How Wall Street Fraudsters Plunder Public Finances, And How to Fight Back

Yves here. This article, part of an ongoing AlterNet series, ‘The Age of Fraud,’ edited by Lynn Stuart Parramore, does the difficult and important feat of unpacking a financial structure that blew up a lot of municipalities in layperson-friendly terms. It also proposes some sound reform ideas. Circulate to friends and colleagues, particularly in communities that have been on the losing end of bad Wall Street deals.

One thing it weighs light on, due to space limitations, is what a cesspool municipal finance has long been. Not are there too often formal and informal kickbacks, but even among the better-indended officials, it’s way too easy for them to be snookered. They lack the expertise to evaluate fancy financial products. They too often fall prey to consultants, whose expertise they can’t readily assess, and their incentives are to recommend complex products. Who would pay a consultant a big fee to say, “Forget about these complex structures, any price savings mean you are eating a lot of hidden risk. Just finance a ten year project with a ten year fixed rate bond”?

By Alexander Arapoglou, professor of finance at the University of North Carolina’s Kenan-Flagler Business School, and a former derivatives trader and head of risk management worldwide and Jerri-Lynn Scofield, who has worked as a securities lawyer and a derivatives trader.

Say your town needs a new bridge. It might turn to Wall Street to come up with strategies to finance the project. This is supposed to be a win-win arrangement, but in the lucrative municipal finance business, one side has turned out to be the big loser. Guess which?

Nearly five years after Wall Street’s shady activities triggered massive funding crises for cities, states, and municipalities, the $3.7 trillion municipal finance cesspool has yet to be dredged. Banks continue to profit from their bad — or even fraudulent — advice that cost billions of dollars of taxpayer money. Meanwhile, the rest of us must tighten our belts, or pay higher taxes, or see services slide.

Let’s take a look at how bankers cooked up scams to drain the public coffers and why they continue to get away with it.

How Your Community Became Wall Street Prey

Many municipalities invested in flawed “structured finance” deals on the advice of bankers who said these complex transactions would give them a better deal than simpler, traditional products. So trusting public finance officials lined up to follow their advice — only to be told later that advice was not to be relied upon.

Tellingly, few (if any) corporations used similar structures to meet their funding needs. Nor did the banks themselves. Unfortunately, these products didn’t work as advertised, and public funding costs exploded as a result.

The financial structures bankers inflicted on the public are not easy to understand, but please try and stick with us: Banks rely on this complexity to obscure just how badly cities and states that followed their advice were hosed.

One common structure combined three key pieces: variable rate demand bonds (VRDBs), letters of credit and interest rate swaps. Municipal treasurers were looking to achieve the equivalent of a fixed rate financing— think of a 30-year mortgage—at lower than the market rate. And they signed on the dotted line in record numbers for these deals, with issuances of these complex bonds peaking in 2008.

Bankers realized that many professional investors — such as money market fund managers — cannot hold long-term debt, and instead prefer investments that can be dumped quickly when market conditions change. So bankers created VRDBs, which were “putable”— allowing buyers to get their money back, in most cases, every week, if they chose. Bankers thought these bonds, which in effect came with a money-back guarantee, would appeal to money market fund investors. At first, they did.

Alas, there’s no such thing as a free lunch. A bond that can be returned, with no penalty charges, every week doesn’t sound at all like the long-term infrastructure financing the city or state wanted. So banks promised municipal clients that if investors wanted to return bonds, the bank would find another buyer. Sounds like it might work out okay, right?

But what would happen if no one wanted to buy these returned bonds? To avoid leaving its municipal client and investors in a lurch, the bank created a guarantee, a letter of credit, that would provide alternative financing. Think of this letter of credit as insurance that would allow the city or state to continue to pay its bills if the market for its bonds dried up, while providing assurance to bond investors that the bond could be redeemed on demand.

The final piece of the structured contraption was a complex derivative, an interest rate swap. It was supposed to convert the weekly variable interest rate on the bonds to a fixed interest rate. This was another form of insurance that was meant to protect the public authority if interest rates went up.

Public finance officials were usually —and fraudulently — told they were getting interest rate swaps at zero cost, and unsurprisingly saw no point in shopping around and comparing terms. In fact, despite what they said, many bankers were ripping off their clients, substantially overcharging them for the swaps included in these defective transactions.

Bottom line: cities and states issued these special bonds, the banks agreed to remarket the bonds if necessary, and these municipal issuers purchased not one, but two types of insurance, at highly inflated costs, to protect themselves from different types of market fluctuations.

Breaking the Basic Laws of Finance

These structures violated a basic law of finance. The municipalities failed to match long-term borrowing with their long-term investments in infrastructure and other obligations. Instead they financed these long-term commitments with short-term borrowings that needed to be indefinitely refunded, week after week, often for as long as 20 years or more. All of the structures put in place to protect the borrowers — the letters of credit, the interest rate swaps — failed when put to the test by the financial crisis.

How? Banks marketed the VRDBs, based upon the credit quality of the banks issuing the letters of credit. When Lehman collapsed in September 2008, investors shunned bank credit. Cities and states found that many investors wanted to dump their VRDBs, and virtually no one wanted to buy them. Big problem, since cities and states still had to pay their bills. So many of them now had to go to plan B and draw on their letters of credit for necessary financing.

Banks Get Rewarded for Failure

The cities and states got a nasty surprise, and found themselves paying penalty interest rates to their bankers not because they’d done anything wrong, but because bank credit ratings had plummeted! Usually, the purpose for including a penalty rate in a standard letter of credit is to protect creditors from a borrower’s shortcomings. Here, cities and states were forced to pay a penalty rate for their bank’s shortcomings. Rather than being penalized for the failures and unsafe banking practices that caused the financial crisis and led bank credit ratings to nosedive, banks were instead rewarded with higher interest payments— a windfall. Needless to say, the cities and states had nothing to do with boneheaded banking moves.

