A Mediator's Perspective on Detroit's Bankruptcy

It has been reported that Detroit's creditors and its emergency manager have begun to meet with the mediator assigned to Detroit's bankruptcy proceeding, and so begins the slow and painful process by which a consensual plan for the adjustment of Detroit's debts will be constructed.

As a commercial mediator, I would expect that the process will follow a certain pattern.

Initially, the parties will identify their positions.  Detroit's emergency manager has already put a bid on the table, 80% haircut for bond creditors.  The bond creditors will insist on no haircut, although they are willing to negotiate some terms.  This, of course, will proceed nowhere.

The mediator's task at this point is to move the parties off their respective positions, and have them identify their interests.

Detroit's emergency manager will identify a whole host of Detroit interests that he wants Detroit to be able to pursue, from infrastructure improvements to basic health and safety upgrades, and he will insist that Detroit cannot pursue these without financial flexibility garnered through a radical reduction in Detroit's outstanding debt.

The creditors' interests are that they avoid financial loss, but they are willing to continue to participate in the construction of the financial solution to Detroit's reconstruction.  They will argue that Detroit will not be able to resolve its issues without continued access to financing, and future financing will not be on offer if current creditors are forced to bear losses.  Bond insurers, who in game theoretic terms are repeat players, have a particular interest in not taking a haircut that signals any willingness to accept losses in future restructurings.

At this point, the mediator will need to make a pivot, to avoid having the parties continue to dig themselves into an argumentative hole.  This mediator's pivot often involves the realization that there are not enough parties at the table, and indeed the most important party to the solution of the conflict is missing.

In order to resolve this conflict, the mediator will need for the State of Michigan to get involved in the process of crafting the solution.  Michigan was instrumental in creating the conflict, inasmuch as Detroit was unable to file as a chapter 9 debtor without enabling legislation passed in the Michigan legislature and signed by the Michigan governor.  Michigan Governor Snyder specifically authorized Detroit's chapter 9 filing.  Now, Michigan needs to be instrumental in resolving the conflict.

Michigan has every interest in seeing Detroit exit bankruptcy and have continued access to the financial markets.  The quicker Detroit is able to accomplish this, the sooner Michigan's other municipalities will escape the financing taint of Detroit's bankruptcy by association.  Moreover, Michigan's participation in Detroit's plan will provide political cover for difficult sale and outsourcing decisions Detroit will likely have to embrace, much as Pontiac had to do.

How might Michigan bring Detroit and its creditors together?  It could take any number of practical solutions, such as having Michigan, or some financial subdivision, act as a first loss guarantor on a certain amount of principal and interest of Detroit's refinancings coming out of bankruptcy.  Michigan could also sponsor private/public partnerships that would invest in Detroit infrastructure improvements. 

Detroit's pension leaders have a constructive role to play in crafting a solution that doesn't just involve accepting a haircut.  One might remember the wisdom and courage of Victor Gotbaum some 40 years ago when he pledged that DC37 would buy New York City bonds that no one else wanted. But one might think it reasonable for Detroit's pension leaders to ask what role Michigan is going to play before they commit pension assets.

There are many possible solutions, but I don't see the mediator getting any of these possible solutions on the table unless Michigan is at the table.

The Difference Between Detroit and Puerto Rico

It seems muniland has gone on a Puerto Rico default watch recently, as it searches the next domino to fall after Detroit.  This is misguided.  Dominoes is a particularly inapt analogy to use in analyzing risk in muniland (as Meredith Whitney might have learned), and this Puerto Rico default watch too shall soon pass.

The principal difference between Detroit and Puerto Rico is that Detroit wanted to default and Puerto Rico doesn't want to default.  Detroit carefully planned out its default, getting special state legislation passed to enable it to become a chapter 9 debtor, and Detroit's game plan is to impose significant haircuts on bond and pension creditors, since Detroit knows it won't be able to access public muniland markets after its chapter 9 filing until well after the cows come home.

Puerto Rico cannot avail itself of chapter 9, and the last thing it wants is to commence a massive creditor restructuring outside of a court-supervised process.  This is not to say that Puerto Rico doesn't face significant economic development issues going forward, but muniland should regard Puerto Rico's successful pension reform that it concluded earlier this year as the best evidence that Puerto Rico not only needs public finance markets but that, unlike Detroit, Puerto Rico places great importance on having continued access to them.

Disclosure:  No holdings of Detroit or Puerto Rico debt.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Follow me on twitter.