Detroit Swap Banks Go First as Bankruptcy Looms: Muni Credit
Wall Street firms that sold interest-rate swaps to Detroit as part of $1.4 billion of pension-bond issues stand to get paid before investors and the retirees the borrowings were supposed to help.
In 2009, the companies -- UBS AG (UBSN) and SBS Financial Products Co. -- could have forced the city to pay a fee to end the agreements, which were designed to cut the cost of the debt. Instead, the firms struck a deal giving them a claim on Detroit’s gambling-tax revenue, guaranteeing they’ll get paid $50 million a year.
Under Emergency Manager Kevyn Orr’s proposal last week to restructure the insolvent city’s finances, the payments get priority over promises to retirees and holders of unsecured debt, including the pension borrowings. Being ranked among secured creditors gives the banks the same protection as investors in water and sewer bonds or general obligations secured by liens on state aid.
“Providers of derivatives have been very careful to make sure they’re at the front of the line,” said Robert Brooks, a professor of risk management at the University of Alabama in Tuscaloosa. “The idea is to get to be first in line if you’re worried about a bankruptcy.”
Orr has said filing for protection from creditors is a last resort. Detroit, with about $17 billion of liabilities, would be the largest U.S. municipal bankruptcy.
The $50 million in bank payments, equivalent to almost 5 percent of Detroit’s annual general-fund revenue, could go toward public safety and street lights in the city of 701,000. The population has dropped about 25 percent since 2000.
Bill Nowling, a spokesman for Orr, didn’t respond to a request for comment. The derivatives obligations are “subject to negotiation with holders,” Orr said in last week’s proposal.
Under Orr’s plan, gambling levies from the Greektown Casino and two other sites go toward paying the derivatives, known as interest-rate swaps. In contrast, at least $5.58 billion in general-obligation, pension and other debts are backed only by the city’s promise to pay.
Municipal borrowers nationwide, including Detroit’s utilities and Louisiana, have paid at least $4 billion to banks to end interest-rate swaps that were supposed to lower borrowing costs. In the contracts, a locality and bank agree to exchange interest payments. If Detroit needed to unwind the swaps today, it would have to pay about $343.6 million, according to documents in Orr’s plan.
“The biggest winners of all in this are the sharks in the municipal-bond market,” said Greg Bowens, a spokesman for Stand Up for Democracy, a Lansing, Michigan-based group that campaigned last year to repeal the law allowing appointment of a financial manager.
Detroit’s unionized workers were pressing to safeguard their pensions when the city borrowed in 2005 and 2006, anchored by swap agreements with Zurich-based UBS and SBS Financial Products. The goal was to invest the proceeds and use the profits to bolster its pensions.
The agreements swapped floating-rate payments into fixed ones to protect against the possibility that interest rates would rise. The strategy backfired when interest rates sank during the recession that ended in 2009 as the Federal Reserve reduced its benchmark borrowing rate near zero.
SBS Financial, created by some owners of New York-based Siebert Brandford Shank & Co., provides swap agreements to the bank’s clients. Through a credit agreement, Merrill Lynch & Co., now part of Bank of America Corp., backed up SBS under the contracts.
“It’s not unusual for banks to come out ahead,” said Darrell Duffie, a finance professor at Stanford University in Stanford, California, who has studied derivatives markets. “They’re experts on handling restructuring.”
In 2009, facing a possible swap-termination fee equal to one-fourth of its budget, the city pledged the gambling-tax revenue as collateral. Since then, the city has been paying about $50 million a year, with $878.7 million expected through 2035, according to Orr’s report. The city budgeted about $57 million for public lighting this year.
Swap providers have been reluctant to let municipalities out of termination payments or other promises under the contracts, said Peter Shapiro, managing director with Swap Financial Group LLC in South Orange, New Jersey. The firm advises municipalities and other entities on swaps.
Oakland, California, officials are considering firing Goldman Sachs Group Inc. from underwriting bond issues because the company has refused to end a 1998 swap without a $14.8 million termination fee.
JPMorgan Chase & Co. was an exception, in the case of Jefferson County, Alabama, Shapiro said. In 2009, the bank agreed to pay $75 million and forgive $647 million in derivative fees to settle with the U.S. Securities and Exchange Commission over undisclosed payments to local bankers.
Municipal investors traditionally have seen unsecured general obligations as less risky than special-revenue bonds, a category that is considered secured debt and includes the swaps contracts.
“Outside of bankruptcy, the municipal markets place great value on general-obligation bonds because they are backed by the full-faith-and-credit promise of the government,” said Patrick Darby, a bankruptcy attorney in Birmingham, Alabama, at Bradley Arant Rose & White LLP who represents Jefferson County. “If you are in Chapter 9, that means you don’t have enough money to keep your promise.”
In bankruptcy, investors in unsecured bonds run the risk that the municipality will force them to take less than they are owed, with no minimum recovery. Special-revenue debt must be repaid using the funding stream pledged as collateral, such as water fees, Darby said.
“Unsecured creditors need to understand that they’re really at the back of the line if there are derivatives in play,” said Brooks at the University of Alabama.
In the $3.7 trillion municipal market, Los Angeles is set to sell about $1.3 billion of notes next week, the biggest offer on the local-debt calendar. The securities mature in February.
Local debt is trailing Treasuries this month and is on pace for its biggest monthly decline this year. Munis have lost about 1.8 percent this month as of June 19, compared with a 0.7 percent loss for Treasuries, Bank of America data show.
The ratio of the interest rates, a gauge of relative value, is about 97 percent, down from above 110 percent last week. The lower the figure, the more expensive munis are compared with federal securities.