Joseph Krist

Municipal Credit Consultant

DETROIT BANKRUPTCY MOVES INTO FINAL ROUNDS

The City of Detroit’s Chapter 9 proceedings are on hiatus until next week. The break provides a good opportunity to assess just where things are and the issues which will confront the City regardless of the outcome of the current trial. Recently concluded testimony centered on the willingness of city officials to follow through on any plan approved by the bankruptcy court. A key component of any Chapter 9 plan confirmation is a determination of feasibility by the bankruptcy judge. In reality, much of the ultimate feasibility of any such plan rests on the willingness and ability of a city’s body politic to take the actions necessary to implement the plan both in the long and short run. Given the recent extended history of the City’s politicians in terms of their ability and willingness to make hard choices in managing the City’s finances, this is clearly a source of concern to all of the various constituencies in these proceedings.

City officials have responded as expected to inquiries on these topics. The judge has however, been quite direct in his questioning of the witnesses called to support the City’s case for approval. He noted the need for sustained support for the plan by both the executive and legislative branches of City government and expressed concerns about certain reversals of previously expressed views about the need for a bankruptcy as well as individual components of the resulting Plan of Adjustment by some of the witnesses. His concerns mirror those expressed by many entities over recent months as the Chapter 9 proceedings unfolded.

The judge also continued to use his position as final arbiter in these proceedings to encourage more negotiation over issues involving the creation of the Great Lakes Water Authority. This issue remains unsettled as suburban participants still want assurances as to the future operations and maintenance of the Authority’s assets as they impact future resource needs to repair and expand the system. Those negotiations continue to occur through mediation.

The issue of whether the assets of the Detroit Institute of Art remains as part of the proceedings as FGIC continues to argue in favor of more equitable treatment of debt holders versus the City’s pensioners. The topic is of continuing interest broadly given the increasing role of pension funding as a source of long term credit pressure for so many issuers.

PENSIONS AT CENTERSTAGE IN STOCKTON

Last week’s decision regarding the status of Stockton CA’s obligation to make payments to the CA Public Retirement System (CALPERS) classified that obligation as contractual and potentially subject to adjustment under the Bankruptcy Code. The decision got wide attention as this is the first of many Chapter 9 proceedings to actually get far enough to have the issue decided judicially rather than through settlement. Franklin Resources had been challenging the City’s plan to meet obligations to CALPERS and therefore to its pensioners in full while offering general creditors like Franklin effectively minimum  payments on obligations owed to them. In a sector of bankruptcy which has a relatively small body of precedent, decisions like this receive much attention. The judge’s decision is not necessarily precedent setting as it is not binding on any other proceeding or jurisdiction. It may not even prevent the judge from determining that the City’s Plan of Adjustment is feasible or confirmable even with the proposed unequal treatment of the two creditor classes. A decision is expected at month’s end.

NEW JERSEY’S PENSION AND CREDIT BIND

Next week, MAGNY will hold a presentation on the State of New Jersey and credit issues confronting the state. First and foremost among the issues which have led to several downgrades of the State’s GO and appropriation debt ratings has been the issue of pension and OPEB benefit funding. The issue was a prime concern for Governor Christie’s first term and he used a fair amount of favorable political capital to reform and strengthen the state’s pension systems which had been chronically underfunded.

Primary among the actions taken was the enactment of legislation designed to address underfunding through scheduled annual payments from general state funds to shore up the available asset bases of the funds. The expectation was that careful fiscal planning bolstered by a recovering state economy would provide the necessary resources to fund the annual payment goals. Unfortunately, the state economy did not grow as expected due to a variety of factors and the state revenue projections overestimated the level of resources available. The impact of Hurricane Sandy exacerbated the State’s economic woes.

The revenue shortfalls could have been addressed in any number of ways including increases in certain tax rates. Political considerations kept that from happening so the State found itself in a deficit position at the end of FY 2014 and facing a projected shortfall for FY 15. One of the major ways the State decided to address this general problem and balance the budget was to effectively renege on the promises contained in the 2010 pension legislation and appropriate a smaller amount than required to the pension funds.

Now the State finds itself in the position of facing an ongoing imbalance between revenue and expense (structural imbalance) and a growing unfunded benefit liability, reversing a trend of improvement experienced in the early years of this decade. One of the primary suggestions which proponents of pension reform advance is the conversion of benefit plans to a 401(k) type model. A recent report by Stephen Herzenberg

Executive Director, Keystone Research Center – How to Dig an Even Deeper Pension Hole – raises questions about whether this would be the most effective path for New Jersey to follow.

The Herzenberg report postulates that a transition of the state’s defined benefit plans to a defined contribution model could cost the state some $42 billion. This would reflect the impact of closing the current system to new employees thereby skewing the average age of beneficiaries higher. The report cites two negative impacts from such a move. First, investment managers are assumed to shift plan assets from higher-return to

safer assets – just as individual investors approaching retirement shift savings away from risky assets to protect themselves against market drops shortly before they start to withdraw money, thereby reducing investment earnings. Second, as DB recipients

age out and retire more and more of the funds remaining in the plans need to be removed from non-liquid assets, such as private equities, and invested in liquid assets that are easy to convert to pension checks for retirees. This will also lower the

rate of return, increasing the taxpayer contributions needed to honor existing pension obligations.

While the State evaluates its options, the downgrades continue and the State finds itself scrambling to get is arms around structural balance and funding of pension liabilities. Investors will be watching presentations such as that scheduled for next week. How the State addresses these difficulties will impact the directions of its credit and the ongoing relative valuations of its outstanding debt.