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Analysts say Wall Street Fees Costing Baltimore Water Bureau Millions

$55 million spent on exotic interest rate swaps to fund water bonds between 2003-2014, and total fees could reach beyond $200 million for all deals in the near future.

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Story Transcript

STEPHEN JANIS, INVESTIGATIVE REPORTER, TRNN: Hello. My name is Stephen Janis, and I am an investigative reporter reporting for The Real News Network in Baltimore.

In Baltimore City, access to water is no longer a given. That’s because the city has begun the process of cutting off people who they say haven’t paid. The past-due balance totals nearly $40 million, including $15 million owed by a small handful of corporate scofflaws. City leaders say their hands are tied. They need people to pay for much-needed infrastructure improvements, which can’t move forward. Advocates counter that a series of steep increases in water bill rates have made access to a human right unaffordable.

But is that the whole story, and is it more than just past-due accounts driving this push for cash? Our next guests say yes, and that in fact Wall Street has cost the city water system just as much and possibly more than late bill payers. And even more troubling, that exotic financial instruments sold by bankers to unsophisticated city officials may have drained the system of much-needed capital. We’re learning about these troubling developments thanks to our guests.

Carrie Sloan, who joins us from Chicago, is a senior research analyst at the ReFund America Project at the Roosevelt Institute, where she works with unions and community organizations on campaigns to restore the balance of economic power from Wall Street to Main Street. Joining us from New York is Saqib Bhatti. Saqib is a fellow at the Roosevelt Institute and director of ReFund America project. He works on campaigns to rebalance the relationship between Wall Street and local communities by advancing solutions to fix inefficiencies in our municipal finance system that cost taxpayers billions of dollars each year. Both have been taking a close look at the city’s books, and what they found raises serious questions about the true nature of the fiscal predicament facing the city’s troubled water system, and how it is affecting residents.

Thank you both for joining us. We appreciate it.

CARRIE SLOAN, SENIOR RESEARCH ANALYST, REFUND AMERICA PROJECT: [Thank] you.

SAQIB BHATTI, DIRECTOR, REFUND AMERICA PROJECT: Thanks for having us.

JANIS: Thank you. Carrie, why don’t we start with you. Tell us a little bit about what you found out about Baltimore, and sort of the scope of the issue and what it means?

SLOAN: Sure. Well, Baltimore currently has 17 interest rate swaps on which they are paying the banks about $12 million a year on net interest costs. So that’s money that the banks are basically collecting from Baltimore that could otherwise be spent on things like infrastructure. That’s just the tip of the iceberg in terms of what these things have cost.

So the cost so far on these swaps includes payments since 2005 totaling $152 million. They’ve also paid tens of millions of dollars to terminate some of the swaps, and we can get into why they did that. But they have spent over $40 million so far just to terminate swaps, to get out of these bad deals.

JANIS: Why does the city enter in these swaps? What’s the point of it from their perspective? What, why would they do this?

SLOAN: The banks pitch interest rate swaps as a way for cities, municipalities, to issue cheaper–basically to get cheaper loans. So if the water department or the city itself wants to raise money for an infrastructure project and they issue bonds, they can issue bonds at a fixed rate or a variable rate. The variable rates that are available are usually lower, but they’re risky. And so the banks pitch an interest rate swap as a way to, to create what they call a synthetic fixed rate. So it’s sold as a way to get the variable rate, that lower variable rate, while reducing the risk of the variable rate.

And so what you have is, the city is paying the variable rate on the bond. They’re getting a variable rate from the bank, and they’re giving the bank a fixed rate. So it’s this sort of side bet, it’s called a hedge. It’s a derivative. And again, the banks pitch it to the city saying, this is going to save you money. This is going to, over the long run you will save money over what you would have spent if you had issued a fixed-rate bond at whatever rate you could have gotten at the time.

But what we’ve seen over and over again nationally is that it didn’t work out this way for cities who have these interest rate swap deals. They were designed in such a way that they were filled with risks, most of which were not adequately disclosed to cities like Baltimore when they were issuing the bonds and attaching the swaps to them. And in late 2008 after the banks basically crashed the economy and the Fed was bailing out the banks, the Fed drastically lowered interest rates. And what you saw then is that the money that the city was getting from the banks on these interest rate swap deals really fell, but the money that they were giving the banks stayed the same. So they’re giving the banks lots of money, they’re getting very little in return from the banks.

And these deals have something called termination penalties. So that traps the city in this deal so that they can’t refinance that underlying debt at these lower available interest rates unless they give the banks this big chunk of money.

JANIS: Talk about Detroit, because Detroit has been sort of compared to Baltimore. And Detroit has cut off water for residents, and Detroit did some of these deals. And just give us a sort of national context on this use of interest rate swaps.

BHATTI: Sure. I mean, the fact is that cities and states all over the country started doing interest rate swaps. And as Carrie mentioned they’ve really gone haywire just about everywhere. Detroit was one of the worst examples that exists. So in Detroit there were a number of interest rate swaps. The water–the Detroit water and sewer district a swap had entered into. And these things really went haywire. And in 2012, they actually had to terminate all of their swaps that the water system had, and they paid over half a billion dollars in termination penalties. $547 million dollars. Of course they didn’t have that money at the time so they had to issue new bonds to be able to pay it back.

