In the News: Recent Developments

November 14, 2011

Governments Using Swaps Emulate Subprime Victims of Wall Street

By Darrell Preston

Ask a Nobel Prize-winning economist what’s the difference between the mayor of Baltimore losing taxpayer money with derivatives sold by Wall Street and millions of Americans defaulting on subprime loans and he’ll say there isn’t any: State and local governments are victims of opaque financing they don’t understand, the same way individuals go broke on borrowing at rates too good to be true. Martin O’Malley, Baltimore’s mayor in 2002, led his constituents into a financial trap that was supposed to save money on water, sewer and other projects. Now O’Malley, 48, is Maryland’s Democratic governor and the state’s biggest city faces a $90 million loss to get out of so-called auction-rate securities, the municipal equivalent of a floating-rate home loan that exploded when subprime lending collapsed and helped push Jefferson County, Alabama, into bankruptcy last week. Like first-time buyers who stretched to finance a house and are stuck with underwater mortgages, borrowers from Baltimore to Denver are locked into more than $50 billion of auction-rate bonds sold by banks, which earned an estimated $20 billion in fees on related derivatives that municipalities and local governments in U.K. are prohibited from using because of the risk for catastrophic loss. U.S. cities face hundreds of millions of dollars more in penalties if they refinance the bonds into fixed-rate securities with the lowest yields since the 1960s.

‘Exploited’ by Banks

“These financially unsophisticated local officials were being exploited by big banks,” said Columbia University Professor Joseph Stiglitz, who won the Nobel Prize in 2001 with George Akerlof of the University of California, Berkeley and Michael Spence, now at New York University, for their analysis of markets with asymmetric information. “The outrage was not just that there were high transaction costs, but that the risk wasn’t understood by those who used them,” Stiglitz said. A request for comment on Baltimore’s move into the auction-rate market was referred to the city’s finance department by Raquel Guillory, an O’Malley spokeswoman. O’Malley leads the Washington-based Democratic Governors Association. Auction-rate securities were used by municipalities, student lenders and closed-end mutual funds to lower costs on 30-year debt by paying short-term interest rates that are periodically reset through sales run by banks. Most of those sales have failed since February 2008, when capital-starved lenders reeling from the worst financial crisis since the Depression stopped acting as buyers of last resort, a role they led issuers and investors to believe they would play.

Biggest Municipal Bankruptcy

Jefferson County, home to Birmingham, the state’s biggest city, became the biggest municipal bankruptcy on record after costs spiraled out of control on its auction-rate debt and related derivatives used to finance a sewer project. The county defaulted on the securities, issued in 2002 and 2003 to refinance fixed-rate sewer bonds, as short-term yields fell. JPMorgan Chase & Co., the largest U.S. bank by assets, led underwriters in the transactions and was the biggest provider of $5.6 billion in related derivatives, according to the U.S. Securities and Exchange Commission. The bank didn’t want the county to declare bankruptcy, Justin Perras, a bank spokesman, said Nov. 10 by e-mail. “While we’re disappointed by the county’s decision to file, we will continue to work toward a fair and reasonable solution.” Bill Slaughter, the lawyer who advised Jefferson’s County Commission on bond sales at the time of the refinancing, said later that he couldn’t figure out the math on the swaps.

Misunderstood Risk

“Neither I nor anybody in the Jefferson County Commission — or for that matter, I’m not even sure that the JPMorgan people that we deal with — really understand how swaps are priced in the global financial market,” Slaughter said in 2005. Cities, state agencies and other municipal issuers accounted for 37 percent of the $152.9 billion that, as of July, remained in the market, which the SEC has said banks rigged. Borrowers “didn’t understand the risk of auctions failing,” Stiglitz, 68, said by telephone from New York. Most of the weekly or monthly sales continue to fail today, raising the chance that issuers will have to pay penalty rates on the debt that could push yields as high as 15 percent when 30-year Treasuries are near a record-low 2.5 percent. In addition, many municipalities are trapped in the securities as refinancing would require the costly unwinding of related swap contracts, a type of derivative. Banks can collect from issuers every time an auction takes place, even when it fails.

