This story is very interesting.  (I have lots of links for this post.)  Approximately 5-10 years ago, banksters sold US cities and states interest rate swaps. Allegedly, it would lower their borrowing costs.

It didn’t turn out that way. Interest rates crashed. The “hedge” was not a true hedge. The cities lost money. They owe banks a lot of money on these failed hedges.

Swaps also played a role in the Greek debt crisis.  The EU has rules limiting the amount of debt each country can have.  Via swaps, Greece found a loophole.  Swaps didn’t count against the debt limit.  Greece bought currency swaps from Goldman Sachs.  The currency swaps were a thinly-disguised loan.  Via the swaps, Greece received money and had to pay a huge amount later, as if they had issued more bonds, breaking EU rules.

The banksters robbed cities with The Golden Rule Of Bankster Theft.

The Golden Rule Of Bankster Theft – The more complicated a derivatives transaction, the easier it is for banksters to rob less-informed investors.  The more complicated a derivatives transaction, the easier it is to claim innocence when the transaction turns out badly for the victim.

It is ironic. President Obama complains that cities should hire more police and teachers. He does not mention how the banksters took cities to the cleaners, via interest rate swaps.

In the USA, cities and states get a special tax loophole. The interest on municipal bonds is Federal tax exempt. This tax loophole fuels the municipal bond market.

Banks borrow at the Fed Funds Rate and buy bonds. When banks buy municipal bonds, the interest is tax-free, which makes the municipal bond interest rate lower than other bonds.

The US municipal bond market exists solely because of a tax loophole. It has no real economic value.

Traditionally, cities sell fixed-rate bonds. Here’s the idea behind the interest rate swap trick. Instead of selling a fixed-rate bond, the city issues a variable rate bond *AND* does a variable-to-fixed swap with a bank.

There was an obvious conflict of interest. The bankster broker gets a commission on the trade. The bankster broker is also the one advising the city accountant. The city accountant was a political appointee, and not a bright guy. There may have been under-the-table bribes to the city accountant, in exchange for making a stupid swap trade.

For most of these swap trades, the city comptroller/accountant did not really understand the fine print of the swap trades.

Reading the details of some of these agreements, it’s obvious that it wasn’t a true hedge, because the swap terms don’t match the bond terms.

The bank’s profit is not merely the commission on the trade. The bank also makes hidden fees based on the way the deal is structured. If the “fair rate” for the city to pay is 4%, but the city actually pays 4.5%, that 0.5% is extra profit for the bank. The hidden fees are usually greater than the explicit commission. When the swap trade blew up, the banks made a ton off of the hidden fees!

Suppose the interest rate for a fixed-rate bond were 5%. The interest rate for the variable rate bond + swap was 4.5%. Superficially, the cities were saving a sure 0.5%.

If the swap terms EXACTLY MATCHED the municipal bond terms, then it would have been a proper hedge.  In reality, the swap terms were completely uncorrelated to the municipal bond terms.  Instead of decreasing risk, the swaps actually increased risk.

If it was a true hedge, the swaps would have decreased risk.  However, it was not a true hedge.  In reality, the cities had a synthetic short straddle.  If interest rates tanked *OR* skyrocketed, the cities would have lost a ton of money.  The “sure 0.5% extra profit” only would occur if interest rates remained unchanged!

Suppose it was a perfect hedge. The city has a $1B bond and a $1B swap. The city pays the bank a fixed rate, gets the variable rate in return, and uses that money to pay the bond coupon. The cashflow matches exactly, and there’s theoretically no risk.

I say “theoretically”, because even in the above scenario, the bank has counterparty risk. The bank can go bankrupt before the swap ends.

Suppose a city did an interest rate swap with Lehman Brothers. The city pays Lehman $100M and Lehman pays the city $100M. Due to the way bankruptcy law works, the city gets shafted when Lehman goes bankrupt! The city still owes Lehman $100M, but they become a regular creditor in bankruptcy for the remaining $100M, collecting only 30% or whatever the other bankruptcy creditors get. According to the above NY Times article, some cities *DID* get shafted when Lehman filed for bankruptcy.

Even a “perfect hedge” has counterparty risk. The bank can go bankrupt.

