Why Detroit's Bankruptcy Could Detonate A $3.7-Trillion Muni Bond Bomb

Includes: HYD, MUB
by: Lou Basenese

Don't sweat it. That's what municipal bond investors are being told by "respected" financial pundits in the aftermath of Detroit's $18.5 billion bankruptcy filing -- the largest in U.S. history. "We view Detroit's default and subsequent bankruptcy filing as idiosyncratic, and not as a symptom of a wider issue in the municipal market," said Jane Hudson Ridley, a credit analyst with Standard & Poor's.

Are you kidding me?

I get that all of the largest municipal bond ETFs -- like the iShares S&P National AMT-Free Muni Bond ETF (NYSEARCA:MUB) and the Market Vectors High-Yield Muni ETF (NYSEARCA:HYD) -- carry very little exposure to Michigan. So thanks to the powers of diversification, the underlying values of the funds won't take a big hit. But this isn't about diversification. It's about a $3.7-trillion muni bond market that's anything but healthy -- and a potentially disastrous precedent being set that promises to undermine 201 years' worth of trust.

Sorry, but that's a pretty big deal, and it's certainly worth sweating over. So consider today's article a super-sized dose of truth serum.

From Moral Obligation to Moral Hazard

Before we get to the current situation at hand, it's important that we have a historical understanding of municipal bonds. (Don't worry, I'll keep it to a couple paragraphs.)

The first officially recorded municipal bond was issued by the City of New York for a canal in 1812. It was a general obligation bond, meaning the city pledged every available resource -- most notably, tax revenue -- to repay the debt. So, in theory, unless the city lost its legal ability to levy taxes, which it never would, investors would be repaid. That's key because every single general obligation muni bond issued since that time has carried the same level of implied safety. Apparently, though, Detroit's emergency manager, Kevyn D. Orr, wants to do away with 201 years' worth of trust established with investors. His restructuring proposal calls for bondholders to be repaid as little as $0.10 on the dollar.

As Jim Colby, senior municipal strategist at Market Vectors ETFs, said, the unprecedented move "begins to challenge what has been the foundation for nearly 70% of all financings done in the municipal bond market: the 'moral obligation' on the part of the issuer of bonds to adhere to the promise to set the ‘full faith and credit’ and taxing power of the entity ... to repay the owners of those bonds."

If Orr succeeds, look for all hell to break loose. Just like we witnessed during the real estate collapse when homeowners started walking away from their mortgage obligations without any recourse, other cash-strapped municipalities are destined to follow Detroit's lead and try to renege, too. "If the outcome is that [Detroit reduces] some liabilities, that could be an incentive" for bankruptcy filings by other cities, said Timothy Blake, managing director of Moody's Investors Service.

The end result? Instead of a moral obligation propping up muni bond prices like it has for two centuries, a moral hazard will undermine them. In a New York second, no less. As Colby notes, "there would be damage done to untold numbers of portfolios as confidence disappears and valuations drop."

But we shouldn't sweat the situation, right?