Detroit could be weeks away from the most spectacular municipal bankruptcy ever. If it defaults the right way, investors and other US municipalities will scream bloody murder — but it’s a lesson they need to learn.
The Motor City’s bankruptcy will be different from anything we’ve seen before. In 1975, New York needed a federal rescue because it spent more than it earned. But it could pay everything it owed, after a time-out.
Detroit is just plain broke. With a $1.1 billion budget, it owes $15 billion.
That would be like New York (no fiscal paragon) owing $844
billion. (In fact, it owes “only” about $200 billion, including promises for retiree health care.)
Detroit’s debt payments and retiree-health-care costs consume one-third of its budget — and almost all its revenues from property and income taxes. Even if it could turn itself around as New York did, it’s dug too deep.
Plus, the debt prevents a turnaround: Money that should go to picking up the garbage and policing the streets instead goes to creditors.
As bankruptcy lawyer Kevyn Orr, the emergency manager appointed to fix the city’s finances, wrote last month, “without a significant restructuring of its debt, the city will be unable to break the cycle of damaging cutbacks in essential municipal services.”
The best thing that can happen to the city now is bankruptcy done right.
Last week, the local media gave the impression that Orr was about to sell off everything from the Van Gogh in the museum to the giraffe in the zoo to pay off lenders. Unused to being in the public eye, he stuck to a line that would sound innocuous in a corporate bankruptcy, “We have to look at everything on the table” — but that just fueled speculation.
Orr should be clear: The giraffe’s not going anywhere.
A municipal bankruptcy isn’t a corporate liquidation — and Detroit’s not going out of business.
The federal law governing city bankruptcies says a judge can’t make Detroit sell the art. “The assets of a Chapter 9 debtor” — like a city — “cannot be liquidated involuntarily,” report experts at the Jones Day law firm.
Yet a city default does have something in common with a corporate default: Some “stakeholders” agreed to a lot more risk than others did.
In the complex world of classes of creditors, the giraffe has a stronger claim than most bondholders.
The bulk of Detroit’s debt burden isn’t ironclad obligations. It owes only $1 billion in “general obligation” bonds — ones backed by the city’s “faith, credit and taxing power.”
It also owes $1.5 billion to bondholders who took a clear risk. Seven years ago, bondholders and insurers lent Detroit money through “certificates” to make its pension payments. If the fact that Detroit couldn’t pay its pensions amid a national boom weren’t warning enough, the documents said in capital letters that “the payment obligations . . . are unsecured contractual obligations of the city. Neither the faith and credit, the taxing power nor any special revenues of the city are pledged.”
These bondholders were on notice that they could lose their cash before the giraffe goes hungry.
But that won’t make it easy for Orr to stiff those creditors.
Indeed, he’ll be making nationwide waves. He may also find himself blamed for the fact that other cities and states must pay more to borrow.
How’s that? Well, if bondholders worry that other cities and states could default, too, they could sell their holdings — causing important people and institutions to lose money.
Municipal debt in the United States totals about $3 trillion, and it’s not just banks who hold it; plenty of regular people do, too — often through mutual funds.
For this reason, you’ll see rising calls for Uncle Sam to bail out the Motor City — or, rather, its creditors.
But pain out of Detroit would actually be a good thing. For example, it would be better for the people who lend money to New York state’s hundreds of public authorities (like the MTA) to (finally) ask if the state ever plans to do anything about its own rising health-care, pension and debt costs — before it gets too late.
Instead, bondholders figure if a New York issuer needed a rescue, some knight will come along.
In a true free market, people who make risky investments don’t get bailed out when the downside materializes. By sticking to that principle, Detroit can help itself as well as others.
That means kids’ right to see art comes before investors’ right to avoid losses.
The bondholders were experts who signed up for risk; the giraffe didn’t.
Twitter: @nicolegelinas