The Detroit Bail-In Template: Fleecing Pensioners to Save Banks

Fleecing Detroit PensionersThe Detroit bankruptcy is looking suspiciously like the bail-in template originated by the G20’s Financial Stability Board in 2011, which exploded on the scene in Cyprus in 2013 and is now becoming the model globally. In Cyprus, the depositors were “bailed in” (stripped of a major portion of their deposits) to re-capitalize the banks. In Detroit, it is the municipal workers who are being bailed in, stripped of a major portion of their pensions to save the banks.

Bank of America Corp. and UBS AG have been given priority over other bankruptcy claimants, meaning chiefly the pensioners, for payments due on interest rate swaps they entered into with the city. Interest rate swaps – the exchange of interest rate payments between counterparties – are sold by Wall Street banks as a form of insurance, something municipal governments “should” do to protect their loans from an unanticipated increase in rates. Unlike ordinary insurance, however, swaps are actually just bets; and if the municipality loses the bet, it can owe the house, and owe big. The swap casino is almost entirely unregulated, and it is a rigged game that the house virtually always wins. Interest rate swaps are based on the LIBOR rate, which has now been proven to be manipulated by the rate-setting banks; and they were a major contributor to Detroit’s bankruptcy.

Derivative claims are considered “secured” because the players must post collateral to play. They get not just priority but “super-priority” in bankruptcy, meaning they go first before all others, a deal pushed through by Wall Street in the Bankruptcy Reform Act of 2005. Meanwhile, the municipal workers, whose pensions are theoretically protected under the Michigan Constitution, are classified as “unsecured” claimants who will get the scraps after the secured creditors put in their claims. The banking casino, it seems, trumps even the state constitution. The banks win and the workers lose once again.

Systemically Dangerous Institutions Are Moved to the Head of the Line

The argument for the super-priority of derivative claims is that nonpayment on these bets represents a “systemic risk” to the financial scheme. Derivative bets are cross-collateralized and are so inextricably entwined in a $600-plus trillion house of cards that the whole financial scheme could go down if the betting scheme were to collapse. Instead of banning or regulating this very risky casino, Congress has been persuaded by the masterminds of Wall Street that it needs to be preserved at all costs.

The same tortured logic has been used to justify the fact that the federal government deigned to bail out Wall Street but not Detroit. Supposedly, the mega-banks pose a systemic risk and Detroit doesn’t. On July 29th, former Obama administration economist Jared Bernstein pursued this line of reasoning on his blog, writing:

[T]he correct motivation for federal bailouts — meaning some combination of managing a bankruptcy, paying off creditors (though often with a haircut), or providing liquidity in cases where that’s the issue as opposed to insolvency – is systemic risk. The failure of large, major banks, two out of the big three auto companies, the secondary market for housing – all of these pose unacceptably large risks to global financial markets, and thus the global economy, to a major industry, including its upstream and downstream suppliers, and to the national housing sector.

Because a) there’s not much of a case that Detroit is systemically connected in those ways, and b) Chapter 9 of the bankruptcy code appears to provide an adequate way for it to deal with its insolvency, I don’t think anything like a large scale bailout is forthcoming.

Holding Main Street Hostage

Detroit’s bankruptcy poses no systemic risk to Wall Street and global financial markets. Fine. But it does pose a systemic risk to Main Street, local governments, and the contractual rights of pensioners. Credit rating agency Moody’s stated in a recent report that if Detroit manages to cut its pension obligations, other struggling cities could follow suit. The Detroit bankruptcy is establishing a template for wiping out government pensions everywhere. Chicago or New York could be next.

There is also the systemic risk posed to the municipal bond system. Bryce Hoffman, writing in The Detroit News on July 30th, warned:

Detroit’s bankruptcy threatens to change the rules of the municipal bond game and already is making it more expensive for the state’s other struggling towns and school districts to borrow money and fund big infrastructure projects.

In fact, one bond analyst told The Detroit News that he has spoken to major institutional investors who have already decided to stop, for now, buying any Michigan bonds.

