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.