Detroit failed, Michigan’s credit rating is almost junk, which is next?
Are the municipals of the US going to fail one by one? Well, it’s not the case. True is that one of the most important cities of the US, Detroit failed for real and another major city Chicago is in big trouble. The beauty of the free market is that, if you let to fail one or two of the most important players, you can save the others, because they won’t repeat the errors of the failed one. If you try to save every city then you are risking to give a bad message to the other municipalities and the probability to have bankruptcies in large scale is too high. The citizens of these two cities are paying a huge cost but otherwise the cost could be much higher.
Alan Greenspan in one of his last appearances, interrogated at the congress about the financial crisis, told us that he was very disappointed from the malfunctioning of the free market. “Some of the mechanisms of the markets didn’t functioned and the irrational exuberance has dominated the mind of investors” he said. Now our question is: will the mechanisms of the free market function this time? We think Alan Greenspan would be very prudent on giving an answer.
But let’s have a look to what is going on in the two municipalities of the States. On July 13, 2013 the city of Detroit filed for Chapter 9. In fact there were many years that the city has been in financial trouble as a result of the not diversification of the industry. This city has been focused very much on the car industry in the 50s and 60s but it was not able to keep the pace with the technology and the reduction of the consume that started at the end of the 70s. That was a result of the increasing price of the oil in the international markets.
The Credit rating companies were not enough fast to preview the bankruptcy for the city of Detroit but they are learning from the past. On May 12 this year, Moody’s downgraded the city of Chicago to the Junk bond level. The exact rating is now Ba1 for the $8.1 Billion debt of the city. This means that the municipal bonds of Chicago belong to the high yield bonds category. The pensions payments are according to Moody’s one of the major reason of this downgrade. This event is going to increase even more the cost of the city to refinance the large debt and for common people this could bring higher taxes. At the same time the credit rating agency maintained a negative outlook for the city. This could possibly mean further downgrades in the near future. The credit rating now is significantly worse because it was a two steps downgrade.
Investors expect to see other downgrades of the municipalities and singular states. Illinois seems to be the next because of the last decision of the Supreme Court, which considered unconstitutional the pension’s reform. Investors may also see the rising yields of the bonds as an opportunity to better remunerate their investments in a moment when the treasury bonds offer very low return rates.