Are the Mice Starting to Roar? Municipalities Turn Defiant with Wall Street

Municipal finance has long been a cesspool. States, towns, hospitals, transit authorities, all have long been ripe for the picking. Sometimes local officials are paid off (anything from cold hard cash to gifts to skybox tickets), but much of the time, there’s no need to go to such lengths, since preying on their ignorance will do. As we’ve pointed out, even though these bodies often hire consultants, those advisors are often either not up to the task (how can people who don’t know finance vet an expert?) and/or have bad incentives (more complicated deals, which are generally more breakage prone, tend to produce higher consulting fees).

Dave Dayen highlighted one example yesterday: the city of Oakland has decided rather than pay $15 million in termination fees to get out of an interest rate swap deal gone bad:

The council voted to demand Goldman Sachs to negotiate with the city to get out of a 1998 interest rate-swap deal without having to pay a $15 million penalty. Currently, because of the locked-in rates, the deal is costing the city $4 million a year. Oakland estimates they have lost $17.5 million on the deal so far, and even though the underlying bonds were sold back four years ago, because of that $15 million penalty, the city will have to continue losing money on the deal until 2021.

So the City Council simply voted to terminate the deal. And if Goldman Sachs won’t let Oakland out, the city will stop doing any business with the bank, per the resolution.

In other words, the headline is: “Oakland to Goldman: Drop Dead.” I sincerely doubt that Goldman would litigate to get Oakland to pay the termination fee, but it will probably instead enlist enforcers, meaning the rating agencies, to issue the usual threats about how Oakland will be downgraded and shunned by investors for daring to press hard to have a transaction renegotiated. Funny how it’s OK in our society to break contacts with individuals over their pensions funds, but not with financial firms, when ZIRP (a tax on savers implemented to prop up the banks that wrecked the economy) is making many of these municipal swaps profitable beyond their wildest dreams.

But the case I like best so far is wee Moberly, Missouri. The New York Times got up in arms last month that a town of 14,000 is repudiating a bond guarantee that it was rushed into by a state authority:

Moberly, where the biggest employer is a state prison, had responded eagerly to a pitch by the Missouri Department of Economic Development to host the project, hoping for hundreds of jobs. The company, Mamtek International, was said to have a sucralose plant in Fujian Province producing a sweetener called SweetO, for use in drinks, candy and pharmaceuticals. Most of the authority debt, to go toward building and equipping the plant, was issued under a federal stimulus program allowing private investors to use tax-exempt municipal financing.

But when a bond payment came due last August, with the building still unfinished, Mamtek officials said they didn’t have the money. Construction stopped; the handful of employees in Moberly were laid off. Weeks of confusion followed, with subpoenas from the Securities and Exchange Commission, rumors of a split between the Chinese company and its United States subsidiary, reports that the plant would be liquidated and fears that the bond proceeds were gone forever.

When the city’s guarantee was called, the Moberly City Council issued a statement saying: “The city’s taxpayers, under these circumstances, should not bear the burden of Mamtek’s failures or be asked to ‘bail out’ their shareholders or investors.”

S&P immediately whacked Moberly’s bond rating from single A to single B (junk), even though the creditworthiness of the outstanding bonds had nada to do with the guarantee. Indeed, if it tried honoring the pledge, the bonds would probably be toast. Missouri state representative Jay Barnes called the initial rating into question:

After spending probably hundreds of hours investigating, reporting on, and then trying to make sure something like Mamtek never happens again, I think by now I’m a bit of an expert on the deal….

The city’s biggest mistake wasn’t backing the bonds, it was relying on the expertise of bond professionals they hired and the oversight of state government. Moberly thought the bond professionals it hired and DED were looking out for them. In truth, the bond professionals and DED weren’t doing much of anything…

The NYT article cites to Standard & Poor’s decision to downgrade the debt. But it was Standard & Poor’s that rated the Mamtek bonds as investment grade material. Without S&P’s stamp of approval, the city would have never approved the bonds. Two years later, S&P and others say the bonds were backed solely on the credit of the city of Moberly. Our investigation revealed something else.

