Detroit Turns Bankruptcy Into Challenge of Banks

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Investment Banking<http://dealbook.nytimes.com/category/main-topics/investment-banking/> |Restructuring & Bankruptcy<http://dealbook.nytimes.com/category/other-topics/restructuringbankruptcy/>February 3, 2014, 9:10 pm // 13 Comments

Detroit Turns Bankruptcy Into Challenge of Banks

By MARY WILLIAMS WALSH </author/mary-williams-walsh/>

Kevyn D. Orr, Detroit's emergency manager.Paul Sancya/Associated PressKevyn D. Orr, Detroit's emergency manager.

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Detroit's bankruptcy is rapidly shaping up as a battle of Wall Streetvs. Main Street, at least as far as the city's creditors are concerned.

Amy Laskey,a managing director at Fitch Ratings<http://topics.nytimes.com/top/news/business/companies/fitch_ratings_inc/index.html?inline=nyt-org>,said in a recent report that she sensed an ªus versus themº orientationtoward debt repayment. And in the view of bondholders, bond insurers andother financial institutions, it only grew worse last week after thecity circulated its plan to emerge from bankruptcy and filed a lawsuiton Friday.

The suit, brought by the city's emergency manager, Kevyn D. Orr, seeks

to invalidate complex transactions that helped finance Detroit's pensionsystem in 2005. In a not-so-veiled criticism, the city said the deal wasdone ªat the prompting of investment banks that would profit handsomelyfrom the transaction.º

The banks that led the deal were Bank of America<http://dealbook.on.nytimes.com/public/overview?symbol=BAC&inline=nyt-org>and UBS<http://dealbook.on.nytimes.com/public/overview?symbol=UBS&inline=nyt-org>.They helped Detroit borrow $1.4 billion for its shaky pension system and



also signed long-term financial contracts with the city, known asinterest-rate swaps, to hedge the debt. Detroit has already stoppedpaying back the $1.4 billion, but for the first six months of itsbankruptcy it kept honoring the swaps contracts and at one point offeredto pay the two banks hundreds of millions of dollars Ð money it wouldhave had to borrow Ð to end them. But the lawsuit now seeks to cancelthe swaps, arguing they were illegal from the outset along with therelated debt transactions.

Perhaps of even greater concern to creditors is the city's 99-page ªplanof adjustment,º the all-important document that details how Detroitproposes to resolve its bankruptcy and finance its operations in thefuture. Banks, bond insurers and other corporate creditors think theyare being asked to share a disproportionate amount of pain under theplan, still in draft form and not yet filed with the bankruptcy court.

ªThe essential issue is the near-total wipeout of the bondholders,º saidMatt Fabian, a managing director of Municipal Market Advisors. He saidDetroit's case appeared to be heading toward a ªcramdown,º orcourt-ordered infliction of losses on unwilling creditors.

Protesters last month outside a federal courthouse in Detroit where ajudge ruled on the struggling city's bankruptcy.Bill Pugliano/GettyImages Protesters last month outside a federal courthouse in Detroit

where a judge ruled on the struggling city's bankruptcy.

Municipal bonds<http://topics.nytimes.com/top/reference/timestopics/subjects/m/municipal_bonds/index.html?inline=nyt-classifier>have been renegotiated and restructured in the past, both in and out ofbankruptcy, with a reduction in interest rates and extension ofpayments. But bankruptcy specialists say that, until now, municipalbondholders have not had losses of principal forced on them by a court.Participants in the municipal bond markets say the dreaded cramdown maybe looming in Detroit, where they are finding themselves increasinglyportrayed as greedy, and where plans are taking shape to elevatepensions above municipal bonds, though both are unsecured in bankruptcy.

Bankruptcy law is based on the idea that losses can be kept to a minimumif all parties work together to share the pain instead of cuttingpreferential deals for themselves at the expense of other creditors.From the beginning of Detroit's bankruptcy last summer, Gov. Rick Snyderof Michigan has said the intent was to ªdetermine the best path forwardthat respects, and is fair to, pensioners and all parties.º

But now Detroit's capital-markets creditors Ð its bondholders, bondinsurers and other financial institutions Ð say the plan of adjustmentis unfair. It calls for the city to give pensioners up to 50 cents onthe dollar for their claims, while other unsecured creditors, like thosethat bought Detroit's general-obligation bonds, would end up with about

20 cents on the dollar. The pensioners' claims would be paid with cash,while general-obligation bondholders would receive notes that Detroitproposes to issue.

