What happens when your interest-rate “swap” goes sour?
Step 4.) Now the city has the money they need to build their project and they have three years to do it. During that time they pay a fixed interest rate on the balance of the bond as amounts are drawn down to pay the bills. If someone asks what kind of debt this is (another question that will come long after there are pigs in the treetops) they will be told the city has a fixed rate of interest – which is a lie of omission because the fixed interest rate only lasts for three years. Once the project is complete the fixed-rate of interest on the debt is flipped over to a variable rate of interest for the next 27 years or more. MAMU then (figuratively) sends the interest payment on a long detour to the Shop ‘n Swap market where the newly created variable interest rate on their bond issue becomes a “derivative” which will flow through a conga line of agents, money handlers and speculators of dubious purpose and questionable reputation such as Wachovia and Morgan Keegan - both companies are among those prominently mentioned in the IRS and Justice Department criminal investigations.
This new “derivative” they’ve created will be invested in “interest rate swaps” which means one or more “counterparties” match up interest rates and quite literally “swap” them. He gets yours and you get his even if his has a higher rate of interest than yours…that’s why he wanted yours. Each of the more than 13 “funds” will add more handling fees while they use the variable interest rates to “swap” with others in this Three Card Monte game. The Swap auctions which auctioned these interest rates (thus the name “auction-rate securities”) were held every 7, 28, and 35 days. Theoretically, your interest rate could change every 7, 28, 35 days but not every interest rate derivative is traded that often. The point is it can change arbitrarily, often, and without the town knowing their interest rate has been “swapped” and changed from what they thought it was. If MAMU’s “swapper” guesses the interest rates wrong then the city whose interest rate he’s swapping will lose a lot of money but he doesn’t worry. Among all those piles of incomprehensible legal papers we let our Mayor’s sign it says we have to pay THEM for all of OUR money that THEY lose. If we don’t replace what they lose in gambling on Over-the-Counter derivative SWAPS, we will be short on our debt payments and that will hurt our credit so whatever they say we have to pay, we have to pay even if we’re paying someone else’s inflated interest rates.
What the hell is a derivative? At the end of this section are the academic definitions of derivatives and interest rate swaps. Just about anything that has an underlying asset, such as the utility project that the bonds are going to build, can be used to create a derivative as a basis for this kind of gambling. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Compulsive gamblers bet on things like that and that’s what this market is – a playground for another kind of compulsive high-roller. Think of it this way. A man and his wife buy an expensive house. After closing on the loan his brother-in-law says, “If you will pay me pay me a fee of 1.5% on the declining balance of your loan, I’ll deliver your mortgage payments for you every month on my way to
Explained that way it sounds crazy - even illegal. But that’s the way the swap or auction rate market works...or the way it used to work. Duncan Kincheloe, CEO of MPUA, MGCM, MJMEUC/MoPEP and MAMU confirms it on page 4 of his bid cover letter to the City of
Since the market collapsed in February, investors are now stuck with these “auction-rate securities.” Auction-rate securities started as long-term bonds sold by municipalities that gave borrowers access to money for 20 or more years. But what's different is that they didn’t have a stated interest rate for the 27 year floating-rate term once their three-year fixed rate was up! Somewhere in your loan papers it talks about variable interest rates but it never says what the interest rate is going to be - something that might have been noticed if anyone had bothered to read the loan documents. After they are offered in a periodic auction every 7, 28, 35 or 49 days where investors bid on them and after the interest rate is “swapped” and “reset” to the new swapped rate – then you have an interest rate. Who you “swapped” interest rates with determined what your new interest rate would be. In theory, borrowers could access money for long periods at what were basically short-term interest rates. Investors were told that if they needed their money back in a short period of time they could sell their securities to other investors at an auction and recover their cash. Brokers and underwriters told investors they could get their money back anytime they wanted it because these auction-rate securities were “good as cash.” All these theories quit working in February 2008.
The lynch-pin fell out of the steamroller when the sub-prime mortgage fiasco caused the big insurance companies that had insured the revenue bonds to get their credit ratings downrated. They had high credit ratings because the credit rating companies didn’t really bother to investigate what the insurance companies were insuring (junk mortgage paper), they just had them fill out a few forms and “assurances” and swear that everything in their company was still hunky dory which was less true as time went on but they weren’t going to admit that. What the rating agencies like Fitch Ratings and Moody’s didn’t bother to check was how much bad paper the insurers were also covering in sub-prime mortgages. When the sub-prime mess began to unravel it eventually blew up the insurers along with everyone else in a spectacular cascading credit failure which is still affecting all our lives. The backing of the insurance companies were the only safety net the auction rate securities had so when investors saw that collapsing also they quit bidding in the auction-rate securities (ARS) auctions leaving those who were already invested in ARS’s holding the bag. If nobody is buying ARS’s, you can’t dump yours and get your money back. In the resulting credit vortex billions of dollars belonging to investors were flushed into a huge black hole because of the lies of greedy underwriters, banks and brokers.