At the time of the bond offering, Moberly had annual revenues of approximately $7 million and had run at a deficit the two prior years. Yet here they were asking for a loan of $39 million on a 15 year note. At the hearings, I asked several witnesses, “If I made $70k a year and had run in the red the previous two years would you loan me $390k to be repaid within 15 years?” Everyone’s answer was, “(Hemming and hawing, oh well that’s different and then finally after being asked to answer the hypothetical) no probably not.”

The Times story also had “market analysts” threatening that Moberly’s defiance might taint the credit of other towns in Missouri. By any logical standard, that’s garbage, but this is how the creditor Mafia operates. Matt Stoller described an earlier incident:

In the early 2000s, several states attempted to rein in an increasingly obvious predatory mortgage lending wave. These laws, pushed by consumer advocates, would have threatened the highly profitable mortgage securitization pipeline.

S&P used its power to destroy this threat. Josh Rosner and Gretchen Morgenson told the story in Reckless Endangerment.

Standard & Poor’s was the most aggressive of the three agencies, however. And on January 16, 2003, four days after the Georgia General Assembly convened, it dropped a bombshell. Because of the state’s new Fair Lending Act, S&P said that it would no longer allow mortgage loans originated in Georgia to be placed in mortgage securities that it rated. Moody’s and Fitch soon followed with similar warnings.

It was a critical blow. S&P’s move meant Georgia lenders would have no access to the securitization money machine; they would either have to keep the loans they made on their own books, or sell them one by one to other institutions. In turn, they made it clear to the public that there would be fewer mortgages funded, dashing “the dream” of homeownership.

It was an untenable situation for the lenders who had grown addicted to the securitization money spigot. With S&P shutting it off to abusive lenders, it was only a matter of time before the Fair Lending Act was dead…

It ended with a warning: “Standard & Poor’s will continue to monitor this and other pending predatory lending legislation.” In other words, any states that might have been considering strengthening their predatory lending laws as Georgia did should beware.

That press release is here. S&P was aggressively killing mortgage servicing regulation and rules to prevent fraudulent or predatory mortgage lending.

Now Moberly is in an interesting position. Its bonds have been downgraded, meaning if any investor were to sell them, they’d take a loss. And if the town were to issue new bonds, it would have to pay a huge premium (unless it was able to sell them to local loyalists). But there is no reason to think that anyone who keeps the Moberly bonds to maturity will lose money. And given that the town’s budget is under strain, it probably isn’t planning to increase its commitments by issuing new bonds of its own any time soon. In other words, the punitive downgrade is a wet noodle lashing.

The flip side is all sorts of pressure from the state is being brought to bear, and local officials may knuckle under for self-interested reasons. But I’m rooting for little Moberly, and if they can pull this off, it might persuade other local bodies to stand up when they have been railroaded into bad deals.

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  1. Andrew

    If anyone asked me. I would say it’s a pretty dumb assed idea to let private agents and corporations assess the value and risk of public state and municipal debt. It is expensive, inefficient, it opens the door wide open to abuse, corruption and the whole concept is rendered a farce by federal fiscal transfers.

    If they need to borrow just borrow from the fed efficiently and at lower cost. The bottom line responsibility for fiscal oversight and risk management has always been with the federal government as the fiscal transfers will still get made. The federal government should be accountable. Get the inefficient hands out financial middlemen out of the way..

    1. Gavin W

      Apologies off the bat, I am a foreign layman when it comes to US banking. Are the states prevented from borrowing from the federal reserve at the discount rate? That seems ridiculous. I realize the banks can flatten the rate over a longer term and for that there should be some premium but there must surely have been a better deal in a falling interest rate environment for the states.

      I guess I’m agreeing with Andrew and hoping for a clarification, the states should be able to borrow at a competitive rate from the government.

