Wall Street Plays Hardball

Taxpayers are taking another hit as strapped local governments fork over billions in fees on investments gone bad

Detroit Mayor Dave Bing is struggling to save his city from fiscal calamity. Unemployment is at a record 28% and rising, while home prices have plunged 39% since 2007. The 66-year-old Bing, a former NBA all-star with the Detroit Pistons who took office 10 months ago, faces a $300million budget deficit—and few ways to make up the difference.

Against that bleak backdrop, Wall Street is squeezing one of America's weakest cities for every penny it can. A few years ago, Detroit struck a derivatives deal with UBS (UBS) and other banks that allowed it to save more than $2million a year in interest on $800million worth of bonds. But the fine print carried a potentially devastating condition. If the city's credit rating dropped, the banks could opt out of the deal and demand a sizable breakup fee. That's precisely what happened in January: After years of fiscal trouble, Detroit saw its credit rating slashed to junk. Suddenly the sputtering Motor City was on the hook for a $400million tab.

During late-night strategy sessions, Joseph L. Harris, Detroit's then-chief financial officer, scoured the budget for spare dollars, going so far as to cut expenditures on water and electricity. "I figured the [utility] wouldn't turn out our lights," says Harris. But there wasn't enough cash, and in June the city set up a payment plan with the banks.

Now Detroit must use the revenues from its three casinos—MGM Grand Detroit (MGM), Greektown Casino, and MotorCity Casino—to cover a $4.2million monthly payment to the banks before a single cent can go to schools, transportation, and other critical services. "The economic crisis has forced us to move quickly and redefine what services a city can and should provide," says Bing. "While we face a tough road ahead, I believe we're on the right path." UBS declined to comment.

Detroit isn't suffering alone. Across the nation, local governments and related public entities, already reeling from the recession, face another fiscal crisis: billions of dollars in fees owed to UBS, Goldman Sachs (GS), and other financial giants on investment deals gone wrong.

Charm Offensive

The seeds of this looming disaster were sown during the credit boom, when Wall Street targeted cities big and small with risky financial products that promised to save them money or boost returns. Investment bankers sold exotic derivatives designed to help municipalities cut borrowing costs. Banks and insurance companies constructed complicated tax deals that allowed public utilities, transit authorities, and other nonprofit organizations to extract cash immediately from their long-term assets. Private equity firms, pointing to stellar historical gains, persuaded big public pension funds to plow billions of dollars into high-cost investments at the peak of the market. Many of the transactions shared a striking similarity: provisions that protected the banks from big losses and left the customers on the hook for huge payouts.

Now, as many of those deals sour, Wall Street is ramping up its efforts to collect from Main Street. "The banks stuffed customers with [questionable investments] and then extorted money from the customers to get rid of them," says Christopher Whalen, managing director at research firm Institutional Risk Analytics. The New Jersey Transportation Trust Fund Authority, for instance, must pay nearly $1million a month at least until December 2011 to Goldman Sachs on derivatives deals tied to municipal debt—even though the state retired the debt last year. The Chicago Transit Authority (CTA), having entered into complex arrangements to lease its equipment to outside investors and then lease it back, could face termination fees of $30million. The investors could collect penalties because American International Group (AIG), which backed the arrangement, has seen its credit rating tumble. "These [sorts of deals] are potentially huge liabilities," says Stanford Law School's Joseph Bankman. "Investors aren't going to be settling for chump change." Goldman Sachs declined to comment.

The financial struggles of America's cities and towns stand in stark contrast to Wall Street, where bonuses at some firms are expected to reach record levels in 2009, less than a year after the peak of the financial crisis. To keep public outrage from reaching a boiling point, banking chiefs are embarking on a charm offensive. Goldman CEO Lloyd Blankfein, who recently sparked controversy when he told a Times of London reporter that his firm was "doing God's work," pledged on Nov. 17 to invest $500million in small businesses and charities. (That amounts to roughly 3% of the $16.7billion Goldman expects to pay its employees this year.)

Politicians have launched their own campaign. Federal lawmakers, troubled by the rising payouts, are trying to limit the damage to municipalities and prevent them from falling prey in the future. Pending legislation in Congress, introduced by Representative John Lewis (D-Ga.) and Senator Robert Menendez (D-N.J.), would impose a 100% tax on termination payments like those in the CTA deals to dissuade banks from going after struggling municipalities. Another proposal would limit the use of derivatives by localities with less than $50 million in assets; lawmakers figure small towns and cities don't have the resources to vet the risks of exotic investments adequately.

Without a federal fix, strapped municipalities like Detroit could be forced to slash vital services even more. The city's public schools, which had been putting off paying textbook suppliers and other vendors, aren't likely to see their funding rise now that banks are taking a bite out of the city's budget. The Royal Oak school district is eliminating after-school music programs and asking parents to pay $100per child to play sports. "We've had to demolish programs because of the squeeze," says Thomas L. Moline, the district's superintendent.

Detroit's public transportation system is also feeling the pinch. Because of budget restraints, bus routes have been canceled and equipment hasn't been fixed. On a cold day in early November, a group of students stood shivering as they awaited the No. 30 bus. The bus comes only once an hour now, compared with every 45 minutes a year ago. Longtime driver Linda Martin, whose bus broke down five times in the past year, helped organize a demonstration in August. Months later, the 56-year-old grandmother of eight was among 113 transportation workers laid off. "These are hardworking people, juggling three jobs sometimes," she says. "If they lose their income, there's a ripple effect throughout the whole community."

Of course, many of the municipal-finance investments blowing up now were fairly standard contracts that clearly spelled out the pitfalls. "Municipalities knew the risks," says James S. Normile, a New York partner at law firm Winston Strawn. "They just didn't think they were going to happen."

