My biggest concern with folks who buy muni bonds is that they don’t do the proper due diligence on a given municipality. It’s very easy to just assume that if a municipality or a city is big enough, there’s simply no chance of default. Given that many of our country’s federal, state, and local governments are fiscally mismanaged, this is a terrible assumption to make.To see a list of high yielding CDs go here.
I want to examine the Detroit bankruptcy in detail, because it’s a great example of what investors should look for before and during an investment in a city’s muni bonds…and what action they can take when a default arises.
Now, it’s important to follow this entire story whether or not you hold Detroit bonds. The city’s bankruptcy affects all bond investments.
The first thing you should do before buying a muni bond is to examine the city’s history of fiscal management. Detroit’s was a disaster, and had been for a long time. It was also riddled with corruption. Buying a muni bond in exchange for a heftier yield was not a wise move. A good tip-off is that one party controlled the city for over 40 years. You want to see parties change up as well as be able to pay its bills from one year to the next, with only the occasional deficit.
Then you have to think about the political situation. Are the governor and the leadership of your investment municipality at political odds? If so, consider avoiding the investment. Here’s why. Detroit is Democratic. The Governor is Republican.
Governor Rick Snyder didn’t explore the above options. Instead, he forced the city into bankruptcy. This move was even criticized by Judge Rosemarie Aquilina, who presided over a case that attempted to block the bankruptcy filing on state constitutional grounds, saying, “I have some very serious concerns because there was this rush to bankruptcy court that didn’t have to occur and shouldn’t have occurred.”
Snyder instead decided to play politics. His voting base are suburban wealthier citizens who don’t have much at stake as far as Detroit is concerned – other than it being a place to go for entertainment or to commute for work (for jobs that still actually exist there, anyway). Yet these same suburban voters have already proclaimed a willingness to pony up when there is cause. Just last year, residents of three neighboring counties to Detroit voted to increase their own property taxes in order to raise funds to operate the art museum! Snyder is too myopic to see this, and too focused on traditional political maneuvering to realize this is an historic crisis.
That’s why you want to look at which parties run the state and local level for your investment protection.
So maybe now you’re in a Detroit muni, or your muni bond fund holds some Detroit bonds. Or maybe you hold other bonds that are at bankruptcy risk. What to do? The first thing is to examine just how bad things are to help determine your next move, so we start with Detroit’s cash flow and balance sheet issues.
The city, like many other governments, spends more than it generates in revenue to the tune of some $100 million every year. The current deficit is $386 million, with expected negative cash flow of about $90 million. As of late April, the city had $64 million of cash on hand and $226 million in current obligations. On the balance sheet, the city has $17 billion in liabilities. It’s looking at $6 billion in enterprise fund debt. There’s $1.8 billion in Pension Obligation Certificates, and $5.7 billion in other post-employment benefits. There’s $1.1 billion in General Fund debt; and the city’s pensions are about $600 million underfunded.
As with any business that’s struggling, it’s important to tackle the current obligations first. After that, the pensions need to be protected. Even though there are funds that guarantee pensions, it isn’t a good idea to just saddle them with the burden. All that does is raise the cost of insuring pensions to every other municipality and state. That will merely increase cash flow out of their coffers, and ironically make it all the more easy for a default to occur.
So how does Detroit tackle current and pension obligations, and how can it ensure that all the longer-term obligations continue to get paid on?
A Common Sense Solution
Of greatest value is the city’s art collection. Yes, Detroit actually has a world-class art collection. Its museum is over a hundred years old, is the second largest municipally-owned museum in the country, owns some 65,000 works, and is considered to have one of the top six collections in the U.S. It has a special emphasis on American artists, with what is considered to be the second best American collection in the country. The city also owns the real estate beneath the collection.
The collection’s value is being assessed by Christie’s, and most experts agree that the value is somewhere around a billion dollars. It would be a bummer to have to sell off the entire thing, although doing so would raise enough money to cover both the $326 million deficit and the $600 million in unfunded pensions, while leaving some money left over to carry the city into next year. And while nobody wants to see the museum close, the collection would find its way into deserving hands that would take care of it. It’s not like these are stray puppies that won’t find a home and end up in a kill shelter.
On the other hand, selling the collection isn’t even necessary. Money is lent against art all the time by specialty finance firms. A 50-60% LTV, probably at an 8 – 10% annualized interest rate, would go a long way towards solving near-term cash issues.
Where You Come In
This is the same analysis you should perform before buying a muni bond. Examine your debtor finances. What collateral do they have? What’s the political risk? And now, here’s why the outcome in Detroit is so important to muni bond investors. If Detroit is permitted to file for bankruptcy, and bondholders get crammed down, nobody will look at municipal bonds the same way ever again. Their perceived and actual risk will increase. Not only does that mean municipalities will have to pay more interest when they choose to fund via debt, but it may dry up some of the credit presently available. That may very well mean higher yields for investors, but if a municipality sees bankruptcy as a way of avoiding hard decisions, then those yields may never be high enough for investors.
Municipal bonds are a cornerstone of many retirement and high net-worth investment portfolios because of their tax-free status. If an investor is in the highest federal tax bracket, a 3% muni bond is paying the equivalent of about 5%. Investors can’t find that rate in bonds anymore, thanks to quantitative easing.
Bond insurers are also at higher risk. We learned that many did not have enough liquidity to cover losses. It could throw that category of investment into a tailspin, as those firms will have to raise more money to be able to meet claims, and in turn, they will charge more to municipalities.
What Should Muni Investors Do?
Whether you hold Detroit bonds or not, call the Governor’s office, and complain about the bankruptcy. Call the city’s emergency manager, as well as the Mayor. Insist on the sale of the art collection. Most muni investors will never pick up the phone, yet now is the time to do it – whether you hold Detroit debt or not. Because if Detroit fails, as mentioned, other municipalities will be given precedent to cite, and that could harm your other investments.
About Lawrence Meyers
Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at firstname.lastname@example.org.
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