Detroit’s Bankruptcy Bad News? Not Until You See Who’s Next

Wednesday, August 7th, 2013        By Michael Lombardi, MBA for Profit Confidential

 

Detroit, once the emblem of the growing U.S. economy, had no other options than to file for bankruptcy. Other cities in California, and cities like Jefferson County, Alabama, have done the same for very similar reasons: registering a budget deficit year-after-year as revenues declined and costs rose—especially pension costs.

Municipal bond investors are crushed when cities file for bankruptcy. But that’s old news. Unfortunately, there could be many more bankruptcy situations at the city and municipal level going forward.

Cities across the U.S. economy are experiencing rising budget deficits, and contrary to popular belief, it’s not just smaller cities; major cities are in the same situation. In fact, two major American cities are in big fiscal trouble.

Chicago, the “Windy City,” is expected to incur a budget deficit of $338.7 million next year. By 2015, this budget deficit will increase to $1.0 billion, moving up to $1.15 billion by 2016. The city is in deep trouble as pension liabilities are soaring—police and fire pensions are in a cash crunch. (Source: Chicago Sun Times, August 1, 2013.) The city has received credit rating cuts and warnings from credit rating agencies. It owes billions of dollars to its suppliers and it can’t pay them.

Baltimore is in a similar situation. In February of this year, the city’s long-term budget deficit was projected to be $750 million. In a desperate attempt to fix the issue at hand—to reduce the budget deficit—the city cut about 2,200 dependants from the health insurance plan it provides to its employees. (Source: Baltimore Sun, August 2, 2013.)

When a city is faced with a budget deficit, it usually has to go out and borrow money by issuing municipal bonds; often, the interest rates on those municipal bonds, if they are not insured, need to be bumped higher to attract risk investors.

Rising budget deficits and too much borrowing are a huge burden. We saw what happened in Detroit. Even more problematic, we even saw, not too long ago, what happened to investors who bought Scranton, Pennsylvania’s municipal bonds: the city defaulted on its payments.

In the first six months of this year (January to June), more than $176 billion worth of municipal bonds were issued. (Source: Securities Industry and Financial Markets Association web site, last accessed August 5, 2013.) It is foolish to think investors won’t see some problems with some of these bonds.

Going forward, I will not be surprised to see more cities succumb to the pressures of a negative budget deficit. Chicago and Baltimore are only two cities to keep an eye on.

I am watching how the federal government reacts to cities going bankrupt. Will the government let them or will it bail out the cities with staggering budget deficits? If it follows the latter scenario, the Federal Reserve will have to go on printing money for a long, long time.