WALL STREET CONFIDENCE TRICK: How "Interest Rate Swaps" Are Bankrupting Local Governments
By Ellen Brown
Global Research, March 22, 2012
URL of this article: www.globalresearch.ca/index.php?context=va&aid=29907
Far from reducing risk, derivatives increase risk, often with catastrophic results. — Derivatives expert Satyajit Das, Extreme Money (2011)
The
“toxic culture of greed” on Wall Street was highlighted again last
week, when Greg Smith went public with his resignation from Goldman
Sachs in a scathing oped published in the New York Times. In other recent eyebrow-raisers, LIBOR rates—the benchmark interest rates involved in interest rate swaps—were shown to be manipulated by the banks that would have to pay up; and the objectivity of the ISDA (International Swaps and Derivatives Association) was called into question,
when a 50% haircut for creditors was not declared a “default” requiring
counterparties to pay on credit default swaps on Greek sovereign debt.
Interest rate swaps are less often in the news than credit default swaps, but they are far more important in terms of revenue, composing fully 82% of the derivatives trade. In
February, JP Morgan Chase revealed that it had cleared $1.4 billion in
revenue on trading interest rate swaps in 2011, making them one of the
bank’s biggest sources of profit. According to the Bank for International Settlements:
[I]nterest rate swaps are the largest component of the global OTC derivative market. The
notional amount outstanding as of June 2009 in OTC interest rate swaps
was $342 trillion, up from $310 trillion in Dec 2007. The gross market value was $13.9 trillion in June 2009, up from $6.2 trillion in Dec 2007.
For
more than a decade, banks and insurance companies convinced local
governments, hospitals, universities and other non-profits that interest
rate swaps would lower interest rates on bonds sold for public projects
such as roads, bridges and schools. The swaps were entered into to insure against a rise in interest rates; but instead, interest rates fell to historically low levels. This was not a flood, earthquake, or other insurable risk due to environmental unknowns or “acts of God.” It
was a deliberate, manipulated move by the Fed, acting to save the banks
from their own folly in precipitating the credit crisis of 2008. The
banks got in trouble, and the Federal Reserve and federal government
rushed in to bail them out, rewarding them for their misdeeds at the
expense of the taxpayers.
How the swaps were supposed to work was explained by Michael McDonald in a November 2010 Bloomberg article titled “Wall Street Collects $4 Billion From Taxpayers as Swaps Backfire”:
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.
Banks and borrowers were supposed to be paying equal rates: the fat years would balance out the lean. But the Fed artificially manipulated the rates to the save the banks. After the credit crisis broke out, borrowers had to continue selling adjustable-rate securities at auction under the deals. Auction
interest rates soared when bond insurers’ ratings were downgraded
because of subprime mortgage losses; but the periodic payments that
banks made to borrowers as part of the swaps plunged, because they were
linked to benchmarks such as Federal Reserve lending rates, which were
slashed to almost zero.
In
a February 2010 article titled “How Big Banks' Interest-Rate Schemes
Bankrupt States,” Mike Elk compared the swaps to payday loans. They were bad deals, but municipal council members had no other way of getting the money. He quoted economist Susan Ozawa of the New School:
The
markets were pricing in serious falls in the prime interest rate. . . .
So it would have been clear that this was not going to be a good deal
over the life of the contracts. So the states and municipalities were
entering into these long maturity swaps out of necessity. They were
desperate, if not naive, and couldn't look to the Federal Government or
Congress and had to turn themselves over to the banks.
Elk wrote:
As
almost all reasoned economists had predicted in the wake of a deepening
recession, the federal government aggressively drove down interest
rates to save the big banks. This created opportunity for banks – whose
variable payments on the derivative deals were tied to interest rates
set largely by the Federal Reserve and Government – to profit
excessively at the expense of state and local governments. While banks
are still collecting fixed rates of from 4 percent to 6 percent, they
are now regularly paying state and local governments as little as a
tenth of one percent on the outstanding bonds – with no end to the low
rates in sight.
.
. . [W]ith the fed lowering interest rates, which was anticipated, now
states and local governments are paying about 50 times what the banks
are paying. Talk about a windfall profit the banks are making off of the
suffering of local economies.
To
make matters worse, these state and local governments have no way of
getting out of these deals. Banks are demanding that state and local
governments pay tens or hundreds of millions of dollars in fees to exit
these deals. In some cases, banks are forcing termination of the deals
against the will of state and local governments, using obscure contract
provisions written in the fine print.
