The Detroit Bankruptcy Is Official – Now Get Ready for "Bailout Bonanza"

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Today (Tuesday), a federal judge ruled that Detroit is eligible for protection under Chapter 9 of the U.S. Bankruptcy Code, making the Detroit bankruptcy official. This is the biggest municipal bankruptcy in U.S. history.

detroit bankruptcy
Abandoned Packard Automotive Plant in Detroit, Michigan.
Detroit filed for bankruptcy back on July 18. It had to legally prove insolvency, that it was authorized to file for bankruptcy, and that it negotiated with creditors in good faith.

And so it did.

"The court finds that Detroit was and is insolvent," Judge Steven Rhodes stated in his decision today.

Detroit faces $18.5 billion in debt; 40% of its streetlights don't work, and nearly 80,000 abandoned buildings pepper the city.

"I've expected this outcome all along," Money Morning Chief Investment Strategist Keith Fitz-Gerald said. "This country lacks the willpower to tolerate failure, even though it's an integral part of capitalism."

So, what does this federal "go-ahead" on the biggest municipal bankruptcy in U.S. history portend for investors?

Detroit Bankruptcy Is a Countrywide Issue

The scale of the problem is not confined to Detroit - bankruptcy is now officially a viable option for municipalities across the country.

And that means general obligation (GO) bonds, which were previously the safest form of municipal debt - municipalities would raise taxes, cut services, do anything rather than force losses on bondholders - are safe no more.

You can bet now that the Detroit bankruptcy is official, the lawyers employed by approximately one dozen other municipalities in similar financial straits have been very busy this afternoon.

With bankruptcy as an option, GO bonds are unsecured, which potentially forces a loss on the investment.

"If that's the case, those formerly secured debts are in fact no safer than junk bonds," Fitz-Gerald explained. "Which means, all of a sudden, in the blink of an eye, all the ratings on municipalities everywhere are suspect."

Bond ratings are supposed to reflect whether or not the issuer will be able to meet payment obligations, but Detroit's bondholders could be left with mere pennies on the dollar - a risk they didn't realize they were taking.

Already under pressure from having misjudged the entire financial crisis, ratings agency Moody's Corp. (NYSE: MCO) has proposed changes on how they will rate local governments' GO bonds thanks to this Detroit bankruptcy.

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And in the meantime, Fitz-Gerald predicts a big change in this country - he believes the Fed will be forced into backstopping municipalities.

"They're going to have to socialize state and municipal risk, just like they socialized Wall Street's risk," Fitz-Gerald said. "The bailout bonanza just got a whole lot more complicated, and potentially a whole lot more expensive for the average American taxpayer."

It's too early to say with certainty what effect the Detroit bankruptcy will have on the investing world - but what the court does next will be key.

"I will be watching carefully for the amount of debt the court will cut, because that is the first indication of the seriousness of this problem," said Fitz-Gerald. "It will affect the ratings, and much more."

So stay tuned, as we continue to break down for readers the Detroit bankruptcy's effect on investors as this case unfolds.

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