Financial Destruction in Detroit

On Friday, Detroit’s emergency manager, Kevyn Orr, filed a lawsuit on behalf of the city challenging the legitimacy of interest-rate swap contracts which were costing the city tens of millions of dollars per year. Swaps contracts come in many forms and can serve a variety of legitimate purposes.

However, they have also been implicated as a factor in currency crises, the long-term capital management crisis, and in the financial meltdown of 2007. After spending years trying to wind down such contracts he inherited from an acquisition, Warren Buffet famously labeled them “financial instruments of mass destruction.”

We normally associate these derivatives with the private sector and especially banking activity. This is misleading. They are sold widely and in a number of arenas. They are not an especially large part of urban fiscal policy. However, they are a factor in the bankruptcies of Jefferson County, Alabama (where Birmingham is located) and Stockton, California, as well as Detroit. In an extensive analysis published last year, the Detroit Free Press noted that the swaps contracts were a direct cause of the bankruptcy.

This contradicts almost all of the discussion of Detroit’s fiscal crisis. Instead, the city’s demographics, its unions, its crime, or its loss of manufacturing are predictably blamed. These are usually cited as causes despite the fact that many cities share these characteristics and are not bankrupt. This is not to say that the city did not face fiscal challenges or that it dealt with them appropriately. But getting to an $18 billion bankruptcy in a city with a legislated debt limit takes some finesse. The finesse was provided by Wall Street.
Kwame Kilpatrick, the city’s former mayor, purchased the contracts in order to get a cash infusion which prevented the layoff of 2,000 city workers. Importantly, because the swaps were not considered debt, they also enabled the city to circumvent the city’s debt limit of 10 percent of assessed property value. The contracts enabled the city’s mayor to act despite a lack of cash and borrowing authority. They also amounted to a bet that interest rates would rise. The city stood to make lots of money if they did. But the foreclosure crisis made a mockery of the city’s ability to foresee interest rate movements. The Federal Reserve has kept interest rates at historic lows since 2008, blowing a giant and recurrent hole in Detroit’s finances. It is now clear that a swap contract is leverage just as much as a bond is and should have been counted against the city’s debt limit.

Blaming public sector unions or pensions for bankruptcies like Detroit’s is the same as blaming homeowners for the financial meltdown. The decisions were made by elected officials and Wall Street banks, yet neither is on the hook for the costs of those choices. Detroit would have been in crisis without the swaps contracts. But the crisis would not have required the same massive cuts to public services and pensions or the sale of valued public assets.

In Detroit, the bankruptcy mess is actually yielding a reason for optimism. Orr has worked tirelessly for months to place blame for fiscal problems on the pensions themselves rather than on the swaps contracts that used them as collateral. However, in suing to get the contracts invalidated Orr has fallen into line with the position that AFSCME, the union which represents city employees, has had all along.

The city’s suit argues that the contracts should be invalid because they illegally violated the city’s debt limits—an opinion that the judge in the bankruptcy case seems to share. The insurers of the contracts argue that they are clearly legally binding and have never been questioned in such a manner before. They are apparently untroubled that their success in court depends on convincing a bankruptcy judge that the money they are owed is not actually money they are owed.

If Orr wins it will set an important precedent that will limit the temptation for both parties to use the contracts. The suit will not resolve the dilemmas that confront American cities. Only significant changes in policy and legal authority can do that. But making it harder for banks and politicians to use financial products to circumvent legal authority benefits everyone.

(Photo by Ian Freimuth CC BY-NC-ND)

2 COMMENTS

  1. I served for several years as a consultant to Mayor Bing in regard to foreclosure issues and property issues in Detroit. Having been a developer in Detroit as well, I think I understand the issues very well.
    I believe Mr McQuarrie’s comments are valid, if a bit exaggerated.
    Certainly the slight-of-hand financing measures the former Mayor and the Wall Street bankers played exacerbated the present financial crisis by kicking it down the road, but the swaps didn’t create the financial issues the city faced then or now.
    This “perfect storm” was a long-term inability to face realities with responsible government. In addition, greed and lack of accountability by numerous elements of city stake-holders conspired to create a circumstance that would inevitably lead to bankruptcy, regardless of the financial shenanigans played by the banks and insurance firms.
    Everyone involved, including the unions, pension funds, city officials, even the electorate who continued to elect myopic and pandering officials have to accept blame for their part in this fiasco.
    Mr McQuarrie’s simplistic exoneration of those stake-holders by comparing them to homeowners being responsible for the meltdown is disingenuous. People who bought homes they knew they couldn’t afford may not have created the playing field, but they certainly contributed to the resulting crisis. They were not innocent victims, but thought they were “beating the system.” So too, elements of the city tried to play the game to their advantage when it was clear to anyone willing to be objective that the city could not afford, with a decreasing tax base, the negotiated pay structures and size of government that continued to be maintained. It was only a matter of time before it came crashing down. The swaps initially postponed the day of judgment, only to make it worse when it did arrive.

  2. I guess I have to say these things again. Lots of cities confront the challenges that Detroit does and are not bankrupt. Lots of cities are bankrupt that do not confront those same challenges. The common denominator is swaps contracts. The way that swaps work make them far more destructive for budgets than other problems like underfunded pensions. The issue isn’t the raw amount, the issue is is cash flow. Swaps ruin budgets because of their effect on cash flow.

    The idea that homeowners are to blame for the foreclosure crisis because they are trying to “beat the system” accounts for about as many foreclosures as “welfare queens” account for people on welfare rolls. This is a trope. In analytical terms it accounts for noise. That Bancroft takes it as causal is a red flag. The idea that everyone is equally culpable is also a trope that is designed to deflect blame. Some actors have professional training and are paid to make sound decisions. Some have influence on decisions one day every couple of years. Those actors are not equally culpable.

    I believe I pretty much lay the blame for the crisis at the door of bad governance, so I’m not sure what Bancroft is adding on this point. Detroit had bad governance by definition, it doesn’t need mentioning. The point is the role of swaps contracts in facilitating bad governance. Nothing Bancroft says here invalidates the point. The issue is that financialization enables bad and opaque governance (in which culpability is very specific) and can make bad situations much, much worse as it did in Detroit.

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