Message to Mayor Emanuel: Play Hardball with Wall Street

May 6, 2015

Last week, Mayor Rahm Emanuel announced that he plans to preemptively terminate a large portion of the City of Chicago’s remaining interest rate swaps, which will cost taxpayers $200 million in penalties.

He is trying to sell this as a shrewd move that will protect Chicago from future risk and help return the city to financial health. Nothing could be further from the truth. In reality, this is little more than a capitulation to Wall Street that will guarantee maximum profits for banks at taxpayers’ expense. This is the moment for the mayor to play hardball and force the banks to take significant concessions to protect the interests of the city’s communities and its bondholders alike. He can do this by suing the banks for misrepresenting risks associated with these deals, in violation of their duty to deal fairly with municipal borrowers, and by initiating a debt strike against the swap counterparties by strategically defaulting on the swap payments.

Emanuel’s decision to pay the banks the full face value of the swap penalties is indefensible. When the termination clauses on Detroit’s swaps were triggered, a federal judge pushed the city to drive a hard bargain with the banks and forced them to take a 75 percent haircut on the penalties. The judge made clear that he believed the city had a strong argument to declare the swaps invalid and said the city would be “reasonably likely” to prevail if it took legal action to get out of the deals. The judge encouraged the city to stop making payments on the swaps and to sue the banks instead. As a result of these negotiations, the city paid just $85 million in penalties instead of $347 million.

Emanuel similarly has a strong argument that the banks that sold toxic swaps to both the City of Chicago and Chicago Public Schools (CPS) did so illegally, and he should use both the legal and financial options at his disposal to get a better deal from the banks. Instead of giving away $200 million to banks, the mayor should launch a debt strike against the swap counterparties. He should refuse to pay them another dime on the city and school district’s swaps. Corporations often use this tactic, which they call a debt moratorium, to increase their leverage in negotiations with creditors. Emanuel should also sue the banks to recover $1.3 billion in past and future payments on these deals. This would give the city and CPS tremendous leverage to extract major concessions from the banks and renegotiate these toxic deals.

The course that Emanuel has instead chosen, to preemptively pay the banks $200 million in penalties to terminate the swaps, will actually serve to maximize taxpayer losses rather than save the city money. The penalties are calculated based on the interest rate environment, and because variable interest rates are still at record lows, it means that paying the banks now guarantees that the city will pay a higher amount than if it has to terminate the swaps later. There is a growing consensus that the Federal Reserve will start raising interest rates soon, which will drive these penalties down. Now is the worst possible time to voluntarily pay these penalties, especially because the mayor actually has a lot of leverage to get a better deal for Chicagoans, if he chooses to exercise it.

Playing Hardball with Wall Street

The amount of the termination penalties is not set in stone. When a swap termination event occurs, municipal borrowers and banks typically enter into negotiations with each other, during which cities can use legal and financial leverage to get a better deal. The reality is that Chicago has a lot more leverage in these negotiations than its swap counterparties. For one, the city has a very strong legal argument that the banks that pitched its swap deals violated their legal duty to deal fairly with the city by downplaying and misrepresenting risks and failing to mention that many of them were rigging the interest rates that the swaps were based on. The city should take legal action to get out of these deals. But beyond that, the city also has tremendous financial leverage vis-à-vis the banks, because it could simply stop making its swap payments, which would actually free up money for the city’s residents, pensioners, and bondholders. In Detroit, a federal judge advocated both of these strategies, and the city was able to save $262 million on its termination penalties as a result.

Suing the Banks

When the City of Detroit was placed under an emergency manager in 2013 and then filed bankruptcy, it triggered termination clauses on its interest rate swaps, which came with hefty penalties that stood at $347 million according to the city’s bankruptcy filing. Through negotiations, the banks agreed to settle for just $250 million. The bankruptcy judge rejected this settlement, and urged the city to either negotiate a better deal or file a legal challenge against the swaps. The city and banks went back to the bargaining table and came back with an offer to settle for $165 million. The judge again rejected the proposal, saying that, “In the absence of this settlement, the city might pursue an underlying claim challenging the swaps themselves,” and adding that the city would be “reasonably likely” to be successful in such a challenge. Ultimately, the judge approved an $85 million settlement, a 75 percent discount on the original figure of $347 million.

