Wall Street plunders Detroit while pensioners take blame

The Detroit bankruptcy has been portrayed as a simple morality tale of city mismanagement, but the crucial role of financial industry chicanery has been conveniently ignored. Municipal debt is a largely unknown but very lucrative field — lucrative, that is, for speculators.

There are so many questions that can be asked about Detroit’s bankruptcy filing. What is Wall Street’s role in municipal debt? How is it that almost $300 million is available for a new ice hockey arena when there is no money for pensions? How is that business taxes can be cut by 80 percent at a time of fiscal crisis? Why did the total of pension liabilities suddenly increase fivefold from earlier this year?

Ambassador BridgeThese are questions that are rarely raised in the corporate media. Asking such questions disarms the narrative of public-employee retirees bleeding taxpayers dry and masks larger systemic issues. It is quite difficult to believe the same folks who brought you the economic crash of 2008, and five years and counting of hard times, are completely innocent of fleecing local governments. Indeed, they are not.

Although it is the stock market that draws the lions’ share of the public’s attention, the bond market is much larger (and, in turn, foreign exchange is a far bigger market than bonds). Municipal bonds, although a relatively small portion of the overall bond universe, are big business — US$3.7 trillion. Yes, you read that correctly — trillions of dollars. That is one big pot of money to tap, and tap it financiers do.

Why pay taxes when you can loan it and earn interest instead?

Absent from discussions about Detroit is why governments have to issue so much debt. The reason is not complicated: Big business, and the wealthy, would much rather loan money at interest to governments rather than pay taxes. It’s not only national governments that are in debt, it’s local and regional governments as well. That is so around the world, demonstrated most vividly by the ongoing European Union crises as one country after another imposes austerity in the face of unsustainable debt.

In North America, Detroit fulfills the same function as Greece does for Europe: A scapegoat. Although it is true that Detroit’s city government is due a share of the blame for poor management, larger economic and social forces, disinvestment and financial industry legerdemain loom much larger. Complex, and poorly understood, derivatives were decisive in Detroit’s fiscal downfall. When local governments had to borrow money (ordinarily to finance large infrastructure projects) in the past, they would issue “plain vanilla” bonds — a set amount of debt paying back a set amount of interest on a specific schedule. A safe, if conservative, investment for buyers of these bonds and  predictable payment terms for the issuer.

Wall Street wanted higher profits from this once staid market, so an ever more dizzying assortment of exotic instruments were conjured, allowing the financial institutions that handle these bond sales to skim off ever more money. Explaining how Wall Street plunders public finances, Alexander Arapoglou and Jerri-Lynn Scofield, wrote on AlterNet:

“Many municipalities invested in flawed ‘structured finance’ deals on the advice of bankers who said these complex transactions would give them a better deal than simpler, traditional products. So trusting public finance officials lined up to follow their advice — only to be told later that advice was not to be relied upon.

“Tellingly, few (if any) corporations used similar structures to meet their funding needs. Nor did the banks themselves. Unfortunately, these products didn’t work as advertised, and public funding costs exploded as a result.”

A common structure, the authors wrote, combines three instruments: variable-rate demand bonds, letters of credit and interest-rate swaps. These are supposed to be forms of insurance to protect cities from rising interest rates, but in actuality are designed to siphon money to the banks, in a classic game of “heads I win, tails you lose.” Municipal treasurers sought to pay below-market fixed interest rates for paying back long-term debt. But institutional investors want to be able to rapidly buy and sell such bonds. Variable-rate demand bonds enable bond buyers to get their money back on demand, in periods as short as a week. The AlterNet authors wrote:

“Alas, there’s no such thing as a free lunch. A bond that can be returned, with no penalty charges, every week doesn’t sound at all like the long-term infrastructure financing the city or state wanted. So banks promised municipal clients that if investors wanted to return bonds, the bank would find another buyer. Sounds like it might work out okay, right? But what would happen if no one wanted to buy these returned bonds?”

The necessity of answering that question leads to the letters of credit and interest-rate swaps, which are forms of insurance. On paper. When financial markets froze in the wake of the Lehman Brothers collapse in September 2008, nobody would buy the variable-rate demand bonds. The interest-rate swaps were sold to local governments as a hedge against rising interest rates. But the buyers of these products had to pay penalties because the bank’s credit ratings dropped and interest rates fell.

Interest rates fell because central banks like the Federal Reserve wanted to shovel piles of cheap money at “too big to fail” banks to keep them solvent. That interest rates would fall was quite predictable, as cutting rates is a standard tool of central banks during recessions.

