When a city is bankrupt, judges have a big say in whose bills will be paid. For now, all eyes are on Detroit and San Bernardino, Calif.

Originally posted at GOVERNING.
By Frank Shafroth

Two battles over public money promises are intertwined in two cities, two states and two courtrooms. In Detroit and San Bernardino, Calif., past promises to fund public pension plans and other retirement benefits have become inextricably linked to the impossibility of paying those obligations. Each of the cities could pay its promised benefits today, but not all of its other obligations. Indeed, the cities may be able to pay off their promises to any given creditor or any set of obligations, but not all of them. The problem is not the pension obligations, per se, nor any other particular liability. Rather, it’s the obligations combined with reduced revenue bases.

It’s like the decisions you would have to make if you were short of cash but had to keep your car running. You would have to decide what trips you were going to make and which ones you weren’t, lest you find yourself stranded in the middle of nowhere. For insolvent cities like Detroit and San Bernardino, there may be sufficient levels of money in the tank to make current pension payments, but the more difficult proposition is how to keep making them. This is especially the case in Detroit where, because of sharp reductions in the city workforce, employee contributions to pension funds are down. Beside owing retirees, the city also has promised payments to investors in its pension bonds or investors who bought its pension obligation bonds.

In a municipal bankruptcy, a federal judge makes the decision whether a plan submitted by the municipality and its creditors about whom to pay and how much is acceptable or not. The judge in effect acts as an official referee in a process to work out a plan to address a city or county’s promises. What city official would want to be Solomon and weigh what service or promise is more essential than another? Cutting the baby in half is not a solution.

For municipalities, breaking fiscal promises through bankruptcy is not like doing so in a corporate bankruptcy. There, the factory or office doors can be closed and locked and the keys turned over to the court. The court then determines how to sell the assets and distribute the proceeds among all the creditors. In addition, there is the federal Pension Benefit Guaranty Corp. created by Congress to protect private-sector retiree benefits.

No such promises have been made by Congress for state and local benefits. Rather, the municipal bankruptcy process involves heart-wrenching decisions about ensuring essential municipal services and meeting promises made to employees. In both California and Michigan, pensions have been deemed by the state to be “guaranteed”—about as close to essential as voters and lawmakers can make a promise.

Yet for any insolvency to be addressed, the judicial referees try to balance the essential against the optimal. That means a determination that pension and post-retirement benefits should be linked to paying everything sustainable and affordable that can be paid after funding the recovery plan and essential services. They must also ensure that there is a dedicated source of payments for promised pensions for the future.

If California’s and Michigan’s protection of pension promises were to be honored in the unfolding judicial processes, the two cities would have no option but to sharply reduce their current workforces. Ironically, such reductions would erode the amount of money going into funds that ultimately support retiree pensions and post-retirement benefits. The reductions would also undermine the options for creating or developing a recovery plan that could stimulate the economy to create new jobs. What kind of a future would that leave for either city, its elected officials, its retirees or its employees?

All eyes are on San Bernardino and Detroit as places where some city promises could come to an end. Yet, in the processes ahead, how these promises are rejiggered will be critical to the respective governments’ futures. Maybe the federal bankruptcy process will offer a way to hardwire affordable payments of pensions and benefits with a dedicated source of payment, and to create a safety net to ensure guaranteed benefits to retirees. Unlike a bankrupt corporation that can close its doors, the bankrupt city remains open, its services operating and its programs responsible to all its citizens.