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.
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.
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.
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.