ªThe capital-markets guys can still sue against this as unfair, and theywill,º Mr. Fabian said.

The debt that raised $1.4 billion for the city pension system in 2005would suffer bigger losses still. The plan of adjustment does not acceptthe entire $1.4 billion as a valid claim, only about half of it. So the



investors who bought that debt, called ªcertificates of participation,ºoften called COPs, would end up with about 10 cents on the dollar. Itwould come in the form of a different series of notes, which has lagsbuilt into the payment schedules.

ªWe understand discriminatory treatment of the COP deal might bepolitically popular, but we believe it to be flawed both legally and asa matter of public policy,º said Derek Donnelly, a managing director forthe Financial Guaranty Insurance Company, a bond insurer that promisedto backstop the certificates in 2005. The insurance made it easier forDetroit's underwriters, Bank of America and UBS, to market thecertificates. And Detroit paid a lower rate of interest on the debtuntil it defaulted last summer just before the bankruptcy.

The financial institutions that helped raise money for Detroit's pensionsystem are dismayed now to see themselves portrayed as shady charactersin the new lawsuit, according to people briefed on the matter. The suitcontends their transaction ªhas put very fatal strains upon the city'sfinances,º but as they see it, the city already had a crushing debt toits own workers, much of which was hidden, before they arrived on thescene. Some of them are now talking privately about lawsuits that wouldunwind the 2005 borrowing and force Detroit's pension funds to returnthe money.

Spokesmen for Bank of America and UBS declined to comment on the lawsuit.

Ms. Lasky and Mr. Donnelly both expressed concern that by giving thepensions priority over capital-markets debts, Detroit's lawyers could bemaking it harder for other Michigan cities, counties and schooldistricts to raise money in the future. Ms. Lasky said that becausemunicipal bankruptcies are so rare, and Detroit's debts so big, the citystood to set an outsized precedent that might even affect cities outsideof Michigan.

ªActions and rhetoric that suggest bondholder rights are not animportant consideration will continue to damage market perception of thestate and its local governments,º Ms. Lasky said.

Bankruptcy experts who are not involved in Detroit's case said it would,in fact, be possible for the city's pensioners to come out at the top ofthe pecking order, even though they were on par with thegeneral-obligation bondholders when the bankruptcy began.

ªYou can treat general creditors differently, as long as you have a goodreason to treat them differently,º said David A. Skeel, a law professorat the University of Pennsylvania<http://topics.nytimes.com/top/reference/timestopics/organizations/u/university_ of_pennsylvania/index.html?inline=nyt-org>who specializes in bankruptcy issues. ªYou don't have to give themexactly the same percentage, but you can't treat them wildly

disproportionately.º

He said it was not at all rare for a bankruptcy judge to approve ahigher rate of recovery for a creditor with some essential businessrelationship with the bankrupt party. While it would be hard to say thatDetroit's retirees fill a conventional business purpose, the city couldstill make valid arguments that its finances would be hurt if it cut theretirees' benefits too drastically because it would then have to findmoney to support them in other ways.



ªThere's also a humanitarian interest in not wanting to cut the pensionsseverely as well,º Mr. Skeel said.

A version of this article appears in print on 02/04/2014, on page B1 of the NewYork edition with the headline: Detroit Turns Bankruptcy Into Challenge of Banks.

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Neltje

Newport Beach CA 46 minutes ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-of-banks/#permid=11094355>

They are afraid they look shady? Really? The banks behaved badly in thiscase, and the derivative swap deal in question took advantage ofunsophisticated politicians with a few crooked pols mixed in from a

shrinking municipality.

Instead of servicing the debt to the people of Detroit and paying theretirees who spent many decades in the service of their city, themunicipality was talked into allowing the bank to cut themselves in onthe contract and it became about servicing the debt to the banks.

