Detroit In Chapter 9: Orr Plays Hardball

Includes: ITM, MUB, MUNI, PZA, TFI
by: Stephen Percoco, CFA


Detroit’s bankruptcy filing will likely set a number of precedents with significant implications for the municipal bond market.

The City has proposed paying unsecured creditors 20 cents on the dollar, even holders of its General Obligation bonds, which have traditionally been viewed as having a priority claim.

It has also proposed canceling $1.4 billion of Certificates of Participation used in a complex and controversial financing to shore up Detroit’s pension funds in 2005 and 2006.

Although trading is sparse, prices of unsecured bonds are above levels implied by the City’s proposed recoveries. Some of the difference may be due to the availability of insurance.

Even though the task is admittedly daunting, if the City is unable to reach an agreement with creditors, it may raise questions about its handling of the bankruptcy process.

On February 21, 2014, the City of Detroit filed its Plan of Adjustment with the bankruptcy court. As most everyone knows by now, the road to Detroit's bankruptcy filing was long. The City reached its zenith along with local automobile manufacturing in the 1950s. Detroit's population peaked at 1.85 million in 1952. By 1990, it had 1.0 million residents. By December 2012, 685,000.

At first, the City's slide was precipitated by the shifting of automobile production to other parts of the country. Over the last decade, however, the automobile industry's decline hastened the erosion in its economic base. As noted in the disclosure statement, the City lost 80% of its manufacturing and 78% of its retail establishments from 1972 to 2007. Commercial buildings and houses were abandoned. Property values declined. The city had to add new taxes to stem the erosion in its tax base. All the while, Detroit remained responsible for providing services throughout the 137.9 square miles within city limits.

In this deteriorating environment, the City also attracted corrupt politicians. Kwame Kilpatrick, who served as mayor of Detroit from 2001 to 2007, was sentenced in October 2013 to 28 years in prison. The losses suffered through corruption added considerably more to the beleaguered city's debt burden.

The Plan of Adjustment. With an estimated $18 billion in liabilities, Detroit is the largest municipal bankruptcy in U.S. history. Through the bankruptcy process, it will address several issues that municipal bond investors are watching closely. Among these: How will retirees fare, given the burden that their pension and healthcare payments impose on the city, and in light of a clause in the state of Michigan's constitution that appears to prevent those payments from being reduced? How will holders of its COPs fare in light of the city's proposal to wipe them out? Will holders of Detroit's unlimited tax general obligation bonds suffer an 80% loss in claim, as proposed in the plan of adjustment?

The table above, tabulated from information in the disclosure statement, provides a listing of all of Detroit's claims and Detroit's estimate of amount of each claim's recovery. The list does not include the $1.473 billion of claims related to the 2005 and 2006 COPs (because they are assumed to be extinguished). It also does not include the estimated cost of the proposed $85 million settlement for the termination of outstanding interest rate swaps on the COPs. Adding those two figures into the mix brings the total amount of claims to $15.58 billion, excluding allowances in Classes 13-15 for other unsecured, convenience and subordinated claims, which are listed as "unknown" by the city. According to our calculations, the total estimated recovery on all claims, as the city proposed, is $8.29 billion. This works out to a potential recovery of 53.2% of the face amount of total claims and a potential haircut of $7.29 billion.

Pension and OPEB Claims. Under the proposed Plan of Adjustment, the largest portion of the haircut, equal to $4.8-$5.3 billion on a combined basis, would be borne by the City's employee retirement funds. However, their estimated recovery percentage (as a percentage of their allowed claims) ranges from 24.4%-31.7%, higher than the 20% estimated recovery on the City's unsecured municipal bonds.

The City has two retirement funds: the General Retirement System (GRS) and the Police and Fire Retirement System (PFRS). Each fund consists of a defined benefit pension plan and an annuity plan. The City also provides Health and Life insurance plans to current and retired employees.

