The Thin Line Between Fiscal & Physical Recovery Versus Unsustainability.


Good Morning! In this a.m.’s eBlog, we consider, Detroit’s remarkable route to fiscal recovery; then we turn to challenges to a municipality’s authority to deal with distress—or be forced into chapter 9 municipal bankruptcy in Pennsylvania, before returning to the stark fiscal challenges to Puerto Rico’s economic sustainability, and then the taxing challenge to Scranton’s efforts for a sustainable fiscal recovery.

Campaigning & Turning around the Motor City’s Fiscal Future. Detroit Mayor Mike Duggan, last week, at the annual Mackinac Policy Conference spoke about the racially divisive public policies of the first half of 20th century which, he said, had helped contribute to Detroit’s long slide into municipal bankruptcy—indeed, the largest municipal bankruptcy in U.S. history—but one which he said had helped lay the foundation for a conversation about how Detroit could grow for the first time in half a century without making the mistakes of the past that had, inexorably, led to an exodus of nearly 1.2 million from 1956 to its chapter 9 bankruptcy—noting: “If we fail again, I don’t know if the city can come back.” His remarks, mayhap ironically, came nearly a half century from the 1976 Detroit riot, a riot which  began downtown and was only curtailed after former U.S. President Lyndon Johnson ordered the 82nd and 101st Airborne Divisions to intervene, along with then Michigan Gov. George Romney ordering in the Michigan Army National Guard. The toll from the riot: 43 dead, 1,189 injured, 2,000 of the city’s buildings destroyed, and 7,200 arrests.  

But, rather than discussing or issuing a progress report on the city’s remarkable turnaround, Mayor Duggan instead spoke of the city’s racial tensions that had sparked that riot, in many ways, according to the Mayor, coming from the housing policies of former President Franklin Roosevelt—a policy which placed or zoned blacks in the city into so-called “red zones,” thereby creating the kind of racial tensions central to the 1943 and 1967 riots—a federal policy adopted in 1934 which steered federally backed mortgages away from neighborhoods with blacks and other racial minorities. Indeed, the Mayor quoted from a 1934 Federal Housing Administration manual that instructed mortgage bankers that “incompatible racial groups should not be permitted to live in the same communities;” the manual also instructed housing appraisers to “predict the probability of the location being invaded by…incompatible racial and social groups…, so that, as the Mayor added: “If you were adjacent to a minority area, your appraisal got downgraded.”

Thus, federal housing policies were a critical component contributing to the historic white and middle class flight from Detroit to its suburbs—suburbs where federal housing policies through the Federal Housing Administration subsidized more than half of the mortgages for new construction—or, as Mayor Duggan described the federal policies: “There was a conscious federal policy that discarded what was left behind and subsidized the move to the suburbs: This is our history, and it’s something we still have to overcome.” His blunt Mayoral message to the business community was that the city’s hisgtory of race and class segregation had to be acknowledged—or, as he put it: “I just wanted to deliver a message to the broader community to say, ‘Look, there’s a place for you to come invest in Detroit. Here are the ground rules, here is the reasoning behind the ground rules… and if you want to come in and invest in the city, move into the city and be part of it with the understanding that the recovery includes everybody, we’d love to have you: The African-American community voted for me, and I can’t tell you what an enormous responsibility that feels like.” Thus, the Mayor made clear that he and the Detroit City Council have been focused on governing mechanisms that ensure longtime Detroiters are not displaced by downtown and Midtown revitalization—enacting an ordinance mandating that housing developments in receipt of city tax subsidies have at least 20 percent of the units classified as affordable housing for lower-income residents, and mandating that 51% of the person-hours for construction of the new Little Caesars Arena be performed by Detroiters: “We’re going to fight economic segregation…It would be so easy in this city to have one area be all wealthy people and one area all poor people.”

The Challenge of Municipal Fiscal Recovery. Judge James Gibbons of the Lackawanna, Pennsylvania County Court of Common Pleas last week heard the City of Scranton’s preliminary arguments in response to a lawsuit by eight taxpayers seeking to bar the municipality from tripling its local services tax. The suit, filed March 2nd, contends that Scranton has been collecting taxes which exceed the legal issuance; it calls for the issuance of a mandamus against the city. In response, city attorneys, note that, as a home rule charter city, Scranton is not subject to the cap that Pennsylvania’s Act 511 stipulates. (The taxing legal and political regime, as we have previously noted, in one of the nation’s oldest cities, comes in the wake of its action to raise the levy from $52 to $156 for every person working within the city limits who earns at least $15,600, with the city justifying the action under Pennsylvania Act 47 and municipal planning code.) The taxpayer group, led by independent Mayoral candidate Gary St. Fleur, in seeking a mandamus action, has charged that lowering taxes across the board is the only way for the city to be able to fiscally recover.