Financial derivatives cost Detroit dearly

Here’s how this scam worked for Detroit, according to Bloomberg, far from a news source hostile to the financial industry:

“The swaps were a bet on the direction of interest rates. Because rates fell rather than increasing, the city owes the banks. Under the terms of the contracts, cuts to the city’s credit ratings allowed the companies to demand the money. Under agreements in 2009, the city pledged casino revenue to cover the payments. [Emergency manager Kevyn] Orr gave the swaps payments, as secured debt, priority over retirees and holders of unsecured debt, including the pension borrowings. While swaps holders would take a 25 percent cut in payments, other creditors would receive much less.”

That last sentence refers to a deal that Emergency Manager Orr attempted to make before the declaration of bankruptcy, in which derivatives speculators would be paid far more than pensioners. Detroit absorbed losses totaling hundreds of millions of dollars due to these derivatives. The Financial Times reports that, due in part to the extra costs sustained from the derivatives, Detroit owes nearly double the principal — in other words, Detroit is effectively paying nearly 100 percent interest:

“As of the end of June, the negative value of the derivatives was almost $300m, according to material from Ernst & Young submitted as part of the bankruptcy court filings. By the time the city ultimately pays off the $1.4bn in borrowing, the total bill just from 2013 onwards will be over $2.7bn, or almost double the original debt, of which $770m will be the cost of the derivatives — far more than the $502m in interest payments, these filings add.”

Merrill Lynch (a subsidiary of Bank of America) and UBS sold Detroit the interest-rate swaps, and when interest rates fell and Detroit’s credit rating was cut, the city signed a deal that pledged tax revenues from the city’s casinos to cover its extra costs, according to the Financial Times. That transaction transformed UBS and Merrill Lynch from unsecured into secured creditors, putting them at the head of the payment line. Prior to the bankruptcy, the two investment banks offered to absorb a 25 percent cut to what they are owed, but at the same time municipal workers were asked to take a 90 percent cut.

Remember that government workers are not eligible for Social Security, so their pensions are what they will have to live on. The average Detroit city government pension is $19,000 a year.

Secured creditors are those who hold debt backed by some kind of legal claim to a physical asset of the city, such as, for example, Detroit’s bond obligations relating to its water and sewer department. Unsecured creditors face steep cuts, including the pension funds scapegoated for the fiscal crisis. Hedge funds are said to be buying up other unsecured Detroit debt, and the more these hedge funds extract, the less there will be for city workers. This is a tactic, used recently by hedge funds speculating on Argentine debt, in which debt is bought at pennies to the dollar with an eye toward getting much more out of the issuer.

A tool for financiers to extract billions of dollars per year

The cost to taxpayers from derivatives is enormous. A group called the ReFund Transit Coalition recently released a study, “Riding the Gravy Train,” in which it reported that researchers have found about 1,100 swap deals in the United States entered into by 100 government agencies that cumulatively are losing more than $2.5 billion per year. The coalition believes that there hundreds of other such deals out there not yet added to the total.

This comes at a time when four out of five transit agencies are cutting service or increasing fares in the wake of the economic downturn. Getting out of these deals is costly — for example, New York state recently paid $243 million to terminate a swaps deal, and $191 million of that fee is being financed by more borrowing.

But there’s plenty of money for corporate subsidies

As Detroit headed toward its declaration of bankruptcy, Michigan Governor Rick Snyder handed some presents to his wealthy benefactors. In December 2011, he signed two anti-union bills that render union membership as a condition of employment illegal; the language of the bills was virtually identical to “model” bills written by the infamous American Legislative Exchange Council (ALEC), a lavishly funded group that writes legislation for state legislatures that will directly benefit its corporate funders.

A less noticed gift by Governor Snyder is a massive tax cut for Michigan businesses that will be paid for by severe reductions in social spending and higher individual taxes. Taking effect in 2012, business taxes were cut by 80 percent (or $1.7 billion per year) under the excuse that such cuts will lead to job creation, although there is no evidence that such cuts actually lead to more jobs. In real life, jobs are created by demand for a product, not tax rates. Low-income people were already paying the largest share of their income in state and local taxes while those making more than $385,000 a year paid the smallest, and lower- and middle-income people are being hit with the highest increases in taxes.

And yes friends, that’s not all. Michigan, on a per capita basis, spends more money on corporate subsidies than any other U.S. state — a total of $6.2 billion per year. When we add these corporate subsidies with the business tax cuts, that’s almost $8 billion per year of subsidies handed out. Note that the total amount of unfunded pension obligations cited by Emergency Manager Orr is $3.5 billion — and that number may be inflated. (More on that below.) Yet there is a steady propaganda barrage that insists the problem is retirees and current workers expecting to be able to retire some day.