The swap trade did not match all the clauses that come with a municipal bond.  For example, many municipal bonds have a “callable” cause, allowing the city to call the bonds if interest rates decrease. The swap trades did not have a “callable” clause, leaving the city exposed to extra risk.

However, there was a much more serious problem. The swap trade was not a perfect hedge. The cities were exposed to risk, if interest rates tanked *OR* if interest rates skyrocketed!

It would only be a true hedge if the swap terms matched the municipal bond terms IN EVERY SINGLE DETAIL.  That was not true.  The cities were exposed to risk.

The bankster broker was guilty of fraud.  He presented the bonds as a hedge, but they were not a true hedge.  The swap trade actually increased the cities risk, when interest rates crashed.  If you read the fine print, the cities were also at risk if interest rates skyrocketed!  The only way the cities could have profited, is if interest rates remained unchanged!  If you read the fine print of the swap contract + municipal bond,  it was actually a synthetic short straddle!

The “benchmark rate” for variable municipal bonds is typically SIFMA. The benchmark rate for the swap was LIBOR.  Right away, we have an improper hedge, because variable municipal bond rates are tied to SIFMA but the swap is tied to LIBOR.  Anyone with basic economic literacy should have know these swaps were not a proper hedge, because SIFMA != LIBOR.  It is flagrant fraud, when the bankster broker said these swaps were a hedge.

Here is one example.

In the case of Oakland, California, in 1997 the city agreed to pay Goldman Sachs a fixed 5.6% rate in exchange for a payment equivalent to 65% of LIBOR until 2021 on a notional amount beginning at $170 million, and reducing over time as the principle on bond debt it mirrors is paid off. As the chart below shows, it was never a good deal for the city over the long-run since the net balance of payments, the difference between Oakland’s constant 5.6% obligation and whatever LIBOR happened to be on any payment date, was always in the bank’s favor. When LIBOR dropped to less than 1% in 2008 Oakland, however, was stuck with a toxic swap contract requiring millions in payments to Goldman Sachs each year, with no meaningful hedging function against climbing variable rates.

Right away, there’s an obvious huge defect.  Variable municipal bonds are linked to SIFMA.  The swap is linked to 0.65 * LIBOR!  It isn’t even close to a hedge.  The cities got ripped off when interest rates crashed.

They also would have been robbed if interest rates skyrocketed, because the swap paid only 65% of LIBOR!  For example, if interest rates went up 6%, SIFMA would have increased by 6%, but the swap would have only paid 4% more!

The swap didn’t even function as advertised.  Cities would have gotten cheated if interest rates skyrocketed, due to the “0.65*LIBOR” clause!  The swap didn’t even provide a hedge against increasing interest rates, which was the official purpose of the swap in the first place!

I know someone who works pricing municipal bonds and the swaps.  He gave me a sample swap term and bond term.  I slightly changed the numbers, so you can’t figure out which specific bond this is.  I’ll call this “FSK Sample Swap”

In the “FSK Sample Swap”, the city agrees to pay 3.2% fixed rate to the bank.  In return, the city gets 0.65*LIBOR + 0.5%.  The swap is for 30 years.  The swap is for $100M.  The notional amount of the swap gradually decreases over time, to simulate amortization.

In the “FSK Sample Swap”, the city agrees to issue a bond for SIFMA + 0.5%.  This is nothing like a hedge.  If the city does the swap and issues a $100M variable bond, the city is STILL EXPOSED TO RISK.  Let’s go over all the risks the city has.

1. (what actually happened) LIBOR crashed, but SIFMA does not decrease by a corresponding amount.
2. (what actually happened) LIBOR and SIFMA are not correlated.  LIBOR can decrease by a lot more than SIFMA.
3. Both LIBOR and SIFMA increase by an large equal amount.  There’s a shortfall of 35%, because the swap only pays 0.65 * LIBOR.  For example, if SIFMA and LIBOR both increase by 6%, the city pays 6% more on its bond but only gets 4% more on the swap.
4. The “simulated amortization” schedule of the swap does not match the coupon schedule of the bond.
5. Most municipal bonds have exotic clauses like “callable”, “put bond”, or other.  These are not mirrored in the swap.
6. The bank can go bankrupt after making the swap trade.  This did matter for cities that did swap trades with Lehman Brothers.

The cities agreed to pay the banks a fixed rate, 3.2%, receiving 0.65*LIBOR + 0.5% in return.

