The Case For A Detroit Bailout

The Financial Times gets to the crux of the Detroit debacle. The FT is overly picky about writers cutting and pasting parts of their articles, so reluctantly I’ll respect their wishes and summarize.

  1. Eventually the argument over the priority of pension and health care obligations is going to end up in the Supreme Court. The FT says this takes 4 years. That seems like a long time but they point out that if left for a political reconciliation it would take decades.
  2. The argument is about middle class rights to constitutionally (at the state level) protected pensions and health care versus the rights of bondholders, also largely middle class investors. Will the federal courts trump state constitutional protections?
  3. Should the pensioners prevail kiss the muni bond market goodbye.
  4. States are sovereign, not subject to federal bankruptcy laws and so would be free to pay creditor classes as they deem appropriate (subject of course to some sort of test of reasonableness). Nevertheless, states will find themselves under tremendous pressure from pensioners to close the unfunded liability hole, wreaking havoc with their budgets.

It seems that there can’t possibly be any good outcome. If the pensioners win the muni market implodes. The illusion that state pensions are solvent vanishes and the states are financially crippled filling the gap. If the pensioners lose municipalities are going to use the Chapter 9 threat to gut their pension plans and the states probably won’t let the opportunity pass either. In either case you are going to have a large part of the electorate going ballistic. Politically neither option is viable.

And that’s why you will see a bailout, probably after the 2014 elections. The probable disruption of the status quo regardless of the legal outcome isn’t politically acceptable. The Left would be under pressure from its labor base to federalize pensions in one form or another. The Right which controls the majority of statehouses would be under pressure to relieve their financial strain. Neither side will let it get to that point, this is truly a kick the can issue. Defuse Detroit, maybe get tough about funding pensions over time and pray it all works out or you’ve retired from office.

Government pensions as we’ve constructed them have always been one of those ideas which sooner or later get torpedoed by economics, demographics or some combination of the two. You can, however, double down on bets and make them go on well past their “sell by” date.

“Fast track” here means about four years. That sounds like a long time, but resolving the legal, financial and generational-equity issues here would take agonisingly longer if left to the workings of the electoral cycle. Think of it this way: what are the chances that the contestants in the next congressional or presidential elections would ask the voters to decide if pension and healthcare promises made by governments are super-priority debts? Because that is what “Detroit” is all about.

The pensioners and Detroit’s public sector unions will argue that the labour contracts, along with the pension and healthcare benefits, are middle-class rights guaranteed explicitly by the Michigan state constitution, and should not be subordinated to Wall Street and the rich, ie bondholders. However, the beneficial owners of most of the bonds are also middle class, and the authority over bankruptcies the US constitution gives the federal courts appears to trump those rights.

Let’s say that this turns out not to be the case, and the unions and pensioners win in the Supreme Court. Then all those unfunded pension liabilities at the municipal level will be understood by the credit markets to have claims equal to, or superior to, those of bondholders. You can forget about the market for muni bonds. New York City? Chicago? Toll road revenue or water rates-based bonds?

 

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