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Trading Lessons

How Interest Rate Swaps Are Crushing America's Cities

Interest-Rates / Banksters Sep 23, 2013 - 12:54 PM GMT

By: Money_Morning

Interest-Rates

Garrett Baldwin writes: It's something you may not even have heard of, but the massive financial burden of interest rate swaps is pressuring city budgets and pinching taxpayers more every year.

But before I tell you what interest rate swaps are, let me show you how they've affected life in America's largest city - New York.


Last week, I drove through the Lincoln Tunnel. The cash fare to travel the 1.5 miles from New Jersey into Manhattan was a whopping $13 - more than 50% more than the last time I was there.

When I jumped on the subway a few hours later, a one-way fare was $2.50, more than 60% more than when I lived in the city in 2008. And my water at the hotel? Shut off in the morning because the water authority was struggling to handle maintenance requests due to being short-handed.

These increases are not the result of the expansion of the transit system or increases in union salaries (common misconceptions).

Ultimately, the explosion in costs and slashing of budgets in New York and many other U.S. cities in recent years are happening because of a little-known type of financial contract - known as an interest rate swap.

You see, U.S. cities and their agencies have been on the wrong side of bad bets with the Big Banks. Now, these municipal agencies are struggling to cover their losses.

Interest rate swaps are costing American taxpayers billions all across the nation as Wall Street rakes in taxpayer money years after the financial crisis.

Interest Rate Swaps: The Big Banks Are the Big Winners

The idea behind interest rate swaps seems logical enough. Interest rate swaps are financial contracts meant to protect borrowers from drastic increases in costs related to the yield of their debts.

All across the country, cities and local agencies got into bed with Wall Street in the hopes of reducing their financial burdens on borrowing costs.

Now, those plans have backfired...

To understand what went wrong, you need to know how interest rate swaps work.

In the case of the MTA, the transit agency pays the bank (for example, JPMorgan) a fixed rate on a bond in the form of interest. That rate is prearranged and is typically just a bit higher than the going market rate at the time of the contract as a means of "locking in" the best deal. In this case, that rate might be 4.5%.

Meanwhile, through the interest rate swap agreement, the bank returns a payment of interest on a variable rate (which floats according to the global debt markets). If the going market rate is above the 4.5%, the MTA would make money. If it is lower than 4.5%, they will end up losing money on the deal. In most cases, it is sold on the premise that both entities will break even over time.

Unfortunately, Wall Street has a funny way of being right all the time. Following the financial crisis, low interest rates have meant that the banks still pay the higher fixed rate, but low variable rates driven by the Federal Reserve's policies have meant lower payments from the banks to the municipal borrowers of these swap agreements. So if the variable rate is 1.75%, but the fixed rate is 4.5%, the borrowers have to somehow cover the difference.

That's where the taxpayers (or users of the agency's services) come in. Fees they pay are being raised to pay for that difference.

The New York MTA, which controls the subway, bus, and other transit systems, has interest rate swap agreements with a number of banks, including JPMorgan, Citigroup, Morgan Stanley, and UBS.

Interest Rate Swaps Have Cost Taxpayers Millions

In December 2011, Michael Stewart of United NY prepared a report on the staggering cost of interest rate swaps to New York City and its agencies alone. In it, he highlighted the impact of these swaps on every major utility and authority in the city.

Just look at the accumulated costs for New York's MTA.

From January 2000 to December 2011, the MTA paid out a net sum of $658 million, thanks to cheap monetary policy in Washington. In order to cover those losses, the MTA is now forced to raise fares or cut jobs and services.

In 2010, the MTA had to cut more than 1,000 transit jobs and steeply cut subway and bus service lines. A city that was already difficult to get around became all that more difficult.

According to United NY, the annual net payments in 2012 for the MTA sit at $117.6 million. The Port Authority, in charge of the Lincoln Tunnel and other crossings into the city, owed $27.7 million. And the water authority, which is struggling to keep the water flowing at all hours, paid $6.2 million. Another $80 million to $85 million on interest swap payments was paid by other entities, including the state, city, and local libraries.

And there's no easy way out.

To terminate these contracts, the city and taxpayers would be on the hook for more than $1 billion. For customers and workers, the results have been devastating.

These weapons of financial destruction have been detrimental all across the country as interest rates have remained low:

  • The Bethlehem School District in Pennsylvania has faced immense cuts across the board.
  • Oakland, which found itself on the wrong side of the bet, had been forced to cut back on police services at a time that crime is on the rise.
  • Harvard University lost millions on a faulty investment by its leadership.
  • And Baltimore, my hometown, is locked in a massive legal suit after banks manipulated the LIBOR rate and led to the city losing millions on swap payments.

A Looming Multi-Trillion Dollar Crisis

In 2012, the Office of the Comptroller of the Currency reported that U.S. banks held $183.7 trillion in interest rate swap contracts on their balance sheets.

Only four financial companies owned 93% of total derivative holdings.

As you may have suspected, those companies are JPMorgan Chase, Citibank, Bank of America, and Goldman Sachs, all four of which received billions in bailout money following the U.S. financial crisis.

Now, they've been raking in billions on these interest rate swap agreements thanks to a little help from their pal Ben Bernanke at the U.S. Federal Reserve and his cheap money policies.

It's bad enough that taxpayers will have to foot the bill on interest-rate agreements and pay the short-term-minded banks the difference between these agreements.

But the real problem isn't the banks making money on the lower interest rates.

It'll be incredibly worse if interest rates rise significantly and the payments start to come from the banks into the coffers of the towns, and for one reason: Banking leverage.

If anything causes interest rates to rise significantly, the contracts could begin to implode on the banks. That could recreate the 2008 crisis all over again with one hook.

And this time, it would be way, way bigger.

If interest rates spiked due to a default by the U.S. government on its debt, or the Federal Reserve were unable to maintain its grip on lending interest, the result would lead to banks being unable to meet all of their obligations on the higher variable rates set forth in their swap agreements.

With these contracts spanning decades, it's uncertain whether this would be sustainable.

This situation was exactly the type of issue that the Dodd-Frank Act was supposed to fix. But bank lobbying and government's inability to foresee any crisis has left American taxpayers vulnerable to these contracts and the nation vulnerable to yet another Wall Street meltdown.

Note: Wall Street's bubbles are everywhere. And we have plenty of reasons to fear any number of them bursting. But there's one that dwarfs all the others. Here's how to prepare for "the mother of all bubbles"...

Source :http://moneymorning.com/2013/09/19/how-interest-rate-swaps-are-crushing-americas-cities/

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