Could Detroit’s Bond Default Bring Higher Borrowing Costs Nationwide?

A friend of McHenry County Blog jotted down some observations about Detroit that might give an indication of the future of Illinois. Here they are:

Motor City Madness

Detroit defaulted on bonds on June 14.

Did anyone in the national media notice?

No one who has been following the situation is surprised that Detroit defaulted.

The City has been incurring large budget deficits for years while levying at their property tax limit for operating purposes.

No one is surprised that that corporate bankruptcy attorney Kevyn Orr (the “Emergency Manager” appointed by Republican Governor Rick Snyder) is asking for adjustments to

  • retiree benefits
  • pensions and
  • creditors of the City’s main operating fund

What IS surprising is that Orr is trying to give a haircut to owners of unlimited tax general obligation bonds (known as “ULT GOs” in the trade), paying them an estimated 17 cents on the dollar.

If successful, that action will increase property taxes for every city and every school district in the country the next time they borrow by making their borrowing riskier and raising the interest rates they pay.

Orr’s move is surprising because the taxes that repay the ULT GOs are not available for operating purposes, so defaulting on these bonds will not help the Detroit pay for basic operations, like police and fire services.

To be sure, Orr faces an uphill battle.

Outside of bankruptcy, Orr would need the approval of virtually every City creditor to his proposal, something he is highly unlikely to get.

So Orr is likely to take Detroit into municipal bankruptcy, where he will have to convince a judge that giving the ULT GO bondholders an 83% haircut without increasing taxes for operating purposes by a dime is fair to both sides.

This would violate black letter law, the principle on which the law is founded (fairness to both creditors and borrowers), and all precedent (yes, there actually have been some municipal bankruptcies before).

Nevertheless, few municipal bondholders thought they were buying shares in a lawsuit, so the bond markets have been roiled by Orr’s comments.

The root causes of Detroit’s problems, of course, have little to do with borrowing, but with lucrative union contracts and gross inefficiency.

Just to give some flavor to that statement, here are a few facts noted in Orr’s “Proposal for Creditors”, dated June 14, 2013, and his “Financial and Operating Plan”, dated May 12, 2013:

  • “The City’s operations have become dysfunctional and wasteful” (Orr’s words)
  • The City’s 47 different unions “impose work rules and other restrictions that have impaired the efficient functioning of City government” (Orr’s words)
  • Detroit hasn’t balanced its budget in more than five years
  • Detroit is levying at its property tax limit for operating purposes
  • 12 of the City’s 52 fire stations are closed on any given day
  • 40% of the City’s street lights don’t work
  • Detroit’s crime rate is the highest of any U.S. City with over 200,000 residents
  • Detroit has had five police chiefs in five years
  • The response time to police calls that average almost an hour
  • The police department’s “extremely low 8.7% case clearance rate [is] driven by the department’s lack of a case management system, lack of accountability for detectives, unfavorable work rules imposed by collective bargaining agreements and a high attrition rate in the investigative operations unit.” (Orr’s words)
  • Detroit has 18,500 retirees versus 10,000 active employees in the government
  • OPEBs (“Other Post Employment Benefits”, government talk for retiree benefits) liabilities are an estimated $5.7 billion and are funded on a pay-as-you-go basis — meaning there are ZERO investments set aside to fund this liability
  • Detroit’s unfunded pension liabilities is estimated to be $3.5 billion
  • Only 53% of City property owners paid their 2011 property taxes

Here are a few other fun facts about Detroit:

  • Population is down 63% from its 1950 peak, and down more than 25% just since 2000 to fewer than 685,000
  • School enrollment is down 60% in the last ten years to fewer than 67,000 students
  • Detroit lost more than 75,000 jobs since 2000
  • Detroit has 78,000 abandoned buildings and 66,000 vacant lots

And we thought things were bad in Illinois!


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