Detroit Under Siege

The city faces a rough road as it makes its way through bankruptcy.
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Detroit is living on borrowed time and borrowed money. “Detroit is technically insolvent,” said Emergency Manager Kevyn Orr in early June. He explained that on a cash flow basis, the city lacked the money to make payments to municipality-based contractors, some of whom had been waiting up to six months for the products or services they’ve already sold to Detroit.

Orr, an expert in municipal restructuring and bankruptcy litigation, took an 18-month assignment in March to repair Detroit’s financial situation sufficiently to enable the city to attain long-term financial viability. He said he preferred to leave the city in such shape that it could operate in a manner that avoids bankruptcy. But when some creditors balked at being paid as little as 10 cents on the dollar, the filing was inevitable — and today it constitutes the largest municipal bankruptcy in U.S. history.

Now, Orr’s assignment is very clear. By October 2014, under current law — whether at the direction of the bankruptcy judge or through the city’s own actions — hundreds of aggrieved parties will experience considerable monetary pain in order to enable the city to wipe out its losses and emerge from bankruptcy having restructured contracts, revenue streams, and operating expenses. His goal is to augment public health, safety, and welfare, and he doesn’t flinch when noting that these objectives supersede creditor interests.

Such interests, he stresses, range from bondholders to pension funds representing retired city workers. Orr says pension contracts, which formerly were considered untouchable, must now be brought into the court proceedings because the accumulated unfunded liabilities on these promises couldn’t be paid off for 68 years, even if there were no further additions to their existing sum of $15.6 billion.

Orr emphatically describes reality this way: On average, U.S. cities spend 80 percent of their budgets on here-and-now services related to protecting the lives and property of residents. This implies that 20 percent of their budgets fund “legacy costs,” such as city worker pensions, health care, and other acquired debt payments.

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By stark contrast, Detroit spends around 43 percent of its budget on legacy costs and if nothing is done, Detroit’s legacy costs by 2017 will absorb 65 percent of annual revenue — leaving meager amounts in the operating budget to support primary citizen services. This rapidly developing scenario has handicapped Detroit’s ability to provide even basic services expected of the city such as trash pickup, lighting, water, roads, and other operations. Further deterioration in operations would affect the quantity and quality of health, fire, police, and welfare-related assistance.

So, where is Detroit headed? What is the roadmap for exiting bankruptcy, and how will the process play out?

 

The Road Ahead

Before examining what Detroit might look like post-bankruptcy, it’s useful to take instruction from what other cities are doing and what they have already done to confront (and, in some cases, overcome) seemingly impossible fiscal crises.

Nearly 40 years have elapsed since New York awakened to its own brink-of-bankruptcy nightmare. Orr refers to New York’s 1975 impending bankruptcy as “a much worse crisis” than that now facing Detroit. Today, cities from coast to coast confront similar choices between restructuring and/or declaring bankruptcy, including Harrisburg, Pa. and, in California, San Bernardino and Stockton.

Like Detroit, New York had, for many years, been trending toward budgetary oblivion, complete with a breakdown in services. Burgeoning crime, recurrent trash pile-ups, and work stoppages attracted unwelcome national and global attention. In 1975, an independent state agency, Municipal Assistance Corp., was established. “Big MAC,” as it was known, sold nearly $10 billion in bonds to keep the Big Apple solvent through the worst of its crises. Today, such borrowing in current dollars would require $44 billion.

Much of New York’s fiscal mischief, like that of Detroit’s, resided in the city’s inability to pay its bills, along with the weird absence of any obligation to balance annual budgets. In exchange for MAC’s large-scale borrowing as a crutch to support New York’s transition to solvency, the city was required to submit a five-year budget that included half a decade of spending plans.

Also, the city was saddled with mandates to submit its budgets to outside scrutiny; in this case, a separate New York State body known as the Financial Control Board. Herein lay the checks and balances, oversight, and transparency that should always exist, especially in public accounting on behalf of taxpayers.

