Time to begin fixing Detroit’s fiscal problems

February 21, 2013

Political moves have drawn some financial data to the surface about Detroit as the city’s long spiral downward continues. Detroit’s Financial Review Team, appointed by Michigan Governor Rick Snyder, filed its report after a study of the ailing city’s finances.

The review team essentially gave the city an “F” and pointed to multiple instances where actual spending did not match budgeted spending (see Table 3 in the Report). Part of this is because Detroit public officials had very little control of the budget process and the city has substantial deficits and declining revenues. However, one bright spot in the numbers is how city’s expenditures have been declining. You can see this in the chart below:

These numbers don’t look like the city has problems, but they also don’t tell the entire story. There are other expenses that have created deficits. There have been bond offerings to fill the deficits, which have increased annual debt service to about $150 million per year. But operationally a lot of credit must be given to Detroit Mayor Dave Bing for tightening the fiscal ship.

The Detroit News ran a groundbreaking story on Thursday, “Half of Detroit property owners don’t pay taxes,” that found that $246 million in property taxes went unpaid last year. From the story (emphasis mine):

Nearly half of the owners of Detroit’s 305,000 properties failed to pay their tax bills last year, exacerbating a punishing cycle of declining revenues and diminished services for a city in a financial crisis, according to a Detroit News analysis of government records.

The News reviewed more than 200,000 pages of tax documents and found that 47 percent of the city’s taxable parcels are delinquent on their 2011 bills. Some $246.5 million in taxes and fees went uncollected, about half of which was due Detroit and the rest to other entities, including Wayne County, Detroit Public Schools and the library.

Delinquency is so pervasive that 77 blocks had only one owner who paid taxes last year, The News found. Many of those who don’t pay question why they should in a city that struggles to light its streets or keep police on them.

Detroit does have very high property taxes and low property values. Another Detroit News story laid it out:

Detroit ranked first among the 50 largest cities in taxes and last among property values in a 2011 study by the Lincoln Institute of Land Policy in Cambridge, Mass. Detroit taxes on a $150,000 house were $4,885, twice the national average of $1,983. The city’s average house price, $16,800, was nearly 10 times lower than the next lowest, Mesa, Ariz.

Detroit is not the only city that has faced such challenges in collecting property taxes. Charlie Henneman, of the Chartered Financial Analyst Institute, wrote to me about how New York City faced similar problems in 1996. New York had a lot of unpaid tax bills (liens), so it bundled and securitized them and sold them to investors. Charlie explains what happened (from his email):

Just following up on the tax lien conversation, here’s a report on New York City’s experience that I just found while looking for an old Credit Week article I wrote (but couldn’t find online).

I was in structured finance at S&P and developed ratings criteria to apply to a pool of property tax liens. I spent two years on the conference circuit talking about tax lien finance.

They are different from one jurisdiction to another, so require a lot of analysis, and New York had to change the law in order to make the transfer legal, but they were able to do so. In 1996 New York had I think a couple of billion in unpaid taxes. The city was nervous about the PR, but moved forward because they were desperate for cash. They were some egregious cases that helped sell the public.

The liens were sold through a trust that issued securities backed by the collateral. It had a liquidity reserve, and two servicers one of which was a major commercial [real estate] asset manager, to foreclose and liquidate properties if necessary. (JR Robert, if memory serves). The goal was to monetize unpaid back taxes and bring properties back to tax-paying status.

The city decided their first deal should focus on commercial real estate so they wouldn’t have to evict anyone.  Once they decided to do a deal, a lot of interesting things started to happen. Money started pouring in just from coverage of the deal in the paper (and it made the tabloids). An initial $500 million pool of collateral at the time of the announcement paid down to $251 million by the time the deal closed six or eight weeks later. Morgan Stanley was the lead and my counterparts had tons of stories, and told me a guy in a limo showed up to their offices with a suitcase full of cash to pay back taxes on several apartment buildings.

The deal performed really well and a lot of properties were rehabbed and brought back to productive status.

Based on the success in New York, Philly and DC followed up with deals of their own. The DC collateral was probably closer to what they’d see in Detroit…

Detroit needs to begin its restoration process by collecting unpaid property taxes. The city is desperate for cash, and if it does enter Chapter 9 bankruptcy, a move to collect unpaid property taxes will show the bankruptcy judge that the city made all efforts to right itself financially.

The best approach is for the city and state to work together as closely as possible to get through these substantial problems. Tribal politics serves neither the city nor the state at this point. Their first joint venture could be a process of collecting unpaid property taxes. Then the city could move on to addressing its long term liabilities (see chart):

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