Promises, Promises … Detroit, Pensions, Bondholders And Super-Priority Derivatives

Unknown Detroit, Corner of Michigan and Griswold 1920

On July 18th, the city of Detroit filed for Chapter 9 municipal bankruptcy, the largest such filing in US history. After kicking the can down the road, with increasing desperation, for many years, then end of the line has been reached. The city is finally admitting that far too many financial promises have been made, and that the majority of these simply cannot be kept. It does not matter whether the promise-holders have a good case for receiving services or needing payments, or whether those promises are legally protected. Promises that cannot be kept will not be kept. It is as simple as that. To complicate matters, however, the architecture of the financial system prioritises promises, in a perhaps counter-intuitive, and certainly self-serving, manner. This will make the task of allocating extremely scarce resources to stakeholders lower down the financial food chain very much more difficult. It is time for a good look at the range of promises made, the competing needs of the recipients, the leverage enjoyed by powerful players in shoring up their own position, and the real world implications for municipalities far beyond Detroit.

Outside of Detroit, for the time being, one would hardly think the United States was standing on the edge of a major financial precipice. Optimism is riding high in America at the moment. Markets have been booming until recently, and consumer sentiment is at its highest level in a long time. People have been spending freely and having no trouble justifying it to themselves.


Are you feeling OK about things? If so, you’re in sync with the typical American consumer.

In fact, U.S. consumer sentiment hit its highest level in six years in July, as more Americans feel better about the economy. The Thomson Reuters/University of Michigan index climbed to 85.1 in this month’s report, from 84.1 in June. It is the highest level since July 2007.

Of course, consumers realize things aren’t perfect. The survey showed they expect interest rates to rise, and that they doubt the economic improvement can keep up the pace. Fear of higher rates has caused many to buy now what they otherwise might buy later.


As always, commentators extrapolate current trends forward and make their predictions for the future on the basis of those trends.


“This high level of confidence points toward a continued expansion of consumer spending in the year ahead,” [consumer sentiment] survey director Richard Curtin said.


Investors have been moving out of money market funds and into stocks and high-yield bond funds, throwing caution to the wind and chasing risk, just as they have done in the run up to so many tops before. It’s no surprise that sentiment echoes the summer of 2007, but people should really try to remember what happened after that. Things look good at a peak, but sadly at the peak there’s nowhere to go but down. That move appears to be underway, and cracks are already showing in the basis for the prevailing up-beat mood.

Optimism doesn’t dissipate in an instant though, even as the fundamentals send major warning signals. The July 18th bankruptcy of Detroit was one such signal, but the implications have scarcely begun to sink in. Despite concerns, the mainstream perception is that Detroit is unique, and not likely to spark a contagion effect. So far investors appear to believe that:


Strange as it may seem, Detroit’s bankruptcy filing—the biggest ever for a U.S. city—doesn’t appear to have unnerved the $3.7 trillion U.S. municipal bond market. Tom Hamilton, finance director of Norwalk, Conn., had no trouble finding buyers for $21 million in general obligation bonds on Aug. 1. Localities from Washington State to Alabama to Massachusetts planned to sell $8.6 billion in debt during the first full week of August, the most since April.

The momentum defies predictions that the muni market would go into a deep freeze following the Motor City’s financial collapse and Detroit Emergency Manager Kevyn Orr’s plan to impose losses on some bondholders. “There’s not a lot of evidence to show this has been the death knell for GO [general obligation] bonds,” says Craig Pernick, senior managing director at Chevy Chase Trust, which oversees about $1.1 billion in munis….

….”Detroit is an incredibly unique situation, and we don’t expect or think it should impact the state or other local communities, which should continue to be judged on their own credit ratings and histories,” wrote Terry Stanton, spokesman for Michigan’s treasurer, in an e-mail.


Detroit is far from unique:


“Everyone will say, ‘Oh well, it’s Detroit. I thought it was already in bankruptcy,’ ” said Michigan State University economist Eric Scorsone. “But Detroit is not unique. It’s the same in Chicago and New York and San Diego and San Jose. It’s a lot of major cities in this country. They may not be as extreme as Detroit, but a lot of them face the same problems.”


Detroit is merely the first of many municipalities to hit the wall, where the realization dawns that far too many promises have been made, and nowhere near all of them can be kept. Different classes of stakeholders are still assuming that their claims will somehow be protected. They are typically thinking of those claims in isolation, without considering the implications for other groups whose rival claims would have to be subordinated. It has been clear for a long time that we would reach this crunch point, hence we have considered the issue of promises that cannot be kept before (February 8, 2011) at The Automatic Earth:


An Unstable Tower of Breaking Promises

Municipalities, which have been borrowing for years to fund spending of all kinds, are shortly going to find it very much more difficult to access the money they would require to maintain their current spending. We are already seeing large scale layoffs in many places, and this is the thin end of the wedge….

