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Gordon T Long

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Sultans of Swap: Smoking Guns!

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Sultans of Swap: The Get Away!

 

 

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SULTANS OF SWAP: Explaining $605 Trillion in Derivatives!

 

SULTANS OF SWAP: Fearing the Gearing!

 

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 SULTANS OF SWAP:  Ties in the Gears!

 

 

Like a wave, the news of angry PATSIES taking their grievances to the courts surged surged all along the global shorelines.

 

From Leipzig, Germany to Los Angeles, angry municipalities and cities who were stung by Swap Agreements are filing legal proceedings against the banks for misleading them.

 

It all seems a little ironic considering these cities and municipalities were using the complex derivative structures for precisely this purpose – to obscure expenses and commitments from the electorate. What officials had not budgeted for was the massive costs that were buried in the fine print.

 

Let’s take a quick world tour to see the carnage showing up in the court rooms.

 

REFERENCES:

 

Act I can be found at:  SULTANS OF SWAP: Smoking Guns!

Act II can be found at: SULTANS OF SWAP: The Sting!

 

 

SMOKING GUNS & FAILED GETAWAYS

 

EUROPE

 

CITY OF MILAN, ITALY

 

ONE of the great advantages of financial innovation, it was often said, was that risk would end up going to those best qualified to hold it. In fact, much of it seems to have ended up in the hands of those least able to understand it. How some of it got there may soon be revealed in an Italian court.

 

On March 17th four big banks, 11 bankers and two former city officials were charged with fraud in connection with the sale of interest-rate derivatives to the city of Milan. The trial is due to start in May. The prosecution relates to a huge bet on interest rates that the four banks—UBS, JPMorgan Chase, Deutsche Bank and Hypo Real Estate’s DEPFA unit—helped the city authorities to take in 2005. The banks helped arrange the sale of €1.7 billion ($2.3 billion) of bonds for the city and then also helped it swap the fixed interest rate it was paying on the bonds for a lower, floating rate. Part of the contract is thought to have involved a “collar”, a way of limiting the range of outcomes on a bet, which protected Milan from rising rates but which also meant it would have to pay out if they fell.  

 

The city claims that it was originally promised interest savings of about €60m on the deal but has now made big losses because interest rates have fallen, triggering payments to the banks. Bankers with knowledge of the transaction claim that, in fact, the city has benefited from offsetting gains as the interest rate it pays on the underlying debt has fallen too. The prosecution also claims that the banks charged more than €100m in fees that were built into the price of the swaps and were not properly disclosed to city officials. The banks all deny any wrongdoing.

 

The outcome of the case will be closely watched elsewhere. In Italy alone, local municipalities had derivatives exposures with a face value of €25 billion last year, according to the Bank of Italy. Some academics reckon that losses on these may go as high as €8 billion. In many of these cases local authorities swapped fixed rates for floating ones, only for collars incorporated into the deals to leave them with losses as interest rates fell. In other cases, losses may only start to show when rates move the other way. Had their bets paid off, however, it seems unlikely that any cities would be crying foul. (1)

 

CITY OF LEIPZIG, GERMANY

 

In Germany scores of public authorities signed contracts that they seem not to have understood. In Leipzig the courts have been asked to rule in a dispute between the city and UBS. That case relates to a complex sale-and-leaseback agreement that the city signed for its local waterworks. Part of the deal reportedly entailed the city agreeing to insure a portfolio of loans against default through a collateralised-debt obligation (CDO). Making good on those loans may bankrupt the city.
 
 In all,
about 100 German local authorities are thought to have entered into sale-and-leaseback agreements with American investors over the past decade in a bid to take advantage of loopholes in tax laws. In many of these deals local municipalities unwittingly agreed to take on credit risks for various counterparties, exposing them to demands for collateral as the ratings of institutions such as AIG, an American insurer, fell. (1)

 

USA

 

Hundreds of U.S. municipalities are losing money on interest-rate bets they made during the bull market in hopes of protecting themselves from higher rates. The deals backfired when rates fell, shriveling the sums paid to municipalities. Now some are criticizing Wall Street and trying to exit the contracts. .. Government agencies that saw the transactions as a cushion against fiscal surprises now are being squeezed by the arrangements. The supply of municipal derivatives swelled to more than $500 billion before falling in the past two years, estimates Matt Fabian, managing director at research firm Municipal Market Advisors. Moody's Investors Service says the surge was fueled by Wall Street marketing efforts, demand from state and local governments and "relatively permissive" statutes on the use of swaps in Pennsylvania and Tennessee, both of which are taking steps to tighten rules.

Many of the deals generated higher fees for securities firms than traditional fixed-rate debt. Government officials, for their part, entered the deals in hopes of reducing borrowing costs. The swaps were introduced in many cases along with floating-rate debt that municipalities issued because it was cheaper than traditional fixed-rate debt. Lower interest rates have served them well on this; their borrowing got cheaper.

