The losing bets

How interest rate swap deals are causing local government agencies to pay millions of dollars to the biggest banks

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Activists demonstrate outside Bank of America in San Francisco on Feb. 21.
PHOTO BY LUKE THOMAS/FOG CITY JOURNAL

By Darwin BondGraham

news@sfbg.com

Wall Street's massive taxpayer funded bailout, initiated by the Bush administration and carried forward under President Obama, never really ended — it just shifted from federal to local sources of funding. Even while local and state governments have been forced to cut back on crucial services, wealthy banks and investment firms are being padded with enormous cash flows sucked directly from the already strained budgets of cities, counties, and public agencies.

That's the message a growing chorus of activists in the Bay Area are bringing before the boards, councils, and commissions that entered into complex financial deals with Wall Street banks, deals that turned toxic in the crash of 2008. Activists want elected officials and the banks to cancel the contracts and refund the public.

The Bay Area is the epicenter of this renewed movement for financial justice. Last week, teachers from Peralta College, organizers with the Alliance of Californians for Community Empowerment (ACCE), Oakland religious leaders, and Occupy Oakland activists organized four protests contesting what they say is bank predation on local communities.

At issue are arcane financial instruments called interest rate swaps. Sold by banks to virtually every sizable government and local agency in the US through the 2000s, rate swaps promised governments the ability to "swap" their potentially costly variable rate payments on bonds into a synthetic fixed rate. Seeking to protect local taxpayers during the volatile 2000s, when floating interest rates were rising, local leaders eagerly signed on.

But the economic meltdown turned those tools into golden handcuffs for local government agencies. Taxpayers are now forced to regularly pay millions to the banks simply because variable interest rates, at the urging of the Federal Reserve, have fallen far below the synthetic rates. These deals might seem numbingly complex, but the effects on local communities are clear and painful.

"The Metropolitan Transportation Commission is paying upwards of $53 million a year on rate swaps," said Alia Phelps of ACCE at a protest on Feb. 21 outside of the former Bank of America building at 555 California Street. "This is money that isn't going to keep routes in service, that isn't paying drivers, nor going to repair buses, or to keep fares lower. We need these swaps renegotiated."

That protest included visits to half a dozen banks. Activists demanded branch managers fax a letter to their corporate headquarters calling on the banks to voluntarily renegotiate swaps signed with the Metropolitan Transportation Commission (MTC), the Bay Area's regional transportation authority, which has lost over $100 million on toxic swap deals.

In 2002 the Bay Area Toll Authority (BATA), a state-level agency operated by the MTC, issued more than $1 billion in bonds to pay for repairs and seismic upgrades of regional toll bridges. Three financial giants stepped forward promising to lower MTC's long-term borrowing costs on these bonds by using interest rate swaps. Ambac, Solomon Smith Barney and Morgan Stanley signed deals with the MTC to cover $300 million in debt.

"With this transaction, we are getting the peace of mind of a fixed debt payment at a significant discount from traditional price levels," MTC's Chief Financial Officer Brian Mayhew said at the time of the deal.

Basically the swap agreement had the MTC paying a fixed interest rate of 4.1 percent to the banks, while the banks paid 65 percent of the London Interbank Offered Rate (LIBOR), a key benchmark used in global financial markets. Whichever party's sum happened to be higher when payments came due would pay the difference. The advantage of the deal, in the eyes of the MTC's managers, was that it would lock-in a low interest rate on MTC's debt, potentially saving as much as $45 million.

Comments

Very nice piece. Could you follow up with a piece on what local and state
entitites are doing to prevent public officials from ever again promoting such
deals? With so many taxpayer dollars servicing debt and interest payments to
banks, it is little wonder fiscal crises are so widespread. It is high time for a
state bank.

Posted by Guest Franklin Graham on Feb. 29, 2012 @ 2:05 pm

that rates may decline and they would have been better off not taking out the insurance.

But that's like someone who takes out a fixed-rate 30-year mortgage only to see rates decline. You make your bets and have to live with the consequences. You can't have it both ways.

Posted by Anonymous on Feb. 29, 2012 @ 3:20 pm

web site

Posted by web site on Dec. 22, 2012 @ 8:06 am

If rates had gone up, Muni's would have made out like bandits. But they bet wrong and would have been better off not entering into the swaps contract.

