Municipal distress has been back in the news again over the last few weeks with the bankruptcy of Stockton, Ca., and the appointment of an emergency manager in Detroit, Mich. In a past article, I wrote about the historical odds of various municipal bonds defaulting. The default rates are interesting and very important of course, but past history may not be an accurate prediction of the future. As a result, it is useful to consider how Stockton and Detroit ended up where they are, and what fate bond holders might face in each case.
Detroit is arguably the biggest mess in the entire municipal bond universe. Other troubled areas like Harrisburg, Pa., and Jefferson County, Ala., are in trouble primarily because of a major bad decision like the unfortunate choice by Harrisburg to build a trash incinerator, which went over budget in construction and provided little revenue. In contrast, Detroit has been a declining city for decades. The population has fallen more than 60% in the past few decades, and businesses have fled at a similar rate. As a result, Detroit has far too many municipal employees for its size. The city also has far too many vacant houses, vacant streets, unused street lights, etc that have to be maintained by the city. The result of all of this under utilization is that real estate prices have fallen dramatically, which has eaten away at the tax base considerably. The problem is so severe that in recent years there have been semi-serious proposals to bulldoze entire neighborhoods that are vacant or close to vacant.
Kevin Orr, Detroit's new emergency manager faces considerable challenges in aligning Detroit's tax revenue and its expenditures, but he seems optimistic that it can be accomplished in a relatively short period of time. Under Michigan's new law regarding the powers of emergency managers, Orr will have the power to break contracts and upend the fiscal environment in Detroit. With $14 billion in debt outstanding, and projected 2013 revenue of $2.5 billion, the city is likely to end up renegotiating some large proportion of its debt outstanding. If Orr and city leaders in Detroit can start making the city a more attractive place to live by reducing crime, reducing the visibility of the city's seedier elements, and bringing businesses back to the area, then the city will be in a stronger position in the long run.
The broader lesson for holders of GO municipal bonds (and funds that hold GO municipal bonds) is to watch demographic trends. An area that is appealing to live in and that has consistent net population inflows is likely to be able to support a lot more in outstanding debt than an area with population declines. Detroit's city workers and their pensions undoubtedly present a challenge, but the city's bigger problem appears to be that people simply don't want to live there.
On the opposite end of the spectrum is Stockton, which recently successfully declared Chapter 9 bankruptcy. The city's creditors argued before the judge in charge of the bankruptcy proceedings that Stockton should not be allowed to declare bankruptcy because it had made little effort to no effort to restructure the enormous pension obligations it faces for current and past city employees. In Stockton in particular, and throughout California more generally, municipalities are facing severe distress mainly due to heavy pension and healthcare obligations. Unlike Detroit and despite its heavy taxes, California continues to maintain its appeal for residents. Most cities are at a minimum maintaining their population, and many have increasing populations.
Despite these favorable demographics, most of the cities in California have given municipal employees enormous salaries and enormous corresponding pensions. These salaries and benefits have sometimes approached the absurd with California lifeguards in some cases earning more than $200K a year in pensions. The salaries and benefits were initially covered by the increasing property boom and associated increase in property values that accompanied the property boom across the state over the last two decades. Once this long property boom collapsed, these salaries quickly became unsustainable.
In contrast most California municipalities themselves held relatively modest amounts of municipal bond debt. The unsustainable debt is much more a result of the pension and healthcare obligations that the municipalities face to Calpers, Calsters, and the retirees themselves (Calpers and Calsters are the pension guarantors for municipal employees and teachers across the state - municipalities send pension contributions to these organizations which invest the money and then pay retirees benefits.) Thus far, the municipalities have shown limited willingness to renegotiate these pension obligations with Calpers, but ultimately most of these distressed cities face a difficult financial burden unless they can restructure the pension and healthcare obligations they owe. Vallejo, San Bernardino, and Stockton, all fall into this category.
While individually the California cities in distress do not have particularly large levels of municipal debt, overall the state and associated municipalities as a whole are enormously important to the municipal markets. Most municipal bond funds hold at least a few million in bonds related to the state of California, and as a result, any agreement between Calpers, bond holders, and municipalities that makes the debt obligations more sustainable should be beneficial to bond holders. Moreover, if Calpers buckles and agrees to renegotiate pension obligations, then that would set an extremely important precedent for the future, and put future distressed municipalities on a path to a firmer financial footing.
These two issues I have outlined above are particularly pertinent for those holding national and certain state specific muni bond ETFs like (NYSE:BFZ), (NYSE:BJZ), (NYSE:MUC), (NYSE:MYC), (NYSE:MCA), (NYSE:MIY), (NYSE:NUV), (NYSE:NAD), (NYSEMKT:NZF), (NYSE:NPM), (NYSE:NQM), (NYSE:NPP), (NQU), (NYSE:PML), (NYSE:PMX), (NYSE:BFK), (NYSE:BTT), (NYSE:IQI), (NYSE:IIM), (NYSEMKT:VKI), (NYSE:VGM), (NYSE:VKQ), (NYSE:BYM), (NYSEARCA:SUB), (NYSEARCA:SMB), (NYSEARCA:SMMU), (NYSEARCA:MUB), (NYSE:KTF), (NYSE:IMC-OLD), and (NYSE:MMU).
For an intro to municipal bonds, their risks, and an analysis of forecasting future bond rates, see my blog here. For readers who are interested in muni bonds, but aren't sure whether they should invest in bonds or exchange traded funds holding bonds, see my recent article here.
Disclosure: I am long NUV, MMU, NZF, NPP, SMB, VKI, MCA, NQM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.