Financial pros urge caution in wake of Detroit's bankruptcy filing

In the two weeks since Detroit filed for bankruptcy protection, Troy, Mich.-based financial adviser Dan Thomas has been hearing from clients “every single day.” “My clients are not convinced that the state charter designed to protect pensioners will be strong enough, because Detroit's bankruptcy is under federal jurisdiction,” he said. “I have clients that are currently working for or are retired from Detroit, so I speculate and talk to them about the probabilities.” Mr. Thomas, owner of Thomas Financial Group LLC, estimates that a third of his clients will be affected by the bankruptcy cuts to health care benefits but that all his clients will be in some way affected by Detroit's financial reorganization. Although Michigan's largest city still needs approval from a federal bankruptcy court in order to officially enter Chapter 9 bankruptcy protection and become the nation's largest city to do so, many advisers find themselves in unfamiliar territory related to Detroit's fiscal collapse. “I have some clients with some individual Detroit muni bonds, and my reaction to them so far has been to stay quiet because I'm waiting to get more information,” said Tim Holsworth, president of AHP Financial Services Inc. in Bay City, Mich. Like a lot of investors and advisers, he is banking on the insurance companies to step up and fill gaps left by the bankruptcy negotiations, which are already pointing toward pennies on the dollar for most stakeholders. “My experience with insurance companies in the past has been good, and I think my clients will get par back,” Mr. Holsworth said. The Detroit municipal bonds owned by his clients were purchased between 2007 and 2009, and they are all insured and scheduled to mature over the next 15 years. Most muni market watchers confessed some surprise that Detroit filed for bankruptcy this summer, just a few months after Michigan's Gov. Rick Snyder appointed Kevyn Orr to take over as emergency manager of the city. But it would be difficult to find anyone familiar with Detroit who wasn't expecting an eventual bankruptcy. “We offered our clients some guidance on Detroit, telling them that bankruptcy was on the horizon,” Mr. Holsworth said. “They knew they could either sell at a loss or wait it out.” Detroit's total debt obligation is estimated at nearly $20 billion, spread across a broad swath of stakeholders, including bondholders, pensioners and vendors. What has some advisers concerned is the precedent that was set in Detroit a few years ago during the bankruptcy of General Motors Corp. when bondholders lost their priority status. “The bonds my clients own have insurance, but they are definitely concerned about how those bonds will be treated,” said Kerry Mayo, an adviser with Capital Financial Advisors of New York LLC in Clifton Park, N.Y. He has clients who are exposed to Detroit through both general-obligation bonds and water system revenue bonds. Traditionally, the general-obligation bonds are considered the most secure type of muni bond, which is supposed to be honored even if it means raising taxes to do so. The water and sewer system bonds are also considered among the safest because they are linked to direct revenue streams. But the proposals by Mr. Orr indicate that Detroit's bankruptcy will seek to treat all stakeholders equal. “It's really going to be a question of whether Detroit treats the general-obligation bonds as secure and the highest and safest form of muni bond issuance,” Mr. Mayo said. “If the courts rule that these bondholders get 20-to-30 cents on the dollar, you're going to throw the whole muni bond market into upheaval, and remember this is happening in the same state that already screwed bondholders when they bailed out the auto industry.” Despite the dire outlook for holders of Detroit's debt, Mr. Mayo said that some of his clients remain convinced that the insurance and the courts will provide enough security for investors. “Right now, we're asking for bids on the general-obligation bonds,” he said. “But a couple of other clients that own water and sewer bonds want to buy more when the price is right.” Not so for Bert Whitehead, Birmingham, Mich.-based founder of Cambridge Connection Inc. and Alliance of Cambridge Advisors Inc.. “I tell my clients to stay away from investing in Detroit. The city is so corrupt there is just no way to un-rotten that apple,” Mr. Whitehead said. “I still have a couple of clients living in Detroit who didn't take my advice several years ago when I told them to move out.”