Illustration by Bloomberg View
Illustration by Bloomberg View

In Detroit, a reckoning is near. A recent report from the city’s emergency manager on its deteriorating finances reads like a municipal adaptation of the Book of Revelation.

The city’s population has dropped by about a quarter since 2000. Its rate of violent crime is five times the national average. Fires are rampant. Streetlights don’t work. The budget deficit is nearly $380 million, while long-term liabilities may total more than $17 billion. Detroit’s emergency manager, Kevyn Orr, has even considered selling the city’s art collection.

Orr is now negotiating a reorganization plan with unions, creditors and bond insurers. If those talks fail, Detroit could become the largest city in U.S. history to file for Chapter 9 bankruptcy protection. The unions should strive to make a deal before that happens, even if it means forcing retirees to take substantial pension and benefit cuts. State taxpayers should recognize that it’s in their best interests to help those retirees out. And Orr must avoid unduly violating bondholders’ trust. The consequences of failure could reach well beyond Detroit.

Union leaders, understandably, don’t want to deny benefits to pensioners who loyally paid into their plans their whole careers. But if Detroit heads to bankruptcy court, Orr will be empowered to reject contracts, modify collective bargaining agreements and force cramdowns on parties that don’t consent to his proposed reorganization. That means pensioners could end up with significantly less than Orr is now offering them.

Clear Arithmetic

It sounds deeply unfair to privilege investors over retirees. But because retirees were promised the most -- Orr estimates the city has some $3.5 billion in unfunded pension liabilities alone -- they will have to give up the most. It’s not an issue of fairness so much as arithmetic.

And the dangers of forcing bondholders to take outsized losses are clear. Michigan Governor Rick Snyder indicated last week that he would support a reorganization plan for Detroit in which unlimited-tax general-obligation bonds would be treated on par with pension and health-care liabilities. Such a plan would not only ensure that Detroit will have a hard time getting access to capital markets anytime soon, it could make investors less likely to fund public projects across the state at reasonable terms.

Given this reality, what should the next steps be?

First, those unlimited-tax general-obligation bondholders should be prioritized over pensions and benefits. This invites an obvious question: Why should they get a better deal than retirees? After all, investing involves clear risks, even in a relatively safe market such as municipal bonds, and most of Detroit’s bonds are insured.

One reason is that those bonds were approved by voters and bought by investors with the understanding that Detroit could raise unlimited tax dollars to meet its obligations. If Orr doesn’t prioritize them, Detroit would be violating the trust that underlies the $3.7 trillion market in municipal debt. The great virtue of that market is that it enables valuable long-term public investment at low interest rates. If Detroit reneges on its agreements, it could open the door for other cities to do the same, and raise costs for everyone.

A more practical and compelling reason to prioritize those bonds is that they make up only about $369 million of Detroit’s liabilities. Even a complete repudiation wouldn’t much reduce the $17 billion the city is on the hook for. It would, however, further impair the city’s ability to borrow -- mostly to make a point.

The emergency manager wasn’t appointed to make a point. He was appointed to get Detroit back on the path toward solvency.

Helping Pensioners

So what about the pensioners? State taxpayers should help make up at least some of their losses. Such a bailout would be politically difficult, and it risks setting a bad precedent. But state taxpayers should remember that if they don’t help out, Orr will have two choices: Impose great suffering on blameless retirees or impose large losses on creditors and risk higher borrowing costs throughout the state. Or maybe both. Bailing out pensioners is not only morally right, but it also will keep money flowing into Detroit’s economy, thus reducing the chances that the city will need help again soon.

Detroit can also help itself -- for instance, by further reducing its payroll and shifting more workers from pensions toward defined-contribution plans. And Orr’s proposal to replace the health-care program with one that relies more on Medicare and federal health-insurance exchanges is on the right track.

One thing not to do: Continue with plans to direct public money toward a new $650 million hockey arena. Study after study has shown that publicly funded stadiums don’t significantly increase jobs, wages or economic growth.

The city will surely face a long and painful period of adjustment, and it may have to hit rock bottom before it can revive itself. It’s critical that Detroit not pull anyplace else down with it.

To contact the Bloomberg View editorial board: view@bloomberg.net.