by Scott Baker
Editor’s note: We have posted two other Opinion articles on the topic of the Detroit bankruptcy over the last two days. This is posted to extend the discussion of what was published previously.
Detroit Industrial Real Estate
The on-again-off-again pending bankruptcy of what was formerly America’s 4th largest city, Detroit, has been all over the news lately. In all of these stories, whether blaming the collapse of the domestic auto industry , profligate workers taking pensions, or, even closer to the truth, speculators (read: banks) who precipitated a housing collapse , and even the fact that only 53% of City property owners paid their 2011 property taxes while approximately $246.5 million in taxes and fees went uncollected for 2011, of which $131 million was due to the City – there is one glaring omission of coverage, whether Detroit is, in fact, broke.
One would think that with such extensive coverage of everything from the city’s crumbling infrastructure to its money-and-personnel starved police department’s pathetic 10% crime-solving rate and 58-minute police department responses , that at least some research would have been given to whether Detroit is, in fact, out of money. Note: I didn’t say, “whether Detroit is bankrupt.” Bankruptcy is a legal finding. Being out of money is a statement of fact. There is a crucial difference, as we shall see.
The courts may have decided the fate of the city by the time you read this. For example, an Ingham County judge issued a stay against the city’s attempt at bankruptcy, ruling it unconstitutional, based on State’s Article 9, Section 24:
STATE CONSTITUTION (EXCERPT)
CONSTITUTION OF MICHIGAN OF 1963
– 24 Public pension plans and retirement systems, obligation.
The accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby.
Financial benefits arising on account of service rendered in each fiscal year shall be funded during that year and such funding shall not be used for financing unfunded accrued liabilities.
History: Const. 1963, Art. IX, – 24, Eff. Jan. 1, 1964
Says the Daily Kos article cited above:
The city must retract its filing for bankruptcy, made literally minutes after appearing in the circuit court, after asking for, and receiving a 5-minute delay – during which they filed for bankruptcy!
Since this Daily Kos article came out, however, an appeals court has let the bankruptcy proceeding continue, and it now seems the State constitution will be flouted. Why should we be surprised that what is happening on a Federal level is mirrored at the State level? The unions are fighting the loss of their pensions, but only on a token basis and are not questioning the fundamental assumption that Detroit is broke, though the same financial statements are available to them as are available to journalists, or to anyone.
Considering that the city’s state-appointed democracy-robbing bankruptcy attorney, Kevyn Orr, is a Washington D.C. attorney and partner at the law firm of Jones Dayare, which is representing Peabody Energy against the coal miners in bankruptcy proceedings, one ought to question any so-called public servant who is saying an entity is broke nowadays. (In addition, Detroit is a particular homing beacon for political corruption, with an ex-Mayor in jail for extortion, racketeering and bribery.) Before we indict Detroit as another city wrecked by greedy public employee pensioners – who in this case, live on an average of $19,000/year – let’s dig a bit deeper into the true situation.
First, in macro-economic terms, as Paul Krugman lays out, the “Great Pension Scare” is yet another inflated attempt by the New Austerians to force everyone but them into penury with bogus statistics claiming imminent default, deprivation, and even moral debauchery. We ought to know better by now then to trust revolving-door Treasurers and Comptrollers looking for future employment in the FIRE sector. In addition, of course, this is Obama’s Gerald Ford moment, when president Ford famously said to New York City – in 1975 suffering its own fiscal crisis – that it should “Drop Dead.” In fact, the current Administration spends three times as much on aid for Columbia as it does for Detroit and could easily afford to help out one of America’s major cities, if it chose to, and if Congress allowed it.
But, getting back to the fiscal reality of Detroit: to understand the true situation, the first thing to understand is the difference between a budget report and a Comprehensive Annual Financial Report (CAFR).
