Detroit’s Bankruptcy Raises Questions That Go Far Beyond the City Limits

The largest and most complex municipal bankruptcy in American history could affect everything from municipal bonds to pension funds, writes Stephen D. Eide.

In an action unprecedented for a city its size, Detroit declared bankruptcy Thursday, making a final, desperate effort to stabilize its long-beleaguered finances. The city faces numerous problems, which perhaps it could have managed had they come at it one by one like bad guys in an old Adam West Batman episode. New York City’s retiree obligations are larger on a per household basis. St. Louis has lost a slightly greater share of its population since 1950. Crime in Detroit is bad, but many cities faced equally desperate challenges during the 80s crack epidemic. However, coming as they did all at once, these problems and many others simply overwhelmed the city, leaving it no better option than bankruptcy.

Detroit has to reduce its $18 billion debt burden, which will be easier inside bankruptcy court than outside, but not by much. In the face of the largest and most complex municipal bankruptcy in American history, the judge and lawyers will have relatively little precedent to go by when addressing questions about, say, cutting pensions and general-obligation bond debt. Some have predicted Detroit’s bankruptcy proceedings could last five years and cost upwards of $100 million in legal fees.

The central figure in this drama is Kevyn Orr, the state-appointed emergency manager who now is, essentially, Detroit city government. Michigan Governor Rick Snyder put Orr in charge in March, after having determined Detroit to be in a state of financial emergency and that the elected mayor and city council had no realistic plan for reform.

What’s most important to understand about Orr is that he is not from the public sector. He has an aggressive negotiating style honed in his years as a corporate bankruptcy attorney (Orr represented Chrysler in its 2009 bankruptcy). An emergency manager with a public sector background would have been more conciliatory with creditors and Detroit probably would not yet be in bankruptcy. But Snyder, himself a former tech executive, said that “Detroit can’t wait,” and more hardball private sector methods would be required. Orr has acted accordingly.

Detroit’s bankruptcy proceedings will involve a zero-sum struggle mainly among three groups: Wall Street (bond holders and bond insurers), retirees, and Orr, acting on behalf of Detroit’s 700,000 citizens. Orr believes bankruptcy is in the public interest. Detroit’s taxes are already the highest in the state, its near-term prospects for economic growth extremely weak and so, in order to free up more revenues to strengthen basic services and reinvest in the city’s future, it must cut the debt. Absent any debt restructuring, payments to retirees and bondholders will soon consume two thirds of all annual revenues.

Orr filed for bankruptcy because he got nowhere in his direct negotiations with creditors. Bankruptcy provides government with a solution to the so-called “hold out” problem. A government can't pay its debt--some creditors get that, and agree to accept less than their full claim, but not all will be willing to take one for the team. Some creditors will hold out, either because they believe their leverage will increase the more desperate the debtor becomes about settling, or they wager they may be able to avoid having their claim reduced altogether. Let the other schmucks take the haircut. Federal bankruptcy law enables a fairer and more efficient debt-adjustment process, by allowing debtors to enact reorganization plans over the objections of a minority of its creditors.

Negotiations with creditors had been rapidly deteriorating in recent weeks, with four separate lawsuits being filed over Orr's restructuring plan, one by Orr himself. The last straw came when the city’s pension boards actually threatened to sue to prevent a bankruptcy filing, resulting in a mad dash (literally) to the courthouse late Thursday afternoon.

What are the broader implications of the Detroit bankruptcy? The first trend to watch is how state and local governments’ borrowing costs will be affected. Orr has proposed deep cuts to Detroit’s so-called “general-obligation” bonds, a controversial move given traditional expectations on Wall Street that these bonds are among the safest credits to invest in. The municipal bond market has already been on edge in recent weeks, following the Federal Reserve’s announcement that it may soon scale back its easy money policy, which has recently facilitated extremely low interest rates for governments, just like all other borrowers. While events in Detroit may not cause investors to be more cautious about lending money to, say, Utah or Westchester County, other Michigan municipalities are extremely concerned that investors will punish them for Detroit’s collapse.

And will Orr also get away with cutting pensions? Article IX, Section 24 of the Michigan constitution specifically protects accrued public pension benefits from being “diminished or impaired.” But Orr argues that pension costs are unsustainable, that, in bankruptcy, federal law will trump state law, and accordingly has called for “significant cuts in accrued, vested pension amounts for both active and currently retired persons.” Many state and local governments face deeper pension shortfalls than Detroit, and thus will be eager to learn if bankruptcy allows even constitutionally-protected benefits to be slashed.

However long it takes, bankruptcy will cut Detroit’s debt, but that’s a necessary, not sufficient condition of any revitalization. On its own, bankruptcy can’t reform city government, reduce unemployment, bring down the crime rate, or reverse depopulation. Eventually, Kevyn Orr will exit the stage, and leave those challenges for Detroit’s citizens and public officials to resolve. In the near-term, the task for Detroit city government is usefully simple: bring down the debt. If progress is made on other fronts along the way, private sector actors will most likely be responsible. Government was not the only cause of Detroit’s decline, and will play, at most, a supporting role in the city’s revival.

Stephen D. Eide is a senior fellow at the Manhattan Institute’s Center for State and Local Leadership.