By James Spiotto
Who said “No pecuniary consideration is more urgent than the regular redemption and discharge of public debt. On none can delay be more injurious, or an economy of time more valuable”?
Was it a representative of a public union, a rating agency official, a bond insurer, an elected official, or the Emergency Manager for Detroit? No. It was George Washington, over 220 years ago, in his State of the Union address on December 3, 1793. Washington and Hamilton were instrumental in having the Federal Government assume the states’ debt from the Revolutionary War since some states were balking at paying such debt. Those states feared their taxes would go to pay Northern speculators or the debt of states who were big borrowers. Washington and Hamilton knew that the progress of the nation could be no swifter than its financial credibility. Now, there are echoes of this debate 220 years later. Will there be the same result?
In the Detroit bankruptcy, there presently is pending the issue of whether the $1.4 billion in certificates of participation (“COPs”) issued by the City of Detroit can be repudiated by Detroit in its Chapter 9 bankruptcy. There is no dispute that, when issued, the COPs were represented in the market to be valid, binding and enforceable obligations of the City of Detroit. No one from the City or the State of Michigan at the time of issuance or prior to the Chapter 9 filing instituted any legal proceeding to void that debt or to request that the $1.4 billion received by Detroit be returned to investors in order to void the debt obligations.
There is no disputing the economic plight of the City of Detroit and its need to take strong action to adjust its debts and reinvest in Detroit. The City must develop a recovery plan that works, appropriately adjust its debt and return to the status it once had in the municipal markets. The question is whether the repudiation of $1.4 billion is going to help Detroit regain financial credibility or will it sour the municipal markets against Detroit and possibly government debt in general.
Repudiation of debt in the United States first took place in the early 1800’s.
To oversimplify the City of Detroit’s position, it seeks to repudiate the debt because it claims Detroit had “a bad mayor and a bad administration” at the time of issuance and therefore should not be responsible for that debt. As we all know, if a corporation or an individual issues debt in the public market claiming that the debt is a valid, binding and enforceable obligation and then later, when it is inconvenient or difficult to pay, claims it was never authorized to incur the debt, there would be serious consequences. That corporation or individual would be open to a flood of litigation, if not criminal investigation, claiming fraud on the investors.
While much has been said about the identity of investors in municipal bonds, it should be remembered that those who invest in municipal bonds are just like all of us, namely workers investing for their retirement through organized pension funds or individually, parents putting away hard-earned dollars for their child’s education or future home buyers investing their savings in hopes of a new home and a better life. The fact that some who are investing those funds may have offices on a well known street in New York should make no difference in the reality of who will suffer the majority of the loss if the bonds are not paid.
Our Founding Fathers, led by Hamilton and Washington, knew that financial credibility was one of the building blocks of a strong nation. Part of the exceptional success of our state and local governments has been their ability to borrow money in the municipal market at a low cost so they can decide, as a state or a city, what the improvements or essential services should be for their constituents. These decisions and the implementation and funding of the decisions can all be done by local action without the need of approval, review and acceptance by some higher government. That ability to make decisions and fund them locally is one of the unique attributes of our government and one that has, in the past, allowed us to create the world’s best infrastructure and the world’s largest economy.
Repudiation of debt by states or local governments is not new. Repudiation of debt in the United States first took place in the early 1800’s. The lessons learned from that repudiation should not be forgotten. In the aftermath of the panic of 1837 and the need for states to borrow to pay for transportation improvements in the North, given the success of the Erie Canal, and for banking services in the South, 19 out of 26 states and two territories borrowed money for economic growth. By the 1840’s, eight states and one territory defaulted. Those that defaulted then experienced either an inability to borrow additional funds or, if they could obtain financing for needed governmental improvements and services, the imposition of a 32%+ yield. By the late 1840’s, seven of the eight states had renounced their repudiation and resumed payment on the debt in order to obtain market access at a lower cost. The state and one territory that were left repudiating their debt struggled for over a decade to obtain funds, let alone at a reasonable cost.
After the Civil War, in response to suggestions that the government should discount the cost of war debt by paying it in greenbacks, a devalued currency, President Grant, in the spirit of Washington and Hamilton 80 years earlier, chose to protect national honor. He stated every dollar of government indebtedness should be paid in gold. Unfortunately, such was not the fate of the failed confederate government’s war debt. By means of the 14th Amendment, debt incurred in aid of insurrection was deemed illegal and void.
Accordingly, the claims by Detroit that it was not authorized to issue the debt despite resolutions, statements and opinions representing to the contrary to the capital market, appear disingenuous at best.
Even more interesting is the recognition by various states and municipalities during the second half of the 1800’s of the need to be involved in the railroad expansion. This was done by using the proceeds of public debt to build facilities in the hope that the railroad would come or utilizing those funds to invest in the railroad to induce the railroad to lay track in their direction. Unfortunately, numerous communities found that the railroad took a different course. Thereafter, towns sought to repudiate the debt as not serving a public purpose. Over 300 cases between 1860 and 1896 made their way to the U.S. Supreme Court. The Supreme Court took a consistent and clear stand upholding the validity of bonds, sometimes overruling state supreme courts that had issued orders essentially reversing prior state court holdings that the bonds were valid and binding. The Supreme Court ruled that efforts by state and local governments to repudiate and invalidate bonds issued to subsidize the railroad facilities violated the Constitution, and the Court established rights of the bond investors
Accordingly, the claims by Detroit that it was not authorized to issue the debt despite resolutions, statements and opinions representing to the contrary to the capital market, appear disingenuous at best. Further, at the time of issuance, there was no outcry of lack of authority. To the contrary, Detroit received and retained the benefit of that purported unauthorized issuance, namely the $1.4 billion used to pay down its pensions. If Detroit could not legally create debt in issuing the COPs, perhaps it substitutes the paid-off pension debt as the legal basis for the obligation of the COPs. If the COPs debt issuance was unauthorized and Detroit had no right to the $1.4 billion, how could it be used to pay down pension debt and how can these proceeds of the COPs be retained by the pension funds?
The question is whether the repudiation of $1.4 billion is going to help Detroit regain financial credibility or will it sour the municipal markets against Detroit and possibly government debt in general.
Further, the inevitable consequences to Detroit and to the municipal market upon which all states and municipalities rely for funding their long-term capital improvements and sometimes their essential services, cannot be tolerated. If past history is a judge, the difference in the market between, the better credits and the weaker credits may range from 150-200 basis points or more. Given Detroit’s need to reinvest in the city and borrow significant sums to do so in the future, Detroit could possibly pay at least 200 basis points or 2% more a year for future borrowings. Over the normal life of a bond (30-year period), this is 60% more of the principal borrowed that does not go to pay for infrastructure or essential services, public workers salaries or pensions, other creditors or tax relief to the taxpayers. While the legal and political correctness of past administrations can be argued, there should be no doubt that good funds were provided by investors, that benefits were received by the City through its use of those good funds to pay down pension obligations and a public benefit was achieved. It strains the notion of fairness and justice if a benefit can be retained but the consideration for it can be repudiated. Repudiation of the COPs may have little public benefit and long-term public pain. Washington and Hamilton warned, and as history has demonstrated, “no pecuniary consideration is more urgent than the regular redemption and discharge of public debt.” The best test of a fair and just result is whether the outcome can be explained to a young child. It is doubtful a third grader would expect that a party could retain the benefits of a transaction without paying the agreed-upon consideration.
James E. Spiotto is Managing Director of Chapman Strategic Advisors, LLC and Co-Publisher of MuniNet Guide.