There is a nascent gathering of interest in examining CAFRs on local, state, and federal levels. It’s too soon to call this a movement, and indeed, it’s hard to have a movement around 10s of thousands of separately calculated CAFRs, but since they all use similar methods of obscuring their reporting government’s true assets, tax and monetary reformers are starting to take notice.
“Per Detroit, pay special attention to the following:
If you take a look at why they say they are broke, what they are doing is extending the pension and other liabilities out 30-years as if (it’s) a liability to be paid in full today. They funnel off much of their “annual” budgetary funds to meet 100% funding today and (this) is why (they use) the buzzword of “in debt” and “pensions short”. They only project out their income 1-year and project liabilities out 30.
And they do so to create the largest base of investment funds on all levels at their disposal.”
Burien’s protege, Clint Richardson, has much more to say about Detroit in a recent blog post, and goes into even more detail when writing of a similar situation, the fabricated Stockton, California, bankruptcy (in a document totaling 250 pages!), where he says:
“The budget report is simply an edited and cut down version of the full report called the CAFR. Same books, but the budget excludes most of the investment wealth within governmental and non-governmental (enterprise/customer-based) funds. Consider the budget as the City’s checking account for the last year, and the CAFR as the City’s combined checking AND SAVINGS ACCOUNT for the last 162 years” Please also note the word “annual” when referring to the yearly budget report. One of the biggest distinctions between the CAFR and the Budget report is that the CAFR is a full accounting of all finances for the entirety of the time that the City corporation has been open. But the budget only focuses on a yearly basis, and what happens within that year. So in the budget report, last year’s profits are not necessary to include within this year’s budget, for the budget is only accounting for this year. And this means that the council and Manager are not “required” to use the fund balances of today that were gained yesterday, for they are not part of the “budget.” (This is) yet another obfuscation tool to hide the real wealth of the City.”
It’s a bit like taking out your empty wallet and saying you’re broke, while ignoring your bank account, your stocks and bonds, the home you own, etc. It’s also like saying that every bill you will ever owe, including the balance on your mortgage, your car loan, your credit card statements, your kid’s college tuition for the next four years”all of it, is now due in full, and, oh, and you are only allowed to count the money you made during the past year to pay for it all! This is exactly what the Post Office’s 75-year health care prefunding requirement is doing to bankrupt that agency. In fact, Richardson makes that analogy specifically:
“Please note that in my documentary, “The Great Pension Fund Hoax“, I covered this pre-funding scheme with the Federal Post Office, which has been borrowing every year to cover the expense of pre-funding its pension obligations and is now in financial trouble and collapse. I maintain today as I did in 2010 when that film was made that this effort is a purposeful attempt to falsely claim bankruptcy for these government entities by the Federal government — whom at any time can eliminate this pre-funding requirement as they created it in the first place. This is just one tactic being used to drive illusionist distress and cause for “financial estates of emergency” in governments that are not in any way in financial trouble. Make no mistake, pre-funding is government’s financial weapon of terrorism.”
Burien and Richardson are not making this up. Here is what frequently cited Moody’s Investment Services says in a June 27 press release (you have to drill down half a dozen links in a typical article to get to this, if it’s available at all, and, based on their scare-mongering, I wonder if many journalists and editorialists have done so), emphasis added:
“The burden of unfunded pension liabilities varies enormously from state to state, according to a new Moody’s Investors Service report, “Adjusted Pension Liability Medians for US States.” Measures comparing the size of each state’s adjusted pension liabilities to its financial resources show a few states facing negligible liabilities and other states with liabilities significantly greater than their annual revenues“. Moody’s uses measures comparing the size of adjusted net liabilities to state resources in its credit analysis because they are indicative of the strain the liabilities are likely to place on finances. Adjusted net pension liability relative to governmental revenues is the measure Moody’s employs in its states’ rating methodology scorecard.”
So, Moody’s, a top ratings agency, is using revenues alone, not total assets, to determine whether there will be a shortfall in future liabilities.
