What will happen to Detroit?

Detroit’s bankruptcy filing—potentially the largest municipal bankruptcy case in the United States—has raised a lot of questions, particularly for those who call the city their home.

How will this decision affect retired city workers’ pensions? Will bankruptcy impact the city’s ability to provide public services? Who will pay for the restructuring? Can bankruptcy do for Detroit what it appeared to do for General Motors? Is this a sign of a nationwide epidemic?

While we can’t predict the future, we can look at Chapter 9, how it came to be, and how it has affected other municipalities in the past.

A Brief History of Chapter 9

Introduced by Congress in 1937, Chapter 9 is the portion of federal bankruptcy code that enables municipalities to seek court protection in the event of a financial crisis and is designed to help ensure that basic government functions can continue while policymakers restructure the debt. Only municipalities and counties—not states—can file for Chapter 9 bankruptcy.

There are good reasons you don’t often hear about cities filing for Chapter 9. A municipal bankruptcy immediately impacts the city’s credit rating and, as a result, means higher future borrowing costs for government. Bankruptcy can also impact a city’s image, which can potentially result in large numbers of residents moving away or less business investment in a region. Public workers have concerns about job security and cut backs on salaries and benefits, while residents may experience higher taxes and fewer public services.

That said, there may also be some advantages to filing for Chapter 9. While most public officials would assert that bankruptcy is not the best “go-to” strategy for struggling municipalities, it may be a necessary last resort. Two key advantages to bankruptcy are that it gives a municipality time and the legal protection it needs to develop an appropriate debt-restructuring plan. To quote Robert Flanders, a former receiver for the city of Central Falls, Rhode Island, who participated in a panel on the topic in late 2012, “Bankruptcy is not the disease for failing cities and towns, it’s the cure.”

According to The Pew Charitable Trusts, Chapter 9 bankruptcies are very rare. Since the bankruptcy proceeding was created in 1937, approximately 620 municipalities have filed Chapter 9—that’s fewer than 10 a year. A total of 28 municipalities have filed for bankruptcy since 2010. In comparison, nearly 12,000 corporations (Chapter 11) and 418,000 individuals (Chapter 13) filed bankruptcy within the past year. Other municipalities that have filed bankruptcy include:

• Harrisburg, Pennsylvania
• Jefferson County, Alabama
• Central Falls, Rhode Island
• San Bernardino, California
• Orange County, California
• Stockton, California

Until Detroit’s filing last week, Stockton was historically the largest municipality to file Chapter 9.

Detroit Files Chapter 9

While many found the news of Detroit’s filing shocking, it also came as no surprise. Detroit governor Rick Snyder hired Kevyn Orr, an expert in bankruptcy law, to be the city’s emergency manager earlier this year.

At the heart of Detroit’s problem is a growing unfunded debt (an estimated $3.5 billion) on benefits owed to current and future retirees. This problem appears to be affecting more than just the city of Detroit. Earlier this year the Pew Center released a survey showing that 61 of the largest cities in the United States had a gap of more than $217 billion in unfunded pension and health care liabilities.

Now that Detroit has made its filing, the first challenge is defending its right to file at all. In a ruling on Thursday, the circuit court judge ruled that Detroit’s filing is unconstitutional in that it interferes with the rights of pension holders.

For now, the future of Detroit’s bankruptcy claim remains uncertain. Even if the claim is found to be constitutional, the length of Chapter 9 proceedings can vary depending on the size of the municipality and the complexity of the case. For example, in the case of Vallejo, California, a city of 118,000 that faced $50 million in debt related to unfunded pensions and other commitments, the process took approximately three years. According to Orr, his goal is to steer Detroit out of bankruptcy by September 2014.

While no one truly knows how Chapter 9 will affect Detroit, there’s no question that what unfolded last Thursday is destined to be a landmark case.