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July 23, 2013 3:18 pm

Screech from Motown’s collapse will be heard in Europe

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Fresh start for Detroit could put debt restructuring on menu for others

Detroit’s bankruptcy is an economic tragedy, a warning about the perils of urban degeneration. But the city’s financial collapse also has lessons for bond investors far beyond Motown. It could lead to a reappraisal of credit risks, possibly escalating funding costs for other troubled cities and regions. Depending on how Detroit emerges, it could help reshape the debate on fiscal austerity and the case for debt restructurings to jump-start local economies, including in Europe.

None of these effects will be visible anytime soon. Detroit’s bankruptcy filing late last week created few ripples in global markets. What matters most to investors right now are macro factors such as the intentions of the Federal Reserve or the Chinese economic outlook.

By comparison, Detroit is just a blip. Even though it is the largest municipal bankruptcy in US history – it has $18bn in debt – the sums involved are small compared with global bond market volumes. Nor was its bankruptcy much of a surprise; its finances were a decades-old accident waiting to happen. Moreover, the process is already subject to legal challenges and may last years.

But Detroit has nevertheless revealed a lack of understanding of the complex and diverse US municipal bond market, especially beyond North America, which raises worries about whether investors are correctly pricing credit risks in an era of ultra-low interest rates.

With $3.7tn in securities, the US municipal debt market is more than half the size of the – globally scrutinised – eurozone sovereign equivalent. The presumption was that these were low risk products acquired for tax benefits and protected by insurance – and that struggling cities could be helped by higher levels of government.

“General obligation” municipal bonds, moreover, are backed by pledges to raise taxes to cover interest and repayments. But such promises look less watertight given Kevyn Orr, Detroit’s emergency financial repair manager, proposes to pay GO bondholders less than 20 cents on the dollar.

European banks have almost certainly acquired significant volumes of US municipal bonds in the search for a few extra points of yield, probably on the basis of scant research – although so far we have few details of who owns what. Bond strategists in London report urgent inquiries this week from investors worrying this is the next “subprime” crisis – remember German banks took much of the initial hit from dodgy US mortgages in 2007. Another worry was that “monoline” insurers protecting US municipal debt might buckle under the strain.

Such fears seem far fetched. But Detroit’s example will inevitably lead to a hunt for the next US city to face financial troubles. If investors demand higher risk premiums as a result, there could be contagion to other markets. Meanwhile, Detroit’s example will keep the pressure on local politicians to maintain fiscal discipline, which will continue to hamper economic growth – even in regions desperate for new economic growth models.

Depending on how Detroit emerges, it could help reshape the debate on fiscal austerity and the case for debt restructurings to jump-start local economies, including in Europe

Detroit’s idiosyncrasies mean a wave of US municipal debt restructurings is unlikely. Historically they are rare, and last week’s sell-off was seen by some investors as an opportunity to buy. Default rates are even lower in other parts of the world. Standard & Poor’s has chronicled just 19 instances of defaults at the rated sub-sovereign government level since 1975. None was a publicly-rated goverment in western Europe, where there is often explicit sovereign level support for struggling regions. Europe’s local government bond market is also smaller – at less than €1tn and dominated by German states’ debt.

However, the strains created by three years of eurozone crisis have raised questions about what happens to local regions and governments when sovereign debt reaches the limits of sustainability – as in much of southern Europe – and the central bank is reluctant to “print money”.

Conceivably, Detroit’s bankruptcy could prove cathartic and provide a fresh start for the US city. As such it might become an example for stressed European regions; German politicians are keen on the principle of “burden sharing” with Europe’s monetary union.

Mr Orr wants a speedy end to the city’s crisis. But history is not on his side; Jefferson County’s bankruptcy in Alabama is approaching three years without resolution. European local government restructurings would be even messier: there is no equivalent to US Chapter 9 bankruptcy proceedings.

Still, the debt restructuring debate in Europe has changed since Greece’s “private sector involvement” last year, which imposed losses on sovereign bond holders. Further sovereign debt restructurings are a step that eurozone policy makers are reluctant to take, yet options for tackling the continent’s debt mountains are limited. Greece was meant to be an exception. Detroit might not be.

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