Wall Street Confidence Trick: The Interest Rate Swaps that Are Bankrupting Local Governments

Far from reducing risk, derivatives increase risk, often with catastrophic results.

—   Derivatives expert Satyajit Das, Extreme Money (2011)

The “toxic culture of greed” on Wall Street was highlighted again last week, when Greg Smith went public with his resignation from Goldman Sachs in a scathing oped published in the New York Times.  In other recent eyebrow-raisers, LIBOR rates—the benchmark interest rates involved in interest rate swaps—were shown to be manipulated by the banks that would have to pay up; and the objectivity of the ISDA (International Swaps and Derivatives Association) was called into question, when a 50% haircut for creditors was not declared a “default” requiring counterparties to pay on credit default swaps on Greek sovereign debt. 

Interest rate swaps are less often in the news than credit default swaps, but they are far more important in terms of revenue, composing fully 82% of the derivatives trade.  In February, JP Morgan Chase revealed that it had cleared $1.4 billion in revenue on trading interest rate swaps in 2011, making them one of the bank’s biggest sources of profit.  According to the Bank for International Settlements:

[I]nterest rate swaps are the largest component of the global OTC derivative market.  The notional amount outstanding as of June 2009 in OTC interest rate swaps was $342 trillion, up from $310 trillion in Dec 2007.  The gross market value was $13.9 trillion in June 2009, up from $6.2 trillion in Dec 2007.

For more than a decade, banks and insurance companies convinced local governments, hospitals, universities and other non-profits that interest rate swaps would lower interest rates on bonds sold for public projects such as roads, bridges and schools.  The swaps were entered into to insure against a rise in interest rates; but instead, interest rates fell to historically low levels.  This was not a flood, earthquake, or other insurable risk due to environmental unknowns or “acts of God.”  It was a deliberate, manipulated move by the Fed, acting to save the banks from their own folly in precipitating the credit crisis of 2008.  The banks got in trouble, and the Federal Reserve and federal government rushed in to bail them out, rewarding them for their misdeeds at the expense of the taxpayers. 

 How the swaps were supposed to work was explained by Michael McDonald in a November 2010 Bloomberg article titled “Wall Street Collects $4 Billion From Taxpayers as Swaps Backfire”:

In an interest-rate swap, two parties exchange payments on an agreed-upon amount of principal. Most of the swaps Wall Street sold in the municipal market required borrowers to issue long-term securities with interest rates that changed every week or month. The borrowers would then exchange payments, leaving them paying a fixed-rate to a bank or insurance company and receiving a variable rate in return. Sometimes borrowers got lump sums for entering agreements.

Banks and borrowers were supposed to be paying equal rates: the fat years would balance out the lean.  But the Fed artificially manipulated the rates to the save the banks.  After the credit crisis broke out, borrowers had to continue selling adjustable-rate securities at auction under the deals.  Auction interest rates soared when bond insurers’ ratings were downgraded because of subprime mortgage losses; but the periodic payments that banks made to borrowers as part of the swaps plunged, because they were linked to benchmarks such as Federal Reserve lending rates, which were slashed to almost zero. 

In a February 2010 article titled “How Big Banks’ Interest-Rate Schemes Bankrupt States,” Mike Elk compared the swaps to payday loans.  They were bad deals, but municipal council members had no other way of getting the money.  He quoted economist Susan Ozawa of the New School:

The markets were pricing in serious falls in the prime interest rate. . . . So it would have been clear that this was not going to be a good deal over the life of the contracts. So the states and municipalities were entering into these long maturity swaps out of necessity. They were desperate, if not naive, and couldn’t look to the Federal Government or Congress and had to turn themselves over to the banks.

Elk wrote:

As almost all reasoned economists had predicted in the wake of a deepening recession, the federal government aggressively drove down interest rates to save the big banks. This created opportunity for banks – whose variable payments on the derivative deals were tied to interest rates set largely by the Federal Reserve and Government – to profit excessively at the expense of state and local governments. While banks are still collecting fixed rates of from 4 percent to 6 percent, they are now regularly paying state and local governments as little as a tenth of one percent on the outstanding bonds – with no end to the low rates in sight.

