Detroit Files for Chapter 9 Bankruptcy

It's the largest municipal bankruptcy in U.S. history.
July 18, 2013

Detroit has officially filed for federal bankruptcy protection, Michigan Gov. Rick Snyder announced Thursday afternoon.

The move represents the largest municipal bankruptcy in U.S. history.

“The fiscal realities confronting Detroit have been ignored for too long," Snyder said in a statement. "I'm making this tough decision so the people of Detroit will have the basic services they deserve and so we can start to put Detroit on a solid financial footing that will allow it to grow and prosper in the future," the governor continued. "This is a difficult step, but the only viable option to address a problem that has been six decades in the making.”

According to the Detroit Free Press, the filing begins a one- to three-month review process of determining whether the city is eligible for Chapter 9 protection.

Snyder and Kevyn Orr, the state-appointed emergency manager running Detroit, defended the move during a Friday morning press conference.

"(I) don't view this as a terrible answer," Snyder said. "We will come out with a stronger, better Detroit, and a format to grow the city."

According to state estimates, Detroit faces more than $18 billion in debt and unfunded liabilities. Snyder called the city insolvent and announced that "bankruptcy is the only feasible option to fix the city’s finances and do what is right for the 700,000 people of Detroit."

He characterized the filing not as a defeat for the city but as an opportunity that will ensure it can focus on improving quality-of-life and growth.

Credit ratings agency Standard & Poors said in an announcement Friday that while the timing was a surprise, the filing itself was not, and Detroit's bankruptcy is not a harbinger of further distress in the municipal sector. The firm said it doesn't expect the Detroit filing to have a direct impact on credit quality in the rest of the state or country.

Orr requested approval for the filing from Snyder on Tuesday, since state law requires the go-ahead from the governor.

In a response to Orr and State Treasurer Andrew Dillon that was filed with the federal bankruptcy court, Snyder said while bankruptcy is a last resort, it's also the only way the city's financial emergency can be addressed.

By Friday afternoon, the filing had already been challenged. An Ingham County judge has ruled that the federal bankruptcy filing violates the state constitution and must be withdrawn. Michigan Attorney General Bill Schuette intends to appeal that decision.

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Snyder says under the status quo, Detroit isn't able to meet basic obligations to citizens and creditors alike. "I know many will see this as a low point in the city's history," Snyder wrote. "If so, I think it will also be the foundation of the city's future -- a statement I cannot make in confidence absent giving the city a chance for a fresh start, without burdens of debt it cannot hope to fully pay."

In June, Orr sent a proposal to Detroit's creditors and met with approximately 150 of them, including the city's unions, retirees, bondholders and others, but it didn't achieve much.

At this point, Orr said in a statement, there is "no reasonable prospect" of reaching agreements with all the parties affected by Detroit's financial hardship in a timely manner. Given the large number of creditors, officials believe the city is unable to negotiate an agreement outside of the more structured bankruptcy process.

Robert Flanders, the state-appointed receiver who led Central Falls, R.I. through Chapter 9 bankruptcy in 2011, said there's little downside to Detroit for filing at this point. While there may be concerns about how the move could impact the municipal bond market in Michigan, any impacts have probably been felt already, given Detroit's long history of financial troubles, Flanders said.

Indeed, some believe the dangers of not addressing the debt were likely worse than any negative consequences that stem from a Chapter 9 filing itself. "They simply have to do this," says Lou Schimmel, the state-appointed emergency manager who oversees nearby Pontiac, Mich., which has struggled with near-insolvency but didn't declare bankruptcy. Outside of Chapter 9, Schimmel says, "Detroit absolutely has no way, whatsoever, to fix their problems."

Flanders said the timetable of the bankruptcy's resolution will largely depend on how amenable the city's creditors are to negotiating a restructuring. The 2008 bankruptcy in Vallejo, Calif., for example, dragged on for three years. But Central Falls' bankruptcy was resolved in just one year. Ultimately, Flanders says, Detroit's creditors will have to determine whether they want to take a haircut in negotiations with the city -- or fight the process, and possibly risk losing even more.

In municipal bankruptcies, lenders, retirees, and current employees -- not to mention residents -- often face competing interests. Negotiating who's first in line to get paid will almost certainly be a highly contentious process. In a plan released earlier this summer, Orr has already asked some creditors to accept pennies on the dollar for what they're owed.

Different states protect retirees' pensions to varying degrees. Part of Michigan's constitution indicates accrued pension benefits are a contractual obligation that "shall not be diminished." But it's unclear whether that language means they'd be wholly protected in the federal bankruptcy process.