Investors Lose

Investors holding the securities lose out each time an auction fails, as that leaves them stuck with bonds that can yield as much as 4.6 percentage points less than similar- maturity fixed-rate municipal debt. Banks have started to see a backlash against their practices as Occupy Wall Street protests that began Sept. 17 in New York have inspired others and spread from Lower Manhattan to 100 U.S. cities and to Europe and Asia. Participants say they represent “the 99 percent,” a reference to a Stiglitz study showing that the richest 1 percent of Americans control 40 percent of the nation’s wealth. Before the auction-rate market seized up, debt offered at those sales that drew no takers was instead scooped up by banks to set a price floor. Like Baltimore, facing a $90 million price to unwind related swaps, issuers nationwide are sticking with the bonds to avoid similar costs.

Issuers ‘Should’ Refinance

Failing to refinance the securities “doesn’t make sense” for municipal borrowers with 30-year rates at about 3.7 percent, almost the lowest since the 1960s, said Robert Brooks, who teaches financial management at the University of Alabama in Tuscaloosa. Taxpayers are exposed to the “risk that markets can move against you in one day,” Brooks said in a telephone interview. “With rates so low, they should just put it into fixed-rate debt.” For some borrowers, such as the California Statewide Communities Development Authority and Florida’s St. Petersburg Health Facilities Authority, not refinancing means they face the risk of paying as much as 15 percent in penalty rates when auctions fail, if the cost of 30-year debt climbs significantly. Standing pat can mean paying fees to Wall Street banks such as Morgan Stanley and Citigroup Inc. that run the auctions. Both were among 11 banks sued by Baltimore’s mayor and City Council in September 2008, claiming bond underwriters and brokers violated antitrust law by concealing their role in propping up auctions as buyers of last resort. The city said that by so doing, the firms concealed the risks and colluded to keep the market from freezing before “concertedly” refusing to support the sales on Feb. 13, 2008. On that date, 87 percent of all auctions failed.

Suit Dismissed

U.S. District Court Judge Barbara Jones in New York dismissed the lawsuit in January 2010, saying the claims were “precluded by the securities laws,” according to a statement from Paul, Weiss, Rifkind, Wharton & Garrison LLP, a law firm that represented Citigroup. Alabama’s Jefferson County wound up in bankruptcy after it defaulted on about $3.1 billion of debt backed by sewer revenue in 2008. The financial crisis had pushed up the cost of its bonds, including the auction-rate debt, and required early repayments that the county couldn’t afford. The swaps tied to the securities also didn’t shield it from rising expenses. Some overseas government borrowers have been banned from using swaps in their finances.

Banned in Britain

In January 1991, the U.K. House of Lords ruled that local authorities weren’t permitted to use swaps and derivatives. Parliament’s upper chamber said such agreements had “the stigma of being unlawful.” Municipal authorities, including the London borough of Hammersmith & Fulham, had speculated on the direction of borrowing costs in the late 1980s using interest-rate swaps. Auditors challenged the transactions, resulting in a series of court rulings that said such activities were outside of the council’s jurisdiction and thus unenforceable by banks involved. In 1997, the U.K. barred local governments from investing in derivatives. Greece used currency swaps, the biggest of which were with Goldman Sachs Group Inc., to hide 5.3 billion euros ($7.7 billion) of debt from 2001 to 2007, Eurostat, the European Union’s statistics office, said in a May report. When the arrangements were added to the nation’s accounts, it spurred a surge in borrowing costs and triggered Europe’s debt crisis. Goldman Sachs did “nothing inappropriate” in arranging the swaps, Gerald Corrigan, chairman of the company’s regulated bank subsidiary, told a U.K. legislative panel in February 2010.

Failed Protection

In the U.S., municipal borrowers used swaps to guard against the risk of higher interest costs on variable-rate debt by exchanging payments with another entity and tying how much they pay to an underlying value such as an index. The agreements can backfire if rates move in unexpected directions, resulting in issuers making larger payments. The derivatives were often designed to offset the risks of increases in the short-term rates tied to auction-rate securities, fixing borrowers’ costs by trading their debt- service payments with another party. Instead, rates dropped. The yield on two-year Treasury notes fell from about 5.1 percent in June 2007 to a record 0.14 percent on Sept. 20. On Oct. 6, the U.S. Treasury sold $10 billion of five-day cash- management bills at 0 percent. As rates fell, the cost to unwind swaps tied to floating- rate bonds rose, since their value tilted in favor of counterparties and required bigger payments to undo.