So much for the protection they thought they’d bought. Instead, they ended up with the equivalent of an insurance policy that requires you to pay someone else when your house burns down. And this peculiar policy leaves you still on the hook for the costs of rebuilding your house.

And what about the second form of insurance, those interest rate swaps? Once again, despite paying more than top dollar, cities and states also didn’t get what they paid for. Wait a minute, you might ask. They couldn’t sell their bonds, and the only reason for having the swaps was to offset interest rate risk from selling bonds. So, no bonds, no need for swaps, right? Wrong. The terms of these deals required continued payment to the banks for these swaps, even though the underlying reason for buying them had vanished. This is a bit like forcing you to continue to pay a hefty homeowner’s insurance premium for years after your house has already burned down.

It gets worse. Not only were the swaps unnecessary, but also the payments cities and states were making on those swaps put them in the red— despite what they’d been promised. The banks, being on the other side of these swaps, were earning money from their positions — and so they were in no hurry to make things right.

Getting a handle on the total costs of these deals to taxpayers—and the offsetting profits to banks — is difficult. But research shows that a subset of these swaps alone costs taxpayers more than $2.5 billion per year.

Unlike China, the U.S. doesn’t execute fraudsters. But if a contractor builds a defective bridge, and it collapses, the city or state that commissioned the project can sue for damages. In extreme cases, criminal charges follow. Bankers follow different rules: When the financial gizmos they designed blew up, they didn’t make good. Instead, they insisted on holding onto the windfalls while blaming the victims for accepting the bank’s bad advice.

No Recovery in Sight

Very little’s been done to get this money back. Elected state and municipal financial officers certainly don’t want to level with constituents about just how badly they were hornswoggled by bank derivatives sales teams. An even bigger problem is our corrupt campaign finance system. National political parties control large war chests necessary for governors and other state officials to run successful state political campaigns. Much of these campaign funds come from financial institutions. You do the math.

If bankers had cheated their private company clients so badly, you can bet that these companies would be demanding their day in court. Notably, some foreign municipal borrowers, such as the city of Milan, Italy, have not been shy about entering courtrooms, and in December, won a major legal judgment against four banks, for aggravated fraud for mis-selling an interest rate swap.

But in the U.S., both political parties seem willing to let these claims go — sweeping them under the rug or settling for pennies on the dollar. Further, public officials haven’t exploited the considerable leverage they have to award or withhold lucrative new municipal business in order to force Wall Street to give taxpayers a break and refinance these deals, as Gretchen Morgenson of the New York Times has recognized.

Regulation: Why it’s Failed and Why it Matters

The structured finance fiasco we’ve outlined is only one drop in the cesspool of municipal finance. Congress has exempted municipal bonds from most major provisions of the federal securities laws that corporations must follow. So, as the SEC admitted in a July 2012 report: “[investors] in municipal securities are often not afforded access to the types of timely and accurate information available to investors in other securities.”

Since the financial crisis broke and as cities and states struggle to pay their bills, Congress and the major regulators have done little to clean up the mess. This is a big problem, because bankers are not stupid. They know that banks have largely paid, at most, token penalties for structuring defective municipal deals, and have in fact, made more money on these bad deals than they would have on simpler deals that didn’t misfire. So what do you think they’ll do, going forward? Clean up their act, and serve the best needs of their clients? Or continue to do whatever they think they can get away with to make the most money, whether or not it suits the needs of their public clients (and taxpayers), chanting caveat emptor under their breath.

Five Fixes: How to Prevent History from Repeating Itself

Existing municipal bond regulation currently focuses on purchasers of these bonds, and financial firms who underwrite, structure, and market such securities. By design, there’s almost no attention to the municipal issuers themselves, and especially, to how Wall Street firms played these cities, states, and other public issuers. That’s where the source of the 2008 municipal finance crisis lies, and where the regulatory spotlight should shine.

Here are five suggestions for reform, which won’t solve all problems, but can serve as first steps to stop Wall Street from making off with more taxpayers’ money.

1. Increase penalties for financial fraud: Congress and the Obama administration have shown little appetite for tackling this problem. States and some cities, however, have their own independent tools for dealing with financial fraud schemes, particularly those that affect their own financings. New York, for example, has its Martin Act, a broad anti-fraud statute that predates federal securities laws and allows the state to aggressively pursue financial frauds. Similarly, California can use its business practices statute to pursue similar ends. Other states have their own remedies. States and cities now should go even further to take the lead in either imposing new penalties, or increasing existing ones, for defrauding them.

2. Adopt explicit derivatives suitability standards: The self-regulatory Municipal Securities Rulemaking Board is currently working on revising standards for what types of municipal securities or municipal structured products investors may purchase. In a largely unregulated market, this is a good idea.

But investor suitability requirements are only the tip of the iceberg. The real issue is suitability standards for the issuing cities and states themselves, particularly for derivatives and structured financial products. We need to ask what types of products are suitable for Wall Street to sell to meet public financing needs.

Currently, deals are conducted according to the fiction that they’re arms-length transactions between equal partners. But that’s far from the case, and banks should understand that they’ll in future be held to a clear set of explicit suitability standards for their sales of derivatives and other structured financial products. Billions of dollars of structured transactions blew up in 2008: How many times must we rerun the same playbook?

