Detroit's bankruptcy battle likely to be long and painful

Kevyn Orr, emergency manager for the city of Detroit
Jeff Kowalsky | Bloomberg | Getty Images
Kevyn Orr, emergency manager for the city of Detroit

People have already fled Detroit in droves. Forty percent of its streetlamps don't work. Don't get sick there; you'll wait a long time for an ambulance. There's even talk about stripping the art from the walls of the city's museums to help pay off more than $18.5 billion in city debt.

Detroit's bankruptcy filing brings into sharp focus the decades-long decline of the once prosperous hub of American manufacturing. In its heyday, it was the nation's fourth largest city.

The case is being closely watched by retired city workers, residents and investors looking for a resolution to a long-running, downward financial spiral that has left the city buried in debt and sparked an ongoing exodus of residents looking for a fresh start.

City officials are also looking for a fresh start, but they could have a long wait. Detroit already faces a slew of lawsuits and is girding for an epic legal battle with creditors. The Thursday filing for the largest municipal bankruptcy in U.S. history came just minutes before a state court judge was to hear arguments on whether to grant an injunction to block the city from taking the extraordinary step.

"Bankruptcy gives us breathing room," Kevyn Orr, the city's emergency financial manager, told reporters Friday. "We were being sued on almost a weekly basis. I pleaded for that not to happen."

That breathing room got a lot tighter Friday when an Ingham County judge said the bankruptcy filing violates the Michigan Constitution and state law and must be withdrawn. Judge Rosemarie Aquilina ordered that Orr and Gov. Rick Snyder take no further actions to try to cut retiree benefits.

"I have some very serious concerns because there was this rush to bankruptcy court that didn't have to occur and shouldn't have occurred," Aquilina said. "Plaintiffs shouldn't have been blindsided," and "this process shouldn't have been ignored."

The move is just the latest indication that the battle over the city's financial future is entering a new,and highly uncertain, chapter.

Here's what could be next for Detroit—and other cities facing similar financial pressures.

Is Detroit really bankrupt?

Based on Thursdays' filing under Chapter 9 of the federal bankruptcy code, it sure looks that way.

Brad Quick | CNBC

According to the paperwork, the city owes billions of dollars to more than 100,000 creditors, including bond holders and city pension funds. Orr, a state-appointed bankruptcy attorney who is trying to clean up Detroit financial mess, has said the city is insolvent—meaning it can pay what it owes with the taxes it collects.

But one of the first things he's going to have to do is prove that to the soon-to-be-named bankruptcy judge hearing the case.

He'll likely point to the "moratorium" Detroit imposed on some bond payments last month. And he'll cite unsuccessful efforts in recent weeks to negotiate lower payments with bond holders and union officials representing retirees.

Orr was able to win concessions from some secured creditors to accept 75 cents on the dollar for about $340 million in debt. But his offer to pay about $2 billion to unsecured creditors owed about $11 billion in debt went nowhere.

Now, he hopes to convince the bankruptcy court that the city can only afford to pay bond holders, retirees, city vendors and the rest of the list of creditors just a dime on the dollar.

Unions representing retirees will likely challenge Orr's claim, saying the city could pay more if it went after tax deadbeats who owe Detroit millions in back taxes.

Others have pointed to city assets like works owned by the city's Detroit Institute of the Arts as possible sources of cash. But unlike other forms of bankruptcy, Chapter 9 does not require the city to apply those assets to satisfy creditors.

(Read More: Detroit bankruptcy could hit millions of retirees)

Can the city really raid its art collection to pay down its debt?

It could, and it's an impressive collection – from muralist Diego Rivera's Detroit Industry frescoes to works by Wyeth, Whistler and Van Gogh. William Randolph Hearst's armor collection is there. So is the original Howdy Doody marionette from the 1950s TV show hosted by puppeteer Buffalo Bob Smith, believed to be worth as much as $1 million.

But it's highly unlikely the city will touch the collection. For one thing, the art is held in a public trust, and any moves to sell it off would face legal challenges from donors. In any case, the proceeds would only be a drop in the bucket compared to the billions the city owes.

"Nothing is for sale, including Howdy Doody," Orr told reporters Friday.

Doesn't the law require a city to uphold its promise to pay pensions and retiree benefits?

Yes, and no. Michigan is one of seven states that specifically protects pension contracts in its constitution. But the purpose of bankruptcy is to give a debtor a fresh start by altering debt contracts under court supervision.

That's why this case is being watched so closely by other cities in Michigan—and other states—that have made generous promises to retirees over the years without paying enough money into their pension funds.

Some legal experts say the retirees may end up on the losing side of the argument. That would call into question the decades-old promises made to millions of other public sectors retirees across the country.

"I definitely think there will be a fight about that," said Randye Soref, a bankruptcy attorney with the law firm Polsinelli in Los Angeles. "But typically the bankruptcy code—because it is a federal statute—would trump state statute."

(Read More: Detroit's 'name is mud,' but fallout likely limited)

So will this fix the city's problem? GM and Chrysler went through bankruptcy and they're doing great. Can't Detroit do the same?

That's what Orr and Snyder are hoping. But these are two very different bankruptcies.

GM and Chrysler went into court expecting to apply the same business model that had served them well through booms and busts over the last century. (To be sure, the 2008 bust was a lot bigger than most.) After a relatively short trip to court - and an infusion of $80 billion in federal bailout funds – both companies are now back on track. Car sales are zooming and profits are rolling in again.

Detroit's business model, on the other hand, is about as badly broken as the four out of ten city street lights that don't work. Citizens wait an average 58 minutes for the police to respond. Only a third of ambulances are in working order.

(Read more: Tear down chunks of Detroit: billionaire landowner)

But the city can't raise more money to fix the mess. Real estate taxes are falling along with property values. Income taxes are down because unemployment is so high; the city has hit the legal limit on income tax rates.

So people are leaving. The shrinking population further cuts tax revenues, but the city boundaries and the cost of city services haven't shrunk at the same pace. Cutting services only drives more people away, further eroding the tax base.

The only hope is that by drastically cutting debt and pension payments—to as little as ten cents on the dollar—the city can regroup and try to rebuild.

Kevin Winter | Getty Images

How long is all this going to take?

It could be fairly quick—or it could take years. A lot depends on how hard the unions and investors dig in for a fight.

The next step will be for the court to identify various classes of creditors, some of whom have stronger claims than others. Creditors like bond investors and pension trustees have access to substantial legal firepower, which they can use to fight hard for a better deal.

On the other hand, the bankruptcy filing gives the city a much stronger had in negotiating with creditors. If the city can get the biggest creditors to go along with an overall plan, smaller creditors will have a tougher time holding out.

"There will be a big battle in the beginning and then you'll see is things calm down—or if there's a battle on every front," said Soref. "If that happens, it's going to take a long time."

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