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Could bankruptcy be the answer?


"Those municipal bonds that were used to patch holes in the city's budget were like sub-prime loans," says the Metropolitan Detroit AFL-CIO's Chris Michalakis. - PHOTO FOR MT BY W. KIM HERON
  • Photo for MT by W. Kim Heron
  • "Those municipal bonds that were used to patch holes in the city's budget were like sub-prime loans," says the Metropolitan Detroit AFL-CIO's Chris Michalakis.

Let's call it the "B" word.


The word that dare not be uttered.

Detroit's ongoing financial crisis has created a vocabulary of decline. There are the widespread layoffs of workers, with severe pay cuts and increased health care costs for those who remain. Meanwhile, residents are forced to endure the consequences of deteriorating city services. Malfunctioning streetlights leave some neighborhoods in the dark for months at a time. Ambulances break down on their way to emergencies. Police can take hours to respond to calls, if they come at all. Grass in parks goes uncut. 

Austerity is the word of the day as the city operates under the terms of a consent agreement forced on it by Gov. Rick Snyder, with state-mandated appointees now exercising newly created power.

Amid all the suffering, though, there is one group that remains untouched by the demands of sacrifice: the banking industry that played such a large role in creating the crisis in the first place. A housing bubble fueled by widespread fraud and predatory lending practices that targeted the poor and minorities drove America into its most severe economic meltdown since the Great Depression. 

When that occurred nearly five years ago, Detroit was already in deep trouble. Decades of flight from the city and the decline of the auto industry here combined to decimate the tax base.

To deal with its chronic budget shortfalls, the city began borrowing massive amounts of money for its general fund obligations. But surviving day-to-day on borrowed millions meant piling up long-term debt, a sea of red ink that by some estimates approaches $21 billion.

That works out to about $30,000 for every man, woman and child living in the city, according to a study done by the consulting firm Foster McCollum White & Associates.

Despite all this, the powers that be have declared that the lenders who provided all this money — knowing that they were doing so despite long-term trends showing the city's revenues were in steep decline — have declared that, no matter what suffering others may endure, the banks will be protected.

There is a mechanism that could, in theory anyway, force the bondholders to share in the sacrifice. But that option has been taken off the table. 

And it's not just for the city of Detroit. Struggling municipalities and school districts across the state that sink into insolvency and find themselves under the control of state-appointed financial managers who have near-dictatorial powers can see labor contracts broken and public assets sold off, but none will be allowed to default on any debt.

The controversial emergency manager law, formally known as Public Act 4, guarantees that will be the case, mandating that financially stressed municipalities and schools taken over by the state must pay in full "all bonds, notes, and municipal securities of the local government and all other uncontested legal obligations." 

Forget about any inherent risks on the part of lenders. 

According to the analysis done by the state-appointed financial review team in May, the city's "mounting debt problem" resulted in it paying nearly $600 million in debt service in 2010. That same year, the ratio of long-term debt to total net assets was more than 32 to 1.

Even so, when Gov. Snyder appeared before rating agencies last summer, he assured them that they had no reason to fear the "b" word, telling them that bankruptcy "was not on the table" for Detroit or any other Michigan city.

As the Free Press reported at the time, the declaration filled the governor with glee:

"Detroit's not going into bankruptcy," Snyder told reporters, as he beamed with encouragement from his meetings Monday with three top bond rating agencies in New York. He said he hopes Michigan's rating returns to the highest levels possible.

It is a joy that critics on the left fail to share.

Not that they want bankruptcy. It's not something anyone wants to go through. But, they say, given the circumstances, fairness demands that everyone share in the sacrifices that are necessary. City workers, pensioners and residents are all feeling the pain. Why shouldn't the bondholders, to employ a widely used euphemism, get a "haircut" along with everyone else?

Especially considering the dubious nature of some of these loans.