3. Empower lawyers to be bounty hunters: Over the last two decades, the combination of a business-friendly Supreme Court and various state and federal legal “reforms” have made it much harder for plaintiffs to win lawsuits. Nonetheless, states, and even cities and municipalities could empower more private lawyers to act as bounty hunters and pursue municipal finance fraud claims on their behalf.

This has worked in the past: The 1998 Tobacco Master Settlement Agreement came about because some state attorneys general enlisted the services of prominent trial lawyers in targeting tobacco companies. That policy was by no means unique: States often farm out litigation to private lawyers. These policies could be expanded at minimal upfront costs, by hiring trial lawyers on a contingency basis, so they’d get a percentage of any money they recover, rather than an hourly fee. Such an arrangement costs the public nothing if the trial lawyers lose lawsuits, and has a huge potential upside if they win. Compare how we regulated and treated tobacco companies, say in the late 1980s, and how we do so now, and imagine what private lawyers might do if we took the leashes off and set them on the trail of municipal finance fraud.

4. Fix arbitration’s pro-banking bias: Wall Street usually tries to get parties to sign agreements to settle potential disputes by arbitration, rather than giving an injured party her day in court. Unsurprisingly, banks have rigged the process to suit their needs. Parties to the arbitration get to select their arbitrators, and this tends to help banks, since they’re repeat customers. Unlike public court proceedings, arbitration procedures aren’t transparent. Decisions aren’t made public, and the supporting reasoning isn’t available to serve as guidance, or precedent, for similar controversies.

Working together, states and cities could use their power to change the standards that apply to the arbitration agreements they sign, making selection of arbitrators fairer, increasing transparency, and publishing decisions, to serve as guidance for future settlements.

5. Make pay more competitive: Competent finance professionals lose out financially, big-time, by pursuing a career in public finance. And the lure of a possible future lucrative private sector job leads many public servants to avoid getting a reputation for rocking the boat.

For cities and states to attract top financial talent, and avoid succumbing to Wall Street snake-oil salesman, they must address this disparity in financial firepower. Here, we can learn from other countries: Singapore combines a tough legal code with high pay for regulators, and gets less corruption and better regulation in return. By contrast, in the U.S., the highest-paid state employee is usually the state university’s head football or basketball coach. States may be broke, but if they can find money to pay the football coach, they should be able to pay what’s necessary to hire people with sufficient financial expertise to prevent taxpayers from being ripped off.

Conclusion: Wall Street sold its municipal clients the financial equivalent of multiple bridges that collapsed. Since Congress and the Obama financial regulators are MIA on cleaning up this mess, it’s now up to states, cities, and municipalities to adopt some obvious fixes to make it harder for Wall Street to bamboozle them — and us, the taxpayers.

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  1. Warren Celli

    This article is stinking,
    Of wishful thinking,

    You waste our time,
    With your appeal to the slime,

    The system is broke,
    These ‘solutions’ are a joke,

    If you want to get exit this oppressive box,
    You have to stop legitimizing the fox!


    “Face it: The hydra-headed government now dominating this country is inherently corrupt. Nobody who supports this kind of government has any standing to complain about the corruption.”

    Deception is the strongest political force on the planet.

    1. sgt_doom

      Ditto to the max! ! !

      This is classic redirection, misdirection, and sophistry.

      Securitization, rehypothecation, credit derivatives based upon credit derivatives …..based upon debt based upon debt. . . .

      And backed with the greatest insurance swindle device in human history, the naked swap (uncovered credit default swaps).

      Add to that all the rigging of all the rates/markets, etc. and we would be better informed to read Taibbi, not this stuff!

      1. nonclassical

        …while there certainly are reading materials which go into even more depth on subject, (“The Devil’s Derivatives”, by Nicholas Dunbar, for one), we need these lessons as often as possible. Yves’ work and site are perused for monitoring of public sentiment-awareness of issues does not appear enthusiastic or informed
        enough to bring “transparency, oversight, accountability” as yet…the public needs all the information it can achieve…

    2. ArmchairRevolutionary

      At first, I thought the same thing, but after thinking about it, I think it makes a lot of sense. It may not be so applicable to larger cities, but smaller cities are one of the last bastions of democracy where councils tend to represent the best interests of their constituents. These cities lack the financial understanding to evaluate financial products. Simple guidelines to follow when inking contracts could have a big impact.

      1. zadoofka

        Then whycome politicians in Jefferson County AL went to jail for fraud and kickbacks, but no banksters are wearing orange jumpsuits?

  2. TomDor

    The bankers have already made their getaway. They paid the security guards to look the other way. What other way is there to explain the ‘settlement money’ paid out in these robberies.

    Enforcement of the law by unleashing the lawyer hounds is a good start but, the next hurdle is making the case when the DeFacto response has been, and continues to be; We can’t subject these criminals to harsh clawbacks and prosecution, it will destabilize and threaten the economy.

    What’s the old saying?

    “He isn’t really a big time crook unless you must let him alone to prevent the loss of public confidence.”

    Oh well, we all use a form of money that is based on trust….the dollar has the unwritten enforcable contract that are the laws of this nation…. if our elected and thence, appointed officials wish not to enforce that contract then, I suppose, many will no longer attribute full faith in our currency. And our officials seem content to overlook the deteriorated esteem they hold… I guess the peoples will no longer matters to them since the people seem utterly supine.

  3. peace

    Accountability. Localities such as Birmingham could (at least attempt to) make examples of corrupt individuals or firms. As another way to stem the tide.

