Detroit's bond creditors skip initial bankruptcy fight

Tue Aug 20, 2013 6:55pm EDT

Aug 20 (Reuters) - Detroit's municipal bond creditors did not object to the city's historic bankruptcy petition by Monday's deadline but may be gearing up for a bigger battle down the road that could pit payments on city bonds against pension payments.

Public labor unions, the city's two pension funds, retirees, vendors, and individuals filed a slew of objections with the U.S. Bankruptcy Court in Detroit. Bondholders, including mutual funds, as well as bond insurers, which guarantee payments on much of the city's debt, were absent from the list.

"I'm speechless," said Dick Larkin, director of credit analysis at HJ Sims. In typical Chapter 9 municipal bankruptcies, bond creditors are on the front battle lines, he noted. The no-show by bond holders means only two of Detroit's 20 largest unsecured creditors, the city's two pension funds, disputed the city's right to proceed in bankruptcy court.

Patrick Darby, a bankruptcy attorney at Bradley Arant Boult Cummings LLP, said that bond creditors may have concluded there are no other alternatives for Detroit but bankruptcy. As the bankruptcy proceeds, bondholders will vie against pension funds and other creditors for payment from the city.

"Maybe they have taken a realistic view and concluded that Detroit is in fact insolvent and needs the protection of chapter 9," he said.

In his initial court filing, Kevyn Orr, Detroit's state-appointed emergency manager, said the city was sinking under more than $18 billion in debt and other obligations. He included much of the city's general obligation bonds among nearly $12 billion of the debt that he considers unsecured. In a bankruptcy, unsecured creditors typically do not fare as well as secured creditors.

Orr's plan, laid out in a June 14 proposal to creditors, lumped voter-approved unlimited tax general obligation bonds with less-secured debt, pensions and unfunded retiree health care liabilities. All would be offered just pennies on the dollar.

Richard Ciccarone, a managing director at McDonnell Investment Management, said bond creditors may believe the Chapter 9 bankruptcy proceeding will give them a chance to argue the city must honor the security provisions in Detroit's debt.

"That (Orr's) proposal called for a discount across the board on bonds regardless of their security didn't seem reasonable," said . "I think (bond creditors) felt they have a chance to fight that in the court."

Detroit's largest unsecured creditors are its two pension funds, which have claims totaling nearly $3.5 billion in unfunded liabilities, according to a city estimate included in a bankruptcy filing. Pension funds and unions dispute the estimate, claiming Orr has overstated the underfunding.

Orr has said he based the city estimate on "more realistic assumptions" than previously used. His figure is five times more than the $644 million gap the pension funds reported based on 2011 actuarial valuations.

The remainder of the city's top 20 creditors largely includes holders of $1.47 billion of debt Detroit sold for its pension funds and hundreds of millions of dollars of general obligation bonds, the court filing said.

No mutual fund that holds the city's bonds filed an objection. Funds reached by Reuters said their Detroit bonds are insured and that only insurers have the legal right to contest the bankruptcy.

"We feel comfortable with the claims paying ability of the bond insurers and will leave the contention of the bankruptcy filing to other involved parties," said John Woerth, a spokesman for the Vanguard Group.

Spokespersons for bond insurers reached by Reuters declined comment on why they opted not to challenge Detroit's bankruptcy.

Bond insurer attempts to stop recent U.S. municipal bankruptcies were not successful.

For Detroit's Chapter 9 municipal bankruptcy to proceed U.S. Judge Steven Rhodes, who is overseeing the case, must first find the city has proved it is insolvent and negotiated in good faith with its creditors, or that there were too many creditors to make negotiation feasible. Rhodes has set Oct. 23 for the commencement of a hearing on eligibility challenges, which largely focused on the constitutionality of Detroit's bid to seek protection from its creditors.

Detroit, a former manufacturing powerhouse and cradle of the U.S. automotive industry and Motown music, has struggled for decades as companies moved or closed, crime surged and its population fell from a peak of 1.8 million in the 1950s to around 700,000 today. The city's revenue fell short of spending, while its budgets and borrowing ballooned.

Ciccarone of McDonnell Investment Management said the fate of general obligation bonds in the Detroit case could have implications for the entire U.S. municipal bond market.

"The chance for 100 percent payment (for unlimited tax GO bonds) still exists - if not on time, over time," Ciccarone said.