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Monday
Jul292013

What happens in Detroit

What happens in Detroit is not going to stay in Detroit. Financially, our local governments are very fragile, weakened from years of little growth and burdened by the legacy costs of an auto-based development pattern that is fiscally unproductive. Defaulting on Detroit's secured creditors will mean higher borrowing costs for many cities. Defaulting on Detroit's unsecured pensioners and retirees, on the other hand, is a cruel precedent that will impact labor negotiations across the country. These impossible choices we're now forced to consider can be made a little more managable for cities that begin shoring up their finances with a strong towns approach.

This is a big week here at Strong Towns with the release of Leigh Gallagher's book The End of the Suburbs, which includes quite a bit of Strong Towns thinking and references. We'll have more on this important book later in the week, but pre-order your copy today so you have it fresh when it comes out. The most important book of the year, guaranteed.

Believe it or not, Detroit is actually on the path to recovery. In the final years before bankruptcy, Detroit was borrowing money just to make debt payments, an amount annually that ultimately exceeded the city's revenue. This while the city crumbled and vital services were drastically underfunded. That's over now and, with a very credible (and I think workable) plan presented by Detroit's emergency manager, Kevyn Orr, I feel like Detroit has a real shot.

What happens next, though, is going to be very interesting in terms of what happens in the future for cities and states around the country.

Detroit's debt is reported to be $18.5 billion. Of that amount, $7 billion is secured and $11.5 billion is unsecured. That's not a minor difference.

Secured debt is backed by some type of asset or revenue stream. Last Friday I shared the news that Detroit is taking on additional debt to build a stadium for the Red Wings. (I'll say again -- that is not a joke -- a bankrupt city is actually building a stadium for a hockey team in the name of economic development.) That debt will be secured as the property tax revenue for the stadium and the development in the vicinity will be pledged to pay that debt. Without that pledge, it is highly unlikely that a bankrupt Detroit could get that loan.

Detroit has a casino that makes monthly profit payments to the city. (As a moral aside, gambling seems a pretty pathetic way to raise revenue from an impoverished population, especially in Detroit.) Those profits were pledged as collateral for debt the city took out to pay its bills. In fact, when the city suspended payments on that debt, the company that insured the transaction filed a lawsuit to seize that revenue, which the city is still receiving. In a strict contract sense, the city should lose that court case. The revenue is there, it was pledged to make the debt payment and so it must.

I suspect, not without reason, that we're not going to be operating in a strict contract sense here. That's because the $11.5 billion in debt that is unsecured is unpaid health insurance benefits to retirees and unfunded pension obligations to the same. In this case, "unsecured" means that if the money isn't there, these benefits don't get paid.

Let's pause here for a second. This is a horrible tragedy. As I quoted Charlie LeDuff a couple weeks ago, "Get the money together or the kids don't have a future." We haven't gotten the money together and so a lot of good, decent, honest people are going to get hurt. Hurt badly. On an individual level, that tragedy cannot be overstated. It is heartbreaking.

On a macro scale, however, there are some important generational reasons to ponder our situation. I'm not gratuitously casting blame when I note that the generation of retirees these funds are promised to inherited a country at its financial apex and rode it downhill in an unprecedented binge of debt-fueled consumption. A twenty five year old today entering the workforce -- or trying to -- not only has their own student loans to pay off but they have the burden of a national debt greater than our GDP that was rung up by a prior generation, the specter of taxes increasing to pay for unfunded retiree benefits that the same prior generation intentionally did not fully fund during their working years, they are having their current health insurance rates increase to lower the costs for this same generation, they have a stock market and a housing market that are being kept artificially inflated for the benefit of that same prior generation, they have trillions of dollars of infrastructure enjoyed by the prior generation but the maintenance of which is totally unfunded, and on and on and on.... 

So with Detroit, we're going to have the first really big conversation about the rights of retired government employees and society's -- specifically, today's employed workers' -- obligations to them. It is probably good that it is happening in Detroit instead of a place like California because there are few that can argue that a Detroit retiree is living a life of undue luxury. In other words, few gratuitous straw men.

Already the Michigan Attorney General, a Republican named Bill Schuette, has stepped in and said that retiree benefits are protected under the Michigan constitution. 

