• Wall Street Swindled Local Governments, Too. Here’s How They Can Get Their Money Back.

    Sep 17, 2014Saqib Bhatti

    Predatory lenders drove municipal governments and taxpayers into debt with risky interest rate swap deals that may have violated federal regulations.

    The story of how Wall Street banks steered unsuspecting homebuyers towards complex mortgages with hidden risks and hidden costs has been well-documented. In fact, the typical sales pitch for adjustable-rate mortgages was premised on the false notion that home values never fall and that borrowers could refinance their loans before interest rates jumped.

    Predatory lenders drove municipal governments and taxpayers into debt with risky interest rate swap deals that may have violated federal regulations.

    The story of how Wall Street banks steered unsuspecting homebuyers towards complex mortgages with hidden risks and hidden costs has been well-documented. In fact, the typical sales pitch for adjustable-rate mortgages was premised on the false notion that home values never fall and that borrowers could refinance their loans before interest rates jumped.

    Less widely understood is the fact that a very similar story played out with cities, states, and other municipal borrowers that were also steered into predatory interest rate swap deals riddled with hidden risks and hidden costs. Banks pitched these deals as a way for municipalities to save money on bond issuances: instead of issuing a traditional bond that had a fixed interest rate, they could take out a cheaper variable-rate bond that had an adjustable interest rate, but use a swap to protect against the risk of interest rate spikes.

    Under this structure, municipalities made fixed-rate payments to banks on their swap deals, while the banks gave them back a variable-rate payment that was intended to offset the interest rate that the municipality had to pay its bondholders. The idea was that this would allow borrowers to get a “synthetic fixed rate” on their debt that was cheaper than what they would have to pay on a comparable conventional fixed-rate bond.

    However, there were numerous risks embedded in these deals. For example:

    • The variable interest rate that the banks paid to the municipality could fall short of the rate that the municipality owed bondholders, creating a shortfall.
    • These deals contained many termination clauses that would allow the banks to cancel the deals and charge municipalities tens or even hundreds of millions in termination penalties.
    • Rather than rising, interest rates could crater, causing the net payments on the swap deals to skyrocket and leaving the municipalities unable to take advantage of the low-interest environment unless they terminated their swaps and paid hefty termination penalties.

    Even though banks tried to downplay or dismiss these risks in order to push interest rate swaps, all of them materialized in the aftermath of the 2008 financial crisis:

    • When interest rates on a type of variable-rate bond known as an auction rate security shot up, the bank payments on the corresponding swaps could not cover those payments, and cities and states across the country were stuck paying double-digit interest rates to bondholders.
    • When Lehman Brothers filed for bankruptcy and defaulted on its swap payments with municipalities, it triggered termination clauses on the bank’s swaps. In an ironic twist, cities and states actually had to pay penalties to Lehman because of the way the termination clauses were written.
    • When the Federal Reserve slashed interest rates in response to the financial crash, it also drove down variable rates on swaps, causing the net payments on the swaps for cities and states to soar and preventing taxpayers from enjoying any of the benefits from the low rate environment.

    As a result, municipalities across the country have been hit with large bills to Wall Street at the same time that they are trying to close record budget shortfalls amid the biggest economic downturn in 80 years. The Detroit Water and Sewage Department is shutting off water to families who have missed just a couple of payments on their water bill so that it can pay off more than $500 million in termination penalties on its swaps. The City of Chicago is now paying $72 million a year on its swaps as a result of the low interest rates, even as entire neighborhoods on the south and west sides of the city fall into disrepair. The school district in Chicago is paying another $36 million a year on swaps, while the Board of Education is invoking budget problems to justify the largest mass school closing in national history. In Wisconsin, the state is now paying $25 million a year on its swaps and making catastrophic cuts to state healthcare programs. These are just a few examples of a trend cropping up everywhere in the U.S.

    It is no accident that the same communities that were disproportionately targeted for predatory mortgages are also bearing the brunt of these predatory municipal finance deals. Across the country, working class communities of color are disproportionately impacted by cuts to public services, and austerity measures serve to exacerbate the crisis in those communities in particular.

    Luckily, there is something that public officials can do to stop the bleeding. Under Rule G-17 of the Municipal Securities Rulemaking Board (MSRB), a federal regulator charged with protecting the interests of municipal borrowers, banks that pitch deals to public officials must “deal fairly” with them. According to the MSRB, this means that they “must not misrepresent or omit the facts, risks, potential benefits, or other material information about municipal securities activities undertaken with the municipal issuer.” In other words, they must not downplay the risks associated with deals like interest rate swaps, and they must not mislead public officials about the likelihood of such risks materializing. The banks must ensure that public officials truly understand the risks of the deals they enter into.