In 2008, according to the financial review team's report, the city engaged in a swap agreement, hoping to obtain better interest rates. Instead it ended up losing what amounted to a bet with the banks that interest rates would rise. Consequently, when rates fell, it ended up having to pay "hedging derivatives" which, over the life of the debt, added an additional $1.1 billion to the amount owed by the city.

Detroit is far from alone is suffering such severe setbacks.

What's come to light recently is a scandal involving what's known as the London Interbank Offered Rate, or Libor, which is supposed to be a "reliable reflection of the rate at which banks are lending to each other." But, as a story on the AlterNet website noted: "It has been widely reported that Libor ... was rigged by a banking cartel ..." What's been widely missing from the coverage, according to the left-leaning nonprofit news organization, was that the Libor rate was used to manipulate, not just tens of millions of consumer loans, but hundreds of trillions of interest rate contracts (swaps) with municipalities across America and around the globe."

The consequences are far-reaching.

Last year, Alabama's Jefferson County filed the largest municipal bankruptcy in U.S. history when it declared it was unable to deal with debt totaling more than $4.2 billion. The primary reason for its financial downfall, as reported by the Bloomberg news service, was a massive sewer project "dogged by political corruption" and a "derivative-laden" refinancing scheme.

Until recently, municipal bankruptcies, which fall under Chapter 9 of the federal bankruptcy code, have been relatively rare. Even when the law first came into effect, to help cities struggling to survive during the Great Depression, it wasn't widely used.

New York City declared bankruptcy in the 1970s. In 1994, Orange County — one of California's most populous and prosperous counties — filed for bankruptcy. As the New York Times reported, officials in that county accused Merrill Lynch and other Wall Street firms of encouraging the county treasurer to "borrow hundreds of millions of dollars on behalf of the county and to invest in exotic, highly volatile securities." The resulting losses totaled more than $1.7 billion by the time OC went belly-up.

In the Pennsylvania capital of Harrisburg, city officials have been battling with the Legislature and governor in an attempt to file bankruptcy so that they can get out from under the crushing debt of a municipal incinerator deal gone bad.

Tova Perlmutter, executive director of Detroit's nonprofit Sugar Law Center — which has gone to court in an attempt to have PA 4 ruled unconstitutional and is helping represent a coalition trying to pass a referendum on the controversial law in November — tells Metro Times that the position taken by some Harrisburg officials is instructive.

An editorial in the Harrisburg Patriot-News summarizes what Perlmutter says is a salient point:

"As the city tries to find a way out of more than $317 million in debt for a city of less than 50,000 residents, the basic game plan has been clear for a while: Sell and lease city assets, renegotiate union contracts and get concessions from creditors. ... [But] it is virtually impossible for Harrisburg to get out from under its debt without the threat of bankruptcy. That does not mean the city will ultimately have to go into Chapter 9, but it will almost certainly need to use the threat of bankruptcy as a negotiating carrot."

By taking bankruptcy completely off the table, Perlmutter says, the city loses the leverage it would have when attempting to negotiate with bondholders and creditors.

But Gov. Snyder isn't the only one determined to keep that arrow out of Detroit's quiver. The Bing administration is also opposed to even considering bankruptcy as a viable option.

"There is no upside for the City of Detroit to declare bankruptcy," Deputy Mayor Kirk Lewis says in reply to an e-mailed question. "It would hobble the region and the state. We believe we can fiscally stabilize the city by re-prioritizing our spending and creating revenue enhancements. Today we're able to provide city services to our citizens, in part, based on our ability to borrow. If we stop paying our lenders, we lose that ability and that just isn't an option."

Meanwhile, other municipalities outside of Michigan do perceive some advantage to bankruptcy.

The Reuters news service reports that there have been nine Chapter 9 municipal bankruptcy filings in the United States so far this year. In California alone, three cities have filed for bankruptcy in recent weeks. Two of them — Stockton and San Bernardino — have a combined population of more than 500,000 residents. The third, Mammoth Lakes, is a small resort town in the Sierra Nevada Mountains.