      1. H. Alexander Ivey

        “Are the states prevented from borrowing from the federal reserve at the discount rate?” They are not prevented but it is not done. You are talking about 2 different things when talking about the Fed and various states. Basically the Fed works with banks, TBTF banks.

        1. Carla

          The Fed is a creature of the private banking cartel. It is not a government agency. Back in the days of phone books (remember?) the Fed was listed in the business pages of the book, not the government pages. We don’t believe in gubnent in this country. And why would we? It’s corporate-owned.

      2. Min

        States should be able to borrow cheaply from the Federal Reserve. However, as of this time, only North Dakota has a state bank, which could get the same deal as other banks. Some other states are considering state banks, too.

  2. vlade

    Yves – for avoidance of doubt, munis and other clients do have their “face ripped off” regularly, but that happens at the deal time (and the problem is transparency of pricing. This could be dealt with relatively simply by requiring the banks to be transparent in pricing – and be able to book as PnL on what they admitted to as PnL in the pricing).

    The move in rates downwards would create no new profits for IBs since they would (have to) be delta hedged at the inception (otherwise their risk limits inclusive of VaR would have blown out immediately).

    It’s a nice soundbite that makes it easy for the public to understand that clients are being ripped off, it just has the downside it’s relatively easily shown as not true. Using soundbites that are nice but provably wrong is dangerous.

  3. Paul P

    Slapp back at the banks by funding projects with taxes.
    A tax-surcharge to fund a specific project, for example.
    Or, taxes can be passed with proviso that were bond rates at a specified, city chosen amount, the city would have an option of tax surchage or bonds.

  4. rotter

    “DED”, what a sad acronym for a state economic development agency. Are they doing that on purpose?

  5. indio007

    Let me get this straight. Mobley guaranteed bonds of Mamtek that where rated investment grade. The source of that rating was the credit worthiness of Mobley itself…

    Investment Banks got that recursive (house of mirrors) financing down pat.

    1. indio007

      I should add the deal was this,

      Goldman Sachs Salesman:

      “Here cosign for this loan! It will never default as long as you agree to pay in the event of default.”



      Goldman Sachs Salesman:

      “Think about awhile, let’s go to lunch. ”


      “Who’s paying?”

      Goldman Sachs Salesman:

      “Let’s flip for it…… Heads I win , Tails you lose.”

    2. LeonovaBalletRusse

      “Investment/Merchant Banks” and “Ratings Agencies” CLEARLY are co-conspirators in monstrous swindles.

  6. Max424

    Fifteen million dollars. That’s roughly what the Fed pays Too Big Fail Banks to –pretty please– take one billion dollars of its extra-free money.

    Too bad Oakland isn’t a part of the United States, because then could they SAFELY borrow and park –and get rich– at the Fed, like the international banks do. Instead, Oakland must consent to: a) letting it fly in a rigged casino, and, b) accept getting ripped off by planet-hopping loan sharks if –when!!!*– the action goes sour.

    Poor bastards. Where is Oakland? Canada?

    *It always does.

  7. fresno dan

    What is always astounding is, why do people pay ANY attention whatsoever to bond rating agencies, which are demonstratably incompetent and corrupt?
    Also, to extent that facts matter, it has been proved that the rating agencies use a different standard for municipal bonds that results in higher rates for the municipalities (or for investors, higher returns with lower risks)

  8. James Cole

    If Moberly successfully repudiates the guarantee, I can assure you, Yves, that the bonds will not be paid back in full since there is no other source of payment now that Mamtek is bankrupt. It looks like the bonds were sold with a “moral obligation” or “appropriation risk” type guarantee, which usually takes the form of a promise to bondholders to seek an annual appropriation of debt service. This type of covenant technically does not bind the legislature/city council to actually make the appropriation. It is done this way so that the guaranty obligation itself does not get treated as “debt” under the state’s constitutional or legislative rules against incurrence of debt. The theory is that “market discipline” will compel the muni to make the appropriations each year if necessary, but the fact is (if I am right about this Moberly guarantee) the bondholders have no legal remedy against the city under the guarantee. Moberly is now therefore facing the full force of this “market discipline.”