‘Playing With Fire’

“You can’t just break out of them, you have to unwind the whole transaction,” Andrew Kalotay, head of the debt-management firm Kalotay Associates Inc. in New York, said by telephone. “It’s when you swap it that you are playing with fire.” “The banks make so much money off of the swaps, they don’t care about the underwriting fee or other fees” collected from municipal issuers, Kalotay said. In testimony at a July 29 SEC hearing held in Birmingham, he estimated that municipal taxpayers have paid $20 billion in fees on swaps valued at $1 trillion in the past five years, noting that banks usually get about 2 percent on such transactions. In the suit against 11 banks and brokers, Baltimore claimed the two-dozen broker-dealers running auction-rate securities sales divvied up more than $600 million in fees each year. Municipal securities made up about half of the $330 billion auction-rate market when it collapsed, and $56.1 billion of the debt remained in July, according to data compiled by Bloomberg. The rest, valued at about $96.8 billion, includes preferred shares of closed-end mutual funds, nonmunicipal student-loan debt and other types. Now when an auction fails, banks reset rates paid on the bonds based on indexes such as the 30-day London interbank offered rate, the cost of loans among banks.

Refinancing Option

Auction-rate issuers can refinance out of the securities “when it’s in their interest,” Michael Decker, managing director at the Securities Industry and Financial Markets Association in New York, known as Sifma, said by e-mail in response to questions about the market. The group represents dealers and underwriting banks. “They’re taking a risk that rates will rise,” Decker said of borrowers that sell floating-rate debt. Even before it froze, banks rigged the auction market, the SEC has said. The agency began looking into banks’ handling of auction- rate securities as early as 2004, when it sent letters to banks seeking written reports detailing “any potentially deceptive, dishonest, or unfair practices” in the auction process, according SEC documents obtained under the U.S. Freedom of Information Act.

‘Cash Alternative’ Pitch

In August 2004, St. Louis-based broker A.G. Edwards gave more than 300 pages of documents to the SEC, including materials describing auction-rate securities as a “cash alternative.” Though some documents said there was a risk of failed auctions, they also said municipal auction-rate securities often provide “higher after-tax yields than many short-term investments” and “investors can enter sell orders at the auction to liquidate their positions at par.” In another document, A.G. Edwards said it had never had a failed auction and that the firm was “responsible for the rates at which we offer daily liquidity.” The broker was later acquired by Wachovia Corp. and then Wells Fargo & Co. In 2006, the SEC said Citigroup, Bank of America Corp. and 13 other investment banks, including A.G. Edwards, used inside knowledge of bids when they ran rate-setting auctions for the securities. The banks, which were only required to disclose their manipulations rather than stop, arranged bids to ensure successful sales. The banks agreed to a cease-and-desist order and $13 million in penalties to settle with the agency.

Undisclosed Role

Merrill Lynch & Co., now part of Charlotte, North Carolina- based Bank of America, failed to adequately inform investors of its alleged role in “propping up” auctions, the SEC said in June. The agency made the assessment in a friend-of-the-court brief sought by a federal appeals panel in New York which is reviewing the dismissal of claims over the bid rigging. In response, Merrill Lynch lawyers said the government was trying to make the issue one of misrepresentation instead of market manipulation. “The SEC contends that Merrill should have updated the website description of its auction-rate securities practices in the fall of 2007 in order ‘to disclose its “then current” practices’ by warning investors that every auction would invariably fail without Merrill’s continued bidding,” the company’s lawyers said in a letter to the appeals court.

