12.26.13

T’was the Day before Christmas…After two days of intense negotiations led by Chief Mediator U.S. Chief District Court Judge Gerald Rosen, the city of Detroit and its swap counterparties—two banks, UBS and Bank of America, on Christmas Eve reached an agreement which will be subject to approval by U.S. Bankruptcy Judge Steven Rhodes, who has set a hearing on the agreement for a week from tomorrow at 9 a.m. Under the agreement, Detroit achieved rare concessions that would cut nearly $65 million of its costs to terminate interest-rate swaps that hedge its pension certificates. Some predict that the unprecedented agreement from a type of contract that normally cannot be reduced, even in bankruptcy, could save the Motor City an estimated 43% of its costs of borrowing what it needs to pay off the two banks. The outcome, if approved next week by Judge Rhodes, reduces what the Motor City will need to borrow to pay off the two banks: instead of borrowing $350 million from London-based Barclays, the city will now only need to borrow $288 million. In announcing the agreement, Judge Rosen stated: “It’s the first, I think it’s fair to say, significant agreement in the bankruptcy…We understand this has been difficult for everybody and we appreciate it.” The issue arose out of the city’s partnerships with the two banks that commenced under former, and now convicted Mayor Kwame Kilpatrick on a series of interest-rate swaps, a type of contract that was supposed to lower the city’s borrowing costs when it originally raised $1.4 billion in 2005―a deal now in in tatters. Just before Detroit filed for municipal bankruptcy last July, the banks said the city could exit the swap contracts if it paid them about $220 million, or about 75 percent of the true cost. By reaching that revised agreement prior to the bankruptcy filing, the banks effectively protected themselves from being subject to the same terms as other creditors in the municipal bankruptcy process. (Without the concessions, the banks, under the unique provisions of federal municipal bankruptcy law, or chapter 9, would have had the authority to sue the Motor City for the full swap termination fee, about $294 million, even though the city is broke and other creditors are expecting to get pennies on the dollar. The federal law incorporates a so-called “safe harbor” for traders in derivatives, including swaps. The safe harbor has sometimes been questioned in corporate bankruptcies under Chapter 11, but Detroit’s case appeared to be the first time it came to the fore in a Chapter 9 municipal bankruptcy. Because, as Mary Walsh Williams wrote, “the new deal was reached in confidential mediation, rather than being imposed by court order, it will not offer legal precedent to other distressed cities hoping to extricate themselves from interest-rate swaps. But the banks’ concessions to Detroit do signal that under certain circumstances, swap contracts are not unassailable after all.”) Under the Christmas Eve agreement, however, the two banks agreed to lower the termination fee to $165 million, or 43 percent of the actual cost. The Motor City will pay $165 million to the banks and spend $120 million on basic city services, including blight removal, updating city information technology and other “quality of life” improvements. Resolution of the swaps deal is an important step for Detroit as it tries to arrange for a new loan — what is known as debtor-in-possession (DIP) financing — to finance essential public services while it is in bankruptcy. Until this Tuesday, more than half of the money from that loan was going to go to UBS and Bank of America to terminate the swaps; now, under the agreement, Detroit will be able to borrow a smaller amount.  In addition, the agreement provides for the release of tax revenues from casinos in Detroit that had served as collateral for the swaps. When the swaps are terminated, Detroit hopes to use the money to backstop the new loan from another bank, Barclays. The proposed settlement gives Detroit and the two banks until the end of January to complete the swap terminations.

Ring Out the Old, and Ring in the New. The original settlement provided about a 75-cent-on-the-dollar payout, equal to about $230 million, to counterparties USB AG and Merrill Lynch Capital Services Inc. to terminate the swaps. The agreement approved Tuesday by Judge Rosen would reduce the cost to $165 million and result in a drop in the size of the Motor City’s proposed $350 million debtor-in-possession loan from Barclays to $285 million. Kevyn Orr’s described the agreement as a settlement that would close the “chapter on a financial deal that helped drive the city to insolvency,” and free up access to $15 million in much-needed monthly casino revenues: “The payout of $230 million as proposed in the original settlement represented a 25% reduction in the swap debt that was valued at $293 million. The new agreement’s payout of $165 million raises the city’s discount to 43%.” As a result of the settlement, Mr. Orr’s office said it would lower the DIP loan to $285 million with $165 million going to cover the termination payment and $120 million to fund improvements in city services. Under the settlement, a pledge of the city’s casino revenues that currently backs the swaps will be shifted to the DIP deal. In addition, Detroit’s income taxes would also be pledged. The DIP agreement with Barclays expires a week from Tuesday. Ernst & Young Capital Advisors LLC consultant Gaurav Malhotra last week testified that the Motor City could exhaust its cash by the end of 2013 and face a $284 million shortfall by June 2015 if the swaps were not terminated. The original settlement (the one reached just before the Motor City filed for federal bankruptcy last July) would have generated between $1.5 million to $3 million in monthly savings on interest rate payments. Under those original plans, the DIP loan consisted of two loans: “Swap Termination Bonds,” totaling $230 million, and the “Quality of Life Bonds,” totaling $120 million.

