Updated below at 4:09pm ET.
Los Angeles lawmakers were expected to vote Wednesday on a proposal to renegotiate or terminate an interest rate swap deal from the mid-2000s that critics say now costs the city millions of dollars a year in fees. If successful, the initiative could make the city the nation's largest to challenge ballooning Wall Street levies that accompany similar interest rate swap deals throughout the nation.
The deals in question are highly complex, but boil down to cities, counties, school districts and other public institutions getting locked into interest payments to banks, in many cases for decades. Many of those deals were initiated before the financial crisis of 2008, and because the transactions promised so-called "synthetically" fixed interest rates, they were seen as a way for public institutions to protect themselves against the prospect of higher interest rates and volatility. After the crisis hit, however, central banks helped drive down interest rates far below what they were when the deals were cemented. Yet, the swap arrangements typically prohibit cities from now refinancing their payments with new, lower interest rates without paying what critics say are prohibitively high termination fees.
In Los Angeles, for instance, a group of unions and community organizations called the Fix LA Coalition estimates that a deal connected to a 2006 wastewater system will cost the city $65 million in swap payments over the next 14 years. The coalition says that to unwind the deal and take advantage of lower interest rates, the city would have to pay a $25 million termination fee on top of the $26 million the city has already paid to terminate another portion of that swap deal. In all, the groups estimate that Los Angeles is now spending $290 million a year in financial fees -- or more than the entire city budget for maintaining its vast array of streets and highways.
In response, Los Angeles council members Paul Koretz and Gil Cedillo have introduced legislation instructing the city’s chief administrative officer to renegotiate or evaluate ways to end the deals without paying the termination fees. They argue that those termination fees should be forfeited by the banks because officials were effectively misled about the possible risks of the interest rate swaps.
"If the people who made the deal at the time had instant hindsight and realized how much they lost, they never would have made the deal," Koretz said in an interview with the International Business Times. "The city was encouraged by the banks to do it, and the banks really didn't explain the downside. We kind of got snookered by the banks. I don't know if they went into it intending to nail us. I think the banks probably didn't expect rates to go down, but they were aware that there was a better chance of it than they let on."
A legal memo written by attorney Brad Miller, a former Democratic congressman from North Carolina, argues that the risks associated with the deals were not properly explained to local officials in cities like Los Angeles, and that therefore the complex transactions did not comply with industry rules against “deceptive, dishonest, or unfair practices.”
The memo, which can be viewed here, points to a June arbitration ruling finding “a continuing but hidden fraud” in a similar swap deal in Alabama. That ruling ordered the bank behind the deal to return the swap payments to the local sewer utility. It followed other public institutions such as the San Francisco Asian Art Museum and the city of Richmond, California, which have also successfully renegotiated their own interest rate arrangements.
"More often than not, local governments do not know they are getting a bad deal," former Goldman Sachs vice president Wallace Turbeville said in testimony to the Los Angeles City Council. "This is not a question of their professional competence or honesty of municipal administrators or elected officials. Rather, mispricing and excessive risk are far more often either intentionally hidden or involve such complex financial structures that no one but large sophisticated banks could comprehend them."
IBTimes requested comment from Bank of New York Mellon, which is the major U.S. financial institution involved in the Los Angeles interest rate swaps. Kevin Heine, a spokesman for the bank, declined to comment. However, in a May interview with Bloomberg News, Heine defended the transaction, saying: “As part of a competitive bidding process on this transaction, the city relied on an independent financial adviser to provide an impartial, objective assessment of the economic benefits of the transaction.”
Meanwhile, Los Angeles officials have defended the financial prudence of the deals. A report released in June by City Administrative Officer Miguel Santana said without the swap deal, the city would have been forced to pay a higher interest rate on the wastewater bonds in 2006, and that compared to that higher rate, the city has saved $21.7 million. The report, prepared by the consulting firm Public Resources Advisory Group, said that compared to that higher interest rate, the city will save $22.9 million more over the next 14 years.
Lisa Cody of the Fix LA Coalition disputed that line of argument, saying that with interest rates lower today, the city could be paying far less if it was permitted to refinance the deal without paying huge termination fees.
“The fundamental problem is that this kind of deal locks cities into an interest rate for the entire duration of a bond deal, which in most cases is 20 and 30 years," she told IBTimes. "The private sector does not enter into 20 year swaps. Their swap deals are typically 3 to 5 years, and often 1 year. Being locked into a synthetically fixed rate for 20 or 30 years means that the municipalities cannot refinance their deals and take advantage of lower interest rates, which means those municipalities are paying a huge price.”
According to Bloomberg News, “Borrowers from cities to universities have paid at least $5 billion in fees to banks that sold them swaps that failed following the financial crisis.” Among the highest-profile examples are:
- In Denver, then school superintendent Michael Bennet engineered a swap deal that ended up costing the city’s school system more than $215 million in Wall Street fees in just five years. Promptly after engineering the deal, Bennet ran for the U.S. Senate and became one of Congress’s top recipients of campaign cash from the financial industry. In 2011, the swap deal was cited in an SEC hearing as a cautionary tale for other cities. According to Jeannie Kaplan, who was a Denver school board member at the time, "No serious fee negotiation has taken place because for that to happen Denver officials would have to admit they made a bad transaction."
- In Detroit, Bloomberg News reports that swap deals connected to the city’s water and sewer department have cost the city more than $500 million in fees to major banks.
- In Jefferson County, Alabama, interest rate swaps in connection with a $1.5 billion sewer project helped push the local government to the edge of bankruptcy. The Securities and Exchange Commission later filed charges against J.P. Morgan Securities Inc.
- In Chicago, the Sun-Times reports that the local teachers union estimates swap deals cost the school system almost $36 million in annual payments and have cost the city more than $120 million since 2003. City officials recently cited budget constraints as a rationale to enact the largest school closure in U.S. history.
UPDATE: The Los Angeles City Council unanimously passed the bill instructing the city to renegotiate or terminate the interest-rate swap deal in question.