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The City of Detroit, Michigan filed for Chapter 9 bankruptcy protection on July 18. (Chapter 9 is the chapter of the Bankruptcy Code that covers municipal bankruptcies.) Detroit is reported to have around $18 billion in debt, making it by far the largest Chapter 9 bankruptcy in history. The next two largest Chapter 9 cases are Jefferson County, Alabama, which filed in 2011 with $4.2 billion in debt and Orange County, California, which filed in1994 with about $2.0 billion in debt.
Distressed municipal bonds can sometimes be good investments because the market for this type of bonds is even more inefficient than for most other types of distressed securities. However, we think it is too early to consider buying any of the Detroit securities. Detroit’s bankruptcy case is likely to be very long and complicated. The city is in a long-term decline, and it faces a whole host of financial and operational issues.
The other two large Chapter 9 cases were relatively simple by comparison. In each of those cases it was a fairly isolated issue that caused the bankruptcy. Even so, both bankruptcies took a fairly long time to resolve.
Orange County was forced into bankruptcy because one of its investment funds bought complicated derivative securities which created large liabilities for the county when the market moved the wrong way. Orange County was able to get a Plan of Reorganization confirmed in a relatively short six months. However, it was almost an additional year before the county’s reorganization was fully effective.
Jefferson County’s problems arose because it borrowed too much money to upgrade its sewer system, and the upgrade did not produce enough revenue to service the debt. That bankruptcy case is still ongoing today, more than 20 months it was filed.
If we are correct about the Detroit bankruptcy taking a long time to resolve, the best opportunities will come many months down the road when bondholders lose patience and dump their holdings. Year-end may be a good time to look at the Detroit debt because many individual bondholders will be tempted to sell their bonds and take a tax loss on them. In the meantime, the Detroit bankruptcy is likely to produce plenty of interesting news to follow.