What Happened in Detroit?

On July 18, the city of Detroit filed for Chapter 9 bankruptcy protection and will seek to reorganize and restructure approximately $18-20 billion dollars of debt.  Often times, municipalities and corporations about to enter bankruptcy will try to come to a compromise with their creditors and go through a “pre-packaged” bankruptcy in which they submit a pre-agreed-upon plan for restructuring to speed up the process and cut down the legal fees and proceedings.  The Emergency Financial Manager, Kevyn Orr, attempted to do this in Detroit before filing.  He approached holders of unsecured unlimited general obligation debt (the general obligation bonds that had been secured with things such as state aid pledges) and asked them to take a large haircut as a part of his proposed debt reduction/restructuring plan.  He also approached retirees living off of municipal pensions about a haircut– a group often considered sacrosanct in restructuring. 

Why Did They File for Bankruptcy?

Simply put, Detroit faced a budgetary shortfall.  Detroit’s bankruptcy was not caused merely by pension shortfalls or a sudden, acute drop in housing prices.  Detroit’s bankruptcy was caused by six decades of massive population decline, corruption, blight, and crime.  In the city of Detroit, 32% of people live below the federal poverty line.  The average home sale in 2012 was $7,500, and half of property owners did not pay their property tax.  Part of Detroit’s plan to revitalize itself involved literally bulldozing a quarter of the city.  The city’s 2012 property and income tax revenues combined were slightly less than $450 million, while the city’s projected 2013 budget deficit was $327 million. 

Why Does it Matter?

Many municipalities have in place pension and benefits programs that are not sustainable.  Most of these municipalities will have years to rectify their situations before the risk of default becomes material.  For the municipalities that are unwilling or unable to address these issues, there will eventually be a time when the interests of bondholders and the interests of employees conflict.

Not only does Detroit represent the largest chapter 9 filing in history, but the Detroit bankruptcy proceedings have the potential to set disturbing precedents for future municipal bankruptcies.  In almost, if not every municipal bankruptcy of the last 30 years, holders of unlimited general obligation bonds have not been forced to take a haircut on their principal.  This is because unlimited general obligation bonds are supposed to be backed by an unlimited pledge of taxes levied by the municipality.  In the case of the Michigan constitution, this backing is supposed to be guaranteed.  The disturbing part, in terms of future precedent, is that Detroit is seeking to extend haircuts to unlimited general obligation bond holders – a group who, as described, is historically considered among the highest priority creditors in municipal bankruptcies.

What Implications do We Foresee?

During the California budgetary crisis, and after every municipal bankruptcy, there has been a media frenzy speculating about impending Armageddon in the municipal bond market.  The argument is this: “If Detroit can force bondholders to take haircuts on their bonds, surely other municipalities will follow suit.”

However, that being said, the muni market as a whole has not responded very dramatically to the news of Detroit’s bankruptcy.  The bonds have traded at a very high yield for some time – in many cases over 10% tax equivalent – so it seems the market had priced in the very real risk of a haircut.  While municipal bonds have been down over the last few months, the broad bond market has been down as well.  Michigan bonds, which as a whole had already traded at a discount to national levels however were hit, and Detroit bonds were of course down substantially. 

As we said, the treatment of bondholders in Detroit’s bankruptcy is going to be watched for precedent, and it may have far reaching ramifications.  We believe, however, that some haircut is probably to be expected and is not necessarily something that will set a precedent.  We believe that Detroit’s debt load is simply too high to reasonably expect otherwise.  Municipalities have a requirement to provide basic services even in bankruptcy, and it is simply unreasonable to expect the city to completely wipe out other classes of creditors – pensioners and public employees.  The debt load has simply reached a level where everyone will have to share the pain in some form. 

If Detroit were able to quickly resolve their bankruptcy and return to normal operations with an improved balance sheet, it may incentivize other municipalities to reorganize through bankruptcy.  While this is a risk, we believe that the complexities of Detroit’s situation will probably result in a long, expensive, bitter, and drawn out bankruptcy.  Detroit, we expect, will spend years going through their bankruptcy proceeding, racking up millions upon millions in legal fees, and will probably have to scale back its public services even further than it already has.  It will probably be at least five years before Detroit can even begin to consider returning to the capital markets to raise money.  Pensioners will see their income and benefits shrink.  While bankruptcy is necessary, we do not expect Detroit’s bankruptcy to be a pleasant experience for the people of the Motor City, and we would not expect other municipalities to be encouraged by Detroit’s situation.

What this Means for H&R Bond Portfolios

The risk of Detroit’s bankruptcy leading to a change of precedent and increased bankruptcy risk in the municipal markets is present, but we do not think that high quality municipal bonds will be hurt.  Instead, we would anticipate a greater differentiation in treatment of high quality versus low quality municipal bonds in the market.  We believe that the risk of default has always been present for all bonds, and this has not changed our outlook on the market.

We continue to believe that our investment strategy—diverse portfolios of high quality municipal bonds that are paid through a variety of different revenues—will perform well going forward.