Under its proposal for PFRS, the City will freeze pension payments to retired policemen and firefighters as of July 1, 2014, and then, after its proposal is approved by retirees, reduce pension payments by 10% with no future cost of living adjustment. (Those retirees who enter into a timely settlement with both the City and the state of Michigan will have their pension payments reduced by only 4%.)

The proposal for GRS is structured in a similar manner, except that the proposed haircut is 34%, and the cut for pensioners who agree to a timely settlement would be 26%.

The City has also made changes to its current post-retirement health and life insurance benefit plans. Previously, it provided supplemental coverage to Medicare-enrolled retirees at a cost of about $175 million annually. As of March 1, 2014, it has reworked its supplemental healthcare coverage plan, directing as many retirees as possible to Medicare, then to Michigan's health insurance exchange and giving them a stipend of $125 per month to help cover costs.

It is difficult to understand the impact of these changes and how the City is accounting for them in the disclosure statement. The amounts listed as allowed claims for PFRS and GRS far exceed the estimated unfunded actuarial accrued liabilities (UAAL) of the pension plans. The difference between the allowed claim and the adjusted UAAL is probably due to the estimated present value of OPEB liabilities; but this is only our guess. The disclosure statement should offer a reconciliation between the two.

Under GAAP, the GRS plan was 77% funded and the PFRS was 96% funded, as of June 30, 2012 (the end of fiscal 2012). On a combined basis, we calculate that the funds were 86.8% funded. That is a fairly high funding ratio. Given the strong performance of the stock market in 2013, the pension funds' combined funding ratio was probably higher at June 30, 2013.

It is surprising to see how well-funded the retirement plans are under GAAP. There have long been fears that the funds suffered significant losses, due in large part to mismanagement during the Kilpatrick administration.

The City does not believe that its pension funding level under generally accepted accounting principles (GAAP) is adequate. It objects to some of the assumptions used to calculate the UAAL under GAAP. Specifically, it argues that the assumed investment return of 8% is too high. In its view, a more appropriate investment return assumption is 6.5%. On that basis, the GRS would be only 56% funded and the PFRS would be only 37% funded.

We agree that the current long-term investment return assumptions under GAAP are too high. We also agree that it is prudent to use a lower number given the downside risk still present in the financial markets. However, the City may face a fight from pensioners on this issue, especially because other public pension plans use the 8% return assumption and have lower funded ratios, but have not cut their benefits.

Yet, the current funded position of the funds does not take into account the debt incurred by the City, including the Certificates of Participation transaction, to reduce the funds' unfunded liability. Detroit's debt is too high, in part because it borrowed money to shore up its pension fund.

In addition, Detroit's pension funds maintained policies that benefited beneficiaries unfairly and increased their funding shortfall. For example, the disclosure statement describes a long-running annuity savings program (ASP) offered to certain GRS beneficiaries (who were also active employees). The ASP functioned as a guaranteed investment contract with a minimum return approaching 7.9%. In 2009, when the GRS fund scored an overall loss of 24.1%, Trustees credited ASP account holders with a 7.9% gain.

At the same time, the funds routinely distributed excess returns achieved over the actuarially assumed rate of return to retirees as a year-end bonus, which came to be known at the "13th check".

According to the disclosure statement, 55% of excess returns (over the actuarial benchmark) were credited to active employee accounts; 17% were distributed under the 13th check program, and the remainder was credited against payments due from the City to fund the retirement plans. These practices guaranteed that the funds' performance would lag actuarial requirements and that the UAAL would continue to increase.

The FT reported in July that the GRS and PFRS funds lost nearly $500 million from 2008 to 2010 on bad real estate and hedge fund investments. The retirement systems also hold a significant portion of their assets in riskier, less-transparent real estate deals that Mr. Orr and his team believe do not have adequate oversight.