. . . [W]ith the fed lowering interest rates, which was anticipated, now states and local governments are paying about 50 times what the banks are paying. Talk about a windfall profit the banks are making off of the suffering of local economies.

To make matters worse, these state and local governments have no way of getting out of these deals. Banks are demanding that state and local governments pay tens or hundreds of millions of dollars in fees to exit these deals. In some cases, banks are forcing termination of the deals against the will of state and local governments, using obscure contract provisions written in the fine print.

By the end of 2010, according to Michael McDonald, borrowers had paid over $4 billion just to get out of the swap deals.  Among other disasters, he lists these:  

California’s water resources department . . . spent $305 million unwinding interest-rate bets that backfired, handing over the money to banks led by New York-based Morgan Stanley. North Carolina paid $59.8 million in August, enough to cover the annual salaries of about 1,400 full-time state employees. Reading, Pennsylvania, which sought protection in the state’s fiscally distressed communities program, got caught on the wrong end of the deals, costing it $21 million, equal to more than a year’s worth of real-estate taxes.

In a March 15th article on Counterpunch titled “An Inside Glimpse Into the Nefarious Operations of Goldman Sachs: A Toxic System,” Darwin Bond-Graham adds these cases from California:

The most obvious example is the city of Oakland where a chronic budget crisis has led to the shuttering of schools and cuts to elder services, housing, and public safety. Oakland signed an interest rate swap with Goldman in 1997. . . .

Across the Bay, Goldman Sachs signed an interest rate swap agreement with the San Francisco International Airport in 2007 to hedge $143 million in debt. Today this agreement has a negative value to the Airport of about $22 million, even though its terms were much better than those Oakland agreed to.

Greg Smith wrote that at Goldman Sachs, the gullible bureaucrats on the other side of these deals were called “muppets.”  But even sophisticated players could have found themselves on the wrong side of this sort of manipulated bet.  Satyajit Das gives the example of Harvard University’s bad swap deals under the presidency of Larry Summers, who had fought against derivatives regulation as Treasury Secretary in 1999.  There could hardly be more sophisticated players than Summers and Harvard University.  But then who could have anticipated, when the Fed funds rate was at 5%, that the Fed would push it nearly to zero?  When the game is rigged, even the most experienced gamblers can lose their shirts.           

Courts have dismissed complaints from aggrieved borrowers alleging securities fraud, ruling that interest-rate swaps are privately negotiated contracts, not securities; and “a deal is a deal.”  So says contract law, strictly construed; but municipal governments and the taxpayers supporting them clearly have a claim in equity.  The banks have made outrageous profits by capitalizing on their own misdeeds.  They have already been paid several times over: first with taxpayer bailout money; then with nearly free loans from the Fed; then with fees, penalties and exaggerated losses imposed on municipalities and other counterparties under the interest rate swaps themselves. 

Bond-Graham writes:   

The windfall of revenue accruing to JP Morgan, Goldman Sachs, and their peers from interest rate swap derivatives is due to nothing other than political decisions that have been made at the federal level to allow these deals to run their course, even while benchmark interest rates, influenced by the Federal Reserve’s rate setting, and determined by many of these same banks (the London Interbank Offered Rate, LIBOR) linger close to zero. These political decisions have determined that virtually all interest rate swaps between local and state governments and the largest banks have turned into perverse contracts whereby cities, counties, school districts, water agencies, airports, transit authorities, and hospitals pay millions yearly to the few elite banks that run the global financial system, for nothing meaningful in return.

Why are these swaps so popular, if they can be such a bad deal for borrowers?  Bond-Graham maintains that capitalism as it functions today is completely dependent upon derivatives.  We live in a global sea of variable interest rates, exchange rates, and default rates.  There is no stable ground on which to anchor the economic ship, so financial products for “hedging against risk” have been sold to governments and corporations as essentials of business and trade.  But this “financial engineering” is sold, not by disinterested third parties, but by the very sharks who stand to profit from their counterparties’ loss.  Fairness is thrown out in favor of gaming the system.  Deals tend to be rigged and contracts to be misleading. 

