Detroit Slides From Industrial Might to Bankruptcy

Detroit was once an industrial might at the peak of the automotive industry. Now, residents have moved out and the city is filled with barren lots and empty buildings. The population that peaked at 1.85 million in 1950, has now declined to 700,000. Median household income is now only $28,000 and more than 36 percent of residents lived in poverty in 2011.

By Steven Church, Dawn McCarty & Margaret Cronin Fisk
Jul 19, 2013 10:01 AM MT
Bloomberg

Detroit, the cradle of the automobile assembly line and a symbol of industrial might, filed the biggest U.S. municipal bankruptcy after decades of decline left it too poor to pay billions of dollars owed bondholders, retired cops and current city workers.

“I know many will see this as a low point in the city’s history,” Michigan Governor Rick Snyder, a Republican, said in a letter yesterday authorizing the filing in U.S. Bankruptcy Court in Detroit. “Without this decision, the city’s condition would only worsen.”

Michigan’s largest city joins Jefferson County, Alabama, and the California cities of San Bernardino and Stockton in bankruptcy. The filing shattered the presumption of many bondholders that local governments, eager to continue borrowing at reasonable rates, would do whatever it took, including raise taxes, to come up with the money to meet bond obligations. Kevyn Orr, the city’s emergency manager, said the debt is $18 billion.

While under court protection, Detroit can stop paying some debts, is temporarily immune from most lawsuits and may be able to ask a judge to cancel contracts, including union agreements. Under Chapter 9 of the U.S. Bankruptcy Code, the first step is likely to be a court fight over whether the city was entitled to bankruptcy protection, a challenge that would ask if the city was truly insolvent and it had no alternative to filing.

‘Early Intervention’

Detroit’s filing “is going to affect a number of local governments around the country,” said Keith W. Mason, a bankruptcy attorney with McKenna Long & Aldridge LLP. “It calls for greater early intervention.”

In trading yesterday, investors demanded higher yields to buy Detroit debt rather than top-rated municipals. Unlimited general-obligation bonds maturing April 2028 traded with an average yield of 5.73 percent, about 2.3 percentage points more than benchmark munis, data compiled by Bloomberg show. That’s the biggest yield gap since June 24. The bonds are insured by Assured Guaranty Ltd. (AGO)

The city that gave the world the Model T and fueled the American love affair with tailfins, chrome fenders and big-block V-8 engines began a long decline in the middle of the last century as U.S. carmakers began moving production out of town, and many residents followed. The stomping grounds of Harley Earl, who helped make the Chevrolet Corvette, and Marvin Gaye, a mainstay of Motown music, emptied as the suburbs swelled. Now the city is plagued by barren lots and empty buildings.

Population Decline

Its population, which peaked at 1.85 million in 1950, has declined to about 700,000, according to U.S. Census data. Manufacturing jobs fell from about 296,000 in 1950 to fewer than 27,000 in 2011. About 60,000 properties in the city, or 15 percent of all parcels, were barren and at least 78,000 buildings were vacant, including 38,000 deemed potentially dangerous, Orr said in a report this year.

Median household income was less than $28,000, compared with $49,000 statewide, and more than 36 percent of residents lived in poverty, 2011 Census data show. The median home value of $71,000 was barely half the $137,000 value statewide.

Orr, 55, filed for bankruptcy after asking creditors owed more than $11 billion to accept just $2 billion in new notes in exchange for canceling their debt. That debt includes about $2 billion in what Orr claims are unsecured bonds and billions more in pension, health-care and other obligations owed to current and former city workers.

Unfunded Pensions

Detroit’s general retirement system, its largest unsecured creditor, is estimated to be owed about $2.04 billion in unfunded liabilities, according to court papers filed today. A pension plan for retired police and firefighters is owed an additional $1.44 billion, court records show.

The city asked a judge to appoint an official committee to represent more than 23,500 municipal retirees in the bankruptcy case. Unions and associations that have offered to represent retirees possess no legal authority to bind those retirees to restructure their pensions and health benefits, the city said in court papers.

“Simply put, the city cannot successfully restructure unless it addresses its crippling unfunded retirement benefit obligations,” according to the filing.

