Detroit’s swaps deadlock

July 8, 2013

Pity Kevyn Orr, Detroit’s emergency manager who was hurried in by the city to clean up a long festering mess. The Greek hero Hercules re-routed two rivers to clean out the filth of 1,000 cattle, whose stable had not been cleaned in 30 years. Orr is attempting a similar feat by slashing and diverting cash flows to stabilize the city’s finances after 30 years of fiscal mismanagement.

Orr has been involved in closed door negotiations with numerous parties after making a lowball proposal for creditor haircuts last month. Some of these negotiations are not going well. Orr filed his first lawsuit against a Detroit creditor, Syncora, a Bermuda based bond insurer, last Friday. Orr alleges that he was forced to file the suit over claims to the legal right to cash flows from Detroit’s casino tax revenues.

In 2009, after Detroit was downgraded and a swap termination event was triggered, a portion of casino revenues were committed to pay off interest rate swap counterparties (UBS A.G.. SBS Financial Products and Merrill Lynch Capital Services as credit support provider to SBS) by an agreement hammered out by Mayor Dave Bing.

The forced swap termination trigger would have required Detroit to cough up several hundred million dollars of cash to pay off the bank counterparties. Instead, the city and bank counterparties agreed that they would receive part of the casino revenues on a quarterly basis in lieu of a termination payment.

But long before this re-negotiation, Syncora had insured the bondholders of Detroit’s pension Certificates of Participation (COPs) against default. Orr defaulted on these COPs by not making a $40 million interest payment on June 14. Since Syncora had insured the COPs against default in 2005 and 2006, they were forced to make up this missed payment to bondholders. Syncora had insured the original COPs and also the interest rate swaps that accompanied the COPs, which were later subject to the termination agreement and renegotiated.

Here is the nub of the lawsuit and conflict between the city and Syncora (page 3):

As part of the (interest rate) swaps transaction, the Counterparties required the Service Corporations (Detroit’s legal entity for COPs transaction) to buy insurance against any default on their swaps payments. The Service Corporations went for this insurance to the same two sureties—including Syncora’s predecessor, XL Capital—that they had used for the insurance on the COPs. Thus, Syncora is the surety for both the COPs and swaps.

Syncora appears to contend that the insured COPs and swaps are linked, and that if a default occurs it has the right to take casino revenue to pay off the COP bondholders. Orr alleges that they are separate transactions.

These, however, are two different sets of insurance policies, and Syncora’s obligations and rights under the two policies are separate and independent. Syncora has no other exposures to or contacts with the City.

Syncora had instructed US Bank, a trustee for the city’s interest rate swaps counterparties, to halt distribution of casino revenues for the 2009 agreement. Orr’s rush to court on Friday asked for an injunction to cancel this instruction to halt the distribution to swap counterparties.

Orr says that he was in the middle of cutting a deal with the interest rate swap counterparties when Syncora’s move halted those negotiations. They relied on the city having access to the casino revenues. I won’t bore you with many more details, but a very important lesson from this event is that muniland issuers have no responsibility to disclose material events around derivatives. Bondholders would have no insight into these negotiations if the lawsuit had not been filed.

Lack of disclosure around derivatives makes a mockery of muniland’s transparency for disadvantaged bondholders. I wrote about this issue last April. Congress, the SEC and the MSRB should know that bondholders are severely disadvantaged by not having derivatives information. There is a giant loophole in continuing disclosure regulations. Detroit’s swaps deadlock illustrates this need.

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