This article was first published by The McAlvany Intelligence Advisor on Monday, February 10, 2014:
It was no surprise to anyone that Kevyn Orr, Detroit’s interim emergency financial manager of the city during its bankruptcy, would uncover a massive fraud dating back to 2005 that helped precipitate the city’s descent into bankruptcy. It’s also no surprise that the two banks and the insurance company involved now want to cut a better deal than Orr is offering to everyone else.
Detroit’s demise is now common knowledge: overpromising, overspending, ignoring economic and financial reality, fraud, deception, payoffs, etc. – it’s all there. What Orr found, however, has largely been covered up.
Back in 2005, the city had one serious cash flow problem: it owed $1.4 billion to the city’s two pension plans, but it had reached its debt limit. The unions were demanding payment. The unions owned the city council and the mayor. Something had to be done.
Enter Bank of America, UBS, and an outfit called Financial Guaranty Insurance Company. They came up with a plan – an illegal workaround – to get the city the money without it appearing to be a loan. For a small fee, of course.
Here’s how the scheme worked, thanks to the investigative efforts of one Curt Guyette:
The solution arrived at by the administration of then-Mayor Kwame Kilpatrick was to sidestep the law by turning to something called certificates of participation, or COPs, which are similar to municipal bonds. But instead of borrowing the money directly, Kilpatrick and his crew – following the advice of investment bankers who would reap massive profits from the deal – set up two nonprofit “service corporations,” which in turn created trusts that would sell the COPs to investors.
Technically, it was these two nonprofits that were obligated to ensure repayment of the debt. The city then entered into a contract with the nonprofits – both of which were controlled entirely by city officials – agreeing to pay them for services rendered.
In other words, they were mere shells.
Only one thing was missing: what would happen if interest rates went up? The revenues flowing from the city-owned casinos to service the COPs couldn’t suddenly be expanded in that event. Enter Financial Guaranty and a little strategy called “interest rate swaps.” It looked like insurance, but it was essentially a bet that interest rates wouldn’t rise. But when the Great Recession hit, and interest rates plummeted, the swaps went against the city – to the tune of $300+ million.
Orr is doing his best, so far as one can tell, to keep everyone happy in a situation where no one is going to be happy. There are a lot of moving parts to his “plan of adjustment” which he filed with the bankruptcy court, headed up by Judge Stephen Rhodes. There’s Governor Rick Snyder’s offer of $350 million of “state” money (actually it’s taxpayers’ money, of course) that’s only available if the unions and pensioners agree, if the state legislators go along with it, and the art held by the Detroit Institute of Art (DIA) isn’t to be sold as part of the deal. Snyder’s offer also includes replacing the pension plans’ trustees with people who are honorable. There’s some money to be ponied up by DIA itself, and some foundation money. All told, that’s about $800 million.
Then there are the two pension plans, seriously underfunded (with arguments over just how much, depending on interest rate assumptions), and the bondholders. What Orr is trying to do is paste a Band-Aid over the Grand Canyon: Detroit’s total unpayables are $18 billion.
When Orr’s plan was leaked to the press, it was learned that he proposed to Judge Rhodes that the pensioners get half of what was owed to them – a 50 percent haircut – while the bondholders get stiffed for 80 percent of what the city owed them. Further, the pensioners would get their half in cash while the bondholders would get a promise – a piece of paper saying that they would get their 20 percent sometime in the distant future.
This rattled the cages of the bondholders, along with Fitch Ratings and a municipal bond guru. Said Fitch:
Any action that suggests [that] pensions’ claims … should be given priority [compared] to that of bondholders could establish a troubling precedent….
Fitch recognizes the delicate political situation surrounding the Detroit bankruptcy, [but], as the state and the city continue down what could be a long road [note the perceived threat here], actions and rhetoric that suggest that bondholder rights are not an important consideration will continue to damage [the municipal bond market’s] perception of the state and its local governments.
This is how a ratings agency like Fitch expresses “concern” that such a deal as proposed by Orr, if approved by Rhodes, would raise the cost of borrowing not only across Michigan but across the country, especially negatively affecting other cities that are in trouble with their finances.
Matt Fabian, writing at Municipal Market Advisors, was much more forthright: he called the deal a “cramdown” and said that bondholders will sue if Rhodes goes along with it.
But then there’s the matter of Bank of America and UBS and Financial Guaranty. They are a party to the crime, but they want special treatment. Rather than include them in his “plan of adjustment” Orr tried to negotiate an outside settlement with them. He cut a deal where the city would pay $230 million of the $300+ million it owes thanks to the collapse of the swaps. Rhodes said no: it was too sweet a deal for them.
Orr went back a second time to the triumvirate and negotiated the settlement down to $165 million – about a 50 percent haircut. Again Rhodes said no.
In his deposition before the judge, Orr admitted that he thought fraud had been committed back in 2005. First of all, there’s a serious question as to whether casino revenues could legally be used to pay off the failed swaps. But secondly, and most importantly, there was fraud involved in getting around the city’s debt limit. As Wayne State bankruptcy professor Laura Bartell put it, the deal was “a clever legal circumvention of the debt limit.”
Rhodes could see the fraud, and apparently thinks Orr ought to go after the miscreants for the $300 million. Orr wants to deal. The stakes are high. Here’s how reporter Guyette explained it:
The potential upside to litigating instead of negotiating is huge. If the swap deals are judged to have been invalid from the beginning, instead of having to pay $165 million more, the city could possibly recoup the $300 million it’s shelled out so far. That’s a swing of $450 million in Detroit’s favor.
And even if the city only succeeded in having the swap debt classified as “unsecured” rather than “secured,” as the banks claim it is, then the banks, instead of being entitled to full repayment, would have to settle for dimes on the dollar, just like all the other unsecured creditors.
Orr has handed the judge this can of worms for him to sort out. The judge will make his ruling within the next couple of weeks. It ought to be a doozy – there’ll be something in there for everyone to hate.
That’s what happens when unions, corrupt politicians, banks, and insurance companies collude to take advantage. Remember that the COPs scam took place during the administration of former Mayor Kwame Kilpatrick, now residing behind bars for 28 years after having been convicted of 38 felonies – thirty-eight! – including extortion, bribery, and fraud.
Judge Rhodes’ ruling on Orr’s “plan of adjustment” will likely trigger all manner of lawsuits from the unions, the pension plans, Bank of America, UBS, Financial Guaranty, and who knows who else. But the lesson is clear: the hidden consequences of years of fraud and deceit are now out in the open. The bills have come due. It’s bill-paying time in Detroit.
Curt Guyette: Democracy Watch: Swaps, COPs & Lingering Questions
Detroit Free Press: Bond rating agency blasts Snyder’s $350-million Detroit pension rescue plan
Detroit Free Press: Snyder pledges $350M to save Detroit pensions, DIA artwork, but hurdles remain
New York Times: Detroit Turns Bankruptcy Into Challenge of Banks
Detroit Free Press: Detroit bankruptcy blueprint gives edge to retirees over bankers, bondholders