Chicago Public Schools’ $100 Million Swaps Debacle Demonstrates High Cost of High Finance

I’ve been late to write up an important series published by the Chicago Tribune earlier this month on a costly swaps misadventure by the Chicago Public Schools. Like all too many state and local government entities, the Chicago Public Schools were persuaded to obtain $1 billion of needed ten-year financing not through the time-and-tested route of a simple ten year bond sale but the supposedly cost-saving mechanism of issuing a floating-rate bond and swapping it into a fixed rate. An impressive, expert-vetted analysis of the deal by the Chicago Tribune estimated that the school authority has in fact incurred $100 million in present-value losses on that $1 billion bond issue.

What is important about this story is that the CPS’ sorry experience has been replicated at state and local entities all over the US and abroad, yet remarkably few have been willing to sue. In some cases, it’s likely that rank corruption was involved, that the consultants hired to vet the deal were cronies and not up to the task, or worse, that key people at the issuer were overly close to the banks involved. In other cases, officials are afraid of banks, that if they sue them, they’ll be put on a financing black list and will have trouble fundraising. That’s nonsense by virtue of how competitive and fee-hungry bank are. And the more government authorities that got the nerve to sue, the less noteworthy any particular case would be.

As the series explains, entities like the Chicago Public Schools has previously been protected from their naivete by not having the authority to engage in fancy finance. But the state of Illinois passed legislation in 2003, written by a lawyer at an in-state bond firm, even though no local entity had asked for these new powers. Here is how local governments were set up to be shorn:

The bill specified that any government able to issue at least $10 million in bonds could enter an interest-rate swap, making the deals accessible to towns with populations as small as 12,000. Lawmakers did not put even that restriction on auction-rate bonds.

The law also gave municipal officials explicit permission to raise taxes in order to pay interest on swaps.

Yet despite the potential risks to taxpayers, the bill included few oversight measures or checks on towns and school districts. For example, the bill did not cap the percentage of debt that could be issued at floating rates. In CPS’ case, that amount at one point rose above 40 percent. The state of Illinois, by comparison, is restricted to 20 percent.

Few Illinois government entities took advantage of the new, um, flexibility, but the Chicago Public Schools did in a big way, issuing $1 billion of auction rate securities by 2007 and swapping them into fixed rates. That amount of auction-rate securities issuance was not only more than any other school district in Illinois issued, it was more than was sold by the state of California. Crisis followers no doubt recall that the auction-rate securities market promised investors that the instruments were almost as liquid as money-market funds, and they could get cash back in weekly auction. The reality was that there was not enough investor buying at auctions. Dealers were supporting the auctions and carrying more and more inventory. When the monoline insurers were facing downgrades, which would have left the investment banks with losses (most issues were guaranteed by monolines), dealers dumped their inventories and quit supporting the market. The deals had clauses so that if the investor was unable to get his money back at a weekly auction, the issuer, here meaning Chicago Public Schools, would have to pay a much higher interest rate.

And that’s before you get to the swap losses.

The story shows a not-surprising backstory: bankers were actively soliciting the Chicago Public Schools with proposals involving auction-rate securities, the hot product of the day. CPS hired a politically connected former banker to evaluate the deals. Any regular reader of this site no doubt has figured out that it takes a high level of expertise to evaluate derivatives, and that’s well beyond the skill level of most “bankers”. The open question here. Even so, in this case the analysis was so slipshod that it raises the question of whether the advisor ever intended to do anything more than provide a paper trial supporting going ahead with the deal. From the Tribune:

To evaluate the complicated deals, CPS officials turned to Cepeda and her firm, A.C. Advisory.

Cepeda has an MBA from the University of Chicago and spent more than 10 years as a banker before founding A.C. Advisory. She also married into one of the most influential political families on Chicago’s South Side. Her late husband, Harvard-trained lawyer Albert Maule, was a grandson of Corneal Davis, a longtime state senator known for delivering black votes for Chicago’s Democratic machine. Maule later was appointed to the city’s police board by then-Mayor Richard M. Daley.

Five months before Maule died of cancer in 1995, he helped Cepeda start A.C. Advisory, according to a 2013 Tribune profile. The firm got its first contract with CPS months later, and Cepeda continues to advise the district and the city. A.C. Advisory received about $4.7 million in fees on CPS deals from 1996 through 2013.

