Detroit’s Old News: Time for Another Round of Bankruptcies

Rodney JohnsonIt seems like only yesterday that Detroit filed for bankruptcy. It’s actually been more than two years since the initial filing, and almost a year since a judge approved the bankruptcy plan.

With the stroke of a pen, bond investors with a contractual claim on the city’s assets and revenue were swept away. This had to be done, we were told, to make room for the junior creditors, including pension funds covering unions, which eventually received almost 100% of what they were owed.

The Detroit bankruptcy made a mockery of the law, arbitrarily assigning assets and creating ownership claims where none existed. Claiming that the value of the Detroit Art Museum could be used for pensions but not for bondholders wasn’t a stretch – it was dishonest. If the museum was owned by the city, then the proceeds from its sale should’ve gone into the pot for all creditors. Period.

Apparently that doesn’t happen in a municipal bankruptcy, where judges seem to decide based on something other than the law.

But the Detroit bankruptcy did have one great thing going for it – timing. The U.S. economy stalled then accelerated in both 2013 and 2014, while the equity markets climbed higher. China was still a juggernaut and Europe seemed to have steadied itself, at least for a little while.

Now, all of that’s behind us.

At a time when things seem bleak, we’re due for another round of bankruptcies in well-known areas. Only this time, the economy and markets won’t provide any cushion.

Global markets are moving lower in a stair-step fashion, with big drops followed by small rallies. Chinese economic reports are disappointing, and are probably overly optimistic, while Europe deals with its own set of difficult issues including mass migration from Syria.

At home we’ve been able to post modestly positive economic numbers, but our markets have joined the rest of the world. It’s as if investors finally looked behind the curtain of the economy, saw the members of the Fed, and weren’t impressed.

With a lack of great investment opportunities in front of us, all of us should be very focused on preserving what we have.

That makes it even more important that investors review their portfolios, looking for potential time bombs like bonds of the issuers below.

Chicago, IL

The windy city has quite a problem. In the face of underfunded pensions, the city did what many government bodies do – it took a holiday.

For several years at the start of this decade the city contributed less to its pensions than it should have.  The decision was out in the open for everyone to see.

Now the holiday is over, and Chicago must come up with hundreds of millions of extra dollars a year. That’s money it doesn’t have.

Mayor Rahm Emmanuel tried to force a pension overhaul on the union members, including teachers, city workers, and first responders. His plan was quashed when the state supreme court ruled against a similar initiative by the governor regarding state level pensions.

The court ruled that, since pensions are contracts, they cannot be impaired. The union workers must get every penny that previous administrations promised, no matter how infeasible the cost.

Now the mayor has proposed a massive property tax increase. Without it the city will have to lay off workers, including policemen and firefighters, forgo street repair, and end its rat-control program.

Bond rating agencies already cut Chicago debt to junk status. Now the city sounds like it will move quickly toward junkyard status. It’s no wonder that Chicago just displaced Detroit as the city with the biggest drop in value in the S&P Case-Shiller Home Price Index.

Wayne County, Michigan

The county that includes Detroit has all of Motor City’s problems, but none of its solutions. The county suffers from that well-known, one-two punch of lower tax revenue and rising pension costs. Currently, Wayne County runs a structural deficit of $52 million, which includes sending $20 annually over the past several years to its pension coffers.

County officials note that they have taken steps to fix their finances, including a 5% pay cut for appointees and a spending freeze. But these changes simply hold some costs in place while others, like pensions, keep growing.

At the same time, there is little the county can do to raise revenue. Detroit has experienced a small revival since the bankruptcy, but the modest uptick in business activity doesn’t generate nearly enough revenue to pay the legacy costs of decades of financial neglect.

Atlantic City, NJ

The third locale on the list is the gambling mecca of the East. The fortunes of Atlantic City have always followed casinos, which is not a good sign in today’s economy. With four of the big gambling houses bankrupt, Atlantic City finds itself hurting for revenue.

The city has a $100 million hole in its budget. This is made worse by the fact that it keeps losing tax refund lawsuits. So far the city has been forced to refund $186 million in taxes after Casino owners contested their assessments.

But the pain isn’t all on the revenue side.

Atlantic City employs 29 city workers per 1,000 residents, almost triple the rate of Newark, with 11 employees per 1,000 residents, and Jersey City, with 10 employees per 1,000 residents. The mayor recommended laying off more than 200 workers, but that would still leave the city with a much higher worker-per-resident ratio than other cities.

So far, the New Jersey government, including the governor, has been quiet on the possibility of a bankruptcy in the state. The state has gone so far as to give the city more time to repay state loans. If Atlantic City goes under, it would be the first municipal bankruptcy in New Jersey since the depression.

While the state government hasn’t mentioned that the city might go bankrupt, it hasn’t taken that option off the table either. It could be that the governor wants to keep all avenues open, since he has the same financial issues at the state level. As long as bankruptcy is possible, he might have more leverage when negotiating pension reforms with unions.

The three examples here don’t complete an exhaustive list. Many other towns, counties, and states have fiscal woes that will only be addressed through some version of bankruptcy or negotiated restructuring.

By the time that happens, investors have already lost. The best way to protect yourself is to go through your portfolio today, and make sure there aren’t any hidden time bombs.

Rodney Johnson

Rodney

Follow me on Twitter @RJHSDent

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Categories: Bonds

About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.