So what is a Swap, anyway?

For the benefit of those who are not financial professionals:

"Swaps" are one type of a contract that is called generally a "derivative" contract. There are many, many types, all of which are irrelevant other than the most popular--the interest rate swap.

An interest rate swap is a contract between two parties where one assumes an obligation to pay a payment based on a floating rate, and the other has an obligation to pay a fixed rate. The simplest version, and the one into which Detroit entered was a contract that, for Detroit, converted their obligation to pay a floating rate of interest into the obligation to pay a fixed rate of interest. This was a separate contract related to a bond issuance. The simplest way to describe this is to put a simple example together.

*Detroit issues bonds, and they are called the "issuer."
*Bondholders pay money to a trustee, who pays the money to Detroit [[the bonds in question were used to fund pension obligations, if I recall correctly, but money is fungible, so it could have been for anything).
*Those bondholders desire a payment based on a floating rate, so that they don't have to take the risk of large rate movements.
*Detroit then had three options:

1. Pay the floating rate of interest, and run the risk that rates go up, which would increase their interest costs.
2. Enter into a swap contract [[which I'll describe below).
3. Don't borrow the money.

They chose #2.

For a swap to work, a dealer [[bank) must locate a counterparty [[the other side of the contract) that has the same need, but in reverse. There are some circumstances where the dealer has two clients with the exact opposite needs, but that is rare. Generally, the dealer will put together different pieces to get the same result.

In these contracts, however, the dealers would ordinarily run the risk that one side [[either Detroit or the other side of the opposite transaction) stops paying on their debt. That can radically increase the risk to the dealer [[AIG, anyone?!?), so they will demand collateral. In this case, the dealers demanded the only thing the City could pledge: its stream of payments from the casino taxes.

The rules are then pretty clear. Detroit now has three options:

1. It can make the payments on the debt as scheduled.
2. It can "break the swap." [[described below)
3. It can forfeit the collateral.

The cost to break the swap is the difference between interest rates at the time the contract was made to the time the contract is broken. If rates go up, the swap is valuable to the party paying the fixed rate, because they'll be paying a below market interest rate.

But rates didn't go up, they went down. Way down. HISTORICALLY way down. As low as they could possibly go. In that case, the cost to break the swap became very, very high for the City.

When the City defaulted, the dealers attempted to seize the collateral. I haven't seen the exact documents, but when you are talking in the hundreds of millions of dollars, those documents are crafted with care and precision, including, I think, a letter from the State Gaming Commission indicating that the collateral could be pledged.

The only other option is to negotiate something with the dealer or counterparty. In this case, a settlement of 75 cents on the dollar seems reasonable to me for a secured debt [[although I haven't seen the exact documents or dollar amounts).

Even in bankruptcy court, secured creditors eat first. There are probably some arguments against the creditors, which is why it is 75 and not 100 cents.

My biggest disappointment is that either no one is trying to explain this to City Council or no one can.

KK made a bad deal--a horrible bet. But I don't see a way legally to simply get out of the arrangement without losing the casino revenue. Getting out of the swap actually lowers the debt service on the existing bonds, which allows the City to borrow some more money for operating costs without increasing their payment.

Happy to answer more questions you may have.

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Originally Posted by BankruptcyGuy

My biggest disappointment is that either no one is trying to explain this to City Council or no one can.

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Great explanation and thanks for doing that.

However, you had a question. On another post on a similar topic I wrote that I had a former boss/mentor go into the pension fund advising business, but he stayed with corporate/private funds and avoided public/municipal pension funds and for good reason.

One of the things he told me was that there are 2 types of muni pension fund trustees:

1. Those trustees that are so unknowledgeable that you can tell them anything, and
2. Those trustees that are so unknowledgeable that you can tell them nothing.

In the case of this council, I would say either answers your question.

Let's shrink down your explanation.

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Originally Posted by BankruptcyGuy

Even in bankruptcy court, secured creditors eat first. There are probably some arguments against the creditors, which is why it is 75 and not 100 cents.

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The problem is that you have citizens and council members who don't believe that secured creditors should eat first. And so they think that somehow, if enough people march on Woodward or in Washington, that somehow secured creditors will take a backseat to everything else.

So it's not that they don't understand your argument. They simply believe that the whole system is rigged against them and needs to be changed.

And, frankly, sometimes that's true....but this isn't one of them.

Just like the Tea Party can talk ALL THEY WANT about de-funding Obamacare. And how if enough GOP senators buck the system and hold the government hostage, and how one lone juror can turn the jury, and how if Mr. Smith could go to Washington.... etc. And frankly, sometimes that's true. But not this time.

