To be clear, I believe filing for bankruptcy by a municipality is not an end. Nor do I believe it necessarily means mass firings, closing of offices and shuttering of municipal services (e.g., police, fire, water, sewer and electric). It does mean, in my view, that there may now be a process, overseen and directed by a judge, to stop the clock on expenses to seek to redress the massive imbalance of revenues and obligations. I feel that Detroit may continue to function day-to-day as a going concern, relieved temporarily from some of the burden of payments. Assuming the bankruptcy court accepts and approves the Chapter 9 filing, I would expect the court to begin directing payments as needed.
The critical element underpinning this event, in my view, also fundamentally sets the foundation for the majority of all financings done in the municipal bond market. That is, of a “moral obligation” on the part of the issuer of bonds to promise to set the “full faith and credit” and taxing power of that entity ahead of other debts in order to repay the owners of those bonds. The state-appointed emergency manager of the City of Detroit has already made representations that he, and the State, may be willing to break that foundation in its effort to save Detroit and put it back on the path to financial solvency.
What is of concern to me here, and has been voiced by analysts and portfolio managers alike, is that the path chosen for Detroit may likely set a precedent for other struggling cities and communities that undermines the totality of municipal finance. Should that occur, I believe there would be damage done to untold numbers of portfolios as confidence may disappear and valuations may potentially drop.
I believe the process, to be sure, will not please everyone and pain will likely be borne. But I urge caution with regards to any precedent-breaking measures that leave a nearly $3.7 trillion municipal bond industry looking worse than Detroit in its darkest day.
James Colby is a portfolio manager and senior municipal strategist at Market Vectors ETFs.