It's also not entirely clear how much the city even owes in unfunded pension obligations. Orr puts the figure at $3.5 billion, but the city's actuaries put it at $644 million. Just nailing down the correct number could be a contentious topic during the negotiating process, says Natalie Cohen, a Wells Fargo securities analyst.

Meanwhile, some investors are frustrated that Detroit is unlikely to give general obligation bondholders special precedence as creditors line up to get paid.

In Rhode Island, for example, the state specifically passed a law prior to Central Falls' bankruptcy filing that ensured bondholders would have priority as municipal debt was restructured. Controversially, that move also ensured they'd get fully repaid while retirees took a major financial hit. The rationale was that if lenders didn't have confidence they'd get repaid in the future, borrowing costs across the state would soar.

But in Michigan, those bondholders will be lumped in with retirees under Orr's plan, a move that some investors object to given their historic view that general obligation bonds should be afforded more protection.

That will likely be a subject of much debate, especially because the state law that authorized Orr's appointment calls for "payment in full of the scheduled debt service requirements on all bonds, notes and municipal securities," which seemingly contradicts the plan.

The bankruptcy filing essentially puts a pause on lawsuits from creditors, which had already begun when the city's pension funds sued earlier this week to block reductions of their benefits.

In Detroit's bankruptcy filing, the city's attorneys emphasized the insolvency of the city, a key criterion a municipality must demonstrate in order for a Chapter 9 petition to be accepted.

To conserve cash, they say, the city failed to make a $39.7 million debt payment due last month and has declared a moratorium on paying unsecured debt going forward. Meanwhile, Detroit has not paid required annual pension contributions, including $37 million for FY 2012 and an estimated $71 million in FY 2013.

At the same time, the city anticipates negative cash flow of $11.6 million as early as December 2013, absent restructuring. It could balloon to negative $404.5 million by the end of the 2015 fiscal year.

The filing also highlights the dramatic cuts to core areas of city operations -- like transportation and emergency services -- that have contributed to poor quality of life in Detroit. Nearly 40 percent of street lights don't work, citizens wait an hour on average to get a response to police calls, and Detroit's violent crime rate is five times the national average.

Detroit has reduced operating expenditures from $1.1 billion in FY 2008 to $692 million in FY 2013. As part of that process, the city's employee headcount has been reduced from 12,000 to 10,000 over the last two years, and wages and benefits have been cut. Capital improvements and much-needed maintenance have been deferred to save money as well.

Those steps, along with higher tax and utility rates, have helped the city achieve more than $200 million in annual savings, but that hasn't been enough to turn the tide, Orr says. While those cuts have caused hardship in the city, they've only had a marginal benefit to the city's financial position and done nothing to relieve debt service and obligations to retirees, according to attorneys.

There's also little reason to expect much help on the revenue side of the equation.The city has the highest per-capita tax burden in Michigan, including a 2.4 percent income tax that is the state's highest, and a property tax rate that's higher than that of any other sizable Michigan city.

Meanwhile, state statute prohibits Detroit from enacting higher tax rates. But even if they were allowed, it's unclear whether residents could even afford to pay them. Nearly 40 percent of Detroiters live in poverty, more than 2.5 times the national rate, and there's also a sense that higher taxes -- especially given the poor quality of city services -- would only further deter people from moving to the troubled city. Orr says raising new revenue is "not a viable option." Attorneys for the city also say selling off city assets won't do much to plug Detroit's fiscal hole.

Historically, Detroit has dealt with these problems by deferring obligations and slashing services. Indeed, for each of the past six years, the city has suffered operating deficits that have largely been closed by issuing debt. Deferring pension contributions, furloughing employees, and borrowing money from outside the general fund were also common strategies.

But Thursday's filing painted Detroit as a city that's finally at the breaking point. Without bankruptcy, officials see few options for reversing a decades-long financial death spiral.

Orr says that 38 cents of every city dollar currently "goes to cover legacy costs, debt and other obligations rather than towards providing service for the city's residents and businesses." He projected that figure to rise to 65 cents of every dollar by 2017 without some sort of intervention.

In his letter to Snyder requesting bankruptcy authorization, Orr said the city is unable to adopt a financial plan that would solve its financial emergency outside of the Chapter 9 process.

Prior to the bankruptcy, Detroit already had the lowest credit rating of any major American city and was considered below investment grade. Friday morning, Standard & Poors announced it had lowered the city's credit rating even further from "CC" to "C."

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