Detroit's Debts, Derivatives, Swaps and Safe Harbors

[renf]

I wondered why Kevyn Orr agreed to pay UBS and Bank of American 75% of what they were owed in those transactions made by Mayor Kilpatrick to fund pensions about eight years ago. Monday’s New York Times had a long essay contending that Congress enacted legislation providing safe harbor in bankruptcy proceedings to many derivatives and other complex financial instruments. If the federal law required 100% payment, Orr cut a good deal with 75%. Yesterday’s paper reported that those two banks have agreed to accept just 43% of what they are owed.
I do not understand what is going on here. If federal law provides a safe haven for derivatives and swaps in Chapter 11 bankruptcy, why would the banks accept just 43% of what they are owed? What is their motivation? It is a good deal for the city. Can anyone explain what municipal debts have been given safe harbor by Congress?

[corktownyuppie]

I wondered why Kevyn Orr agreed to pay UBS and Bank of American 75% of what they were owed in those transactions made by Mayor Kilpatrick to fund pensions about eight years ago. Monday’s New York Times had a long essay contending that Congress enacted legislation providing safe harbor in bankruptcy proceedings to many derivatives and other complex financial instruments. If the federal law required 100% payment, Orr cut a good deal with 75%. Yesterday’s paper reported that those two banks have agreed to accept just 43% of what they are owed.
I do not understand what is going on here. If federal law provides a safe haven for derivatives and swaps in Chapter 11 bankruptcy, why would the banks accept just 43% of what they are owed? What is their motivation? It is a good deal for the city. Can anyone explain what municipal debts have been given safe harbor by Congress?

Bankruptcy treats secured debts differently from unsecured debts. In plain language, the debt you have on your mortgage will allow your lender to take your house if you fail to pay. Your credit card is an unsecured debt. Nothing specific is held as collateral on the loan. So if you file bankruptcy, your unsecured debts could be wiped away. But failure to pay your mortgage still means that the bank can take it back.

Swaps and derivatives are specific types of investments which are secure by collateral. I don't think it is fair to say that Congress has somehow granted them "safe harbor". I think it's more accurate to say that congress allows secured creditors to have a higher priority than unsecured creditors. And that it was the parties to the transactions themselves [[the city and the investors/lenders) who agreed to make those loans secured.

Back to your question...why would they agree to take 75 or 50 cents on the dollar?

Well, one reason is because there is a reasonable argument to make that the transactions themselves were never legal, and are therefore void. The lenders know that if this goes to court, every single party that wants a piece of that money will spend major resources to fight them in court. Rather than take the chance that they fight and lose everything, they agreed to take a 25% cut.

Of course, Judge Rhodes -- without overtly saying so -- implied that there's no way that the settlement would survive a challenge from the other creditors. So rather than waste time and money, go back to the table and come up with a better deal.

Thats a huge gift to Orr and the City Residents, who are now armed with a signal from the Judge that the City would be on the winning side of that argument.

Less than 50 cents on the dollar is enough for the lenders to take as a sure thing rather than risk time and money and end up with 0. Of course the union leadership says they are still not satisfied, but that has only slightly more credibility than when North Korea threatens -- by fax machine -- to bomb South Korea.

Overall I think this is a good sign for the bankruptcy proceedings, as creditors are falling in line to take their cuts rather than spend 10 years litigating.

[renf]

Thank you, Corktownuppie, your explanation is very clear. The banks
prefer some money in hand rather than going through the litigation
process that might result in their getting even less. Judge Rhodes pushed
Kevyn Orr to go into that second round of negotiations with the bank.
Thanks.

[Dan Wesson]

Can anyone explain what municipal debts have been given safe harbor by Congress?

I'll take a stab at this.

My take on this is two fold...

1) Many such arrangements are provided protection by law. Recent revelations of the power and influence that Wall Street wields in Washington by the way of Lobbying and Campaign donations go a long way.

2) Derivatives are just that. Contracts between parties that are derived from something else. In this case Interest Rate Swaps. Bets that are made on which way Interest may go. The Rate is variable therefore contracts were made that would pay off if the Rates rose. The losing side was when the rates didn't rise. Guess what side of the bet Detroit found itself in. Actually the amount negotiated was an amount to buy their way out of the Contract.