This should be a lesson for Emanuel. Of course Detroit, unlike Chicago, got its swap termination penalties reduced during the course of bankruptcy proceedings. The judge’s legal rationale, however, was not tied to the specifics of the bankruptcy process. He believed the swaps themselves were likely invalid based on the facts of the underlying deals and that the city would have been on strong legal footing if it had stopped making payments altogether.

Similarly, Emanuel should challenge the legality of the city’s swap deals and those of CPS and use that legal leverage to try to get a better deal. Whereas Detroit was able to make the banks take a 75 percent haircut on its penalties, Emanuel is proposing to pay the banks 100 cents on the dollar. That is financially irresponsible.

Although city officials often worry that they will get cut off from the credit markets if they sue banks, these concerns are unfounded because the interests of bondholders and swap counterparties are actually at odds with each other. In Detroit, bondholders were actually advocating for the city to take an even harder line against the banks because the swap penalties would have left less money for the bondholders. Many of the city’s creditors objected even to the final $85 million settlement. In fact, taking legal action against the banks should theoretically improve Chicago’s standing among bondholders, because it would free up money for payments to bondholders.

Instead of preemptively paying Wall Street $200 million in penalties to terminate the swaps, Emanuel should sue the banks to recover nearly $800 million in past and future payments on the deals for the city and $500 million for CPS. The banks that pitched these deals like violated the fair dealing rule of the Municipal Securities Rulemaking Board by misrepresenting or omitting “the facts, risks, potential benefits, or other material information” with respect to these deals. Emanuel has several legal options at its disposal to recover that money, including filing a lawsuit in state court for breach of contract.

Launching a Debt Strike

In addition to suing the banks, Emanuel should also follow the Detroit bankruptcy judge’s advice and refuse to make any more payments on the swaps. The banks have little leverage to compel the city to pay. The worst they can do is terminate the swaps and demand the city pay $200 million in penalties, but since Emanuel already stands ready to pay them that, the city really doesn’t have much to lose. In fact, Emanuel should coordinate with the city’s other governmental units that also have interest rate swaps and launch a coordinated debt strike against their swap counterparties. Corporations routinely use this tactic, which they call a debt moratorium, to increase their leverage in negotiations with creditors and compel them to write down debt.

Chicago Public Schools is already facing more than $260 million in penalties because the termination clauses on its swaps have already been triggered. The city’s enterprise funds also have swaps tied to their debt that could carry penalties of more than $200 million if the funds’ ratings are downgraded. Between the city, its enterprise funds, and CPS, Emanuel controls more than $660 million that the banks want. This represents money that is pure profit for the banks—they have not lent the city or CPS any money against this amount. Instead, interest rate swaps are side deals that simply involve an interest rate exchange between two parties—an exchange that has turned into an unexpected windfall for banks as a result of the financial crash that they caused.

If Emanuel were simply to withhold this money, the banks would be at a loss. Banks cannot compel municipalities to file bankruptcy to try to recover this money (and in Illinois in particular, municipalities are not allowed to file bankruptcy anyway). They could seek a court order, but if Emanuel were also to take legal action against the banks, the judge could very well grant a stay on any payments until the court case was resolved, which could take years and would involve a discovery process that would likely be embarrassing for the banks. That would leave the banks with two options: strike a cheaper negotiated settlement like Detroit’s counterparties did, or risk an adverse court ruling through which they could actually be forced to pay back the city and CPS all the money they have already made on these deals—up to $1.3 billion.

