The Significance of Detroit’s Bankruptcy

Detroit has, by some estimates, $18.5B in debt. Its population is just 714,000, which means that the debt load is about $26,000 for every man, woman, and child in the city. Children don’t work and therefore cannot pay a debt, nor do retirees. A very large proportion of its working-age able-bodied citizens are unemployed, I have seen estimates from 16% to this Bureau of Labor Statistics site which claims 23.1%. The reality is far worse, because unemployment does not count people who have dropped out of the work force for any reason. By any estimate, there is no way that Detroit’s taxpayers can bear the burden of Detroit’s debt.

But that is not the issue today.

The issue is that Detroit finally defaulted. It failed to service this debt. Servicing has nothing to do with paying it back. Servicing only means paying the interest.

I read an article earlier today with a headline announcing Detroit was “insolvent”. I was witness to a discussion in which one person asked what insolvency means and another said liabilities are greater than assets. Fair enough, I thought, but my first response was that we now have a vastly more lenient standard. Insolvency is when a debtor can’t make a payment, can’t service the debt.

But upon further thought, there is a simple answer. Detroit’s asset is the stream of tax revenues it anticipates collecting from taxpayers. Any stream of payments may be discounted by the interest rate to calculate its Net Present Value (NPV). Insolvency is when NPV of tax revenues < NPV of debt.

By this metric, Detroit was insolvent a long time ago. Now, hopefully in bankruptcy court, they can separate the pension fund, which will get whatever assets were held against pension liabilities. Hopefully they give the secured creditors whatever assets were used as collateral. These ought to be in private hands anyways. Along those lines, hopefully they sell off productive assets and give those to creditors.

Also, hopefully, they will renegotiate the contracts with police, fire, teachers, and other city workers to provide a realistic, market-based wage and more importantly no defined-benefit pension plan.

Then, free from the burden of the debt, their taxpayers can breathe easier and, perhaps, begin to prosper once again.

Unfortunately, the problem of bankruptcy will roll on to the next bank, insurer, pension fund, or annuity. Who owns Detroit’s bonds? I bet some of them are owned by other pension funds.

2 thoughts on “The Significance of Detroit’s Bankruptcy

  1. Mark Wallace

    In layman’s terms, “insolvent” means that you can’t pay your bills. For state and local governments (those that can’t print “money”), tax revenues plus new borrowing must be at least as much as operating expenses plus debt service. One “kicker” is that debts include not only bonds issued, but also pension payments due.

    Reply

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