The protection from Congress was because these derivatives are not just a bet between two parties alone. There are many other parties betting on that same deal. Much like a gambler rolling dice, the other gamblers are making side bets with each other based on whether he makes his number or not.

Like the butterfly who flits it wings in Hawaii and creates a Hurricane in the Atlantic. These side bets can cascade much like they did when Lehman went under and Credit Default Swaps had to be paid off which was the main reason for the TARP... or there would be tanks in the street.

That's what makes derivative bets so dangerous there ain't enough money existing to cover all the side bets made.

[Wesley Mouch]

Thank you, Corktownuppie, your explanation is very clear. The banks
prefer some money in hand rather than going through the litigation
process that might result in their getting even less. Judge Rhodes pushed
Kevyn Orr to go into that second round of negotiations with the bank.
Thanks.

The process seems to be working. The first actors get better deals. The more you wait and hold out for everything. The less maneuvering room you have.

The judge signaled to the creditors that he didn't want to see retirees get slammed. But they are touchable. Retirees can settle now and set the terms. Or they can fight. The more they fight, the less room there'll be as others make their settlements. Its kinda like musical chairs. Don't be the last one to sit down.

Unions are the dumbest. Their leadership needs to be seen to be strong. That works better in contract negotiation with only one other party. This negotiation is multi-party. The leaders get rewarded for 'holding out' for the best deal. But what's really happening is everyone else is sitting down and taking the good chairs. They've be much smarter to settle early and set the terms of the debate. The problem is that the union leaders care more for their power than they do for their members. Members would be well-advised to understand this. Its the same reason leadership will sometimes let a plant shutdown -- hurting the local members, but strengthening their overall bargaining position.

[Eber Brock Ward]

If you are a fan of the city getting out from under its mountain of debt:

- It looks like the deal that Rhodes denied was reported to be about 75 cents on the dollar, resulting in about $230 million to UBS and BoA Merrill Lynch [[http://www.freep.com/article/2013121...financing-debt)
- That would mean that there is about $307 million outstanding to those two banks.
- The new proposed deal is about $165 million [[http://www.detroitnews.com/article/2...165M-bank-deal)

Using math, it would appear that the new deal is a bit under 54 cents on the dollar for two apparently SECURED creditors[[!). If Rhodes accepts this deal, the impact on the remaining unsecured creditors cannot be overstated, as it would essentially set an absolute ceiling at 54 cents on the dollar for folks like the other bondholders, the pensioners, and other claimants.

If you accept Orr's position that the city owes $18B in debt, containing about $6B in health care liability, the city's post-bankruptcy liabilities may be even less than $6B dollars or so [[$18B minus the $6B in health care, minus an additional ~50 cents/dollar on the other $12B in liabilities).

Great for the city to get out from 2/3 or more of its liabilities, but not so much for the creditors.

[jt1]

If you are a fan of the city getting out from under its mountain of debt:

- It looks like the deal that Rhodes denied was reported to be about 75 cents on the dollar, resulting in about $230 million to UBS and BoA Merrill Lynch [[http://www.freep.com/article/2013121...financing-debt)
- That would mean that there is about $307 million outstanding to those two banks.
- The new proposed deal is about $165 million [[http://www.detroitnews.com/article/2...165M-bank-deal)

Using math, it would appear that the new deal is a bit under 54 cents on the dollar for two apparently SECURED creditors[[!). If Rhodes accepts this deal, the impact on the remaining unsecured creditors cannot be overstated, as it would essentially set an absolute ceiling at 54 cents on the dollar for folks like the other bondholders, the pensioners, and other claimants.

If you accept Orr's position that the city owes $18B in debt, containing about $6B in health care liability, the city's post-bankruptcy liabilities may be even less than $6B dollars or so [[$18B minus the $6B in health care, minus an additional ~50 cents/dollar on the other $12B in liabilities).

Great for the city to get out from 2/3 or more of its liabilities, but not so much for the creditors.

$6B is tied to debt for the DWSD. I don't believe this will be negotiated down as it is tied to stable revenues. Now DWSD may be spun off/sold and the debt would go with the deal which would lower the total to $12BB to be negotiated.

