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On July 18th, Detroit filed for bankruptcy, making it the biggest municipal default in American history. Contemporary observers of the city would be hard pressed to tell that it was once one of the fourth most populated cities in the country and produced three-quarters of America’s war machine in the Second World War. Detroit’s bankruptcy has been decades in the making, a consequence of political corruption, deindustrialization, globalization, “white flight,” and poor budgeting. Given that Detroit’s tenure in bankruptcy court will likely last until the end of 2014, if not beyond, extempers will face a host of questions this season about how Detroit got to this point, how it can fix its debt, whether the federal government should come the assistance of the beleaguered city, and what impact its bankruptcy may have on the rest of the United States, namely those cities who are approaching the same fiscal cliff that Detroit has already driven off of.
This brief will provide a brief overview of Detroit’s problems, how those problems are being addressed at present, and then discuss implications of its bankruptcy. Readers are also encouraged to use the links below and in the related R&D to bolster their files about this topic.
Road to Disaster
As noted above, Detroit was once the fourth largest city in the United States and as The Atlantic notes on July 25th, it was the Silicon Valley of its day. The major automotive companies that made Detroit home, notably General Motors, Ford, and Chrysler, were centers of research and development and funded the city’s prosperity. However, this prosperity began to erode by the middle of the twentieth century. First, carmakers started to relocate their operations to Southern states to escape the clutches of the United Auto Workers (UAW) union and the move towards globalization in the 1980s and 1990s, bolstered by free trade agreements like the North American Free Trade Agreement (NAFTA), saw automakers start basing their operations abroad. This left fewer high paying jobs in Detroit that once attracted young citizens to the city. Also, African Americans began to come to Northern cities like Detroit seeking work. Middle and lower class whites, who had an unwelcoming attitude towards the newcomers because of the economic competition that they posed since African Americans were willing to work for lower wages and who feared that African American movement into their neighborhoods would depress property values, began to leave the city by the 1950s. This “white flight” created a situation in Detroit akin to other places of African American migration like Newark, New Jersey and St. Louis, Missouri whereby white, affluent suburbs lined an inner city core made up largely of poor, minority residents. In 1943 an 1967 these racial tensions exploded into riots, with the 1967 episode lasting five days, leaving forty-three dead, and 1,100 injured. As The Washington Post of July 26, 2013 notes, Detroit’s population dropped nine percent in the 1960s as 385,000 whites fled the city, but African American migration into the city increased by thirty-seven percent. Today, African Americans are eighty-three percent of Detroit’s population. Taken together, these two causes, among a host of others, depopulated Detroit and its population in 1950, which stood at more than 1.8 million people, according to USA Today on July 25th, now stands at 701,000.
The ultimate effect of this depopulation is that Detroit had fewer tax dollars to support city services and infrastructure. The poor residents left behind had a lack of skills and did not make enough money to keep these services running smoothly. In an act of financial suicide, city politicians and planners, who have been Democratic since 1962, did not find a way to match the city’s declining tax base with services and benefits offered to city workers. Thus, as Detroit’s fiscal problems were getting worse, city planners kept digging a deeper hole. The result is Detroit’s current fiscal mess, whereby the city owes its creditors more than $18 billion.
Another failure of Detroit is to maintain an environment that people want to live in. Political corruption, which has a tendency to flourish in single party controlled environments because there is little outside incentive to change, flourished under Mayor Kwame Malik Kilpatrick, who was elected in 2001 at the age of thirty-one and considered a future leader in the Democratic Party. Kilpatrick took over at a time when Detroit appeared to be recovering, with new casinos and hotels downtown. However, as Forbes noted last week, his administration was rife with corruption as he made the city pay for meals and a family car. He also used his office to funnel contracts to a preferred city contractor and evaded taxes. Amazingly, despite rumors of corruption and alarming evidence of mismanagement, Kilpatrick was re-elected in 2005. He was forced out of office in 2008 after an affair was unearthed with his chief of staff and he was subsequently convicted on fraud and tax evasion charges. This past March he was also convicted on 24 of 30 charges, which included racketeering, bribery, and extortion, all of which may land him in prison for the rest of his life. It is estimated that Detroit lost a quarter of its population under Kilpatrick’s tenure as mayor and his legacy lingers in the ruins of Detroit. Consider these alarming facts (provided by the previous cited USA Today article): the city’s unemployment rate is 18.6%, it has 78,000 abandoned buildings, 66,000 vacant lots, forty percent of its street lights do not work, it takes an average of 58 minutes for the police to respond to a criminal incident versus eleven minutes nationally, and only 8.7% of its crimes are solved. In this environment it is hardly surprising that young people and young families refuse to live in Detroit and participate in the revival of the city.
