Morgenson on Municipalities’ Swap Fiascoes

Gretchen Morgenson has a fair number of critics among readers of this blog, which I think is a tad unfortunate. Most of her articles are in fact sound; she is very reliable on executive comp, anything in the equity markets, or where she is working form legal documents, generally lawsuits. It’s when she wanders into debt markets that her attempts to present material to a mass audience sometimes include nails on chalkboard slips.

This week, she has a pretty decent piece on how municipalities got hosed in various swap transactions. She is being savaged for a foot in mouth at the top of the piece, and this is the precisely the sort of thing that gets her in trouble: using Greece (a story in the headlines) to update readers on municipalities’ swaps woes, and worse, calling the Greek currency swaps “credit default swaps.” What completely mystifies me is why, after being repeatedly hectored on the blogosphere, she does not clean this sort of thing up. Josh Rosner is her co-author on an upcoming book. Why doesn’t she run her pieces by him to avoid obvious gaffes?

Yet the Gretchen-bashing for its own sake has gotten a life of its own. Another blogger criticizes Gretchen for allegedly only discovering muni derivatives fiascoes now. Huh? She wrote about this in 2008 as well. And I don’t see anyone yelling at Chris Whalen for addressing this supposedly stale topic when he wrote about muncipalities and derivatives this week.

I suppose I am more sensitive to this than most, since I regularly shred articles long form in the Times, Journal, and once in a very great while, the Financial Times. Yet Gretchen gets piled on when many of the articles I pummel (and readers typically agree with my harsh take) get a free pass from most other bloggers (including one on Goldman’s marks on AIG’s CDS….which happened to be by the very same Gretchen Morgenson).

As an aside, I’ve waded into this argument before. My first blog conversation of sorts with Felix Salmon was on the very subject of a 2007 Gretchen Morgenson piece, where I made the case in some detail that while I though a piece by Morgenson had been sloppily written, that some of his salvos were less than fair.

Now it is fair to say that municipal finance has long been an ugly nexus of incompetence, chicanery, and greed. Pay to play scandals are endemic. But even when you don’t have ugly combinations of venal officials meet underhanded financier, you routinely find its kissing cousin, chump officials hire venal advisor in cahoots with underhanded financier. The article cites Andy Kolaty, a fixed income expert:

“The basic problem is the swap adviser gets paid only if there is a transaction — an unbelievable conflict of interest,” he said. “It’s the adviser who is supposed to protect you, but the swap adviser has a vested interest in seeing something happen.”

Yves here. And that is as good as it gets. To put it politely, there are often other ways these advisors are compensated.

And it is also human nature to rely on assurances made by the salesman, when they in fact have no legal standing.

Some readers will no doubt say that governments should not get involved in complicated financial instruments. But they are under pressure to minimize costs to taxpayers, so when a banker peddles and approach that professes to do that, they feel duty bound to listen, particularly if they know other entities like them are doing the same (remember, there is no penalty for screwing up in an entirely conventional manner). And even sophisticated players like Harvard have been burned on swaps too, so it isn’t clear that even being a smarter buyer has produced better outcomes.

Nevertheless, as one reader pointed out in a recent post, the complexities are often not where they seem to be:

To me the other HUGE issue is that a lot of the deception was “hidden in plain sight”, to use a Sherlock Holmes metaphor. Relatively simple statements with non-intuitive meanings (or meanings requiring non-trivial parsing).


1. ‘It can’t go up more than 2% a year’. “It” is the interest rate in this case, but a lot of unsophisticated borrowers would have been encouraged to assume (or certainly not corrected if they did assume) that “It” was their PAYMENT.
2. ‘The starter rate is (some ridiculously low number).’ Same as above. The borrower thinks this is the INTEREST rate, when in fact it is the (minimum) PAYMENT rate and the principal is thereby increasing.
3. ‘The loan will reset in X years’. Ignoring the fact that if the minimum payment schedule is followed, the loan will RECAST much sooner.

