Will Detroit’s Dubious Bankruptcy Affect the Future of Municipal Finance?

[Originally published by the American Interest]

 

On December 10th, nearly 17 months after going bankrupt, and a year after entering trial, the city of Detroit finalized its bankruptcy proceedings. In many ways, the deal should be viewed as a bright spot. The city shed $7 billion in debt, dedicated another $1.4 billion toward service improvements, and reformed its pension system. But the deal did not go well for financial creditors. In what amounted to a dubious application of bankruptcy law, bondholders received fractional returns, while the city scrambled to preserve retirement benefits and even an art collection. This may seem like it would only harm unsympathetic victims: the large financial institutions that were foolish enough to lend to Detroit in the first place. But it could jeopardize the future borrowing ability of not only the Motor City, but also many other distressed municipalities that have come to take credit for granted.

Detroit declared bankruptcy in July 2013 to address the $18.5 billion in debt it had accrued—most of it over just the past two decades. The city’s finances began declining in the 1950s, and race riots and suburban flight soon worsened its economic prospects. But as the Detroit Free Press noted, the city’s debt didn’t become substantial until the mid-1990s, when officials not only failed to address public employees’ rising retirement costs, but also hired new employees despite depopulation. This caused the city’s unfunded pension liabilities to escalate, and by 2005 debt had risen to $9 billion. In response, mayor Kwame Kilpatrick organized a complex, $1.4 billion loan from Merrill Lynch and UBS intended to shore up the pension system and stabilize interest rates. But in January 2009, Standard and Poor’s downgraded Detroit’s credit ratings to junk status, which adjusted the terms of the loan and forced early payments. By 2013, the deal accounted for one-fifth of Detroit’s debt, and was costing $50 million annually. This, along with $300 million deficits and sub-par services, impelled Michigan to take control of the city, enlisting bankruptcy lawyer Kevyn Orr as Emergency Manager. Detroit soon declared Chapter 9 municipal bankruptcy, entering district court before U.S. Judge Steven Rhodes.

The principal fight in Detroit’s bankruptcy—as with corporate bankruptcies—concerned the order in which creditors would be paid. The city had more than 100,000 of them, including major financial institutions, individual bond-buyers, and current and retired employees. According to federal law, priority in Chapter 9 bankruptcy goes first toward secured creditors, namely, bondholders whose loans are backed by dedicated tax revenue streams, and who thus expect full returns because of a city’s unlimited tax-raising ability. There is no priority, however, for unsecured creditors, such as employees and general obligation bondholders, who fall second in line for payment, and have historically seen their contracts violated and returns diminished by bankruptcy.

Another staple of municipal bankruptcy, albeit one that falls outside of legal parameters, is the obligation to liquidate assets. Federal law prohibits courts from forcing this on municipalities, since that would violate their 10th amendment sovereignty. But that doesn’t mean, according to market analyst Jim Spiotto, that there isn’t an unwritten rule between cities and creditors that before bankruptcy everything possible should be done to meet payments, and that bankruptcy itself should be conducted in creditors’ best interests: “In the municipal market, there’s a position that if you issue bonds to it, they are presumed valid, binding and enforceable,” Spiotto said by phone. If municipalities “lack credibility in the market, the cost of borrowing goes up.”

So the two basic guidelines for bankruptcy are first, to liquidate in good faith, and, second, to use the proceeds for a well-ordered payoff of creditors—and Detroit’s ran afoul of both. From the moment of declaration, there were two sacred cows that the courts, cheered on by the media, were bent on protecting. The main one was public employee pensions, which unions insisted be paid in full, citing a Michigan law guaranteeing this. The other was the art collection of the Detroit Institute of Arts, which was valued at up to $8.5 billion. What ended up protecting both, and moving the case forward, was a deal that came to be called the “Grand Bargain.” Various philanthropies, along with the state, pooled their resources to pay the city $816 million for the art. Detroit was then required to transfer the art into a non-profit that was insulated from bankruptcy proceedings, and to use that money for bankruptcy payoffs.

During bankruptcy negotiations, this money went toward pensions, setting the tone for the entire deal. Once made public in November, the plan—which represented settlements between creditors—found that uniformed employees would recover 100 percent of their pensions and non-uniformed ones 95 percent. There were some reforms to the pension system: Pensioners saw substantial cuts to health benefits and cost-of-living increases, and now they must pay into the system if it becomes underfunded.

Creditors who actually lent money, however, fared far worse. Insurers of the unlimited-tax bonds, which were supposedly secured, got 74 percent returns, and limited-tax bondholders got 34 percent returns. But the firms Syncora and Financial Guaranty, who insured the $1.4 billion loan in 2005, suffered most. During the proceedings, Detroit filed a suit challenging the loan, claiming that it had been organized using legal shenanigans that would help the city circumvent a state debt-limit law. This, of course, had not prevented Detroit from collecting the loan at the time, but the city believed that it should be exempt from having to pay it off, an assumption that Spiotto found preposterous:

“Detroit’s position,” he wrote for MuniNet Guide, is “to repudiate the debt because it claims Detroit had ‘a bad mayor and a bad administration’ at the time of issuance and therefore should not be responsible for that debt.  As we all know, if a corporation or an individual issues debt in the public market claiming that the debt is a valid…obligation, and then later, when it is inconvenient or difficult to pay, claims it was never authorized to incur the debt, there would be serious consequences.”

