Panic in Detroit Part Two

The Emergency Manager in Detroit, Kevyn Orr, just released his first report as E.M., painting a bleak picture of Detroit’s current financial status.This report was mandatory, with Orr going through some of the details found in his very short tenure on the job so far. What the E.M. reported was pretty dire, with the City of Detroit “insolvent” no matter how you care to measure that term. What exactly did he report? He gave a numbers rundown, which showed how Detroit has simply papered over its problems for the past five or so years. But the E.M. doesn’t just delve into numbers, because running a City is not just about reading a spreadsheet. It is about providing critical services to residents. Kevyn Orr recognized that in his report, and did not just talk about cutting, but also spoke of the need to invest in things that have been broken for years. But that “investment” will not be made into existing systems, but will come with hard management changes, including privatizations, that will change the face of how Detroit is managed. For those that have launched objections to a “state takeover” I say that you should have put your house in order before calamity struck. How bad is it? Let’s lift the hood with the E.M.

Detroit has been running deficits for years. But rather than face those deficits the City has chosen to borrow money through bond offerings to paper over debt. I am not familiar with Michigan state law when it comes to municipal bonding but I would have to say that for Michigan to allow these borrowings is flat out bad policy. That does not even begin to speak of the insanity of the bond lenders, whose bad judgement will now be rewarded by a haircut, likely a major one. From the E.M. report, we see the extent of the financial problems, and the papering over of debt.

Excluding proceeds from debt issuances, the City’s expenditures have exceeded revenues from fiscal year 2008 to fiscal year 2012 by an average of $100 million annually. These financial shortfalls have been addressed with long‐term debt issuances (e.g., $75 million in fiscal year 2008, $250 million in fiscal year 2010 and $137 million in fiscal year 2013) and by deferring payments of certain City obligations,such as contributions to the City’s two pension funds.The accumulated unrestricted deficit was $326.6 million at the end of fiscal year 2012. Fiscal year 2013 (year ending June 30, 2013) is currently projected to add approximately $60 million to the accumulated unrestricted deficit balance(excluding the impact of the $137 million debt issuance).

Pretty bad numbers just in that paragraph, but there is more to come. One of the ways to determine insolvency is through cash flows, and whether you have enough cash on hand to maintain yourself as a going concern. Detroit, today, does not. From the report:

The City had negative cash flows of $115.5 million in fiscal year 2012 (year ended June 30, 2012)and borrowed a total of $80 million from Bank of America in March 2012 (of which $50 million was drawn by the General Fund) to avoid running out of cash. The City is projecting negative cash flows of approximately $90 million in fiscal year 2013 and would run out of cash by year‐end if not for (i) the deferral of payments for City obligations, including pension contributions,and (ii) the receipt of proceeds from the escrow account established as part of the $137 million August 2012 bond refinancing transaction, disbursements from which are controlled by the State.
As of April 26, 2013, the City had actual cash on hand of $64 million but had current obligations of $226 million to other funds and entities in the form of loans, property tax distributions, and deferred pension contributions and other payments. Therefore, the City’s net cash position was actually negative $162 million as of April 26, 2013. The City has been deferring, and will need to continue to defer, payments on its current obligations in order to avoid running out of cash…….The City of Detroit continues to incur expenditures in excess of revenues despite cost
reductions and proceeds from long‐term debt issuances. In other words, Detroit spends more than it takes in – it is clearly insolvent on a cash flow basis.

So the City is not able to stay afloat, except by not paying its bills. The E.M. uses the term insolvent. Take note of the pension deferrals, as those will at some point become a major issue. (FY 2013 pension deferral will be $108 million, after paying $31 million into the fund). Unfunded pension liability? Over a half billion dollars, measured with existing actuarial and financial assumptions, but likely to be much higher when those assumptions are updated. But that is chicken feed compared to the unfunded OPEB obligations, which stand at $5.7 billion, mostly for retiree health care. Why worry about that now? From the report:

During fiscal year 2013, in order to make current annual required contributions and repay prior year deferred pension contributions, the General Fund would have had to make aggregate pension contributions of approximately $139 million, which together with healthcare benefit payments (approximately $200 million), total approximately $339 million (33% of fiscal year 2013 revenues, excluding the impact of debt issuance). Annual payments on account of these legacy liabilities are expected to increase in the future if no action is taken to mitigate them.

33% of total revenues for those two items alone. How about other debt?

The City has obligations totaling at least $15 billion, including General Fund debt ($1.1 billion),
enterprise fund debt ($6.0 billion), Pension Obligation Certificates (“POCs”) and related derivative instruments ($1.8 billion), …..

That is one big hole. Orr talks about the lack of capital investment stifling productivity, about a City operation to produce and sell electricity that loses money and is in need of major capital investment, and all of the operational reviews needed of city departments. In order to produce results Orr will be forced to seek major restructuring, and all stakeholders will be impacted negatively. Orr is holding the potential for a Chapter 9 filing in his pocket, but you have to think he may have to pull that card eventually. An editorial in the Detroit News put it in pretty straightforward terms.

What Orr needs residents, employees and creditors to wake up to is the reality that this crisis can’t simply be managed away. Orr used the word “insolvent” in his report for a reason: Detroit can’t keep operating unless drastic changes are put in place.

“We can’t cut enough” to balance the budget, Orr said. “We have to negotiate with stakeholders.”

For Detroiters, that means accepting that certain services will be delivered in a different way, likely by private contractors, and many of the jewels they’ve been so possessive of will either be sold or transferred into regional authorities.

Employee unions must recognize that additional concessions are necessary. Detroit can’t afford to keep promises made in the past.

If pensions can’t be touched under state law, then the savings will have to come from retiree health care benefits. Current workers will likely see far less generous benefits when they retire. Those unions that haven’t participated in past rounds of pay cuts must get on board.

If the E.M. is forced into Chapter 9 the same type of battle will open between bondholders and city pensioners as we are seeing in Stockton and San Bernadino Califormnia. But Detroit is much larger, and the battle will be on a grander scale. Emergency Manager Orr has a very difficult task, both financially and operationally. Will he avoid Chapter 9? The odds are stacked against him. More to come.

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