Monday, February 27, 2012

The blight of interest rate swaps

It's no secret that state budgets (not to mention their public pension funds) have been under intense pressure lately, a problem made significantly worse by perpetually accommodative Fed policy. Much like our federal budget, these state funding crises have stemmed from both the revenue side and the spending side, caused by decades of politicians who habitually promised the world to their constituents without bothering to do any contingency planning at all.

But a recent report from SEIU sheds light on yet another drag on state and municipal budgets at a time when they can least afford it, once again aided and abetted by Fed policy--and, of course, benefiting banks everywhere at the expense of taxpayers. To summarize...
Big banks are profiting at state and local governments’ expense using the same toxic financial instruments that helped crash the economy.  These derivatives known as interest rate swaps, were sold to governments with a promise that they would lower their borrowing costs but have now become a huge liability. The banks have already taken as much as $28 billion from state and local governments.  Now, during the worst public budget crisis in memory, the big banks seek to collect billions more from toxic deals that local and state governments are trapped into and are forcing layoffs and cuts to services to cover payments to banks.
I do take issue with the assertion that these are "the same toxic financial instruments that helped crash the economy", but that disagreement is immaterial to this discussion. The quick and dirty of it is that banks enticed state and local governments everywhere to "lock in" their interest rate costs--both pre-existing and projected--at what were at the time multi-decade lows. Those governments were effectively borrowing money in advance, often paying interest to the banks on loans never made (for projects not yet approved or begun). When the economy tanked and interest rates went even lower, the governments were still on the hook for the higher interest rate expense.

Adding insult to injury, the weakened economy meant that those not-yet-approved projects would in fact never begin (as spending measures were reined in), meaning that the governments had "locked in" interest rates on non-existent borrowing needs--without a project to fund, the swaps became naked bets on interest rate movement, bets that the governments had no way of winning in the face of loosening Fed policy.

The governments therefore were (and still are) left paying an insane tab to the banks for no reason whatsoever. If this whole scenario sounds familiar, that's because it is--I wrote several months ago about a similar scenario involving Bobby Bonilla and the Mets, in which case Bonilla was effectively playing the role of the bank. These interest rate swaps also cost the Port Authority of New York/New Jersey vast sums of money, sums that they are now trying to recoup via increased tolls and fees (as though they weren't high enough to begin with).

While the states should have known better than to get into these arrangements to begin with, the fact that these local budgets are now suffering so badly as a result shows yet another side effect--an unintended consequence--of the Fed policy that I have spent so many words on this blog deriding. The only way to solve the problems that these governments--state and otherwise--now face is, of course, through more monetary stimulus!! And round and round and round we go... aren't centrally planned economies fun?


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