Driving around some parts of Detroit can feel almost apocalyptic. Once home of Motown, the big three US car manufacturers and almost 1.8 million people, many communities now lay abandoned, homes burnt out and only 700,000 people remain.
In July, Detroit became the largest US city to file for bankruptcy. It owes $US18.2 billion in long-term debt, or $27,000 for each resident. About $US9.2 billion of the shortfall is in unfunded pension liabilities.
Last week Judge Steven Rhodes heard from Detroit residents about why the city should not be allowed to go bankrupt. They are fearful that he may decide that federal bankruptcy law trumps their pension entitlements.
Detroit is not alone in facing the question of what to do about generous promises that were made in the past by people who would never be around to deliver them.
The Centre for Retirement Research at Boston College says states pensions are 27 per cent underfunded.
Moody’s believes the CRR’s estimated shortfall of $US1 trillion is about $US1.7 trillion too conservative and that states are actually underfunded by about 52 per cent.
The credit ratings agency says Illinois is the most underfunded of the states and estimates that it owes $US133 billion, or 241 per cent of its revenue. Connecticut is in the second most precarious position with liabilities totaling 190 per cent of revenue, then Kentucky (141 per cent), New Jersey (137 per cent) and Hawaii on (133 per cent). Nebraska is the closest of all the states to meeting its commitments.
Detroit owes billions to pensioners but it also owes billions to bondholders, the investors who helped pay for roads and other infrastructure spending.
Municipal bonds are issued when an investor agrees to lend to the government in return for a regular interest payment and a promise that the money is returned in full after an agreed period of time. They are considered a super-safe investment and unlike corporate bonds or savings accounts, the income from municipal bonds is not taxed, making them attractive, usually to the uber-rich. But because they are normally such a safe investment they don’t offer a great return. The average yield on a general-obligation municipal bond over 10 years is about 2.71 per cent, while with a 30-year municipal bond it is about 4.22 per cent.
In its bankruptcy filing, Detroit proposed to not only cut its pension benefits but to repay bondholders just a small percentage of what they are owed.
Pensioners argue that Michigan's state constitution protects their pensions, while investors that hold general-obligation municipal bonds point to laws that require local governments to pay them first, even if that means closing schools and sacking police.
The concern is that if Detroit is allowed to shirk its obligations and not pay bondholders what they are owed then what will happen to a market that relies on that pledge in order to trade.
Meredith Whitney, who made a name for herself by correctly predicting that Citigroup was in trouble before the financial crisis, believes Detroit's bankruptcy is just the precipice of a wave of municipal defaults.
“The aftershocks of the largest municipal bankruptcy in US history will be staggering, and Detroit will set important precedents,” she wrote in July in a Financial Times opinion piece. “Leaders across the country cannot continue as they have. They must choose sides because there is simply not enough money to go around. Will they side with taxpayers, unions or the municipal bondholders?
“[Detroit] bondholders, who up until last week thought they would be protected in almost any scenario, are being forced to make a contribution to the fiscal problem. Elected officials, for the first time in a very long time, are siding with residents,” she wrote.
Whitney’s haters argue that she has cried wolf before on the municipal bond market.
In September 2010 her research firm released a 600-page report warning about a spate of municipal defaults. She then appeared on US 60 Minutes and told investors to expect “50 to 100 sizeable defaults … worth hundreds of billions of dollars.”
Following her comments, the municipal bond market lost about a year’s worth of returns in the space of two months and helped propel 29 straight weeks of investor withdrawals from municipal mutual funds.
This time around the $US3.7 trillion municipal bond market doesn’t appear rattled either by Detroit’s situation or Whitney’s prediction of a knock-on effect.
That is largely because mutual funds have just 0.003 per cent tied-up in Detroit. There are a number of state laws that prevent municipalities filing for bankrupt protection.
Also, since 2007 only 26 municipal borrowers have defaulted on their debts according to Moody's, far fewer than Whitney predicted.
Interest rates on some bonds have crept up but most see Detroit as an isolated incident.
Michigan municipalities are selling the most bonds since July; Bloomberg data shows $US88 million in debt being offered this week.
Traders expect Detroit bonds to continue to rebound much like the Californian market did after Stockton, San Bernardino and Mammoth Lakes defaulted and sought court protection. Borrowing costs for those areas reached a six-month high after the filings, and have since fallen to the lowest since 2008.
While the municipal bond market seems to have shrugged off Detroit’s woes, it will be Judge Rhodes’s decision next month on Detroit’s eligibility for bankruptcy that will determine if pensioners and bondholders will be shortchanged.
Mathew Murphy is a Walkey Award winning journalist based in New York.