Friday, March 21st, 2014

Detroit Emergency Manager Seeks to Unleash an Infero of Moral Hazard

One of lesser followed aspects of Detroit’s bankruptcy is a lawsuit filed by emergency manager Kevyn Orr to repudiate $1.4 billion in debt by claiming it was illegally issued. This appears to be mostly a negotiating tactic, but if the judge ends up agreeing with this, it will unleash an inferno of municipal moral hazard that will no doubt be exploited by politicians around the country.

Michigan, like many states, limits the amount of indebtedness cities can incur. To top off pensions, former mayor Kwame Kilpatrick borrowed $1.4 billion. To circumvent debt limits, he created special purpose entities to do the borrowing. Orr now claims these were sham entities, and so the debt issue was illegal, so the city is entitled to pocket the $1.4 billion and not pay it back.

Keep in mind that creating special purpose corporations of various types for this sort of purpose is widespread municipally and in the corporate world. Also keep in mind that Kwame Kilpatrick was a crook who’s going to spend the next 28 years in prison for corruption. It’s an interesting claim that an outright criminal who borrows money can claim that because his scheme is crooked he doesn’t have to pay the money back (Both Kilpatrick and Orr were both speaking ex-cathedra as municipal CEO). What kind of logic is this?

If Detroit successfully repudiates this debt, municipal leaders elsewhere would almost have to be idiots not to take advantage of the same trick. Elect a crooked mayor or merely one with few scruples. Borrow an insane amount of money by skating on the edge of the law. Then sue yourself claiming you couldn’t possibly have legally done the deal, so don’t have to pay the money back. Rinse, repeat.

The feds should drop the hammer on this hard on this. I don’t have a lot of sympathy for big banks. On the other hand, when someone takes out the municipal equivalent of a “lair’s loan”, they shouldn’t be allowed to profit from being a crook.

In large municipal bankruptcies, it’s pretty common to claim that the indebtedness is all the fault of those greedy bankers who deceived the poor servants of the public. I believe similar claims were made and generated quite a bit of municipal recovery in Orange County and Jefferson County, Alabama. But look closely and I think where you find a shady banker operating, you’ll often find a shady client as well.

Why do people keep electing crooks like Kilpatrick to office? Well, if it turns out those guys are able to fleece out of town bankers to the tune of $1.4 billion, why wouldn’t you? Looks like he might have cut a pretty savvy deal after all. This sort of behavior shouldn’t be rewarded. You can be sure shady municipal borrowing will only be on the increase if the courts allow the Detroit to play a heads we win, tails you lose game with the banks. Think about that the next time your city engages in legal contortions to dig itself even deeper into debt.

Speaking of Detroit, the free market Manhattan Institute will be doing a one hour live streamed event this Monday the 24th with Michigan Gov. Rick Snyder and Detroit emergency manager Kevyn Orr. It’s at 1pm ET and is called “Detroit: The Next American City of Opportunity.” You can access the event at: http://www.publicsectorinc.org/2014/02/detroit/. If you want to submit questions, tweet them to @ManhattanInst with the hash tag #SaveOurCities.

17 Comments
Topics: Public Policy
Cities: Detroit

17 Responses to “Detroit Emergency Manager Seeks to Unleash an Infero of Moral Hazard”

  1. Josh S says:

    If this tactic is successful, and even has a hint of being repeatable, the rating on municipal bonds will nosedive and interest rates will soar, essentially making a “safe” investment into a junk bond. (Not that Chicago/IL isn’t practically there already, but that’s another matter…)

    The hazard of this situation is not the possibility of not paying back the loan, it’s the possibility that the state or federal government will cover the loan, masking the risk of the municipality while making the “out of town bankers” whole too. If everyone gets what they want on the taxpayers’ dime, why not repeat? If someone gets fleeced in the process, won’t they be twice shy the next time?

  2. John Morris says:

    Isn’t this a case where certain parties defrauded everyone? If the city hid real debts/ liabilities then the taxpayers were defrauded. The bankers may or may not have been- some may have been involved and cashed in.

    Bottom line is we probably need to throw a lot of people in jail for a long time and go after their assets.

    Obviously this is the tip of a huge iceberg since government accounting often borders on fraud to start with.

  3. John Morris says:

    @Josh S is right. Loans to Detroit were made because lots of people assumed they would be covered by the state or federal government. The actual city finances mattered a lot less.

  4. @Josh S, that’s actually the scenario that I’m most afraid of. The big banks have a fat pipe into the Treasury and Fed and can easily get made whole without anyone knowing about it. Hence it becomes a backdoor federal bailout and the whole thing gets swept under the rug.

  5. John Morris says:

    If you don’t want this to be swept under the rug- it’s better it explodes now.

    This threatens cities because many are already junk level credits (or actually bankrupt) extending and pretending with similar tricks.