Michigan is almost alone in the nation with its explicit protection of public pension benefits in its state constitution. Because of that protection, the issue is sure to become contentious when U.S. Bankruptcy Court Judge Steven Rhodes is expected to take up the matter in the coming weeks.

Mr. Schuette, also a Republican, said he would join the Detroit federal bankruptcy case filed last week "on behalf of Southeast Michigan pensioners who may be at risk of losing their hard-earned benefits."

Mr. Schuette added that Michigan's constitution is "crystal clear" in stating that pension obligations may not be diminished or impaired.

That's an interesting -- and rather odd -- constitutional clause. If the city can't pay them, what are they supposed to do? For this case, however, that is not going to be the argument. The city can pay the pension benefits, but only if they stiff their secured creditors.

We have a face for the unsecured creditor -- the retiree on a fixed income who worked for years in the rough city of Detroit and now is barely making it on a small pension -- so let's put a face on the secured creditor. Who buys municipal debt?

The largest purchaser of municipal debt is -- yes, you guessed it -- pension funds. I couldn't find a figure on how much Detroit debt the two Detroit pension funds own, but needless to say, a default on secured debt will impact someone's pension fund.

Many wealthy investors also purchase municipal bonds. While the rates are low, the earnings are tax free and, of course, they are secured from loss. It is kind of funny too, in a gallows humor kind of way, to discover that European banks own about $1 billion of Detroit debt

Earlier this year, Cyprus experienced the first "bail in" of the European financial crisis. Instead of money being put into a country's banks to make them solvent -- alla Greece, Portugal, Spain and Ireland -- the EU required depositors at the bank to use their money to keep the bank solvent. It was just announced that 47.5% of the funds of large depositors would be seized by the bank (exchanged for equity in a worthless bank is the nicer way to put it). Markets were a little skittish that this might represent a new trend -- rob depositors to fix bank malfeasance -- but Cyprus was enough of an anomaly that it didn't seem to have long term consequences.

Let's go back a little bit further to the auto industry bankruptcy and bailout. Again, we had secured and unsecured creditors. In the government-led restructuring, the unsecured creditors received very favorable treatment while the secured creditor not so much.

One is an anomaly. Two is a trend. Three is on the way from trend to a new standard.

We can stiff these secured creditors -- sure -- and that might even feel like the moral thing to do, but it is not without ramifications. Those ramifications -- higher borrowing costs -- may not matter to Detroit when they can pay their bills again, but it will have a big impact on that next round of fragile municipalities. What type of interest rates are they going to have to pay to attract investors to buy their debt?

Municipal bond funds saw outflows of $1.2 billion in the week ending July 24, on concern that Detroit's filing for bankruptcy - the largest in U.S. history - will set an important precedent and more cities could follow suit. It was the ninth consecutive week of outflows from the fund type.

In Minnesota (hardly in the fiscal shape of Illinois or California), we are considering the construction of a $1.8 billion light rail line. Just a 2% premium on that project for higher borrowing costs due to skittish investors would mean an additional $110 million annually in interest costs (assuming a long, 20-year payback window). For perspective, that's about double the money my entire DOT district gets in an annual appropriation, just in added interest on one project.

For places that are really financially fragile, higher borrowing costs could be killer immediately. For the rest, it just adds to the overall pressure.

In short, what happens in Detroit is not going to stay in Detroit. Financially, our local governments are very fragile, weakened from years of little growth and burdened by the legacy costs of an auto-based development pattern that is fiscally unproductive. Defaulting on Detroit's secured creditors will mean higher borrowing costs for many cities. Defaulting on Detroit's unsecured pensioners and retirees, on the other hand, is a cruel precedent that will impact labor negotiations across the country. These impossible choices we're now forced to consider can be made a little more managable for cities that begin shoring up their finances with a strong towns approach.

 

We've got an important announcement over at the Strong Towns Network we'll be making sometime Monday or Tuesday. Come and hang out with us there and join the conversation, if you're so inclined. 

And if you'd like more of my work, check out my book, Thoughts on Building Strong Towns (Volume 1). It is a primer on the Strong Towns movement and an essential read for those wanting to get up to speed quickly.

