From a thread in the Economics of Money and Banking, Part Two MOOC:
The money view? Banking regulations? Exploitation? Why did this happen?
Robert S Mitchell:
"In the swap deals, the banks would pay the city if rates rose, while the city would pay the banks if they fell. As it turned out, rates fell and the city had to pay the banks about $50 million a year and pledge $11 million a month in casino tax revenue as collateral."
"Detroit's financial expenses have increased significantly, and that is a direct result of the complex financial deals Wall Street banks urged on the city over the last several years, even though its precarious cash flow position meant these deals posed a great threat to the city. The biggest contributing factor to the increase in Detroitâ(TM)s legacy expenses is a series of complex deals it entered into in 2005 and 2006 to assume $1.6 billion in debt. Instead of issuing plain vanilla general obligation bonds, the city financed the debt using certificates of participation (COPs), which is a financial structure that municipalities often use to get around debt restrictions. Eight hundred million dollars of these COPs carried a variable interest rate, which the city synthetically converted to a fixed rate using interest rate swaps.
These swaps carried hidden risks, and these risks increased after the Federal Reserve drove down interest rates to near zero in response to the financial crisis. The deals included provisions that would allow the banks to terminate the swaps under specified conditions and collect termination payments, which would entitle the banks to immediate payment of all projected future value of the swaps to the bank counterparties. Such conditions included a credit rating downgrade of the city to a level below âoeinvestment grade,â appointment of an emergency manager to run the city and failure of the city to make timely payments. Projected future value balloons in low, short-term rate conditions. This is because the difference between the fixed swap payments made by the city and the floating swap payments projected to be paid by the banks increases. Because all of these events have occurred, the banks are now demanding upwards of $250-350 million in swap termination payments."
I wonder if the LIBOR rate manipulation affected Detroit's interest rate swaps, since LIBOR was manipulated downward, and Detroit's swaps were long on rates.
It seems like fraud on the public to me. Thank you for your information.
Robert S Mitchell:
I was reminded of Professor Mehrling's explanation of how AIG failed, in Lecture 20 "Credit Derivatives". From the Lecture 20 Notes:
"When the referenced risky asset started to fall in price, the value of the insurance rose. This is a liability of AIG, so it cut into their capital buffer (AIG had no dedicated reserves against these CDS because it thought they were essentially riskfree). Not only that, but AIG had agreed to post collateral, and mark the CDS to market, so these losses were not just book losses but involved payments into a segregated account that Goldman Sachs controlled, about 30 billion at the time AIG failed."
AIG was exposed on credit default swaps, Detroit was exposed on interest rate swaps. But in both cases, the banks on the other side had written into the contract terms that triggered big payments, in case of a ratings downgrade for example. So when rates went down, Detroit was downgraded by the ratings agencies, and UBS (similar to what Goldman Sachs did in the case of AIG) demanded payment immediately of the future projected values of the swaps.
The Fed bailed AIG out, though. From wikipedia:
"AIG's credit rating was downgraded and it was required to post additional collateral with its trading counter-parties, leading to a liquidity crisis that began on September 16, 2008 and essentially bankrupted all of AIG. The United States Federal Reserve Bank stepped in, announcing the creation of a secured credit facility of up to US$85 billion to prevent the company's collapse, enabling AIG to deliver additional collateral to its credit default swap trading partners."
Why doesn't the Fed and/or the government step up to help Detroit? Why not have a SIGTARP for distressed cities, and states?
According to Kevin Puvalowski, testifying before Congress, shown in Q&A with Neil Barofsky, from about 50:35 to 51:13:
"And if you add all of those programs up, and assume that every program was fully subscribed at the same time, you get a total amount of support, from the government, of 23.7 trillion dollars."
$23.7 trillion for banks, but the government can't help Detroit with something like $18 billion? (And that figure might be inflated to better make the Emergency Manager's case).
SIGTARP mentions "retirement accounts" as a concern of the FRBNY leading to the AIG bailout, on page one of its report. Why isn't it concerned about the retirement accounts of the inhabitants of Detroit?