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How Did OTC Derivatives Get School Districts into Trouble?

There was a not-well-publicized article at Bloomberg.com early last week, detailing how many school districts in Pennsylvania have got into big trouble due to OTC (over the counter) derivative products such as swaptions sold by investment banks. It reminds me many years ago in 1990s when Orange County in California went into bankruptcy by getting into some very exotic derivative contracts. A lesson is never learned and history always repeats itself. Last time the blame was mainly on Orange County, but this time, the blame most likely falls on the investment banks at Wall St.

Public financing used to be a low margin and low profile business comparing to all the other business for investment banks. It is not that much different than the real estate mortgage business in the good old days. Last 7-10 years, however, similar to the increasing mortgage securitization and MBS products, there have been a large increase of complex OTC municipal derivative contracts between municipalities and investment banks. Lucrative fees are not made by issuing municipal bonds, but by following up services and selling additional derivatives related to the original financing. This process is very similar to printer manufacturers selling inkjets, they make little money on the printer itself to get you hooked, then reap great profit in the ink cartridges which they have the monopoly and consumers do not have any choice. Similar practice also happens when stockbrokers or insurance agents continually sell and resell the same or similar products to you in order to make more in fees.

Let us take a look at one particular example in details from the article. Erie City School District in Pennsylvania, back in 2003, was in desperate need for cash. One of the schools, Roosevelt Middle School, was out of money to buy text books, no cash to fix building with heating failure, roof leaking and ceiling tile falling on student's head. What was worse is that the district had to pay higher interest on the $38.7M bonds issued back in 2001 when interest rate was higher.

Here comes one of the most prominent investment banks at Wall St. and district's financial advisor firm. They persuaded the school board to engage a complex 4 factor swaption contract by betting basically that the short term rate will stay low and spread between 1 year and 30 year will widen. As a result of this bet, Erie received $785k upfront cash, their financial advisor firm got $60k, bond insurer received $57k, lawyers and others $106k. This contract, according to Bloomberg data, was worth $2M by selling it at the open derivative market at that time, so the i-bank reaped $1M profit without taking any risk.

Of course, out of convenience, neither the i-bank nor the financial advisor firm which is supposed to be at Erie's side told the school board how much profit the bank was making. Actually it was up to the bank to decide how much of the $2M it would give to the district.

As you might have guessed, the interest rate bet did not work out when short term interest rates had actually risen and yield curve had flatten thus spread had narrowed. By June 2006, the swaption had left Erie with a $2.9M liability which district couldn't take the pain any longer anymore and threw in the towel. In July, they paid the i-bank $2.9M to terminate the swaption contract just to get out. I checked the short term rate and yield curve, if they could have held on for another year and half, when short term rate dropped and yield curve became steep again, they would probably have made money. Not bad for the i-bank, it made $1M fee upfront and $2.9M at the end without committing any of their own capital, so it is basically free money for them. Too bad for Erie, a $785k loan turned into $2.9M repayment in 3 years. Should I say 140% interest rate per year? This makes mafia loan sharks look good, maybe even qualified as charitable organization.

This swaption is a OTC derivative, meaning it doesn't get regulated by SEC, and it doesn't go through the public bidding process, and it is purely a private contract between the two parties. It is probably the most unequal, unfair and aggressive contract one can ever imagine. One side is the school board members who have their regular daytime jobs and are doing this part time and voluntarily, and have no knowledge about finance, capital market, derivative, let alone swaption which is an option (derivative) on top of an interest-rate swap (another derivative), and are fully blind sided. The other side is the most sophisticated i-bank who has full knowledge of this complex product from their computer models, its value from open derivative market with bid/ask price, the markup, and can sell this product anytime they choose to reap unbelievable profit without committing any capital and risk.

Unfortunately in 2003, under many years of heavy lobbying by financial advisory firms, both House and Senate in Pennsylvania passed the law by 197-0 and 45-0 margin to allow municipal derivatives, based on the claims made by those firms that these products can give them much needed upfront cash and "save" them money. The founder of the financial firm advising Erie district had contributed $469k to Pennsylvania elected officials, political action committees and candidates for office. When Erie district needed help to understand the deal proposed by the i-bank, conveniently this firm became Erie's financial advisor as recommended by the i-bank. Now you know where the "free lunch" is coming from.

As someone said to Bloomberg, this situation is "like trying to decide whether a used-car dealer is offering you a good price or not." "There's a car appraiser down the street who tells you he will provide an independent evaluation. But he's paid only if there's a sale". What is worse here is that the appraisal is lobbying very hard for your business and pretends to be on your side, but what he does not tell you is that he is actually working for the party at the other side of the table to rip you off.

This is not the most outrageous deal. Another case happened at Bethlehem's school district. In 2005, the school board had entered two interest-rate swaps with this i-bank and another prominent Wall St. i-bank jointly, again without competitive bidding. This time, the district took in $900k, the financial advisor firm made $630k fee, the two i-banks each made $840k and $900k respectively. According to Bloomberg, the fees to i-banks were 5 times higher, but the fees to financial advisor firm in this case were amazingly 10 times higher than comparable interest-rate swap deals at that time.

During the past 4 years in Pennsylvania alone, banks have pitched at least 500 deals totaling $12B like the one sold to Erie, and most of them have been made without public bidding, by just taking the word for it from their financial advisor firms. Many of the swaps today turn out to be wrong bets and schools have to pay banks or they need to pay a steep exit fee as Erie did to cancel the deal. And since these deals are over the counter, we don't know how many and how bad of these municipal derivatives out there in the country. If more of this kind of bad deals surface in the future at mainstream newspapers and magazines, it is particularly damaging to the reputation and image of i-banks at Wall St.

Local districts and state governments have already faced declining tax revenues from falling real estate market but increasing expenses from foreclosure, and many government pension funds have suffered subprime losses, you don't want to get them angrier with another ticking OTC derivative time bomb. Merrill has made a sound judgment, probably from the new management, by buying back the subprime loan from Springfield, MA pension fund at the same price as it was originally sold. Merrill no doubt suffers losses by doing this but avoids potential lawsuit from angry municipality. But most importantly, Merrill shows that they are capable of doing the right thing in order to repair its badly damaged image and reputation from previous top management. It might be wise for i-banks to just bite the bullets, rewind those derivative contracts, and waive any losses on the school districts, as Merrill did to Springfield. Otherwise this will become a growing and very bad publicity issue for them.

The current OTC derivative debacle is quite different than Orange County in 1990s which was a more isolated case. This time, it is more widely spread and globally, involved much more capital and parties that no one can get out alone but everyone is tangled together. Also Orange County in CA is one of the richest counties in US, many families there can afford to send kids to private schools, not the case for many counties in Pennsylvania like Erie. Unfortunately Roosevelt Middle School mentioned above was eventually shut down in 2007, and kids have to go to a temporary space the school district is leasing from a church today. As Erie schools superintendent said "they (the Wall St. i-banks and their financial advisors) don't have to put their interests over the kids."


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