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Swap Till You Drop: Will Frank Protect Munis from Wall Street's Ticking Time Bombs?

06/22/2010 02:38 pm ET | Updated May 25, 2011

As the fight for financial reform on Capitol Hill enters its final stages, it is worth reviewing what is being done to protect states and localities from the Wall Street con. On Thursday, the House-Senate conference committee on financial reform will take up the controversial section of the bill dealing with derivatives reform. Not a local issue right? Wrong. SEIU's Big Banks campaign has uncovered about 71 states and localities which have bought into dangerous derivatives and swaps deals to finance local priorities.

This information was not easy to uncover, and the total number of muni's holding these little ticking time bombs is not known. For the big banks, these deals are off book and off record, and politicians of course don't like to brag about getting swindled. It is only when these deal explode and there is a huge shortfall that the public begins to be aware. Sometimes even that is not enough, and some districts are in denial about the problems posed by their investment portfolio.

Wisconsin School Districts

In Wisconsin, five school districts got snookered by a German investment firm peddling a "synthetic" collateralized debt obligation put together by the Royal Bank of Canada. After the school districts put $200 million of their precious retirement funds into the hands of these con artists, the funds promptly lost almost all their value. The school districts thought they were investing in the actual corporate bonds not insurance on the bonds default. The school districts have sued, but in the mean time the international firms have succeeded in seizing funds from school district trusts to compel payment.

Alabama Counties

A much more publicized case in Jefferson County, Alabama, involves JP Morgan Chase. JP Morgan arranged the refinancing of the Jefferson County sewer system in 2002 and 2003. The deal involved $5 billion in interest-rate swaps, meant to lock in lower borrowing costs. JP Morgan has been accused of funneling millions of dollars to buddies of the County Commissioner, who in turn bribed the local pols to sign off on the crappy swap deals. While the little fish are in prison, the big fish -- the JP Morgan bankers -- got off after paying a $722 million dollar fine to the SEC to end their investigation. Jefferson County is now facing bankruptcy.

City of Los Angeles

Some localities are fighting back. With Los Angeles facing a nearly $500 million budget gap, forcing it to slash services, cops and librarians, the Los Angeles City Council unanimously voted to put an end to swaps deals and other banking practices that created the city's budget crisis. The move will save the city $19 million immediately.

The LA measure sets new community standards for banks doing business with the city: taxpayer money will only be invested in banks actively working to help families keep their homes and expand lending to small businesses to create jobs. These conditions are clearly the way to go and will be at the forefront of the efforts by taxpayer, housing and labor groups to get their cities and towns to engage in responsible finance.

Will Barney Frank Do the Right Thing?

While cities and states are fighting a defensive battle against bad swaps deals in the courts and legislatively, it's Congress' job to fix the problem and proactively protect cities and states from predatory investment schemes by the big banks.

Let's hope Barney Frank, Chairman of the House Financial Services Committee, agrees. Frank admits he screwed up the derivatives issue in the House. Now is his chance to get it right by adopting the Senate package of derivatives reforms, which contains a fiduciary responsibility for any swaps dealer selling derivatives to state and local governments. This simply means that the dealers need to act in the best interest of their client.

The big banks are fighting it tooth and nail. They say that if the provision were to pass, they might have to stop selling derivatives to states and localities. Hmmm, does that mean that they know these deals are NOT in the best interest of their clients? Maybe the fiduciary responsibility should apply across the board, not just to local governments. The Senate package of reforms also forces the vast majority of derivatives deals onto open exchanges where clear pricing information will be available, and the bill forces the big banks which control 90% of the derivatives market, to spin off their swaps desks into a separately capitalized affiliate, putting an end to taxpayer subsidies for Walls Street gambling.

The goal of the big banks is to kill the Senate derivatives chapter and especially the fiduciary responsibility section. "The toxic swaps that are strangling public budgets and forcing drastic cuts to essential services around the country are more painful evidence of why we can't let wall street and the big banks water down derivatives legislation," says SEIU's Steven Lerner.

The big question at the moment is whether Barney Frank, who has raised questions about the fiduciary responsibility language, will allow the Senate derivatives chapter to prevail? Take action and stay tuned; hearings are being broadcast live this week on C-Span 3.