Theft, By Any Other Name

It’s funny how people want equal treatment under the law, right up until unequal treatment works in their favor…

To say that the city of Detroit is going through a rough patch is an understatement. It can’t pay its bills, and is underfunded on its pensions by more than $3 billion.

Everyone owed money by Detroit is ticked off and looking for their cut of whatever settlement is eventually worked out.

However, some people are looking for a bigger slice than they should receive.

In general, bankruptcy ranks creditors by the quality of their claim — from strong claims backed by identified assets or streams of revenue, to weak claims that are simply unsecured debt. Everyone in the same group is typically treated equally.

In the Detroit case, the pension funds representing current and future retirees are no more than unsecured creditors who rely on the “full faith and credit” of the city to make good on its promises.

At this point, that’s obviously not a strong claim.

However, neither are many bondholders’ claims. But the pension fund trustees are arguing that they deserve more than the bondholders, because…well, just because.

It’s true that the pension funds represent individuals, but at the end of the day, bondholders are people too.

It’s likely that many retirees outside of Detroit hold bonds issued by the city, and are reliant on the city making good on its debts to fund their own retirement plans.

This point seems to have escaped the Emergency Manager of Detroit, Kevin Orr, who put forth a plan to pay the pension funds 40 to 50 cents on the dollar, while paying bondholders 20 cents on the dollar… even though their claims are backed by the exact same thing — the full faith and credit of the city.

But it gets worse.

Not only are bondholders apparently entitled to only half of what pension funds should get (at least according to the city), but one particular group of bondholders is entitled to even less.

This special group, per the city’s plan, should receive only 10 cents on the dollar!

What was their crime or misstep that led to this bottom rung on the ladder? Well, they lent money to the city… to contribute to the pension funds!

In 2005, Detroit issued $1.4 billion of Certificate of Participation (COPs) bonds. The city used proceeds to catch up on its pension funding.

The thinking was that, as long as the pension fund earned more on its investments than the city owed to the bondholders, then everything would be okay. Oh, and that one day the city would have to pay off the bonds… but that was down the road somewhere.

Now that the city is flat broke, everyone is looking for someone to blame. Current leaders and a bankruptcy judge are claiming that the 2005 deal broke a law governing how much debt the city could issue. On this basis, the city is claiming it owes the bondholders of the COPs almost nothing.

So, in an incredible case of irony, people who lent money to Detroit, so that it could catch up on its pension funding, are now told that the loan was illegal, so the city is going to greatly reduce what it’ll pay the lenders in order to give those same pension funds even more!

Hmm.

I have an idea. If the loan was illegal, then why doesn’t Detroit simply withdraw the illegal proceeds from the pensions and send the funds back to their rightful owners?

I guess that would be even less popular than treating people equally.

Many years ago, Warren Buffett saw this coming. He used to provide insurance for municipal bonds — called BH (Berkshire Hathaway) Insurance — but he stopped doing so in the mid-2000s.

He pointed out that when municipal authorities fail to manage their finances well in the years ahead and have to make a choice, they’ll always choose their constituents over bondholders, no matter what the law says. It looks like he nailed that one.

With a Puerto Rican default on $70 billion in debt looming, and other unknown landmines sprinkled around the U.S., now is a good time for municipal bond investors to scan through their portfolio and make sure they know what they own.

It is entirely possible that one day you’ll get a letter pointing out how you have been deemed “less equal” than someone else who is scrambling for assets.

Rodney

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About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.