    There are billions of dollars of debt outstanding with similar structures. New York State itself relies extensively on this type of borrowing. As we are now seeing, these non-legal obligations are the first to default in times of distress, due to the lack of legal consequence. However, not all municipal guarantees are moral obligation, many are actualy legal obligations to which the full credit and taxing power of the municipality are pledged–such Harrisburg PA’s guaranty of the obligations of its waste processing plant.

    I think we will be reading and hearing more about these “moral obligation” and “appropriation risk” type structures as they default in the near future.

    1. LeonovaBalletRusse

      What is Prospectus for? Will a Prospectus guarantee that a Muni bond will not go bad? Investors in Munis take risks, and they want the highest return on their principal that they can get, tax-free. Were investors born yesterday?

      The ratings agency has already sunk the rating on the bonds, to penalize bond holders in the secondary market. Let the investors hold the bond until default or maturity. The city’s guardian did the right thing, setting a fine example of Spartacus 2012.

  9. jefemt

    Despite the reactive derisive comments, seems like Meredith Whitney was right, just ahead of the curve on timing?

    1. Art Eclectic

      See also, the article a few days ago on Noubini. Nobody likes it when Cassandra shows up in the middle of the party and suggests that the punchbowl has been spiked. They only want to see her when they’ve already gotten their ride home and all that’s left is the guests who can’t hold their liquor.

  10. DP

    I’ll ask for the hundredth time why criminal enterprises Moody’s and S&P are still in business. They are the dumb cousins of the banksters who are the black sheep of the family. They are parasites who latch on to and suck blood from nearly every financial transaction without doing anything of value. And in extreme cases like Georgia and predatory lending laws, they’ll even pick up the baseball bats and play enforcer for the banksters.

    No wonder Warren Buffett loves them.

  11. K Ackermann

    Mobery should issue savings bonds. Small denomination, hold-till-maturity bonds.

    I’d buy one just because.

    1. steve from virginia

      It would solve the problem if a few of these ‘bankers’ and whatnot were to spend some time inside a municipal lockup.

      Try to swipe a city-owned stapler (or a parking meter bwo ‘Cool Hand Luke’) and see what happens, steal cash flow and it’s: “Thank you! Please take another!”

      If jail doesn’t work bring back flogging in the town square. If flogging doesn’t work, cut off bankers’ heads of with a samurai sword on television!

  12. jsmith

    Once more with feeling:

    What does it even mean that cities, states and counties don’t have the ability to pay their “debts” in the United States of America when we print our own currency?

    This is a fascist system of fraud and graft, by fraud and graft and for fraud and graft, period.

    Like any good confidence-man/propagandist rip-off, the scenario APPEARS to make sense – e.g., wulp, we do have a balanced budget amendment in this state, we owe these banks the money, etc – but when one steps outside of the bubble one quickly sees that it’s complete and total horsesh*t.

    Yes, the propaganda has been relentless and multi-tiered for the last new decades.

    Besides the whole “private sector” always does it better meme, you’ve had the “states’ rights” meme, the “balanced budget” meme and on and on and on until the American people are so brainwashed that they believe this horsesh*t and think it’s anything more than the fraud, graft and theft it truly is and then hamstring themselves by not allowing themselves recourse to the federal money they deserve in our political system.


    1. LeonovaBalletRusse

      franco, this scam was revealed on that Frontline expose, but it wasn’t referred to by JPM mouthpieces as a scam. DB was JPM’s Point Man/Bag Man in EZ.

  13. steelhead23

    As Andrew hints above, this kind of drag on our economy could be remedied by socialized banking. The left needs to get away from the “regulate them like the wayward children they are” and recognize banking profits for what they are – a drain on prosperity. As long as the quest for profits is allowed, there will be deals like these.

  14. Scattershot

    Regarding the Oakland deal, the reporting seems very biased and simplistic. It sounds like Oakland issued a floating rate bond and decided to swap the payments to a fixed rate. Now they are coplaining that rates dropped so they are paying a higher rate than the current market rate.

