The current transportation debate has put a spotlight on how we restore and protect the integrity of our transportation system but should also illuminate the road that brought us here – specifically, the amount of risk accepted by our agencies and the integrity of the decision-making process.
Back in 2001, options on interest-rate swaps, commonly known as “swaptions,” from UBS were used by the Massachusetts Turnpike Authority to generate cash in the short run while gambling on interest rates in the future. Swaptions are derivative instruments (exotic, usually high-risk investments speculating on everything from the weather to the spread between various interest rates) and are largely unregulated by the SEC. The MTA struck another swaption deal in 2002 with Lehman Brothers to offset some of the risk of the UBS swaption. This provided short-term cash payments for the MTA but, with 35 percent of its debt in derivatives, exposed the Commonwealth to extreme market risk and potential termination penalties in the hundreds of millions of dollars. The rating agency Fitch warned about serious financial risk associated with this decision in 2002.
Just a few years later, the worst-case scenario may come to pass.
One of the swaption deals arranged by UBS has ballooned from an original payment received of $22 million to a looming termination penalty due of around $400 million. The Lehman Bros. swaption, which was used as an offset, was unfortunately terminated with the Lehman Bros. bankruptcy.
To make matters worse, Ambac Assurance Corp. insured the UBS swaption. But because Ambac is teetering on insolvency, UBS may have the second necessary condition to demand the termination payment. The questionable decision making that led to this looming catastrophe on an agency already operating under financial constraints has brought us a perfect storm of our own making, worsened by market conditions few could have predicted. But we are not alone.
Three federal agencies (the IRS, the Department of Justice and the Securities and Exchange Commission) and a loose consortium of state attorneys general have for several years been gathering evidence of similar situations (NYTimes article). Bid-rigging, tax evasion and what appears to be collusion among the banks and other companies are some of the behaviors discovered while state and local governments took approximately $400 billion worth of municipal notes and bonds to market each year.
Meanwhile, UBS, the largest wealth manager in the world, which has recently been taken to task by the IRS for providing a tax haven for 52,000 U.S. citizens, has accepted a Swiss government bailout and is in a position to receive U.S. federal tax dollars with the AIG bailout as a conduit. Here in Massachusetts, the attorney general fought and won a $35 million settlement with UBS based on misleading investment advice to Massachusetts municipalities.
The IRS is even going so far as to challenge the tax-exempt status of municipal bonds and their derivatives in a number of places. This would make government officials unwitting accomplices in breaking federal tax rules since proceeds from tax-exempt bonds appear to have improperly generated investment income for banks and insurers. In Philadelphia, for example, the former city treasurer is serving a 10-year sentence for accepting illegal payments in exchange for steering city bond business and other contracts to selected companies.
We only need to look as far as Jefferson County, Ala. for company. Last year, a number of their derivatives instruments failed, leaving the county with vast bills that cannot be paid. Jefferson County is now seriously considering declaring what would be the biggest governmental bankruptcy in United States history. Among the governments that have sued large financial firms are the cities of Chicago, Baltimore, Oakland and Fresno, Calif.; the state of Mississippi; and a number of counties, school districts and at least one water-and-sewer district. The lawsuits were consolidated in November, in federal district court for the Southern District of New York.
Here in the Commonwealth, there are five potential strategies for relief that should be considered:
* Explore legal action. Seek recovery and/or other relief. Look into the inception of the deals and the advice relied upon. The Turnpike is seeking its own outside legal advice.
* Hold hearings regarding decision-making to answer questions about the integrity of the process and restore public confidence.
* Guarantee the debt by putting the full faith and credit of the Commonwealth behind it, and then abolish the Turnpike Authority, a strategy apparently being pursued.
* Put the MTA into Chapter 9 bankruptcy to isolate the debt.
* Re-evaluate federal, state and local regulation. Protective controls should be put in place to reflect the state’s fiduciary responsibility of taxpayer’s money.
