Detroit Denial

Last week Detroit, Michigan, became the latest and largest US City to file for bankruptcy, following similar filings during 2011/12 by the California cities of San Bernardino and Stockton, Jefferson County, Alabama and, not to forget, Central FallsRhode Island, Boise County Idaho and HarrisburgPennsylvania. With debts of $US18BN, $3 billion of which is owed to its retirement system, Detroit is the biggest municipal bankruptcy in the US, so far. The city has been in decline for decades after its population peaked at 1.8m back in the early 1950s but has declined to around 700,000 as the US auto industry shrunk and manufacturing workers sought employment elsewhere. Although private sector jobs have gone, thereby shrinking both the tax-base and the city services provided, public sector entitlements have gone through the roof and corruption has allegedly been endemic within it.

This is a story that is not limited to Detroit. According to star banking analyst, Meredith Whitney, “There are five more towns like Detroit in Michigan alone, with many more municipalities across the country in similar positions.”

We thought that it may be of interest to look at a Municipal bond of Michigan, at least that managed by Eaton Vance. As can be seen, it halved in value from 2004 to 2008, rallied into 2012 and, after being tantalisingly close to the prior high, started its collapse.

weekly_blog_130724

 

Most “Munis” are considered to be risk-free, accruing investment-grade status from the rating agencies, (those same agencies who gave AAA to AIG, Fannie and Freddie to name but a few,) but as can be seen in the chart above, the de-flationary jolt of 2007/09 treated this Michigan bond as “Junk.”

Of particular concern to creditors’ has been the 20 cents on the dollar offer to the holders of Detroit’s $370m “general obligation bonds,” where holders have a right to compel the borrowing government to levy a property tax on residents to satisfy the obligation, hence the credit rating agencies see them as very strong credit quality.

There is a major problem with Detroit, however, in that the average house-hold income is less than $28,000, compared with $49,000 state-wide, with more than 36% of Detroit residents living in poverty, according to a 2011 census. As such, increased local taxation is unlikely to fill the void. Furthermore, with “general obligation bonds” now representing some $900BN of the $3.7 Trillion municipal-bond market, or 25% of it, investors will be demanding a higher coupon from municipalities as the perceived risk of holding this debt has risen. This will place additional pressures on highly indebted municipalities and states.

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