After filing for the largest municipal bankruptcy in U.S. history, Detroit Emergency Manager Kevyn Orr said he viewed the move as a "tool" for turning around the Motor City after decades of decline.
It is possible that Chapter 9 bankruptcy will allow Detroit to restructure its $18 billion-plus debt and focus on providing basic services. Orr said in a report he wrote after he was hired that his goals were simply to keep the city's streetlights on, fire engines running and ambulances on call. Time will tell. He said he hopes the process, if the petition for bankruptcy is accepted, will be finished by late summer or fall of 2014. But even if bankruptcy works for Detroit, some participants in America's $3.7 trillion municipal bond market worry that the city's treatment of creditors and retirees will set a harmful precedent.
The Securities Industry and Financial Markets Association, an industry trade group, wrote in a letter to Michigan's state treasurer that the filing "could have potentially significant, negative municipal securities market implications, and could increase the cost of borrowing for all Michigan municipalities."
Detroit's failure will change municipal bond markets if only because it is the largest city in the U.S. to go bankrupt, and municipal bankruptcies are rare. Only eight cities and localities have filed for bankruptcy since 2010, according to Governing magazine, and three of those petitions were dismissed. Previously, Jefferson County, Ala., held the record for the biggest municipal bankruptcy filing, at $4.2 billion. Stockton, Calif., a city of 300,000, was the largest in terms of population. Detroit's bankruptcy dwarfs both those cases and will significantly shape Chapter 9 law.
The actions Orr took before filing for bankruptcy, however, may prove more disruptive to bond markets than the bankruptcy proceedings.
He announced a month before filing for bankruptcy that the city would stop making payments on some of the city's more than $11 billion in unsecured debt, and offered less than 10 cents on the dollar to holders of unsecured debt and unfunded pension liabilities. Orr included general obligation debt, backed by the city's taxing power, in the category of unsecured debt instead of giving those bonds top priority.
The move rattled some market players. The money management firm Blackrock wrote that "treating all creditors equally calls into question the value of the 'full faith and credit' pledge bestowed to holders of GO bonds and could have far-reaching implications -- in Detroit, in Michigan and beyond."
The bond-rating agency Moody's Investors Service called the default "unconventional and precedent-setting," saying that the decision to lump general obligation holders in with unsecured creditors was "a break from tradition." Defaulting on debt generally considered low-risk could raise funding costs for cities everywhere.
Nevertheless, cautioned Tracy Gordon, a public finance expert at the Brookings Institution, general obligation bonds might be "the prettiest horse in the glue factory" in a situation like Detroit's, but they're still ultimately understood to be unsecured.
Detroit is also in a unique situation thanks to Michigan law. Many states restrict cities' ability to file for Chapter 9 bankruptcy or offer bondholders greater protections. Michigan places relatively few restrictions on municipal bankruptcies and gives emergency managers extraordinary powers.
Gordon also points out that, unlike other distressed cities, the Motor City's problems have been 60 years in the making and are part of a much broader set of economic and political issues than the average fiscally strained municipality faces. Like many cash-strapped cities, Detroit has mismanaged its pension system. Unlike anywhere else, however, it has seen its population shrink from 1.85 million in 1950 to less than 700,000 today, reflecting generations of racial tension, corrupt government and industrial decline.