Detroit, Emergency Managers — October 23, 2013 at 12:05 pm

Detroit Emergency Manager Orr finds a way to put banks before retiree pensions with yet more city debt


Borrowing from Peter Barclays to pay Paul UBS and Bank of America

As the trial to determine Detroit’s eligibility for Chapter 9 bankruptcy begins today, Emergency Manager and bankruptcy specialist Kevyn Orr has found a way to ensure that banks are paid off before the tens of thousands of retired city employees with modest pensions earned through their years of service. He has arranged a $350 million loan from Barclays Capital, a financial institution that was involved in an international banking scandal just last year. $230 million of that loan will be used to pay off UBS AG and Bank of America’s Merrill Lynch:

The city of Detroit has received a commitment from Barclays plc for a $350 million loan after it emerges from Chapter 9 municipal bankruptcy court.

About $230 million of the secured debt would be used to exercise termination rights on $1.4 billion in city pension fund interest rate swap debt incurred in 2005 and 2006 with UBS AG and Bank of America’s Merrill Lynch.

The other $120 million would be used to fund the improvement of city services, according to a news release. Orr said in his June 14 Proposal to Creditors that he plans on spending $1.25 billion over 10 years to fund improvements in public safety services, blight removal efforts and information technology upgrades.

The loan is secured with income tax and casino tax revenue, and net cash proceeds from the possible sale or lease of city assets exceeding $10 million. The loan repayments would have priority over all other post-petition claims, and pre-petition unsecured claims.

The Detroit City Council voted unanimously this week to nix the deal which is contingent upon the city being eligible for bankruptcy and being able to negotiate a deal with Bank of America and UBS.

The advocacy group Michigan Forward Urban Affairs Group, which was instrumental in overturning Public Act 4, the Emergency Manager law that preceded PA 436, the current EM law, came out strongly against the deal and issued an excellent position paper that spells out their reasoning (pdf).

Michigan Forward Chair Brandon Jessup told radio host Tony Trupiano last night that the deal essentially ensures that Detroit will remain under state control for the foreseeable future. His segment begins at the 12:00 mark:

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Let’s just look at this deal for a minute. This Executive Order 17 has a poison pill with it. It says that, if the Emergency Manager leaves, that it immediately places this loan in default. That gives Barclays and Bank of America and UBS direct access to Detroit city income taxes as well as our casino revenue, taking at least $8 million immediately every month as long as the city of Detroit does not have an Emergency Manager or doesn’t have state receivership. So this is all a ploy to keep the city of Detroit pretty much without local representation, having no say over their finances or how they govern themselves.

With this deal, which is being described as the “first of its kind”, city casino revenues, city income tax revenues, and revenues from selling off city assets worth more than $10 million are used as collateral. The interest rate on the loan is a minimum of 3.5%, ten times higher than the current two-year Treasury yield which is a mere 0.35%:

“This is beginning to look a lot more like a corporate bankruptcy,” [McDonnell Investment Management LLC chie research officer Richard] Ciccarone said. “There seems to be movements by those bankruptcy attorneys to incorporate into municipal bankruptcy as much as they can from what they’ve been practicing in the corporate arena.” […]

“The state and the restructuring community wants this kind of financing to work so as to facilitate future bankruptcies,” said Matt Fabian, managing director at Municipal Market Advisors. “The state is doing what it can to make sure DIP [debtor-in-possession] lenders are protected and repaid.”

If the city fails to close the deal, it could be good for unsecured creditors, Fabian added.

“The failure of the DIP probably would mean better recovery for other creditors,” he said. “In theory it’s going to make the state and city more inclined to settle at better terms for the rest of the city’s creditors, because they’ve put an emphasis on speed.”

The $350 million notes carry an interest rate based on the London Interbank Offered Rate plus 2.5%, plus a 1% LIBOR floor, translating into an effective rate of 3.5%. If the city defaults, the spread rises by another 200 basis points.

Those rate terms are “pretty rich,” said one portfolio manager.

“Two-year muni [paper] is yielding 35 basis points right now, so assuming that it’s tax free, that’s a pretty big number,” said Robert Miller, senior portfolio manager for Wells Capital Management.

The 3.5% interest rate “represents a hefty premium over the two-year Treasury yield, which closed yesterday at a mere 0.35%,” Triet Nguyen, managing partner of Axios Advisors LLC, which specializes in high-yield debt, wrote Monday in an article on MuniNet Guide.

“It’s ironic that Kevyn Orr is so anxious to get a release of the casino revenues that he’s willing to turn a ‘soft’ liability (i.e. the swaps) into a hard-dollar settlement with the banks, at a time in the interest rate cycle when those swap liabilities could actually start to decline,” Nguyen said.

It’s worth noting that the interest rate is based on the London Inter-bank Offered Rate (LIBOR) rate. Last year, Barclays was busted manipulating the LIBOR rate in order to rake in huge windfall profits:

The LIBOR (London Inter-bank Offered Rate) index is the most important set of numbers in the global financial system. Used as a benchmark for interest rates around the world, it’s assembled by asking a panel of big banks to estimate what it would cost them to borrow money today, if they had to. Hundreds of trillions of dollars in derivatives, corporate loans, and mortgages are pegged to these rates. Yet we now know that for years LIBOR rates were rigged. Barclays has agreed to pay nearly half a billion dollars to regulators for its manipulations, and a host of other big banks are under investigation for similar misdeeds.

Rigging LIBOR was shockingly easy. The estimates aren’t audited. They’re not compared with market prices. And LIBOR is put together by a trade group, without any real supervision from government regulators. In other words, manipulating LIBOR didn’t require any complicated financial hoodoo. The banks just had to tell some simple lies.

They had plenty of reasons to do so. At Barclays, for instance, traders were making big bets on derivatives whose value depended on LIBOR; changing rates by even a tiny bit could be exceptionally lucrative.

So, there’s that.

The fact is that Detroit is in the financial emergency that it currently in because of past loans used to pay off past debt. This move to take out yet another loan may reduce the overall debt owed by the city but has the end result of ensuring that large banks step to the front of the line and are paid off first. Note that none of the $350 million is earmarked for ensuring that Detroit pensioners are protected. Rather, they are left to fight over the remainder with all of Detroit’s other creditors.

The reality is that, although the City Council has rejected the scheme, they are compelled to come up with something that generates an equal amount of funding for the city, an unlikely scenario. Kevyn Orr reached out to over 50 financial groups before landing on the deal with Barclays. He is clearly excited about the deal, saying, “We are very encouraged by the level of interest we received from the financial community, its implicit support of the work we are doing and their desire to participate in the ongoing recovery of one of America’s great and vibrant cities.”

The “level of interest from the financial community” is unsurprising. This end run around the bankruptcy process is very attractive to the alternative of going through the Chapter 9 bankruptcy process which could result in them receiving far less than what they are owed and certainly far less than the $230 million they’ll receive by making this deal with Kevyn Orr.

You can read the terms of the deal in Orr’s Executive Order #17 (pdf).

[Keyyn Orr photo from Detroit City website]