The Detroit roadmap

“It will rise from the ashes,” reads Detroit’s city slogan. It pays homage to the city’s emergence from its Great Fire of 1805 that ultimately led to the industrial powerhouse that ushered America into the 20th century.

Detroit’s subsequent fall from grace has been so well documented that it became synonymous with urban decline.  Two years ago this week on December 3, 2013, the city was ruled eligible to file for Chapter 9. Facing liabilities of US$18.5b at the time, Detroit eventually became the largest city in U.S. history to file for and then be declared bankrupt.

{mosads}But Detroit has a new story to tell having emerged from bankruptcy just a year later in December 2014. The city is on course to rise from the ashes once more, and its journey from bankruptcy can be held up as a model for government restructuring policy. 

Detroit’s story reflects a broader situation of financial distress across many other cities and municipal entities, including school systems, utilities and pensions. More cities are finding it difficult to raise revenue through persistent unemployment, shrinking industries and populations yielding smaller tax-bases. This can lead to a slippery slope culminating in long-term structural imbalances and limited access to credit markets.  If the wrong policies are implemented – crisis can unfold. 

Policymakers should take heed: economic firefighting only delays the inevitable requirement for a total restructure. We played an active role in devising and implementing Detroit’s restructuring plan which in the event provided a roadmap for successful restructuring for the future of cities.

Control the balance sheet

Cities should look for efficiencies in their operating budgets, consider whether to continue providing non-core services and explore public-private partnerships. Blunt tools, like blanket cuts, don’t account for the large number of exceptions that would have to be made to maintain services like first responders. So, despite the urgency for cost cutting, it is critical to undertake a department-wide analysis.

It is equally important to monitor underlying trends that will impact future revenue estimates. It is prudent to have a long-term perspective on city finances, beyond periodic audits. This requires capital investment in systems, updated budgeting and audit processes, and regular strategic financial reviews.

Get a grip on liabilities

Nuances in contractual and state law protections can present the biggest challenge to restructuring pension liabilities. It is therefore important to invest in actuarial analyses, financial forecasts and scenario planning. Administrators can conduct a substantive review of existing medical plans and benefits for active employees and retirees, and benchmark them against other cities.

Municipalities need to be mindful of federal subsidies that are available to retirees for medical coverage when developing proposals. Officials can then seek to cap the municipality’s commitment to funding these obligations.  A city’s capacity to restructure debt liabilities will likely be dependent on the type of instrument and the structure of the security or pledge on dedicated revenue streams.

Negotiate smartly with creditors

Any reduction in public benefits is likely to be controversial; access to bankruptcy proceedings placed Detroit in a better position to prioritize its obligations.  The preparation of a clear restructuring blueprint  – with proposals for all creditors, unions, pension systems and debt holders – is critical to a productive negotiation process and creates breathing space for the city to negotiate. 

Detroit’s consultations resulted in around a 70 percent reduction in unsecured obligations to creditors – an estimated recovery of approximately US$2.9b on US$11.5b of long-term obligations.  Under the pension settlement, general retirees saw their pensions cut by 4.5 percent and waived future living cost adjustments. Uniformed retirees did not reduce their pensions, but similarly gave up a portion of future benefit increases.  The city also reduced its exposure to retiree medical liabilities by $5bn, by establishing two voluntary employee beneficiary associations to administer healthcare benefits.

With respect to financial creditors, the city negotiated discounts to bondholders’ claims, with financial unsecured creditor recoveries ranging from 13 to 74 cents on the dollar.

Invest today for a better tomorrow

Once budget savings have been made, the challenge for administrators is to secure a sustainable future by reinvesting savings smartly and securing funds for capital expansion. Distressed municipalities, facing less favorable debt markets, need to engage private investment for capital projects. Some examples include public-private partnerships and privatization of assets or utilities. The city may consider offering tax breaks or other concessions to attract private investment and business migration.  Any windfalls from these proposals help provide resources for realistic investments in public safety and improving citizen’s quality of life.

Facing the future

Back in 1805, when their city was blazing, the people of Detroit formed a human chain from the river to the fire. They passed buckets of water up the chain in an effort to extinguish the flames. In the 21st century, when the city faced financial ruin, the tools at its disposal were more sophisticated. Financial discipline, reduced liabilities and planning for economic development enabled it to turn financial distress into a platform for growth. Detroit can once again face the future with confidence. Other cities can too.

Atalla is Ernst & Young’s Global Government & Public Sector leader george.atalla@ey.com. Malhotra is managing director at Ernst & Young Capital Advisors LLC gaurav.malhotra@ey.com.  The views reflected in this article are the views of the authors and do not necessarily reflect the views of the global EY organization or its member firms.