By the end of 2010, according to Michael McDonald, borrowers had paid over $4 billion just to get out of the swap deals. Among other disasters, he lists these:
California’s
water resources department . . . 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 program, 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.
In
a March 15th article on Counterpunch titled “An Inside Glimpse Into the
Nefarious Operations of Goldman Sachs: A Toxic System,” Darwin
Bond-Graham adds these cases from California:
The
most obvious example is the city of Oakland where a chronic budget
crisis has led to the shuttering of schools and cuts to elder services,
housing, and public safety. Oakland signed an interest rate swap with
Goldman in 1997. . . .
Across
the Bay, Goldman Sachs signed an interest rate swap agreement with the
San Francisco International Airport in 2007 to hedge $143 million in
debt. Today this agreement has a negative value to the Airport of about
$22 million, even though its terms were much better than those Oakland
agreed to.
Greg Smith wrote that at Goldman Sachs, the gullible bureaucrats on the other side of these deals were called “muppets.” But even sophisticated players could have found themselves on the wrong side of this sort of manipulated bet. Satyajit
Das gives the example of Harvard University’s bad swap deals under the
presidency of Larry Summers, who had fought against derivatives
regulation as Treasury Secretary in 1999. There could hardly be more sophisticated players than Summers and Harvard University. But then who could have anticipated, when the Fed funds rate was at 5%, that the Fed would push it nearly to zero? When the game is rigged, even the most experienced gamblers can lose their shirts.
Courts
have dismissed complaints from aggrieved borrowers alleging securities
fraud, ruling that interest-rate swaps are privately negotiated
contracts, not securities; and “a deal is a deal.” So
says contract law, strictly construed; but municipal governments and
the taxpayers supporting them clearly have a claim in equity. The banks have made outrageous profits by capitalizing on their own misdeeds. They
have already been paid several times over: first with taxpayer bailout
money; then with nearly free loans from the Fed; then with fees,
penalties and exaggerated losses imposed on municipalities and other
counterparties under the interest rate swaps themselves.
Bond-Graham writes:
The
windfall of revenue accruing to JP Morgan, Goldman Sachs, and their
peers from interest rate swap derivatives is due to nothing other than
political decisions that have been made at the federal level to allow
these deals to run their course, even while benchmark interest rates,
influenced by the Federal Reserve’s rate setting, and determined by many
of these same banks (the London Interbank Offered Rate, LIBOR) linger
close to zero. These political decisions have determined that virtually
all interest rate swaps between local and state governments and the
largest banks have turned into perverse contracts whereby cities,
counties, school districts, water agencies, airports, transit
authorities, and hospitals pay millions yearly to the few elite banks
that run the global financial system, for nothing meaningful in return.
Why are these swaps so popular, if they can be such a bad deal for borrowers? Bond-Graham maintains that capitalism as it functions today is completely dependent upon derivatives. We live in a global sea of variable interest rates, exchange rates, and default rates. There
is no stable ground on which to anchor the economic ship, so financial
products for “hedging against risk” have been sold to governments and
corporations as essentials of business and trade. But
this “financial engineering” is sold, not by disinterested third
parties, but by the very sharks who stand to profit from their
counterparties’ loss. Fairness is thrown out in favor of gaming the system. Deals tend to be rigged and contracts to be misleading.
How
could local governments reduce their borrowing costs and insure against
interest rate volatility without putting themselves at the mercy of
this Wall Street culture of greed? One possibility is for them to own some banks. State
and municipal governments could put their revenues in their own
publicly-owned banks; leverage this money into credit as all banks are
entitled to do; and use that credit either to fund their own projects or
to buy municipal bonds at the market rate, hedging the interest rates
on their own bonds.
The creation of credit has too long been delegated to a cadre of private middlemen who have flagrantly abused the privilege. We
can avoid the derivatives trap by cutting out the middlemen and
creating our own credit, following the precedent of the Bank of North
Dakota and many other public banks abroad.
Ellen Brown is an attorney and president of the Public Banking Institute, http://PublicBankingInstitute.org. In Web of Debt,
her latest of eleven books, she shows how a private cartel has usurped
the power to create money from the people themselves, and how we the
people can get it back. Her websites are http://WebofDebt.com and http://EllenBrown.com. The Public Banking Institute’s first conference is April 26th-28th in Philadelphia.