How could local governments reduce their borrowing costs and insure against interest rate volatility without putting themselves at the mercy of this Wall Street culture of greed?  One possibility is for them to own some banks.  State and municipal governments could put their revenues in their own publicly-owned banks; leverage this money into credit as all banks are entitled to do; and use that credit either to fund their own projects or to buy municipal bonds at the market rate, hedging the interest rates on their own bonds. 

The creation of credit has too long been delegated to a cadre of private middlemen who have flagrantly abused the privilege.  We can avoid the derivatives trap by cutting out the middlemen and creating our own credit, following the precedent of the Bank of North Dakota and many other public banks abroad.

28 Responses

  1. The Conspiracy to Crash the Dollar and allow China to take over as worlds Trade currency !!!

    This video explains the attack on the dollar by Glenn Beck .

    Kevin Freeman: Terrorists, Nations Plot Attack to Doom Dollar

    theres a motive behind the Gold trade that really needs to be better understood , HERE IS the Plan by China to Collapse the US Dollar , and they are going to use Gold as the vehicle : http://www.stansberryresearch.com/pro/1202CHINAPT2/LOILN325/PR
    In this Report on Page 4 it explains how Operation Twist will drive down Gold prices because the Bonding Buying by the Federal Reserve will fund central banks to invest in equities markets and private investment will chase these equity valuation increases out of their Commodities holding position , this is to Chinas advantage wouldn’t you say ? http://landing.rarecoinwholesalers.com/Content/pdf/CollapseOfgoldReport.pdf
    I put your article together with these others to show a connection between players that opens the door to the discussion about where the effort to collapse the dollar trade currency status was being discussed in the highest levels of US Government and top rating agencies ,
    The Scam against the USA was all found here ,
    Ron Paul , Glenn Beck wants a Gold backed dollar but if China ends up cornering the Gold market with the Help of the Federal Reserves Long Bond Buying operation Twist program , hows that going to work ?

    The above link is By This same Advertisement New America 1 .com, and it has been advertising the dollar crash for some time now ,I think its been Glenn beck , Alex Jones , and others that have been pushing this advertising , so are they working with other interests that are Chinese backed because this fear driving advertisement is all about buying Gold to avert a Dollar crash and that Directly benefits Chinas attempts to become the worlds TRADE CURRENCY and takeover the Dollars position ??? http://pro.stansberryresearch.com/1202ENDOFAMR/6PSIN316/

    And here is the federal Reserve saying he will help China become the Worlds Trade Currency and crash the Dollar …. so isn’t this a crime , knowing China is working on Corning the gold market for this very reason ???
    Bernanke says gold standard wouldn’t solve problems , http://www.reuters.com/article/2012/03/20/us-usa-fed-gold-idUSBRE82J17A20120320

    • This article talks about the plan to use those Bond Funds that form capital in the Operation Twist that the Federal Reserve is engaged in now like it says in this report on page 4 , they are buying 4 trillion bucks worth of bonds it says, http://landing.rarecoinwholesalers.com/Content/pdf/CollapseOfgoldReport.pdf to then be Invested into the equities markets to inflate the Dow and make it look like there is growth this could crash the gold market , http://www.zerohedge.com/news/next-leg-ponzi-revealed-central-banks-begin-buying-us-stocks-outright-starting-today
      This is using taxpayer debt to create a FAKE rally in the equities markets to suck the gold investors out of gold and back into the equities driving down Gold so the Chinese can buy it cheaper and further consolidate the worlds gold supply , just Like The Stanfield research advertisement talks about . This is really bad someone needs to be looking into this scam , its a direct assault on the US Dollar !!! Man do we even realize the DEBT we all are being crushed with by these Actions that are just crushing the dollar and giving China the means to over take the US dollar ?

