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Detroit bankruptcy could hit millions of retirees

The city of Detroit has faced serious economic challenges in the past decade, with a shrinking population and tax base while trying to maintain essential services.
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The city of Detroit has faced serious economic challenges in the past decade, with a shrinking population and tax base while trying to maintain essential services.

With its bankruptcy filing, the city of Detroit has entered uncharted territory. It's a dark place that no major U.S. city has ever gone—but that could change.

Despite the uncertainties surrounding what's expected to be a hard-fought legal battle, the outcome promises to inflict more pain on Detroit's already-beleaguered residents, businesses, creditors, investors and city workers, whose pension plans may now be invalidated.

The case will also set a legal precedent that will be watched closely by other major cities across the country, which are struggling under the weight of years of accumulated debt and underfunded pensions covering millions of public-sector retirees.

"Everyone will say, 'Oh well, it's Detroit. I thought it was already in bankruptcy,' " said Michigan State University economist Eric Scorsone. "But Detroit is not unique. It's the same in Chicago and New York and San Diego and San Jose. It's a lot of major cities in this country. They may not be as extreme as Detroit, but a lot of them face the same problems."

(Read more: Who's living large in Michigan? The governor!)

The bankruptcy filing follows a decades-long decline of a city that prospered through much of the last century as the capital of U.S. manufacturing. But as that industrial base has declined, so to have the city's fortunes.

Detroit has endured booms and busts in the past. Even as the auto industry has roared back to life since the Great Recession, the economic recovery has left the Motor City in its rear-view mirror.

Though unemployment has fallen from a peak of nearly 28 percent in 2009, some 16.3 percent of Detroit workers are still without a paycheck. As a result, income tax revenues have fallen 30 percent in the last decade. Meanwhile, the national recovery in home prices has yet to spread to Detroit. Property taxes are 20 percent lower than 2008 levels.

As tax revenues have shrunk, the cost of maintaining city services has grown. Tens of thousands of abandoned buildings and vacant lots, and a resulting increase in fires and crime, have increased the burden on firefighters and police. Some 40 percent of the city's streetlights don't work.

"There's no way Detroit can afford to service 140 square miles anymore," said Scorsone. "So for parts of the city, if your streetlight's out they're not going to fix it. If your road has massive potholes, it's going to turn it to gravel. It's that stark."

Many residents have responded by simply moving away. Once American's fourth-largest city, Detroit's population has fallen by a quarter since 2000. A shrinking population further erodes the tax base, intensifying the budget squeeze.

As tax revenues have shrunk, the city's financial obligations have grown—mainly to an ever-expanding pool of 30,000 retirees, promised life-time pensions and health benefits by short-sighted government officials over decades who consistently failed to fund those future obligations. The city now owes more than $17 billion—roughly $25,000 for every resident.

Union officials, who have vowed to fight any effort to reduce benefits to retirees and vested workers, claim the city has undermined the pension fund by outsourcing city services to workers who don't pay into the system.

"As older people leave the workforce, the city has been privatizing those jobs instead of bringing people back in to pay into the fund," said Ed McNeil, special assistant to the president of Michigan AFSCME Council 25, which represents city workers.

Union officials also argue that the city is owed hundreds of millions of dollars in unpaid taxes that should be collected before retirees are asked to take a cut in benefits.

(Read more: Detroit becomes largest U.S. city to file for bankruptcy)

"If they went after that money, they could pay their debts," said McNeil.

Investors holding Detroit's bonds have already taken a hit as the steady erosion of the city's finances has slashed the city's credit rating to junk status. Last month, Kevyn Orr, a bankruptcy lawyer named to restructure Detroit's debts, declared a "moratorium" on some interest payments.

In the days leading up to Thursday's bankruptcy filing, Orr had been working with individual creditors to renegotiate those debts at dimes on the dollar.

That could help close the gaping financial hole in the short run. But inflicting too much pain on bondholders could have dire long-term consequences, according to Kim Rueben, a senior fellow at the Urban Institute who specializes in municipal finance


"You don't want to have to do that because you want to keep your ability to borrow again to rebuild your city," she said.

Orr must now persuade a bankruptcy judge to invalidate the city's pension contracts, freeing him to reduce payments to retirees. The unions' lawyers will argue that pension and health benefits are protected by Michigan's constitution, one of seven states that specifically ban cuts in retiree pension and benefit payments.

That's why the case will be closely watched by states such as Illinois and California, which also have badly underfunded their pensions. If Detroit is allowed to cut payments to its retirees, city and state workers in those states and others could see their future benefits pared back.

Future public sector workers can all but count on lower retirement benefits, as many state and local governments scale back the kind of financial promises that sank Detroit. With retirees living longer, those promises have become too costly to make.

(Read more: The new geography of American prosperity)

"I think there is going to need to be an understanding with public employees that working for 30 years and being able to have a pension for that much time or longer is not sustainable," said Rueben.

Automakers said they plan to standby the city.

"We believe a strong Detroit is critical for a strong Michigan and our industry. The city has a difficult job ahead, and we are optimistic that governmental leaders will be successful in strengthening the community," said Jay Cooney, a Ford spokesman.

Chrysler said it "believes in the City of Detroit and its people. We not only continue to invest in the city and its residents by adding to our presence in Detroit, we also are committed to playing a positive role in its revitalization."

The crisis is also being watched closely in the White House.

"The president and members of the president's senior team continue to closely monitor the situation in Detroit," said Amy Brundage, a White House spokeswoman. "While leaders on the ground in Michigan and the city's creditors understand that they must find a solution to Detroit's serious financial challenge, we remain committed to continuing our strong partnership with Detroit as it works to recover and revitalize and maintain its status as one of America's great cities."

—By CNBC's John W. Schoen. Follow him on Twitter @johnwschoen.

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