….We have built our civilization on an unstable tower of promises. We have all been part of the problem, and now we must all look for ways forward that cause the least harm to the fabric of society. There are no ‘solutions’ in that there is nothing that will get us business as usual, but there are better and worse ways to address the intractable situation we are facing.


Abandoned Packard Automobile FactoryDetroit Today:

It is useful to look at the situation facing Detroit today, and the multifaceted predicament in which it find itself. It was once arguably the wealthiest city in America, and a powerhouse of industrial production. But that was decades ago. The heyday of its auto industry is long gone, and with it some two thirds of the population, leaving under-inhabited, unserviceable sprawl in a state of increasing decay. From a peak of 1.85 million residents, the population has fallen to just over 700,000 today, with a quarter having left since 2000.

The population density – 21 per acre in the 1950s – is now down to 8 per acre. There are some 78,000 abandoned buildings, and many vacant lots in between, making it unaffordable to provide services such as public transport or policing to sparsely populated areas. Urban blight is a chronic problem, with abandoned properties being targeted by arsonists and those who strip every last item of value. These ruined shells lower the value of surrounding properties. A downward spiral has been underway for many years:


As tax revenues have shrunk, the cost of maintaining city services has grown. Tens of thousands of abandoned buildings and vacant lots, and a resulting increase in fires and crime, have increased the burden on firefighters and police….”There’s no way Detroit can afford to service 140 square miles anymore,” said Michigan State University economist Eric Scorsone. “So for parts of the city, if your streetlight’s out they’re not going to fix it. If your road has massive potholes, it’s going to turn it to gravel. It’s that stark.”


The remaining inhabitants face high unemployment and under-employment, with the official statistics understating the problem considerably. Those who could leave have mostly done so. Those who remain live in a city where 70% of parks have been closed in recent years and 40% of the street lights don’t work. Despite one of the highest violent crime rates in the country, the police force has been cut by 40%, and emergency response times are five times longer than the national average. It takes an hour for the police to respond to a 911 call, and only a third of the ambulances are drivable. Some 50,000 stray dogs roam the streets in a city unable to afford the cost of dealing with them. Meanwhile, Detroit residents pay the highest property and income taxes in the state.


Chronically poor governance and corruption have contributed considerably to the malaise:


Detroit’s former Mayor Kwame Kilpatrick, his father and a city contractor are currently on trial for corruption. Kilpatrick has been charged with for racketeering, extortion, mail and wire fraud, bribery and tax evasion and faces more than 20 years in prison.


Detroit has been borrowing to meet on-going obligations for many years. In the process of trying to stave off financial disaster in the short term, it has been accumulating more and more longer term obligations, even though it could not service the existing ones. The city has been digging itself into a deeper and deeper hole:


The city started borrowing to plug budget holes in 2005 under former Mayor Kwame Kilpatrick, who was convicted this week on corruption charges. That year, it issued US$1.4-billion in securities to fund pension payments. Last year, it added US$129.5-million in debt, 9.3% of its general-fund budget, in part to repay loans taken to service other bonds. “We have no lights, no buses, poor streets and now we’re paying millions of dollars a year on our debt,” said David Sole, a retired municipal worker and advocate for Moratorium Now Coalition, a Detroit group that fights foreclosures and evictions. “The banks said they need to be paid first. But there is no money.”

Banks including UBS AG, Bank of America Corp.’s Merrill Lynch and JPMorgan Chase & Co. have enabled about US$3.7-billion of bond issues to cover deficits, pension shortfalls and debt payments since 2005, according to data compiled by Bloomberg. Liabilities rose to almost US$15-billion, including money owed retirees, according to a state treasurer’s review. The debt sales cost Detroit US$474-million, including underwriting expenses, bond-insurance premiums and fees for wrong-way bets on swaps, according to data compiled by Bloomberg. That almost equals the city’s 2013 budget for police and fire protection….

….While [Kilpatrick] ran Detroit, the city embarked on two of its most expensive bond issues, first paying US$46.4-million in fees to UBS and others to borrow US$1.4-billion for pension obligations. A year later, the city paid US$61.8-million, including insurance costs, for UBS to sell US$948.5-million in bonds, replacing two-thirds of the debt sold the previous year. Some pension debt traded at about 65 cents on the dollar in the most recent trade Feb. 12, according to data compiled by Bloomberg….After the pension bonds, the city continued to issue general-obligation bonds and short-term debt totaling about US$1.3-billion, according to data compiled by Bloomberg.

The city ran into “liquidity problems,” according to the 2012 financial statement. Because of low ratings and deficits, it was unable to borrow and turned to the Michigan Finance Authority, which arranged a US$129.5-million bond issue underwritten by a Bank of America unit. Costing US$1.6-million in fees, part of the proceeds went to repay the unit for an earlier US$80-million loan — and part of that loan had been used to service other debt, according to the financial statement.