In retrospect, the beauty of New York’s approach to resolving its chronic budgetary woes is that MAC did its job and then shut down, without trying to perpetuate itself with new spending contrivances. MAC set a good example. The agency paid severance to its last three employees, sold its desks and computers, and then closed its doors. Ironically, this year, it is now the state of New York that currently faces growing financial turmoil in the form of a $21 billion deficit between 2013 and 2016.

There are other, more timely episodes of municipalities struggling to come to grips with fiscal threats — in this case stemming principally from ominously large legacy costs, especially pensions and health care benefits, in Stockton and San Bernardino.

In California, as in Detroit, daily operating budgets that fund basic citizen services — from EMS to housing shelters — are being squeezed to the danger point by longer-term contractual payments required by the California Public Employees’ Retirement System (CALPERS) to fund current and future worker and retiree pension funds. For the most part, these legacy costs consist of defined benefits.

They are, by most generally accepted private accounting standards, seriously underfunded because promised benefits are predicated on rates of return on investment well above 7.5 percent per year. If rates of return yield 4 to 6 percent, rather than 7 or 8 percent, the pension funds will fail to generate the healthy, generous stream of benefits promised to current and future retirees. To resolve these funding deficiencies, either contractual beneficiaries must take a reduced payment or the cities must raise taxes. Often, a combination of both is proposed.

However, as Doug Bernstein, a partner at Plunkett Cooney in Bloomfield Hills, points out, San Bernardino recently opted to divert some revenue away from CALPERS to fund its operating budget. In this way, the city plans to restore essential services to its residents (Stockton, until now, has declined to follow that same path).

If San Bernardino can short-circuit its seminal contractual obligation — a scenario faced by scores of large cities across the country — and it survives legal challenges and derailment by special interests, then much of America’s debt can be eliminated in less time than many analysts now fear.

Another source of optimism for ultimate resolution of Detroit’s fiscal dilemmas relies on a combination of resources, both internal and external, that can be applied to a troubled municipality.

With the perspective of decades, Michigan cities have availed themselves of fiscal expertise from the outside. Emergency financial managers have put Benton Harbor, Ecorse, Flint, Hamtramck, and Pontiac back on track. And in Grand Rapids, a critical mass of private-sector wealth, wisdom, experience, and innovation came from within the city to help solve its past fiscal problems. Both methods — external and internal assistance — brought a clean slate to residents.

 

Let’s Not Kid Ourselves

Admittedly, responses to the fiscal crises noted above offer tangible hope for a reset of Detroit’s financial situation. Nevertheless, the task ahead is daunting for Orr and those most financially at risk.

As an experienced emergency manager, Orr has pulled no punches. He lists the guts of Detroit’s financial drift, giving meaning to the expression, “Detroit’s Death Spiral.” He began by noting the ongoing implosion of the city’s population. Since 1953’s peak of 1.8 million residents, Detroit’s population, according to the 2010 U.S. Census, had already shrunk to 713,000. The Southeast Michigan Council of Governments estimates the city’s current population at around 685,000, reflecting the perception of deteriorating conditions when it comes to safety, property values, and economic opportunity.

It’s true that Detroit and Michigan have benefited from better-than-expected auto sales, despite slow overall U.S. economic recovery during the current business cycle upswing. Yet the city’s unemployment rate, while down from a recession peak of 23 percent to 18.3 percent as of mid-year, remains well above the U.S. city average of 14.2 percent, according to the U.S. Bureau of Labor Statistics (for cities with populations above 620,000 residents). More significantly, city revenue from income taxes in 2012 was only two-thirds what it had been at the city’s peak.

To convert the skeptical, Orr compares the stress-points of city finances to one’s personal budget. If Detroit were an individual earning $1,000 per month, that person would owe $1,800 per month, thus requiring greater sums of borrowing each year to make up the difference between income and outlay. If a family member or friend were supplying the extra funds, the borrowed money could no longer be considered loans but, rather, outright grants, never to be repaid.

Orr states unequivocally that in Detroit’s case, the coming months will see payments to creditors, contractors, and debt-holders deferred. “We must break our addiction to debt,” he says. In bankruptcy court, disparate interests will be brought to the bargaining table in order to relieve the existing debt burden on the city. To affect positive change, Orr specifies changes in work rules in the labor arena, the streamlining of city operations, and relief from current debt obligations.

