How Big Banks' Interest-Rate Schemes Bankrupt States
By Mike Elk
February 25, 2010 - 12:04pm ET
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.
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