While some of these strategies are mutually exclusive and others complementary, all should be considered. Special assurances and protections should be implemented to spare the taxpayers such potential risk exposure and expense. Additionally, in such a buyer-beware atmosphere, going forward, the Commonwealth needs to take preventative measures to insure the integrity of the process. In this way, we keep our eyes on the road with two hands firmly on the wheel.
Rep. Lori A. Ehrlich, D-Marblehead, is a certified public accountant in her second term as a state legislator. She serves on the Joint Committee on Transportation and the Joint Committee on Revenue.
Lori is my State Rep and she deserves a ton of credit for her research and effort in writing this piece. Her evaluations are bipartisan and her “strategies for relief” are reasonable and deserve prompt consideration. Let’s put all discussion about tolls and gas taxes behind us and focus on the reforms that are needed to clean up this mess. Good job!
“If it seems to good to be true – it IS too good to be true.” I guess that goes for derivatives and swaptions.
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p>The rationale for paying all those high salaries for those money managers seems thinner and thinner, at least to me.
–Leo
We have someone with the financial experience to understand this stuff on the transportation committee. We’re probably still only skating on the surface of knowledge on this issue. Hearings are definitely a must and all of the options listed should be explored, at least so we know all the pros and cons.
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p>Bottom line: a lot of shady things went on and it should be the Pike and those who were responsible for the Pike at that point who are held responsible, not the commuters who have been paying their tolls every day just to get to work. Commuters shouldn’t have to bail out the bad business decisions of Charlie Baker and Paul Celluci’s failed political appointees.
Aloisi?
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p>True enough… But bad business decisions aren’t necessarily the core of the problem: the Pike has been a political football for years. It didn’t help when Bill Weld thought he’d score points by grabbing a sledgehammer and knocking down a toll booth. In 1997 the whole thing gotten shaken up again when the Pike was turned into two separate entities, the Pike (west) and the MHS (east). Jane Swift thought she could bully Mihos and Levy and have her way with the tolls. Romney tried his own special brand of ‘reform’. So, in a very real sense, the Pike has been like a juggler during and earthquake: some balls are going to get dropped. I think that the worst business decision, actually, was to treat all this upheaval and hoo-haa as ‘business as usual’. Somebody ought to have stepped up and said something. I think that was the fault of the legislature.
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p>So, yeah, I agree with you: bad business decisions ought to be punished. But we ought, If only for sanity sake, to figure out where bad business environments end and bad business decisons begin.
It’s certainly well past time that change was instituted. The legislature can’t punt this one any longer — it’s the forth quarter and we’re down a few points.
… I had no idea what was going on. While it sounds naive to say this, it is scary to think how much of a ride were taken on by Wall Street. I think besides being on the verge, if not already in the poor house, bankers are in for a whole heck of a lot of trouble. I say lock them up!
This is a compelling piece of work. What a horrifiying situation. The number one priority of the state should be to protect the taxpayer. Number two should be to determine exactly who in the MTA was responsible for making these risky and ill-adivsed investments.
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p>I know municipalities work with strict guidelines on investments…they cannot take on too much risk. Do state agencies like the MTA not have similar guidelines? I guess what I’m asking is: Was this a failure of oversight (are there no guidelines for state agencies to follow when making investments?) or was this criminal (did someone at the MTA not follow the guidelines?).
So who does the hearings? What committee?
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p>Geez, do we even do big fat intimidating hearings in this state?
House Post Audit:
Linsky of Natick – Chair
Swan of Springfield- Vice Chair
Miceli of Wilmington
Timilty of Milton
Stanley of Waltham
Welch of West Springfield
Peake of Provincetown
Richardson of Framingham
Smith of Everett
Hargraves of Groton
Ross of Wrentham
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p>Senate Post Audit:
Pacheco of First Plymouth and Bristol
Fargo of Third Middlesex
Baddour of First Essex
Candaras of Berkshire, Hampden, Hampshire and Franklin
Michael O. Moore of Worcester and Norfolk
Morrissey of Norfolk and Plymouth
Hedlund of Plymouth and Norfolk
I think what I would add to this conversation is simple wariness regarding the incompatibilities of the public weal and the profit motive. The Pike is actually an engine of our economy, moving many many people in and out of Boston daily (as is also true for the MBTA) in a manner that can be decidedly counted as a public good.
