The Ineluctable Challenge of Weighing a City’s Past Versus its Future

eBlog

February 20, 2014
Visit the project blog: The Municipal Sustainability Project

Electronic Musical Chords. Nathan Bomey of the Detroit Free Press yesterday did a terrific interview with U.S. Bankruptcy Judge Steven Rhodes, with Judge Rhodes telling him he never believed the City of Detroit had to choose between paying its creditors or reinvesting in services. Judge Rhodes noted that cuts to Detroit’s pensioners and bondholders were necessary, but said that without a feasible plan to place the city on a financially sustainable path, retirees and financial creditors would have fared worse down the road, so, he said: “[T]he goals of satisfying the interests of creditors and satisfying the interests of the residents in my view were never in conflict…In fact, they were symbiotic. In order for creditors to be repaid, there had to be a vital city:” Please note I have taken the liberty of highlighting some of Judge Rhodes’ responses, as they seem especially insightful.

QUESTION: Do you think Detroit’s collapse was an isolated incident or does it portend a broader crisis of some sort?
ANSWER: It was in some senses unique to Detroit and in some senses a part of a national phenomenon. The part that’s national is the economic factor of it, the decline of manufacturing generally in this country and the migration of what manufacturing remains really out of the Rust Belt.
Q: And our unique amount of mismanagement and perhaps even corruption?
A: We did have obviously one corrupt mayor. It’s hard for me to judge how much of the city’s issues are directly attributable to that.
Q: You chose Judge Rosen to be your mediator. What was the reasoning behind that?
A: I was convinced of the importance of mediation and a mediated and negotiated settlement to the prompt disposition of the case. And I also felt that the prompt disposition of the case was essential to the city’s revitalization.
So I felt it was necessary to appoint the strongest possible mediator that I could. And I felt that Chief Judge Rosen had all of the necessary qualities. Weight of office. Weight of personality. Commitment to the city. Personal and professional contacts. Political contacts. He was the right person.
Q: Early on you set a really expeditious pace for the case.
A: I didn’t really perceive of it as expeditious. I perceived of it as what was necessary given the circumstances of the case.
Q: Is it accurate to say that you prioritized the health and welfare of the people of Detroit over the repayment of creditors?
A: Everyone in the state had a personal stake in the outcome of the case. Even more specifically, in order for any plan to be feasible, the city had to develop a plan by which it could deliver municipal services adequately.
So the goals of satisfying the interests of creditors and satisfying the interests of the residents in my view were never in conflict. In fact, they were symbiotic. In order for creditors to be repaid, there had to be a vital city.
Q: By the time Detroit filed for bankruptcy, were pension cuts inevitable?
A: Inevitable’s a pretty strong word. I would say very highly likely.
Q: People blamed Kevyn Orr and perhaps even you for cutting pensions. But in reality, the promises to pay those pensions had been broken many years ago.
A: The city did not have the resources in its pension plans to fulfill its obligations to pensioners. There really never was much dispute about that.
Q: But from a legal perspective it wasn’t a difficult call for you?
A: That’s true. We in bankruptcy impair contracts all day, every day. That is what we do.
Q: No municipal bankruptcy judge had had to decide that question or been willing to decide that question. Was there hesitancy that you’re going to be the first?
A: There was always going to be lots of groundbreaking in the Detroit case. It is certainly true that there was not a lot — or sometimes even any — precedent for the legal decisions I had to make.
Q: Former Mayor Kwame Kilpatrick’s $1.4 billion debt deal, executed in 2005 and 2006, was a disaster for the city. Was it the point of no return financially?
A: Yes. I have said the city should have filed for bankruptcy then and perhaps even before then.
Q: The governor has said he was always representing each individual person in Detroit. Was democracy suspended in Detroit?
A: The people lost the ability to have the direct impact that they have when there’s a mayor and a City Council in charge when the emergency manager was appointed. That’s a taking away of democracy to that extent.
Q: But you never felt that the law was unconstitutional obviously.
A: I did not. And really, primarily for the reasons that Gov. Snyder identifies. The democratically elected Legislature passed this law. The governor signed it. The city is an arm of the state. And it is always subject to state law.
Q: One of the most surprising moments of the bankruptcy was when you killed the second swaps settlement. There was a gasp in the courtroom. Did you hear it?
A: I can’t say that I did. But I was not surprised that they were surprised.
Q: Your relationship with Detroit emergency manager Kevyn Orr seemed complicated. At times you chided him. But also you’ve praised the job that he did. What is his legacy in Detroit?
A: I hope his legacy is that he took on an enormous and some might say impossible challenge and met that challenge with grace, dignity, professionalism, and proficiency. Of all of us who were challenged by Detroit’s insolvency, he had the most challenging and difficult job of all.
Q: How much credit does Gov. Snyder get for authorizing the bankruptcy?
A: A lot of people maintain that it was a very courageous thing for him to do and that it was something his predecessors were not willing to do and did not do. From an economic or fiscal perspective, it doesn’t seem to me it was a very hard decision. As I’ve said, it should have been made a long time ago. Politically, on the other hand, I’m sure it was hard for him.
