A City Stalled

 
 

detroit_spread

After decades of decline, Detroit is trying to reorganize under the largest municipal bankruptcy filing in U.S. history.

Is the city finally on the road to recovery?

Just try running a city on an $18.5 billion deficit. When a city goes bankrupt, the effort becomes less of an attempt to reorganize and more of a fight to survive. The struggle to stay afloat amid a deluge of demands is overshadowed by the possibility that recovery will never happen. A city’s bankruptcy creates a ripple effect that reverberates through the community’s entire economy. It isn’t just that the city can’t pay its bills; it’s that those bills include everything from public services to infrastructure to retirement funds. But before anyone files for bankruptcy, residents go through a service bankruptcy.

For the city of Detroit, the money disappeared decades ago. Now, the money borrowed against the future has risen to such exorbitant heights, there was nowhere else to go but into bankruptcy court. When the city filed Chapter 9 in July 2013, at least $18 billion in debt, it became the largest municipal bankruptcy on record, creating a financial disaster that has left scars on the landscape as deep as any physical event could.

The Fall of a City
Much like a natural disaster or industrial accident, a series of economic crises in Detroit has leveled the once-thriving city. Houses stand empty, many caving in. Factories are crumbling. Streets are deserted and neighborhoods abandoned. Yet to say that no one saw it coming would be untrue. Detroit’s problems could be seen coming as far back as the 1950s, when the population—then just under two million—started to drop. The steady free fall continued for the next six decades. Sixty years later, the numbers are shocking: the population decreased to 684,799 by December 2012, according to the U.S. Census Bureau, and now hovers just above 700,000. Yet population decline is only a symptom of deeper, more insidious problems.

Those problems seem to stretch out longer than Eight Mile Road, which slices through the city’s middle, also creating a cultural chasm between the upper and lower classes. A city once thriving, thanks to the auto industry, Detroit fell hard when automakers struggled, first from foreign competition, then from financial collapse. According to city records, employment went from more than 350,000 in 2000 to around 275,000 in 2012. Less than half of residents over age 16 have jobs. Unemployment stands at 18.6%—more than double the national rate.

Fueled by such unemployment, the city soon realized even more problems. Taxes went unpaid. Amid a shrinking revenue base, basic services like ambulances, police departments and fire departments were slashed. Soon, equipment broke down and there was no money for repairs. Taxes were raised. Residents, many unemployed or underemployed, couldn’t afford to pay even before the tax bills went up. They moved out, leaving behind properties that didn’t sell. Eventually, those properties fell into ruin, and the city could not afford to tear down dilapidated structures. Property values plummeted. Crime went up. More residents left. Police departments lacked the resources to respond adequately; today, fewer than 10% of all crimes committed are solved.

Currently, Detroit’s per capita taxes are, according to its own figures, double those of neighboring municipalities. Some blame the political system, which many experts claim has overspent and borrowed against future revenue for too many years. No matter now. The money the city is able to collect falls far short of what it needs to keep the lights on—literally: 40% of street lights in the city don’t work. And with 63% of the city residents now gone, the remaining 37% are responsible for the entire tax base.

If only they could. The Detroit News reported that 47% of landowners in Detroit were delinquent on their tax bills in 2011. That amounted to $246.5 million in taxes and fees not collected by a city already underwater financially. And now, the bankruptcy filing brings Detroit’s faltering economy to a halt.

By many accounts, it was a move that was long overdue.

Abundant Obligations
In September 2013, union reps from Detroit headed to Washington, D.C., to represent many factions of the city’s labor force, from teachers to auto workers to municipal employees. The goal was to appeal to President Obama and somehow ensure that workers weren’t forgotten in the bankruptcy payout. Yet the obligations are so far-reaching that union concerns may be toward the back of a seemingly endless line.
Aside from the uncertain future for police, teachers and municipal workers, there are questions about what more the city needs to trim in order to dig out. At the Detroit Institute of Art, the outcry was loud and furious over rumors surrounding the possible sale of its collections in order to bail out the city. The city’s recently appointed emergency manager Kevyn Orr said there is no plan or intention to sell the city’s artwork, though his office did hire auction house Christie’s to develop an appraisal of the collections, according to the New York Times. Orr could not be reached for comment.