Cepeda’s firm was the primary adviser on three of CPS’ four auction-rate deals, district records show; on the first such deal, she was the secondary adviser….

Spreadsheets from A.C. Advisory on three bond issues from 2003 and 2004 showed that the district stood to save nearly $90 million in interest costs over the life of the bonds by using auction-rate securities and swaps instead of traditional fixed-rate debt.

But experts consulted by the Tribune questioned Cepeda’s analysis and her depiction of the risks involved. “This is not a sophisticated analysis,” said Northwestern’s Hagerty, who reviewed the spreadsheets.

For one, the calculations were based on a worse credit rating than the district had at the time. They also ignored the fact that CPS always bought insurance on its fixed-rate bonds, which results in better interest rates. Both of those decisions drove up the predicted cost of the fixed-rate option.

In an email to the Tribune, Cepeda said the rates she used were based on the rates CPS likely would have paid.

More significantly, her analysis assumed that the interest-rate swaps linked to the auction-rate bonds would insulate the district completely from fluctuating rates. It predicted that the district would be responsible only for the fixed-rate payments specified in the swap.

But the auction rate CPS would pay on the bonds and the floating rate it would receive from the swap were unlikely to match exactly.

The swaps in A.C. Advisory’s analysis were relatively inexpensive products linked to the London Interbank Offered Rate, or Libor, the rate banks charge one another for short-term loans. Experts say that rate cannot be counted on to move in lockstep with municipal bond rates, particularly auction rates. In the years ahead, they would diverge dramatically.

Eventually auction rates would soar above Libor, reaching as high as 9 percent and eating into the projected savings. But while the bond contracts mentioned the possibility that payments could hit these maximum rates, A.C. Advisory did not point out that potential cost in any of the documents that CPS supplied in response to the Tribune’s public records requests.

That worst-case scenario should “absolutely have been clearly laid out” in any analysis comparing the cost of fixed-rate debt with auction-rate bonds, said Florida Director of Bond Finance Ben Watkins, who chairs the debt committee of the Government Finance Officers Association.

The district’s use of swaps also jacked up the cost of refinancing the bonds in the future and left the district unlikely to benefit if rates dropped — a risk Watkins said he would never take.

“You’re taking a position that rates will never be better,” he said.

The story also reports that an advisor that warned against the deals was given the cold shoulder by the Chicago Public Schools’ staff.

If you can only read one part of this series, I recommend the story on the last auction rate securities deal that CPS did, in July 2007, which also proved to be the most costly to the district. The city’s agent, Bank of America, clearly knew that the auction rate securities market was in trouble, yet pressed the Chicago Public Schools to do the deal.

The school district may well have recourse, and the Tribune series has led to calls for try to recoup some of the baked-in losses. Rahm Emanuel has pooh-poohed the idea, saying “there’s a thing called a contract,” so the idea of using the threat of withholding the city’s future business to force banks to the negotiating table won’t be deployed. But there are other options:

CTU [Chicago Teachers Union] Vice President Jesse Sharkey waved what he said was an application for arbitration with the Financial Industry Regulatory Authority, a self-regulatory organization that operates the largest dispute resolution forum in the securities industry.

It’s not clear whether the six-year window to file a FINRA claim is still open. CPS inked its last swap contract in 2006, and in 2008 the worsening economy aggravated the deals. Brad Miller, an attorney and former congressman who has worked with the Chicago Teachers Union, believes a lawsuit would be a better course of action.

“Illinois law does not apply the statute of limitations to claims by government entities,” he said in an email. “The city and CPS can bring claims in court under Illinois state law and not have a timeliness problem.”

I’m not keen about FINRA arbitration since SEC commissioner Kara Stein has called out the regulator for issuing paltry fines. But perhaps more important, local politicians need to feel more heat. If you are in Illinois, call or write your state legislator, and if you are in Chicago, write or call the mayor’s and the Chicago Public Schools’ offices.

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  1. YankeeFrank

    Its nice to see that Mayor of Chicago Rahm Emanuel understands his job as protecting financier profits over the public good. “There’s a thing called a contract” indeed. Rahm’s going to hell, the miserable turd. He and Obama can be bunk-mates.

