Detroit Put In Pretty Minimal Effort to Avoid Its Debt Ceiling
Oh man do I not understand municipal finance. The lawsuit that Detroit filed on Friday, to try to get out of paying some of its bonds (and related swaps), is very sad and very strange, and it is about a very goofy trade. But that goofy trade was apparently a masterpiece of municipal finance. It was "The Bond Buyer's Midwest regional Deal of the Year" for December 2005. 1 I don't get it.
In 2005, Detroit had a problem. It owed its municipal workers' pension plans $1.7 billion, and was constitutionally required to pay them. It didn't have $1.7 billion. And it couldn't borrow $1.7 billion, because a state law imposed a debt ceiling on all Michigan cities, and Detroit didn't have $1.7 billion worth of room under its debt ceiling.
So instead of borrowing $1.7 billion, it entered into "service contracts" with two "Service Corporations." The Service Corporations, which were brand-new shell companies staffed with Detroit city officials, would provide Detroit with $1.7 billion worth of services, and in exchange, Detroit would pay the Service Corporations $1.7 billion over the next 20 years. I mean, $1.7 billion plus interest. A present value of $1.7 billion.
Those numbers are a little off, but the point is, that's not debt, that's just a contract. The debt ceiling applied to debt, but not to regular contracts. Detroit could, for instance, enter into an employment contract with a police chief. It could agree to pay the chief $100,000 for a year's work. That wouldn't create $100,000 of "debt" for debt ceiling purposes. A contract where Detroit agrees to pay money in the future for services in the present and/or future is not "debt," in common usage or apparently in Michigan law. "Debt" is only a particular form of contract where:
- You give me money now, and
- I agree to pay you money later, and
- that's it. 2
What services did the Service Corporations provide? Well here is the technical answer:
In their respective Service Contracts, the Service Corporations have agreed to perform the service in the current year and in future years of reducing the financial burden of the Subject UAAL of the GRS or PFRS, as applicable, by funding a specified amount of such Subject UAAL and related Ancillary Amounts on the Closing Date. In return for such present and future services, the City has agreed in the Service Contracts to make the COP Service Payments and certain additional payments (collectively, Contract Payments).
There are some abbreviations there, but the key words are "reducing the financial burden ... by funding a specified amount ... on the Closing Date." That is, the service provided by the Service Corporations was to give Detroit money, in 2005, to give to its pension plans. And in exchange for that service, Detroit would pay the Service Corporations "Contract Payments" for the next 20 years.
The service was "give me money now." That's, um, debt? The Service Corporations, of course, got the money by issuing bonds -- er, "Certificates of Participation" -- to investors. The COPs were backed by the amounts Detroit owed to the Service Corporations. For services. The Service Corporations did nothing else, so the COPs were in effect pure pass-throughs of Detroit's obligations -- contractual obligations, I guess -- from the city to the bondholders.
Detroit's emergency manager is asking a court to invalidate this whole thing because there were no services, it was just debt by another name. And ... I mean, he's obviously right about that? Which doesn't necessarily mean that he should win! Just because something was obviously designed to dodge a rule, doesn't mean that it didn't work.
Also, there are equities the other way too. Detroit really did need the money in 2005 -- it was obligated to fund those pensions -- and it didn't have a way to get that money. Its banks thought up a ... creative? ... way for it to get the money. Here is a good DealBook article about the difficulty of the situation, which notes that the banks that concocted this plan "are dismayed now to see themselves portrayed as shady characters in the new lawsuit." I mean, pretty much anyone portrayed as a shady character will feel dismayed, that's just a normal reaction, but here they have a point: "as they see it, the city already had a crushing debt to its own workers, much of which was hidden, before they arrived on the scene." I dunno, that seems fair.
Mostly I am just boggled by how simple this was. Corporations do sometimes try to manipulate their debt figures by characterizing things as "contracts" that are "really" debt. Most classically, the difference between leasing a durable good for a long time, and borrowing money to buy it, is fuzzy, so there are accounting rules designed to clarify when a lease should be treated like a "regular" contract (no liability up front, deduct payments as they're incurred) and when it should be treated like debt (liability up front). Similarly off-balance-sheet securitizations sometimes walk a fine line between "selling" assets and "borrowing against" them, and again there are rules about which is which. I suppose there are other, dodgier flavors of debt recharacterization that the accountants haven't figured out. I'm sure they're delightful.
But surely no company would reduce its debt by just entering into a "service contract" with a shell company that provided the "service" of giving it money, and got that money by issuing bonds to investors? Come on! That would be way too easy. My intuition is that "too shady for corporates" is a good warning sign that municipalities shouldn't do it, but I get the impression that that rule of thumb is violated a lot.
Anyway. I guess there's going to be another debt ceiling fight in Congress? Ugh. I have told you my preferred debt ceiling dodge to avoid that fight. It is not a particularly complicated or clever dodge, but after reading about Detroit I'm beginning to think it's more sophisticated than it needs to be. Just set up The United States Debt Service Corporation, and have it provide the service of giving Treasury some money every month. In exchange for that service, Treasury can enter into a contract to pay the USDSC money in the future. A lot like debt, really, only different! Also, not different. But it's a "service." Then USDSC sells bonds backed by those contract payments and, voilà, ceiling-free debt. It worked so well for Detroit!
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See Exhibit G to Detroit's complaint (page 444 of 799 of the PDF).
I guess there could be a little bit of other stuff -- debt has covenants, usually -- but the point is, it's present money for future money. As opposed to present/future services for future money.
That's page 1 of the offering circular for the 2005 Certificates of Participation, attached as Exhibit A to Detroit's complaint (page 28 of 799 of the PDF).
(Matt Levine writes about Wall Street and the financial world for Bloomberg View.)
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