While it is possible to buy a home for $500 or less, and investors are being tempted to do so, this does not generally constitute a solution to urban blight. A cheap home is not necessarily good value:


The solid red brick house on a block of similar homes in Northwest Detroit sounds like a steal at $3,728. But in many ways, it’s a lemon. The house, sold at an auction last fall, sits at the edge of Detroit’s infamous urban blight. And scrap thieves, or “strippers,” have taken anything of value, including the kitchen sink and metal pipes, requiring repairs of up to $15,000.

“You could take a great picture of this house, put it online and make buyers … think it’s a good thing,” said Antoine Benjamin, chief operating officer of real estate firm Benjigates Estates, which bought the house at a Wayne County auction to renovate and rent out. “But you have to understand how close you are to wasteland.”….

….Low property prices in Detroit in the wake of the housing crash in 2008 have lured investors from California to China. Speculators bank on high returns….but small-time speculators eyeing quick profits often let the houses fall into disrepair because they lack the funds for renovations or end up abandoning them — and frequently do not pay real estate taxes. In 2011 alone, the last year for which data is available, Wayne County had to write off $170 million in uncollected taxes on Detroit properties. About 100,000 city-owned properties, many of which are abandoned, are in limbo until a study of local property values is completed…..

….”The lack of property code enforcement means there is no risk for investors who buy here and neglect their properties,” said Khalilah Gaston, executive director of the local nonprofit Vanguard Community Development Corporation. “We have to ensure there is risk and not just reward.” One speculator, 22-year-old graduate student Darin McLeskey, who also runs a non-profit urban farming group, noted Detroit’s many rules on property use but few resources to police them.


Tearing down destroyed homes and consolidating the remaining population does make some kind of sense, since servicing a more concentrated population would be simpler, more efficient and less expensive::


Blight has made Detroit unmanageable. As the tax base shrinks, the cost of municipal services such as police and fire protection, bus service and garbage collection, stays the same or even rises. Sparsely populated neighbourhoods see increases in crime and fires, including arsons. “We have a city built for 2 million and only 700,000 people living here,” said John George, who has run the grassroots Motor City Blight Busters organization for the last quarter century, tearing down about 300 dwellings mostly by hand in the city’s impoverished Brightmoor neighbourhood. “We have to get rid of what we don’t want, don’t need and can’t use.”….It’s hard to get people to make an investment in a war zone.”


However, attempting to move people has its challenges, as the documentary Detropiaexplores:


Ewing and her producing partner Rachel Grady spent more than a year in Detroit chronicling the personal predicaments of residents and workers in their crumbling city. Ewing says Detroit can survive if its residents move to one or two dense neighborhoods and the rest of the city is transformed into farmland or lumber fields. But Ewing concedes that solution has serious obstacles. “You can’t use eminent domain in Detroit and you can’t force people to move,” she says. “There is no financial incentive to get people to move. If there were one, a lot of people would consider it. But there’s no money to do that.”


There are, however, signs of hope emerging from the bottom up – notably the urban gardening movement – but it remains to be seen what impact they will have in an environment where the challenges appear set to get worse before they get better. Legalizing urban gardening is a useful first step. Until recently, the as many as 355 urban farms remained illegal under the city’s zoning regulations:


Michigan’s Right to Farm Act protects farmers from nuisance claims by providing that any farm that follows the state’s “Generally Accepted Agricultural Management Practices” is per se not a nuisance….Under the RTFA, cities have been wary of permitting commercial agriculture because they would not be able to control issues like odours and traffic.



Lafayette Gardens, Downtown DetroitIn Detroit, where it is exceptionally difficult to exert public control over anything due to lack of funds, there appears nevertheless to be much to gain from allowing people to make the best possible use of vacant land:

In front yards, backyards and on vacant land where nothing but weeds and debris used to be, an urban farm belt is forming, bringing neighbours back to the earth where just a few years ago, no one would come outside. “In 2006, there was nobody on these streets. Some people had lived here for 30 years and were utterly discouraged,” said Riet Schumack, the woman at the center of the farmway taking over the area near Fenkell and Eliza Howell Park.

In seven years, that section of Brightmoor has transformed and been organized under the moniker Neighbors Building Brightmoor. Students tend two youth gardens and sell the food at local farmers markets. Adults grow everything from food to flowers in gardens called Ladybug Lane and Rabbit Run. Houses begging to be torn down are painted brightly, with inspiring prose. And young adults from elsewhere have moved in to start small commercial farms, gardens and parks on two-and three-lot stretches where the houses are long gone and the land was left barren.


In another sign of hope, young people, who are increasingly of limited means and prospects nationwide, are beginning to regard Detroit as somewhere they may be able to afford:


The last census shows a 60% increase in the number of college-educated residents under the age of 35 living in Detroit. The city offers solid, cheap housing and groups like are dedicated to attracting new residents.