Fixing the Problem
Michigan has taken an economic beating more than any other state over the last twenty years. Its recession began nearly a decade before the credit crash of 2008, which nearly plunged the economy into a depression. In 2010, former businessman Rick Snyder, a Republican, was elected governor to replace outgoing Democrat Jennifer Granholm. In a story that did not receive as much coverage as neighboring Wisconsin, Snyder set to work reducing the unfunded liability in Michigan’s Public School Employees Retirement System (MPSERS) and his reforms have reduced what was a $45 billion pension liability by more than $30 billion. As The Christian Science Monitor pointed out on July 21st, these reforms forced school employees to contribute more of their money towards healthcare plans, introduced a voucher system like what Wisconsin Representative Paul Ryan wants to do with Medicare, and places employees into a 401k benefit-style plan for retirement.
When Detroit’s fiscal woes appeared unsustainable, Snyder, with the help of the state legislature, appointed Kevyn Orr, a restructuring specialist and University of Michigan graduate, as an emergency manager for the city, with the power to restructure union contracts with the 43 public sector unions in the city and negotiate deals with Detroit’s various creditors. Orr represented Chrysler in its 2009 bankruptcy and as a tip of the cap to Detroit’s racial makeup, he’s African American. The Huffington Post of July 24th provides an excellent analysis of Detroit’s fiscal obligations and extempers should click on this link to access a graph showing its obligations and an explanation of those obligations. It’s a great tool that you can place in your files, unlike this brief. Unfortunately, as The Christian Science Monitor of July 18th points out, Orr was only able to get Bank of America, Corp. and UBS AG to accept a reduced amount of what they were owed, amounting to 75 cents on the dollar. Since it is estimated that Detroit has over 100,000 creditors this was not an acceptable arrangement, so Orr announced on July 18th that the city would file a Chapter 9 bankruptcy.
The Huffington Post of July 24th spells out what this Chapter 9 bankruptcy means for the city. Chapter 9 of the bankruptcy code deals with municipal bankruptcies, but less than 500 cities have qualified for it in its history, which dates back to 1937 when Congress was dealing with bankrupt cities in the Great Depression. Currently, Detroit is before a federal judge, Steven Rhodes, who will evaluate whether Detroit qualifies as “insolvent.” This means that it cannot pay back its debts and has made a good faith effort to pay those it owes but cannot reach a meaningful settlement. This, of course, is open to interpretation. Those who hold bonds to the city argue that they should not have to take a “haircut”, which means that they will receive less of what they owe, possibly ten cents on the dollar, and labor unions argue that Orr has not negotiated with them in good faith. It is important for extempers to recognize that in this case, federal bankruptcy law supercedes state law, which has important ramifications. Detroit’s pension debts, which make up $3.5 billion of the city’s overall debt, and healthcare debts, which total $5.7 billion, are considered unsecured debt. Unsecured debt means that those who are owed do not own physical assets or property that can be seized in the event of a bankruptcy. Unsecured debts are typically handled after secured debts in a bankruptcy process and Orr has indicated that pensioners may only get ten cents for every dollar they are owed like some bond holders. The tricky legal question is that Michigan’s state constitution, like that of other states such as New York and California, prohibits an impairment of pension benefits. However, since Detroit’s bankruptcy is a federal question, this constitutional provision may be null and void. If it is, it could set a dangerous legal precedent for municipal unions in places like Chicago to deal with. Judge Rhodes has already placed a freeze on state actions to halt Detroit’s bankruptcy, clearly paving the way for a settlement in his courtroom.
One advantage of a Chapter 9 bankruptcy is that it will not allow other creditors to propose an alternative plan to what is being offered by Orr. Orr’s preliminary plan calls for the city to exit bankruptcy court in September 2014, where he hopes the court will rule on Detroit’s insolvency and determine how much, if anything, it owes its creditors. However, this is an accelerated time scale since it typically takes longer for a year to determine a city’s insolvency and their plans to move out of the bankruptcy process. For example, it took Stockton, California, which went through a very rough bankruptcy process like what Detroit is doing now, more than a year to be declared insolvent. Orr’s preliminary bankruptcy plan, released in June 2013 calls for demolishing vacant buildings in the city, privatizing public transportation, and imposing an income tax on commuters into the city, who cost it more than $40-$45 million annually, according to The Huffington Post of July 24th. However, regardless of how long the process takes or what plan is adopted, Detroit will have a long road to recovery and needs to find a way to consolidate its territory. The Washington Post of July 26th points out that the city is too big spatially for the residents that currently live there. For example the Post explains that Detroit has 700,000 people spread out over 140 square miles, which would be like taking the population of Washington D.C. and spreading it across an area the size of Manhattan, Boston, and San Francisco combined. The size of the city complicates its upkeep, as some places look like warzones, while others are densely populated and others, like downtown, are home to renewed construction of residential and commercial buildings. Detroit architecture expert Dan Austin summarizes this nicely in saying that “Most cities practice something called urban planning but Detroit is more like Jackson Pollack, where you throwing something wherever you can.”