The real concern of bond investors, says Hoffman, is not the default of Detroit but the precedent the city is setting. General obligation municipal bonds have always been viewed as a virtually risk-free investment. They are unsecured, but bondholders have considered themselves protected because the bonds are backed by the “unlimited taxing authority” of the government that issued them. Detroit, however, has shown that the city’s taxing authority is far from unlimited.  It already has the highest property taxes of any major city in the country, and it is bumping up against a ceiling imposed by the state constitution. If Detroit is able to cut its bond debt in half or more by defaulting, other distressed cities are liable to look very closely at following suit. Hoffman writes:

The bond market is warning that this will make Michigan a pariah state and raise borrowing costs — not just for Detroit and other troubled municipalities, but also for paragons of fiscal virtue such as Oakland and Livingston counties.

However, writes Hoffman:

Gov. Rick Snyder dismisses that threat and says the bond market is just trying to turn Detroit away from a radical solution that could become a model for other struggling cities across America.

A Safer, Saner, More Equitable Model

Interestingly, Lansing Mayor Virg Bernero, Snyder’s Democratic opponent in the last gubernatorial race, proposed a solution that could have avoided either robbing the pensioners or scaring off the bondholders: a state-owned bank. If the state or the city had its own bank, it would not need to borrow from Wall Street, worry about interest rate swaps, or be beholden to the bond vigilantes. It could borrow from its own bank, which would leverage the local government’s capital into credit, back that credit with the deposits created by the government’s own revenues, and return the interest to the government as a dividend, following the ground-breaking model of the state-owned Bank of North Dakota.

ellen brownThere are other steps that need to be taken, and soon, to prevent a cascade of municipal bankruptcies.  The super-priority of derivatives in bankruptcy needs to be repealed, and the protections of Glass Steagall need to be restored. While we are waiting on a very dilatory Congress, however, state and local governments might consider protecting themselves and their revenues by setting up their own banks.

Ellen Brown
Web of Debt

Monday, 5 August 2013

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Comments

  1. ronwf says

    Anyone who figured that the bonds of this country’s major cities and figured that they were risk free never took a look at those cities’ books. The true limit of the taxing powers of these cities is not their States’ constitutions – it’s the property values of their real estate and the wealth of their citizenry. Detroit used to have 2.3 million people in it. Now it has 0.7 million people in it. When people leave they take their wealth with them. When industries move out they take their jobs with them. When these all abandon their properties the property values plummet. If you tax people to the point that it becomes profitable for them to leave you get … Detroit, where the people have no wealth to tax and the property values are so low that there’s no way to get sufficient revenues from it to support basic government services no matter how much you raise taxes.

    The solution is for the city governments to limit themselves to supplying basic services of a high enough quality to attract people and businesses without taxing them to death in order to supply non-essential services and pay inflated salaries and benefits (i.e., at rates higher than that of private industry and the surrounding suburbs) to the employees. Then people will move back in. Until then, Detroit will simply contract more and more until only those people who cannot afford to leave, those people who are unskilled and are most dependent on government services, are left.

  2. ronwf says

    So the City of Detroit, instead of buying actual insurance, decided to gamble with it’s money, lost – and it’s the banks fault? How about considering that it was the City’s choice to gamble in the first place that is at fault? Or that the City’s decision to borrow money year after year after year instead of actually only spending as much as it could collect in taxes and revenues was the primary cause?

    Fault the bankruptcy laws as much as you want for who they give priority in who gets paid off first. That’s fine. But it was the decision to overspend and then double down by gambling with what money they had that drove the City of Detroit to bankruptcy. It’s not the banks’ fault – they didn’t hold a gun to the head of the City of Detroit and tell them they had spend more than they took in and then to borrow money year after year instead of cutting expenses and negotiating labor contracts they could afford.

  3. TomDegan says

    We’re being held hostage to the plutocracy’s abuse of the system. Was this a great country or what!

    • -Nate says

      It _was_ until too many foolish people voted gop and they have clearly wasted no time in giving those same people the screwing of the century .

      -Nate

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