So the problem of pensions is easily solvable. Michiganders outside Detroit shouldn’t have to pay, some might say. But that ignores that the state, certainly the counties surrounding Detroit, benefits from the city’s infrastructure. Corporations that once had operations in Detroit benefited from the investments the city made in its physical environment and from the workers who were educated in public schools and universities. The city’s social amenities also provide benefits that cross borders. Corporations and better-off people fled to the suburbs — to the north, crossing county lines — to avoid paying for such services, a familiar tactic of capital.

But some infrastructure, evidently, is worth an investment. At the same time pensioners on fixed incomes are facing large cuts and city services are drastically reduced, $283 million of public money are proposed to be lavished on a new ice hockey arena, for a team (the Detroit Red Wings) owned by Mike Ilitch, who is worth $2.7 billion. This in an area that is already paying off two football stadiums, and has two arenas in current use.

Detroit can do this because a separate entity, the Detroit Development Authority, will hand out the subsidies, and the authority has a special stream of revenue from property taxes that its can tap before revenues are sent to the city treasury. Ultimately, the state is said to control these funds, and as it is the state that forced Detroit’s declaration of bankruptcy, it could divert that money to, say, fixing street lights or repairing ambulances.

Is the size of Detroit’s pension shortfall being inflated?

One final question is: What is the size of the pension shortfall? As recently as February 2013 — five months before the bankruptcy filing — Detroit’s unfunded pension liability was listed as $650 million by the state, yet Emergency Manager Orr has claimed the liability is $3.5 billion without providing any details as to the reasons for the fivefold increase. The investment management firm BlackRock, in an analysis on the ramifications of Detroit’s bankruptcy filing, said:

“There is question as to whether the [emergency manager’s] plan is inflating pension and [other post-employment benefits] liabilities. … This $3.5 billion now represents nearly one-third of the amount Detroit owes to its unsecured creditors, and raises required pension contributions to approximately 100% of the city’s $1 billion forecasted budget deficit over the next five years.”

The dramatic increase in the size of the pension liabilities seems to be based on a report prepared by an actuarial consultant that used a different methodology to calculate the liabilities — but the emergency manager refuses to release the report. Meanwhile, there are indications that the consultant did a less than rigorous job of tallying its numbers. Cate Long, writing in the MuniLand blog, in discussing this issue, asked:

“A ‘very rough preliminary guesstimate’ is what Orr was using in his ‘good faith’ negotiations and is now taking to bankruptcy court? … Pension calculations can seem to be a form of voodoo. Moody’s applies a lower discount rate, like the [consultant’s] report did, to pension liabilities, while the two other major raters do not. Pension liability methodologies are, in essence, just opinions. … Orr could help everyone understand his case by releasing the [consultant’s] report for study by actuaries and others.”

As recently as 2005, Detroit’s pension obligations were fully funded. But when the pensions’ portfolios suffered losses from the economic downturn, the city government decided to issue bonds to fulfill its obligations. A series of refinancings, underwriting fees and penalties for credit-rating cuts has cost the city hundreds of millions of dollars. It is currently impossible to say definitively that Emergency Manager Orr is artificially inflating the pension shortfall, but it is not difficult to see the rationale for doing so: The greater the liability, the deeper the cuts that can be imposed, especially on pensions.

Austerity comes in many flavors, but it is never the financial industry that has to cut back. Detroit’s mayors and councilmembers can, and should, be taken to task for failing to investigate the snake oil financiers were selling them, but that does not ameliorate the rapacious grabbing of public money by the snake-oil salespeople. The financial industry does not create wealth, it confiscates wealth. The time is long past to chop off the vampire squid’s tentacles and reduce banking to a public utility serving the public interest under democratic control.

Speculators trade in two weeks what the world makes in a year

Speculation rests on phenomenal amounts of money sloshing around the globe. We could call this endless wave a permanent tsunami, except that would grossly understate the size of the financial wave.

If we could pile up all the money that is exchanged in financial markets and make a literal wave out of it, it would make for an astounding sight were we on the International Space Station, towering above the clouds. The wave would rise so high it might swamp the space station itself.

All right, I am getting fanciful here. And we wouldn’t want to contemplate having to bail out the space station in zero-G conditions. But we are talking about an international financial industry that has truly grown to monstrous proportions, beyond any reasonable necessity.

How big? The combined daily trading average on the world’s foreign-exchange, bond and stock markets is very roughly about US$6 trillion. If that total seems amazing, it is for good reason: By way of comparison, the gross domestic product of the world is about $65 trillion. To put it another way, in 11 business days financial speculators trade instruments and contracts valued at more than all the products and services produced by the entire world in one year.

