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Motor City Meltdown

The municipal-bond industry’s reputation as a safe haven could get a drastic makeover now that Detroit has filed for bankruptcy protection. Here’s what investors need to know.

Jeff Westergaard, 08/15/2013

This article originally appeared in the August/September 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

Detroit, once a gleaming example of U.S. manufacturing muscle for most of the last century, is in the midst of a spectacular fall from grace. The cradle of the country’s automobile industry filed July 18 for protection under Chapter 9 of the U.S. Bankruptcy Code. The decision to file makes Detroit the largest city to file for bankruptcy in U.S. history. Earlier, in what he claimed was an effort to avoid such a filing, Detroit’s state-appointed emergency manager, Kevyn Orr, unveiled a massive and controversial proposal to substantively restructure the entirety of the city’s $19 billion liability profile, offering pennies on the dollar to many of the city’s major creditors.

Detroit has suffered for decades from a deteriorating economy characterized by rapid population loss, high unemployment rates, and an eroding tax base. Resulting revenue losses coupled with significant mismanagement led to poor delivery of basic city services, huge budget deficits, and a liquidity crisis, which officials say has now rendered the city insolvent. Absent structural changes, city and state officials estimate that Detroit’s accumulated unrestricted general fund deficit could grow to more than four times its current level of $326.6 million (negative 26.5% of general fund spending) to $1.4 billion by fiscal 2017. The city currently isn’t paying its obligations as they become due; it deferred more than $100 million of pension contributions, and it missed a $39.7 million scheduled anticipating too much revenue and accumulating too many liabilities.

Taken together, these factors combined to create a sense that credit quality in the muni market was strong and that credit analysis was somewhat superfluous.

Cracks in a Safe Haven
The 2007–2008 crisis, of course, changed all of that. By the end of 2008, assumptions about relative yields of municipals to Treasuries and the unassailable strength of the bond insurers and their AAA rated credit were no longer valid.

In Washington, D.C., legislation that passed in February 2009 contained a number of significant provisions designed to support the muni market. As the year unfolded, normalcy slowly returned to the muni market. That year saw the first Build America Bond issues come to market in what would turn out to be an incredibly popular issuing vehicle for taxable muni debt. Over the course of 2009 and 2010, taxable municipal issuance from this program hit nearly $200 billion. While there was still a great deal of uncertainty facing investors in the muni market, particularly from the risks posed by economic and real estate market weakness, by the fourth quarter of 2010 the worst seemed to be over.

Alas, it wasn’t. In the second half of 2012 there was a renewed focus on credit risk. In the summer, over a span of just a few weeks, three California issuers declared bankruptcy: Stockton, Mammoth Lakes, and San Bernardino. The filings gave pause to the calm of the market. California had handled municipal bankruptcies before. In 2008, Vallejo, Calif., declared bankruptcy, but all debt service payments were made on time and the city exited Chapter 9 four years later. The cause of Vallejo’s trouble—untenable employee wage contracts—did not seem to be a systemic problem that would spread to other towns.

By contrast, the Stockton and San Bernardino situations appear to present a more general danger. In both cases, the cities are part of the California “Inland Empire,” where the economic and housing booms that preceded the crisis were strong. In both cities, property values plummeted and unemployment increased dramatically, placing intense stress on both revenues and expenses.

Jeff Westergaard is Morningstar’s director of municipal analytics.

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