At a press conference yesterday with Mayor Dave Bing, Orr said even a casual observer could see Detroit was “not on a sustainable footing” and there was no more time for delay.

‘Deepening Insolvency’

“Detroit has been working its way to a level of insolvency for decades,” he said. The city was “continuing to borrow, continuing to defer pension payments, continuing not to pay its bills on time, continuing a deepening insolvency -- $18 billion.”

Orr said he hoped Detroit would emerge from bankruptcy by the late summer or fall of 2014. Meanwhile, the city would keep its normal routines.

“Services will remain open, paychecks will be made, bills will be paid,” he said. “Nothing changes from the standpoint of the ordinary citizen’s perspective.”

Ken Klee, who led Jefferson County’s restructuring, said the process may take three years in Detroit.

“That will depend on the judge,” said Klee, of Los Angeles-based Klee Tuchin Bogdanoff & Stern LLP. “Most judges believe that Chapter 9 needs to be consensual.”

Different Rules

Chapter 9 is reserved for municipalities and differs from the rules used by companies in Chapter 11. Before the filing, Orr said the city’s total debt included more than $5.4 billion in debt guaranteed by water and sewer fees. Those utility-related bonds would have been refinanced and fully repaid under Orr’s pre-bankruptcy proposal.

Orr’s proposal to restructure its debt and long-term obligations included cutting pension payments for public employees, ending cost-of-living increases, removing some workers from the system and making the rest pay more.

Snyder, 54, said at a press conference today in Detroit that he sped up the filing process to pre-empt litigation seeking to halt it.

“I said, ‘Enough of these outside lawsuits, let’s get into bankruptcy court,’” he told reporters. “The decision had already been made, I simply hadn’t signed the letter yet.”

City pension plans sued Snyder and Orr this week, contending a bankruptcy filing would conflict with a provision of the Michigan Constitution that bars any government in the state from reducing pension benefits. Two similar suits were filed in the same state court earlier this month on behalf of individual retirees and current workers.

Emergency Order

The retirement systems sought an emergency restraining order yesterday to stop the bankruptcy. The city filed moments before Ingham County Circuit Court Judge Rosemarie E. Aquilina in Lansing could rule.

Aquilina, citing the state constitution, did temporarily bar “any further action that may cause the accrued financial benefits of the retirement systems or their participants from in any way being diminished or impaired.” Today she refused a request by the state to put that order on hold.

The city asked for a court order setting Aug. 19 as the deadline for objections and other filings contesting its eligibility to seek bankruptcy protection.

Federal bankruptcy petitions normally freeze any litigation affecting assets of the petitioner. The federal judge in charge of the case will have to decide whether to honor the limits of the state constitution or the county court ruling.

Plans ‘Dismayed’

The city employee pension plans said in a joint statement that they were “dismayed” by the bankruptcy.

“We are surprised and disappointed that the emergency manager would file a Chapter 9 petition before he has had substantial negotiations with the retirement systems and other significant creditor constituencies,” Robert Gordon, an attorney for the plans, said in the statement.

Orr said yesterday that he “bent over backward” in talks with creditors.

“We’ve spent a lot of time negotiating in good faith,” he said. “We’ve had over 100 meetings with stakeholders.”

A showing of good faith is a threshold question when filing under Chapter 9, said Kenneth E. Noble, head of the insolvency and restructuring practice at Katten Muchin Rosenman LLP in New York.

Filing ‘Rushed’

“The filing was rushed in the sense that he wanted to file before a state-court judge could issue an injunction,” Noble said in an e-mail. “This may make the showing more difficult than it might otherwise have been.”

Detroit is the home of General Motors Co. (GM), while Ford Motor Co. (F) is in nearby Dearborn and Chrysler Group LLC is based in suburban Auburn Hills. GM and Chrysler both went through their own bankruptcies in 2009 and are thriving again.

Job losses at U.S. automakers intensified a decline that began in the 1950s, when white homeowners began moving to the suburbs, Scott Martelle, author of “Detroit: A Biography,” said in an e-mail before the filing.

“As the tax base eroded, basic city services eroded, too,” he said. Detroit “is too big geographically -- 140 square miles -- for its dwindling and impoverished tax base to support.”

