The name of the game is to obtain optimal return for any given investment. This means finding a security — a bond, stock, or perhaps some arcane financial product — with a yield that is worth the risk of the investment. Treasury notes have low yields because they are safe; junk bonds have high yields because, well, it’s in the name.
The risk-versus-reward aspect of the market’s quest for returns may be the thing that gets it into the most trouble. Interest rates — the reward for an investment in, say, a municipal bond — are also a proxy for risk. The bigger the yield, the higher the risk. This is a double-edged sword, and the market is, on a good day, clumsy. On a bad day, such as in the wake of the late-2000s financial crisis when interest rates were pushed to record lows, the market become desperate for yield and inadvertently set itself up for the chopping block.
In many ways, failure to wield this double-edged sword with sophistication contributed to the fallout from the Detroit bankruptcy filing. The scope of the damage is still unclear, but bondholders, pension funds, and other debt holders — many of whom were compelled to invest because of the relatively high yields offered on municipal bonds — are on the chopping block and face the possibility of massive losses on their investments.
“Let me be blunt,” Michigan Gov. Rick Snyder said in a video statement on July 18. “Detroit’s broke.” That same day, Snyder authorized Kevyn Orr –the emergency manager for the city — to seek municipal bankruptcy protection.
With as much as $18.5 billion in debt, Detroit is the largest U.S. municipality to ever file for bankruptcy protection. Broadly speaking, the city’s problems are a fairly textbook function of declining revenues and out-of-control costs. The city’s population has declined by nearly half over the past 60 years, which means tax revenues have all but evaporated. And Detroit has been underfunding its pensions for decades: It’s short as much as $3.4 billion in retirement benefits for police and firefighters.
For a brief interval – between 1994 and 2002, when Dennis Archer was mayor of the city — Detroit seemed to have hope despite its slowly declining economic position. Archer was able to manage the city in such a way that actually resulted in its bond rating being upgraded several times. Maintaining a high credit rating was necessary if Detroit, already borrowing a tremendous amount of money, was to skate through its financial difficulties without disaster.
But when Archer left office in 2002, he was replaced by the now notorious Kwame Kilpatrick, who ended up in a federal penitentiary over a sex scandal, perjury, obstruction of justice, fraud, and almost two dozen more felonies. Kilpatrick resigned in 2008, by which time the damage had been done.
For the city’s part, perhaps it was assumed that once it started selling bonds to cover costs, the ship would right course — and markets were hungry enough for returns that they couldn’t agree more. But under a swapping deal negotiated with the banks managing bond sales, the city learned that easy money isn’t a replacement for political competence and tax revenue.
The city’s inability to shore up its finances forced the appointment of an emergency manager, a position created by law under Gov. Snyder. Emergency managers tasked with handling municipal bankruptcies across the country have been given tremendous powers in the hopes that they can prevent catastrophe. Orr was appointed Detroit’s manager in May and laid out a plan in June to lower the city’s overhead, including tackling pension plans and retiree health insurance commitments. But this plan fell through, and the city filed for bankruptcy.
The proceedings have been anything but straightforward, and two of the city’s pension funds have recently taken legal action to prevent Orr from downsizing retiree benefits.
The Michigan state constitution protects public pensions, as union power runs deep in the state, and the document has created a bit of a legal mess. A circuit court judge in the state has found the bankruptcy motion unconstitutional in the spirit of the aforementioned protections, saying, “I’m finding the actions that were taken in filing bankruptcy as overreaching and unconstitutional,” according to a report from Bloomberg.
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