City Journal Summer 2014

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Summer 2014
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Steven Malanga
Detroit’s Message to Investors « Back to Story

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It is pretty obvious that bankruptcy law is being re-written based upon political power. We watched the union members at GM get preference over secured bond holders. We watched union members keeping their pensions but salary workers loosing theirs. Why? Because salary workers weren't well connected democratic donors. Now, we watch the city of Detroit re-writing their laws as well. All I can say, if it has a union label, don't invest in it. If it is a city bond, don't buy it (or demand much more interest to make up for the risk).
For some years I have thought anyone who bought city bonds was a fool. I didn't know exactly how they would be shafted, but I was confidant that they would be shafted.

Investors thought they could rely on so-called "black letter law" but they are now finding out that legal precedent means nothing. It's all about political power. And a small number of bond investors will be trumped by people like Orr.
I find the author's attitude about all this interesting. Steve, I am a long time reader and mostly admirer. I think I have it right that your authorial style is to go all-in. You report the facts and then you also jump right in with judgments. Here you are much less prone to judge. Why is that?

If I had to guess I would say it is it is not clear where a Malanga or a City Journal ought to come down on this. On the one hand, you could excoriate Orr for giving Wall Street a haircut (and an unprecedented one) in favor of those greedy pensioneers. Or you could just rattle the saber loudly about the ill effects on the market in the long term, which you come close to doing but not in a full-throated way.

But on the other hand you know well that circumventions of general obligation provisions have a long history, and one that is not necessarily made respectible, as with prostitutes, with age. Now comes Orr to say that COPs are a form of borrowing, no matter that the lawyers have signed off on them as a kind of non-debt contract. That's all bull, as everyone knows.

Note COPs do not represent a Madoff-style Ponzi scheme, per a number of commenters here. So they cannot be ruled out of bounds on the face of it--too many lawyers and politicians have agreed otherwise. But it is a fake legal construct nonetheless, and one that you'd think a respectable voice of opinion like City Journal would want to out.

So my sense is that you are in a bit of a quandary. This issue does not lend itself well to the good/bad proselytizing that you excel at--and I mean that as a compliment!

Seems to me the root problem here is that on large issues like this there can be more than one root problem. Skirting debt limitations worked so well because it met the interests of so many disparate parties. Now the whole contraption is stuck together, and to take it apart, as Orr seems willing to do, will injure not only rich Wall Street types but the muni market more generally. Choose your poison.
"Because of Orr, the certificates of participation worked better than anyone ever imagined. The city got to keep all the money from the sale of the certificates, but only had to pay back $0.10 on the dollar (or something like that)."

--

Agreed. There's moral hazard if the investment banker hucksters who created these schemes are not brought to book (at least by clawing back their commissions and fees). Trouble is that there may be no lawful way to do that.

--

Detroit (and other cities) will have to pay higher risk premia in the future. That's the only injury to the city, apparently.

"Detroit failed because the auto industry fought hard and kept other large employers out of the area. When they bailed out, there was nothing for fail over. "

Rubbish. The metropolitan settlement splayed over Wayne, Oakland, Macomb, and Washtenaw Counties in Michigan has 4 million people resident in it. The the domestic product amounts to about $208 bn in toto, of which durable goods manufacture accounts for about 12%. There are lots of other employers there.

Per capita personal income in the Detroit/Ann Arbor zone is 6% below the national mean. Could be better, but not bad. The real mess is the core city. However, 82% of the residents of the Detroit metropolis do not live in the core city. The municipality known as the 'City of Detroit' is an administrative unit nearly coterminous with the slums of the metropolitan settlement. Urban sprawl of a sort you see anywhere creates some of these effects, but in Detroit's case, the municipality's problems were exacerbated when a crew of hucksters took charge under a vulgar pinko union goon named Coleman Young. They've remained in power by playing the race card and trashing the place so thoroughly that functional adults leave when they can afford to, leaving them with the right-sized electorate which maintains them.

Read William Nojay's account of working as a management consultant attempting to run the City transit system in Detroit. I tend to doubt you'd find the Oakland or Macomb County governments run that way.

Detroit's real problem is a homicide rate (48 per 100,000) that is 10x the national mean - and the political leadership that made it happen.
To D Johnson's remarks, I think they are correct, except to say: "If Bernie Madoff had Orr working for him, he would have been able to keep his entire fortune, serve no time for the scheme, and only the investors would pay the price."

