscellaneous liabilities

Concerns for Bondholders: Security Pledge

× General Obligation Unlimited Tax (GO-ULT) Bonds: Voter-approved full faith and credit

general obligation of the city. The city is authorized and required to levy ad valorem taxes without

limitation as to rate or amount upon all taxable property to pay principal and interest on the

bonds.

× General Obligation Limited Tax (GO-LT) Bonds: Payable as a first budget obligation from any

available funds including any collections from property taxes. Levy rates are subject to

constitutional, statutory and charter limitations.

× GO-LT & GO-ULT Distributable State Aid (DSA) Bonds: Provides a statutory lien on certain

state revenue sharing payments Detroit expects to receive from Michigan under provisions of Act

140 in each city fiscal year.

× Pension Obligation Certificates (POC): The city has an unconditional obligation to pay all

service payments related to the POCs per contractual agreements with its two retirement service

corporations. That obligation is not subject to appropriation.

5

Concerns for Bondholders: Security Pledge (continued)

× POC Swap Agreements: Secured claims arising under service agreements related to POC-

related interest rate swaps. Detroit directs the revenue received from wagering taxes on a daily

basis to a trustee for collateral for the quarterly payment to counterparties.

× Water Supply System Revenue & Sewage Disposal System Revenue Bonds & Loans:

The city issued bonds and received loans from the State of Michigan’s Revolving Loan Funds to

finance capital improvements which are secured by liens on net revenues of each respective

system.

× Pension Liabilities: Maintains two single-employer pension plans. Michigan’s Constitution

Section 24 of Article IX states that financial benefits of these plans are contractual obligations

and “shall not be diminished or impaired”.

× Other Post-Retirement Benefits (OPEB) Liabilities: Maintains the Health and Life Insurance

Benefit Plan and the Supplemental Death Benefit Plan for retirees. There is no specific article

referencing OPEB in Michigan’s Constitution lending additional protections in bankruptcy.

6

Detroit- Bonded Debt Liability Profile ($ in millions)

7

$1,848

$981

$1,718

$638

$1,400

$379

$161

$8

$369

$100

Sewer Revenue Senior Lien

Sewer Revenue Second Lien

Water Revenue Senior Lien

Water Revenue Second Lien


GO-LT Distributable State Aid

GO-LT


GO-ULT

GO-ULT Distributable State Aid

Secured and Unsecured Liabilities ($ in millions)

8

$2,900

$2,400

$879

$473

$379

$100

$21

$8

$5,700

$3,500

$1,400

$369

$265

$161

$34

Sewer Revenue Bonds

Water Revenue Bonds

Pension Swap Agreements

State Sewer Loans

Distributable State Aid GO-LT

Distributable State Aid GO-ULT

State Water Loans


Unfunded OPEB Liability

Unfunded Pension Liability


GO-ULT

Other

GO-LT

Notes and Loans

Unsecured Secured

Insured Coverage - $7.65 Billion Total Debt Outstanding

9

% Insured All Issuers, 86.2

% Uninsured All Issuers,

13.8

Insurer Exposure by Security Provision ($ in millions)

10

0 200 400 600 800 1,000 1,200 1,400 1,600

Syncora Capital

National Public Finance

MBIA Insurance

Financial Guaranty (FGIC)

Berkshire Hathaway

Assured Guaranty Municipal

Assured Guaranty Corp.

Ambac

Millions

Syncora CapitalNational Public

FinanceMBIA Insurance

FinancialGuaranty (FGIC)

BerkshireHathaway

AssuredGuarantyMunicipal

AssuredGuaranty Corp.

Ambac

GO-ULT 34,380,000 88,245,000 0 81,665,000 87,190,000 77,635,000

GO-LT 0 92,705,000

Water Revenue 296,105,000 462,830,000 0 371,735,000 735,555,000

Sewer Revenue 474,215,000 471,160,000 0 381,160,000 622,635,000 879,930,000

Pension Certificates 1,250,155,000 148540000

Ratings for Detroit Insurers

Insurer Moody's Investor Service Standard & Poor's Ratings Service

Ambac Assurance Corp. NR NR

Assured Guaranty Corp.

A3

AA-

Assured Guaranty Municipal Corp.

A2 AA-

Berkshire Hathaway Assurance

Corp.

Aa1

AA+

Financial Guaranty Insurance Corp.

NR

NR

MBIA Insurance Corp.

Baa1

A

National Public Financial

Guarantee Corp.

Baa1

A

Syncora Capital Assurance, Inc. Ca CC

11 Ratings information is taken from sources considered to be accurate.

Uninsured Debt Profile

12

$17

$69

$100

$379

$489

Sewer Revenue-secured

GO-LT

GO-ULT Distributable State Aid

GO-LT Distributable State Aid

Water Revenue-secured

Detroit’s Pension and OPEB Liabilities: Why They Matter

× Another precedent setting issue in the Detroit bankruptcy case is how pension and post-

retirement health care (OPEB) benefits will be treated.

