“The Program,” MAMU’s toxic financing – Part 4 of 4

The “boring-is-best” rule of bonds

Neither the Cayman Island ‘Connection’ nor the collapse of the auction rate securities market seem to have rung any alarm bells with anyone on the board of the MDFB, a department of the State of Missouri they’re still processing revenue bonds for little MAMU connected towns with the same auction-rate garbage in them. Are the Lt. Governor and the board also among the useless non-reading officials we are burdened with who rubber-stamp an administrator’s proposals without checking the details? Why are MDFB and MAMU, at this moment, still pushing their members into the same toxic swap loans that have been under criminal investigation since 2005 by the IRS and the Justice Department? The fact that this derivative interest rate swap system has had the seal of approval of the Governor, eight of his political friends, the Lt. Governor and three heads of departments for at least eight years or more, tell us that the state condoned these impossible-to-track financings in offshore banks. Public money in a Cayman Island Branch of a foreign bank is not an accountable or transparent use of public funds nor can Cayman Island accounts be attached by agents of the law if public money someone is hiding there needs to be recovered. Why does the state of Missouri enable the money of a number of little Missouri towns to sit in a Cayman Island Bank right next to the loot of the world’s greatest crooks, criminals and drug kingpins?

The prime directive of government is “Do no harm.” It’s on the very first page of Missouri’s Bill of Rights. “That all constitutional government is intended to promote the general welfare of the people….that to give security to these things is the principal office of government, and that when government does not confer this security, it fails in its chief design.” Our highest state officials and the VIP’s of the Missouri Development Finance Board “failed in their chief design” when they threw us to MAMU and the wolves of the derivative swap market.

The public’s trust and good will has been exhausted. Decades of manipulation, lies and corruption scandals from Watergate to the local city pork projects have taken their toll on our attitude toward government at every level. People are fed up with being over-taxed and under-served. Capitalism has become little more than a bail-out for bloated corporations whose idea of a “free” market is that they are free to privatize their profits and they’re also free to “socialize” their losses on the backs of taxpayers. Elected officials quite correctly have learned to fear asking disgruntled voters to approve levy increases, tax or bond issues. Instead, they jump on every “alternative” money-raising scheme the special interest hucksters can invent, such as TIF and TDD, and Kincheloe’s Payday Loan Laundry, as long as these new “creative financing methods” give them more money to spend while circumventing constitutional requirements for voter approval.

Kincheloe’s MAMU financing offered them a loophole which he explained on page 2 of his bid letter to Rolla on their latest $18 million utility project, would give them the two things they craved, no public accountability and no public referendum on the project: “The Program [MAMU’s financing program] does not require lease-purchase participants to fund a Debt Service Reserve and no voter referendum is required.” The debt-service reserve is a protection for the taxpayers and so is a voter referendum so naturally the loopholes of “The Program” had great value to our politicians if it gave them a way to deep-six both accountability and fiscal prudence. They did not have to answer a single question to justify the project nor did they have to face any awkward discoveries they couldn’t explain about Cayman Island bank accounts during a prolonged referendum campaign. As the whole interest-rate swap market started collapsing after the February market shutdown, some governmental entities that had taken this sucker-bait found themselves paying - not the tiny rates and fees Kincheloe quoted in the Rolla bid letter – but interest rates of 10% and 20%, much more than the fees and rates they started with. Their interest rate swaps soured and their interest rates soared. Jackson County Alabama is a nightmare case study in what happens when officials “trust the experts” instead of doing the due diligence we require of our public officials.

The Fleecing of Alabama: The Bills Come Due

JPMorgan Chase led four banks in selling interest-rate swaps to Jefferson County at six times the going rate. Now, the FBI is investigating the bankers, the SEC has sued a local politician and the county is on the verge of going bust.

By William Selway and Martin Z. Braun, Bloomberg Markets - July 2008

As nighttime temperatures plunged in Birmingham, Alabama, last October, Dora Bonner had a choice: either pay the gas bill so she could heat the home she shares with four grandchildren, or send the Birmingham Water Works a $250 check for her water and sewer bill. Bonner, who is 73 and lives on Social Security, decided to keep the house from freezing. "I couldn't afford the water, so they shut it off," she says.

Bonner's sewer bills have risen more than fourfold in the past decade. So have those of others in Jefferson County, which has 659,000 residents and includes Birmingham, the state's largest city. What's threatening to increase them even more isn't the high cost of treating waste; it's the way county officials chose to finance the $3.2 billion in debt they took on to build a new sewer system. The county relied on advice from a bank, JPMorgan Chase & Co., to arrange its funding, rather than use competitive bidding.

Like homeowners who took out mortgages they couldn't afford and didn't understand, Jefferson County officials rejected fixed-rate debt and borrowed instead at rates that varied with the market. The county paid banks $120 million in fees--six times the prevailing rate--for $5.8 billion in interest-rate swaps. That was supposed to protect the county from rising rates for their bonds. Lending rates went the wrong way, putting the county $277 million deeper into debt. In February, the county's interest rate soared to as much as 10 percent, up from 3 percent just weeks earlier. The swaps have now compounded the risk that Jefferson County will file for bankruptcy as it faces its worst financial crisis since it was founded in 1819.”

