Why Wall Street and Main Street Should Work Together to Save Municipal Bonds in Detroit
Here we go again. Another epochal battle between Wall Street and Main Street. Since July 2013 when it declared Chapter 9 (municipal) bankruptcy, Detroit has been struggling to restructure its financial obligations. The city’s government, under the auspices of emergency manager Kevyn Orr, recently issued a plan that will allow it to escape bankruptcy and finance future operations. Many different parties, such as creditors, pensioners, and bondholders, have claims to the city’s remaining assets and this “plan of adjustment” allocates remaining resources among these parties. This plan will be submitted to bankruptcy judge Steven Rhodes for approval. The proposal’s details have already ignited contentious debate: bondholders will receive up to 20 cents per dollar while pensioners will receive up to 50%. At first glance, this allocation may seem just: city workers deserve to earn as much as their deferred compensation as possible, even if it is at the expense of Wall Street bondholders. However, this proposal is far more unsettling than it first appears. By returning meager assets to bondholders, especially when compared to other claimants on debt, Detroit risks unleashing negative effects that will reverberate far beyond its borders.
Before we continue, I would like you to pause and reflect back on your hometown. Your high school. The roads you learned to drive on. The library where you learned to read. The sewage system that allowed your house to remain sanitized. Many of these facets, common across almost city in America, were made possible at least partially due to bondholders. Cities issue bonds that signify a promise of payment to the current bondholder. Investors are enticed to purchase these municipal bonds because they are promised interest. As an added sweetener, all interest from these bonds is exempt from federal income tax (in most cases). Investors are able to earn 3% to 5% tax-exempt returns on many of these bonds. Current taxpayer dollars cannot possibly fund every major city infrastructure project, making bonds an absolute necessity. These bonds are seen as one of the safest investments one can make. That is, until Detroit decided to ask a court to force bondholders to only accept 20 cents on the dollar while pensioners were guaranteed 50 cents per dollar.
Although bond repayment structures are often renegotiated, asking a court to force bondholders to lose value will have serious value. Since only 1 in 10,000 cities with a AAA credit rating go bankrupt three years after a bond issue, Detroit dwells in largely uncharted legal territory. The city’s treatment of bondholders, and the judiciary’s response to it, will be closely watched for what happens to bondholders in Detroit will undoubtedly establish a precedent. If bondholders appear to be unfairly targeted, the markets will respond. And their response probably will not be pretty. Cities will be forced to offer higher interest rates to compensate investors for perceived increased risk from municipal bonds. Although the likelihood of municipal default will remain extremely slim, especially as the economy begins to improve, risk averse investors will not forget how they were treated in Detroit.
Do you remember the libraries, schools, roads, and sewers I asked you to envision earlier? If interest rates on the bonds necessary to finance this critical infrastructure increases, then cities will be less likely to issue bonds to fund capital improvement programs since they will have to pay more to entice investors to purchase their bonds. Pension obligations are important, but so are safe roads. Commitments to our senior citizens are important, but so are revitalized schools equipped with 21st century infrastructure. Enticing qualified people to work in government with is important, but so are well-maintained airports. In 2008, my hometown, Oak Park, California, issued about $30 million in bonds dedicated to “repairing water damage and failing roofs; removing hazardous materials; making schools earthquake safe; replacing outdated fire and security systems; and improving classrooms.” Many of these improvements were completed while I was in high school. I saw firsthand how my school’s infrastructure increased in quality. Although I didn’t know it at the time, I had the bond market to thank because there was no way Oak Park Unified School District, or any other municipal entity, could fund a large capital improvement program exclusively through current tax dollars. If you think one school district is not a good example, consider the fact that Illinois recently issued $1 billion in new bonds to fund a wide array of projects. As cities and states seek to bring their infrastructure into the 21st century, the last thing they need is increased risk due to Detroit’s shortsighted decision.
Appeasing pensioners by gutting municipal bonds may be good politics, but it is undoubtedly poor policy. If municipal bondholders are perceived to be treated unfairly, then market forces will make it more difficult for cities to finance critical infrastructure projects. Perhaps the headlines are misguided. Maybe, in reality, there should be no battle waged between Wall Street and Main Street at all on this issue. Who knows, they might even be on the same side.