The Surprising Ways Bankrupt Cities Make Money

When American cities are deep in debt, they get creative to crawl out of the red.

In November, the Detroit Institute of Art came up with a way for the Motor City to keep its beloved collection—which was otherwise going to be auctioned off, piece-meal, in the fallout of the city’s 2013 bankruptcy. Ironically, the only works not up for grabs were Diego Rivera’s Detroit Industry frescoes depicting the city’s boom years: strong, somber, masculine factory workers forging steel, fitting pipes, each mammoth mural espousing the multicultural dream of the unionized proletariat. But it was only the sheer impossibility of the frescoes’ removal—not sentimentality—which would leave them untouched by the creditors who’d been trawling the galleries for months.

The museum had been city-owned for nearly a century, which made most of the 57,604 pieces possible collateral on the road to municipal solvency, along with a massive restructuring of labor union pensions, utility shut-offs, and loans from the state. But before the museum became a part of this “grand bargain”, trustees and citizens organized themselves around battle cries like that of the Committee to Defend the DIA: “The people of Detroit cannot stand by while the financial barbarians loot and pillage this priceless trove of human culture!” The fear was that, among other things, the sales would not ultimately sustain Detroit’s economic independence, and more importantly that, had the museum actually been liquidated it would have instigated a similar draining of civic morale.

By divesting the collection to a series of charitable trusts, the DIA committed to contribute $100 million to the city’s recovery over the next twenty years, and thus the likes of Vincent van Gogh’s 1887 self-portrait, the world-famous Madame Cezanne, and a trove of pre-modern limestone relief carvings, among others, were able to remain, and become part of possibly the most creative solution in American history to a municipal fiscal crisis. As of January 5, the DIA board announced that it had reached that goal in present day value.

Prior to The Great Recession, the most famous municipal fiscal crisis was New York City’s in the 70s—which also had a surprising component to its solution. At the time of its near-default, according to Kim Phillips-Fein from a retrospective in The Nation, “The city had 19 public hospitals in 1975, extensive mass transit and public housing, public daycare and decent schools. The municipal university system—the only one of its kind in the country—provided higher education to all, free of charge. Rent stabilization made it possible for a middle class to inhabit the city. For many, the fiscal crisis showed that it was no longer possible for New York to finance these kinds of services.”

And so it was on a cool, October dawn when the Daily News delivered a famous headline. At the time, President Ford—in an effort to teach the country a lesson about the failures of FDR liberalism—refused the governor’s pleas to save the city from the brink of bankruptcy. And the periodical infamous for its penchant for sensational headlines gave the decision its most memorable spin, with a photograph of Ford, mid-snarl: "FORD TO CITY: DROP DEAD."

But by that point, a very different entity had stepped forward to, at the very least, prevent the city from defaulting on its October 17 deadline: the New York teacher’s union.

Two weeks before the Daily News’ Ford-shaming headline, The United Federation of Teachers had voted, at the eleventh hour, to scrape $150 million from their pension fund to begin to pay off the $453 million debt. The saving of the city, in this respect, was initiated by public school teachers, who of course were only the first part of a much more complex exit from fiscal crisis, but whose pensions put some pressure on federal and state governments to follow suit: Ford did eventually come through with a $2.3 billion government backed loan—despite his ideological commitments.

Today, the top two primary sources of municipal debt are “current employee salaries and benefits [and] retired employee pensions and benefits,” according to  Peter Conti-Brown, a bankruptcy scholar at the Stanford Law School. Though there’s always been, of course, those more idiosyncratic instances like that of Orange County’s in 1994 when then-treasurer Bob Citron made heinous speculative investments based on interest rates predicted by a mail-order psychic and astrologer. And the tiny town of Moffett, Oklahoma which, in 2007, when ordered to shut down a speed trap on Route 64, almost immediately defaulted (its only other source of revenue was a salvage yard, which couldn’t support the two shiny new police cruisers they’d recently procured for the aforementioned lucrative ticketing scheme).