And so now 40% of the water bill that the residents are paying is actually going directly to paying off the loans that they had to take out in order to pay off these termination penalties. And one of the things that really did become a financial burden on Detroiters was the fact the water bills rose precipitously after 2012. The undisclosed–or the part that’s not as well known and not as well publicized is that a big part of the reason why water bills went up was because they had to pay these half a billion dollar in termination penalties on the swaps.

JANIS: And you talked, we talked before this interview. We talked a little bit about how Wall Street is sort of luring these cities that really don’t have the sophistication to make these kind of deals into these sort of deals that are sort of not to the advantage of residents. Can you talk a little bit about that process?

BHATTI: Sure. I mean, what we basically have happening at the municipal level is the same thing that happened to homeowners. In much the same way that banks pitched predatory deals, predatory mortgages to homeowners, that hidden costs, hidden risks, were designed to fail, were overly complex. We’re actually seeing the same things happening on the municipal side with cities and states. Cities, states, and school districts, particularly ones that are distressed. Where banks sort of see the opportunity, and they swoop in with a pitch that will save you a lot of money. It’s based on some new financial engineering, we came up with new innovations.

But what they don’t adequately disclose, and adequately they don’t stop to understand, are all the risks that are entailed. And so there’s, the hidden risks really end up being hugely costly at the end of the day if they’re materialized. And one of the things that happened with interest rate swaps in particular is that basically there was a perfect storm of all of the risks that materialized when the banks crashed the economy. It was one of those things where people, public officials couldn’t have seen it coming. But what had happened, basically all the risks that they were told would never actually happen, they would never materialize, they did. And so it really left taxpayers holding the bag.

And this issue of predatory municipal finance is one that we really need to be paying more attention to. Because the fact is that it’s a big way in which Wall Street’s able to extract a lot of revenue from cash-strapped budgets as it is, and it’s something that is an alternative narrative we need to be talking about instead of just talking about austerity and cuts.

JANIS: Now Carrie, you know, Baltimore City officials say that we’ve had three consecutive double-digit rate increases. And they say this is because we have to replace infrastructure. How much of this rate increase could be attributed to some of these swaps that the city’s gotten into?

SLOAN: I can’t answer the specifics on how much of the rate increases can be attributed to the swaps. I can say that just the water and wastewater departments alone have spent more than $15 million on net interest costs. That’s–I’m sorry, excuse me. $55 million since 2005 on the swaps that they had. And again, the termination fees that the city has spent in the last few years total more than $40 million. So just that together is more than $90 million, which is much more than, again, what they’re saying they are owed. This $40 million figure.

And the other piece of this story is that some of the bonds that they issued, including water department bonds that they had swaps on, were auction rate securities. And the auction rate securities were another example of a tricky, complicated deal that banks pitched to cities like Baltimore as a way to save money on borrowing costs. And what ended up happening is that the banks did not disclose that they were participating in the auction rate bond market, and keeping it afloat. And so it looked like it was safe to cities like Baltimore when they got involved in it, and in fact it really wasn’t. And when the banks stopped propping up the market and it crashed in February of 2008, these auctions started failing all over the place and cities like Baltimore were stuck with these sometimes double-digit penalty interest rates.

And they had swaps on top, which mean that it was very difficult for them to get out from under these bonds to refinance into a fixed-rate bond, because they would have had to pay a termination fee. And some of the termination fees that Baltimore has paid have in fact been to get out of these auction rate securities. In fact in 2013 they spent more than $18 million to finally unwind some of the auction rate securities that they had. The $18 million was to terminate the swaps.

So this is another example of the banks pitching these deals, not disclosing the risks, taking advantage of vulnerable, cash-strapped municipalities. And the more vulnerable these, or the more cash-strapped these municipalities are, I think the more likely they are to fall for these kinds of deals when you have a sophisticated bank sales team basically saying, you need this infrastructure project? I can help you get it cheaper.

JANIS: But I have to ask the question, this sounds like–does sound like a reprise of the mortgage issue. How is this–is this legal? I mean, is it legal for Wall Street firms to make these kind of deals with municipalities where they sort of are playing both sides of the deal?

BHATTI: I mean, that’s sort of the real issue, is that if we look back to the foreclosure crisis, actually most of the practices that got us into trouble were perfectly legal. The fact is that the laws, when it comes to Wall Street regulation, are very lax and they’re very friendly to Wall Street. Even some of the provisions of Dodd-Frank financial reform that were put into place to try to prevent the worst abuses have been [blocked in] rule making.

For instance, most of the interest rate swaps that are out there and certainly most of the ones that the city of Baltimore has were linked to this interest rate index called LIBOR, the London Interbank Offering Rate, which is basically the interest rate that banks charge each other. Well as it turns out, a lot of the banks were actually manipulating those rates, and there’s, it was at the time a group of 16 banks that set the rate based on self-reported interest rates. And at this point more than half of them have admitted to manipulating the rate. Several have paid fines. Some have even pleaded guilty to antitrust charges.

And so a lot of these things actually are grounds for saying actually, we should take another look at these deals. Baltimore’s actually one of the cities that–actually on this count was better that they actually did file a lawsuit for LIBOR manipulation, more generally for the impacts it had. But the piece that’s sort of interesting about this is that in addition to just the impact of LIBOR on a bunch of different deals that Baltimore may have had, there is a particular provision that applies to municipalities specifically which says that banks–it’s called the Fair Dealing [rule] of the Municipal Securities Rulemaking Board.

And what fair dealing means is that when a bank pitches a deal to a city or a state, or to a public entity borrower, what they actually have to do is they have a burden to make sure that the person who they’re talking to actually understands the risk they’re taking on. It’s not enough to say, well, there’s a disclosure somewhere in fine print at the bottom of page 79. You actually have to be able to make sure the person you’re talking to understands the risks they’re taking on. And if you misrepresent the risks, downplay the risks, omit mentioning the risk, all of those things are grounds for saying that you actually probably violated a law.

And so the reality is the way that these deals were typically pitched, the standard pitch, talked about all of the upside, really deemphasized the downside. They would paint best case scenarios, all the money you could save if everything went your way, and they wouldn’t typically tell you about the worst case scenarios.

Carrie mentioned auction rate securities which is a particular type of predatory deal that also really, when the market collapsed in 2008, one of the things that we saw in Chicago was that Bank of America was pitching these deals to Chicago Public Schools at the same time that their own internal analysis, they have internal memos that said that the, it was headed for a market meltdown. The word meltdown is a direct quote. At the same time, after that memo was written, they actually sold the deals to CPS saying hey, you should do these deals, they’ll be good for you.

So all of these things actually do speak to a violation of the Fair Dealing rule, and so we really should be looking at legal angles. And luckily there are a few places that have started taking action against predatory financial deals.

JANIS: Carrie, we reached out to the Baltimore Finance Department. They have not responded, but if they come back and say, well, this deal’s saving us money on the other side, how would you respond to that? Is that, would that be an accurate characterization?

SLOAN: If they were to say that about the swaps–I think the fact that they’ve been trying to get out of some of their swap deals speaks to the fact that they are aware that they’re not good deals. But often, and Saqib mentioned that Baltimore has been a lot better than many other cities in terms of taking action, trying to take action against banks. We often hear from city officials, oh, we have–we’ve saved money on these deals. That’s very rarely true. And you can–I think there is often this resistance in other cities to admit being snookered by a bank. No one wants to admit that they got suckered by a smooth-talking salesperson and cost the city, or the school district or whatever it is, millions of dollars.

I think that the numbers that are available in their own records show how terrible these deals have been for the city.

JANIS: And Saqib, going forward what are we, what needs to happen? Is there some sort of legislative reform that we’re looking at, or is it just a matter of transparency that you guys are trying to sort of put forward? What needs to happen to address this issue so that water rate payers aren’t taken to, taken to the bank, basically?

BHATTI: I mean, the key thing we really need is we need for the city of Baltimore and other municipalities that are in a similar situation, that instead of first pushing the, pushing the pain onto residents who are already struggling to get by who are disproportionate with people of color, instead of really forcing cuts onto them or by shutting off their water or closing their schools or pushing up rates, what they need to be doing is taking all legal and economic options at their disposal to try to get the money back from banks.

Right, so this includes filing legal claims, and here there are some strong legal claims. It includes joining other cities and calling for a boycott of the banks unless they would renegotiate. In 2012 the city of Oakland actually implemented a boycott of Goldman Sachs because Goldman Sachs would not renegotiate their interest rate swap where they’d been paying $4-5 million a year on a swap that actually serves no purpose because they’ve already refinanced the underlying bond. But they can’t get out of the swap deal. We need–but Oakland alone can’t do it. What you actually need is a number of cities to come together, because of course there’s power in numbers.

And so we need for cities, states that are in a similar situation both to sort of say we’re going to withhold business from you until you fix these deals, and we’re going to actually at the same time try to take legal action. Whether it’s by filing direct lawsuits, or really trying to request that the Securities Exchange Commission federally open an investigation into this.

And then of course the real big thing is that we do need reform at the federal level. We need a–you know, most of banking is actually regulated by, or is regulated at the federal level and the laws that apply are passed by Congress. And so what we really need is we need strong Congressional action to have a structural fix to this. But in the meantime there are actions that cities and states could take, and Baltimore should very well be pursuing those instead of first shutting down the water and driving up rates.

JANIS: Well Saqib and Carrie, I really appreciate you joining us. This has been fascinating, and I think given the situation in Baltimore very relevant and very important. I hope you keep up your work and keep in touch with us. So thank you for joining us.

BHATTI: Thank you.

SLOAN: Thank you.

JANIS: And my name is Stephen Janis. I’m an investigative reporter for The Real News Network, reporting from Baltimore. Thank you.

End

DISCLAIMER: Please note that transcripts for The Real News Network are typed from a recording of the program. TRNN cannot guarantee their complete accuracy.