“Down Home” Derivatives: It’s Athens, Georgia Too, Not Just Greece
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07 June 2010.
07 June 2010.
By now, pretty much anyone reading this is aware of the destructive role played by derivatives – largely, although not exclusively purveyed by Goldman Sachs –
in creating the mess in Greece now rolling through Europe under the rubric of the “Euro debt crisis”.
What may be a bit more shocking is that these same sort of dubious government financial practices turn out to be just as “popular” WITHIN the US as well.
And what could be more prototypically American than the Southern state of Georgia,
where cosmopolitan Atlanta has spawned “mini-mansion” suburbs as far as the eye can see, while the rest of the state remains, well, a bit under-developed, as some might put it.
But in the wake of Black September 2008, it turns out that several municipalities in metropolitan Atlanta are also paying the price for their embrace of exotic, high-risk derivative securities —
to the tune of hundreds of millions of dollars, as this investigation by The Atlanta-Journal Constitution has found.
[N.B. By now, this article may be behind the “pay wall” of the newspaper, usually known as AJC – if so, our apologies … just part of the “cost of doing business” in this economediatic world 😉 .]
At least a dozen local governments and other institutions that used derivative deals called swaps to try to lower the cost of bond issues have ended up owing as much as $394 million in fees to the Wall Street investment banks that set up the deals, an AJC analysis of public debt documents shows.
That total includes at least $100 million in fees paid to firms such as Goldman Sachs, J.P. Morgan and UBS AG just to cancel the deals when they went sour.
The city of Atlanta was among the hardest hit by its use of swap schemes — complex, multi-party deals involving varying interest rates, cash payments and loan guarantees.
Atlanta shelled out about $86 million to cancel most of its derivative deals.
The city also still owes roughly $79 million on another soured swap deal, an obligation it hopes it can reduce in time.
Other local entities caught up in the swaps meltdown include the city of Marietta, Georgia State and Emory universities, and the Woodruff Arts Center.
The huge fees owed the banks came on top of millions of dollars paid to the firms to broker the original deals, which amounted to about $4 billion in financing.
Some of the borrowers have had to take on more debt and pay higher interest rates on new bonds to replace the problematic deals, boosting the costs of financing the bonds even further.
These hefty refinancings and fee payments occurred even as the city of Atlanta and other institutions were cutting budgets, laying off employees, reducing services and being downgraded by bond rating agencies because of budget shortfalls.
In each case, the higher costs will likely be passed on to taxpayers or the users of the various institutions, which include the city’s water system and airport, some area hospitals and other facilities.
Often, the details of the deals are buried in arcane bond documents.
The refinancings and payments over the past two years didn’t gain much notice in city council meetings,
and the huge fees involved in terminations and refinancings are often folded into the costs of the new loan deals.
The nearly $400 million in swaps fees uncovered by the AJC were found in just a sampling of local institutions.
It’s unclear just how much swaps may have cost public debt issuers here, or across the nation.
Some estimates put the total value of swaps and other interest-rate derivatives around the globe at more than $400 trillion.
“That is the one question that everyone is trying to answer,” said Bart Hildreth, a municipal finance expert at Georgia State University’s Andrew Young School of Policy Studies.
Informed of the AJC’s findings, John Sherman, president of the Fulton County Taxpayers Foundation, said: “There is no place for such risk in government.”
Sherman said several local development projects in recent years included both tax abatements and risky swap deals that are now adding to the strain on municipal budgets.
“I believe it falls under the same heading: throwing away taxpayer money when we can’t afford it,” he said.
For municipal borrowers, though, the complex deals carry more risk than the old-fashioned, fixed-interest bonds that once were used almost exclusively,
said David Nix, a bond and derivatives lawyer with Kutak Rock in Atlanta. The borrower “needs to understand what they’re getting into,” he said.
How did things turn out this way?
Municipal borrowers under pressure to cut costs and keep taxes in check were wooed by investment bankers and financial advisers who offered creative ways to tap cheaper sources of capital, say experts.
The swap deals involve cities and other borrowers who trade cash payments with investment banks while other parties provide financial guarantees and pricing information.
All parts of the deal have to function smoothly for them to work properly.
