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Lesson from Detroit
The Regulatory Reform Urban Democrats Hate

The Detroit bankruptcy is giving some Wall Street firms a splitting headache. The embattled city’s emergency manager Kevyn Orr is pursuing a lawsuit that would let the city stop making payments on a $1.44 billion pension deal centering on what the city’s lawyers are now calling “sham” contracts. Orr is arguing that the deal establishing these contracts—invalid from the start— could fatally burden Detroit. The FT explains:

The complaint, filed with the US bankruptcy court in the eastern district of Michigan, which is overseeing the proceedings, alleges that the city violated a state rule by borrowing more than 10 per cent of the assessed value of private property owned in the city.

Facing a massive pension shortfall in 2005, along with 2,000 lay-offs, the city created “shell entities” to circumvent the law – “at the prompting of investment banks that would profit handsomely from the transaction”, according to the complaint.

Did crooked Detroit politicians, desperate for cash to keep the con running, sign such a bad deal with greedy Wall Streeters that it broke the city’s back? And was the deal so grotesquely one sided and did it violate enough state laws that it was invalid from the get go? And if so, how do you disentangle the mess?

If the facts are as stated in the city’s complaint. it’s impossible to summon up much sympathy for the greedy and conniving i-bankers who took the unfortunate Detroit taxpayers to the cleaners. But Detroit was a willing client—felonious officials, products of the same kind of one party Democratic urban machine that has gutted other American cities, were as eager to circumvent the laws as the Wall Streeters.

While the bankers may be forced to disgorge some or all of their gains, those officials aren’t in criminal court because of their reckless behavior, and that points to the larger questions raised by this case. We need much tougher laws and much more aggressive regulations when it comes to protecting the interests of both taxpayers and retirees in state and local government. Craven politicians promise big pensions to their unions but then don’t set aside enough money to pay those pensions. If they paid the true cost of the pension promises, voters would be enraged by the necessary tax hikes and spending cuts. The union leaders go along with the scam. They look good to their members, and the problems won’t pop up for decades.

Then, when the due date on the pension arrives and the money isn’t there, politicians reach out to the i-bankers who, in exchange for fat fees, will help the city hide its problems for a few more years. This was the cycle of lies, fraud and desperation that Detroit found itself in, and it isn’t alone. This method of winning cheap popularity at a devastating long term cost has become standard operating procedure in cities and states across the country. At its heart it involves pension fraud: government workers are promised lifetime payments, but inadequate provisions are made for when those promises are supposed to be paid.

Anybody who did this in the private sector would go to jail and rightly so. Pension fraud is one of the worst kinds of fraud; people in their seventies and eighties whose pensions suddenly become insecure don’t have many options. Private sector pension law puts company pension funds under all kinds of restrictions, and in many cases there are criminal penalties for failing to comply with the law. Congress urgently needs to pass a safe pension act to extend the same protections that private sector workers have to public pensions.

Union bosses and machine politicians will hate this law. They want to keep the pension merry-go-round spinning. Most Democrats will fight these reforms with all the fury and guile they can command; the corrupt institutions at the heart of this mess include some of the most important power brokers in the party. Too bad: the status quo puts taxpayers, bondholders and pensioners at unacceptable risk.

And while urban Democratic politicians love to posture as the enemies of Wall Street, in reality they are some of its best and most lucrative customers. Wall Street is happy to charge fat fees to city and state governments whose irresponsible pension management has put them into a financial hole. This needs to stop, and it won’t happen without better regulation and tougher enforcement of some common sense pension laws that normally regulation happy Democratic pols and union bosses hate.

Beyond all that, the Detroit case could cause big problems in the municipal bond market. Suppose Detroit isn’t the only city to have negotiated shady refinancing arrangements in collusive agreements with Wall Street shysters? Suppose a number of municipal financial deals are similarly illegal and similarly vulnerable to a court challenge?

Detroit is already making life tougher for other panhandling cities by offering extremely tough terms to bondholders in bankruptcy proceedings. It wouldn’t take much to weaken investor confidence in the finances of a number of machine-ruled big cities, and city and state governments throughout the country can expect bond buyers to ask some hard questions and to demand larger risk premiums as the pitfalls of lending to badly governed municipalities becomes more clear.

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  • Bruce

    Well stated. Pension fraud is a looting of taxpayers and is no better than theft. Harsh prison sentences should be handed out and reforms should be retroactive.

    • Corlyss

      As a rule, any group regardless of size that is powerful enough to swing elections by confiscating money from impressed members against their wills and donating it to politicians to get prejudicial treatment for its members is committing “rent seeking.” It should be punishable by death.

      • Andrew Allison

        Did you mean “preferential”? ;<)}
        How 'bout we just kill all the lobbists?

        • Corlyss

          No. I used it in the 2nd definition sense.
          I’m not really against lobbyists. If it weren’t for lobbyists, legislators wouldn’t know up from sideways. It’s the lobbyists that educate the legislators because they’re too busy running for office to know anything outside their life own experience.

