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Detroit turns bankruptcy into challenge of banks

Detroit's bankruptcy is rapidly shaping up as a battle of Wall Street vs. Main Street, at least as far as the city's creditors are concerned.

Amy Laskey, a managing director at Fitch Ratings, said in a recent report that she sensed an "us versus them" orientation toward debt repayment. And in the view of bondholders, bond insurers and other financial institutions, it only grew worse last week after the city circulated its plan to emerge from bankruptcy and filed a lawsuit on Friday.

The suit, brought by the city's emergency manager, Kevyn D. Orr, seeks to invalidate complex transactions that helped finance Detroit's pension system in 2005. In a not-so-veiled criticism, the city said the deal was done "at the prompting of investment banks that would profit handsomely from the transaction."

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The banks that led the deal were Bank of America and UBS. They helped Detroit borrow $1.4 billion for its shaky pension system and also signed long-term financial contracts with the city, known as interest-rate swaps, to hedge the debt. Detroit has already stopped paying back the $1.4 billion, but for the first six months of its bankruptcy it kept honoring the swaps contracts and at one point offered to pay the two banks hundreds of millions of dollars—money it would have had to borrow—to end them. But the lawsuit now seeks to cancel the swaps, arguing they were illegal from the outset along with the related debt transactions.

Perhaps of even greater concern to creditors is the city's 99-page "plan of adjustment," the all-important document that details how Detroit proposes to resolve its bankruptcy and finance its operations in the future. Banks, bond insurers and other corporate creditors think they are being asked to share a disproportionate amount of pain under the plan, still in draft form and not yet filed with the bankruptcy court.

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"The essential issue is the near-total wipeout of the bondholders," said Matt Fabian, a managing director of Municipal Market Advisors. He said Detroit's case appeared to be heading toward a "cramdown," or court-ordered infliction of losses on unwilling creditors.

Municipal bonds have been renegotiated and restructured in the past, both in and out of bankruptcy, with a reduction in interest rates and extension of payments. But bankruptcy specialists say that, until now, municipal bondholders have not had losses of principal forced on them by a court. Participants in the municipal bond markets say the dreaded cramdown may be looming in Detroit, where they are finding themselves increasingly portrayed as greedy, and where plans are taking shape to elevate pensions above municipal bonds, though both are unsecured in bankruptcy.


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