  4. nick b

    So much of this article is hyperbole and opinion. I cant tell if the author is trying to describe short term VRDBs or auction rate securities (ars). It’s all muddled together in a narrative that leaves out a lot. This post would be better served by restricting the criticism to interest rate swap bankers. If you’re really interested in how these things get sold and bought, do a little research. Go through the minutes of your city/town council or school board. Generally these things have to be introduced and explained and it’s part of the public record. But to label all of ‘municipal finance’ a giant ‘cess pool’ shows a poor understanding and appreciation of the majority of ‘block and tackle’ municipal finance: issuing fixed rate securities that successfully fund schools, hospitals and roads.

    1. sgt_doom

      This post reminds me of the way Planet Money likes to make subjects as murky as possible, and unnecessarily so.

      We are in agreement, good citizen!

    2. Yves Smith Post author


      I’ve been in finance for over 30 years.

      Muni finance was a cess pool long before there were swaps. Anyone who worked on Wall Street in 1980s could tell you that.

      Kickbacks and corruption are way too common, and sadly so is a lot of preying on ignorance. Saying that normal processes and looking at minutes of meetings will show you who’s getting payoffs or how the governing bodies decided to hire incompetent or corrupt advisors (they ALL rely on advisors and their reports as the basis for their funding decisions) is astonishingly naive.

      And your objection to their use of terminology is also misplaced. Did you miss that the author of the article is an expert in this field? Or did you bother using Google?

      An auction rate security is an VRDB. Help me. VRBDs are a broader category (they include ARS) because you don’t have to have an auction for some VRDBs.

      The key is that rates reset on a short-term basis, typically weekly.

      See here for instance, an article on US Municipal Bonds, right at the very beginning:

      Variable rate demand bonds, variable rate demand notes or variable rate demand obligations (these names are used interchangeably and are all referred to in this disclosure as “Bonds”) are securities on which the interest rate is reset periodically – typically weekly, although reset intervals vary from Bond to Bond.

      1. nick b

        You paint with a very broad brush. It’s easy to say everyone’s corrupt and leave me with the challenge to prove otherwise.
        b/t/w I like your blog, been a reader for years.

        1. nick b

          A variable rate demand note is short term money market instrument. The rate changes, usually daily, and is generally set by the short term trading desk prior to the open of business. The buyer is promised liquidity based on the date of reset. ie: if you want to put them back to the desk who underwrote the deal they must accept them and pay you par. Auction rate securities are also a variable interest rate product. Rates are reset by auction on the auction date. There is no mandatory put however. You need a bid at the auction. No bid equals no sale. You are stuck. It seems a small distinction, but the structures fared very differently in the financial crisis and so did the consequences for both issuers and holders.
          Yes I googled the author. I’m not sure what differentiates an ‘expert’ from somebody who’s worked in the industry.

          1. Yves Smith Post author

            He was the head of global risk management, not just a practitioner. That means a much broader purview and considerable knowledge of more products.

            And the Jefferson County and the municipal transit deal blowups weren’t ARS (they used LIbor as the reference rate, they weren’t auctioned off Libor), so I don’t see how you can say ARS were less problematic.

            And saying it’s a cesspool is not tantamount to saying everyone is corrupt, just that corruption is widespread. Go talk to journs who cover this beat. What you see in the media is a fraction of what they dig up (a lot they have to omit due to lack of reader patience with how many people involved, they need to anchor the narrative on a few players and the worst aspects of the conduct).

          2. nick b

            I’m not communicating my point well enough. I think the author muddled a lot of the story together to prove a point. He completely leaves out the impact of the loss off the municipal insurers and how that impacted the market, these deals and who could own them. He also does not mention that the thinness of trading in the municipal market that exacerbates liquidity problems and can create the kind of wild volatility that blows up well laid plans. This is byzantine stuff, it’s insanely interconnected and different all at the same time. I was not trying to make the point that ARS were less problematic, in fact, I believe quite the opposite. But it’s a detail not my main point.

    3. nonclassical


      “explanation” at a local level is interrupted by lawyer-legaleze translation of whatever is being proposed…(in larger venue-I’ve experienced such). What is first brought forth sounds little like lawyerly evaluation of…

      It would be better for all to study resources available…citing many, many such
      egregious practices based upon derivatives…

  5. McMike

    Libor rigging, bid fixing, fee rip-offs, municipal face-ripping… and yet, the municipalities are still turning to Wall Street for advice, bond underwriting, investment brokering, privatization schemes, and other products.

    I served on a pension board and I can tell you why, three reasons: lemmings, conflict of interest, and other people’s money.

    The incentive structure for municipal and pension money managers guarantees that the only safe course is to do what everyone else is doing. And of course everyone else is doing what the “experts” (wall street) are telling them to do: buy their stuff. Each entitiy hires a wall street expert, and that buys them carte blanche to fob off blame, becuase they sought expert advice.

    As long as they do what everyone else does (and so get about the same results as everyone else), they are immune from blame. And what everyone does is whatever wall street tells them to do.

    The goal is to be invisible in the middle of the pack.

    The other problem is, as awlays, they are investing other people’s money anyway. The taxpayers or pensioneers in this case.

    So, municipalties take the advice of the sharks, make chum out of the poeople’s money, and then sleep well at night.

  6. clarence swinney

    Senator Grassley is fighting a proposed $75M bonus for 90,000 IRS employees.
    They have probably earned it but must consider sacrifices during this Great Recession.
    44M on Minimum Wage and 46M on Food Stamps.
    We must all sacrifice some to help regain Economic Growth not just Wealth Growth at the top.

  7. Carla

    I was hoping for an article that would give US, the people, some strategies for stopping Wall Street plunder of the public coffers.

    This was very disappointing.

    It is excruciatingly clear by now that neither the bankers nor our elected officials have any incentive to address these crimes, in which, of course, they are complicit.