[BankruptcyGuy]

If federal law provides a safe haven for derivatives and swaps in Chapter 11 bankruptcy, why would the banks accept just 43% of what they are owed? What is their motivation? It is a good deal for the city. Can anyone explain what municipal debts have been given safe harbor by Congress?

Ok, some basics:

Secured debt, as noted, is treated differently than unsecured debt. These debts are secured by casino revenues.

The swaps are in default for non-payment, and that happened before bankruptcy, so it is what's called a pre-petition default. The City would have the option of either curing the default [[which it can't, not enough cash), working something out with the lender, or turning over the collateral.

Why would the banks accept less than 100%? Two reasons:

1. There is an argument, although I don't think it's really a good one, that the City of Detroit was acting without authority when it entered into that agreement. No one can predict with certainty how such a matter would be viewed by the judge.

Two side notes: 1a. This clearly demonstrates how much better City counsel is compared to those representing the unions and pensioners. Do you know what you do when you have an issue that has some risk? Use it as leverage in negotiations. What you don't do is demand that the issue be resolved immediately, lose on the issue, and then leave your clients completely without leverage. But I digress.

1b. Judge Rhodes threw the City residents a huge lifeline by sending everyone back to the drawing board. Huge savings for the City. Someone send him a gift basket.

2. Time value of money. Even with a default, it would take time for the swap counterparties to collect the money due. The best they could do is casino revenue, over time, after fighting in state and federal court for years. Money now is worth more than money [[possibly) later.

As to your last question, I don't know what you mean by "safe harbor." Do you mean which debts are given which priority? Did the NYT use those exact terms, or can you post a link to the article?

[corktownyuppie]

2. Time value of money. Even with a default, it would take time for the swap counterparties to collect the money due. The best they could do is casino revenue, over time, after fighting in state and federal court for years. Money now is worth more than money [[possibly) later.

I like that. In bankruptcy, a bird in the hand is worth more than 2 that may or may not be in a bush down the road.

Wondering if you could switch out of professor role and pundit role.

Can you comment on the trustees' strategy to fight this every step of the way? Most retirees I talk aren't even being made aware that the funded liability is not at risk. [[Or if they are being made aware, they clearly have no idea about what is their worst case scenario, since many are still concerned about losing 80% of their pensions).

[Dan Wesson]

Here's a piece about banks, bonds and Detroit from Bloomberg...

http://www.bloomberg.com/news/2013-0...llion-fee.html

[BankruptcyGuy]

Can you comment on the trustees' strategy to fight this every step of the way? Most retirees I talk aren't even being made aware that the funded liability is not at risk. [[Or if they are being made aware, they clearly have no idea about what is their worst case scenario, since many are still concerned about losing 80% of their pensions).

My father-in-law, who is visiting for Christmas, is a retired DPD, and I concur that they are not getting good information.

In my humble opinion, their representation has been horrible. What I think happens is that they retain counsel whose experience has been negotiating collective bargaining agreements. In that process, yelling to the media and objecting to everything are mainstays of the strategy book. Counsel is doing a great disservice to their clients--in bankruptcy court, negotiate the best deal you can get, and then take it.

[corktownyuppie]

I certainly hope that their public face in the press isn't the same attitude they are using in mediation with Rosen.

And if you're willing to share, I'm curious about whether and how your father in law's opinion has changed after bring enlightened on the process and how it is all working. Not that it's worth much, but my father's opinion will be dependent on how much they stand to lose on the pensions and how fairly it is spread among retirees. He is frustrated because he is consistently being told that the pension trustees position is that no one will lose anything.

[BankruptcyGuy]

I certainly hope that their public face in the press isn't the same attitude they are using in mediation with Rosen.

And if you're willing to share, I'm curious about whether and how your father in law's opinion has changed after bring enlightened on the process and how it is all working. Not that it's worth much, but my father's opinion will be dependent on how much they stand to lose on the pensions and how fairly it is spread among retirees. He is frustrated because he is consistently being told that the pension trustees position is that no one will lose anything.

Great question. I think he's past the denial stage, and on to the acceptance stage. Luckily for him, he worked 10+ yrs in the private sector, so he has access to Medicare, which some do not. Realistically, the DPFPS is much better funded than DGRS, so the discount probably won't exceed 5-10%. I think he's adjusted to the concept that there is a haircut in his future.

