9 questions about Detroit's bankruptcy you were too embarrassed to ask

By Danielle Kurtzleben Sep 19, 2014, 8:00am EDT

One of Detroit's tens of thousands of abandoned and deteriorating homes stands empty.

Even if you know nothing about Detroit's bankruptcy, you have likely heard some of its litany of bankruptcy-related problems. The fire department has been using makeshift alarm systems constructed from pop cans and doorbells to alert them to emergencies, the Detroit Free Press found. A recent report recommended the city tear down 40,000 buildings. The city reported that Detroit's police had an average response time of 58 minutes to top-priority calls (though that may not be the best measure of effectiveness, as the Wall Street Journal argued). At one point around 40 percent of the city's streetlights were out. And the city (in)famously shut off water for thousands of residents earlier this year.

Behind the collapse of basic services in Detroit is simple reality: the city is out of money. It's so far in the red, in fact, that it's doing something cities almost never do: declaring bankruptcy.

The bankruptcy process began a year and a half ago, but the trial itself is just finishing up its second week. Here's how Detroit got to this point — and what comes next.

1) How bad are Detroit's fiscal problems?

Very bad — Detroit will be the biggest municipal bankruptcy in US history. Its $18-billion bankruptcy is more than four times the next-biggest municipal bankruptcy, which was Jefferson County, Alabama's $4.2-billion bankruptcy case in 2011. Detroit's bankruptcy is also agonizingly complex; the city has around 100,000 creditors — including retirees, banks, and bond insurers — to appease.

Creditors like that will often try to prove that the city isn't really insolvent — that it just needs to reach deeper to pay them back. So it's a testament to Detroit's fiscal woes that many of its creditors have put up little fight as to whether the city was insolvent; they simply conceded that it was.

"It's notable that while in a lot of cases financial creditors fight very hard on the insolvency question, they did not in Detroit," says Melissa Jacoby, professor of law at the University of North Carolina. "They all sat that out. It was unions and retiree associations that fought it."

2) Where did all that money go?

This chart from the Huffington Post tracks where Detroit's debts came from. It shows that around half of the city's obligations are worker-related, counting up pension-related obligations and retiree health benefits.

Source: Huffington Post

Bankruptcy doesn't save a city from basic fiscal problems, of course; it's primarily an issue of debt. Many of the holders of that debt will end up receiving much smaller payouts than they were anticipating. And the city is hoping it can stave off those huge future bills on the retiree side by taking big steps like stopping providing health benefits to retirees.

3) So were Detroit's retirees living large?

On average, no. CNN's Melanie Hicken reported in 2013 that Detroit's average annual pension for retired police officers was $30,000, which is lower than Kansas City, Dallas, and Chicago, and just over half of the $58,000 received by LA cops. In addition, general city workers received just over $18,000 per year on average. Moreover, some public-sector retirees may not receive Social Security benefits or may see those benefits reduced.

Of course, those are averages; the size of a pension in part depends on a person's salary when they're working, so some people ended up with much more generous pensions. And these pensioners are receiving healthcare benefits, so that modest-looking $18,000 also does come with coverage against one of the biggest costs a retiree faces.

One complication is that there were many improper payments. For decades, the Detroit pension fund made payments outside of normal disbursements to pensioners, as well as active workers and their families, the New York Times reported in 2013. Those payments included "bonuses to retirees, supplements to workers not yet retired and cash to the families of workers who died before becoming eligible to collect a pension," the Times' Mary Williams Walsh wrote.

4) Why is Detroit so poor?

Detroit's fortunes have always been closely linked to the health of the city's auto industry. A booming auto industry and the Great Migration of southern blacks to the north helped make the city a bustling and fast-growing metropolis in the early- and mid-20th century. But then a variety of factors helped push people out again.

One main issue was that with all its eggs in the manufacturing basket, Detroit was set up for problems when the auto industry started to decline. In an in-depth 2013 feature tracking Detroit's decline, the New York Times writes that the dispersion of the auto industry in the 1960s was in part a function of race (as blacks and whites refused to work side by side) and in part labor disputes, as factories spread out to ensure a strike in one place didn't kill productivity everywhere. This was exacerbated by greater foreign competition in the auto market. The bottom line was that people began to leave Detroit — and lots of working-age people leaving means fewer people to pay taxes.

Source: Detroit Free Press

Take a city once built for 1.8 million people and fill it with around 700,000 people, and you have some basic problems just keeping the city running — all that sprawl and fewer people are one reason police response times have been so slow, for example.

Not that these economic and population woes are the only reason the city is struggling financially. As the Free Press showed in its 2013 in-depth report, "How Detroit Went Broke," the city suffered from financial mismanagement, as mayors and city councils mismanaged city funds. For example, the city boosted retiree benefits but raised taxes so high that they drove people into the suburbs. Falling property values haven't helped, either. In a vicious cycle, a flight of people can pull down property values, meaning fewer revenues in property taxes, making it harder to catch up financially.

But no matter who's to blame, it is undeniable that Detroit is economically depressed. As of July, the Detroit metro area had an unemployment rate of 9.8 percent, compared to the nation's 6.2 percent, according to the Labor Department. And according to the Census Bureau, the city's 2008-2012 poverty level was 38.1 percent, compared to the national rate of 16.3 percent.