For Atlanta and other such borrowers, the deals went south when the economic meltdown began in 2008:
Investment bank Lehman Brothers, a party to many of the swap deals, crashed.
Credit markets that set key short-term interest rates froze up.
Interest rates dropped as the recession deepened, causing the swaps’ value to Wall Street firms to soar.
The impact on the bond-financing deals was significant:
Many municipal borrowers were forced to refinance their bonds – or face dramatically higher loan payments.
And the cost of terminating the deals rose, in some cases, by tens of millions of dollars.
All this occurred just as Atlanta and other entities were also cutting jobs and services to deal with growing budget deficits.
“It was the perfect storm,” said Carmen Pigler, a former investment banker who was hired as the city’s chief of debt and investments in 2009, after the troubled agreements had been inked.
“Everything that could go wrong did go wrong.”
To plug holes in its budget, Atlanta cut jobs and raised property taxes last year — even as it paid more than $58 million to terminate swaps on airport bonds.
About $98 million more in swap liabilities or swap termination fees are tied to the city’s water and sewer bonds, whose ratings are now just above junk status.
Georgia State University’s experience in swaps was typical.
It saw $58 million in debt balloon into more than $74 million after a swap-and-debt deal to purchase a downtown building went bad.
First the bonds’ insurer faltered, then the credit markets failed.
That forced J.P. Morgan to take over the bonds in 2008,
which in turn accelerated the university’s repayment schedule from 30 years to just five.
To meet its obligations, the school had to borrow almost $9 million from its GSU Foundation.
To get out of the deal, the university issued new bonds last year for more than $74 million.
The extra $16 million went to refinance the bonds, pay off the foundation and cover roughly $7 million in swap payments, termination fees, interest and underwriting costs.
Defenders of the soured deals say few could have predicted the magnitude of the financial crash that caused them to implode.
Also, they say, despite the huge termination and refinancing costs, some borrowers have managed to largely break even once earlier savings achieved from the agreements are counted.
Until the crisis hit, Atlanta was able to reduce the interest rate it paid on one airport bond by about 2.5 percent compared to a fixed-rate bond, said Pigler.
Still, said Georgia State’s Hildreth, many of the municipal borrowers likely didn’t fully understand the risks of the deals before signing on.
Meanwhile, say other critics, Wall Street bankers, bond lawyers and advisers often glossed over the risks while pushing the deals, which generated millions of dollars in fees for their firms.
“Swaps are inherently risky, and they are not to be entered into lightly or by the faint of heart,”
said Lee McElhannon, director of bond finance for the Georgia State Financing and Investment Commission,
which issues bonds for public universities and other state facilities.
The agency hasn’t done any swap deals, he said, because “you don’t want to gamble with the state taxpayers’ money.”
But plenty of other states, counties and other government units took that risk, sometimes with devastating results.
Alabama’s Jefferson County, where Birmingham is located, relied on swaps to lighten its debt load,
but it instead mushroomed during the financial crisis, almost bankrupting the county.
Convictions of dozens of county officials and other players followed, and the federal Securities and Exchange Commission fined J.P. Morgan in connection with the deal.
Georgia’s municipal and state borrowers were generally slower to embrace swaps and other financial derivatives, and none appear to be threatened with insolvency by deals that have gone bad.
Like other borrowers, Marietta got a first-hand lesson in the risk of swaps.
Sam Lady, Marietta’s finance director, said the city’s interest costs jumped about $75,000 a month when a $7 million swap deal with Morgan Stanley began to go sour in 2008.
“We saw that exposure and dealt with it accordingly,” said Lady, who wasn’t involved in the decision to set up the swap.
It cost Marietta about $2 million to pay the termination fees and to refinance into traditional fixed-rate bonds last year,
and the related bond debt jumped from $29 million to $31 million as a result, he said.
Over the long haul, he said, the city should save money through lower interest payments.
But, he added, if an investment banker proposed a swap agreement today, “I don’t think we would entertain [it].”
A city’s finances “are supposed to be conservative,” he said.
[With many thanks to RLS for pointing us in this direction. ]
David Caploe PhD
Editor in Chief
EconomyWatch.com
President / acalaha.com
