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Detroit bankruptcy can’t be model for other cities

In debating the meaning of Detroit’s collapse, commentators on the right and the left have found evidence for the benefits of municipal bankruptcy as a way to put distressed cities back on track.

“More bankruptcies, please,” David Skeel wrote in the Weekly Standard, pointing to federal laws that might make adjustments in unfunded pension liabilities possible.

But the record on municipal bankruptcies – from Central Falls, R.I., to Vallejo, Calif. – demonstrates how such expectations ultimately come to little, and for good reason. Bankruptcy will never play a significant role in municipal reform beyond its rather modest current one.

Its advocates conceive of a process that would work like corporate bankruptcy, restoring troubled cities to strength, as happened with General Motors, Twinkies and other high-profile comeback stories. But, for the most part, even corporate bankruptcy doesn’t work like corporate bankruptcy is supposed to work, as Haifa University’s Omer Kimhi and others have pointed out: About three-fourths of companies that file for bankruptcy do so to liquidate their assets under Chapter 7 of the bankruptcy code, not to reorganize under Chapter 11. And these figures don’t account for the many attempted reorganizations that eventually result in liquidation.

Obviously, we can’t liquidate municipalities. No matter how insolvent and dysfunctional a city may be, if people still live there, basic services must continue to be provided.

This is a huge challenge right now in Detroit, where entire neighborhoods have been mostly abandoned save for an isolated squatter or elderly widow, who, given existing resources, are very difficult to serve and protect.

Bankruptcy will cut Detroit’s debt, thereby freeing up revenue to devote to services. It won’t address the city’s high poverty and crime rates, its cratered tax base (property values aren’t expected to start growing until 2021), and 16 percent unemployment rate. Bankruptcy can’t eradicate corruption or a union-friendly political culture. Two years after emerging from bankruptcy, Vallejo’s budget remains unbalanced, services are still diminished and the city has yet to regain access to credit.

And let’s not forget that debt reduction comes at a cost: Detroit’s legal and professional-services fees have already run into the millions and, in the distant post-bankruptcy future, the city will likely face a steep borrowing premium when it re- enters the bond market.

The localities that stand to benefit most from bankruptcy are those that have been overwhelmed by some unforeseen catastrophe, such as a big, one-time tort settlement, as was the case in Bay St. Louis, Miss., in 1977 and South Tucson, Ariz., in 1983. The government abruptly finds itself saddled with a claim it can’t pay, but the source of the debt is isolated and doesn’t impugn the locality’s basic ability to function.

The 1994 bankruptcy of Orange County, Calif., while not wholly unforeseen, was rooted in an overleveraged investment plan run by the county treasurer. When, contrary to his expectations, interest rates rose, lenders threatened to seize collateral, and bankruptcy became the only option. But Orange County’s basic ability to function was never in question, and, after restructuring its debt in bankruptcy, it returned to credit markets relatively rapidly.

By contrast, Detroit’s troubles are many and deeply rooted. Municipal bankruptcy can’t remedy a lack of political will.

Indeed, Section 904 of the federal bankruptcy code’s Chapter 9, which permits cities to reorganize their debts, specifically prohibits courts from interfering with a city’s “political or governmental powers” while in bankruptcy. The municipal debtor retains exclusive authority to design its reorganization plan, and thus decide which debt should be cut and by how much.

That is why, despite their well-documented pension problems, the three recent California bankruptcies either didn’t seek (Vallejo) or aren’t currently seeking (Stockton and San Bernardino) pension cuts through the Chapter 9 process. Detroit is seeking pension cuts in bankruptcy as a result of the state’s emergency-manager law, not the bankruptcy process itself.

Of course, Congress could strengthen Chapter 9, thus giving unelected federal judges authority over debt, taxation, service levels and decisions about whether to merge with nonbankrupt neighboring communities. The University of Chicago Law School’s Eric Posner welcomes this prospect because “federal courts have a reputation for impartiality.”

But it’s hard to imagine that most Americans and their representatives in Congress would embrace an even more thorough takeover of city operations by federal judges. Resistance to Michigan’s emergency-manager law, which allowed the state-sanctioned takeover of Detroit’s city government, has been strong enough.

It’s also difficult to imagine Congress waiving the requirement that only insolvent cities be allowed access to bankruptcy. Insolvency is a very rare condition among local governments in the U.S., particularly among general-purpose entities such as cities and counties.

The many struggling cities in Michigan, Pennsylvania and upstate New York will always retain taxing authority and a monopoly over public services. Thus, their revenue position is inherently more stable than that of a failed corporation with an obsolete product or fatally uncompetitive cost structure.

Although it would be unfair to characterize the pro-bankruptcy arguments as a solution in search of a problem, most cities now are far less concerned with insolvency than the “crowd out” effect on their finances. Pension and health care costs continue to rise more rapidly than revenues, leaving less and less room in budgets to support basic services.

On a per-capita basis, New York City owes more in retirement obligations than Detroit does, but it’s also a wealthier, growing city. It won’t face insolvency anytime soon, but neither will services improve much, so long as employee-benefit-cost trends continue.

In essence, the “more bankruptcies, please” approach will never go far because cities are simply different from corporations. Insolvency will always be rarer in the public sector than in the private sector, and respect for local self-government will always limit bankruptcy judges’ power. Municipal bankruptcy has a useful but limited role to play in reforming local finances. As a solution to cities’ most pressing needs, it’s a dead end.

(Stephen Eide is a senior fellow at the Manhattan Institute’s Center for State and Local Leadership.)

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