DETROIT (Reuters) - Detroit had no choice but to strike a deal with holders of interest-rate swaps contracts as the city scrambled to guarantee access to cash in the days before its bankruptcy filing, according to depositions by the city’s emergency manager and a key financial adviser.
The city has asked the federal judge overseeing its historic municipal bankruptcy filing to approve the deal with Merrill Lynch and UBS AG, which would allow Detroit to end the swaps at a discount and give it unfettered access to casino tax revenue. The casino money served as collateral for the swaps contracts.
Creditors led by bond insurer Syncora Guarantee are objecting to the deal, and late last week grilled Kevyn Orr, Detroit’s state-appointed emergency manager, and Kenneth Buckfire, Orr’s top outside financial consultant, ahead of a hearing on the objections in U.S. bankruptcy court.
Syncora and others claim the deal favors the swap counterparties over other creditors and would eliminate casino revenue, which totals about $180 million a year, as a potential source for paying Detroit’s obligations.
In sworn depositions taken by attorneys for insurers and bondholders, Orr and Buckfire described the contentious negotiations leading to the July 15 agreement with Merrill Lynch Capital Services, a unit of Bank of America, and UBS AG.
Buckfire said he believed the city was in a “life and death” predicament as the swaps counterparties threatened to declare Detroit in default and demand payment the city could not afford.
Orr said before reaching agreement with Merrill and UBS, the city had also considered contesting the validity of the swaps. Originally agreed to in conjunction with the sale in 2005 and 2006 of $1.4 billion of debt for the city’s two pension funds, the contracts hedge against interest rate changes.
He declined to describe how the city might challenge the contracts, citing attorney-client privilege.
Orr also argued the deal with Merrill Lynch and UBS was needed to head off a Detroit cash crisis by year end. “If we don’t have this agreement, there’s a very real chance, yes, in a steady state, we will run out of cash,” he said.
At the time of the agreement, Orr said, the city lacked enough cash to fund a termination payment in the range of $200 million to Merrill and UBS, and he expected no financial bailout from the state of Michigan or the U.S. government.
Buckfire, co-founder and co-president of Miller, Buckfire & Co, gave the most detailed description yet of tense negotiations with Merrill Lynch and UBS in June as the city ran dangerously low on cash.
A mid-May analysis of Detroit’s finances by Ernst & Young prompted Buckfire to seek Orr’s approval to enter the negotiations. Without a deal, Buckfire said he believed Detroit was at risk of losing access to the casino revenues.
Buckfire set up the June 4 meeting after advising Orr the city could not risk having its swaps counterparties declare a default and cut off access to the casino money. “The city’s ability to operate would be in severe jeopardy and it became a life or death issue for the city,” he testified.
Entering the June 4 meeting, the city estimated it would owe $400 million in cash if the swaps counterparties declared Detroit in default, Buckfire said. With no default, the city owed the counterparties only $50 million a year, he said.
At the meeting, which Buckfire described as “very tense and difficult,” the city stated it was seeking a deal because Detroit could not meet its obligations.
“They were extremely aggressive toward the city,” Buckfire recalled. “They brought up several times the fact that the city had been in default since 2012, that we continue to add defaults to our pile of defaults.”
Buckfire said he interpreted the statements as a threat to terminate the swaps. “It was a direct risk on the city’s survival,” he said.
Talks continued a few days later, with the city facing a June 15 deadline for a payment to bondholders that the city could not afford. “We felt compelled to complete a business agreement with them prior to that date in order to protect the city at all costs,” Buckfire said.
He added that the agreement with the swaps counterparties was aimed at three objectives: to guarantee continued access to casino revenues; to eliminate swaps counterparties as creditors in the event of a bankruptcy filing, and to help the city obtain financing at some point in the future.
Orr, in his response to questions, reviewed issues related to the city’s bankruptcy filing. Orr did not make the decision until three days before the Chapter 9 municipal bankruptcy filing and engaged in contingency planning until then, he said.
The city manager also said an investigation into the validity of the $1.4 billion of pension debt was ongoing and he hinted Detroit may be probing the validity of contracts with its pension funds that led to the debt sale. If the pension debt was improperly issued, that could call into question the validity of the swaps agreements.
Orr said the examination, disclosed in a previous court filing, includes a “whole panoply of issues,” including the cost and duration of any litigation that might challenge the debt.
Even if the swaps were not valid, there may be other “prudential reasons” the city would seek to terminate them, Orr said. Termination could give Detroit unencumbered access to casino cash worth about $11 million a month to the city.
Orr also acknowledged that he hoped the forbearance agreement on the swaps contracts might prompt other creditors and labor unions to strike their own deals.
“We were hoping to get a round of agreements in place,” Orr testified, according to his deposition transcript. However, no subsequent agreements were reached.
Additional reporting by Thomas Hals; editing by David Greising, Daniel Grebler, G Crosse