× Included in the city’s “unsecured” liabilities under the Emergency Manager’s plan are an

estimated $3.5 billion of unfunded pension liabilities and $5.7 billion of unfunded OPEB liabilities.

× Under the proposed restructuring plan, bondholders and city retirees are pitted against each

other for a limited amount of resources. Both are being offered pennies on the dollar of their

pledged payments.

13

Detroit’s Pension and OPEB Liabilities: Why They Matter

× The state constitution provides a potential hurdle to the Emergency Manager’s plan.

× Michigan’s Constitution Section 24 of Article IX states that “The accrued financial benefits

of each pension plan and retirement system of the state and its political subdivisions shall

be a contractual obligation thereof and shall not be diminished or impaired thereby”.

× Even with that, the question remains unclear whether that protection must remain in a

federal bankruptcy court.

× OPEB benefits do not benefit from constitutional protection.

14

Detroit Pensions: Where They Stand Now

× Pension benefits are accounted for in two single-employer plans, the General Retirement

System (GRS) and the Police and Fire Retirement System (PFRS).

× The funded status of each plan as of June 30, 2011 (the most recent actuarial valuation date) is

as follows:

GRS PFRS Total

Amortization period 30 years 30 years

Asset valuation method 7-year smoothed market 7-year smoothed market

Investment rate of

return (net)

7.9% 8.0%

Projected salary

increases

4.0% - 8.9% 5.0% - 9.2%

Inflation Rate 4.0% 0% for 4 years; 4%

thereafter

Cost-of-living pension

adjustments

2.25% 2.25%

Actuarial value of

assets ($000s)

$ 3,080,296 $ 3,804,760 $6,885,056

Actuarial accrued

liability (AAL) ($000s)

$ 3,720,167 $ 3,808,643 $7,528,810

Unfunded AAL (UAAL)

($000s)

$ 639,871 $ 3,883 $643,754

Funded ratio 82.8% 99.9% 91.4%

15

× Despite the data on the preceding slide, the city’s actual unfunded pension liability is highly

contested.

× Combined UAAL as of last actuarial valuation: $643.8 million.

× The city’s total estimated UAAL for fiscal year 2012 is $977 million.

× The Emergency Manager has estimated the UAAL to be $3.5 billion.

× Orr states that the actuary’s numbers are understated due to:

× Aggressive and unrealistic assumed annual rates of return on investments

× Smoothing of funding levels over seven years

× Its lengthy 30 year amortization period.

Detroit Pensions: What’s the Real Liability?

16

× Some of the city’s actuarial assumptions and

asset valuation methods are within industry

norms and others are outliers.

× With the exception of the assumed rate of

return (7%), Orr hasn’t disclosed what

assumptions were used for his calculations.

× Actual investment returns for the city have

fluctuated greatly over the past few years.

× Pension liabilities are considered to be ‘soft

liabilities’ as they are based on a series of

assumptions.

Detroit Pensions: What’s the Real Liability?

17

Key Pension Takeaways

× Pension and OPEB liabilities account for a significant segment of the city’s “unsecured”

liabilities.

× Under the proposed restructuring plan:

× Retirees’ benefits would be reduced significantly.

× The level of protection from constitutionally protected benefits will be tested.

× Retirees and bondholders are being pitted against each other.

× The actual liability is unknown and contested.

× How these benefits are treated in bankruptcy court may set a precedent for how pensions are

treated by other distressed localities.

18

Mutual Fund Holdings Analysis

× Analyzed most recent holdings data available to Morningstar for both open end and

closed-end mutual funds

× Holdings reports are from a period beginning 3/31/2013 to 6/30/2013, therefore the

data is historical in nature

× Over 200 funds were found to have Detroit obligation exposure

19

Mutual Fund Exposure to Detroit Obligations (% of total MV)

20

13.53

12.03

11.54

10.13

6.92

6.76

6.49

6.17

5.04

4.98

Oppenheimer- ORMIX

First Investors- FTMIX

First Investors- FTTMX

Fidelity- FMHTX

Nuveen- NUM

Nuveen- FMITX

AllianceBernstein- AMIAX

Eaton Vance- EMI

Wells Fargo- WHYMX

Putnam- PXMIX

Mutual Fund Exposure Secured vs. Unsecured (% of total MV)

21

8.53

9.73

9.78

9.57

6.92

6.76

4.25

6.17

5.04

4.69

5.00

2.30

1.76

0.56

0.00

0.00

2.24

0.00

0.00

0.29

Oppenheimer- ORMIX



Fidelity- FMHTX

Nuveen- NUM

Nuveen- FMITX


Eaton Vance- EMI

Wells Fargo- WHYMX

Putnam- PXMIX

Secured Unsecured

Mutual Fund Exposure Insured vs. Uninsured (% of total MV)