I have personally called BS within the last month on a young work colleague’s statement regarding the interest rate on his car loan. Got him annoyed enough to check his contract right through, in fact, because he wanted to prove the old fogey wrong. 20 minutes later he’s cursing under his breath, and is on the phone to his fiancee to work out how far they can accelerate the payment schedule.

Now this is a genuinely smart guy, who got taken in by the difference between flat (quite prominently displayed) and reducible (quietly hidden away, in small print) interest rates. He and his fiancee also earn enough so they can in fact blitz the loan and write off the interest paid to experience.

(And when he asked me why I was so sure of my contention, I told him I’d seen the same stunt pulled on a good friend of mine many, many years ago, and never forgotten it. From what he then said I suspect he’s not going to forget either, and also not going to forget that a ‘family friend’ brokered the finance for him.)

Yves again. While these examples are retail, the same principles and risks apply as far as not very sophisticated “institutional” customers are concerned.

Morgenson sets out a good bill of particulars on the swaps front. The ridiculous part of these deals is that the municipal market is sufficiently deep that most issuers can sell bonds that are a good fit with the life of the underlying project, thus circumventing the risk of maturity mismatching. But plain vanilla bond deals are not very attractive to Wall Street firms, so municipalities were pressed to enter into variable rate debt deals, usually in the auction rate securities market, and swap back into fixed rates.

However, these deals blew up when the auction rate securities market froze in early 2008, and Morgenson misses a line of attack here. The ARS market had been propped up by dealers for some time, with auctions that failed winding up being carried by the banks (as in the auctions were the way that investors could get their money back readily; the market was billed as a weekly auction, but in fact was an OTC market with a once a week trading window). That was a cost they had been willing to bear until the monolines started looking wobbly. Many of these ARS were rated AAA by virtue of a monoline guarantee; if the monoline was downgraded, so to would the insured bond. The dealers did not want to be stuck holding inventory, since if it was downgraded, they would show losses. They started aggressively trying to reduce their holdings, and en masse, quit supporting the auctions. Under the terms of the agreements, if an auction failed, the investors were due a penalty rate for the loss of liquidity, the investors got a penalty rate.

Some state attorneys general went after the banks (some investors had their funds effectively frozen, and while some were happy as clams with the penalty rates, many had been sold the product as being as safe and liquid as a money market fund) and got big settlements.

But what about the municipalities? Were they misled about the risks of auction failure too? Were they told that the market worked only thanks to active involvement of the dealers? Morgenson says the governments are not willing to cross the money types:

What is especially maddening to many in the municipal securities market is that issuers are now relying on the same investment banks that put them into swaps-embedded debt to restructure their obligations. According to those who travel this world, issuers are afraid to upset their relationships with their bankers and are not holding them accountable for placing them in these costly trades.

Yves here. Is this a variant of Stockholm syndrome?

Chris Whalen points out that swaps contracts have wound up being an exceptionally bad deal for municipalities, thanks to the Fed’s ZIRP de facto banking subsidy:

OTC derivatives are multiplying the economic pain that ZIRP is causing to interest rate sensitive investors.

The Fed’s current interest rate policy has caused the City of Los Angeles to go into the red to the tune of $10 million per year because of interest rate swaps sold to the city by Bank of New York Mellon (BK). That’s right, thanks to Chairman Bernanke and the FOMC, and an OTC interest rate swap, the City of Los Angeles must pay $10 million per year to BK so long as the Fed continues ZIRP — potentially until 2028.

By skewing interest rates down below the true rate of inflation, the Fed has levied a tax on all of the OTC interest rate counterparties that were trying to hedge against higher interest rates. And there are literally thousands of other cities, states, public agencies and insurers around the world which are caught in the unintended consequences of ZIRP. When you recall that the Fed has been and continues to be the chief cheerleader in Washington for OTC derivatives, the implications for the global economy are truly mind boggling.