Furthermore, as this Reuters article, coming out the following day (June 28), points out (emphasis added):
“The shortfall numbers in these studies, to put it simply, are all over the place. There are many variables that go into these models, but the main factor that causes variation is the expected rate of return on the assets in the plans. The official assumed return on the assets that are held in trust to pay pension liabilities is 8 percent, according to the Public Fund Survey. Fiddling with this projected rate of return can cause swings in the amount of unfunded liabilities. The Moody’s study uses an unconventional assumption. According to the Adjustments to state pension liabilities document:
Accrued actuarial liabilities will be adjusted based on a high-grade long-term taxable bond index discount rate as of the date of valuation (of the fund).
Rather than using the average historical investment return rate of 8 percent, Moody’s uses a return on a taxable bond index . This return would be no higher than that on a basket of high-rated corporate bonds ranging from 4.4 to 6.2 percent, the FT says. The problem with using this rate is that we have been in a five-year period of zero-interest rate policy while the Federal Reserve has artificially suppressed interest rates to promote financial stability and spur economic growth”. Moody’s model, in periods of artificially suppressed interest rates, has enormous flaws .”
In fact, Moody’s itself seems to recognize the negative impact on projected pension returns of its new methodology, based on the “Pensions Final Adjustments” report sent to me by David Jacobson, their AVP – Communications Strategist, Public Finance Group (Page 4):
“Because interest rates are currently at an historic low, the market approach to measuring liabilities results in much larger current total liabilities than those reported using the conventional governmental approach.”
The very fact that Moody’s and others are using expected rates of return, which are additionally “all over the place,” demonstrates how these ratings firms are forecasting liabilities years, if not decades, into the future, just as Burien and Richardson say. And there are more reasons to suspect the expected rates of future return are geared low, perhaps too low. The Journal of Accountancy’s June 25, 2012 article “GASB vote places unfunded pension liabilities on government balance sheets” says (emphasis added):
“GASB on Monday approved Statement No. 67, Financial Reporting for Pension Plans , and Statement No. 68, Accounting and Financial Reporting for Pensions . Statement No. 68 will require governments with defined benefit pension plans to disclose a “net pension liability” on their balance sheets.
That liability equals the difference between the total pension liability and the value of assets set aside in a pension plan to pay benefits. The statement calls for immediate recognition of more pension expense than is currently required. This includes immediate recognition of annual service cost and interest on the pension liability, plus the effect of changes in benefit terms on the net pension liability.
Currently, the pension liability on a government’s balance sheet is based on the difference between the contributions they are required to make to a pension plan in a given year versus what they actually funded. The change reflects the view that pension costs and obligations should be recorded as employees earn them, rather than when the government contributes to a pension plan or when retirees receive benefits.”
So, the GASB — the Governmental Accounting Standards Board, which is the main body for determining how pensions will be evaluated, has determined the current evaluation method under-accounts for liabilities. (Yet, even with these recent adjustments, Michigan as a whole, has a lower Net Pension Liability Relative to Economic Indicators (3.4%) than average (7.9%), according to Moody’s “State Pension Liability Medians” report, Table 3 on page 11. Detroit, really inner city Detroit may be doing poorly, but the state is not, and the state could, if it chose to, spread the wealth to rescue what is still, by far, its largest city).
Walter Burien is no fan of the GASB. In an email to me, he said:
“I Note GASB is a 100% “Private Association” created by the large government gangs in the first place to in effect bypass their own monopoly laws. They have done so by letting GASB.org call the shots in which Government internally networking together as a monopoly never openly would have been able to arrange for.”
In any case, Detroit is recognizing this GASB-led change already, according to Orr’s June, 2012 report “City of Detroit Proposal for Creditors,” page 24 (hey, how about a Report for Citizens?):
“In addition, the Governmental Accounting Standards Board has issued a statement (No. 67), effective during the City’s 2014 fiscal year, requiring municipalities to recognize their unfunded pension benefit obligation as a liability and to more comprehensively measure the annual costs of pension benefits.”
