Detroit: The Spoiler?

Includes: MUNI
by: John M. Mason

I grew up in Michigan. I remember my parents taking me to Detroit for visits to "the big city." They were special, they were grand, and they were something to remember. This was the 1950s.

I moved from Michigan. I remember going back to Detroit for conventions. I remember going back to visit relatives in the Detroit suburbs. I remember returning to Detroit and playing in some very competitive amateur golf tournaments at the Detroit Golf Club and touring other major golf clubs in the Detroit area.

I remember the almost continuous decline in the city of Detroit. I remember the decline and demise of Tiger stadium. I remember the Detroit Lions moving their stadium out of Detroit. I remember hearing about how dangerous and unsafe Detroit was. And, I remember pictures … and pictures … and pictures of a city that seemed to be "closing up."

Am I surprised that Detroit has declared bankruptcy? No, not at all! Detroit, in my mind, should have been put into bankruptcy years ago.

States and municipalities, many analysts have claimed over time, can always issue more debt. Therefore, state and municipal debt has almost always been treated as "risk free". Furthermore, it has been the general feeling, sometimes written into constitutions and by-laws, that states and municipalities cannot put themselves into bankruptcy.

Thus, the obligations of states and municipalities have been considered to be solid and lenders and pensioners can feel safe about any commitment issued to them.

"The bankruptcy challenges a long-held assumption in the $3.7 trillion municipal-bond market that large cities will take whatever steps necessary, including raising taxes, to cover their debts," writes William Selway in Bloomberg.

But, Detroit has been taking "whatever steps necessary" for years. As we read in the Wall Street Journal:

"For years Detroit has been gutting services and sucking taxpayers dry to finance retirement and debt obligations. Nearly 70% of parks have been closed since 2008, and four in ten streetlights don't work. The city has cut its police force by 40% in a decade. Response times are five times longer than the national average, and it has one of the highest violent crime rates in the country.

Meanwhile, Detroit residents pay the highest property and income taxes in the state. Last year its business tax doubled. About 40% or revenues go toward retirement benefits and debt, much of which was issued in the last 10 years to finance pension contributions …"

And, the population of Detroit, which was around 1.8 million in the early 1950s, was less than 800,000 in the most recent census.

To me, the situation is primarily a result of two things. First of all, we see, especially in cities and municipalities, that the people in office are basically the people that vote. Thus, in many, many cases, the people voting have put themselves into office and supported pensions and other benefits that primarily make themselves better off. We have seen such behavior over and over again throughout the nation.

Second, during the environment that this particular kind of self-serving behavior has taken place, the United States has experienced the biggest expansion of credit inflation in its history. That is, the federal government, through its debt creation and monetary policy, has provided the foundation for a massive production of debt within the whole society. Whereas, the federal debt outstanding has increased at about a 7 percent compound rate of increase since the early 1960s, the private sector debt has increased around a 12 percent compound rate of growth during the same time period. Within this mix, state and local government debt has risen somewhere around a 10 percent compound rate.

Basically, the production of credit inflation over this time has created a culture of debt that builds upon itself. In such an environment, should local governments be prudent and balance their budgets and fulfill their obligations? Why should they when no one else -- the federal government, the state governments, businesses, and households -- is holding back.

Once again, the statement of Charles (Chuck) Prince, the Chairman of Citigroup comes back into mind: "If the music is playing, you need to continue to dance."

But, the music seemingly has stopped -- in spite of the extraordinary attempts of Ben Bernanke and the Federal Reserve System to keep the music playing. The banks and the financial markets just would not pass on the Fed's largesse to the Motor City.

The state government of Michigan considered a bailout. In the end, it decided that it just could not pull off such a bailout and that a Detroit bankruptcy was the only choice.

Now, we wait for the other dominoes to fall. There have been several cities and localities that have filed for bankruptcy. Three in California, including San Bernardino and Stockton; Jefferson County in Alabama has filed along with Harrisburg in Pennsylvania. In addition, the city of Central Falls, Rhode Island and Boise County, Idaho have also filed.

With the filing of Detroit, the largest city to declare bankruptcy, the stage is set for others to join this group.

In the Financial Times we read, "Rating agencies and institutional investors in municipal bonds say they will reconsider their views on so-called 'general obligation' (GO) bonds, if Detroit is allowed to treat the owners of these securities as unsecured creditors."

The potential damage? In the Bloomberg article the following quote is published: "'None of the other cities are as far along, but there are dozens, if not hundreds of cities that have similar issues,' said Alan Mallach, a senior fell at the Brookings Institution …" Mallach concludes, "Every other industrial city has problems that could send them down the same path."

Analysts have been presenting us with this possibility for several years now. Perhaps the most vocal had been Meredith Whitney who has been particularly hard on the finances of state governments. She has just presented her current views in a new book title "Fate of the States."

What we are seeing, in my mind, is the way that municipalities, localities and states can string out their problems postponing -- it seems like forever -- the resolution of their fiduciary obligations, their debts and their pension commitments.

As reported above, the assumption that these governmental entities "will take whatever steps necessary" to keep themselves solvent has allowed them to postpone correcting their ways for extended periods of time. The problem has been seen, and analysts like Meredith Whitney have been crying that "the world is falling apart" for several years. The city and municipal officials have been very good at holding off the creditors.

We now have to ask, "Is the run of these officials over?" "Has the self-serving nature of many of these governmental bodies along with the support of the federal government's credit inflation reached an end?" As with most crises it seems like the further we go along, the bigger the entity becomes that fails. And, it now looks as if bigger and bigger "fish" are now falling.

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.