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How broke is Detroit? It'll come down to number-crunching

Tuesday, 20 Aug 2013 | 10:57 AM ET
Protesters stand outside the Theodore Levin United States court house in opposition to the city of Detroit filing for bankruptcy.
Justin Solomon | CNBC
Protesters stand outside the Theodore Levin United States court house in opposition to the city of Detroit filing for bankruptcy.

State and city officials trying fix Detroit's financial mess claim that bankruptcy court is the only option left to reverse a decades-long downward spiral.

A witches brew of opponents to the nation's largest-ever bankruptcy filing—including city unions, pension fund managers, bondholders, bond insurers, vendors, and a long list of other creditors—say the city can be saved without such extreme measures.

A court will decide who is right based on a parade of expert witnesses who will present conflicting accounts of the city's financial wreckage.

NetNet TV: Should we bail out Detroit?
CNBC's John Carney, Jeff Cox, Patti Domm and Ted Kemp debate whether the Federal government should seriously consider bailing out Detroit.

Nothing about this case is simple. With more than 100,000 creditors, multiple classes of bond holders and tens of thousands of current and future retirees owed billions in pension payments, the case is already shaping up as the most complex since Congress set up municipal bankruptcy rules more than 75 years ago.

One of the most contentious questions rests on the arcane art of actuarial analysis: the mix of math and forecasting assumptions used to determine how much the city needs to set aside today to meet its obligations to retirees decades in the future.

The city says the current collection of pension funds is some $3.5 billion short of the mark; city unions and other skeptics say the city has badly overstated what it needs to make good on promised retirement benefits.

Those estimates rely on a series of assumptions about how big those payments will be years in the future, along with the investment return of the money set aside to fund those payments. Tweaking those assumptions by a fraction of a percentage point today can change future projections by hundreds of billions of dollars.

That's why the legal case for Detroit's insolvency will likely rest on a series of expert witnesses both sides will call to crunch the numbers for the court—even if no one can establish with certainty whether the city's dire financial projections would come to pass without big debt write-downs.

"The city doesn't have to show that there aren't other arguments, just that its assumptions are reasonable," said Andrew Gottfried, a bankruptcy lawyer with Morgan Lewis. "That's what judges do all the time in bankruptcy; they have to value future income. It's a common exercise."

There will be no shortage of arguments when Judge Steven Rhodes, who is hearing the case, gavels the opening of the trial on October 23. Those trying to block the city from moving forward had until midnight Monday to file their objections.

(Read more: Pandemic of pension woes is plaguing the nation)

Detroit's unions were among them, arguing in several filings that the city has not proven it is insolvent and has not negotiated in good faith with its creditors. The unions also claim the filing violates the state constitution because the law protects retirement benefits for public workers and that it violates the U.S. Constitution by encroaching on states' rights.

Under the rules for a Chapter 9 municipal bankruptcy, the city must first show that it tried to work out a repayment plan with creditors before going to court. To demonstrate that good faith effort, Detroit's emergency manager, Kevyn Orr, will likely point to weeks of talks with creditors earlier this year which yielded settlements with just a handful of bondholders.

Orr will also have to show whether the city can pay its bills, or whether it is so broke that it cannot do that if the court does not help to renegotiate the terms.

The burden of proof for Orr is large. Since 1954, there have been 62 filings for Chapter 9; about half of them have been thrown out of court or settled.

By one measure—the annual flow of cash in and out of city hall—the case for insolvency is pretty easy to make. Since 2004, the city has run deficits of between $155 million and $326 million (last year's gap)—borrowing each year to make up the shortfall, according to a review in February by the Michigan Treasurer's office.

The borrowing spree to cover those deficits added nearly $1 billion to the city's debt. It also cost the city its good credit rating, which made it progressively more expensive to keep borrowing, according to Katilyn Pulcher, a credit analyst with Standard & Poor's.

"Now they've gotten to the point where they can't even afford to borrow because the interest cost would be too high," she said.

Other Detroit watchers argue that the city's debt burden wasn't necessarily unsustainable. Richard Larkin, a credit analyst with investment advisor Herbert J. Sims, noted in a recent analysis that the city pays off its debt faster than most, which could give it more breathing room if it restructured those payments.

"Just like you refinance your mortgage, they could refinance it to stretch out the debt—that could save them $257 million over 10 years," he said.

Opponents of the bankruptcy filing also argue that Detroit isn't trying hard enough to collect the money it needs to pay its bills.

(Read more: It's feds vs. state as Detroit heads to bankruptcy hearing)

What Detroit didn't do
CNBC's Josh Lipton reports there were about 30 objections filed to the bankruptcy of Detroit. Gov. Scott Walker (R-WI), where Detroit went wrong and Wisconsin went right.

No one disputes that city tax revenues have been falling for years, down 30 percent in the last decade alone, largely because the population has been shrinking. Once the nation's fifth-largest city, more than 60 percent of its residents have fled since the population peaked in 1950. In the past decade, that count shrank by a quarter.

But an analysis of city tax records in February by the Detroit News found that nearly half of the city's 305,000 property owners failed to pay taxes last year, leaving some $246 million uncollected.

Some of those properties were abandoned by mortgage lenders that foreclosed on houses and then walked away before taking ownership and before assuming responsibility for paying taxes. In 2010, the Government Accountability Office found that Detroit was among the cities hit hardest by the practice.

But homeowners owe much of the unpaid taxes, which fund services they are no longer getting. In any case, the city's dismal track record in collecting revenues does little to bolster the argument against letting the city proceed with its Chapter 9 filing, according to Gottfried.

"To say they should have been more aggressive in collecting taxes doesn't eliminate the problem," he said. "Virtually every debtor who comes into bankruptcy court could have done things better in the past. That's why we're here."

Bankruptcy opponents also point to other sources of cash the city could raise to pay its bills.

Detroit's district court, for example, is owed some $280 million in unpaid fines and other payments on everything from parking tickets to drunk driving violations, according to the Treasurer's financial review. While the average collection rate for courts in nearby counties is 60 percent, Detroit is collecting just under 8 percent, the report found.

(Read more: Detroit's bankruptcy battle likely to be long and painful)

Then there are assets the city could sell—everything from Belle Isle, a 985-acre, city-owned island park; to Detroit Institute of Art masterworks that include Van Gogh, Bruegel and Wyeth; and the original Howdy Doody marionette said to be worth $1 million.

Skeptics of such sales argue that relying on one-time asset sales to satisfy an accumulated $18 billion debt is a little like trying to pay the rent with nickels found under the couch cushions.

"A lot of the assets that Detroit has to sell are not liquid assets," said S&P's Pulcher. "It's not cash sitting around in the bank."

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

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