Today’s New York Times published one of the most important stories yet about the Detroit bankruptcy, a story that shines a harsh light on the financial institutions whose tricky deal-making helped tank the city’s finances. At the heart of the story is Detroit’s decision to enter into swap contracts that were spectacularly ill-advised. Mary Williams Walsh gives us the history:
“Detroit entered into the swap contracts back in 2005, when it tapped the municipal bond market for $1.4 billion to put into its workers’ pension funds. Much of the deal was structured with variable-rate debt, and the swaps were intended to work as a hedge, to protect Detroit if interest rates rose. But as things turned out, rates went down, and under those circumstances, the terms of the swaps called for Detroit to make regular payments to UBS and Merrill Lynch Capital Services, now part of Bank of America. Detroit has been doing so, even in bankruptcy. The swaps now cost it about $36 million a year.
“In retrospect, it seems clear that Detroit was already struggling in 2005 and was a poor candidate to borrow the $1.4 billion. The borrowing required an unusual structure to avoid violating the city’s legal debt limit. In 2009, the debt was downgraded to junk, putting the city out of compliance with the terms of the swaps. So Detroit restructured the swap obligations, offering the two banks the tax revenue that it received from local casinos as a backstop.”
How did Detroit get taken down this road to disaster? In his report on the Detroit bankruptcy for Demos, Wallace Turbeville raises an important question about the ethics of the financial institution that negotiated the pension financing deal that did so much to precipitate Detroit’s bankruptcy. Turbeville wonders whether Detroit officials were taken advantage of because they didn’t understand what they were doing—or worse, that they did understand:
“In addition, the city’s counterparty on certain of the pension swaps was a small firm from Ohio, called SBS Financial, reportedly backed by Merrill Lynch and Bank of America. This unusual arrangement calls out for further inquiry, especially as it might relate to advisers to the city on the swaps. (Locally based advisers to municipal governments often have close relationships with regional financial firms. In the past, these relationships have been shown to influence the advice provided by municipal advisors.) This is particularly concerning because Sean Werdlow, Detroit’s Chief Financial Officer at the time of the initial COPs financing, reportedly assumed a position at SBS in November 2005, five months after the deal closed. Given the significance of the COPs and related swap transactions, this should be discussed and, if warranted, pursued.”
Sean Werdlow is employed by Siebert Brandford Shank & Co., LLC; he’s now the Senior Managing Director and Chief Operating Officer.
The company’s website discloses the following relationship between itself and SBS Financial:
“In 2005 the principal owners of Siebert Brandford Shank created a separate single purpose corporate entity, SBS Financial Products Company, LLC (“SBSFPC”) to serve as a principal in interest rate swap transactions with Siebert Brandford Shank municipal issuer clients. Since that time SBS Financial Products has executed swaps for numerous issuers across the nation. SBSFPC derivatives professionals work in conjunction with the Siebert Branford Shank advanced analytical investment banking staff to develop and implement comprehensive plans of finance that include a range of traditional fixed income and derivative products.”
I join Wallace Turbeville in hoping that appropriate agencies will look into this history.