The same subprime chaos that has felled chief executive officers on Wall Street and forced banks to write off $322 billion has plowed into Jefferson County and other municipalities. That means local officials now have to pay to banks money that otherwise might have been used to build schools, hospitals or public housing. Meanwhile, the U.S. Securities and Exchange Commission and the Justice Department are now investigating bankers and officials involved in Jefferson County's swap agreements. Bankers who worked for New York-based Bear Stearns Cos. and JPMorgan when Jefferson County bought its swaps have been told they might face criminal charges under an antitrust investigation of the municipal derivatives industry, according to records filed with the Financial Industry Regulatory Authority Inc. On April 30, the SEC sued Larry Langford, the former county commission president, for fraud in allegedly accepting $156,000 from a local banker while refinancing the sewer debt. Langford denies any wrongdoing. JPMorgan spokesman Brian Marchiony declined to comment for this article.

The Federal Bureau of Investigation has raided financial advisers in California, Minnesota and Pennsylvania to get files. In January 2007, Charlotte, North Carolina-based Bank of America Corp. agreed to cooperate with federal prosecutors in exchange for leniency. Bank of America spokeswoman Shirley Norton declined to comment.

Jefferson county--which weathered the U.S. Civil War in the 1860s and racial strife in the 1960s--is now scrambling to avert what would be the biggest municipal bankruptcy in the nation's history, measured by outstanding bonds. "It's going to come back to us, to the people," says Bonner, a retired waitress. "Whether you're poor or you're rich, you're going to end up paying." JPMorgan, Bank of America, Bear Stearns, and Lehman Brothers Holdings Inc. charged Jefferson County about $50 million above prevailing prices for 11 of the interest-rate swaps the county bought between 2001 and '04, according to the September 2005 issue of Bloomberg Markets ("The Banks That Fleeced Alabama").

None of the fees were disclosed to the commissioners, records show. Porter, White & Co., the Birmingham-based financial advisory firm later hired by the county to analyze its swaps, said the banks raked in as much as $100 million in excessive fees on all 17 of its swaps. The swaps are contracts in which the county and the banks agreed to exchange periodic payments based on the size of the outstanding debt and changes in prevailing lending rates. Swaps are derivatives, which are unregulated financial contracts tied to the underlying value of a security, commodity or index. (More….)

In the Bloomberg article, Alabama Congressman Jim Bachus summed it up, “The entire controversy would have been avoided if Jefferson County had simply used the kind of financing all municipalities once used: fixed-rate bonds, which through the early 1970s were almost always sold through competitive bidding. On a 30-year issue at a fixed rate, then everybody knew the risk," Bachus says. "Now, with these swaps and these different transactions, the taxpayers, the ratepayers, even the county--I don't think they understood what they were getting into." Even the culpable Jefferson County Commissioner Smoot admitted they’d been conned. He said the commission “misplaced its confidence in the bankers and advisers.” Smoot said, “I blame the people who said they were the experts. The big Wall Street bankers, where are they now, they violated our trust.” Smoot was wrong. He and his fellow commissioners were responsible; they are entirely to blame. Who told Commissioner Smoot that his job was to become a “we-trust-the-experts” chump for Wall Street con artists?

If you don’t understand anything about derivatives, interest rate swaps and auction-rate securities you have lots of company. Almost no one understands them except the people who invented this dangerous game and most of them have quite deservedly lost their jobs. Some, but not nearly enough of them, are going to prison. There are a few things to be learned from this fiasco. We obviously have a generation of elected officials who do not understand, and appear to never have run across the concept of prudence and conservative money management in public affairs. Like a toddlers they cannot be left alone for one minute to run our cities, schools and other public bodies without our constant supervision. Their addlebrained philosophy that they should “trust the experts” is simply a cover-up for laziness and lack of aptitude and it has landed us in one financial mess after another – the most damaging and costly messes for us are the ones originating from MJMEUC-MoPEP and MAMU.

The Birmingham News on March 02, 2008, published an editorial written by finance editor Jerry Underwood, “Jeffco ignored boring-is-best rule of bonds” that should be required reading for everyone elected to any public office, “This March, Jefferson County officials admitted the county (read: the taxpayers) must come up with $184 million in collateral or its swap agreements could be terminated. If that happens, the county would have to pay as much as $341 million to cover its part of the “swap” deals.” Underwood said, “Jefferson County's financial practices will go into a textbook outlining the folly of officials who blundered their way into what could be the largest municipal bankruptcy of all time.” The legacy of the elected officials who “trusted the experts” is going to be that they were the biggest schmucks in Jefferson County’s entire history.