 

 But municipalities also added swaps to the mix, promising to pay a fixed rate to banks, often 3% or more, while receiving payments from banks that vary with interest rates. On the swaps, the municipalities generally have been losers, as the interest that banks have to pay them have often fallen below 0.5%. Government budgets are stretched thin, prompting officials to look for dollars wherever they can. The clashes over the swaps come amid growing scrutiny of the municipal-bond market, where the U.S. government is investigating whether there was bid rigging in certain cases.” (7)

 

CITY OF LOS ANGELES

 

Municipalities in America are also grappling with derivative contracts they barely understand. The city of Los Angeles is pressing Bank of New York Mellon to soften the terms of an interest-rate swap on $443m of bonds that is costing the city money because rates fell. (1)

 

The Los Angeles city council approved a measure this month instructing city officials to try to renegotiate an interest-rate deal with Bank of New York Mellon Corp. and Belgian-French bank Dexia SA. The pact, reached in 2006 to help fund the city's wastewater system, currently is costing the city about $20 million a year. The banks declined to say how they would respond to a request to renegotiate.(7)

 

JEFFERSON COUNTY ALABAMA

 

Jefferson County in Alabama is teetering on the edge of bankruptcy after it entered into swaps that were worth more than $5.4 billion at their peak. (1)

 

Jefferson County in Alabama is on the brink of bankruptcy after sinking 100 percent of its $5 million sewer system financing into swaps. JP Morgan and CDR were also involved there.”(3)

 

NEW MEXICO

 

They were touted as a state-of-the-art financing tool that would help New Mexico stretch its highway improvement dollars. Nearly five years later, state officials are trying to keep the $420 million in fancy financing from turning sour. In the last six months, one of the banks involved in the so-called interest rate swaps has gone bankrupt and the state has had to post about $16 million in collateral because the value of the investments dropped. That's in addition to major political fallout. The swaps and how a California company was selected to handle them are at the center of a federal grand jury investigation that derailed Gov. Bill Richardson's nomination as commerce secretary. (2)(3)

 

PENNSYLVANIA

 

In Pennsylvania, 107 school districts entered into interest-rate swap agreements from October 2003 to last June. At least three have terminated them. Under one deal, the Bethlehem, Pa., school district had to pay $12.3 million to terminate a swap with J.P Morgan Chase & Co., according to state auditor general Jack Wagner. J.P. Morgan declined to comment. State lawmakers have proposed restrictions on municipalities' ability to use swaps. "It's gambling with the public's money," Mr. Wagner said. "Elected officials are simply no match for the investment banker that's selling the deal." (7)

 

 

While the investigation focused on the Bethlehem Area School District, Wagner called his report a “case study” of the use of swaps by all local governments in Pennsylvania. The Department of Community and Economic Development’s records indicate that 626 swap filings were made in Pennsylvania between October 2003 and June 2009, which related to $14.9 billion in debt. The precise number of different swaps and the precise amount of debt cannot be determined because the DCED data may include some double-counting. During this time period, 107 of Pennsylvania’s 500 school districts, or 21.4 percent, and 86 other local governments reported to DCED that they entered into swap agreements. At least 13 investment firms, including Citibank, Goldman Sachs, J.P. Morgan, and Morgan Stanley, have entered into swap agreements with Pennsylvania school districts and other local governments. (8)

 

 

CHICAGO, DENVER, KANSAS CITY, PHILADELPHIA, MASSACHUSETTS, NEW JERSEY, NEW YORK & OREGON

 

 “The Service Employees International Union said Chicago, Denver, Kansas City, Philadelphia, Massachusetts, New Jersey, New York and Oregon all are in the hole on swaps agreements they made with financial firms. The required payments range from a few million dollars to more than $100 million a year, the union said.  Such deals are deepening the misery faced by state and local governments throughout the U.S., already facing their worst financial squeeze in decades because of shrinking tax revenue and stubbornly high pensions and other costs.”(7)

 

[Study by the Service Employees International Union,]  (15)

 

 

The “Stop the Swaps” Campaign by the Service Employees International Union (SEIU) www.SEIU.org

 

EIGHT CALIFORNIA MUNICIPALITIES

 

Eight California municipalities, including Los Angeles, Fresno and San Diego County, filed civil class-action, or group lawsuits. The suits, most of which were consolidated with others in U.S. District Court in New York City, allege that banks colluded by deliberately losing bids in exchange for winning one in the future, providing so-called courtesy bids, secretly compensating losing bidders and allowing banks to see other bids.

 

Brokers participated in the collusion by facilitating communication among banks and sharing in illegal profits, the civil class-action suits allege. (2)(4)

 

OAKLAND, CA

 

Escaping isn't cheap or easy. Under a transaction between Oakland, Calif., and a Goldman Sachs Group-backed venture, Goldman paid the city $15 million in 1997 and $6 million in 2003, according to Oakland financial reports. But now, the city stands to lose about $5 million this year.  That money "is coming out of taxpayers' pockets and could be used for other things," said Rebecca Kaplan, a city council member. She wants the city to renegotiate. But the city faces a $19 million termination payment. Oakland officials didn't respond to requests for comment. (7)

 

SAN FRANCISCO BAY AREA TOLL AUTHORITY

 

Last August, a unit of bond insurer Ambac Financial Group sued the Bay Area Toll Authority for payments it said it was owed under various swap agreements. The authority paid Ambac $104.6 million to terminate the swaps after the insurer's credit ratings were downgraded and bonds associated with the swaps were retired. Ambac claims it is owed $156.6 million under the agreements.  The toll authority, which is fighting the claim, said it made the payment, and Ambac sued for the other part of what it says it is owed. An Ambac lawyer couldn't be reached for comment.(7)

