People in Detroit took over the streets in front of the federal courthouse demanding an end to the state-imposed bankruptcy of the city. "Make the Banks Pay" they chanted., a photo by Pan-African News Wire File Photos on Flickr.
Detroit weighs lawsuit against Bank of America, UBS over soured debt deal
8:39 PM, January 23, 2014
By Nathan Bomey
Detroit Free Press Business Writer
The City of Detroit faces a game of chicken with two global banks after U.S. Bankruptcy Judge Steven Rhodes rejected their proposed swaps settlement and said the debt might have been illegal to begin with.
On one side, the city is openly considering suing UBS and Bank of America Merrill Lynch in what would be a dynamic showdown over a disastrous pension debt interest-rate deal from 2005 that soured quickly and stuck the city with a $50-million-per-year bill. The swaps deal helped to plunge Detroit into Chapter 9 bankruptcy.
On the other side, the banks could fire a pre-emptive strike by seizing the city’s casino taxes, a vital source of revenue that Detroit put at risk in 2009 when it pledged the revenue stream as collateral on the debt deal.
Getting rid of the swaps is crucial to Detroit’s financial sustainability because it would free up cash that could be used to reinvest in improved services, such as police, fire and blight removal.
When Rhodes on Jan. 16 rejected, for the second time, a deal between the banks and the city to eliminate the swaps contracts, the detente between the city and the banks lifted — and the prospect of a protracted battle over the swaps, which were brokered by the Kwame Kilpatrick administration, rose dramatically. The latest proposal would have paid the banks $165 million.
Rhodes said it’s “likely” a lawsuit challenging the legality of the swaps would succeed — and he’s the judge that would consider the challenge.
Still, there’s also a reasonable chance Detroit and the banks could reach a new settlement over the swaps at a dramatically lower price than the previous deal, which Rhodes described as too much money for the banks.
“I think what he wants to do is to have the banks take a haircut that more closely approximates what they’re going to ask the pensioners to take,” said John Pottow, a University of Michigan bankruptcy law professor. “I think they’re back at the negotiation table right now.”
The judge said last week that he “strongly encourages” the banks and Detroit to negotiate a cheaper resolution to the complex swaps transaction, while acknowledging that litigation might be inevitable.
Detroit purchased the swaps to secure a steady interest rate of about 6% on a $1.4-billion borrowing deal that helped eliminate the city’s unfunded pension liabilities in 2005. But the deal backfired when average U.S. interest rates collapsed during the financial crisis.
In other words, the city was stuck with a fixed-rate mortgage when a variable-rate mortgage would have been a far better deal.
To make matters worse, in 2009 the city pledged its casino cash as collateral on the swaps to avoid an immediate payment of up to $400 million, putting the city’s most reliable source of revenue in danger of going directly to the banks if the city defaulted on the debt.
The city has since defaulted on the swaps several times. Kevyn Orr’s appointment as emergency manager, for example, was precipitated by a swaps default.
But that doesn’t mean the city will be forced to pay the full amount of the swaps, which were worth nearly $250 million at the end of 2013.
Rhodes last week said the city would probably win a challenge to the legality of the deal if it pursued a lawsuit, giving Orr significant firepower to negotiate a better deal with the banks.
The city had proposed paying $165 million, negotiated down from a previous settlement of about $230 million, in a deal personally endorsed by bankruptcy mediator Gerald Rosen, aggressively pursued by Orr and pushed by Detroit’s bankruptcy law firm, Jones Day.
Rhodes killed the settlement, saying it was “higher than the highest reasonable number” and chided the city for perpetuating “hasty” financial decisions that got the city into trouble in the first place. “If it were close, the court would approve it. But it’s not close,” Rhodes said. “It’s just too much money.”
Orr told the state’s Financial Advisory Board on Wednesday that he would decide within days whether to battle the banks in court or whether a new settlement was within reach.
The banks could gear up for a lengthy battle, but Rhodes has already signaled that he believes their case is weak — meaning the banks would have to bet on winning an appeal.
“I don’t think it’s in their (the banks’) best interests,” said Laura Beth Bartell, a Wayne State University bankruptcy law professor. “I don’t think that’s likely. If they dig in, what happens? They get sued, the case is brought before Judge Rhodes, and Judge Rhodes holds that they’re unsecured creditors.”
Bartell said the banks will probably lean toward a settlement.
“The banks want money now,” she said. “They’d rather have less money now than the possibility of more money much later because money makes more money.”
On July 18, Detroit, a city of 700,000 that lost more than half of its population between 1950 and 2010, became the largest U.S. municipality to file for Chapter 9 bankruptcy protection, citing debts and projected long-term liabilities of $18 billion.
Contact Nathan Bomey: 313-223-4743 or nbomey@freepress.com. Follow him on Twitter @NathanBomey.
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