Underwood concluded: “There is a reason municipal finance is supposed to be a snooze. The financial crisis that's bringing Jefferson County to its knees illustrates why that has long been the rule. County governments are supposed to issue boring, plain-vanilla bonds. They're not exciting but at least you know how much you owe and when those payments are due. Plus, it's never a good idea to pile on any more debt than you have to, because you just never know what treacherous curve lurks just around the corner. There is one more rule in this boring-is-best strategy: Steer clear of the blandishments of Wall Street bankers, who always have an exotic product to pitch to unsuspecting rubes who can't tell a ticking time bomb from a legitimate investment. Looks like Jefferson County ignored all these rules, and probably others. Fact is, these wounds appear to be self-inflicted - and we are all going to pay for them for many years, if not decades.”

Our elected officials didn't use the Boring-is-Best rule either.

“The Program,” MAMU’s toxic financing – Part 3

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 Las Vegas but first I’ll launder your check into chips to play Roulette. If I win at Roulette, I’ll give you some of my winnings, but if I lose you’ll have to replace all the money I lose so I can make your mortgage payment otherwise you’ll default on your loan. Oh yes, whether I win or lose you’ll still have to pay me my 1.5% commission on the declining balance of your mortgage.”

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 Rolla. Kincheloe said this about the proposed lease-purchase, derivative SWAP financing plan for Rolla’s $18 million revenue bonds for a utility substation project: “If the fixed rate on the Lease is, say, 2.6% at the time of redemption but the market for SWAP is 3%; the City would receive a payment from the Program. [MAMU is the “Program”] Conversely, if the SWAP market is less than the stated rate on the Lease, then the City would be required to make up the difference [to MAMU]. Conversely, if the SWAP market is less than the stated rate on the Lease, then the City would be required to make up the difference [to MAMU].”

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 & Bell were giving their professional assurances (for a fee) for the bonds but they knew nothing about any of this.

And the Cayman Island Connection was….? In the Investment Agreement of Rolla’s 2006 MJMEUC-MAMU financing contract (which the council didn’t see but which their mayor obediently signed) it described how: “Depository” Bayerische Landesbank acting through its Cayman Islands Branch, and UMB Bank, N.A. as trustee, under that Trust Indenture dates as of December 1, 2006 by and among Missouri Development Finance Board (the “Issuer”), the Missouri Association of Municipal Utilities (the “Sponsor”) and the Trustee providing for the issuance of up to $50,000,000 principal amount…” Why was there a Cayman Island Branch of a foreign bank involved in this loan? The documents don’t explain, the Gilmore & Bell lawyer can’t explain and MAMU either can’t or won’t explain. The MDFB-MAMU “Cayman Island Connection” probably explains why the IRS is so interested in busting up these derivative swap swindles. A lot of people down the conga line who were using these bonds were making money for themselves by manipulating our interest rates in the auction-rate securities market but they probably weren’t paying income taxes on their ill-gotten gains. That’s why they were smuggling diamonds out of the country in tubes of toothpaste. Things like that tend to upset the IRS.

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).

"The Program," MAMU's toxic financing - Part 2

The MAMU bond laundry… down the rabbit hole.

Roughly, this is how they work the system as tax-free municipal utility revenue bonds are laundered into lease-purchase loans with hidden interest-rate swaps:

Step 1.) MAMU rounds up members who are planning* to do utility capital improvements and who will pay any amount of money to take advantage of MAMU’s magic trick - avoiding the risk of submitting their plans to voters as required in Article VI, Section 27(a) of the Missouri Constitution. MAMU then drives their flock to MDFB, the “conduit issuer,” where they fill out a few skimpy forms to get in on the next MDFB pool bond issue. According to MDFB’s 2007 state audit it’s clear that MDFB is none too particular about how the questions are answered.

(*In some cases they weren’t planning any capital projects they got pushed into it. When they signed their MoPEP contract one of Kincheloe’s great business ideas was that they would all buy diesel generators and become a generator farm and produce their own electricity with the most expensive fuel on the market. Kincheloe loaned them the money to buy the generators through MAMU. The generators are mostly gathering dust now because now Kincheloe doesn’t want to ‘buy’ any of their diesel generated electricity because if he buys it he has to give MoPEP members “MoPEP credits” for producing diesel kilowatts that cost 20-100 times the market rate per kWh. It’s getting hard to tell who is swindling whom here.)

Step 2.) Once the MDFB has a large enough flock of money-hungry sheep in the shearing pen, they issue a single pooled tax-free municipal revenue bond issue to fund all the applicants. Tax-free municipal bonds almost sell themselves, tax-free utility revenue bonds are nearly the same – it’s the tax-free part that makes them so good. They are prized in the market so the interest rates are usually lower than plain revenue bonds. Because they are desirable as an investment and big brokerage houses that do the bond underwriting need tax-free munis to service their biggest clients who always need tax-free investments, the servicing fees are negotiable but the little towns aren’t told that, they don’t know that with their tax-free municipal bonds they have leverage to get the lowest fees. They’re told it will be difficult to unload their bonds so a lot of people will have to be paid a lot of money to process and sell their bonds mostly based on a percentage of the loan. This is just bunk.

