CHICAGO – Detroit should drop its plan to unwind its costly interest-rate swaps and instead argue in bankruptcy court that they were unethical transactions that should be declared illegal, a former municipal investment banker said in a report released Wednesday.

Detroit’s swaps, which hedge a chunk of its pension certificates, represent one of its riskiest financial transactions, and helped drive the city into declaring bankruptcy, Wallace Turbeville, senior fellow at the progressive policy group Demos, said in the report, “The Detroit Bankruptcy.”

The Demos report takes issue with several of Detroit emergency manager Kevyn Orr and Gov. Rick Snyder’s decisions as the city embarks on what would be the largest Chapter 9 case to date.

Orr’s $18 billion debt figure for the city is inflated; the city’s pensions have played a relatively minor role in its problems; and the state government’s actions helped drive Detroit into insolvency, the Demos report said.

And the decision to issue floating-rate debt hedged by eight interest-rate swaps was such an “objectively imprudent” decision that it should be scrutinized in court, Turbeville says.

A former muni investment banker at Goldman Sachs, Turbeville said he would never have entered into such a risky swap transaction with a city that had Detroit’s long-term structural problems and hinged on termination events like a one-notch downgrade.

“The law recognizes special duties that sophisticated financial institutions owe to special entities like cities in providing complex financial products,” Turbeville said in the report. “A strong case can be made that the banks that sold these swaps may have breached their ethical, and possibly legal, obligations to the city in executing these deals.”

Orr wants to borrow $350 million to cover the swap termination payment, a move that could cut deeply into Detroit’s cash flow, Turbeville warned.

Michigan should step in to support its largest city, starting with a backstop of the swaps that would let the city avoid the termination payment, he said.

Detroit entered into the swaps in 2005 and 2006 to hedge $800 million of floating rate pension certificates issued to fund its two pension plans. The remaining roughly $750 million of COPs were issued as insured fixed rate debt.

“I would actually be pretty aggressive” in fighting the swap counterparties in court, Turbeville said Wednesday in a conference call with reporters.

“It seems to me that doing a giant 25-year swap with the city of Detroit that was terminable on one downgrade, considering the city of Detroit and its structural issues; aggressive is one word for it, impudent is another that I prefer,” Turbeville said.

“I would make the case that the city didn’t understand it,” he said. “You might even say some people understood it and decided not to talk about it.”

The swaps even seemed to cost the city more money than the fixed-rate piece of the deal, overturning the purpose of the hedges in the first place, he argues in the report.

The total cost on the floating-rate COPs and the accompanying swaps may have been as much as 0.50% more a year than the fixed-rate portion. That translates into $14 million more a year in interest costs, “a significant sum that calls for explanation,” he wrote.

Turbeville argues that Detroit would likely have been able to sell all $1.5 billion of the COPs as fixed rate with insurance. 

“The banks and insurance companies were in a far better position to understand the magnitude of these risks and they had at least an ethical duty to forbear from providing the swaps under such precarious circumstances,” the report says.

Keeping the swaps in place while fighting their legitimacy in court may be the city’s smartest move, assuming interest rates rise rather than fall over the near term, Turbeville said.

The cost of a termination event could continue to shrink -- and the counterparties may even end up owing the city.

“If everybody were behaving the most rationally, the state would figure out how to keep the swap outstanding,” Turbeville said. “That’s the optimal solution in a properly functioning political environment.”

Debt service on the COPs -- which Detroit has stopped paying -- and the swap payments are relatively stable payments that the city is able to make, Turbeville argues. The problem is with the large termination payment, estimated now at $300 million.

“Even in the best case, a full payment of the termination payment could reduce available cash flow if the terms of debt issued to fund the payment are harsh, a burden the city should not have to bear,” Turbeville writes. “Worse, the city would be exposed to floating interest payments on the floating-rate COPs that would no longer be synthetically fixed by the swaps.”

The pension certificate deal itself, with a complex structure dubbed innovative at the time, could also be called into question, Turbeville argues.

UBS AG and Siebert Financial Products with Bank of America Merrill Lynch are the swap counterparties.

UBS Financial Services Inc. was the book-running manager on the original COPs deal. Citi and Siebert, Brandford, Shank & Co. were the co-senior managers for the Series A portion – the fixed-rate piece -- with 12 co-managers on that piece. Loop Capital Markets, Merrill Lynch & Co., and Morgan Stanley were co-senior managers on both the Series A and B cops.

Lewis & Munday acted as bond counsel for the transaction, and Robert W. Baird & Co. Inc. was financial advisor.

As with all insolvent cities, Detroit’s central problem is cash flow, Turbeville said.

A big part of the problem is Michigan’s decision to cut state aid at a time when the city was trying to recover from major revenue losses in the Great Recession.

The state should help by offering emergency funding or a restoration of its state aid cuts, he argues.

Michigan has cut $67 million in annual state aid since 2011, according to the report.

About $24 million of that was due to the city’s population loss and associated impact on population-driven state funding formulas. But the remaining $43 million was due to changes in the state’s revenue sharing policies.

“These cuts account for nearly a third of the city’s revenue losses between fiscal year 2011 and fiscal year 2013, coming on the heels of the revenue losses from the Great Recession and tipping the city into the cash flow crisis that it is now experiencing,” the report said.

“Furthermore, the Legislature placed strict limits on the city’s ability to raise revenue itself to offset these losses.” 

On the debt side, Turbeville disputed Orr’s $18 billion figure as “just wrong.”

For example, it includes $5.8 billion of water and revenue debt, which is supported by revenues from a large enterprise system that serves nearly half of the Michigan population.

It also includes a controversial unfunded pension liability estimate of $3.5 billion that is based on what Demos calls “extreme assumptions.”

“To say the pension fund kills the city, it’s like if you were stabbed, strangled and blown up, did you die from the strangling?” Turbeville said. ”That’s why I find this whole thing illogical, except for the fact that somebody didn’t like pensions.”

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.