Detroit Goes Down In History (Analysis)

By:  Peter Hayes and James Schwartz, BlackRock Municipal Bonds Group

The City of Detroit on Thursday filed for Chapter 9 bankruptcy protection, assuming its place in US history as the largest-ever municipal bankruptcy. Despite its size and the infamy of the event, the impact on the broader municipal market is expected to be negligible.

Detroit's Chapter 9 filing on July 18 came slightly sooner than expected, but in no way was a surprise to the market. Governor Rick Snyder, in authorizing the filing, cited the "fiscal realities" in the city that "have been ignored for too long" and deemed bankruptcy "the only viable option to address a problem that has been six decades in the making."

We would caution municipal market participants against making correlations between Detroit and any other municipal issuer. Local government stress, as indicated by general obligation (GO) bond defaults, remains extremely rare. According to Moody's, the one-year default rate was 0.03% over the past five years, a period that included a severe recession. Furthermore, Detroit's situation is clearly unique, as indicated by the emergency manager's own assessment:

• The city's population has declined 63% since its 1950 high and 26% since 2000.
• Unemployment peaked at a startling 23.4% in June 2010, up from 6.3% in 2000, and remained at an elevated 18.3% in June 2012.
• Detroit's violent crime rate is five times higher than the national average and the highest of any large city.
• Approximately 40% of the city's street lights are not functioning; 78,000 structures and 66,000 lots are abandoned and blighted. Arson is prevalent, with 12,000 fires each year, 60% in derelict or unoccupied buildings.
• Detroit's general fund deficit currently stands at $375 million, or roughly $700 million when adjusted for recent deficit borrowing. That's within the context of a $1 billion fiscal year (FY) 2014 budget. The city had projected negative cash flow of $198 million in FY 2014, and by the end of FY 2013, will have deferred $100 million in pension funding.

The city's problems, while long known to the municipal market, have had little bearing on it—a scenario we expect will continue, even in the wake of the bankruptcy filing. In fact, the news of the record filing did little to unnerve the market in the immediate aftermath. While some indirect action such as outflows or price weakness could ensue in the near-term as the market digests the news, we would remind investors that headlines rarely tell the whole story.

For the broader municipal market, we do not anticipate a widespread systemic effect. The basic fundamental credit underpinnings of the municipal market remain very healthy and, in fact, are better than they were in 2008.

Two of the funds in D2 Capital Management's Tax Free Income Portfolio hold negligible positions in Detroit revenue bonds.  Detroit revenue bonds are secured by city enterprise revenues, such as the city’s water system, and have been excluded from the city manager’s recovery plan, at least as proposed currently. The plan proposes to pay these obligations in full, without involvement in the bankruptcy case, because they are secured by special dedicated revenues from enterprises that are not part of the city’s general operations.

The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.

 

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