But that's a little like complaining about buying fire insurance after it turns out that your house never burned down. Muni's bought insurance and, in the end, turns out they didn't need it. Boo hoo.

Posted by Guest on Dec. 22, 2012 @ 8:36 am

municipalities have volunteered to pay more to the banks for their "lost profits"? Of course not. Municipalities made a financial bet and got it wrong. They wanted insurance and are now complaining that they'd have been better off without it. Well, boo freaking hoo. That's like trying to cancel your fire insurance after you didn't have a fire.

So fire the muni's CFO and move on. There are on one-way bets in the markets.

Posted by Anonymous on Feb. 29, 2012 @ 3:07 pm

You're using the logic of capital, where people don't matter, what does is greed and profits for large corporations.

I think the Occupy moment is helping us see things differently: it doesn't have to be this way. Banks don't have to rob from people and cities, to profit. We can hold banks accountable and make sure our cities are able to fulfill their social purpose: to care for the people.

Sadly, the city of Oakland has been unable to do so. Again, Occupy Oakland has been picking up the slack, as documented in the Occupy Oakland Serves the People Fact Sheet. See: http://occupyresearch.net/oakland.

Posted by yvonne on Mar. 01, 2012 @ 1:24 pm

fraud, deception or a lack of consideration, then a swap is simply what it purports to be - a hedge or speculation that a muni CFO made that didn't work out.

You can't have it both ways. If the swap had worked out, would goldman Sachs have been able to walk away from it's obligation? Of course not.

Heads I win, tails you lose is not a sustainable scenario.

Posted by Guest on Mar. 01, 2012 @ 1:37 pm

To Guest

Are those the values that our society should live by? "Heads I win, tails you lose."

The fact of the matter is: Goldman Sachs has been able to walk away from its debt obligation. As has other banks, such as JP Morgan Chase, Wells Fargo, and Fannie & Freddie Mac.

Propublica maintains a great list of these bank and corporate bailouts, paid for by we the taxpayers: http://projects.propublica.org/bailout/list

Posted by yvonne on Mar. 02, 2012 @ 5:55 am

Previous two comments are completely missing the point.

This absolutely isn't "like trying to cancel your fire insurance after you didn't have a fire." Rather, this is about justice.

When the big banks got stuck with billions in toxic derivatives (including interest rate swaps) what did the federal government do? Answer: they got bailed out.

When cities got stuck with billions in toxic derivatives, mostly interest rate swaps, what did the feds do? No help. Banks win.

If the commenters above can explain how this is "fair" and reasonable, my hat's off to them.

Posted by d on Feb. 29, 2012 @ 5:26 pm

But just because the banks got bailed out doesn't mean that anyone and everyone should. This "me too - I want some" attitude is exactly the problem.

The simple fact is that muni's were speculating on interest rates when they should have been sticking to their knitting and - I don't know - maybe fix a street or something?

If you back a horse to win in a race and it loses, you can't ask for your stake back. If you bet on red and black comes up, you can't take your chip back. The world doesn't work like that, contracts are valid and if cities and counties made bad bets, then they should suffer.

And unlike banks, cities can raise taxes.

Posted by Anonymous on Feb. 29, 2012 @ 5:54 pm

Wow: "just because the banks got bailed out doesn't mean that anyone and everyone should. This "me too - I want some" attitude is exactly the problem."

I'm not sure how to respond to this. It's an amazingly anti-democratic, indeed plutocratic comment. Unfortunately you've commented anonymously, but I wouldn't be surprised if you were an investment banker yourself. You've clearly shown what you value. You value bank profits and executive salaries over clean and safe streets, libraries, schools, and transit.

As to the finer points, again you're missing key facts; cities weren't speculating. Interest rate swaps were sold to governments as "hedges." A hedge is a risk mitigating instrument that was sold to reduce possible harms from interest rate fluctuations.

If you read San Francisco's (and Oakland's, and virtually all other Bay Area government agencies') policy on the use of rate swaps to finance borrowing, you'll find that government is explicitly barred from using rate swaps to speculate, or as an investment tool period.