    1. Dave

      Things were so simple before the digital revolution. Folks had jobs. Cities had revenues, and when money was borrowed for that which was necessary it was expected that it would be repaid in due time. Now that fewer folks have jobs, for some reason there is less revenue. Now that some folks in the public sector have really good jobs, there is need for more revenue. Since the revenue has diminished there is a search for painless alternatives, especially since money is now seen as necessary for that which is not really necessary. We need to maintain or even increase our and their obscenely high standard of living you know. Even a slight decline is unacceptable.

      This creative financing along with excessive debt in general is seen as a solution to the problem of a diminishing standard of living in the general public and diminishing revenue of government entities. In other words, since growth in production and employment appears to be slowing, or even worse, the search for something for nothing has intensified.

      I suggest that this is another form of ranting against the wind. We have had it too good for too long and no amount of financial wizardry is going to fix the problem.

      1. McMike

        Generally speaking, these complex deals aren’t concocted merely to pay the salaries of middle management civil servants.

      2. sgt_doom

        A word to the wise: When perusing the misinformational books over the past five years claiming to dispense “wisdom” and “fact” on the economic meltdown, upon researching the owners of said publishers of this swill, one routinely finds that they are owned by hedge funds and/or private equity funds, an odd reality given the lack of profit in that industry, especially as regards poorly selling global finance books.

      3. nonclassical

        …government is “the people’s” only method of oversight…it is TRUTH, coming forward, that will allow perspective to be applied to real events…that TRUTH is largely still hidden from the American people, attempting to pay to survive…

  8. allcoppedout

    I didn’t think the article much use. Paying municipal accountants more is not part of the answer. It’s time finance was stripped of complexity and those committing fraud were jailed (I’d go as far as suspended sentences for all bank clerks who sold ppi – their mens rea is higher than most dumb crooks I used to put away).
    In the time of pension mis-selling here,many university lecturers who oped-out of the very good employer scheme were the accountants who should have spotted the obvious scam in the private offers which claimed they would do better without the employer contributions (often twice the personal contribution).
    I wanted to know more about the criminality involved, where the fees and kickbacks ended-up and so on – what might stand up on court – maybe some inside story on what the banks thought they were doing. In short I could have put this ‘insight’ together from reading the Guardian or NYT.

    1. McMike

      If I understand you correctly, you are blaming accountants and bank clerks for the malfeasance & negligence of wall street sales executives, county treasurers, and elected officials?

      1. sgt_doom

        I suspect we are all blaming those super-rich, at the helm of Wall Street, who buy up all those corrupt congresional critters to insure the passage of that Private Securities Litigation Reform Act back in 1995, to decriminalize the actions of attorneys, accountants and derivatives dealers involved in financial fraud!

      2. nick b

        I don’t think he was trying to say that at all. One of the ‘suggestions’ in the article was paying local govt finance officials more, so ‘quality’ people will join govt and hopefully understand these financial instruments. Allcoppedout boiled it down to hiring a better accountant.

        The article completely misses the point. Municipal interest rate swaps are an inappropriate hedging tool for the vast majority of us municipalities. They should be restricted if not banned.

        No one can accurately predict the future of interest rates. You can create a model and make very educated guesses, but unless you have a crystal ball, you’re going be wrong sometimes. An interest rate swap is a bet made to hedge interest rate risk over a period of time. There can be a significant downside, and such investments are just not appropriate for public funds. And it doesn’t matter how smart you are either. Harvard lost itself half a billion dollars on interest rate swaps, and they’re not done paying out yet either.

    2. Yves Smith Post author

      Straw man. The article said nothing about paying accountants more. It cited Singapore as a model. In Singapore, as we have written before, top civil servants are paid on the same level as top professionals (think law firm parters). So they don’t have to look to the revolving door (currying favor with people in the private sector to make a good living). They also have very tough and independent internal audit.

  9. Jerry

    The headlines in Brazil state:
    Brazil protests expose deeper social issues
    Small demonstrations have turned into large-scale violent protests, illustrating the vast gap between rich and poor
    When will we see kickback….why should I pay for a building, stadiums, etc for events in which ticket prices are far beyond my means; in Wisconsin, why should my tax dollars support private schools and charter schools when there are public schools; etc. If people desire things beyond what is supported by all and available to all, those other things are private and should be funded privately.

    1. nick b

      It’s a pretty good suggestion actually. The states could easily form ‘bond banks’ that did all the debt issuing for the state’s municipalities. Local officials would apply for funding at the state bond bank and bonds would be issued through the state. This would save localities the expense of hiring bankers and buying credit ratings as all issues statewide would flow from one credit. It would shrink the number of issuers to a more manageable number for investors and increase liquidity for issuers and investors alike. It would probably lead to more liquid and transparent markets as well.

  10. Jon Davies

    Isn’t the key lesson that municipalities need to understand what they are doing.

    There will always be “snake-oil salesman” trying to invent and sell the latest clever financial product so it is essential that elected officials should understand what is being done in their name. The Warren Buffet school of investment of “we don’t make investments when we don’t understand what is going on” would be a good one to apply.

    Your point that long term investment requires long term finance is the bare minimum.

    I just despair that we can actually do anything about the financial madness that affected such a large number of organisations.

    1. Yves Smith Post author

      The problem is most officials feel very vulnerable to someone saying “you did this deal for 4.5%. How irresponsible! If you’d done this structure, you’d have paid only 4.25%. Waste! Must have been corruption! You cost your citizens hundreds of thousands of dollars”.

      They feel VERY pressured to take the cheapest-looking deal.

