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Obama Administration will bailout Detroit

by Eileen Norcross on September 27, 2013

in Debt, Federalism, Pensions, Public Finance

The Obama administration announced today it plans to send Detroit $320 million to “aid in its recovery,” according to The Hill.

The dollars come from existing federal money that is being re-purposed. It includes $24 million to rehabilitate buses and install safety cameras, $1.35 million for a community policing program, and the underwriting of 150 new firefighters. There are also funds for streets lights, police bike patrol, $3 million to hire new police, dollars for urban revitalization, and $25.4 million for demolition. A few months ago the administration said Detroit would have to work with creditors to resolve its bankruptcy issues. The city owes its creditors $18.5 billion.

Another example of how Detroit ended up in this awful position is highlighted in yesterday’s New York Times report of how Detroit City Council members skimmed $2 billion off of the pension system’ “excess earnings” to give employees ‘extra payments’ that had nothing to do with their pension benefits. This practice which spanned a 23 year period was justified as follows, quoting the NYT:

“People were having a hard time, living hand-to-mouth, and we thought we would give them some extra,” Ms. Bassett said.

Of all the nonpension payments, she said, 54 percent went to active workers, 14 percent went to retirees and 32 percent went to the city, which used its share to lower its annual contributions to the fund. The excess payments were often made near the end of the year, when recipients needed money for the holidays, or to heat their homes.

Of course the practice sounds wrong. Except it’s really another example of what happens when pensions value their liabilities based on asset returns. Detroit gave workers these “excess earnings.” New Jersey and scores of other states believed they were overfunded also and they “skipped payments” when the market was hot in the 1990s and early 2000s. The accounting gave them the illusion that this would all work out in the end. It is a dangerous fiction that these pension systems operate under.

That illusion of “overfunding in boom years” flows from the practice – discussed often in this blog – of discounting liabilities based on expected asset returns.The math really matters. For a long discussion, see here. 

How much damage has this accounting assumption and all the behaviors that flow from it caused? For Detroit – a significant amount. The city reports its pensions are underfunded by $634 million. It’s actually $9 billion underfunded on a market basis. 

I am not entirely surprised by the bailout, which sounds like a mini-stimulus via federal municipal grant programs. And I openly wonder what it portends for other cities that find themselves looking at similarly dire economic and financial situations.

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