Besides funding, the issue of benefits has come front-and-center as a result of the bankruptcy. In September, the Bankruptcy court invited city retirees to express their feelings about potential cuts to their pensions. This event was widely covered by the media. Many newspapers published brief interviews with people who say they cannot afford to take any cuts.

At the same time, there are allegations that some of the burden of Detroit's pension plans may be avoidable. Every active worker in Detroit supports two retirees. The WSJ, in an editorial, said that there are many retirees in their 30s and 40s, who also now have second careers.

With the wasteful operating practices outlined above, the borrowings taken on by the City to plug the unfunded liability and the imperative of restoring the City's financial health (in part so that it can continue to meet its pension obligations), Detroit's pension beneficiaries must recognize that they too have an obligation to help the City regain its financial footing.

Representatives of the city's unions and retirees appear to be fighting proposed cuts every step of the way. First, they objected to the City's Chapter 9 filing on grounds that pension benefits are guaranteed by the state of Michigan's constitution, and so, the bankruptcy court has no jurisdiction in this matter. The court disagreed with this view, arguing that pension benefits are a contractual right that is not entitled to special protection in a municipal bankruptcy.

The ruling has enabled the bankruptcy process to move forward. It also set stage for a potential lawsuit by retirees to enforce their right to an "undiminished" pension under Article 9, Section 24 of the state's Constitution (the "Pensions Clause").

The Pensions Clause of the Constitution of the State of Michigan. Here it is:

Article IX, Section 24: The accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby.

Two key words, according to our unschooled legal eyes, are "thereof" and "thereby." In this case, it might read: "The accrued financial benefits of the City of Detroit's public pension plans is a contractual obligation of the City of Detroit, which shall not be diminished or impaired by the City of Detroit". Yet, Detroit could argue, rightfully we think, that it is not diminishing its public pension plans on its own, arbitrarily, but rather through the Chapter 9 bankruptcy process, under order of the court and together with pensioners and other creditors to restore the City's financial viability.

We find it hard to believe that the state, its legislature and the people of Michigan would have intended that pensions be protected by the Pensions Clause under any and all circumstances. For example, what if the pension impairment prohibition interfered with other provisions of the state Constitution, such as limits on debt and taxes? Shouldn't the viability of the state (and its political sub-divisions) be paramount?

It is also possible that the Pensions Clause may be interpreted as obligating the state to support every Michigan municipal pension fund that becomes financially troubled. For that interpretation to hold, however, the courts would have to rule that the Pensions Clause effectively makes the state a party to every municipal pension fund executory contract in Michigan. We think that's a stretch.

Perhaps the more relevant question is what happens if the pension fund beneficiaries decide that they cannot accept the final deal offered through the Chapter 9 process? Then, an activist court in Michigan might order the state to pick up the difference between what the Chapter 9 Plan of Adjustment has offered and what the pensioners think they are due. In order for that to happen, though, the pension fund's representatives would almost certainly have to prove that the Plan of Adjustment is unfair to pensioners.

Bottom line here? We do not think that the Pensions Clause is a slam dunk for Detroit's pension funds. We also think that the interests of all of Michigan's public pension funds would be best served by avoiding a test of it in the courts. Rather than seeking to preserve benefits at all costs and challenging pension cuts solely on state constitutional grounds, we think that the beneficiaries and their representatives should focus on improving the plans to ensure their long-term viability and assisting the City in its quest to restore its financial health and its economic base.

There may still be a case here for tweaking the reduction in pension payments. For example, if possible and practicable, it would be desirable to avoid cutting the pension payments of those retirees with the lowest incomes, especially those whose household incomes are below the poverty level. Similarly, we do not think that it would cost the City anything to agree to a periodic review of whether the plans can afford to make a cost of living payment (permanent or temporary) to plan beneficiaries.

Other initiatives might seek to eliminate overly-generous benefits to some plan beneficiaries in favor of shoring up the plans' ability to meet the needs of all beneficiaries. In our opinion, this would not constitute a diminishment or impairment of overall plan benefits.