Still, the renaissance is small and the difficulties remain immense, as Detropia points out:


The recent renaissance that has been taking place in downtown Detroit, one led by artists, hipsters and Dan Gilbert – the founder and chairman of Quicken Loans – has been exaggerated and aggrandized by the media, Ewing argues. “650,000 of the 715,000 residents aren’t aware of what’s happening and aren’t affected by it at all,” she says. “To believe this could fix 60, 70 years of a slide, it’s not reality.”


Detroit exists in a kind of limbo, where centralized services have been gutted, partly due to falling tax revenues and the cost of serving a sparse population, but also due to other financial priorities – notably payments for pension, general obligation bondholders and derivative contracts – competing with the needs of residents. Bankruptcy is partially an attempt to redress the balance, so that the interests and welfare of city residents are no longer subordinated to the debt repayment.

Detroit’s municipal bankruptcy will address those competing priorities, and decide how the limited resources will be committed in the future. It will be about deciding to what extent different promises, under different forms of guarantee, are to be broken. Guarantees are not worth the paper they are written on when payment simply cannot be made. Unfortunately, many people rely on the value of their respective claims, so the pain of default will be both deep and widespread.


The city was placed under emergency management by Michigan governor Rick Snyder.


“The citizens of Detroit need and deserve a clear road out of the cycle of ever-decreasing services,” Snyder wrote. “The city’s creditors, as well as its many dedicated public servants, deserve to know what promises the city can and will keep. The only way to do those things is to radically restructure the city and allow it to reinvent itself without the burden of impossible obligations.”


The Bankruptcy Act was amended in 1934 to include municipalities, but municipal bankruptcy is relatively rare, with only some 60 cities, towns, villages and counties having resorted to it since the 1950s.

Under emergency manager Kevyn Orr, a turn-around specialist previously involved in the Chrysler restructuring, the city sought Chapter 9 bankruptcy on July 18th, with debts and liabilities estimated at $20 billion. Defaulting on about US$2.5 billion in unsecured debt was intended to conserve scarce resources in order to be able to pay current employees, providing for police, fire and other services. In recent months, the city has been forced to rely on state-backed bond money to meet payroll for its 10,000 employees.

Orr had been attempting to negotiate a deal with stakeholders such as pensioners and bondholders, which would have required them to accept pennies on the dollar in settlement of their claims. The proposals were rejected, precipitating the bankruptcy filing. This is now being challenged in court on the grounds that negotiations were not undertaken in good faith, but Orr has described further negotiations as “impracticable”. Given that there are many creditors (a 3504 page list of creditors was submitted to the court), and relatively little legal precedent, the case is expected to be long, complicated and expensive:


Douglas Bernstein, a bankruptcy attorney at Plunkett Cooney in the Detroit suburb of Bloomfield Hills, said he expected the case would last one-to-three years and would be very costly. “This could run to tens-of-millions to hundreds-of-millions of dollars,” he said. “It’s a very complex landscape and it’s one that’s going to be watched very closely by municipal investors,” said Robert Amodeo, a portfolio manager at Western Asset in New York.


The Detroit Institute of Arts has decided not to object to the bankruptcy, although it is possible it’s substantial collection could be liquidated to cover some of the city’s debts. This would seem to be one of the milder prices the city might pay, given the range of competing claims to whatever assets exist.

Judge Steven Rhodes has scheduled a hearing to determine if Detroit is eligible to file for bankruptcy under Chapter 9 beginning on October 23.


Pension Obligations:

The city’s two largest unsecured creditors are its two pension funds, covering an expanding pool of 30,000 retirees who have been made unfunded promises of life-time pensions and health benefits. Chronically underfunded public sector pension obligations, guaranteed under Michigan state law, represent a large, and growing, component of Detroit’s financial predicament:


About 40% of revenues go toward retirement benefits and debt, much of which was issued in the last 10 years to finance pension contributions. Payments on $1.6 billion of pension-related certificates of participation consume nearly every dollar of property tax revenue.


Promises are easier to make than to keep, especially when the political benefits of making them accrue to one administration, while the cost falls on a later one. The funding gap for pensions currently stands at $3.5 billion, with another $5.7 billion owed in post-employment benefits such a life insurance and healthcare, for an overall deficit of $9.2 billion. The blunt instrument of bankruptcy would see the vast majority of these obligations wiped out, as federal bankruptcy law would be expected to trump the state law pension guarantee. The issue is already subject to legal challenge by the public labour unions, with some support at the state level:


Public labor unions took aim at Detroit’s historic bankruptcy filing on Monday, asking a U.S. court to toss the city’s bid for protection from its creditors because it is constitutionally flawed on both the state and federal levels. A union that represents public-sector workers even took the unusual step of arguing that Chapter 9 of the federal bankruptcy code, under which municipalities seek protection from their creditors, violates the U.S. Constitution….

