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.....)