Attorney Bernstein explains the “ultimate showdown” of filing for bankruptcy merely initiates an even greater focus on the substantive issues, which revolve around pensions and health care contracts.

Pat O’Keefe, president of O’Keefe, a strategic advisory firm in Bloomfield Hills, cautions that “courts typically are not fond of embroiling themselves in extended, intense, intricate, and high-stakes negotiations among aggrieved parties.”

Therefore, the more relevant question centers on whether the Michigan Constitution protects Detroit’s public employee pensions — or does federal bankruptcy law take priority in determining the outcome? Unions might prefer taking the Chapter 9 pathway, believing federal law, by which bankruptcy courts are guided, trumps state law. The thinking here is that the federal system might provide more sympathy to their contracts, although that is open to debate.

O’Keefe suggests that there is always the possibility of a trade-off arranged between sizeable health care cost savings (because health care benefits don’t carry contractual state protections like those afforded to pensions) and the promised pension funds. The thought here is that an agreement might be reached on some “carve-out” of health care concessions to protect pensions, or the plans will be covered under the Affordable Care Act, or Obamacare.

For bondholders and most creditors, significant and painful losses of income are likely to occur. Even for secured bondholders, there is some speculation that only 70 cents on the dollar would be forthcoming.

A “danger point,” according to Bernstein, “is that there exists virtually no case law to act as precedent for Detroit’s bankruptcy proceeding.” He added there are “no publicly documented opinions from the relevant courts by which to instruct judges.”

 

Time Is of the Essence

As the weeks available to effect Kevyn Orr’s preference for a strong and successful bankruptcy reorganization speed by, it becomes imperative to ratchet up the action.

Not unlike the difficult and never-ending alliance-building required by Gen. Dwight Eisenhower in the European Theatre of Operations during World War II, Orr is tasked with commanding, cajoling, and comforting disparate interests in order to focus the parties on the efficacy of winning the war.

Failure to do so is analogous to fighting an expensive, exhaustive, World War II-type combat over the next 14 to 16 months, only to confront continued trench warfare thereafter if the city isn’t reorganized correctly.

This is why Orr may well engage in running ideas and alternatives up the flagpole over the balance of 2013 and into next year. It would not be unusual for his team to leak information to media or affected groups and individuals in order to cement support for final restructuring.

Under a successful bankruptcy process, Detroit must emerge with manageable debt and a scaled-back, but more efficiently operated, budget. Its budgetary horizon would span five years at a time, with thorough and frequent audits conducted by outside municipal finance experts. Competitively bid services would predominate throughout the budgeting and contract categories, with annual feedback from all vendors.

Indeed, sizeable savings and benefits are now accruing to taxpayers and residents throughout Michigan and across the country, thanks to more competitively bid and outsourced services as well as the sale or leasing of unmanaged or improperly managed assets and properties. Undoubtedly, some of these initiatives hold tremendous promise for Detroit as it emerges from Chapter 9. Referencing some successful turnaround efforts from the past two years is illustrative.

In the summer of 2012, Chicago sought large-scale competitive bids to fix major portions of its infrastructure. Two firms now compete head-to-head with city workers to deliver cheaper, but superior quality, curbside recycling for Chicagoans. Officials report cost reductions of $2 million in the first six months alone, a 35 percent savings.

Several investment firms are lined up to supply capital for improving and constructing 750 miles of water pipes for the sewer system, rapid bus transit and transit stations, municipal buildings, and numerous parks and playgrounds. Midway Field is also considered saleable, the idea being that invested capital from the private sector would be recouped in user fees, according to the Los Angeles-based Reason Foundation.

Also instructive for Detroit’s workout is Sandy Springs, Ga. The city, comparable in size to Lansing, has earned the title “The city that privatized everything.” Facing utter fiscal chaos, the city’s interim manager, Oliver Porter, today boasts that Sandy Springs is fixed and thriving.

He says the city “owns no buildings and very little equipment, so we don’t fret over depreciating assets or property.”

