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In Detroit Bankruptcy, Delay Is Better Than Error

April 29, 2014

By Stephen Eide

According to its official timetable, the Detroit bankruptcy is seven months from resolution, but there are already signs that the process won't prove as beneficial as expected. In recent deals with bondholders and pension funds, the city has caved to creditor demands, substantially reducing the fiscal relief it stands to gain from bankruptcy.

For these and other bad deals that may follow, the timetable itself, not Emergency Manager Kevyn Orr, should bear most of the blame. Under pressure to settle the bankruptcy before his term in office ends this fall, Orr is losing the upper hand with creditors. It appears that in municipal bankruptcy, haste can lead to waste.

Many factors contributed to Detroit's fiscal collapse, but its worst debt problems were all pension-related.

Had Detroit never offered defined benefit pensions to its workers, its debt burden would be less than half the size it was when the city filed for bankruptcy last July. Gone would be the $3.5 billion in unfunded pension liability, as well as the $5.7 billion in retiree health care debt (employers don't offer health benefits to retirees unless they're also offering pensions).

Since it's impossible for a defined contribution plan to be underfunded, Detroit would never have had to tap credit markets to fund retirement benefits. That would eliminate Detroit's $1.4 billion in pension obligation debt, whose interest rates, incidentally, were stabilized by swaps that in turn burdened the city budget with hundreds of millions in liabilities.

Without any pension-related debt, Detroit would owe $7.5 billion in revenue and general obligation bonds. Had these been its sole debt commitments, the city probably could not have qualified for municipal bankruptcy.

Orr, appointed by Michigan Gov. Rick Snyder in March 2013, understands the importance of pension reform for fiscal relief. Shortly before filing for bankruptcy, he called for "significant cuts in accrued, vested pension amounts for both active and currently retired persons."

Orr has since walked back on that demand.

On Tuesday, he announced settlements with both the city's retirement systems that will guarantee no cuts to accrued benefits for public safety members and only 4.5% cuts to non-uniformed workers and retirees.

Just weeks prior, Orr had called for cuts of at least 6% and 26%, respectively and, for both, the elimination of cost-of-living increases. The public safety settlement partially reinstated the public safety members' cost-of-living increase.

Wall Street, too, has benefited from Orr's eagerness to settle. Last week, some general obligation bondholders that were originally classified as "unsecured" creditors and positioned for 85% cuts agreed to a deal with the city that reclassified them as secured creditors facing only 25% cuts.

Orr tried three times to settle the city's swap liability, initially at a recovery rate far above what most other creditors could expect.

Only because Judge Steven Rhodes rejected the first two proposed deals as too generous to the swap counterparties did Orr manage to settle for $85 million (down from $230 million), a major win for taxpayers and other creditors.

Judge Rhodes must still approve the pension and general obligation bond settlements, and workers and retirees must approve the former.

Significant legal uncertainty surrounds how much Detroit could have extracted from any of these creditors. But, with the exception of a suit he filed to invalidate the city's pension borrowing, Orr seems determined not to press the city's case in court, even though litigation could yield deeper debt cuts. Litigation is expensive, and more importantly, time-consuming, and time is one thing Orr does not have.

Public Act 436, Michigan's "Local Financial Stability and Choice Act," lets a local government vote out its state-appointed emergency manager after 18 months.

Orr can be removed in September, and his self-imposed deadline for exiting bankruptcy is Oct. 15. (It also bears mentioning that this a gubernatorial election year in Michigan and, all things being equal, Snyder would surely prefer to see progress with the bankruptcy before voters go the polls on Nov. 4.)

Having a state-appointed emergency manager direct a municipal bankruptcy is a good idea for a few reasons. State appointees care less about politics (Orr can play the bad cop to Detroit Mayor Mike Duggan's good cop), relations between state and city will be more harmonious, and why should the same officials responsible for the bankruptcy be left in charge to lead the city back to solvency?

But by sunsetting Orr's term in office, Public Act 436 has incentivized haste. $1,000-an-hour rent-seeking lawyers are not the sole reason for why bankruptcies tend to be expensive and lengthy. Municipal bankruptcy exists to provide insolvent cities such as Detroit a means to cut their debts, but the federal bankruptcy code also requires that creditors be treated as fairly as possible. Sometimes good law takes time.

All may not be lost for Detroit. Some crucial negotiations remain and Judge Rhodes has shown himself willing to reject bad deals.

The larger question is what lessons should be drawn from Detroit, which will not be the last city to face insolvency.

Future cities on the brink will scrutinize Orr's approach to determine whether bankruptcy can help them, and if so, how to proceed. Eighteen months may not be enough time to overcome a fiscal catastrophe long in the making.

Original Source: http://news.investors.com/ibd-editorials-perspective/042814-698707-detroit-bankruptcys-short-time-limit-could-hurt-the-city.htm

 

 
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