Those wonderful people who brought Hostess Brands, Inc. to its knees and left the country bereft of Twinkies for a time — are back. This time they’re looking at the city of Detroit, Michigan. [Reuters] To wit:
“Monarch Alternative Capital, which played a major role in the bankruptcy of Twinkie-maker Hostess Brands Inc, and several other funds have scooped up more than $600 million of debts of Jefferson County, Alabama, according to court records. But nowhere is attracting more attention than Detroit. With $8.6 billion in long-term debt, Detroit would be comparable to the biggest corporate failures if it eventually files for bankruptcy, a major advantage for big hedge funds that are used to investing hundreds of millions of dollars at a time.” [Reuters]
What could possibly go wrong? Let’s review. Buying up ‘distressed debt’ isn’t anything new — as long as there were corporate bankruptcies aplenty vulture capitalists could purchase debts and then ‘assist in the process of turning companies around.’ The first problem for the vulture squadron is that corporations are now sitting on loads of cash. There just aren’t as many shaky corporations as there used to be — companies like Hostess Brands, Inc. with a dubious history of mismanagement and duplicitous dealings with its workers. The second problem for the flying Cathartes Aura Crowd is that they need to find “investment” opportunities for their own cash. When Investment meets Opportunity there’s the possibility of a down-side, elegantly demonstrated in Jefferson County, Alabama.
The Jefferson County Debacle
In 1996 Jefferson County, Alabama decided to repair and replace portions of its aging sewer system such that untreated sewage would not be flowing into rivers during heavy rains. The county issued revenue bonds (payable from system collections) for the $1.5 billion project in 1997. The county also purchased derivative “protection” for some of the fixed rate debt. All seemed well until the $1.5 billion project increased to $2.2 billion and the county was saddled with approximately $3 billion in debt.
By late 1997 one Republican county commissioner was raising red flags: “The financing — which refinanced floating-rate debt with fixed-rate debt, and then used the derivative to essentially convert it back to floating-rate again — left it with a higher interest cost than when it began, she said. She estimated it raised the county’s expense by some $1.2 million a year, creating alarm about cronyism, excessive fees and fraud.” [Bloomberg] She was right to be alarmed.
When the financing began (with the ‘assistance’ of JPMorganChase) about 95% of the county’s debt was fixed rate, and by the end the percentage of floating rate (auction rate) debt was about 93% of the total. There was cronyism aplenty:
“The bank’s fees on the swaps weren’t disclosed; rather, they were embedded in the interest rates the county paid. JPMorgan overcharged the county on the swaps to cover the cost of more than $8 million in secret payments made to friends of county commissioners who worked for local companies, a step to secure JPMorgan’s lead role, according to the SEC.” [Bloomberg]
The commissioner’s worst fears were given tangible form when in 2007 an independent review of the fees charged reported that the $120 million in swap fees were about $100 million more than was warranted.
In the period between January and March 2008 as the country skidded into the Mortgage Meltdown the credit ratings of the two companies that insured Jefferson County’s bonds was slashed, and now without a “solid” credit rating money market funds and other investors started dumping the bonds.
The financial chaos included people going to jail for bribery and corruption charges, the county frantically trying to raise revenue, and the bankers engaged in negotiations to try to stabilize the situation. The last two years have been a whirlwind in which the Jefferson County Commission have been trying to raise revenues — often blocked by Republicans in the state legislature — and closing down facilities in order to get the finances under some modicum of control. [Al.com]
As of April 19, 2013 the situation still hasn’t been resolved, with a cram-down proposal — roundly criticized by creditors — on the table as the county tries to exit bankruptcy. [Al.com]
There are some important points to remember from the ongoing saga of the 658,000 people trying to figure out what’s been happening to the city of Birmingham and its surrounds.
First, this financial mess was created in so-called good financial times. A county commission seeking to do the right thing was sold a financing scheme which fitted the revenue plans of the investment bankers but was a poor fit for long term capital projects. The collusion of government leaders with investment bankers equated to long term losses and some rather long jail sentences. The oldest rule in contract negotiations was ignored: If you don’t understand it, don’t sign it.
Secondly, someone forgot that the derivatives market was essentially an unregulated Wild West version of capital investment, and we can assume it wasn’t the bankers making that mistake.
Third, while revenue bonds are a common form of financing for municipal projects, they must be repaid from generating revenue from the specific project. True, the issuance of revenue bonds allows local governments to bypass legislated debt limits, but there has to be income to pay them off. Fancy financing is not a substitute for INCOME. Put more bluntly — while revenue bonds are great for toll bridges they aren’t necessarily a good way to finance larger systems such as sewer and water or other public utility services. General obligation bonds might have been a better suggestion back in 1996.