No proof that MDFB’s fees are cheaper. In Rolla’s case A.G. Edwards/Wachovia have been the underwriters for at least three MDFB-MAMU pool bonds over a period of the last five to eight years that we know of and we suspect Wachovia has been the chief underwriter in a lot more of MDFB’s financings. It would have been useful if the state auditor had checked to see if the MDFB and MAMU were competitively bidding MDFB’s lucrative bond “servicing” deals for all these pooled bonds as they are required to do but it doesn’t appear that the auditor checked that either. The result is that additional fees hidden in the body of the boilerplate – which can’t be found except by diligent plowing though 60 or 80 pages of legalese (that’s why they call it “due diligence”) - may add up to three or four times more than the commercial service fees would have been had the cities done the bonds on their own. Everyone assumes that the fees charged by the MDFB are less than from a competitively bid commercial company. Everyone assumes this because it’s what MDFB and MAMU tell them. But if the MDFB can’t prove they are providing cheaper fees for these financing issues than the commercial market is charging, and if their loan approval process is so superficial or so politically driven that a recent loan defaulted just months after they approved it, then, do the taxpayers of Missouri really need the Missouri Development Finance Board?

At this point the bonds have been issued, sold and the towns have the bond money they need for their projects. They could have stopped the process right here and do what all public entities used to do and what the well-managed ones still do - take a nice low fixed-rate of interest on their bonds, build their projects and pay back a fixed-rate loan with a steady predictable amount of P&I for the next 20 years, but that’s not what happens at MDFB anymore especially not since the Governor, the Lt. Governor and eight of their political friends hooked up with Duncan Kincheloe and his MAMU “Payday Loan Company.”

Step 3.) Each city’s revenue bonds are now rolled over into so-called “lease-purchase” contracts (a lease-purchase is just a short-term loan pretending to be a yearly renewable lease) between MAMU and each town that had a share of the pool bond funding. Each city is now not only paying the MDFB their proportional share of the bond pool servicing fees but they’re each handing over their bond proceeds to MAMU so MAMU can rent their own bond money back to them as a lease-purchase contract so MAMU can take a fee based on a percentage of the declining balance for the next 30 years! If you’re not already choking - read that again. The cities are paying MAMU an annual fee of 1.5% on the unpaid balance of the bonds for the next three decades to rent their own money from MAMU, another Kincheloe financing middleman. If you still find it hard to believe let’s try it another way. You can tell that by looking at MAMU’s audits that they do not have the cash to make a loan for lunch much less these multi-million dollar lease-purchase loans. So where does MAMU get the multi-millions they “loan” cities for lease purchase loans? The cities give MAMU the millions they just borrowed from MDFB so MAMU can loan or lease-purchase the millions back to them. If it makes your brain hurt, take an aspirin because from here it just gets worse.

If you think that’s just ridiculous you’re right but all swindles look ridiculous when taken apart. Kincheloe’s ‘hook’ is that his member cities are more than willing to pay MAMU 1.5% interest on the unpaid balance of the debt for the next 30 years of this high-risk adjustable interest rate on their bond debt and they’ll play any kind of absurd ring-around-the-rosy because they’re desperate to avoid letting the voters speak their minds in a referendum. Kincheloe has them convinced his “Program” provides them with the legal cover to do this. He can’t prove it of course, he just tells them it will work and they believe him - cult members never question their prophets. Do the cities care how much extra costs and fees they are paying to avoid public accountability? Probably not because their utility rate payers will pay those costs along with all the others so what do they care? If there is anything Duncan Kincheloe is good at it’s setting up straw corporations like MoPEP and MAMU to shuffle paper for the purpose of collecting money from the gullible for the benefit of the conniving.

The “tax-free” bond fingerprint. One of the smoke screens they will try to throw up is that the revenue bonds belong to MDFB not the cities. Wrong. A tax-free municipal bond, is one issued by a municipal, county or state government, whose interest payments are not subject to federal income tax, and sometimes also state or local income tax. There is no doubt that this bond money belongs to the cities, not to MDFB. The bonds describe MDFB as the “conduit issuer” of the bonds not the “owner” of the bonds. The tax-exempt status of the bonds is unique and can only derive from being an issue of the cities and towns that own the bonds no matter what misleading names they call the overarching financial issue such as, “Lease-Revenue Bonds” or “Commercial Paper.” If they’re tax-exempt bonds they are municipal bonds. The minute they ceased being the bonds of some qualified municipality they would cease to be “tax-free.”

The excuse, that this unnecessarily expensive, tortuous system of laundering utility revenue bonds into 30-year lease-purchase contracts (which conveniently gives MAMU decades of 1.5% income for doing minimal paperwork) voids the constitutional requirement for a referendum vote because the bonds have been laundered into lease-revenue contracts, won’t hold up to a legal challenge. Lease-purchase contracts and “commercial paper” by themselves cannot be tax-free. Only municipal bonds can be tax-free and these are tax-free municipal bonds. Neither new name on the cover page can cover up the fact that the original funding underlying the lease-purchase contract is still in tax-free municipal utility bonds no matter how many laundries they run them through or how many alias’ they give them. No matter what cosmetics they use to try to disguise the original tax-free municipal bonds they began as and they remain, tax-free municipal bonds issued to each city. The proof is that each of these so-called “Commercial Paper” or “Lease Revenue Notes” contains “Opinion of Bond Counsel” letters and the documents repeatedly refer to the underlying tax-free muni bonds that are being exploited to leverage debt to gamble in the interest-rate swap market.

