Image credit: Map of the City of Detroit in the State of Michigan, 1835, Library of Congress
By Jason Zweig
5:32 pm ET July 19, 2013
The massive bankruptcy of Detroit this week could put bondholders in jeopardy of not getting all their money back.
It isn’t the first time that the holders of bonds issued in Michigan have had problems: Something similar happened 170 years ago.
In the aftermath of the real-estate bubble of the mid-1830s and the bust that followed, Michigan became one of nine states to repudiate at least part of their debts.
According to William Amasa Scott’s history of states that reneged on their loans, originally published in 1893, the state of Michigan borrowed $5 million in 1837 – at least $110 million in today’s money – to finance internal improvements. At first, most of the bonds were bought by merchant banks in England and the Netherlands. But the panic of 1837 was in full cry, land values collapsed and the American banks that took the rest of the bonds soon went bust. In 1841 and 1842, the state of Michigan found itself unable to meet the interest payments on the bonds.
Michigan was far from alone. Pennsylvania, Florida, Mississippi, Arkansas, Indiana, Illinois, Maryland and Louisiana also defaulted on their debt around the same time. Several, including Michigan, repudiated – or failed to pay back – at least a portion of their debt.
In his outstanding book America’s First Great Depression: Economic Crisis and Political Disorder After the Panic of 1837, Alasdair Roberts writes:
“Michigan fever” was raging in 1836; in that year, more public land was sold to settlers in Michigan than had been sold in the entire [United States] in 1833… In March 1837, legislators [authorized] a cross-state canal and three cross-state railroads…comprising almost one thousand miles of rail and canal, within a one-hundred-mile band of largely unsettled territory…Michigan’s legislators did not intend to finance the improvements through taxes. Following the model of the Erie Canal, they would borrow the whole amount…
Michigan, after a struggle to place the bonds, ending up selling two-thirds of them to the private, Philadelphia-based Bank of the United States and to the Morris Canal and Banking Co., a New Jersey outfit that was operating jointly as a canal developer and an international bank. But the banks were leveraged to the hilt and ended up pledging their Michigan bonds to European investors as collateral for the two banks’ own debts.
The Bank of the U.S. and the Morris Canal had promised to pay Michigan the $3.7 million they owed the state over the course of four years – but, once the banks went bust, the bonds were gone and Michigan didn’t have the money the banks had promised for them. The holders of the bonds, mostly in Europe, demanded payment, but the cupboard was bare – so Michigan was forced to default.
The grandstanding was intense. Charles Butler, a New York lawyer acting as agent for the big London banks that largely held the bonds, negotiated on the scene in the early 1840s. The Michigan legislature, he wrote at the time according to Roberts, was “an impulsive body…[with] queer notions of matters of things…It is all a lottery.”
Michigan ended up privatizing much of its public-works projects to raise some revenue and, as its economy recovered, paid off most of its debt by 1849.
The silver lining: As research by economic historian John Dove has found, the states that defaulted or repudiated, like Michigan, ended up imposing strict constitutional amendments to limit the amount of debt they could issue. Michigan ended up banning any pledge of its credit to a private corporation seeking to borrow under its aegis and also outlawed the purchase by the state of any private company’s stock – practices that had previously been common among U.S. states. As a result, argues Dove, Michigan’s bonds ended up trading at higher prices in the 1860s, after European investors returned to the U.S. bond market, than those of states that didn’t impose such limits.
In the long run, then, Detroit’s default could be good news for Detroit and the municipal-bond market alike.
But that long run could be long indeed.
Source: WSJ.com, Total Return blog