The leniency of the U.S. bankruptcy code has long been unique in the Western world. In the crush of 2008, The Economist even speculated that Europe, in order to see its indebted businesses through the worst of retrenchment, might take a cue from America. In addition to European insolvency almost always resulting in liquidation, British “suppliers [had] the right to terminate contracts in the event of bankruptcy, quickly disrupting a firm's activities, whereas in America counterparties have to stay as long as they receive reasonable reassurance that they will be paid.” In personal bankruptcy, Chapter 11, by essentially favoring the debtors’ future recovery, provides, in the most idealistic scenarios and under the supervision of a judge, entrepreneurial protection and encourages bold ventures—or rather it ensures that a failed risk does not haunt a person (incorporated or otherwise) forever and ever. In fact, according to Nathalie Martin, professor of law at University of New Mexico, it was our approach to bankruptcy that was chiefly responsible for allowing the U.S. to compete with other highly-developed European economies in the decades following the American Revolution.

However, municipal bankruptcy law—Chapter 9—didn’t come into existence until late into The Depression, as part of the many-pronged programs of the New Deal. Before, struggling municipalities were expected to solve their crises primarily with tax increases, but this was no longer feasible in the face of the 1930s’ poverty stricken populace. But even so, municipal bankruptcy is still a state issue: Only about half of the union allows for its municipalities the option of filing for Chapter 9, and until recently was used as a recovery tool in cases few and far between. Until the market crash in 2008, bankruptcy in the case of cities was still a dirty word. Case in point: New York. Remember—President Ford was in the minority in urging the city to file. But times have changed.

David Skeel, professor of corporate law at University of Pennsylvania, says, “The received wisdom before Detroit… was that real cities don’t file for bankruptcy, and on the rare occasions they did, it was idiosyncratic.”

Since 2008, over 50 petitions for Chapter 9 have been filed, and 13 cities have successfully gained protection. Detroit is only the biggest municipal bankruptcy in America, but not alone in its crisis, nor in its creative approach to recovery.

Conti-Brown says, “The common route [to recovery] is a kind of Solomonic undertaking—everyone loses a little as the debt is restructured. But sometimes public employee unions hold more sway and retain more of their members’ benefits in the process; sometimes such unions are less powerful and receive less.” Additionally, Skeel says that, “Historically… what’s tended to happen is the state has stepped in and provided some money in return for some control over the city’s budget… What’s complicated that recently is that the states have not been in great shape.”

When Bridgeport, Connecticut, filed for Chapter 9 in 1991, they received help from a state oversight board, and also convinced Chase Manhattan to keep its Connecticut headquarters in Bridgeport which helped. There were other approaches, too, one part of which was arranging for Donald Trump to buy out 100 acres of publicly owned property to develop an amusement park and motor race track, though that never came to pass. In 1992, The New York Times reported that there were also “measures including a plan to recover delinquent property taxes by selling tax liens to a private collection agency,” as well as acquisitions for aid from the state, and “concessions from the city’s unions.”

Among the more colorful approaches in recent years was Harrisburg, Pennsylvania’s. In 2011, having been huckstered by a corrupt company to build an up-to-code (and ultimately faulty) trash-to-energy incinerator, the Keystone State’s capital city petitioned for Chapter 9. They sold the incinerator for $130 million, as well as auctioned off a collection of Wild West artifacts owned by a former mayor which brought in nearly $4 million. It also monetized its parking assets, which included privatizing garages, in effect doubling the price of city parking which, for virtually the first time, they began enforcing.

Jefferson County, Alabama was another big municipal bust of the Great Recession. Under a tight deadline imposed by the EPA, their biggest sinkers also came from civic infrastructure: a new sewer system with muddy financial dealings. In addition, the county also lost 25 percent of their operating budget from an occupational tax of those who worked in the county but lived outside it, and was now responsible for $800 million in liabilities.

Their exit from bankruptcy? They cut their payroll, as well as almost a quarter of the workforce. They shut down many of their satellite courthouses in the suburbs, in addition to a number of “nonessential” services: A nursing home sold to a private operator (to the tune of $8.3 million), a public hospital shut down, and the closing of a massive county laundry facility. Patrick Darby, who represented Jefferson County in its bankruptcy filing, said “I have to say in all fairness, what we did here is easier than it would’ve been in California or up north because we don’t have unions… we don’t have public sector unions and so we don’t have to fight that if we want to lay people off.”

“So you might say that historically filings for cities have been really rare and idiosyncratic, but now there’s a little bit more of a pattern,” says David Skeel. “Just as American industry has shifted from defined benefit contributions and very strong collective bargaining to defined contribution pensions and weaker collective bargaining, we may be seeing a shift in public employment as well, and it may be that 15 years from now this all looks like history.”

