How Wall Street Fraudsters Plunder Public Finances, And How to Fight Back

13 September 2013 by Alexander Arapoglou , Jerri-Lynn Scofield

Yves here. This article, part of an ongoing AlterNet series, ‘The Age of Fraud,’ edited by Lynn Stuart Parramore, does the difficult and important feat of unpacking a financial structure that blew up a lot of municipalities in layperson-friendly terms. It also proposes some sound reform ideas. Circulate to friends and colleagues, particularly in communities that have been on the losing end of bad Wall Street deals.

One thing it weighs light on, due to space limitations, is what a cesspool municipal finance has long been. Not are there too often formal and informal kickbacks, but even among the better-indended officials, it’s way too easy for them to be snookered. They lack the expertise to evaluate fancy financial products. They too often fall prey to consultants, whose expertise they can’t readily assess, and their incentives are to recommend complex products. Who would pay a consultant a big fee to say, “Forget about these complex structures, any price savings mean you are eating a lot of hidden risk. Just finance a ten year project with a ten year fixed rate bond”?

By Alexander Arapoglou, professor of finance at the University of North Carolina’s Kenan-Flagler Business School, and a former derivatives Derivatives A family of financial products that includes mainly options, futures, swaps and their combinations, all related to other assets (shares, bonds, raw materials and commodities, interest rates, indices, etc.) from which they are by nature inseparable—options on shares, futures contracts on an index, etc. Their value depends on and is derived from (thus the name) that of these other assets. There are derivatives involving a firm commitment (currency futures, interest-rate or exchange swaps) and derivatives involving a conditional commitment (options, warrants, etc.). trader and head of risk management worldwide and Jerri-Lynn Scofield, who has worked as a securities lawyer and a derivatives trader.

Say your town needs a new bridge. It might turn to Wall Street to come up with strategies to finance the project. This is supposed to be a win-win arrangement, but in the lucrative municipal finance business, one side has turned out to be the big loser. Guess which?

Nearly five years after Wall Street’s shady activities triggered massive funding crises for cities, states, and municipalities, the $3.7 trillion municipal finance cesspool has yet to be dredged. Banks continue to profit Profit The positive gain yielded from a company’s activity. Net profit is profit after tax. Distributable profit is the part of the net profit which can be distributed to the shareholders. from their bad — or even fraudulent — advice that cost billions of dollars of taxpayer money. Meanwhile, the rest of us must tighten our belts, or pay higher taxes, or see services slide.

Let’s take a look at how bankers cooked up scams to drain the public coffers and why they continue to get away with it.

How Your Community Became Wall Street Prey

Many municipalities invested in flawed “structured finance” deals on the advice of bankers who said these complex transactions would give them a better deal than simpler, traditional products. So trusting public finance officials lined up to follow their advice — only to be told later that advice was not to be relied upon.

Tellingly, few (if any) corporations used similar structures to meet their funding needs. Nor did the banks themselves. Unfortunately, these products didn’t work as advertised, and public funding costs exploded as a result.

The financial structures bankers inflicted on the public are not easy to understand, but please try and stick with us: Banks rely on this complexity to obscure just how badly cities and states that followed their advice were hosed.

One common structure combined three key pieces: variable rate demand bonds (VRDBs), letters of credit and interest Interest An amount paid in remuneration of an investment or received by a lender. Interest is calculated on the amount of the capital invested or borrowed, the duration of the operation and the rate that has been set. rate swaps. Municipal treasurers were looking to achieve the equivalent of a fixed rate financing— think of a 30-year mortgage Mortgage A loan made against property collateral. There are two sorts of mortgages:
1) the most common form where the property that the loan is used to purchase is used as the collateral;
2) a broader use of property to guarantee any loan: it is sufficient that the borrower possesses and engages the property as collateral.
—at lower than the market rate. And they signed on the dotted line in record numbers for these deals, with issuances of these complex bonds peaking in 2008.

