INSIGHTS

On July 22, 2013

Detroit: A Long Time Sick Patient Finally Enters Intensive Care

The Detroit bankruptcy filing is an ongoing developing story but here are some big picture observations we can offer up front:

• The fiscal and economic health of Detroit is not well and hasn’t been well for some time. This decline has been decades in the making. While it was hoped that a bankruptcy filing could be avoided, long-time observers of Detroit are not surprised at the current place the city finds itself. This did not come out of the blue.

• Filing for bankruptcy among municipal entities remains very rare. Because of this, there is not much precedent available. The bankruptcy process is often long, contentious, and highly unpredictable. Competing lawsuits are likely to play their part. Toss in always-thorny political factors and predictions of how issues will be resolved easily take on a speculative nature.

• Caution must be applied when taking the specific problems of Detroit and generalizing them to the entire municipal bond market. Credit quality among a very large majority of municipal issuers has actually improved as housing values and revenue collections have grown and expenses and debt issuance have moderated. The municipal bond market is very large with over 55,000 issuers. Every day, thousands and thousands of issuers continue to make the difficult choices that allow them to honor their obligations.

• An important issue to watch is how Detroit’s sizable pension and health care obligations to its existing and retired workforce will be treated in bankruptcy. Numerous municipal entities across the nation are feeling, in varying degrees, the pressure of high costs in this area. The high profile pension problems of Detroit will bring the issue to the forefront again for all municipal entities and put pressure on the need for pension reform. This challenge is not going away.

• The municipal bond general obligation pledge and how it is viewed in bankruptcy is another issue that will bear watching. Traditionally, the full faith and credit pledge on general obligation bonds was seen as primary and on a higher plane than other obligations held by municipalities. The reality of Detroit’s severe economic and fiscal deterioration is likely to overwhelm that notion, particularly given the prevailing political climate in a post-financial crisis/what-size-haircut-are-you-going-to-take world.

• “The potential reduction in the general obligation pledge worries me. I always thought general obligation bonds were stronger than revenue bonds.” This observation is perhaps a little too simple. While it is true certain pledges have traditionally been viewed as stronger than others, long time municipal credit analysts and market participants have always recognized the importance of assessing each credit on its own, one at a time. They have seen countless revenue bonds exhibit higher ratings and/or more stable credit quality than many general obligation credits over time.

• There is no replacement for knowing what you own through rigorous municipal bond credit analysis. One way to avoid the uncertainty of figuring out the kind of pledge you have and how that pledge might hold up in court is to perform appropriate credit analysis and invest in municipal bonds with credit quality strong enough to keep you out of a courtroom in the first place. Municipal bond investors, armed with careful credit analysis and sober judgment, have plentiful choices to do just that.

• There are many factors that filter into a prudent assessment of municipal bond credit quality but an entity’s service area remains a very critical one. The decline in Detroit’s service area - population, property values, economic activity, employment and income levels - has given city officials less and less to work with, with each passing decade. Detroit is an unfortunate example of how a severely wounded service area contributes to nearly impossible budgetary challenges.

• Harsh treatment of the city’s general obligation bonds in the bankruptcy process could widen spreads generally in the municipal bond market. The municipal bond market, on the other hand, has shown remarkable resiliency and little spread widening in the market as a whole in the face of Jefferson County, Stockton, and San Bernardino. The market tends to take things in stride if it sees these severe credit situations as reasonably rare non-surprises caused by somewhat unique circumstances.

We hope the big picture observations listed above will provide some perspective for municipal bond investors as they navigate through the clutter of Detroit news stories and speculation, both informed and uninformed, that are sure to come in the days ahead.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Municipal Disclosures webpage. For additional risk information see the Blog and Commentary Disclosures website. For additional commentary or financial resources, please visit www.aamlive.com