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Side Effects of Detroit’s Collapse

JUL 23, 2013 4:05pm ET
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Detroit’s financial collapse and its dilapidated real estate is a troubling example of the interdependency of local housing market recovery patterns, the job market and economic development that according to insiders does not bode well for other local markets.

Detroit’s troubles are not new, nonetheless its Chapter 9 bankruptcy filing, “the nation’s largest government bankruptcy in history,” is triggering national concern over whether it is “a sign of more trouble to come,” says president and co-founder of NewOak, James Frischling.

“Detroit filed because they’re on their own and had no choice,” he said, while Michigan is being criticized for failing to provide sufficient help for Detroit and the debate over who should do what continues. In his view, the most pressing concern is: “Who’s next?”

And while none of this is directly related to housing or mortgages, saysRick Sharga, EVP at Auction.com, a mortgage market expert with decades of experience in all aspects of default and loss mitigation,“it's all part of the overall economy, and likely to have at least some ripple effect on the industry as the issues are ultimately resolved.”

Detroit is a unique case where the housing crisis was more a symptom of the city's underlying problems than it was the root cause, Sharga told this publication. Housing did not help avoid Detroit's bankruptcy because its foreclosure problems, “which played a large role in the city's housing market meltdown,” were different than what happened in states.

In California, Arizona, Nevada and Florida, he says, “rapidly escalating home prices, overbuilt housing inventories and lending practices that allowed unqualified borrowers to get loans on overpriced properties started the foreclosure cycle,” with high unemployment and a second wave of foreclosures.

Over the past five years insiders have routinely noted the nation’s worst economic crisis since the Great Depression was unusual because it was driven by a housing market collapse. For the first time in the nation’s history in these states and elsewhere in the country the housing crisis was the precursor of the overall economic crisis.

Detroit was an exception where the economic meltdown led to massive job losses and subsequent loan defaults, says Sharga. As automotive industry jobs and thousands of automotive industry support jobs vanished, tens of thousands of residents left Detroit causing a chain reaction that included cumulative drops in housing demand and home prices initiating “a cycle that fed on itself from there.”

Then simple mathematics took over. “The city's tax base had been decimated by the loss of jobs (and taxable income), loss of businesses, loss of population and depreciation of real estate values. And much of the population that remained was comprised of low-income families, who depended more heavily on city services, while paying less in taxes,” he explained. As a result now Detroit owes pension money to former city workers and “there was simply no way the city could handle this current and future debt with its dwindling revenue streams.”

The unavoidable question is whether other cities may follow suit.

As of today, he says, Chicago recently announced massive cuts to its public school system, in order to divert budget dollars to cover pension costs and several cities in California have filed for bankruptcy protection over underfunded pension commitment challenges. Worse than seeing a city the size of Detroit get to this point, he adds, is the possibility, as some economists predict that “this may be a harbinger of things to come.”

Those who argue Detroit’s bankruptcy is unique are focused on population decline, the auto industry and mismanagement of operating budgets, agrees Frischling.

Due to its “overreliance and dependence on the auto industry,” he said, Detroit saw its population dwindle over the past 60 years from a high of 1.8 million in the 1950s to less than half that number today.

The economic situation and tax revenue drops have been “particularly brutal on Detroit,” he said, even after borrowing heavily to meet its operating budgets could not meet its obligations. “But caving under the weight of nearly $20 billion of unfunded pension liabilities is exactly what is scarring municipal bond investors that other cities may follow suit. Chicago and Los Angeles, for example, carry unfunded pension liabilities of $19 billion and $30 billion, respectively.”

According to Frischling, for eight consecutive weeks municipal bond investors have been pulling money from muni market funds, including nearly $1.5 billion last week.

The U.S. housing and auto sales recovery momentum"due to low interest rates and reasonably available credit contributed greatly to the stabilization of manufacturing sector which has previously been a weakness to U.S. economic growth," said Ron D'Vari, CEO and co-founder of NewOak.

He quotes economists forecasting the sales of previously owned homes will rise from 5.18 million to a 5.26 million annualized rate in June from 5.18 million in May that indicate “continued recovery and normalization of the housing sector,” and also warns that due to the Federal Reserve's so-called quantitative easing policies, “the housing improvements momentum is not certain” in the foreseeable future.

Research data support such concerns. Higher interest rates and rising U.S. home prices are likely to scale back strengthening housing metrics during second half-2013, according to Fitch Ratings.

While affordability “is still quite attractive and housing is still undervalued versus incomes,” said Fitch managing director Robert Curran, other issues expected to restrain housing demand include “widespread negative equity, challenging mortgage qualification standards and excess supply due to foreclosures in certain markets.”

“This risk has been the main reason Bernanke and other Federal Reserve board members tried to calm the market by reiterating their cautious stance and willingness to push out the tapering of QE 3 until economy has shown real sign of health," D'Vari said.

Detroit is just one example among many struggling local markets that do not have a clear recovery in sight.

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