It seemed like a good idea at the time.
In the two decades before the 2008 financial collapse, the investment banking industry sidled up to state and local finance officials with an offer they couldn’t refuse. Instead of issuing plain vanilla 30-year fixed-rate bonds to build roads, schools and parking garages, why not sell variable rate bonds at lower rates and buy a swap that would fix the total payment at something lower than what they’d pay in the fixed-rate market?
It was supposed to be win-win. The government agency got a slightly lower rate, while the investment bank earned fees. If the variable bond’s rate rose above the fixed rate target – the scenario that government finance officials feared most – the swap counterparty (the banks often off-loaded the instruments to speculators) paid off the government agency. If the variable bond rate went down, the swap payments moved in the other direction: from taxpayers to speculators. Either way, the government’s total cost was supposed to stay fixed.
There was a slight problem with the formula, though – one that would cause tremendous grief later on. Changes in the variable rate bonds were almost always tied to an index of actual municipal bond transactions compiled by the U.S.-based Securities Industry and Financial Markets Association (SIFMA). Changes in the swaps, on the other hand, were tied to the London Interbank Offered Rate (Libor), which is set by the British Bankers Association based on reported rates from global banks. If Libor moved lower at a faster pace than SIFMA, government agencies’ hedge would come up short.
By the late 1990s, the muni swap bond deals started coming in as many permutations as Wall Street could imagine. The city of Oakland, Calif., for instance, sold a $187.5 million variable rate revenue bond to investors. How did they do it? Earlier this month Oakland became the first city in the nation to demand cancellation of a swap, or the company that sold them the swaps in the first place Goldman Sachs – would be banned from doing business with the city.
To eliminate the risk of rising rates, Goldman came up with an exceedingly complex structure. The city paid Goldman a fixed rate that was slightly lower than what was then available in the market. It simultaneously purchased a variable swap that required Goldman to pay off the city’s variable rate bond, plus make a payment to the city that was tied to Libor. If Libor went down, so did the city’s payment.
As the world has learned in recent months, the banks behind Libor have been reporting incorrect lower rates to make their finances appear more stable. Government investigators and regulators are also investigating allegations that bank insiders manipulated the Libor rates to benefit their proprietary trading desks.
The revelations sparked a major class action lawsuit filed earlier this year by the city of Baltimore, which entered into dozens of swap-based municipal bond contracts in the past decade that were tied to Libor. The suit accused more than a dozen financial institutions involved in setting Libor rates of engaging in a systematic conspiracy that resulted in “hundreds of millions, if not billions, of dollars in ill-gotten gains.”
“Just about every jurisdiction in the U.S. was affected,” said Michael Hausfeld, one of the attorneys representing Baltimore. “It affected hedge funds, money market investors, institutional investors. The total losses could exceed tens of billions of dollars.”
The additional losses from misreported Libor rates only exacerbated what had already become an exceedingly bad deal for public agencies. Most swaps contracts included large cancellation fees. In a falling interest rate environment where long-term tax-exempt bond rates have fallen to well below 4 percent, it became prohibitively expensive for governments to refinance floating rate debt that had been fixed via the swaps contracts at 5 percent or more.
“If the swap was done in a high-rate environment and you’re in a low-rate environment, it’s going to cost you a lot to get out,” said Peter Shapiro, managing director of the Swap Financial Group, whose clients besides Baltimore include a Virginia housing authority, Georgetown University and the Newseum in Washington, D.C. “A lot of people are incurring large swap termination costs just to get away from the risk.”
Shapiro estimates that more than $200 billion in government agency swaps contracts were affected by the rate manipulation and total losses to governments alone could be in excess of $1 billion. A report issued in early June by a coalition of urban transit advocacy groups estimated the Libor scandal cost 13 big city transit agencies $92.6 million in reduced payments, led by San Francisco’s Bay Area Rapid Transit system with a $17.1 million loss and the New York Metropolitan Transportation Authority with a $16.9 million loss.
“Because we bailed out the bank and the Fed has pushed rates down to nothing, these deals have turned sour,” said Saqib Bhatti, a research analyst with the Service Employees International Union who helped compile the report. “That’s why we think the banks should be forced to renegotiate these deals.”