Detroit Emergency Manager Kevyn Orr has proposed sweeping changes to city finances. Those changes have worried some Detroiters. (Getty Images)

5) This is all a downer. Can we have a music break?

Yes. But let's keep it Detroit- and hardship-themed.

Marvin Gaye's 1971 "Inner City Blues," recorded by Tamla Records (a subsidiary of Motown Records), is about life in a city where it's impossible to get ahead. So it might sound familiar to today's residents.

6) How can a whole city go bankrupt?

A city files for bankruptcy when it has so many debts and so few assets to handle those debts that it doesn't think it can successfully meet its obligations. The city doesn't necessarily have to be entirely out of money; rather, it simply might know it cannot meet its future obligations. So like an individual or a corporation, it files for bankruptcy to seek protection from its creditors while it figures out a more workable plan of attack on becoming financially stable.

That said, there are plenty of cities around the US that have major fiscal problems (Chicago is a good example). But Chicago or any of those other cities couldn't just march into bankruptcy court tomorrow and get a deal on its debts.

That's in part because different states have different laws governing municipal bankruptcy. Some states don't allow it at all; in the rest, the state has to specifically permit a city to go through it. This map from Governing magazine shows states' different laws.

Source: Governing Magazine

But that's not all; getting a court to agree that your city is, indeed, in need of bankruptcy is extremely hard.

"It is very, very difficult for a municipality to be eligible for bankruptcy. The standard is extremely high," says Jacoby. A city has to prove insolvency, she says, and one way to do that is establish "service delivery insolvency." That's when a city can't provide basic services to residents, like water, lights, and safety.

The legal steps toward bankruptcy in Detroit have been going on for more than a year. In early 2013, Michigan appointed bankruptcy attorney Kevyn Orr as Detroit's city's emergency manager. In July 2013, the city first filed for bankruptcy, with Gov. Rick Snyder's approval. The city argued that it needed bankruptcy because of its sky-high debt and more than 100,000 creditors, as USA Today reported. In December, Judge Steven Rhodes agreed that Detroit is eligible for Chapter 9 bankruptcy, the part of the code that deals specifically with municipal bankruptcies.

After a series of attacks on bus drivers, transit workers in Detroit went on strike late last year, demanding surveillance cameras and better policing. (Source: Getty Images)

7) How common is city bankruptcy?

In part because of state laws and that high bar for entry, it's relatively rare. According to an early 2013 analysis by Governing magazine, only 0.6 percent of eligible municipalities filed for bankruptcy in the prior five years. That figure is even smaller if you're looking at cases that weren't dismissed.

While municipal bankruptcies aren't necessarily becoming more common, the last six years have made them much more visible. The Great Recession has made fiscal times tough in lots of municipalities. Among the six biggest municipal bankruptcies (including Detroit's), five have taken place since the financial crisis, according to data gathered by the New York Times.

8) How far along is the Detroit bankruptcy process?

In a trial that opened on September 2, Judge Rhodes is trying to decide on whether the city's bankruptcy proposal is "feasible." According to Jacoby, "the two components he's surely going to consider are whether the city will be able to service the restructured debt on one hand and whether the city will be able to return to an adequate level of municipal services for its citizens on the other hand."

So it's not just about making sure investors are comfortable and happy; its about making sure residents are as well (relatively speaking).

9) So what's left to do?

Many creditors over time have reached agreements with Detroit about how much they will finally be paid. Pensioners, for example, agreed last year to take cuts of up to 4.5 percent, plus smaller cost of living adjustments, as the Times reported. But there have been some holdouts. As of Monday Sept. 15, one of the major ones stopped slowing the process: Detroit reached a deal with Syncora, a bond insurance company that has been the one of the city's toughest creditors. A city buys insurance on its bonds as a way of boosting its creditworthiness, Jacoby explains. The insurers will pay out on the bonds if the city defaults, and that is what has brought companies like Syncora into the bankruptcy trial.

Syncora, which says it's owed $333 million, will receive only 13.7 percent of that as a result of this deal, according to Bloomberg. This represents a huge step for Detroit moving toward a final resolution.

Previously, Syncora had banded together with Financial Guaranty Insurance Corporation, another large bond insurer, to lead the charge against the city's restructuring plan. FGIC claims it's owed $1.1 billion and is still fighting hard for it. Given Syncora's deal, Rhodes has adjourned the trial for a week to give FGIC more time to prepare its case.

If Detroit doesn't reach a deal with FGIC, Rhodes could tell Detroit to stick with its current plan of adjustment, which would give those investors around 10 cents on the dollar, Bloomberg reports.

There will be much more left for Detroit to do in terms of rebuilding; it faces potentially knocking down tens of thousands of blighted homes and trying to rebuild a city that has been devastated by a shrinking manufacturing industry. That will be an important test for whether its plan of adjustment gives the city enough breathing room to recover; the city has a lot of problems to solve.

"If the city's plan of adjustment has set aside enough money for public services, enough money to improve public services, to try to improve the city's built environment and address those underlying problems, and if the bankruptcy itself has done enough to awaken philanthropic commitments to the city and investment interest in the city, then things might improve for Detroit," says Michelle Wilde Anderson, professor of law at Stanford University. "It really remains to be seen."

9 questions about Detroit's bankruptcy you were too embarrassed to ask