Detroit “Swaps” were Illegal; Now, What About All the Others Across the Country?

The Detroit Free Press reported on Tuesday, that in the City of Detroit bankruptcy case, a trial on the issue of whether Judge Steven Rhodes will authorize pre-bankruptcy interest rate swaps deals was suspended, when the judge ordered the City’s attorneys to go back and renegotiate with the banks for a better deal, and report back to him on Friday. The deals were negotiated — on the eve of the bankruptcy filing — with Bank of America and UBS to pay off old swaps deals.

Equally importantly, Judge Rhodes is pressing for documents in which the city assessed the legality of the 2005 swaps agreement. He wanted, the Free Press said, “to comprehend why the city agreed to pay 75 cents on the dollar to 82 cents on the dollar — it would be about $230 million today — to get rid of the swaps. The judge argued that 75 cents on the dollar is typically a great deal for creditors in bankruptcy.” He’s quoted, “How can I decide whether this was a fair settlement without understanding the city’s assessment of the strengths of its claim against the banks?” — i.e., in their decision a few days before the bankruptcy filing to settle with the banks rather than sue them for an illegal deal.

A September 25, 2013 Free Press article explored the issue of the legality of the 2005 swaps in the context of the ongoing bankruptcy case. The 2005 deal with a BOA/UBS entity, SBS Financial Products, involved “two layers of speculative financial instruments. The first of these was ‘pension obligation certificates of participation’ — essentially IOUs that allowed Detroit to borrow money to give to its two pension funds. The second layer involved interest rate swaps, a high-risk bet that Detroit lost. The certificates of participation carried a variable interest rate. So the city bought the swaps as a hedge against the risk that interest rates would rise. In fact, interest rates fell sharply during the 2008-09 financial crisis. The city lost the bet, adding to the pensions’ underfunding by as much as $770 million over the next 22 years.”

Further, “Under the terms of the swap contracts, the banks were owed up to $400 million in early 2009 when the city’s credit rating fell below investment-grade status. That could have triggered a bankruptcy filing then because Detroit couldn’t make the payment. But former Mayor Ken Cockrel Jr. negotiated a deal pledging casino tax revenue as collateral instead. That converted the swaps into ‘secured’ obligations, which means they must be paid off in bankruptcy.”

The September article speculated that were Judge Rhodes to reject the City’s settlement with BOA/UBS, the 2009 deal would become an open issue, and the City could argue that the pledging of the casino revenues as collateral was illegal. (At least one creditor, Ambac Assurance, has claimed that the 2009 pledge of casino revenues as collateral is contrary to the provisions describing allowable use, in the state Gaming Control and Revenue Act.) A ruling that that pledge was illegal would remove the collateral from the 2009 deal, converting it to unsecured debt, and BOA and UBS would be compelled to join the crowd of other clamoring unsecured creditors.

But the question of illegality appears to go back even to the original 2005 deal. Although the September article does not discuss this, one bullet-point in a sidebar to the article notes that “Michigan law prohibits borrowing more than 10% of the property value of the city. Certificates of participation were used as an alternate to issuing bonds as a way for the city to circumvent this borrowing restriction.”

All of this makes for a fascinating study in swindling. But what difference it will make, beyond the ins and outs of finance and the law, will depend in large degree on the political environment — what it will be possible to make the American people accept. That environment is one of growing resistance, organized in large part by LPAC’s campaigns, and reflected in the recent declaration of the Detroit Board of Education.

This entry was posted in Austerity & Bank Bailouts, Bail-in Policy, Banking System, Glass Steagall and tagged , , , , , , , , , . Bookmark the permalink.

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