      And remember, it’s not just municipalities who get snookered with derivatives, it’s also corporations and investors. It’s just the failures are often bigger and more visible with public officials.

      The problem is pretty basic. It’s easy to assess the nominal price (the expected all in payments). It’s very hard to assess the risk adjusted price accurately (particularly since standard models greatly understate tail risks, recall how Taleb hectors finance professionals). So people fixate on what they understand and tend to ignore or underweigh the rest.

      1. Jon Davies

        I can appreciate the big pressure on officials to get the best “superficial” rate. Somehow we need to get it accepted that the risk adjusted price is impossible to compare by a mere mortal. Even the so called experts at Long Term Capital Management didn’t get that right.

        The debate has to be about acceptable forms of financing i.e no complex derivatives. Someone has to make a judgement about the types that are acceptable. Maybe it should be the voters who decide what level of risk their community should take in financing. I think we would be surprised by the sophistication of their decisions. I would rather trust them than the views of the rating agencies who have destroyed their credibility for assessing risks.

  11. Adam

    This isn’t the first time. Michael Milken and Fred Carr pumped little municipalities and regional development authorities full of junk bonds coupled with guaranteed investment contracts (sort of a proto-CDS) from Executive Life in the 1980s. Result was disaster, but the Street learned the playbook.

  12. Paul Tioxon

    So, the circulation of capital from the private sector to the public sector, via Wall St financial innovations follows this route: cut business taxes, providing the pretext to borrow money from the capital markets and then, demand that the highest bidding government entity pay for locating anything in their jurisdiction.


    Discover Where Corporations are Getting Taxpayer Handouts Across the United States

    “A growing number of state and local governments are disclosing which companies they are giving tax breaks and other subsidies in the name of job creation and economic development. Yet much of that information is being disseminated through hard-to-find reports and web pages. SUBSIDY TRACKER brings together the information from those far-flung sources–along with unpublished data obtained through open records requests–to create the first national search engine for state economic development subsidies.

    Each entry identifies the recipient company and, depending on availability, provides data on the dollar value of the subsidy, the program and state or local agency involved, the location of the subsidized facility, and the employment impact of the subsidy. Each entry also indicates where the data came from, so the user can go to the original source for more details. For more information on the data, see the User Guide.

    Subsidy Tracker is a work in progress. We are continually adding data, both published and unpublished, from more programs and increasing the years of coverage. Subsidy Tracker currently contains data on more than 249,000 subsidy awards from 426 programs in all 50 states and the District of Columbia.

    NEW: We have just added a new feature to Subsidy Tracker called MEGADEALS. It consists of entries on every subsidy package worth at least $75 million we could find from the past three decades—240 in all. It draws not only from the official disclosure data otherwise used here but also fills gaps in that data by using a variety of other information sources. See here for a report on megadeals and a spreadsheet download of all the entries.”

    Have fun looking up what is coming out your hide right where you live!

    1. Mr. Jack M. Hoff

      Way to go Paul. More light needs to be shed on that subject. Perhaps the bankers aren’t the only crooks in any given town. Seems to me that city administraters are paid very lucrativly and they all follow the same master plan which obviously starts in a centrally planned arena. Otherwise, why would they all do the same thing from coast to coast? And a good part of what they do is to play the ‘look what business I’m bringing to town, maybe there’s a job going to be available… never mind that the tax breaks, free buildings, etc. always cost the taxpayers more than any revenues acheived from a few more jobs. And thats “if” the business stays on. If in fact the business is sucessful, they never pay taxes again. They simply threaten to move to another town if their demands aren’t met. Fact is, Corporate US dictates to the public what it wants, all the way from Washington DC to any small town. Why do you suppose the TPP trade deal is being held in secret, and will be rammed up our asses like a freight train?

      1. Paul Tioxon

        An involuntary facebook of the 1%

        We bring transparency to influential social networks by tracking the key relationships of politicians, business leaders, lobbyists, financiers, and their affiliated institutions. We help answer questions such as:

        Who do the wealthiest Americans donate their money to?
        Where did White House officials work before they were appointed?
        Which lobbyists are married to politicians? Who do they lobby for?

        All of this information is public, but scattered. We bring it together in one place. Our data derives from government filings, news articles, and other reputable sources. Some data sets are updated automatically; the rest is filled in by our user community.

        If you like LittleSis, you may also try:

        1. Mr. Jack M. Hoff

          Your site is hard to navigate Paul. But after some time there I get the idea. This is precisely what good people should be exposing, not things that cause bickering and argument. I’m just saying that stool pigeons can act like theyre on one side but be serving other interests…. I wonder cruising the varous blogs, why so many are obviously disinterested in exposing anything that effects real change. Rather they beat around the bush and accomplish nothing. Like the govt themselves, they serve to de-sensitize people to the atrocities committed.

  13. washunate

    Fraud, meet prosecution. There is no other solution.

    And getting to suggestion number 5 really undermined the credibility of the rest of the article for me. It is laughable to claim that skills gaps are the problem in our society, or that support staffers more generally have meaningful influence over decision-makers.

    One bigger picture quibble, too:

    “Since Congress and the Obama financial regulators are MIA on cleaning up this mess”

    That’s completely backward. The Administration isn’t MIA; they’re directly involved in continuing the mess. A randomly selected group of people from the phone book would have accidentally prosecuted more financial crooks by now.

  14. ScottS

    but even among the better-indended officials, it’s way too easy for them to be snookered. They lack the expertise to evaluate fancy financial products.

    Lyle Lanely: You know, a town with money is a little like the mule with the spinning wheel. No one knows how he got it and danged if he knows how to use it.

    [crowd laughs]

    Homer: He heh… mule.