But Los Angeles is starting to consider taking more aggressive moves, and that may embolden other government bodies to act:

Los Angeles is thinking about moving billions of dollars in municipal deposits as well as nearly $30 billion in pension assets away from the largest banks in order to redress the perceived wrongdoing by BK and other large banks. You can probably guess that the City of Los Angeles will be using…

But at IRA we believe that it is better to get even than to get mad, especially when there are billions of dollars in public funds at stake. This is why we have begun to assist public sector agencies in negotiating the repudiation of OTC derivatives positions that are causing unanticipated losses to customers like the City of Los Angeles. The message to the OTC derivatives dealers is simple: Take back the deceptive, unfair and misleading OTC contract or else the public sector client will pursues any and all options. Remember that defrauding a state agency is a felony in most jurisdictions.

This could get interesting, and for a change, in a good way….

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  1. attempter

    Morgenson says each entity alone is scared to stand up to these gangsters.

    I can’t imagine why they don’t get together to not only denounce these non-existent “contracts” (how can a contract a con man swindled you into be valid?) but indict and prosecute the criminals involved. I guess many of the crooks are still in office. Stockholm Syndrome indeed.

    When I was reading the article I dreamed of somebody, perhaps some town, standing up publicly to denounce it all. Could a Welch-type “Have you no sense of decency sir” moment ever occur today? The morning of that hearing, would anybody if asked have thought McCarthy’s downfall could start unwinding from such a moment, that the spell could suddenly be broken like that? Probably not. Stockholm Syndrome indeed.

  2. pedantic detective

    “hidden in plain sight” is not from sherlock holmes, and it is technically not a metaphor. it is a theme originating from edgar allan poe’s “the purloined letter” featuring poe’s own detective, auguste dupin.

  3. Allen C

    “By skewing interest rates down below the true rate of inflation, the Fed has levied a tax on all of the OTC interest rate counterparties…”

    Let’s fix this…By subsidizing interest rates below the true rate of inflation and market based risk premium, the government has levied a tax on every saver.

  4. Bruce Krasting

    I think two key reason for the disaster is the securitized mortgage market were these two foundations:

    1) There will never be a national turn down in RE prices in any given 12 months.

    2) There will never be a year where housing prices fall by more than 5% in any region.

    Those rock bottom assumption were of course blown to smithereenes. When we woke up to the reality that both #1 and #2 happened we got ZIRP as a result.

    And now ZIRP is hurting LA and and you want them to walk on their contract?

    Where does that go? It goes to the very worst place we could possibly go. If we don’t like the results we just rip up the contracts. On that basis 20% of homeowners should just stop servicing their debts. Why are these homeowners any different than LA?

    Do you think that the folks in LA were not smoking cigars and drinking champagne when they inked the deal in question? Of course they were. They wanted this deal. It was not pushed on them by evil bankers. So now, due to unforeseen events, the deal is a disaster. Tough luck, so sorry.

    This effort that is now afoot to allow people to walk from their mistakes is going to backfire in a very spectacular way. Those that are spearheading this effort will come to regret it. It will just take a few years to realize the damage that is being done.

    In 2-4 years I think interest rates in the US will have to revert to the historic mean. Meaning 5% short rates and 7-8% longer rates. When this happens the likes of LA will not have any rate protection. They will have lost their insurance policy. And they will sink into the Pacific and bring the rest of the State and country down with it.

    If you go into a fix floater without a collar you are making a bet. LA bet and lost. You want to rewrite that history go ahead. I’ll remind you how wrong you are when it becomes obvious. Trust me, it will.

    1. psychohistorian

      The problem here is that the bailouts should have never happened.

      What you have now are circumstances where folk are trying to protect themselves from the effects of the economy not crashing around the perps that got us here.

      Of course it is bad manners to default on contracts but if the mentality that constructed this house of cards is not addressed then the results will be ugly and misdirected with the real problems not being addressed. Exactly what the rich want is us fighting amongst ourselves for the scraps while they get away with all the money.

    2. HereWeGoAgain


      I think you’re dead on when you say that the people spearheading this are going to regret it, but at the same time, I think this push is inevitable. There’s too much public rage and the cities and states are too screwed for cash for a different outcome right now, I think.

      One thing I’m really curious about is why you conlude that long-term interest rates are going to 7-8%? My guess is in the 20% range, so I’m wondering what kind of assumptions you are making (or, more succinctly, who is going to be stupid enough to lend money for over 10 years at 7% to a government that is borrowing over $100 billion/month for as far as the eye can see?).