….For his part, Michigan Attorney General Bill Schuette said in a filing that even if the bankruptcy case continues, the city cannot be allowed to ignore state constitutional protections for retirement benefits earned by its employees….….”Throughout this bankruptcy process, protections enshrined in the Michigan Constitution by the citizens of our state must be honored, respected and followed,” Schuette said, pointing to a constitutional prohibition against diminishing or impairing accrued retirement benefits for public workers.


The scale of the unfunded obligation the pension funds represent for the city depends on the assumptions built into the actuarial models that predict what payouts might be able to be made years hence from a set fund size today. It matters how the assets are currently valued, and it matters what rate of return on assets is assumed over several decades. The higher the assumed rate of return on assets invested, the lower the extent to which the pension promises are underfunded on paper at the moment. The public sector unions use an assumed annual rate of return of 8%, while Mr Orr bases his underfunding figures on a rate of 7%, which he describes as “more realistic”:


Although the city currently lists US$643.7-million in unfunded pension liabilities, Orr in his report said the number is closer to US$3.5-billion if “more realistic assumptions” are taken into account.


As we can see, that relatively small difference makes a very large difference to funding projections, which matters because Mr Orr could take over the pension funds if he can demonstrate that they are funded below 80% of what would be necessary to make promises payouts:


Officials working for Mr. Orr said their estimates of a 7% rate of return on the funds’ investments is more realistic than the 8% used by the funds, which they said was too high because it didn’t account for demographic changes of pensionholders and the funds’ investment mix. The emergency manager also estimates the funds’ assets based on current market values rather than actuarial values over the life of the beneficiaries, reduces the impact of a “smoothing” process that can mask losses and cuts the amortization period for the liability by about half.

“By any measure, the [pension funds] will require significant future contribution that the City cannot possibly afford,” Chuck Moore, senior managing director at restructuring firm Conway MacKenzie, wrote on the city’s behalf in court papers….

….Many public pension funds wrestle with trying to come up with a realistic estimate for the anticipated return on investments. The average across 126 public pension plans covering about 85% of the market is 7.75% a year, according to Keith Brainard, research director of the National Association of State Retirement Administrators. The average for most corporate pension funds is about 8%.

But recently, both the state of Indiana and the District of Columbia lowered their expected return to less than 7%, according to Mr. Brainard. According to the report prepared by consultancy Milliman, Detroit pension funds should expect a return of only 6.3% to 6.57% a year, even as Mr. Orr’s team is relying on a more optimistic 7% return. With those numbers, the city might actually have underestimated the shortfall, according to the report.


Bankruptcy may allow Orr to move forward on a politically intractable issue that has festered for many years, but finally come to a head. Although it was possible to see this endgame coming for a very long time, the political will to address it has always been lacking. Other jurisdictions are facing similar problems, and seven other states have legal prohibitions on cutting retiree pension and benefit payments. They will be watching Detroit, but what is happening there is only the opening salvo in terms of the challenges facing pension expectations.

In the era of financial crisis we are re-entering, after a few years’ hiatus, even the lowest currently assumed rates of return are very likely to prove to be extremely over-optimistic. The pension math that looks dire at 7% is going to look drastically worse at 2% or less, and once the financial assets held by the funds start to be marked to market at pennies on the dollar, the game will be over. Pensions are not secure. Counting on payouts is very risky, as the math is unforgiving. Even near a financial top, and using very optimistic assumptions, it should be obvious that most pensions amount to promises that cannot be kept. Under circumstances of substantial economic contraction, the illusion will disappear entirely.


General Obligation Bonds

Investors in municipal bonds are typically looking for a dependable income, stable bond prices and shelter from taxes. They have generally come to regard these investments as risk-free, even as the obvious problems faced by municipalities have been mounting. The bankruptcy of three cities in California last year seems not to have been interpreted as the warning signs that they were, and so far, relatively speaking, neither does the bankruptcy of Detroit. This complacency is highly unlikely to last, however, as the extent of the inevitable losses in Detroit becomes clear. The clear risk is that bond prices will crash on spiking yield, and that this will precipitate a rush for the exits. A move in this direction has begun, and concern is rising, but as yet it remains a muted response.

Detroit lists, among its top twenty creditors, holders of $1.47 billion of certificates of participation and hundreds of millions of dollars of general obligation bonds that Mr Orr has made clear he considers to be unsecured debt. He has said that the city is insolvent, and that shared sacrifices are necessary from all creditors if the city is to have any hope of revival.

Bondholders, like pension funds, would be expected to get pennies on the dollar in a municipal bankruptcy, but have not objected to the filing as the pension funds have. Neither have bond insurers, which would be liable to cover debt payments on the city’s behalf if it is unable to fulfil the obligation itself. If bonds are substantially written down, the losses to bond insurers will be huge, and that would have broad consequences for municipal borrowing costs.


