The decline and fall of Detroit

After years of industrial decline and ballooning debt, the once-great Motor City has gone bankrupt, says Simon Wilson. Is it a sign of things to come?

How can a city go bankrupt?

Just as anyone else can, given that America lets its cities sink or swim in a way that seems alien to Europeans. In Britain, cities are constrained in what they can borrow, and receive support from central government, which redistributes wealth from richer to poorer communities.

Yet there is little chance of federal intervention following Detroit's bankruptcy, which President Obama greeted merely with a bland statement saying he was watching events closely. That's because US cities fund their entire budgets including education, police and health services and payments to city pensioners from their own tax base, with only limited support from state or federal governments.

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What happened in Detroit?

When a city's tax base shrinks, for example because the rich are leaving town and the population is falling (Detroit's has collapsed from two million to 700,000 since the 1950s), a city has to borrow to maintain essential services. In Detroit, that process was worsened by the doughnut' effect, in which well-off individuals and firms escaped the tax demands and urban decay by moving to legally separate, more lightly taxed satellite districts. So Detroit ran up unsustainable debts and became trapped in a vicious circle of falling revenues leading to poorer services, more population flight, a lower tax base and further borrowing.

That process, accompanied by the slow-motion collapse of the car industry over the past 40 years, and decades of corruption and economic mismanagement, reached its inevitable conclusion last week. "Detroit went bankrupt ten years ago," says Greg Prost, chief investment officer with Ambassador Capital Management; "we've been waiting for this for a long time."

Is Detroit unique?

Chapter 9 bankruptcies (municipalities, counties and other public entities) are rare but not unknown. There have been fewer than 700 since the provision was created in 1937, and only 36 since 2010. But the scale of Detroit's bankruptcy, with more than $18bn of debts, is unprecedented.

Other US cities have faced virtual insolvency or near-collapse in recent decades, including New York, Pittsburgh and Baltimore. But all avoided outright bankruptcy and to varying degrees made economic recoveries. Prior to Detroit, the biggest municipal bankruptcies were in 2011, when Jefferson County, Alabama, went bankrupt with $4.23bn in debt; and in 1994 when Orange County, California, entered court protection after losing $1.7bn on interest-rate bets.

How does the bankruptcy work?

Chapter 9 bankruptcy is similar to Chapter 11, which applies to corporations, in that it offers legal protection to a city while it renegotiates its debts. Detroit owes $18.5bn in long-term liabilities, including about $7bn to bondholders, $3.5bn to city pensions, and $6.4bn to fund other employee benefits, mostly retiree healthcare. The city's emergency manager', Kevyn Orr, a bankruptcy lawyer involved in Chrysler's restructuring, was imposed on the Democrat city by Michigan's Republican state governor in March.

Having filed for bankruptcy on the basis that the only way to provide services is to cut debt repayments Orr is now involved in complex negotiations and intensive legal wrangling. Once that has played out, secured bondholders could come off better than retirees, who face big falls in income.

Is there an upside?

The bankruptcy will involve hardship for about 20,000 city pensioners, unknown losses for bondholders, and may make it harder for the city to raise capital in the future. But the move had been widely expected and seen as unavoidable, and many in the Motor City as well as many commentators see the bankruptcy as a way of kick-starting its recovery.That's not necessarily a pipe dream: Orange County emerged from bankruptcy within a year and nine years later had a triple-A bond rating. No one is suggesting Detroit's recovery will be as quick or easy. But there are already signs that the city is "capable of reimagining its future", as a recent FT editorial put it.

Are there any signs of Detroit making a comeback?Several financial services firms moving back into the centre from the prosperous suburbs; Chrysler opening its first corporate office in the city in decades; upmarket food chain Whole Foods opening its first shop there. And in September, the city is due to break ground on its first urban tram network since the 1930s. Detroit's revival is possible, given a workable bankruptcy settlement in the courts, ongoing private investment and support from Michigan state. The question is whether Detroit will be a one-off, or whether it presages further turmoil in the market for US municipal bonds.

Is Detroit just the first domino to fall?

Detroit inevitably sets a precedent, reckons US analyst Meredith Whitney in the FT, since in effect the bankruptcy means the city authorities siding with residents to protect the city's survival and against unions and bondholders. That suggests its aftershock effects on the municipal bond market could be "staggering".

On the contrary, argues Lydia DePillis in The Washington Post, the impact on other cities' bond-raising will probably be limited. For one thing, the stigma of bankruptcy has been fading as the issue of out-of-control pension systems becomes more pervasive. For another, the case of Detroit, with its "death spiral of disinvestment and mismanagement", is likely to be considered a one-off.