Just when you thought Wall Street couldn't get any more clever in their attempts at predatory lending, they have.
Big Banks have created an exotic financial instrument that is the equivalent of a payday loan for cash-strapped state and local governments, innocently labeled an "interest rate swap."
In the United States, states and local governments cannot run deficits. This year states face a $357 billion budget shortfall and local governments are facing an additional $82 billion budget shortfall. States have begun cutting basic services like snow removal, reduced garbage pickup, and in Colorado Springs they went to the pawn shop - selling police helicopters on the Internet.
In a desperate effort to meet budget needs, states and local governments over the last decade have gone to the big banks to ask for exotic instruments known as interest rate swaps. These desperate state and local governments were taken advantage of in the same way that Greece was by Goldman Sachs. Likewise, these swaps are threatening the economic health of local cities and states.
These interest rate swaps have cost American taxpayers $28 billion alone in fees and excessive interest. The money which could have been used for badly needed basic services instead goes to help the big banks develop more sophisticated practices to steal money off of regular Americans. Big banks led by Goldman Sachs used deceptive marketing to get states and local governments to buy these swaps.
How do they work? State and local governments take out variable rate bonds to pay for infrastructure projects. In the typical deal, these governments agreed to "swap" interest rates on variable-rate bonds. The government would pay the bank a fixed rate in exchange for a variable payment that would track the interest actually due on the bonds. Make much sense to you? Me neither, at first. That's why banks loved these things.
They sound like easy money to broke states and municipalities, but it's really easy profits for the banks. Basically a bank would peg the interest of a bond at a fixed rate in exchange for the interest rate of the bond that was set by larger macroeconomic forces, such as the Federal Reserve. According to the sales pitch, each party to the transaction might occasionally pay more than the other, but the payments would likely balance out over the life of the contract. Slick-tongued bankers assured the governments that in the end they would end up with something like a low-cost, fixed rate bonds.
Part-time municipal council members all over America desperate to fund infrastructure projects during the Bush economy signed up without understanding that these swaps were worse than most payday loans. On the other hand, many of the people involved in these transactions knew they were losing propositions. According to Economist Susan Ozawa of the New School:
The markets were pricing in serious falls in the prime interest rate.... So it would have been clear that this was not going to be a good deal over the life of the contracts. So the states and municipalities were entering into these long maturity swaps out of necessity. They were desperate, if not naive, and couldn't look to the Federal Government or Congress and had to turn themselves over to the banks.
Like payday loans, the states and local government taking out these interest rate swaps knew they were bad deals, but had to take them anyway. They had no other way of getting money.
As almost all reasoned economists had predicted in the wake of a deepening recession, the federal government aggressively drove down interest rates to save the big banks. This created opportunity for banks - whose variable payments on the derivative deals were tied to interest rates set largely by the Federal Reserve and Government - to profit excessively at the expense of state and local governments. While banks are still collecting fixed rates of from 4 percent to 6 percent, they are now regularly paying state and local governments as a little as a tenth of one percent on the outstanding bonds - with no end to the low rates in sight.
Banks and states were supposed to be paying equal rates. However, with the fed lowering interest rates, which was anticipated, now states and local governments are paying about 50 times what the banks are paying. Talk about a windfall profit the banks are making off of the suffering of local economies.
To make matters worse, these state and local governments have no way of getting out these deals. Banks are demanding that state and local governments pay tens or hundreds of millions of dollars in fees to exit these deals. In some cases, banks are forcing termination of the deals against the will of state and local governments, using obscure contract provisions written in the fine print. As Business Week points out, Detroit signed a similar deal that seemed too good to be true:
A few years ago, Detroit struck a derivatives deal with UBS (UBS) and other banks that allowed it to save more than $2 million a year in interest on $800 million worth of bonds. But the fine print carried a potentially devastating condition. If the city's credit rating dropped, the banks could opt out of the deal and demand a sizable breakup fee. That's precisely what happened in January: After years of fiscal trouble, Detroit saw its credit rating slashed to junk. Suddenly the sputtering Motor City was on the hook for a $400 million tab.
The banks were responsible for the ruined economy and weakening credit market. And the sad part is the banks that are responsible for the crisis are profiting off of their ruin and projected to collect $28 billions. They wouldn't be able to receive these kind of profits unless the economy crashed. In essence, banks designed a clever manipulative way to bail themselves out on the back of American taxpayers at the state and local level that most of us can barely understand. Except this time, the banks might not get away with it.
The U.S. Department of Justice and the California, Florida, and Connecticut attorneys general are currently investigating the fact that it appears that nearly every major bank was involved in a nationwide conspiracy to rig bids and drive up the fixed rates state and local governments pay in these exotic loans. Sen. Robert Menendez and Rep. John Lewis have introduced legislation which would impose a 100% tax on derivative termination fees to keep banks from seeking to collect on these deals, but banks cannot wait to act.
On Tuesday, the Service employees International Union launched a major action in Los Angeles to get that city to terminate such toxic loans and demand their money back. SEIU, in conjunction with a variety of union and community groups, are launching campaigns to get back the money that states invested in these toxic deals.
However, let us not forget the bigger point of this story: States shouldn't have to pay $28 billion a year to Wall Street in order to balance their budgets. The states, which unlike Wall Street didn't wreck the economy, shouldn't suffer the consequences of Wall Street's irresponsible behavior. The states and local government should have been bailed out by the federal government long before Wall Street.
