My friend and pastor, Father Joe out in Valparaiso, is always good for some words of wisdom. One of his pithy axioms is “doing the same thing over and over again and expecting a different result is the definition of insanity."
It’s unfortunate the people of Detroit didn’t learn and take this lesson to heart.
Last Thursday, the city of Detroit became the largest city in U.S. history to file for Chapter 9 bankruptcy. Chapter 9 is a part of the U.S. bankruptcy code dedicated specifically for municipalities, and theoretically states as well. This section enables these governments to restructure financial obligations to employee unions, bond holders, creditors and pensioners and retirees.
I don’t think the outcome in Detroit was all that surprising. Detroit’s 2012 budget was more than $1.1 billion. Running an operation of this size is a complicated job. When voters for decades elect people who are not up to the task, there is plenty of culpability and hardship to go around.
According to analysis I’ve seen from AllianceBernstein, Detroit has about $8 billion of outstanding debt in the form of bonds. Of this $8 billion debt, $5.4 billion consists of revenue bonds issued by the city’s Sewer and Water authority. This means the service of these bonds is based upon dedicated sewer and water revenues and these bonds are expected to continue performing.
The remaining $2.6 billion of bonds are general obligation bonds backed by city tax receipts. It is expected the terms on these bonds will be renegotiated, and the bankruptcy will most likely result in losses. These bonds, however, were also issued with municipal bond insurance backed by specialized insurance companies. So actual losses incurred by bond holders may be mitigated.
My gut feeling is in Northwest Indiana, individual investor losses related to this financial calamity are probably extremely limited. Most exposure will come through muni bond mutual funds which tend to be extremely diversified and so any impact will likely be mathematically almost meaningless.
My main concern related to Detroit comes in the area of contagion. While Detroit certainly has some monumental problems, it’s not the only place that does. If politicians elsewhere observe Detroit’s bankruptcy as a viable solution to decades of mismanagement they will be tempted to follow suit.
Our financial system can endure a “one-off” Detroit type event. If however, municipal bankruptcies become more systemic, the stability of the still fragile financial system will be vulnerable.
Detroit’s problems should not be viewed in a vacuum. If this situation ends up being a canary in the coal mine investors want to make sure to be paying attention.