Q: When did you first hear about the concept of the grand bargain?
A: I remember Judge Rosen sketching it out for me in the broadest details after he had the parties on board in concept, but I’m not sure I can tell you precisely when that was.
Q: Mr. Orr has said he was skeptical at the beginning. Some people withheld judgment. What was your initial reaction? Did you think it was doable?
A: I had no basis to judge that other than the optimism that Judge Rosen was exuding. He was optimistic about it from the beginning, and so was I.
Q: It’s well established at this point that cities cannot be forced to sell assets in municipal bankruptcy.
A: Yes, that’s true.
Q: What would have happened had Kevyn Orr decided selling DIA property was necessary?
A: I would have needed to be persuaded.
Q: Because you said in your opinion the DIA and the attorney general would be more likely to prevail if there was to be an argument over this in court.
A: Not only was I persuaded of that, I was also persuaded of the necessity of maintaining the DIA and the art in the DIA intact to assist in the city’s revitalization.
Q: There were many who said we should prioritize pensions or services over keeping an admittedly wonderful art collection. How did you balance that from a philosophical and judicial perspective?
A: I understood that perfectly well. But here’s the thing about bankruptcy. Bankruptcy requires shared sacrifice. And the deeper truth than that immediate one that they were trying to express is simply this: Without a revitalized city, any pension promises that the city might make would be impaired.
A revitalized city was essential to any long-term promises that the city might make to any creditor, including the pensioners.
Q: Were there nights where you thought, I am going to have to cram down something here?
A: Oh yeah. I believed that until the last creditor settlement. Until FGIC and Syncora settled — those were the last two — I assumed and believed that they would not settle and that I would have to consider the city’s request to cram down the plan over their objections.
Q: Syncora in particular waged an extremely aggressive campaign against the city. At one point you even told both sides to stop using war analogies because it had gotten so intense. What did you make of their strategy?
A: They argued zealously, but they always did it with civility. And their arguments were well argued, well structured, well organized, well presented. They were really good lawyers. So I had no problems with the zealousness with which they advocated their position.
Q: Of course at the end of the case, when they attacked the ethics of the mediators, you were extremely upset.
A: I was. I felt that was totally unjustified. And I struck it, and I was prepared to consider sanctions until they apologized for it.
Q: How close did you come to sanctions?
A: Well, I would have been interested in what they had to say on why they shouldn’t have been sanctioned. But I felt like sanctions should be given very serious considerations and not minor sanctions either.
Q: How taxing was this case for you personally?
A: There were obviously times when it was extremely taxing for me personally. It was, for stretches and sometimes long stretches, very intense.
Q: We were all at news conferences where Judge Rosen was present and in some ways he was much more visible as a mediator than a lot of people expected. Were you worried about that at all?
A: Judge Rosen is a political animal in a way that I totally am not. So I had complete faith and trust in his political judgments as to what he felt he needed to do to fulfill his obligations as a mediator.
When I appointed him and he agreed to be appointed, I told him that his deliverable to me was a confirmable plan of adjustment in this case and he delivered that.
Q: How much did you coordinate with Judge Rosen during the case and how much did you know about what was happening in mediation?
A: At the beginning of the case, we agreed on two basic principles. The first was, I would keep pedal to the metal in litigation, and he would keep pedal to the metal in mediation, and we would run them in parallel with one important exception. If he recommended to me that I let off on the gas and apply the brakes to litigation, I would do that. I would follow his recommendation when he thought that would facilitate settlement.
There were also times when he thought it would facilitate mediation for me to advance litigation and to hold a hearing and to ask the hard questions of the lawyers to get them to realize what the strengths and weaknesses of their case were. I would do that.
Q: Did the city need $1,000-per-hour attorneys to run this case?
A: The question is for me whether their fees were reasonable or not and I’ve made my judgment about that.
Q: They could have made more money elsewhere, right?
A: I assume. The rates that they charged were in some senses for them below market rates because they did discount the ultimate fee that they charged to the city in many different ways. The city’s lawyers brought to the case an expertise that is very rare in this country.
Q: Did you believe that the city needed to account for the DIA’s value in some capacity in the plan? Could the city have executed a plan of adjustment without someone accounting for the value of the museum?
A: It did. The plan we have takes no account of the value of the art. So the answer to that question is yes. It gets back to the fact that what the city does with its property is entirely its own decision and not one that the bankruptcy court can exercise any control over whatsoever.
Q: Then the natural question is, was there a false crisis in the sense that the DIA was never really in trouble?
A: Well, the question you’re raising really is at what point in the process from beginning to end could or should that issue have been resolved.
If I had decided early in the case and teed up the issue of whether the art was in play or not, would we have gotten $816 million in a grand bargain? I’m not sure about that.

