"Far from reducing risk, derivatives
increase risk, often with catastrophic
results." - Derivatives expert Satyajit Das,
Extreme Money (2011)
The "toxic
culture of greed" on Wall Street was highlighted
again last week, when Greg Smith went public with
his resignation from Goldman Sachs in a scathing
oped published in the New York Times. In other
recent eyebrow-raisers, London Interbank Offered
Rates (or LIBOR) - the benchmark interest rates
involved in interest rate swaps - were shown to be
manipulated by the banks that would have to pay
up; and the objectivity of the International
Swaps and Derivatives
Association was called into question, when a 50%
haircut for creditors was not declared a "default"
requiring counterparties to pay on credit default
swaps on Greek sovereign debt.
Interest
rate swaps are less often in the news than credit
default swaps, but they are far more important in
terms of revenue, composing fully 82% of the
derivatives trade. In February, JP Morgan Chase
revealed that it had cleared US$1.4 billion in
revenue on trading interest rate swaps in 2011,
making them one of the bank's biggest sources of
profit. According to the Bank for International
Settlements:
[I]nterest rate swaps are the
largest component of the global OTC derivative
market. The notional amount outstanding as of
June 2009 in OTC [over-the-counter] interest
rate swaps was $342 trillion, up from $310
trillion in Dec 2007. The gross market value was
$13.9 trillion in June 2009, up from $6.2
trillion in Dec 2007.
For more than a
decade, banks and insurance companies convinced
local governments, hospitals, universities and
other non-profits that interest rate swaps would
lower interest rates on bonds sold for public
projects such as roads, bridges and schools. The
swaps were entered into to insure against a rise
in interest rates; but instead, interest rates
fell to historically low levels.
This was
not a flood, earthquake, or other insurable risk
due to environmental unknowns or "acts of God". It
was a deliberate, manipulated move by the Federal
Reserve, acting to save the banks from their own
folly in precipitating the credit crisis of 2008.
The banks got into trouble, and the Federal
Reserve and federal government rushed in to bail
them out, rewarding them for their misdeeds at the
expense of the taxpayers.
How the swaps
were supposed to work was explained by Michael
McDonald in a November 2010 Bloomberg article
titled "Wall Street Collects $4 Billion From
Taxpayers as Swaps Backfire":
In an interest-rate swap, two
parties exchange payments on an agreed-upon
amount of principal. Most of the swaps Wall
Street sold in the municipal market required
borrowers to issue long-term securities with
interest rates that changed every week or month.
The borrowers would then exchange payments,
leaving them paying a fixed-rate to a bank or
insurance company and receiving a variable rate
in return. Sometimes borrowers got lump sums for
entering agreements.
Banks and
borrowers were supposed to be paying equal rates:
the fat years would balance out the lean. But the
Fed artificially manipulated the rates to the save
the banks.
After the credit crisis broke
out, borrowers had to continue selling
adjustable-rate securities at auction under the
deals. Auction interest rates soared when bond
insurers' ratings were downgraded because of
subprime mortgage losses; but the periodic
payments that banks made to borrowers as part of
the swaps plunged because they were linked to
benchmarks such as Federal Reserve lending rates,
which were slashed to almost zero.
In a
February 2010 article titled "How Big Banks'
Interest-Rate Schemes Bankrupt States," Mike Elk
compared the swaps to payday loans. They were bad
deals, but municipal council members had no other
way of getting the money. He quoted 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.
Elk wrote:
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 little as a tenth of one percent
on the outstanding bonds - with no end to the
low rates in sight.
... [W]ith 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 of 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.
By the end
of 2010, according to Michael McDonald, borrowers
had paid over $4 billion just to get out of the
swap deals. Among other disasters, he lists these:
California's water resources
department ... spent $305 million unwinding
interest-rate bets that backfired, handing over
the money to banks led by New York-based Morgan
Stanley. North Carolina paid $59.8 million in
August, enough to cover the annual salaries of
about 1,400 full-time state employees. Reading,
Pennsylvania, which sought protection in the
state's fiscally distressed communities program,
got caught on the wrong end of the deals,
costing it $21 million, equal to more than a
year's worth of real-estate taxes.
