Detroit's Bankruptcy and Market Reentry
| Citation | Vol. 37 No. 1 |
| Publication year | 2020 |
Detroit's Bankruptcy and Market Reentry
James L. Tatum III
In 2018, four years after the Motor City went bankrupt, Detroit reentered the municipal securities market and issued new debt. The bond offer is both indicative of the city's financial turnaround and is counter to the theory that bankrupted municipalities will be punished by markets with prohibitively expensive interest rates post-bankruptcy. This Article examines chapter 9 of the Bankruptcy Code, and the ramifications for bankrupted municipalities as they reenter the municipal securities market.
Introduction...............................................................................................66
I. Municipal Securities Market........................................................68
II. Detroit 's Decline and Bankruptcy Filing.................................70
III. Chapter 9 of the Bankruptcy Code..............................................74
A. Great Depression and Municipal Finance ................................. 75
B. Filing for Bankruptcy ................................................................. 77
C. Disposition of Assets and Liabilities .......................................... 79
D. Governments in Bankruptcy vs. Companies in Bankruptcy........ 81
E. Plan of Adjustment ..................................................................... 82
IV. Financial Turnaround—A "Fresh Start"..................................83
V. City's Bond Offer............................................................................85
VI. Market Conditions .........................................................................86
VII. Market Penalties............................................................................88
Conclusion...................................................................................................92
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On December 4, 2018, Detroit increased its initial offer of $111 million in general obligation bonds to $135 million.1 The initial offer was oversubscribed.2 In other words, there was more demand for the bankrupted city's debt than there was debt to offer.3 The City was able to increase the amount of debt offered and decrease the interest rate from the initial offer.4 Predominant views on chapter 9 of the Code posited that the City should have been shunned from the marketplace.5 Not only should the City have paid a market penalty—an exorbitant rate of interest—when it reentered the market, it should not have been able to reenter so quickly.6 The City issued new debt at terms comparable to other insolvent (yet not bankrupted) municipalities,7 which is an invitation for further analysis. This Article takes up that invitation to examine Detroit's case and to provide investors, citizens and elected officials information on municipal bankruptcy.
For the purposes of this Article, it is important to elaborate on the obstacles to analyzing municipal bankruptcy. one, municipal default—failure by the debtor to pay principal or interest—is rare.8 Two, of the small number of municipalities that default on their debts, an even smaller number petition a bankruptcy court for debt adjustment under chapter 9 of the Code.9 Moreover, petitions do not always result in a case. Boise County, Idaho had its petition
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rejected by the Bankruptcy Court in 2011.10 Harrisburg, Pennsylvania was ordered to rescind its petition by Governor Tom Corbett that same year.11
Even the word "municipality" must be analyzed to fully illustrate the difficulty inherent in any analysis of municipal bankruptcy. "Municipality" describes all manner of creatures—counties, cities, towns, and special districts like school districts, water and sewer districts, public utilities and development authorities.12 Special districts represent the majority of municipal bankruptcies.13 However, those municipal units are not the focus of this analysis and have not been the focus of market analysts or bankruptcy experts in their commentaries on the impact of chapter 9 on creditworthiness.14
Detroit's case was chosen for analysis for three reasons. One, the City filed for bankruptcy.15 Two, pre-bankruptcy, the City was financially and economically distressed.16 Three, the City issued new debt within a few years post-bankruptcy.17
Once more, there is insufficient data to use statistical analyses to evaluate theories related to municipal bankruptcy because municipal default and bankruptcy are rare occurrences. In lieu of statistical analyses, limited theories and information can be derived from the limited number of cases in existence. Despite these limitations, cases such as Detroit's bankruptcy offer an opportunity to better understand chapter 9 of the Code.