Mr. St. Fleur, an independent candidate for mayor, has initiated a ballot measure to force 76,000-population county seat Scranton into chapter 9 municipal bankruptcy, citing a Wells Fargo report from October 2016, which found that a 2014 audit of Scranton revealed $375 million in liabilities and $184 million in unfunded non-pension post-retirement public pension benefits to government employees. (Mr. St. Fleur’s group, last February, had also objected to the city’s annual petition to the court to raise the tax—an objection rejected by visiting Judge John Braxton—a decision which, unsurprisingly, prompted the taxpayer group to initiate its own suit, notwithstanding that Scranton is a home-rule community, so that, in Pennsylvania, it has the authority to levy taxes.) Unsurprisingly, the anti-tax challengers’ attorney, John McGovern, counters that Act 511, which, when enacted 52 years ago, authorized the local Earned Income Tax, which authorizes municipalities and school districts the legal authority to levy a tax on individual gross earned income/compensation and net profits (the tax is based on the taxpayer’s place of residence or domicile, not place of employment) is separate from the Pennsylvania personal income tax. He charges that the Act has two “very specific” sections which cap how much the City of Scranton can tax, charging: “Call it a duck or a goose, call it a rate or a cap, but for the city to say it can tax whatever it wants, that alone is dangerous and absurd,” adding: “At this point, we’re dealing with 2017, and the city is spending like a drunken sailor…State law clearly states there is a cap to taxation through the Act 511 law…If we do not win, that would allow any city to raise taxes in any amount it wants.”

In contrast, David Fiorenza, a Villanova School of Business finance Professor and former CFO of Radnor Township, noted: “Scranton has made progress from three years ago, in part due to the renegotiating of some city union contracts and the low-interest rates on debt…The challenges this city will face will be the uncertainty of the state and federal budget as it relates to school funding and other funds that have been relied on for some many years.” Kevin Conaboy, whose firm is representing the city, told the court the city may raise its taxes under the state’s home-rule provisions, and he noted that Pennsylvania’s home rule provisions supersede a cap in the state’s Act 511 local tax enabling act. Moreover, Scranton city leaders have deemed the revenue increase essential for Scranton’s recovery under the state-sponsored Act 47 workout for distressed communities, to which Scranton has been subject since 1992.

Is the Bell Tolling for Act 47? The case is re-raising questions with regard to the effectiveness of the state’s municipal fiscal distress law, Act 47, a program which some critics charge has become an addiction rather than a cure. Villanova School of Business Professor David Fiorenza, referring to a 2014 change to the state enabling law, believes municipalities stay in the program for too long: “Act 47 is effective, but continues to present a problem as cities are able to request an extension after the five-year time period has expired…A five-year time frame is sufficient for a municipality to assess their financial situation and implement any changes. However, if the economy enters a recession during this time period, it will impede their financial progress.”

Physical & Fiscal Atrophy. Puerto Rico has lost two percent of its people in each of the past three years—but a two percent which in fiscal terms is far more grave from a fiscal perspective: the two percent, according to the insightful fiscal wizards at Federal Reserve Bank of New York, means that “If people continue to leave the island at the pace that has been set in recent years, the economic potential of Puerto Rico will only continue to deteriorate.” That outflow is comparable to 18 million Americans emigrating from the 50 states: it marks nearly a 12% drop: some 400,000 fewer Puerto Ricans today compared to 2007—meaning, increasingly, a U.S. territory entrapped in a fiscal tornado: unemployment is at 11.5%, so, unsurprisingly, the young and mobile are leaving the island behind. With unemployment at 11.5%, Puerto Rico in a quasi-chapter 9 municipal bankruptcy, federal law discriminating against the territory’s economy, and its municipalities unable to access chapter 9—the $74 billion accumulated debt and quasi-federal takeover has created incentives for more and more Puerto Ricans, from all economic levels, to leave—creating a vicious fiscal cycle of reduced government revenue, but ever-increasing debt: Puerto Rico’s municipal bond debt has grown 87 percent just since 2006—making the increasing obligations a further incentive to emigrate.