However, under the old accounting assumptions the liability would be $1.5B less than the $3.5B pension fund deficit. Say the Orr report:
“Even if the City were not to change prior actuarial assumptions, pension UAAL is projected to grow to nearly $2 billion by 2017. The adoption of realistic actuarial assumptions would result in a significantly higher number for UAAL.”
Note that liability is projected out to 2017. Now we’re getting somewhere. Five years of liabilities, but not five years of revenues, let alone counting of past assets. Judged that way, we’d all be broke!
Accounting is not only about arithmetic truth; it is also about choices of what and how to account.
I became curious about this accounting question when this NY Times article about Detroit’s proposed bankruptcy came out and so I looked up Detroit’s Comprehensive Annual Financial Report (CAFR) 2012 (you might want to keep this document open — we’ll be referring to it a lot in this article). All government CAFRS — variously estimated to number between 184,000 — 230,000 – are now available online, yet somehow, the media doesn’t seem to know how to use Google or Bing, and they just take the official word of their condition from public officials. The decline in investigative journalism is a subject for another article, but the ability to promulgate almost any kind of financial mistruth is one glaring result, and the criminogenic environment it creates is costing us trillions.
When I asked Justice Party candidate Rocky Anderson at a political stopover (about 1:13 in, where he also states support for State Banks and Greenbacking (debt-free money issuance direct from government)) if comprehensively auditing the CAFRs would be a good idea, he heartily agreed. It’s too soon to say there is a “CAFR Reform Movement” but there are cracks in this long-time method of legally separating money from the taxpayers for the benefit of Wall Street and its fund managers, and then turning around and saying the client governments are broke.
Here’s a summary breakdown of some major assets in the Detroit CAFR for FY 2012:
- $5.1B in the Detroit pension fund (page 180)
- $308.4M in 5 government funds (page 55)
- $262.6M in Derivatives (a good year for the sewage and water funds, apparently — page 59)
- $214.1M in various Authorities and city corporations (page 63. These are corporations within the corporation of Detroit, incorporated in 1806(!) — page 68)
- $1.2B in cash/cash equivalents and investments (page 84)
- $205M in total government agency funds (page 192)
Now, as to deficits:
The claim from another NY Times story is that the city is $3.5B short in pension payments. This figure is repeated in many articles, but virtually all of these articles are citing Kevyn Orr or his spokesperson, and lack reference to the underlying figures. A New York Times article in their Dealbook section says this figure came “(s)eemingly out of nowhere “!
Well, it came form somewhere. Here’s where: the original source is on page 23 of Orr’s “City of Detroit Proposal for Creditors”
“Further analysis by the City using more realistic assumptions (including by reducing the discount rate by one percentage point) suggests that pension UAAL will be approximately $3.5 billion as of June 30, 2013.”
Remember that these “realistic assumptions” include adopting a rule that the GASD has not even implemented yet.
But, what is the pension UAAL, you may ask? The acronym finder describes it thusly:
“A pension funding plan should be based on an actuarially determined annual required contribution (ARC) that incorporates both the cost of benefits in the current year and the amortization of the plan’s unfunded actuarial accrued liability (UAAL) .”
But wait a minute, this includes amortized liabilities years out, but what about amortized revenues?!
Let’s break free of the jargon for a moment, since it is misleading, perhaps deliberately so.
It turns out, from the CAFR, that the pension and annuity benefits for FY 2012 was only half a billion dollars ($509M — page 180). At a consistent rate of payout, and assuming no ROI increase in the pension fund, it would take 10 years to fully exhaust the fund, but during that time, there’s will also be additional money put in, in the form of employee contributions and employer contributions (e.g. $454M in FY 2012, which leaves just $55M in deficit, or about 9.3%) funded by taxes (remember those?) during that 10 years. Since there are already enough assets in the pension fund to cover the so-called “shortfall” this year and a few years ahead, the additions alone could offset the entire projected deficit, even with modest returns.
