CHICAGO — Detroit’s fiscal problems could act as a contagion for local governments across Michigan and the state itself, driving up borrowing costs and restricting access to credit, warns a new report by the Legislature’s independent Senate Fiscal Agency.

Michigan localities are suffering, including older urban centers like Detroit, Flint, and Pontiac, as well as dozens of small, newer suburban municipalities that are struggling with special assessment debt tied to failed housing developments.

But as Michigan’s economic engine, the Motor City’s ability to recover fiscal stability is crucial for the state’s own future, state officials and market participants said.

“There’s a lot of concern over the municipal bond market right now, and Michigan already has a premium on its borrowing costs,” said Eric Scorsone, the report’s author and a senior economist for the fiscal agency.

The report does not quantify the premium.

Scorsone said the report is intended to help lawmakers and Treasury Department officials monitor Mayor Dave Bing’s deficit-elimination plan.

“We’re taking a very careful look at the city and the same for Detroit Public Schools,” Scorsone said. “They’re two huge units of government that have to be carefully watched, and we have to see if these deficit-elimination plans are working.”

He added that the report has sparked phone calls from investors and other bond market participants who follow the city’s fiscal position.

“People are interested in the city and what’s going on. They think the new mayor might have the city moving in the right direction, and that it will be a better investment in the future,” Scorsone said. “Things might start to look better. Time will tell.”

For Detroit, the stakes are high, and its ability to maintain market access is crucial, market participants said.

The junk-rated city has relied on short-term borrowing to cover cash shortfalls since 2007.

Last March, it issued $250 million of long-term deficit elimination bonds in an effort to cut much of its accumulated deficit and to put an end to short-term borrowing as city officials worried that access to the credit markets was becoming increasingly difficult.

Those bonds were backed by Michigan’s double-A credit.

“The extent to which Detroit avoids bankruptcy is the extent to which the capital markets remain open to it,” said G. Allen Bass of Michigan bond counsel firm Lewis & Munday.

A bankruptcy, default, or even near-default would mean restricted market access to other struggling Michigan cities.

“Guilt by association has certainly been known to happen in the municipal bond industry,” said Richard Ciccarone, head of municipal research at McDonnell Investment Management. “It may not be long-lasting, but at first blush the market tries to sort things out, and during that period, credits with like characteristics do get grouped together and suffer changes in their market pricing or trading.”

Detroit’s failure would also have national and international ramifications, according to Bass.

“There could be 'knock on’ effects as bond investors look at other distressed major cities in other states with fiscal difficulties,” he said. “The international effect of [the 1975] New York City default caused the federal government to make loans to the city after its initial refusal. Allowing [Detroit] to fall into default or bankruptcy suggests a federal government too weak to help, underscoring international perceptions of the national economy.”

Detroit and state officials say a default is not imminent, but agree that a failure to address problems could mean insolvency or default in the future.

“Bankruptcy, default, insolvency — none of those things are on the agenda right now,” said Bing spokesman Dan Lijana. “When the mayor talks about it, he’s saying if we don’t do what we need to do, those are the types of things we could be staring in the face. We need to make difficult cuts and difficult decisions and recognize that the city cannot operate the same way as it did in 1990 or 2000.”

Ciccarone noted that the threat of contagion could have a positive impact, forging a closer working relationship between the city and the state and leading to needed legislative reforms.

Legislative action at the state level is a prerequisite for Detroit’s path to recovery, Bass said.

One place to start is with Act 72, the local government fiscal responsibility act that allows the state to take over a municipality after declaring a state of fiscal emergency, the veteran bond attorney said. 

“The question is whether Act 72 is up to snuff, and I think it’s got some problems with it,” Bass said. The law should give local governments more flexibility, including the ability to enter into public-private partnerships, share services with other municipalities, and amend contracts.

Many legislative solutions to Detroit’s problems can be found by studying templates established by municipal fiscal crises during the Great Depression and New York City’s default in 1975, Bass said.

“We have very clear precedents, and the templates are there,” he said. “The city is going to have to turn to the state, because that’s the source of the legal power. This is going to take a legal framework greater than home rule.”

All three rating agencies have hit Detroit with downgrades in recent years, and its credit is now in non-investment grade territory.

The report notes steep declines in nearly all of the city’s chief revenue sources except casino dollars.

Scorsone said that while the issuance of $250 million of deficit bonds chopped the accumulated deficit to $85 million from $330 million, it meant a rise in the city’s long-term debt burden. 

With a pledge by Michigan backing up the bonds, Detroit captured interest rates ranging from 2.42% on a 2014 maturity with a 5% coupon to 5.35% on a 2035 maturity with a 5.25% coupon.

The city currently has $1.4 billion of limited- and unlimited-tax general obligation debt, up from $943 million as of fiscal 2008, according to the Senate report. The city has another $5.1 billion of outstanding sewer and water bonds.

The 2011 budget assumes that the general fund will pay out $100 million, or 8%, of its total general fund expenditures as of fiscal 2011.

A key question for Detroit’s long-term viability is whether its revenue sources, primarily income and property taxes, will begin to recover, Scorsone said.

It will take a few years to tell, and will take several years overall for the city to regain its footing, according to the report.

“The mayor is on the right track, and that’s good,” Scorsone said.

Several obstacles loom. They include the possibility of further cuts in state revenue sharing — a key revenue source for the city that has already declined 30% over the last 10 years — and a $4.8 billion other post-employee benefit accrued liability.

“There are a lot of wild cards, and unfortunately many of them are on the negative side,” he said.

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