    I’m not sure if the $15M is a fixed penalty or just the current value of the contract they entered into, but blaming Goldman for rates falling after Oakland decided to hedge a bond deal appears to be bank bashing to me, and I’m not even with a bank! The banks have done a lot that deserves criticism, but this particular case doesn’t seem to be in that category.

    1. James Cole

      You are correct in that there is an element of caveat emptor here that is being missed. The $15mm is almost certainly a mark-to-market settlement amount that essentially constitutes to a make-whole redemption premium (which is what it would be called if it were call protection on a bond instead of a termination payment on a swap).

      The city council was probably handed a 200-page book that included, deep in its bowels, boilerplate disclosure of the various risks presented by the swap, but their professional advisors were probably all gung-ho about the deal (because they are conflicted due to contingent fee arrangements) and showed them various scenarios that de-emphasized the risk, so I suppose there is plenty of blame to go around here.

      Because this is a relatively old swap, the basis of this swap is probably either a cost-of-funds swap or a BMA swap (i.e. a rate that either equals or closely tracks the rate payable on the variable-rate bonds), later swaps in the muni market were typically done using a percentage of LIBOR as the basis, so I am wondering what kind of additional leverage unhappy municipalities can exert over their bankers by threatening to sue for fraud on a LIBOR manipulation theory. I would think our banker friends would be happy to quietly make these swaps go away than to have discovery in a case like that.

    2. DP

      Scattershot, do you seriously think anybody on the Oakland City Council understood what an interest rate swap was or could have explained it even after they entered into it? Where do you think the idea of an interest rate swap came from? Do you seriously think Goldman would have been as motivated to push an interest rate swap to the city of Oakland had their profit margin on the transaction not been grossly inflated because of the opaque nature of the derivatives market, which Goldman fights to keep that way by making sure there is no exchange for derivatives with price quotes?

    3. Yves Smith Post author

      I’d add to James’ helpful comment. The fact that the swap wasn’t designed to terminate when the underlying bond was retired at a modest fee level (as opposed to “early termination MTM payout” is a really bad design feature and suggests this was one of the ways, if not the way, that Goldman loaded extra profit potential into the deal in a manner that Oakland and its advisors would miss. That’s the problem with derivatives generally, it’s the fine points that allow undue risk to be dumped on hapless buyers.

  15. Capo Regime

    Indeed. Of course without the “credit lifeline” municipalities will of course be forced to go to austerity and of course increase property taxes–perhaps even dramatically. They will be in many cases between a rock and hard place–pension obligations, labor contracts in case of union workers etc. Ideally some fee clawbacks but that will be small change. Not blaming the victim but it will end very sadly for many. The end of excess brings much gnashing of teeth. Ugly days ahead…

  16. Capo Regime

    As an aside if there is a more corrupt enterprise than muni bond, housing finance authority bonds or in case of referendum states lease back hustles word of it has failed to get out. As more of these blow up they will make countrywide look like pikers. City council, local bond counsels, local deal guys, are into it up to their eyeballs. More than one prominent local/state politician goes and becomes the local presence for the several wall street banks.

  17. Capo Regime

    If you think you can buy members of congress for low dollars, imagine state legislators and city council people…..The mice that roar will likely have many of their own complicit in the mulcting.

  18. sierra

    Welcome to the future!!
    This well founded article is just scratching the surface of a corrupt banking system (Isn’t this all “legal”?) and a broken economic one.
    I’ts all a game…if you don’t understand the “rules”, you shouldn’t be “playing”!!
    (The Greater Fool Theory!)

  19. briansays

    being local across the bridge fortunately its nice to read some news on Oakland other than the nighly homicide report (I’m no joking–110 for 2011, 59 so far in 2012)

    maybe they need to have a local citizens group pay a visit to wall street??

    1. Capo Regime

      Wow 2 people a week killed in oakland. Its terrifying. Good thing we are keen on spreading our enlightenment around the world.

