STOCK MARKET WATCH -- Monday, 19 November 2012

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4. Big Banks Squeeze Billions in Profits from Public Budgets

http://www.seiu.org/images/pdfs/Interest%20Rate%20Swap%20Report%2003%2022%202010.pdf

Big banks are profiting at state and local governments’ expense using the same toxic financial instruments that helped crash the economy. These derivatives known as interest rate swaps, were sold to governments with a promise that they would lower their borrowing costs but have now become a huge liability. The banks have already taken as much as $28 billion from state and local governments. Now, during the worst public budget crisis in memory, the big banks seek to collect billions more from toxic deals that local and state governments are trapped into and are forcing layoffs and cuts to services to cover payments to banks. Big banks must renegotiate or cancel the derivatives, which could prevent the transfer of billions of dollars from public budgets to big banks.

Bank Deals Turn Toxic: Increased Costs for Governments, Windfall for Banks

Banks like JPMorgan Chase, Bank of America, and Goldman Sachs initially marketed derivative deals with the promise that they would help state and local
governments reduce their cost of borrowing for public improvement projects. In a typical deal, a state or local government agreed to “swap” interest rates
on variable-rate bonds, with the government paying the bank a fixed rate in exchange for a variable payment that would track the interest due on the bonds.
If interest rates were projected accurately, the payments would more or less balance out over the life of the contract and the public entity would end up with
something similar to a fixed-rate bond. Derivatives, however, have turned into a windfall for banks and a nightmare for taxpayers. In the wake of the financial collapse, the federal government aggressively drove down interest rates to save the big banks and spur economic recovery. The unintended consequence was the creation of an opportunity for banks – whose variable payments were tied to prevailing interest rates – to reap a tremendous profit from the deals. While banks are still collecting fixed rates of 3 to 6 percent, they are now regularly paying public entities as a little as a tenth of one percent on the outstanding bonds, with rates expected to remain low in the future. Over the life of the deals, banks are now projected to collect billions more than they pay state and local governments – an
outcome which amounts to a second bailout for banks, this one paid directly out of state and local budgets.

While banks have benefitted, state and local governments have been trapped in expensive and risky debt. They are paying above-market rates and are
exposed to even higher penalty rates if banks and other financial institutions withdraw support for their complicated variable-rate debt. Yet the banks have
made it prohibitively expensive for state and local governments to refinance by demanding tens or hundreds of millions of dollars in fees to terminate
derivatives. In some cases, public entities have gone ahead and made the payments out of desperation; in others, the banks have actually forced termination
of the deals just to collect the huge termination fees. The overall effect is staggering. Banks are estimated to have collected as much as $28 billion in
termination fees alone from state and local governments over the past two years. This does not even begin to account for the outsized net payments that
state and local governments are now making to the banks.
Finally, there is also mounting evidence that it is no accident that these deals have gone so badly, so quickly for state and local governments. Ongoing
investigations by the U.S. Department of Justice and the California, Florida, and Connecticut Attorneys General implicate nearly every major bank in a
nationwide conspiracy to rig bids and drive up the fixed rates state and local governments pay on their derivative contracts.

If the allegations are true, the banks’ illegal practices have directly contributed the outsized costs and risks now faced by state and local governments...