Bad interest rate swaps contribute to Detroit water crisis and financial crisis

Aug 6, 2014 at 1:00 am

Last week I sent the following email to Bill Nowling, spokesman for Detroit Emergency Manager Kevyn Orr:

"Back in 2013 I asked you if emergency manager Orr and his team were considering investigating the COPs [Certificates of Participation] interest rate swaps that would become an issue in the bankruptcy proceedings. My recollection is that, at the time, you said something that mirrored a line that David Bromberg, a somewhat obscure singer/song writer, had in one of his songs:

 'A man should never gamble more than he can stand to lose.'

The issue of interest rate swaps related to the COPS deal has, of course, been settled in bankruptcy court, with the city getting a substantial discount on the payout the banks said they were owed after Judge Rhodes said that, if the city were to sue, the likelihood was that it would win. (Please correct me if I've got that wrong.)

I'm writing today to inquire if EM Orr has instructed the city's team of lawyers to investigate the $537 interest rate swap termination fee the Department of Water & Sewerage paid to various banks in 2012.

The city, under EM Orr, has obviously taken an aggressive approach to shutting off water to households delinquent in their water bills. Has team Orr been equally aggressive in trying to determine if there was any illegality involved in those swap deals? What, if anything, has been done to try and recoup some or all of the more than half-billion dollars DW&SD lost as a result of this bad bet? Or have Mr. Orr and his team determined that the deals were fair and square, and that the DWSD simply gambled more than it could afford to lose and is now paying the price for that bad bet?"

"The EM has only looked at the city certificates," was Nowling's terse reply.

In fact, the city has done much more than just look at those "certificates." A lawsuit has been filed by the city over a $1.3 billion bond deal, struck during the Kilpatrick administration. It's a complicated matter, but an essential part of the whole issue is the potential illegality of an elaborate scheme devised to shore up the city's pension funds in a way that skirted state-imposed debt limits.

As with that deal, the water department entered into a swaps agreement supposedly designed to protect it from rising interest rates. That was back before the economy collapsed in 2008, and interest rates fell to almost nothing. That proved disastrous for units of government around the country. According to a recent Bloomberg report, "states and localities have paid more than $4 billion to banks to back out of the [swaps] agreements ..."

Why bring all this up now?

Because the issue of these DWSD swaps was raised in a complaint recently submitted to the bankruptcy court's Judge Steven Rhodes. The complaint was filed on behalf of a number of city residents who've had their water shut off, as well as several groups active in the fight to stop the shut-offs.

They're seeking, among other things, the implementation of a "water affordability plan with income-based payments for DWSD residential customers."

And here's how the dots get connected between the $537 million DWSD had to borrow to terminate the swaps deal, and the current crisis involving thousands of shut-offs: "The effect of these interest rate swap termination payments was that certain banks through DWSD bond funds, and infrastructure repairs were not made, resulting in significant leakages in the systems, which contributed to the increased water bills, and higher rates for residential users," according to the complaint.

The complaint also points out that some of the banks involved in the swaps deal have gotten into legal hot water for their actions elsewhere.

"In 2010, Bank of America agreed to pay $137 million in restitution for its involvement in a conspiracy to rig bonds on 88 municipal bond contracts," according to the complaint. Also noted in the suit is the fact that, "In December 2012, UBS [a bank based in Switzerland] agreed to pay $1.5 billion to U.S., U.K. and Swiss regulators for attempting to manipulate the LIBOR." (LIBOR is an acronym for London Interbank Offered Rate, which sets an important interest-rate benchmark.)

Given the fact that former Mayor Kwame Kilpatrick, who is now is serving a decades-long sentence in federal prison for running the city as if it were a criminal enterprise when these deals went down, it doesn't seem unreasonable to at least suspect that something shady might have been going on.

Nonetheless, Orr and the legal team from Jones Day — where Orr was a former partner, and which has as clients both Bank of America and a division of UBS — have, as the complaint points out, "failed to investigate the misconduct or take measures to recoup any portion of the $537 million in suspect termination fees paid to the banks ..."

Wallace Turbeville has a theory as to why it might be that sort of investigation hasn't been launched.

A lawyer who formerly worked for Wall Street giant Goldman Sachs, Turbeville is now a senior fellow at Demos, a left-leaning public-interest organization based in New York City. So he has an insider's knowledge of how the world of high finance works. He also has an intimate knowledge of Detroit and its bankruptcy, having produced an in-depth report on the issue.

This is one of the things Turbeville had to say regarding swaps and Jones Day in a previous blog about Detroit: "Jones Day is a huge law firm with a large municipal finance practice. It has rendered hundreds of validity opinions in municipal swaps and bond deals. Such a law firm would hardly welcome any finding that a municipality's financial obligations were invalid."

What would be welcome by the folks filing the complaint in Judge Rhodes' court would be a full-fledged investigation of the swaps that have cost the city and, ultimately, the residents buying its water, dearly.

But the time for doing that is running out, according to Brad Miller.

A former Democratic congressman from North Carolina who served on the House Financial Services Committee, Miller is now an attorney for the law firm Grais & Ellsworth, which has been looking at the possibility of taking action against banks involved in these kinds of swaps deals.

The way Miller describes it, the swaps were sold not as bets, but as a way for cities borrowing money through bond sales to protect themselves against the possibility of rising interest rates. The banks involved in the deals, under the guidelines of an obscure regulatory body known as the Municipal Securities Rulemaking Board, had the obligation to make sure municipalities fully comprehended the risks — and potential costs — of entering into the swaps deals.

"It could be that the risks weren't fully disclosed, or just outright misrepresented," explained Miller, who says he's been talking with employee unions as well as activists here in Detroit. "If you start turning over the rocks, there's no telling what you might find."

But for any action to be taken, it must happen within six years of when things turned sour — which is 2008.

"If action is going to be taken," says Miller, "it better be soon rather than later. Because there might not be a later." — mt

Curt Guyette is an investigative reporter for the ACLU of Michigan. His work, which focuses on Michigan’s emergency management law and open government, is funded by a grant from the Ford Foundation. You can find more of his reporting at . Contact him at 313-578-6834 or [email protected].