Only now that the narrative around Detroit is pretty well established – city in long-term decline whose distress was intensified by a series of corrupt city governments, compounded by state governments that were opposed to Detroit’s interests – does an important additional factor come to light, that of derivatives losses.
While the bad derivatives bets were far from large enough to have changed the outcome (one commentator called the bankruptcy a “five-decade Katrina,”) it’s another example of how Wall Street wins, even on a relative basis, while little people lose.
Just as Jefferson County, which was faced with big payments (this for a massive sewer project) and got snookered by Big Finance in its efforts to minimize the costs of its funding. Detroit did JeffCo one better by first going the extend and pretend route by borrowing $1.4 billion in 2005 to address its pension shortfall. The piece de resistance was a series of derivatives done in connection with that financing.
The problem is that the most detailed account on this so far, from the Financial Times. leads me scratching my head as to how much the derivatives trades cost Motown. Here is the overview of the transactions:
…the city government decided to deal with the underfunding…. by establishing two service corporations, which in turn established trusts which sold so-called Pension Obligation Certificates of Participation to investors – in effect IOUs.
The city also bought credit insurance which would reimburse these investors if the trusts defaulted. (The trusts, meanwhile, relied on the city to make payments so they would not default.)
At the time, it was cheaper for Detroit to issue floating-rate debt and then fix its interest payments by buying an interest rate swap than it was to issue fixed-rate debt. So the service corporations went to Merrill Lynch and UBS and bought interest rate hedges to protect from the possibility of sharply rising interest rates.
These interest rate hedges quickly turned into a problem for the city, because a downgrade in Detroit’s credit rating and other factors in 2009 triggered a clause forcing Detroit to buy itself out of the deal, at a cost of several hundreds of millions of dollars. Detroit averted that potential crisis by signing a deal that backed future payments with tax revenues from the city’s casinos.
Prior to the BK filing, Merrill and UBS, who were secured creditors by virtue of these deals, were willing to take a 75% haircut on $340 million. Municipal workers (remember, not eligible for Social Security) were asked to take 90% reductions and other unsecured creditors, over 80% losses.
Now $340 million sounds like chicken feed when you compare it to the gap on the unsecured creditor part of the discussion, which was the $2 billion the city offered pre-bankruptcy versus the $11 billion of liabilities. Here’s where I am not certain that the $340 million figure, which comes from the Wall Street Journal, and corresponds to the “several hundred million” in the Financial Times extract, is comprehensive. We also have this bit from the FT:
As of the end of June, the negative value of the derivatives was almost $300m, according to material from Ernst & Young submitted as part of the bankruptcy court filings. By the time the city ultimately pays off the $1.4bn in borrowing, the total bill just from 2013 onwards will be over $2.7bn, or almost double the original debt, of which $770m will be the cost of the derivatives – far more than the $502m in interest payments, these filings add.
Now the differences, I assume, result from the fact that the positions are still open (as in the valuations change on a daily basis) plus there may be differences in valuation methods among various experts. As I read it, the losses on the derivatives are that $300 to $340 million. But what termination fees would be applicable? I’m assuming they would be considerable. I’m also assuming that they weren’t included in the banks’ negotiation ask because a. banks are suddenly getting a lot of heat in the media, and the banks had a rare moment of semi-circumspection and b. the termination fees might be voidable in a BK (can BK experts confirm or deny?).
The other bit that is unsatisfying is that we seldom see the true cost of these bust deals. We get the usual narrative of “well it looked like a good idea at the time” because borrowing floating and swapping into fixed is cheaper on paper. But the cost of all those hidden risks (the options) built into the deal is never included in that computation. I wish it would become routine for someone with access to muni databases to do a quick and dirty: “Here’s what the deal would have cost if they had done a simple fixed rate financing. This is what it actually in the end cost them.” Having a running roster of the amount of damage done by clueless governments listening to financial sirens might help give the locals the hard data to say, “Thanks but no thanks” when the derivatives pushers come calling.