The PROMESA Board’s proposed plan to revert to fiscal sustainability does not appear to address the physical demographic realities: it assumes the population will shrink just 0.2 percent each year over the next decade, relying on that projection as the basis for its projections of tax receipts and economic growth—projections which Sergio Marxuach, Public Policy Director at the Center for the New Economy in San Juan, generously describes as: “[R]eally, really optimistic.” The harsh reality appears to be that the growing earnings disparity between Puerto Rico and the continental U.S. is so stark that any family focused on its health, safety, and financially viable future—in a situation of today where the Puerto Rican government has closed schools to save money—means that teachers can double or triple their earnings if they move to the mainland: doing that math adds up to younger generations of child-bearing age being increasingly likely to leave Puerto Rico for the mainland. Coming on top of Puerto Rico’s more than a decade-long population decline, it seems that, more and more, for those who can afford it, the option of leaving is the only choice—meaning, for those who cannot afford to—the Puerto Rico left behind could become increasingly older and less fiscally able to construct a fiscal future.

Detroit Bankruptcy Trial: Day 2: Let the Battle Begin

             September 4, 2014

Visit the project blog: The Municipal Sustainability Project 

Day 2.  The second day of the historic trial where Judge Rhodes will have to determine whether Detroit’s proposed plan of adjustment is fair, feasible, and in the best interest of creditors will be a task, as this day emphasized, more complex than any previous trial in U.S. history, because, under the city’s proposed plan, the city’s tens of thousands of creditors would get vastly different returns on their claims. Under the proposed plan, current and former employees, as well as investors, will be forced to take less than the $10.4 billion they are owed if Judge Rhodes approves the plan, which proposes to cut $7 billion of the debt. Detroit’s attorney, Bruce Bennett, began the second day of the trial by arguing that a dismissal will lead to higher taxes and a rush to the courthouse by creditors trying to recoup money. “Dismissal followed by increased taxes will only mean the downward spiral will continue or get worse,” Bennett told the judge. “We don’t need to guess about the future or gaze into crystal balls.” Bennett spoke for about three hours over two days. On Tuesday, he argued that Detroit will not survive being kicked out of bankruptcy court. “This is the city’s last, best chance and it’s going to work,” Bennett said early Wednesday. He acknowledged the plan, which includes about $1.4 billion to upgrade public safety and other services, is not perfect. “In the future, things will happen that we haven’t planned for,” Bennett said. “Unexpected things will most certainly happen and other people, not the emergency manager and not necessarily the team that put all this together is going to have to adjust to the future over time,” Bennett continued. “We expect those adjustments. We expect those changes. They are impossible to predict or nail down.” In closing, he paraphrased Gov. Rick Snyder, who authorized the city’s bankruptcy filing in July 2013. The bankruptcy “should not be viewed as the lowest point in the city’s history, but the beginning of the city’s recovery.” “The facts will show that Detroit has earned this court’s help in escaping from its current distressed state,” Bennett told Rhodes. The second day of Detroit’s municipal bankruptcy trial quickly got to the heart of the matter, with holdout creditor Syncora telling the federal court the Motor City had “a million ways” to raise funding to pay off its more than 100,000 creditors; while holdout creditor Syncora’s lawyer testified before Judge Rhodes that Detroit cannot legally justify treating its retirees better than financial creditors―demanding that it be paid 75 percent of what it believes it is owed, rather than pennies on the dollar—or as its attorney, Marc Kieselstein testified: “Something that’s within shouting distance” of Detroit pensioners.” Challenging everything from Detroit’s access to casino tax revenue and its ability to fix the city’s broken streetlights, pushing for the sale of city-owned art and trying to access retirees’ personal financial information; Mr. Kieslstein described Kevyn Orr’s proposed plan of adjustment as “record-breaking, bone-crunching” discrimination. Syncora and fellow bond insurer Financial Guaranty Insurance Co. — which is on the hook for more than $1 billion — claim the city’s debt-cutting plan pays them as little as 6 cents on the dollar for the $1.4 billion in troubled pension debt they insured to help former Mayor Kwame Kilpatrick prop up the city’s pension funds in 2005. Mr. Kieselstein argued that Detroit’s Emergency Manager and key architect of the city’s plan of adjustment pending before the court, Kevyn Orr, improperly considered the “human dimension” of pension cuts when he devised the plan of adjustment: “This plan has epic levels of discrimination…“It didn’t have to be this way.” He added: “This isn’t ‘Back to the Future.’ Mr. Orr is not Marty McFly. He cannot pilot the DeLorean back in time” and change the fact that the city’s plan does not meet the law’s requirement to be in the “best interests” of creditors. The deal should face higher scrutiny, and be rejected, because it causes “unfair discrimination’’ between two groups of unsecured creditors — retirees and bondholders, Mr. Kieselstein said. Detroit does not have any evidence that justifies the disparate treatment, he added.  But Sam Alberts, an attorney for the U.S. government-appointed Official Committee of Retirees, told the court the cuts would be “life-changing” for retirees and that they would otherwise face “drastic” reductions in health care benefits, adding that Detroit’s former work force was also seeing significant, costly changes to its health care benefits and was hardly getting away without pain: “The benefit reductions to these retirees are, by any measurement, life-changing.”