If Detroit gets its way in bankruptcy court, the cost of borrowing money for cities and states around the nation could spike, the chief executive of bond insurer Assured Guaranty warned on CNBC on Tuesday. Like other debt insurance companies, Assured charges the bond issuer a fee in exchange for a promise to make the payments in the event of default. This arrangement makes it easier for cities and states to borrow money for a variety of projects in the $3.7 trillion muni bond market, while providing investors the peace of mind that they’ll be paid back. The total exposure for Assured in Detroit is about $2.1 billion, Dominic Frederico said in a “Squawk Box” interview. The company has insured $1.8 billion of water and sewer bonds, which are secured with a pledge to pay these bonds with “special revenues.” Assured also has about $300 million of general obligation (GO) bonds, backed by a pledge to raise taxes if needed to pay the debt.

At about $530 million, GO bonds represent a only small slice of the city’s overall $18 billion in debt. But how they’re treated could change the dynamics of the financing options for municipalities, Frederico said: “Debit is basically priced based on risk. If you increase the risk of the debt, therefore you increase the cost of the debt.”


Like the pension funds, owners of general obligation funds feel that their investment should be protected, and should receive priority in bankruptcy, but there seems to be little awareness or consideration by any party of the needs of other parties:


“The reason people are so concerned is there has been an expectation that GO [general obligation] is about as good as it can get, and even in a bankruptcy it ought to take priority over some other liabilities, and what Kevyn Orr is trying to do is treat all the unsecured debt with parity.”—Patrick Early, chief municipal analyst at Wells Fargo Advisors


Residents in particular get short shrift in the consideration department, as if the property tax well were bottomless:


UBS muni-bond strategists said Monday that legal precedents, while few, favor holders of general obligation bonds backed by an unlimited property tax. They also believe that the city’s water and sewer bonds will be insulated from the city’s insolvency.


Detroit’s bonds have been junk-rated since 2009 – one of less than forty out of 7500 municipalities to be so. Nevertheless, investors piled in despite the clear risk signals, such as high bond yields. At times of heightened optimism, investors, and society at large, throw caution to the wind and chase yield without understanding that this means chasing risk:


Investors jumped at the high yields on Detroit’s debt because they expected the city to borrow and raise taxes to the hilt to avoid default. If Motown risked defaulting, creditors bet that the state or federal government would swoop in like Superman and save the city in the nick of time …. Meanwhile, investors appear astonished that there’s no such thing as a risk-free return, which they should have learned from Greece and Argentina. One question to ask now is if Detroit isn’t too big to fail, is any city?


In the case of the bond insurers, who do understand the relationship between risk and yield, much of their exposure stems from insurance of earlier bond issuance, prior to the financial crisis of 2008:


“If you look at our exposure … the GO came in, the last bit was in 2008. Most of it was 1999 and 2003,” Frederico said. “On the water and sewer, the last insurance we did was 2006. So it’s not like we’re chasing the ambulance and running right up to the doorsteps of bankruptcy.”


No municipality has ever forced a cut in principal on general obligations through bankruptcy, hence complacency that Detroit’s situation might pose a broader, systemic threat, particularly to investment-grade municipalities.


Tim McGregor, director of municipal fixed income at Northern Trust, says localities that are investment grade won’t risk missing bond payments because they need access to the market for capital projects. Norwalk is using the proceeds from its latest bond issue to pay for roadwork and repairs to a seawall damaged by Hurricane Sandy. “Tax-exempt financing is the cheapest source of financing, a lifeline to all their public-purpose needs,” McGregor says.


Todd McInturf/The Detroit News Supremes 1965-nowDiana Ross, Florence Ballard grew up in Frederick Douglass public housing complex

Banks and Derivative Super-Priority

Both pensioners and general obligation bond holders argue that they should have priority in claiming from the city’s inadequate assets in bankruptcy. However, a different class of creditor has legally senior status. Holders of financial derivatives enjoy super-priority in bankruptcy. Thanks to changes to bankruptcy law in 2005, they are not subject to the ‘automatic stay’ provision intended to prevent a disorderly grab for collateral by competing creditors. As such, they are able to press their claim immediately, prior to bankruptcy proceedings and therefore before claims by competing creditors are considered. This may potentially leave nothing for other creditors to divide during subsequent proceedings:


Under both the Dodd-Frank Act and the 2005 Bankruptcy Act, derivative claims have super-priority over all other claims, secured and unsecured, insured and uninsured. In a major derivatives fiasco, derivative claimants could well grab all the collateral, leaving other claimants, public and private, holding the bag….

… Harvard Law Professor Mark Row maintains that the super-priority status of derivatives needs to be repealed. He writes: “[D]erivatives counterparties, . . . unlike most other secured creditors, can seize and immediately liquidate collateral, readily net out gains and losses in their dealings with the bankrupt, terminate their contracts with the bankrupt, and keep both preferential eve-of-bankruptcy payments and fraudulent conveyances they obtained from the debtor, all in ways that favor them over the bankrupt’s other creditors.”