Another California town — Vallejo, which is near San Francisco — successfully emerged from three years of bankruptcy protection last summer.

There's good reason for all this action. As noted in the Washington Post:

"Declaring bankruptcy used to be a last resort for cities, not only because it would cripple their ability to borrow for years to come but because of the blow to their reputation. But that attitude has started to change as more cities have found themselves facing fiscal catastrophe; bankruptcy offers an opportunity to start over with a clean slate."

An online legal journal, AmLaw, summed up the results of the deal Vallejo agreed to:

"That plan calls for reduced interest payments to bondholders, scaled-back health benefits for city workers, and retooled collective bargaining agreements with municipal labor unions that will cut pay for Vallejo employees ..."

The bottom line, according to one of the lawyers who represented the city, which racked up a reported $11 million in legal fees, was this: "Everyone's taking a hit, that's the maxim of bankruptcy."

It is a maxim that should be applied to Detroit and the rest of Michigan, say critics of Snyder's stance and PA4.



Under current law, there's no straight path to Chapter 9. A city or school district in financial distress has to be under the authority of an emergency manager, who is the only one who can recommend bankruptcy. If that happens, it is up to the governor to make a final determination.

Which means that, at least the way things stand now, it's not going to happen.

Among those who disagree with that position is attorney Kenneth M. Schneider. A lifelong resident of the city whose firm Schneider Miller has a downtown office, Schneider laid out his feelings in a letter to Metro Times.

He points out that Detroit's financial crisis has many causes, including suffering "more than our fair share of crooks and incompetents in local government."

But there's much more to it than that. Spurred by federal policies, the city's residents began making an exodus to the suburbs in the 1950s, when the population reached a peak of nearly 2 million. By the time of the 2010 census, that figure had fallen to 713,000. And the hemorrhaging continues unabated. According to the most recent estimate from the Southeast Michigan Council of Governments (SEMCOG), slightly more than 685,000 people remained in the city as of December 2011.

That drastic drop, coupled with the loss of high-paying manufacturing jobs, put the city in a seemingly intractable downward spiral. Even the best of politicians would have been hard-pressed to avert the crisis now facing the city, Schneider asserts.

He likewise thinks Detroit will be unable to cut is way to solvency.

"The state's emergency financial managers, advisory boards, and other measures are politically offensive and ultimately ineffectual," he contends.

Part of the reason they're ineffectual, he explains, is that the severe austerity measures being imposed will only serve to drive even more people away as services decline even further, continuing the spin downward.

"We have to maintain our basic services, but we can't do that and sustain all the debt we have," he asserts. "We're going to chase the rest of the taxpayers out of the city. We have to let the bondholders share in the pain."

Chris Michalakis, president of the Metro Detroit AFL-CIO, see things similarly.

He points to the series of bonds issued between 2005 and 2011— totaling more than $600 million — that the city used to plug short-term deficit holes in an attempt to remain solvent.

"Those municipal bonds that were used to patch holes in the city's budget were like sub-prime loans," he says. "They carried a high reward for the bondholders because they were supposed to come with a risk. But the way it has worked out, they're getting their high rate of interest but assuming zero risk because of the way they are being shielded. That's the opposite of how free-market capitalism is supposed to work. I see it as another way of bailing out Wall Street. The banks made bad decisions, bad investments, and they should have to suffer the consequences of those decisions."

When it's pointed out that the former union members now receiving pensions and medical benefits from the city — one of the primary costs proving to be an overwhelming burden — would also have their fate in the hands of a federal judge, and could be hit hard if the city were to declare bankruptcy, Michalakis doesn't waver.

He admits that, from the viewpoint of labor, bankruptcy harbors both pros and cons. In the end, though, he says it comes down to a matter of fairness. And what's not fair is for workers, retirees and residents to bear the brunt of the crisis while the banks are allowed to skate.

