Bankrupt Detroit Shouldn't Scalp Bondholders

Timothy Lavin writes editorials on politics, economics, taxation and defense for Bloomberg View. He was a senior editor at the Atlantic.
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Detroit, which just became the largest U.S. city to seek Chapter 9 bankruptcy protection, is in many ways unique. It has managed to lose a quarter of its population since 2000, for one thing. For another, its liabilities are a staggering $17 billion, according to an estimate by Emergency Manager Kevyn Orr -- in a city of roughly 700,000.

That's why plenty of analysts are asserting that Detroit's bankruptcy is also a unique case. Its finances are so calamitous, they argue, and its demographic and fiscal spirals so severe, that investors will treat its bankruptcy as a one-off event. So the haircut its bondholders will inevitably take is unlikely to result in significantly increased borrowing costs elsewhere.

Don't be so sure. Orr -- who will be in the driver's seat in bankruptcy, and can force cramdowns on creditors as long as one party getting a haircut consents to his reorganization plan -- has indicated he will treat roughly $369 million in unlimited-tax general obligation bonds on par with pension and benefit liabilities.

Those UTGO bonds were approved by voters and backed by tax revenue. They're generally about as safe as it gets. So treating them on par with unsecured pension debt is a good way to panic investors. Five other cities and three school districts in Michigan are also under emergency managers. About 10 percent of the state's population lives in a locality under budgetary oversight. School districts in Pontiac and Buena Vista have recently defaulted. If Orr follows through and treats those UTGO bonds the same as other unsecured debt, investors could be forgiven for wondering if the state is still committed to honoring its obligations.

That's why we argued here that Michigan taxpayers should step up and help bail out some of Detroit's pensioners. Doing so would ease their suffering and ensure that money still circulates in Detroit's economy as it reorganizes. But -- more selfishly for taxpayers -- it would also help ensure that borrowing costs don't rise across the state.

As for the UTGO bonds, Orr would be risking an awful lot of credibility -- in Detroit and elsewhere in the state -- for a paltry sum of money, given the scale of what the city owes. Ultimately, that's the best argument against giving those bondholders an ugly haircut.

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