Bad Derivatives Trades Added to Detroit’s Woes

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.

Jefferson County, which was faced with big payments (this for a massive sewer project), 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.

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  1. Yonatan

    Looks like a standard EHM play. Load the mark up with debt, taking fees and payments up front, open the trapdoor to trigger the default, then loot the assets. Read John Perkins’ “Confessions of an Economic Hit Man” to see this played over and over again elsewhere in the world.

    1. Jim Haygood

      ‘… borrowing $1.4 billion in 2005 to address its pension shortfall.’

      Double-entry bookkeeping, comrades. The proceeds of borrowing (cash) are credited to assets, but they are exactly offset by the liability of the new debt. Net change to equity: zero.

      Usually these trusts are intended to move obligations off balance sheet, avoid cash contributions to mask deficits, and to speculate on equities and interest rates.

      A classic prototype was the $2.75 billion borrowed in 1997 by then-N.J. governor Christine Whitman, in order to avoid a cash pension contribution and thus cut the state’s deficit.

      Effectively, N.J. leveraged up by buying stocks on $2.75 billion of borrowed margin. It worked great until March 2000 … then it didn’t. Not only did N.J. ultimately earn a negative rate of return on its leveraged spec, it also lost its AAA credit rating and is now one of the lowest-ranked states.

      What a fine legacy from a Sloane-ranger, horsey-set airhead with an investment banker husband. At least she’s shown the courtesy of removing herself from the public arena, unlike damaged-goods political lifers (I’m talkin’ to you, weiner man) who just can’t stay out of the ring.

      1. Systemic Disorder

        Yes, but Whitman’s Wall Street buddies made out like bandits, and that rather was the point. Whitman’s speciality was re-financing state debt at slightly lower interest rates with an extended period of repayment, temporarily cutting the budget in a trade for more interest payments over the longer term.

        When George Pataki was New York governor, he did the same thing. If I am not mistaken, Menem did this when he was president of Argentina, with the investment bank that did the restructuring work getting about US$100 million for its “work,” just in time before the Argentine collapse.

    2. nonclassical

      …”economic hit man” is composed of South and Central American “Chicago Boys” extortion, from 70’s, 80’s….Americans, unaffected, ignored the obvious-chickens would be home to roost…

      ..for documentation of roosting, view Naomi Klein’s, “The Shock Doctrine-Rise of Disaster Capitalism”:

      ($3.99 and free shipping)

  2. HS

    Since the Federal Reserve is printing $85 billion/month to provide a perpetual dumping ground for Wall Street’s garbage securitized assets, why don’t they buy Detroit’s Pension Obligation Certificates of Participation?

    Oh, wait. If they did that, then the crisis couldn’t be used as a model for municipal privatization, as Wall Street intends.

    1. Jron

      This was my first thought too. Municipal governments are always a little “corrupt”, but with Detroit it has been something the press has amplified. This serves two purposes, the public has little idea the mafia is working over the public domain and it accelerates privatization. I haven’t read much on NC about ending Democracy in Detroit, which was done with more press implying that the “children” needed to have that taken away from them too.

    2. steelhead23

      I suspect a bit of sarcasm in your comment, but I think you’re mistaken about the beneficiaries of such largess. It would not be the pensioners, but the banks that purchased that debt. I am among the crazies who believe that idiotic creditors should take a beating here. Rather than a bailout, I want them to take it in the shorts. Yes, this would mean that the bankruptcy could make Detroit virtually unlivable. Killing vampires isn’t easy or pretty.

      1. Susan the other

        The Fed can buy any asset it chooses. Munis included. So that’s a good question: why doesn’t the fed buy up the pension obligations of Motown? Those obligations are for all purposes munibonds because they are IOUs backed by default insurance and the dedicated proceeds of Detroit’s casinos. I’d say that is a much better deal than the MBS the Fed is so generously buying from the banksters. Let’s just leave the banksters out of this, go around them, and establish new conduits for democratic distribution. Direct interaction between the Fed and the cities.

        1. allcoppedout

          I live in sight of England’s spine – the Pennine hills. Every now and then, on a full blue moon once can see Britain’s latest deterrent silhouetted in the night sky. The pigs fly better than one might expect.

          Right answer Susan, and like so many, fit only for ridicule in today’s kleptocracy. I want to see these answers in practice. You’d think, once rolling this snowball would ‘gather moss’. I’m serious, yet the world is now beyond sense. I used to think there were enough of us to change opinion. The sadness of all this is that rationality has gone on holiday when needed in the fight.

  3. vlade

    Agree, I’d have liked the “fixed would be X, this was Y” comparison.

    Say, if the city had an IR swap with CSA (Credit Support Annex) – i.e. required to post collateral daily/weekly, it’s unlikely they took into account the cost of posting collateral (if you have to finance 300m on daily basis, it can get pretty expensive quickly).

  4. Kendra

    [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”]

    You mean the locals that trusted the sirens too before they ended up losing their homes? Also, why is it such a stretch to assume that the “clueles” folks in Government don’t have a vested interest in causing the “damage” to begin with?

      1. Minicannon

        Doesn’t sound like anyone would blame the ‘people’s represenative Gov’mint’ if everyone believed that’s what we have now. Jimmy Carter just said he doesn’t. The Kochs-CATOs and all that money are mobilizing the libertarians for the final solution, or as they like to call it, the golden free market.

