Detroit And The Rule Of Empathy

Investors and borrowers were rankled that Thursday's bankruptcy filing was expected to hit bondholders of some of the city's general-obligation debt following a proposal by Detroit's emergency manager, Kevyn Orr, to rank these bonds alongside other unsecured debt. Some investors expressed surprise that the city could slash the general-obligation bonds' value, as they are backed by Detroit tax revenue and payments are guaranteed by the Michigan Constitution. "I understand the strategy of trying to break out from the [unsecured creditor] herd and say, 'I'm different,' " Mr. Orr said. "But, from our perspective, unsecured creditors share in the unsecured creditor pool." Michigan Gov. Rick Snyder also said that these bondholders should have recognized the risks they were taking when they bought the bonds. "These are sophisticated buyers….This is not your couple living out in the Midwest going through the mortgage crisis," he said.

--WSJ, July 26, 2013

Michigan governor Rick Snyder believes that Detroit’s bondholders should have recognized the risk that, in banana republics, contractual obligations are unenforceable. He also believes that sophisticated investors should be subordinated because, well, because they’re sophisticated, and probably rich as well. If Mom and Dad owned the bonds, that would be different because Mom and Dad didn’t know that they were living in a banana republic when they bought the bonds. And Mom and dad aren’t rich.

Of course, Michiganders already know how worthless bond indentures can be: they are not enforceable if the company in question employs a lot of Democratic autoworkers. Employees come before bondholders, everyone knows that. We’ve already seen this movie in California, where the public sector unions have trumped GO bondholders in Stockton and elsewhere. Pensions are sacred, while bond indentures are so yesterday. And anyway, bondholders are rich.

You may recall that the incumbent president once said that, in choosing a Supreme Court justice, he wanted a judge with empathy. Not a commitment to the rule of law, but empathy. An empathetic judge will always rule on behalf of the weaker party, irrespective of the facts in the case. An empathetic judge will put his finger on the scales of justice in favor of the poor, the sick and the elderly. In other words, an empathetic judge is not blind like the famous statue, but rather has big open eyes and stares empathetically at the plaintiff or the defendant or the pensioner.

There is nothing inherently wrong with replacing the Rule of Law with the Rule of Empathy. France did that a long time ago, and they’re still chugging along. But it does require that, going forward, bond investors must appreciate that they have no contractual rights, and that they shouldn’t waste their time reading the covenants. In America today, a GO bond is just as good as a Czarist war bond.