Unbelievable gall.These are American Citizens from Detroit we are talking about. I thinkthe fact that the Federal Govt isn

t stepping in makes the USA look weakin the eyes of the country and the world. Also, the entire publicservant class is watching with fear- it is undermining our entire systemof governance.

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Mark T.

/is a trusted commenter/ New York NY 47 minutes ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-of-banks/#permid=11094340>

Readers should keep in mind that some or all the CoPs are insured bybond insurers. I believe FGIC is the main one on the hook. FGIC is, Ibelieve, in run off because it was perceived insolvent by the state thatregulates it. This means that the real loss in this specific case willnot be borne by CoP holders but by other insureds of FGIC whose recoverywill be diluted by increased claims of CoP holders. But in principle thearticle is correct, that this is an attack on the main external sourceof municipal financing, the capital markets. Proving once again that nogood deed goes unpunished.



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Mark T.

/is a trusted commenter/ New York NY 1 hour ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-of-banks/#permid=11094036>

It strains credulity to say that refinancing pension liabilities as theCOP

s did increased the city

s debt. That would seem to be the classicexample of form over substance.


Joker

Gotham 4 hours ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-of-banks/#permid=11092064>

The bankers should quit this annoying mosquito whine. What do they thinkit means when a municipality declares bankruptcy? This isn

t somebloodless investor business. Rather it is a time of pain and acrimonyand destitution.

The moral of the story is don

t lend to shaky municipalities next time.

If you do, prepare for the consequence. Such a situation would be veryhelpful to us all.


Gene

/is a trusted commenter/ Atlanta, GA 4 hours ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-

of-banks/#permid=11091794>

It is ridiculous to suggest that the city of Detroit was duped. Commonsense tells you that there is not now and never was a free lunch. Howcan you become over a billion dollars short in your pension fund withoutknowing it? How can you borrow a billion dollars and relend it, makingenough to pay the interest and pay off the principal without taking anyrisk? Why would a lender insist on hundreds of million in cancellationfees if you paid of the loan if there was no risk that you would do so



and why would you agree to a loan you couldn

t pay off early?

The reality was simple. There was a spread between short term and longterm interest rates. You were going to borrow money at the lower rateand lend it at the higher rate, covering the interest owed and using thedifference to pay off the loan or fund other activity. However, thisspread had historically fluctuated and if it went the wrong way youcould be forced to pay more in interest than you received.

What would have happened if interest rates had gone the other way andDetroit was making even more money? Would Detroit have let the investorsout of the transaction. If the investor was going bankrupt do you thingthe bankruptcy judge would have insisted Detroit pay back the billion%2Bat 100 cents on the dollar?

No investor will now loan Detroit a dime without an ironclad guarantee.Even then, only a fool would do so.


pm

philadelphia 6 hours ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-of-banks/#permid=11090743>

shylock is at it again


Stage 12

Long Island 7 hours ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-of-banks/#permid=11090341>

Ms. Lasky

s concern about the impact of a derivatives cramdown onMichigan cities, counties and school districts to raise money in thefuture has no merit. The market for straitforward municipal bonds willdo fine, only investors of shady, crippling derivatives should be

worried, and rightfully so. These financial instruments cripple themunicipalities that get suckered into buying them: look at what happenedto Birmingham where people went to jail over it. They should beoutlawed. If not, then at least let their bad reputation and possibilityof precedent setting bankrupty cramdown kill them off.

ªActions and rhetoric that suggest bondholder rights are not animportant consideration will continue to damage market perception of thestate and its local governments,º Ms. Lasky said.




Ray

Brooklyn 7 hours ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-of-banks/#permid=11090476>

If you go back to the very earliest days of "interest rate swaps",you

ll find a cover story in The Economist titled "CSFB

s Italian Job"detailing how the investment bank attempted to swindle the Italiantreasury by hoodwinking some unsophisticated treasury official. The bankhad to reverse that transaction because of the outrage. How is itdifferent all these years later when the banks have been swindlingentire cities or even local municipalities in Alabama by the same methods?

