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A bright spot in Detroit's bankruptcy

July 26, 2013: 11:35 AM ET

While some are comparing Detroit with other recent muni bankruptcies, the truth is it has much bigger problems than other troubled cities. It's not necessarily bad news.

By Cyrus Sanati

130726110958-detroit-aerial-view-614xa-1FORTUNE -- Detroit's recent bankruptcy filing should be looked at by both investors and the media in a different light. Far from being a disaster -- the outcome of which will inevitably be a very long trip through the court system -- it could end up being a net positive for not just the city's beleaguered residents, but for both the debt markets and the nation as a whole.

That's because while the severity of the city's problems are far worse than in other municipalities, the core issues that have placed Detroit in front of a judge aren't as idiosyncratic as some would like to believe: entitlements. While entitlement spending and legacy costs aren't behind the recent spate of muni meltdowns, they are something that nearly all major cities will need to grapple with down the road.

Detroit's bankruptcy and the potentially disastrous impact looming for its pensioners could serve as the bargaining chip cities facing similar issues need in order to force their unions to come to some sort of compromise regarding ruinous pension and health care payouts. This could prevent a number of cities from repeating Detroit's mistakes, which could inject some much needed confidence back into the $3.7 trillion municipal bond market.

MORE: Detroit: After bankruptcy, then what?

Detroit has been a fiscal basket case for decades, thanks to a toxic brew of bad governance, high crime, and a shrinking population. No other city best embodies the death of U.S. manufacturing than that of Motor City with its abandoned lots, shuttered schools, and rickety infrastructure. So when the city filed for bankruptcy protection last week, few were surprised.

Detroit's bankruptcy filing has inevitably led to a flurry of comparisons with other municipalities, which have recently either defaulted on their debt or filed for bankruptcy. But such comparisons are off the mark. Those other cities and towns were pushed into insolvency mainly due to inept spending on city projects or because of drastic changes in property values, neither of which is behind Detroit's fall.

For example, the city of Harrisburg, Pa., was put into state receivership this year after the city struggled to pay off debts associated with an expensive trash incinerator project that ended up burning up more cash than garbage. Meanwhile, Birmingham, Ala.'s bankruptcy filing came about mainly because of a massive new sewer project that flushed billions of dollars of city cash down the toilet. And then there are the flurry of California municipalities experiencing trouble, like Stockton, Monrovia, Fresno, Mammoth Lakes, and so forth. The main issue there is the sharp drop in property values, which has zapped the revenue side of the city budget.

Detroit, however, is in hot water for different reasons. Indeed, of all of the city's problems, spending too much on city services isn't one of them. This is, after all, the city where the average police response time is 50 minutes, nearly five times longer than the 11 minute average in other U.S. cities. It is where 40% of its streetlights are inoperable and where in the last five years more than half of its parks have closed. Detroit has an unemployment rate more than twice the national average and only 7% of eighth graders are considered proficient in reading.

But of all of Detroit's issues, and there are clearly many, it is the sharp and relentless decrease in its population that appears to have hastened the city's trip to bankruptcy court. Detroit's population declined by 25% in the last decade, which has had a devastating impact on the city's finances. Since 2002, Detroit has experienced a 40% decrease in tax receipts and a 50% decrease in state funding because of this population drop. And while the city's expenses have also declined, they are down just 15% during the same time period. This disparity created a huge hole in the city's balance sheet, which has averaged around $100 million annually since 2008.

"The City of Detroit continues to incur expenditures in excess of revenues despite cost reductions and proceeds from long‐term debt issuances," according to a recent eport on the state of the city's finances issued by Detroit's state-appointed Emergency Manager. "In other words, Detroit spends more than it takes in -- it is clearly insolvent on a cash flow basis."

Detroit has little in the way of options when it comes to raising additional revenue. It can't jack up city tax rates, as they are already at the state-mandated legal limit, nor can it receive additional cash from Lansing, as state payouts are strictly linked to population size. Detroit could have turned to the debt markets as it has since 2008, but that would have just compounded the city's debt problems.

MORE: Detroit's benevolent dictator

So if the city can't raise more revenue, it must cut its expenses. But Detroit has already cut services to dangerously low levels, meaning that further austerity measures would barely move the needle. Detroit therefore needs to reduce its liability payments, which currently consume around 42% of the city's budget. This is the primary reason why Kevyn Orr, the city's "Emergency Manager" put the city into bankruptcy. He was unable to secure deals with Detroit's creditors that would have brought the city's debt payments down to a level that the city could handle.

