There
are 7 stages to executing a successful sting operation. Whether this is the
modus operandi behind the Sultans of Swap operating in the $605 Trillion OTC
Derivatives market or just simple coincidence, I will leave it to you shrewd
reader to determine. The seven stages do however offer us an
instructive theater guide to better understand these murky instruments called
Interest Rate Swaps.
Act I
can be found at: SULTANS
OF SWAP: Smoking Guns!
Act II can be found at: SULTANS
OF SWAP: The Sting!
In Act
II of our fictional play before we broke for Intermission, we saw the
mechanics of how our Sting might be perpetrated. We saw how our PATSIES were
“Fearing the Gearing” and being
forced to rewrite their existing SWAP contracts with horrendous fees and
collateral requirements. This is money that the public purse didn’t
budget for and has no hope of raising. What will our PATSIES do now? They
have little choice -either pay the shylock’s usury fees or sue!
Once again our audience was witness to some strange happening when the lights
came up during the intermission.
Like a
wave, the news of angry PATSIES taking their grievances to the courts surged
all along the global shorelines. Let’s take a quick world tour to see
the carnage showing up in the court rooms.
SMOKING
GUNS & FOILED GETAWAYS
EUROPE
CITY
OF MILAN, ITALY
ONE of
the great advantages of financial innovation, it was often said, was that
risk would end up going to those best qualified to hold it. In fact, much of
it seems to have ended up in the hands of those least able to understand it.
How some of it got there may soon be revealed in an Italian court.
On
March 17th four big banks, 11 bankers and two former city officials were
charged with fraud in connection with the sale of interest-rate derivatives
to the city of Milan. The trial is due to start in May. The prosecution relates
to a huge bet on interest rates that the four banks—UBS, JPMorgan
Chase, Deutsche Bank and Hypo Real Estate’s DEPFA unit—helped the
city authorities to take in 2005. The banks helped arrange the sale of
€1.7 billion ($2.3 billion) of bonds for the city and then also helped
it swap the fixed interest rate it was paying on the bonds for a lower,
floating rate. Part of the contract is thought to have involved a
“collar”, a way of limiting the range of outcomes on a bet, which
protected Milan from rising rates but which also meant it would have to pay
out if they fell.
The
city claims that it was originally promised interest savings of about
€60m on the deal but has now made big losses because interest rates
have fallen, triggering payments to the banks. Bankers with knowledge of the
transaction claim that, in fact, the city has benefited from offsetting gains
as the interest rate it pays on the underlying debt has fallen too. The
prosecution also claims that the banks charged more than €100m in fees that
were built into the price of the swaps and were not properly disclosed to
city officials. The banks all deny any wrongdoing.
The
outcome of the case will be closely watched elsewhere. In Italy alone, local
municipalities had derivatives exposures with a face value of €25
billion last year, according to the Bank of Italy. Some academics reckon that
losses on these may go as high as €8 billion. In many of these cases
local authorities swapped fixed rates for floating ones, only for collars
incorporated into the deals to leave them with losses as interest rates fell.
In other cases, losses may only start to show when rates move the other way.
Had their bets paid off, however, it seems unlikely that any cities would be
crying foul. (1)
CITY
OF LEIPZIG, GERMANY
In Germany
scores of public authorities signed contracts that they seem not to have
understood. In Leipzig the courts have been asked to rule in a dispute
between the city and UBS. That case relates to a complex sale-and-leaseback
agreement that the city signed for its local waterworks. Part of the deal
reportedly entailed the city
agreeing to insure a portfolio of loans against default through a
collateralised-debt obligation (CDO). Making good on those loans may bankrupt
the city.
In all, about
100 German local authorities are thought to have entered into
sale-and-leaseback agreements with American investors over
the past decade in a bid to take advantage of loopholes in tax laws. In many
of these deals local
municipalities unwittingly agreed to take on credit risks for various
counterparties, exposing them to demands for collateral as the ratings of
institutions such as AIG, an American insurer, fell. (1)
USA
We started in Act I with Interest Rate Swaps in Greece. In Act II we
broadened our discussion to the EU and touched briefly on the US. Now we see
the following in the US.
HUNDREDS
OF US MUNICIPALITIES
“Hundreds
of U.S. municipalities are losing money on interest-rate bets they made
during the bull market in hopes of protecting themselves from higher rates.