We think that conceptual changes must also be made to all employee pension plans. Instead of providing an entitlement based solely upon the number of years worked and the average (or highest) salaries earned over those years, benefits should be based upon need, taking into account other sources of income or perhaps even the living expenses of beneficiaries. In addition, all plans should have the right to reduce benefits in bad economic times, or after a string of bad years of investment performance.

DIA Settlement. The Detroit Institute of Art holds thousands of paintings worth, by some estimates, well over $1.0 billion. In December, the auction house Christies completed an appraisal that valued 38 of the DIA's artworks (those originally bought by the DIA or the City) at between $454 million and $867 million. (Any sale of the rest of DIA's collection, which consists of paintings that were originally donated to the Institute, may be subject to legal challenge.) The DIA, through gifts and grants from charitable organizations, corporations and individuals, has committed to contribute $365 million over 20 years, and has proposed to raise an additional $100 million over 20 years to support the City's pension plan. In exchange, it would expect to keep its collection intact ("the DIA Settlement").

In early January, the state of Michigan offered to contribute $350 million to pay City creditors - primarily the pension systems - and support the DIA settlement. In exchange, it wants to be released from any further responsibility to support Detroit's retirement systems. The state's $350 million contribution is a prerequisite for those who have already pledged $365 million under the DIA settlement.

The combination of DIA pledges and state support is therefore $815 in nominal terms (including the DIA's pledge to raise an additional $100 million over 20 years), and roughly $700 million in net present value, calculated by discounting the DIA's 20-year funding commitment at 3%. The $700 million estimated NPV of pledged funds is modestly above the $660 million mid-point of Christie's auction estimate for the 38 readily saleable artworks.

We would be surprised if creditors agree with these proposals. The City (and the state) may want to avoid selling off the DIA's collection, primarily because the DIA's collection is part of their heritage; but the relationship between the DIA's presence and the attractiveness of Detroit as a place to live in is indirect, at best. (After all, the DIA's presence did not prevent the deterioration in the City's economic base and the decline in its population.)

There may be very good reasons for keeping the DIA's collection, but this is an asset that benefits the entire state of Michigan and not just the City of Detroit. The DIA settlement should not, in our opinion, take precedence over creditors' right of recovery, nor should it be tied to retiree approval of pension plan revisions.

As long as the City is proposing big haircuts to creditors' allowed claims, the creditors are entitled to improve their recoveries from the sale of DIA's art collection. There is a sufficiently large discrepancy between Christie's estimate and one commissioned by the Detroit Free Press to warrant obtaining a second formal estimate on the 38 paintings deemed readily saleable. Christie's auction estimate should also be supplemented with an estimate of the value of those donated artworks which did not come with any explicit restrictions against their future sale. If the City cannot muster enough contributions (from the DIA, the state or others) to match this broader value estimate (less expected selling costs), then that portion of the collection should be sold and the net proceeds made available to creditors, even if it jeopardizes the DIA's viability.

Despite the structure of the current proposal, there is no valid reason (from the creditors' perspective) for linking the state's $350 million contribution to the DIA settlement. Any proposed decision by the state to support Detroit's retirement systems can and should be made separately on the merits. If the state's contribution to the Plan of Settlement would be lower than $350 million without the DIA settlement, then it should communicate that reduced figure to both the pension funds and the rest of the creditors. The DIA collection might then be sold separately (and presumably within estimated valuation ranges) for the benefit of creditors, if necessary.

Detroit Water and Sewer Department (DWSD). The Department is one of the oldest and largest municipal water utilities in the country, supplying water to four million customers in Detroit and 127 suburban communities. It also provides wastewater collection, treatment and disposal services to the city and 76 suburban communities.

For more than 35 years, DWSD was a defendant in a lawsuit filed by the EPA alleging violations of the Clean Water Act. The lawsuit was originally filed in 1977. Federal oversight of the utility ended in March 2013.

