As Nobel Prize-winning economist Joseph Stiglitz sees it, banks that sold interest-rate swaps to Detroit “should be at the bottom in line” among those paid in the city’s record bankruptcy.
Instead, they may be first, ahead of retired city workers and investors. UBS AG and Bank of America Corp., which sold the swaps to the city as a way to cut the cost of borrowing for pension contributions, won the preferential treatment in 2009, four years before Detroit’s $18 billion bankruptcy filing. The banks probably will get 75 percent of what they’re owed while unsecured bondholders and pensioners will get less than 20 percent under Emergency Manager Kevyn Orr’s plan to restructure.
“It’s a perversity when those with no skin in the game have a better chance of getting paid than those who put up real cash,” said Joseph Fichera, chief executive officer of Saber Partners, a New York financial adviser to companies and governments. “The bondholders had money at risk up front, skin in the game, with a promise for future payments.”
The city’s bankruptcy, the largest municipal filing in U.S. history, highlights weak regulation of banks and advisers that structure deals in the $3.7 trillion municipal-bond market, said Marcus Stanley, policy director for Americans for Financial Reform, a Washington-based group that seeks stronger bank regulation.
“It’s a glaring example of why we need stronger regulation of the banks and advisers who put the money of investors and taxpayers at risk,” said Stanley. The bankruptcy shows “what happens to cities when they’re sold products that only benefit the banks.”
Detroit was among dozens of cities, counties and school districts that once purchased unregulated derivatives contracts from Wall Street banks, a step that promised to reduce borrowing costs.
Interest-rate swaps are derivatives in which two parties agree to trade interest payments on a set amount of debt, letting one side create a fixed payment on variable-rate debt. They were sold to municipal issuers as a way of cutting borrowing costs on debt with variable interest rates as well as a hedge against rising rates.
Public officials were often unaware of the large bank fees and risks associated with such trades, which resulted in billions of dollars in unexpected costs. As borrowing costs fell to near historic lows in recent years, the agreements backfired and forced U.S. municipal borrowers to make more than $4 billion of payments to end them, according to data compiled by Bloomberg.
Policy and public-finance specialists are questioning traditional assumptions used to set priority in bankruptcy. Stiglitz, 70, an economics professor at Columbia University who won the Nobel Prize in 2001, and Robert Johnson, president of the Institute for New Economic Thinking, a New York public-policy organization, questioned the treatment of retired city workers and general-obligation bondholders in a conference call with reporters last month.
Orr’s treatment of general-obligation holders as unsecured, even though they expect to have the full backing of a government borrower, also has drawn the wrath of investors and analysts. Orr, 55, was appointed by Michigan Republican Governor Rick Snyder.
“I have a problem when people give 40 years of their lives to earn a pension and now we want to take that away,” said Johnson in a interview. “It’s a terrible precedent.”
Detroit next month will ask U.S. Bankruptcy Judge Steven Rhodes for permission to buy its way out of the swaps contract at a discount as part of a settlement with UBS and Bank of America.
Under the proposal filed by the city on July 18, swap providers would be paid at least 75 percent of what they’re owed, depending on when the contract is canceled. City attorney Corinne Ball, a partner at Jones Day in New York, said in court on Aug. 21 that the discounted value of the swaps was about $190 million.
That means the swaps providers are owed about $253.3 million. Retirees and many of the city’s other unsecured debtholders, with about $11.5 billion of claims, were asked to take about $2 billion, or 17 percent, under Orr’s June 14 proposal.
Bond insurer Syncora Guarantee Inc. has asked the judge to reject the settlement. Syncora is also suing the swap providers in federal court in New York over the settlement.
Syncora is seeking to stop the swap providers from settling with the city, claiming that the bond insurer could be economically harmed by the deal.
Detroit now owes $1.4 billion from debt it issued in 2005 and 2006 to fund its pension contributions. That includes fees of $108.2 million to sell and insure the debt. About $18 million of that went to underwriters, including UBS and Merrill Lynch, which later became part of Bank of America.
The swap providers may be paid ahead of other creditors because they negotiated to have payments to them treated as secured debt backed by collateral, said Mark Berman, a bankruptcy attorney with the law firm of Nixon Peabody in Boston, who isn’t working on the Detroit case.
“Secured creditors are at the top of the food chain,” he said.
Swap providers protected their position in 2009 when Detroit faced paying about $400 million to end the agreements after its ratings were cut. In exchange for not pushing the city to make the payment, equal to about one-fourth of its budget, the banks asked the city to agree to pledge a secured revenue stream from gambling tax revenue.
“Everyone was facing the possibility of a massive default by the city,” Ball told Rhodes at the Aug. 21 hearing. “So the city did the responsible thing.”
The agreement vaulted the swap providers ahead of other creditors, including those who bought the $1.4 billion of bonds sold in 2005 and 2006 for pension costs that were tied to the swaps.
“The holders of those derivatives got moved up in the capital structure,” said Johnson. “The settlement raises the question of whether the city officials who entered the agreements knew what they were doing.”
By settling with the swap providers, Orr freed up about $10 million a month. Under the agreement, the city was paying the providers about $50 million a year. Orr’s settlement saves the city $80 million and provides funds to improve city services, said Bill Nowling, Orr’s spokesman, in an e-mail.
Bill Halldin, spokesman for Bank of America, and Karina Byrne, UBS spokeswoman, declined to comment on the arrangements.
Changing bankruptcy policy to prevent any debt, even one generated by a losing swaps contract, from being backed by collateral would be a mistake, Berman said.
“It’s a way to ensure yourself that you’re going to get paid,” he said. “There is no reason in my mind why anybody dealing with a borrower shouldn’t be able to analyze the risk of payment or default and where the risk is high to negotiate for collateral.”
Congress in 2010 approved the Dodd-Frank law that regulated derivatives for the first time. Rules since adopted by the Commodity Futures Trading Commission place stricter standards on banks when entering into contracts with municipalities. Separate rules enforced by the Securities and Exchange Commission require greater disclosure of the risks in bond deals such as the one in Detroit.
Cities shouldn’t be allowed to use their money to bet on interest rates, Stiglitz said in last month’s conference call.
“Municipalities have a long history of betting and not getting anything in return,” said Robert Brooks, finance professor at the University of Alabama in Tuscaloosa, in an interview. “That’s not a strategy municipalities should be pursuing.”
States and cities plan to borrow $4.5 billion of long-term debt next week, led by California’s $764 million general-obligation bond deal, data compiled by Bloomberg show.
At 3.1 percent, yields on benchmark 10-year muni bonds are at their highest since April 2011, data compiled by Bloomberg show. That compares with 2.9 percent for Treasuries with similar maturity.
The ratio of the two yields, which shows relative value, is about 107 percent, higher than the five-year average of 101 percent, data compiled by Bloomberg show.
Following is a pending sale:
Atlanta will sell about $568.7 million in revenue bonds tied to its water and sewer system as early as Aug. 26 to finance refunding of earlier debt, a sale document shows. The system had about $596.7 million in 2012 operating receipts, with about $404.5 million available to repay obligations, according to the document. It lists about $3.2 billion in long-term debt as of March. The tax-exempt bonds are rated Aa3 by Moody’s Investors Service, its fourth-highest grade. Units of Wells Fargo & Co. and Goldman Sachs Group Inc. are managing the sale.