Kincheloe’s loophole has a loophole. In the MAMU bid to Rolla on May 16, 2008, Kincheloe describes this shell game of laundering bonds into lease-purchase contracts and he explains that it is done to avoid the constitutional requirement for a referendum vote of approval by the folks at home. “The program does not require lease-purchase participants to fund a Debt Service Reserve and no voter referendum is required.” Even if anyone told the several city council’s that they were paying double fees and might soon pay even more in swap penalties to use the “Kincheloe loophole” they wouldn’t care. They are obviously willing to spend any amount of the public’s money to keep the public from voting on what they want to do and quite likely spoiling their plans to do it. If a citizen happened to ask why they weren’t taking a referendum vote first as prescribed in Article VI, Section 27(a) of the Missouri Constitution (such a question would be asked right after pigs fly) they can tell the home town folks that it’s just a lease-purchase contract with MAMU not really a utility revenue bond issue which must have a referendum vote. There’s only one thing wrong with Kincheloe’s bond laundry…the revenue bonds had already been issued to the cities by MDFB before the bond proceeds were handed over to MAMU to be camouflaged as lease-purchase contracts. Before MDFB put their names in the bond pool they should have received a certificate of the results of the referendum vote in each pool city that was held by the folks back home. Oops! Why were the Lt. Governor and the eight FOG’s (Friends Of the Governor) willing to overlook this critical piece of paper – the Certificate of Election Results – proof that there had been a home town referendum BEFORE the MDFB issued the bond proceeds in the city’s name and sent the bonds on to the MAMU lease-purchase laundry? Why were they so eager to help generate cash so MAMU and Wachovia could invest in the auction-rate securities market?

If any city had asked to see the full scope of the loan paperwork (which they never do because they don’t know there is anything else but the few papers they’re being force fed) and if they had read every page of it (which they wouldn’t, reading being another thing that will only happen after pigs fly) they would have discovered, as we did, that the interest payments from the bonds, d.b.a. the lease-purchase contract, were being sent on to other financial agents each of whom would charge the city another percentage for using their money in a financial contrivance they knew nothing about. The ‘other’ financial agents also charge fees. At one point in the latest Rolla-MAMU contract there are no less than 13 different “funds” that will be set up with a different beneficiary attached to each fund and none of the beneficiaries were the City of Rolla. Blissful in their ignorance, the Rolla City council think they are getting a fixed rate of interest that will not exceed 5% (the fixed rate only lasts three years, then it coverts to a floating rate) and they think they’ve gotten a real cheap deal on the fees by going through MDFB-MAMU for their money. Why do they think that? Because Kincheloe said so and so did Dan Watkins, the guy who runs their utility department. Dan said it was a good deal and they “trust the experts.” After all who would know more about complex Wall Street financing deals than a guy who can climb a utility pole?

Why we must vote on utility revenue bonds but not other types of revenue bonds. The state limits every public entity to a certain percentage of debt - a percentage based on the total assessed real estate valuation of the district - that’s their “debt ceiling.” But the state only counts General Obligation bonds – the ones people vote on and pay off on their property taxes – in that debt ceiling calculation. Revenue bonds are exempt from that debt limit total so that’s why cities like to use revenue bonds instead of GO bonds. Revenue bond debt is kind of off-the-radar, almost secret debt. However, one type of revenue bond debt is different – it’s revenue bonds for utility projects. The courts decided this because revenue bonds for utility projects are repaid by the utility users in their utility rates and fees so they work almost the same as G.O. bonds – repayment is a direct financial obligation of the voters in both G.O. bonds and utility revenue bonds. If the majority of citizens vote for a utility revenue bond to build a new sewer system their sewer user rates will go up by whatever amount necessary and for whatever number of years necessary to pay off the utility revenue bonds. That’s okay because voters agreed, when they went to the polls to vote on the bond issue, to pay the increased fees as stated on the ballot – they knew what the deal was going in. However, if, by use of the alleged loophole claimed by the MDFB-MAMU “bond laundry,” the city can pile up unlimited amounts of utility revenue bond debts that the public will be forced to pay off in their utility rates but which, because of this MAMU trickery, they never get to vote on, then any irresponsible bunch of elected and official fools can abuse this loophole repeatedly and run up a crushing burden of debt that the town and residents cannot survive.

In the unlikely event that the ‘MAMU loophole’ were challenged and upheld by the court then citizens would forever be denied their constitutional right to vote on revenue bonds for utility issues i.e. taxation without representation. The people would be helpless to stop reckless officials from ruining their community’s financial condition. Such a court decision would also put utility rate increases beyond reach of the Hancock Amendment. Voiding two constitutional amendments at one blow by use of his ‘revenue bond laundry’ is beyond even Duncan Kincheloe’s powers. In the entire legal history of Missouri the record of decisions issued by the Missouri Supreme Court and the several Missouri Appellate courts says that if they were asked the question today, “Can a utility revenue bond issue be disguised as a lease-purchase contract to avoid compliance with Art. VI, Sec. 27(a)?” their answer would be a firm “no” because it has never been their habit to take a cavalier attitude toward the financial fortunes and security of the communities of this state and the constitutional rights of its people. (continued….)