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NYC Moderate

NYC, NY 7 hours ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-of-banks/#permid=11090452>

1. Interest rate swaps are a basic derivative that effectively made theloans that Detroit took have a fixed percentage rate, rather than anadjustable one, similar to a mortgage. This protects the borrower in

case interest rates rise over time. No one saw the unprecedented drop ininterest rates and for anyone to claim that they were duped into thisbasic agreement is simple false. Woe to any new borrower who doesn

thave a fixed percentage rate now as rates only have one direction to go in.

2. The lenders are not asking for a preferred treatment relative toother creditors (like pensioners). Legally, debt claims are the same aspension claims and lenders are simply trying to maintain that equality.

3. assuming lenders lose their case, this will make borrowing money moreexpensive for every other city - but perhaps its should be.

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E.C. Williams

Detroit, Michigan 5 hours ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-of-banks/#permid=11090452:11091246>



The story omits a few important points. A federal judge acting asmediator negotiated 2 separate deals that would allowed Detroit toborrow several hundred million dollars from another bank to settle whatwas owed on the swaps. Both deals were rejected by the presidingbankruptcy judge because he believed the underlying debt was invalid. Infact, many were saying the deal was illegal when it first took place.The problem is that the deal required Detroit to repay from a specificrevenue stream - casino revenue. However, under Michigan law, casinorevenue can only be used for education related purposes. The only reasonthe banks are secured creditors is because the debt is secured by aspecific revenue stream. However, legally, the city of Detroit can

t usethat money to pay this debt.

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Mark T.

/is a trusted commenter/ New York NY 58 minutes ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-

of-banks/#permid=11090452:11094191>

Both NYC Moderate and E.C. Williams are misguided in talking about theswaps. The lawsuit filed Friday has nothing to do with the swaps - theswap banks are not defendands and the word "casino" does not appear inany of the 799 pages you can download from the KCC website. I checkedwith Acrobat s "find" feature. The lawsuit is to invalidate the CoP sthat were issued in 2005 (the swaps were secured with casino revenue in2009). The CoPs securitized payments that Detroit makes regularly to itspolice and firefighting forces, which were for some reason not employeesof the city but of independent agencies. The funds were used to shore upactuarial deficiencies in the pensions owed the police and firefighters.

The lawsuit claims that the financing was "debt" from the perspective ofthe City (even though it looks like the only thing that changed fromDetroit

s persopective was the account that got those payments) and theamount of the "debt" exceeds Detroit

s debt ceiling under Michigan law.Whether a securitization is "debt" is a complicated fact-intensiveinquiry that is beyond the scope of a news article or blog post. Thecomplaint actually tells you very little about why Detroit thinks it isdebt. But any comments about banks and swaps and casinos just shows alack of understanding of the facts of this lawsuit.

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Charles Reed

Hampton GA 7 hours ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-of-banks/#permid=11089380>

Detroit was destine to be messed up because of legacy cost, and the city



was just not prepared for the retirement of Henry Ford dream come true.However instead of the Federal Government stepping in on a train wreakthat been predicted for year now, and working out things with industryand a uneducated work force who believed in the Unions to a fault.

You got these Cadillac healthcare plans and 90% of the profit from thesales is wrap up into paying workers and retired workers just was notgoing to cut it. At some point the workers were paid to much as with theretired population.

However bank did supply dollars, but the bank polluted the economy causethe borrower the ability to pay them back. Banks did the same thing withthe homeowners in making home loans but the broke the homeowners legs byinjecting every weird financial product Walls Street and Orange Countycould come up with.

Now not only Detroit but at some point (which maybe now) the hammer comedown, and there is a correction on Walls Street, because Bernanke

sprint machine left the station Friday and Yellen got to rein in thecriminals!

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Roger

Columbus 15 hours ago<http://dealbook.nytimes.com/2014/02/03/detroit-turns-bankruptcy-into-challenge-of-banks/#permid=11088921>

It seems like banks should evaluate the credit worthiness of anyone theylend money to, and if they decide to take the risk and lend the money,they risk losing it all if the borrower can

t pay it back. They lent

money to shaky Detroit, to shaky home buyers over the last 20 years andto shaky everyone and now they want everyone else, mainly the government(e.g. the public), to pay up so that thyey don

t lose any money and thycan all get their bonuses. And, they want to do this at the expense ofretired pensioners. This doesn

t seem fair, or honorable, to me.


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