Emergency Financial Manager, Appointment Would Trigger "Credit Event" and Hit DWSD Hard

Governor Snyder's announcement last Friday that the State of Michigan was initiating a review of the City of Detroit's finances, the first step in the appointment of an Emergency Financial Manager (EFM), has triggered concerns about the financial impact such an appointment would have on the Detroit Water and Sewerage Department.

Following the Governor's announcement, The Bond Buyer, a national trade publication that covers the municipal bond industry, warned (here) that DWSD could face "huge fees" triggered by the appointment of an EFM, which would be a "credit event" under insurance policies that accompany $1.6 billion worth of water bonds.

[T]he appointment of an emergency manager . . . would trigger termination events on [credit default] swaps that hedge $948 million of pension obligation certificates issued in 2006 and $1.6 billion of water bonds. Detroit in early 2009 narrowly avoided a $400 million termination fee tied to the pension certificates after it was hit with a downgrade that prompted a termination event. Local officials negotiated for months with the two counterparties to achieve an amended agreement that avoided the payment. If the state appoints an emergency manager, Detroit would face the same problem again.

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Last April, Fitch Ratings downgraded the city's $2.1 billion of water bonds, citing in part an extensive derivative program at the Detroit Water and Sewerage Department that hedges $1.6 billion of the debt. "In recent years the negative fair value of the department's swaps have risen, increasing the termination risk associated with the swaps," Fitch's Doug Scott wrote. "Should the department be required to post collateral, it would negatively affect the department's financial profile to some extent."

The city is planning to come to market with a water bond refunding to shed the swaps and avoid termination payments. The price tag of the termination fees remains uncertain, but it would likely be in the hundreds of millions. At the end of 2010, the negative valuation of the water and sewer bond swaps was $165 million. (emphasis added)

Cite: "Detroit May Face Huge Termination Fees for Swaps." The Bond Buyer 2 Dec. 2011

The issue (and risk) of termination fees is discussed in the financial notes section of DWSD's 2010 Water Fund Financial Statement (here) beginning at p. 25.

Comment: I profess no expertise in this area, but this report seems rather alarming to me. At a minimum, faced with penalties in the "hundreds of millions" range, DWSD would have to delay or defer a number of significant capital improvement projects. If someone with a background in public finance or municipal bonds (or credit default swaps) can shed light on this issue, please comment. Your input would be appreciated.  

Update (12/6): The Detroit News reports this morning (here) that "The [State of Michigan] has yet to approve a deficit elimination plan Detroit submitted in July, a delay that puts a hold on the sale of about $900 million in bonds for capital improvements of the city water-sewer system."

Additional Resources:

• “Moody’s: Detroit Ratings On Review For Cut On Possible State Takeover,” Wall Street Journal, December 7, 2011 (subscription required)
• “Detroit on Review by Moody’s Will Pay $211 Million to Cut Swaps,”  Bloomberg Business Week, December 8, 2011 
• “Moody’s Puts Detroit GO, Water Debt on Negative Watch,” The Bond Buyer, December 8, 2011 
  

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