Alabama and Michigan Cases. Different Approaches: The states of Alabama and Mich

Question

Alabama and Michigan Cases.  

Different Approaches: The states of Alabama and Michigan reacted to the impending bankruptcy of their respective local government in very different ways. Consider the approach of each state. What are the pros and cons of each state’s approach? Feel free to conduct independent research on these cases to enhance your understanding of each situation. Please Below is the case Study:

Minicase: Detroit Bankruptcy

The underlying cause of Detroit’s financial problems was a long-term erosion of its tax base, especially the failure of the auto industry in which both General Motors and Chrysler eventually declared bankruptcy. With the ero- sion of its industrial base came a loss of jobs and population. Then a deep recession worsened the city’s revenues. Michigan’s policy of cutting back on aid to local governments made the revenue problem worse. The end of fed- eral antirecession assistance also played into the financial difficulties of the city. Inadequate revenue forced layoffs that reduced contributions to the pen- sion funds at the same time that the recession reduced the value of existing pension holdings, increasing the amount of money the city owed to the pensions.

A city in financial trouble sometimes adopts complicated, risky, and pos- sibly illegal strategies. Banks, investment houses, and financial advisers eager to make some money sell such schemes to anxious city officials. When these strategies go sour, the city is left with unsupportable levels of debt. Such prob- lematic arrangements featured in Detroit’s story.

In 2005, Detroit workers successfully sued to force the city to contribute what it owed to their pension fund. With no money to pay for the court set- tlement, the mayor wanted to borrow money to put into the pensions. However, the city had already reached its state-mandated debt limit, making ordinary borrowing impossible.

Financial advisers and bankers helped the city work out a plan to get around this limit. The city created two service corporations—spinoff organi- zations from the city with independent borrowing power—whose sole func- tion was to borrow money on the city’s behalf. To encourage and protect potential investors, the city agreed to a variable interest rate on much of the borrowed sum. If interest rates rose, the city would have to pay a higher rate of interest on much of the $1.4 billion it was borrowing. Encouraged by the banks and financial advisers, the city then swapped the variable rate loans for fixed rate loans at 6 percent, as a guarantee against a rising rate. But then, instead of rising, the interest rates fell, leaving the city with an expensive fixed rate of interest instead of the less expensive variable one. The banks with whom the city was dealing required a very high penalty fee to cancel the contract. In 2009, when the city’s credit rating was downgraded, violating the terms of the swap agreement, the city restructured the agreement to reduce the risk to the banks of the city’s default, depositing its revenue from casinos directly into an escrow fund from which the banks could draw money if the city defaulted. Later, when the city defaulted on its payments, the banks took the city’s casino revenues.

In March 2013, Governor Snyder appointed Kevyn Orr from the law firm Jones Day to be the city’s emergency financial manager. Jones Day repre- sented both the city and the state in the bankruptcy proceedings. Orr had broad authority to change the city’s budget, renegotiate or void union con- tracts, sell city assets, privatize services, and deal with creditors on the city’s behalf. Under Michigan law, a city can declare bankruptcy only if that course is recommended by the state-appointed emergency financial manager.

Orr rejected the possibility of getting out of some of the city’s obligations on the ground that those obligations had been illegal. He argued that the chance of success in court was only 50–50, and the city didn’t have time for a lengthy court proceeding. As an expert in bankruptcy law, he undoubtedly knew that interest swaps and other derivatives get favorable treatment in federal bankruptcy proceedings.

Orr began negotiations with the city’s creditors. Offering only pennies on the dollar to obligations that he determined were not secured, not sur- prisingly, he was unable to get all the parties to agree voluntarily to his pro- posals. Failing to get such agreement, he petitioned for bankruptcy for the city. He wanted to change the pension system to a defined contribution rather than a defined benefit plan, which puts much more risk on the employee instead of the employer, he advocated deep cuts in employee health care, he proposed deep pension cuts as a way of forcing labor conces- sions and recommended only modest reductions in the amounts owed to the banks holding the interest swaps. While he was managing the city’s finances, he skipped the city’s contributions to the pension funds, while maintaining payments on outstanding bonds and the interest rate swaps and continuing to pay “certain important” vendors.1 Orr had exaggerated both the extent of the pension’s underfunding—as a result of borrowing, the pen- sion was reasonably well funded—and had also exaggerated the relative importance of the pension and health insurance obligations compared to other obligations of the city.

The bankruptcy judge ruled that Detroit was eligible for bankruptcy and that pensions could be reduced despite the state constitutional prohibition on reducing pensions. However, he rejected Orr’s proposal for how much the banks should be given to terminate the interest rate swaps and consequently how much of the city’s casino revenue could be recovered and used to reduce future borrowing and help restore city services. Orr’s first proposal to the bankruptcy court was to pay 80 percent of what was owed to the banks hold- ing the interest rate swaps; when that was rejected, he proposed 60 percent. When the judge rejected this proposal as well, Orr and the banks agreed to a 30 percent settlement. The final deal approved by the bankruptcy judge also cut the pensions considerably less than Orr’s original proposal.

The governor generally kept a low profile while this was going on, but with his backing, the state did eventually contribute some money to prevent creditors from forcing the sale of art in the city’s museum and to reduce the impact of cuts on retiree pensions. Despite this late-stage support, the Washington Post argued that Governor Snyder had “pushed Detroit into bankruptcy. The New York Times similarly noted that “Gov. Rick Snyder of Michigan on Friday defended his decision to force Detroit into bankruptcy as a necessary step to halt its decades-long decline and resolve its spiraling debt crisis.

