In 2005, the city of Detroit faced a monumental dilemma: It desperately needed to borrow more than $1.4 billion to help shore up its two pension systems, but doing so would far exceed the legal limit on the amount of debt it could amass.The solution arrived at by the administration of then-Mayor Kwame Kilpatrick was to sidestep the law by turning to something called certificates of participation, or COPs, which are similar to municipal bonds. But instead of borrowing the money directly, Kilpatrick and his crew – following the advice of investment bankers who would reap massive profits from the deal – set up two nonprofit “service corporations,” which in turn created trusts that would sell the COPs to investors. Technically, it was these two nonprofits that were obligated to ensure repayment of the debt. The city then entered into a contract with the nonprofits – both of which were controlled entirely by city officials -- agreeing to pay them for services rendered.In other words, they were mere shells.“At the time, it was seen as a clever legal circumvention of the debt limit,” says Laura Bartell, a Wayne State University Law School professor who specializes in bankruptcy.Last Friday, lawyers representing the city filed a federal lawsuit claiming that the deal was illegal from the start, and because of that Detroit should not be required to continue paying off the debt. The case is now in the hands of U.S. Bankruptcy Judge Stephen Rhodes.The lawsuit came as a complete surprise to most people, even those who have been following the bankruptcy proceedings closely. Until this point, attention in this aspect of the bankruptcy proceedings has been focused instead on interest rate swaps, a controversial side deal to the COPs transactions.A type of hedge, these swaps were essentially a very high-stakes gamble. In effect, the city bet that interest rates were going to rise over time. If they did, the banks would be on the hook for the increased costs. Instead, the economy crashed in 2008, and interest rates fell to almost nothing. As a result, the cost to the city has been about $300 million in payments to what are known as the swap counterparties – Bank of America/Merrill Lynch and UBS, an investment bank based in Switzerland.For the better part of a year, the city has been trying to end the swaps. The banks claim that the cost of doing so should be about $300 million, and that the city is in a bad negotiating position because, even in bankruptcy, the swap payments are secured by casino tax revenues (as a result of another deal, struck in 2009).This is where the weeds thicken.
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