The Motor City’s Future. Michigan Governor Rick Snyder is considering options for the state to provide debt relief for the cash-strapped Detroit Public Schools (DPS)—a system with an estimated $55 million annual cost to finance its accumulating debt. Governor Snyder has proposed a $75 million distressed schools fund as part of his 2016 executive budget as part of a plan to help financially struggling school districts across the state, telling the legislature: “We are still evolving in terms of the best way to implement the entire program, but there are districts that need substantial readjustments in terms of their finances…I’d like to start establishing a reserve fund for financial resources to do the restructurings…I don’t view this is a bailout, but only where we’re truly solving problems in the long term.” Such a fund would be designed to help DPS cover debt payments, or shifting shift DPS into a new district, with the remaining bonds being serviced with an outstanding levy. The Governor’s strategy director, John Walsh, however, told the Detroit News: We’re not talking about [municipal] bankruptcy — the governor has been very clear about that…We have to find a method that will recognize that they can’t bear the weight [of their debt].” Because the school system is not part of Detroit’s budget, its financial distress was not addressed in the Motor City’s plan of debt adjustment—nor was it part of the so-called “Grand Bargain,” they magic elixir to the city’s obtaining U.S. Bankruptcy Judge Steven Rhodes’ blessing of its largest in U.S. history municipal bankruptcy exit plan. Nevertheless, it is difficult to imagine a more critical criterion to the Motor City’s future than the recovery and financial and educational stability and competence of its school system. It will be key not only to any hope of reversing the unprecedented decline of the city’s population, but also to its future. In Detroit, the challenge is especially daunting: according to the Ann E. Casey Foundation KidsCount report, Detroit continues to have more children living in extreme poverty than any of the nation’s 50 largest cities: More than 59 percent of Detroit children lived in poverty in 2012, the most recent year for which data is available—an increase of 34 percent since 2006. It is, in some ways, a microcosm of the state, where one in four children live in extreme poverty, according to the report—itself an increase of 35 percent over six years, to nearly 25 percent―a devastating percentage which some attribute to steep cuts to social services. The other side of such decreases, one may observe, imposes a double whammy: huge increases in burdens on the City of Detroit―reports of child abuse and neglect increased 77 percent in Detroit from 2008-12, with about 15 percent of Detroit children living in homes that have been investigated by child protection workers: confirmed neglect or abuse increased 40 percent. The death rate for young people ages 1-19 increased 14 percent between 2004 and 2012, mostly because of increased homicide and suicide among teenagers―and a devastating and discouraging message to families with children that might be considering moving to Detroit. Fortunately, the Casey Foundation report showed improvements in some measures of well-being:
• The number of children in out-of-home care decreased 71 percent in Detroit, and 33 percent statewide.
• Births to teens aged 15-19 decreased 13 percent in Detroit, and 16 percent across the state.
• The number of fourth-graders scoring “not proficient” in reading declined 24 percent in Michigan, and 16 percent in Detroit, from the 2008-09 school year to the 2013-14 school year.
The Motor City’s public school system carries roughly $2.1 billion of debt, of which approximately 75% is unlimited-tax general obligation bonds secured by Michigan’s School Bond Qualification and Loan Program. Another $325 million is long-term state aid revenue bonds, secured by an intercept feature on state aid; and $108 million is in the form of loans from the Michigan School Loan Revolving Fund, according to Moody’s Investors Service. In 2013, fixed costs, including debt service and retirement costs, made up 35% of operating revenue and were expected to grow at least 3% or more in fiscal 2015, according to Moody’s, which maintains junk ratings and a negative outlook on the district. The Detroit School District faces a $170 million deficit in fiscal 2015.

