In the US, municipal bonds — bonds issued by city or other municipal governments — have been widely viewed as “safe” investments. Detroit may cause that view to change drastically. Reggie Middleton has been sounding the alarm for a few years:
Following up on my timely post “Here Come Those Municipal Defaults That Everyone Said Couldn’t Happen, Pt 2“, I comment on Meredith Whitney’s OpEd in the Financial Times. If you remember, she — like I — warned of municipal defaults years ago and was ridiculed for such. Ms. Whitney is quoted as saying:
“As jarring as the reality may be to accept, Detroit’s decision last week to declare bankruptcy should not be regarded as a one-off in the U.S. municipal market.” she said.
“There are five more towns like Detroit in Michigan alone. There are many more municipalities across the country in similar positions.”
“The bill for promises past is now so large for some cities and towns that it is crowding out money for the most basic of services — in the case of Detroit, it could not even afford to run its traffic lights,” she said.
“Will [lawmakers] side with taxpayers, unions or the municipal bondholders? If they back residents, money will be directed to underfunded public services at the expense of pensions and bondholders. If they side with the unions, social services will continue to be cut and the risk to bondholders will increase considerably. If they side with bondholders, social services and pensions are at risk.”
In the case of Detroit, elected officials, for the first time in a very long time, are siding with residents, Whitney said. This is a new precedent that boils down to the straightforward reality of the survival and sustainability of a town or city, she said.
“After decades of near-third-world conditions in the richest country in the world, the city finally stood up and said enough was enough,”
Well, this is the problem. Defaulting on revenue bonds where the underlying asset (ex. a housing project, utility, or infrastructure project) is not generating the sufficient cash flows is part and parcel of the risk of investing in said class of bonds. This is widely accepted and understood, which is likely why those bonds have a slightly higher yield.
For some obscene reason, defaulting on the general obligation bonds which purportedly carry the “full faith and credit’ of the municipality as a back stop is deemed as wholly different affair. The reason? Who the hell knows? This is a point I tried to drive home in the original “Here Come Those Municipal Defaults That Everyone Said Couldn’t Happen” article in 2011. Backing by the full faith and credit of a public entity does not make an investment risk free. To the contrary, if said entity is fundamentally insolvent, the investment is actually “riskful” as opposed to risk free.
Treating these bonds as unsecured in the bankruptcy is essentially the way to go. If you don’t want to do that, well you can still consider them backed by the full faith and credit of the insolvent municipality, which is essentially unsecured — and move on anyway — particularly as many potential collateral assets of value would have likely been encumbered by agreements with a little more prejudicial foresight.
