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What happens in Detroit

What happens in Detroit is not going to stay in Detroit. Financially, our local governments are very fragile, weakened from years of little growth and burdened by the legacy costs of an auto-based development pattern that is fiscally unproductive. Defaulting on Detroit's secured creditors will mean higher borrowing costs for many cities. Defaulting on Detroit's unsecured pensioners and retirees, on the other hand, is a cruel precedent that will impact labor negotiations across the country. These impossible choices we're now forced to consider can be made a little more managable for cities that begin shoring up their finances with a strong towns approach.

This is a big week here at Strong Towns with the release of Leigh Gallagher's book The End of the Suburbs, which includes quite a bit of Strong Towns thinking and references. We'll have more on this important book later in the week, but pre-order your copy today so you have it fresh when it comes out. The most important book of the year, guaranteed.

Believe it or not, Detroit is actually on the path to recovery. In the final years before bankruptcy, Detroit was borrowing money just to make debt payments, an amount annually that ultimately exceeded the city's revenue. This while the city crumbled and vital services were drastically underfunded. That's over now and, with a very credible (and I think workable) plan presented by Detroit's emergency manager, Kevyn Orr, I feel like Detroit has a real shot.

What happens next, though, is going to be very interesting in terms of what happens in the future for cities and states around the country.

Detroit's debt is reported to be $18.5 billion. Of that amount, $7 billion is secured and $11.5 billion is unsecured. That's not a minor difference.

Secured debt is backed by some type of asset or revenue stream. Last Friday I shared the news that Detroit is taking on additional debt to build a stadium for the Red Wings. (I'll say again -- that is not a joke -- a bankrupt city is actually building a stadium for a hockey team in the name of economic development.) That debt will be secured as the property tax revenue for the stadium and the development in the vicinity will be pledged to pay that debt. Without that pledge, it is highly unlikely that a bankrupt Detroit could get that loan.

Detroit has a casino that makes monthly profit payments to the city. (As a moral aside, gambling seems a pretty pathetic way to raise revenue from an impoverished population, especially in Detroit.) Those profits were pledged as collateral for debt the city took out to pay its bills. In fact, when the city suspended payments on that debt, the company that insured the transaction filed a lawsuit to seize that revenue, which the city is still receiving. In a strict contract sense, the city should lose that court case. The revenue is there, it was pledged to make the debt payment and so it must.

I suspect, not without reason, that we're not going to be operating in a strict contract sense here. That's because the $11.5 billion in debt that is unsecured is unpaid health insurance benefits to retirees and unfunded pension obligations to the same. In this case, "unsecured" means that if the money isn't there, these benefits don't get paid.

Let's pause here for a second. This is a horrible tragedy. As I quoted Charlie LeDuff a couple weeks ago, "Get the money together or the kids don't have a future." We haven't gotten the money together and so a lot of good, decent, honest people are going to get hurt. Hurt badly. On an individual level, that tragedy cannot be overstated. It is heartbreaking.

On a macro scale, however, there are some important generational reasons to ponder our situation. I'm not gratuitously casting blame when I note that the generation of retirees these funds are promised to inherited a country at its financial apex and rode it downhill in an unprecedented binge of debt-fueled consumption. A twenty five year old today entering the workforce -- or trying to -- not only has their own student loans to pay off but they have the burden of a national debt greater than our GDP that was rung up by a prior generation, the specter of taxes increasing to pay for unfunded retiree benefits that the same prior generation intentionally did not fully fund during their working years, they are having their current health insurance rates increase to lower the costs for this same generation, they have a stock market and a housing market that are being kept artificially inflated for the benefit of that same prior generation, they have trillions of dollars of infrastructure enjoyed by the prior generation but the maintenance of which is totally unfunded, and on and on and on.... 

So with Detroit, we're going to have the first really big conversation about the rights of retired government employees and society's -- specifically, today's employed workers' -- obligations to them. It is probably good that it is happening in Detroit instead of a place like California because there are few that can argue that a Detroit retiree is living a life of undue luxury. In other words, few gratuitous straw men.

