The Bankruptcy of Detroit: Part 3 Laura Fallon

Why it Almost Certainly Wouldn’t Happen Here

In an environment where UK local authorities are increasingly issuing Section 114 notices and receiving capitalisation directions there is concern that something like Detroit could happen here. There have been instances where local authorities have stopped lending to certain peers: reputational risk is often a big factor here but there is also a concern that the authority could default on an investment, much as Detroit did. There are a number of reasons why Arlingclose feel that this is very unlikely to happen.

It is an important point to context to say that what happened to Detroit is the exception for a US municipality and not the rule. Contrary to the impression of little local councils being thrown to the wolves by a federal government that just doesn’t care, municipal bankruptcies in the USA are rare. There are only about 60 cases of municipalities in the US successfully filing for bankruptcy since the 1930’s. This is in part because many states make it illegal for a local government organisation to go bankrupt, or require them to apply for special permission from the state government to do so. Like in the UK, municipalities in the USA are in the vast majority of cases regarded as safe investments and enjoy low interest rates and investment grade credit ratings.

The main difference in the few instances when a municipality does get into financial trouble is that in the UK, unlike the USA, the national government has consistently shown a willingness to step in and help them. In the UK it is typically not seen as in the national interest to let a local authority default on its debt, have to hugely increase council taxes or stop providing essential services. The most common way this happens is by issuing a capitalisation direction that allows the struggling council to borrow for not normally allowed revenue expenditure. Loans will usually be made by the PWLB so are effectively underwritten by central government and the UK taxpayer as a whole. The loan is paid back by the council with interest over a period of time: smoothing out the effect of an acute disaster for local residents. Even where a capitalisation direction is not given specifically PWLB lending is allowed for refinancing purposes, as happened with Thurrock recently, so the UK taxpayer remains the ultimate lender of last resort.

The Federal US government did not step in to help Detroit. Although, the Michigan State government did give some financial assistance in exchange for essentially taking over the financial function, this was clearly not enough to save the city. In the same way the Federal Government did not intervene in 2009 when the State of California experienced a budgetary crisis and issued IOU notes in place of certain payments that were due. Whilst States and municipalities do receive federal funding, particularly in time of crisis such as the Covid-19 pandemic, the Federal Government in the USA does not see it as its job to bail them out.

A second point is that in the UK councils operate in a stricter regulatory framework than the US and importantly are not allowed to borrow for revenue expenditure, which was part of what got Detroit into so much trouble. They must also, by law, set a balanced budget and if they can’t are required to issue what is called a Section 114 notice that then halts all non-statutory expenditure. In recent years Northamptonshire, Croydon and Slough have issued such notices due to not being able to set a balanced budget.

Finally, the UK is run on a more centralised basis than the USA with a much lower proportion of taxes collected locally. Whilst this has many disadvantages it does have the advantage of smoothing out the effect of some local areas being particularly impoverished or experiencing exceptional population decline. This would make the extremes of what happened to Detroit less likely to happen here as a similar area in the UK would be likely to receive a greater distribution of income from elsewhere. The employee healthcare costs that helped bankrupt Detroit don’t have to be paid by UK Councils, because healthcare over here is free on the (centrally funded) NHS.

One could argue as to which is fairer. The costs of Detroit’s bankruptcy were met in part by institutional creditors but mainly by former employees who lost their healthcare entitlements and part of their pensions. Even if they had a slightly generous allocation of these in the first place, most of these employees wouldn’t have had especially high paying jobs and Detroit’s problems wouldn’t have been their fault. In the UK the same costs are met in a slightly more spread-out way by the Council tax payers in that area and everyone else who lives in the UK and pays taxes: whose fault it won’t be either. Moral hazard is of course a consideration: if authorities in the UK know they’re more likely to get bailed out are they more likely to make poor decisions or take too higher risks? Most authorities in the UK do not get into serious financial difficultly, but then again most in the USA don’t either.

What it does mean is that anyone lending to a local authority in the UK can have more assurance that they are really most unlikely to find they don’t get their money back when they were expecting it. Anyone working for a local authority is not in the realistic position of worrying that their pension is not going to be paid when they retire. Local authorities themselves can expect they’ll continue to enjoy low interest rates if they need to borrow and, in the exceptional instance where they don’t access to the PWLB.

Related Insight

The Bankruptcy of Detroit: Part 1

The Bankruptcy of Detroit: Part 2

Local Authority Counterparty Risk