Most of us are familiar with stock exchanges, and that is the financial market that draws the lions’ share of corporate mass media attention. But that is actually only a tiny portion; an average day’s turnover on the world’s stock markets amounts to $270 billion. Bond markets (government debt, corporate debt and the myriad of “asset-backed” securities continually cooked up) are several times larger, and foreign exchange is vastly larger than bond markets.

Much of this daily $6 trillion turnover is in derivatives, swaps, futures contracts and assorted legerdemain. Almost all of this is nothing more than self-interested speculation; trading for the sake of the largest possible short-term profits regardless of the cost to the rest of the economy or the destabilizing social costs of these giant pools of capital sloshing around the world, pouring in capital here and pulling capital there as opportunities for short-term profits wax and wane.

Why do stock markets exist?

In theory, stock markets exist to distribute investment capital to where it is needed and to enable corporations to raise money for investment or other purposes. In real life, neither is really true. A corporation with stock traded on an exchange can use that status to issue new shares, raising money without the burden of dealing with lenders and paying them interest. But large corporations can raise money in a variety of ways, for example by issuing bonds or other interest-bearing debt, or by selling shares directly to private investors.

Nor do corporations necessarily wish to float new stock — doing so is disliked by investors because profits are diluted when spread among more shares. Instead, it is more common for large companies to buy back shares of their stock (at a premium to the trading price), which means less sharing of distributed profits.

From 1981 to 1997, for example, non-financial corporations in the United States bought back $813 billion more in stock through buyback programs and corporate takeovers than they issued.* That is money that was diverted from investment, employee compensation or community development, and constitutes still more money stuffed into financiers’ pockets.

Most of the action on stock exchanges is simply speculation, and as computers become more sophisticated, the speculation drives higher trading volumes and becomes more remote from the actual business of the company in which stock is bought. “Day trading,” where speculators buy and sell stock within minutes to earn profits on price fluctuations became common in the 1990s, but in the following decade the big Wall Street firms showed their muscle while bringing speculation to an unprecedented level.

These firms created sophisticated computer programs that buy and sell stocks in literally milliseconds. The programs issue thousands of buy orders that are canceled in minuscule fractions of a second in order to manipulate prices to the benefit of the computer owner. These price differences are only pennies, but are done on such enormous scale that the profits skimmed in this fashion are estimated to be as high as $21 billion per year — only a “handful” of these high-speed computer traders account for a majority of all stock-exchange trades.**

Speculation for its own sake

Speculation tends to reinforce itself. During the two years I spent working on a financial news service during the 1990s stock-market bubble, I repeatedly heard traders say the dramatic price rises could not last but they would continue to ride the bubble as long as the consensus view that the long bull market would continue remained in place. The primary reason for why market players believe stock prices will rise at a given time is because they believe other market players believe stock prices will rise. Not nearly as “scientific” as financiers would have you believe.

Bond and foreign-exchanges markets are no less fueled by speculation, and it is the gargantuan size of these markets that give the larger players in them the power to dictate to the world’s governments, extracting budget-busting bailouts, imposing austerity and raising their needs above all social considerations.

Their size is truly monstrous: the world’s 1,000 largest banks held an estimated US$102 trillion of assets in 2011. Separately, the “shadow banking” system (hedge funds, private-equity firms and other investment companies) is worth an additional $67 trillion.*** Financiers hold an amount of capital that is more than two and a half times larger than the world’s gross domestic product.

As more money is diverted into speculation because there are insufficient opportunities for investment, the size of the financial industry and the percentage of corporate profits claimed by the financial industry steadily grows — the size of both banks and unregulated “shadow banks” have increased since the beginning of the economic crisis in 2008. This capital is a function of the amount of money flowing upward to the rich becoming larger than they can use for personal luxury consumption or investment; these torrents of money are diverted into increasingly risky pure speculation.

Too much money comes to chase too few assets, rapidly bidding up prices until there is no possible revenue stream that can sustain the price of assets bought at inflated levels, triggering a crash. The very size of financial markets is a major contributing cause of economic instability. That size is in turn a product of the continual downward pressure on wages — an increasing share of corporate revenues go toward executive pay and profits as the share going toward wages declines.

A financial industry swollen to such gargantuan sizes have no relation to the actual needs of the economy. It is money that could be used for wages (which would strengthen the economy) or for productive investment were it not so concentrated and under-taxed. Austerity, after all, is only for working people.

* Doug Henwood, Wall Street [Verso, 1998], page 3
** Charles Duhigg, “Stock Traders Find Speed Pays, in Milliseconds,” The New York Times, July 24, 2009
*** TheCityUK; the Financial Stability Board