22

9.95

9.73

10.44

9.33

5.01

5.33

2.04

4.56

0

4.69

3.58

2.3

1.1

0.8

1.91

1.43

4.45

1.61

5.04

0.29

Oppenheimer- ORMIX



Fidelity- FMHTX

Nuveen- NUM

Nuveen- FMITX


Eaton Vance- EMI

Wells Fargo- WHYMX

Putnam- PXMIX

Total Insured Total Uninsured

Detroit - Trading Analysis

× Analyzed trades reported to the MSRB between 5/1/2013 and 7/30/2013

× Divided into two periods- prior to Emergency Manager report on 6/14/2013 and after

× Acknowledging that this is a period of rising rates for the municipal market with record

amounts of mutual fund outflows we still see clear evidence of yield impact

× Analyzed various security pledge backed issues to judge market implied credit risk and

yield levels

23

Unlimited Tax General Obligation Bonds

0

5

10

15

20

25

30

35

40

45

50

0 2 4 6 8 10 12 14 16

Trading Activity May 1- July 30, 2013

Pre-Event Post-Event Poly. (Pre-Event) Poly. (Post-Event)

24

Limited Tax General Obligation Bonds - Insured

0

2

4

6

8

10

12

14

0 2 4 6 8 10 12 14

Trading Activity (May 1-July 30, 2013)


25

Limited Tax General Obligation Bonds - Uninsured DSA

0

1

2

3

4

5

6

7

0 5 10 15 20 25



26

Limited Tax General Obligation Bonds - Uninsured Non-DSA

0

10

20

30

40

50

60

0 0.5 1 1.5 2 2.5 3 3.5


Pre-Event Post-Event

27

Insured Water and Sewer Revenue Bonds

0

1

2

3

4

5

6

7

8

0 5 10 15 20 25

Insured Water


Poly. (Pre-Event) Poly. (Post-Event)

0

1

2

3

4

5

6

7

8

0 5 10 15 20 25 30

Insured Sewer


Poly. (Pre-Event) Poly. (Post-Event)

28

The Market is Differentiating Among Bond Insurers

0

1

2

3

4

5

6

7

8

9

0 5 10 15 20 25 30

Post-Event Water & Sewer Trading By Insurer

Assured Guaranty Berkshire Hathaway MBIA

Poly. (Assured Guaranty) Poly. (Berkshire Hathaway) Poly. (MBIA)

29

Our Conclusions - Is this a Watershed Event for the Municipal

Market?

× Potentially momentous implications for sovereign rights of states versus power of

federal bankruptcy laws over constitutional protection of pension benefits

× Potentially watershed revision of opinion regarding the fundamental security offered by

unlimited tax general obligation pledge

× Critical determination of the value that bond insurance may provide in the aftermath of

the financial crisis

× Emphasis on differentiating the source of security backing bond issues becomes acutely

important

30

APPENDIX

32

Mutual Fund Exposure by Security Provision (% of total MV)

Fund Sewer Revenue Water Revenue

Unlimited Tax

G.O. Limited G.O.

Limited G.O.

With DSA

Parking

Revenue

Oppenheimer-

ORMIX 5.02 3.51 3.70 1.30 0.00 0.00

First Investors-

FTMIX 5.18 4.55 0.00 2.30 0.00 0.00

First Investors-

FTTMX 2.58 7.20 1.02 0.74 0.00 0.00

Fidelity- FMHTX 3.84 5.73 0.56 0.00 0.00 0.00

Nuveen- NUM 2.99 3.93 0.00 0.00 0.00 0.00

Nuveen- FMITX 3.9 2.86 0.00 0.00 0.00 0.00

AllianceBernstei

n- AMIAX 2.21 2.04 0.00 2.24 0.00 0.00

Eaton Vance-

EMI 1.17 5.00 0.00 0.00 0.00 0.00

Wells Fargo-

WHYMX 3.48 1.56 0.00 0.00 0.00 0.00

Putnam- PXMIX 2.87 1.82 0.00 0.29 0.00 0.00

33

Mutual Fund Exposure by Insurer (% of total MV)

Fund Ambac Assured Gty.

Berkshire

Hathaway MBIA/National Syncora

Oppenheimer-

ORMIX 1.73 3.67 0.00 4.55 0.00

First Investors-

FTMIX 0 5.18 0.00 4.55 0.00

First Investors-

FTTMX 0 5.80 1.28 3.36 0.00

Fidelity- FMHTX 0.56 1.79 0.90 6.08 0.00

Nuveen- NUM 0 3.31 0.10 1.60 0.00

Nuveen- FMITX 0 0.75 0.00 4.58 0.00

AllianceBernstein-

AMIAX 0 2.04 0.00 0.00 0.00

Eaton Vance- EMI 0 1.17 0.00 3.39 0.00

Wells Fargo-

WHYMX 0 2.45 0.00 1.56 0.00

Putnam- PXMIX 0 3.35 0.00 1.34 0.00

34

Uninsured Water Revenue Bonds

0

2

4

6

8

10

12

0 5 10 15 20 25 30 35

Trading Activity (May 1- July 30, 2013)


35

Pension Certificates of Participation (Insured)

0

5

10

15

20

25

0 5 10 15 20 25 30

Trading Activity (May 1- July 30, 2013)


36

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