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February 28, 2011

Wall Street Back to Its Old Tricks

Charles Morris

One might have thought, given recent credit market debacles, that bankers might have tamped down the ingenuity quotient on new products, especially those sold into troubled markets – like today’s very shaky municipal bond market.

Not at all.  A recent "Citi Outlook" on the municipal market sees "An Exciting Year Ahead" for "Muni Derivatives." For example, they expect a burgeoning market for credit default swaps on munis, and especially in muni synthetics.  They also expect "a fruitful environment for TOBs," although they lament that investors "still vividly remember their 2008-2009 experience and are not willing to jump aggressively into this trade."  Hmmm.  What might that "2008-2009 experience" possibly have been?  And what on earth is a TOB anyway?

TOBs are "Tender Option Bonds."  A hedge fund, a mutual fund, or maybe a bank (Inv 1) transfers a block of highly-rated long-term fixed-rate munis to a trust – a "Special Purpose Vehicle" in the parlance (we heard a lot about those in 2008).  The trust issues floating rate notes to new investors (Inv 2), with the special feature that  Inv 2 can tender the floating rate notes to the trust at par at regular intervals, often every week.  The cash from the floating rate note sale usually goes to Inv 1, less a reserve, although he’ll have to return it when the notes mature.

Why the tender option?  So Inv 2 will accept a short-term floating muni rate, which is currently very low, locking in a big profit for Inv 1, who is collecting the much higher fixed rate.

The trust never issues notes against the full value of the original bonds.  The surplus value is represented by a ‘residual certificate’ issued to Inv 1, that captures whatever profit is left over after paying Inv 2.   In addition, the use of the cash Inv 1gets from the note sale allows him to buy more bonds and repeat the trick.

And now you know what happened in 2008-2009.  Short-term rates shot up, the world’s Inv 2s naturally didn’t tender, a lot of Inv 1s defaulted, and everybody lost a ton of money.  If all the parties were professionals, no one would mind.  But a lot of muni mutual funds played this game, and their retail investors got hit pretty hard.  And not just retail investors.  A group of Norwegian cities is suing Citibank for when their $115 million TOB position suddenly vanished.

Can We Stop This Nonsense?

Municipal finance is one of the murkier, duller, backwaters of the financial system, much as subprime mortgages once were.  It is also notoriously corrupt, perhaps especially in small towns where a few "good ol’ boys" can steer the financing goodies.  So it amazes how deeply "creative" financing has wormed its way into an already suspect system.

In the fall of 2009, the SEC entered into a settlement with JP Morgan Securities relating to the now-notorious sewage bonds for Jefferson Co., a poor area in Alabama.  Although Morgan neither admitted nor denied any of the SEC’s allegation, it consented to the entry of a consent order. The narrative of the consent makes interesting reading.  I’ve interlaced the SEC’s account with some background from a Bloomberg article.

  • The County had financed a major sewer project with $2.9 billion in long-term fixed rate bonds at 5.25%.  In the early 2000s, a raft of bankers descended on the County offering to restructure the debt using swaps and other derivatives that would in theory save the County millions in interest.
  • $3 billion in new financing was arranged by 2003, involving auction-rate securities, variable rate bonds, and some fixed-rate debt.  Morgan underwrote the auction and variable securities.  According to Bloomberg, the banks earned about $55 million in fees on the placement.
  • Ostensibly to eliminate interest rate risk, eleven banks sold the County interest rate swap contracts totaling a notional $5.6 billion.  Bloomberg reports that the fees on the swaps were $120 million, or about six times market rates.
  • The SEC focuses on three of the swaps structured by Morgan, with a total notional of $2 billion.  In order to win those contracts, Morgan made $8.2 million of payments.  $3 million of that amount went to Goldman Sachs (!), for agreeing to withdraw from the competition, with the remainder divided among three local securities firms.  (To be fair, Goldman had to send $300,000 of its payoff to one of the bagman/local securities firms.  Allegedly, substantial amounts of that money found its way to at least one of the  County commissioners. All of those amounts were charged to the bond investors.
  • None of the payments was disclosed in any of the deal documents, nor were the recipient firms listed as providing any services on the deal.  In other words, they were bribes.

Did all this complexity serve any purpose other than running up bank fees? They must have. Alan Greenspan always assured us that while such deals look complicated, they improve efficiency, and so the County must surely have benefited.  Let’s see.

  • The County was at first delighted, and even held seminars showing off their financial prowess.
  • $2.2 billion of the bonds were ‘auction-rate securities,’ which meant that rates were reset at regular intervals by an auction process.  If an auction failed to find sufficient bidders, the rate was escalated.  Almost all auctions failed in 2008, but the banks refused to step in as buyers, as they always had in the past.  At about the same time, the insurer on this bond issue was downrated.  Altogether, the County’s interest expense more than doubled.
  • At the same time, the interest rate swaps reversed, as short-term rates spiked, and the County was forced to lay out large sums to cover its swaps obligations.  When they tried to withdraw, Morgan sued them for $647 million.  (As part of the SEC settlement, Morgan withdrew that suit.)

No progress has been made on the sewers, sewer bills have been quadrupled to meet the County’s interest obligations, and the authorities are still considering declaring bankruptcy, in part because of the huge burdens of debt service it was saddled with.  Poor people in Jefferson County are being forced to choose between water and heat, because they can no longer afford both.

That all raises the question, what kind of people are these bankers?  Did they have mothers and fathers who told them about right and wrong?  How could they go into a poor county in their custom-made shirts, pay bribes, and then screw their clients by exacting $175 million in fees for products that were set up to fail?

Update: As of just a few weeks ago, JP Morgan, undaunted and unembarrassed, was still trying to exact money out ofJefferson County.

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