 

RICHMOND, CA

 

Richmond, Calif., is expected to restructure a $65 million agreement with Royal Bank of Canada that could cost the struggling city an estimated $3.5 million a year, based on current interest rates. Under the revised deal, Richmond would make smaller, more regular payments to the bank over time. In November, RBC and city officials rejiggered a separate transaction that would have cost Richmond about $2.5 million. An RBC spokesman said bank officials are working with the city to "restructure the underlying bonds in a way that best serves the city's interests and those of its residents." The "goal of the original transaction was to lower borrowing costs for the city," the bank spokesman said, adding that the bonds didn't perform s anticipated because of downgrades at bond insurers that backed them. Richmond's vice mayor, Jeff Ritterman, said he still is reviewing next month's proposed restructuring. Financial woes have forced Richmond to cut its budget and lay off employees. (7)

 

NEW YORK STATE

 

New York State provides a good example. An Oct. 30, 2009, filing describing its swaps shows that for the most recent fiscal year, April 2008 to March 2009, the state paid $103 million to terminate roughly $2 billion worth of swaps -- more than a quarter of which resulted from the Lehman bankruptcy in September 2008. (2)(5)

 

COLORADO – DENVER TEACHERS PENSION

 

DPS (Denver Public Schools) entered into negotiations with JP Morgan and CitiGroup, agreeing to issue fixed-rate bonds secured by DPS school buildings and other properties. DPS then began discussion to enter into an interest-rate swap agreement with JP Morgan, Bank of America and the Royal Bank of Canada. We believe that following ensued: DPS entered into a swap transaction, believing that interest rates would stay high. As recent financial news tells us, interest rates fell. We are concerned that this may have translated to a loss of taxpayer dollars.

 

… and on and on. Get the message?

 

 

ANALYSIS

 

1- MILAN versus UBS / JP MORGAN / DEUTSCHE BANK / HYPO 

 

We will first consider the largest of what is now referred to as the PIIGS. Italy could easily trigger a cascade of the already tenuous Greek financial problems into a EU financial crisis.  

 

FEES ON THE DEAL ACCORDING TO THE CLAIM: €100 million

COST OF MILAN INTEREST RATE DERIVATIVE: €1.7 billion

FEE: 5.9%

 

ITALIAN MUNICIPAL DERIVATIVE EXPOSURE: €25 billion

Assuming fees of approximately 5.9%

FEES: €1.5 BILLION

(were paid by taxpayer or build into the contract obligation)

 

Where did the tax money come from to pay these fees? It didn’t. It was part of the obligation. This might be compared to an interest only option ARM or a ‘pick and pay’ mortgage? You know what happened when the home owner actually had to pay! This time however, municipalities either:

 

1- Pledge more assets as collateral

2- Pay up with unbudgeted cash

3- Challenge the agreement in court.

 

Politically, the easiest approach is to challenge the agreement in the courts.

 

The Italian situation is based on only €25 billion of the total derivative contracts outstanding. According to the Bank of International Settlement (BIS) $605,000 Billion of Derivatives currently listed by them have been sold. Lehman’s recent report indicated they had 1 Million derivatives contracts outstanding.

 

My ‘back of the envelope’ suggests we are talking some monumental fees here!

 

WORST CASE:      DERIVATIVE NOTIONAL VALUE = $605T         5.9% x 605T        FEES: $35.7T

                         GROSS MARKET VALUE = $25.4T                   5.9% x 25.4T       FEES: $1.5T

MINIMUM CASE:   GROSS CREDIT = $3.7T                               5.9% x 3.7T        FEES: $221 BILLION

 

Now comes the collateral calls which our list shows are just as serious if not much worse.

 

2- LEIPZIG versus UBS

 

This case is instructional if for no other reason it brings out the wide spread use by cities and municipalities of complex financial vehicles. Here we see ‘sale-and leaseback’ agreements used in over 100 German local governments. We have seen this ‘privatization’ approach in the US from New Jersey Turnpike to toll bridges. How many US contracts are structured in the same fashion as the City of Leipzig OTC contract.

 

What is coming out in court is that as part of the agreement the City was Guaranteeing the portfolio of other people’s debt. If they were actually selling a CDS which is used for such purposes then they would get a revenue stream. In this case it may be that ‘in lieu’ of this revenue stream the agreement credited this obligation. The bottom line is that like AIG’s CDS exposure on CDO’s they also have to come up with the collateral. The US government gave AIG the collateral to pay Goldman Sachs. No one is coming forward to backstop these guarantees.

 

3- CITY OF LA versus BANK OF NY MELLON

 

The City of LA and Jefferson County Alabama shows us two things:

 

1- Officials did not understand the obligations and corresponding risk they assumed on Interest Rate Swap agreements they entered into.

 

2- The dollar value of these contracts is daunting in comparison to the size of their operating budgets. LA is disputing a $0.5 Billion swap structure while Jefferson County’s is $5.4 Billion.  

 

4- JEFFERSON COUNTY ALABAMA versus JP MORGAN

 

“Alabama's Jefferson County sued JPMorgan Securities and JPMorgan Chase and Co, alleging fraud related to the accumulation of its massive sewer bond debt, a senior county official said. The county sued for compensatory and punitive damages, seeking a jury trial over what it says were fraudulent transactions tied to interest rate and bond swaps earlier this decade as it sought to upgrade its sewer system.