In
a March 15 article on Counterpunch titled "An
Inside Glimpse Into the Nefarious Operations of
Goldman Sachs: A Toxic System," Darwin Bond-Graham
adds these cases from California:
The most obvious example is the city
of Oakland where a chronic budget crisis has led
to the shuttering of schools and cuts to elder
services, housing, and public safety. Oakland
signed an interest rate swap with Goldman in
1997. ...
Across the Bay, Goldman Sachs
signed an interest rate swap agreement with the
San Francisco International Airport in 2007 to
hedge $143 million in debt. Today this agreement
has a negative value to the Airport of about $22
million, even though its terms were much better
than those Oakland agreed to.
Greg
Smith wrote that at Goldman Sachs, the gullible
bureaucrats on the other side of these deals were
called "muppets". But even sophisticated players
could have found themselves on the wrong side of
this sort of manipulated bet. Satyajit Das gives
the example of Harvard University's bad swap deals
under the presidency of Larry Summers, who had
fought against derivatives regulation as Treasury
Secretary in 1999. There could hardly be more
sophisticated players than Summers and Harvard
University. But then who could have anticipated,
when the Fed funds rate was at 5%, that the Fed
would push it nearly to zero? When the game is
rigged, even the most experienced gamblers can
lose their shirts.
Courts have dismissed
complaints from aggrieved borrowers alleging
securities fraud, ruling that interest-rate swaps
are privately negotiated contracts, not
securities; and "a deal is a deal". So says
contract law, strictly construed; but municipal
governments and the taxpayers supporting them
clearly have a claim in equity.
The banks
have made outrageous profits by capitalizing on
their own misdeeds. They have already been paid
several times over: first with taxpayer bailout
money; then with nearly free loans from the Fed;
then with fees, penalties and exaggerated losses
imposed on municipalities and other counterparties
under the interest rate swaps themselves.
Bond-Graham writes:
The windfall of revenue accruing to
JP Morgan, Goldman Sachs, and their peers from
interest rate swap derivatives is due to nothing
other than political decisions that have been
made at the federal level to allow these deals
to run their course, even while benchmark
interest rates, influenced by the Federal
Reserve's rate setting, and determined by many
of these same banks (the London Interbank
Offered Rate, LIBOR) linger close to zero. These
political decisions have determined that
virtually all interest rate swaps between local
and state governments and the largest banks have
turned into perverse contracts whereby cities,
counties, school districts, water agencies,
airports, transit authorities, and hospitals pay
millions yearly to the few elite banks that run
the global financial system, for nothing
meaningful in return.
Why are these
swaps so popular, if they can be such a bad deal
for borrowers? Bond-Graham maintains that
capitalism as it functions today is completely
dependent upon derivatives. We live in a global
sea of variable interest rates, exchange rates,
and default rates. There is no stable ground on
which to anchor the economic ship, so financial
products for "hedging against risk" have been sold
to governments and corporations as essentials of
business and trade. But this "financial
engineering" is sold, not by disinterested third
parties, but by the very sharks who stand to
profit from their counterparties' loss. Fairness
is thrown out in favor of gaming the system. Deals
tend to be rigged and contracts to be misleading.
How could local governments reduce their
borrowing costs and insure against interest rate
volatility without putting themselves at the mercy
of this Wall Street culture of greed? One
possibility is for them to own some banks. State
and municipal governments could put their revenues
in their own publicly-owned banks; leverage this
money into credit as all banks are entitled to do;
and use that credit either to fund their own
projects or to buy municipal bonds at the market
rate, hedging the interest rates on their own
bonds.
The creation of credit has too long
been delegated to a cadre of private middlemen who
have flagrantly abused the privilege. We can avoid
the derivatives trap by cutting out the middlemen
and creating our own credit, following the
precedent of the Bank of North Dakota and many
other public banks abroad.
Ellen
Brown is an attorney and president of the
Public Banking Institute, PublicBankingInstitute.org.
In Web of Debt, her latest of 11 books, she
shows how a private cartel has usurped the power
to create money from the people themselves, and
how we the people can get it back. Her websites
are WebofDebt.com and
EllenBrown.com.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
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