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p>In calculus and in algebra a common strategy for determining how a variable might have an effect within a function is to simply zero it out: in effect, to ask; “what happens when this is gone”. Let’s play that game here: what would happen if the Pike just up and disappeared? Whenever I ask this question the first answer I get is, invariably, “well, the revenue from the tolls would be gone” . This view is as though the only benefit to the state, of having the Pike, is to generate money. But that’s not nearly good enough. Ask the question in a different way: what happens if the thousands upon thousands of people who drive the Pike daily were to suddenly stop coming into the city (regardless of whether they pay tolls or not.) The answer is simply that the economy of Boston, and thus of Massachusetts, might very well collapse. . It’s also a major conduit between Mass and New York.
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p>On the other side is the raw greed of the profit motive. UBS (and Lehman, et al…) are little better than date rapists: exploiting some level of intimacy into criminal self-satisfaction. They neither care, nor bother, with the public good.
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p>I like this one. I feel very strongly that, at least in the Pike/Lehman swaptions/swaps a great deal of naked collusion occurred.
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p>While hearings like this are certainly all to the good, I’m unclear why this is one of the proposed “strategies for relief”. This is a strategy for understanding, not relief. The decisions have been made. With any luck, such hearings would have significant bearing on future decision making, but can’t, as far as i can see, provide anything like relief in this instance.
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p>Yet… I can’t help, too, thinking that decisions made weren’t made in a vacuum. Given the Big Dig and the decades long political and organizational upheavals something like this might have been more or less inevitable: A lot of the need for funds to cover operating expenses comes from the imposition of Big Dig debt and the continual use of tolls as political footballs… as well as the crazy divisions between east and west created in 1997 (created, it seems to me, for wholly political reasons.) This is not the first attempt at ‘reform’…
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p>Yes. This is the best option. I think guarantee and abolish is good. We need more forward carefully, however, with what it is we put in place of the Authority… We could be at the end of a long period of more-or-less constant upheaval… or we could just mark the middle section of an ongoing mess.
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p>I think this is an option only as a sub-strategy of the first strategy: if we find sufficient evidence of chicanery in the swaptions negotiations then, I envision, years upon years of court cases… If only for protection. However, I’m not certain that this is strictly necessary: the Pike isn’t insolvent.
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p>I think this goes hand in hand with the hearings options: it’s not relief, but it is providing input for future decision making…
Charlie left the administration 8/31/98. Does anyone know when these swaptions were issued?
First the dates are the day the swaptions were signed and agreed to the decisions and the initiation of the process came months before the actual agreements are signed and agreed too.
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p>JP Morgan June 18, 1999
UBS May 31, 2001
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p>Lehman Bros has 6 documents starting in 2002
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p>Bob has the links on the previous post here at BMG
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p>Great post and Great Work Representative Erhlick!
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p>Can I ask you are there any other agencies who have used Swaptions or other exotic forms of debt management? I am including MBTA, MWRA or any other state agency? It certainly would be nice to get the cards all out on the table so we may have a clear picture of the hole we need to climb out of. I would also agree that it maybe time to just cut the MTA lose and let it fall instead of leveraging the Commonwealths credit in an attempt to renegotiate these Swaptions. Placing this about of debt and even renegotiated Swaptions is still gambling on the future of the economy. My hope is that we have learned a lesson from these current events and are not willing to just rush into more of the same hoping we will do better. Maybe the state and our Agencies need to attend Gamblers anonymous and get off the betting for good. To obligate this entire debt onto the tax payers at this time will only accomplish one of two things dry up all remaining capital in our state government or force taxes even higher at time when many more residents will be facing lay-offs and cut backs. Preventing the State from being able to bond meaning full projects that are necessary to support the infrastructure that will be the foundation of a recovery would be extremely short sighted. With the MBTA sounding a cry that the “sky is falling” on them as a result of the debt they are carrying we need a comprehensive assessment of the entire states financial position and a comprehensive plan to pay back debt so we do not hamper our recovery.
