Eight Implications of a Detroit Bankruptcy

On December 3, to the dismay of its creditors—including the American Federation of State, County, and Municipal Employees (AFSCME), a union representing thousands of Detroit retirees—the city of Detroit was declared bankrupt.

Under federal bankruptcy code, municipal protection under Chapter 9 is not a given. One must first convince a judge of insolvency. This is precisely what happened when US Bankruptcy Judge Steven Rhodes sided with Emergency Manager Kevyn Orr. At more than 18 billion dollars in the red, he ruled, Detroit had in fact been bankrupt for years.

In another blow to the retirees, Rhodes also ruled that pensions were not protected under federal bankruptcy law. Don Haider, a professor of management and strategy at the Kellogg School and a former deputy assistant secretary of the U.S. Treasury, remains convinced that, one way or another, questions about the inviolability of city contracts—even where seemingly protected by a state constitution—will likely end up before the US Supreme Court. AFSCME is “going to appeal Judge Rhodes’ decision as fast as they can to get this issue resolved,” he says.

But there’s no guarantee that an appeal will come fast enough for Detroit’s creditors. Orr is determined for the bankruptcy to proceed as quickly as possible. “He would like to see Detroit out of bankruptcy by September,” Haider explains. “He wants to implement a plan to deliver basic services again, so people have police, fire, streetlights and buses, and predictability of city services."

Of course, the implications of the recent rulings extend far beyond Detroit, its citizens, and its 100,000 creditors. Whether and how Detroit recovers from bankruptcy—largely uncharted waters—impacts all government levels. What changes might we all see going forward?

Greater Need for Disclosure
In the past, little incentive existed either for municipal unions or city officials to disclose the full costs of negotiated contracts, whether salaries or future retirement benefits. Officials kicked the can down the road, says Haider, knowing full well that those who struck the deal would be out of office by the time the day of full-cost reckoning arrived.

Needless to say, that day has finally come—especially for older US cities: Detroit, Chicago, Philadelphia—the latter of which, for all practical purposes, couldn’t even open its schools this year. And the new order is changing what interested parties expect in the way of disclosure from cities.  The Chicago City Council, for instance, recently decided to hire its own budgetary staff and develop independent analytical capability—steps more local governments are likely to take. The SEC has also stepped up its expectations, finding last year that New Jersey and Illinois—in not disclosing the magnitude of their pension liability when borrowing—are therefore guilty of deceiving their bond purchasers. Citizens are also taking a closer look at city finances, questioning why, for instance, public employees contribute so little to their own health care. Finally, business and taxpayer groups are demanding transparency. Explains Haider, “They want to know: What is our future liability going to be?”

Changes to the Collective Bargaining Environment
“What’s happened in Detroit is happening in a lot of other cities,” says Haider, “and that is, their cost of labor and pensions and retiree healthcare is squeezing everything else off the budget.” In Chicago, for instance labor and pension costs eat up 75–85% of the city’s operating costs. That doesn’t leave much money for investments in education or infrastructure.

Having previously served as the budget director and chief financial officer for the City of Chicago, Haider knows a little something about negotiating union contracts. In the past, he says, all benefits previously won by unions were “established contractually”—setting a precedent and basis for future negotiations. But if a city can plausibly threaten bankruptcy, its financial weakness can in effect be its negotiating strength. Instead of a mayor telling unionized workers that the city can’t afford a new benefit level, explains Haider, “now you say, ‘We can’t afford it and what you are seeking may not be what you really want given our situation.’”

Stingier Benefits for Public Workers
This new reality could also put public workers’ existing benefits back on the bargaining table—speeding up, for instance, the transition from defined retirement benefits (received by more than 90% of public sector workers) to defined retirement contributions (already received by 70–75% of private sector workers). “I feel great sympathy for public retirees who learn that what they worked so hard for may not survive intact,” says Haider. “Going forward, what public employees enjoyed in the past is unlikely to be the same for future employees.”

New Political Alliances
Increased tensions between city governments and union workers could have political reverberations as well, Haider points out. Mayoral alliances with unions will be tempered by affordability, as well as a legal environment where the constraints of financial solvency will stiffen public response to threats of labor strife.

More Support for Cities Struggling with CalPERS
Few will be impacted by the Detroit ruling more than struggling municipalities in California. Four cities in California—San Bernardino, Valejo, Stockton, and Desert Hot Springs—are in the process of entering or exiting bankruptcy. But unlike Detroit, these cities have thus far been unable to touch the pensions of city workers. “CalPERS”—the California Public Employees’ Retirement System—“is like the 800 pound gorilla,” says Haider. Because CalPERS, the largest state pension system in the country, is a state institution, the argument goes, intervention by a bankruptcy court would violate the 10th amendment, which protects the sovereignty of states from federal bankruptcy law. But the recent decision that federal bankruptcy law trumps city contracts bolsters the argument that federal bankruptcy law could also trump state law. This would help cities like San Bernardino hoping to extract themselves from CalPERS’ grip.

Recognition that States Are Responsible for Cities
In the past, states have offered assistance to their local governments, helping them refinance debt, or borrowing on their behalf. But Michigan failed to intervene in time. “At the end of the day,” says Haider, “local governments are corporate creatures of the state. States are responsible for their local governments. And there are financial consequences should they let their local governments flirt with insolvency.” Borrowing costs for local governments across Michigan have increased, as have the costs for the state itself.

Arguably, Michigan has also incurred a reputational cost. “Here is its major city that is being dealt with in bankruptcy, [though] the suburbs are very sustainable.” The state didn’t respond sufficiently to Detroit’s decline as the city lost its population, industry, jobs, and tax base.

Harder for Cities to Raise Money
The precedent of a Detroit bankruptcy increases the risk associated with general obligation bonds. These bonds, backed by the full faith and credit of a municipality, were previously considered safe—very safe. But what does “full faith and credit” mean in an age where municipalities can declare bankruptcy? As unsecured general obligation bonds become riskier, it will cost cities more to raise money. Investors’ interest may trend more toward revenue bonds. “Detroit’s revenue bonds may be worth more than Detroit’s general obligation bonds,” says Haider.

A New Detroit
Haider watched first-hand as both New York City and Chicago dealt with nearly paralyzing financial hardships. As Chicago’s budget director, for instance, Haider watched the city’s industrial base erode, its jobs moving to the sunbelt: “I woke up some mornings thinking, Will the last person out turn out the lights?”

But New York City survived, and Chicago survived, and Detroit will survive too. “I think Detroit could have a really robust future,” says Haider, “But it has to get over this hurdle. Bankruptcy isn’t the worst thing in the world. It’s a tool. It’s a process. And it can facilitate getting on to a better future than the one Detroit has now.”

Importantly, says Haider, there is no evidence that Detroit signals an era of municipal bankruptcies and bond defaults. (Not least because bankruptcy doesn't come cheaply: Detroit's legal fees are reportedly approaching $100 million.) If anything, Detroit may simply serve as a catalyst for getting state governments more involved in the financial sustainability of their local governments; encouraging public sector unions to partner with their localities to accommodate the new financial environment; and enabling creditors to arrive at the negotiating table before the actual bankruptcy filing.

Editor's Note: The above photograph is used under a Creative Commons license. Credit belongs to Ann Millspaugh.