The Global Urbanist

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How Detroit's emergency financial manager is needed to control infrastructure costs across the US

Neither the right nor the left of Michigan politics likes the fact that the state governor has appointed an emergency financial manager to take control of the City of Detroit, but as Isidoros Kyrlangitses shows, the new manager will be critical in calming the municipal bond market and preventing infrastructure costs from inflating across the US.

Cities: Detroit

Topics: City politics, City finances, Urban economics

The Detroit skyline seen through broken windows, symbols of the city's long-term decline. Photo: Muwumba (CC BY-ND 2.0)
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Last week Rick Snyder, governor of the state of Michigan, appointed Kevyn Orr, a lawyer responsible for restructuring a bankrupt Chrysler, as emergency financial manager (EFM) of the city of Detroit, with powers to override elected officials on all of the city's financial decisions.

The appointment faces criticism because of the state's interfering with local government, disregarding a democratically elected city council, and unnecessarily involving Michigan in a Detroit problem. The political left and political right are both critical of Michigan's EFM process. But they both disregard the macroeconomic implications of Detroit's situation for the entire United States. The country's $2.9tn (US dollars) municipal bond market is on pins and needles with every bankruptcy of a local government, and if Detroit were to go bankrupt it would be the largest by far. That is the situation the state of Michigan is trying to prevent with its EFM solution.

The risk to the cost of infrastructure

Cities with sound financial management should not have to pay a higher interest rate because of another city's mismanagement. This is the reasoning behind allowing an EFM to overrule a democratically elected city council in distress.

So what is an EFM? In Michigan, when a city's finances are deemed to be distressed, the state governor may appoint an EFM to take over the city until financial stability is restored. An EFM can sell city assets, cut budgets, hire and fire city staff and reorganise departments. Under Michigan's new and untested Public Act 436 an EFM can renegotiate labour conditions or interfere in the management of pensions.

Not all states have this option. In California the cities of Vallejo and Stockton simply filed for "Chapter 9" bankruptcy when their finances were unsustainable. Under this chapter of the US bankruptcy code, a federal court can override union contracts, state labour laws, and bondholder conditions to return a city to sustainability. Michigan's EFM's are not as powerful as the federal courts, being unable to adjust bondholder agreements or raise taxes, and thus offer a softer alternative to bankruptcy.

Michigan currently has five cities under an EFM. Detroit would be the sixth city under state control, but it would be by far the largest government entity to be taken over due to financial distress. Detroit has over 700,000 residents with long-term debt obligations of over $8.6bn which balloon to $14.99bn when pension and benefit liabilities are included. Compare that to Stockton, the largest US city so far to have declared bankruptcy. Stockton only had a debt load of $0.5bn for its population of over 290,000. The largest government entity to go bankrupt was Jefferson County, Alabama with $4.2bn in debt related to infrastructure mismanagement and corruption. Detroit's $8.6bn debt load is even larger than the state of Michigan's $7.6bn debt. The scale and complexity of the city has made Detroit a focal point in which people foresee a precedent being set.

So why does Michigan go for an EFM rather than just letting cities declare "Chapter 9" and letting federal courts figure it out? One advantage is the state maintains control over the city's financial situation. Another is to ensure that a bankruptcy outcome doesn't hurt the credit rating of every other city in the state. Brooks Patterson, executive of neighbouring Oakland county, has repeatedly said that if Detroit goes into bankruptcy court, it will affect his county's bond rating. No Michigan cities have ever filed for bankruptcy. California's cities under bankruptcy are causing nervous litigation closely watched by America's $2.9tn municipal bond market. That is a sizable chunk compared to the United States' $15.6tn economy. The municipal bond market is a financial tool used to fund schools, municipalities, airports, sewers, roads, and most other infrastructure in the country. In Vallejo, for the first time in a municipal bankruptcy, the interest rates paid to bondholders was curbed. As the scale of bankruptcies grows and more people are affected, there is fear among bondholders that popular opinion will demand sacrifices from them. Just the uncertainty of this scenario occurring has the market demanding an interest rate premium from Detroit and Los Angeles of around 5%, compared to 3.1% for a 30-year federal bond.