The Jones Day lawyers who represented both the state and Detroit in bankruptcy proceedings believed that bankruptcy was the only way to solve Detroit’s problems and that the emergency financial manager could not pos- sibly come to voluntary agreements with all the creditors and thus avoid bankruptcy. They expressed that opinion in emails before one of their own, Kevyn Orr, was appointed as the emergency financial manager. They felt that the purpose of the emergency financial manager was to check off the boxes and make it look as if all possible alternatives had been exhausted, thus making Detroit eligible for bankruptcy.4 It thus appears that the gover- nor, the law firm representing the city and the state, and the emergency financial manager all felt that Detroit had to declare bankruptcy. One likely reason was so that the pensions could be cut, bypassing constitutional guar- antees for pensions.

It is possible that there was no realistic alternative for Detroit besides bankruptcy, even if every possible alternative had been tried and failed, but forcing the city into bankruptcy seemed predetermined, other rescue options were not seriously discussed. Some states prefer to avoid bankruptcy for their cities, because they can exert more control over the outcomes with an emer- gency manager and because bankruptcy in one jurisdiction has a contamina- tion effect of hurting others in the state, but if there is a constitutional protection preventing reductions in pensions, bankruptcy may seem like a good way to get around the constitution and reduce pensions. At the same time, federal bankruptcy law protects payments for various derivatives, such as interest rate swaps. If the goal was to cut worker and retiree pensions and protect the banks, bankruptcy was a reasonable tactic. The bankruptcy judge just didn’t go along to the extent that the state’s appointed financial manager proposed. There is always that risk with a bankruptcy proceeding.

Minicase: Why Did Jefferson County, Alabama, Declare Bankruptcy?

In December of 1996, responding to a lawsuit arguing that its leaking sewer system was violating the federal Clean Water Act, the county issued debt to repair the sewer system. The project cost more than initially projected, and the financing was more expensive than it should have been, causing a huge run-up in fees that homeowners paid for sewerage. In 2002 and 2003, J. P. Morgan refinanced the bonds, converting what had been primarily fixed- rate bonds into variable-rate issues and linking the sale with interest rate swaps. The deal was supposed to save the county money, because interest rates on the bonds would be based on auctions that would occur at short intervals. Any increase in interest rates due to the auctions was supposed to be offset by the interest rate swaps, an investment by the county with the bank that was supposed to return more money if interest rates rose.

The deal was corrupt from the start. The bank had paid out millions in bribes to county officials and their friends, some unrelated to the deal, to get the business, and then charged the county much higher fees, which were not revealed, to cover the extra costs. But the really serious trouble started in 2008, when the auction market froze. In accordance with common practice, Jefferson County had sold the sewer bonds with insurance to protect the buyers, but the bond insurers, as a result of the housing crisis, lost their top ratings. Many institutional investors were permitted to invest only in bonds insured by top- rated companies, forcing them to dump the bonds insured by the companies with lowered ratings. With so few buying, many of the bond auctions failed.1 Investors dumped Jefferson County’s sewer bonds on banks that had agreed to serve as buyers of last resort, triggering contractual requirements for the county to pay off its debt in four years rather than the expected thirty or forty years. 2 With no auction prices to fix the interest rates, the county was forced to pay a default interest rate, which was much higher than the auction rates had been. When municipal auction rate notes are issued, they typically include a default rate of interest, which in this case was capped at 12 percent. 3 The investment linked to the bonds—the interest rate swaps that depended on interest rates at the time—did not generate more revenue for the county as they were supposed to, because interest rates fell sharply. During the reces- sion, banks were not lending and hence not paying high interest rates to attract capital for them to lend out. The county had to pay very high interest rates on its bonds and got very low returns on its linked investments, all the while paying high transaction fees. In September of 2008, Jefferson County defaulted; it failed to make a payment of principle of $46 million on the bonds.

Default on the bonds made it impossible for the county to refinance to take advantage of lower interest rates; no one would lend money to a county that could not pay back its debt in a timely fashion. To make matters worse, in 2009, a new tax was declared illegal by the court. The state tried again with a different tax, which was declared illegal in 2011. Each of these events threw the county into a desperate situation with regard to revenue.

The county tried to negotiate with its creditors and worked out a deal that would reduce its obligations to the banks but required state cooperation to replenish the revenue of the county and to create an independent sewer authority to issue bonds on the county’s behalf, with a state-backed guaran- tee. The state refused to go along, forcing the county into bankruptcy.

Explanation / Answer

The impending bankruptcy of the state of Michigan could be attributed to the state’s high risk approach taken by it after the failure of the auto industry in the state. The bankruptcy of General Motors and Chrysler shook the strong industrial base of the state and plunged the state into a recession. Recession lowered the revenue inflow for the state and the play of different factors led to an increase in the amount that the city owed to the pensions. To get out of the trouble the city adopted strategies that were highly risky and this led to its eventual bankruptcy. In terms of pros the plan to pay variable interest rates would have worked in the state’s favor if the interest rate had declined. However with the rise in interest the city had to pay higher interest and this increased its cost of debt. The cons of the plan were that the plan was highly risky. As turned out later Detroit was unable to meet its obligations.

In contrast the case with the Alabama state was different. The state, though did make use of a derivate instrument, it was the corrupt practices that took place that led to its downfall. The state started facing financial problems due to the high costs of repairing its leaking sewer system. The deal was corrupt and bribes were paid. The bribe amounts extended in millions and with limited buying several of the bond auctions failed. The pro of Alabama’s approach was that the investment was directly linked to the bonds. On the flipside the plan entailed paying off of high interest rate to attract more capital. Eventually the county went into bankruptcy, unable to service both principal as well as interest payments.

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