    • Usurous,Commodity backed currency issued by private central banks is evil. We don’t need globalist shill Beck or the penny stock pump and dumper Porter Stansberry to tell us that or anything else. Stansberry is notorious for plagerizing Peter Schiff inorder to build up a customer base to run there scams. http://www.youtube.com/watch?v=F9FRMWx0n-w

      I don’t like bilderburg supported (eg, 2.7 mill campaign donation from Peter Thiel) goldbug Ron Paul or Alex Jones for promoting him despite knowing this (and not reporting it). Jones also promotes stanberry to this day.

  2. Sadly, I no longer trust a single financial institution out there. I have sold all of my stock, cashed out my IRA’s and retirements, and am walking away from my home and rental (underwater and up-side down) properties that will take 30 years to return to their original purchase values once/if a “normal” real estate market ever returns.

    I’d rather start from scratch than spend the rest of my life slaving to pay the banks for what I’ve lost as a result of their devious manipulations. The schemes foisted upon the heretofore unsuspecting public are so convoluted and complicated that the average person has no hope of even beginning to comprehend their inner workings.

    Although I do realize I am inextricably intertwined in the global financial system, in spite of the personal costs now, I am going to get as arms-length as possible from the system. I need a replacement car? Here’s an idea: I’ll SAVE my money ahead of time and pay cash when the time comes.

    I used to chuckle at my depression-era grandfather’s aversion to banks. Now, I wish he was alive today so I could tell him how RIGHT he was.

  3. […] taxpayers.How the swaps were supposed to work was explained by Michael McDonald in a November 2010 Bloomberg article titled “Wall Street Collects $4 Billion From Taxpayers as Swaps Backfire”:In an interest-rate […]

  4. I have to be honest here, I am unable to comprehend these “Derivative” products, and I suspect 99% of the world’s population have no idea either. Why on earth are Local Govts getting involved in these dodgy deals with the Wall st 1%?
    What is Congress (you know, the Peoples representatives) doing about this?
    I hate to say it, but the USA is now firmly in the hands of the “NY Banksters”, and the ‘shemozle’ in Washington is just a side show, but I suspect the American people know that already. It’s going to take another Revolution for the people to take back their country from these swindleing criminals.


    Here is yet another disturbing example of how the 1% are getting wealthier – “interest rate swaps”. And guess who is manipulating them so the 1% don’t have to pay up? The biggest of the already fat Wall Street cats. What a surprise. The more we look, the uglier it gets. So JPMorganChase and the Muppeteers have found yet another way to make lots more for themselves.

    Banks are endlessly profiting at the expense and the financial health of state and local governments, while legalized graft, in the form of lobbyists, funnel back millions to those very same elected politicians, all made legal through the Supreme Court ruling of Citizens United. The best government money can buy!

    This past week, ex- employee of the month Greg Smith said that Goldman-Sachs referred to our local bureaucrats and the gullible suckers at the raw end of a swindle as “muppets.” So according to them, WE are all muppets, suckers to be swindled. WOW!!!!

    What is capitalism today? Here’s a brutal and in my opinion, accurate definition: “Capitalism … is completely dependent upon derivatives . We live in a global sea of variable interest rates, exchange rates, and default rates. There is no stable ground on which to anchor the economic ship, so financial products for ‘hedging against risk’ have been sold to governments and corporations as essentials of business and trade. But this ‘financial engineering’ is sold, not by disinterested third parties, but by the very sharks who stand to profit from their counterparties’ loss. Fairness is thrown out in favor of gaming the system. Deals tend to be rigged and contracts to be misleading.”

    One might imagine that somewhere, in some deep, dark hidden place, the puppetmasters are laughing at us as they pull the strings and manipulate us into running in one direction or another while they gleefully harvest the earnings that are gotten from the fearmongering that they have created, and which keeps the world on the brink of financial collapse. I mean, haven’t we all heard that “Now is the best time to buy gold.” ???? or “You can get an amortized thirty-year-loan at 3.5% for five years.” That’s what they were doing before, and they’re still doing it.

