One of the worst fears in the condition of America’s cities was realized yesterday when U.S. Bankruptcy Judge Steven Rhodes approved the city of Detroit’s application for bankruptcy protection.
“The city no longer has the resources to provide its citizens with basic police, fire and emergency services,” Judge Rhodes explained his ruling, as cited by NBC News.
Detroit was home to over 1.8 million residents in the 1950s, and it was once one of the leading industrial centers of America and the world, but mismanagement and poor preparation for future needs pushed the city down a long road of degradation, driving residents away and revenues along with them. With less than 700,000 residents today, the city cannot generate enough income to cover a $3.5 billion shortfall in pension obligations, nor service the costs of its $18 billion of debt.
“This once proud and prosperous city cannot pay its debts,” Bloomberg quotes Judge Rhodes, as he lamented the city’s fall from its prior glory.
But the impact of Detroit’s bankruptcy extends far beyond its city limits – even far beyond neighboring townships and its state of Michigan. The risk profiles of cities all across the country now need to be reassessed, along with the risks associated with their debts.
As Alan Mallach of Brookings Institution warned to Bloomberg, “Every other industrial city has problems that could send them down the same path [as Detroit’s]. None of the other cities are as far along, but there are dozens, if not hundreds of cities that have similar issues.”
Just what are those “similar issues”? “Projected pension and health-care obligations for the 61 biggest cities will top assets by about $217 billion,” Bloomberg cites a study by the Pew Charitable Trusts. The largest cities in America owe more than they are worth.
How sound, then, are their bonds? What precedent might Detroit’s bankruptcy set for the treatment of municipal debt and investors’ capital?
Measures Being Considered
In a last ditch effort to avoid a Detroit bankruptcy, Michigan State Governor Rick Snyder drew on a special provision of state law granting the appointment of an emergency city manager empowered with special authority that overrides even those of the city’s elected officials.
When both men came to the conclusion that bankruptcy was the only viable option, emergency manager Kevyn Orr proposed closing the $3.5 billion pension shortfall by cancelling an equal amount in pension payments, in addition to cancelling $1.4 billion of unsecured bonds issued in 2005 and 2006 that went directly into the city’s pension fund. The proposal would then replace the cancelled debt with a $2 billion bond issuance at 1.5% interest, the intent of which is to spread out the pain among bondholders, the pension system, and other unsecured creditors.
In approving the bankruptcy application, Judge Rhodes is thereby opening the door to cuts to Detroit’s pension obligations. This was met with indignation by the American Federation of State, County and Municipal Employees representing Detroit city workers, who vowed to appeal yesterday’s bankruptcy approval that they claim violates Michigan state law protecting pensions from cuts.
Judge Rhodes’ ruling, however, was naturally well received by municipal bond investment managers, as it allows the risk of bankruptcy to be spread out instead of being born by bond holders alone. “To us, it was good enough to hear [Judge Rhodes] say that nothing is off the table, including the pensions,” Rafael Costas, co-director of municipal debt at Franklin Advisers Inc., breathed a sigh of relief to Bloomberg.
However, Judge Rhodes made it clear in his comments that just because his approval of the bankruptcy filing opens the door to pension cuts, yesterday’s ruling does not necessarily imply he will approve Orr’s proposal in its entirety. The judge explained that any plan would have to take into account how cuts would impact all creditors, including retirees and current city workers.
Investor Due Diligence
Investors holding municipal investments ought to reflect on how other city bankruptcies would impact them. In the quest for yield in this low-yield environment, investors should be careful not to wade too far out into the deep waters of high-yield high-risk bonds offered by townships with debts far in excess of revenues.
Consider their money flows carefully. Assess their future growth potential. Are they building for the future? Are they attracting more residents? What industries are they home to, and how are those industries expected to perform going forward? What measures are they taking to attract the industries of the future?
Remember that failing to prepare for its future needs was a major contributor to Detroit’s demise.
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Optimism Amidst the Gloom
Yet while the deteriorating financial conditions of cities and townships across the nation are worrisome, it may be of some comfort to municipal bond holders that the risk of insolvency would not rest upon their shoulders alone.
Bankruptcy judges are always cognisant of the reverberations that cancelling a bankruptee’s debts – city or company – would send throughout the markets, particularly bonds. The whole purpose of bankruptcy is to permit rebuilding and regrowth – which are not possible without continued investment from creditors. Hence, reducing the pain born by bond holders is vital to ensuring funds keep rolling in to finance city operations.
Yet this does not mean it is now open season on pensioners, many of whom have devoted their entire working lives to serving the citizens of their communities in schools, hospitals, police stations, and fire halls. Judges overseeing municipal bankruptcies will, like Judge Rhodes, seek to spread the pain around.
The bond market’s reaction to yesterday’s ruling allowing Detroit to seek creditor protection was thus rather mixed. While the price of Detroit’s general obligation bond maturing in 2020 fell and its yield rose to 7.29%, the city’s July 2016 sewer and water bond rose a little, its yield falling to 5.21% on the assurance by Orr that the city would honor its water bonds, as well as on his proposal to lease the city’s water services to private sector operators for a fee.
While bond investors must always be prepared for a drastic cut to their bond values on the increasing likelihood of further municipal bankruptcies, a diversified mix of municipal bonds spread out over multiple regions can still serve as a viable means of generating a higher yield than is available in the Treasury market, knowing that the courts see bankruptcy as a means to rebuild a city, not as a punishment to destroy it.
Judge Rhodes concluded the summary of his ruling, as cited by USA Today, “At the same time, [Detroit] has an opportunity for a fresh start. I hope that everybody associated with the city will recognize that opportunity.”
While all involved share a portion of Detroit’s demise – from employees to retirees to investors to banks – all will equally share in the city’s future growth. As outgoing mayor Bing noted in his public address transcribed by Bloomberg, “There’s going to be pain for a lot of different people. In the long run, the future for the city will be bright.”
Joseph Cafariello
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