Were Detroit’s Swaps Unfair?
(Corrects reference to issuers in 13th paragraph.)
The judge overseeing Detroit’s bankruptcy has rejected a $165 million settlement between the city and the banks that provided the city with interest-rate swaps. This startling development raises fundamental issues about the fairness of the original deals and the quality of the advice Detroit received before, during and after the transactions.
Although bankers typically aren’t responsible for ensuring that their clients get the best deal possible (they usually have no presumed fiduciary duty), securities laws and regulations require that bankers deal with clients fairly. And while fairness must be evaluated on a case-by-case basis, to paraphrase former Supreme Court Justice Potter Stewart’s quip about pornography, we know how to recognize it when we see it.
So, one big unanswered question in this debate is: Where were the regulators? State and local governments are supposed to be protected from Wall Street’s aggressive practices by securities laws and regulations, particularly Rule G-17, issued by the Municipal Securities Rulemaking Board. This rule, known as fair dealing, says that bankers must treat clients fairly and prohibits any “deceptive, dishonest or unfair practice.” That “or” is important.
In the last decade, interest-rate swaps were a hot financial product in state and local governments and not-for-profit debt issuance, known as the municipal market. Time was, most municipal issuers would sell plain vanilla fixed-rate debt such as 30-year bonds to finance their projects. But beginning in the 1990s and accelerating in the early 2000s, bankers increasingly persuaded governments to forgo simplicity and adopt a more complex arrangement that promised to create a “synthetic fixed rate” well below the plain vanilla one that would supposedly save governments millions of dollars.
There was a catch, of course. Cities had to enter into a series of transactions to achieve the simple goal of low-cost fixed-rate financing. They had to issue a floating-rate bond, and then they often had to buy bond insurance, purchase other financial products, pay dealers an annual fee for those bonds and then enter into a fine print agreement to “swap” payments of the floating rate to pay the swap provider a fixed rate.
But the swap bank usually wouldn’t swap or pay the actual cost of the government’s new floating-rate debt. It would only pay an amount tied to a bond index that was supposed to approximate the actual cost the government was on the hook to pay. And this would usually be required to continue for 30 years. Sound complicated? It is.
The banks also demanded to be protected should anything go wrong. They enforced a complex formula to determine the value of the deal if it was canceled before the end of 30 years. This formula to unwind the swap, in the parlance of the trade, was called the termination payment. It was designed to create a precise dollar amount for the future payout that was promised but was being canceled. And because this transaction, unlike any swap in the corporate market, was usually for 30 years, the termination payment could be huge when an issuer was most likely to cancel, particularly in the early years. This is the amount of debt, even after it was reduced through several rounds of negotiations, that the Detroit judge said is just “too much.”
One might wonder how a government employee could know about all this when evaluating, financing and determining whether such a deal is good for citizens. How evenly matched are the public servant making $80,000 per year and the big-bonus Wall Street banker making $500,000 a year?
Governments often hire advisers to help negotiate with the banks. Until the Dodd-Frank Act reforms, however, these advisers were unregulated and unlicensed, and there were no professional standards. My grandfather, a barber, had to have a license, but municipal advisers didn’t.
Furthermore, an adviser’s access to information (and often whether they were recommended for the job) was dependent upon the bankers with whom they were supposed to be helping governments negotiate. The bankers held most of the cards and most government officials relied upon the banker’s reputation, disclosures and analyses in making decisions.
This brings us back to fairness. Were the original deal and subsequent negotiations conducted according to the rules? Were they fair? The federal “fair dealing” rule sought to protect issuers such as Detroit and made them akin to a protected class. Yet, rules are only as good as their enforcement, which has been sparse, to say the least. The Securities and Exchange Commission is more likely to see governments as the perpetrators of security law violations than as the victims.
About 20 years ago, Orange County, California, one of the wealthiest areas in the U.S., went bankrupt because of interest-rate swaps on the investment side of the balance sheet. Litigation ensued as the county went after the bankers and recovered significant amounts.
Today, no issuer wants to sue their banker and have to potentially admit they didn’t fully know what they were doing. Moreover, most advisers and bankers have persuaded governments that the market would penalize them if they sued a banker. In other words, bankers would punish governments by refusing to sell their bonds or to make markets, or through other actions that would drive up their costs on the plain vanilla deals. (Titans of the corporate market such as Ron Perelman and Donald Trump apparently don’t know of this threat or aren’t intimidated by it, and often litigate to protect their interests.)
In the case of fair dealing on the swaps, a city can’t enforce the rule on its own. Regulators have to step in. So far, Detroit hasn’t asked for any help. But maybe the judge’s characterization of an interest rate swap as unfair will spur regulators to look into the origins of the deal. Everyone has an interest in determining if the playing field was level and whether bankers followed the rules. That’s known as market integrity.
Detroit is a glaring example of a much larger market problem exposed by the financial crisis: Swaps gone awry have burdened taxpayers and not-for-profit institutions across the U.S.
This has largely gone unnoticed because the tens of millions -- and in some cases hundreds of millions -- in termination payments imposed on cities such as Detroit have been simply plowed back into other bond issues that convert the swaps back to the deals the governments probably wanted to do in the first place. As one observer of the municipal market told me: In medicine, doctors bury their mistakes. In the municipal market, we refinance them.
The ruling of a federal judge and the resulting national attention should compel regulators to look into the origins of Detroit’s transactions and ensure they were done according to the rules. It is in the self-interest of both bankers and issuers to ensure market integrity is maintained.
(Joseph S. Fichera is senior managing director and chief executive officer of Saber Partners LLC, a New York adviser to corporations, governments and regulators on the financial markets.)
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