    This is a burden that was not met in the typical swap transaction. As a rule, bankers highlighted the upside and minimized the potential downside in pitching these deals. This was in violation of MSRB Rule G-17 and municipalities like Chicago and Detroit have legal recourse to potentially win back hundreds of millions from Wall Street. Cities, states, and other municipal borrowers can pursue these legal claims by filing for arbitration with the Financial Industry Regulatory Authority (FINRA).

    The Baldwin County Sewer Service, a privatized utility in Alabama, successfully used a similar legal argument earlier this year to win back its swap payments and get out of its deals without any termination penalties. The total value of the award was approximately $10 million. The potential claims could be many magnitudes higher for cities and states that had significantly greater swap exposure.

    However, officials in municipalities with swaps need to act fast, because time may be running out. FINRA has a six-year eligibility period on these claims. Because many of the risks associated with swaps materialized in October 2008, when interest rates plummeted as a result of the federal response to the financial crisis, it is possible that the clock could run out on these claims as early as October 2014. Public officials like Mayor Rahm Emanuel in Chicago and Governor Scott Walker in Wisconsin should act now to potentially recover millions for their constituents before it is too late.

    Saqib Bhatti is a Fellow at the Roosevelt Institute and Director of the ReFund America Project.

    Image via Thinkstock

    Share This

  • Taxes Are Never Just a Class Issue

    Sep 4, 2014Joelle Gamble

    Tax reforms can't solve all economic inequality, because they won't change the reality of race in the U.S. economy.

    Tax reforms can't solve all economic inequality, because they won't change the reality of race in the U.S. economy.

    The threat of corporate inversions to the American tax base sprung an interesting political dialogue around tax reform in the United States. We’ve seen debates on how to stop the spread of inversions and arguments that they aren’t a problem at all. Some call for the abolition of the corporate tax rate as a whole and others completely reject such suggestions. I find these discussions of tax reform and its effects on the economy informative yet simultaneously slightly disappointing.

    What bothers me about how tax reform debates shake out is how absent they can become of socio-political realities, particularly the reality of race.

    One line of progressive argumentation follows simply: If everyone pays their fair share of taxes, we can support public spending and job growth, and we’ll all do better. The argument firmly stands, but there is an important caveat.

    It’s easy to harken back to the 1950s when tax rates were high, social services were relatively steady and economic security stretched across economic strata. But who was really secure then? Even the high points of job security for the American economy still left African Americans (and other racially marginalized groups) behind. This a structural phenomenon, instituted by socially racist institutions and a deep history of systemically harming the Black community.

    We can’t take race out of conversations around economic inequality. The reality of race is that even fixes to the broader federal revenue landscape don’t always address the structural barriers of racism. A rising tide can’t lift all boats, if some boats are bolted to the seafloor.

    Black unemployment consistently exceeds that of whites, both post-Recession and since such data has been available. Gaps between white unemployment and black unemployment shrank in 2009. This was not due to falling black unemployment but instead due to skyrocketing white unemployment.

    This racial gap in economic success extends beyond the employment rate. In fact, it is deeply entrenched in the way wealth is distributed in the U.S. The gap between median Black wealth and median white wealth stands at about $236,000 dollars. Flagrant discrimination, in part, contributes to this gap. But it is perpetuated by generations of asset accumulation policies that are targeted at those who already own assets.

    Corporate tax reform alone isn’t sufficient to fix the effects of decades of second-class status conferred on African Americans. The government does not just need sufficient funding to create equality within the economy. Distribution of these dollars is equally important. It needs to reflect the nuances of structural inequalities built into multiple aspects of our tax code.

    Take federal housing spending policies as a prime example. Ending ineffective tax incentives, such as the mortgage interest reduction, can start to tilt the scales toward those who are not already wealthy. Seventy-seven percent of the benefits of the mortgage interest reduction accrued to homeowners with gross incomes of above $100,000. We need to rethink housing subsidies so that the benefits of federal programs do not heavily favor those who already own homes.

    We need corporate tax reform to ensure that all participants in our economy are paying their fair share. But we also need a federal benefits structure that ensures that the concept of a "fair share" considers our history of discrimination when determining which Americans need those benefits most.

    Joelle Gamble is the National Director of the Roosevelt Institute | Campus Network.

    Share This

  • Campus Network Looks Ahead for Policy Engagement

    Aug 22, 2014Joelle Gamble

    The Roosevelt Institute | Campus Network has nine years of success under its belt, and is ready for more in its tenth.