The most interesting change is that he, among many other Detroit retirees who have left the city and state, spent years badmouthing it, saying how it would never come back. Now that he's figured out that every person who leaves Detroit is one less person to pay the bills, the tune has changed to one with more optimism.

[Wesley Mouch]

My father-in-law, who is visiting for Christmas, is a retired DPD, and I concur that they are not getting good information.

In my humble opinion, their representation has been horrible. What I think happens is that they retain counsel whose experience has been negotiating collective bargaining agreements. In that process, yelling to the media and objecting to everything are mainstays of the strategy book. Counsel is doing a great disservice to their clients--in bankruptcy court, negotiate the best deal you can get, and then take it.

Certainly, habits are one thing. Labor attorneys are usually masters of 'no'. But I think the main things is that union and pension attorneys think that their constituents want to hear 'you won't lose a penny -- I'm standing up tough for you'. True? No. But the audience likes it.

On the other hand, the city attorneys know that their city's future depends on success, not posturing.

This to me is the main weakness of how we've setup collective labor bargaining. The system does not encourage leaders who tell their members the truth about how bad things are.

[renf]

http://dealbook.nytimes.com/2013/12/...-detroit-case/
This is the link to the NY Times story, published earlier this week, about
a safe harbor for those banks who are owed funds by the city of Detroit.

[Eber Brock Ward]

$6B is tied to debt for the DWSD. I don't believe this will be negotiated down as it is tied to stable revenues. Now DWSD may be spun off/sold and the debt would go with the deal which would lower the total to $12BB to be negotiated.

Good point, I'd totally forgotten that. Again, if you accept Orr's numbers, it's $18B comprised of something [[very roughly) like:
- $6B DWSD secured debt [[secured by the Net Revenues of the DWSD system)
- $6B Retiree healthcare costs [[which can essentially be wiped out with the stroke of Orr's pen)
- $6B Unsecured debt [[GO bonds, pensions, other miscellaneous obligations)

$6 billion gone if Orr can spin off DWSD and rid the city of that debt [[I, perhaps wrongly, recall that the DWSD debt is double-barrel, meaning that a city general obligation pledge backs the pledge of DWSD revenues.

That leaves us with $12B left.

Another nearly $6B gone when Orr moves retirees to a stipend or Obamacare.

That leaves us with a bit more than $6B left, represented by the unsecured creditors.

Then, if we use around 50 cents/dollar or so for the ceiling for those remaining unsecured creditors, based on the recent settlement for the swap deal [[if Rhodes approves it), at least $3B of that should be wiped out.

Leaving only, at a max, $3B remaining of a pre-BK $18B debt load. Granted, I'm just working this out on the back of a virtual napkin now, but what a potentially fantastic outcome for the actual residents of the city, even if it's unfortunate for bondholders, retirees, etc.

[Novine]

Your math only highlights what some people knew from the get-go which is that the debt numbers being thrown around town were overhyped and that most of the pain is going to be inflicted on pensioners and employees. The city doesn't even have to spin off DWSD to be rid of the debt, it was never an obligation of the city in the first place. It's only included to allow Orr and Snyder to pump up the debt numbers. That's not to say that unloading that debt isn't a good thing for the city. It is. But a good chunk of that debt was already being paid off with existing debt millages. Getting those off the books won't add a dime to the city's ability to put more dollars into services for residents.

[Eber Brock Ward]

Your math only highlights what some people knew from the get-go which is that the debt numbers being thrown around town were overhyped and that most of the pain is going to be inflicted on pensioners and employees..

Incorrect. The debt number was pegged at $14.108 Billion as long ago as June, 2010 [[http://www.crcmich.org/PUBLICAT/2010s/2011/rpt373.pdf <-- see page 7 of the PDF).

The city doesn't even have to spin off DWSD to be rid of the debt, it was never an obligation of the city in the first place.

Incorrect. Water bonds are issued by the "City of Detroit, Michigan." Here's an example deal from a few years ago: http://emma.msrb.org/ER546579-ER423371-ER825503.pdf

It's only included to allow Orr and Snyder to pump up the debt numbers.