This Article will proceed in seven parts. Part One is an overview of the municipal securities market. Part Two chronicles Detroit's financial distress and
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economic decline. Part Three intersperses details from Detroit's case with a history of municipal bankruptcy and a review of its form and function. Part Four briefly discusses the City's financial turnaround and the theory that bankruptcy provides a "fresh start." Part Five details the City's offer of new debt. Part Six provides an overview of the market conditions—or economic environment in which the City made its offer. Part Seven evaluates the theory that bankrupted municipalities will face stiff market penalties upon reentry.
States and municipalities levy taxes on the incomes, property and purchases of the citizens within their boundaries.18 The resources from those levies are expended for services like police and fire safety, parks and recreation, and trash removal.19 However, demands for safe and reliable infrastructure—roads, water and sewer systems, and other capital projects—often exceed annual tax collections.20 In an alternative to tax collection, states and municipalities issue bonds.21 A bond is a debt instrument that represents a liability on the part of the bond's issuer or debtor and an asset on the part of the bond's purchaser or creditor.22 Bonds can be structured in many ways.23 The bond's indenture or contract will specify the amount borrowed (principal), cost to borrow (interest rate), method of repayment (security interest) and when the borrowed money must be repaid (maturity date).24
For municipal bonds, the debt instruments are typically structured either as general obligation bonds ("general obligations") or revenue bonds ("special obligations").25 The main difference between the two is the method of repayment.26 General obligations are supported by the borrower's "full faith and credit."27 In layman's terms, full faith and credit means the borrower's power to
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levy taxes.28 Because tax payments are compulsory and the power to tax is in some ways inexhaustible, general obligations are viewed as safe assets (at low risk for default).29 Revenue bonds are riskier, however: municipal units that operate in a business-like manner—a municipal airport, water and sewer district, or port authority—use revenue bonds to raise money for capital projects. The revenues from proprietary activities are the method of repayment, hence the name "revenue bonds".30 Unlike the near inexhaustible power to tax, public projects sometimes fail.31 If revenues from the public project are insufficient to service debt, creditors have no recourse and cannot compel the debtor to pay them with other resources.32 In any case, even the riskier special obligations are safe assets relative to corporate bonds issued by private companies.33
In total, the market for those debt instruments—municipal securities market—was measured at $3.8 trillion in 2018.34 That market also includes financial derivatives.35 These are the complex instruments—options, swaps and futures—that came to the public's attention in the midst of the Wall Street crash of 2007.36 Such instruments also had a role in both Detroit's bankruptcy in 2013, and the bankruptcy of Jefferson County, Alabama in 2011.37 However, those securities have a much smaller role in the municipal securities market compared to traditional bonds.38
Investors in the municipal securities market often desire to purchase safe and secure assets with a tax preference. The tax preference comes in the form of accrued interest paid out to owners of municipal bonds and is mostly exempt from federal income tax.39 Vanguard, the mutual fund and financial advisory firm, for example, offers thirteen investment funds that exclusively invest in
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municipal bonds to its customers.40 Fidelity,41 Charles Schwab,42 and other mutual fund and financial advisory firms have similar investment options promoted on the basis of their low risk and tax benefits. Because of the low default risk and tax benefits, the municipal securities market attracts institutional and individual investors alike.43 Low default risk does not mean a zero-default risk, however.
Thomas Sugrue's Origins of the Urban Crisis is an unparalleled treatise on the entropy that has occurred in so many American cities.44 The book details how Detroit, the "Arsenal of Democracy," known to produce tanks for World War II as easily as it produced Cadillacs, shrank from a population of 1.8 million in 1950 to approximately 1 million in the 1990s at the time the book was published.45 In short, the City was subjected to the same forces that left Buffalo, Cleveland, and Pittsburgh equally desolate.46 Suburbanization—a trend incentivized by racially exclusive federal home loans and local land use restrictions—pushed white urban residents to suburban areas with lush lawns and white picket fences.47 Deindustrialization followed.48 Vertical development, a feature of cities, was suboptimal for snake-like assembly lines that could spread out on wider and cheaper land in the suburbs.49 Equally important...
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