Nevertheless, Mr. Kieselstein further sought to attack the grand bargain, telling the court it would have a “devastating impact” on financial creditors — that it was nothing more than a “fraudulent transfer,” with Syncora’s lead attorney adding that all of the bankrupt city’s creditors could get 75 percent of their debt paid back if the city “maximized the value of the art collection as well as other assets.” The attorney further testified that Detroit “has many options for raising revenue that have not been explored fully enough,” promising this would be “proven during the course of court proceedings.” Those involved with $1.4 billion of certificates the city issued in 2005 could come away with little or nothing, while city workers with pensions would take comparatively smaller losses. “Bankruptcy is, sadly, the land of broken promises,” said Mr. Kieselstein, who said that the city had unfairly and needlessly chosen some creditors over others since it filed for bankruptcy protection in July 2013.

The Fine Art of Municipal Bankruptcy. Holdout creditors also attacked the city’s refusal, in its plan of adjustment, to sell the art from the Detroit Institute of Art—in effect attacking the dynamic heart of the city’s plan for exiting bankruptcy: the so-called grand bargain, with FGIC’s attorney, Alfredo Perez, attacking the city’s claim that it would be take a long time to determine whether art can be sold the world renowned DIA, and telling the court the Institute has limited economic value for the region—prompting Judge Rhodes to ask Mr. Perez: “If the city owned the schools that its children were educated in…would you want those sold or monetized too?”  To which Mr. Perez responded no, telling the court schools are vital to the wellbeing of the people of the city. (DIA attorney Arthur O’Reilly had already, in his opening statement, testified that it is clear the art is held in trust for the public’s benefit and cannot be sold under any circumstances, vowing to fight any future plans to sell art “on an object-by-object basis if necessary.”). Mr. Perez said most of the DIA’s collection was donated to the city without conditions attached — but that even those pieces could probably be sold because bankruptcy allows debtors to slash contracts. But Mr. O’Reilly testified that the grand bargain and the case “is about respecting charitable donations and the people’s right to art and culture.” He testified that about 95 percent of the DIA’s collection of 60,000 pieces was donated or acquired with donated money, warning that a bankruptcy case dismissal would jeopardize the art collection; he vowed to fight “piece by piece” any attempt to liquidate art, telling the court, the façade of the DIA reads: “Dedicated by the people of Detroit to the knowledge and enjoyment of art,” and asking: “What would that mean if that statement was rendered a dead letter?” O’Reilly asked the judge. O’Reilly spoke after the city’s lawyer wrapped up his opening statements in Detroit’s bankruptcy trial Wednesday. Bennett warned about dire results if the city is unable to dump more than $7 billion in debt and free up money for improved services.

Transition Back to Local Elected Leaders. Yesterday, attorneys for Mr. Orr’s team told Judge Rhodes that the proposed plan of adjustment’s $1.4 billion reinvestment plan has critical support from the city’s elected officials, despite some apprehensions about details of the plan—a key point, because Judge Rhodes has emphasized that the city’s elected leaders must be committed to the plan after Mr. Orr is gone—a departure that could happen within weeks. Mayor Mike Duggan and City Council President Brenda Jones are scheduled to testify during the trial that they understand the plan of adjustment and will implement it—albeit, Mr. Orr’s lead attorney in the trial, Bruce Bennett, yesterday acknowledged that some changes will be necessary to accommodate for unforeseen events. He argued that the plan of adjustment will place the city on a path to an economic recovery by restoring services and drastically reducing the city’s crushing debt load: “In the future things will happen that we have not planned for…(and the city) will have to adjust,” adding that the restructuring would prove that Michigan Governor Rick Snyder was correct to authorize the largest municipal bankruptcy in U.S. history.

