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.
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