This was the issue in the MF Global brokerage failure of 2011, where derivative holders were able to confiscate the contents of customer segregated accounts that had been illegally co-mingled with company funds and pledged as collateral against financial bets that went against the company. Between one day and the next, customer funds simply disappeared from their accounts and into the hands of the derivative counterparties. Even customers’ gold holdings were emptied, leaving them with warehouse receipts.

At the time it caused a stir, but not nearly on the scale one might have expected if the issue were more widely understood, and the broader implications better appreciated. We find ourselves in a world of excess claims to underlying real wealth, and the financial industry has both the ability and the legal right to press its claims ahead of all others.

The 2005 legal amendment to bankruptcy, which has has broader reach than just the United States, greatly reduced the risk for financial institutions to deal with weak parties. In fact it gave them an incentive to do so, in the knowledge that their claims would be protected, and that they could, in fact, engineer a bankruptcy at such time as it might suit them in order to claim the available assets. The result was a considerable expansion in ‘instruments of financial innovation’, and with them systemic risk:


This amendment which was touted as necessary to reduce systemic risk in financial bankruptcies also allowed a whole range of far riskier assets to be used, making them too immune from the automatic stay in the event of bankruptcy. Which meant traders flocked to a market where risky assets would be traded and used as collateral without apparent risk to the lender. The size of the repo market hugely increased and riskier assets were gladly accepted as collateral because traders saw that if the person they had lent to went down they could get your money back before anyone else and no one could stop them.

It also did one other thing. Because the repo and derivatives traders ran no risk – they could get their money out of a failing bank before anyone else, it meant they had no reason at all to try to stop a bank from going under. Quite the opposite. All other creditors – bond holders – risk losing some of their money in a bankruptcy. So they have a reason to want to avoid bankruptcy of a trading partner. Not so the repo and derivatives partners. They would now be best served by looting the company – perfectly legally – as soon as trouble seemed likely. In fact the repo and derivatives traders could push a bank that owed them money over into bankruptcy when it most suited them as creditors. When, for example, they might be in need of a bit of cash themselves to meet a few pressing creditors of their own.

The collapse of both Bear Stearns, Lehman Brothers and AIG were all directly because repo and derivatives partners of those institutions suddenly stopped trading and ‘looted’ them instead.


The systemic risk enhanced by super-priority is now in turn used to justify its continued existence. It has had a considerable effect where, instead of weak companies, the derivative strategy has been applied to public entities such as cities and states. Many are now trapped in a web of debt, being forced to kick the can down the road at any price, because the cost of the alternative – financial meltdown – would be unthinkable.


Let us say you are a bank or broker that has bought up a lot of European bank and sovereign bonds from Italy, Spain and Greece for example. You would be very exposed to great losses should those countries or their banks default. You are relying on the politicians forcing their tax payers to bail out you and the other banks you trade with. What if they don’t?

One solution would be to sell as many of those bonds as you could accepting the inevitable losses as being better than a much larger loss if the banks or nations or both, defaulted. The other solution, counter-intuitively, would be to do more business with them. But make sure it is repo lending and derivative trading. Specifically offer the banks in troubled nations CDS insurance on their own bad debts and currency swaps. How would this help? First, lets keep in mind that the trade in both these types of derivatives did increase by 18% in the first 6 months of 2011 precisely as the Euro crisis has worsened.

If a bank or nation was to default on you as a mere bond holder, you would have to wait in a the queue of creditors to see what you were going to be given back. And some ‘hair cut’ would be likely.

But if you had done rather a lot of derivatives trading (CDS insurance and currency swaps are both derivative trades) then you would not have to wait. You would seize all the collateral the bank had pledged to you for repo lending or derivative trading and walk away. Now you will say that if you had done CDS insurance then you might well have to pay back out the money you had seized. Except that possession is nine tenths of the law. While lawyers set about arguing about what you owe, the critical fact is that in the mean time, in the height of the crisis you HAVE the money.


Abandoned Russell Industrial ComplexDetroit is one of the public entities caught in this financial derivative web. Like many other municipalities worldwide, they had been sold interest rate swaps – bets on the movements of interest rates, supposedly intended as insurance, to protect the city in the event of an interest rate rise. The contracts would, in theory at least, have paid out had interest rates risen, but the bet went against the municipalities when rates fell instead, leaving them liable for hundreds of millions of dollars in losses.In Detroit’s case, the city was on the hook for $439-million as of June 30, 2012. Interest rate swaps are based on the LIBOR rate, which was subject to manipulation by the very parties who stood to gain from winning bets on movements of interest rates. Payment of these losses is now the top priority in the municipal bankruptcy process:


The Detroit bankruptcy is looking suspiciously like the bail-in template originated by the G20’s Financial Stability Board in 2011, which exploded on the scene in Cyprus in 2013 and is now becoming the model globally. In Cyprus, the depositors were “bailed in” (stripped of a major portion of their deposits) to re-capitalize the banks. In Detroit, it is the municipal workers who are being bailed in, stripped of a major portion of their pensions to save the banks. Bank of America Corp. and UBS AG have been given priority over other bankruptcy claimants, meaning chiefly the pensioners, for payments due on interest rate swaps they entered into with the city.


