It’s Michigan versus Wall Street in the battle over Detroit’s future

March 24, 2012

It’s hard to follow the news from Detroit without getting a sense of impending doom. Detroit’s fiscal problems are enormous, and Michigan’s governor, Rick Snyder, has been fighting to gain control of the city’s books through his treasurer while he’s off in Europe on a trade mission. Thirty public-worker unions have agreed to concessions requested by Detroit Mayor Dave Bing to help balance the budget. Meanwhile a state appeals court is weighing whether to overturn a lower court order that would bar the governor’s review team from signing an agreement with Detroit because the team violated open meeting laws.

Every level and branch of Michigan government has a dog in this fight. It’s good theater, but the real war over Detroit’s future will be fought among its bondholders, interest-rate swaps counterparties and bond insurers.

In short, Detroit needs about $140 million in cash to make it through the end of its fiscal year. This will allow the city to pay workers and keep current on its debt service while continuing to downsize the government and make it more efficient. Rather than lending the cash to the city, the governor wants control. Detroit has been making its bond and derivatives payments, and a good portion of the bonds are insured by either MBIA or Assured Guaranty, but it’s the nasty derivatives counterparties that wield outsize power over the city’s future.

Detroit has about $3.8 billion in interest-rate swaps outstanding, according to its most recent public filing (CAFR of June 30, 2011, page 113). These Wall Street weapons of mass destruction were sold to the city in a series of transactions since 1997, allegedly to hedge interest-rate risk. The interest-rate swaps were necessary because Wall Street dealers sold variable interest-rate bonds for the city that needed to be hedged. Of course, Wall Street could have sold fixed-interest bonds from the beginning, negating the need for the swaps, but complexity means that Wall Street earns more in fees. Guiding less-informed public officials to the most profitable products seems to be an art form, and it often allows the public officials to push the fiscal reckoning out into the future, long after they have completed their terms.

Detroit’s derivatives could blow up the city because many contain “termination” clauses that require accelerated payments to the dealer on the other side of the transaction. The terms vary by contract, and public documents don’t give us much detail. But if the credit rating of Detroit or its bond insurers (MBIA and Assured) falls below a certain level, then an accelerated lump-sum payment must be made to the dealer. For some of the swaps, if the governor appoints an emergency manager to oversee the city’s derivatives, payments could turbocharged, too. It’s a dangerous standoff, and we don’t know how to decipher the situation, since the information is not publicly disclosed.

On the other side of Detroit’s derivatives sit Citigroup, JPMorgan, Loop Capital, Morgan Stanley, SBS and UBS. If any or all force their termination agreements, then the city, which lacks the cash to pay them, could be forced to default on its bonds and possibly be put into bankruptcy. This would leave the bond insurers, MBIA and Assured, two firms that are not financially strong themselves, to make principal and interest payments on the bonds they insured.

I argued earlier in the week that Bing should not be forced out of control of the city. I still believe this and know he can be a strong partner with Snyder and State Treasurer Andy Dillon. The media have described this battle as the city against the state, but it is really Michiganders against Wall Street. Unless someone takes up the leadership mantle and rallies all the branches of government to get the city and state through this, then Wall Street will declare victory.


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