Skarbeck: Bankruptcy sends Detroit into uncharted waters

July 27, 2013

Ken SkarbeckDetroit’s record $18 billion Chapter 9 bankruptcy filing is by far the largest municipal failure in history.

The city missed a $39.7 million pension payment last month, which set the bankruptcy wheels in motion.

Detroit’s debts include $3.5 billion in unfunded pensions, $6.4 billion in unfunded health benefits, and $8 billion in bond debt. Included in the bond debt is a $1.4 billion cost for complex interest-rate swaps that backfired—derivatives designed by Wall Street banks that were supposed to help alleviate the city’s debt problems.

The city has two pension plans: the General Retirement System and the Police and Fire System fund. As recently as June 30, 2011, the plans proclaimed to be 83-percent and 100-percent funded, respectively. Kevyn Orr, the emergency manager for Detroit, now says those funding figures were misleading, boosted by unrealistic actuarial and investment return assumptions.

Analysis of the pension funds under “more reasonable assumptions” sliced the funded status of the general fund to 65 percent and the police and fire fund to 78 percent. Orr says the city would need to contribute $200 million to $350 million annually to fully fund promised benefits. Those contributions will not be made now that the city has filed bankruptcy.

Detroit’s troubles can’t necessarily be traced to lavish benefits obtained via union bargaining. Unlike some of the pension abuse stories exposed in California, the average pension for a Detroit city worker is about $19,000. Police and fire retirees, who do not receive Social Security benefits, collect about $30,000 annually.

Detroit’s decline has occurred over decades, fed by the troubles experienced in the auto industry and an exodus of population to the suburbs. Government mismanagement over the years has exacerbated the city’s slide. The city’s 139 square miles, capable of supporting 2 million people, now has 700,000 residents and a hollowed-out tax base that cannot support the cost of delivering government services.

The legal playbook for a large municipal Chapter 9 bankruptcy is largely undeveloped. Until recently, public pension obligations were viewed as untouchable contracts. However, in the 2011 municipal bankruptcy of Central Falls, R.I., retirees had their pension benefits cut 50 percent. And while the Michigan constitution prohibits cuts to public benefits, Detroit’s leaders argue that federal bankruptcy law trumps that prohibition. Orr has said all city workers could see sizable cuts in benefits.

Thus, the Detroit saga will establish new ground in the field of municipal bankruptcy. For example, general obligation municipal bonds have historically been viewed as safe and secure, backed by the pledge of government tax revenue. Yet already, certain Detroit general obligation bondholders have heard they may receive pennies on the dollar because of the city’s inability to increase tax revenue. Observers say a default on these bonds may harm the state of Michigan’s ability to borrow money at market rates, and could send repercussions throughout the broader municipal bond market.

Cities struggling with looming liabilities will be watching the Detroit bankruptcy for tactics on how they might handle pension obligations and bond debt in times of crisis.•


Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.


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