Initial Thoughts on the Detroit Bankruptcy

Over the past four months I have been working on a report that reviews both the economics and law surrounding state bankruptcy. I intend to summarize some of my findings once the report comes out. What I have learned suggests several important points about Detroit’s recent filing for bankruptcy.

First, Detroit’s case is likely to reaffirm the precedent that pension benefits can be cut in bankruptcy, even for existing retirees. This had already been established by Central Falls, RI where pensions were cut by up to 50 percent (although the state agreed to make up half of the cut for the first five years) . The cuts in Michigan are also likely to be deep. This is despite the fact that the state constitution protects pensions. Federal bankruptcy law governs. Unions, which have been assuring their members for decades that the pensions will never be touched, regardless of the level of underfunding, are likely to face a growing level of concern among their members. We may see unions placing relatively more emphasis on pension funding and less on wages in future negotiations.

Second, unions are benefiting from a curious turnaround in the calculation of Detroit’s liabilities. For years Detroit followed the standards set by the Governmental Accounting Standards Board and discounted future pension benefits by the assumed rate of return on pension assets, currently 8 percent. Most economists believe these obligations should be discounted at a much lower rate. Unions have strongly resisted doing this because it increases the estimated underfunding. In calculating Detroit’s liabilities, the Emergency Manager lowered the discount rate to 7 percent. This apparently had the effect of giving the pension plan an additional $3.5 billion in unsecured claims, thus ensuring that workers get a larger share of the total recovery. Had he used a risk-free rate as most economists advocate, retirees would have had an even larger claim. It seems that using a lower discount rate actually benefits unions as a city or state approaches insolvency.

Third, any final plan to emerge from bankruptcy is likely to include significant asset sales, possibly including the estimated $2 billion worth of art owned by the city. The law is not clear on whether Detroit’s creditors can force the city to sell these assets against its wishes. But the fact that they account for approximately ten percent of the losses that bondholders and pensioners are being asked to take and that many retirees will press for their sale in exchange for smaller cuts may influence the city’s position.

Fourth, it is interesting that retiree health benefits have been included in the list of claims against the city. Unions and governments have long argued that retirees do not have a legal right to these benefits. Since they can be withdrawn at any time, cities should not have to prefund them. But if this is true, then they should also not be listed as an unsecured asset in a bankruptcy proceeding. The fact that they have been indicates that governments should begin to set aside money to pay for future claims. This will add a new strain to city budgets.

Fifth, I expect this filing to move relatively quickly. Although a state judge issued an injunction ordering the city to withdraw its petition, federal law governs. If higher state courts do not remove the injunction, federal courts will. I do not think creditors will succeed in challenging the petition, since the city is clearly insolvent and has tried to negotiate a deal. The real test is how quickly the Emergency Manager can put together a plan for emerging from bankruptcy. I expect him to act quickly and to present a plan that is fair to all creditors, given the financial circumstances. If he does this, there are not many grounds for the court to refuse approving it, even if a majority of creditors object. This area of the law is still undefined, however.

Last, there should be no bailout. Steven Rattner, has recently argued to the contrary. His reasoning seems to hinge on the assertion that “the 700,000 remaining residents of the Motor City are no more responsible for Detroit’s problems than were the victims of Hurricane Sandy for theirs, and eventually Congress decided to help them.” This is false. The victims of Hurricane Sandy were hit by a natural disaster whose damage was largely beyond their control. Detroit’s failures are largely the result of decades of mismanagement and corruption by both elected leaders and union officials. If the residents of Detroit are not responsible for the quality of its elected officials, who is? And if city workers are not responsible for the positions taken by union leaders, who is? Democracy only works if people accept responsibility for the leaders they elect. Bailing out Detroit would dramatically reduce the pressure on other cities and states to reform their finances. The bailout of Wall Street is still preventing regulators from dealing with banks that are too big to fail. And the government’s interference in the auto bankruptcies set bad precedents that we may still someday regret, despite the strong rebound of the companies involved.

Finally, debt reform of one type or another was inevitable. The money simply is not there. The first rule of getting out of a downward spiral is to hit bottom as quickly as possible. Only then does the future become brighter than the past. Although bankruptcy can eliminate Detroit’s debt overhang, its real future will depend on a willingness to create an environment that is welcoming to all people and businesses. That has been a relatively foreign concept.