    “We know the old way of doing things isn’t going to cut it anymore. We want to pioneer a new process of civic engagement…” This is the opening line of the purpose statement our Roosevelt Institute | Campus Network staff articulated for this year. Its brazen rejection of the status quo and forward-looking promise of a new mode of policy change encapsulates the ethos of our network as we move into a new year.

    The Roosevelt Institute | Campus Network has nine years of success under its belt, and is ready for more in its tenth.

    “We know the old way of doing things isn’t going to cut it anymore. We want to pioneer a new process of civic engagement…” This is the opening line of the purpose statement our Roosevelt Institute | Campus Network staff articulated for this year. Its brazen rejection of the status quo and forward-looking promise of a new mode of policy change encapsulates the ethos of our network as we move into a new year.

    We believe that local, people-centric policy change can ripple into larger national change. We believe in the power of communities organized into networks to innovate, incubate, and promulgate impactful ideas.

    This statement also pulls on the history of innovation and impact that the Campus Network has had over the past nine years. Founded on the conviction that student voices matter beyond Election Day, we have seen our members from across the country inject powerful ideas into the political debate and make tangible change in their communities. From starting revolving loan funds in Indiana to creating educational access in New Haven, from building capacity for non-profits in D.C. to combating student homelessness in Los Angeles, we have been and will continue to be committed to an unconventional and effective model of policy change.

    Even in the past year of the Campus Network (2013-2014), students have taken enormous strides toward building a forward thinking, locally driven, and more inclusive policy process. Our presence has grown to over 38 states, with chapters at a diverse range of institutions, public and private, community college and four-year university. Ideas generated from our network have been read over a half-million times and our work has been featured in outlets like The Nation, Al Jazeera America and Time Magazine Ideas.

    But, more than the power of the ideas or the prestige of the platforms which support them, the people in this network are what excites me the most about the years to come.

    This first week of August, we hosted our 9th annual Hyde Park Leadership Summit at the Franklin Delano Roosevelt Presidential Library and Museum. We gathered the leaders of Roosevelt chapters that have been around since our founding and the leaders of new chapters growing this year for a weekend of community-building, training and strategic thinking.  The overflowing energy, big thinking mentality, and willingness to pound the pavement summit attendees displayed was invigorating and holds the promise of a highly impactful year for our network.

    And, we need that kind of energy and passion. We have a great deal that we want to accomplish.

    • We’re rolling out a new training curriculum to support chapters as they do policy research, organize their peers, and engage with stakeholders.
    • We’re pioneering a state-based approach to engaging young people in policy with our NextGen Illinois initiative and our new Chicago staff presence.
    • Highlighting that our network is about people, we’re investing deeply in our chapter leaders and national student leadership team, increasing opportunities for training, conferences, and publishing.
    • With specific, actionable projects under our belt, we’re launching another year of our Rethinking Communities Initiative. (Check out our new toolbox here.)
    • Through increased and innovative usage of online tools and social media, we’re building community amongst the members of our network. We recognize that you don’t necessarily have to be in the same room as someone to be connected to them.
    • As we approach out 10th year as a network, we’re making a special effort to engage and reengage our distinguished alumni. Roosevelt alumni have gone amazing places; we’re reconvening them to help chart the course ahead with us.

    With our powerful team of national student leaders, an expanded level of staff capacity, and a little grit, we will continue to grow and strengthen the Campus Network to tackle issues today and build progressive leaders for tomorrow.

    Let’s get to work!

    Joelle Gamble is the National Director of the Roosevelt Institute | Campus Network.

    Share This

  • Stefaan Verlhurst: Mean and Lean Local Government

    Aug 21, 2014

    The Next American Economy project brought together 30 experts from various disciplines to envision tomorrow's economic and political challenges and develop today's solutions. Their assignment: be bold, and leave the conventional wisdom -- and their own opinions -- behind. In today's video, Stefaan Verhulst of GovLab speculates on future municipal policy that allows cities to do more with less.

    The Next American Economy project brought together 30 experts from various disciplines to envision tomorrow's economic and political challenges and develop today's solutions. Their assignment: be bold, and leave the conventional wisdom -- and their own opinions -- behind. In today's video, Stefaan Verhulst of GovLab speculates on future municipal policy that allows cities to do more with less.

    Stefaan Verhulst, Co-Founder and Chief Research and Development Officer of GovLab, speculates on future municipal policy that allows cities to do more with less. Combining open-source data with crowd-sourcing networks, city government will be able to connect experts with public problems more efficiently. An enlightened municipal agenda can help battle the recent governance deficit and lack of government trust rising in the US, Stefaan said.

    Share This