Bernie Madoff had excellent lawyers working for his defense, I believe. The difference here is that no one is prosecuting. It is not Mr. Orr, but the Michigan and U.S. Justice Departments that are keeping various criminals involved out of jail. If prosecutors charged various officials and businessmen involved, and had the venue set somewhere in rural Michigan, you could practically guarantee that people would go to prison. After all, their crimes are documented by an extensive paper trail.
Douglas Johnson May 05, 2014 at 6:35 AM
Tell me if I'm reading this right:

1) Detroit is broke. Let's say it needs $100M this year (made up number)

2) City doesn't have $100M so, ala Bernie Madoff, it sets up fake corporations that issue "certificates of participation" which promise to pay investors a return over time that exceeds their investment.

3) The sale of the certificates covers that $100M need, but increases the city's overall debt burden a lot.

4) Having done that for many years the debt is now really, really crazy and the cert of participation doesn't even work now.

5) Orr takes over. He says the city managers created fake corporations in an obvious shell game like Bernie Madoff and therefore the taxpayers shouldn't be on the hook for that debt.

6) Just like in the Bernie Madoff Ponzi scheme, the investors are out of their investment.

7) Unlike the Bernie Madoff scheme, no one is talking about sending the city managers to jail.

8) Orr calls it fraud, but he only punishes those who were duped by the fraud.

9) Because of Orr, the certificates of participation worked better than anyone ever imagined. The city got to keep all the money from the sale of the certificates, but only had to pay back $0.10 on the dollar (or something like that).

If Bernie Madoff had Orr working for him, he would have been able to keep his entire fortune, serve no time for the scheme, and only the investors would pay the price.

And yet I don't think Orr comes off like this at all in the piece. So perhaps I'm missing something. Can someone tell me what I'm missing?
Read what Brian Reilly says below and understand the true implications of this. Detroit will cease to exist unless RADICAL economic reform is instituted. There is not, nor is there likely to be in the near or distant future, a citizenry productive enough to pay the debts and obligations of the city. The alternative is to borrow more money from someone somewhere. This is a clear case of throwing good money after bad.
You can get a house, or the basic shell of a house in Detroit for $400. There are many people who can work at minimum or subminimum wage to rehabilitate the town. Brownfields can be bought for pennies on the dollar, and with some lenicy from the courts and the EPA, can be cleaned up and resold or leased for 20 cents on the dollar. And you have food stamps, local gardeners, yodda-yodda.

This suggests that Detroit, pensions and all is a kind of urban enterprise zone, where anyone with low wages and restricted pensions could still live on cheap real estate, "bus themselves" instead of asking government to take care of them, and become as competitive a locality for new business as China.

That is the direction this city and the Feds should go before we hear any more whining about insufficient tax breaks and public benefits.
"Though most states have laws or constitutional restrictions on borrowing, governments (and their financial advisors) have found ways to sidestep them." And therein lies the problem. Merely because state and local governments have found ways to sneak around legal restrictions placed on municipal and state debt does not mean they should continue to be allowed to do so. When it comes to investing in Democrat- and union-controlled municipalities, the doctrine of caveat emptor applies.
The problem with comments that have an axe to grind is that they are not interested in solutions. Of course, lenders, financial and legal advisers, the big three auto companies are to blame for the situation. Also, however, so are the politicians, the civil service, the unions and, ultimately the workers. What does that prove? Nothing, except...
The key here is our inherited right of fair play. That is what the rule of law is all about. When we think that is being subverted, for whatever reason or purpose, we lose respect for those who are entrusted to adjudicate.
One example will explain. When Chris Christie was the US Attorney for New Jersey and raked up some 137 convictions of public officials (top to bottom), there was and probably still is a news reporter roundtable on NJ public television. In finding that ALL 6 members of the Pleasantville board of education had been indicted for graft (official misconduct in technical terms) the lead reporter shook his head and said "not one of them thought this was wrong?" No more need be said.
Good for Orr. It's high time fantasy public credit was castrated, and the entitlements and other bribery that it attempts to finance as well. Someone should do the same to the United Stats Government.
"Orr alleges, by contrast, that the corporations were basically “pass-through” shells, “without economic substance,” and that the money they raised was indeed Detroit debt. He’s asking the court to relieve the city of that debt. “City officials turned a blind eye to the requirements of state law,” Orr’s suit contends."

Maybe he can't relieve the city or the service corporations of the debt, but surely the contracts between the City and the services corporations can be abrogated in bankruptcy court. After that, the services corporations could file, at which time creditors might object arguing fraudulent conveyance, and dragging in the underwriters, bond raters, etc?