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Reader Comments (4)

Are all auto-based development patterns fiscally unproductive?

I think there is an argument to be made that by building our cities so that we can travel within the city by car we are incurring a lot of additional expense. Both in terms of more land used for roads, and in terms of making it feasible to spread further out, requiring more miles of roadway (and water and sewer and electric and communications, etc.).

Perhaps it would make more financial sense for the car to be limited to carparks at the periphery, for travel between cities rather than within cities. Much as most people currently would prefer to travel across town along the route they prefer, at any time they prefer, and as quickly as possible without any stops along the way (unlike mass transit), and the fact that our cities are already built for cars and the transition would be difficult.

We only have to look to the old pre-auto cities in Europe to see how pleasant it can be to live in an area without cars (something few Americans have ever experienced) -- and if it is fiscally responsible too? It seems like we need some cities in America to create car-free districts as soon as possible so that we can measure and compare the costs.

July 29, 2013 | Unregistered CommenterForaker

I'm trying to parse the articles regarding the Redwings stadium, and so far as I can see, the City of Detroit is not backing any of the debt. The Detroit Development Authority is backing some of it, and the state and county too.

Could be a distinction without a difference, as the bonds are supposed to be paid by business taxes on the DDA area, which is downtown Detroit, but I'm not sure.

July 29, 2013 | Unregistered CommenterOmri

I gotta say...on the stadium thing, I'm of two minds. I agree that the idea of a bankrupt city taking on debt (or in this case, promising revenue streams, since it the state is technically the bond issuer) is a bit repulsive, Detroit is in an interesting situation.

Downtown is the largest employment center and thus, an area of great vitality. Midtown is the heart of the 'Detroit Renaissance' as the most functioning multipurpose area of the city, and thus also an area of great vitality. These two areas, however, are highly isolated from other functional urban areas. Since they are almost the only bright spots in Detroit's long-term viability, they are vital to the city's ability to survive and prosper.

Speculative development may have no place as 'normal operations' in a city that wants to prosper for the long haul, but Detroit is not a functional city at the moment. Connecting Downtown and Midtown with a vibrant urban fabric is a strategic priority for the continued (and increased) vitality of those two cash cows, and a significant opportunity to increase the amount of financially productive space in the city. Couple that with the fact that this would be using a long-established local asset (the Red Wings) instead of betting on getting a team, and that that asset currently is in a drive-in-drive-out location that isn't benefiting the failing metropolis as much as it could, and I can easily understand why the city and state would think this is a noble cause.

I guess it comes down to when is 'gambling' OK? Detroit is in dire straights...might this be precisely the time to take a chance? Three things need to be understood to make that decision:
1. What are the bonds paying for? And would it be logical/viable/just to have Olympia pay for more?
2. How big is the downside? AKA What does the city stand to lose? (revenue streams, but how much does it currently make vs. how much is needed and what value-capture could be possible around the new development area)
3. How big is the upside? This could potentially have MUCH higher and more sustainable yields down the line than most other large investment projects.

July 29, 2013 | Unregistered CommenterSkyler Yost

I fear that the worst is yet to come for the greater Detroit region. When people left Detroit, they didn't all leave the area; most of the population just shifted to the suburbs. Although it looks to me like the City of Detroit proper is hitting bottom right now - I certainly hope so, anyway - I hardly know what to say about the future of the suburbs other than that it's not bright. SEMCOG, the south-east Michigan MPO, recently approved an expansion of I-94 and I-75 that will destroy parts of the reviving Midtown area. The public hearing lasted for hours and those who were there said that everyone spoke against this expansion - but construction is slated to begin next year.

I just read an article this morning on L. Brooks Patterson, the long-time executive of Oakland County (a Detroit neighbor). He says: “I love sprawl. I need it. I promote it. Oakland County can’t get enough of it.” (http://www.businessweek.com/articles/2013-07-25/detroit-is-dead-dot-long-live-oakland-county#p1)

Leaving his hubris aside, none of this paints a rosy picture for south-east Michigan. And it begs the question of what happens when Detroit's suburbs reach the point where Detroit is now.

July 29, 2013 | Unregistered CommenterMeika
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