Detroit has called in a new mechanic to attempt a major rebuild. Kevin Orr, the emergency manager appointed by Michigan's governor, has looked under the hood and decided that bankruptcy is the only option for the beleaguered city. So how does a city go bankrupt, and what happens next?
Motown has been caught up in a confluence of destructive forces over the past 30 years that ultimately led to insolvency. Some of the forces were external: globalization of the auto industry, corporate mismanagement, demographic shifts, and migration of manufacturing to right-to-work states in the South. Other wounds were self-inflicted: excessive borrowing, benefit promises without adequate funding, official corruption, and a basic failure to acknowledge the mounting crisis and take painful decisions.
Sometimes the outlook is so hopeless that the only way out is a do-over. U.S. bankruptcy law provides an opportunity for entities to gain temporary relief from creditors in order to implement a recovery plan. Individuals seeking to restructure personal debts file under Chapter 13 of the code. Corporations utilize Chapter 11 to renegotiate with lenders and live to fight another day (think GM, American Airlines and Bi-Lo).
Municipalities fall under a much less frequently visited section of the code, Chapter 9. Because they typically have the power to tax, cities and counties rarely find themselves in sufficiently dire straits to warrant legally mandated relief. However, since the financial crisis, the elite club of bankrupt governments is growing in membership and includes Harrisburg, Pa., Jefferson County (Birmingham), Ala., and San Bernardino, Calif.
But Detroit is in a league all its own. With $18 billion in debt, the filing is the largest in U.S. history by a wide margin, four times bigger than the previous record holder. Importantly, that colossal debt includes over $9 billion in unfunded pension and health benefits owed to current and future retirees.
Therein lies a major obstacle in achieving a restructuring. In corporate cases, pension plans are subject to negotiation and potential reduction along with most other obligations. But municipal bankruptcies present special challenges, as pension and health benefits are typically protected by state constitutions, limiting the legal authority of courts to modify previously authorized payouts.
Given the magnitude of the city's financial hole and the impossibility of meeting current obligations, some reduction in retirement benefits will be necessary (along with significant reductions in the payouts to other creditors). Detroit is running a $380 million deficit and has been borrowing for years to pay current expenses (similar to putting the house payment on the credit card). As one large repayment came due and could not be rolled over, Detroit finally ran out of options.
Legal challenges have already been filed, and court battles will continue for a year or more. But despite the painful sacrifices that will inevitably be required, some good may come from the process. Litigation of pension reductions will establish precedent for future large city reorganizations. And just maybe it can serve as a cautionary tale for other troubled municipalities that still have time to act.
Christopher A. Hopkins, CFA, is a vice president of Barnett & Co.