But some public entities, lacking the financial expertise, proved to be willing buyers for Wall Street's more dubious ideas. Consider the plight of Hoosier Energy Rural Electric Cooperative. In 2002 a group of attorneys and investment bankers presented the tiny nonprofit utility, indirectly owned by its 800,000 mostly rural customers, with a quick way to earn some money. Hoosier Energy leased a power plant near the Wabash River in Sullivan County, Ind., to John Hancock Financial Services. Hancock then turned around and leased it back. As a result, the utility netted $20million while Hancock planned to reap tax benefits on the facility. The bankers and lawyers, meanwhile, made $12million. The transaction was part of a broader trend: Over the past decade dozens of utilities, transportation agencies, and other public nonprofit entities struck so-called leaseback deals to collect cash on their assets.

Around the same time the Hoosier agreement was finalized, the IRS began cracking down on leaseback deals. The federal agency in a memorandum called them a "sham" that lacked any business purpose beyond tax evasion and amounted to a circular exchange of assets and cash. Legally speaking, a transaction that merely reaps tax rewards and has no other economic purpose is often considered an abusive tax shelter. Although the IRS hasn't ruled on Hancock's tax breaks, U.S. District Court Judge David F. Hamilton concluded in an opinion last fall that they looked "abusive." Hancock says it believes it's entitled to the tax benefits.

Vulnerable Public Transportation

Now Hancock is exploiting a technicality in the 3,000-page pact with Hoosier that could allow the financial firm to wiggle out of the contract and collect a fat fee. Even though Hoosier has continued to make all of its payments, it fell into technical default after Ambac Financial Group (ABK), which backed the transaction, suffered a credit-rating downgrade. Having not found a suitable replacement, Hoosier faces a $120million penalty, a sum that could exhaust its cash and credit lines. "It's a huge challenge for us," says Donna L. Snyder, Hoosier's vice-president for finance. "We're a small not-for-profit."

Hoosier may have to pay up soon. In September the Seventh Circuit Court of Appeals ruled the utility had to find a new guarantor this year or pay Hancock the money. If the latter happens, residents could face higher electricity rates. Already, Hoosier has hiked rates 3% because of the uncertainty of the deal. In the meantime the utility is conserving cash by postponing environmental upgrades to its coal plants and putting off payments to other power companies in the co-op. Says Jonathan Chiel, John Hancock's general counsel: "We've acted reasonably, and we believe no party to the transaction should seek to gain an unfair advantage."

Public transportation systems around the nation could be vulnerable to leaseback blowups. Moody's Investors Service (MCO) estimates that 25 big municipal transportation authorities entered into deals similar to Hoosier's. The fallout could be more than just financial. In recent years the Washington Metropolitan Area Transit Authority tied up a third of its subway fleet—almost 300 cars, some 30 years old—in a series of pacts with investors, some of which required keeping the same equipment running until 2014. To avoid violating the terms, the transit authority rejected a 2006 recommendation by the National Transportation Safety Board (NTSB) to replace or retrofit older cars. The NTSB warned at the time that in the event of a crash the old cars posed a higher risk of injury to passengers than newer models. One of the old cars was involved in a wreck in June that killed nine people. A spokeswoman for the transit authority said it lacks the funds to replace the cars.

Even public institutions that entered into relatively common investments are getting hurt. Many chased risky deals only in the later years of the credit boom and now are paying hefty fees on those underwater assets.

In 2006 the Teacher Retirement System of Texas hired T. Britton HarrisIV to overhaul the $100billion pension fund. The portfolio, one of the 20 largest pension funds, was still recovering from the dot-com bust earlier in the decade. Harris, a veteran of investment firm Bridgewater Associates and the Verizon Communications (VZ) employee pension plan, told board members: "My approach has never been incrementalist."

True to his word, Harris revamped the pension fund. For years, Texas Teachers had focused on stocks and bonds, relying on in-house managers to invest the money. The new investment officer proposed a huge shift into risky investments that promised better returns, including private equity and real estate. In April 2008—right after the fall of Bear Stearns—Wall Street chiefs flocked to Austin to seal their investment deals with the pension fund. Harris even hosted a dinner at a local steakhouse for Morgan Stanley's (MS) John Mack, Lehman Brothers' Richard Fuld, and Laurence Fink of BlackRock (BLK). "Being novices, there's a certain level of trust with decision-makers," says Tim Lee, executive director of the Texas Retired Teachers Assn. The pension fund's target stake in alternatives swelled to 29%, from 8%.

Then the crash came. Texas Teachers recently reported that its new private equity and real estate investments had dropped by 15% and 33%, respectively, in the first nine months of the year. Among the clunkers: Colony Capital VIII, a fund that invested in the buyout of Station Casinos, a Las Vegas casino operator that later went belly-up, and Neverland Ranch, the estate of the late Michael Jackson. It likely will take a while for the portfolio of alternative investments to recover.

Wall Street, though, will keep collecting its share. Private equity firms and hedge funds typically charge a hefty 1% to 2% fee on the total pool of assets under management even if their strategy loses money. On Texas Teachers' $13.5billion portfolio, that amount to tens of millions a year. The fund says it remains committed to alternative investments. "We are long-term and very liquid," says Harris. "This should be a time when the investments we make should prove rewarding."

Many of the million-plus educators who rely on the pension fund for their retirement benefits are worried about their financial fate. The fund's obligations exceeded its assets by $22billion this year. To make up the difference, the fund's board asked Texas legislators this summer to increase contributions both from taxpayers and active teachers, but lawmakers rejected the proposal. That means retired teachers, who haven't seen a cost-of-living increase since 2001, aren't likely to get a bump anytime soon. Says Bill Barnes, a retired school principal from Fort Worth: "The whole question is: Where's the money going to come from?"