Detroit’s embedded time bomb

October 23, 2013

There are a lot of moving parts in the Detroit story as it goes through the largest municipal bankruptcy in U.S. history. The strangest part of the story has been the interest rate swaps that were layered onto the city’s 2005 and 2006 pension obligation bonds.

The purpose of the swaps was to lower the city’s borrowing costs by using interest-rate arbitrage. Theoretically, if financial conditions had remained “normal,” the swaps would have been beneficial for the city. Instead, Detroit’s credit rating was downgraded and the financial crisis upended the delicate conditions that underpinned the swaps.

On July 18th, when Detroit’s Emergency Manager Kevyn Orr filed for municipal bankruptcy, he also filed a proposed settlement with the swaps counterparties. Orr’s proposal would pay the counterparties – UBS and Bank of America Merrill Lynch – between 75 and 82 cents on the dollar to terminate the swaps and move them out of the picture. This action insulates UBS and Bank of America from the hatchet job that Orr plans to give to other creditors in the course of the bankruptcy process. Those unprotected creditors include bond insurer Syncora, which insured the interest-rate swaps and the underlying pension obligation bonds.

In the end it comes down to who has legal control of the city’s $15 million per month of casino tax revenues. About $4 million per month has been used since 2009 to pay UBS and Bank of America on their swaps deals. Federal bankruptcy judge Steven Rhodes ruled that the city has control of the excess $11 million. Reuters reports:

Syncora had tried to block Detroit from accessing an estimated $11 million in monthly tax revenue from the city’s three casinos, claiming it had a lien on the money, which had been used as collateral since 2009 to secure the city’s interest-rate swap agreements. Detroit’s emergency manager, Kevyn Orr, and one of his top consultants said in sworn depositions that the casino revenue is key to city’s survival.

Syncora on Thursday [October 10] filed an appeal in U.S. district court in Detroit of an August 28 ruling by Bankruptcy Judge Steven Rhodes granting the city access to the casino funds.

Here is where the story gets fuzzy. Orr solicited firms for $350 million in “debtor in possession” financing to buy out UBS and Bank of America and terminate their swaps agreements. He chose Barclays in a closed process to provide this money. The terms of the Barclays DIP loan are:

Repayment: Tax revenues of the city (including casino taxes)

Maturity: Barclays facility appears to mature if there is a dismissal of the bankruptcy or on the effective date of the plan of adjustment…. which means that Detroit will have to raise more funds to pay off this Barclays loan when the bankruptcy is complete (page 20).

Interest rate – One month Libor plus 250 basis points, but Libor not less than 1 percent (minimum rate of 3.5 percent).

Default: If Detroit defaults, the 250 basis point spread becomes 450 basis points and city must pay it off at a rate of $4 million a month.

Call: After one year the note can be called with 10 days notice.

Additional terms:

Any money that the city raises from asset sales over $10 million must be used to pay down the note.

With consent of the city (which appears cursory) Barclays can sell off parts of the loan to other banks and financial firms (in other words, it may syndicate the loan).

The loan is secured by a first priority lien on monies from casino tax revenues, income tax revenues and asset sales over $10 million.

The city can seek no additional financings.

Orr has said he pursued the swaps agreement in order to free up the city’s casino revenue. But the terms of this new deal set the casino revenue as collateral, and city taxes will have to pay off the Barclays loan (You can see this at the bottom of page ten of the Barclays term sheet).

Paying for the swaps will just be transferred to the Barclays loan. This deal simply redirects where a stream of tax payments will go. It’s not clear why Orr doesn’t treat UBS and Bank of America the same way as other creditors during the bankruptcy process. Why the need for all this fancy action? Many in Detroit are saying that Orr is giving preferential treatment to these banks. The City Council rejected his proposal yesterday.

This deal makes no sense. Why the rush to cash out UBS and Bank of America?

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