Implications
The big question about a Detroit bankruptcy is how pensioners will be handled, both with their pension checks and healthcare benefits. Detroit faces a problem in resolving its $3.5 billion pension debt because if it significantly reduces pensions it could hurt the revival of the city because many elderly retirees still live there. Less purchasing power equals an economy that remains in the doldrums. Also, a significant reduction of benefits would impair Detroit’s ability to attract qualifier public servants. The city has already lost qualified police and firefighters because of cuts Orr has already imposed on workers, which include how much they can be compensated for overtime. The Christian Science Monitor of July 20th takes a more long-term view and says that if Detroit manages to impair pension benefits, it could lead to other cities like Santa Fe, Oakland, and Chicago to follow suit.
Conservatives fear that a federal bailout will eventually be given to Detroit, which they are wanting to call the second bailout of the city following the automotive bailout of 2008-2009. Potential 2016 Republican presidential candidate and Kentucky Senator Rand Paul has said that Detroit will be given a bailout “over his dead body.” The Obama administration has given passive signals that a Detroit bailout is not on their agenda, potentially recognizing the moral hazard of giving a bailout to the city and having other localities and even states follow through in the near future. President Gerald Ford in 1975 refused to bailout New York City, so any hopes by Detroit of an Obama rescue are slim, especially with a Republican controlled House of Representatives. The public at large also opposes a Detroit bailout, with a Quinnipiac poll finding that sixty-eight percent of independents and seventy-three percent of Republicans oppose it, although fifty-one percent of Democrats support it. The issue also breaks on racial lines as sixty-three percent of whites oppose it, but fifty-seven percent of African Americans, and forty-eight percent of Hispanics support it. Nevertheless, while the Obama administration may not give Detroit a direct bailout, Obamacare may give the city a boost, which has conservative commentators up in arms. The Washington Times, bastion of conservative thought, wrote on August 1st that Orr’s plan is to take city employees who take early retirement, which means they retire before the age of sixty-five, usually after twenty-five years of service, and toss them onto the new healthcare exchanges set up by the Affordable Care Act. Under this plan, Detroit would not have to pay the full healthcare premiums of early retirees and would instead give them a small stipend, with Obamacare funding the rest of their premiums, since the legislation requires subsidies up to 400% of the poverty line. Unlike private businesses, local governments are not penalized for dumping coverage for their retirees. Conservatives fear that if Detroit follows through with this other municipalities will follow, which is what Chicago is moving to do alongside Detroit, and that this could add $1.4 trillion to the federal debt, on top of $58 trillion in Medicare and Medicaid debt of the next seventy-five years, and $17 trillion in additional debt created by Obamacare.
Another implication of Detroit’s bankruptcy is that if the city gives unsecured bondholders a significant haircut, its borrowing costs will explode in the future since it will be deemed a significant credit risk. Also, Detroit going under proves that no municipality is safe from bankruptcy and it could sent shockwaves through the municipal bond market, making bondholders reluctant to lend money to cities that are approaching Detroit’s situation. With higher borrowing costs, Detroit may find the funds for a recovery hard to come by and it could face Stockton, California’s future where crime continues to flourish, people continue to leave the city, and young people stay away.
Finally, there is the political equation in Detroit’s bankruptcy. Snyder faces re-election in 2014 and a successful rescue of Detroit could boost his re-election hopes in what is, in national terms, a blue state. A successful rescue of Detroit could also make him a potential presidential or vice-presidential contender. One reason that I do not think that Detroit will receive a federal bailout is that if President Obama tried this it could result in blowback against Democrats in 2014. Faced with the chances of possibly reclaiming the House in 2014, President Obama will likely avoid talking about Detroit as much as possible. There is also a heavy racial component in Detroit politics that cannot be ignored. For the city to right itself, wealthier white suburbs like Oakland County, which is one of the wealthiest counties in the country, may need to assist in Detroit’s rescue. However, white suburban residents have distanced themselves from the minority core of the city and it is unlikely that they favor cooperation. These tensions have played out in the past when Detroit’s ability to host major events has been questioned by the suburbs, which led Councilwoman Barbara Rose-Collins to argue that “European rulers have traditionally taken what they wanted from other people, be they white, be they black or be they brown. No one is taking anything.” For Detroit to be rescued, these tensions must be reduced and people of all races in Greater Detroit, which includes its suburbs and the urban core, must come together and focus on a unified vision of what can get Detroit back to prominence. That is going to be easier said than done, considering the lingering historical racial antagonisms in the city, but it is probably the surest way for Detroit to recover.