The deals backfired when rates fell, shriveling the sums paid to
municipalities. Now some are criticizing Wall Street and trying to exit the
contracts. .. Government agencies that saw the transactions as a cushion against
fiscal surprises now are being squeezed by the arrangements. The supply of
municipal derivatives swelled to more than $500 billion before falling in the
past two years, estimates Matt Fabian, managing director at research firm
Municipal Market Advisors. Moody's Investors Service says the surge was
fueled by Wall Street marketing efforts, demand from state and local
governments and "relatively permissive" statutes on the use of
swaps in Pennsylvania and Tennessee, both of which are taking steps to tighten
rules.
Many
of the deals generated higher fees for securities firms than traditional
fixed-rate debt. Government officials, for their part, entered the deals in
hopes of reducing borrowing costs. The swaps were introduced in many cases
along with floating-rate debt that municipalities issued because it was
cheaper than traditional fixed-rate debt. Lower interest rates have served
them well on this; their borrowing got cheaper.
But
municipalities also added swaps to the mix, promising to pay a fixed rate to
banks, often 3% or more, while receiving payments from banks that vary with
interest rates. On the swaps, the municipalities generally have been losers,
as the interest that banks have to pay them have often fallen below 0.5%.
Government budgets are stretched thin, prompting officials to look for
dollars wherever they can. The clashes over the swaps come amid growing
scrutiny of the municipal-bond market, where the U.S. government is
investigating whether there was bid rigging in certain cases.” (7)
CHICAGO,
DENVER, KANSAS CITY, PHILADELPHIA, MASSACHUSETTS, NEW JERSEY, NEW YORK &
OREGON
“The
Service Employees International Union said Chicago, Denver, Kansas City,
Philadelphia, Massachusetts, New Jersey, New York and Oregon all are in the
hole on swaps agreements they made with financial firms. The required
payments range from a few million dollars to more than $100 million a year,
the union said. Such deals are deepening the misery faced by state and
local governments throughout the U.S., already facing their worst financial
squeeze in decades because of shrinking tax revenue and stubbornly high
pensions and other costs.”(7)
Study by the Service Employees International Union –
Detailed Spreadsheet List,
The
“Stop the Swaps” Campaign by the Service Employees International
Union (SEIU) (15)
Watch
VIDEO: WSJ Takes On
Interest Rate Swaps
PENNSYLVANIA
In
Pennsylvania, 107 school districts entered into interest-rate swap agreements
from October 2003 to last June. At least three have terminated them. Under
one deal, the Bethlehem, Pa., school district had to pay $12.3 million to
terminate a swap with J.P Morgan Chase & Co., according to state auditor
general Jack Wagner. J.P. Morgan declined to comment. State lawmakers have
proposed restrictions on municipalities' ability to use swaps. "It's
gambling with the public's money," Mr. Wagner said. "Elected
officials are simply no match for the investment banker that's selling the
deal." (7)
While
the investigation focused on the Bethlehem Area School District, Wagner
called his report a “case study” of the use of swaps by all local
governments in Pennsylvania. The Department of Community and Economic
Development’s records indicate that 626 swap filings were made in Pennsylvania between
October 2003 and June 2009, which related to $14.9 billion in debt.
The precise number of different swaps and the precise amount of debt cannot
be determined because the DCED data may include some double-counting. During
this time period, 107 of Pennsylvania’s 500 school districts, or 21.4
percent, and 86 other local governments reported to DCED that they entered
into swap agreements. At least 13 investment firms, including Citibank,
Goldman Sachs, J.P. Morgan, and Morgan Stanley, have entered into swap
agreements with Pennsylvania school districts and other local governments.
