Detroit's Finances versus Cleveland's: Food for Our Own Thoughts

What happened to Detroit?  What does it mean to have a city declare bankruptcy?  Some of the issues Detroit faces are unique, but others could be repeated in other cities.  Altogether, it's well worth our time here at Ways of the World.  We'll give some background and comment in a conclusion about two factors generating broader caution for some of you.

Do Weak Economies Automatically Lead to Poor City Finances? No.

We've often heard it said that Detroit is a poor city.  Pictures of abandoned property and dilapidated buildings frequently accompany press reports on the financial developments.

This is so, and some of the numbers are striking.  Median household income was a mere $25,193 in 2011, just half of the national number of $50,502, which many argue is barely adequate itself.  The share of the population with incomes below the federal statistics measure of poverty is 40.9%, compared with the nationwide 15.9%, and as you can imagine, well more than half of the children live in poverty-stricken households.  Also in 2011, the latest data we could locate for the city, the unemployment rate was 29.3%, compared to a national total then of 10.3%.[1] Good grief.

But such challenging economic conditions by themselves don't automatically push the local government into a bankrupt condition, we learned.  Clearly, much of Detroit's trouble comes from the poor state of the U.S. auto industry until fairly recently.  It occurred to us to look at some other upper Midwest city with heavy industrial involvement to see what that might mean elsewhere.  Cleveland doesn't have as much concentration in one sector as Detroit, but back in 2000, both cities had a sizable 18%-plus of their residents employed in total manufacturing, a noticeably larger amount than the nation's 14% at that time.  By 2011, Detroit's share in manufacturing had fallen to 11.4% and Cleveland's to 12.1%, close enough for us to use it for comparison.

Household incomes in Cleveland in 2011 were nearly the same, $25,371, as in Detroit.  Unemployment was not as high, 19.5%, but still "awful" compared both to the national total and to anything we might deem desirable.  Same with poverty: people in poverty-stricken households were 34.3% of the population then.  So the economy of Cleveland too has suffered with outsourcing of manufacturing and the severe recession.

However, the government of the City of Cleveland is quite solvent and in fact carries a bond rating from Moody's of A1.  This is not at the high end, but it's certainly adequate, described by Moody's as "upper medium grade and subject to low credit risk"[2], and thus, far from a condition of bankruptcy.

A Financial Tale of Two Cities

We're hardly experts at municipal budgets and finance, but we've read a lot of press reports and  looked at recent financial reports for both cities.

1.  The most obvious fact is that Detroit has a lot of debt.  Kevyn Orr, the emergency manager of the city government appointed by the governor of Michigan, says the debt is about $18 billion.  We identified $8.4 billion of long-term bonds as of June 30, 2012, equivalent to $11,942 per resident.  There are other obligations related to pension and health-care funding.  We'll comment more on those.  For Cleveland, to give some context, long-term bonds totaled $2.7 billion on December 31, 2011, or $6,862 per resident of that city, just 60% as much as Detroit.  It handles its pensions differently, as we'll see below.[3]

2.  Detroit was spending more per resident than Cleveland.  Over the last few years, Detroit spent about $2,500 per resident; it began to cut this back in 2010 and was down to $2,261 in its fiscal year 2012, which ended June 30, 2012.  As its financial condition deteriorated, it reduced its employees from 13,420 in 2009 to 10,525 in 2012.  Cleveland's city government has been spending right at $2,000 per resident each year from 2007 through 2011 (its fiscal year coincides with the calendar year).  It has also reduced the number of its employees, from about 8,500 through 2009 to 7,700 in 2011.

3.  The two cities have different mixes of taxes.  About 42% of Cleveland's revenue comes from income taxes and only 8% or 9% most years from property taxes.  The heavy use of an income tax means it can reach the incomes of non-residents who work in Cleveland, and the "Notes" to their financial statements indicate that the vast majority of the income tax receipts indeed come from non-residents.  Detroit's revenues consist of just 13% to 15% income tax and 12% to 14% of property tax.  The greater reliance on property tax makes their revenues more dependent on local property values, which have been falling, eroding the tax base.  Detroit also collects a sizable chunk from a wagering tax and both cities have other fees and proceeds from leases and other business-type activities.  But we are struck with Cleveland's outreach to its suburban population for revenue, a source that on the face of it, might well be utilized more effectively by a city like Detroit too.

