About the bonds of Detroit, Barron’s said: “A lot of investors bought this debt because they assumed that the state of Michigan wouldn’t let its largest city default.”1 In other words, they assumed Detroit was “too big to fail.” Nonetheless, Detroit did default and became the largest municipal bankruptcy in history. This bankruptcy, with unfunded municipal employee pensions among the competing creditors, is a hugely important precedent. Is any city too big to fail?
Essential to understanding the record bankruptcy of “Detroit” is that it applies only to a small part of metropolitan Detroit. The bankrupt City of Detroit has only 17 percent of the population of the metropolitan area. Of the two Detroits, Smaller Detroit is broke, but Bigger Detroit, which is five times as big, isn’t.
Of course, Smaller Detroit used to be a lot bigger. “Coming out of World War II,” the Detroit Free Press reflected, “American industry was triumphant, and few centers of industry were riding higher than Detroit … Detroit exercised an outsized influence on the state’s politics and economy.”2 What is now Smaller Detroit, once a boom town, had its population peak in 1950 at 1.85 million. (On a personal note, in 1950 I was in the second grade in the Detroit public schools.) Since then, the city has lost 61 percent of its population, which at 714,000 is less than it was in 1920.
At its peak, the City of Detroit’s population represented 71 percent of the metropolitan area, now it is 17 percent; it was 29 percent of the State of Michigan, now it is 7 percent. Detroit is the largest city as a proportion of the state to go bankrupt. Its shrinkage made it politically easier to let it fail, as well as economically more likely that it would.
These striking trends are shown in the following 100-year population graph.
Source: U.S. Census data.
This basic demographic pattern is shared by many old manufacturing cities in the northeast United States. These include St. Louis, Cleveland, Buffalo, Pittsburgh, Cincinnati, Baltimore, Chicago, Philadelphia, Boston, and Milwaukee -- listed in the order of percent population loss since their peak, which like Detroit was in 1950 for all of them except Milwaukee (which was in 1960). All have lost a large proportion of their population, ranging from 63 percent to 20 percent; all are significantly smaller than the rest of their respective metropolitan populations; and all have become much smaller proportions of their respective states.
The following table summarizes these changes.
Source: U.S. Census data.
Are any of these too big to fail? Is Smaller Detroit a leading indicator for others? All our old cities show the same pattern of absolute and relative population loss, but on the positive side, the credit quality of the others has held up much better than Detroit’s, as judged by bond ratings of their general obligation debt. Detroit is in default, but none of the others is currently rated below single-A. Population loss has not been destiny in this respect, at least so far. Nonetheless, with the instructive Detroit precedent, with shrunken populations, and with underfunded municipal pensions common, we can conclude that nobody, not even the much bigger City of Chicago, should be thought of as too big to fail.
The bond ratings of the City of Detroit by Standard & Poor’s and Moody’s were below-investment grade or “junk” BB/Ba-3 ratings by 2009. That year, the city’s chief financial officer met with Wall Street analysts to discuss its mounting financial problems. “What happens if Detroit goes bankrupt?” he was asked. His reply: “We don’t. The state will step in and ensure that they right the ship and that the bonds are paid.”3 It didn’t. The bonds weren’t. Instead the state sensibly insisted that the city declare municipal bankruptcy and give the creditors some serious haircuts. Michigan’s largest city was decisively not too big to fail. Which is as it should be. Should investors assume that any city is too big to fail? Nope.