Clearly you know very little about this subject, or you are simply trying to argue the point so as to confuse others.

Your last comment is unrealistic. Anyone and everyone in CA knows that cities can't just raise taxes.

Posted by d on Feb. 29, 2012 @ 6:40 pm

You pay a bank to take away all your interest rate risk.

Goldman etc. absorbed that risk so the entity that bought that insurance can't just turn around and say "oh, turns out that risk never occured so we want to reverse the deal.

Society could not function if everyone could simply back out of every deal that didn't work out.

Fire the muni CFO's that made these dumb deals, but you can't blame the banks for delivering exactly what was asked of them.

Posted by Anonymous on Mar. 01, 2012 @ 7:31 am

I wonder why more attention wasn't paid to this sooner? Instead, we got treated to all that brouhaha over public workers as we turned a blind eye to systemic corruption and financial schemes like this one. The real problem is that the system is rotten to the core. The financial elites and their lobbyists write the laws that affect them, and impose rules on the rest of us that has led to a system of financial apartheid. Max Keiser, who hosts the Keiser Report, explains how it works~

“In America, they have financial Jim Crow laws. If you’re a white Goldman Sachs partner, you can borrow money at zero percent or less than zero percent. Anyone else, you’re borrowing money at 16%, 20%, 35% – payday loans annualizing at 300%. So they’re using interest rates to create a two class society. Fellas who are on the inside who get zero percent interest charged to them and everyone else who is basically an underclass, a permanent underclass in the United States and around the world who are charged exorbitant fees to borrow money. That’s almost a financial apartheid if you will and it is orchestrated on purpose to create this huge social divide for profiteering purposes.”

http://www.active-investor.com/max-keiser-on-financial-apartheid-plus-a-...

Posted by Lisa on Feb. 29, 2012 @ 6:56 pm

It's much more like buying fire insurance because you are worried about a fire. You don't get your premium back if there turns out to be no fire.

The rest of your post is just the usual hopeless left-wing doggerel.

Posted by Anonymous on Mar. 01, 2012 @ 7:33 am

Anonymous poster: you keep using these analogies that are completely inappropriate and incapable of explaining the problem. IR swaps aren't like "fire insurance" for individual homeowners. They're complex derivative products used by major institutions to hedge risks against normal market fluctuations.

Had the market not crashed and capitalism not almost died in 2008, and had the Federal Reserve Bank no dropped interest rates to virtually zero, and had the US Treasury not bailed out the biggest banks with trillions of dollars of taxpayer money... then you might have a point about why cities should be expected to stick with their IR swaps. After all, we would be living under normal market conditions.

However, none of this is true. Instead we underwent a world historical crisis and there was unprecedented government and central bank intervention in the markets to bail out private capital. These political interventions in turn have made municipal IR swaps into toxic assets, yet the cities are not bailed out.

Your repeated attempts to avoid the factual/contextual basis of an IR swap with the "fire insurance" analogy reeks of bad faith and a purposeful attempt to obscure the issue. It echoes the politicians' obsession with the "national debt is like household debt" analogy. It's appealing to people because it breaks the issue down into everyday troubles they can understand, but the problem is that such analogies are enormously deceptive.

Posted by d on Mar. 01, 2012 @ 8:28 am

If my cat was a dog it would bark.

The city insured against a risk. That risk never happened and so obviously things worked out such that the insurance proved to be expensive.

Boo freaking hoo.

The cities took one side of a bet that misfired. The bansk that sold the insurance kept their word and honoured their commitments.

Your only legit complaints are against near-sighted muni bosses and the federal government. So go ask for a bailout. But you won't get one.

Posted by Guest on Mar. 01, 2012 @ 9:26 am

We don't have capitalism. What you saw was a failure of Croni-capitalism or a form of socialism/communism with a fiat currency that's you saw and it did fail. Been brewing for a long time and it's just starting.

Posted by Guest on Mar. 15, 2012 @ 7:49 am

Completely dismissing reality and appealing to abstractions and false comparisons.

Cities certainly made a "bet," but they did so making the perfectly reasonable assumption that there wouldn't be a once-in-a-lifetime market rupture and near collapse of the global financial system. What began in 2008 changes everything. What don't you get about that?