“The Program,” MAMU’s toxic financing– Part 1

Editor’s note: For the next few blogs we will change the subject to explain another of the “products” offered by Kincheloe & Co. - financing your capital projects through MAMU, the lobbying and financing arm of the MPUA consortium. The tax-free municipal revenue bond loans MAMU has arranged for member cities since 1999 are now the topic of headline stories about the collapse of the auction-rate securities market. Most Missouri cities that have had capital financing set up through MDFB and MAMU over the last eight years aren’t aware that they are part of this growing financial scandal or what effect it may have on their debt repayment and/or their utility costs. Here’s how it happened:

How the Missouri Development Finance Board and MAMU pimped Missouri towns into the interest-rate swap market.

On July 17, 2008, Missouri Secretary of State Robin Carnahan and the securities representatives of ten other states swooped down on Wachovia’s offices in St. Louis in a “this-was-not-a-raid” to collect documents Wachovia had been tardy in handing over to the SOS. The inquiry was in regard to Wachovia’s lending practices and their involvement in certain toxic financing mechanisms that go by several names, “derivatives swap market” a.k.a. “auction-rate securities” a.k.a. “GIC’s or Guaranteed Investment Contracts,” which actually aren’t guaranteed at all. They go by several names because this isn't a regulated market so there is no standardized glossary of terms for these Nigerian-like investment vehicles. Bloomberg.com has been covering the auction-rate melt-down since 2005, before it began to melt-down but now that everyone is covering the scandal, reporters and editorial writers often use different terms for the same thing. “Interest rate swapping” is what they do with the interest money produced by a revenue bond. “Auction-rate securities” are what the scammers sell to investors. They’re two sides of the same coin.

Carnahan said she was responding to the complaint of 70 Missouri citizens who complained that they were ripped off by Wachovia’s sales of auction-rate securities and other illegal securities practices. What Secretary Carnahan doesn’t appear to know is that one of the Typhoid Mary’s of this toxic loan scam has been generating auction rate securities right under her nose and doing it – not just one rich investor at a time but – but in large job lots on the backs of Missouri towns. These loans were done for the unwary towns that borrowed money through the Missouri Development Finance Board (MDFB) in collaboration with the Missouri Association of Municipal Utilities. (MAMU is the lobbying and finance arm of MPUA, MJMEUC-MoPEP and MCGM) MDFB and MAMU have been using the interest rates generated from MDFB-MAMU utility revenue bonds to invest in the derivative swap market - probably without the knowledge of the little towns they were exploiting.

So Secretary Carnahan actually has - not 70 victims of this lending scam - but thousands. All the rate payers in all the little towns who will have, or already have had, their utility rates raised to repay the high interest rates of derivative swaps gone wrong. The “auction-rate securities” victims in these small towns probably read the story in the paper and said, “Tisk-tisk, what bad things those city people get up to,” without having a clue that their own city officials have borrowed money through MDFB-MAMU and they have had their interest rates traded in the very same “auction-rate securities market.” They were the scam victims they were reading about.

MAMU brags they have funded as many as 40 loan projects for a total of $155,000,000, in loans that may all have started out as tax-free revenue bonds for public entities but then, behind the backs of the people in the city council’s that approved the loans, the interest money was funneled into the auction-rate securities swindle. The MDFB brags that they have funded a total of 187 projects for a total principal debt outstanding of $2.1 billion. How many of those 187 loans were revenue bond loans of the kind that were laundered into MAMU lease-purchase loans which were secretly redirected into the poisonous interest rate swap market.

Auction rate securities are essentially long-term debt products, like revenue bonds whose variable or ‘floating’ interest rate is reset every 7, 28 or 35 days at an auction between banks and other derivate speculators. An interest-rate swap is exactly that. Two parties, called “counterparties” actually swap interest rates. If the market changes and you happen to be holding the wrong interest rate – you’re screwed and the other guy makes money. When the auction-rate credit market seized up and imploded in February it created a cascading credit failure that has reached international proportions. The crash of the auctions left clients high and dry with no way to redeem their investments in ARS’s that they were originally told were "cash equivalents." It wasn't that the ARS's were worthless it was just that when the auctions that determined their value vanished, without the auctions to measure their value they became….worthless.

These transactions were all done in the OTC or over-the-counter market, the “gray market” in Wall Street's back alleys where the flashlights of the Securities and Exchange Commission regulations do not reach,so there was no recourse through the SEC until in 2005 when the Justice Department and the IRS started investigating and came up with plenty of criminal activity. It has taken four years but the criminal trials are now beginning which is why the big banks and investment firms are suddenly willing to make reparations for the money IRS and Justice says they swindled out of their clients. In one case a broker was caught at customs with diamonds hidden in toothpaste tubes. He was transporting his clients’ ill-gotten gains to the safety of their Swiss bank accounts and Cayman Island deposit boxes.