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p>It would appear that the lack of oversight and regulations by agencies like SEC and the three rating giants like Moody’s have led us down a path that is proving to be down hill white knuckle ride and how we manage the fall will be critical on how we land and if we walk away. Rewarding gambling of this kind by our own State Agencies and the “to large to fail financial sector” is likely to only put off the inevitable and leave our country and our state with one huge mortgage, the inability to maintain any kind of safety net for the rank and file citizens who go to work every day and try to maintain a small slice of the American Dream and an inability to prosper in a recovery because of the necessary increases in Taxes to pay the mortgage..
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p>As with AIG, CitiGroup, BofA et al. these industry giants should be in a sink or swim on their own policy failing to stay above the tide they should be allowed to follow the rules of the safety nets we have been relying on for 65 years, FDIC and Bankruptcy. These were the lessons we learned from the last Great Depression and put into place to help prevent loses from trickling down to every citizen, wiping out our future.
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p>Yet we find that not only has deregulation and an unfettered free Market has run amok but that under Legislative interference by a decade plus of Republican Leadership in Washington have actually bankrupted a critical system of our safety net system FDIC.
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p>Link: http://www.boston.com/news/nat…
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p>As a result instead of a pay as you go insurance system that FDR put into place to protect every Americans savings we are also now finding out we have to increase the mortgage just to cover the system that was suppose to be self reliant. How many more time bombs are out there for Americans to dodge as we try to survive this collapse?
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p>Yet all of these issues need to be removed from politics and need 100% of our attention to correct the past and to move forward to protect the future and of repeating the past. Lets start with all the cards face up.
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p>As Usual just my Opinion
From the NY Times –
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p>http://www.nytimes.com/2009/03…
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p>Will this preclude the swaptions crisis here?
Per Rep Ehrlich’s post, ” Back in 2001, options on interest-rate swaps, commonly known as “swaptions,” from UBS were used by the Massachusetts Turnpike Authority to generate cash in the short run while gambling on interest rates in the future.”
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p>Per WoburnDem (posted above), the first swaptions issued were dated June 18, 1999 and issued by JP Morgan.
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p>Per Emily Micolonghi in the office of Secretary of Administration and Finance, “the Secretary of Transportation chairs the Turnpike board. The Governor appoints the other board members. But the Turnpike board does not report to anyone; it is an independent authority. A&F has no role in its finances.”
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p>Charlie Baker’s tenure as Secretary of A and F concluded with his resignation on August 31, 1989.
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p>Conclusion: Mr. Baker played no role in the mess that occurred (and is still occurring) at the Mass Pike.
Charlie left in 1998 not 1989.
When Baker served as the Secretary of Administration and Finance, he had at least some oversight capacity over the various authorities of this state — at the very least a soapbox. A lot of what I’m speaking about comes from personal sources rather than articles, but here’s one that shows he at least wasn’t keeping a keen eye on taxpayer dollars – while others were much more concerned.
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p>So, at the very least Baker’s guilty of not paying enough attention and not sounding the warning alarm when he was in a position of authority and able to do so. That would have meant going against the establishment and possibly would have hurt him personally over the long haul, but the result is that while Baker was in the Administration serving in high-ranking positions, he was allowing people like Celluci to lie to the people of Massachusetts, saying that the Big Dig was on time and on budget when it clearly wasn’t. Going against the grain has personal consequences — but so does not telling the truth. We’re all paying for that now.
the nonsense of the Turnpike Authority, or any of the other politically connected independent authorities, put to an end. The turnpike is just another of many roads in the Commonwealth, no more, no less. The authority was created as a vehicle to sell the bonds, get the financing and build it. Everything else since then has been an excuse to maintain the jobs in the authority from top to bottom. Eliminate them and merge it into the MHD.