More Fallout from Crisis: Muni Swaps

US Banker | March, 2010

For banks that built up significant portfolios in the municipal interest rate swap business, it may be time to consider what to do when the customer isn't always right.

On Friday the Los Angeles City Council directed the city to ask the holders of two $158 million swaps to ease the terms of deals that one official pronounced a "rip-off." The measure followed advocacy by the Service Employees International Union, which has seized upon the cost of exiting swaps as a central point in a nationwide effort to blame banks for heavily indebted municipalities' service cuts.

A municipal swaps version of The Huffington Post's "Move Your Money" campaign, the effort could harm banks' relationships with local governments and potentially force concessions on some of the more than $200 billion of municipal swaps outstanding, some industry observers said. More broadly, it underscores banks' weakened political standing, and the threat that poses to their day-to-day business.

"I'm not sure you really want to litigate the swap contract. Municipal finance is a tight community," said Jeffrey Cohen, an attorney for Patton Boggs who has worked for borrowers and issuers alike.

Though many big banks have exited the municipal swap business — both JPMorgan Chase & Co. and Bank of America Corp. largely shut down new issuance after a series of price-fixing scandals — the outstanding contracts are a tempting bone to pick for municipalities facing job cuts and ratings downgrades.

Distressed public entities have already won concessions on termination fees in Detroit and Jefferson County, Ala. Many believe healthier jurisdictions may already be quietly getting in on the game. If municipalities can issue debt at lower rates, "they're going to raise whatever defense they've got," Cohen said.

According to several industry observers, substantive grounds for demanding renegotiation are often reed-thin. By swapping variable-rate debt payments for a fixed-interest obligation, a local government bought protection from the risk of rising interest rates, while paying significantly less interest than it would on a comparable fixed-rate municipal bond.

In Los Angeles' case, that meant that the city entered into a 2006 deal to pay 3.4 percent a year on $317 million of debt to Bank of New York Mellon Corp. and Dexia SA, receiving the prevailing adjustable rate payment in return. For a couple of years, that was a good deal, producing several million dollars of savings a year. But when the Federal Reserve dropped interest rates to nearly zero during the financial crisis, the city's 3.4 percent payment started earning it 0.15 percent back. Terminating the agreements would require an immediate fee of $29 million.

In one sense, the change did not make any difference — the very reason the city had taken out the swap in the first place was that it did not want to gamble on interest rates, and its total payments on the bond-and-swap package remained steady. Construed in a different sense, however, the fallout from the financial crisis allows banks to buy municipal taxpayer dollars for fewer than 5 cents each at a time when Los Angeles was facing widespread cuts to city services.

That was how city Councilman Richard Alarcon saw it at a meeting late last month, where he called for city staff to demand that Dexia and Bank of New York Mellon "negotiate in good faith and give us back our money." It's not clear that everyone involved understood the purpose or mechanics of the deal — Natalie Brill, the city's debt management chief, was asked to explain it several times — but the subject was a crowd pleaser. Applause met Alarcon's more aggressive statements, and the audience audibly gasped when Brill said the swaps agreements would last until 2028.