Will Detroit Follow in GM’s Footsteps and Stiff Creditors?

GM building photoA recent Reuters article regarding the likelihood of a bankruptcy filing by the city of Detroit may come as a surprise to those who have heard nothing but positive spin on Motor City’s resurgence since General Motors and Chrysler emerged from their Obama-manipulated bankruptcies. Who can forget Clint Eastwood’s 2012 Super Bowl ad which gave a heartfelt tribute (paid for by Italian-owned Chrysler) trumpeting Detroit’s comeback? It seems like the outlook is now not so rosy for Detroit as its emergency manager Kevyn Orr puts the odds of a bankruptcy for the city at 50/50.

A proposal has been set forth by Orr to creditors offering them just pennies on the dollar reminiscent of GM’s low-ball offer to its bondholders which was made just prior to their bankruptcy filing. The GM offer was not made in good faith and never had a chance of succeeding. The parallel reality is that Detroit is broke, just like GM was. It will now be interesting to see if Detroit’s bondholders will be disproportionately punished compared to union creditors, as was the case with GM.

I would put the odds at greater than 50/50 for a Detroit bankruptcy, given the precedents set by the city’s automakers in their bankruptcy filings. In Obama’s America, bankruptcy has become something to be proud of. In fact, the president campaigned on a platform that celebrated the bankruptcies of GM and Chrysler. The strategy seemed to work, despite costing taxpayers billions of dollars on a process that saw politically-favored groups like the UAW bailed out at the expense of the less politically-connected bondholder group.

If or when Detroit files for a bankruptcy, it will become the largest US city to ever do so. Similar to the GM and Chrysler bankruptcies, precedents are being set for how entities that are broke (in the Detroit case, municipalities) will deal with their fiscal dilemmas in the future. It is likely that Orr is setting up a costly “pre-packaged” bankruptcy process for Detroit, something commonly used in the corporate world but never before attempted for a municipal bankruptcy. If the pre-packaged approach is not used, an even more costly conventional Chapter 9 filing would be a long and complex process.

The outcome of any Detroit bankruptcy may raise borrowing costs for other municipalities, particularly those in Michigan, as creditors become more cautious in risking their money investing in bonds (specifically, unsecured) that would not be as credit-worthy as previously assumed. Most important is how secured or insured municipal bondholders will be treated; expectations are that they will have to be paid in full.

Those who invested in unsecured bonds for the city of Detroit may not have learned a lesson from the travesties of the GM and Chrysler bankruptcies which saw bondholders unfairly subordinated to politically-favored groups. We will now have to closely watch the Detroit situation to see what lessons can be learned for future potential creditors of municipalities. One can only hope that “the rule of law” will be less abused than it was during the city’s automakers’ bankruptcy processes.

Mark Modica is an NLPC Associate Fellow.