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Imported From Detroit: Financial Fallout

When Detroit declared bankruptcy last week, the financial markets took the news more or less in stride. However, this could become yet another factor affecting interest rates on savings accounts, mortgages and other bank products.

Detroit is the largest American city to file for municipal bankruptcy. It has just over 700,000 residents, and its financial liabilities could reach $20 billion. At a staggering $28,500 in liabilities per resident, that presents a compelling reason why the city declared bankruptcy.

Indeed, Detroit's condition has been so bad for so long that perhaps the muted response from the financial markets can be chalked up to a sense of inevitability. Still, while this bankruptcy may not have been a huge surprise, it does raise a number of questions whose answers are as yet unknown:
  1. Who's next? Detroit is far from the only U.S. local government in deep financial trouble -- even some states face unmanageable pension obligations. Mayors, governors and other officials around the country are going to be watching the Detroit bankruptcy carefully, and if it turns out to be a fairly painless way of hitting the reset button, expect a series of other governments to start showing up in bankruptcy court.
  2. How far does Detroit want to go? Bankruptcy does not have to be drastic. Sometimes, a slight reorganization of obligations can structure them in a more manageable way. If, on the other hand, Detroit looks at this as an opportunity to wipe much of the slate clean, expect it to have a much more disruptive impact on the pension system and on lenders -- if, of course, the bankruptcy judge goes along.
  3. How do Detroit's creditors make up their losses? The lenders and bond holders to whom Detroit owes money have their own obligations to meet. If they are caught seriously short by Detroit's bankruptcy, then there could be a ripple effect of other defaults.
  4. What are pensioners going to do? While private employees have largely been set adrift on the uncertain waters of defined contribution plans over the past three decades, public employees have enjoyed the certainty of defined benefit plans. Detroit's bankruptcy could undermine that certainty, and add to America's already troubling retirement crisis.
  5. Will lenders become more reluctant? As it stands now, banks already have very low ratios of loans to deposits, meaning they have little incentive to attract more deposits. If high-profile loan defaults make banks even more skittish about lending, it could result in a worst-of-both-worlds scenario for consumers, where loan rates go up while rates on savings and money market accounts and stay near zero.

From Wall Street to the European Union, the domino effect when one of a series of interdependent entities gets in financial trouble has been painfully evident in recent years. With its bankruptcy announcement, Detroit becomes the latest domino to wobble. How far it tips over and how many other dominoes it takes with it will be an important story in the second half of 2013.

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