However, during stimulus negotiations last year, Republicans in Congress demanded that hundreds of billions of dollars of money for the states and local government be cut from the stimulus. As a result, states and local government are now facing a $469 billion budget shortfall. In order for state and local governments to balance their budget, it's expected that they are going to cut 900,000 teachers, firefighters, highway workers, nurses and other public employees. This will only further slow our economic recovery.
In December, the House passed a version of their Jobs Bill where they took $75 billion of unused TARP Funds and gave it in aid to the states. This was a step in the right direction.
However, Senate Republicans vowed to filibuster any attempt to use TARP money for anything other than making Wall Street bonuses the largest on record. They refused to allow that $75 billion to be used to help states maintain basic services. The Republicans would hate to see the profits of their friend on Wall Street. They would see rather see local economies falter, bridges collapse, and garbage go uncollected than hurt the profits of their friend on Wall Street.
So that means it's time for us as citizens to fight to clean up Wall Street. It's time we prohibit these kind of risky financial instruments as well as predatory lending. Furthermore, we need to take the last $75 billion slated to be given to Wall Street and instead given to the states and local governments that the banks bankrupted in the first place.
Follow Mike Elk on Twitter: www.twitter.com/MikeElk
11. Any serious call to prohibit interest rate swaps would be met by howls of derision by the financial managers of any substantial borrower. It would be utterly irresponsible to deprive financial managers of the most important tool they have for mitigating their interest rate risk. Even limiting interest rate protection to caps instead of swaps would probably increase the cost of borrowing for municipalities, since caps always cost money, while some swaps are very cheap.
I have no doubt that banks are often predatory, but this article doesn't show it.
Disclosure: As an attorney, I have represented both borrowers (including municipal authorities issuing bonds) and lenders in many kinds of financial transactions involving swaps. I am currently involved as an independent consultant (because of language skills) in a case involving allegations of financial fraud in a transaction to various kinds of swaps.
7. The linked article about Detroit does not contain enough information to determine the basics of the transaction referred to, or exactly what it means that Detroit was suddenly "on the hook" for $400, or indeed if it is an interest rate swap. It can hardly be that the termination provisions of a swap are in the "fine print" -- termination is one of the key provisions of any swap agreement.
8. Obviously, one reason why a borrower to buy protection against interest rate increases, and the swap counterpary is willing to sell protection against interest rate increases, is because, at a certain price, they disagree about which way interest rates are likely to go.
9. "They had no other way of getting money." Of course they did. They could have issued fixed rate debt, but it probably would have been more expensive than issuing floating rate debt with an interest rate swap.
5. The Ozawa qote is undated and unlinked. Floating and fixed interst rates available to municipalities rose from about 2000 to 2005, and then declined. The the expectaation of a short term decline is only partially relevant to the issue of entering into swaps for long term debt. For long term borrower, at the proper price, it makes sense for a borrower to swap floating to fixed in any interest environment. Since municipal bonds can run for decades, the risk is substantial. In the last 30 years or so, interest rates have fluctuated from about 20% to less than 1%.
2. The swaps entered into by the Greek government were in no way comparable to interest rate swaps. The Greek transactions were secured loans disguised as swaps, designed to conceal the loans from the European Union auditors.
3. To state generally that swaps "predatory" is like saying "contracts are predatory." A "swap" is just a kind of contract.
We have to start by refusing to call this crime by euphemisms: it's not "lobbying," it's not "campaign contributions," and it sure as HELL ain't "¢orporate freedom of $peech."
Although our country was founded on some novel ideas, like having 50 semi-autonomous states stitched under a Federal government, those ideas have never really been made to work. Washington DC took over the entire Republic, and financial crime took over a very-willing Washington DC. Ever since our founding, we have been repeatedly shipwrecked by financial disasters happening every 40 years or so, for the same basic reasons. This go-around is no different, except that the stakes are global now.
Now, the government tax rate has been relatively consistant at 20% of GDP for-well, for the lifetime of anyone reading this. Some years it is 18%, some years it is 22%, but it stays in that area. The financial sector for most of last century was about 5% of GDP. It grew to 20% to help fuel the mergers of the 80's, and fed on credit card fees and interest. Now Bank taxes are the same size as Federal taxes!
But it gets worse. Federal taxes provide the Military, some police, airport support (air traffic controllers), farming assistance, small business loans, the national park system, etc...
Banks provide us with cards so we don't have to carry cash, and provide us with money for short term wants that eats up funds for long term needs (and yes, I pay $75 in interest a month on the !@#$% things myself).
The national govenment hires millions of workers and those workers spend their money at local shops. The banks pay a smaller number of people higher wages ($100 million bonuses are not given out in government service), and those folks spend it on luxuries we will never see, or see much of the trickle down from.
Bank taxes are much worse than Government taxes!
Or to put it another way, of every dollar spent in the US, 20 cents goes to the banks.
Now if I spend a dollar on a cheeseburger, it may make me a bit fatter, but I can see where my money goes. I pay a farmer to grow wheat (bread), cows (cheese, burger), etc. I pay some guy in a wonder bread plant to make the bun, I pay some guy minimum wage to assemble the burger and say "would you like fries with that," etc. I pay money for a good!
If I go to the barber, I get a haircut, I pay money for a tangible service!
If I pay a bank fee, I pay money for...?
The "value," that the financial sector claims it provides is basically "we help businesses finance projects." Well, they don't provide the money, they get it from us. They do provide credit cards to people-and then hope that those people keep a balance so they can get interest, and if not, charge fees to pay for the cards-even while charging businesses 5% for the priviledge of taking credit cards.
To my mind, it is a tax!
Con't
Or did you think people losing jobs and the government cutting workers doesn't affect government services and the economy?