At the time the swap trade was executed, this seemed like a good deal, because LIBOR was 5%.  The city was paying 3.2% and receiving 3.75%.  However, if LIBOR either decreases or increases, then the bank starts losing money on the swap.  It’s a synthetic short straddle.

Actually, I lied in my example.  The city actually paid 3.9%.  The city was losing money in the deal right from day 1.  For most of these swap trades, the amount paid by the city was *ALWAYS* more than the amount the bank paid in return.  Interest rates when straight down after the swap trade was signed.  Using 3.9% instead of 3.2%, the bank obviously overcharged the city by 0.7%+.  In addition to the commission charged on the swap, the bank made a hidden fee of 0.7%.

The cities agreed to pay the bank a fixed rate, 3.9% in my example, and the bank agreed to pay the city 0.65*LIBOR +0.5%. When LIBOR was 5%+, this seemed like a good deal. However, LIBOR crashed to 0% after the housing market crashed. When the banks were able to pay 0.5% instead of 3.8% on their side of the swap, they made a huge windfall.

After the housing market crashed, the Federal Reserve cut the Fed Funds Rate to 0%. This caused LIBOR to crash to 0%. This led to the ridiculous situation where cities were paying the banks a high fixed rate, receiving almost nothing in return.

LIBOR crashed to near 0%, but SIFMA did not crash!  This left the cities with a huge loss!  They had issued variable bonds linked to SIFMA (still 3-5%), but were only collecting LIBOR (now 0%) on the swap!

If the cities had a perfect hedge, it wouldn’t have mattered. The small return on the swap would have matched the coupon on the variable rate municipal bond. They didn’t have a perfect hedge. This led to losses for the city governments, when interest rates crashed. LIBOR decreased by a lot more than SIFMA.  Cities had to keep issuing variable rate bonds to maintain the hedge.

What the above articles didn’t mention is that the cities would have *ALSO* lost money if interest rates skyrocketed, because the swap only paid 0.65 * LIBOR.  It wasn’t a bet that interest rates would increase.  It was a short straddle.  The only way the deal would have worked out for the cities, is if interest rates never changed.

Due to the housing crash and recession, cities had their credit ratings downgraded. The spread between SIFMA and LIBOR increased.  LIBOR crashed to below 0.25%, because the Federal Reserve kept the Fed Funds Rate at 0%-0.25%.  At the same time, SIFMA did not decrease!  That’s the risk of issuing bonds with a coupon linked to SIFMA, and hedging with a swap with the rate linked to LIBOR.  When they issued new variable-rate bonds to hedge their swap, they had to pay a higher rate due to the lower credit rating. Instead of making a sure 0.5% extra, the cities were now stuck with a sure loss!

Even worse, the banksters manipulated the market for LIBOR. The banks had a huge obligation to pay LIBOR to cities and for other swap contracts. The banks had a synthetic long position in LIBOR; they would make more money if the LIBOR rate tanked. In addition to the Federal Reserve keeping the Fed Funds Rate at 0%, the banks further manipulated the LIBOR rate down.

According to the Spitzer YouTube video, here’s how LIBOR is determined. The person making the LIBOR index calls the 16 biggest banks, and asks them what interest rate they were charging other banks. Then, the banks flat-out lied to the index maker, manipulating the “official” LIBOR rate!

Normally, to rig the stock market, you have to go out and buy/sell to manipulate the price, losing money in the process.  The LIBOR index price is determined by interviewing banksters, asking them what the rate is.  The banksters lied to the LIBOR index maker.  The banks manipulated LIBOR, without spending a single penny!

By manipulating LIBOR down, the banks cleaned up even more on the swap contracts!

In addition, banksters rigged the municipal bond market! Traders at the big banks got together, and agreed to fix prices for municipal bonds, forcing cities to pay even more!

Here is another example of bankers rigging prices. When there was a default on the Greek bonds, there was a scheduled payout on Greek Credit Default Swaps. However, what is the proper payout? The payout rate was determined by a committee of banksters, all of whom had huge short positions in CDS! They rigged the CDS payout to be artificially low, so they could profit. Similarly, banksters rigged LIBOR so they could profit.

The LIBOR loans are not traded on an official exchange.  The only records are kept by the banks themselves.  The only way to find out the LIBOR rate is that the index maker calls the banks and asks them the rate.  The banks lied to the index maker, manipulating the rate.