Bankers realized that many professional investors — such as money market Money market A short-term market where banks, insurance companies, corporations and States (via the central banks and Treasuries) lend and borrow funds according to their needs. fund managers — cannot hold long-term debt, and instead prefer investments that can be dumped quickly when market conditions change. So bankers created VRDBs, which were “putable”— allowing buyers to get their money back, in most cases, every week, if they chose. Bankers thought these bonds, which in effect came with a money-back guarantee, would appeal to money market fund investors. At first, they did.

Alas, there’s no such thing as a free lunch. A bond Bond A bond is a stake in a debt issued by a company or governmental body. The holder of the bond, the creditor, is entitled to interest and reimbursement of the principal. If the company is listed, the holder can also sell the bond on a stock-exchange. that can be returned, with no penalty charges, every week doesn’t sound at all like the long-term infrastructure financing the city or state wanted. So banks promised municipal clients that if investors wanted to return bonds, the bank would find another buyer. Sounds like it might work out okay, right?

But what would happen if no one wanted to buy these returned bonds? To avoid leaving its municipal client and investors in a lurch, the bank created a guarantee, a letter of credit, that would provide alternative financing. Think of this letter of credit as insurance that would allow the city or state to continue to pay its bills if the market for its bonds dried up, while providing assurance to bond investors that the bond could be redeemed on demand.

The final piece of the structured contraption was a complex derivative, an interest rate swap. It was supposed to convert the weekly variable interest rate on the bonds to a fixed interest rate. This was another form of insurance that was meant to protect the public authority if interest rates Interest rates When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…

The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation.
went up.

Public finance officials were usually —and fraudulently — told they were getting interest rate swaps at zero cost, and unsurprisingly saw no point in shopping around and comparing terms. In fact, despite what they said, many bankers were ripping off their clients, substantially overcharging them for the swaps included in these defective transactions.

Bottom line: cities and states issued these special bonds, the banks agreed to remarket the bonds if necessary, and these municipal issuers purchased not one, but two types of insurance, at highly inflated costs, to protect themselves from different types of market fluctuations.

Breaking the Basic Laws of Finance

These structures violated a basic law of finance. The municipalities failed to match long-term borrowing with their long-term investments in infrastructure and other obligations. Instead they financed these long-term commitments with short-term borrowings that needed to be indefinitely refunded, week after week, often for as long as 20 years or more. All of the structures put in place to protect the borrowers — the letters of credit, the interest rate swaps — failed when put to the test by the financial crisis.

How? Banks marketed the VRDBs, based upon the credit quality of the banks issuing the letters of credit. When Lehman collapsed in September 2008, investors shunned bank credit. Cities and states found that many investors wanted to dump their VRDBs, and virtually no one wanted to buy them. Big problem, since cities and states still had to pay their bills. So many of them now had to go to plan B and draw on their letters of credit for necessary financing.

Banks Get Rewarded for Failure

The cities and states got a nasty surprise, and found themselves paying penalty interest rates to their bankers not because they’d done anything wrong, but because bank credit ratings had plummeted! Usually, the purpose for including a penalty rate in a standard letter of credit is to protect creditors from a borrower’s shortcomings. Here, cities and states were forced to pay a penalty rate for their bank’s shortcomings. Rather than being penalized for the failures and unsafe banking practices that caused the financial crisis and led bank credit ratings to nosedive, banks were instead rewarded with higher interest payments— a windfall. Needless to say, the cities and states had nothing to do with boneheaded banking moves.

So much for the protection they thought they’d bought. Instead, they ended up with the equivalent of an insurance policy that requires you to pay someone else when your house burns down. And this peculiar policy leaves you still on the hook for the costs of rebuilding your house.