    There is no apparent solid financial foundation. It all appears to be a slick shell game, all smoke and mirrors. Is it any wonder that the economies of countries throughout the world are teetering on the brink of collapse?

    Can we save ourselves from drowning in this “global sea of variable interest rates, exchange rates, and default rates”? According to Ellen Brown “We can avoid the derivatives trap by cutting out the middlemen and creating our own credit…” We can do this by creating state, city, county, and local public banks based on the model of North Dakota.

  6. The financial departments from any level of government has no business what so ever getting involved in these swaps and derivatives. It isn’t possible to have every nuance explained with the crystal clarity that public servants need in order to sign on the dotted lines. You fail to comprehend that you are being set up and so must show the financial grifters the door.

    • Gary has it right. What are these governments doing investing in this crap in the first place? From worthless mortgage pools to this junk? It has been front page for 20 years that the banks are liars and thieves and the geniuses in state treasury departments are still investing money in them?

      You demand the banks be regulated so that public official “A” won’t be victimized? Do you know who regulates the banks? Have you been paying attention? Goldman Sachs “graduates” have been running the treasury department and overseeing the SEC and the rest of the so called financial watchdogs since they were created.

  7. […] Wall Street Confidence Trick: The Interest Rate Swaps that Are Bankrupting Local Governments (webofdebt.wordpress.com) […]

  8. […] The Doobie Brothers 1996 #6-South City Midnight LadyThe Doobie Brothers 1996 #2-Jesus Is Just AlrightMusic video worth blogging: Michael McDonald Sweet Fredom, featuring the late Gregory Hines and a young Billy CrystalWelcome, Griffin Michael McDonaldWhat’s Happening! ~ Doobie Bros (1 of 2)★PLAN TOYSの木製玩具(木のおもちゃ)★6087★ 建設車セットIFBB pro Michael Kefalianos stops by MHP headquartersWall Street Confidence Trick: The Interest Rate Swaps that Are Bankrupting Local Governments […]

  9. […] Wall Street Confidence Trick: The Interest Rate Swaps that Are Bankrupting Local Governments – Our Take: In case anyone needed another reason to be angry at the banks and the government bailouts here you go.  Before the financial crisis banks convinced a lot of municipalities to enter into interest rate swaps where they traded a fixed rate of interest which they are required to pay to the banks for a variable rate which fluctuated with the market which the banks were required to pay to them in return.  Read the article for the middle of the story and how all this happened because its a great overview in laymen’s terms.  The end you have probably already guessed is the banks ended up making out like bandits at the expense of the municipalities. […]

  10. Its nice to see we as Americans are beginning to wake up. Its never too late!

  11. […] example of the story we talked about in Friday’s Best of the bond market, entitled ”Interest Rate Swaps are Bankrupting Local Government’s“. This part from Cate’s article sums it up well: “The interest-rate swaps were […]

  12. […] Banker Swaps Bankrupt Local Tax Payers  https://webofdebt.wordpress.com/2012/03/22/wall-street-confidence-trick-the-interest-rate-swaps-that-… […]

  13. One of the favorite scams of the financial gangsters is investment transaction backdating. Basically, an investment “trust” company is supposed only to buy shares on behalf of client investors (“muppets”) and to book the purchase to the specific client account at the time of purchase. However, what really happens is that the investment is bought through a company such as Goldman Sachs with “time to pay”. This allows the “trust” company to wait and see what happens to the investment before booking it, back-dated, to a client account. The rest should be obvious – investments that do well get booked to “friendly” accounts (i.e. to ultrawealthy criminals who will never need a pension) and those that do badly are booked to designated losers, such as pension funds for the Little People. This is of course serious fraud in every country of the world but little islands in the Caribbean are out of reach of the laws of the countries whose pension funds etc. are being swindled and nowadays all politicians except Iranian ones are owned by the gangsters anyway. In fact it is often the case that the directors of pension funds are secretly working for the gangsters. That’s no different from union leaders secretly working for governments. You always know when a union leader is *not* working for a government because that government will go out of its way to destroy the man and his union (recall Thatcher vs Scargill in Britain). These big financial institutions did not become corrupt, they were always corrupt. They were created specifically for the purpose of corruption and the theft of property (i.e. “foreclosure”) from the slave classes. The whole show is now so rotten with “credit” that burning it all down and starting over will be the only cure.

