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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Yves Smith has written the popular and trenchant financial blog "Naked Capitalism" since 2006.

Yves has spent more than 25 years in the financial services industry and currently heads Aurora Advisors, a New York-based management consulting firm specializing in corporate finance advisory and financial services. Prior experience includes Goldman Sachs (in corporate finance), McKinsey & Co., and Sumitomo Bank (as head of mergers and acquisitions). Yves has written for publications in the United States and Australia, including The New York Times, The Christian Science Monitor, Slate, The Conference Board Review, Institutional Investor, The Daily Deal and the Australian Financial Review. Yves is a graduate of Harvard College and Harvard Business School.