 

In a sense, this represents enlightened 21st century thinking because Porter recognizes that few municipalities or other public bodies publish balance sheets or capital statements.

According to the Mackinac Center for Public Policy, Porter has said the secret to outsourcing and load-shedding (sales of assets and services to private firms and individual entrepreneurs) is “shopping around with private vendors. The key is writing the contracts well,” Porter insists. Sandy Springs’ accomplishments include bringing fire and police into 401(k)-defined contribution retirement plans, rather than offering pensions such as those that are creating massive funding shortfalls for Detroit.

Meanwhile, cities and universities in Ohio, Kentucky, and Oregon have privatized 18-hole golf courses, small airports, and power grids in order to focus on core operations. Closer to home, more than half of Michigan’s strapped school districts (e.g., Fowlerville and Utica) can now redeploy into classrooms millions of dollars in annual savings derived from competitively bid custodial, cafeteria, transportation, and health care functions.

Many other avenues to significant reform lie ahead. Foley, Minn., for example, a town of 2,600, is replacing some public police with a private security force. Foley officials estimate their savings at $53,000, tantamount to a 40 percent yearly gain in productivity.

To that end, Detroit could share service providers with other bordering communities where economies of scale and quality improvements are negotiated and monitored. These arrangements could cover parks and recreation, utilities, transportation, maintenance agreements, and other cost-effective contracts. Other efficiencies might evolve for trash-hauling, fire, police, EMS, and other services. Top spending priorities require augmenting money for protection of citizen lives and property, and elevating the results of such spending.

According to Orr’s analysis, Detroit’s annual revenue now hovers around $1 billion. It would be another colossal error in judgment to assume that this annual revenue stream will grow over the next few years, or that the imposition of higher tax burdens would somehow keep businesses and individuals from leaving Detroit.

Under such circumstances, the clear minimum objective of restructuring is to adopt the U.S. city average that 80 percent of any municipal budget be used for basic services. Doing so will free up $250 million each year in Detroit. To get there, an extra 23 percent of Detroit’s budget now made up of worker and retiree legacy costs and other contractual liabilities and debt are no longer affordable.

If the parties to the restructuring are unable to align themselves with this essential amount of reform, then we will see a greatly extended period of fiscal agony, population unrest, and loss of local control in Detroit.

 

The Chapter 9 Scenario

History demonstrates that with good leadership, Detroit has proven itself to be a masterfully dynamic and innovative city. But without citizen cooperation, inspired by real leadership characterized by attributes of trust, vision, and energy, it is difficult to meld the critical mass necessary to overcome near-term financial threats. Due to Detroit’s Chapter 9 filing, its financial uncertainties have become magnified for all to see. Fiscal hurdles will seem insurmountable, and long-term creditworthiness may remain impaired, even when emerging from bankruptcy.

Pension issues — possibly the single largest part of an overall resolution — could be tied up in the courts for years. Even during current restructuring discussions, parties to the debate cannot agree on the amount by which pension debt is underfunded. Furthermore, on many other seminal issues, jurisdictional matters are unclear and untested. O’Keefe muses that if the court were to consider the impact of pension cutbacks on pensioner-family spending on food or other necessities, the judges might look very differently on the Detroit Institute of Arts’ estimated $2 billion in assets. What Orr considers “off the table” as an asset belonging to Detroiters might well be considered by the courts to be an asset worthy of sale.

O’Keefe observes that some might consider General Motors’ bankruptcy as replicable for Detroit. But GM, besides being a private, for-profit, corporate entity, was very different. He notes that GM’s bankruptcy had heavy federal structures imposed, and moved very swiftly. Neither condition is likely to prevail in Detroit’s case.

The more one studies Detroit’s past and present difficulties, the more there is excitement, coupled with gnawing tension, as to the outcome. Most of the tension stems from knowing that months of vicious wrangling lie ahead. Excitement wells up from an understanding that Detroiters possess an ever-present, special spirit of risk-taking and bargaining — an ingrained desire to win over the odds and showcase results that can inspire others. If Detroit can prevail in the realm of municipal finance in a manner that truly reinvigorates the entire state, it will relegate its financial nightmare to a thing of the past.

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