Two news stories highlight the precarious nature of the restructuring that has laid the foundations for the next economy. They don’t seem to be related at all, but they highlight the twisted nature of “risk” and what it means when interest rates are low but investors are developing a renewed appetite for risk.
The first is the bankruptcy of Detroit, a long time coming, which was filed today. The city has $18B in liabilities that they’d like to cut to $2B – hence a Chapter 9 liquidation filing, a declaration of surrender. The city is beyond broken and needs to start again. The second story is the rise of collateralized loan obligations (CLOs) and how our old friend Captain Morgain, er, JP Morgan is making a big bet on sketchy loans.
How are they related? Both stories show risk laid bare, and both stories have a backstory of pushing the ol’ red button with RESET in big letters on it.
The population of Detroit, 1900-2010
Let’s start with Detroit. The city has been in decline, along with manufacturing in America generally, for at least 60 years. The population has declined a stunning 62% in the last 60 years and the process seems to be accelerating. Large sections are being turned into “urban farms” once they are cleared of unwanted and deteriorating houses. The process of decline is, if anything, accelerating with an unemployment rate of 16%, nearly 1 in 6 people without work.
There has never been a larger municipal bankruptcy in the US, and the implications are vast – and almost certainly headed for the US Supreme Court. A partial default on pensions is very likely, hitting people with the most to lose the hardest. Someone born in Detroit and retiring from a public job right now has watched this terrible decline their entire life – and is now about to be screwed at the very end of it. Words cannot describe the sadness of Detroit and the punishing dark cloud of death that has hung over it for decades.
The United Artists Theatre in Detroit, built in 1928 but closed since 1974
This is a city that never saw the last boomtimes in the 90s, but is in the process of erasing the previous boom of 80 years ago, too. It’s as if the great automotive revolution never happened as the population approaches what it was a century ago.
But if the bankruptcy is approved, it will affect more than Detroit. Municipal bonds across the nation will be looked at with greater scrutiny as investors, once bitten, become much more risk adverse. These bonds were once the gold standard of secure investments – they didn’t pay well, but they were always secure. Not any more. The precedent set by Detroit, a city that desperately needs to start over in so many ways, moves their cloud over every city. Who might be next? And if municipal bonds are harder to float, how will the nation build up the infrastructure that is in a terrible deficit?
At the other end of economic news, JP Morgan is said to be making a big move in CLOs right now. They have been hot this year after a 5 year collapse and cautious rebuild through the restructuring. These are bundled sub-prime loans from commercial banks that are structured so that you can pick the level of risk you are comfortable with. If you buy in with a big net return, you will get big money every year but are the first to absorb any default in the bundle of loans. At the top end, you get less of the interest payment but more security at the time of default.
Jamie Dimon, CEO of JP Morgan
JP Morgan is buying in at the top end in a big way. The total value of CDOs in 2007 was $92B and just about zero in 2010, but the first half of 2013 saw $44B already issued. JP Morgan wants in on the party again! These are not quite the same as the bundled mortgages that brought the system down in 2008, but they do carry a lot of risk.
It’s good that investors have an appetite for risk, and with interest rates so low this is definitely the way to go. But the big bet being made by Morgan shows how much investment banks are willing to throw the dice once again. The Fed even warned that “prudent underwriting practices have deteriorated” and has issued new guidelines. The system, as we know it, depends on proper risk analysis and rating – which is what utterly failed in 2008.
What’s the problem? There is evidence that a lot of the CLOs being written are from commercial banks unloading their problem loans from the past so that they can improve their capital balance sheets. That does free up money for new lending, which is good. But this is the way the market pushes the reset button when there is not a systematic method of forgiveness for bad loans.
So in this world, risky business loans are hot and declared safe, but municipal bonds are going to be perceived as risky. This may seem backwards, but it’s all part of the process of unloading the bad stuff left over from the last collapse onto the market so that it can deal with it appropriately – and we can all move ahead. Ahead into what? It’s hard to say with such a perverse view of risk in this market.
What we can say is this – bless the good people of Detroit and all the best to you after decades of neglect. You’re getting the short end of this process that has given banks a way to unload their debt at the same time your pensions are failing and your city is being plowed back under.
Barataria - The work of Erik Hare 
I never understood the metropolitan area of Detroit. If I had more free time or money I would have wanted to see a baseball game there altho it may be in the burbs. Tell me and the fellow readers a little bit about the surrounding area of greater Detroit.
I don’t know much about the area, to be honest. I have been following the downfall of Detroit city for a long time, and it seems that the public has finally become aware of how bad it is.
