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A Tale of Two Cities

An analysis of two obligors shows two municipalities at opposite ends of the credit spectrum.

Rachel Barkley, 08/28/2012

Municipal bonds, traditionally one of the safest investment asset classes, have provided a stable source of income for investors even in environments of economic volatility. But with the demise of the bond insurance industry, the undermined credibility of credit-rating agencies, and increased media attention on the funding shortfalls faced by state and local governments, investors have put a renewed focus on the underlying credit quality of municipal issuers and obligors of debt.

The muni market is vast, with 1.5 million active bonds and more than 100,000 unique issuers, each of whom offers a variety of debt securities to the market. Assessing credit quality in the muni market can be difficult for investors because of the wide range of credit factors that influence obligors’ ability or willingness to repay their debt.

Four Pillars
Morningstar approaches this problem by basing its municipal credit analysis on four pillars: economic strength, financial condition, debt and long-term-liabilities profile, and management and operating environment. Morningstar analysts then determine the overall credit quality of the issuer.

To illustrate how widely the credit quality of local governments can vary, we have chosen two cities of similar populations that lie on opposite ends of the credit spectrum: Detroit, Mich., and San Antonio, Texas.

Detroit has a pressured credit profile characterized by weak economic and demographic trends, limited financial liquidity, and very high debt levels. The city is under strict state oversight, and its ability to meet operating and debt obligations is questionable. Conversely, San Antonio has a strong credit profile with limited weaknesses and minimal risk exposure to bondholders. San Antonio’s local economy is diverse and remained resilient through the nation’s recent recession. Its strong management practices have allowed the city to keep its financial flexibility while continuing to provide healthy service levels.

Economic Strength
When we look at a city’s economic strength, we analyze the size, diversity, and stability of the area economy. The property-tax base is a main factor for local governments, but we also examine demographic data, such as population and employment.

San Antonio’s economy is strong and growing, anchored in military and government. The unemployment rate is below the national average. Wealth indexes are satisfactory, aided by a low cost of living and economic expansion. Bucking trends of the national housing correction, property values remain stable. Detroit’s economic and demographic profile is extremely weak. Over the past decade, Detroit’s population has fallen by nearly 25%, bringing it to its lowest level since 1910. Although this means that the labor force has declined in number, unemployment rates remain exceptionally high. Wealth levels are low with roughly one third of its residents living below the poverty line. Local industries are diversifying somewhat, but the area economy continues to be dominated by the volatile auto industry.

Financial Condition
Morningstar’s financial-condition pillar measures the issuer’s financial flexibility. For local governments, this includes consistency of operating results, reserve levels, revenue diversity and volatility, revenue and expenditure flexibility and liquidity levels.

San Antonio’s financial picture has been strong with operating surpluses for each of the past five audited years and current reserves equal to more than 25% of total spending. The city’s major revenue sources are diverse and remained relatively stable in the recent recession. Restrictions on revenue increases are moderate and have not had any adverse effect on the city’s financial profile.

Detroit’s financial position is very poor. It has a history of significant budget gaps because of a lack of spending controls and drops in revenues. This resulted in negative reserves and significantly limited financial flexibility. To fund basic operations, the city borrowed from the market for cash flow purposes, which we generally consider to be a credit negative. The city has adopted a plan to eliminate its deficit reserve position, although executing it will be challenging given revenue raising constraints set by law, spending mandates, and a contentious political atmosphere.

Debt and Long-Term Liabilities
Next, we measure financial commitments, including debt, pension, and other post-employment benefit (OPEB) obligations. San Antonio’s debt levels are above average, although considerably lower than Detroit’s. Capital needs for San Antonio are moderate, and its long-term liabilities are well managed. The city participates in state pension plans, which are more than 90% funded. OPEB obligations account for a minimal amount of city spending.

Detroit has an extensive debt profile and a complex swap portfolio. Pension liabilities for Detroit are well funded, at comparable levels to San Antonio. However, Detroit’s high funded ratios are because of the city’s previous debt issuance to fund its pension obligations. Detroit’s current unfunded liability for OPEB plans are massive and are expected to further pressure future budgets.

Management and Operating Environment
Our analysis then centers on the overall management of the entity. For local governments, this focuses on management’s ability to control its debt and financial profile. We consider whether a government has put in place sound policies and procedures. Fiscal planning and the operating environment, and any obstacles imposed by the operating environment, are also included in our analysis.

San Antonio’s management is strong, with prudent financial policies and extensive ongoing budgetary oversight. No operating environment constraints are noted.

Detroit is subject to state oversight. The political environment for the city has been contentious between management, its unions, the state, and local elected officials. In our opinion, the political atmosphere has made it difficult for the city to achieve stability in finances and operations. To remain solvent, we think that Detroit’s management team, whether elected or state appointed, needs to further restructure the organization, cut expenditures, and balance budgets.

Overall Credit Quality
We believe that the long-term credit quality of San Antonio is good. With a stable economy, sound financial profile, and strong management, the city should remain a stable investment with minimal risk exposure over the next several years. In contrast, Detroit’s long-term credit profile is poor and is expected to remain so for at least the next two years. The instability of its economic base, financial operations, and ability to pay obligations is concerning.

Rachel Barkley is a municipal credit analyst with Morningstar.

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