Already the Michigan Attorney General, a Republican named Bill Schuette, has stepped in and said that retiree benefits are protected under the Michigan constitution. 

Michigan is almost alone in the nation with its explicit protection of public pension benefits in its state constitution. Because of that protection, the issue is sure to become contentious when U.S. Bankruptcy Court Judge Steven Rhodes is expected to take up the matter in the coming weeks.

Mr. Schuette, also a Republican, said he would join the Detroit federal bankruptcy case filed last week "on behalf of Southeast Michigan pensioners who may be at risk of losing their hard-earned benefits."

Mr. Schuette added that Michigan's constitution is "crystal clear" in stating that pension obligations may not be diminished or impaired.

That's an interesting -- and rather odd -- constitutional clause. If the city can't pay them, what are they supposed to do? For this case, however, that is not going to be the argument. The city can pay the pension benefits, but only if they stiff their secured creditors.

We have a face for the unsecured creditor -- the retiree on a fixed income who worked for years in the rough city of Detroit and now is barely making it on a small pension -- so let's put a face on the secured creditor. Who buys municipal debt?

The largest purchaser of municipal debt is -- yes, you guessed it -- pension funds. I couldn't find a figure on how much Detroit debt the two Detroit pension funds own, but needless to say, a default on secured debt will impact someone's pension fund.

Many wealthy investors also purchase municipal bonds. While the rates are low, the earnings are tax free and, of course, they are secured from loss. It is kind of funny too, in a gallows humor kind of way, to discover that European banks own about $1 billion of Detroit debt

Earlier this year, Cyprus experienced the first "bail in" of the European financial crisis. Instead of money being put into a country's banks to make them solvent -- alla Greece, Portugal, Spain and Ireland -- the EU required depositors at the bank to use their money to keep the bank solvent. It was just announced that 47.5% of the funds of large depositors would be seized by the bank (exchanged for equity in a worthless bank is the nicer way to put it). Markets were a little skittish that this might represent a new trend -- rob depositors to fix bank malfeasance -- but Cyprus was enough of an anomaly that it didn't seem to have long term consequences.

Let's go back a little bit further to the auto industry bankruptcy and bailout. Again, we had secured and unsecured creditors. In the government-led restructuring, the unsecured creditors received very favorable treatment while the secured creditor not so much.

One is an anomaly. Two is a trend. Three is on the way from trend to a new standard.

We can stiff these secured creditors -- sure -- and that might even feel like the moral thing to do, but it is not without ramifications. Those ramifications -- higher borrowing costs -- may not matter to Detroit when they can pay their bills again, but it will have a big impact on that next round of fragile municipalities. What type of interest rates are they going to have to pay to attract investors to buy their debt?

Municipal bond funds saw outflows of $1.2 billion in the week ending July 24, on concern that Detroit's filing for bankruptcy - the largest in U.S. history - will set an important precedent and more cities could follow suit. It was the ninth consecutive week of outflows from the fund type.

In Minnesota (hardly in the fiscal shape of Illinois or California), we are considering the construction of a $1.8 billion light rail line. Just a 2% premium on that project for higher borrowing costs due to skittish investors would mean an additional $110 million annually in interest costs (assuming a long, 20-year payback window). For perspective, that's about double the money my entire DOT district gets in an annual appropriation, just in added interest on one project.

For places that are really financially fragile, higher borrowing costs could be killer immediately. For the rest, it just adds to the overall pressure.

In short, what happens in Detroit is not going to stay in Detroit. Financially, our local governments are very fragile, weakened from years of little growth and burdened by the legacy costs of an auto-based development pattern that is fiscally unproductive. Defaulting on Detroit's secured creditors will mean higher borrowing costs for many cities. Defaulting on Detroit's unsecured pensioners and retirees, on the other hand, is a cruel precedent that will impact labor negotiations across the country. These impossible choices we're now forced to consider can be made a little more managable for cities that begin shoring up their finances with a strong towns approach.

Editorial Notes: Photo credit: Mike Russell/wikipedia

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