The suburbs of Detroit are pretty nice places, and contain some of the wealthiest zip codes in the country. The Lions, Tigers, and Redwings all play in arenas in downtown Detroit….which is actually pretty nice. The Pistons are out in the suburbs. The city contains the largest number of theater seats in the country after New York. The Fox Theater is magnificent. Lots of history in Detroit. A world class symphony. The Detroit Institute of Arts has one of the finest art collections in the world. The architecture includes some of the best examples of 1920’s art deco skyscrapers….the kind of beautiful buildings we think we don’t have the money to build anymore. Michigan contains some of the best universities in the country. Wayne State in the city, along with University of Michigan in Ann Arbor (an hour away), and Michigan State in East Lansing (an hour and a half away) actually conduct more research than the famed “research triangle” in North Carolina. Step outside of this small downtown center, and the rest of the city is a ruin. There are pockets that contain breathtaking homes and mansions from the 20’s, 30’s, and 40’s….Palmer Park, the Boston-Edison neighborhood, Indian Village…but the majority of the city looks like a war zone. The close-in suburbs are hip and cool…Royal Oak, Ferndale, Birmingham….bars, restaurants, nightlife….lots of neighborhoods that contain starter homes for young hipster families, and wealthy neighborhoods for the elite. The far suburbs contain gorgeous parks, lakes, and nature preserves. Great places for hiking, boating, skiing, etc. Not to mention that is just a short drive from the Detroit metro area to beautiful northern hardwood forests, incredible beaches along Lake Michigan, camping, hunting, fishing…lovely summer resort towns and winter ski areas of Petoskey, Charlevoix, Harbor Springs, Saugatuck, Grand Haven, Pentwater, Traverse City, and Mackinac Island. It is so sad what the city has become, because there is also still so much good there.
It is also a very divided place. Over 80% African-American in the City, with just the opposite in the suburbs. Livonia (one of the suburban cities) was, just a few years ago, the whitest city in the country with a population that is something like 98% to 99% white. To say the area is dependent on the automotive industry is an understatement. In living there, you feel like everyone is somehow involved. If you don’t work directly for GM, Ford, or Chrysler, then you probably work for a company that does business with them….and that represents a vast array of businesses….ad agencies and marketing firms, parts suppliers, engineering firms, construction firms, architects, furniture, office supply, IT, real estate, call centers, health care organizations, etc. If the American auto industry suffers, it has an incredible ripple effect through entire industries.
Detroit is what happens when the money and investment in this country go into financial instruments and schemes rather than producing something. I refuse to believe that we, as a country, can’t afford to build things…can’t afford education anymore….can’t afford health care anymore…can’t afford pensions anymore…..there is a lot of money out there. It’s just going into the financial slot machine that is Wall Street to benefit the few holding the cards rather than building the things that give us vibrant, colorful cities and well paying jobs…..
Thank you. I agree that we do have the resources to be decent people but we have chosen not to. Your comment is quite a blog post in itself, and thanks for sharing it here!
Well said (written) as I never got the picture that you just depicted here. I always felt in the back of my mind that there was wealth and industry and culture nearby. I also like your politics. Thanks!
Generally interest income on municipal bonds is exempt from federal taxes. The exemption is more valuable to the those in higher marginal tax brackets. A possibility for Detroit is for Michigan and the federal government to bail Detroit out and then recover the costs by lowering the federal tax exemption. The money has to come from somewhere.
That is an interesting idea. I do wonder if there should be another FDIC modeled agency for this sort of thing, and that could be a funding source!
Here’s something that might interest you. Krugman just put on his blog comparison be tween Pittsburgh and Detroit that in the 70’s were monoculture cities (steel and autos) He contends that because Pittsburgh did not sprawl out as much (hills? rivers?) the greater metropolitan area took better care of the core. Plus since the core was easily accessed and also for outmigrating commuting workers to suburban jobs the center was able to hold. I know nothing at all about the racial politics of Pittsburgh.
I went to college in Pittsburgh (Carnegie) and I fell in love with the place. The story I was told was that the Mayor of the town gathered all the industry leaders into the “Renaissance Conference” and told them that everyone would have to give something. Westinghouse started the Robotics Institute with Carnegie. PPG built a new office building, a symbol of the city. Rooney of the Steelers promised a Superbowl win (and gave them four).
Pittsburgh got past the racial problems and made the city work. It’s just that kind of city, in the end, and they have done so much better than Cleveland or Detroit.
I think it is the most beautiful city in the US, too. And it just plain works!
I’ve been reading the recent media coverage, and I feel like the story is quickly turning into one of unfunded pension obligations…like that’s the only problem. But as I understand it, Detroit’s total debt is $18 billion, and the pension obligations are $3.5 billion. Isn’t the other $14.5 billion a bigger deal? Doesn’t it take more to service the debt of $14.5 billion vs the $3.5 billion? What am I missing? My fear is that all that is going to be talked about is that those darn unions have ruined the city by demanding extraordinary pensions. This is just not true. I think the bigger issue is that we haven’t really stepped up to take care of our people in old age. Pensions all over the place are unfunded. Corporations decided it was too expensive to offer pensions, so now they’ve pushed responsibility onto the individual and switched to 401k’s and similar programs. However, we also know that individuals aren’t very good at saving or managing investments for retirement, either. Add to that the huge hit that even the well-invested people took when the economy tanked in 2007-2008, and I think it all says that we don’t really have a great way to prepare for retirement. We have gotten good at letting the financial world figure out how to concentrate the money in their pockets no matter the situation….good markets, bad markets…Wall Street still makes money, and we sit around and tell someone that worked for the City of Detroit for 30 years their $1900 a month pension has to be cut. What’s the answer?