In July 2011, DWSD agreed to take remedial measures, as specified in an Administrative Consent Order (ACO) from the District Court to address "persistent dysfunction," including "deficiencies in maintenance, capital expenditures, planning, staffing and procurement." The Michigan Dept. of Environmental Quality is overseeing DWSD to monitor its compliance with the ACO.

In 2011, based upon the recommendations of a committee appointed by the District Court, the City will seek to transfer the functions of DSWD to a new utility called the Great Lakes Water Authority (GLWA), which will lease the properties of DWSD from the City of Detroit.

The disclosure statement does not indicate whether the City has considered other alternatives for DWSD, such as selling the system outright or contracting out the operations to a third-party management firm. If either of these alternatives might provide a better outcome for the City and its creditors, they should be considered and pursued.

Detroit's Plan of Adjustment recognizes six classes of DWSD Water and Sewer bonds with aggregate claims of $5.78 billion. These are revenue bonds: i.e. unsecured bonds that benefit from a pledge of the net operating revenues of DWSD. They are also insured (by Assured Guaranty, MBIA or FGIC).

The bonds are classified as impaired in the Plan of Adjustment, but their estimated recovery percentage is 100% of their principal amount. (As unsecured bonds, they are not entitled to past due interest, but many of the bonds are covered by insurance.) If the Great Lakes transaction is not completed before confirmation, bondholders will receive an equal principal amount of new DWSD bonds (unless the City elects to reinstate the old DWSD bonds, in which case it will file a notice of reinstatement prior to the confirmation hearing).

If DWSD completes the Great Lakes transfer before confirmation, bondholders will have the option of receiving either an equivalent principal amount of new GLWA bonds or cash. The City says that it intends to pursue the quickest recovery option for DWSD bondholders.

At a quick glance, the DWSD bonds have recently been trading at 95-97 (percent of par value), which effectively discounts one or two forward interest payments. The bonds should trade closer to (or even above) par as the confirmation hearing date approaches.

Secured General Obligation (GO) Bonds. Six classes of secured GO bonds totaling $485 million in three series (2010, 2010E and 2012) are secured by state payments of distributable aid from sales tax receipts.

The six classes are actually comprised of three separate bond series: (1) the City of Detroit, Michigan, Distributable State Aid General Obligation (Limited Tax) Bonds, Series 2010, (2) the Michigan Finance Authority, Local Government Loan Program Revenue Bonds, Series 2010E and (3) the Michigan Finance Authority, Local Government Loan Program Revenue Bonds, Series 2012. The Series 2010E bonds are federally taxable.

Each series is deemed to have a security interest in the distributable state aid, but at different levels of priority (i.e. first lien, second lien and third lien). Nevertheless, the Plan of Adjustment classifies all of these bonds (and all six claim classes) as unimpaired. We presume that they have been receiving interest payments throughout the bankruptcy, and would have received principal payments, if any were due.

It is difficult to get a good read on the current market values of these bonds. Despite total outstandings of $485 million, there are 37 separate bond issues - 12 in the Series 2010, 6 in the Series 2010E and 19 in the Series 2012 - with maturities ranging from 2014 to 2035. Some of these bond issues have not traded since 2010. Only a few have traded over the past month, according to TRACE. It is generally only the longer-maturity bond issues that trade. As far as we can tell, most trades are small ($30,000 in face value, or less). Recent trading yields on these bonds have ranged from 0.5% (for bonds maturing in 2014) to as high as 7.14%.

Among what one could loosely call the "active" issues, we think that the least risky bonds in terms of credit quality are the 5.0% Series 2010s due 11/1/30 (CUSIP: 251093S50) and the 5.25% Series 2010 due 11/1/35 (CUSIP: 251093S35). These are also the bonds with the largest par values outstanding - $75.2 million and $82.9 million, respectively. Recent yields for these issues for bonds that traded in early March were around 5.2%.

