The Dimming of Detroit

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On Friday, July 19th, 2013, Governor Rick Snyder authorized the Chapter 9 bankruptcy requested by Emergency Manager Kevyn Orr for the city of Detroit.  Specifically, the city was unable to make a scheduled payment of $39.7 million for pensions and sought federal court protection in a bankruptcy proceeding.  While a combination of urban flight, auto industry restructuring, and government mismanagement all played a role in the steady decay of the Motown City, the eventual ruling from federal bankruptcy court may have significant ramifications throughout the U.S.

A Chapter 9 bankruptcy allows municipalities to receive protection from creditors as they seek to renegotiate more favorable debt repayment terms.  Detroit city officials are hoping that a federal court judge will grant a favorable ruling that extracts major concessions from bondholders, creditors, unions, and retirees.  On the other hand, creditors and bondholders are holding out hope that the bankruptcy proceedings will result in declines in compensation and benefits for city employees and retirees, so that will free up more money to pay back their investments and loans extended to the city.

There are two extreme scenarios to look at this issue:

  • Scenario 1:  Force bondholders and creditors to take a significant loss on their bond investments which will help facilitate the city’s efforts to reorganize their finances to fulfill agreements with unions and retirees.
  • Scenario 2:  Invalidate union and pension agreements and impose significant cuts to beneficiaries, so that can free up finances to pay back bondholders and creditors.

In all probability, neither scenario is likely and there will probably be some hybrid of both.

While Scenario 1 would be celebrated by union and retirees, this would be the worst case scenario for the financial community.  There is obvious appeal with this option because those most vulnerable to the financial crisis, blue-collar workers and retirees, would not see their standard of living impacted.  Even though highly-compensated bankers and investors would be subjected to severe losses, they have abundant resources to withstand it.

Though populists would love this result, there are potential long-range consequences that would be hurtful to the overall economy.  An unfavorable ruling to creditors will likely result in a credit crunch for cash-poor municipalities.  There is already a premium that municipalities faced when seeking funds to cover budget shortfalls.  That will only be exacerbated if the federal judge rules harshly against the creditors, who will be less enthusiastic about extending credit to poor municipalities without demanding even higher premiums.  It could also emboldened local officials to continue making irresponsible spending choices and not face harsh outcomes because they can go to a federal district judge to wipe away their debts.

Choosing Scenario 2 also carries significant political risks.  While bond investors would be overjoyed with this ruling, that will only embolden political activists to express their rage over the immoral, greedy actions of bankers.  Imagine the sympathy generated by showing retirees, who have limited means to recoup losses that were previously promised to them, struggling to make ends meet as health care cost rise and bills mount.  Contrast that image with the smug image of a well-groomed executive in a Jaguar and plush mansion.   That would be a public relations disaster for the financial community and will only increase calls for greater financial reform where more stringent regulations could hamstring corporate profits and restrict compensation levels.

Another problem with Scenario 2 is that it creates a moral hazard where taking on irresponsible risk is rewarded.  The declining fiscal finances have been well-documented over the last decade.  City of Detroit public officials have been convicted or indicted on charges of embezzlement and financial mismanagement.  Bondholders were already rewarded with higher than market returns because the default risk at Detroit is higher than most cities.  With that higher return, there is more risk.  Therefore, they should accept huge losses in this case and allow markets to work.  Poor decisions should result in severe consequences, otherwise markets will not function properly.

While it pains me to see that collateral damage will be felt by ordinary Americans, we must allow markets to run its course in this case.  Pain must be spread to all parties, though the brunt should be felt by the financial community.  Any result that overwhelmingly favors one party over another will only lead to more irresponsible actions in the future.  Investors must realize that there is no such thing as a risk-free investment.  When finances of an underlying bond falter, they must realize the consequences of a poor investment.  If that means losing all or a substantial portion of principal, then consider that to be a hard knocks lesson to learn.

Let this also be a lesson to citizens that there is huge downside to running large fiscal deficits, so they must hold their public officials accountable.  While we expect our government to provide quality service, we must realize that paying these services through more debt and higher taxes are not sustainable.   That will only drive wealth out of a community and lead to further decline and decay.

While the shade of indebtedness is dimming Detroit, let us ensure a brighter future elsewhere by shining the spotlight on poor investment practices and shoddy fiscal management.

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