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Woes of Detroit Hurt Borrowing by Its Neighbors

Detroit city grate is missing a cover. With cut backs to city services, Detroit's infrastructure has fallen into disrepair.
Justin Solomon | CNBC
Detroit city grate is missing a cover. With cut backs to city services, Detroit's infrastructure has fallen into disrepair.

The Detroit Effect has rippled all the way to Wall Street.

Two weeks after Detroit declared bankruptcy, cities, counties and other local governments in Michigan are getting a cold shoulder in the municipal bond market.

The judgment has been swift and brutal. Borrowing costs are up around the state, in some cases drastically. On Thursday, Saginaw County became the latest casualty when it said it was delaying a $60 million bond sale planned for Friday. It had hoped to put the proceeds into its pension fund.

It was the third postponed bond sale in Michigan since Detroit dropped its bombshell on July 18. Earlier this week, the city of Battle Creek said it would postpone a $16 million deal scheduled for August because of concerns that investors would demand interest rates that were too high. And the previous week, Genesee County withdrew a $54 million bond sale from the market for the same reason.

(Read more: Michigan issuers feeling heat from Detroit filing)

Detroit's bankruptcy, the largest ever by a municipality, has raised fundamental concerns about the safety and security of municipal bonds, certainly in Michigan but potentially elsewhere in the country, too. The municipal bond market appears to be sending Michigan's cities a message that no matter how well rated they are, they are going to have to postpone their plans and projects or pay more for them.

When Jefferson County, Ala., declared bankruptcy in 2011, there were warnings it had tainted the credit of all other municipalities in the state, but the expected fallout never materialized. After Orange County, Calif., came through its bankruptcy in the 1990s, its borrowing costs actually fell. But Michigan appears to have something new — a bankruptcy that makes it harder for others in the state to borrow.

Detroit's state-appointed emergency manager, Kevyn Orr, has proposed imposing deep cuts on some bondholders — treating them the same, in effect, as retired Detroit workers who have been receiving city-paid health insurance that will now end. Mr. Orr's bankruptcy plan would put them all at the back of the line for whatever money is available, as unsecured creditors.

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And because the city's bankruptcy filing was approved by the governor, Rick Snyder, it is seen as the best distillation of how Michigan will treat certain bondholders in times of trouble.

Putting a city's "full faith, credit and taxing power" behind a bond no longer means what it did in the past, anywhere in the state, critics say. The governor and Mr. Orr have said they are not concerned about the effect of the bankruptcy plan on the municipal bond market as a whole. But other participants find their treatment of indebtedness profoundly disturbing, and their anxiety has spilled over to other Michigan municipalities.

(Read more: Christie's hired toappraise Detroit's art collection)

"A lot of the people I talk to are investors who are just very angry about this," said Matt Fabian, a managing director at Municipal Market Advisors. "Bonds are so cheap everywhere across the whole market, there's no reason to put anyone in Michigan bonds right now."

Sara Wurfel, a spokeswoman for Governor Snyder, acknowledged the concerns, but said they were overblown. She called Detroit's financial breakdown "an incredibly unique situation," and said the bond rating agencies would continue to rate Michigan's other municipalities individually, each on its own strengths and weaknesses no matter what went on in Detroit.

"Michigan is home to hundreds of local communities across our state, rated by the credit agencies," she said. According to a recent analysis by Standard & Poor's, she said, "only two of those aren't investment grade. There continue to be an abundance of sound, smart investments to make in Michigan and our local communities. Michigan's fiscal house is in order and sound."

Mr. Fabian and others who work with municipal bonds cited two main concerns coming out of Detroit. First was the city's plan to put several different kinds of bonds, plus the retirees, into one big category — unsecured creditors — even though bonds were issued with many different ratings and promised investors different interest rates accordingly. If Detroit succeeds in lumping them all together in a single bankruptcy class, then by logic, the bonds of other Michigan cities should have their ratings changed to reflect that. The ratings would go down, and the investors holding the bonds would take losses.

Creditors recalled that Michigan's state treasurer helped to market some of Detroit's debt, encouraging investors to buy it as very safe.

(Read more: Detroit makers struggle with production shortages)

"Now they're saying that the investors are getting what they deserve, and they should have known better," Mr. Fabian said. "So you can't really trust the statements of the state government."

The other concern was that the federal bankruptcy court might ultimately approve Detroit's treatment of bondholders, setting a precedent that distressed cities in other states might be tempted to follow. Their borrowing costs would then also rise, and that would undercut the way most of the country's roads, bridges and schools are built — planned and financed at the local level.

Local officials in Michigan were putting on brave faces Thursday, saying the chill in the market might prove to be temporary, or to have been caused by broad credit conditions unrelated to Detroit. As the Federal Reserve has signaled a coming end to its easy-money policies, interest rates have been rising, making it more expensive for almost everyone to borrow.

"There's been a lot of things going on in the market," said Linda Morrison, the city finance manager for Battle Creek. Since last spring, her city had been planning to raise $16 million to pay for a new roof and better seating for the Kellogg Arena, among other improvements. She said that none of the projects were needed urgently and that Battle Creek could afford to wait for more favorable market conditions.

She said she was aware that Detroit's bankruptcy plan had dealt a blow to longstanding beliefs about a city's "full faith, credit and taxing power." But, she added, maybe the judge would decide things in the bondholders' favor, and the markets would come back.

"Who's to say that the court won't decide it that way?" she said.

By Mary Williams Walsh of The New York Times