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Creditors unfairly crammed down in Detroit bankruptcy

Caricature by US Air Force
Caricature by US Air Force
Photo by: Anne Savage

If you thought Detroit’s bankruptcy wasn’t appalling enough, you should take a look at the city’s bankruptcy proceedings. The decisions being made, most of which are political, are doing little to resolve the actual problem of making Detroit solvent and fully operational. Instead, the bankruptcy judge and the politicians are betraying the bondholders in favor of pensioners who aren’t even living in Michigan. The ripple effects of this debacle will ripple through the municipal financing market, and hamper municipalities from raising money, while also sticking it to muni bond investors.

The bankruptcy process should be straightforward. The debtor sells assets, thus raising enough cash to make good on short-term obligations and keep vital operations running. Then the debtor and creditors renegotiate long-term obligations so that they become manageable over time, showing favor to secured creditors and, if necessary, wipe out the unsecured creditors. The asset sales benefit the people actually living in Detroit, keep the secured creditors happy, and the city retains its essential services.

That’s not how things operate in Detroit, which has $18 billion in liabilities, of which about 20% are pension-related. The latest news is that pension funds will receive 25 cents on the dollar, while bondholders and unsecured creditors receive a mere 22 cents on the dollar.

The bondholders are understandably livid. It was their money that helped to fund the city all these years, and by extension, the pensions. The bondholders are wondering why retirees in Florida and Arizona getting so much of the pie. They don’t live in Detroit. They have no ties to the city. The money they receive from city pensions doesn’t get spent back into the Detroit economy. These retirees didn’t invest in the city at risk to themselves. How does bailing out pensioners, basking in the sunshine, help Detroit?

It doesn’t. The reason for this move lies in the labor unions, which place the interests of its members over the well-being of the city and, by extension, the very bondholders that funded the city and the pensions in the first place. The bankruptcy judge is required to let the unions have a seat at the bargaining table, but he doesn’t have to approve a deal this poorly conceived.

The bondholders are being squeezed out in another manner, rebuffed in their attempt to rightfully collect as much as possible from the sale of easily-monetized assets like the city’s art collection.

Like any other asset, this world-class art collection (consisting of 66,000 pieces) should be evaluated and sold off in its entirety. It’s been estimated to be worth some $2.5 billion. Yet, Christie’s only evaluated 5% of the art collection, and lowballed its value to a range between $454 million to $867 million. How does a $2.5 billion collection get appraised for less than a third of its value? Bondholders have raised the question as to whether someone directed the auction house to deliberately undervalue the collection.

Additionally, in a strange ruling, the bankruptcy judge is refusing to let an independent party evaluate the collection, despite creditors’ offer to pay for it. Why aren’t bondholders being permitted to even get the collection independently evaluated at no cost to the city?

What’s going on?

Critics of the plan point to several culprits. The first is emergency manager Kevyn Orr, an unelected official allegedly paid by Gov. Rick Snyder out of secret slush funds. There has been ample criticism that a Chapter 9 bankruptcy was both unnecessary and planned in advance of Orr’s appointment. There are charges that Orr has shown undue favoritism to union pensioners, following his own precedent while representing Chrysler, in which unions ended up owning 55% of the automaker. It seems odd that a man who had tax liens on his own home would end up being the man to shepherd Detroit out of bankruptcy.

The second culprit appears to be Gov. Snyder, who apparently has abandoned the traditional Republican philosophy of fiscal responsibility. Gov. Snyder doesn't appear to care about Democrat-heavy Detroit, as he won’t offer the city a bailout, which in turn harms the creditors. His dismissal of Detroit’s problems are hypocritical considering his call for a federal balanced budget, and for “shared sacrifice” in his 2011 inaugural address. It has left bondholders thinking that fiscal responsibility for Republicans is all well and good but only when it benefits Republicans. Given that Detroit is 85% Democratic, it stands to reason that the Republican governor could not care less what happens to the city, as it does not consist of his voting base.

On the Democratic side, various foundations want to transfer the art into a non-profit entity, in order to prevent it from being sold off, with the foundations contributing a few hundred million dollars to shore up the pensions. This is more likely a move by wealthy special-interest elites who want to “protect the art”.

Bondholders ask how is “protecting art” more important to maintaining basic services, like police and fire, for Detroit’s citizens? How is it more important than fiscal responsibility? Why is artwork, however important and treasured it may be, being given precedence over bondholders? The artwork will find good homes, after all. Creditors insist this is typical Democratic values at work.

Meanwhile, the damage to the municipal finance market may be devastating.

Municipal bond investors and financiers see Detroit, and realize that their investment may not be as secure as muni investing traditionally has been thought to be. Imagine if a bondholder has money invested in a city, the city goes bankrupt, and suddenly a bunch of politicians and erratic judges decide that assets aren’t really assets and can’t be sold.

The result from the Detroit debacle is that lenders will be more reluctant to lend, making financing more difficult to obtain, forcing municipalities to pay higher interest rates (if they get financing at all). In short, that means more risk in muni securities.

A lot of retirees invest in muni bond funds because of their tax-exempt status and perceived low risk. Now, that risk will have increased, and retirees will abandon muni funds. The cascading effect will ripple through the entire financial system.

Americans are already seeing the effects in the financial markets. When rumors began circulating that Detroit might default, municipal investment values fell about 10%. If the bondholder deal is approved at 22 cents on the dollar, it’ll get worse.

Everyone needs to put their respective agendas aside. The entire art collection must be sold. The bondholders and secured creditors should be first in line to receive a payout, and at substantially increased levels than is currently being suggested.

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