Cities find the fine print is costing millions
Local governments fork over billions in fees on investments gone bad
(MSNBC/Busniness Week) -- By Theo Francis, Ben Levisohn, Christopher Palmeri and Jessica Silver-Greenberg
Detroit Mayor Dave Bing is struggling to save his city from fiscal calamity. Unemployment is at a record 28 percent and rising, while home prices have plunged 39 percent since 2007. The 66-year-old Bing, a former NBA all-star with the Detroit Pistons who took office 10 months ago, faces a $300 million budget deficit — and few ways to make up the difference.
Against that bleak backdrop, Wall Street is squeezing one of America's weakest cities for every penny it can. A few years ago, Detroit struck a derivatives deal with UBS and other banks that allowed it to save more than $2 million a year in interest on $800 million worth of bonds. But the fine print carried a potentially devastating condition. If the city's credit rating dropped, the banks could opt out of the deal and demand a sizable breakup fee. That's precisely what happened in January: After years of fiscal trouble, Detroit saw its credit rating slashed to junk. Suddenly the sputtering Motor City was on the hook for a $400 million tab.
During late-night strategy sessions, Joseph L. Harris, Detroit's then-chief financial officer, scoured the budget for spare dollars, going so far as to cut expenditures on water and electricity. "I figured the [utility] wouldn't turn out our lights," says Harris. But there wasn't enough cash, and in June the city set up a payment plan with the banks.
Now Detroit must use the revenues from its three casinos — MGM Grand Detroit, Greektown Casino, and MotorCity Casino — to cover a $4.2 million monthly payment to the banks before a single cent can go to schools, transportation, and other critical services. "The economic crisis has forced us to move quickly and redefine what services a city can and should provide," says Bing. "While we face a tough road ahead, I believe we're on the right path." UBS declined to comment.
Detroit isn't suffering alone. Across the nation, local governments and related public entities, already reeling from the recession, face another fiscal crisis: billions of dollars in fees owed to UBS, Goldman Sachs and other financial giants on investment deals gone wrong.
Wall Street promised big, with small print
The seeds of this looming disaster were sown during the credit boom, when Wall Street targeted cities big and small with risky financial products that promised to save them money or boost returns.
Investment bankers sold exotic derivatives designed to help municipalities cut borrowing costs. Banks and insurance companies constructed complicated tax deals that allowed public utilities, transit authorities, and other nonprofit organizations to extract cash immediately from their long-term assets. Private equity firms, pointing to stellar historical gains, persuaded big public pension funds to plow billions of dollars into high-cost investments at the peak of the market.
Many of the transactions shared a striking similarity: provisions that protected the banks from big losses and left the customers on the hook for huge payouts.
Now, as many of those deals sour, Wall Street is ramping up its efforts to collect from Main Street.
"The banks stuffed customers with [questionable investments] and then extorted money from the customers to get rid of them," says Christopher Whalen, managing director at research firm Institutional Risk Analytics...Cont'd...LINK