And what about the second form of insurance, those interest rate swaps? Once again, despite paying more than top dollar, cities and states also didn’t get what they paid for. Wait a minute, you might ask. They couldn’t sell their bonds, and the only reason for having the swaps was to offset interest rate risk from selling bonds. So, no bonds, no need for swaps, right? Wrong. The terms of these deals required continued payment to the banks for these swaps, even though the underlying reason for buying them had vanished. This is a bit like forcing you to continue to pay a hefty homeowner’s insurance premium for years after your house has already burned down.

It gets worse. Not only were the swaps unnecessary, but also the payments cities and states were making on those swaps put them in the red— despite what they’d been promised. The banks, being on the other side of these swaps, were earning money from their positions — and so they were in no hurry to make things right.

Getting a handle on the total costs of these deals to taxpayers—and the offsetting profits to banks — is difficult. But research shows that a subset of these swaps alone costs taxpayers more than $2.5 billion per year.

Unlike China, the U.S. doesn’t execute fraudsters. But if a contractor builds a defective bridge, and it collapses, the city or state that commissioned the project can sue for damages. In extreme cases, criminal charges follow. Bankers follow different rules: When the financial gizmos they designed blew up, they didn’t make good. Instead, they insisted on holding onto the windfalls while blaming the victims for accepting the bank’s bad advice.

No Recovery in Sight

Very little’s been done to get this money back. Elected state and municipal financial officers certainly don’t want to level with constituents about just how badly they were hornswoggled by bank derivatives sales teams. An even bigger problem is our corrupt campaign finance system. National political parties control large war chests necessary for governors and other state officials to run successful state political campaigns. Much of these campaign funds come from financial institutions. You do the math.

If bankers had cheated their private company clients so badly, you can bet that these companies would be demanding their day in court. Notably, some foreign municipal borrowers, such as the city of Milan, Italy, have not been shy about entering courtrooms, and in December, won a major legal judgment against four banks, for aggravated fraud for mis-selling an interest rate swap.

But in the U.S., both political parties seem willing to let these claims go — sweeping them under the rug or settling for pennies on the dollar. Further, public officials haven’t exploited the considerable leverage Leverage This is the ratio between funds borrowed for investment and the personal funds or equity that backs them up. A company may have borrowed much more than its capitalized value, in which case it is said to be ’highly leveraged’. The more highly a company is leveraged, the higher the risk associated with lending to the company; but higher also are the possible profits that it may realise as compared with its own value. they have to award or withhold lucrative new municipal business in order to force Wall Street to give taxpayers a break and refinance these deals, as Gretchen Morgenson of the New York Times has recognized.

Regulation: Why it’s Failed and Why it Matters

The structured finance fiasco we’ve outlined is only one drop in the cesspool of municipal finance. Congress has exempted municipal bonds from most major provisions of the federal securities laws that corporations must follow. So, as the SEC admitted in a July 2012 report: “[investors] in municipal securities are often not afforded access to the types of timely and accurate information available to investors in other securities.”

Since the financial crisis broke and as cities and states struggle to pay their bills, Congress and the major regulators have done little to clean up the mess. This is a big problem, because bankers are not stupid. They know that banks have largely paid, at most, token penalties for structuring defective municipal deals, and have in fact, made more money on these bad deals than they would have on simpler deals that didn’t misfire. So what do you think they’ll do, going forward? Clean up their act, and serve the best needs of their clients? Or continue to do whatever they think they can get away with to make the most money, whether or not it suits the needs of their public clients (and taxpayers), chanting caveat emptor under their breath.

Five Fixes: How to Prevent History from Repeating Itself

Existing municipal bond regulation currently focuses on purchasers of these bonds, and financial firms who underwrite, structure, and market such securities. By design, there’s almost no attention to the municipal issuers themselves, and especially, to how Wall Street firms played these cities, states, and other public issuers. That’s where the source of the 2008 municipal finance crisis lies, and where the regulatory spotlight should shine.

Here are five suggestions for reform, which won’t solve all problems, but can serve as first steps to stop Wall Street from making off with more taxpayers’ money.

