U.S. Markets closed

Detroit not a one-off, aftershocks will be staggering: Whitney

Matt Clinch
Getty Images

Detroit's leaders have set an important precedent in siding with residents rather than unions and bondholders in their decision to declare the city bankrupt last week, Meredith Whitney wrote in the Financial Times.

As part of Detroit's restructuring plan, Emergency Manager Kevyn Orr wants to treat general obligation (GO) bonds as unsecured debt. If that request is approved by the bankruptcy judge, the $3.7 trillion muni-bond market could be turned on its head, as would the long-held assumption that GO bonds represent a relatively risk-free investment.

(Read More: How your city might pay for Detroit's money mess )

The root of the problem of struggling municipal finances is local lawmakers being allowed to break promises to voters and run up large tabs for future taxpayers, Whitney a banking analyst at Meredith Whitney Advisory Group LLC said in an opinion piece in the paper.

"As jarring as the reality may be to accept, Detroit's decision last week to declare bankruptcy should not be regarded as a one-off in the U.S. municipal market." she said.

"There are five more towns like Detroit in Michigan alone. There are many more municipalities across the country in similar positions."

(Read More: Michigan Appeals Court halts challenges to Detroit's bankruptcy filing )

Detroit finally filed for bankruptcy on July 18 after years of a slow decline in its population and its once famous auto manufacturing industry. But the legal battle hasn't finished yet. The outcome could inflict more pain on Detroit's already-beleaguered residents, businesses, creditors, investors and city workers, whose pension plans may now be invalidated.

Three lawsuits were filed by city workers, retirees and pension funds earlier this month on worries that an anticipated bankruptcy petition by Detroit would lead to cuts in retirement benefits, with a federal judge on Wednesday expected to rule on whether U.S. law trumps Michigan's constitutional protections.

(Read More: Detroit becomes largest US city to file for bankruptcy )

These promised pensions and other benefits for public employees, which have strong legal protection, need to be questioned, according to Whitney.

"The bill for promises past is now so large for some cities and towns that it is crowding out money for the most basic of services - in the case of Detroit, it could not even afford to run its traffic lights," she said.

"Will [lawmakers] side with taxpayers, unions or the municipal bondholders? If they back residents, money will be directed to underfunded public services at the expense of pensions and bondholders. If they side with the unions, social services will continue to be cut and the risk to bondholders will increase considerably. If they side with bondholders, social services and pensions are at risk."

(Read More: Detroit bankruptcy could hit millions of retirees )

In the case of Detroit, elected officials, for the first time in a very long time, are siding with residents, Whitney said. This is a new precedent that boils down to the straightforward reality of the survival and sustainability of a town or city, she said.

"After decades of near-third-world conditions in the richest country in the world, the city finally stood up and said enough was enough," she said in theFinancial Times.

-By CNBC.com's Matt Clinch. Follow him on Twitter @mattclinch81.

More From CNBC