    Every day this goes on, more good money goes after bad and the ultimate reckoning gets worse.

    The good news is that many of these same cities are holding the lid on lots of potential economic growth. Zoning alone removes hundreds of billions in potential land value.

  6. wkg in bham says:

    @Josh: “the rating on municipal bonds will nosedive” When the bonds were issued, Detroit’s was already at junk status. That’s why the special entities were created. The bonds were secured by revenues from casino taxes. Proceeds from the bond sale went into various municipal worker pension trust funds.

    I don’t know how Detroit comes out on top, no matter the resolution. Suppose the entire deal is ruled fraudulent. Then wouldn’t a big legal “undo” button be pushed? That is, the money is transferred from the pension fund accounts back to the banks and the city gets its casino revenue back. The only nifty aspect of this alternative is that we could prosecute all the officers and directors of the special entities; and every lawyer participating in their creation. The only problem I see in the case is trying to figure out just who was defrauded.

  7. John Morris says:

    “The only nifty aspect of this alternative is that we could prosecute all the officers and directors of the special entities; and every lawyer participating in their creation.”

    Isn’t that a start? Might be hard to get to the bottom of it but this is exactly what needs to happen.

    A kid can spend 10 years in jail for smoking a joint but public officials and bankers can collude to break a clear law and rack up billions in debts and walk away.

  8. George V. says:

    Here in Detroit, everyone seems pretty certain the city is going to get big discounts on its debt and that the banks will continue lending to the city as if nothing happened. Which – to me – sounds way to good to be true, but I’ve yet to find any official sources stating otherwise. If you ask Detroiters why this won’t incentivize other cities to go bankrupt on purpose, their answer is that other cities can’t be sure the bankruptcy judge will be as lenient in the future.

    There has to be more to this story than we’re being told. I think Aaron is on the right track with his back door bailout scenario. The White House can say whatever, but the bottom line is that Metro Detroit was still the 12th largest metropolitan area in the country last census, and it’s also the most perilous. Between the Big 3 and the City of Detroit, it could easily go the wrong way real quick, and frankly, our economy is still too fragile to deal with that.

  9. Chris Barnett says:

    So what if the Fed starts buying municipal bonds under QE3 but Michigan and the Federal Government still allow Detroit to go through a GM/Chrysler style packaged BK?

    This would prevent a gross selloff in the muni bond market while still potentially allowing an unwinding of the pension bond deal.

  10. John Morris says:

    Wow, I’m speechless. No doubt that belief in a bailout of some kind was the basic reason all this debt accumulated. A sell off of muni bonds to their real value is the solution. The faster the swamp is drained, the faster pressure builds to confront real financial problems.

    End The Fed.

  11. Chris Barnett says:

    John, if the Fed can bail out housing by printing dollars to buy all manner of other debt critical to the economy, they can bail out municipalities by printing dollars to buy municipal bonds.

    Just sayin’.

  12. John Morris says:

    I guess I thought the purpose of government was to prosecute crime & fraud, not actively contribute to it.

  13. Chris Barnett says:

    I think this falls under “insure domestic tranquility” and “promote the general welfare”, not so much under “establish justice”. (Quotations from the Preamble to the Constitution.)

  14. As a recent arrival to Detroit, my impression is that even the city’s tiny surviving business elite class of registered votors had bankrolled quite a bit on Kilpatrick: incredible personal charisma, part of a reasonably accomplished Michigan politcal family, youthful savvy, etc. That he was a pathological liar only manifested itself later, and (as is often the case) it didn’t abrogate his charm, which was front and center even during the sentencing. As you can imagine, I don’t think the initial hope was that he’d be such a cunning crook. Since voter turnout is Detroit is low even by America’s standards (many people keep an address outside of the city to get cheap car insurance, and then must opt out of voting altogether), it’s really difficult to put a finger on the Detroit constituency. After all, if the US Census reports are accurate, Detroit is the most homogenous major city in America. But how much those demographics parallel the electorate is anyone’s guess, making it harder than ever to pinpoint a political/ethical median…or, for that matter, who exactly managed to propel Mike Duggan into the mayor’s office last fall.

    “Repudiate” seemed like an unusual word at first to describe this this lawsuit, but in the broader context of the implications that you smartly point out, in seems right on the money.

  15. EngineerScotty says:

    Someone’s gotta take a bath, after all–the question is: who?

    Pensioners?

    Banks and other institutional creditors?

    The taxpayers of Michigan and the United States?

    Probably some of all of the above…

  16. George says:

    Detroit should be allowed to fail on its own. Fiscal discipline must return to government. I hope we don’t reward bad governance.

  17. Nathanael says:

    You haven’t quite got this right, Aaron.

    If the debt was illegally issued, the correct form of restitution is to unwind the transaction entirely. So the city would have to repay the principal, but the interest would be cancelled.

    This is probably the correct thing to do. Nobody profits.

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