(8)
CITY
OF LOS ANGELES
Municipalities
in America are also grappling with derivative contracts they barely
understand. The city of Los Angeles is pressing Bank of New York Mellon to
soften the terms of an interest-rate swap on $443m of bonds that is costing
the city money because rates fell. (1)
The
Los Angeles city council approved a measure this month instructing city
officials to try to renegotiate an interest-rate deal with Bank of New York Mellon Corp. and
Belgian-French bank Dexia SA. The pact, reached in 2006 to help
fund the city's wastewater system, currently is costing the city about $20
million a year. The banks declined to say how they would respond to a request
to renegotiate.(7)
JEFFERSON
COUNTY, ALABAMA
Jefferson
County in Alabama is
teetering on the edge of bankruptcy after it entered into swaps that were
worth more than $5.4 billion at their peak. (1)
“Jefferson
County in Alabama is on the brink of bankruptcy after sinking 100 percent of
its $5 million sewer system financing into swaps. JP Morgan and CDR were also
involved there.”(3)
NEW
MEXICO
They were
touted as a state-of-the-art financing tool that would help New Mexico
stretch its highway improvement dollars. Nearly five years later, state
officials are trying to keep the $420 million in fancy financing from turning
sour. In the last six months, one of the banks involved in the so-called
interest rate swaps has gone bankrupt and the state has had to post about $16
million in collateral because the value of the investments dropped. That's in
addition to major political fallout. The swaps and how a California company
was selected to handle them are at the center of a federal grand jury
investigation that derailed Gov. Bill Richardson's nomination as commerce
secretary. (2)(3)
OAKLAND,
CA
Escaping
isn't cheap or easy. Under a transaction between Oakland, Calif., and a Goldman Sachs Group-backed venture,
Goldman paid the city $15 million in 1997 and $6 million in 2003, according
to Oakland financial reports. But now, the city stands to lose about $5
million this year. That money "is coming out of taxpayers' pockets
and could be used for other things," said Rebecca Kaplan, a city council
member. She wants the city to renegotiate. But the city faces a $19 million
termination payment. Oakland officials didn't respond to requests for
comment. (7)
SAN
FRANSICO BAY AREA TOLL AUTHORITY
Last
August, a unit of bond insurer Ambac Financial Group sued the Bay
Area Toll Authority for payments it said it was owed under various swap
agreements. The authority paid Ambac $104.6 million to terminate the swaps
after the insurer's credit ratings were downgraded and bonds associated with
the swaps were retired. Ambac claims it is owed $156.6 million under the
agreements. The toll authority, which is fighting the claim, said it
made the payment, and Ambac sued for the other part of what it says it is
owed. An Ambac lawyer couldn't be reached for comment.(7)
RICHMOND,
CA
Richmond,
Calif., is expected to restructure a $65 million agreement with Royal Bank of Canada that could cost
the struggling city an estimated $3.5 million a year, based on current
interest rates. Under the revised deal, Richmond would make smaller, more
regular payments to the bank over time. In November, RBC and city officials
rejiggered a separate transaction that would have cost Richmond about $2.5
million. An RBC spokesman said bank officials are working with the city to
"restructure the underlying bonds in a way that best serves the city's
interests and those of its residents." The "goal of the original
transaction was to lower borrowing costs for the city," the bank spokesman
said, adding that the bonds didn't perform s anticipated because of
downgrades at bond insurers that backed them. Richmond's vice mayor, Jeff
Ritterman, said he still is reviewing next month's proposed restructuring.
Financial woes have forced Richmond to cut its budget and lay off employees.
(7)
NEW
YORK STATE
New
York State provides a good example. An Oct. 30, 2009, filing describing its
swaps shows that for the most recent fiscal year, April 2008 to March 2009,
the state paid $103 million to terminate roughly $2 billion worth of swaps --
more than a quarter of which resulted from the Lehman bankruptcy in September
2008. (2)(5)
COLORADO
– DENVER TEACHERS’ PENSION
DPS
(Denver Public Schools) entered into negotiations with JP Morgan and
CitiGroup, agreeing to issue fixed-rate bonds secured by DPS school buildings
and other properties. DPS then began discussion to enter into an
interest-rate swap agreement with JP Morgan, Bank of America and the Royal
Bank of Canada. We believe that following ensued: DPS entered into a swap
transaction, believing that interest rates would stay high. As recent
financial news tells us, interest rates fell. We are concerned that this may
have translated to a loss of taxpayer dollars. (2)
EIGHT
CALIFORNIA MUNICIPALITIES
Eight
California municipalities, including Los Angeles, Fresno and San Diego
County, filed civil class-action, or group lawsuits. The suits, most of which
were consolidated with others in U.S. District Court in New York City, allege
that banks colluded by deliberately losing bids in exchange for winning one
in the future, providing so-called courtesy bids, secretly compensating
losing bidders and allowing banks to see other bids.