I would be glad to have others poke holes in this.
You are omitting the lawyers. I realize banks etc are politically unpopular but it is foolish to allege that they are acting fraudlently. Detroit and it's lawyers held that the structure was legal. The lawyers for the special entities held that the structure was legal. The bank's lawyers held that this structure was legal. The concept that some banker was going to lend money without all of those reassurances is silly. Obviously this has not been tested in court and one must presume that all those lawyers have significant arguments as to why this was legal. Perhaps those arguments would no win but I think that this is not a clear cut case.
Rather than viewing municipal debt as risk-free and sacrosanct, the Detroit bankruptcy will force lenders to understand that they cannot fund failed cities and failed policies without substantial risk. Maybe the Detroit bankruptcy will stop the funding of municipal kleptocracies and restore fiscal sanity to the municipal fisc. I'm not crying for anyone stupid enough to lend money to Detroit thinking that they do not have to do any due diligence on the enterprise itself.
Motown is a third world city run by third world politicians
You make a bad investment, you pay the consequences.

But the cities should have been shut down by the states. An idea to consider for the future is that only general obligation bonds be allowed in local and state finance, with each local bond to be approved by a state clearinghouse administered by the state, and state borrowing only by specific authorizing legislation.
Why does Steven Malanga hate facts ??? He would drape drape a soggy towel over what is obvious:

-- "The Detroit borrowing was orchestrated through two independent entities, which the city itself had created to skirt state borrowing limits." (Where "skirt" is a silly usage. This was fraud and conspiracy with broker participation and bribe-driven ratings tacked on the instruments.)

-- "Orr alleges, by contrast, that the corporations were basically 'pass-through' shells, 'without economic substance,' and that the money they raised was indeed Detroit debt. (Reflecting standard bankruptcy practice. Fraud shells are collapsed routinely, as the Jack Olson comment relates to the ENRON failure.)

The Big Fraud, here, was committed by the bond brokers where they bribed rating services to issue fraudulent ratings and opinions on these instruments.

Detroit failed because the auto industry fought hard and kept other large employers out of the area. When they bailed out, there was nothing for fail over.

Don't pretend that capitalism's "Free Market" is a magical tool. It is not a part of democracy and it does not aims to Gouverneur Morris's Preamble elements including the general welfare. Bone up on the Solow-Sand exogenous growth model and its microeconomic sub-models. There's no feedback whatsoever to connect company decisions to long-term needs. Leaving long-range planning to the Big Three, on the production side an oligopoly, was what doomed Detroit.
Still...where is the apportionment of responsibility to city leaders? Were crimes committed? Who suffers the consequences? Given centuries of bankruptcy law and the rush by Detroit to acquire and spend more money, this didn't necessarily seem a totally bad bet. This rather predictable "blame the victim" defense lets Detroit, it's properties, and it's leaders...off the hook. And, therefore, likely to commit such financial shenanigans again. We can only hope they are given fewer opportunities...
When contracts are written that everyone knows, from their inceeption, to be both illegal and unlikely to be fulfiled, that is best described ad decadence. When governments make promises to pensioners and never plan to ful fill them, and the current beneficiaries of this fiction take the buck, knowing that those who come after them (and were not at the decision-making table) will be left unserved, that is cultural failure.

The Detroit bankruptcy is an attempt to set a new path to discharge of debt and asset re-allocation in ways best described as radical. Mr. Orr (a decent man) is doing all he can to find an orderly way to break every agreement and law pertaining to debt and finance in municipal Detroit, with the full co-operation of the government. After thay figure out how to do it in Detroit, it is coming to a city near you, and fast.

Last, Detroit will be left (post bankruptcy) with a court ordered plan for existence after all the chicken have been plucked and put in the pot and consumed. Detroit does not have the administrative talent to carry out this court order, and no interest in developing that talent, nor carrying out the order in the first place. Detroit will soon be in an even worse (if that is possible) spot with zero assets, zero cash, and no more goodwill of any sort. Then it will come to naked force, and it will not end well.
One of the main features of Enron's bankruptcy was its use of "special purpose entities", nominally independent businesses but actually backed by Enron stock. Aren't cities and states doing the same thing with "service corporations" and sham sales of government buildings on which they certificates of participation which taxpayers must redeem? What the cities and states are doing is issuing debt which isn't supposed to be debt, floating bonds which are not bonds (they are "certificates of participation") under laws which are not laws?
No one who has paid attention to the bankruptcy proceedings in Detroit, GM, or in various California municipalities would seriously consider buying bonds from entities with serious pension debt. Even secured debt is not safe. I would also hazard a guess that public sector unions will not give an inch in financially challenged governments. Why should they. They can win in bankruptcy.
Well, lending to cities you know are broke is also a mug's game.
It is rank folly to expect the law to be observed when powerful political forces wish it otherwise.

Lending to cities is a mug's game.