Many US cities now have huge losses on these swap contracts. Some cities are paying a fee to terminate the swap. Some of them are going to pay out the loss for the next 20 years.

Why is government debt sacred? Why don’t the mayors and governors say “We entered into these swap contracts, and it turns out the bankster broker lied to us. We’re defaulting.” Why not default? If there is a trial regarding the default, the discovery in the lawsuit would lead to discovery of all the corruption regarding these swap deals.

The NY attorney general likes to file lawsuits regarding bank corruption.  There certainly is enough evidence for a lawsuit.  Unfortunately, banks own the government, and that isn’t likely.  If there was a lawsuit regarding these swaps, there would be several key issues:

1. The bankster broker told cities that the swap contracts were a hedge.  The swap contracts actually increased the cities’ risk.  The swap contract was actually a synthetic short straddle.
2. The cities lost money when interest rates tanked.
3. The cities also would have lost money if interest rates skyrocketed, because the swap only paid 0.65 * LIBOR.  But hedging against increasing interest rates was the sales pitch for the swap!
4. The swap was not a true hedge, because the swap terms didn’t exactly match the municipal bond terms.  If you hedge incorrectly, you increase your risk rather than decreasing it, which is what actually happened.
5. The banks manipulated LIBOR downward, causing cities to lose even more money on these swap trades.
6. The banks also manipulated the price of municipal bonds.
7. The swap trade was mispriced.  The cities were overcharged, in the fixed-rate they paid on their side of the swap.  As evidence, for most of these swap trades, the fixed-rate paid by the city was *ALWAYS* more than than the rate paid in return by the bank.  The swap trade was a synthetic short straddle, so initially the city should have come out slightly ahead; that’s the premium you should collect when you sell a short straddle.
8. The city accountant/comptroller may have been to stupid to know about the defects in these deals.  The bankster broker should have known.  The bankster broker is guilty of fraud, by misrepresenting the swap contracts as hedges.

Here’s another way to look at it. The cities thought they were hedging interest rate risk and locking in a sure gain. Instead, they were taking a huge bet that interest rates would not change. When interest rates tanked, the cities too a huge loss.  The cities would have also lost money if interest rates skyrocketed, due to the “0.65*LIBOR” clause.

The swap and derivatives market did not explode until after the gold standard was completely abandoned in 1974. If you read the fancy math for derivatives calculations, profits come from the Federal Reserve and negative real interest rates. Derivatives profits are fueled by 0% interest rates, high inflation, and negative real interest rates. When a bank does a swap trade, they borrow from the Federal Reserve at 0% to finance the transaction. The Federal Reserve is an indirect participant in every single swap trade and derivative trade.

Summarizing, banksters robbed cities via interest rate swaps. The same bank was advising cities to do the deals, taking a commission, and acting as counterparty to the trade. That’s an obvious conflict of interest. In addition to the explicit commission, banks earned hidden fees based on the way the deal was structured. Cities were overcharged for the fixed-rate they paid on their side of the swap.  The cities thought they were hedging, when they actually were making a huge bet that interest rates would not change. When interest rates crashed, the cities took a huge loss. There also would have been a huge loss if interest rates skyrocketed, which was supposed to be the official reason for the swap in the first place!  There was the ridiculous outcome where cities were paying banks ~3.9% for their side of the swap, but the banks were paying almost nothing in return. Even worse, banks rigged LIBOR, the rate that determined the amount banks paid cities on the swap. Banks also rigged the municipal bond market, forcing cities to pay more for their bonds.

There can’t be a default or investigation, because that would lead to widespread investigation of these deals, the corruption in banks, and corruption in government.  Banksters own the government, preventing a proper investigation.

Most of the details of these swap trades are secret. One source estimated the total loss to governments at $28B+. That’s money funneled from local governments into bankster pockets. If government leaders were honest they would say “We’re defaulting on these swaps. If you want to collect, go ahead and sue us and we’ll expose all the corruption of these deals.” In many cases, the politicians signing the deals were also corrupt, and they don’t want a proper investigation.

The government and financial system are completely corrupt.  It’s too corrupt to fix.  The most likely outcome is a complete crash of the system, and hopefully people will start over with something better.