Limited Tax General Obligation Bonds. The proposed treatment for LTGO bonds raised eyebrows for many muni bond investors. General obligations bonds are backed by the full faith and credit of the municipality issuing them. For years, investors have taken this pledge as akin to a security interest. They believed that municipalities would do everything they can to avoid defaulting on them.

In fact, Detroit has raised taxes consistently over the years to offset the drop in revenues associated with population decline. It has also received waivers from fully implementing a state-mandated reduction in income taxes for more than a decade.

The City has been levying real estate taxes at maximum allowed statutory rates for some time now. It is the only municipality in Michigan to levy a utility user tax and a casino tax. Under these circumstances, most interested parties would probably agree that the City's ability to raise taxes is limited now and for the foreseeable future. Consequently, given the persistence of the City's problems, amplified by the 2008 economic recession, it should not have been much of a surprise that the City would seek to reduce the burden of its general obligation (GO) debt through the bankruptcy proceedings.

Still, the magnitude of the proposed haircuts was surprising. The City has said that it views GO debt as unsecured, and is offering 20 cents on the dollar on total LTGO-allowed claims of $163.5 million. This may be at odds with the views of many investors and also the bond insurer, Ambac, which on Nov. 8, filed a complaint against the City to enforce what it believes is the right of the LTGO bonds to be paid from the City's tax revenues before all other expenditures.

Recent prices for Detroit's LTGO's have varied considerably. Some bonds have traded in the 30s, others in the 70s. The difference appears to be whether the bond is wrapped with insurance. Those that are insured (by carriers with the strongest claims-paying abilities) are trading at higher levels.

Unlimited Tax General Obligation Bonds. These are GO bonds with the added support of a pledge to raise taxes to whatever level is necessary to ensure the timely payment of principal and interest. In practice, that pledge is tempered by potential limitations by the bankruptcy process. Those limits are communicated clearly to investors in the bonds' official statements. In practical terms, therefore, the unlimited tax pledge should give a bond issue priority over other GO bonds.

It remains to be seen how UTGOs will be treated. Detroit is an important test case. The city is proposing to give the $375 million of allowed UTGO claims the same rate of recovery, 20%, as the LTGOs. That proposal has already been challenged in a lawsuit brought by National Public Finance Guarantee Corp. and Assured Guaranty, two bond insurers who argue that the UTGO debt requires special (and better) treatment than LTGOs. The City views the UTGOs as unsecured debt, and has treated them accordingly in its proposed Plan of Adjustment.

One possible way to bridge some of the differences between what the City thinks it can afford and what bondholders believe they are due would be to build in incentives that would effectively reduce the City's debt burden, if it is able to improve its overall credit standing. For example, the new bonds could grant the City an optional redemption at a discount to par value after several years. Similarly, they could provide for a reduction in the coupon rate, if their credit rating improves to investment-grade. These provisions might limit creditor recoveries, but they would also provide incentives that might cause the new bonds to rise in value at a faster pace than they might otherwise.

Certificates of Participation. In 2005 and 2006, in order to plug a hole in the funded position of its pension funds, the City of Detroit issued $1.4 billion Certificates of Participation (COPs). The hole had to be plugged in order for the City to continue to qualify for certain state aid.

The state required that unfunded pension liabilities had to be closed over a specified number of years. Rather than bear this added annual burden, however, the City decided to raise the financing to fill the hole immediately and pay back the debt over a certain time. In doing so, however, this was essentially equivalent to taking on margin debt. It implicitly assumed that the fund managers could generate returns on the $1.4 billion in excess of interest costs.

This was an off-balance sheet transaction. The City may have run up against its statutory debt limit. (The disclosure statement does not say definitively that it did. Mr. Orr says that it probably did.). So it created two special purpose corporations - The Detroit General Retirement System Service Corporation and the Detroit Police and Fire Retirement System Service Corporation - which, along with a couple of Funding Trusts provided a structure that avoided breaching the City's debt limit.