Also incorrect. See the answer above about $14.108 Billion a few years ago.

That's not to say that unloading that debt isn't a good thing for the city. It is.

Agreed.

But a good chunk of that debt was already being paid off with existing debt millages. Getting those off the books won't add a dime to the city's ability to put more dollars into services for residents.

This, too, is incorrect. Interest alone on long-term GO [[non-DWSD) debt was $129,097,503 per year for debt that wasn't deferred by refunding or otherwise, per our last CAFR, and the ~9 mills to support unlimited tax debt yielded $69,141,680 [[page 47 of CAFR) [[http://www.detroitmi.gov/Portals/0/d...Statements.pdf). That means that the millage was short about $60 million dollars! And since we didn't default on those obligations until recently, that means that we had to make up that $60 million somewhere, and the answer is that it was being taken from the city's general fund in order to pay the bondholders.

I don't know what you think, but I think $60 million could go a long way toward providing the residents with services, if it were back in the general fund instead of being spent on bond interest.

I've seen you post here a long time and know that your heart is good, but Novine please don't believe the people that would lie to you and say "it's not that bad," because the proof is in the numbers that date from before Orr and even before Bing.

[corktownyuppie]

Your math only highlights what some people knew from the get-go which is that the debt numbers being thrown around town were overhyped and that most of the pain is going to be inflicted on pensioners and employees. The city doesn't even have to spin off DWSD to be rid of the debt, it was never an obligation of the city in the first place.

I think Novine is correct in the sense that the DWSD debt isn't dependent on funds from the general operations budget because it is being paid by revenue from the water system. And, therefore, spinning off DWSD won't affect our general fund.

The 2011 Bonds are not general obligations of the City and do not constitute indebtedness of the City for purposes of computing its debt limitations....

The bigger issue is that the employees and former employees of the DWSD [[such as my father) don't show up as a liability on DWSD, they show up on the City's general fund.

If the pension and health care budget for DWSD employees was backed by DWSD revenue, this would be a totally different story.

Alas, it is not. And that is why we're here today.

[corktownyuppie]

Also worth noting that even though DWSD bonds are not tied to the City, the reality is that in a default situation, there's litigation risk about whether the City -- as owners of DWSD -- would be eventual guarantors of the DWSD debt.

In any case, where I'm getting to is that the borrowing costs for DWSD are being unfairly impaired by the City's bankruptcy, driving them way up. This isn't a sustainable situation.

[Eber Brock Ward]

Also worth noting that even though DWSD bonds are not tied to the City, the reality is that in a default situation, there's litigation risk about whether the City -- as owners of DWSD -- would be eventual guarantors of the DWSD debt.

In any case, where I'm getting to is that the borrowing costs for DWSD are being unfairly impaired by the City's bankruptcy, driving them way up. This isn't a sustainable situation.

I don't think so. The OS and, surely, the Bond Ordinance make perfectly clear that they are not a GO of the city. If you click on the link to the OS that I posted, you'll see the following in bold on the cover page of the OS:

The 2011 Bonds are not general obligations of the City and do not constitute indebtedness of the City for purposes of computing its debt limitations imposed by constitutional, statutory or charter provisions. The 2011 Bonds also do not constitute a charge against the general credit or taxing power of the City, nor is the City liable for the payment of the 2011 Bonds except from the sources herein described.

Nevertheless, the issuer still is the "City of Detroit," and it is city debt.

[corktownyuppie]

I don't think so. The OS and, surely, the Bond Ordinance make perfectly clear that they are not a GO of the city. If you click on the link to the OS that I posted, you'll see the following in bold on the cover page of the OS:

The 2011 Bonds are not general obligations of the City and do not constitute indebtedness of the City for purposes of computing its debt limitations imposed by constitutional, statutory or charter provisions. The 2011 Bonds also do not constitute a charge against the general credit or taxing power of the City, nor is the City liable for the payment of the 2011 Bonds except from the sources herein described.

Nevertheless, the issuer still is the "City of Detroit," and it is city debt.

I'm not sure if you are agreeing with me or disagreeing with me, as the bold quote that you posted is the same one that I quoted in my post above yours.

