As Detroit teeters on bankruptcy, creditors are left holding the bag

After decades of sad and spectacular decline, it has come to this for Detroit: The city is $19 billion in debt and on the edge of becoming the nation’s largest municipal bankruptcy.

An emergency manager says the city can make good on only a sliver of what it owes — in many cases just pennies on the dollar. A decision about whether to file for bankruptcy is widely expected this month.

Detroit’s dire fiscal condition is sending ripples of concern through the normally placid capital markets that all state and local government rely on to raise cash for everything from road improvements and school roofs to libraries and parks. Holders of Detroit’s municipal bonds — always touted as among the safest investment vehicles — are being asked to take on staggering losses.

It also has worried the city’s 9,500 employees and nearly 20,000 retirees, who have much to lose. Under the plan put forward by emergency manager Kevyn D. Orr, a former D.C. bankruptcy lawyer, retirees will have to absorb significant reductions in pension and health benefits.

The choice before bondholders and retirees is stark, given that both groups would inevitably face steep cuts in a bankruptcy.


Kevyn Orr, emergency manager for the city of Detroit, speaks at a public meeting at Wayne State University Law School in Detroit on June 10. Whether Detroit careens into the largest U.S. municipal bankruptcy depends on Orr’s convincing creditors during the next two months that his plan will revive a city plagued by deficits, crime and strained services. (Jeff Kowalsky/Bloomberg)

The city’s massive debt is matched only by a devastating loss of revenue and residents — a long-term condition that has escalated in recent years.

The city’s population has plummeted by 26 percent since 2000, while the unemployment rate has jumped from 7.3 percent to 18.6 percent. Property tax collections are down 20 percent and income tax collections are down by more than a third in just the past five years — despite some of the highest tax rates in the state. Even casino taxes, a bright spot in recent years, are projected to decrease because of increased competition from nearby Toledo.

All of that has led to an alarming erosion of municipal services. The city is home to nearly 80,000 abandoned and blighted structures. It recently announced plans to close 50 of its remaining 107 parks. Police response times are up to nearly an hour, and 40 percent of the city’s street lights do not work. Meanwhile, Detroit has the highest violent crime rate among the nation’s big cities.

“The best analogy I have heard for what is happening in Detroit is that this is a five-decade Katrina,” said Peter Hammer, a law professor and director of the Damon J. Keith Center for Civil Rights at Wayne State University in the city.

“Now, you either get a voluntary agreement from people holding long-term debt, or you get bankruptcy,” he added.

Orr has been searching everywhere for new revenue to help fix the problems. He has talked about spinning off the city’s water and sewer department into a separate authority. He has resurrected a proposal to lease the city’s beloved but deteriorating Belle Isle Park to the state. He also has reportedly explored selling some of the prized works owned by the Detroit Institute of Arts, as well as auctioning off a collection of vintage cars.

Meanwhile, the city is working to fan an encouraging trend for young people to move downtown. Several businesses, including Quicken Loans, have also moved their operations into the city’s mostly hollow core. But for the city’s fortunes to truly be reversed, analysts say that Detroit must first get out from under a mountain of debt — even if that means bankruptcy for the city and pain for creditors.

Yet Detroit’s plan to avoid bankruptcy has rattled investors and financial experts.

The settlement offer by Orr would treat holders of Detroit’s general obligation bonds no differently from investors who bet on risky securities with few guarantees.

That is spooking the municipal bond market, which has long operated under the belief that when a city is in fiscal distress, holders of bonds backed by the “faith and credit” of a municipality get most of their money back.

By ignoring those long-standing assumptions, the plan could cause “major repercussions for municipalities and bondholders alike,” according to a recent report from Morningstar. Even though many bondholders would be made whole by insurance, fallout from Detroit’s predicament could still come in the form of investors demanding higher interest rates when local governments try to raise money by selling bonds.

“This goes against the precedent of how the municipal market has believed things to be,” said Matt Fabian, managing director of Municipal Market Advisors, a firm tracking the municipal bond market. “It turns out that the distinctions between bonds are just window dressing, and that now when it really counts, they were not meaningful. This should give investors pause in buying general obligation bonds in Michigan.”

More generally, market watchers are concerned about the aggressive stance taken toward bondholders in Orr’s proposal. They say it reflects a sentiment that has grown since the financial crisis hit in 2007, when many Americans felt that policymakers bailed out Wall Street at the expense of Main Street. Now there is widespread feeling that institutional investors should more fully share the pain when fiscal distress hits.

A handful of municipalities have fallen into insolvency in the past couple of years, including Central Falls, R.I., Jefferson County, Ala., and San Bernardino and Stockton, Calif. In each case, there has been a growing opposition to “paying Wall Street,” or any creditors, at or near parity with employee unions, according to a recent Municipal Market Advisors newsletter.

“This is a change in focus, and likely a surprise for most of the municipal bond industry, who, to this point, have viewed their relationship with issuers as more a partnership than a contest for value,” the newsletter said.

But given Detroit’s fiscal state, some feel the city has few choices.

“There are a lot of businesses that have gone through bankruptcy and have come out and done well,” said Dennis W. Archer, a former Detroit mayor. “ Nobody wants to do that. But if you can come out and produce a quality product — in this case, a great city — where you are safe and the like, then it would be worth it.”

Michael A. Fletcher is a national economics correspondent, writing about unemployment, state and municipal debt, the evolving job market and the auto industry.
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