Saeldredge, I am seeing the story turn into a pension story, and I agree that this is ludicrous. It is not the largest part of the potential default in Detroit, but since you got me thinking about it I can see two reasons why this part took off:
1) Human interest – no one really cares about ordinary bondholders, which is unfair since Muni bonds are often held by local residents. In a big default on all obligations, the only people that anyone really feels sorry for are the pensioners. It makes a good story – and they have been the most vocal about the BK long before it was filed. So the media wants to focus on that out of a sense of “reality teevee”.
2) Unions – the right likes the story this way because it suggests that greedy unions are the problem. They are guaranteed pay but the rest of Detroit suffers? That is the angle that it is taking in the right wing media right now.
As for the solution, I don’t know at this point. Public employees are the only ones who really get a pension these days.
This is directed to both Eric and Sal (?). I think the media sometimes at the directives of their owners likes to point to pensions. Krugman had an article on this about the so called very serious people. That often we don’t take into account growth (GDP) very well, admittedly a hard thing to do. But I want to toss in a couple of new ideas. Should local pensions (police, firefighters, teachers) reward people who stay local and consequently this is a disreward for those who move away or far out? I know this is always a contentious issue. Also I briefly researched sprawl in Pittsburgh. According to some accounts it is quite bad and surprisingly rugged terrain with ridges and valleys can encourage sprawl. I have seen this in Rapid City SD. Erik I would like you to write an article on sprawl. Also in the Pittsburgh reports they mention the size of the houses and the number of occupants plus their belongings. The more I think about it sprawl really does encourage excess spending (more motor vehicles,, fuel, repairs, yard tools, maintenance). I am partly guilty with a 1 1/2 lot near a railroad track. But hey I took the bus this weekend (bus is only 2 blocks away and going to a congested area DT plus I am a bus driver).
Several points, the first is that we agree that there are people who want this to be the main issue. Handling pensions in this day is something I have to think about – are they really dinosaurs that should not exist, going with a 401(k) model, or should we encourage more companies to offer them? I don’t really know.
I have been thinking more about sprawl and its costs. Long ago, I wrote on that a lot. It is worth revisiting, especially as poverty becomes a more suburban problem all the time.
I think are a couple of points to consider in terms of pension and sprawl:
1) I read some stories on this issue that point out 401K’s were never meant to be the primary means of funding retirement. They were initially designed for another purpose. I don’t pretend to know all the in’s and out’s of that, but, if true, it helps explain how they really don’t do the job we’d like them to do. Are pensions bad? Bad is a relative judgment.,,,companies moved away from pensions because they saw them as being too costly. This means they decided they were “bad” ways to spend “their” money, and that there were “good” places to spend the money instead. I think “good” in this context means, profits, shareholder returns, bonuses for executives. I say that because companies have seemed to spend far more time and energy on cutting costs and financial restructuring to achieve profit targets rather than other forms of investment and innovation. R & D spending is down, spending on employee training and development is down. For all this technology innovation we have today, venture capital seems to be encouraging development of apps…or using technology to replace rather mundane functions and cut costs. There seems to be little investment into technology that would be truly revolutionary….where are the Edison’s and the Einstein’s?
2) Yesterday’s suburban sprawl is today’s globalization. The reason we have sprawl is that cities and states started to compete against one another for jobs and tax dollars. So, we offer companies big tax breaks to move to our town, they move the jobs in, and people move in. Why should I still live in a smaller house in the city and commute out to the suburbs for my job? The new city makes it cheaper to build a new, bigger house, and the tax burden is less because they don’t have the infrastructure to support. So, first we hollowed out our cities, and now it’s happening to the country as a whole. I don’t know what the answer is….but Detroit was one of those cities that had residence requirements to work for the city. So, policemen, firefighters, teachers, etc. all had to live in the city. In the long run, it didn’t help. In Michigan in particular, take a look at some of the comments of the Oakland County Executive L. Brooks Patterson. Oakland County is the wealthy suburbs, basically….Patterson saw no reason to worry about Detroit…he felt it didn’t have an impact on the economic development of Oakland County at all…..
Just a few rants from me….
Scott
Sal and Erik, I think you guys are kinda on the correct track. David Sirota in Salon just posted an article on corporate welfare (tax breaks, loopholes, and subsidies i.e. stadiums). If either of you could come up with a clean simple answer to this question. In some public pensions were not they used as a substitute for social security rather than a complement? I think this was true for my dad who was a teacher for 25 years in MN and SD.
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