Emergency manager Kevyn Orr has negotiated a 25% haircut for holders of interest rate swaps, confirming their primacy in comparison with other claimants:


Bank of America Corp. and UBS AG would accept 75 cents on the dollar from Detroit on $343.6 million in swaps liabilities in a deal with Kevyn Orr, the city’s emergency financial manager, according to a person familiar with the negotiations….

….The swaps were a bet on the direction of interest rates. Because rates fell rather than increasing, the city owes the banks. Under the terms of the contracts, cuts to the city’s credit ratings allowed the companies to demand the money. Under agreements in 2009, the city pledged casino revenue to cover the payments. Orr gave the swaps payments, as secured debt, priority over retirees and holders of unsecured debt, including the pension borrowings. While swaps holders would take a 25 percent cut in payments, other creditors would receive much less.


Under the agreement, the city would pay UBS, Bank of America, and SBS $225 million by Nov. 1 to terminate the interest-rate swaps. This sum represents approximately 15% of Detroit’s total annual all-source revenues for the year:


This $225 million is not a debt; rather it represents 75% of the “current negative value” (to Detroit) of swaps agreements with those banks on $1.4 billion in 2005 city borrowing. That is, it is a payoff on a Libor-rigged derivatives bet that Detroit was conned into making in 2005 by those banks, after borrowing from them. And if the payment is delayed beyond Nov. 1, to a second payment deadline of Mar. 31, 2014, under Orr’s agreement it will reportedly be 80% of the “current negative value” of the bet, or likely $250 million. Orr’s office announced that he had agreed with the banks on this derivatives payoff on July 16, two days before declaring bankruptcy against pensions, retiree health funds, and other general creditors, giving the derivatives payoff first priority in bankruptcy.


This is not Kevyn Orr’s fault. He is simply playing the hand he has been dealt. Detroit’s bankruptcy is an attempt to make the best of a bad situation, where far too many promises have been made that now cannot be kept. There will be losses for all, but less so for those at the top of financial food chain.

Detroit will not be the only municipality placed in this position over the next few years. In fact is it likely to be the first of many forced to make impossible choices while being held over a barrel by financial institutions with senior claims, essentially to everything:


I think this means that some of the biggest banks, themselves, have already constructed and greatly enlarged a now truly massive trip wired auto-destruct on the banking system. If they have and they have explained any of this to our politicians then it would explain why our governments have been so abjectly willing to bail out any and all of the biggest banks and sacrifice anything else in the process. Any hint of reluctance and the banks can make veiled reference to the extreme ‘risk’ of systemic ‘panic’ and forced liquidations.


At The Automatic Earth, we have written before (July 27, 2012) about the implications of casino capitalism, where, thanks to regulatory capture, the rules are written by, and enforced on behalf of, those who stand to benefit from them:


Bubbles and the Titanic Betrayal of Public Trust:

In our era of catabolic casino capitalism, the financial system has been hollowed out. Huge risks have been taken with other people’s money for short term private profit. Reserve requirements have been whittled away to almost nothing in an attempt to maintain monetary expansion, and now there is virtually no cushion against financial crisis. The lack of capital adequacy requirements in the derivatives market has left a large construct of virtual value with toxic levels of counterparty risk, and a built-in meltdown mechanism thanks to perverse incentives to burn things down for profit.

It has been legal in places to rehypothecate collateral infinitely, meaning it is permissible to employ a small amount of collateral to underpin a vast quantity of loans, again leaving no margin for error. We have seen complex financial instruments mis-sold to municipalities all over the world, and ‘assets’ sold to customers then shorted by the financial institutions that sold them.

We have seen loans made to people, companies and governments that could not possibly repay them, because the sellers were able to collect their fees upfront, while selling the huge risk on to investors through securitization. Due diligence was virtually non-existent for many years, while systemic risk grew unchecked. As crisis has developed as a result of these, and many other, abuses, the response has been austerity for the masses while the insiders, who should have known better, have been able to walk away from the consequences of their recklessness. The public sector is being asset-stripped as the great collateral grab gets underway.


With the bankruptcy of Detroit, and the light that is about to shine on the inner workings and the foundations of the financial system, it will become increasingly obvious how precarious is our current position. This issue is far larger than Detroit, and far larger than the United States. The financial system is global, and highly interconnected. Shocks can propagate very quickly, picking up momentum as they travel. We are seeing the beginnings of the next phase of the on-going credit crunch, in the US at the municipal and state level, but also in Europe and beyond. This is a good time to question the prevailing blind optimism and look instead for an understanding of how the system really works, and where its architecture and internal dynamics are taking us.

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