    Lyle Lanely: The name’s Lanely! Lyle Lanely. And I come before you good people tonight with an idea. Probably the greatest… Aw, it’s not for you. It’s more of a Shelbyville idea.

    [starts to walk out of the room]

    Mayor Quimby: [at the podium] Now wait just a minute! We’re twice as smart as the people of Shelbyville. You just tell us your idea and we’ll vote for it!

    Lyle Lanely: All right. I’ll tell you what I’ll do! I’ll show you my idea.

    [runs over to a display covered by a sheet, and he whips it off, revealing a diorama of Springfield with a monorail model going through it]

    Lyle Lanely: I give you the Springfield Monorail!

    [crowd gasps]

    Lyle Lanely: I’ve sold monorails to Brockway, Ogdenville, and North Haverbrook, and by gum I’ve put them on the map!

    [holds up a map of the U.S. with those towns’ names drawn on with pen]
    Lyle Lanely: [begins to chant rhythmically] Well sir, there’s nothing on Earth like a genuine, bona-fide, electrified, six-car monorail! What’d I say?

    [points at Ned Flanders]

    Ned Flanders: Monorail!

    Lyle Lanely: What’s it called?

    Patty Bouvier, Selma Bouvier: Monorail.

    Lyle Lanely: That’s right, monorail!

    [runs up to the stage, the crowd begins chanting]

    Crowd: Monorail. Monorail. Monorail.

    [continues underneath those who speak]

    Miss Hoover: I hear those things are awfully loud.

    Lyle Lanely: [playing the piano on stage] It glides as softly as a cloud.

    Apu: Is there a chance the track could bend?

    Lyle Lanely: Not on your life, my Hindu friend.

    Barney Gumble: What about us brain-dead slobs?

    Lyle Lanely: You’ll be given cushy jobs.

    Grampa Simpson: Were you sent here by the devil?

    Lyle Lanely: No, good sir, I’m on the level.

    Chief Wiggum: The ring came off my pudding can.

    Lyle Lanely: Take my pen knife, my good man. I swear, it’s Springfield’s only choice! Throw up your hands and raise your voice!

    Crowd: [singing] Monorail…

    Lyle Lanely: [speaking] What’s it called?

    Crowd: [singing] Monorail…

    Lyle Lanely: Once again!

    Crowd: [still singing] Monoraaaaaaaaaaaaaaaaaaaaaail!

  15. Frank Miata

    Dear Yves,
    As you point out, municipal finance has been corrupt for a long time. One comment called for a state banking scheme to cut out the banksters from the marketing of municipal bonds-nice idea. Guess why this will never happen? The state government legislators are even more craven than their national counterparts. Political pressure, economic warfare (threats to move jobs out of state) huge propaganda machine to snow the mob: all opposed to rational solution. It will be easy for journalists to point to your blog in the next crisis and ask permission to reprint the many good pieces on the depravity of banksters and finance capitalism.
    By the way, that was an unkind thing to suggest that we might imitate China and shoot our fraudsters. Have you lost your sense of humor?

    1. nonclassical

      “anti-government” repubLIEcons blame state governments, who had nothing, nothing, nothing to do with Wall $treet economic disaster…scapegoating of victims, at its finest…

  16. impermanence

    Banking is theft, something people have known for thousands of years.

    Pay-off the right people [in this case, the ENTIRE professional class], set-up pins and fire that cannon ball!

    The only question is when this will happen again [after this era’s thieves are dead and buried].

    1. nonclassical

      …when it will happen again..? When history has been thoroughly revised, or forgotten…(“Wall $treet-A History”-Geisst)

  17. Swamp Fox

    The CIA ad NSA are far far far dirtier ……

    Judson Witham Is 100 % Correct THIS IS THE NSA LINK ….

    30,000 Demand Investigation of S&L Collapses, Contra Link
    by Christic Institute
    NOTICE: TO ALL CONCERNED Certain text files and messages contained on this site deal with activities and devices which would be in violation of various Federal, State, and local laws if actually carried out or constructed. The webmasters of this site do not advocate the breaking of any law. Our text files and message bases are for informational purposes only. We recommend that you contact your local law enforcement officials before undertaking any project based upon any information obtained from this or any other web site. We do not guarantee that any of the information contained on this system is correct, workable, or factual. We are not responsible for, nor do we assume any liability for, damages resulting from the use of any information on this site.

    Christic Institute, Thursday, November 15, 1990

    LOS ANGELES–The Christic Institute today delivered to Congressman Tony Beilenson (D-Calif.) petitions from 30,000 citizens demanding a public Congressional investigation of evidence that CIA-sponsored covert operatives may have looted dozens of savings and loan institutions, funneling those monies into the illegal contra resupply operation during the time aid to the contras was outlawed by Congress.

    Beilenson is chair of the powerful House Permanent Select Committee on Intelligence, which oversees the operations of the Central Intelligence Agency and other covert agencies.

    “The Christic Institute has uncovered evidence that covert operatives and drug traffickers exploited dozens of S&Ls to launder funds destined for the illegal contra war,” said Daniel P. Sheehan, the Institute’s general counsel. “This evidence suggests that the links among S&Ls, covert operatives and organized crime can be traced to the `off-the-shelf enterprise’ described by Oliver North before the Iran-contra investigating committees.

    “It appears that S&Ls may have made fraudulent loans in order to siphon money to the contras at a time when Congress had cut off aid to the rebels.”

    The Christic Institute also cited a series by Houston Post reporter Pete Brewton which said that “at least 27 failed financial institutions (25 S&Ls and two banks) had links to CIA operatives or to organized crime figures with links to the CIA.”