Some may have concerns that strategically defaulting on the swaps would cause the city’s credit ratings to slide further. However, the city’s bonds are already trading at junk levels. Moreover, the rating agencies have already made clear that they intend to further downgrade Chicago’s credit rating anyway when the state’s blatantly unconstitutional “pension reform” bill is overturned by the Illinois Supreme Court. Ironically, a strategical default on swap payments could actually improve the city’s credit rating, since it would free up more cash for payments to bondholders, as mentioned above.

The Termination Penalties Maximize Bank Profits

Instead of using the city’s leverage to drive a hard bargain with the banks, Emanuel is proposing to preemptively terminate the swaps and pay $200 million in penalties. The mayor’s contention that doing this will protect the city against future termination risk is illogical. In effect, his argument is that he is eliminating the risk that the city could be forced to pay banks $200 million in the future by paying them $200 million now. He isn’t eliminating the risk; he is realizing it by voluntarily signing a $200 million check to Wall Street. This may be proactive, but that’s cold comfort to the Chicagoans who need that $200 million to fund essential services in their communities like mental health clinics and libraries. This $200 million payment isn’t just bad for communities, it is also bad finance.

The standard interest rate swap contract has termination clauses built in. If any “termination events” take place, then the bank has the right to terminate the swap and collect termination penalties. These termination events include credit rating downgrades below a certain threshold, among other things. In the case of Chicago, further downgrades in the city’s credit rating could trigger termination clauses on the its swaps. Conversely, if a municipal borrower wishes to terminate a swap, it may do so at any time by paying the termination penalty to the bank. This is what Emanuel has decided to do.

These termination penalties are equal to the fair value of the swap at the time that it is terminated, which is calculated as the net present value of all future payments on the swap over its remaining life, based on the current interest rate curve. What that means is that these penalties guarantee the banks all of their future profits on the swaps. The standard way the penalties are calculated does not change regardless of which party terminates the swap or for what reason. Emanuel is not saving Chicago any money by terminating the swaps, but instead is simply choosing to absorb those losses now, so he can claim he was proactive.

In reality, the city is actually likely to save money if he waits. Variable interest rates have been stuck at historic lows since 2008, when the Federal Reserve slashed rates to near zero in response to the financial crisis. This has caused taxpayer payments on all traditional interest rate swaps in the country to balloon. Chicago now pays approximately $70 million a year on its swaps, and CPS pays another $36 million a year. Because the termination penalties represent future payments based on the current interest rate curve, this has also caused the penalties to skyrocket. As the Federal Reserve gradually increases interest rates, which it is widely expected to do, these penalties will come down. By paying the banks $200 million now, while rates are still at historic lows, Emanuel will guarantee that the banks get a larger payment than they would if the swaps were terminated six months or a year from now.

Furthermore, the mayor plans to issue new debt to pay off the $200 million. What that means is that Chicago taxpayers will also be stuck paying interest on this $200 million for the next 30 years or so. On traditional 30-year bonds, the interest ends up being roughly equal to the principal, which means these termination penalties could end up costing taxpayers around $400 million.

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Emanuel is trying to spin his decision to pay the banks $200 million to terminate the city’s swaps as a bold move that will save the city money in the long run. This is untrue. Paying the banks now would amount to little more than a handout to Wall Street that would maximize their profits at taxpayers’ expense. First of all, there is no financial benefit to paying the banks early since interest rates are expected to rise, which would cause the penalties to decline. Secondly and more importantly, the city has tremendous legal and financial leverage to get a better deal from the banks and could likely bring the $200 million penalty down to a fraction of itself if Emanuel played hardball. If he sued the banks, the city could win nearly $800 million in past and future payments and CPS could win $500 million. If he launched a debt strike against the swaps, the banks would have limited recourse. Instead of paying the banks $200 million in a feeble attempt to put the swap fiasco behind him, the mayor should take legal action against these toxic swaps and immediately cease all payments on these deals. That would be the bold thing to do.

For more bold solutions that Mayor Rahm Emanuel can pursue to bring new, progressive revenue into Chicago’s coffers, see the ReFund America Project’s report, Our Kind of Town: A Financial Plan that Puts Chicago’s Communities First.