        1. Nathanael

          Indeed. Now that Jimmy Carter has said outright that we do not have a “functioning democracy” (his words), perhaps something will start to change…

          It matters when famous people say things which everyone was suspecting.

  5. Jim Haygood

    Detroit’s evil plan to slash its health care liabilities: send them to the exchanges!

    As Detroit enters the federal bankruptcy process, the city is proposing a controversial plan for paring some of the $5.7 billion it owes in retiree health costs: pushing many of those too young to qualify for Medicare out of city-run coverage and into the new insurance markets that will soon be operating under the Obama health care law.

    Shame about the 13th amendment … otherwise Detroit could raise some serious cash by turfing out its citizens to terms of indentured servitude.

    But availing itself of Obuggercare will at least shake some change out from under the couch cushions.

    Thank you, Mister President! May we have a second helping, please?

  6. ENEN EverNewEcoN

    Privatize The Profits, Socialize The
    Marry To Monopoly For
    Maximum Effect.
    Cost Brake With Simpson-Bowles.
    Use The Adversity As A Profit Center.
    Where Sufficiently
    Severe, Use To Privatize.

    At It’s Outset, Medicare Was
    National Health Insurance For
    Unwanted Customers.

    Amtrak Was For Unwanted Customers
    For RR’s That Didn’t Want To Compete
    With Air/Highways During Their Growth
    Phases, Though Car Passenger Miles
    Are Usually Much Higher, Depending
    On Transit Planning.

    ObamaCare’s De Facto Quasi-National
    Health Insurance Built Exquisitely In
    The Fashion Of Privatize The Profits,
    Socialize The Costs, Pre-Textualize
    Blaming The Government For Cost, And Then
    Privatizing. Except, It Invented Skipping
    To Privatization From The Beginning.

    And Hence, One Doesn’t Wait For Simpson-
    Bowles Style Caps To Be Advanced. They’re
    Already Built In, Along With A Regime
    Of Fixed Profit Boxes.

    The Emergency Managers In Michigan And
    Detroit, Particularly, Thus, Are Essentially
    Analogous To Gordon Gekko’s Man At
    Blue Star Airlines.

    Romney’s Privatizing Britain’s NHS Piece
    By Piece, And ObamaCare’s Actually A
    Carbon Copy Of RomneyCare.

    RomneyCare’s Indeed A Great Improvement In
    The The World Of Trickle Down Economics,
    But Neither RomneyCare Nor ObamaCare
    Resembles What Could Be And Should Be
    In Health Care.

    1. F. Beard

      Where does one draw the line if not at zero percent? As the OT does except from foreigners (Deuteronomy 23:19-20)?

      1. Nathanael

        Inflation rate + 5%, which is as much as you can reasonably expect even for very risky investments. This is based on historical records.

  7. washunate

    “Only now that the narrative around Detroit is pretty well established…does an important additional factor come to light, that of derivatives losses.”

    Isn’t this exactly part of the narrative? The incompetence/corruption (pick your poison) of local leaders engaging in gambling because pension/healthcare promises were systematically underfunded?

    I agree Wall Street’s involvement in all this is, you know, criminal…

    but I’m confused what’s wrong with the narrative? If Democratic politicians all over the country hadn’t participated in the public/private partnerships of fraud and deception and can kicking, these things wouldn’t have happened.

    How many bank executives (and city leaders) did Detroit prosecute? How many years did the city budget adequately fund future promises at realistic rates of return and tax bases?

  8. Beatrice H

    People tend to forget that the 2005 Bankruptcy Act made derivatives a safe harbor in cases of bankruptcy. That means other creditors are the ones left holding the bag.

    1. run75441


      Good mention. I had forgotten how TBTF got their first in line status in Chapter 11 with the 2005 Bankruptcy Act which also slammed the door on students. And just in time for the 2008 Wall Street collapse.

  9. allcoppedout

    We abolished slavery and I was taught this was for moral reasons. Closer reading of the British case discovers a very ugly, economic solution – we paid off the slavers. My sense of derivatives and financialisation is that this is repeating on a grand scale and the plan is to indenture us all. Our ‘freed’ slaves had to put in 40 and a half hours for board and by the time you read the small print more than 60, plus growing their own on allotments. This ‘abolition’ was about opening up Africa for British manufactures.

    Derivative almost means piggy-backed. Calculation of the weight is almost impossible as it never seems carried on the original back and the money measurements are ‘nominal’ in a very special case of the term. The schemes were invented to confuse and draw us into sophisticated argument. Science and manufacturing process use databases that are more complex, but you can see how the links and statistical controls work. These systems also provide information on when to shut down the system for maintenance.

    I don’t know where Yves’ get her figure from here and would like to know more – I’m sure her informed guess is based on better knowledge than I have. It always seems to me that the opportunity costs of this financial chicanery are massive. Apart from people being thrown into poverty, if these schemes are so ‘clever’ we could apply them to such as going 90% ‘green’ in ten years as we wind-down the fossil fuel companies (a long cartel since at least coal mining in 19th century Europe keeping prices high). The effort could have gone into this 10 years ago.

    In this pigs might fly territory we are not allowed to do what is right, sensible, decent or even vote (Internet)on what direction we want to go. We are now derivatives in a liquidation auction getting the same treatment as ‘freed slaves’ watching the masters get paid off.

  10. vachon

    I feel like I’m the only person on the planet that has never traded derivatives. Where did I go wrong?

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