Bad News for Muni Bonds as Detroit Turns the Bankruptcy Key

Late Thursday afternoon, the city of Detroit filed for bankruptcy. Was anyone surprised? The city’s massive debt and a shrinking local tax base made this almost inevitable.

Detroit is by far the largest municipal bankruptcy in U.S. history. Court action to sort out assets and liabilities will take months, if not years.

Lawyers will watch this case as precedent for other large cities. Unions, retirees and municipal-bond investors should keep an eye on Detroit, too.

Motown just started the motor of a big, complicated machine with many moving parts. Let’s look at a few.

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The general idea of bankruptcy is the same for cities, businesses and individuals. If your debt surpasses your ability to make payments, a court steps in to make everyone accept some kind of equitable solution.

The arguments will get ugly because so many people have a stake in the outcome. Like all cities and states, Detroit sold tax-free municipal bonds to finance public-works projects. Individual investors, mutual funds, pension plans and many others own Detroit muni bonds. Are they in danger of losing principal?

Maybe. Muni bonds come in two flavors.

“Revenue bonds” build specific income-producing assets. Toll roads are a good example. A city might sell $100 million worth of bonds to build a highway, and then pay back the bonds from the resulting tolls.

These bonds are legally attached to the assets they build. The city can’t use road revenue to build an art museum. In bankruptcy, revenue bond owners have a priority claim on the asset built with their money. They can still get hurt if the asset loses value, but they have some protection.

“General Obligation” or “GO” bonds are used at the issuing city’s discretion. Detroit GO bonds are very cheap right now.

On the other hand, anyone who was paying attention knew the risk. Some of them received higher yields as compensation for it. Others bought bonds a long time ago when Detroit was doing well. The court will decide how to split up whatever is left.

Detroit GO bond investors will also have an “interesting” fight against an entirely different group of victims …

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Many of our Uncommon Wisdom readers may remember when employers offered “defined benefit” pensions. People worked at the same place for years, then retired with a guaranteed monthly payment for life.

Those pensions are rare now, replaced by 401(k) and similar plans. They still exist in many unionized city governments, including Detroit. The city was supposed to set aside enough cash to meet future obligations under those contracts. They may have to fight for that money.

Back in March of this year, the governor of Michigan appointed Kevyn Orr as Detroit’s “Emergency Manager.” His job was to make sure the city took every possible step to avoid bankruptcy. As we now see, he decided bankruptcy was the best option.

Orr has said he considers Detroit GO bonds to be on the same level as the city’s pension funds. The GO bond-holders say they should get paid first. The city’s retired public employees disagree. The law is not entirely clear who is correct.

According to Orr, Detroit owes various parties about $11 billion in “unsecured” debt. The bankruptcy process will see how much money it can get for the city’s assets. The total will likely be much less than $11 billion. This is why everyone is fighting to be first in line.

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Detroit’s pain will probably get worse before it gets better. The story is sad for many reasons. The automotive industry helped the U.S. economy dominate the world. We’re all beneficiaries in various ways.

History is unfolding right in front of us. Heavy industry and manufacturing are moving overseas as technology changes the nature of our work. Detroit’s financial woes are a consequence of much-greater forces.

The rest of the country is changing, too. We may see other large cities follow Detroit’s path. Investors will need to adjust their thinking about risks in municipal bonds.

As much as everyone dreads bankruptcy, sometimes it is the only choice. When the court finishes its work, someone will turn the key and rev up a new motor.

Detroit, you gave us all that new-car sound. Thank you — and good luck.

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LAST-MINUTE UPDATE: Minutes after I wrote the above, news broke that a Michigan state judge said a Detroit bankruptcy violates the state constitution and must be withdrawn.

Since bankruptcy is a federal matter that is already under way, the state judge may not be able to stop it. I’m telling my editor to go ahead and publish this Afternoon Edition. You can visit the Bloomberg Detroit page for the latest developments.

I know we have some Detroit-based readers, and I’d love to get your perspective. Click here to send me your take.

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Some other news to wrap up the week  …

  • Shares in Google (GOOG) ended 1.55% lower, but up from the day’s worst level. Profit fell short of estimates, mostly due to lower mobile advertising rates.
  • The tech sector is having a rough earnings season. Advanced Micro Devices (AMD) shares plunged 13.15% today after the chipmaker forecasted lower profit margins.
  • The low-tech burritos at Chipotle (CMG) are selling like hotcakes. So are the restaurant chain’s shares, which gained 8.55% today. Hungry for more? Read this.

Good luck and happy investing,

Brad Hoppman

Publisher

Uncommon Wisdom Daily

Your thoughts on “Bad News for Muni Bonds as Detroit Turns the Bankruptcy Key”

  1. What Detroit has done is a Ponzi scheme of gigantic proportion! Those in charge including the current manager are crooks and should be thrown in jail. What has happened to Detroit is their own fault! Period!

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