The COPs are expected to price on May 23 through a syndicate led by UBS Financial Services Inc., which is serving as the managing underwriter. Interest is payable each June 15 and December 15, beginning Dec. 15, 2005, for series 2005-A; and Dec. 15, March 15, June 15, and Sept. 15, beginning Sept. 15, 2005, for series 2005-B, with capitalized interest paid through Oct. 15, 2005. The series 2005-A COPs mature 2007-2025, and the series 2005-B COPs, 2007-2025.
The 'BBB+' rating is based on the City of Detroit, MI's unconditional contractual obligation to make its service payments, which are not subject to appropriation. The city is bound to make its contractual payments to the service corporations for the full term of the contracts. Under the trust agreement, the service corporations will assign their right to receive service payments to the funding trust for the benefit of certificateholders. Failure to make COP service payments when due allows the contract administrator to file a lawsuit against the city to enforce payment of the contractual obligation. A court may require the city to raise the payment through a tax levy without limitation as to rate or amount. Voter approval would not be necessary to levy such supplemental taxes. This transaction does not affect normal annual pension payments, just the funding of the unfunded accrued liabilities. Proceeds are deposited with the pensions systems and managed the same as other assets.
The transaction is designed to:
-- Reduce the annual funding cost of the unfunded liability from 7.9%/7.8% for GRS/PFRS to 5.8% for both systems;
-- Minimize financial risk;
-- Incorporate new amortization schedules of the unfunded liability, as adopted by the retirement boards;
-- Spread savings evenly over the amortization period ($395 million present value).
The Michigan Constitution and the Home Rule City Act enable the city to establish the pension systems and provide for their funding. The obligation to fund normal and unfunded accrued pension liabilities is further clarified through Shelby Township Police and Fire Retirement Board v. Shelby Township, and the Public Employees Retirement System Investment Act.
The Detroit City Council in February 2005 adopted ordinances which provided for the alternative pension liability funding.
The city has two retirement systems: the General Retirement System (GRS) and the Police and Fire Retirement System (PFRS). Each has a strong history of pension funding and rapid amortization of the unfunded liabilities. As recently as 2002, the GRS was 91.6% funded and the PFRS, 103.2%. The estimated funding for 2004 is now 77.6% for the GRS and 79.7% for the PFRS, both primarily due to diminished asset value. The estimated unfunded liability for fiscal 2004 (June 30 year-end) is $1.7 billion, up from $1.3 billion in fiscal 2003. The sharp increase in the annual cost of the UAAL is due primarily to the short amortization for both systems: specifically, 15 years for the GRS and 14 years for the PFRS. The GRS extended the amortization period to 20 years and the city is negotiating with the PFRS for a similar extension, but is not assumed for this transaction. State law and GASB require pension liability funding of no more than 30 years.
GRS Service Corporation and PFRS Service Corporation are nonprofit corporations formed by the city to receive COP service payments. The service corporations irrevocably assign to a funding trust (formed under the trust agreement) all rights to receive, collect and enforce all COP service payments. Since the service corporations are not expected to have an active role, the funding trust and service corporations will enter a contract administration agreement with the U.S. Bank National Association, the contract administrator, to administer payments under the service contracts and the swaps. The service corporations will enter the interest rate swaps with the swap counterparties. The funding trust issues the certificates to the certificateholders, and the city makes service payments through the contract administrator and funding trust to the certificateholders. Proceeds of the certificates will be deposited with the two pension systems.
Through an interest rate swap, the LIBOR-indexed floating rate certificates (FRCs) will be swapped into fixed payments. After a short lock-out period, the FRCs are callable at par on interest payment dates. Unlike other variable-rate transactions which have various term structures that may change and require liquidity support, the FRCs have interest rates that fluctuate with the three-month LIBOR rate on U.S. dollar deposits plus a margin. The actual rate is set by the contract administrator each quarter according to LIBOR rates available through Moneyline Telerate, Inc. A liquidity provider is not necessary for the transaction as there is no remarketing or liquidity risk. Since the rate is tied to LIBOR, there also is no basis risk. Swap termination payments are subordinate to the certificates. The counterparties meet high-quality standards and must post collateral.