It's time for the yahoos on both sides to shut the hell up and let the adults get to work.

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Originally Posted by BankruptcyGuy

Even in bankruptcy court, secured creditors eat first. There are probably some arguments against the creditors, which is why it is 75 and not 100 cents.

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A little bit off-topic, but can you explain how the unions got higher priority than both secured and unsecured lenders during the GM and Chrysler bankruptcies? I understand they were weird, "pre-rolled" bankruptcies, but I imagine that the precedent set in those cases is fueling the belief that everything is on the table for all parties, so to speak.

The GM deal was a “prepackaged” bankruptcy filing where all the creditors “negotiated” a settlement amongst themselves first with the “aid” of the Presidential Task Force on the Auto Industry led by Timothy Geithner and Larry Summers. Remember that GM needed $15+ billion in federal loans, so the government was heavily involved with the pre-packaged plan.

By the deadline of March 30, 2009 the GM bondholders rejected the government's first offer, but the unions agreed to the preferential terms. A bondholder counteroffer was ignored. The bond holders wanted to get 58% of the stock of the reorganized GM and were offered 10%. The Task Force won out and the bond holders were given a very large haircut.

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Originally Posted by JBMcB

A little bit off-topic, but can you explain how the unions got higher priority than both secured and unsecured lenders during the GM and Chrysler bankruptcies? I understand they were weird, "pre-rolled" bankruptcies, but I imagine that the precedent set in those cases is fueling the belief that everything is on the table for all parties, so to speak.

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Often in bankruptcy, the contributor of new equity [[in the GM/Chrysler cases, Uncle Sam) gets to set the terms and conditions of the contribution, unless that contribution violates the absolute priority rule [[creditors get paid in order of their priority). Unsecured bondholders and the pension funds there were both in the same place, and therefore, the investor [[government) can choose between one and the other.

If the State contributes to Detroit's plan, they will likely demand some say over where the money goes as well.

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Originally Posted by BankruptcyGuy

If the State contributes to Detroit's plan, they will likely demand some say over where the money goes as well.

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The wrinkle, of course, being that any contribution may be required to prioritize pensioners over unsecured debtors in order to be constitutional, right?

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Originally Posted by BankruptcyGuy

If the State contributes to Detroit's plan, they will likely demand some say over where the money goes as well.

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Of course BG is using "will likely demand" in the sense of "absolutely will, with mathematical certainty, demand".

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Originally Posted by corktownyuppie

The wrinkle, of course, being that any contribution may be required to prioritize pensioners over unsecured debtors in order to be constitutional, right?

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Sort of. Parties will have the right to object, so if a deal is struck between the city and the pensioners, the bondholders will have the right to object. That deal may or may not pay the pensioners 100%, but if it doesn't, and they object, it could be a long process to resolve that objection. Long as in U.S. Supreme Court long.

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Originally Posted by BankruptcyGuy

Often in bankruptcy, the contributor of new equity [[in the GM/Chrysler cases, Uncle Sam) gets to set the terms and conditions of the contribution, unless that contribution violates the absolute priority rule [[creditors get paid in order of their priority). Unsecured bondholders and the pension funds there were both in the same place, and therefore, the investor [[government) can choose between one and the other.

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OK, it makes sense that the new creditor gets some say on whom gets paid. However, the secured bondholders got a worse deal than the unsecured UAW pension funds, and the bankruptcy still went through. There was a lawsuit involved but it got thrown out - I'm not exactly sure why, I think the other courts were all deferring to the bankruptcy court, which pretty much approved whatever the government sent it.

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Originally Posted by JBMcB

OK, it makes sense that the new creditor gets some say on whom gets paid. However, the secured bondholders got a worse deal than the unsecured UAW pension funds, and the bankruptcy still went through. There was a lawsuit involved but it got thrown out - I'm not exactly sure why, I think the other courts were all deferring to the bankruptcy court, which pretty much approved whatever the government sent it.

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There are two types of bondholders. In the GM and Chrysler cases, the unsecured got crammed down.

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Originally Posted by BankruptcyGuy

There are two types of bondholders. In the GM and Chrysler cases, the unsecured got crammed down.

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The suppliers took it in the shorts on all of their receivables. Quite a few little parts-making shops went under.

Prof. Eileen Norcross of George Mason University, writing for RealClearPolicy on how cities in general are unreasonably optimistic about the state of their pension funds, and using Detroit as an example:

"Before filing, the city reported that its unfunded pension obligations totaled $644 million. On further inspection, emergency manager Kevyn Orr determined it was $3.5 billion. On a fair-market basis, I calculate Detroit's pension obligations are closer to $9.5 billion."

Whole article is here.