Motor City In Peril

Includes: F, GM
by: Fletcher Greer

Detroit filed for Chapter 9 Bankruptcy on Thursday, initiating the nation's largest municipal bankruptcy in modern history. The $18 Billion of Detroit financial obligations is over 4 times the $4.2 Billion size of the next largest municipality, Jefferson County, AL, which declared Bankruptcy in 2011.

The Motor City has been plagued by financial woes for years. With ballooning debt and pension obligations, a declining population, and difficulties in the Auto industry, Detroit's balance sheet has continued to deteriorate. Earlier, Governor Rick Snyder appointed Kevyn Orr, as an emergency financial manager for the city. Despite efforts by both the city and state governments, Detroit's slide toward federal court has not been entirely unanticipated. This somewhat unsurprising news should have thusly been mostly priced into the market, so market-wide effects from the bankruptcy announcement should be minimal. Orr insists that Detroit's bills will still be paid, and city services will continue to be provided.

This however, is not the typical bankruptcy. Detroit officials have led the public to believe that general obligation investors will have the same priority as city workers. This runs contrary to market custom: where bondholders have precedence over all other claimants. One of the biggest obligations that the city owes is to public sector pension funds. One of the bankruptcy challenges is this, a constitutional provision that states: "The accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby." This would indicate that limiting pension payouts is legally impossible, signaling greater losses for municipal bond holders.

It remains to be seen what can be done to alleviate Detroit's financial woes. Cuts to public services would only exacerbate poor performance. The average 911 response time is 58 minutes, compared to 11 minutes nationally. Furthermore, the violent crime rate is 2,137 per 100,000 people, more than 3x that of New York. Further cuts to services would continue to drive residents (and taxpayers) away from a city that has seen its population drop from 1.8 million in 1950 to 680 thousand today.

This happened on Friday. An Ingham County judge ruled that Detroit's bankruptcy be withdrawn. Judge Rosemary Aquilina cited the constitutional provision guarding retirement benefits. She went on to say "It's cheating, sir, and it's cheating good people who work. It's also not honoring the president, who took [Detroit's auto Companies, (NYSE:GM), (NYSE:F)] out of Bankruptcy." The attorney representing some of the pension plan members cited the Stockton, CA bankruptcy, a bankruptcy which did not compromise pensions. Although this represents a current obstacle, the bankruptcy would likely be dealt with in a federal court which may not make use of the cited constitutional provision.

Vice President Joe Biden suggested a bailout as a possibility to avoid the entire process, saying that the administration had not yet considered help from the federal government as a possibility. Detroit's local leaders are not pushing for federal assistance at this time. Detroit, which was once America's 4th largest city, seems to have less importance than the automobile manufacturers that call the city home. These companies, and their suppliers, are no longer held hostage to the stagnation of Detroit, but rather have spread production to additional areas in the U.S., Canada and overseas. They are therefore buffered against any shocks that this municipal action might produce.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.