How Wall Street -- not pensioners -- wrecked Detroit

While clueless elites continue to blame "reckless public pensions," a new report tells a very different story

Published November 20, 2013 4:00PM (EST)

                                    (AP/Lawrence Jackson)
(AP/Lawrence Jackson)

In its house editorial yesterday, USA Today retold the now-accepted story of Detroit's bankruptcy. Railing on "reckless public pensions," the newspaper told its readers that the Motor City is "Exhibit A for municipal irresponsibility" because it allegedly "negotiated generous pensions" that were too lavish. In this fable, the average Detroit pensioner's $19,000 a year stipend -- which many get in lieu of Social Security -- is somehow defined not only as excessive, but also as the primary cause of the city's financial problems. Detroit, thus, becomes a weapon in the larger Plot Against Pensions, as the right holds it up as a cautionary tale supposedly showing that A) police officers, firefighters and sanitation workers are greedy and B) America cannot afford to fulfill negotiated agreements to pay public-sector workers a subsistence retirement benefit.

No doubt, there is a tiny grain of truth in this otherwise inaccurate story. Yes, it is true, Detroit is a cautionary tale for governments about financial management and legacy costs. However, it is not a cautionary tale about allegedly greedy employees living the MTV Cribs life off taxpayers. As an eye-opening new report from a former Goldman Sachs executive documents, it is instead yet another cautionary tale about Wall Street's too-good-to-be-true schemes that end up being, well, too good to be true.

Commissioned by the think tank Demos, the new report out today from former investment banker Wallace Turbeville shows that contrary to the myths about a bloated municipal government overspending on lavish social services, Detroit's "overall expenses have declined over the last five years" by $419 million thanks to the city "laying off more than 2,350 workers, cutting worker pay, and reducing future healthcare and future benefit accruals for workers." Today, Turbeville notes that "Detroit has a significantly smaller workforce per capita than comparable cities." Yet, those draconian cuts still left the city with an annual $198 million shortfall because of three big problems -- none of which has anything to do with supposedly greedy public workers and their allegedly overly "generous" pension benefits.

First and foremost, Detroit suffered from an unprecedented loss of public revenue. As I've previously reported, this was brought on by many factors. The most obvious of those were the recession and free-trade-related deindustrialization, both of which decimated the city's manufacturing job base and drove population out of the city. On top of that, the state of Michigan reduced its revenue sharing with the city.

Second, the city and state spent -- and is still spending -- big money on wasteful corporate subsidies to politically connected private interests. That includes a reaffirmed commitment to spend $283 million -- or more than the city's entire annual budget shortfall -- on a new professional hockey arena. Such profligate expenditures have drained revenues out of city coffers.

But perhaps the least discussed factor is the financing cost associated with a series of Wall Street-engineered debt deals back in 2005 and 2006. These schemes crafted by UBS and Bank of America's Merrill Lynch were supposed to reduce pension fund obligations by using derivatives to try to "synthetically" convert variable-rate interest instruments into fixed-rate contracts.

A few years ago, these schemes were all the rage, as the financial industry's Masters of the Universe swooped into places like Detroit, Denver and Jefferson County, Ala., throwing so-called certificates of participation, campaign contributions and graft at school boards and city councils, all with the promise that the interest-rate swaps were the key to financial nirvana. Predictably, it was a jackpot for Wall Street and their bankrolled politicians, but it was the opposite for taxpayers.

In Denver, for instance, then-school superintendent Michael Bennet traded his acquiescence to Wall Street's swap scheme for Wall Street contributions to his U.S. Senate campaign -- all while the interest-rate swap scheme he approved blew a $177 million hole in the city's school budget. In Alabama, JPMorgan made out like bandits, while the interest-rate swap scheme plunged Jefferson County into both bankruptcy and an epic bribery scandal .

It is a similar story in Detroit, even though you probably haven't heard about it. What you've probably heard is that the city's "legacy expenses" jumped by $62.8 million between 2008 and 2013 -- and you've probably heard pundits recklessly assume that "legacy expenses" are the same as retirement benefits. But such an assumption hides what's really going on.

As Turbeville shows, in the five years leading up to today's crisis, the city's pension contribution expenses were essentially flat. Yes, its healthcare contribution expenses increased, but they rose by less than the nationwide annual increase in healthcare expenses, meaning Detroit experienced nothing out of the ordinary on that score. So if benefits didn't drive the legacy cost increases, what did? As Turbeville documents, it was fees, financing costs and payments incurred by Wall Street's swap scheme. Those expenses constitute more than 61 percent of the total legacy-cost jump.

In his report, Turbeville notes that "the banks are now demanding upwards of $250-350 million in swap termination payments" in order to let Detroit out of the apocalyptic swap scheme. In an actual bankruptcy, creditors might have to forgo some of those fees -- or in the industry lingo, they might have to "take a haircut." But in the era of bailouts, ordinary Americans have to take haircuts, but Wall Streeters almost never do. Thus, the banks' demand for termination payments has been turned into yet another opportunity for the financial industry to swindle Detroit taxpayers. Specifically, Detroit's Republican-appointed emergency manager is pushing the city council to take on an additional $350 million in debt from a new loan with Barclays.

Bloomberg News notes that Barclays' infusion of capital won't go to supporting city services nor to preventing cuts to the city's average $19,000-a-year pensions. Instead, officials are pushing draconian pension cuts, while the lion's share of the Barclays loan -- $230 million -- would go to pay Bank of America's termination fees in the old swap deal. As if deliberately underscoring how all of these machinations serve to enrich Wall Street rather than to support the city, Detroit officials have tried to keep the fees associated with the new loan secret. As the Detroit Free Press reports, Barclays attorney admitted that "revealing the fees could invite competitors to offer financing to Detroit at a better rate."

In other words, the bank aimed to keep the terms secret in order to keep bank profit margins as high as possible.

To be sure, Detroit's pension system is not entirely blameless. It has certainly had its share of problems. But as Turbeville concludes: "While [Detroit] emergency manager Kevyn Orr has focused on cutting retiree benefits and reducing the city’s long-term liabilities to address the crisis, an analysis of the city’s finances reveals that his efforts are inappropriate and, in important ways, not rooted in fact. Detroit’s bankruptcy was primarily caused by a severe decline in revenue and exacerbated by complicated Wall Street deals that put its ability to pay its expenses at greater risk."

Though the complex details of the interest-rate-swap transactions can obscure what's really happening, there should be no confusion: The "inappropriate" policies now being foisted on Detroit represent disaster capitalism in its purest form. The disaster is for pensioners, who had little to do with the city's financial crisis, but who nonetheless get all the blame from conservative activists, Wall Street-sponsored politicians and talking point-driven media. The capitalism, meanwhile, is for the big banks who helped engineer the city's financial crisis, and who now get to hide behind the esoterica of municipal finance as they continue profiting from the emergency.


By David Sirota

David Sirota is a senior writer for the International Business Times and the best-selling author of the books "Hostile Takeover," "The Uprising" and "Back to Our Future." E-mail him at ds@davidsirota.com, follow him on Twitter @davidsirota or visit his website at www.davidsirota.com.

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Bankruptcy Banks Cities Debt Detroit Editor's Picks Pensions Public Workers Wall Street