This section also includes deductions of:
- $ 317,388,978 for ” Premiums to Insurers and Damage Claims” and
- $200,048,571 for “Member Refunds and Withdrawals” and
- $ 11,725,495 for General and Administrative Expenses
– though perhaps the Premiums entry should not be paid by the workers’ pension fund(?) – and these additional costs combined with the pension payouts slightly do slightly exceed a billion/year, but even at that rate, it would be 5 years before the fund is exhausted. And remember the Reuter article criticizing the way expected returns are calculated (see above). ROI is very difficult to predict. More on alternative investments that might be easier to predict, and even counter-cyclical, later.
But perhaps a more important question to be asking is: since when are governments supposed to pay expenditures from the returns on investments (ROI), instead of directly from taxes? And since when are they supposed to make a profit? Most people assume government expenses should be pay as you go, with just enough left over to get them through the year from that year’s tax receipts.
Burien, in the email referenced above, says:
Government was NOT supposed to operate at a profit. How did they get around this restriction?
ANSWER: If for example a city had a 100-million dollar profit for the year from any of its operations, at a stroke of a pen they create or deposit into a “liability fund” and poof, there goes the profit re-designated now as a liability.
Now, returning to the pension fund:
First, the pension fund returns are mediocre (see above), plus they are plagued with corruption, and THAT, more than the amount of payouts, is the real story here. But no one will take on Wall Street money (mis)managers. No one wants to withdraw money from Wall Street brokerage houses and invest it elsewhere, least of all Comptrollers and Treasurers who want jobs there later.
Second, a Public Bank might be a much better, and counter-cyclical, investment, which would invest in the city/state. The Bank of North Dakota’s Return on Equity (ROE) has averaged 20+% for over ten years, and it has returned $300 million in dividends, while other states and cities — like Detroit — are paying interest on credit they could generate themselves if they deposited their money into a public bank. A public bank can be set up in a municipality; it does not have to be done at the state level. Even if the ROI was comparable, there would still be the added benefits of
1. Not paying high management fees (see below)
2. Not paying high interest rates on bonds for money already raised in taxes
3. Investing in the local community (hopefully in a more responsible way if such loans are made by independent, conservative, bankers working for the state, as North Dakota’s State Bank has done since 1919)
4. Supporting local community banks and lending institutions (like Credit Unions). North Dakota has the highest per capita bank to person ratio in the country
5. Support for local small businesses, which are credit-starved in Detroit
6. Job creation both in the banks supported and from the activities of the public bank
7. Revenue creation (see dividend payouts, above)
8. Performing their fiduciary duty by protecting taxpayer money in the event of a major bank bail-in (a forced deposit for equity swap proposed by the FDIC and the Bank of England in a joint 2012 report).
Third, there is the matter of how much in fees Detroit pays (page 178). This turns out to be hard to find. There is this nebulous category of “Investment Expense” totaling $31m for the pension fund as of June 30, 2012 when the report closed (BTW, how have things changed in the year since then? Where is the 2013 report?). But is that for the fees for fund management or something else? In any case, the management of a public bank would be far, far less. The president of the Bank of North Dakota, for example, earned under $300 thousand last year.
I especially like noticed this line :
Nearly half a billion due to brokers for “securities lending” whatever the hell that is…
And another half a billion is invested in 32 other national currencies (page 90), certainly not helping Detroit, Michigan, USA!
So far, we have been mostly looking at the pension fund liabilities and assets, but there is much more having to do with overall assets and liabilities due bondholders. Richardson says in his blog entry on Detroit, in response to me (emphasis in the original):
“To get the more full picture, you should be looking at the individually (discretely) presented fund balances, which also use creative accounting. These fund balances are then placed into the final net assets after future liabilities are considered.