If California's hands-off approach eventually leads to a federal judge demanding bondholders sacrifice their premiums, then interest rates for all of California's cities will adjust higher to compensate for the additional risk of losing money. Building and maintaining in California will be more expensive to finance. Fewer projects would get completed. Fewer roads, bridges, transit systems, water and sewer systems would lead to a general decline in quality of life for the entire state. This threat of contagion is the scenario Michigan wants to avoid with its EFM solution. Cities with sound financial management should not have to pay a higher interest rate because of another city's mismanagement. This is the reasoning behind allowing an EFM to overrule a democratically elected city council in distress. The state is overruling the council to preserve the financial integrity of all other democratically elected city councils in Michigan.

Any bondholder sacrifice in Detroit will be shared by all municipalities across the state and potentially across the country through higher interest rates. And maybe that's the fairest solution of all in sharing the pain.

Unpopular on the left and the right

The political left does not like the EFM solution because Michigan's right-wing government will get to appoint a manager in a left-wing city whose budget decisions will lead to job and service cuts. They would prefer the state and federal governments provide financial aid that would be used at city council's discretion. But such funds (say, from the federal housing and urban development budget or from Michigan's revenue sharing arrangements) have not helped improve Detroit's decline in the past, and the state and federal government are not under any illusions that more aid will help the city in the future.

The political right does not like the EFM solution because of the potential for state funds to be involved to help with cash flow as the EFM reorganises the city's finances. Detroit is due to run out of cash this summer. The right would prefer for Detroit to just file Chapter 9, regardless of the contagion fears on other cities' finances. Some would argue that governments are over-leveraged and higher interest rates are just what is needed for greater fiscal prudence among municipalities. This stance assumes a stagnant world where additional roads and infrastructure will not be required to accommodate growth or improve efficiency. It's a stance that ignores America's historical growth since its inception and doesn't acknowledge that an increase in the cost of funding infrastructure will lead to a decline of infrastructure or a rise of local taxes.

The municipal bondholders are an easy target for all sides. It doesn't help that the tax-exempt status of municipal bonds attracts ultra-rich investor like Warren Buffet and hedge funds as well as banks and pensions. Among investors municipal bonds are considered safe investment vehicles because of governments' power to raise funds through additional taxes. The tax efficient investors are depending on higher taxes to fund their investments. There is a belief among investors that if municipal finances got into serious trouble the federal government would bail them out. The federal government would have more justification bailing out democratically elected local governments than it did in bailing out the auto industry. But the auto industry bailout required only a few billion dollars. The municipal bond market is $2.9tn. The current Chapter 9 bankruptcies are setting precedents that are amplified and priced throughout the municipal bond market. A Vallejo, Stockton, or Detroit bankruptcy affects the price of everyone's sewer, water, and road construction. Governor Snyder is trying to establish Michigan as an exception, with responsible government that fulfills its obligation to bondholders in hopes that the state's municipalities will be rewarded with cheaper financing.

Delaying the inevitable?

Detroit is the epitome of financial distress striving for sustainability. The challenge for the EFM is how to plug the $15m monthly cash flow gap by increasing revenues while cutting expenditures. There is fear the EFM may face too many obstacles and be required to send Detroit to file a Chapter 9 bankruptcy. Such an action would raise the question: why even bother with the added bureaucracy of an EFM in the first place?

Detroit's challenge is not just a financial one. High crime and a dysfunctional property tax system are not quickly fixed. In 2012 there were 386 homicides making the homicide rate 53 per 100,000 (NYC's rate is 6.4 and London's is 1.1). Budget cuts and the threat of bankruptcy has lowered the police moral as they deal with a shrinking force, and the chance their pay and pensions will be cut under bankruptcy proceedings. The property tax system is so convoluted that half of Detroit's property owner's don't pay taxes. (Why would anyone when you can buy a Detroit home at a government auction for $500? The city then inflates the assessment to tens of thousands and sends you an annual property tax bill for $3,000. Residents just avoid paying taxes for three years. The city forecloses on the property and the resident buys it or an equivalent at auction for $500.)

Crime, tax revenue, shrinking population, and a demoralised city staff are not problems an EFM can resolve by simply cutting expenditures. Governor Snyder may have hope in an EFM solution, but bondholders see an inevitable road to bankruptcy. A Detroit bankruptcy and how it is handled will be a headline discussed by all American households. Detroit's decline is a familiar story to them and they will want to see sacrifices among all parties including municipal bondholders. Any bondholder sacrifice in Detroit will be shared by all municipalities across the state and potentially across the country through higher interest rates. And maybe that's the fairest solution of all in sharing the pain.


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