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Tuesday, 24 May 2016

A class, darkly

Detroit turns bankruptcy precedents upside down

Bondholders in Detroit’s $18 billion bankruptcy must feel like they’re in a mirror universe. A restructuring plan filed by the city’s emergency manager would effectively turn bankruptcy precedents upside down by paying equity holders – in this case, ordinary Detroiters – at the expense of secured creditors. Such a shareholder-friendly approach might save the city and anoint Judge Steven Rhodes a hometown hero. But it may yet come at a market price.

Detroit’s Chapter 9 case is a long way from a more familiar Chapter 11 bankruptcy. When a company can’t make good on its debts, shareholders get wiped out first, with creditors carving up what’s left. 

Cities don’t have shareholders, and there are few precedents to the bankruptcy of a major municipality, but viewed through a financial lens, residents arguably play a similar role. They appoint management to run the city and they benefit from its expenditures, whether it is police protection, sanitation or other services - a bit like equity holders sharing in a firm’s profits. 

Far from getting wiped out, Detroit’s citizen-shareholders appear on track to get paid something. A plan of adjustment put forward by the city’s state-appointed emergency manager would set aside $1.5 billion over 10 years for essential services like hiring cops and firefighters, getting the street lights working and bulldozing abandoned buildings.

Meanwhile, even supposedly secured creditors are getting squeezed. Judge Rhodes twice rejected the city’s attempts to strike a deal with UBS and Merrill Lynch over roughly $290 million they were owed to terminate a bad interest rate hedge. The judge said the city was being too generous – even though swaps claims effectively function as secured debt under normal bankruptcy law.

The banks have since agreed to accept just $85 million to terminate the swaps. The compromise could help the emergency manager force through a plan that calls for most unsecured creditors, including general obligation bondholders, to receive just 20 cents on the dollar. Many retired city workers might get more like 70 cents on their pensions.

Of course, a restructuring that skimped on city services wouldn’t give Detroit much of a shot at rebuilding. Taking up Motown’s cause could also cement the legacy of Rhodes, set to retire from the bench at the end of the year, as a hero in the city where he spent his career. But the full cost of sticking it to creditors may come eventually, and be shared widely by all municipal borrowers, in the form of higher interest rates.

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Context News

Detroit’s emergency manager on March 3 asked a federal bankruptcy court to approve a deal to terminate a swaps deal with two investment banks.

UBS and Merrill Lynch, a unit of Bank of America Corp, agreed to accept $85 million from the city to terminate the swaps, which were used to hedge interest rate risk on some of Detroit’s pension debt.

The figure was far lower than two earlier deals that would have seen the city pay $165 million and $230 million to cancel the swaps arrangement. In a recent court filing, the city pegged its swaps liability at $288 million.

Both earlier deals were rejected by U.S. bankruptcy judge Steven Rhodes, who said they were too expensive for the city. So-called “safe harbor” provisions for swaps and other derivatives in the U.S. bankruptcy code mean the banks would have been entitled to receive 100 cents on the dollar.

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