    “The savings and loan collapse will cost taxpayers over $500 billion,” said Sara Nelson, the Institute’s executive director. “If it is true that S&L money went to the contras, then the U.S. public was duped into paying the bill for the contra war after Congress had outlawed contra aid. The evidence pointing to a systematic fraud on the American people demands a thorough investigation.”

    Separate investigations have been conducted by the Institute, the Houston Post and Congressman Frank Annunzio, chair of the House Banking subcommittee on financial institutions. Each investigation has raised serious questions about the relationships among failed S&Ls, the illegal contra resupply operation and CIA operatives.

    Christic Institute activists joined professional canvassers from the Citizen/Labor Energy Coalition to gather the signatures. In one day of canvassing in 22 cities, more than 30,000 people signed the Christic Institute’s petition demanding an investigation of the links between covert operations and the S&L collapse.

    “The response to this petition has been enormous,” said Nelson, “and shows just how upset people are that Congress has failed to investigate the intelligence connection to the S&L collapse. We hope that Congressman Beilenson will take this message very seriously.”

    In late 1988, during its ongoing investigation of the _Avirgan v. Hull_ lawsuit, the Christic Institute uncovered evidence that CIA-sponsored drug traffickers may have used dozens of thrifts in several states to launder cocaine profits destined for the illegal contra war in Nicaragua.

    _Avirgan v. Hull_ was filed in May 1986 on behalf of journalists Tony Avirgan and Martha Honey. Avirgan was one of more than 20 reporters injured in May 1984 when a terrorist bomb was detonated during a press conference in La Penca, Nicaragua. Eight people were killed in the explosion, including an American reporter for the Religious News Service.

    Following investigations by Avirgan and Honey and by the Christic Institute, a suit was filed charging that the bombing was planned and carried out by a racketeering enterprise involved in drug trafficking, gun smuggling, money laundering and assassination.

    The suit is on appeal before the 11th Circuit Court in Atlanta. Oral arguments in the appeal are expected to be heard in the coming weeks.

    1. nonclassical

      Follow the name, Alan “Buzzy” Krongard….CIA, Iran Contra, Deutche Bank, “puts” on United and American Airlines, 911…

    1. Mr. Jack M. Hoff

      Swamp Fox, you’re absolutely right. Thats a fascinating website there. Isn’t it funny how gullible the populace of this country have been for so long. I had heard it said that Nixon was the mobs man put into office. Its pretty plain from those revelations that Reagan sure was, and every one since. That should be rewuired reading in schools….

  18. Conscience of a Conservative

    I believe there are a couple of contributors to this problem.

    First the muncipal official in charge of these projects, can lack experience and may have gotten to this position more due to party loyalty, affiliation and nepostism than to pure skill. Add to that this is not their money. Enter Wall Street who sees the money as prime booty to be looted.

  19. Big Picture

    This crap has been documented, but mostly ignored by the corp. owned media. This is from Feb. 2008.
    Feb. 1 (Bloomberg) — James Barker saw no way out. In September 2003, the superintendent of the Erie City School District in Pennsylvania watched helplessly as his buildings began to crumble.

    The 81-year-old Roosevelt Middle School was on the verge of being condemned. The district was running out of money to buy new textbooks. And the school board had determined that the 100,000-resident community 125 miles north of Pittsburgh couldn’t afford a tax increase. Then JPMorgan Chase & Co., the second-largest bank in the U.S., made Barker an offer that seemed too good to be true.

    David DiCarlo, an Erie-based JPMorgan Chase banker, told Barker and the school board on Sept. 4, 2003, that all they had to do was sign papers he said would benefit them if interest rates increased in the future, and the bank would give the district $750,000, a transcript of the board meeting shows.

    “You have severe building needs; you have serious academic needs,” Barker, 58, says. “It’s very hard to ignore the fact that the bank says it will give you cash.” So Barker and the board members agreed to the deal.

    What New York-based JPMorgan Chase didn’t tell them, the transcript shows, was that the bank would get more in fees than the school district would get in cash: $1 million. The complex deal, which placed taxpayer money at risk, was linked to four variables involving interest rates. Three years later, as interest rate benchmarks went the wrong way for the school district, the Erie board paid $2.9 million to JPMorgan to get out of the deal, which officials now say they didn’t understand.

    “That was like a sucker punch,” Barker says. “It’s not about the district and the superintendent. It’s about resources being sucked out of the classroom. If it’s happening here, it’s happening in other places.”

    1. washunate

      So the head of an organization claims openly that he engaged a six figure contract he didn’t understand?

      Doesn’t that speak exactly to the problems in our system, the complete lack of accountability and basic standards for people RUNNING our educational and healthcare and other supposedly public organizations?

  20. rd

    It is still surprising that states leave individual entities such as counties, school districts etc to fend for themselves against a banking industry that is dedicated to theft more than anything. You would think that smaller entities at least would have somewa to get expertise. The comment that state legislatures would never go for state banks is unfortunately probably accurate. In the depths of the great recession 1.8 some of our state legislators looked at the dakota experience and proposed doing the same thing here. Great wails from the Repugs but the frightening thing was that our democratic treasurer said he was against it because he had good relationships with wall street and (unbelievably) the Bank of America. That made my hair stand up on end.

  21. People Opinion

    The buyer is pledged liquidity founded on the designated day of reset. ie: if you desire to put them back to the table who underwrote the deal they should accept them and pay you par. It’s all muddled simultaneously in a narrative that departs out a allotment. This post would be better assisted by constraining the condemnation to interest rate swap bankers. If you’re really involved in how these things get sold and bought, do a little research. Nice post.

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