Do Detroit’s troubles spread beyond the Motor City, or even the state of Michigan?
A headline in Friday’s edition of The New York Times suggests that Detroit’s financial collapse at the very least is causing severe problems in other areas of Michigan and perhaps the whole state: “Woes of Detroit Hurt Borrowing By Its Neighbors.” The story goes on to say, “The Detroit Effect has rippled all the way to Wall Street.”
It’s no surprise that investors would become suspicious of any bonds issued within, or by, the state of Michigan, but the reaction has become much more drastic.
On Thursday, Saginaw County found that the environment for borrowing was so bad that it had to delay borrowing a sorely needed $60 million. To make matters worse, Saginaw County was trying to borrow the money to take care of part of its pension obligations.
Think about that situation.
Saginaw County’s pension plan needs the money to make good on its guarantee to current and future retirees. But investors, in Michigan and elsewhere, are saying, at least for now, that there is no reason to take the risk of The Detroit Effect hitting Saginaw County as well. The Saginaw borrowing collapse was the third in just the few weeks since Detroit declare Chapter 9 bankruptcy.
Battle Creek – the home of Kellogg’s cereal – was afraid it wouldn’t be able to afford the high interest rates likely insisted upon by bond investors. The Detroit Effect already hit Genesee County a week earlier.
If you’ve never owned a municipal bond, there are several features that have made them attractive to investors. First of all, their interest payments are free of federal income taxes and also state taxes when held by a resident of the state where the bond is issued. For example, if a New York resident buys a bond issued by, say, the city of Sacramento, the New Yorker will not have to pay federal taxes on the bond, but will be subject to New York state’s relatively high income tax.
So why would any investor buy a bond offered by an issuing authority in another state instead of a local bond? Simple – because the hypothetical yield would be high enough to offset the added tax obligation. There are some issuers, such as the Commonwealth of Puerto Rico, that offer interest rates – which are often exempt from taxation by most states – that are so high that they are very attractive to investors.
Municipal bonds are graded for credit quality by one or more of the rating agencies such as Standard & Poor’s, Moody’s or Fitch. The ratings run from a high of AAA to a low of “not rated.”
What has frightened investors about the Detroit bonds is the fear that either the Chapter 9 bankruptcy will take precedence over the “general obligation” guarantee on the highest-rated bonds or that the bankruptcy proceedings will involve lengthy delays in the payments of interest or principal.
The worst case, of course, is that pension obligations will trump bond obligations.
Since Detroit’s bankruptcy is the largest in municipal history, it might take well over a year to sort things out. Who gets paid how much of what they are owed – retirees, current workers, creditors, bondholders or any of a number of creditors standing in line?
Then there is the fear of contamination wherein cities or school districts, for example, that are on the borderline, see that Detroit is – so to speak – getting away with it. I can foresee a lot of business for bankruptcy lawyers in the next few years.
Bud Stevenson, a stockbroker, lives in Fairfield. Reach him at Bsteven254@aol.com.