The Michigan Constitution Can't Protect Detroit's Retirees

Promises can't create money for a broke city.

Detroit's public unions have been despondent since last week when a federal judge effectively threw out all their legal arguments. The unions had approached multiple state courts to halt Detroit's bankruptcy filing on grounds that it violated their constitutionally guaranteed pension benefits. Judge Steven Rhodes stayed these lawsuits. What's more, he moved them—along with all future bankruptcy proceedings—to his court rather than leave them in the hands of state judges, many of whom the unions have helped elect.

Although he still has not ruled whether Detroit's fiscal situation is dire enough to make it eligible for Chapter 9 protection as Michigan Governor Rick Snyder and Kevyn Orr, the emergency manager Snyder appointed, claim it is, most observers believe that the judge's actions signal that the bankruptcy, the largest of its kind in American history, can now proceed.

Any way you look at it, at this stage unions have to accept the cold reality that their city is broke. At best they can use their constitutional protections to squeeze a marginally better deal in bankruptcy court—not keep it out of that court. Nor can preserve all the promises to their retirees.

This is unfortunate given that, despite all the hype about unions negotiating lavish pension benefits, an average city retiree gets only about $20,000 annually—and police and firefighters about $30,000. Most of these people are on fixed incomes, and police and firefighters don't receive any Social Security. Retired city managers get six figures, but there are only a few hundred of them among the city's 20,000 retirees.

Yet thanks to corruption, fiscal mismanagement and the city's notoriously bloated labor rolls, Detroit's accumulated debt is more than $18 billion—about 16 times its current annual revenue. Out of this about $7 billion or so is secured debt—$6 billion in revenue bonds for the Water and Sewage Department, among other things. Orr plans to refinance this debt and get a better deal from bondholders while handing the management of the department to a regional authority.

But he can't do what was done in the case of the auto bailout (in which he represented Chrysler): Put unsecured (union) creditors ahead of these secured (private) ones. Doing so would risk a court smack down and raise borrowing costs for the whole state. It would also create havoc in municipal bond markets nationwide given that Detroit's bankruptcy will set a precedent for many more that are likely to follow.

Orr wants unsecured creditors—and he has taken the unorthodox step of putting some general obligation bondholders in this category—to accept a $2 billion payout on $11.5 billion worth of debt. This debt includes an estimated $5.7 billion in retiree health-care benefits, $3.5 billion in pension liabilities and the rest in general-obligation and other debt to private lenders.

Orr has offered private lenders only 10 cents on the dollar—a considerably worse deal than the unions will get. But even if he gives them nothing and hands over the entire $2 billion to unions, that will still leave unions more than $7 billion short of what's needed to cover the pension and health-care liabilities of retirees. The latter don't enjoy any constitutional protections. Unions could try and make up some of the shortfall through city asset sales but that won't get them very far given that Detroit's debt-to-asset ratio is 33:1.

Orr is saving about $1.25 billion over the next decade to tackle crime—Detroit has the highest murder rate among its peer cities—and improve other services. That's the only way the city will have a fighting chance of halting its population losses and making a comeback.

Unions could try to convince a court that this money legitimately belongs to them because their pension-related debt is protected by the state constitution.

"But it is hard to see how that argument would prevail," argues Patrick Wright of the Mackinac Center for Public Policy. "Practically speaking, a judge will be hard pressed to order the city to deprive its residents of essential services for the sake of a constitutional promise to retirees."

It is no coincidence that Judge Rhodes repeatedly emphasized that his decision to take over the bankruptcy proceedings was necessary to protect the "public interest."

In the absence of a state or federal bailout, the only other way that the city could possibly live up to its promises is by raising taxes. Detroit's taxes, however, are at their "current legal limit," as Snyder noted in his letter approving Orr's bankruptcy filing. Even if they weren't, Detroit's "residents cannot afford to pay additional taxes," he maintained.

In any case, a judge doesn't have the power to force a city or state to raise taxes, especially if that violates its own laws. At most, if Judge Rhodes felt that Detroit has the ability to do so and pay its debt, he could rule that Detroit is ineligible for bankruptcy protection. "But creditors face an uphill battle in disputing Detroit's eligibility for Chapter 9 bankruptcy protection," notes Scott A. Wolfson, a Detroit lawyer who specializes in bankruptcy. 

Like Michigan, many other states including New York, Illinois and California constitutionally protect the pension benefits of government workers. Yet the lesson from Detroit so far is that these protections are not worth a lot when a city, having systematically mismanaged its finances, is flat broke.

A version of this column originally appeared in Bloomberg View.