Will Detroit debt sink bonds?

Detroit is in bad shape: It’s population is way down, some neighborhoods are abandoned, the city is more than $17 billion in debt—and now officials are skipping payments. Kevyn Orr, Detroit’s emergency city manager, is attempting to make a last-chance deal to prevent a costly bankruptcy battle. The outcome could affect the ability of cities across the country to raise money through municipal bonds.

Municipal bonds have long been seen as a safe investment because even in bankruptcy, bondholders were among the first in line for payouts. But Detroit’s unprecedented debt—$25,000 per person in a city where a third live below the federal poverty line—could see that change. Some proposals by the city give some bondholders as little as 10 cents on the dollar and cut pensions to the bone.

That is leading many bondholders to believe they could actually get more in bankruptcy than in a last-ditch pre-bankruptcy deal. The legal battle, however, would pit Michigan laws against federal laws.

Michigan law protects pensions and retirement plans, but that conflicts with federal statutes. In such a high-stakes case, the U.S. Supreme Court may have something to say before all is decided. Lawyers argue the Tenth Amendment—powers not given to the federal government or prohibited to the states are reserved for the states—gives Michigan law priority.

If the court rules against such an argument, it will put unions on high alert for their pensions in struggling municipalities across the country. And if the court goes the other way and bondholders take never-before-seen losses, they may no longer trust struggling municipalities to follow through on debts. The bond system is old and respected, the way many cities pay for all kinds of projects, including schools and community colleges.

The bottom line, though, is that no one knows. Other bankruptcies have been smaller, or like in Stockton, Calif., proceedings aren’t far enough along to guide Detroit’s steps. American political scholar and Detroit native Michael Barone doesn’t seem optimistic: “Those who have visited both Detroit and Hiroshima will have trouble guessing which country won that war.”