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Friday, August 16, 2013

No Cliche Left Behind in the New York Times Ridiculously Mistaken Assault on the Detroit Swap Settlement

The New York Times ran an editorial today entitled "No Banker Left Behind" about a motion in the Detroit bankruptcy for approval of a settlement and compromise between the city and some interest-rate swap counterparties.  The editorial board of the Times was outraged that the counterparties were receiving 75% of their claim when pensioners are, according to the Times, looking at a 90% haircut.  The Times thinks that this is about "protecting pensions; protecting municipalities from Wall Street; and, at long last, revoking the obscene privileges of banks that allow them to prosper on the failings of others."  But, in truth, the only thing the editorial demonstrates is the utter ignorance of the Times about basic bankruptcy law, pension funding and the utility of interest-rate swaps in finance. I wonder where in the world the Times' editorial board got its information because it's so horribly ignorant of all the relevant facts.  I put up this post so that somewhere in the world the correct understanding will exist.

First, the Times shows no awareness of interest rate risks the city faced in 2005 when it entered into the swaps.  Interest rates rose consistently throughout 2005; from CNN/Money, Sept. 20, 2005: "The Federal Reserve raised a key short-term interest rate Tuesday and suggested more rate hikes are on the way ...The central bank's policy-makers boosted their target for the federal funds rate a quarter-percentage point to 3.75 percent, the highest level in more than four years.  The rate increase was the 11th straight since June 2004 as Alan Greenspan and other central bankers seek to keep inflation under control. In its heavily scrutinized statement, the Fed said that more "measured" rate increases were likely in the coming months."   The city reasonably must have feared further rate hikes would be another drain of its already constrained cash.  So they sought to lock in those rates by entering into a swap, where they would pay a fixed rate of interest on the notional amount and receive floating rate payments from the counterparties (which two payment streams were probably netted such that the city just kept paying its floating rate interest and also paid (or was supposed to pay) the counterparties of just the difference by which the fixed rate specified in the swap exceeded those payments).

This was economically equivalent, the Times seems not to grasp, to issuing fixed rate debt to refinance the floating rate debt.  Why didn't the city just do that?  Probably two reasons:  1) the amount of debt was large enough that the market would not have been able to absorb it all efficiently and the city would have had to pay more than it wound up paying under the swap to get the market to digest the fixed rate issue; and 2) the city's credit probably had deteriorated since the floating rate debt was issued and they wanted to preserve the lower spread or at least the optics of a lower spread.

The key takeaway here is that the transaction is no less proper or common than issuing fixed rate debt. It is economically the same thing.  The Times' editorial board, and whoever fed them the story, sadly seem not to grasp that simple fact, as it insists of shoe-horning this into the narrative it clings to of greedy speculators on Wall Street taking advantage of poor ignorant municipalities.  When it is just a commonplace, plain vanilla form of risk management.

Second, the Times fails to grasp how the claim of the counterparties arose.  The Times recognizes that it reflects interest rate movements adverse to the city; rates did not rise as they thought, they fell.  What the Times fails to recognize is that this is not particularly driven by the fact the transaction was a swap.  The city would have been faced the same problem had it just issued plain vanilla fixed rate debt.  The swap claim does not represent an extra charge of some kind, it is just the accumulation of  years of differential between the fixed rate Detroit would have paid on fixed rate bonds and the floating rate on the paper it kept outstanding.  In principle, the city should have trued up the difference between floating and fixed rates every quarter or biannually.  That is how most swaps are written.  But the city was probably too cash constrained to do that, that is, to pay regularly what it would have been paying had it just issued fixed rate debt. So effectively it seems to have financed the fixed vs floating rate spread, which is economically equivalent to getting a plain vanilla loan from the swap counterparties in an amount equal to the interest payment differential.  And it appears the counterparties were not willing to make that loan unsecured, so they took collateral.  There is nothing  out of the ordinary about making a secured loan to finance a weak credit. Had the counterparties not done that, Detroit would have run out of cash sooner.  That is the key takeaway of point 2, that this transaction was economically equivalent to a secured loan from the counterparties that was just a way to stretch Detroit's cash farther.  It would have run out of cash earlier and in some other way without this financing; the swap did not make anything worse than it would otherwise have been, once the city decided to protect itself against interest rate hikes that seemed reasonably likely before September 2008.

Last, the Times falsely equates the counterparties, who were clearly secured according to the Times' narrative, with the unsecured retirees and further overstates the retirees' haircut.  Obviously, as any one with financial or legal experience knows, secured creditors are entitled to be paid in full from their collateral in bankruptcy.  They do not have to compete with unsecured creditors.  And it would be crazy to make them do so.  They are not insurers of pension benefits.  Back when ERISA was set up, a political choice was made to not cover public sector workers.  This enabled state and local politicians and public sector unions to engage in mutual back-scratching practices over the past four decades without the nuisance of a federal regulator telling them the promises were unsupportable.

The Times' presentation of a 90% haircut of the pensions is totally false.  First, recoveries are estimated to be closer to 20% but more important, the 90% figure ignores the funds already transferred to the city pension fund and the value earned thereon, which is functionally the retirees' collateral.  The haircut is only applicable to the unfunded portion, not the whole pension!

It's super-pathetic that the Times puts out such nonsense based on such fundamental ignorance of so many key aspects of the motion.  I do really wonder where they got it into their head to write an editorial about this -- was it some union, a progressive activist,  a politician with an agenda or a reporter?  In any case, the person who brought it to their attention is equally ignorant, or perhaps outright mis-representing the facts and the law to the Times' editors.