The Detroit Emergency Manager, Kevyn Orr, has announced the third iteration of a settlement of a massive derivatives deal gone wrong, a key element of the largest municipal bankruptcy in history. On the surface, it appears to be a significant improvement over the prior versions. But appearances can be deceiving.
The proposal includes a new provision that places the possible misdeeds surrounding the city’s financial dealings squarely before the bankruptcy court by releasing the bank counterparties from liability in deals related to, but different from, the swaps. There may even be other undisclosed concessions in the settlement. Maybe this new settlement is not an improvement after all.
In 2005 and 2006, Detroit entered into a dicey deal to issue more than $1.4 billion of “Certificates of Participation,” or “COPs,” converting an unfunded pension contribution obligation to an obligation to the holders of the COPs. Orr has said that the city used COPs rather than conventional municipal bonds in order to evade a legal cap on additional city debt, just as the Demos report on the Detroit bankruptcy suggested last year. Finally, Orr filed suit to void the COPs deal on February 3rd. He has not explained why this took so long to do and why he had to be pushed by the court and observers like Demos to take action.
An integral part of the deal was a huge—$800 million, spanning more than 25 years—series of swap transactions. The swaps included termination provisions allowing the banks (and the insurance companies that guaranteed city payments under the swaps) to require immediate payment of the present value of all projected future payments. Under today’s low short-term interest rate environment, that amount would be large. At times, it has gotten as high as more than $400, and more recently it was calculated as almost $250 million. Worse still, on termination, the bank counterparties, UBS and Merrill Lynch, could grab a stream of tax revenues representing about 20 percent of Detroit’s meager cash resources, until the termination payment was fully paid. This would devastate the city’s revenues, making its bankruptcy even worse.
Orr negotiated a swap settlement agreement that was signed last July 3rd, just days before the bankruptcy proceeding was filed. It cut the settlement amount by 20 to 25 percent and allowed the city to finance the payment so that it could be paid over time. In December, the bankruptcy court judge, Judge Rhodes, refused to sanction the agreement. Orr renegotiated the deal, coming back with a $165 million offer. Again, the bankruptcy court rejected the proposal, finding the payment to be too high. The judge said that there was a substantial probability that that the swaps would be found void if they were challenged, so that the banks would get nothing. He found that the settlement amount did not reflect this probability.
Yesterday, Orr announced a third proposal. This time, the payment has been cut to $85 million and it appears that the banks will be paid over time, preserving some access to tax revenues. The announcement did not detail the terms of repayment—the interest rate, the payback period and potential defaults, for instance. Nonetheless, on its surface, it appears that the deal is a substantial improvement over prior proposals. The bankruptcy court will have to approve.
This version of the settlement has a new term. UBS and Merrill Lynch are said to be released from any potential liability under the original $1.4 billion COPs deal. Remember that Orr has sued to void that deal as an evasion of legal limits on debt. The senior managing underwriter of the COPs deal was UBS and Merrill Lynch was among the co-managers. Typically, the managing underwriters play a leading role in structuring municipal financings. It is entirely possible that UBS and Merrill Lynch thought up the COPs deal and pushed it with the city. No one familiar with the municipal finance business or with the corrupt city administration at the time would be shocked if the managing underwriters used (shall we say) extraordinary means of persuasion to secure the lucrative deal. We do know that the costs of issuance disclosed in the COPs offering materials were in the range of $46 million without a breakdown of its components. But the banks could well have made much more from the overall deal.
Maybe this settlement is not nearly as good as it appears for the city. The swaps may be voided for one thing. But even if the settlement amount is found to be fair given litigation risks, the release puts the potential liability of UBS and Merrill Lynch under the COPs deal in play before Judge Rhodes.
When this new version is presented, Judge Rhodes should require a full airing of everything Orr knows and can find out about the possible liability of these banks in connection with the dodgy COPs transaction. Otherwise, he cannot possibly assess whether the settlement is in the interest of the beleaguered people of Detroit. Shedding light on the COPs deal would benefit Detroit and inform the public of bank practices used when they underwrite the debt of states and localities around the country.