The Detroit Bankruptcy in Review
We are approaching the ten-year anniversary of Detroit’s 2013 bankruptcy filing. In light of 2022’s market downswing, as well as recent high inflation, this could be a useful time to brush up on the history of Detroit’s bankruptcy, as other distressed municipalities could find themselves in jeopardy in the future.
With over $15 billion in obligations at the time of filing, Detroit became the biggest municipality in U.S. history to file for Chapter 9 reorganization. Technically, that record still stands today, although in 2016 Puerto Rico began a process resembling bankruptcy, governed by a special act of Congress abbreviated PROMESA. States and territories do not currently have an avenue for bankruptcy, but the path for cities is well established under Chapter 9.
So what happened to Detroit? As background, consider that the city’s population declined by an incredible two thirds across 60 years. After a long period of decline accelerated by the financial crisis of 2008-09, Detroit’s access to the bond market dried up. Note that blaming the bond market for drying up misses the point. Borrowing capacity comes from the ability to service that borrowing, and the bond market sizes itself accordingly. Deficits, along with a dearth of opportunities to raise new revenue through taxes, created the problem. Once the bond market shut, deficits became impossible to finance.
Past a certain point, Detroit’s ship was simply destined to hit the bankruptcy iceberg. That point was probably crossed years before 2013. Perhaps the first lesson to glean here is that bankruptcy became the unavoidable conclusion of a very, very long process. Today, the troubled finances of cities like Chicago or New York do not nearly approach Detroit’s situation. Chicago, for example, started losing net population around the same as Detroit sixty-odd years ago, but its total population has drifted lower by only about 25%. A recent downturn after a long period of stability will put incremental pressure on Chicago’s budget—and Chicago already has above-average property taxes along with the highest sales tax of any major city in the country—but Chicago is still not facing anything like Detroit’s situation.
Over time, a larger and larger share of Detroit’s declining tax revenue was directed to servicing pension obligations. When pensions demand too large a share of a city’s budget, the result is often called “service insolvency” a euphemism for operational dysfunction. There is simply no money to do the things government is supposed to do. When high-tax municipalities struggle with things like basic road maintenance or emergency services, frequently the problem is that too much money is being directed to the people who did those same maintenance and emergency jobs in the past. Deficit hawks often complain about how the U.S. government is “mortgaging the country’s future.” In the case of cities, you can really see that mortgaging happen in real time. When troubled cities have received windfalls of Federal money intended for economic stimulus or Covid relief, that money has often been diverted to pensions. At some point, the city is being run for the pensions’ benefit, not the population’s.
Service insolvency and general dysfunction can cause a city to lose population, but taxpayers rarely pick up and leave because their street has too many potholes. Things have to get really bad and stay bad for a long time before a major city faces an existential crisis like Detroit. In some ways, it is amazing how long Detroit held out before bankruptcy. Perhaps the second lesson of Detroit is that cities can experience a decades-long pre-bankruptcy process where conditions get steadily worse before the city’s checks finally stop cashing.
All the involved parties were lucky that over $800 million of outside assistance came from charities and the state of Michigan in a funding package known as the Grand Bargain. The Grand Bargain staved off threats to repossess the Detroit Institute of Art’s collection, which at the time was listed as an asset of the city itself. The Grand Bargain gave the state an ongoing oversight role in the city’s affairs, which has probably been helpful in keeping the bankruptcy plan on track over the past decade. A third, perhaps obvious, lesson of Detroit’s bankruptcy is that it helps if the process is subsidized by outside parties. If we witness any more major municipal bankruptcies in the future, it will be interesting to see what role outside benefactors play in the process.
The outcomes from bankruptcy were not as bad as feared. Early concerns about potential losses for bondholders and pensioners turned out to be exaggerated. After being threatened with losses of 80%-90%, general obligation bondholders ultimately received “haircuts” of only about 25%. Some bondholders and creditors received lower amounts due to less favorable surety backing their obligations, but their cuts were not as severe as those early threats. Meanwhile, bonds specifically backed by water and sewer revenues were repaid in full, in keeping with the bankruptcy code.
In truth, bondholders and other “traditional” creditors were a relatively minor stakeholder in the bankruptcy. The city’s total direct financial obligations to financial creditors were in the vicinity of $1 billion. Detroit’s biggest creditors by far were pensioners whose obligations were underfunded by many billions of dollars. Threats of 50% haircuts on pension payments did not ultimately materialize, as haircuts ranged from just 0%-4.5% on day one. However, health benefits were cut drastically, and future cost of living raises were reduced or eliminated. Consumer prices have risen about 30% in the past ten years, so those missing inflation adjustments really add up! A hypothetical 55-year-old retiree in 2013 would have been faced with surprise out-of-pocket health insurance expenses over the past ten years, which would only start to fall this year once they qualified for Medicare at 65. Adding the drag from inflation, that is a serious lifestyle setback. Between healthcare cuts and more modest reductions in cash benefits, pensioners’ total benefits have probably been reduced by about one third, on average. Here we have a fourth lesson of municipal bankruptcies, that pensioners are effectively the bankrupt city’s main lenders and stand to lose the most.
Detroit itself seems to have benefitted from bankruptcy, as its budget has mostly remained balanced over the past decade, Covid-related disruptions notwithstanding. The city is not nearly out of the woods financially, particularly as its bankruptcy agreement calls for it to start contributing to its pension funds again after a long hiatus starting in 2024. However, property values have stabilized and increased since the bankruptcy filing. 2017’s opening of Little Caesars Arena was another positive development. The tax base is improving. Detroit still has a long way to go but has seen improvement over the past decade. The bankruptcy process was a blessing in some respects.
Miles Putnam, CFA