These so-called ‘investment instruments’ or derivatives were hawked to investors as “just like cash” investments. The only thing that is “just like cash” is cash. Now that the auction-rate securities market has collapsed investors have been left with what some estimate is $330,000,000,000 (that’s billions) in losses. To shut up the rich investors and big hedge fund managers who were calling for government regulation and threatening lawsuits, several banks and investment firms, Morgan Stanley, JP Morgan Chase, Citigroup, Merrill Lynch and now Wachovia, are trying to work out refund deals for some, not all, of the investors they “allegedly” deceived. The big squeaking wheels are going to get the grease but what about the little towns in Missouri that MDFB and MAMU have ripped off with the same investments in the same market for the last eight years? The raid on Wachovia on July 17 by Secretary of State Robin Carnahan was, she said, for the 70 investors who complained to her. Wachovia has now offered to make good for her 70 investors and others but Wachovia also used many, if not all, of the MDFB-MAMU generated revenue bond loans that they underwrote to gamble with in the same auction-rate market. Who is going to be our squeaking wheel to get back our grease? They’re making noises about shutting off the payouts next year. Anyone who isn’t in the queue will be flat out of luck unless they hire a lawyer and sue.

Why a state agency is involved in this investment rip-off. The MDFB story started in 1982 when the state decided it would speed up economic development, and thus increase the taxes they could collect, if they made it easier for Missouri towns, cities, counties, school districts etc. to go into debt for economic development and utility infrastructure projects. After going through several legislative remakes and names, in 1993 the state ended up with the Missouri Development Finance Board (MDFB) as “a body corporate and politic.” RSMo100.250-297 and 100.700-100.850. The MDFB's mission was to assist businesses and public entities obtain financing through the issuance of conduit revenue bonds, direct loans, and issuance of tax credits.

The MDFB could do several kinds of things but one of their main activities was to pool the small and large revenue bonds of public entities and process them together which, they claimed, would reduce the administrative costs and fees associated with issuing bonds through the usual commercial bond agents and underwriters. This encouraged small towns to consider going into more revenue bond debt because all they had to do was fill out a few overly-simple forms and the MDFB would make money appear. Hot damn, it was easier than printing money! Doing business through MDFB and MAMU also had this very attractive bait. They were told by MAMU Ex. Director, Duncan Kincheloe, that by laundering their MDFB utility revenue bond into a MAMU lease-purchase they could take advantage of an alleged loophole in the law (Article VI, Section 27(a)) which Kincheloe claimed (but did not have to prove) would keep local government from having to submit the utility bond issue to their voters in a referendum. Laundering the bond issue into a lease-purchase would also, he claimed, (but he has also has never had to prove this) eliminate the need for a bond reserve fund. With no local referendum the voters would be forced to pay the debt off in their utility bills whether they wanted the project or not. Hoorah! From the point of view of local politicians it was better than finding the freaking fountain of youth.

The MDFB is governed and controlled by a group of political VIP’s. Lt. Governor Kinder (R) and eight of the sitting governor’s best friends serve for staggered four year terms. Three state department directors, all the Governors appointees, are voting members. These 12 very VIP’s were supposed to oversee staff and carry out the statutory mandate. Currently the members are: Lieutenant Governor Peter D. Kinder, Chairman,

• Mr. John D. Starr, Vice Chairman
• Mr. Larry D. Neff, Secretary
• Mr. Nelson C. Grumney, Jr., Treasurer
• Mr. Richard J. Wilson
• Mr. L. B. Eckelkamp, Jr.
• Ms. Danette D. Proctor
• Mr. John E. Mehner
• Mr. S. Lee Kling
• Mr. Gregory A. Steinhoff, Director, Department of Economic Development
• Mr. Don Steen, Director, Department of Agriculture
• Mr. Doyle Childers, Director, Department of Natural Resources

The MDFB did not just deal in small potato loans for small towns. When Mel Carnahan, father of the current Secretary of State, was Governor he had to call an emergency special session of the Missouri General Assembly (costing taxpayers millions) just to pass one small amendment to a statute to avoid default of Branson’s massive revenue bonds which were processed by MDFB. A loan default by Branson’s government would have damaged the state’s credit rating and that could not be allowed. Despite the disclaimer on all revenue bonds that they are not a debt of the state, city, county etc….they are. A loan default can ruin the credit rating of a state, city, county or school board for decades. The disclaimer that “this revenue bond is not a debt of the issuer,” is just a legal fiction to keep revenue bond debts from being counted into the municipality’s constitutionally restricted debt.

In 2007, the MDFB got a special state audit which unfortunately did little more than skim the surface of what MDFB is doing. State Auditor Susan Montee (D) gave the MDFB a few hand smackings over alleged political favoritism in deciding the new DREAM awards (what a surprise) and criticized them for taking advantage of their travel compensation. Members of the board serve without compensation but are “reimbursed for their reasonable and necessary expenses incurred in the performance of their duties.” The board thought it was ‘reasonable and necessary’ to spend $101,000 during the last three years for chartered air services to taxi members to board meetings because, as they explained to the auditor, they’re too important to waste their time driving to Jefferson City for board meetings.

