Interest Rate Swaps Result in a $4 Billion Backfire

Wall Street firms convinced governments and nonprofits that they could lower interest rates on bonds sold for public projects such as roads, bridges, schools and other things. Unfortunately, that promise has resulted in payments of more than $4 billion in termination payments to the likes of Citigroup, J.P. Morgan Chase, Bank of America, American International Group, UBS, Morgan Keegan, Goldman Sachs and Wells Fargo, to name a few. The firms peddled financial derivatives known as interest rate swaps in the 1990’s to the entities betting they could lower the cost of borrowing. In an interest rate swap, two parties exchange payments on an agreed upon amount of principal. Most swaps required borrowers to issue long term securities with interest rates that changed every week or month. The borrowers would then exchange payments, making them pay a fixed rate to a bank or insurance company and receiving a variable rate in return. Often, borrowers got lump sums for entering into such agreements. This allowed government entities to pay a rate lower than what they would have if they had sold conventional fixed rate securities.

Borrowers from New York to California are now paying to get out of the agreements. In contrast to the subprime crisis, few taxpayers know anything about the cost of untangling the municipal swaps. Any disclosure of payments to Wall Street is well hidden in documents borrowers have to provide to investors when selling bonds. After the credit crisis, borrowers had to continue selling adjustable rate securities under the agreement and the payments made by Wall Street firms were no longer enough to cover the municipalities’ own debt costs. As is nearly always the case, the financial manipulations were a boon for Wall Street firms. While banks got paid to underwrite municipal bonds for projects, they were able to generate additional fees if the borrower used a swap with the transaction. Since the contracts were unregulated and privately negotiated, the profits to Wall Street were never disclosed.

In Jefferson County, Alabama $5.8 billion of swaps generated $120 million in fees for banks, with as much as $100 million more than it should have based on the prevailing rates, according to the SEC. The derivatives led to a $722 million settlement with J.P. Morgan in November 2009 after an SEC probe and the conviction of a county commissioner who referred business to bankers for under the table bribes. Even prestigious Ivy League schools were wrapped up in the swaps. Harvard University paid $500 million to end the swaps.

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