 

"We are suing for fraud because they conspired to profit with interest rate swaps to the detriment of the county," said Assistant County Attorney Charles Wagner. "They caused us to spend more money and enter into ill-advised bond swaps for unjust enrichment of themselves. They suppressed material facts and fraudulently charged the money back to the county," he said.

 

Jefferson County is struggling to stave off what would be the largest municipal bankruptcy in U.S. history over a multibillion dollar sewer debt accumulated in part because of the transactions, which have triggered multiple lawsuits. The U.S. Securities and Exchange Commission earlier this month fined JPMorgan Securities $75 million and the bank agreed to forfeit $647 million in fees it was going to charge the county over the transactions.

 

"The county did not know and could not reasonably have known about the bribes, kickbacks and payoffs involved in these financial transactions," said the lawsuit, filed in Jefferson County circuit court. "Had the county had knowledge of the schemes it would not have entertained the plan to restructure the county's fixed-rate debt," the lawsuit said.” (10)

 

5- NEW MEXICO FINANCIAL AUTHORIY & STATE DEPARTMENT OF TRANSPORTATION

 

1- We see the use of PPP/PFI in New Mexico which we saw in Greece.

 

“The financing, which also included $1.1 billion in fixed rate bonds, provided $1.6 billion for Governor Richardson's Investment Partnership. The money has helped pay for a wide range of road projects and the Belen to Santa Fe Rail Runner commuter train.” (3)

 

2- Accountability is lost is the haze of complexity.

 

“CDR was paid more than $950,000 out of bond proceeds, but Finance Authority boss Bill Sisneros, who took over after the initial deal with CDR was done, says the company's role in the bond transaction isn't clear. He said, "CDR was paid by the counter-parties in the swaps, so there is a question of who they were advising."

 “Who was responsible for the collateral provision? ‘We have no idea,’ said Duff, adding that no one currently working at the NMFA can say and those who might know have long since left the agency. NMFA officials have found few records on file relating to swap negotiations” (3)

 

3- Easy to feed at the public trough.

 

“NMFA records show that among those lobbying for the swaps was a lead banker for JP Morgan, Chris Romer. His company ended up among the five banks that entered into swap agreements with the state. JP Morgan was also the lead underwriter for the bond portion of the GRIP financing. Mike Stratton, a high-powered Denver consultant and political adviser to Richardson, was also working on behalf of JP Morgan.”(3)

 

Jefferson County in Alabama is on the brink of bankruptcy after sinking 100 percent of its $5 million sewer system financing into swaps. JP Morgan and CDR were also involved there.”(3)

 

“CDR got the initial swap deal several months after its president, David Rubin, donated $25,000 to a Richardson political committee called Moving America Forward. In June 2004, the finance authority entered into a sole source, no-bid contract with CDR to handle millions of dollars held in escrow from the sale of the GRIP bond refunding. The money was originally invested in U.S. treasury bills rather than state and local government securities, until CDR proposed actively managing the escrow accounts. A week before the finance authority's then-chief financial officer Keith Mellor recommended a sole-source, no-bid contract be given to CDR to manage the escrow, CDR's owner contributed $75,000 to another of Richardson's political committees. The main justification for moving ahead with the sole source contract was that federal regulations were going to change and there wouldn't be time to go through a full procurement process before that happened. Sisneros told the Legislative Finance Committee last October that CDR was the source of information that the federal regulations were going to change. Sisneros last week recalled receiving numerous calls from Stratton's (aide) trying to set up a meeting with CDR to discuss the escrow work. "They really wanted to meet," Sisneros said. In the end, Sisneros said, there was no reason to hurry. The federal regulations didn't change until after CDR finished its work on the escrow account. "The Treasury Department ended up moving very slowly," Sisneros said. CDR was involved in three transactions in New Mexico, according to a study conducted for the Legislative Finance Committee. All three involved the sale of variable rate bonds. State agencies and colleges historically have sold fixed rate bonds. The difference between the two is that the variable rate bonds carry more risk to the state because if interest rates increase, the state has to pay more. Federal and state law enforcement agencies have been asking questions about all three bond issues. Besides the finance authority GRIP bond issue, authorities have expressed interest in the fact that:

 • CDR was the financial adviser to the Region III Housing Authority, which is under a state grand jury investigation. That investigation involves misspending money from another bond issue. But how Region III came to hire CDR as a financial adviser has been a matter of interest to federal authorities.

• CDR was involved with JP Morgan in a University of New Mexico bond issue. Federal investigators are curious about the relationship between JP Morgan and CDR. That curiosity extends past New Mexico's borders and includes the states of New Jersey, Alabama and others.“(3)

 

4- Interest Rate Swaps Usage Employed.

