Washington & Wall Street: Wall Street Feeds on Bankrupt Detroit

The bankrupt city of Detroit is going through a terrible process of identifying all of the vacant buildings in this once teaming metropolis. The New York Times reports:

All over Detroit, scores of these workers — on some days as many as 75 three-person teams — have been wending their way through the streets since December, cataloging on computer tablets one of this bankrupt city’s most devastating ailments: its tens of thousands of abandoned and dilapidated buildings.

Once the census is complete, Detroit will likely face an inventory of 100,000 vacant buildings and must then decide how to deal with this blight. A city built for almost 2 million people must decide how to best accommodate a third of that number today. And even as the city government struggles to deal with the logistics and cost of demolishing many of these buildings, it must also fight with its creditors in court. 

At the end of December, we paid tribute to the reporting of Mary Williams Walsh of The New York Times, who has chronicled the Detroit bankruptcy and particularly the role of some of the biggest banks in the world in making the city’s woes even larger. At the beginning of February, the Times reported on how veteran U.S. Bankruptcy Judge Steven W. Rhodes had essentially ordered the stricken city to fight the banks over fraudulent derivatives transactions that could cost Detroit hundreds of millions it does not have. 

The banks, including UBS AG and Bank of America’s Merrill Lynch unit, had reached a settlement with the city of Detroit that would have let the bankrupt metropolis off the hook for what are essentially gambling debts to the tune of $165 million. But Judge Rhodes rejected the deal. “The court ... will not participate or perpetuate hasty and imprudent financial decision-making,” Rhodes said in making his ruling. “It’s just too much money.”

The Detroit News reports that Rhodes called the deal too generous and urged the negotiators, who had reached a Christmas Eve settlement between Detroit and the banks, to resume negotiations aimed at terminating a deal that helped trigger the biggest municipal bankruptcy in U.S. history. When a settlement was not reached, however, Judge Rhodes essentially forced the city to litigate. 

“Instead of paying UBS AG and Merrill Lynch $165 million,” The Detroit News reported, “Detroit could try to negotiate a less expensive deal and Emergency Manager Kevyn Orr could sue to recover $300 million paid to the banks, the judge said.” Orr, who reportedly has dragged his feet in terms of challenging the banks, finally filed a lawsuit that strong suggests that these global financial institutions committed deliberate fraud against the city of Detroit. The Times reported:

The suit, brought by the city’s emergency manager, Kevyn D. Orr, seeks to invalidate complex transactions that helped finance Detroit’s pension system in 2005. In a not-so-veiled criticism, the city said the deal was done “at the prompting of investment banks that would profit handsomely from the transaction.”

The complaint filed by Detroit details how the banks created a series of sham transactions that allowed the financially strapped municipality to borrow money above and beyond the legal debt limits. The purpose of the borrowings was to allow the city, incredibly, to continue to make pension payments to its police, fire fighters, and city employees pensions. Now Detroit is suing in court to claw back those same pension payments and have the transactions crafted by UBS and Merrill Lynch declared null and void.

The banks created sham companies and sham service transactions to allow the city to raise the cash needed to stay current on contributions to these pensions, but none of these transactions were real. UBS and Merrill Lynch also involved US Bancorp in the scheme and created a “trust” that had the sole right to receive the payments which flowed from this complex arrangement. The complaint notes:

The two series of the 2005 [certificates of participation] were sold to the public in May and June of 2005, raising $1.44 billion, and the 2005 Funding Trust, after accounting for the costs of the transaction and the generous fees paid to bankers and others, turned over $1.37 billion of the proceeds to the Service Corporations

So reading the complaint, it seems that the banks and others took out $70 million in fees or almost 5% of the transaction to facilitate an act of fraud against the people of Detroit. The bottom line is that these banks helped the city of Detroit illegally borrow $1.4 billion to make payments on pension obligations – payments that are now being reversed in bankruptcy. Had this money not been borrowed and the pension payments not been made, Detroit would have filed for bankruptcy protection sooner and would be further down the road to resolution and recovery.

These transactions illustrate how Wall Street banks use derivatives and other subterfuges to defraud customers – in this case a large American city. While the details of this bankruptcy will be worked out in time, the larger question is why do federal regulators like the Federal Reserve Board, Office of the Comptroller of the Currency, FINRA, and the Securities and Exchange Commission allow banks to prey upon public sector entities in this way? These transactions were clearly not suitable or even legal, yet nobody in Washington says a word.


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