Banking & Finance, Economic Development, and Government

Will Detroit's bankruptcy end irresponsible lending?

September 17, 2013
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Detroit’s bankruptcy will ultimately have a positive impact on cities across West Michigan and the U.S.

The initial reaction to Detroit’s bankruptcy stressed the impact on those workers who depend on the city for salaries, pensions and retiree health expenses.

There’s also the impact on the city’s bondholders and contractors, who won’t be fully compensated for lending the city money or fulfilling their contracts. These negatives are real and serious.

Ancillary effects will also be significant.

Certain cities and states may not be able to borrow or will have to pay higher interest rates, as investors more carefully scrutinize the risk associated with government loans. In most cases, the ancillary effects of the Detroit bankruptcy will have a positive impact.

As with the federal government, many state and local politicians have pursued irresponsible spending policies. Everyone lending money has a responsibility to determine if their funds will be used in a responsible manner. To the extent loans fund irresponsible government spending, the investor is partially responsible for enabling such spending. Without the risk of bankruptcy, lenders will continue to act as enablers to irresponsible politicians.

The most frequent objectionable spending practice involves borrowing money to fund current expenditures, such as pensions. Pensions represent compensation for current services. Prudent financial behavior dictates paying for such expenses out of current income. This is what 90 percent of companies in the private sector have done. These companies have moved to defined contribution plans (where pensions are funded from current expenses) from defined benefit plans (where pensions are too often funded from future income). The public sector has resisted this prudent change.

With Detroit’s bankruptcy, investors will either hesitate or demand much higher interest rates when lending funds for such irresponsible behavior. A New York Times article captures the essence of the change.

"Two weeks after Detroit declared bankruptcy, cities, counties and other local governments in Michigan are getting a cold shoulder in the municipal bond market. The judgment has been swift and brutal. Borrowing costs are up around the state, in some cases drastically. On Thursday, Saginaw County became the latest casualty when it said it was delaying a $60-million bond sale planned for Friday. It had hoped to put the proceeds into its pension fund."

Detroit’s lenders should have been more alert to the risks of lending to politicians engaged in destructive behavior. While Detroit’s politicians bear primary responsibility for their behavior, they would not have been able to incur Detroit’s massive debt without the assistance of their lenders or those who voted them into office year after year.

Detroit’s bankruptcy provides important lessons.

It warns politicians of the consequences of reckless behavior. It reminds voters of their responsibility to elect prudent politicians.

And it restrains lenders from supporting ill-advised behavior on the part of future politicians. By limiting irresponsible financial behavior, Detroit’s bankruptcy will also limit the pain and suffering associated with future bankruptcies.  

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