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A Swing and a Miss

September 21, 2013

“I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.”
– Paul Volcker

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Annual LIBOR rates fell below 1% in late 2009, when Detroit had promised to pay the banks 6%. http://research.stlouisfed.org/

Paul Volcker, the Former Federal Reserve Chairman, is very critical about Wall Street and has plenty to say about the way that the big banks have invested in financial derivatives on their own account.  He laments the “too big to fail” status that we’ve given to them over the past few decades.  He is widely quoted as saying that the last useful innovation from Wall Street is the ATM.

An interest rate swap is a very common derivative.  Here, two counter-parties agree to exchange cash in the future based on interest rates calculated against a notional amount.  For example, a borrower who only qualifies for a variable interest rate loan but desires a fixed rate, will find a party willing to pay it cash based on variable rates in exchange for the borrower’s payments based on a fixed interest rate.  The global market (notional amount) for these transactions is huge –  $500 trillion.  (By comparison, the US Gross Domestic Product, which measures the goods and services produced by our country’s labor force and property, is $17 trillion.)

When interest rates plummeted in 2008, many were stung by these financial arrangements.  Include Detroit.

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Financial engineering for Detroit’s 2005 bond issuances. Click the schematic to find an excellent article from the Detroit Free Press.

In 2005, Detroit issued $1.4 billion in bonds to help it shore up its underfunded pensions.  The sentiment was right, but the approach was badly flawed.  The transactions have Wall Street’s fingerprints all over them – they are classic examples of the type of financial engineering and legal positioning that brought so much damage the last few years.  The bond issuances were celebrated by Kwame Kilpatrick, Detroit’s mayor at the time and by Wall Street itself.  They even won a prize that the industry hands out to themselves.  A publisher called “The Bond Buyer” gave it the Midwest Regional Deal of the Year.  The financial firm that served as Detroit’s financial advisor bragged about its role and the finagling it underwent to structure the deals.

“This award is another great testament to the creativity and tenacity Baird demonstrates in helping our clients meet their financing needs,” said Keith Kolb, Director of Baird Public Finance.

“The Detroit Retirement Systems Funding Trust was Michigan’s first pension financing and the state’s largest municipal transaction on record. The offering enabled the city to have the flexibility to extend the amortization schedules upon receipt of local approval.

The challenge for Baird and the City of Detroit was to demonstrate the city’s clear authority to do the transaction, even though there is no single law that authorizes the transaction and there was no precedent in the state of Michigan for this kind of deal.”

“This was undoubtedly the most complex transaction I’ve ever been involved with,” said Tom Gavin, Managing Director in Baird’s Naperville, Ill. Public finance office, who worked with city officials, advisors and Baird associates Stephan Roberts and Robert Lewis for about a year to close the deal at the end of May 2005. “The law allows all of the elements of the deal, but doesn’t combine them in one place, so we had to put those elements together to demonstrate the city’s clear authority.”

These transactions were complicated and ultimately backfired.  Detroit locked in 6 percent interest rates to UBS and Merrill Lynch, but with changes in the markets just a few years out, found themselves on the wrong side of the deal.  In 2009, when the credit rating agencies downgraded Detroit’s bonds, the city was contractually committed to pay the two banks to get out of the deal.  Instead, the parties agreed to a separate deal in which Detroit secured the shortfall with future tax collections from the casinos that operate in the city.  In this second deal, UBS and Merrill Lynch maneuvered secured creditor status and as such, they stand to obtain priority payments over the pensioners, the bond investors and various other creditors in the city’s bankruptcy case.

At the time of Detroit’s bankruptcy filing, the derivatives themselves were $300 million underwater.  (UBS and Merrill have agreed to accept 75 – 82 percent, depending on how soon the city can come up with the money.)  The total loss on this bet will cost Detroit a minimum of $770 million – on debt issuances of less than twice that amount.  This exceeds the interest expense itself, $500 million.  All in, the total bill is $2.7 billion, including principal.

Kilpatrick pitched the deal to a skeptical city council for a full year as a way to prevent layoffs and save $277 million a year on pension obligations before they consented.  It was a swing and a miss and contributed to the city’s demise.

From → America

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