It wasn’t the best of times, it quickly became the worst of times. This classic Dickens’ line sets the scene, mutatis mutandis, for a modern tale of two cities that turned to derivatives in time of need. As the old century rolls into the new, political inertia pushes both Athens and Detroit to source more debt and hedge, for better or for worse, with sophisticated derivatives. But when the market turns against them, they find their fate far worse than when they began.
Act one of this story opens in Athens in 2001. The Greek government is caught between a rock and a hard place. On the one hand, they have US Dollar and Japanese Yen debt worth around $10 bn euros. On the other hand, Greece has just entered the Eurozone and is required by the Maastricht Treaty to reduce its debt to GDP ratio. It cannot take on additional debt to pay its obligations without jeopardizing its membership in the common currency.
Cut to Detroit. The year is 2005. The City has a constitutional obligation to pay 1.7 bn dollars to its municipal workers’ pension plan. However, the Home Rule City Act maintained by Detroit’s charter limits the amount of debt the municipality can incur in relation to the value of real and personal property in the city. In this case, Detroit has a remaining borrowing allowance of $660 mm, or in other words, the city is $780 mm short of meeting its obligations.
In Act two, the fates of our distant cities converge. Both cities turn to complex, highly tailored derivatives to mask debt acquisition. In Athens, the Greek Government reaches an agreement with Goldman Sachs to swap their USD and JPY debt for Euro debt through a cross currency swap which Goldman executes at an unrealistic historical rate skewed in Greece’s favor. The result is that 2% of Greece’s debt is synthetically erased and the currency swap does not show up as debt on Athens’ books. Now that this debt has been consolidated in one counterparty, Greece enters into an interest rate swap with Goldman to repay the shrouded loan, albeit at a notional value exceeding the $15 bn principal. Goldman finances its end of the loan by issuing $15 bn in bonds.
In Detroit, a clever scheme is devised to borrow money in a way that will not be recognized as debt. The City establishes two Service Corporations (essentially pass-through entities) to interface with a funding trust. Rather than issue debt directly, Detroit enters into a contractual relationship with the Service Corporations. Under this contract, the Service Corporations provide the city the service of assistance in meeting Detroit’s constitutional obligations in exchange for a stream of payments over time. In reality, the Service Corporations are hired to give Detroit money, but because it wears the disguise of a contract with no liability upfront, it is not flagged as debt. The funding trust issues $1.4 bn in bonds known as Certificates of Participation (COPs) and remits the proceeds to the Service Corporations, which in turn pay them directly into the ailing pension funds. In order to protect itself against rising interest rates, Detroit strikes up swaps with Merrill Lynch and UBS to fix the interest rate payable.
In Act three, interest rates move against our tragic characters. On the day Athens signs its swap with Goldman, it already owes $793 mm more than the $2.8 bn it initially borrowed. Four years later, as Detroit’s troubles are just getting underway, the Greek debt to Goldman Sachs has already swelled to over $5 bn. Meanwhile, as interest rates stateside bottom out, the floating-to-fixed swaps that Detroit is holding are already a $300 mm dollar liability. Flash forward and by the time the initial $1.4 bn debt is repaid, payments will total $2.7 bn, or almost double the original debt.
The final scene brings our protagonists together, center stage. Their common plight is bemoaned. Both cities tried to erase debt from their books by obfuscating their borrowing with complex derivatives, tailor-made by investment banks. Yet the debt never went away; it was instead lent back to them in highly leveraged bets. Neither city validated the deals with an independent advisor or took them to market for competitive bids. In Athens’ case, the contract they signed with Goldman expressly prohibited them from disclosing any details of their trade. In Detroit, officials simply neglected to seek counsel before dealing in sophisticated products. In hindsight, both cities agree that they were unaware of the risks they were taking on and did not understand the derivatives they were dealing in. Finally, in the aftermath, both of our players eventually struck deals with their creditors to stop the damage from ballooning further. Greece locked in its debt with Goldman at $5.1 bn and Merrill Lynch and UBS agreed to a restructuring that would reduce Detroit’s debt burden by 25%.
As the curtain falls on the weeping protagonists, the Chorus steps forward to render the moral of our play:
Thus far, with rough and all-unable pen,
Our bending author hath pursued the story,
Of cities twain laid low tragediennes,
Derivatives maligned and fell from glory.
Here is the moral: Never use derivatives to bet,
To hide the full amounts of your true debt,
And when you manage risk, seek an advisor,
Thus all your hedging choices will be the wiser.
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