 

“Records show state finance officials at the time were attracted to the swaps because the state DOT couldn't afford to pay any more than $162 million a year in debt service. The swaps allowed the state to sell more bonds by using a variable interest rate. "So to (keep the $162 million cap) they kind of came up with these fancy damn things that make me crazy," said Sisneros, who was hired by the finance authority in June 2004 after the swap deals were completed. The interest New Mexico had to pay was much lower than fixed rates offered at the time, Sisneros said.” (3)

 

5- Counterparty Risk

 

“Last September, the NMFA was left scrambling after the huge Wall Street bank Lehman Bros. went under. Lehman, which has since filed for bankruptcy, had one of the state's swaps. At that point, the Lehman default could have cost the state $4 million under the swap terms. But NMFA officials say they were fortunate to get Deutsche Bank to pick up the deal and continue the arrangement. But what about the future viability of the four other original swap banks, which include JP Morgan, UBS, Goldman Sachs and RBC? ‘Keeping these agreements going is dependent on these counter-parties keeping solvent,’ Duff said.”(3)

 

6- PENNSYLVANIA

 

“In Pennsylvania, 107 school districts entered into interest-rate swap agreements from October 2003 to last June. At least three have terminated them. Under one deal, the Bethlehem, Pa., school district had to pay $12.3 million to terminate a swap with J.P Morgan Chase & Co., according to state auditor general Jack Wagner. J.P. Morgan declined to comment. State lawmakers have proposed restrictions on municipalities' ability to use swaps. "It's gambling with the public's money," Mr. Wagner said. "Elected officials are simply no match for the investment banker that's selling the deal." (7)

 

Auditor General Jack Wagner Calls on General Assembly to Ban Risky “Swap” Contracts by Schools, Local Governments

Urges new efforts to recover millions in taxpayer losses in Bethlehem Area School District and throughout Pennsylvania

 

HARRISBURG (Nov. 18, 2009) – Auditor General Jack Wagner said today that the General Assembly should ban the use of “swaps,” after a special investigation completed by his department found that the Bethlehem Area School District lost at least $10.2 million of taxpayers’ money in these risky and complex financial instruments. Wagner also recommended that all Pennsylvania school districts, local governments, and municipal authorities stop entering into swap agreements and immediately terminate any active swaps to which they are a party. “Quite simply, the use of swaps amounts to gambling with public money,” Wagner said. “The fundamental guiding principle in handling public funds is that they should never be exposed to the risk of financial loss. Swaps have no place in public financing and should be banned immediately.”

 

While the investigation focused on the Bethlehem Area School District, Wagner called his report a “case study” of the use of swaps by all local governments in Pennsylvania. The Department of Community and Economic Development’s records indicate that 626 swap filings were made in Pennsylvania between October 2003 and June 2009, which related to $14.9 billion in debt. The precise number of different swaps and the precise amount of debt cannot be determined because the DCED data may include some double-counting.

 

During this time period, 107 of Pennsylvania’s 500 school districts, or 21.4 percent, and 86 other local governments reported to DCED that they entered into swap agreements. At least 13 investment firms, including Citibank, Goldman Sachs, J.P. Morgan, and Morgan Stanley, have entered into swap agreements with Pennsylvania school districts and other local governments.

 

In 2003, the General Assembly passed, and the governor signed, Act 23, which amended state law to explicitly permit local governments to enter into “qualified interest rate management agreements” or “QIRMAs,” commonly referred to as interest rate swaps, or just swaps, which are a type of derivative. Swaps were an attractive investment instrument when interest rates on variable-rate bonds and notes were low in comparison to fixed-rate bonds and notes, because they allowed local governments to take advantage of the lower rates while, in theory at least, providing a hedge against large increases in those rates. These exotic financial instruments are neither investments nor debt; they are contracts between a bond issuer (such as a school district) and an investment bank to exchange (“swap”) cash flows during an agreed-upon term based on other securities or indices. When the two sets of cash flows are exchanged, the side that generates the larger payments receives the difference between the sums.

 

Until September 2008, the swap agreements were generally favorable to the Bethlehem Area School District, and it received cash payments from its investment bank counterparties. However, the swaps became unfavorable to the school district after the worldwide collapse of the banking system. The district was forced to pay $12.3 million to investment bank J.P. Morgan in May 2009.

 

Wagner’s investigation focused on the Bethlehem Area School District’s swap agreements entered into between April 29, 2003 and June 27, 2006. During that period, the district entered into 13 different swaps – the most of any school district in Pennsylvania. The 13 agreements related to $272.9 million in debt for school construction projects.

 

Wagner reviewed just two of the district’s swaps because those were the only two that had concluded by the time of his investigation. The two swaps cost district taxpayers $10.2 million more than if the district had issued a standard fixed-rate bond or note. Ironically, the swaps cost taxpayers $15.5 million more than if the district had simply paid the interest on the variable-rate note without any swaps at all. The district’s losses were largely due to excessive fees and other charges and the termination payment. “Because the district has many other swaps still in effect, the ultimate financial impact on the taxpayers remains to be seen,” explained Wagner.

 

Wagner noted that, while Act 23 was written primarily for the benefit and protection of the financial services industry, the swaps problem is not peculiar to Pennsylvania. The state of Tennessee has banned local governments from using these risky investments, New York State’s attorney general is investigating a possible ban, and the U.S. Congress is considering federal regulations.

