Detroit, Now What?

Detroit will miss a payment on it's pension obligation certificates, setting in motion a slow mechanism to raise taxes "without limit as to rate or amount."

Missing payment on this obligation is interesting for several reasons. Traditional unlimited tax GOs are normally paid by taxes that are levied above and beyond statutory limits in good times and bad. These POCs are not. This means that once the unlimited tax mechanism is implemented mandating payment of vested pension obligations of the retirement system and therefore the POCs that have a acquired those rights, the city's budget will be unaffected because the payments will be covered by new revenues.

Things will get messy in the meantime. Normal unlimited tax general obligation securities would be enforceable by Mandamus and these will be too. But if the city or other parties wish to put up a fight, the unusual nature of the pledge may result in a lengthier implementation of the remedy. The ultimate outcome is more certain than the timing, the Michigan Supreme Court has determined that pension funding payments are constitutionally mandated and that a court can compel a municipality to make them by raising taxes or levies without limit.

Syncora may opt to novate the exposure from SCA to SGI under this scenario and implement a claims moratorium, though we are not sure they would want or are able to implement either of these alternatives. The company was confident enough to increase it's SCA exposure to this credit in the first quarter by buying a $25M chunk of the FGIC-insured bonds for about 67% or par.

The secondary news sources we have seen indicate that Detroit also plans to default on it's ULT and LT GO bonds. ULT GO debt payments may be made by money that would not otherwise be available to the city, so defaulting on these makes no financial sense. The calculus of politics and public relations never makes sense, so we won't dwell on it. Assured Guaranty, NPFG, Syncora and any other guarantors of this debt will face the smoothest process of compelling the city to caugh it up.

LT GO holders and guarantors such as Ambac are sadly screwed unless they have an additional security interest such as state aid. Otherwise their only hope for timely payments of principal and interest is state intervention. Even with a default, actually expunging any of LT GOs for good still seems unlikely without a bankruptcy filing or creditor agreement.

In sum, Detroit is on track to follow the Vallejo model: crushing weak securities while having no choice but to make strong ones whole or near whole. Look for LT GOs to be slashed along with OPEB and non-vested employee benefit liabilities.