  14. (What follows is the history of civilisation concentrated in a ten minute read and horribly simplified.)

    All this of course started thousands of years ago with the development of farming. Farming slowly developed and produced more than could be used immediately. This is where the Protection Racket started and produced kings and administrations who took the surplus for themselves and built gigantic structures which said “How Great Am I”
    Farming as it developed took up less and less time for the farmer and allowed more and more people to leave and became part of manufacturing, government,Landlords,Aristocracy etc. The economy was based on barter.
    Then money arrived to replace barter and the concept of taxation/rent and other charges replaced taking surplus.
    The basic attitudes did not change and money concentrated into the hands of landlords and businesses and thereby banks. The only thing that all people trusted were the rare metals -Gold and Silver. Because these metals were in short supply, the concept of lending/borrowing became more and more common together with the concept of interest as a reward to the lender who gradually got richer and richer as the gold and silver concentrated more and more to the point that governments themselves found they had to borrow from the banks. We all know what the result of the foregoing has been.
    It is quite clear that the basic attitudes towards money by EVERYONE must change. Money must be released from it’s shackles of being based on the value of things and be based on the value of production and work hours for that production( production being the end result of any form of meaningful work). The concept of getting interest on excess concentration of money must go because money must work.
    Societies will have to change.
    How requires much thought and many bruised egos.

    • Agreed. Money today is just a series of accounting entries keeping track of who owes what to whom. There is nothing backing it but the credit of the people collectively. We’ve seen with FDIC insurance and the bank bailouts that the only thing that really makes our money secure is the backing of the government and the taxpayers, the ultimate guarantors. So the government and the taxpayers might as well own the banks and get the proceeds. Then we wouldn’t need to worry about capital, reserves, etc. The bank would just be a great computer in the sky keeping accounts.

      • Can things be changed?
        Something has got to be done.
        But what and how?
        Things cannot carry on as they are!

  15. […] Wall Street Confidence Trick: The Interest Rate Swaps that Are Bankrupting Local Governments (webofdebt.wordpress.com) Share this: Pin ItShare on TumblrDiggPrintEmail bailout, barack obama, britain, british monarchy, cap and trade, federal reserve, foreclosures, government, obama, political, politics, soetoro, subversion, treason, yes we can American International Group, Credit default swap, debt, derivatives, federal reserve, Federal Reserve Act, Federal Reserve System, freddie mac, Isaac Newton, JPMorgan Chase, politics, woo4 Banking Cabal’s (CFR) Pump Dump Modus Of Mitt Romney ~ Assures An Obama Win For Collectivism! Stopping The Banking Cabal: Italy’s Mobilization For Glass-Steagall To Be Introduced In The House Of Delegates! […]

  16. This is a global problem and it is not just local governments, hospitals, universities and other non-profits that that have suffered with mis-sold interest rate swaps.

    Across the pond in the UK, there are (equally hard fought) legal claims being pursued by hundreds of small and medium enterprises (SMEs).

    In at least one English suit it is being alleged that one of the banks’ misrepresentations stems from the LIBOR fixing scandal.

    An excellent BBC Radio 4 broadcast, touching on the issues in this post and featuring Derivatives expert Satyajit Das (author of Extreme Money) is available here:

    [audio src="http://lexlaw.co.uk/Interest-Rate-Swap-Misselling-r4report03052012-LEXLAW-Solicitors.mp3" /]

  17. […] morgan chase, libor rates, percent, rate, Sachs, State, toxic culture, University, way Hat tip: Web of Debt by Ellen Brown Far from reducing risk, derivatives increase risk, often with catastrophic […]

Leave a Reply to Gary Cancel reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: