Morgenson on Municipalities’ Swap Fiascoes

Gretchen Morgenson has a fair number of critics among readers of this blog, which I think is a tad unfortunate. Most of her articles are in fact sound; she is very reliable on executive comp, anything in the equity markets, or where she is working form legal documents, generally lawsuits. It’s when she wanders into debt markets that her attempts to present material to a mass audience sometimes include nails on chalkboard slips.

This week, she has a pretty decent piece on how municipalities got hosed in various swap transactions. She is being savaged for a foot in mouth at the top of the piece, and this is the precisely the sort of thing that gets her in trouble: using Greece (a story in the headlines) to update readers on municipalities’ swaps woes, and worse, calling the Greek currency swaps “credit default swaps.” What completely mystifies me is why, after being repeatedly hectored on the blogosphere, she does not clean this sort of thing up. Josh Rosner is her co-author on an upcoming book. Why doesn’t she run her pieces by him to avoid obvious gaffes?

Yet the Gretchen-bashing for its own sake has gotten a life of its own. Another blogger criticizes Gretchen for allegedly only discovering muni derivatives fiascoes now. Huh? She wrote about this in 2008 as well. And I don’t see anyone yelling at Chris Whalen for addressing this supposedly stale topic when he wrote about muncipalities and derivatives this week.

I suppose I am more sensitive to this than most, since I regularly shred articles long form in the Times, Journal, and once in a very great while, the Financial Times. Yet Gretchen gets piled on when many of the articles I pummel (and readers typically agree with my harsh take) get a free pass from most other bloggers (including one on Goldman’s marks on AIG’s CDS….which happened to be by the very same Gretchen Morgenson).

As an aside, I’ve waded into this argument before. My first blog conversation of sorts with Felix Salmon was on the very subject of a 2007 Gretchen Morgenson piece, where I made the case in some detail that while I though a piece by Morgenson had been sloppily written, that some of his salvos were less than fair.

Now it is fair to say that municipal finance has long been an ugly nexus of incompetence, chicanery, and greed. Pay to play scandals are endemic. But even when you don’t have ugly combinations of venal officials meet underhanded financier, you routinely find its kissing cousin, chump officials hire venal advisor in cahoots with underhanded financier. The article cites Andy Kolaty, a fixed income expert:

“The basic problem is the swap adviser gets paid only if there is a transaction — an unbelievable conflict of interest,” he said. “It’s the adviser who is supposed to protect you, but the swap adviser has a vested interest in seeing something happen.”

Yves here. And that is as good as it gets. To put it politely, there are often other ways these advisors are compensated.

And it is also human nature to rely on assurances made by the salesman, when they in fact have no legal standing.

Some readers will no doubt say that governments should not get involved in complicated financial instruments. But they are under pressure to minimize costs to taxpayers, so when a banker peddles and approach that professes to do that, they feel duty bound to listen, particularly if they know other entities like them are doing the same (remember, there is no penalty for screwing up in an entirely conventional manner). And even sophisticated players like Harvard have been burned on swaps too, so it isn’t clear that even being a smarter buyer has produced better outcomes.

Nevertheless, as one reader pointed out in a recent post, the complexities are often not where they seem to be:

To me the other HUGE issue is that a lot of the deception was “hidden in plain sight”, to use a Sherlock Holmes metaphor. Relatively simple statements with non-intuitive meanings (or meanings requiring non-trivial parsing).


1. ‘It can’t go up more than 2% a year’. “It” is the interest rate in this case, but a lot of unsophisticated borrowers would have been encouraged to assume (or certainly not corrected if they did assume) that “It” was their PAYMENT. 2. ‘The starter rate is (some ridiculously low number).’ Same as above. The borrower thinks this is the INTEREST rate, when in fact it is the (minimum) PAYMENT rate and the principal is thereby increasing. 3. ‘The loan will reset in X years’. Ignoring the fact that if the minimum payment schedule is followed, the loan will RECAST much sooner.

I have personally called BS within the last month on a young work colleague’s statement regarding the interest rate on his car loan. Got him annoyed enough to check his contract right through, in fact, because he wanted to prove the old fogey wrong. 20 minutes later he’s cursing under his breath, and is on the phone to his fiancee to work out how far they can accelerate the payment schedule.

Now this is a genuinely smart guy, who got taken in by the difference between flat (quite prominently displayed) and reducible (quietly hidden away, in small print) interest rates. He and his fiancee also earn enough so they can in fact blitz the loan and write off the interest paid to experience.

(And when he asked me why I was so sure of my contention, I told him I’d seen the same stunt pulled on a good friend of mine many, many years ago, and never forgotten it. From what he then said I suspect he’s not going to forget either, and also not going to forget that a ‘family friend’ brokered the finance for him.)