Don’t Rush to Bankruptcy Judgment. A week after pushing Detroit neighbor Wayne County, Mich. to junk territory, credit rating agency Standard & Poor’s analyst Jane Ridley yesterday wrote it is premature to “start treating Detroit’s neighboring municipality as if it were about to file for municipal bankruptcy: As we recently saw in Detroit, bankruptcy is a significant issue, with serious potential repercussions for bondholders. We take very seriously any possibility of bankruptcy, but we don’t want to rush to judgment before letting the process to take its course.” Nevertheless, Ms. Ridley wrote S&P could change its view of the likelihood of municipal bankruptcy if Michigan were to appoint an emergency manager, based upon the experience of the accelerated transition from Gov. Snyder’s appointment of Kevyn Orr to Detroit’s filing for federal bankruptcy protection…if past is prologue: “While many consider it a positive step to bring in a third party who has powers to make changes, such as the Emergency Manager option, given Detroit’s recent experience and very rapid move to bankruptcy, our view on the county’s trajectory could well change with the appointment of an emergency manager.” Last Friday S&P downgraded Wayne to BB-plus from BBB-minus, with a negative outlook―costing the county its final investment-grade rating; Moody’s moodily had at the beginning of the week dropped the county three notches to junk. The respective downgrades came in the wake of newly elected County Executive Warren Evans’ warnings when he took office last month that Wayne County is on a trajectory to run out of cash by August 2016 and that municipal bankruptcy or state takeover are on the table without major financial fixes.

Tense Futures & Pasts. For every municipality in severe fiscal distress, the challenge between the past and the future—between public pension obligations versus capital investment for a sustainable future can best be described as a nightmare. For instance, in Stockton, as U.S. Bankruptcy Judge Christopher Klein opined, notwithstanding the Golden State constitution, the federal chapter 9 municipal bankruptcy law trumps the state constitution protection of public pension contracts. So there was a legal basis—as there is, with, presumably, U.S. Bankruptcy Judge Meredith Jury’s acquiescence―but there is a harsher reality. Not only are there unique attributes to California’s CalPERS public retirement system vis-à-vis municipalities, so that, for instance, had Stockton, in its proposed plan of debt adjustment, opted to include reductions in pensions; CalPERS would have cut pensions a little more than half for current retirees and employees in order to avoid having other California municipalities being forced to subsidize Stockton: CalPERS had no authority under state law to cut by a lesser percentage. Even as it was—and is in San Bernardino, which faces a similar quandary with regard to its public pension obligations to CalPERS—any action to cut pensions would likely have rendered Stockton far less competitive in its ability to attract qualified recruits to its public safety departments—a critical factor for cities in distress which, more often than not appear to have disproportionate rates of violent crime—a vital issue to address in any plan of adjustment or municipal bankruptcy recovery plan. So, for example, San Bernardino ranks as a city with one of the highest violent crime rates in California, should the city, as part of its developing plan of adjustment, opt to impair its CalPERS contract, technically employees would have 6 months to find another CalPERS job (state law)—under California law such individuals would be deemed “legacy” or “classic” employees: that would enable their retention of their current pension formulas with their new employer; however, if they were unable to find another job until after 6 months, they would then be deemed a “new” employee in CalPERS and take a significantly reduced pension benefit. This complex state-local dilemma narrows—an understatement—a California city’s options. In San Bernardino, the city had already lost 100 police officers due to compensation reforms prior to its filing for municipal bankruptcy protection—even though, on too many days, the city has been in Code Blue―that is, only responding to crimes in progress. It is, thus, nearly impossible to contemplate what would the impact on the city’s public safety would be were it to propose—as part of its plan of debt adjustment due in May to Judge Jury—adjustments in its public pension obligations. Would the city risk losing another 100-150 police officers? What would be the chances of the city to attract highly qualified replacements? What might be the impact on families—either those weighing whether to stay—or, much less, those who might be considering moving to San Bernardino? This is part of the intractable imbalance in municipal bankruptcy between a city’s obligations to its municipal bondholder creditors—vital capital, after all, and its employees and retirees: to its most critical goal in putting together its plan of debt adjustment: to transition back to service solvency. But as one reader aptly notes: “creditors don’t care about this fact and don’t understand it…the need, for a municipality, to be a viable employer is critical to ensuring service solvency.” That can be especially true in the Golden State, where, currently, it takes 100 applicants to get a single police officer.