On the other side of the issue is John Llewellyn, vice president of government relations at the Michigan Bankers Association.

In his view, allowing Detroit to enter into bankruptcy would be a terrible mistake.

As with the Snyder and Bing administrations, a primary concern for Llewellyn is the potential for collateral damage bankruptcy could cause — not just for Detroit, but also for other municipalities and the state as a whole.

The concern is that once one city, especially one as big as Detroit, defaults on debt, other dominoes will tumble, and the cost of borrowing will go up for everyone, including the state itself.

It is a legitimate fear, says Robert W. Doty, a Sacramento-based financial adviser to bond issuers and the author of a primer on municipal bonds.

The way he sees it, any city that enters into bankruptcy and seeks to cause losses for the bondholders who invested in it, runs the risk of "dooming their future.'

"If you attack lenders, you can't expect them to come back and loan you money in the future. You put a curse on your name."

Llewellyn agrees.

"You can't willy-nilly attack the confidence of the markets," he says. "People need to know they have a safe place to invest their money."

And then there's the matter of image. For people outside of the state, Detroit and Michigan are largely perceived as one and the same. The stigma of bankruptcy would attach itself to the whole state.

As for all the positive images generated by efforts such as the Pure Michigan campaign, well, you can just kiss that goodbye, goes the thinking.

All of which is part of the reason he helped form Citizens for Fiscal Responsibility, the business-oriented group that has challenged the proposed emergency manager referendum based on the claim that the heading on petitions that were circulated had an inadequate font size.

As for the fairness issue, Llewellyn, who points out that he was born in Highland Park and says that the feeling of distress seen in Detroit on his visits now is "palpable," says there's no guarantee everyone's going to walk away from bankruptcy happy with the decisions handed down by a judge. 

"Everything is very cloudy going in, and there's no guarantee everybody is going to love the options when they come out," is the way he puts it.

But for Frank Joyce — a communications specialist who advises the Sugar Law Center and a longtime community activist who has been studying the effects of PA 4 — the key word is "everybody." 

"A bankruptcy judge is required to bring everybody to the table" and spread the pain fairly. Among those sitting at the table, he says, would be duly elected city officials. 

Joyce and attorney Schneider both also make the point that, rather that scaring investors away, its possible that the type of restructuring that can occur in bankruptcy would result in a city that is on a much more stable financial footing, making it more attractive in the long run. 

Don't get the wrong idea, says Joyce.

"It's not that I think bankruptcy is some panacea," he says.

But neither is PA 4. Look, he says, using Detroit Public Schools as Exhibit A. On its second emergency manager, the district continued to go deeper into debt because the underlying problems of funding and student flight haven't been solved.

There's also the issue of disenfranchisement felt when authority is stripped from elected officials, Joyce says.

Detroit City Councilman Kenneth V. Cockrel Jr., in an interview with Metro Times, says he's reluctant to talk at all about the possibility of bankruptcy, explaining that the financial markets carefully follow the views of public officials and could end up downgrading the city's credit rating based on some stray comment.

He did caution proponents of bankruptcy to be wary, making the point that there are no guarantees of debt relief if the issue ever did end up in front of a judge.

Interviewed by phone on Friday, hours after the state Supreme Court ordered that a referendum on the emergency manager law be put on the ballot for November, Cockrel pointed out that another level of uncertainty has been added to the whole issue.

There is another factor at play as well. As Joyce observed, there's no guarantee that even an emergency manger could lead Detroit into financial solvency. Which would mean that the city could still end up declaring bankruptcy.

After all, many of the problems that brought it to this point remain unresolved. People continue to flee a city struggling to provide services while dealing with the crush of overwhelming debt.

Just because there are a lot of people who fear even uttering the "B" word, it may still be unavoidable.


Curt Guyette is Metro Times news editor. Contact him at [email protected]

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