    1. OIFVet

      Rahm Emanuel believes in the sanctity of contracts only insofar as said contracts benefit the financial industry/private special interests. He has also explained at length the sanctity of the terrible parking meter rent extraction deal. For him, the “sanctity” of contracts does not extend to contracts with public employee unions, like Chicago public school teachers. That’s why Rahm and his likes in state government wrote a law that busted the contracts on teachers’ pensions and those of other unionized public employees in Illinois. Unfortunately for him, an Illinois Circuit Court judge disagreed: Circuit Court Judge Strikes Down Illinois Pension Overhaul Law

      Won’t we rid ourselves of this meddlesome parvenu next March? I hope the public anger will overcome Rahm’s considerable campaign chest.

    2. different clue

      We like to comfort ourselves that Emmanuel and Obama and so forth will go to hell. But we really can’t rely on that. What if hell doesn’t exist? Then Emmanuel and Obama and so forth will have the last laugh. What if the only hell they ever experience is the hell on earth we can force them to experience if we can somehow figure out how to do it. And gather the focused power to do it.

  2. craazyman

    This entire post is a debacle. Seriously suffering from “ED” — Editorial Dysfunction. Definitely there’s an evident need here for private lessons in “EC” Editorial Construction along with “MMI” — Mathematical Model Interpretation. Wandering words and lazy logic do not convincing convey complex quantitative causistry. The reader, who simply wishes to lay back lazily and be filled with pleasurable knowledge, fails to experience the full thrust of the author’s argument. The Infinite Model Theorem (IMT) reveals the source of confusion. Given a mathematical model (A) formulated by an idiot savant (B), there exists, simply by reference to reality inspection, a second idiot savant (C) who critiques A and formulates a contrasting model (D). If we let B = n and C = n + 1, it can be shown that there exists an infinite number of idiot savants and resultant models, all of which purport to explain the phenomenon under observation — in this case, “the future”. You can observe the future, but the perspicacious analyst will note the future never actually arrives, which renders any definitive statement about it’s construction to be simply an exercise in probability theory. This of course introduces a second set of idiot savants and infinite numbers of contrasting mathematical models, which exist by reference to the IMT. The probability density function formed by the model creation function is sufficiently abstract that it requires a third set of idiot savants and models to be translated into quantification. As a result, there exists a fourth set of idiot savants and models. QED. The process only reaches a conclusion when the money runs out, since even idiot savants are smart enough to realize they can’t work for free and make a living.

  3. Fair Economist

    Chicago Public Schools is a huge operation (2013 revenue: 4.8 billion) and has no business contracting out for financial advice. They can certainly afford to have financially savvy people on staff – people who *don’t* have conflicts of interest. And they paid almost $300,000 per year for somebody who couldn’t even get the credit rating right or account for insurance (or perhaps chose not to – conflict of interests, again)? That sounds like some nasty corruption to me.

    1. craazyman

      all lot of people on Wall Street get paid a lot more than that for not getting credit ratings right.

      $300,000 sounds like a really good deal!

    2. craazyman

      all lot of people on Wall Street get paid a lot more than that for not getting credit ratings right.

      $300,000 sounds like a really good deal!

    3. Yves Smith Post author

      Your assumption is incorrect. CPS only financed four times from 2003 to 2007. That’s not even remotely frequent enough to justify having a corporate finance expert on staff, PARTICULARLY since someone competent to evaluate these deals would make well over $2 million a year on Wall Street.

      It’s cheaper to just say no and do simple fixed rate bonds, but then someone will try arguing that CPS is wasting money by not using more complex financial structures.

      1. lambert strether

        Right, because complexity is always a money-saver…. I can’t help but recall the old saw that “You can’t cheat an honest man” with a lot of thus stuff.

  4. Working Class Nero

    It would interesting to know if this bond agreement was put together by the same “Friendly FIRE” elements so eloquently described by Robert Fitch back in 2008:

    Obama’s political base comes primarily from Chicago FIRE—the finance, insurance and real estate industry. And the wealthiest families—the Pritzkers, the Crowns and the Levins. But it’s more than just Chicago FIRE. Also within Obama’s inner core of support are allies from the non-profit sector: the liberal foundations, the elite universities, the non-profit community developers and the real estate reverends who produce market rate housing with tax breaks from the city and who have been known to shout from the pulpit “give us this day our Daley, Richard Daley bread.”