The Plan of Adjustment proposes canceling the debt. Mr. Orr alleges that the financing was "bad for the city," so it should not have been done in the first place. FGIC, which has insured $1.1 billion, or 75% of the outstanding COPs, has filed a suit saying that the City is rewriting history, alleging that it was the "victim of fraud on a massive scale," according to the New York Times, when in fact, it benefited enormously from the transaction.

At this time, it is difficult to predict how the COPs will fare. Unless the City can prove other problems with the transaction, we would be surprised if it succeeds in its bid to cancel the debt. Even though the COPs transaction caused the City to exceed its debt limit, it should not have the right to confiscate the funds.

If at the end of the day, their claim is allowed by the Court, the COPs should at the very least receive the same treatment as the GO bonds. In that case, they would be entitled to the 20% recovery proposed by the City for all unsecured creditors. If they are also able to convince the Court that their claim should be granted priority status, or that the City can afford more debt, then the recovery on the COPs will be higher.

Like most of Detroit's other debt issues, the COPs seem to trade by appointment. A large proportion of the issue - $1 billion by some estimates - was placed with European investors. The COPs are also listed on the Luxembourg Stock Exchange. On March 17, nearly $16 million of the floating rate (3-month LIBOR, plus 0.24%) due 6/15/34 traded at 27. Before that, $2.45 million of the 4.948% Series 2005-A Certificates traded at 38.25 on February 17.

In one sense, the trades at such low levels are surprising, because all of the outstanding COPs are insured. However, there may be some doubt about whether FGIC and Syncora Guarantee, the bond insurers, will be able to cover these obligations, especially if the COPs are wiped out. Both insurers have had their ratings withdrawn as a result of losses suffered during the financial crisis. On the other hand, if the COPs are cancelled because the transaction was fraudulent, that might allow the insurers to cancel their policies.

The Interest Rate Swaps. In conjunction with the issuance of the COPs, Detroit entered into interest rate swap contracts to fix the interest rate payments on $800 million of floating-rate COPs. In the aftermath of the financial crisis, when interest rates fell, the swaps proved to be costly. Moreover, as Detroit's financial condition deteriorated, it was required to post collateral - pledges of tax receipts from the local casino - to support its obligations on the swaps.

The City has tried to negotiate a cancellation of the swap contracts, which would trigger significant penalties. A proposed $165 settlement with UBS and Bank of America, the swap counterparties, was rejected by Judge Steven Rhodes of the Bankruptcy Court as too costly. A second agreement of $85 million awaits the Judge's final decision.

Syncora Guarantee has threatened to cancel its insurance on the swaps, because the proposed settlement allows the banks to seek compensation under the insurance policy to cover their losses.

Although we understand that the swaps are costly, it sure seems like the City is buying high and selling low. It has paid dearly for interest rate protection that, in hindsight, it did not need, but is now seeking to cancel the swaps just when it seems like interest rates are poised to rise. Perhaps there are other mitigating factors that have not yet been disclosed by the City or through media reports.

The Bankruptcy Process. Throughout the course of the bankruptcy, creditors have complained that the emergency manager, Kevyn Orr, has not negotiated in good faith. In his June 2013 presentation to creditors, when Mr. Orr told creditors to expect significant reductions in their claims, bondholders complained that Mr. Orr had reached his position without much of their input.

In the latest go-round, it has been reported that the City moved to disband an unsecured creditors committee that the U.S. Trustee believed was required under the bankruptcy code. Lawyers for the City argued that the provision applied only to cases under Chapter 11. The Emergency Manager also claims that it speaks to creditors on a daily basis, so there is no need to provide another forum.

