For all practical purposes, Detroit has been bankrupt for years. Yesterday, the city’s state appointed emergency manager Kevyn Orr took the first step in making the Motor City’s insolvency official, filing for bankruptcy protection from roughly 100,000 creditors.
If Detroit is allowed to move forward with its bankruptcy filing, bondholders will be fighting each other tooth and nail for the meager resources the city has to offer. For now, though, bondholders are unified with a single message: bankruptcy would be unfair to those who have lent Detroit around $2 billion.
But no one should be crying for bondholders. Lending to munis may have always involved little risk, but there was still risk. Call it the black swan of municipal lending risk or whatever you want, but the bond investors should be held just as liable as Detroit’s leaders for letting the city’s debt spin out of hand.
Not only should Detroit’s bankruptcy be allowed to proceed, but this largest municipal bankruptcy filing in U.S. history should serve as a reminder to bond investors that due diligence in managing credit risk is still an important aspect of finance.
On Thursday, the Securities Industry and Financial Markets Association (SIFMA) sent a letter to Michigan Gov. Snyder, arguing that bondholders are entitled to full repayment under state law, and that a Detroit bankruptcy “could have potentially significant, negative municipal securities market implications.”
SIFMA and other critics of Orr’s bankruptcy move have warned that the filing could cause municipal borrowing rates to rise across the state. Bondholders may think twice about lending to cities and counties for public works projects, payroll, and pension obligations.
To that we should all respond, “Great!”
General-obligation bonds have long been considered one of the safest forms of investing in the United States because local governments guarantee their repayment with tax dollars as necessary. Rhode Island recently faced a related situation, after guaranteeing loans to a now-defunct videogame company called 38 Studios. The private firm failed, leaving the state on the hook for around $75 million plus interest. Some individuals in the Ocean State said the government shouldn’t pay out such a large sum, especially with a strapped pension system and a $30 million budget gap this year. The Governor decided Rhode Island had a moral obligation to make good on the loan, though, and the state is making cuts to services as necessary to repay the lenders.
Rhode Island also passed a law a few years ago guaranteeing municipal bondholders first rights to tax dollars in the event its cities declared bankruptcy. This has been important for the state, as there are half dozen cities on the cusp of bankruptcy this year, but lenders are still funneling money into state municipalities.
Municipalities in Michigan are concerned that Detroit forcing its creditors to take haircuts will raise borrowing costs across the Wolverine State. And they might be right. The question is whether this is a problem in the long run.
Muni-debt is often important for helping cities and counties meet payroll as tax receipts typically flow into government coffers at uneven intervals. But muni-debt is also used to fund often dubious economic development projects, unnecessary infrastructure projects, and as a stop-gap measure so that municipalities can kick the can down the road on properly funding their pensions.
Higher borrowing costs will force cities to be more thoughtful with their bond issuance, will force more fiscal responsibility, and may also force some local leaders to address budget problems today instead of continuing to stiff arm responsibility. Detroit is not alone in letting its pension liabilities get out of control — although its $16 to $18 billion in unfunded pension liabilities are vying for some Olympic medal in mismanagement.
Bankruptcy in Detroit will allow the city better leverage to work with creditors on refinancing obligations. Ideally it will also force the city to divest itself of property it doesn’t need to own, and to outsource many of the city services that it has proven incapable of efficiently managing-both as cost saving measures and to ensure bondholders get the maximum return available.
There are interests that have to be held in balance in this situation. Bondholders deserve the most repayment available; the city must do everything it can to pay back money that it owes. And to the degree that the state constitution guarantees payment, the law must be honored.
At the same time, the city should use whatever legal room it can to force bondholders to carry some of the risk of their lending. Once the money has run out they need to recognize they were taking risks with their lending and have to be held responsible too.
The city is maxed out on its tax dollars and raising rates will just bleed more taxpayers out of the system. Detroit’s property taxes are already so high — some of the highest in the country — that nearly half of the city’s resident’s just don’t pay them. (See this scary map about tax lien foreclosure risk in Detroit.) Its time to refinance the debt, get the bankruptcy proceeding in the rear view mirror, and let the Motor City start to build itself again as a city of the future.