    Aggregate them and what emerges is a constellation of interests around Obama that I call “Friendly FIRE.” Fire power disguised by the camouflage of community uplift; augmented by the authority of academia; greased by billions in foundation grants; and wired to conventional FIRE by the terms of the Community Reinvestment Act of 1995.

    And yet friendly FIRE is just as deadly as the conventional FIRE that comes from bankers and developers that we’re used to ducking from. It’s the whole condominium of interests whose advancement depends on the elimination of poor blacks from the community and their replacement by white people and—at least temporarily—by the black middle class—who’ve gotten subprime mortgages—in a kind of redlining in reverse.

    This “friendly FIRE” analysis stands in opposition to the two main themes of the McCain attack ads. Either they try to frighten people into believing that Obama is a dangerous leftist who hangs with Bill Ayers the former Weatherperson; or they assert he’s a creature of the corrupt Chicago machine.

    There are a few slivers of meat floating in this beggar’s broth of charges. Yes,Obama worked with Ayers, but not the Ayers who blew up buildings; but the Ayers who was able to bring down $50 million from the Walter Annenberg foundation, leveraging it to create a $120 million a non-profit organization with Obama as its head. Annenberg was a billionaire friend of Ronald Reagan and Margaret Thatcher. Why would he give mega-millions to a terrorist? Perhaps because he liked Ayers’ new politics. Ayer’s initiative grew out of the backlash against the 1985 Chicago teachers’ strike; his plan promoted “the community” as a third force in education politics between the union and the city administration. Friendly FIRE wants the same kind of education reform as FIRE: the forces that brought about welfare reform have now moved onto education reform and for the same reason: crippling the power of the union will reduce teachers’ salaries, which will cut real estate taxes which will raise land values.

    1. Doug Terpstra

      Disturbing insight into the consummate chameleon and his dark netherworld of Chi-Town cronies. Emanuel is one shrewd operator when it comes to the selectuve sanctity of contracts. What a creepy crime syndicate.

  5. Chauncey Gardiner

    …”The school district may well have recourse, and the Tribune series has led to calls for try to recoup some of the baked-in losses. Rahm Emanuel has pooh-poohed the idea, saying “there’s a thing called a contract,” so the idea of using the threat of withholding the city’s future business to force banks to the negotiating table won’t be deployed.”

    I look at this in the context of Wall Street’s and the corporatists’ ongoing attack on PUBLIC education and PUBLIC services through funding mechanisms such as we see in this instance. Similar to what occurred in Jefferson County, Alabama and elsewhere.

    1. kimsarah

      I was thinking the same thing. Somebody ends up on the short end of the stick — taxpayers and pensioners — while somebody else makes out like a bandit — the crime syndicate cronies and banksters.

  6. Benedict@Large

    For those unfamiliar with Rahm’s bio, after leaving the Clinton White House, he spent some time in Chicago before moving on to the US House of Representative, where he came with bags full of money, thereby almost instantaneously propelling him into a leadership role. Of those months in Chicago, Rahm spent 16 of them working for a major banking firm, for which he received $12 million in compensation. (Nice job if you got the “resume”.) To say today then that Rahm owes a few favors is quite the understatement. He owes everything he is to the elites of Chicago FIRE.

  7. Butch In Waukegan

    Rahm, like Obama, promised the most transparent administration evah, with similar results

    From the linked article:
    That bill was drafted by an attorney for Chapman and Cutler, a law firm that represented banks involved in $770 million worth of CPS bond deals between 2004 and 2009, according to the Tribune.

    A spokesman for Chapman told the Trib that the division of the law firm that represented those banks is separate from the division that wrote the bill.

    The article reveals more connections between Obama’s charter schools cadre and this bond deal.