 

Wagner also found that the district was the victim of a variety of deceptive marketing tactics: fees that were characterized as being paid by the investment banks were actually ultimately charged to the district; the agreements resulted in huge hidden profits for the investment banks that were not required to be, and have not been, disclosed to the district; the intermediaries involved in the deals – such as the district’s former financial advisor – had apparent conflicts of interests as a result of representing the interests of counterparties as well as the district; and at least two of the transactions were structured to provide the district with substantial up-front cash payments at the inception of the agreements as an additional inducement, totaling $5.8 million, while failing to disclose to the district that the investment bank was making a huge and immediate profit on the deal that was far in excess of the cash paid to the district. As a result, Wagner recommended that local governments should hire their financial advisers through a competitive selection process and periodically evaluate the quality, cost, and independence of the services provided.

Wagner urged the General Assembly to act on his legislative recommendations immediately. “These toxic products are being peddled to well-meaning but relatively unsophisticated local officials every day throughout the commonwealth,” he said. “The risk of huge losses is compounded by a lack of transparency in the deals and the failure of federal regulators to impose accountability on firms who created and marketed these products in the first place. These dangerous deals work in favor of the gambling houses and not the gamblers, and they must stop now.”

Wagner referred his findings to numerous state, federal, and independent entities. Among the recipients are the Pennsylvania Office of Attorney General, Pennsylvania Securities Commission, State Ethics Commission, U.S. Departments of Justice and the Treasury, U.S. Securities and Exchange Commission, and U.S. Commodities Futures Trading Commission.

 

“I encourage the law enforcement agencies, in particular, to investigate and prosecute any conflicts of interest involved in these transactions,” Wagner said, “and to pursue all avenues that may be available to recover funds for the taxpayers of this district and elsewhere.”

 

Wagner conducted his investigation at the request of State Sen. Lisa Boscola, following a series of investigative reports by the media about the Bethlehem Area School District’s use of swaps. This is the second investigation report of the district released by Wagner in as many months. In October, Wagner reported that the district had maintained inadequate controls over more than $11.5 million of laptop computers and also had exercised poor oversight of an internal investigation related to the drug arrest of a former middle-school principal that cost the district $52,726.

 

Wagner commended the district for its cooperation with the investigation and its positive response to most of the recommendations in the report. He said that he would follow up in the future to determine the status of action on his recommendations by both the district and the General Assembly.

 

A complete copy of Wagner’s special investigation report is available at www.auditorgen.state.pa.us.

Auditor General Jack Wagner is responsible for ensuring that all state money is spent legally and properly. He is the Commonwealth’s elected independent fiscal watchdog, conducting financial audits, performance audits and special investigations. The Department of the Auditor General conducts more than 5,000 audits per year. To learn more about the Department of the Auditor General, taxpayers are encouraged to visit the department’s Web site at www.auditorgen.state.pa.us.

 

 

7- CHICAGO, DENVER, KANSAS CITY, PHILADELPIA, MASSACHUSETTS, NEW JERSEY, NEW YORK & OREGON

 

“The Service Employees International Union said Chicago, Denver, Kansas City, Mo., Philadelphia, Massachusetts, New Jersey, New York and Oregon all are in the hole on swaps agreements they made with financial firms. The required payments range from a few million dollars to more than $100 million a year, the union said.  Such deals are deepening the misery faced by state and local governments throughout the U.S., already facing their worst financial squeeze in decades because of shrinking tax revenue and stubbornly high pensions and other costs.”(7)

 

REPRINTED FROM SEIU.ORG BLOG

SEIU Blog

12:17 PM Eastern - March 9, 2010

 

Stop the Swaps

If you thought taxpayers were done funding payouts for Wall Street, think again.

Sunday's New York Times ran an article blowing the lid off a Wall Street scheme called "interest rate swaps" that are sucking money from cities and states across the country. The swap deals were originally sold to communities as a way to shield against unpredictable interest rates. But, when the banks crashed the economy, the rules of the game changed.

Now, all these swap deals are doing is generating pure profit for the big banks - and it's being paid for with our tax dollars.

Help stop the swaps. Demand a public investigation into these shady deals: http://action.seiu.org/stoptheswaps


These swaps deals amount to the biggest Wall Street bailout you've never heard of - around $28 billion nationwide. The city of Oakland, CA alone is paying $5.2 million annually for a swap deal with Goldman Sachs. That's enough to completely resolve the city's outstanding budget gap - and avoid cuts to critical services. Instead, it's being used to fill Goldman's profit pool, while city services go on the chopping block.

Help expose swap deals in your community; demand an investigation: http://action.seiu.org/stoptheswaps

Taxpayers have already given enough to bailout Wall Street. But that hasn't stopped them from taking more. With communities feeling the squeeze in a tough economy, the last thing we can afford to do is send billions of our local tax dollars to Wall Street.

