The subprime mortgage crisis isn’t the only calamity Wall Street created that’s upending the finances of US states and cities.
For more than a decade, banks and insurance companies convinced governments and nonprofits that financial engineering would lower interest rates on bonds sold for public projects such as roads, bridges and schools. That failed promise has cost more than $4 billion, according to data compiled by Bloomberg, as hundreds of borrowers from the Bay Area Toll Authority in Oakland, California, to Cornell University in Ithaca, New York, quietly paid Wall Street to end agreements since 2008.
California’s water resources department this year spent $305 million unwinding interest-rate bets that backfired, handing over the money to banks led by New York-based Morgan Stanley. North Carolina paid $59.8 million in August, enough to cover the annual salaries of about 1,400 full-time state employees. Reading, Pennsylvania, which sought protection in the state’s fiscally distressed communities programme, got caught on the wrong end of the deals, costing it $21 million, equal to more than a year’s worth of real-estate taxes.
“It was brilliant, and it all blew up on me,” said Brian Mayhew, chief financial officer of the Bay Area Toll Authority, the state agency that gave Ambac Financial Group Inc, the New York-based bond insurer that filed for bankruptcy this week, $105 million to end $1.1 billion of interest-rate agreements. The payments equal more than two months of revenue on seven bridges the authority oversees around San Francisco.
Budget deficits
The termination payments to Wall Street firms come at the worst possible time. The longest recession since the Great Depression left states facing budget gaps of $72 billion next fiscal year, according to the National Conference of State Legislatures. US cities saw their general fund revenue fall the most since at least 1986 in the budget year that ended June 30, according to the National League of Cities.
Wall Street banks and insurers peddled financial derivatives known as interest-rate swaps to governments and nonprofits that bet they could lower the cost of borrowing. There were as much as $500 billion of the deals done in the $2.8 trillion municipal bond market before the credit crisis, according to a report by Randall Dodd, a senior researcher on the Financial Crisis Inquiry Commission, published by the International Monetary Fund in June.
Borrowers from New York to California are now paying to get out of agreements. Altogether, they have made more than $4 billion of termination payments to firms including New York-based Citigroup Inc, New York-based JPMorgan Chase & Co and Charlotte, North Carolina-based Bank of America Corp since the beginning of 2008, according to a review of hundreds of bond documents and credit-rating reports by Bloomberg News.
In contrast to the subprime crisis, few taxpayers know anything about the cost of untangling municipal swaps. The only disclosure of payments to Wall Street often is buried in documents borrowers have to give investors when they sell bonds.
In many cases, firms getting payments aren’t explicitly identified and government officials often don’t call attention to payments made to cancel contracts. Many of the telephone calls and e-mails from Bloomberg News to dozens of government and nonprofit officials over the last eight months seeking comment on derivative transactions went unanswered.
‘No reason’
“Money that should be invested in students, classrooms and fixing infrastructure in Pennsylvania is instead lining the pockets of Wall Street,” Jack Wagner, the state’s auditor general, said in a statement in April after calling on lawmakers to ban swaps. “State and local governments must stop gambling with public money,” he said.
In an interest-rate swap, two parties exchange payments on an agreed-upon amount of principal. Most of the swaps Wall Street sold in the municipal market required borrowers to issue long-term securities with interest rates that changed every week or month. The borrowers would then exchange payments, leaving them paying a fixed-rate to a bank or insurance company and receiving a variable rate in return. Sometimes borrowers got lump sums for entering agreements.
The swaps were popular because governments and nonprofits could pay a rate that was lower than what they would otherwise face had they sold conventional fixed-rate securities. The agreements backfired after the credit crisis broke out. While borrowers had to continue selling adjustable-rate securities under the deals, the payments made by Wall Street plunged and no longer were enough to cover the municipalities’ own debt costs.
Banks and insurance companies such as New York-based American International Group Inc started designing municipal swaps in the 1990s as derivatives trading on Wall Street soared. Derivatives are agreements whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather. They were blamed in part for causing the global financial panic.
The financial manipulation was a boon for Wall Street. While banks got paid to underwrite municipal bonds for public projects, they were able to generate additional fees if the borrower used a swap with the transactions. Because the contracts were unregulated and privately negotiated, the profits that Wall Street booked were never disclosed.
“The basic idea from the bank’s perspective is just to do a swap because that’s where the money is,” said Andrew Kalotay, head of the debt-management advisory firm Andrew Kalotay Associates Inc in New York.
