In this article, we will take a closer look at the causes that led the City to go bankrupt and how the problem may be widespread throughout the United States.

To learn more about the provisions under Chapter 9, click here.

Examining Root Cause of the Problem

Property and sales tax revenues are primarily the two main sources of revenue for any local government and funds mainly all of the local government operations from police, fire, community development, etc. This also means that if either one of these revenues takes a hit, all the “essential” services will either need to be reduced or cut to make ends meet. It’s also important to note that in times of an economic downturn, these two revenues tend to decline together, severely impacting the local government operations. The reason behind this is the sole dependency of these revenue sources on the current population of the local government.

Hence, population size along with its healthy growth rate is the main revenue source for any government.

When there is a recession the property values tend to take a hit, impacting property tax revenues that are based on current property values. Along the same lines, during the recessive economic times, residential or commercial developments are also pretty slow, leading to little to no growth in the property tax base to mitigate the revenue losses.

Furthermore, consumer spending habits also dramatically change during economic downturns due to either job losses or closing of various businesses. This means that sales tax revenues, based on consumer spending, also takes a huge hit for any local or state governments.

A Long & Constant Population Decline in the City

According to the U.S. Census data, the year 1950 recorded the highest population for the City at 1.9 million residents. This number has declined over the years and during the year the city filed for bankruptcy, its population was merely 690,000 – a 63% decline. This decline in population led to a smaller tax base and served a detrimental blow to the City’s overall revenue sources.

Before the economic downturn, the City was already struggling with high unemployment rates and minimal growth in new businesses in the city. The economic downturn of 2008 worsened the unemployment situation as more and more businesses started closing and laying off people. Also known as the Motor City, one of Detroit’s major business, General Motors (GM), has had its fair share of economic troubles that trickled down to the workforce, employment and the economic output of the City. Nevertheless, GM filed for Chapter 11 bankruptcy in June, 2009.

Detroit’s Crippling GO Debt

The City of Detroit carried one of the largest GO debt portfolios, worth $18 billion, prior to filing for bankruptcy. This debt included huge sums of pension liabilities that worsened during the financial crisis. Similar to other local governments, when the pension fund portfolios aren’t performing and producing the return equivalent to the predetermined “discount rate,” the burden to meet the pension cost then falls on the City to come up with additional funds to meet its pension obligations.

Hence, the debt service burden and the pension liabilities, along with a declining tax base, eventually forced the City to file for bankruptcy.

Issue of Crime and Abandonment

Historically, Detroit has been struggling with crime for a very long time and the economic instability fueled this fire in many cases. When a City or County government is struggling with its finances, they are often faced with cutting essential public services like police and fire services that directly contribute to increased crime rates. In the recent crime statistics, Detroit has consistently ranked in the top five cities in the U.S. with the most murders.

Furthermore, the issue of residential and commercial building abandonment has always been an issue for the City, and throughout the economic downturn, it worsened. According to the data collected by the Washington Examiner, post the City’s bankruptcy filings, the City had over 78,000 abandoned buildings. The issue of abandonment not only leads to loss of property tax revenues but also leads to more crime in those areas.

Don’t forget to check out the municipal bond screener here to find bonds meeting your specific investment criteria.

The Plan of Adjustment for the City of Detroit

After filing for bankruptcy in July 2013, the Bankruptcy Court of Eastern District of Michigan issued a bench ruling in November 2014 confirming the City of Detroit’s Chapter 9 plan of adjustment and paving the way for the City’s exit from the largest and most complex municipal bankruptcy case in U.S. history. The plan of adjustment reduced the City’s estimated $18 billion debt burden by approximately $7 billion and created a framework for the City to adhere to going forward:

• The plan of adjustment highlighted that all unsecured debt is subject to an approximately 20% recovery on their claims in the form of new securities to be issued by the City and a potential to share in any increased revenues realized by a revitalized City.

• Detroit’s current active employees would continue to earn pensions in the future under traditionally defined benefit formulas, rather than defined contribution arrangements.

• The two pension funds – the Police & Fire Retirement System and the General Retirement System – would operate under more conservative investment return assumptions. This will ensure better predictability and stability of pension contribution, which is critical for the City to be assured that it has sufficient funds for operations.

• The City’s plan of adjustment can be found here and it highlights the treatment of all debts in accordance with the court-approved plan.

Click here to learn more about the municipal debt due diligence process.

The Bottom Line

The largest municipal bankruptcy in the U.S. was a combination of a demographic shift, political decision-making, and financial unpreparedness. Similar to other municipal bankruptcies, it also served as a prime example, contrary to the common investor sentiment, that municipal debt is recession-proof and the government can simply raise taxes to ward off any fiscal deficits.

Sign up for our free newsletter to get the latest news on municipal bonds delivered to your inbox.

Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.