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Joe Barbieri has Bachelors' degrees in both Civil Engineering and Commerce from the University of Toronto. He has worked in the Financial Services field for over 13 years, with over 10 years on the institutional side of the business. He has covered positions from Fund Accounting to Investment... More
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  • Is Detroits' Bankruptcy A Canary In The Coal Mine? 0 comments
    Jul 30, 2013 11:47 AM

    When people discuss Detroit's bankruptcy, it tends to be treated as a single event. There are articles that ask whether this can happen again. (3) It has happened in the past to other U.S. cities, so yes, it can happen again. (1) As with many financial issues, the blame is usually placed on unions, workers, pensioners, the economy, or just fate. There is little blame placed on mismanagement or creditors, or why decisions were made. In fact, pensioners and workers are now being called creditors in some cases to allow them to receive less than full value for what they are owed. (2)

    The truth is that there are many issues involving this situation, but they should all be brought to light. The fact is that when money is borrowed, the interest on that debt will always be the largest expense when looking at a very long time horizon. Where is the evidence for this statement? Look at a typical homeowner. The interest on a mortgage will typically inflate the cost of a house by more than 50%. As an example, if you borrow $400,000 and pay 5% interest on it over 25 years, you would pay close to $300,000 in interest using an amortization table. The interest rate of 5% is not that high, and this assumes a perfect record of payments and the same interest rate over that time. If you are a city or government, you will have longer time horizons, which means even more interest would accumulate. In the case of the homeowner, would they have $300,000 in utility bills, renovations, property taxes or other home expenses over 25 years? Not likely. This leaves interest as the biggest expense. How this interest is managed is key to the sustainability of any entity, and this is what should be examined in the case of Detroit. Paying people for pensions and salaries is sustainable if the work is performed because this money is used to provide a service, and the services add value in their own right through more investment, higher real estate prices, and more money spent within the city. Interest is basically money given for financing or investment return, which provides no value in the future.

    What to do now? The management of cities, states, or any other entities must be examined with sustainability in mind. Sustainability means a process should be feasible forever, not 20, 50 or 100 years only. This means looking at how the money is managed since the money is the constraint that most organizations have. The famous responses of "we cannot afford this" or "we don't have the budget for that" are symptoms of this constraint. Why all this fuss about one city? It is likely that what happened in Detroit can and will happen anywhere. A lot of attention is being given to these bankruptcy court cases because they will set a new precedent for state and city laws with respect to pension payments, salary payments and who is prioritized when money is not managed properly. (2) A canary in the coal mine? You bet!

    Sources:

    1) http://business.financialpost.com/2013/07/24/detroit-bankruptcy-hearing-begins-as-lawsuits-to-slow-process-pile-up/

    2) http://www.montrealgazette.com/business/First+hearing+Detroit+bankruptcy+city+wants+judge+freeze/8701198/story.html

    3) http://www.cbc.ca/news/business/story/2013/07/19/f-vp-pittis-detroit-business.html

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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