02/10/2012 07:21 pm ET | Updated Apr 11, 2012

Bankruptcy for Detroit?

The city of Detroit faces a fiscal crisis as it runs out of cash to pay employees, vendors and bondholders. This crisis has been born of many years of inadequate budgeting to address a growing structural imbalance. Since the recession of 2001, the city government has faced major declines in income and property tax revenues, but at the same time has been seemingly unable to cut spending at the same rate as revenues were falling.

Starting in 2005, the city began to run ever-growing deficits and burned cash at an alarming rate. Finally, in 2012, a national consulting firm was brought in and estimated that the city would run out of cash as of April.

Detroit's crisis coincides with a tough new law in Michigan known as P.A. 4 of 2011 or the Fiscal Accountability Act. This act provides a mechanism through which the state oversees -- and if necessary directly intervenes -- in a local fiscal crisis. This can include the suspension of local leadership and the imposition of an "emergency manager" if the crisis is deemed serious enough. Currently, emergency managers are in place in three Michigan cities -- Flint, Benton Harbor and Ecorse.

No irony is lost in the fact that two of Detroit's biggest companies, General Motors and Chrysler, went through bankruptcy in 2009 and have emerged stronger than before. Municipal bankruptcy is considered by many to be a last resort for localities in fiscal trouble. It is much different than corporate or personal bankruptcy. For one thing, a judge cannot appoint a receiver. Even more importantly, a federal judge cannot sell city assets to pay bills, force a municipality to raise taxes or redirect services and the city budget.

What a federal judge can do, and has in some municipalities recently, is terminate and rewrite contracts, particularly labor union contracts.

City governments are generally employee-intensive businesses where the majority of the costs go to labor compensation. In recent years, the increase in the cost of benefits -- including retiree pension and health care costs -- has far exceeded the growth in wages.

In the bankruptcy case of Vallejo, CA, the federal judge reduced retiree health costs substantially. In the case of Central Falls, RI, retirees in bankruptcy court agreed to major cuts in pension benefit payments. This is the first time that bankruptcy has been used in such a fashion.

For Detroit, a reduction in these retiree costs is a potential benefit in bankruptcy. The city government has a little more than $2 billion in outstanding debt. At the same time, the city owes more than $5 billion in retiree health care costs over the next thirty years. While the city's pensions have funding behind it, the city's retiree health care liability has no funding to back it. For the city to reach short and long term solvency, these costs must be addressed. So, it seems obvious that bankruptcy is a must.

However, municipal bankruptcy has some real downsides. It likely would be costly and long in duration. The bankruptcy in Vallejo -- a city that's much smaller than Detroit, with only 100,000 residents -- took three years. Further, there could be negative impact on the bond markets. Other Michigan municipalities may face higher borrowing costs and it would be black eye for the state.

More importantly perhaps, in addition to addressing these costs, the city government needs to realign city services. A federal judge cannot address these structural changes. City officials or an emergency manager can address these kinds of critical structural readjustments.

At the end of the day, Detroit may find bankruptcy a necessity. But before that occurs, state and local officials need to seek every opportunity to find solutions that maintain critical city services while funding or reducing long-term legacy costs.