As Detroit Bankruptcy Looms, Rhode Island City Offers Gloomy Lesson

PHILADELPHIA -- Bankers, consultants and elected officials gathered at a conference here on Wednesday to discuss a hot political question for the formerly sleepy municipal bond industry: how to sell the need to protect the rights of bondholders -- the often large, distant financial institutions who extend the credit that keeps towns humming -- when cities enter financial crisis. The issue has most recently been thrown into relief as a Monday deadline for the city of Detroit to accept a consent order to fix the city's budget looms.

"While the economists have declared the recession to have been over for almost three years now, the problems of state and local governments continue to mount," said Bob Kurtter, the managing director for U.S. state and regional ratings at Moody's Investors Service. "Default continues to be rare," he said, but "our ratio of downgrades to upgrades has been negative for the past 12 quarters."

As more cities and states struggle to fill the $1.26 trillion gap between what they have actually set aside for pensions and retirement benefits and what they have promised, municipal accountants will grapple with questions that will increasingly resemble those faced by Detroit or former Rhode Island Supreme Court Justice Robert Flanders when he was appointed last year as receiver for Central Falls, a struggling former factory town in the Ocean State.

From the comments of Flanders and others at the municipal bonds conference, it seems like the industry is in agreement about one thing going forward: someone is going to have to suffer, and it shouldn't be bondholders. And the draconian measures needed to stave off financial disaster will often require an unelected official -- be it a receiver in Rhode Island or an emergency manager in Michigan -- to assume near-dictatorial powers.

Bankruptcy, Flanders said, should no longer be a dirty word. Sometimes it's the only way to extract concessions from public employees unions and retirees, who he said weren't very happy when he first proposed slashing pensions by 50 percent.

"They looked at me like I had three heads, and it wasn't a very happy meeting, as you can well understand," he said. It was only bankruptcy's provisions that let Flanders, as city receiver, actually go through with those cuts, he noted. "We could blow up any contract we liked."

Public employees' concerns should be balanced, he argued, against the investors whose money allows cities to operate. Rhode Island has a retroactive lien law protecting bondholders who have unsecured general obligation bonds.

A lienholder statute, Flanders said, is "enormously controversial, because the argument is, how can you expose your retires and employees to take all the hits while Wall Street -- i.e. the bondholders -- gets favored treatment, even when they knew going in they were unsecured?"

"But the answer, and the one that carried the day in Rhode Island, is that no, you can't look at it as Wall Street versus Main Street, it's protecting the taxpayer against confiscatory tax rises that would be needed if the interest rate got jacked up, and so this was sold and adopted as a pro-taxpayer measure," he said.

Pro-taxpayer or not, one of Flanders' fellow panelists, Eric Schaffer of law firm Reed Smith, said that any choice about who to favor first when a city goes under is "a political decision ... When the legislature steps in and says we're going to protect someone, then that's at someone else's expense."

Not everyone at the conference, which was organized by industry newspaper the Bond Buyer and focused on "Distressed Municipalities," was as enthusiastic about bankruptcy's powers as Flanders, and 22 states either outright forbid or do not give specific authorization for municipal bankruptcy, according to Moody's. But cities will struggle with the same questions Central Falls has faced whether or not they can take advantage of Chapter 9 protection.

Kurtter downplayed the significance of one option that Detroit and many other cities are looking at to stave off bankruptcy: privatizing city services. Mayor Dave Bing has privatized management of city buses and wants to do the same for public lighting.

Wall Street interest in privatization is high, Kurtter said. "There does not appear to be a shortage of interested bankers, interested corporations. There is an adequate amount of capital."

But voters across the country, he said, are not "anxious to turn over public assets to private ownership so that someone who's not elected can raise fares, tolls, fees or other costs that would create a greater burden to them at a time when they're stressed."

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