Detroit assumed its place in US history as the largest-ever municipal bankruptcy. Despite its size (Detroit estimates its liabilities at $18 billion) and the infamy of the event, the broad municipal market impact is expected to be negligible.
Sooner Than Expected, But Not Unexpected
Detroit’s Chapter 9 filing on July 18, although sooner than expected, was in no way a surprise to the market. The filing came one month after emergency manager Kevyn Orr’s June proposal to pay creditors pennies on the dollar in settlement of debt totaling $11.5 billion. Many viewed Mr. Orr’s plan as a prelude to bankruptcy from the outset. For more detail, see our recent thoughts on this subject in “Distress in Detroit.”
The proposal met with tough opposition from creditors (we had our own say on this matter) and legal action from pensioners also facing severe haircuts. In fact, a motion filed in state court the same day by a pension fund seeking a temporary restraining order to prevent the filing appears to be the catalyst for the sooner-than-expected event.
What Happens Next?
The city now has to convince a bankruptcy court that it is insolvent and eligible for Chapter 9 protection. Creditors will likely argue the city is not insolvent, pointing to current cash flow and assets owned (which are potential candidates for liquidation).
Bottom line: This is going to be a long and protracted battle, with court challenges along the way. The Chapter 9 filing is but the first chapter in what is sure to be a lengthy negotiation that could offer no clarity for years. It is likely to become a very expensive exercise for the already fiscally barren city.
For the broader municipal market, we do not anticipate a widespread systemic effect and investors should expect little market impact. The city’s problems, while long known to the municipal market, have had little bearing on it – a scenario we expect will continue.
While some indirect action such as outflows or price weakness could ensue in the near-term as the market digests the news, we would remind investors that headlines rarely tell the whole story. The basic fundamental credit underpinnings of the municipal market remain very healthy and, in fact, better than they were in 2008.
Detroit Is the Exception, Not the Rule
For those fearing a Detroit repeat elsewhere in the US, we would submit – there is no reason to panic. Detroit’s situation is unique, as indicated by the emergency manager’s own assessment:
- The city’s population has declined 63% since its 1950 high and 26% since 2000.
- Unemployment peaked at a startling 23.4% in June 2010, up from 6.3% in 2000, and remained at an elevated 18.3% in June 2012.
- Detroit’s violent crime rate is five times higher than the national average and the highest of any large city.
- Approximately 40% of the city’s street lights are not functioning; 78,000 structures and 66,000 lots are abandoned and blighted. Arson is prevalent, with 12,000 fires each year, 60% in derelict or unoccupied buildings.
- Detroit’s general fund deficit currently stands at $375 million, or roughly $700 million when adjusted for recent deficit borrowing. That’s within the context of a $1 billion fiscal year (FY) 2014 budget. The city had projected negative cash flow of $198 million in FY 2014, and by the end of FY 2013, will have deferred $100 million in pension funding.
Municipal bankruptcies are rare, but not unprecedented. And while the federal government has already indicated a reluctance to intervene, Michigan may step in to protect the creditworthiness of the state and its municipalities, and to ensure fair treatment of all interested parties. We hope it will take action to do so, following the example of other states before it (consider Rhode Island in the case of Central Falls). In our view, the state’s failure to act could cost Michigan and its municipalities much more in the long-term than Detroit saves today.