      Did you ever read Sidney Homer’s “A History of Interest Rates”? There are normally wild swings around that historic mean, and that historic average occured on the backdrop of a growing industrial base.

      Your thoughts are alway appreciated.

      1. Bruce Krasting

        I watched many countries in LA do the 20% interest/20% inflation thing. It does not work for long. It blows itself up. Same in the US. I don’t think rates can get to 10% for an extended period of time. We will blow up. The great sucking noise. If we get back to 7% the drag will be like a wet sack of cement. That would put mortgages at 8%. Growth falls to zero. Interest rates would have to follow.

    3. ZA

      Muni rate securities and mortgages… both contracts. There is an offer, acceptance, consideration and specified penalties for breaking the terms they set forth. There is no moral aspect to them.

      Morgan Stanley was perfectly capable of paying the note on their 5 buildings in San Francisco. Blackstone skims billions from the Fed’s MBS purchase program over the past year and was certainly able to make the note on Stuy Town. In violating these contracts, they made a business decision, based on their liabilities versus the penalties for walking away. There has been, and will be, absolutely no penalty on their ability to borrow.

      States now have to make the same decision. They sure as hell aren’t going to be able to raise taxes/cut services without provoking a diaspora. If that money has to come out of a bankster’s ass, well, I would take my chances in court right now.

      1. anon

        I’d go further and say that a contract is supposed to be broken when fulfilling it is more onerous than paying the penalties for its breach. It flows from the “rational actor” assumption underlying much of contract law, from the desire to increase the system’s efficiency, and from the desire for predictability/certainty in contracts (where each party can know in advance approximately when the contract will be breached and what they will receive/pay in the event of a breach).

    4. anon

      “I think two key reason for the disaster is the securitized mortgage market were these two foundations . . . .

      2) There will never be a year where housing prices fall by more than 5% in any region.”

      I’m pretty sure that prices in the Bay Area declined by over 5% from 1990 – 1991. Since prices in the US declined by almost 3% during that period, I’d guess that other metro areas declined by over 5% during that time as well.

      See, e.g.,

      and compare the SFXR index value in the spring and summer of 1990 with the corresponding value in 1991 (73.50 vs 69.56, 74.57 vs 69.46, 75.12 vs. 70.13, 75.15 vs 70.83). You see a similar pattern in Boston. (e.g., 70.91 vs 63.35 for April 1990 vs 1991).

      How hard would it have been for them to fact-check that before constructing a model using such faulty assumptions?

    5. Marshall Auerback

      The “sanctity of contracts” information presupposes a basic symmetry of information between two consenting parties. I respect a lot of Bruce’s insights, but does he really think that the deceptive, unfair and misleading OTC contracts done by the Wall Street banks should be upheld on the basis of some bogus “sanctity of contract” argument? Remember that defrauding a state agency is a felony in most jurisdictions.

      This whole Wall Street house of cards boils down to: risky bets, private profits, socialized losses. Worse, yet, it misaligns interests so that Wall Street profits are higher if there is economic and social instability—and Wall Street is powerful enough to generate exactly those conditions. Until Wall Street is constrained and downsized, it will continue on its path of death and destruction.

      In spite of all the happy talk about the end of the recession and the successful resolution of the financial crisis, things are much worse today than they were two years ago. Commercial real estate is toast. Option ARMs (the toxic mortgages with low teaser rates) are resetting ahead of schedule because of clauses that allow mortgage holders to jack up rates as homeowners go underwater. Every class of consumer debt—much of it securitized—looks a lot like subprime mortgages. Euroland and Japan are cratering, the UK is going to try to reduce its budget deficit, and even China has decided to slow its growth to reduce inflation pressures. Note that all of these markets are linked, and for every debtor that goes delinquent there are numerous linked financial products that go bad. There are well over $500 trillion of those products still floating around.