For the last eight years the elected officials in the little towns have been “trusting the experts” at MAMU to be the middleman for their utility project funding. Until this summer when questions began to be asked about the MDFB-MAMU bond funding of a utility revenue bond project in Rolla, no one knew that any of these incomprehensible things called “derivatives, swaps” and “auction-rate securities” had anything to do with their MAMU funding. They did not know because they “trusted the experts” so they didn’t read their loan papers which contained references to all these terms and described how they would be used. “Derivatives” and “swaps” and “interest rate reset periods” were never explained to them by MAMU officials or - what would have been much better - by a reputable financial consultant, a disinterested third-party who might have told them the truth about the great risks inherent the derivative markets. When a lawyer from Gilmore & Bell was forced to come to a Rolla council meeting in July to answer questions about Rolla’s proposed MAMU loan, he admitted he didn’t know much about the process or the swaps or the risk and he claimed he knew nothing about the Cayman Island banks that are involved the 2006 MDFB-MAMU bond funding even though Gilmore & Bell was the firm that provided the Opinion of Bond Counsel for that same issue, which they were by then calling “MDFB’s Commercial Paper Lease Revenue Notes.” Strange that Gilmore &
And the
The “good as cash” lie. Kincheloe claims, also on page four that, “The Lease-Purchase Agreement provides that the obligations can be redeemed in full, plus accrued interest, at any time. While there is no redemption premium, the redemption is dependent on the market for SWAPS at the time of redemption.” He also confessed, “Consequently, since the future [SWAPS] market is unknown it is impossible to determine the redemption savings/costs at this time.” This lie that they can get their money back “any time” is what Wachovia and other big banks and investment houses are being sued for telling investors. The obligations could not be redeemed “at any time.” People still have billions locked up in that failed market because they couldn’t get their obligations “redeemed at any time.” That’s why the banks are volunteering to pay back at least some of the money for the investors they swindled.
Kincheloe surely knew by July 2008 that the market had collapsed in February 2008, but Kincheloe was still selling investments in this imploded market whose participants were under criminal investigations by the Justice Department! He had to know it was all over the news. If he didn’t know it raises serious questions about his financial expertise, if he did know it raises an even more unsavory question. Rolla’s loan paperwork in June and July included interest rate swaps even while newspapers around the world were daily announcing the market disaster. Kincheloe also must have known that the interest rates some cities were hit with on their derivative swapped interest rates were double digit rates not his tiny 1.6% example.
If the members of Rolla’s city government or any of the other small towns that did business through MAMU had read Kincheloe’s bid letter, they wouldn’t have understand a word of it. How could they? Revenue bonds laundered into lease-purchases, with fixed-to-floating-rate interest payments used to create derivatives to be traded in the unregulated interest rate swap market, is not a common topic of the morning coffee klatches in Main Street coffee shops. If our local officials can’t understand it and can’t explain it to their constituents then they shouldn’t get us involved in it. We expect to get ripped off by gypsy roofers and diet pill salesmen but we don’t expect to be lured into scams by our own state government in the form of MDFB and quasi-governmental organizations like MAMU and MJMEUC. A pimp is a pimp is a pimp no matter how many VIP’s are on their board.
Here’s the question the council should have asked Kincheloe at the July Rolla city council meeting.
“Why, if the auctions of these so-called investments imploded in February ’08 and the market shut down, are you and MAMU and MDFB still out hawking these same dirty investments to Rolla and all the other public entities that are in the ’08 bond pool? Exactly what are you guys up to?” But only one member of the Rolla City Council, Donna Hawley, had the nerve to ask any questions. (continued….)
Definitions:
Derivative: In finance, a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Futures contracts, forward contracts, options and swaps are the most common types of derivatives.
Interest rate swap: A derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. As such, interest rate swaps are very popular and highly liquid instruments. In an interest rate swap, each counterparty agrees to pay either a fixed or floating rate denominated in a particular currency to the other counterparty. The fixed or floating rate is multiplied by a notional principal amount (say, USD 1 million). This notional amount is generally not exchanged between counterparties, but is used only for calculating the size of cash flows to be exchanged. The most common interest rate swap is one where one counterparty A pays a fixed rate (the swap rate) to counterparty B, while receiving a floating rate (usually pegged to a reference rate such as LIBOR).