A year before Detroit, Stockton, California, defaulted mostly due to bad projections of property taxes which were expected to sustain the state’s generous pension program—which of course didn’t pan out after the sub-prime mortgage bust. The mid-sized city of about 219,000 had, like other Californian municipalities, a history of incredibly strong labor unions and contractual obligations to the state’s health and retirement management agency CalPERS. Bankruptcy protection allowed Stockton to negotiate a decrease in the amount they owed one of their biggest investors and pass a new sales tax.

But the neighboring bankruptcy in Vallejo just four years earlier, subject to the same hampering circumstances, was different: For the first time in U.S. history, the judge ruled that labor union contracts, previously iron-clad, could be forcibly renegotiated in the event of a Chapter 9 bankruptcy. Marc Levinson, who has represented Vallejo and Stockton, says that Vallejo “reduced its workforce, stopped making road repairs… it didn’t replace fire and police vehicles when it should have, it cut back the hours on the library, closed city hall for one day every two weeks…” They removed the minimum staffing requirements for fire trucks, and reduced its police department by 40 percent.

“In some cases these protections have come via litigation (as in California),” says Conti-Brown, “where public unions sue to challenge the constitutionality of the municipalities’ actions… In other cases (as in Michigan), the unions work through the legislature to either pass a law or amend the state constitution to ensure that protection. In other words, every union knows that in a fiscal crisis, its members’ benefits will be on the chopping block.” While the Michigan Constitution forbids pensions from being cut, Judge Rhodes ruled—not dissimilar to the ruling in Vallejo—that federal bankruptcy law overrides that protection. So facing the possibility of even more austere cuts in the event of non-compliance, pensioners voted by a landslide for a 4.5 percent cut and a ceasing of inflation adjustment. Upon the electoral results, Emergency Manager Kevyn Orr said, “I want to thank city retirees and active employees who voted for casting aside the rhetoric and making an informed positive decision about their future and the future of the city of Detroit.” But what Orr is calling “rhetoric” here seems to be more accurately the “casting aside” of city workers’ secure income—and ultimately without having had much of a choice either way.

So what does this all mean? Every municipality comes up with its own unique solution, and in the case of Jefferson County that meant shutting down a “charity hospital;” in New York that meant laying off 6,000 school teachers who’d leveraged their pensions; and in Vallejo that meant making it possible for the courts to compel unions to break their collective bargaining agreements, a ruling which now extends to the rest of California, and, having some of the strongest labor unions in the country, seems plausible that it could extend to other states, too. And if we’re going to talk about rhetoric, unions are the group often identified as the primary problem behind fiscal insolvency—when, rather, it’s other underlying fiscal crises that make it impossible for those municipalities to fund the pensions they’d committed to long ago. As Marc Levinson says, “It’s just that we’ve made these promises to people who’ve given their lives in service based on this promise and now we can’t afford it!”

But this has been true, with or without Chapter 9 bankruptcy—and with or without a judge’s ruling that collective bargaining agreements can be broken—since the 1970s when the biggest city in America was facing down the possibility of bankruptcy.

Kim Phillips-Fein says that the crisis in New York “brought about a change in the city’s leadership, as clubhouse Democrats were deposed in favor of a younger generation of business-friendly liberals. For these new leaders, the downsizing of New York became a badge of honor: a sign that liberals were not beholden to such special interests as organized labor but could speak the rhetoric of efficiency."

And in this regard, the case in New York is not unique, nor the case in Detroit. It seems that in nearly every instance, except those that are truly idiosyncratic or downright weird, bankruptcy has been a means of surreptitiously, and generally without any explicit electoral participation, undermining the institutions of American liberalism.

While keeping the DIA in Detroit was worth the cost of privatizing, it’s possible that the institution may slowly change in the hands of new private interests. Just days after the grand bargain was settled, the DIA had a gala scheduled that could’ve been a sad affair had Michigan’s Supreme Court overruled their proposal. On November 3, they celebrated the grand bargain and raised an additional one million dollars from museum supporters in attendance. They toasted to the new museum status, which means that the DIA will never face the possibility of “forced liquidation” ever again. And there they were, wandering the Rivera Court, looking on at the frescoes of their city’s bygone era, a vision of worker’s solidarity, in the museum that had been saved by the people, but which no longer belonged to them.