Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Municipal Bankruptcy Actually Works
Transcript
- Lucas: So a city runs out of money. It can't pay its bills, its pension obligations are piling up, bondholders are calling. What happens next? You might think it just defaults, cuts services to the bone, and suffers through years of dysfunction. But there's another path — municipal bankruptcy, specifically Chapter 9 of the bankruptcy code. Luna: And it's remarkably rare. Since the law was created in 1937, fewer than 700 municipalities have ever filed. Compare that to the roughly 20,000 corporate bankruptcies every year. Lucas: Right. And the poster child for municipal bankruptcy is Detroit in 2013. That was the largest filing in U.S. history — the city had about $18 billion in debt. It's a case that shows you exactly how Chapter 9 works and what it means for taxpayers, retirees, and bondholders. Luna: Before we get into the mechanics, I want to point out something about this show. We keep it ad-free — no sponsor breaks, no mid-roll interruptions. If walking through the economy with us has made something click, you can support that choice at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small way to keep this independent. And it really does help. So — Detroit. How did a city end up in bankruptcy court? Luna: Decades of decline. Population fell from a peak of 1.8 million in 1950 to about 700,000 by 2013. That meant a collapsing tax base, but the city still had to maintain infrastructure built for twice as many people, plus generous pension and health benefits for unionized workers. Lucas: By 2013, Detroit had a $327 million budget deficit, $18 billion in total debt, and its credit rating had fallen to junk. Emergency manager Kevyn Orr was appointed by the state of Michigan to take over the city's finances. And in July 2013, he filed for Chapter 9. Luna: Chapter 9 is different from Chapter 11, the corporate version. For one thing, a city can't be forced to liquidate — you can't sell off city hall or the fire stations. The city has to keep providing basic services. Lucas: Exactly. The goal is restructuring, not liquidation. But there's a key threshold: the city must be specifically authorized by its state to file. Michigan had a law allowing it, but many states don't. About half the states don't authorize Chapter 9 at all. So if you're a city in, say, Idaho or Georgia, you have no legal path to bankruptcy court. Luna: And even if you can file, you have to prove you're truly insolvent, that you've tried to negotiate with creditors in good faith, and that you actually have a plan to fix the finances. It's not a quick fix. Lucas: Detroit's case took about 16 months to resolve. The big fight was over pensions. In corporate bankruptcy, pensions are often protected by the Pension Benefit Guaranty Corporation, but for municipalities, there's no federal backstop. State constitutions vary on whether pensions are contractual obligations that can be impaired. Luna: Michigan's constitution says pensions are a contractual obligation. But the federal bankruptcy code can override state law in some circumstances. So there was a massive legal battle. Lucas: In the end, the plan cut general retirees' pensions by about 4.5 percent and eliminated cost of living adjustments. Police and firefighter pensions were not cut. But health benefits for all retirees were significantly reduced. Bondholders took a bigger hit — about 80 percent of their unsecured claims were wiped out. Luna: That's the opposite of what many people expected. Usually bondholders are senior to everyone. But in Chapter 9, the city argued that pension obligations had priority because of the public safety angle and state law. Lucas: And the court agreed. So the bankruptcy process allowed Detroit to shed about $7 billion in debt, invest $1.5 billion into blight removal and city services over 10 years, and exit bankruptcy in December 2014. The city's finances have improved since — balanced budgets, some surpluses, a population that finally stopped falling. Luna: But there's a darker side. Retirees who lost health coverage at age 65 or older faced real hardship. And the city's infrastructure is still crumbling — water mains burst regularly, streetlights were only fully restored by 2024. Bankruptcy didn't fix everything. Lucas: No, it's a tool, not a cure. And the political cost is enormous. The emergency manager who filed for bankruptcy was unelected, appointed by the governor. That whole dynamic raises questions about democratic accountability. Some cities, like Vallejo, California, filed for Chapter 9 in 2008 and emerged with deep cuts to services that residents still feel. Luna: Vallejo's story is interesting. They filed after the city couldn't afford its police and firefighter salaries and pensions. The city argued that public safety costs were unsustainable. In Chapter 9, they were able to reduce pension payments to those retirees — but it took years of litigation. Lucas: And that's the thing — Chapter 9 doesn't instantly solve the problem. It's a long, expensive process. Legal fees for Detroit's bankruptcy alone were over $170 million. For a city already broke, that's a huge cost. Luna: So who really benefits from municipal bankruptcy? Bondholders take a haircut, but they're sophisticated investors who price in risk. Retirees, on the other hand, often lose a chunk of their income with no fallback. Lucas: That's the trade-off. And it's why so few cities file — the political fallout is brutal. Threatening bankruptcy is often more powerful than actually doing it. When a city threatens Chapter 9, unions and creditors often come to the table with concessions, because they know the alternative could be worse. Luna: Take Chicago. The city has massive underfunded pension liabilities — around $30 billion — and has been flirting with bankruptcy talk for years. But it hasn't filed, partly because Illinois doesn't authorize Chapter 9 for its cities. So Chicago can't file even if it wanted to. Lucas: Which is a good reminder that Chapter 9 is only available where states allow it. And many states don't, because they don't want the stigma of a city bankruptcy on their watch. So instead, cities in those states have to rely on state bailouts or draconian cuts. Luna: Is there any federal proposal to create a uniform process? I know there's been talk of a 'Chapter 10' for municipalities. Lucas: It's been floated in academic circles, but there's little political will. The National Bankruptcy Review Commission actually recommended a new chapter in 1997, but Congress never acted. The fear is that making bankruptcy easier would encourage more filings and raise borrowing costs for all cities. Luna: And bond markets already price in default risk. Detroit's bonds before bankruptcy traded at deep discounts. After bankruptcy, the city was able to issue new bonds at investment-grade rates — but that took years of rebuilding credibility. Lucas: So the legacy of Detroit's Chapter 9 is mixed. It proved the process can work — a city can exit bankruptcy and regain fiscal health. But it also showed that the pain is real and concentrated on the most vulnerable: retirees and residents who depend on basic services. Luna: And it raised a fundamental question: Should city residents get to vote on whether to file for bankruptcy? In Detroit, no one voted. The emergency manager made that call. That doesn't sit well with a lot of people. Lucas: It doesn't. And that tension between local democracy and fiscal necessity is at the heart of every municipal bankruptcy. There's no clean answer. Luna: If you were advising a mayor today who's staring at a pension crisis and a deficit, what would you say about Chapter 9? Lucas: I'd say: don't file unless you absolutely have to, because the cost — financial and political — is enormous. But if you do file, be prepared to make hard choices quickly. Detroit's success came from a clear plan, strong legal team, and willingness to alienate powerful interest groups. That's not easy to replicate. Luna: And if you're a retiree in a city that might file? Lucas: Diversify your income sources. Don't count on a city pension alone. And pay attention to your state's laws — because whether you have any protection depends on where you live. Luna: Alright, that's a sobering note to end on. Thanks, Lucas. Lucas: Thanks, Luna. We'll be back next time.