  8. Wayne Gersen

    This kind of financial information gets lost in reporting on public education, which tends to go in the direction of “brave politicians fighting back against unions”. Here’s what I took away from this:
    =>Mayor Emmanuel’s unwillingness to sue the banks will shift the blame to the school district in the same way victims of predatory loans are blamed for their gullibility in accepting liar loans from banks.
    =>The school district will be required to make budget cuts to offset the revenue lost as a result of financial mismanagement… and the budget cuts will affect the children in the schools while the banks who made the loans will be held harmless
    =>The involvement of investors who make contributions to political campaigns and who MAY stand to gain if more for-profit charter schools open is suspicious to say the least
    =>It appears that these financial decisions were made during Arne Duncan’s tenure as CEO of the CPS… a link that was not made in this post but one which is not lost on many education policy wonks like me.
    Thanks for bringing all this to the forefront…

    1. Sluggeaux

      I haven’t slogged through the actual Tribune reporting, but if Arne Duncan was CEO when these “heads-I-win, tails-you-lose” interest rate swap deals were crafted, this was straight-up looting by the FIRE sector. As Robert Fitch pointed out back in 2008, that is what Barry, Rahm, and Arne do — they appear to be smooth-talking shills for these FIRE-friendly schemes like interest rate swaps and mandatory private health insurance.

      However, the legislative watchdogs are happy to take the Dark Money and sign-off on giving away our public patrimony, infrastructure, and collective savings. The attribution to W.C. Fields above is spot-on: “You can’t cheat an honest man. Never give a sucker an even break or smarten up a chump.”

  9. Fíréan

    Thank you for posting this article.
    While the looting in the USA at street level gets much main stream media attention, the looting of America and other nations at this level, the $ millions and billions, receives little or no attention, no punished for the guilty nor restitution for the losses, and may well be continuing until we know of it after the fact.

  10. NotSoSure

    Orange County Redux soon perhaps? You really have to be “high” to see the benefits of high finance. I wonder if “persuasion” involves visiting places and imbibing substances that truly makes you “high”.

  11. not_me

    Someone please inform me why pay-as-you-go would not work for State and local governments? Or if/when not, then how about interest-free loans from the monetary sovereign (eg. US Treasury), if not outright grants?

    1. Yves Smith Post author

      I would assume the bonds were issued to finance major capital expenditures, as in school construction. You can’t do that on a pay-as-you-go basis.

      1. Jay M

        The builders could be assessed fees to finance the capital expenditures for new schools. Deferred maintenance uses bonds which usually are guaranteed by the property owners. It is a tangled web we weave . . .

        1. Jay M

          I meant to mention that fees would raise the cost of housing, while property taxes rising because of costs of decaying infrastructure inhibits inner city investment to the point of collapse.

          1. kimsarah

            Many communities do levy impact fees on the developers and home builders to ease the burden on current property owners, many of whom are on fixed incomes.
            The idea that those who bring growth should help pay for the growth is a good one, but those industries and the chamber oppose it because the impact fees end up getting passed onto to the new construction, raising the cost to the buyers and potentially cutting into the profits of the builders.
            As for Yves’ point, standard bond issuances without the trickery of interest rate swaps is sort of a pay as you go approach. Many lock in at good rates, and if rates go lower they can refinance the bonds and save money. Of course those cities with a sound financial history and 8 percent or more budget reserve are the most attractive to buy bonds from.

            1. kimsarah

              Taxpayers know up front what the cost will be to them over the long haul, and there are no surprises. Many places require a voter referendum when issuing large amounts of debt, and those that don’t at least try to win political support from the people or risk getting thrown out of office.

  12. run75441

    Detroit did something similar to back up city pensions which they did not may the minimum contributions to over the years to the tune of $1.44 billion (Kilpatrick).

    “At issue is a 2005 deal engineered by then-Detroit Mayor Kwame Kilpatrick, UBS and Merrill Lynch-backed SBS Financial Products The city borrowed $1.44 billion in variable-rate debt to eliminate its unfunded pension liabilities. It was the financial equivalent of a Hail Mary pass that was not only intercepted but returned for a touchdown.”

    In the state’s constitution, there can be no cutting of pensions by the legislature or the governor. No state court can do it; but, a federal court can do so and did cut pensions for workers (Rhodes). To back these swaps up, the city signed over casino funds equally $180 million annually.

    UBS and BofA were the holders of the swaps. I would have to check further but Orr agreed to pay both 75 cents on the dollar plus some large sums of money and future consideration. Why they got special consideration for gambling is beyond me. The state Republicans did little to help metropolitan Detroit which makes up 52% of the state’s GDP.

  13. Jay M

    I like “financial equivalent of a Hail Mary pass”. Is devolution the same as crapification? In a gilt edge day it would be “a Hail Mary pass that is financially sound”. Would we have all lived in Proust’s novels, as decaying ivy on the walls of the city.

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