Click here to contact your attorney general and demand a public investigation into interest rate swaps: http://action.seiu.org/stoptheswaps

 

 

 8- EIGHT CALIFORNIA MUNICIPALITIES

 

“Eight California municipalities, including Los Angeles, Fresno and San Diego County, filed civil class-action, or group lawsuits. The suits, most of which were consolidated with others in U.S. District Court in New York City, allege that banks colluded by deliberately losing bids in exchange for winning one in the future, providing so-called courtesy bids, secretly compensating losing bidders and allowing banks to see other bids. Brokers participated in the collusion by facilitating communication among banks and sharing in illegal profits, the civil class-action suits allege.” (4)

 

“Three advisers to local governments, CDR Financial Products Inc., Sound Capital Management Inc. and Investment Management Advisory Group Inc., were searched by the FBI in November 2006. More than a dozen banks and insurers were subpoenaed and former bankers at New York-based JPMorgan Chase & Co., Bear Stearns & Cos. and UBS AG of Zurich were advised over the past year that they may face criminal charges. Now, federal prosecutors are investigating whether New Mexico Governor Bill Richardson’s administration steered about $1.5 million in bond advisory work to CDR, which donated $100,000 to Richardson’s political committees.  CDR also advised Jefferson County, Alabama, on more than $5 billion of municipal bond and derivative deals. A combination of soaring rates on the bonds and interest-rate swaps is threatening the county with a bankruptcy that would exceed Orange County, California’s default in 1994. Jefferson County paid JPMorgan and a group of banks $120.2 million in fees for derivatives that were supposed to protect it from the risk of rising interest rates. Those fees were about $100 million more than they should have been based on prevailing rates, according to James White, an adviser the county hired in 2007, after the SEC said it was investigating the deals.” (4)

 

9-OAKLAND CA

 

“Oakland has just voted to repudiate interest rate swaps costing it $5 million/year according to an announcement put out by the SEIU. Across the entire Bay Area, such swaps are costing nearly $150 million per year, and our guess is that every city will do this.” (11)



 

“Councilman Richard Alarcón is the one leading the City of LA’s charge to repudiate a pre-crisis interest rate swap agreement that it made with Bank of New York Melon. Doing so would save the city $19 million per year, and with a budget gap of over $200 million, LA needs every dollar it can get its hands on.

The swap -- one it made on a water bond pre-crisis -- was supposed to protect the city against higher interest rates, though of course rate have collapsed, meaning the city remains on the hook for protection it doesn't need. This is a hot topic, as numerous cities around the country are in a similar situation, a topic which Gretchen Morgenson covered yesterday. We spoke to Alarcón yesterday. He says the city isn't alleging fraud or misrepresentation or anything like that.

The basic idea: the city needs a break, and if Bank of New York Mellon doesn't give them one, the city is ready to use the power of moving its business in order to get what it wants. It's that simple.

"If they refused to renegotiate, we probably won't want to do business with them again."

This is likely to be the beginning of a major swap repudiation campaign across California.

Next stop is Northern California. And in between there are numerous cities with similarly strapped budgets. And Los Angeles doesn't just want to stop at swap repudiation. In addition to getting out of the agreements, it wants to impose its own CRA-like rules on banks: so more branches, more lending in the city, and more ATMs. Says Alarcon: "We believe it's socially irresponsible for banks to negotiate deals during good economic times, and then in bad economic times to reap totally unanticipated profit... we'd just as soon not work with a bank that would take money from the taxpayers of the city of Los Angeles" (12)
 

10- SAN FRANSICO BAY AREA TOLL AUTHORITY

 

 

“Ambac Financial Services LLC faces an uphill battle in convincing a court that the Bay Area Toll Authority shorted it by $50 million on swap termination payments, securities lawyers and swap advisers said this week. The company sued BATA in federal court earlier this month, alleging that the toll bridge operator didn't get firm, actionable market quotes for the swaps it terminated after Ambac's credit rating fell to junk. Ambac said loss calculations show that BATA owed $156.6 million, not the $104.6 million BATA paid to terminate the swaps.

 

"We believe that Ambac's legal arguments are questionable," said Peter Shapiro, managing director of Swap Financial Group LLC in South Orange, N.J. Shapiro and others interviewed for this story cautioned that they haven't seen the details of the swap contracts between Ambac and BATA, but they said most municipal bond issuers stick close to the standard terms in the International Swaps and Derivatives Association's Master Agreement.

 

Oakland-based BATA is a government agency that operates seven state-owned toll bridges in the San Francisco Bay Area. In July, it terminated $1.1 billion of swaps with Ambac Financial, a unit of bond insurer Ambac Financial Group Inc., because the insurer's credit ratings had fallen to junk status. BATA made swap termination payments of $105 million based on a market quotation process. According to court documents, BATA and Ambac entered into six swapagreements in 2002, 2004, and 2005. Under the agreements, BATA hedged its variable-rate debt exposure by paying fixed rates to Ambac in return for a flow of variable-rate payments.” (14)

 

11- RICHMOND CA

03-23-10-Richmond_CA.gif

 

 12- NEW YORK STATE

 

Municipal Swaps: “Here’s how municipal swaps worked (in theory): Say an issuer needed to raise money and prevailing rates for fixed-rate debt were 5 percent. A swap allowed issuers to reduce the interest rate they paid on their debt to, say, 4.5 percent, while still paying what was effectively a fixed rate.” ….  “The auction-rate securities market, used by issuers to set their interest payments to bondholders, froze up. As a result, these rates rose.”