Yet, it is clear that the City's Plan of Adjustment will be challenged by a number of creditors, including representatives of pension plan beneficiaries, holders of its GO bonds and holders of its COPs. If, in fact, negotiations have taken place, they have apparently reached an impasse on a few important issues.

Of course, this could be a tactic by the City: its first salvo in the negotiating process. It could also turn out that the differences between the City and certain creditors are so great, that they cannot be resolved through negotiations at this time.

The negotiations are complicated by the existence of bond insurance on nearly 90% of the City's outstanding GO debt and all of the COPs. The City may seek to negotiate directly with bondholders, but bondholders may have less incentive to take a tough stand, because their bonds are wrapped by insurance. The insurers, on the other hand, have a strong incentive to fight potential claims to the end, especially because their losses could be significant. This is especially true for those insurers that are still recuperating from the effects of the 2008 financial crisis. Already, as noted above, certain bond insurers have filed suit against the City to protect their positions, in part because they do not feel that they will be adequately represented in creditor negotiations. Insurers should have a seat at the table, but their participation in the negotiating process presents significant challenges, because their only incentive is to minimize near-term losses.

When the gap between what the City believes it can afford to pay and what the creditors believe that they are due is wide, the negotiating process takes on a special importance. In this case, we think that it is critical that the City of Detroit provide in the disclosure statement to the Plan of Adjustment (and also in face-to-face communications with creditors) an explicit analysis supporting its proposed 80% haircut to unsecured claims. In our opinion, it does not make this case clearly. Apparently, we are not the only analysts that think so.

For example, the City discusses the steps that it has taken to address its "lopsided balance sheet" in the disclosure statement, but it does not include either a historical or a projected balance sheet in the accompanying financial package. Likewise, the City discloses detailed historical and projected statements of revenues, expenses and cash flows, both on a legacy basis and pro forma for the proposed restructuring, but it does not provide a bridge between the two that facilitates a comparison.

Most importantly, we think that the City needs to provide an analysis of how much debt it can afford and how much financial flexibility it needs to pursue its goals and meet potential contingencies. That debt calculation would provide an objective measure that would facilitate approval of the Plan of Adjustment, or a cramdown, if necessary.

We think that the City should file its Fiscal 2013 Comprehensive Annual Financial Report. The disclosure statement contains summary figures of 2013 financial data in the discussion, so it is clear that the financial statements for the CAFR have already been prepared. The City also needs to file its 2013 CAFR in order to continue to qualify for state aid (even if the state is willing to grant a temporary waiver during the bankruptcy process).

We also believe that the City should make available audited fiscal 2013 financial statements for GRS and PFRS, its two pension plans. Given the strong performance of the equity markets in 2013, we recognize that making these statements available might complicate negotiations with plan beneficiaries, but the City must demonstrate to pensioners that Detroit's lopsided balance sheet is due, in part, to debt taken on to fund the pension plan (e.g. the COPs financings). Pensioners must also take some responsibility for restoring the City's financial health to give the City the means to rebuild its economic base, which will ensure that the City is able to meet its pension obligations in the long run.

Floating a Plan of Adjustment with an incomplete disclosure statement and a lack of a sufficient consensus among creditors probably only makes sense when there is a pressing need to complete the restructuring quickly to conserve cash or avoid future losses. Of course, there is also a stigma associated with bankruptcy, so it is best to get past the bankruptcy process as soon as possible.

At the same time, getting out of bankruptcy too quickly might be a bigger mistake, if the City does not take advantage of the protections afforded by the process to complete necessary reforms. Although we have argued that the City has not made a strong enough case to justify its proposed haircuts to unsecured creditors, we also do not think it has made a strong enough case to prove that the proposed cuts should not be higher. If Detroit exits bankruptcy too quickly, without completing necessary reforms, it could end up back in bankruptcy within a short period of time.

We hope that the City is able to adjust its approach, if necessary, and reach agreement with creditors on a timely basis on a bankruptcy plan that best meets the long-term needs of all stakeholders.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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