President Barack Obama is monitoring the situation, Amy Brundage, a White House spokeswoman, said in a statement.

‘Great Cities’

“While leaders on the ground in Michigan and the city’s creditors understand that they must find a solution to Detroit’s serious financial challenge, we remain committed to continuing our strong partnership with Detroit as it works to recover and revitalize and maintain its status as one of America’s great cities,” she said.

Chapter 9 will give Detroit an advantage over companies that use Chapter 11. Unlike companies, municipalities don’t need to ask the bankruptcy court for permission to pay any bills they ran up before filing for court protection, including wages, utilities and rents.

That means creditors can’t put as much pressure on a city over its spending habits, as sometimes happens in Chapter 11. Chapter 9 creditors also can’t offer their own reorganization plan and aren’t entitled to form an official committee with legal fees paid by the municipality. Unsecured creditors typically have those rights under Chapter 11, which companies use to try to stay in business and reorganize.

Setting Priorities

“The city can prioritize its own needs, not the creditors’,” said Mark Schwartz, a former bond lawyer who tried unsuccessfully to help the city of Harrisburg, Pennsylvania, restructure debt using Chapter 9. That case was thrown out of bankruptcy after a judge found that filing wasn’t authorized under state law.

Standing in Orr’s way are the retirees and bond insurers. To get a court to approve a restructuring, the emergency manager must show that the plan is “fair and equitable,” Noble said.

“That will draw a lot of litigation, since bonds and retiree liabilities have never been reduced,” Noble said. Issues include how high tax levies must be and whether assets such as an art collection should be sold or preserved to draw tourists, he said.

Among the biggest drains on the city’s general fund, which pays for police, fire and other basic services, are health benefits paid to retired city workers, mostly former police and firefighters, according to Orr’s May report. Without changes, the city will pay $163 million for retiree health-care costs in the next fiscal year, which starts July 1, the report found.

Unfunded Pensions

Unfunded pension liabilities may reach $3.5 billion, Orr said.

Retirees would get $100 to $250 a month to defray health-care costs, according to Orr. Detroit has about 20,100 retirees, about twice the number of active employees, he said.

Orr, who was appointed by Snyder, said before the filing that if he couldn’t strike a deal with creditors and employees, he would file for bankruptcy, giving a judge the power to impose losses on creditors. Orr has ordered an investigation of all benefit programs, including pension systems.

Under Chapter 9, Orr can try to force creditors to take losses by persuading the judge to approve a so-called plan of adjustment that eliminates debt. Creditors can counter that by arguing the plan isn’t feasible, Craig Barbarosh, a bankruptcy partner at Katten Muchin in Orange County, California, said in an e-mail.

Detroit’s bankruptcy is the biggest in the U.S. based on the size of its debt, followed by Orange County, which filed in the 1990s, and Jefferson County, which filed in 2011.

Orange County

In Orange County, creditors were eventually repaid in full after the bankruptcy ended and after years of lawsuits. Jefferson County is seeking to impose bigger losses than creditors have ever taken in a municipal bankruptcy.

Orr is proposing even larger cuts for creditors than the ones put forth in Jefferson County.

Orr said at today’s press conference that residents would see improvements in services within 60 days, as he begins to shore up funding. He said he has no plans to begin selling assets, such as the city-owned art collection at the Detroit Institute of Arts.

“Right now, there’s nothing for sale, including Howdy Doody,” he said, referring to the original puppet used on the 1950s children’s television show and kept at the art institute.

Orr said he was most surprised when he delved into Detroit’s finances over how long mismanagement was tolerated.

“This has been going on for decades,” he said. “I know a lot of people are outraged over my appointment. I wish there’d been a lot more outrage over the past 10 or 20 years.”

The case is City of Detroit, 13-bk-53846, U.S. Bankruptcy Court, Eastern District of Michigan (Detroit).

To contact the reporters on this story: Steven Church in Wilmington, Delaware at schurch3@bloomberg.net; Dawn McCarty in Wilmington at dmccarty@bloomberg.net; Margaret Cronin Fisk in Detroit at mcfisk@bloomberg.net

To contact the editors responsible for this story: Andrew Dunn at adunn8@bloomberg.net; Michael Hytha at mhytha@bloomberg.net

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