In the continuing battle over perceived power and who will control Detroit’s coming financial reckoning, few wield more real power than bondholders and the ratings agencies they use to assess their investments. With more than $12 billion in total liabilities and a total liabilities-to-net assets ratio of more than 32-to-1, Michigan’s largest city is a cautionary tale for any municipality operating under the delusion that the bills of tomorrow never can come due today.
In its latest downgrade of Detroit’s unlimited and limited general tax obligations, Fitch Ratings raises multiple cautions because of the inability — refusal? – of City Hall to aggressively manage its weakening financial position. Any of them, left unchecked, could tip the city into an uncontrolled fiscal tailspin that could unleash vicious financial forces uninterested in respecting the niceties (such as they are) of local political customs. Among Fitch’s findings, issued in a statement last week:
TERMINATION EVENT TRIGGERED: Under the terms of swap agreements related to the city’s pension [certificates of participation], a recent rating downgrade triggered a termination event that will require the city to pay to its counterparties an estimated $50 million per year plus interest on the unpaid balance for the next seven years. While not a substantial amount of the overall budget, the city’s precarious financial position is poorly equipped to accommodate this increased expense.
LIMITED EXPENSE REDUCTION PROGRESS: The city has implemented fewer than one-half of the 1,000 layoffs announced in December 2011, and has tentative agreements from unions on modifications to labor contracts. However, the agreements have not been ratified and Fitch is concerned the ability to effect sufficient spending reductions to avoid further significant financial deterioration in the current year is increasingly limited.
SEVERE IMPLICATIONS OF EMERGENCY MANAGER: Efforts to avoid imposition of an emergency manager under Act 4 have so far been unsuccessful. City and state officials have been working on a proposal to implement increased managerial powers by either the city (in the Mayor’s proposal) or a control board appointed primarily the state (in the state’s proposal), but there is an apparent lack of consensus. The possibility still exists that the state will impose an emergency manager, which would make swap termination payments of a reported $350 million due immediately rather than over seven years. [Emphasis added.]
CONTINUED DELAY IN EXPENSE REDUCTION: Even if the near-term cash shortage is addressed, Fitch remains concerned that the level of recent annual operating shortfalls is unsustainable and is most likely to be addressed with sizable spending cuts, which have proved challenging to implement to date. Increasing pension payments contribute to the need for these cuts.
IMMEDIATE SWAP TERMINATION: If the termination is triggered by the appointment of an Act 4 emergency manager, absent another agreement with its counterparties, Detroit faces a potential immediate payment equal to up to one-third of its fiscal 2012 general fund budget.
Yes, I know: It’s all so boring. But the inconvenient truth is that this dull stuff is the epicenter of the pressure driving the mayor, City Council and the state of Michigan toward a historic confrontation over who will wield the responsibility of leading Detroit out of hole largely of its own making. It’s the real world outside the bubble of Detroit and an economic model of its own sorry making.