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How hedge funds can help Detroit avoid bankruptcy

The city of Detroit owes its creditors $15 billion. Today it offered them a pretty raw deal. Kevyn Orr, the lawyer tasked by the Michigan state government with sorting out the mess, said it would default on some of that debt and offer creditors a mere ten cents on the dollar for other parts. If they balk, Orr has said he will take the city to bankruptcy court.

Detroit wouldn’t be the first municipality in the US to go broke. A handful of smaller cities had to do so, thanks to poor decisions made at the height of the housing bubble. But Detroit would certainly be the biggest—far eclipsing the previous record-holder, Jefferson Country, Alabama, which defaulted on over $4 billion of bonds in 2011.

At root, Detroit’s problems have less to do with the 2008 financial crisis than with a long civic decline in the US manufacturing heartland. But a massive bond deal arranged not long before the crash has seriously exposed troubled European banks to the Rust Belt’s woes. So it’s rather ironic that Detroit’s rescue, like its downfall, could also come from Wall Street financial whizzes: In this case, hedge funds and private equity firms.

Debt for miles

Detroit’s most basic problem is its shrinking population. Not enough people are paying taxes to fund the city’s obligations, which will require some 67% of its revenue through 2017, according to Orr. Today, it’s effectively insolvent.

Orr’s plan uses a mix of balance-sheet juggling and cuts to health and pension benefits to free up some $1.25 billion over the next decade, to invest in solving the city’s basic problems. But though Orr today revealed a $3.5 billion shortfall in the city’s pension funding—and will ask unions to accept less money in the future—the pensions are, in fact, still relatively well-funded.

Therein lies a source both of Detroit’s woes and its possible salvation. In the heady days of 2006, to fill a $1.5 billion hole in its pension liabilities, the city converted them into debt called “certificates of participation,” or COPs, which it sold through a legally separate financial vehicle at a floating interest rate. Then it entered into a swap with UBS that converted those to fixed rates.

This swap became very expensive when rates dropped after the financial crisis. A very similar arrangement led to the Jefferson County bankruptcy, and a massive scandal that sent several financiers to jail.

But the owners of this $1.5 billion in now-imperiled COPs are largely European banks, including Dexia, Commerzbank and SocGen. They have been seriously weakened by the continent’s problems. They don’t want to write down more debt. And it’s not clear whether a bankruptcy court would force the city to keep paying the special purpose vehicle that issued the COPs and that in turn pays the banks. As a hedge fund analyst of my acquaintance put it, the contract to pay the COPs is “going to be treated the same as the guy who mows the city hall lawn, they can choose to assume or reject it in bankruptcy.”

Now, the bond insurance companies who wrapped the bonds have every incentive to let negotiations drag on—the longer they go without resolution, the longer before the insurers have to pay up. In the Jefferson County bankruptcy, it took five years from default to settlement. Detroit, though, has less time; Orr’s mandate as emergency manager expires in less than 18 months, and he’d ideally like to have the city either restructured or out of bankruptcy by then. So, unless there’s a break in the deadlock in negotiations, analysts expect him to move quickly toward bankruptcy—which should worry those European banks.

That’s where the hedge funds come in. They can buy the debt from the European banks at a better rate than ten cents on the dollar, giving them the certainty of immediate cash, and then negotiate a slightly better settlement with both the insurers and the city. A similar trade helped Jefferson County resolve its bankruptcy, as investors bought cheap debt and restructured it.

“It helps a lot when someone whose cost basis is 30 [cents on the dollar] is happy to take 50,” the hedge fund analyst said. “It’s a lot harder when your cost basis is 100 and they’re offering 50. People who are very commercial want to get a resolution.”

Will it trade?

Whether hedge funds and other outside investors can get involved will depend on the willingness of those European banks to sell their debt. In Jefferson County, bond owners were willing to make a deal at a loss, but in another recent bankruptcy—that of Stockton, California—most chose to fight it out in the courts.

That’s not the resolution Detroit’s citizens want, and it’s probably not in the best interest of its creditors, either. After today’s meeting, dealers were reportedly bidding 10 to 15 cents on the COPs. But we’ll have to wait for European markets to open on Monday to see if there’s any movement to sell. Whether this fight takes years or months will largely depend on who’s more interested in making a deal than taking a stand.

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