Kevyn Orr’s proposal to Detroit’s creditors last week included a wealth of information about the extent of the destruction of Detroit as a livable city, much of which has already been addressed elsewhere. The report also includes a good deal of information about just how badly the city was mismanaged financially. As I said before, I think that Detroit offers a case study (however cartoonishly bad) of many of the practices that have been used in other cities and states, so it’s worth looking more closely at what may be coming down the pike for the rest of us non-Detroiters.
The debt time machine
Stiff taxpayer resistance to rate increases over the past few decades has left state and local governments with a very limited set of options to fund themselves. Their way out of the impasse has been to turn to debt markets, where municipal issuers have one enormous advantage – the coupons they pay bondholders are exempt from income tax, making them a core holding for individuals and taxable institutions.
In one sense, municipal borrowers in debt markets face a similar set of decisions as individuals. Like the rest of us, municipalities can borrow for either long-term capital projects (analogous to a home mortgage) or to cover short-term gaps in revenues (like using a credit card to cover monthly expenses).
But there’s a crucial difference between individual and municipal borrowing in the timing of repayment. Most borrowing by individuals involves loan payments that chip away at both principal and interest over time. By contrast, borrowing in the municipal bond market means that the borrower only makes interest payments until the principal is due at term. Depending on the interest rate and other factors, this can give the borrower a chunk of money upfront while pushing the need to make an enormous principal repayment years or even decades into the future.
For cash-strapped municipalities like Detroit, this time-machine effect can be a budgetary godsend that transforms immediate funding gaps into distant future liabilities. To give a sense of just one of the ways Detroit has used debt, the chart below comes from emergency manager Orr’s report, and shows the annual funding gaps in the Detroit’s General Fund (the account used to pay out ongoing expenses). The height of each bar is the total deficit for each fiscal year, while the darkest section at the bottom of each bar is the reported deficit. The difference – the lighter segments – has been filled by various bonds the city issued over time.
By issuing these three series of bonds, Detroit’s city government has been able to fund its current operations without having to pay anything more than immediate issuance costs and some interest payments – the ultimate cost lies far in the future.
Of course, these are far from the whole picture when it comes to Detroit’s liabilities – in practice, the city has taken a similar time machine approach to most areas of its finances, whether through direct bond issuance or just generally making promises about future benefits. And Detroit has been far from alone in doing this. According to data from SIFMA, municipalities have racked up nearly $4 trillion in municipal bond debt.
Municipal borrowers also make use of a tactic that allows them to keep principal repayments far in the distant future. By repeatedly issuing new bonds to pay off existing debts (in addition to issuing entirely new bonds), municipalities are able to roll their liabilities into the future, while also lowering the interest payments due in the interim.
This sort of refinancing has until very recently made all the sense in the world for local politicians. Thirty years of generally declining interest rates made for almost constant opportunities to lower interest costs (albeit with some interim volatility). The bond bull market also boosted demand for the bonds so that issuers had a market. Best of all, the ability to lower interest costs – while delaying the inevitable repayment – could produce “savings” that bolstered budget projections.
The picture today has changed, however, and at the worst possible time. If interest rates continue to rise as they have over the past month, then at worst the revolving door of refinancings at lower interest rates could eventually become difficult if not impossible. Even if rates remain historically low, the interest costs will still likely be higher than they have in recent years. Either way, municipalities face a potential combination of higher borrowing costs and continued slow growth in tax receipts.
Perhaps worst of all, this would take place just as historical pension and retiree healthcare commitments (themselves a form of time machine) are coming due, many without adequate funding.
How big of a problem is this? There are admittedly too many variables to know, and reputations have been made and tarnished on doomsday predictions for the municipal bond market. It’s also important to note that the awful combination of a shrinking population, falling property values, industrial decay and extraordinary government corruption and ineptitude that has plagued Detroit is (thankfully) unique in the US. Nonetheless, the structural problems remain, and it’s difficult to see a brighter future for local spending on infrastructure, education and other essential services without a significant rethinking of commitments made to citizens, retirees and bondholders in sunnier times.
With thanks to Katya Grishakova for helpful comments that kept me from going full (Meredith) Whitney.