Banks Controlled Auctions

The banks that oversaw auctions “acted at their own discretion as ‘market makers’” before February 2008, when dealers pulled their capital out after suffering unrelated losses, Federal Reserve economists Song Han and Dan Li said in a study last year. Almost a quarter of auctions failed before the market froze because there were no bids, they said. “Dealers were not only the bidders-of-last-resort but also the only bidders in these auctions,” the report said. Banks “sold a defective product but didn’t explain the risk,” said Columbia’s Stiglitz. He called it a case of “exploiting market ignorance.” After working well for 30 years, the auction-rate market “collapsed of an unexpected deep and widespread crisis in the financial markets,” said Sifma’s Decker. “Lots of market participants — dealers, investors, issuers, bond insurers and others — failed to see the emerging depth of the crisis, and all the parties were hurt,” he said.

Credit Crisis

The 2008 freeze up might have been avoided had the subprime-mortgage market remained solvent. Insurers that guaranteed repayment of the municipal debt in the auctions also backed securities tied to housing loans. As losses from mortgage securities mounted in 2007 and 2008, the insurers lost their top credit ratings. Without those top scores, investors began to shun the auction-rate bonds the insurers guaranteed. Securities dealers that also had acted as buyers of last resort in the periodic debt sales began to step away as well, partly because of subprime-mortgage losses among banks. Today, banks continue to grapple with fallout from that meltdown while borrowers in the moribund auction-rate market remain stuck. Baltimore provides a typical example. The city, where almost 21 percent of residents lived below the federal poverty level in 2009, has confronted tight finances in the past four years and closed a $60 million gap in this year’s $2.3 billion operating budget. Mayor Stephanie Rawlings-Blake cited moves such as unpaid time off for city workers in explaining how the gap was closed in a summary of the spending plan.

Baltimore’s Roadmap

The city is developing a 10-year fiscal roadmap to help establish budget priorities, improve efficiency, set up a pro- growth tax structure and establish a path toward lower property levies, Rawlings-Blake said in a Sept. 28 statement. She said planners will look at employee-benefit and public-service costs. Some of the city’s almost $350 million in auction-rate debt was issued under former Mayor O’Malley and Sheila Dixon, a former City Council president and mayor who resigned last year following a plea agreement in a federal corruption case. The mayor and council both agreed to the deals, records show. By law, the council and its committees aren’t involved in planning or selecting how to borrow, Dixon said by e-mail. The Finance Board, which includes the mayor, has responsibility for borrowing, she said. Peggy Watson, Baltimore’s finance director under O’Malley and now the governor’s deputy chief of staff, didn’t respond to a telephone call seeking comment on the borrowing.

Risks Were Known

Baltimore “understood the risk” when it issued auction- rate securities in the early 2000s, said Stephen Kraus, the city’s treasury management chief. At the time, the market was commonly used to lower municipal-financing costs. The city hasn’t directly lost money on the securities. Yet without paying $90 million to unwind swaps tied to the bonds, it has sacrificed the ability to refinance the long-term debt at historically low interest rates. Today, short-term rates near zero mean the city of almost 621,000 has little incentive to refinance. So with each new auction, taxpayers keep adding to fees already paid to underwriters for failed sales. Those costs have amounted to about $7 million, according to data compiled by Bloomberg. “The cheapest thing to do for now is sit tight until the market changes,” Kraus said in a telephone interview. Refinancing would necessitate unwinding swaps tied to the debt, and paying that $90 million for the privilege. On a 2004 issue of 30-year water bonds, rates rose by 0.73 percentage point to 5.98 percent in its first failed weekly auction on Feb. 22, 2008. On Sept. 30, the same bond priced at a yield of 0.053 percent, matching a July 1 low. A failed Nov. 4 sale put the rate at 0.123 percent.

Low Cost

Yields on top-graded fixed-rate municipal bonds maturing in 20 years averaged 3.4 percent in October, more than six times the interest and fees on similar auction-rate debt, according to data compiled by Bloomberg. Still, the risk remains that the market will change. “We have a team ready to move at the first sign of increased rates,” Kraus said. “We’ll move quickly.” Bond contracts spell out penalty rates for failed auctions. They can reach as much as 15 percent, according to data from the Municipal Securities Rulemaking Board, the industry’s self- regulator. Other securities have penalty costs that are closer to market rates. The penalties key off of benchmarks such as 30-day Libor and add 1.25 percentage points, or are set at 1.5 times the 30- day commercial paper rate, said Mark Conner, a principal at Corporate Treasury Investment Consulting LLC in Baltimore.