Is Detroit Already Recovering?

Amid the uncertainty, there are signs of life. Businesses and residents have not abandoned the city. A group of 28 Detroit firms, including Ford, GM, Chrysler, PNC, Comerica Bank, Penske, the Detroit Lions and Blue Cross Blue Shield of Michigan, recently took out a full-page ad in newspapers around the country touting support for the city. The ad called Detroit a “major center of innovation in technology, manufacturing, financial services, health care, education and more” and noted residential and downtown office occupancy rates were at “their highest levels in decades.”“The renewed energy of our city is palpable and real,” it read.This optimism and civic pride has also been reflected in the wide-ranging “Opportunity Detroit” campaign, which highlights business, residential and cultural improvements around the city. In some respects, the effort seems to be working. As William Diehl of Global Automotive Advisory said, Detroit is growing, and ironically, it could be for precisely the same reasons Detroit is in trouble—property values are low, making it easy for people to invest. “People are investing like crazy in buildings and in different functions,” he said. This has had a positive effect on  the area. Housing prices, for instance, are climbing, according to the National Association of Realtors—in the third quarter, prices were 44.3% higher than in the third quarter of 2012.Even the businesses that have left the city have not gone far. William Hamm of Berkeley Research Group has seen a migration of businesses to the suburbs. “There are two Detroits,” he said. “There’s the city of Detroit and then there is the ring of suburban communities that surround Detroit. Businesses have moved out of the city because they saw the service bankruptcy coming. Those suburbs appear to be doing well—property values are holding up.”Other investments are relatively easy to find. Hamm has seen properties selling for as low as $1 a parcel. “You could take the money in your wallet right now and buy a couple of blocks,” he said. That comes with service and financial concerns, but it appears there are investors willing to wait for the tide to turn.Meanwhile, in September, the federal government pledged at least $300 million in financial support to help clear blighted and abandoned properties, shore up transportation infrastructure and provide public safety assistance, including new police, firefighters and arson investigators. While only a small percentage of Detroit’s total liabilities, the money is a step in the right direction as the city fights its way back into the black.

Ira Herman, a partner in the New York office of Thompson & Knight, said that the balancing act in Detroit has been going on for a long time. “If you look at Detroit’s finances over the past decade or more, the city has been borrowing money without a sufficient income stream in place to pay back its creditors,” he said. “Essentially, Detroit has been selling off the family jewels to pay its day-to-day operating expenses.”

“If Detroit were a for-profit business, it would be so deeply undercapitalized that it could never survive,” Herman added. “With the loss of the broad tax base the city used to have, how was it going to pay back all of its loans? The city has been borrowing for years to pay its ongoing expenses: wages, pensions, health and welfare obligations, and the like. They were selling long-term bonds not to build infrastructure, but to pay operating expenses.”

Herman also noted that, despite the outcry against Detroit reneging on its pension and welfare benefits obligations, there could be a large loophole that allows that to happen. “The State Constitution and other applicable laws include provisions protecting pensions and welfare benefits, among other obligations,” he said. “However, Chapter 9 bankruptcy is a federal law, and under the supremacy clause of the U.S. Constitution, it could trump the state constitution and other laws.”

Business as Usual
Still, business goes on. For William Diehl, doing business in Detroit is just another day at the office. President and CEO of Global Automotive Advisory for BBK, Diehl works in Southfield, a Detroit suburb. His company has been part of the Detroit business scene since 1977. He believes the writing was on the wall even then. “Detroit has had a legacy of overspending their budget for decades,” he said.

Diehl sees two main impacts of the bankruptcy: the increased cost structure due to the market’s view of municipal bonds as a much riskier venture; and an inability to provide credit from the service providers, which will cause a higher rate structure. Municipalities, he said, have had the benefit of lower rate structures from all of their vendors, which they’re no longer going to see.

Diehl also believes the supply chain will be impacted because businesses will be much more reluctant to provide services. Vendors will be affected when the city reduces the number of contracts.
The risks have increased substantially, Diehl said. That changes the risk structure not just in Detroit, but in other municipalities, as well. Cost structures are rising, including insurance. “The reality’s come home; there’s a lot more risk in this environment,” he said.

