Insurers’ holdings of Detroit municipal bonds

Eroding tax base, unemployment undermine the city’s viability

by Rodger Nayak and Raisa Luis

reprinted with permission from SNL Finmancial

Detroit’s fiscal struggles have been no secret for many years as it has suffered a flight of its tax base and, after the recession, a rapidly rising unemployment rate.

Nonetheless, several insurers maintained holdings of Detroit municipal bonds as of the end of 2012, SNL data show. Filings by these insurers indicate these bonds represent relatively small percentages of their investment portfolios, with some insurers noting that much of their municipal portfolios are insured. Rating agencies have downgraded many Detroit bonds to junk status, as they consider it likely that the terms of the bonds will be revised to the detriment of creditors as the restructuring process unfolds.

Complete report, with charts can be viewed here.

Michigan Gov. Rick Snyder named an emergency manager, Kevyn Orr, on March 14 in an effort to restructure the city’s debt obligations and avoid bankruptcy. Orr, a Jones Day lawyer who once represented Chrysler amid its turnaround, delivered a shock to creditors June 14, when he released a restructuring proposal that contradicts the typical priority of debt that municipalities pay. It places its general obligation unlimited tax debt on par with pension obligation certificates, unfunded pension liabilities and accrued retiree health care benefits. This upends the convention that general obligation bonds are among the safest kinds of debt.

“The treatment of all of those types of debt is really a sharp contrast from the traditional risk assumptions that people associate with different types of legal securities,” Morningstar analyst Elizabeth Foos told SNL. “We feel if that’s upheld, if GOULT bondholders are treated similarly through this process of repayment as the pension liabilities, or retiree health care, that could really set a precedent.”

Filings by these insurers indicate these bonds represent relatively small percentages of their investment portfolios, with some insurers noting that much of their municipal portfolios are insured

Insurers’ holdings of Detroit municipal debt appears to consist largely of water and sewer bonds, SNL data show. The debt payments on those bonds could be hit by Orr’s restructuring plan. Standard & Poor’s Ratings Services downgraded them to junk July 3, stating that a restructuring or negotiated agreement for payment of the debt remains a possibility. S&P considers any repayment of the bonds inconsistent with its initial terms as a default.

“The bottom line is we really weren’t able to rule out that there potentially would be a debt restructuring,” S&P credit analyst Scott Garrigan told SNL.

Fairfax Financial Holdings Ltd. held, by a substantial margin, the largest amount of Detroit securities as of Dec. 31, 2012. SNL data show that the holdings largely consisted of water and sewer bonds and were rated NAIC-1, the highest designation.

Fairfax said in its Form 10-K filed March 8 that about $4.0 billion of its $6.9 billion municipal bond portfolio as of Dec. 31, 2012, was insured by Berkshire Hathaway Assurance Corp. Its Detroit debt had a carrying value of $239.9 million, or about 3.5% of the total municipal portfolio, as of the end of 2012.
On the life side, Sammons Enterprises Inc. holds the largest amount of Detroit bonds, with all its holdings consisting of debt backed by Detroit’s schools. The debt is rated NAIC-1.

Restructuring, Uncertainty

Much uncertainty remains as the financial restructuring process proceeds. Arlene Bohner, a director of public finance at Fitch Ratings, said the biggest question mark is how the different types of debt will be treated, since Orr’s plan treats all unsecured debt the same.

“Whether it be state court or federal court, this is going to end up in court,” she told SNL. “Bondholders believe they have protections, pensioners believe that they have protections under the Michigan constitution, so it’s all going to clash, and it will be very interesting to see how it shakes out.”

Orr has said he is going to continue negotiations with creditors regarding a restructuring of the debt, and he is expected to announce soon whether he plans to file for Chapter 9 bankruptcy. Orr has pegged the odds of bankruptcy at 50%, but Morningstar’s Foos said it will be challenging for the renegotiation of the debt to be successful.
“I think it’s going to be extremely difficult given the questions at hand, and the extremely significant haircuts that investors and retirees are being forced to take, for them to avoid a Chapter 9,” she said.