4.  Pensions.  Two years ago, we wrote about state and local governments here and, among other issues, emphasized the continuing use of defined benefit pension plans by many of them.  We said then that these were problematic, burdening cities and states with payment obligations if the plans' investment results were weak, requiring added funding from the governments' current budgts.  Sure enough, this is one of the main factors for Detroit, which has both pension and retiree health plans.  We identified $640 million of unfunded pension liability and $5.7 billion of unfunded health care liability.  These are just the numbers we found in one financial statement and press reports suggest that at least the pension amount is much greater.  In addition, some of Detroit's funding payments in recent years were made by issuing bonds, not using current revenue, so they are still a debt overhanging the city's finances.  Cleveland, by contrast, has enrolled its employees in the Ohio Public Employees Retirement System, a state-wide plan that includes both defined benefit and defined contribution [401(K)-type] aspects and ties its health benefits to Medicare.  Some of its retirees are not included directly in the health plan.  Similarly, in 2011, just weeks after our own article on these topics, the City of Atlanta negotiated and enacted reform of its pension system, adding defined contribution elements; they also increased employees' own contribution rates to the defined benefit plan.

Detroit's Bankruptcy: Pensioners and Bondholders Face Same Unpleasant Outcome

Overall, we can see Detroit's issues: greater spending, albeit at a slowing pace; greater reliance on an eroding tax base with less appeal to a potentially more generous revenue source; a huge debt load that was allowed to grow; and a huge pension and health burden it tries to shoulder on its own.

Municipal bankruptcy is, fortunately, rare.  However, this means that there's little precedent for how to handle a city in such dire straits.  In a bankruptcy proceeding, the debts – the pension benefits and the bond obligations – would be reduced, and the bankruptcy court's work is meant to help this occur in as orderly a fashion as possible.  Still, Mr. Orr, the emergency manager, has rankled both unions and bondholders by proposing that both pensions and bonds be reduced markedly in the settlement plan.  We surmise that both unions and bondholders – stakeholders not usually on the same side of issues like this – expected that tax increases could simply make up any shortfalls.  Or at least that their particular item was safe from any reduction.

In this case, there also remains the very basic issue of whether Detroit is eligible to file for bankruptcy.  In a trial currently expected in October, Mr. Orr must show that the city is "insolvent" and that it has negotiated with unions and other contractors in good faith on its own already.  As you can see, both unions and others believe they have not been dealt with in this fashion.  The court will have to decide.

Take-Aways for Us as Citizens and Retirees

Is there a take-away for you readers?  We'd call two points to your attention.  First, on Tuesday this week, there was a primary election for the next government of the City of Detroit.  New York City is in the midst of an election campaign season.  In Detroit, a business leader actually got the most votes for mayor and the second candidate is in the union camp; these two gentlemen will vie in a general election in November.  The good showing of a business leader in that city is surprising; we suspect there will be other surprises before it's over.  In New York, several of the candidates for mayor and for comptroller have been involved in scandals.  The Detroit situation should show us how important it is to have trustworthy, responsible officials and it should give us pause about electing people who have given evidence otherwise, even if it's in an unrelated field.

Second, to offer a bit of advice that follows out of these issues: plan and commit for your own retirement.  Take on that responsibility.  We're going to talk more about health care here soon with ObamaCare on the horizon, but it's important to pay attention now to plans and coverage.  We can be busy arguing the justice of various structures for both pensions and health care, but that shouldn't divert our focus from making sure our own needs are covered to the best extent we can.  Cities have "Rainy Day Funds" – Cleveland has one; there's no mention of the word in the Detroit financial report – and we should too.

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[1] Our economic data for cities come from the U.S. Census Bureau's American Community Survey, a massively detailed annual survey that replaced the old "long-form" on the Decennial Census.  The coverage and timing vary somewhat from the regular monthly unemployment data and those figures for the total U.S. do not match.  Find the American Community Survey at http://factfinder2.census.gov/faces/nav/jsf/pages/wc_acs.xhtml.  Accessed August 9, 2013

[2] Moody's Investor Service.  Rating Symbols and Definitions. June 2013.  Page 5.  https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004

[3]We took the cities' budget data and other financial information from their Comprehensive Annual Financial Reports or CAFR, a standardized presentation using Generally Accepted Accounting Principles (GAAP) devised by the Governmental Accounting Standards Board, a private organization similar to the Financial Accounting Standards Board for businesses.  The Detroit document is at http://www.detroitmi.gov/Portals/0/docs/finance/CAFR/Final%202012%20Detroit%20Financial%20Statements.pdf  and the Cleveland publication at Comprehensive Annual Financial Report - 2011.