America's First Big-City Bankruptcy of 2013

Rich Smith
Detroit city bankrupt
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In the early days of the financial crisis, banking analyst Meredith Whitney famously predicted the near-death experience of Citigroup (C). But when Whitney came back on the national stage to warn of a similar financial apocalypse striking the municipal debt markets in 2011, that warning fell flat.

The wave of municipal bankruptcies never happened. The "hundreds of billions" of dollars lost to investors were not, in fact, lost. America dodged a bullet -- but none of that is going to help Detroit.

The Motor City Stalls

You see, according to Kevyn Orr, the state-appointed financial manager charged with saving the Motor City from itself, Detroit's in pretty dire straits right now. The population upon which it levies taxes to pay its bills has shrunk by two-thirds from its apex. And of those few Detroiters still living in the city, 18 percent are unemployed -- and consequently paying little or no taxes.

Meanwhile, the city is saddled with $15.7 billion in bond debt, pension liabilities and other long-term obligations on its balance sheet. Just keeping up with the interest payments on all this debt, and paying the health benefits of public employee retirees, cost Detroit $461 million of the $1.1 billion it's expected to collect in tax revenue this year.

That leaves less than $640 million with which to pay for all the daily services required by a city of more than 700,000 -- just $905.76 per citizen.

Lies, Damn lies and Damnably Difficult Statistics

That's not enough -- not without borrowing money to pay for the services these citizens need. As a result, if things keep on going as they have been, then by June 30, Detroit will have spent $380 million more than it collected in tax revenues.

Orr says that already, the city is "insolvent on a cash basis." And all this, of course, is before you even consider how to try to tackle Detroit's debt and start digging out of the hole the city's in.

According to Orr, if Detroit took every revenue dollar it collects for the next 20 years, and devoted all of it to paying down debt -- turned out the lights, let the potholes pot and the retirees eat cat food -- it still wouldn't collect enough money to pay off its debt.

Stating the obvious, Orr warned: "No one should underestimate the severity of the financial crisis."

Anybody got the number for AAA?

So what is the solution? Orr has a laundry list of ideas, none of which is going to be popular.

  • The city can cut the benefits it pays its retirees -- essentially breaching the contracts it's signed with its workers over the years.

  • It can lay off workers now on the job, breaking the social contract with its citizens (and probably eroding its tax base further as these citizens flee a deteriorating city).

  • Last but not least, Detroit can try to renegotiate payment terms with its lenders, and cut its "debt principal" -- which both sound like reasonable options ... until you realize that they're really just a polite way of saying: "Default on the debt."

On one hand, yes, default can dispose of a debt problem rather quickly. On the other hand ... good luck borrowing money in the future, once you've proven to lenders that you're quite willing to stiff them when the bill comes due.

The Endgame

The likely endgame for all of this, of course, is that Detroit will probably have to follow Harrisburg, Pa., Jefferson County, Ala., and Stockton, Calif., into Chapter 9 bankruptcy court. It won't be the first U.S. city to go this road. It probably won't be the last.

But (for the time being, at least) Detroit can claim the distinction of having been the biggest U.S. city to ever go completely bust.

Motley Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Citigroup Inc.