In his scathing resignation letter to Goldman Sachs, Greg Smith wrote:
Get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them.
He was referring to derivative products sold to private investors, but this is applicable to government clients too. Firms like Goldman Sachs have made a killing selling interest-rate swap deals to various government agencies, including transit agencies. The politicians who bought them were (to put it mildly) unsophisticated investors.
Here’s how municipal swaps worked (in theory): Say an issuer needed to raise money and prevailing rates for fixed-rate debt were 5 percent. A swap allowed issuers to reduce the interest rate they paid on their debt to, say, 4.5 percent, while still paying what was effectively a fixed rate.
Nothing wrong with that, right?
The contracts, however, assumed that economic and financial circumstances would be relatively stable and that interest rates used in the deals would stay in a narrow range. The exact opposite occurred: the financial system went into a tailspin two years ago, and rates plummeted. The auction-rate securities market, used by issuers to set their interest payments to bondholders, froze up. As a result, these rates rose. For municipalities, that meant they were stuck with contracts that forced them to pay out a much higher interest rate than they were receiving in return.
Even worse, municipalities were locked into these deals with very high early-termination fees. This is precisely the situation that the city of Oakland (CA) finds itself. The cash-strapped city received an up-front benefit of $9.1 million from the interest-rate swap, but now must pay out $5 million annually to Goldman Sachs as part of the Faustian bargain. The swap deal runs until 2021, and the early termination fee is $19 million.
But that pales in comparison to what has happened at the MTC:
Fast forward to 2009. A year into the financial crisis, interest rates collapsed. LIBOR, which had been fluctuating around 5 percent and reached a peak of 5.8 percent in September of 2007, plummeted to virtually zero. The flow of payments became entirely one-sided, from MTC to banks that offered this deal. The advantage of the swap evaporated, and it became a toxic asset. While the Federal Treasury would offload similar toxic assets from the “too big to fail banks” using the TARP program, local governments were stuck with them.
As Ambac careened toward bankruptcy in 2010 due to its absurdly over-leveraged portfolio of credit default swaps, the MTC was forced to terminate its swap agreement with the company, paying the exorbitant sum of $104 million, after already having paid out $23 million in interest. All of this was essentially bridge toll money, surrendered by drivers crossing the seven state-owned bridges administered by BATA: the Bay, Antioch, Benicia-Martinez, Carquinez, Dumbarton, Richmond-San Rafael, and San Mateo bridges. The drain on MTC funds indirectly affects all of its programs, including operational support for AC Transit, Muni, and other regional bus and train services.
Incidentally, one major client of Goldman Sachs is the California High-Speed Rail Authority (CHSRA). Goldman’s expert advice on structuring Public-Private Partnerships was that private investors receive 100% revenue guarantees — and to wait until the project reaches profitability before privatizing. In other words, taxpayers assume all the risk while Wall Street investors get all the profit. Like the interest-rate swaps, this would be a horrible deal for taxpayers.