Penalty Rates

Such formulas would mean an auction-rate bond yielding 2.25 percent if the Libor fixing reaches 1 percent, or 1.5 percent if commercial paper climbs to 1 percent. Last week, 30-day Libor averaged about 0.25 percent, while commercial paper was 0.32 percent, according to data compiled by Bloomberg. Both rates topped 5 percent in December 2007, at the start of the longest recession since World War II. If an issuer’s credit ratings are cut, the spreads and multipliers increase, Conner said. For example, the penalty may climb to Libor plus 1.75 percentage points. The rating cuts on bond insurers had this effect on some auction-rate securities. Denver refinanced $1 billion of floating-rate debt into fixed-rate bonds after the 2008 market freeze. It paid about $4.3 million to refinance $503 million of auction-rate securities, according to Bob Gibson, director of financial management. He said the city has recently paid as little as 0.06 percent on some of its remaining $206 million of auction-rate bonds. The penalty rate on some may reach 12 percent, municipal rulemaking board data indicate.

‘Cheap Money’

“It’s a great time to be a borrower but not a great time to be an investor,” Gibson said. It’s “cheap money.” Borrowers continue paying fees to banks handling the sales, even though the failure rate on more than 68,000 bond auctions since February 2009 may exceed 80 percent, according to the rulemaking board in Alexandria, Virginia. Its guidelines govern much of the $2.9 trillion municipal-securities market. Dealers do less in running auctions now that they have ceased propping them up, Conner said. Most holders have standing “sell” orders and dealers spend less time seeking out bidders, he said. “Traders aren’t busy phoning buyers to disseminate prices,” Conner said. “There’s very little work associated with auction-rate securities now.” Houston pays 0.25 percent of the principal each year for some auctions, though dealers sometimes volunteer to accept lower fees, said Shawnell Holman, deputy controller for the city’s debt. Houston, which has $480 million of auction-rate securities, in July sold long-term bonds to replace $75 million of the debt, used for convention-center financing.

Refinancing ‘Made Sense’

“Long-term rates were so low it made sense to reduce variable-rate exposure,” Holman said. Houston is the fourth- largest U.S. city by population. Some issuers “have required contracts to be renegotiated,” said Joseph Fichera, chief executive officer of Saber Partners LLC, a New York-based financial advisory firm. “There is an opportunity for a win-win restructuring or replacement of the broker-dealer with one more responsive to the issuer.” “Broker-dealers should be paid for sales, not fails,” Fichera said. After February 2008, some auction-rate securities issuers couldn’t refinance into fixed-rate debt because investors wouldn’t buy their bonds at prices that made the refinancing worthwhile, Conner said.

$60 Billion Returned

High penalty costs drove refinancings, said Chris Chakford, a managing director at SecondMarket Inc., a New York-based company that runs a trading system for auction-rate debt. Lawsuits by the SEC and state regulators led to the return of at least $60 billion, mostly to individual investors. Some bondholders sold the securities at discounts of as much as 15 percent, Chakford said. “There is no liquidity, but there is a spread there,” he said. “There are opportunities for traders.” Low prices give issuers a chance to repurchase their debt at a discount, much as publicly traded companies can buy back shares when prices drop. Education lenders such as Brazos Group Inc. in Waco, Texas, once among the largest issuers of auction- rate securities, have tried buybacks, regulatory filings show. While Portland, Oregon’s biggest city, considered buying back some of its $132 million of auction-rate debt, Treasurer Eric Johansen said concern that the process lacked clarity blocked pursuit of the transaction. “We’re happy with them right now,” Johansen said. “We’re not planning to do anything with them.” Baltimore is also doing nothing about its auction-rate securities, at least for now. If interest-rates rise, the penalties for unwinding related swaps should fall, said Ed Gallagher, the city’s finance director. “Until that happens, we must live with them,” Gallagher said. “They’re expensive to get out of.”

© 2011, Bloomberg News, November 14, 2011

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