In regard to MDFB’s revenue bond lending practices, State Auditor Montee pointed out the following in the 2007 audit: “During fiscal years 2006 and 2005, the MDFB recorded bad debt expense of $3,498,074 and $9,448,681, respectively. These expenses were primarily related to three loans totaling $17.8 million. For one of these loans, the MDFB began recognizing bad debt expense the year after the loan was made.” The first bad loan was for a fish museum in Springfield for $2.5 million. The terms were 0% interest for 3 years and 3% for 10 years. The second bad loan was for $2.5 million to a developer of a historic building in St. Louis. He got 0% interest for 40 years and still defaulted! The third was $12.8 million to a developer to restore the Old Post Office in St. Louis. He only had to pay 1% for 40 years but defaulted within one year! MDFB responded to the auditor that their “loan approval process is comparable to that used by commercial banks in the state.” We sincerely hope not.

Unfortunately the auditor did not dig more deeply into their involvement in derivatives and the swap market, i.e. the same auction rate securities that were the target of Secretary of State Carnahan’s July 17, 2008, “not-a-raid” of Wachovia in St. Louis with the securities representatives of ten other states. The audit merely recommended the MDFB reevaluate its loan approval process. Good advice since their loan application process consists largely of having the applicant fill out a form only a little more taxing than getting a Kroger check cashing card. They also had to swear allegiance to the state and claim that their project will create jobs so the Governor who appointed them could take credit for the new jobs they created. Nothing in the application form or on the MDFB web site alerts the applicants to the derivative swap investment risks they are assuming in entering into MDFB’s “Public Entity Loan Program.” There is nothing about the risks inherent in derivatives or interest rate swaps on their web site or in any of their loan documents. This is not the “full disclosure” required by either the federal or state investment laws.

For the first years after they were organized MDFB probably issued only plain vanilla revenue bonds because that was the only kind there were back then - nothing fancy - just safe, fixed-rate, tax-free municipal revenue bonds. Because they were highly prized tax-free munis the market ate them up and the public entities who were financing their local projects with ordinary fixed-rate revenue bonds knew every year of their 20-year loan terms exactly what they had to pay in principal and interest – there were no surprises. Sometime in the 90’s the MDFB seems to have gotten bored with safe, fixed-rate financing and decided to play with the new exotic stuff. Those were the days of the “Go-Go” market on Wall Street. Wet-behind-the-ears MBA’s, the new “financial engineers” of Wall Street, were coming up with all kinds of fancy financial tools - not all of them exactly legal. Some of this investment activity like the derivative swap auctions was in off-the-books type of investing in an underground financial market that wasn’t regulated or monitored by the Securities and Exchange Commission. It was the era of overnight riches on Wall Street and the computer bubble was getting bigger by the minute. The smart new financial engineers claimed the old market rule – “what goes up must come down” - no longer applied to their cool new world. Everyone wanted to jump on their Get Rich Super Train. Enter the slick ‘new’ financing plan cooked up by the MDFB and MAMU called “The Program.”

Missouri cities, school boards, counties etc. are forbidden by law to invest in derivatives. (RSMo 30.950) Anyone who wasn’t illiterate or two years old in 1994 knew that dabbling in derivatives was how Orange County California (one of the richest of Republican bastions) lost $1.6 billion of their Republican taxes because their fool of a comptroller thought he could beat the house. No one with an ounce of common sense would touch derivatives after that widely publicized fiasco and certainly not for investments of public money. After the Orange County disaster, most states, including Missouri in 1997, hastily passed laws forbidding any public entity to invest in derivative land mines just in case anyone was stupid enough to try it. The MDFB and MAMU were either too dumb to grasp the obvious danger in playing with derivatives or perhaps they deluded themselves into thinking they were too smart to get caught.

Missouri law requires that every political subdivision adopt a formal investment policy. If a town has not adopted their own investment policy reflecting these and other rules, the Missouri Secretary of the Treasury’s “Investment Guidelines for Missouri Political Subdivisions” automatically becomes their default investment policy. The city’s “Investment Guidelines” must contain: (1) A commitment to the principles of safety, liquidity and yield, in that order, when managing public funds. The policy must specifically contain, (2) A prohibition on the purchase of derivative securities, either directly or through a repurchase agreement; (3) A prohibition on the use of leveraging whether through a reverse repurchase agreement or otherwise; (4) A prohibition on the use of public funds for speculation; (5) A requirement that on a regular basis the investments of the political subdivision shall be revalued to reflect prevailing market prices; (6) A requirement that investments which are downgraded below the minimum acceptable rating levels shall be reviewed for possible sale within a reasonable time period; and (7) A requirement that the current status and performance of the investments of the political subdivision be reported regularly to the governing body of the political subdivision. In one fell swoop MDFB and MAMU managed to violate all seven of the principles of the state’s investment policy for municipalities. (cont.....)