Brokers
participated in the collusion by facilitating communication among banks and
sharing in illegal profits, the civil class-action suits allege. (2)(4)
…
And on and on. Get the message?
After
a long Intermission, let us get back to the conclusion of our play.
ACT
III – THE GET AWAY
The
third act is the unraveling of the plot. The characters involved in the heist
will be turned against one another or one of the characters will have made
arrangements with some outside party, who will interfere. Normally, most of
or all the characters involved in the heist will end up dead, captured by the
law, or without any of the loot; however, it is becoming increasingly common
for the conspirators to be successful, particularly if the target is
portrayed as being of low moral standing, such as casinos, corrupt
organisations or individuals, or fellow criminals.
Act
III begins with all our actors on stage. The PATSIES are scared. They finally
understand their Interest Rate Swap and realize what they or the political
predecessor had agreed to. Do they take the Greek option and come clean
by blaming it all on the previous government? To most this is not an option.
Needing help, they have assembled all the actors to give them advice.
What
the endless list of legal proceedings above tells us is:
1-
Swaps have permeated into every facet of local, municipal, city and state
governments.
2- Swaps are a major financial instrument being used broadly in debtor nations
and governments.
3- When the PATSIES find themselves in the gears they more often than not
sue. They plead ignorance, not too dissimilar to US homeowners who expected
to make a killing on their overleveraged McMansion. All are turning out to be
very messy Getaways.
What
should be readily apparent to the shrewd observer is that the biggest debtor
in the world, with the least means of paying and an international reputation
for devious behavior, is missing. Where is Uncle Sam in all this?
Prima
Facie says Uncle Sam must have participated in some minor fashion.
We are
going to try something different in our play. For those who have seen Avatar
in the cinema, you will recall you were given special glasses so you could
view the show in 3D and therefore get the full impact of the presentation. We
are going to do the same thing but with a modern day “internet”
twist so you see the reality of all this.
I
invite you to click the following link – read the complaint – (at least the yellow highlighted
section) – then hit the back button on your browser before
we continue. Ready? CLICK
[NOTE:
FOR LEGAL REASONS THE COMPLAINT CAN
NOT BE VIEWED ANY PLACE OTHER THAN VIA THIS LINK]
COMPLAINT
If
this doesn’t sit you up straight then you need to check for a pulse!
I am
sorry dear reader, the getaway has already happened! The masked getaway
happened New Year’s Eve while we were all preparing to party. I believe
ladies and gentlemen you have just witnessed a near perfect getaway! To me,
the most probable justification for such an unprecedented action would be a
collateral call on US government obligations of historic proportions.
There are of course other possibilities.
Just
in case some of our readers don’t yet realize the significance of what
happened, I can assure you that you will. Everyone will eventually pay
through our servitude with higher taxes, reduced entitlement programs and a
much lower standard of living for years to come, if the facts in this
complaint are valid.
OCCAM’S
RAZOR
I am not a conspiracy buff. I believe in Occam’s Razor. The simplest
answer is likely the answer and not to assign suspicions to more complicated
possibilities or sinister people. In my opinion, what is going on here is not
conspiracy but rather just plain stupidity sprinkled heavily with greed,
unintended consequences, moral hazard, hubris and the remnants of the
Greenspan PUT.
Sure
there are plots and strategies, but they will be noise when the $605T in
derivatives start to unwind. Yes, $605T has a $3.7T net credit exposure but
there are $36T CDS (Credit Default Swaps) that must be paid and not one
person has accrued a cent for that payout. Everyone expects to be ‘out
of town’ by that time! Everyone has their eye on the exit without
trying to draw too much attention. It is still former Citigroup CEO Chuck
Princes’ lament: “as
long as the music is playing, you’ve got to get up and dance!”.
I AM
ACCUSING NO ONE OF ANY CRIMES. How can I be
accusatory in what is predominately a completely unregulated, non-exchange
traded, off-shore, off-balance sheet, modern day wild west? What laws other
than contract and tax laws? All the Sultans of Swaps are likely acting
according to the letter of the few domestic laws applicable and in the manner
carefully crafted by their legions of highly paid litigators. Even if effective
legislation existed, there will still be examples of wayward behavior when
the amounts of money involved are in the 100’s of millions and
billions. Unethical and illegal behavior unfortunately should be fully
expected. This is why laws must be comprehensive, unambiguous and harshly
enforced. Former Fed Chairman Greenspan’s ‘laissez
–faire’ philosophy was nothing short of naïve
irresponsibility that has resulted in the global financial system being
placed in a criminally tenuous position!
