Published July 19, 2013
One theory holds that the future of an insolvent city such as Detroit lies with its creditors, that is investors in municipal bonds who can help the city rebuild as it emerges from bankruptcy.
Under that theory, current bond holders should be the bankrupt city’s first priority and first in line for debt repayment so that the city’s fiscal reputation remains intact and, just as importantly, its borrowing costs don’t skyrocket. Current city employees and those receiving pensions from the city are lower down the totem pole.
Another theory holds that a bankrupt city’s first priority is the citizens who live there. Consequently, first in line for payment should be current city employees – policemen, firemen, public works employees and so on – so that the city maintains an adequate level of services while the bankruptcy process winds its way through the courts.
Detroit has taken the latter approach, seeking to maintain as many services as possible while trying to negotiate settlements with bondholders that would have meant severe losses on those bondholders’ investments.
Failure to reach agreement with those bondholders played a key role -- among numerous long-term factors -- in forcing Detroit to file for bankruptcy Thursday, citing more than $18 billion in debts it cannot repay. Detroit is largest U.S. city ever to file for bankruptcy.
“The first thing that needs to be done is to achieve a balance between the bondholders and city employees,” said Gary Sasse, a municipal finance expert and director of Bryant University’s Institute for Public Leadership in Smithfield, R.I.
In Rhode Island, Sasse explained, state law protects bondholders in the event of a municipal bankruptcy. And that’s exactly how it played out when the small city of Central Falls, R.I., passed through bankruptcy in 2012. City employees and pensioners were hit hard, forced to renegotiate existing and past contracts. But the city never missed a payment on its general obligation bonds.
Sasse said protecting bondholders is critical to protecting the financial reputation of the city in question, as well as other municipalities in the state and the state itself. If that reputation becomes tarnished and investors lose faith in a city’s ability to repay its debt, it could have a contagious effect on the rest of the state.
“When you do a restructuring the way the bondholders are treated is going to have an impact on the financial credit and the future of the city,” said Sasse.
Striking a Balance Will Be Difficult
But finding a balance that satisfies both bondholders and former and current city employees is difficult in municipal bankruptcy cases. Sasse said the latter group inevitably has to reconcile itself with significant reductions in salaries and pension payouts and benefits.
“It’s unrealistic to think you can restructure a community without addressing unsustainable and unaffordable employee retirement pensions and benefits,” he said.
As it stands in Detroit, neither group is remotely satisfied and the city had no choice but to put the matter before a bankruptcy judge.
James Hohman, assistant director of fiscal policy at the Michigan-based Mackinac Center for Public Policy, said a restructuring plan proposed by Detroit’s emergency manager Kevyn Orr placed funding the city’s current operations as the top priority. Second priority is paying off secured debts such as payments for water and sewer bonds, which have dedicated revenue streams.
Where it gets “complicated,” according to Hohman, is negotiating repayment toward the city’s unsecured debt, which includes Detroit’s general obligation bonds and its unfunded liabilities toward retired city employees’ pensions and benefits.
Orr had asked bondholders to accept a restructuring plan that would have required investors to accept less than 20 cents for each dollar they invested. They declined.
Now a trade group that represents bond investors, the Securities Industry and Financial Markets Association, has warned that requiring such concessions from Detroit bondholders could have a chilling effect on the entire U.S. municipal bond market, according to a report in the Wall Street Journal.
Hohman is skeptical that Detroit’s situation will have a widespread ripple effect, however.
Detroit’s situation is unique in that the city has seen its population dramatically decline in recent decades – 28% since 2000 – as families and businesses have fled to the surrounding suburbs. That loss of population has drastically cut into the amount of tax revenue the city can raise and has “largely exhausted their options for raising money to pay their other obligations,” said Hohman.
Labor leaders in Detroit aren’t happy either.
“Detroit cannot afford any further attacks on working families, who have already sacrificed so much without a say in the process. City workers have already made severe concessions to keep the city afloat. It is time to put the needs of Detroit residents above the interests of out of town creditors,” said Chris Michalakis of the Metro Detroit AFL-CIO and Karla Swift of the Michigan State AFL-CIO in a joint statement.
Ultimately, a federal judge will have to sort out Detroit’s financial morass, attempting to strike a balance between all the players in a process that could take several years.