      While it is true that every derivative has both a buyer and a seller—so that every “event” should be a zero-sum game, with the seller paying the buyer—that works only if bad bets can be covered. But we know that Wall Street institutions are not good counter-parties. So what happens instead is that there is a rush to liquidity as everyone tries to sell out positions in assets to cover their commitments, causing asset values to plummet. Be prepared for another global crisis by summer. And also get ready for another Washington bail-out of Wall Street, because the $23 trillion promised so far will not be enough, especially if “sanctity of contract” becomes the operative principle.

  5. Independent Accountant

    I am rarely critical of GM. However, I have little sympathy for the municipalities. I see this “wilful blindness” every day with individual tax clients. They rarely if ever ask for an independent opinion about a product. Why? They must write a check to get it. Are they so stupid as not to know the salesman has a commission on the table and “no deal, no fee”? Where do they think the salesman’s fee is coming from? The tooth fairy?

  6. velobabe

    bruce “1) There will never be a national turn down in RE prices in any given 12 months.”
    that’s what jamie dimon said, under oath. he believed it.

    jerry brown is going to save california, as the rest of usa.

    what’s wrong with getting 7-8% longer rate on your money, that’s probably not going to happen.

    1. velobabe

      Auction Rate Update

      What You Can Do to Help: Call for Additional Information

      Thank you for contacting us about our investigation into auction rate securities. As the next step in our ARS investigation, we are seeking to obtain additional data from individuals who have previously contacted us regarding their purchase of auction rate securities. This information will be critical to aid in the prosecution of our cases. To provide us with this additional information, please visit our new website at and fill out the questionnaire.

      I lost $150,000. in buying what i thought were tax free muni’s through morgan stanley right around February 13, 2008 the date these ARS dried up as it was told to me.

  7. Dave

    Thanks for that.

    I read Morgenson’s article to see what the hubbub was about–not much. So what if she swapped “credit” for “currency,” and so what if it’s not new news. The more times and the more ways this is explained the better for the public to understand the tragedy and self-dealing that has been public finance.

    1. Anal_yst

      I could not agree more that certain public finance issues need to be explained, but Gretchen, and the NY Times are doing the public a disservice with this article, and the link contained therein about CDS.

      There is simply NO excuse for an institution like the Times to run such drivel, end of story.

      Appreciate the mention, Yves, but I’m not bashing Gretchen just for the sake of it; I’ve written previously on her pathetic work. See

      In fairness, I don’t read all of her work, but what I have read has been absolutely and inexcusably terrible.

  8. i on the ball patriot


    Ennoble the violence,
    Exalt the corruption,
    Cherish the destruction,
    Celebrate the death of your fellow citizens,
    We are all warriors,
    Death dealing cannibals,
    Exulting in the slaughter,
    Of our own spirits,
    With mass produced egos of shit,
    And carbon copy brains of emptiness,
    The predators,
    The reapers,
    The hellfire missiles,
    The CDSs,
    The SIVs,
    The swaps,
    The robots of torture,
    The Nobel Peace Laureate,
    Debates the tasering of innocence,
    If it saves one life,
    Then it serves the god of public safety,
    And the scam,
    ‘Rule of Law’,
    Melts on the side walk,
    Like a dropped popsicle,
    On a hot,
    Memorial day,
    Stupid fucking cowboy scamericans,
    Will they ever run out of Indians to kill?
    Will they ever realize that they are the Indians?
    Stupid fucking cowboy scamericans …

    Deception is the strongest political force on the planet.

    1. velobabe

      patriot ps, i have been printing out your prose for a while now and mailing, yes USPS, to my business partner who has never owned a computer. he loves them!

  9. ben

    I agree with your basic point here – and to go a bit further, you shouldn’t criticize Morgenson for missing a line of attack. There are so many open lines of attack in this field, that it’s altogether impossible to write something the length of a newspaper column without leaving things out.

  10. nowhereman

    Alas, back to the rating agencies, you know those entities that perpetrated one of the most blatant frauds yet to go unpunished. Put triple A ratings on garbage produced by the banksters that were then peddled to states, municipalities, pension funds,other banks, insurance companies, countries, etc, all seeking better returns due to ZIRP.
    We now are beginning to see the fallout as Cities, States, Countries and other institutions scramble to make up for the huge loses, while the perps get away scott free.
    And now, yes now I see that we all will have to live with austerity measures, as the fraudsters get huge unfathomable bonuses.
    I’m sorry, I’m not buying it. And yes you can break a contract, if you are a fraudster, but not if you are a citizen. Fuck that, we should all tell them to go to hell, we ain’t paying you cheating bastards one more cent.
    Tear it down and start over. Put the crooks in jail. Take back the wealth they stole from the country, and above all make sure that this will never happen again.