The OS and Bond Ordinance are clear in that they are not a GO of the city. But the bonds are pricing negatively as a result of the city bankruptcy. S&P had the underlying ratings of the DWSD bonds at BB- last time I looked...definitely in junk territory.

Even if the bonds are sheltered from the GO of the city, as per Novine's position, the bottom line is that DWSD is still owned by the City of Detroit and can be used to satisfy creditors in bankruptcy court. Therefore, there may be a major restructuring necessary to lower their borrowing costs or in order to shore up the City's operating fund. What that will look like is still yet to be determined, but bankruptcy gives the EFM a lot of discretion in terms of what can happen.

Anyway, my main point is that while Novine is accurate about the DWSD being separated from City Operations and its General Fund, there are two "nails in the coffin" that justify City Attorneys in citing their debt as part of the problem and not a way to "inflate the debt issue" to justify bankruptcy:

[[1) Employees of DWSD create liabilities that escape the confines of DWSD financial strength. So even if DWSD is AAA rated, their employees past, present and future, create liabilities that extend to the City via health care and pension costs.

[[2) The City is the owner of DWSD and can be forced in bankruptcy to restructure or sell the DWSD in order to satisfy creditors. Of course, the terms and proceeds of the sale will be diminished by the amount of debt that DWSD is carrying. So even though the debt doesn't belong to the City in a direct way...it definitely affects directly how much the City could get for it in a sale to pay off creditors.

So in conclusion, I find that Snyder's, Orr's, and Wall Street's analysis of DWSD having "association risk" with the City -- as well as DWSD's balance sheet being used to bolster the argument in favor of City Bankruptcy -- is the correct one.

[Novine]

I read the CRC report back in 2010. If you get into the details, you'll see that most of that debt is attributable to three things:

1. DWSD Debt
2. Employee pensions
3. Employee retirement health care

Back those out and the outstanding debt of the city is nowhere near $14 billion. The same is true today. As I stated "most of the pain is going to be inflicted on pensioners and employees". Still true.

DWSD debt may have the "City of Detroit" on the bonds. But as revenue bonds, those are obligations of the users of the system, not the city. Those of us in the suburbs who use the city are going to be on the hook for those debts before the taxpayers of Detroit. But you never hear Orr or Snyder say that, do you?

"That means that the millage was short about $60 million dollars! And since we didn't default on those obligations until recently, that means that we had to make up that $60 million somewhere, and the answer is that it was being taken from the city's general fund in order to pay the bondholders."

The millage can't be short. If there are debts not being serviced by the debt millage, those other debts aren't true GO debts. In any case, the current millage does cover the majority of the outstanding debt payments. I agree that it doesn't help for the city to have $60 million going out of the General Fund to pay down debt. But put it into context, if Orr managed to squeeze that down to 50% of the debt owed, it would free up $30 million a year? That's hardly game changing. Also, in the context of a $2.6 billion dollars that Detroit spent in 2012, $129 million is less than 5% of that total. That's hardly a crushing level of debt.

My point isn't to minimize Detroit's problems but bring the focus back onto where the pain is going to come into play. It's not going to be the banks but the employees and pensioners who are going to feel it. The whole smokescreen of conflating DWSD debts and focusing on the swaps, etc. is to downplay that aspect of the debt discussion.

[DetroitPlanner]

DWSD debt may have the "City of Detroit" on the bonds. But as revenue bonds, those are obligations of the users of the system, not the city. Those of us in the suburbs who use the city are going to be on the hook for those debts before the taxpayers of Detroit. But you never hear Orr or Snyder say that, do you?

No, but I have noticed that once this became knowledge suddenly the demand to rationalize the water system has gone away! I don't even know how you would untangle that if it became to 'us' and 'yours' as certainly some of that debt is for projects that benefit the City more than the burbs, but a lot of it was to expand and to improve the burb's system. It is ONE system with one owner, many users to be sure.

[BankruptcyGuy]

http://dealbook.nytimes.com/2013/12/...-detroit-case/
This is the link to the NY Times story, published earlier this week, about
a safe harbor for those banks who are owed funds by the city of Detroit.

Thank you. The NYT article refers to a situation which is not applicable to Detroit--Detroit posted no cash to support the swap transaction, only future cash flow.