The
actors in my estimation who are most at fault in our play are the sleepy eyed
DIRECTORS and specifically the House of Representatives Finance Committee
– chaired by Barney Frank and the US Senate Banking Committee –
chaired by Christopher Dodd. If you are looking to assign responsibility for
this mess, it begins and ends there.
The
Sultans of Swap have proven that capitalism works brilliantly! In the US
Gilded Age of Robbers Barons, capitalism also worked magnificently. Our great
grandfathers understood rampant greed first hand and knew that smart
legislation and regulatory enforcement were mandatory. They also knew guards
must always man the sentinels. We are coming up on two years since the
financial crisis erupted. What meaningful legislative bill (if any) has been
passed? If we are this slow arriving at the scene of the crime, how can we
possibly believe we can out run the crooks? We will always be ‘a dollar
short and pound light’ operating within the current legislative
framework.
Whistleblower
Harry Markopolos testified before the Madoff Congressional Hearings, that the
US legislative process and regulatory enforcement are seriously ill-equipped
to either understand the financial world we now operate in or stay abreast of
the breathtaking advances in structured finance. I don’t want to appear
cynical, but I see it as NASA level rocket scientists being supervised by
politicians who likely failed high school algebra. They don’t even know
what questions to ask. Unfortunately the people ALWAYS willing to help the
legislators with both the questions and answers are the Washington army of
paid lobbyists. Lobbyists, as we are all acutely aware, have never been
accused of having the public interest as their prime motivator. So who will
tell the emperor he has no clothes? Remember, it is ultimately our pockets
that are being picked.
GOVERNMENT
IS NO LONGER SERVING THE PEOPLE!
Some
would argue it is no longer a government for the people.
White
Collar crime has been interesting to watch over the last 10 years. I used to
have a filing tag entitled ‘malfeasants’. By 2005 it had become
such a large file I had to start breaking it down into sub categories. It was
very telling to me that something was seriously amiss morally.
I was
on the conference call when Jeff Skilling stepped down, Ken Lay took over
Enron and Andy Fastow explained that Enron’s problem was the
‘short crowd’. I heard the same ‘short seller’
refrain during Bear Stearns and Lehman just days before they both collapsed.
I heard it again earlier this month from the Greek Minister of Finance and
even Angela Merkel and Nicolas Sarkozy. It never changes. I have concluded it
takes two – an incompetent PATSY and someone with a STRATEGY.
I
remember Bernie Evers, the founder and CEO of the Wall Street darling stock,
WorldCom, weeping as he was led away in handcuffs while hearing all the
townspeople and church parishioners saying how honest he was. I recall Dennis
Kozlowski the CEO of Tyco, a beaten man and imprisoned man, watching his wife
desert him even after spending millions of Tyco shareholder money on an
exotic island birthday party for her. I watched Joseph Nacchio’s
meteoric rise after leaving ATT to lift Qwest to prominence only to be
sentenced to six years behind bars. The message is that none of these men
thought of themselves as criminals. They perceived themselves as tough minded
businessmen taking advantage of legal loopholes for competitive advantage,
with a business STRATEGY that the lawyers felt they could defend in court. It
was worth the business risk of being challenged and possibly receiving
inconsequential fines. It took irate public and panicked politicians to force
the penalties to match the impact of the crimes.
If you
notice, all these examples are from the dotcom bubble. I don’t recall
anyone being led away in handcuffs since the largest financial crisis in
modern times has occurred. The Sultans of Swap are ripe for the wrath of
public anger when real interest rates rise, taxes are increased, retirement
entitlement promises are slashed and shortages squeeze the life out of the
public in the years to come.
The
public in Iceland would have made Johnny Depp proud when they said ‘forget about it’
in a public referendum concerning Iceland’s debt. This was a monumental
stand that got little US media attention. We are hearing the Greek public say
NO! We are seeing US Tea Parties say NO. Scott Brown’s stunning
election in the bluest of blue states was the public saying NO! We are now
hearing the Service Employees International Union (SEIU) say NO!
