July 19, 2013
David R. Kotok




Long awaited and now finally arrived, Detroit’s bankruptcy was expected and priced into markets. Some Detroit debt had been trading down to 30 cents on a dollar prior to the announcement.

Let’s dig into this news. Detroit will now be a poster child. It will reveal the tragic decline in the economics of many cities and other jurisdictions that did not correctly manage their fiscal affairs.

The news is filled with photographs of empty buildings and reports of population declines. The statistics show the remaining residents’ income deterioration. The high taxation rates implemented to correct imbalances completely destroyed the fiscal viability of the city.

In the days of the Wild West we had ghost towns when the ore ran out. In the modern world we have large unfunded liabilities, a population drain (Detroit lost two-thirds of its peak 2 million) and then a financial wreck.

We will have a bankruptcy fight to watch. Conflicting interests will battle over payments. This afternoon, a judge ordered a reversal of the bankruptcy action. So the courts are now in a fight with the State’s Governor as legal combat attempts to preserve pension benefits which are unfunded and not economically viable.

Who will get paid, who will lose money, and how much? The battle will rage. Labor contracts will be rewritten, and pension benefits will be reexamined. Unsecured creditors, derivative counterparties, and vendors will compete for a limited pot of money. Secured creditors may take haircuts. This fight will be over many innings and will not be quickly resolved.

While we watch this denouement unfold in Detroit, much as we have watched it unfold in other cities, Cumberland takes a more disciplined approach with municipal bonds. Stay away when credit is questionable. Do not get sucked into a higher yield on a weaker credit. It is all about credit.

At Cumberland, we look at everything the rating agencies do and say. We also analyze and score credit internally. We combine research to synthesize a judgment about whether to buy, sell, or hold a specific bond.

Remember all municipal bonds are idiosyncratic securities: they are not all exactly alike. Their structures, priorities of payments, intricacies of clauses in bond indentures, and pricing of various options within the bond indenture all reflect the individual characteristics of each bond. Homogeneity does not exist in the specifics of municipal bonds.

In the old days bond buyers used to say, “Well it’s insured and rated AAA – that’s all I need to know. Just give me the coupon, call date, and maturity date.” Those days are gone and will not be back for a long time.

There are over 90,000 municipal entities in the US. There are approximately 40,000 separate bond issues that trade in sufficient depth for information to be tracked in databases. Bond investors need to understand that this specific type of municipal bond credit research and resulting assessments are more important than ever.

We would like to suggest a metaphor. There are approximately 6,000 stocks trading in the U.S. They are widely followed by advisory companies and are collectively assembled in over 1,000 ETFs (exchange-traded funds). They get a lot of attention.

There are almost seven times as many separately trading bond issues as there are stocks. These are collectively assembled in a few mutual funds and a few ETFs and are mostly held in passive structures or by passive investors. Think about it: seven times as many instruments, perhaps, get one-seventh of the scrutiny of stocks in terms of detail. Many analysts estimate the earnings for IBM. Few analysts dissect the trust accounting of a major city.

Detailed research and data tracking are critical in this $3.7 trillion asset class of municipal bonds. When it comes to the data, governmental units are usually more transparent than corporations are. Public bodies and reporting systems make relevant information available, although the structure of the information portrayal is complex. Despite its complexity, municipal bond data is available; all you have to do is examine it. In 99% of the cases, it is forthright and can be relied upon.

Any bondholder that holds Detroit debt today asked to be put at risk for this event. Detroit’s financial disaster was visible and predictable. If the bondholder suffers a loss, so be it. At Cumberland, we hold only one small Detroit piece and it is insured by Berkshire and is rated AA.

Credit is the key component in Muni-land. The rules by which this $3.7 trillion asset class should be addressed are straightforward: (1) perform credit analysis, (2) make sure you get paid, and (3) walk away from trouble fast.

We will watch the events in Detroit transpire and learn from them. Detroit joins a growing list of troubled municipalities in the U.S. Its predecessors like Harrisburg, PA, and Vallejo, CA, are part of that list.

The best advice for investors is to stay away from tomorrow’s bankruptcy. There is plenty of evidence to afford early warning signs.


David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors

Category: Markets

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

10 Responses to “Detroit!”

  1. ilsm says:

    A local Detroit band: “The Big 3 Killed my Kids”.

    They can sell 16M units, as the imported “content” rises nothing happens for the US or Detroit.

  2. Bridget says:

    Who still owns Detroit munis? Gamblers, speculators, bottom feeders. It is to be devoutly hoped that their haircuts proceed on a percentage of what they paid for their dross, and not par value.

  3. Greg0658 says:

    MarkShields: “And I just think — I just want to think about Detroit in this sense. We won World War II. We were the arsenal of democracy. Detroit was the arsenal of the United States, and Michigan really — 75 percent of all the aircraft engines that were built for the Allies in World War II were built within Detroit and its environs, every — every truck that brought troops and supplies to defeat Nazi Germany.”

  4. 4whatitsworth says:

    Detroit has a great history and I wish it well. In my view it is what many would call a socially progressive place and represents the great experiment of socialism in the United States.

    Great point about those ghost towns..

  5. Bridget says:

    I guess my point is that it would be a worthwhile exercise to look beneath the surface of the creditors’ claims. As to bondholders, did they pay pennies on the dollar, did they buy credit default swaps, do they have insurance? As to retires, do they have Medicare and social security? Are they beneficiaries of predatory benefits formulas, rewarding them with sums of money that no reasonable person would say they earned? I think those things are relevant in trying to assign haircuts to different classes of creditors.

    • Interesting argument — but do we want to create a ;legal difference between the original bond buyers and someone who purchases that bond from them ?

      What does that do?

  6. DeDude says:

    When the economy was booming all the rich and middle class people enjoyed living there and harvested a lot of wealth. Then things go bad and taxes have to go up to cover some of the expenses of things going bad. Now all of those who had harvested the wealth of the good times are running away from any responsibility and leave the problems and debt to be taken care of by those who do not have the resources to get the heck out of there. Not fair, not pretty, but very american.

  7. [...] Read more… [...]