Let Courts Handle Detroit's Inevitable Bankruptcy

A pre-packaged bankruptcy that requires state involvement would be politically explosive.

Michigan Governor Rick Snyder has postponed his decision to appoint an emergency manager to deal with Detroit's fiscal crisis. He was expected to act after a state audit last month found that the city's long-term debt was $12 billion, $2 billion more than previously reported. But the delay won't postpone Detroit's inevitable date with insolvency.

The main issue that Snyder, a Republican, will ultimately have to confront is whether to put Detroit through a managed bankruptcy, which would be legally less nettlesome but require his maximal involvement, or a conventional Chapter 9 court process that will be legally arduous but would minimize his role.

He should opt for the latter.

The audit pegged the city's annual debt-service costs alone at $597 million, while its three biggest sources of revenue generate only $538 million. Worse, the value of the city's net assets, which in 2010 were worth $265 million, has collapsed and they now have a negative value, the report said.

More urgently, Detroit will run out of operating cash before the fiscal year ends in June (although that didn't stop it from handing out year-end bonuses to nonunion employees). Snyder had allowed Detroit to borrow $137 million through a municipal-bond sale on the state credit card last summer. Before the funds could be released from escrow, however, the city was supposed to meet prescribed restructuring goals under a consent agreement.

The city failed, no surprise, thanks to squabbling between a dysfunctional city council and Mayor Dave Bing. The council even blocked Bing's effort to hire a private law firm to help overhaul contracts with unions and vendors, even though the city has little in-house expertise to handle something this technical and complex.

The upshot was that the state has halted the release of $30 million of the bond money. Bing is planning to stretch out his meager resources by furloughing the city's 11,000 workers for long periods, starting this month, but no one believes this will delay the inevitable. Short of a federal bailout or divine intervention, Detroit will be insolvent within a matter of months.

In a "prepackaged" bankruptcy, as opposed to a conventional process, deals are cut with as many creditors as possible in advance of a court filing and followed quickly with a plan for reorganization. This would put the burden on Snyder for negotiating "haircuts" with public-employee unions, investors, and vendors. Detroit would be the largest U.S. city to undergo anything like this, and Snyder would be in uncharted legal territory.

Every decision he makes would be politically fraught. President Barack Obama was criticized for offering a better deal to the United Auto Workers than to secured creditors during the auto-industry bankruptcy. Should Snyder do the opposite and favor secured creditors over public unions—either because it is legally the right thing to do or to keep Detroit's future borrowing costs low—he will be accused of crony capitalism, especially given his background as a business executive.

Indeed, city leaders regarded even the original consent agreement, which came backed by the state credit card, as an affront just because it required them to clean up their books under state oversight. Protests broke out. Jesse Jackson flew in to join a coalition of pastors, civil-rights leaders, and local officials condemning the alleged assault on the city's democratic rights. "We are prepared to go from education, mobilization, litigation, legislation, demonstration and civil disobedience," Jackson said.

That showdown would pale compared with what would happen when Snyder tries to get public unions to accept pennies on the dollar in order to reduce the city's crippling legacy costs. Many in Detroit still believe that the city is going broke not because it overpromised but because of meddling from Lansing, Michigan's capital. Consider what a union representative, Ed McNeil, said at a recent city council meeting.

"We're going to get the people out of Lansing out of Detroit," he said. "If we get them the heck out of here, we won't be broke."

A conventional Chapter 9 bankruptcy would be legally arduous because each side will mount pitched court battles to get a bigger portion of the spoils. But unions will have a harder time protesting the final outcome. And if they do and enhanced security becomes necessary—not a remote possibility given the fierce public-union demonstrations that erupted in Lansing when the Legislature passed a right-to-work law—it would be much better if a judge orders it rather than Snyder.

Politicians, even well-meaning ones, can't save Detroit. Any salvation will have to come directly from the courts.

This column originally appeared in Bloomberg View.