What
does it mean to our Sultans of Swap? Their STRATEGY is built on certain
perceived TRUISMS:
1.
People pay their taxes; therefore Sovereign Debt is the Holy Grail
2. Economic growth may slow but is continuous and will outstrip the growth of
cumulative debt payments
3. Potential penalties for possible regulatory actions will be insignificant
compared to
the ‘Vig’ or the ‘Take’ or the
‘Sting’. It is worth the business risk.
All
of these ‘truisms’ for the first time in my lifetime now solicit
questions.
The
famous actor Lon Chaney starred in the 1914 film The Embezzler. The
silent era plot could have been our theater guide for this play. I felt it
was unfair to the vast majority of the Sultans who are simply providing
‘legally’ innovative solutions to fulfill their constituents' and
clients' addictions.
Embezzlement is the act of dishonestly
appropriating or secreting assets, usually financial in nature, by one or
more individuals to whom such assets have been entrusted.[1]
Wikipedia
Lon Chaney
Learn
more at the SULTAN SWAP SENTINEL
SOURCES
(1) 03-18-10 Cities in the casino - Municipalities and derivatives
The Economist
(2) 03-17-10 Banks Stealing From Colorado Teachers'
Pension The Huffington Post
(3) 01-25-09 State Bond Deal Losses its Luster
Albuquerque Journal
(4) 01-23-10 California Probes Muni Derivatives as Deficit Mounts
Bloomberg
(5) 03-05-10 The Swaps That Swallowed Your Town
New York Times Gretchen Morgenson
(6) 03-11-10 Banks win on Swaps while DPS loses courtesy of Bennet &
Boasberg? ColoradoPols.com
(7) 03-22-10 Interest-Rate Deals Sting Cities, States
Aaron Lucchetti, Wall Street Journal
(8) 11-08-09 Auditor General Calls on General Assembly to Ban Risky
“Swap” Contracts by Schools, Local Governments
(9) 03-12-08 High Finance Backfires on Alabama County
Wall Street Journal
(10) 11-13-09 Alabama
county sues JP Morgan over sewer bond debt Reuters
(11) 03-09-10 And Now Oakland Just Voted To Repudiate Interest-Rate Swaps With
Wall Street Business Insider
(12) 03-09-10 A Preview: California's Coming War On Banks And Pre-Crisis Swaps
Business Insider
(13) 03-09-10 A Preview: California's Coming War On Banks And Pre-Crisis Swaps
– Slide Set Business Insider
(14) 08-21-09 Ambac Suit a Long Shot; Lawyers, Swap Advisers Don't See a Win for
Insurer AllBusiness
(15) 03-09-10 Stop
the Swaps SEIU Blog
Gordon T. Long
Tipping
Points
Mr. Long is a former senior group
executive with IBM & Motorola, a principle in a high tech public start-up
and founder of a private venture capital fund. He is presently involved in
private equity placements internationally along with proprietary trading
involving the development & application of Chaos Theory and Mandelbrot
Generator algorithms.
Gordon T Long is not a
registered advisor and does not give investment advice. His comments are an
expression of opinion only and should not be construed in any manner
whatsoever as recommendations to buy or sell a stock, option, future, bond,
commodity or any other financial instrument at any time. While he believes
his statements to be true, they always depend on the reliability of his own
credible sources. Of course, he recommends that you consult with a qualified
investment advisor, one licensed by appropriate regulatory agencies in your
legal jurisdiction, before making any investment decisions, and barring that,
you are encouraged to confirm the facts on your own before making important
investment commitments.
© Copyright 2010 Gordon T Long. The information herein was
obtained from sources which Mr. Long believes reliable, but he does not
guarantee its accuracy. None of the information, advertisements, website
links, or any opinions expressed constitutes a solicitation of the purchase
or sale of any securities or commodities. Please note that Mr. Long may
already have invested or may from time to time invest in securities that are
recommended or otherwise covered on this website. Mr. Long does not intend to
disclose the extent of any current holdings or future transactions with
respect to any particular security. You should consider this possibility
before investing in any security based upon statements and information
contained in any report, post, comment or recommendation you receive from
him.