    2. briansays

      that don’t include the wounded
      5 hit standing outside a movie theatre the other night around 9:30 PM all to the hospital
      suspect(s) at large

      gangs and guns running the streets
      shoot first often mistaken id then run
      and so it goes

  20. dirtbagger

    It seems that the root of many of the problems with bonds – be it mortgages or muni’s, is that both the borrower and lender are using short term financing to fund longer maturity debt. Both parties then use structure exotic agreements to try and mitigate the interest rate risk.

    In theory, if the interest rate risk is properly priced, the insurance for rate risk should be fiarly equal to the cost of financing longer term debt with longer term interest rates. In this world there is no macro net advantage to borrower or lender to insure for interest rate risk.

    In the real world, the interest rate risk premium is assymetric. The details of the deal are buried in 1000 pages of legalese such that the issuer usually comes out the winner. Advisors to local governments convince them that they can get a free lunch and fund long term projects with cheaper short term debt. Part of this is probably due as much to ignorance as to corrupt city hall slobs.

    Many of the problems could have been avoided by funding long term projects with long term debt. If the project doesn’t pencil out at the higher rates, then the project is not affordable.

    1. LeonovaBalletRusse

      The Lenders avoid long-term like the plague, they don’t want to be “locked in” to gain with limits, they expect great inflation long-term to reduce their gain unto insignificance. That’s why “zero-interest” bonds are floated, as virtual “Arabic lending” (“without interest”), so the lender gets the gain up front, even if the bond loan money “vaporizes.”

      1. James Cole

        Leonova, I must object:

        Lenders do not generally avoid long-term debt. Certainly some lenders do, sometimes, and certainly long-term debt can be difficult for poor credits to obtain, but we have just lived through the greatest rally in long-term treasury debt in at least two generations. There are currently approximately $30 trillion of fixed-rate bonds outstanding in the US. Also, in a falling rate environment, lenders would prefer long-term fixed-rate debt, as it locks in above-market rates. In any event, Oakland and Moberly would have had no problem issuing traditional 30-year fixed-rate debt to sensible, conservative investors, if they hadn’t been swayed into the “synthetic fixed rate” structure by their bankers.

        Zero-interest bonds (more commonly, “zero-coupon bonds”) are called that not because they don’t accrue interest, but because the accrued interest is not paid out to bondholders but is accreted to the principal and compounded, with the net effect being that the bond investor pays a steeply discounted price at inception and is then paid par at maturity (i.e. $400 now gets you $1000 thirty years from now). I don’t know of any instance where zero-coupon bonds have been viewed as consistent with Islamic finance principles, but, in any event, the lender certainly does not “get the gain up front” as you suggest.

  21. Francois T

    If Moody’s officials had been “invited” into one of the Federal year-long holiday camps, at taxpayer expense in exchange for prolonged restriction of freedom of movement in 2008, we wouldn’t be in this predicament.

    But it is obvious that much more generalized* pain and suffering will be needed before people blow the political and financial elites out of the water.

    * that is, it’ll need to whack the upper middle class simultaneously in the face and kahunas.

  22. LeonovaBalletRusse

    Yves, the FIX has been in forever in New Orleans when it comes to munis: lawyers and bond dealers of the .01% do the deals with political hacks who “answer to the People.” Banana republic forever.

  23. briansays

    my daily Oakland report from across the bridge hopefully safe

    another 2 shot dead last night

    meanwhile not all doom and gloom
    Giants won the All Star game
    and then for those of you old enough to remember Steve McQueen in Bullett

    7.3 million hits in 1.5 days

    but unlike steve mcqueen he doesn’t have jacqueline bisette waiting at home

  24. Kunst

    The financial industry combines the best features of the gambling industry and the mafia. Ratings agencies are part of the enforcement branch. Wouldn’t it be interesting if those seeking to enforce financial contracts had to prove that the other party’s understanding of the deal was equal to their own, that they gave truly informed consent.

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