The Bankruptcy of Detroit: Part 2 Laura Fallon

How Can a Whole City Go Bankrupt?

Bankruptcy is essentially a legal construct in which a person, business or other legal entity can get relief from some of the debt it owes when it has no ability to meet its obligations and no realistic possibility of doing so in the future. Just like a person going bankrupt, the city had to show it really was in this situation and then go through complicated negotiations as to how much less its creditors would get and how it would move forward.

The process was long and fraught. In return for some financial help the State of Michigan had instigated greater financial oversight of the city council from April 2012. In February 2013 the state government took control of the finances of the city council appointing an emergency financial manager. A May 2013 report stated that Detroit was ‘clearly insolvent on a cash flow basis’ and would have a cashflow shortfall that year of $162m and a $386m budget deficit within two months. There were then unsuccessful attempts to persuade some creditors to voluntarily take a 10% haircut on their investments. The city defaulted on some unsecured debts and pension obligations in June 2013. It filed for Chapter 9 bankruptcy protection on the 18th July 2013.

The bankruptcy was fought hard primarily by representative of retirees of the city who were set to lose out on pensions and payments for healthcare if the city went bankrupt. The day after the bankruptcy was filed, 19th July, a judge ruled that the filing violated Michigan’s constitution due to its effect on pension payments and was not allowed. However federal US law does allow bankruptcy judges to renegotiate the pensions of municipalities on bankruptcy. It fell to a bankruptcy court to rule on this clash between state and federal law as to whether Detroit’s bankruptcy was actually legal, which it did, finally, on 3rd December 2013.

The bankruptcy process in the end took 17 months of what became known as ‘The Grand Bargain’. Negotiations were made with different groups of creditors as to how much they would lose. Out of $18 billion of debt the biggest chunks owed were $6.4 billion in debt backed by specific future revenue streams (such as tolls on a bridge, or ticket sales from a sports stadium), $6.4 billion was owed in post-employment benefits (mainly the healthcare costs of retired workers) and $4.9 billion was owned in pension obligations. Other debt was to wall street banks as part of swap counterparties and in generally issued bonds both secured and unsecured. Initially threatened with a 50% cut to their pensions, retired workers in the end had pensions cut by 4.5% with a slightly more painful stop in any cost of living increases. Deals were negotiated with other creditors receiving between 14% and 75% of their initial investment.

Perhaps the most publicised part of the case was whether 66,000 valuable pieces of art held by the Detroit Institute of Art would need to be sold to pay creditors. Art or pensioners? In the end $800m was raised voluntarily by pleas to save the art collection. This included from the foundations of the automobile firms that had made the city famous and from private philanthropists. The institute was then made a private organisation independent from the financial health of the city government.

Nine years on from it filing for bankruptcy protection the City of Detroit is in somewhat better shape and, the 2020 pandemic year excepting, is managing to set a balanced budget. The city has undergone a lot of redevelopment, some funded by new borrowing, with some areas seeing significant gentrification. That said it remains ranked either the poorest of nearly the poorest big city in America and continues to be adversely affected by population decline and urban blight. It is currently rated BB by S&P and Ba2 by Moody’s: a below investment grade rating. Challenges remain: under terms agreed in the bankruptcy in 2023 the city must increase pension payments, in the mid-2030s all terms of the ‘grand bargain’ are set to end. The city will continue to face tough challenges and hard choices in the years ahead.

Related Inisghts

The Bankruptcy of Detroit: Part 1

A Local Taxation Tale of Two Cities

Local Authority Counterparty Risk