Two months ago Detroit filed for bankruptcy, turning its $18 billion debt into the largest municipal bankruptcy filing ever. The financial markets followed with significant sell-offs of municipal bonds, making debt more expensive for other cities, counties or towns. Some local governments, such as Saginaw County, Mich. postponed their bond sales this summer because of this situation, according to news reports.
The main question on everybody’s mind: Is Detroit the beginning of a flood of municipal bankruptcies? Are more counties, cities and towns going to follow in Detroit’s footsteps?
Let’s get the facts straight:
Most counties, citiesand towns cannot go into bankruptcy
While the federal government allows municipalities to file for bankruptcy under Chapter 9 of the U.S. Bankruptcy Code, 26 states either do not allow or have no specific authorizations or unclear laws regarding bankruptcy for counties, cities and towns. This totals to more than 17,500 localities in 26 states, about 43 percent of all local jurisdictions.
Municipal bankruptcy is a very rare event
Out of 3,069 counties, only two counties — Orange County, Calif. and Jefferson County, Ala — have ever declared bankruptcy. When we look at all the counties, cities and towns, 14 of them have filed for bankruptcy over the last five years, according to Governing magazine data. This is one in 1,525 eligible counties, cities and towns.
Five of the filings were dismissed, leaving only nine county-city-town bankruptcy filings over the last five years. In contrast, there were more than 300,000 commercial bankruptcy filings over the same time period, according to the American Bankruptcy Institute and Epiq Systems.
The overwhelming majority of counties, cities and other localities practice sound fiscal and debt management.
That’s why bankruptcy is such a rare event and municipal bonds are one of the safest investments in the United States. For example, municipal bond issuers of Baa Moody’s credit rating had 0.3 percent default rate over the last 42 years, lower than corporate issuers of AAA rating.
Counties, cities and towns are fiscally conservative for a number of reasons. The market taxes any missteps in fiscal stewardship at the local level.
Credit agencies will lower the credit ratings of an impendent muni bond issuer, consequently causing higher borrowing costs for a county’s future debt. The county has to cover this additional debt service expense either by cutting other costs or raising revenue.
Often, counties cannot raise taxes without the approval of their constituents or state government, making the revenue option a hard path to choose. Counties are also constrained by state limitations on the amount of debt they can issue or prohibitions against bankruptcy.
Counties impose limits on themselves, as well, for issuing debt, to avoid bigger problems down the road. For example, Montgomery County, Md., in addition to other criteria, uses a spending-affordability approach, which stipulates that the annual bond interest payment (together with lease payments) should not be higher than 10 percent of the operating budget. In addition, the county pays upfront another 10 percent of the planned bond issuance as a type of down payment.
The threat to municipal debt and general obligation owners has been overblown. Because municipal bankruptcies are such a rare event, the media can overplay cases such as Detroit. But Detroit is the exception to the trend, not the trend. One exception does not warrant a one-size-fits-all federal regulation of states and localities, nor interference with reform initiatives on the ground.