As Goes Detroit, So Goes Your Local School District

Detroit is in trouble. According to Kevyn Orr, the emergency manager appointed by Michigan’s governor to lead the city’s restructuring, Detroit has racked up 17 billion dollars of liabilities—a tab Orr claims the city simply cannot pay.

Choices for creditors are stark. Pensioners, city workers promised healthcare, and unsecured bondholders—that is, those not holding revenue bonds tied to specific streams—must either agree to accept drastic cuts or roll the dice in bankruptcy court. “This would be the largest city to go bankrupt,” says Don Haider, a professor of management and strategy at the Kellogg School, “and it really would force the issue that no one wants to force of who gets paid, in what order.”

A Detroit bankruptcy would indeed be unprecedented. But this is by no means the first time a large American city has found itself on the brink. Haider knows a thing or two about this: he was the deputy assistant secretary of the U.S. Treasury in the 1970s when New York City was in a similar position.

New York City Then
Back then, says Haider, New York City essentially made up their own accounting rules: “Tomorrow’s revenues were today’s revenues…but we pay the bills when we pay the bills.” The system was “a Ponzi game,” says Haider, and whenever the city came up short, it borrowed money. Eventually, the city had accumulated so much short-term debt that it had more than a quarter of all of the short-term municipal debt outstanding in the entire country.

When the banks finally balked, the State of New York came to the rescue. But the rescue became untenable when the state’s credit ran dry. So the federal government stepped in, putting the city under a de facto receivership. Eventually, a deal was struck to ward off bankruptcy: city workers’ pay levels were frozen, pensions were placed at risk, and banks owed money were forced to buy even more unsecured bonds to refinance the city.

Eventually, in the late 1970s, the economy began to improve. This, combined with high inflation and frozen expenditures, allowed the city to climb its way back to financial health. But New York City’s brush with bankruptcy resulted in some long-lasting changes: generally accepted accounting principles (GAAP) were ushered in for state and local governments, as were tightened disclosure and revised bankruptcy laws. And, says Haider, the deal struck was (as in other bankruptcy and near-bankruptcy cases) designed to be so punitive to all involved that nobody would risk making the same mistakes in the future.

Detroit Today
And yet, here we are. Once again, says Haider, mismanagement, poor disclosure to bondholders, and an all-around unwillingness to truly accept that “everybody’s got to participate, everybody’s got to feel pain or face even worse consequences” has led Detroit where it is today.

Whether Detroit restructures inside or outside of bankruptcy court, the requisite haircuts are going to be severe—worse, predicts Haider, than what New York saw. For one, “there was a lot of slack” in the public services offered by New York City. “The Staten Island ferry was 10 cents. The actual cost was probably two dollars,” says Haider. “Tuition at the City University was free. New York owned its own radio station.” Detroit, needless to say, doesn’t have the same slack built into its public services.

In addition, New York City was the financial capital in the U.S., an extraordinarily wealthy city with a “tremendous ability to refinance itself.” But Haider questions whether Michigan banks could step up to help the city even if they wanted to. And with the State of Michigan reluctant to take on Detroit's debt, it seems unlikely that the federal government will offer assistance as it did to New York City and the State of New York.

“Profound” Ramifications of a Bankruptcy
None of this makes Haider optimistic about Detroit’s future. But while the city may be in trouble regardless of how negotiations unfold over the next few weeks, the implications of a bankruptcy would go far beyond Detroit.

“This bankruptcy may well open up huge risk factors and risk premiums that are going to ripple through the markets,” says Haider. “How are you going to structure bonds in the future [so] that they’re inviolable, that absolutely I will pay you—you can take my blood, you can take my bones?…If ‘full faith and credit’ doesn’t mean ‘full faith and credit’, then there will be a flight to revenue-backed bonds.” This would lead to severe credit crunches and impede local economies’ ability to operate and grow.

Especially in poorer areas. Wealthy municipalities may always be able to raise money with relative ease. But an underfunded local school district? Not a chance. “The rich are going to get richer and the poor are going to get poorer; it’s really going to sort out borrowers,” says Haider, forcing states to do more borrowing on behalf of less privileged local governments.

And even rich municipalities would be in trouble if the tax-exempt status of interest on municipal bonds were changed—an issue independent of a possible Detroit bankruptcy, but part of the uncertainty that overhangs the 3.7 trillion dollar municipal-debt market. Right now, such loans are effectively subsidized by U.S. taxpayers. But if the subsidies ended, municipalities would have to borrow on the regular market—a very expensive prospect.

Needless to say, the unglamorous but essential world of public finance faces rather turbulent waters these days—which a Detroit bankruptcy would only stir further. The only thing we can be certain of, says Haider, is that the various municipal bankruptcies that have begun to weave through the court system are headed all the way to the Supreme Court. Bankruptcy is messy, and bankruptcy judges will have different opinions about ‘full faith and credit’ contracts, obligations to pensioners and bondholders, and the conditions under which a contract can be broken. Says Haider, “The ramifications of this are really rather profound.”

Artwork by Felipe Briceño, a department administrator at the Kellogg School.