by Brad Houle, CFA
Senior Vice President
On June 6, the city of Detroit declared Chapter 9 bankruptcy, which is the largest municipal bankruptcy in U.S. history. Detroit has an estimated $18 to $20 billion in debt and over 100,000 creditors. The city has suffered a long, slow decline over the past few decades as the U.S. auto industry has withered. According to the U.S. Census 2010 findings, the population base in Detroit has declined 60 percent from 1960 to 2010. Moody’s Corporation has reported that Detroit’s general fund revenues have declined 25 percent since 2007 As the population has declined the city has struggled to provide city services due to their shrinking tax base.
Municipal bond investors are among the creditors who have effectively loaned money to the city of Detroit for operating expenses as well as capital improvements. How bondholders are treated in this bankruptcy is being carefully monitored by municipal bond investors. Part of Detroit’s debt is general obligation municipal bonds that are theoretically backed by the city’s taxing authority. In question is the value to be recovered by these bondholders who theoretically bought bonds with the assumption that they were backed by the city’s full taxing authority. In addition to debt holders, there are pension recipients that are also in the mix of creditors. Detroit also has an unfunded pension liability that is between $3 and $3.5 billion, depending upon the assumptions used in the calculations.
Unfortunately, it looks as if the bankruptcy process is going to pit the bondholders against the pension recipients and the taxpayers to see who will bear the burden. How the remaining value is going to be divided is an open question at this point. Federal bankruptcy law treats each creditor equally while Michigan has strong protections in place for public employee pensions in the event of a bankruptcy.
Detroit is an extreme example of a municipality in financial distress. While there are other cities that are facing financial challenges, such as Chicago, the probability of default is fairly low. Chicago still has a dynamic economy, a recovering real estate market and a more stable population. Detroit had no other options other than bankruptcy due to an extraordinary drop in population impacted by a revolutionary change in the auto industry. This population decline coupled with corresponding erosion in the economic base created a downward spiral that Detroit could not reverse, which may impact bondholder’s recovery potential.
While the Detroit bankruptcy has made headlines and has caused bond investors to reconsider how cities with similar problems are evaluated; historically, municipal bonds have been a safe investment. According to Moody’s, the default rate on rated bonds has been .012 percent for the 40-plus years of data available. Looking at it differently, of the greater than 1 million municipal bond issues outstanding, only 71 have defaulted since 1970.
| Moody's Rated Municipal Issuer Defaults 1970-2011 | |||
| Type of Bond | Defaults | Percentage | |
| Housing | 29 | 40.80% | |
| Hospitals | 22 | 31.00% | |
| Education | 3 | 4.20% | |
| Infrastructure | 4 | 5.60% | |
| Utilities | 2 | 2.80% | |
| Cities | 2 | 2.80% | |
| Counties | 1 | 1.40% | |
| Special Districts | 1 | 1.40% | |
| Water & Sewer | 1 | 1.40% | |
| State Governments | 1 | 1.40% | |
| Non-General Obligation | 66 | 93.00% | |
| General Obligation | 5 | 7.00% | |
| Total | 71 | ||
Our Takeaways from the Week:
- The situation in Detroit is an extreme example of a city in financial distress.
- Municipal bonds historically had very low default rates and are an important component of many investors’ portfolios.
Source: Moody's Corporation