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.