By Darrell Preston dpreston@bloomberg.net
September 13, 2012
JPMorgan Chase & Co. (JPM), the third-largest muni-bond underwriter, stood to gain more than just its share of $7.8 million in fees by helping Detroit’s water and sewer (87962MF) unit issue new debt after the city staved off insolvency.
- AFSCME Local 207 Secretary-Treasurer Mike Mulholland pickets with large group of DWSD workers at DWSD Huber plant Aug. 15, 2012.
The municipal department’s $659.8 million June bond sale let it pay more than $300 million to banks, including JPMorgan, to end interest-rate swap agreements while raising its borrowing cost. The utility, with 1,978 employees, plans to fire four of every five workers, while debt service has climbed to more than 40 percent of revenue, internal documents show.
As cash-strapped cities from San Bernardino, California, to Harrisburg, Pennsylvania, grapple with insolvency, the Detroit example shows that Wall Street banks never lose. That’s especially true when it comes to arranging transactions to escape distressed debt and swaps initially sold by the lenders. Along with the fees, the deal helped banks such as UBS AG (UBSN), once an underwriter of the debt, recover payments to terminate swaps.
“Interest-rate transactions that have gone horribly wrong”
- During an orgy of Wall Street predatory lending before the big bust in 2008, Detroit also borrowed $1.5 BILLION in pension obligation certficates from UBS and Siebert, Brandford and Shank. It has several times defaulted on the debt, and ended up having to commit to another $1 billion to UBS to stave off complete economic collapse, according to a report from the Detroit Financial Review Team appointed by Michigan Governor Rick Snyder under Public Act 4. The Swiss-based UBS is one of six banks being sued by Britain, the city of Baltimore, and other municipalities across the U.S. in the LIBOR interest-rate fixing scandal.
“They’re paying huge amounts of money for interest-rate transactions that have gone horribly wrong,” said Michael Greenberger, an expert on derivatives at the University of Maryland’s law school. “If this is a strategy that makes sense to do, then you do it, and you hire a banker. You can’t just walk to the corner store to underwrite bonds.”
Costly Swaps
Municipal borrowers from the Metropolitan Water District of Southern California (MWDSCZ) in Los Angeles to Italian towns and Harvard University in Cambridge, Massachusetts, have paid billions of dollars to banks to end interest-rate swaps that didn’t protect taxpayers from unforeseen changes in interest rates. In the bets on borrowing costs, a municipal issuer and another party exchange payments tied to interest-rate indexes.
Obligations linked to swaps initially sold by Wall Street banks as hedges to save tax dollars have cost the Detroit utility more than $500 million to unwind, an amount added to its debt. Before paying $314 million to end some of the agreements in June, it spent $222 million raised in a December 2011 bond sale to end others.
The money used to unwind the swaps would almost cover the utility’s $571.7 million in planned capital spending for the five years through June 2016, according to bond documents. Or it would be enough for the sewer system’s $519.8 million fiscal 2013 budget, with millions to spare.
Separate Entity
The department, while a part of a city that’s under state fiscal oversight, operates as a separate entity with its own board and serves areas outside the municipality. It provides water to 3.8 million people in Detroit and 124 other communities, as well as sewerage to 2.8 million people in the city and 76 more cities and towns.
Beyond the utility’s cost to end the swaps, it bought back auction-rate securities at a premium from proceeds of its bond sale in June and is paying a higher interest rate on the debt it sold to raise the money for the purchases. Trading in the bonds shows that the borrowing through a deal lead-managed by Goldman Sachs & Co. (GS) cost the city more than was necessary, because the price was too low.
- AFSCME Local 207 President John Riehl (l) and Vice-President Lakita Thomas (r) consult with another member during protest at Coleman A. Young Municipal Center. Locals 207 and 2920 are taking strike votes Sept. 25 and 26.
“Detroit has a bad history in the bond market,” said John Riehl, president of the local public-workers union and a senior sewage plant operator for the utility. “They’ve done some foolish things over the years.”
No Comments
Naomi Patton, a spokeswoman for Mayor Dave Bing, didn’t immediately respond to a request for comment on Detroit’s borrowing history and referred questions about the June sale to utility officials.
Matthew Schenk, the utility’s chief operating officer, and James George, assistant finance director, didn’t respond to at least two telephone calls seeking comment on the deals. Tiffany Galvin, a Goldman Sachs spokeswoman, and Elizabeth Seymour of New York-based JPMorgan, also an underwriter, both declined to comment.
Karina Byrne, a UBS spokeswoman, didn’t respond to a request for comment. Another swap counterparty whose agreement was terminated in June was Loop Financial Products.
The transaction in June added to the utility’s financial pressures at a time when Detroit was trying to avoid insolvency that could have forced it to default on its debt. The city’s predicament added to the department’s reasons to get out from under the swaps.
Termination Triggers
Under terms of the derivative deals, appointment of a review team by the state to oversee the city’s finances was one event that could trigger termination and require the utility to make payments to unwind its swaps, according to bond documents. Continue reading