 

TERMINATION FEE $103M (5)

SWAP VALUE: $2B

FEE: 5.2%

 

“Another aspect to these swaps’ designs made them especially ill-suited for municipal issuers. Almost all tax-exempt debt is structured so that after 10 years, it can be called or retired by the city, school district or highway authority that floated it. But by locking in the swap for 30 years, the municipality or school district is essentially giving up the option to call its debt and issue lower-cost bonds, without penalty, if interest rates have declined” (5)

 

 

13- COLORADO – DENVER TEACHERS PENSION

 

“In 2007 DPS began to address pension-related issues and made a decision to raise $750 million for two primary purposes:

* To refinance pension certificates of participation from bonds issue in prior years, so as to redirect more money into the classroom

* To fully fund the DPS retirement system in anticipation of a merger between the DPS teachers retirement system and PERA, the Colorado retirement system.

 

DPS entered into negotiations with JP Morgan and CitiGroup, agreeing to issue fixed-rate bonds secured by DPS school buildings and other properties. DPS then began discussion to enter into an interest-rate swap agreement with JP Morgan, Bank of America and the Royal Bank of Canada. We believe that following ensued:

-       DPS entered into a swap transaction, believing that interest rates would stay high. As recent financial news tells us, interest rates fell. We are concerned that this may have translated to a loss of taxpayer dollars.

-       The Times article specifically cites two major concerns with these types of transactions: a lack of understanding on the part of the public institutions and lack of transparency in the transaction as a whole. Because of our fiduciary responsibilities, we ask for a public accounting of these matters.

 

We, the Board Members of the Denver Public Schools listed below, believe we have a duty to the children and employees of our district, as well as to the taxpayers to make certain that all the facts concerning these transactions are made clear to the public.”

 

 

CONCLUSIONS

 

1- FEES: The fees that were contained within these agreements are bigger that the GDP of some of the G7 countries

 

2- RISK:  Derivatives were continuously touted by Fed Chairman Alan Greenspan as instruments that created stability in this system by spreading risk around. He repeated this refrain at every testimony I listened to from 1999 through 2005. What is consistent in all the legal claims is that public officials did not in fact understand the risks they were assuming on behalf of the public.

 

3- GUARANTEES: Cities and Municipalities as evidenced by the City of Leipzig were acting as CDO credit guarantors in much the same fashion as AIG.

 

4- DOLLAR LEVELS: The contracts were being entered into by unelected officials on the behalf of their elected officials who did not understand the details. The political pressures were to solve the problem with ‘creative accounting magic’. Consistently, neither the financial officials nor public elected representatives understood what was in the brew which had the strength to financially bring down the city or municipality.

 

5- ACCOUNTABILITY: Because of the complexity of the deals and the required expertise that must be brought in, we see that accountability is often lost. The best example is where someone must depend on a doctor or lawyer for advise but ultimately it is the patient or clients decision. When things go wrong both blame the other.

 

6- POLITICAL GRAFT: We continuously see extravagant fees paid for various services to arrange these complex financial instruments. The derivative contracts are so large that millions in consulting service fees is considered ‘small potatoes’. Political connections allow many to feed at the public’s expense.

 

7- COUNTERPARTY RISK: As was seen in New Mexico when Lehman Bros went into bankruptcy, if Deutsche Bank hadn’t stepped in, the state would have been on the hook for unexpected costs. In New York States situation, Lehman’s failure forced debt issuers to pay $12M.

 

8- TERMINATION COSTS: To exit a swap we are seeing fees of approximately 5% as spelled out in New York State filings.

 

9- DURATION: Often the terms of the agreement are such that the SWAPS are non-callable which in the case of Municipalities mean they can’t be retired without large termination fees when tax revenues allow for pay downs. This is counter to how municipal bonds have worked for decades.

 

 

SOURCES

 

(1) 03-18-10 Cities in the casino - Municipalities and derivatives  The Economist 

(2) 03-17-10 Banks Stealing From Colorado Teachers' Pension The  Huffington Post

(3) 01-25-09 State Bond Deal Losses its Luster Albuquerque Journal

(4) 01-23-10 California Probes Muni Derivatives as Deficit Mounts  Bloomberg

(5) 03-05-10 The Swaps That Swallowed Your Town  New York Times Gretchen Morgenson

(6) 03-11-10 Banks win on Swaps while DPS loses courtesy of Bennet & Boasberg? ColoradoPols.com

(7) 03-22-10 Interest-Rate Deals Sting Cities, States  Aaron Lucchetti, Wall Street Journal

(8) 11-08-09 Auditor General Calls on General Assembly to Ban Risky “Swap” Contracts by Schools, Local Governments

(9) 03-12-08 High Finance Backfires on Alabama County  Wall Street Journal

(10) 11-13-09 Alabama county sues JP Morgan over sewer bond debt  Reuters

(11) 03-09-10 And Now Oakland Just Voted To Repudiate Interest-Rate Swaps With Wall Street Business Insider

(12) 03-09-10 A Preview: California's Coming War On Banks And Pre-Crisis Swaps  Business Insider

(13) 03-09-10 A Preview: California's Coming War On Banks And Pre-Crisis Swaps – Slide Set  Business Insider

(14) 08-21-09 Ambac Suit a Long Shot; Lawyers, Swap Advisers Don't See a Win for Insurer  AllBusiness

(15) 03-09-10 Stop the Swaps  SEIU Blog

 


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Mr. Long is a former senior group executive with IBM & Motorola, a principle in a high tech public start-up and founder of a private venture capital fund. He is presently involved in private equity placements internationally along with proprietary trading involving the development & application of Chaos Theory and Mandelbrot Generator algorithms.

 

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