Yves again. While these examples are retail, the same principles and risks apply as far as not very sophisticated “institutional” customers are concerned.

Morgenson sets out a good bill of particulars on the swaps front. The ridiculous part of these deals is that the municipal market is sufficiently deep that most issuers can sell bonds that are a good fit with the life of the underlying project, thus circumventing the risk of maturity mismatching. But plain vanilla bond deals are not very attractive to Wall Street firms, so municipalities were pressed to enter into variable rate debt deals, usually in the auction rate securities market, and swap back into fixed rates.

However, these deals blew up when the auction rate securities market froze in early 2008, and Morgenson misses a line of attack here. The ARS market had been propped up by dealers for some time, with auctions that failed winding up being carried by the banks (as in the auctions were the way that investors could get their money back readily; the market was billed as a weekly auction, but in fact was an OTC market with a once a week trading window). That was a cost they had been willing to bear until the monolines started looking wobbly. Many of these ARS were rated AAA by virtue of a monoline guarantee; if the monoline was downgraded, so to would the insured bond. The dealers did not want to be stuck holding inventory, since if it was downgraded, they would show losses. They started aggressively trying to reduce their holdings, and en masse, quit supporting the auctions. Under the terms of the agreements, if an auction failed, the investors were due a penalty rate for the loss of liquidity, the investors got a penalty rate.

Some state attorneys general went after the banks (some investors had their funds effectively frozen, and while some were happy as clams with the penalty rates, many had been sold the product as being as safe and liquid as a money market fund) and got big settlements.

But what about the municipalities? Were they misled about the risks of auction failure too? Were they told that the market worked only thanks to active involvement of the dealers? Morgenson says the governments are not willing to cross the money types:

What is especially maddening to many in the municipal securities market is that issuers are now relying on the same investment banks that put them into swaps-embedded debt to restructure their obligations. According to those who travel this world, issuers are afraid to upset their relationships with their bankers and are not holding them accountable for placing them in these costly trades.

Yves here. Is this a variant of Stockholm syndrome?

Chris Whalen points out that swaps contracts have wound up being an exceptionally bad deal for municipalities, thanks to the Fed’s ZIRP de facto banking subsidy:

OTC derivatives are multiplying the economic pain that ZIRP is causing to interest rate sensitive investors.

The Fed’s current interest rate policy has caused the City of Los Angeles to go into the red to the tune of $10 million per year because of interest rate swaps sold to the city by Bank of New York Mellon (BK). That’s right, thanks to Chairman Bernanke and the FOMC, and an OTC interest rate swap, the City of Los Angeles must pay $10 million per year to BK so long as the Fed continues ZIRP — potentially until 2028.

By skewing interest rates down below the true rate of inflation, the Fed has levied a tax on all of the OTC interest rate counterparties that were trying to hedge against higher interest rates. And there are literally thousands of other cities, states, public agencies and insurers around the world which are caught in the unintended consequences of ZIRP. When you recall that the Fed has been and continues to be the chief cheerleader in Washington for OTC derivatives, the implications for the global economy are truly mind boggling.

But Los Angeles is starting to consider taking more aggressive moves, and that may embolden other government bodies to act:

Los Angeles is thinking about moving billions of dollars in municipal deposits as well as nearly $30 billion in pension assets away from the largest banks in order to redress the perceived wrongdoing by BK and other large banks. You can probably guess that the City of Los Angeles will be using…

But at IRA we believe that it is better to get even than to get mad, especially when there are billions of dollars in public funds at stake. This is why we have begun to assist public sector agencies in negotiating the repudiation of OTC derivatives positions that are causing unanticipated losses to customers like the City of Los Angeles. The message to the OTC derivatives dealers is simple: Take back the deceptive, unfair and misleading OTC contract or else the public sector client will pursues any and all options. Remember that defrauding a state agency is a felony in most jurisdictions.

This could get interesting, and for a change, in a good way….

Originally published at Naked Capitalism and reproduced here with the author’s permission.

One Response to "Morgenson on Municipalities’ Swap Fiascoes"

  1. rc whalen   March 7, 2010 at 4:22 pm

    The term that none of the proponents of OTC swaps and critics of Ms Morgenson want to hear is “suitability.” It is a legal term that applies to both retail and institutional customers. OTC derivatives are not “suitable” for most Buy Side customers. I know this because we have helped two clients walk away from OTC interest rate swaps by speaking this powerful word through counsel. Now why would some of the largest banks in the world allow our clients to walk away from these “sacred” contracts, to paraphrase Tim Geithner, if there was no problem?Trust me, this party is just getting started.