  11. Investcal

    “the market was billed as a weekly auction, but in fact was an OTC market with a once a week trading window”

    In the 19th cenury snake oil salesmen were tarred and feathered and ridden out of town on a rail. This practise sould be reinstated.

  12. liberal

    Tanta, the much-celebrated deceased co-blogger at Calculated Risk (may she rest in peace), really didn’t like Gretchen M. I really did like Tanta.

    That being said, I liked stuff GM wrote early in the decade. Post-Enron, she commented in some article something questioning the “quality” of corporate earnings. That was one of the data points I used not to put my savings back into the stock market.

    Little did I know how back the “quality” really was (i.e., the entire financial sector being one big scam).

  13. Anon

    Yves, thanks for sticking up for Gretchen Morgenson, she deserves support. Honestly I think the reason people sometimes pick on her is not because she’s wrong, it’s because she is so *right* nearly all of the time. Those who work in financial services and do the sort of bad things that Gretchen M. is pointing out as wrong have a huge need to discredit. Cognitive dissonance is real…”Boy, Gretchen must be stupid, because if she’s not, I’m evil…and THAT can’t be true, can it?” G.M. is right vastly more often than she’s wrong. She has done much more public good than 99.99% of the citizenry. Long live Gretchen Morgenson.

  14. Karen

    I’ve long wondered why so many financial “professionals” like city and county Treasurers, pension fund managers, and insurance company investment managers signed financial contracts as dangerous as some of these auction-rate securities apparently were.

    I’ve always thought you should NEVER sign anything you don’t understand (which obviously means you shouldn’t sign anything you haven’t even read) – yet people who are PAID to look after large budgets, and who I assume are licensed professionals, appear not to have understood the contracts they signed.

    Isn’t that professional negligence?

    Just wondering.

    If I were as careless about the work I do, there’d be a bunch of fallen-down bridges in several states, with people killed in the process…

    1. HereWeGoAgain

      “If I were as careless about the work I do, there’d be a bunch of fallen-down bridges in several states, with people killed in the process…”

      Well, the Supreme Court hasn’t ruled repeatedly in favour of negligent engineers, saying that everybody who uses the bridge should have done their due diligence to ensure structural integrity, and that thhey, and not the builders, are therefore responsible for any losses.

      However, the Courts have done a very thorough job of insulating the financial industry from the consequences of any of their own actions. The Treasury and the Fed have done the rest. Not surprisingly, this increased trather than reduced the ensuing bad behaviour.

  15. MuniAdvisor

    This is my first time visiting Naked Capitalism – kudos and thanks to most all participants for well-considered and insightful comments. However, despite my lack of bona fides in this forum, I’ll risk provoking your indignation at the presumptuous newcomer and remind an obviously very bright group of individuals of something you already know: that derivatives applications (including quality of execution and fee/profit levels) in the municipal space fell all along the spectrum between “criminal” and “compelling” – with the vast majority falling into the “not unreasonable” category (i.e., decisions were informed by a thorough risk/benefit comparison of available alternatives). The extreme cases will always make the news, hindsight is 20/20, and people will often point fingers rather than accept responsibility for their decisions.

    I am not advocating “caveat emptor” and condemn unequivocally instances of egregious profits and knowingly facilitating ill-advised transactions. But over-simplifying and over-reacting will not benefit municipal market borrowers – instead it will place an irrational premium on minimizing political risk at tremendous but, of course, invisible, opportunity cost. I have little doubt that opportunity cost, and the lack of accountability for it at public entities, has, year after year, and in innumerable cases, quietly cost local governments many, many times the “losses” associated with the high profile transactions gone bad. Balance, ladies and gentlemen – please?

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