Wednesday, March 10, 2010

State/Local Governments: Dupes or Incompetent?

The impact of derivative swaps by state and local governments to insure against interest rate swings is again surfacing in this continuing Fed policy of zero interest rates (ZIRP).  The most recent story has been Los Angeles, which bought interest rate swaps from the Bank of New York Mellon to protect it from higher interest rates and in this zero interest Fed environment now finds itself paying the Bank of New York Mellon $10 million annually until either interest rates go up or until 2028.

The heart of the issue is were these governmental entities the victims of fraud or incompetent?  They were convinced by sales presentations to convert 10 year bonds that could be retired or restructured into 30 derivatives contracts which did not allow call or retirement, without penalty, if interest rates fell.  Some in the investment world have argued that it is buyer beware, although the governmental entities are often characterized as greedy, and, now, with lower interest rates they are whining.  Some commentators have focused on a New York Times writer who cannot grasp the different types of derivatives and swaps despite repeated criticism.  Was there a reliance upon the presentations of the securities brokers and investment bankers and were those presentations too optimistic and not forthcoming in the possible negatives?  In Italy, as we have previously reported, Bank of America has become the focus of a national fraud investigation with respect to its advice and sales of swaps to municipalities.  In Jefferson County, Alabama, the fraud was in the favorable placement of bonds and purchase of swaps with a securities broker.  In that case the former mayor of Birmingham took bribes and got 15 years in prison, the broker got only 52 months, and the broker's consultant-intermediary got 4 years in prison.  Notice the securities broker who wanted the business and made the bribe payments only got 52 months.  JP Morgan Chase, Bear Stearns, and Goldman Sachs paid the broker to secure the business.  While SEC fines have been paid the banks are demanding dismissal of fraud charges.  Several states have found themselves stuck with swaps, such as New York which paid $103 million to terminate $2 billion of swaps and still had $3.74 billion of swaps as of 11/30/2009.

Obvious, world-wide, governmental entities have been taken by fast talking investment salesmen.  As Felix salmon observes in this last link, interest rate swaps are sold rather than bought.  He points out that if the governmental entities had known enough to design the swap they wanted and asked for bids, there would have been less problems.  My experience is that governmental entities do not understand the counter party risks, the downsides, and the constraints and penalties, because they focus on the "savings" in the future of increasing interest rates.  In doing so, they fail to cost out the different scenarios and options before being sold.

We have discussed how auction rate securities were sold as liquid investments when, in fact, there was no guarantee by the issuing banks that the auctions would be held or the securities bought back if the market froze.  When the market did freeze, the cry of individual investors caused state and US regulators to force the banks to settle with these individual investors, but the governmental entities have had to fend for their selves.

Hawaii has lost $250 million in writedowns of $1 billion in auction rate securities bought from one securities broker, who had lobbied the Legislature to approve the investments, working for Citigroup.  While the State was limited to no more than 20% of auction rate securities to cash assets, the investments may have actually approached 29%.  Hawaii has rejected an unspecified offer from Citigroup to settle.  Maui County is suing Merrill Lynch over a similar investment.  There have been mixed judicial outcomes of governmental entities suing, because those which have tried to recoup 3 times the losses by alleging anti-trust violations have run afoul of SEC law and regulatory power over multiple participants preempting anti-trust law.  The proper way to proceed is to allege fraudulent, unfair, and misleading practices.

The same is true with respect to the interest rate swaps bought by governmental entities.  They should be repudiated and told to take the deceptive and misleading contracts back.  If they will not make a reasonable offer to settle, they should be sued for felony fraud.  However, one needs to be very careful in selecting an appropriately experienced attorney without conflicts of interest with the OTC dealer community.

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