Page 50-53 Enterprise funds =
Total current assets — $7,065,834,682
Total current liabilities — $503,209,822
Total noncurrent liabilities — $6,254,198,203
Total assets — $ 308,426,657
Over $3 billion of that is “Bonds and Notes Payable — Net”, meaning future payments more than one year away.
So looky there, here is $7 billion being held that is being reported as only $308 million.
As you go through the report, you will find this trick applied.”
As for the pension fund, the true travesty is reported as:
- Employer Contributions – $378,356,067
- Plan Member Contributions – $64,545,425
“Employer contributions” are taxpayer money.
“Plan Members” are the workers.
Pension funds are just a way to strip taxpayer money and invest it, using employee benefits and retirement as a lame excuse to collect taxpayer money (as debt).
Actual pension assets (investments) total another $5.1 billion. (This confirms my figures too.)
My friend, that means we are already sitting at over $12 billion in current assets, despite the CAFR statement of net assets claiming only $11 billion. And we’ve only looked at two types of funds.
How about the “discretely presented component units” (page 62-63)? They have assets of over $500 million, long-term debt of $166,728,140, and only reported as $214,130,890 or less than half their asset value.
Then you can read how some tricks work in the “Notes to financial statements”:
(j) Deferred Revenue
Deferred revenue represents revenues received, but for which the revenue recognition criteria have not been met . Accordingly, these revenues are deferred until such time as the revenue recognition criteria is met.
(So why don’t they refer liabilities until they are actually current liabilities?)
(k) Bond Premiums, Discounts, Issuance Costs, and Deferred Amounts on Refunding
In the government-wide and proprietary fund financial statements, bond premiums and discounts are deferred and amortized using the effective interest method. Issuance costs (deferred charges) and gains and losses (deferred amounts) on refunding are deferred and amortized over the life of the bonds using the straight-line method.
In other words, the liabilities reflect things like interest, so the actual liabilities of today are much less without future interest charges.
On page as “Interest paid on Bonds, Notes, and Leases”, we see interest on just Enterprise funds at ($224,029,617).
I suggest reading the notes section.
Clearly, the CAFRs need an independent audit, not from an emergency auditor who specializes in bankruptcy filing, but from a team of unbiased forensic accountants out to measure and present a realistic picture of Detroit’s assets, liabilities, and projections for both in the future.
What about the surrounding area?
Few articles address the fact that Detroit is surrounded by some of the richest counties in America, though former Labor Secretary Robert Reich did address this. Are some of those residents holders of Detroit bonds? Of Detroit land (for future development once they clear away those pesky poor people)? Follow the money…
The “Money” is not at all convinced that Detroit is toast. Several prominent speculators are already salivating over opportunities in a city designed to hold 2 million that currently holds 700,000. See here:
John Battelle (Twitter, @johnbattelle), Founder, Executive Chairman and CEO of Federated Media, and also Founder of OpenCo (hosting a Detroit startup event on September 11), believes that the spirit of the community will lead people to rally and become better.
“I believe Detroit is a shining example of how the people and innovative companies of a city are routing around bureaucracy and old thinking to re-imagine what can happen when a community pulls together around shared values.”
Bankruptcy Creates Certainty
Peter Allen , Founder and President of Peter Allen and Associates, an expert in the Ann Arbor, Michigan property market and adjunct University of Michigan faculty member, believes that the bankruptcy will restore a sense of certainty to the Detroit real estate market after years of uncertainty. Allen said:
“Uncertainty is bad for real estate with its long term investment horizon. Banks and investors need to see 3-5 years out with reliability.”
In fact, Allen is bullish on Detroit right now despite the bankruptcy filing.
“Now is a better time to invest in Detroit than two days ago. And it was a fantastic investment time even then.”
So, people who are paid to know, argue that there is value in Detroit, even now.
Who are we to argue?