Detroit breakdown: Default or bankruptcy a clear option for the Motor City

Default or bankruptcy is now squarely on the table in Detroit, which bodes ill for holders of municipal bonds issued by Michigan's largest city. In analyzing a May 12 preliminary financial recovery plan from the state-appointed emergency manager for Detroit, Moody's Investors Service today concluded that it is a “negative for Detroit bondholders.” Moody's analyst Genevieve Nolan said the plan indicates that Detroit requires significant and fundamental debt relief to help shore up its finances, which is “a clear indication that a default or bankruptcy is a real option.” For anyone familiar with the history of financial mismanagement in Detroit, or familiar with the muni market overall, such a grim outlook will not come as a surprise. “For several years, Detroit's finances have been below average,” said Ronald Bernardi, a municipal bond trader and president of Bernardi Securities Inc. “In recent years, they've been issuing debt just to pay their operating costs. Anyone that is invested in Detroit the last several years has been investing in junk credit.” Emergency manager Kevyn Orr was appointed in March by Michigan Gov. Rick Snyder to step in and try to right the city's financial course. The city has $15 billion worth of long-term pension liabilities and a growing $327 million deficit. “Professional investors understand that Detroit's problems are user-specific,” said Harris May, president of Strategic Partners Investment Advisors Inc. “In my opinion, financial planners should stress that municipal bonds are no different than other types of investment, and they must diversify their portfolios,” he added. “Investors that depend on their coupon income cannot afford to be frightened by headlines into believing that all of their municipal bonds are poor investments, and sell them out of fear.” According to the Moody's report, the majority of Detroit's debt consists of enterprise debt that is repaid from water and sewer revenue, not the city's general operating budget. “We currently rate both the city's water revenue and sewer revenue lien debt Baa3 with a negative outlook,” Ms. Nolan wrote in her analysis. Moody's rates Detroit's general obligation debt at an even lower Caa1. The $6 billion in enterprise fund debt represents 68% of Detroit's debt, followed by $1.8 billion in pension obligation certificates (20% of the debt), and $1.1 billion in general fund debt (12% of the debt). Mr. Orr's report, which was the first major development in the emergency manager process, indicated that salaries, wages and overtime accounted for the largest portion of the city's expenditures, comprising nearly 33% of the 2012 operating budget. “The relative burden on each of the stakeholders, such as city employees, pension beneficiaries and bondholders, will be determined by the implementation of the emergency manager's recovery plan,” Ms. Nolan said. Ultimately, as Mr. May summed it up, anyone who bought Detroit muni bonds with their eyes wide open should be in a position either to ride it out or shrug it off. “With some exceptions, there are few surprises in the municipal bond market and the problems with Detroit have been well-publicized for years,” he said. “Detroit's bonds have from some time only been suitable for high-risk investors.”