1. Increase penalties for financial fraud: Congress and the Obama administration have shown little appetite for tackling this problem. States and some cities, however, have their own independent tools for dealing with financial fraud schemes, particularly those that affect their own financings. New York, for example, has its Martin Act, a broad anti-fraud statute that predates federal securities laws and allows the state to aggressively pursue financial frauds. Similarly, California can use its business practices statute to pursue similar ends. Other states have their own remedies. States and cities now should go even further to take the lead in either imposing new penalties, or increasing existing ones, for defrauding them.

2. Adopt explicit derivatives suitability standards: The self-regulatory Municipal Securities Rulemaking Board is currently working on revising standards for what types of municipal securities or municipal structured products investors may purchase. In a largely unregulated market, this is a good idea.

But investor suitability requirements are only the tip of the iceberg. The real issue is suitability standards for the issuing cities and states themselves, particularly for derivatives and structured financial products. We need to ask what types of products are suitable for Wall Street to sell to meet public financing needs.

Currently, deals are conducted according to the fiction that they’re arms-length transactions between equal partners. But that’s far from the case, and banks should understand that they’ll in future be held to a clear set of explicit suitability standards for their sales of derivatives and other structured financial products. Billions of dollars of structured transactions blew up in 2008: How many times must we rerun the same playbook?

3. Empower lawyers to be bounty hunters: Over the last two decades, the combination of a business-friendly Supreme Court and various state and federal legal “reforms” have made it much harder for plaintiffs to win lawsuits. Nonetheless, states, and even cities and municipalities could empower more private lawyers to act as bounty hunters and pursue municipal finance fraud claims on their behalf.

This has worked in the past: The 1998 Tobacco Master Settlement Agreement came about because some state attorneys general enlisted the services of prominent trial lawyers in targeting tobacco companies. That policy was by no means unique: States often farm out litigation to private lawyers. These policies could be expanded at minimal upfront costs, by hiring trial lawyers on a contingency basis, so they’d get a percentage of any money they recover, rather than an hourly fee. Such an arrangement costs the public nothing if the trial lawyers lose lawsuits, and has a huge potential upside if they win. Compare how we regulated and treated tobacco companies, say in the late 1980s, and how we do so now, and imagine what private lawyers might do if we took the leashes off and set them on the trail of municipal finance fraud.

4. Fix arbitration’s pro-banking bias: Wall Street usually tries to get parties to sign agreements to settle potential disputes by arbitration, rather than giving an injured party her day in court. Unsurprisingly, banks have rigged the process to suit their needs. Parties to the arbitration get to select their arbitrators, and this tends to help banks, since they’re repeat customers. Unlike public court proceedings, arbitration procedures aren’t transparent. Decisions aren’t made public, and the supporting reasoning isn’t available to serve as guidance, or precedent, for similar controversies.

Working together, states and cities could use their power to change the standards that apply to the arbitration agreements they sign, making selection of arbitrators fairer, increasing transparency, and publishing decisions, to serve as guidance for future settlements.

5. Make pay more competitive: Competent finance professionals lose out financially, big-time, by pursuing a career in public finance. And the lure of a possible future lucrative private sector job leads many public servants to avoid getting a reputation for rocking the boat.

For cities and states to attract top financial talent, and avoid succumbing to Wall Street snake-oil salesman, they must address this disparity in financial firepower. Here, we can learn from other countries: Singapore combines a tough legal code with high pay for regulators, and gets less corruption and better regulation in return. By contrast, in the U.S., the highest-paid state employee is usually the state university’s head football or basketball coach. States may be broke, but if they can find money to pay the football coach, they should be able to pay what’s necessary to hire people with sufficient financial expertise to prevent taxpayers from being ripped off.

Conclusion: Wall Street sold its municipal clients the financial equivalent of multiple bridges that collapsed. Since Congress and the Obama financial regulators are MIA on cleaning up this mess, it’s now up to states, cities, and municipalities to adopt some obvious fixes to make it harder for Wall Street to bamboozle them — and us, the taxpayers.



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