“As citizens and service-users, we’re going to pay more money because the cost to the municipality is going up,” Diehl said. Even cities beyond Detroit will experience the impact. “We’re going to find it’s going to be tough for the city as an organization. You’re going to have to be a lot more focused on your credit risk.”

Because of its size and severity, Detroit’s bankruptcy will also impact policy, Diehl said. Then, he suspects, cities like Chicago that are in similar financial difficulty will look at the bankruptcy alternative. “It’s not the impact of Detroit, it’s the view that this is the opening of the flood gates for significant bankruptcies going forward.”

Impact on Insurance
If the city can’t meet its obligations to retirees, where will their healthcare coverage come from? One idea being floated is to move the city’s retirees into health care exchanges. The potential savings to the city: $120 million.

Residents and businesses have already seen an impact on insurance in other areas like auto insurance, which has skyrocketed. According to the June 2012 presentation “City of Detroit: Proposal for Creditors,” the average auto insurance premium was $3,993, $1,000 more than rates in neighboring Dearborn. Homeowners rates are also higher than average, coming in at an estimated $1,543 annual premium. The numbers are high for a city whose housing prices have plummeted more than 22% in the last five years, according to a Trulia market trend study.

When the city can’t meet the obligations, who will? William Hamm, director and economic consultant with Berkeley Research Group in Emeryville, Calif., said that monoline insurers writing municipal debt will feel the pain, at least in the short term. Insurers have underpriced municipal risk, in Hamm’s estimation. Long-term, however, he believes it will be good for business from an insurer’s perspective. “There will be more of a demand for it,” he said, adding that there is always a class of investors who aren’t concerned with holding general obligation bonds without insurance backing them.

Hamm believes coverage will always be available somewhere, but that premiums will reflect the new reality for the bond market. “There is usually someone willing to take on the risks the investor doesn’t want to bear, but the investor will usually have to pay for that.” He noted that insurers are well positioned to capitalize on investors who are looking for help sharing the risks.

A Model for Recovery?
Bankrupt municipalities are unusual, but they are becoming increasingly more common as cities, counties and even states struggle to recover from events or decisions that hit hard. In California, where the state struggles with debt that reached $16 billion in 2012, several cities have already filed for bankruptcy protection, including Stockton, Mammoth Lakes (which was dismissed) and San Bernardino.

The city of Vallejo, Calif., filed for bankruptcy in 2008. The city of 117,000 was $16 million in the hole—a small amount compared to Detroit. But the city saw the writing on the wall early. Expenses were outpacing revenue, and it had to stop. The city entered into bankruptcy protection, and has since improved on its financial picture enough to be released from bankruptcy in 2011. Vallejo even adopted several initiatives intended to reduce crime and increase livability. These include high-tech monitoring cameras to assist the police force, deputizing citizens, imposing a 1%-per-person tax hike and helping encourage neighborhood watch groups, which have grown from 15 to 350. Other California cities are calling Vallejo a model for their own recovery.

Hamm, however, doesn’t agree. In fact, he believes the city is still running in a service bankruptcy condition. “They have emerged from legal bankruptcy, but they still have closed a number of fire stations and they haven’t hired back all the police they laid off,” he said. They are still far below standard in terms of police officers and fire fighters per population. “They have this deficit, and it’s unclear how they’re going to be able to close that deficit,” he added.

Vallejo is without access to the credit markets, but the larger problem is its burden with regard to pensions and health insurance for retirees, Hamm said. Those burdens have increased relative to revenue since the city emerged from bankruptcy. “They’re by no means out of the woods. I don’t think bankruptcy solved Vallejo’s problem,” he said.

Still, Vallejo is in a better position than Detroit, simply based on the sheer size of the bankruptcy.  What has taken Vallejo a number of years will take Detroit “multiple decades,” in Hamm’s estimation. It is a long-term effort that he said involves rebuilding municipal government to ensure better decision-making with an eye to the long term.

Until then, the bills must be paid. That leaves a big question looming, and the answer is one that may not be appealing. “Who’s going to get paid and who is not?” asked Herman. “Since there is not enough money to go around, someone has to go unpaid in whole or in part. The only question is who will bear the loss and how big of a loss will they suffer.”

 

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About the Author

Lori Widmer is a Philadelphia-based freelance writer and editor who specializes in risk management and insurance.

 
 
 

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