Detroit’s derivatives slip through the net

April 18, 2012

If you were thinking of buying some of the city of Detroit’s bonds, you might want to tread lightly. Although the city was able to come to terms with the state and avoid the appointment of an emergency manager, it still faces enormous challenges. The biggest threat to Detroit’s fiscal stability is the risk that its derivatives counterparties will activate triggers in their interest rate swaps. If this happens, the counterparties will force a lump-sum payment, draining cash from an already shaky situation.

From the outside it’s difficult to know exactly what is happening in the city. A recent Moody’s report says that counterparties may have already activated these triggers, but it’s impossible to get any public information from the city. There is a big regulatory gap or loophole that shields Detroit from having to tell investors, or their citizens, the status of these derivatives contracts.

Here is how I described the situation facing Detroit on Mar. 24:

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….

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…. It’s a dangerous standoff, and we don’t know how to decipher the situation, since the information is not publicly disclosed.

What I feared for Detroit back then has happened. Moody’s disclosed in an Apr. 9 report downgrading Detroit water and sewer bonds that a termination event had been triggered for the city’s certificates of participation (COP) interest-rate swaps. Although the Moody’s report gave no details, the interest-rate swaps were $297 million “out-of-the-money” on June 30, 2011, the most recent public information we have for the derivatives (CAFR of June 30, 2011, page 113).

So, in a worst-case scenario for Detroit, the city could be forced to pay $297 million in cash to the bank on the other side of the swap. We know that Detroit’s counterparties are Citigroup, JPMorgan, Loop Capital, Morgan Stanley, SBS and UBS, but we don’t know which one is involved with the COPs.

I tried to reach Cheryl Johnson, Detroit’s finance director, over a number of days, but she didn’t return calls. I wondered if Detroit had a responsibility to disclose the swap termination event, because it seems material to the city’s finances. After a call with the chief legal officer of the MSRB, Ernesto Lanza, I learned that there is no specific requirement to disclose derivatives events like the one Detroit is having. MSRB 152c-12, the rule that mandates disclosure of “material’ events for issuers, does not have a category for derivatives, a private contract between Detroit and the banks. Lanza said that there had been fewer than 10 voluntary disclosure filings related to derivatives, hardly a stampede to transparency.

Unless Detroit decides to disclose the information voluntarily, investors will have to wait until the 2012 Comprehensive Annual Financial Report (CAFR) is made public in 2013. Given that Detroit’s credit rating is the lowest of any major American city, at B2, it might be a worthwhile gamble for Detroit to go for full disclosure on its swap dealings unless the bank counterparties have imposed confidentiality agreements. Detroit is deep in a hole, and its best tool right now is sunlight.

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