Fourth, in an age of securitized indebtedness, remembering that one man’s debt is another man’s asset is crucial. Complicated transactions involving the securitization of debts (public or private) are chancy deals and no amount of financial wizardry can paper over the dangers associated with market based interest rates and the impact of derivative trading.
A bit of the ham-stringing, belt tightening, misery associated with the Birmingham Debacle can be seen in the current political and economic troubles on display in Detroit, Michigan.
Motor City Meltdown
Detroit is in debt. The amount and the ways to reduce it are at issue, but the debt is still there. It’s between roughly $10 and $12 billion. One “turn around” firm has suggested that the only way for Detroit to survive financially is to gut public employee contracts, sell off city assets, and slash city services. [DFP] The mayor begs to disagree, and the next round in this fight may well concern whether or not to put the city under the control of an emergency manager to — gut public employee contracts, sell off city assets, and slash city services. Enter the Cathartes Aura Crowd.
Cathartes Aura Capitalism
There is a way to make money off misery. Simply buy up debts and negotiate a discount above a potential selling price. For example, one might buy up bonds for 66 cents on the dollar and renegotiate with the city for an 80 cent per dollar repayment rate. Then there’s the corporate model Visteon example, buy up the debt, pay off the secured lenders without telling them they aren’t going to end up owning the company, and then take over. [Bloomberg] Whether the example is corporate or public the end game is essentially the same. A “turn around” is always destructive. And, there’s been little as obviously destructive as the turn around at Hostess Brands, Inc.
Ding Dong The Deal Is Dead
The first issue in dealing with the Twinkie Defense is to take care not to defend the indefensible. In a country with looming acknowledgement that sugar should not be the main food group, and that confections should not be a major source of nutritional input, the Twinkie and the Ding Dong were probably gone’ers. When product sales go down there is very likely a good reason. What is disturbing is that a combination of corporate mis-management and union desperation created a recipe for disaster.
What we can say with some degree of confidence is that corporate management achieved that fossilized level of thinking in which profits were comprehended only in the short term — to be returned to investors — and not as revenue to be divided between long and short term company needs. Funds the union gave up for re-tooling and renovations simply flowed back into corporate coffers to no particularly good effect except to keep stock prices elevated. The deeper the management got into financing with investors whose eyes were focused on short term returns the less able it was to evaluate its own structure, brands, and operations. The company finally became a manifestation of the coriolis effect in corporate financing as it flushed itself down the porcelain. The vultures awaited:
“Apollo Global Management and Metropoulos & Co., which made a joint offer to snap up the famous cream-filled cakes, have also entered the contest to buy Drake’s, which include Devil Dogs and Yodels, according to a source who requested anonymity because the sale process is private.” [HuffPo]
The union contracts were wiped out, the assets were sold, and the “company” split into the fragments investors were willing to buy up.
No one should have any pleasant delusions that the application of Cathartes Aura Capitalism to municipal financing won’t achieve the same purposes. Whether the object is to “restore” financial stability or to “return” to profitability, the play book is essentially the same. Reduce expenses (cut services, decrease employment costs), identify profit opportunities (privatize), and sell assets which will create immediate revenue. It’s the word “immediate” that should concern us.
Creditors in the case of Jefferson County, Alabama aren’t willing to take a hair cut in the immediate future even though stabilizing the indebtedness of Birmingham’s public government is a more worthy public goal with long term benefits.
Creditors and investors in Detroit’s debt aren’t willing to wait for an uptick in the local economy predicated on the resurgence of the auto industry; they’d as soon get an immediate return on their investments.
Creditors in the Twinkies example weren’t willing to wait for, or perhaps even suggest to the management, a company reorganization in which some brands were dropped in order to focus on increasing sales in profitable divisions in the long view.
And here we have the ultimate problem with Financialism — the rigid attention to short term gains and quarterly reports which provide opportunities for immediate profits — long term development, whether it’s for a viable sewer system in Alabama, a pension plan in Michigan, or a bakery plant in Houston, are sacrificed on the altar of Immediate Profitability and Stock or Bond Market Prices.
At least the Turkey Vultures have a slightly longer term view than our Cathartes Aura Capitalists — while the vultures can expect to live about 16 years in the wild, their Cathartes Aura cousins on Wall Street are often looking no further than the next round of quarterly reports.