It changed everything enough to cause the Fed to bail out the banks. They were "too big to fail," remember?

Are cities not "too big to fail"? Are cities, local communities something you want to fail?

Local government is currently failing. Children are suffering. Schools get closed. Transit cut. Parks and buildings and streets fall apart. Budget cuts are harming our communities because local government is working with smaller revenues, and has to pay higher percentages of tax dollars to the banks under these onerous deals.

There is a solution that would simply involve extending the privileges given to the bankers to the masses of people through their local governments, and it would partly involve canceling these toxic swap deals.

You're arguing for an unfair, plutocratic system. Don't be surprised when the vast majority of Americans disagree with you. We want to live in a democracy, where our federal government and the economic system works for everyone.

Posted by d on Mar. 01, 2012 @ 11:05 am

have hedged that instead.

And don't forget that low rates are great for muni's - they enable cheap borrowing and refinancing. It's high rates that's the concern they wanted to insure against. Markets could have gone either way - that's why you hedge.

Muni's haven't lost anything other than the premia they paid for the insurance. And they are saving a bundle from lower rates. Save your aympathy for someone worthy of it, not some bureaucrat in a cheap suit who thought he was being a smartass.

The swaps are contracts and there is no legal basis to overturn them. If you think differently, then sue.

Posted by Guest on Mar. 01, 2012 @ 11:40 am

Wall Street argues that derivatives are not insurance or like insurance, because if they were, they'd be required to submit to regulation and meet reinsurance and capital requirements, amongst other onerous burdens.

Posted by marcos on Mar. 01, 2012 @ 11:33 am

deemed to be sophisticated financially. These bozo's at the city were clueless, I'd agree, and should be fired. But they made a one-way bet which could have gotten huge rewards. They just happened to be wrong.

But now muni's can borrow at record low rates, so what they lost on one side, they gained on the other.

Posted by Guest on Mar. 01, 2012 @ 11:47 am

Swap derivatives are not regulated like insurance.

Posted by marcos on Mar. 01, 2012 @ 12:00 pm

CFO's are assumed to be more financially aware, sophisticated and responsible. If they foul up, it's their head. They can't whine: "boo hoo, it's not fair".

Posted by Guest on Mar. 01, 2012 @ 12:17 pm

You're using the logic of capital, where people don't matter, what does is greed and profits for large corporations.

I think the Occupy moment is helping us see things differently: it doesn't have to be this way. Banks don't have to rob from people and cities, to profit. We can hold banks accountable and make sure our cities are able to fulfill their social purpose: to care for the people.

Sadly, the city of Oakland has been unable to do so. Again, Occupy Oakland has been picking up the slack, as documented in the Occupy Oakland Serves the People Fact Sheet. See: http://occupyresearch.net/oakland.

Posted by yvonne on Mar. 01, 2012 @ 1:26 pm

"The Oakland City Council has voted unanimously to end a contract with Goldman Sachs that locked it into a financial deal called an high interest rate swap. The city signed on with the bank in 1998 on the premise it would reduce costs of its bonds amid rising interest rates. But after the 2008 financial meltdown, the Federal Reserve cut interest rates to near zero. As a result, Goldman’s rate dropped to 0.15 percent — even as it continued to require Oakland to pay a rate of almost 6 percent. The city council is calling on the city to refuse to do business with Goldman Sachs unless it ends the deal without requiring a $15 million payout. The vote comes after a long campaign by city workers, unions, the Occupy movement and local clergy members. "It’s really been through direct action and public pressure that we’ve been able to build for this," says Alysabeth Alexander, political action chair for SEIU Local 1021, who helped organize the Oakland community and present testimony to the council members. "This is actually the second swap that SEIU 1021 has taken on and we’re going to continue to do this with our community partners and take on Wall Street. It’s not right that, in this fiscal crisis, that they’re profiting off of our local governments."

http://www.democracynow.org/2012/7/9/oakland_city_council_seeks_to_cut

Posted by lp on Jul. 09, 2012 @ 6:04 pm

renege on it without ruining their credit rating, which in turn means they won't be able to borrow or issue bonds.

And nowhere needs to borrow like Oakland.

Posted by Guest on Jul. 09, 2012 @ 6:30 pm