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Here’s how Detroit’s bankruptcy will actually work

Detroit: Hitting bottom. (Carlos Osorio/AP)

At 4:06 p.m. Thursday, Detroit filed a 16-page petition for bankruptcy protection. The action was expected, but it came faster than most observers had bargained for--and now everybody's trying to figure out what happens next. Here are the basics.

How is a city going bankrupt different from a company or a person?

Chapter 9 of the federal bankruptcy code, which applies to municipalities, counties, and other public entities like school districts and utilities, differs from Chapter 11--which applies to corporations--in a few important ways.

First of all, it's much rarer, with fewer than 700 cases since the provision was created in 1937, and 36 since 2010. For that reason, case law is still being settled--although Chapter 9 gives a municipality much broader authority to rewrite union contracts, only after the bankruptcy of Central Falls, R.I. did it become clear that cities would have the ability to escape their pension obligations.

It's clear, however, that Chapter 9 forbids debtors from simply dissolving to pay creditors, as a company might. Also, courts tend to have a less active role in the restructuring process, limited to approving a plan and making sure it's followed; the debtor doesn't need court approval to dispose of its assets as it pleases in the meantime.

Is it possible to emerge successfully from bankruptcy? 

Yes. A conscious, deliberate, enforceable reconstruction plan can actually put a municipality on a much firmer footing than any other process. Orange County, for example, emerged from its 1994 bankruptcy within a year, and nine years later had a triple-A bond rating.

Is there any way that Detroit could have avoided this one? 

Probably not. Michigan Gov. Rick Snyder had been pushing for it for months, passing a revised version of an emergency manager law that voters had rejected last fall. Detroit's appointed manager, Kevyn Orr, had only managed to work out deals with two large banks out of the city's tens of thousands of creditors. Its public employees unions, having already offered large concessions, were unwilling to lose as much as Orr says is necessary. With a tax base that's been cut in half over the last half-century, there's simply not enough money to satisfy everyone voluntarily.

I understand why Detroit had to file for bankruptcy. Why would it want to?

Along with gaining the ability to re-shape its contracts with creditors and public employees, bankruptcy grants cities a stay of all collection actions, buying them time to closely analyze their finances and put together a plan.

"This is a tool," said Orr at Thursday's press conference. "I understand that people who don't do this for a living see this as a negative." Instead, he explained, he sees it as a way of turning a city around.

Who gets hurt most? 

Detroit is about $18 billion in debt, and will only be able to pay out a fraction of that in the short term. The two main groups of creditors arguing they're entitled to that money are public employees and retirees, and bond holders. The investors are likely to make out better, since more of that debt is secured; the city will continue to pay water and sewer bondholders. Most of the pension debt has no similar backstop.

City residents will likely suffer a lack of anything other than the most rudimentary public services for a long time, but the impact is likely to be felt most keenly by those who lost a large chunk of the retirement they were counting on.

What are unions saying? 

They're livid about the likelihood of restructured pensions and health benefits, having already offered large concessions, and say they were trying to come to a solution before Orr raced to the courthouse to file the bankruptcy petition Thursday. And they've vowed to fight any default of the city's obligations ("It's war," says the head of the police and fire pension fund). So far, though, there's been no talk of work stoppages; city services will continue as normal.

What will the city have to do to work this out? 

Just because you petition for bankruptcy protection, and even get approved by the governor, doesn't mean you'll be able to go through with it.

Detroit will first have to prove that it is fiscally insolvent and filed the petition in good faith, which many of its creditors will dispute in a series of hearings. If a to-be-appointed judge grants the petition, the city manager will put together a reorganization plan, including cuts to services, the sale of assets, and reductions in what it plans to pay pensioners and bondholders. Then, according to the Detroit Free Press, it will have to put the plan to a vote of creditors. If not enough of them agree, the city manager could pursue a "cram down" procedure, asking a judge to rule that the dissatisfied creditors are not being reasonable. Orr has said he's aiming to bring the city out of bankruptcy by the end of next year, which most analysts view as very optimistic.

If he manages to put together a package of funds for reinvestment, Detroit may manage to become healthy again, but it will require more than just financial restructuring: The whole city needs to be reorganized into a smaller space, because it can't go on serving 40 percent of its former population over the same 140-square-mile footprint.

Will the state or federal government have to get involved? 

Steve Rattner, who oversaw the bankruptcies of General Motors and Chrysler, says Detroit's process will be much harder, since the city can't bank on rising revenues like the auto companies could. For that reason, it may have to seek financial assistance from the state just to keep city services running, and Rattner figures the Obama administration won't be interested in helping out. Gov. Rick Snyder, having pushed for the filing, may feel pressure to come through.

What effect will this have on other cities? 

The inevitable downside of municipal bankruptcies is that they make cities a riskier bet for investors, so they'll have a harder time raising money for public works like utility systems and bridges. But the stigma of bankruptcy has been fading as more cities go through it, and as the problem of out-of-control pension systems becomes more pervasive. And it's likely that Detroit, with its death spiral of disinvestment and mismanagement, will be considered sui generis--other cities around the country are doing much better, and bondholders may evaluate each on the merits.

"The situation for Detroit is just so unique," said Jack Dorer, a managing director at Moody's Investors Service, on a Reuters panel last month. "They are under dire financial straits, and I think the other high-profile bankruptcy cases that we've seen often involve things like enterprise risk, so it's different."

Other cities in Michigan might not be as insulated, though.