SWAPS

Pimco explains that an interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Swaps are derivative contracts and trade over-the-counter—with the most commonly traded and most liquid interest rate swaps are known as “vanilla” swaps, which exchange fixed-rate payments for floating-rate payments based on LIBOR, the interest rate high-credit quality banks (AA-rated or above) charge one another for short-term financing. (LIBOR, “The London Inter-Bank Offered Rate,” is the benchmark for floating short-term interest rates and is set daily.) Although there are other types of interest rate swaps, such as those that trade one floating rate for another, plain vanilla swaps comprise the vast majority of the market.

 

By convention, each participant in a vanilla swap transaction is known by its relation to the fixed rate stream of payments. The party that elects to receive a fixed rate and pay floating is the “receiver,” and the party that receives floating in exchange for fixed is the “payer.” Both the receiver and the payer are known as “counterparties” in the swap transaction. Interest-rate swaps came into existence in the 1980s and rapidly bloomed into a trillion-dollar market. It is really over the last decade and a half that banks and other financial institutions have pushed swaps with municipalities, especially in the context of the issuance of municipal debt—claiming such swaps would offer a way for local governments to save money by borrowing at variable interest rates, while also hedging away the risk that they would pay more when interest rates went up. Instead, however, as we have seen in Jefferson County and now Detroit, such deals have become money-losers for many local governments: interest rates went down, and the leveraging had ferocious fiscal impacts. The terms of the swaps under such circumstances require local governments to make regular payments for many years or even decades — whatever the long-term life of the issued municipal bonds. In the case of the Motor City, for instance, Detroit had already defaulted on the related debt, but was still meeting its swap payments obligations—at a cost of about $36 million a year. Even worse, while the filing for chapter 9 municipal bankruptcy automatically stays what a city must pay to its other creditors, because the federal law provides a so-called safe harbor for swaps or derivatives in bankruptcy, that becomes a debt which keeps on collecting. The Motor City and Jefferson County, moreover, have not been alone in suffering for ill-advised swap deals. As Ms. Williams wrote: “Many other municipalities have had similar bad experiences with interest-rate swaps. But most local officials have found to their chagrin that there is almost no way to get out of the deals without paying a budget-busting termination fee. The legal provisions were written that way because banks that trade in swaps and other derivatives often have multiple offsetting trades on their books, and nonpayment on one trade can cause toxic cascades that ripple through the financial system, as happened in 2008. Requiring companies and cities to pay up even in bankruptcy was supposed to guard against such collapses.”

Less Harried in Harrisburg. General William Lynch, the City of Harrisburg’s state-appointed receiver, Tuesday said “We have driven a stake in the heart of the incinerator [debt] today and from today forward, the city will not be on the hook for any of that,” in the wake of hand-delivering wire-transfer documents to the Commonwealth Court of Pennsylvania of the proceeds from two municipal bond deals designed to keep Pennsylvania’s capitol city  out of municipal bankruptcy and on the road to recovery: “It reinforced our notion that our folks knew what they were doing.” The municipal bond sales financed the Lancaster County Solid Waste Management Authority’s $130 million purchase of the city incinerator and a $287 million issuance of revenue bonds by the Pennsylvania Economic Development Financing Authority to fund a 40-year lease of parking assets to Harrisburg First, a consortium of Guggenheim Securities, Piper Jaffray & Co., Standard Parking Corp., and Trimont Real Estate Advisors. Bond financing overruns from incinerator project alone accounted for about $365 million of the city’s debt, which exceeded $600 million. As part of the incinerator transaction, the Lancaster authority, which has renamed the facility the Susquehanna Resource Management Complex, receives $16 million toward the purchase price: $8 million from the previous owner and $8 million from the Commonwealth of Pennsylvania. The purchase is supported by 20-year waste disposal contracts with the City of Harrisburg and Dauphin County, in addition to a 20-year power purchase agreement with the Commonwealth of Pennsylvania’s Department of General Services. The transfer marks a capstone for General Lynch’s Harrisburg Strong plan, but was also critical according to General Lynch, because getting to the market in December while interest rates remained low and before the city would encounter another cash-flow crunch meant: “We will get through this first payroll in January and then we had to have an infusion of funds, and this will provide that.” Pennsylvania placed Harrisburg into receivership in November 2011 after federal bankruptcy Judge Mary France invalidated the City Council’s filing for federal Chapter 9 municipal bankruptcy—and after the city council three times rejected a state-sponsored financial recovery plan known commonly as Act 47.

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