Denver Schools Get Whacked
Gretchen Morgenson of the New York Times is single-handedly resurrecting the Gray Lady's reputation as a muckraker of the first order. Having already blown a big hole in the side of Goldman Sachs with her December, 2009 story exposing its crooked deal with hedge fund king John Paulson, Morgenson this week took an ax to Colorado's Democratic Senator Michael Bennet, uncovering a Jefferson-County style scam he helped perpetrate on the Denver School system on behalf of several Wall Street banks (including primarily JeffCo villain JP Morgan Chase) while acting as Denver's school superintendent years ago.
The essence of this deal is that Bennet arranged for the Denver school system to raise $750 million for its pension fund using an exotic transaction that involved interest rate swaps. Had the schools raised money using traditional fixed-rate bond issues, the debt would have featured 7.2% interest rates. Instead, Bennet and JP Morgan worked together to raise bucketloads of cash from investors using variable-rate debt with interest rates of about 5%. The banks then slapped an interest-rate swap on the deal that allowed the Denver school system to mimic a fixed-rate loan -- for a fee, of course.
Again, just like in Jefferson County, Alabama, the basic idea here was similar to a homeowner who buys a house with an option-ARM mortgage instead of a traditional fixed-rate loan. You pay less in interest up front, but you're more exposed if the rates change in the future. So to protect against rate changes, you enter into the interest-rate swap, by which a bank like JP Morgan assumes your variable-rate risk in exchange for a fee.
Imagine Satan's very own credit card contract agreement and you get a sense of how much this borrowing is costing the citizens of Denver; so far, the school system has already paid over $115 million in interest and fees since the deal was struck, or about $25 million more than originally anticipated.
And just like the Alabama sewer deal, where JP Morgan slapped an absurd $750 million termination fee on Jefferson County when the deal went south, in Denver the only way out of the deal is an $81 million termination fee, which Morgenson notes would be roughly 19% the size of Denver's annual payroll.
In Jefferson County, local politicians took bribes to sign off on these crappy deals. There's no such allegation of bribery in the Bennet case per se, but instead what ended up happening is that Bennet, after he left the Denver school system, collected campaign contributions from many of the banks involved, including JP Morgan and Bank of America.
Back in February and March when I wrote about Jefferson County I was told by one federal investigator that there were multiple cases involving toxic interest rate swaps similar to the Alabama deal that were still under investigation. In her piece, Morgenson lists some of the municipalities that are cracking under the strain from these deals -- they can be found in major cities all across the country, and there are hundreds of similar deals in Europe, Italy in particular. Morgenson writes:
Last March, the Los Angeles City Council told its treasurer and city administrative officer to renegotiate interest-rate deals the city had used to try to lower its debt payments with the banks that sold them. "If they are unwilling to renegotiate, then those financial institutions should be excluded from any future business with the City of Los Angeles," noted a report by the City Council.
In Pennsylvania, some school districts have unwound interest-rate deals, and the state's auditor general, Jack Wagner, has urged other issuers to follow suit. "For the sake of Pennsylvania taxpayers, I call on the other school districts that have entered into similar swaps contracts to get out of these risky agreements as soon as they possibly can," he said in a statement in February.
Financial stress from these deals could not come at a worse time for cities, towns and school districts already saddled with high costs and falling revenue. Although it is difficult to tally how many public entities entered into interest-reduction deals, a recent analysis by the Service Employees International Union estimated that over the last two years, state and local governments have paid banks that arranged these transactions $28 billion to get out of the deals, seeking to avoid further crushing payments.
Many transactions remain on public issuers' books. S.E.I.U. estimates that New Jersey would have to pay $536 million to get out of its derivatives contracts, while California faces $234 million in such payments. Chicago is looking at $442 million in termination fees to unwind its transactions, and Philadelphia would have to pay $332 million.
It's not hard to figure out why these deals are popping up all over the place. X or Y politician gets into office and is faced with budgetary problems. He is then approached by Wall Street hustlers who make him a fancy offer that sounds impossible to refuse: sign on for a bond-and-swap deal now, we'll give you upfront cash to help your immediate budget problems disappear. And if the deal blows up, the blowing up will happen on someone else's watch, long after you've left office. In the meantime, here's a bribe/batch of campaign contributions/donation to your favorite PAC to help soften up your conscience.
It's a formula that allows current politicians to look like heroes even as they're sticking future politicians with irresolvable financial burdens. The problem mimics the bonus issue on Wall Street, where bankers look to score big bonuses this year by doing deals that may look good now, but in the long run may go south, affecting not them, but their company's bottom line. The geniuses at AIG who made millions in bonuses building up the world's biggest gambling debt is a classic example of this phenomenon. And when you get politicians and bankers who are both mercifully free from the ravages of conscience and are both operating on the same pitifully short time horizons, the result will be deals like this Denver thing, where it's a temporary win-win for the dealmakers and an unspeakably huge loss for taxpayers down the road.
At least in Jefferson County the principals on the government side -- in particular then-County Commissioner Larry Langford -- had the excuse that they didn't understand these intricate swap deals, as most normal human beings do not. They could at least say they thought it might all work out in the end. Not so with Bennet; he worked for years as a structured finance guy under loony Christian billionaire Phillip Anschutz (who is probably best known for having helped fund religious films like the Sam Rockwell instant non-classic Joshua and the Christ-as-lion epic The Chronicles of Narnia). So he should have known better, but clearly did not.
Bennet now looks dead as a national political figure. It will be interesting to see what other consequences this story might hold for the Democratic Party, as (and this seems mainly to be a coincidence) is this just the latest in a long line of similar rate-swap scandals that have all in one way or another been tied to Democratic pols. The bigger question is, how exactly do we stop these deals from happening? If Wall Street keeps making it easy to push today's debts into the laps of tomorrow's politicians, when exactly does that stop being a tempting situation for our current leaders?
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