Washington & Wall Street: Big Banks Back Down in Detroit Bankruptcy

In February, we reported on the depredations of large banks operating in the derivatives market focused on public sector entities, especially the bankrupt city of Detroit. Most recently, The New York Times reported that the banks involved in the swaps contracts at issue in the Detroit bankruptcy were forced to settle for a substantial discount to their original termination fee of $230 million. 

The Times reports:

Judge Steven W. Rhodes of United States Bankruptcy Court for the Eastern District of Michigan ruled that Detroit could proceed with a plan to pay $85 million to UBS and Bank of America over several months to terminate the financial contracts, known as interest-rate swaps. The city entered into the swaps in 2005 as part of a transaction that was supposed to help finance pensions.

The fact that these big derivatives dealer banks have been forced to back down from their contractual “termination fees” is significant for a number of reasons. First and foremost, the agreement may – emphasis may – help the city of Detroit settle its remaining issues in the bankruptcy before the state-imposed management regime expires in September. 

With the prospect of settlement with UBS and the Merrill Lynch unit of Bank America, Detroit may now be able to pressure the other creditors into a settlement. Otherwise, this city of three quarters of a million people may descend into fiscal and social chaos as the litigation drags on for years.

But the other reason that the concession by the banks is significant is that there is mounting public opposition to the exploitation of unsophisticated state and local governments by some of the largest financial institutions in the world. Indeed, Steven W. Rhodes of United States Bankruptcy Court for the eastern district of Michigan basically ordered the city of Detroit to litigate over the derivative swaps contracts. The Times reports:

Last December, the city proposed paying $230 million, with borrowed money; Judge Rhodes told it to keep negotiating. In January, Judge Rhodes was more explicit when he rejected Detroit’s second proposal, to pay the banks $165 million, saying it was “just too much money.” He noted at that point that Detroit would have a reasonable chance of success if it sued the banks outright, calling the swaps invalid and refusing to make any payments at all. But he urged the city and the two big banks to try to renegotiate a settlement. “They might have been discouraged and hardened their positions,” Judge Rhodes said. “They chose instead to re-engage. The message,” he added, “is that now is the time to negotiate.”

The fact that a veteran federal bankruptcy Judge like Steven Rhodes called the derivatives contracts at issue here “invalid” sent paroxysms of pain through the nervous system of Wall Street. The small group of very large banks that dominates the over-the-counter (OTC) derivatives business has spent decades avoiding a confrontation with a federal court over OTC derivatives contracts. Why? Because a reasonable jurist might reach the obvious conclusion suggested by Judge Rhodes, namely that these instruments are a fraud and violate a number of federal securities laws and regulations.

The big threat to the banks is now realized, namely that the concession by the two institutions in the Detroit bankruptcy now opens the door for hundreds of other state and local government agencies to seek concessions or even outright rescission of OTC derivatives contracts. This prospect is a dire threat, not just for legal and financial reasons, but because the major federal regulators led by the Federal Reserve and Office of the Comptroller of the Currency have been at great pains to remind the large banks to avoid opportunities for “reputational risk.”

Indeed, the Service Employees International Union has begun a national campaign to educate state and local governments about the possibility of rejecting OTC derivatives contracts. As in Detroit, in many cases these contracts were used by local officials to circumvent fiscal rules and regulations, but that does not make the appeal by the SEIU any less attractive to elected officials facing the prospect of severe budget cuts or even municipal bankruptcy. And the big banks potentially have put themselves in the middle of a political firestorm, the very outcome that federal regulators wanted to avoid. 

The SEIU document contains information on dozens of derivatives transactions with state and local governments featuring a who’s who of Wall Street’s biggest banks. Just consider some of the inflammatory rhetoric coming from one of America’s largest public sector unions:

Big banks are profiting at state and local governments’ expense using the same toxic financial instruments that helped crash the economy. These derivatives, known as interest rate swaps, were sold to governments with a promise that they would lower their borrowing costs but have now become a huge liability. The banks have already taken as much as $28 billion from state and local governments. Now, during the worst public budget crisis in memory, the big banks seek to collect billions more from toxic deals that local and state governments are trapped into and are forcing layoffs and cuts to services to cover payments to banks.

Sadly, the victims in fiscal debacles like the bankruptcy of the city of Detroit and others are the public sector employees of the mismanaged cities and towns and the investors of the large banks. Both these constituencies will pay, but the corrupt union bosses and elected officials who fed at the public trough and promoted these derivatives schemes in the first place, often to make sham payments to public sector pensions and other fiscal obligations, will simply take their money and walk away.