Scrambling in Scranton. Pennsylvania Auditor General Eugene DePasquale has warned that the City of Scranton could be forced to file for municipal bankruptcy in three to five years, because its pension funds are poised to run out of money. The sobering news, presented at a press conference at City Hall, is contained in an audit Mr. DePasquale’s office conducted of the funds’ condition from January 2011 to January 2013. The municipality’s pension funds face paying out as much as $10.5 million owed to retired police and firefighters because of the $21 million back pay court award to active members—a report the auditor general’s office did not even evaluate in its audit. With a funding ratio of just 16.7 percent, the city’s firefighters fund is in the worst condition of any plan in the state, according to the state auditor—with benefits at risk in as soon as 2½ years. The non-uniform fund isn’t much better, projected to be insolvent in 2.6 years, while the police fund has less than five years. The fiscal dilemma came as Mr. DePasquale is visiting municipalities across the Liberty Bell state to draw attention to the public pension crisis. Pennsylvania sports the greatest number of public pension systems of any of the 50 states—and the auditor’s office is apprehensive that hundreds of other municipalities have severely distressed plans, defined as having a funding ratio (the percent of liabilities covered by assets) of less than 50 percent. In Scranton, according to Mr. DePasquale, he is especially apprehensive about the 16.7 percent funding ratio for the firefighters fund. His audit shows the pension funds’ financial condition steadily deteriorated over the past few years, despite the city’s contributions. Six years ago, Scranton contributed $3.3 million to its three retirement funds; the city’s pension fund’s financial advisor last week announced the contribution for 2015 will be $15.8 million. However, the city could pay $12.3 million because a state law allows Act 47 distressed municipalities to reduce contributions. But, as the Auditor General noted: it’s clear the severely financially distressed city cannot afford to continue making those types of payments, making bankruptcy “a clear possibility within five years.” For its part, the city recently adopted a commuter tax, which is expected to raise $5 million annually for the pension funds. Now Scranton is considering selling its sewer authority to make a one-time payment to the funds. City officials are also talking with unions about possible pension concessions, according to the Mayor. While the Auditor General had praise for the city’s efforts to catch up, he is concerned that more must be done―focusing on reform to the municipal pension system, including: consolidating plans into a statewide system and increasing funding to municipalities with distressed plans, adding: “We don’t see any way this can be fixed by Scranton alone…I believe strongly that a statewide solution is needed.” Even though Gov. Tom Corbett and the Pennsylvania Legislature debated state pension system reform this summer, it has yet to address the pension crisis some municipalities face.

Rolling the Dice. With its economic mainstay—casinos—closing at a record pace, Atlantic City is turning to its homeowners to avoid insolvency and meet bond payments in the wake of some 33% of its casinos to go dark. The city’s $261.4 million budget for 2014, with 14% of revenue dedicated to debt service, includes a 29% increase in property taxes—that is a 29% increase in addition to last year’s 22% increase. Atlantic City Mayor Don Guardian plans for the city to issue $140 million of debt by year-end in order to satisfy tax appeals for casinos, which opened in Atlantic City in 1978 and heretofore have paid about 70 percent of the city’s property tax levies. But with the seemingly endless run of casino closings, the city is both being forced to issue more debt—and to find other revenue sources. Atlantic City homeowners paid an average of $5,273 annually last year, but this year, warns Finance & Revenue Director Michael Stinson, those amounts will likely have to increase as will its borrowing, although the city’s costs of borrowing will be state-supported under the Garden State’s Qualified Bond Act, with payments tied to $20 million in state aid. The program will earn the bonds a credit grade that is one level below New Jersey’s, notwithstanding Moody’s reduction in the city’s credit rating to junk this summer. Revel Casino Hotel, which closed this week, is the third gambling destination to shut this year, after Caesars’ Showboat last week, and the Atlantic Club in January. Trump Plaza is scheduled to close the week after next—meaning some 33% of the city’s casinos will have closed this year—at a cost of not just significant cuts in property tax revenues, but also about 7,300 jobs. In addition, Atlantic City faces payments to casinos that have appealed tax bills after the recession eroded their assessed property values. With a poverty level of approximately 30 percent –and a homeownership rate of 34 percent, about half the state average, according to Census data, the turn of gambling events could have significant repercussions for remaining homeowners. Atlantic City was the No. 2 U.S. gambling destination until 2012, when it was overtaken by Pennsylvania. New Jersey Governor Chris Christie has invited casino representatives, elected officials, and labor leaders to a meeting next Monday in an effort to reverse the adverse momentum—looking to draw up a blueprint based on retail, entertainment, tourism, and other non-casino revenue. The bleak fiscal situation comes just four years after Governor Christies announced a five-year plan to revive the city, including $261 million in tax breaks to the Revel Casino and the creation of a state-run tourism district. There is concern that was a bet that has not paid.