But unlike Harrisburg or Birmingham, the debt Detroit issued is manageable. Indeed, only $675 million of the city's estimated $18 to $20 billion debt load is actually linked to general obligation (GO) bonds. It is expensive debt, yielding some 10% per year for investors, which is absurdly high for a muni bond, but it isn't what is drowning the city.

What has Detroit wrapped in chains is the estimated $15 billion in entitlement payouts the city owes its retired city workers. That number represents the present value of what it will cost the city to pay pension, health care and other retirement benefits it has promised its former city workers.

It is one thing to fall into bankruptcy because of a stupid mistake, like spending too much on a trash incinerator project, but it is another thing entirely to be in bankruptcy because of ballooning entitlement expenses. Detroit's problems are structural, so they require radical surgery. Unfortunately, the city waited till the very last possible moment to address this issue. It chose to slash city services and jack up taxes instead, which led to increased migration, thus making the situation even worse. The cuts in police coverage mean that Detroit has a violent crime rate that is five times the national average for large cities. Meanwhile its taxes on a per capita basis are the highest of all Michigan cities. Would you live there?

This is Detroit's reality, and it is now facing the issue head on. It wants its bondholders to take a haircut on what they are owed, but that would be a mistake. By setting that precedent, the city would potentially raise borrowing costs for both itself and the state of Michigan for years to come. Since Detroit took out that debt to pay its pensioners, that is where it needs to start cutting first.

But instead of working with the city, the unions have fought it by suing to keep their benefits at 100%. Bankruptcy takes away their ability to sue and forces them to work with the city to hammer out some sort of deal. This is a good thing -- time for delaying the situation is over. But the worst thing the city can do is to strike a compromise that still keeps the city's tax rates high and its services low. It will continue to lose people, jobs, and revenue if it doesn't make the city a nice place where people want to live and work. As such, Detroit should play hardball and threaten to flush its pensioners into Lake Michigan unless they take a deal that allows the city to get back up on its feet.

The unions are scared beyond belief, and, frankly, they should be. When private businesses cancel their pensions, the Pension Benefit Guaranty Corporation (PBGC) steps in and pledges to pay beneficiaries half of lost benefits. That is not the case with pensions connected to a government entity, which means that if Detroit is successful in canceling its pensions, then its former workers could theoretically lose everything. This is the card that Detroit should play -- and it just might have to -- because even if it wipes out its bondholders and throws its workforce on Obamacare it would still be in the red.

MORE: SAC Capital punished for the government's own failure

Cities and unions across the nation are watching the Detroit case as they are facing similar issues regarding pension and legacy costs. Large, former industrial towns with powerful unions, like Chicago and Philadelphia, now have to make the painful cuts to city services that Detroit made years ago. Chicago, for instance, laid off some 2,000 teachers this month to cover a $400 million increase in pension costs.

To be sure, no other major city is as far gone as Detroit when comparing revenue to legacy costs. Presently, Detroit spends around 43 cents of every dollar it takes in to service its legacy costs. Other large cities pay no more than 20 cents on the dollar. But while a default of another major city isn't imminent, that doesn't mean that it couldn't happen five or 10 years down the road. Chicago, for instance, will see its pension costs triple by 2015.

The worst thing for Chicago and its mayor, Rahm Emanuel, to do is repeat Detroit's mistake and continue to raise taxes and cut services to levels that make people flee to the suburbs. The time for negotiation is now, and Detroit's bankruptcy gives these cities a blueprint to work off to achieve some sort of compromise with its former and current city workers. At the same time, unions watching the drama play out in Detroit will be more apt to sit down and negotiate. Taking a moderate cut in benefits now is much better than losing them all together.

Detroit has been in trouble for years, but last week it finally waved the white flag. While some are comparing Detroit's bankruptcy with that of the other muni bankruptcies of late, the truth is Detroit has much bigger problems. Far from being a bad thing, Detroit's bankruptcy actually empowers the city so it can force its unions to listen to reason and work out some sort of compromise to prevent the city from slipping further into economic and political irrelevance. In doing so, Detroit's leaders and its unions will be ensuring that there is actually will be a city left that can pay something -- even if it is less than what it had promised in the past.

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