Nonetheless, Judge Rhodes bought the city’s argument, rejecting Syncora and Financial Guaranty’s claims for bigger returns. By October, high legal fees had forced the firms to accept 14 percent recoveries, meaning they suffered more than $1 billion in combined losses.

Thus, the ruling was a case study in how politics can affect what are supposed to be technical legal decisions. In some ways, it mirrored the 2009 bailout of Detroit auto companies GM and Chrysler, which were handed federal money in lieu of bankruptcy. The bailout was criticized as a political maneuver by President Obama, since it was used to pay workers before large lenders. It would be hard to argue, especially given Detroit’s heavily Democratic politics, that the same Main-Street-versus-Wall-Street sentiment didn’t influence Judge Rhodes. Here, too, large financial institutions with sound legal cases but minimal popular support took a backseat to workers, who are unionized and thus have strong political pull.

Perhaps even more brazen was how lenders were treated by Detroit, given the city’s unwillingness to liquidate. While Detroit did promise some land and future infrastructure revenue to Syncora and Financial Guaranty, it still mostly hoarded its voluminous and often burdensome assets. The city owns roughly 40,000 properties within its boundaries, and many lie fallow, but few went up for sale. Except for trash pickup, Detroit also did not privatize any services or utilities, which can provide huge upfront windfalls when requiring infrastructure sales. And rather than auctioning off its art, the city permanently transferred it to the non-profit for a one-time payment of less than 10 percent of the collection’s value. Detroit had always been disingenuous for clinging onto this non-essential asset while ignoring basic services; now it appears negligent for not having maximized its value despite bankruptcy and massive debt. “Did the city of Detroit employ all the methods necessary, and all the assets at their disposal, to make the payments they were required to by law?” asked Cumberland Advisors analyst John Mousseau. “The answer is clearly no.”

Of course, Detroit’s bankruptcy, dubious as it may seem, was still celebrated as something that would save the city money while merely hurting distant firms. But down the road, it will likely have negative ramifications for average citizens. Even before bankruptcy, Detroit’s junk-level bond rating caused high borrowing costs, and this affected its ability to fund services. According to its 2013 Comprehensive Annual Financial Report, 9.8 percent of the budget goes for interest payments, and an egregious bankruptcy will worsen the problem for city and state, said longtime credit advisor Dick Larkin. In the month before Detroit’s bankruptcy, Michigan was already experiencing a rising credit spread, and six months later, yields had risen by as much as half a percentage point. According to Bloomberg data, Michigan now pays the second-highest yield spread of any state. From 2009 to 2013, Detroit’s credit rating went from BB, S&P’s top notch for junk, to C-, the rating for default. By September of 2013, months after bankruptcy, Fitch’s further downgraded the city to D. Larkin believes that in the future, this bankruptcy may prevent Detroit from borrowing altogether. “The real pain of Detroit’s bankruptcy,” he said, “hasn’t been felt yet.”

If Detroit’s case becomes the norm, other cities could face borrowing troubles too. Many of them, after all, are either bankrupt, are nearing it, or at very least have massive debt. Ones that in recent years have filed for bankruptcy alongside Detroit include Stockton, San Bernardino, and Vallejo in California; Jefferson County, Alabama; and Central Falls, Rhode Island. Ones that have long been on bankruptcy watch mostly include other cities in California or the Rust Belt, such as Compton, Fresno, Harrisburg, and Pontiac. Those with massive debt include New York City at $93 billion, and Chicago at $33.5 billion. While these cities vary in economic strength, their cause for debt is similar—almost all have workforces whose benefits exceed what local taxpayers can fund. Because of their similarities, one’s profligacy may affect the perceived creditworthiness of others. For example, Chicago—where unfunded pension liabilities also represent a majority of debt—suffered a triple credit downgrade the day before Detroit’s bankruptcy.

University of Pennsylvania law professor David Skeel has argued that bankruptcy could be an effective way for cities to shed these obligations. But that depends on how it is used. Like in Michigan, many states have provisions to protect pension contracts, and while federal bankruptcy law allows them to be violated, it doesn’t mean that courts will pursue this to great degree. Detroit forced only minimum cuts onto employees relative to bondholders, and similar tact has been taken in other recent bankruptcies. Stockton’s deal in October of 2014 granted employees full pensions, but under a penny on the dollar to some bondholders. After preliminary hearings, San Bernardino looks poised to do the same, for fear of hurting its relationship with CalPERS, the state retirement system. The questions are whether other cities, recognizing an easy way to shirk payments, will also file for bankruptcy, and if so, how badly this will hurt the municipal bond market.

Spiotto didn’t think that many cities would do this, or that the bond market would be affected. “The vast majority of municipalities pay their debts,” he said, “and I don’t think that’s going to change.” Instead, cities will note the high cost that Detroit has paid in money and reputation, and avoid bankruptcy. Larkin concurred, adding that the $3.7 trillion municipal bond market is influenced more by Federal Reserve policy. But all the advisers I spoke with agreed that if certain cities indeed filed, it would at least endanger their local and state finances.

For cities to avoid this, they will have to embrace internal reforms, namely to their retirement systems. If they do file, they can conduct their bankruptcies either in good faith, or boost their populist appeal by using them to discriminate against financial firms. Detroit has long taken the latter approach for other policies, to ill effect, but following the Motor City’s politicized bankruptcy deal, the worse may be still to come.