Unappealing Options. Jefferson County, Alabama Commissioner George Bowman and several litigants who filed an appeal of the decision approving the county’s municipal bankruptcy plan of debt adjustment on behalf of ratepayers on the county’s sewer system yesterday wrote Alabama Gov. Robert Bentley and Attorney General Luther Strange requesting they intervene in the appeal of Jefferson County’s municipal bankruptcy case, writing that the Governor and Attorney General should “do their job to protect the public interest by joining in the existing appeal.” Commissioner Bowman said they hope to meet with Governor Bentley and the AG to discuss a number of issues raised in the appeal, including their apprehensions with regard to the plan’s proviso that the federal court oversee implementation of the plan — and sewer system rate increases — for the next 40 years. The appeal promises to add to the hefty price tag for Jefferson County taxpayers: Jefferson County has already expended close to $30 million for its bankruptcy—a price that is certain to veer upward with the appeal. In their appeal, the litigants claim the federal oversight violates Alabama’s rights in violation of the U.S. Constitution. Commissioner Bowman opposed the County’s decision to file for municipal bankruptcy protection in 2011; he also voted against the county’s plan of adjustment or exit plan which U.S. Bankruptcy Judge Thomas Bennett approved a year ago last December—a plan which authorized Jefferson County to issue $1.8 billion of sewer refunding warrants to write down the county’s debt, and exit what was, at the time, the largest municipal bankruptcy in U.S. history. Commissioner Bowman complains that the federally approved plan of adjustment burdens some of Jefferson County’s poorest citizens with 40 years of sewer system rate increases which he believes they will be unable to afford, warning that over the next forty years rates will increase 471% to service the sewer refunding warrants that have been issued. U.S. District Judge Sharon Blackburn has previously rejected the claim by Jefferson County that because the plan of debt adjustment has already been implemented the appeal is moot; Judge Blackburn made clear she has discretion to overturn various provisions in the plan of adjustment—both issues on which Jefferson County has appealed to the 11th U.S. Circuit Court of Appeals.

Underwater in Puerto Rico. Moody’s has downgraded Puerto Rico’s general obligation rating to Caa1 from B2, reporting that the territory’s anemic growth is harming tax revenues—imperiling the Commonwealth’s liquidity. The gloomy, if moody assessment comes as the U.S. House Judiciary Subcommittee on Regulatory Reform, Commercial and Antitrust law readies its hearing next Thursday on draft federal legislation to allow Puerto Rico government-owned corporations to restructure their debts under Chapter 9 municipal bankruptcy. The hearing comes amid increasing apprehension that the Twilight Zone for U.S. territories—which are neither states nor municipalities—leaves them no options for bankruptcy protection—unlike every other corporation in the U.S. The Commonwealth of Puerto Rico has said that while it supports amending Chapter 9, it fears that waiting for Congress to act could be like waiting for Godot. Moody’s downgrade now drops the island lower than S&P’s and Fitch’s most recent reassessments. Moody’s Caa is used for state and local bonds in “poor standing and subject to very high credit risk.” Moody’s analysts Ted Hampton and Emily Raimes wrote in yesterday’s report that tax revenue shortfalls, because of sluggish economic growth, may harm the Commonwealth’s liquidity; they noted that General Fund revenues have been coming in 2.5% below projections through the first 7 months of the fiscal year: “In view of still anemic economic trends, the revenue gap could widen after April income tax payments…Puerto Rico’s Economic Activity Index as of December was down 1.4% on a year-over-year basis.” The dynamic duo also noted apprehension about Puerto Rico’s ability to issue new debt to would shore up liquidity, adding that Puerto Rico anticipates a 35% increase in debt service in FY 2016―even more daunting will be the subsequent years as rising debt service requirements impose an ever increasing burden―noting that the Commonwealth’s debt burden is high compared with U.S. states: Puerto Rico’s adjusted net pension liability was 223% of revenues compared with a U.S. state median of 60% of revenues: “Downgrades of some ratings to Caa2, a notch below the commonwealth’s GO rating, reflect the vulnerability of pledged revenues to a constitutional provision that provides a claim in favor of general obligation bondholders.”

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