Here to take us beyond the headlines is Lyle Fitterer, CFA, CPA, managing director of Wells Capital Management’s Municipal Fixed-Income team. Lyle joined guest host Andy Azinger in this excerpt of On the Trading DeskSM from Friday, July 26, 2013.
Was the bankruptcy in Detroit more a matter of when, Lyle?
I think it was only a matter of time. If you look at the capital structure of Detroit and the amount of debt outstanding, and unfortunately look at what’s gone on from a population perspective in the City of Detroit over the last 50 to 60 years, they really cannot support the amount of obligations they have. That doesn’t mean that you can’t invest in the area. It just means that you need to know what you’re buying and what sort of security pledge you have.
Can you define what a security pledge is?
We’re going to want to see an actual statement that says [municipalities] are providing bondholders a first lien or a pledge of the municipality’s taxes and their taxing ability. And it’s going to be a first budget priority lien, which effectively means that you get back to where you were and that bondholders have secured priority claim on the revenues of that municipality that are generated by taxes, and they’re paid before other obligations to the city.
In Detroit, of the reported $18 billion of debt, about half of that is said to be attributed to health care for retirees and pensions. Does that make Detroit a different kind of a problem?
I don’t think it makes it a different kind of problem. Stockton and San Bernardino are two municipalities in California that have filed bankruptcy where that was the big component of what forced them effectively into the same situation. What we’ve been saying for quite a while now is that investing in municipal bonds is basically evolving. The rest of the capital markets look at a capital structure. There’s senior debt, subordinated debt, preferred debt, junior subordinated debt, and even equity. And, in the muni market, I think one of the benefits of Detroit going through this process and even Stockton and San Bernardino is they’re establishing a capital structure. And from a long-term perspective, that’s probably a good thing. It gives you a little bit more clarification. It tells you how to better price securities in the marketplace.
Now, would you consider Detroit to be the canary in the coal mine, an example of what can happen to other American cities, Lyle?
I would say no. I think you’re going to hear a lot about [bankruptcies]. Meredith Whitney came out again saying, “I told you so, and this is just indicative of what’s going on across the United States.” My counter to that would be, look, this has been going on for a long time. You need to do your credit work. There are good credits out there that can service their entire capital structure. There are other credits out there that are going to have difficulty servicing their entire capital structure on a go-forward basis. There have been a tremendous number of local and state municipalities that have done things to help the situation from a long-term perspective; changing their pension plan, changing the way that their pension employee benefits are being paid. How is health care covered by these systems on a go-forward basis? You know, they’re changing from a defined benefit plan to a defined contribution plan. They’re making the employees make contributions and trying to shore up their unfunded pension obligations or their pension plans from a long-term perspective. They’ve been taking down the amount of debt that they’re issuing. They’ve been rebuilding rainy-day funds. So, yeah, there are going to be more Detroits out there. I wouldn’t expect another municipality of this size to file bankruptcy anytime soon, but there are probably smaller ones out there that are in a similar situation. But it all comes back to you need to do your credit work.
That is it for this week, Lyle. Thank you so much for joining us again here On the Trading Desk.
Great, thanks for having me.