          • Andrew Allison

            Except self-interest versus the public interest!
            “In public choice theory, rent- seeking is spending wealth on political lobbying to increase one’s share of existing wealth without creating wealth.” (Wikipedia)

          • Corlyss

            I notice that that statement in Wikipedia is unsourced. Lobbying efforts often come to naught, therefore I’d question the reasonableness of applying the term to lobbying per se. It’s actually getting the preferential treatment into laws that qualifies. Lobbying is just another form of free speech. No one is forced to listen or act.

    • free_agent

      You write, “reforms should be retroactive”.

      Wouldn’t that be an ex-post-facto law?

      • Corlyss

        Yes, in the sense that Bruce has in mind. Punishment for something that wasn’t a crime when the act was committed is an unconstitutional ex post facto law.

        • Bruce

          Technically, your descriptions are accurate. It would be after the fact, but I think it is a given that fraud is illegal. So is it invalid to go back to something that was fraud and determine that it is worthy of a jail sentence, given that it was fraud with public money instead of private money? I think it would be legitimate. It was also an undermining of our democracy by vote buying, although you would be hard pressed to find a law against this form of vote buying.

          • Corlyss

            If what the city officials did meets the statutory elements of fraud, then there is no need for retroactive laws. If what the city officials did does not meet the statutory elements of fraud, then prosecutors are dead in the water. If they are guilty of fraud, the judge or jury is limited in punishment to what the statute provided as punishment at the time the crimes were committed. The legislators can’t change the elements or increase the penalties now, and have those apply to acts already committed by the city officials. Of course what Detroit officials did was an offense against the public and against representative democracy, but only in the sense of the routine definition of “offense” not in a legal sense. I don’t know what the bribery and election laws in Michigan are. Traditionally, by de facto agreement, both parties do not look too closely at the wrong-doings of the other because you see what it can lead to. Politics is such a dirty business that only the voters can discipline the system and the players. Until the voters care, and obviously the black voters in Detroit didn’t care, nothing substantive can be done. When the voters care, they can clean up the system very quickly. Unfortunately, most voters in most big cities dominated by machines have yet to demonstrate that they are “mad as h*e*l*l and aren’t going to take it anymore.”

        • Joseph Blieu

          if you think that ex post facto laws are unconstitutional you should review some environmental and super fund law.

          • Corlyss

            A lot of what EPA did, at least before these jackbooted thugs in this administration, was by consent decree and negotiated settlements. That’s different from criminal conviction under a classic ex post facto law. Inconceivable that industry would not have sorted that out already, but if you have examples, I’d like to know them.

  • Anthony

    Besides denouncing corruption we should understand the politico-economic system that makes it ubiquitous. The temptation for Wall Street Firms to leverage municipal politicos to bring in vast sums of money is strong, especially since those who would be guardians have their palms out too. If the operational ethic WRM is looking out for number one, then corruption (pension or otherwise) will be chronic rather than occasional (more a systemic product). Regulatory reform may not be enough.

    • Andrew Allison

      I agree in principle, but must point out that it is the duty of banksters to make as much money for their shareholders as they can withing the bounds of the law, and of public officials to put the interests of (all) their constituents ahead of their own. Neither side comes to party with clean hands, but isn’t the bottom line that the public officials grossly violated the public trust? Just asking.

  • Pete

    “We need much tougher laws and much more aggressive regulations when it comes to protecting the interests of both taxpayers and retirees in state and local government. ”

    The only law needed is right-to-work … or better yet, the outlawing of public sector unions.

    • Doug

      Even non union public workers get pensions. All public pensions should be covered by the same kinds of laws that protect private pensions from employer abuses.

  • johngbarker

    Finally, a clear definition of progressive politics.

  • free_agent

    From a historical point of view, (isn’t WRM a historian?), the question is, Why didn’t the Employee Retirement Income Security Act of 1974 (ERISA) cover public pensions as well as private pensions? That was 40 years ago, and it would have saved everybody a lot of pain.

    • Andrew Allison

      Who knows, but at a guess, abuses of private pension plans became manifest in the late sixties, well before the public-pensions-for-votes game really took off. Extending ERISA to encompass public pensions is unlikely to happen as long as unions own the Democratic Party.

      • Corlyss

        Unions love bailouts as much as businesses do. It would be Democrats that would want to save the public employee union pensions by having ERISA amended to cover them. “Everybody’s money is nobody’s money.” – Eric Sevareid. Of course unions would think they should be able to get some of everybody’s money.

    • Corlyss

      It’s no surprise that ERISA didn’t. Municipal bankruptcies are exceedingly rare. Governments are considered ongoing entities. Nobody expects them to go out of business so to speak.

  • TommyTwo

    And in an alternate timeline in which the i-banks would not have participated in this scheme:

    Those heartless fat-cat bankers are refusing to lend money to help Detroit turn itself around, using the laughable excuse of some obscure state rule. After we bailed them out from their irresponsible greedy behavior, don’t they have any measure of responsibility to us? Instead, they are hoarding our cash and keeping our economy depressed, rather than making the obvious investments in a city that our President himself has testified is recovering!

  • Corlyss
  • Bretzky1

    This is exactly why municipalities should be allowed to borrow funds only from the state government.

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