Many of the biggest budget busters are on Wall Street, not Main Street.
Whatever happened to the swaptions–the crazy, derivative financing that the Massachusetts Turnpike Authority (MTA) used to provide an influx of cash early in the century? Anyone know how much they cost us? How much they are still costing us? And more relevant to today’s headlines, what impact did swaptions have on the tragic-comedy know as the MBTA?
At Naked Capitalism, Yves Smith is accusing the Globe of covering up for Wall Street in The T’s long, winding, infuriating road to failure, its article on the State of the T. I’m all for criticizing the Globe, but I’d prefer to have the facts on my side. And I can’t find them. I’m accustomed to research, but I can’t find the bottom-line on this one. How much fiscal damage was done by swaptions.
There are big gaps in stories about the securitization of municipal and state finance. The first round of stories were in 2009 when there was quite a bit of discussion about swaptions. The issue was well-explained here on BMG by Representative Lori Ehrlich (D-Marblehead):
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.
Government bonds are typically a conservative investment. Bond holders accept a fairly low interest rate in return for a very safe investment. Another benefit is the fact they are generally tax exempt. Fifteen years ago, the banks that weren’t typically conservative. The banks who backed the bonds also persuaded governments to turn the bonds into swaps. Corporations rarely do deals like these, because they generally avoid making long-term bets on interest rates. But bankers sold the idea to public borrowers. In return for the increased risk, governments received cash payments.
approved a plan to refinance as much as $2.275 billion of the former Turnpike Authority’s Metropolitan Highway System Revenue Bonds at lower interest rates to dramatically reduce transportation debt service costs. Included are bonds related to risky financial transactions, “swaptions”, originally entered into by the former Turnpike Authority. By refinancing the swaption-related bonds, MassDOT will save an estimated $2.5 million per month.
The swaptions were originally signed by the Turnpike Authority in 2001, when UBS paid the Turnpike $23 million to enter into contracts with a notional value of $800 million. The $23 million was used to finance the Big Dig, but the swaptions ultimately exposed the Commonwealth to substantial risk. Last year, the Authority was at direct risk of having to pay UBS $261 million. Transportation Reform legislation signed by Governor Patrick in June 2009 improved the Authority’s bond rating, eliminating the need to pay $190 million of that amount. A follow-up settlement with UBS negotiated in July 2009 saved the additional $71 million following the July rating upgrade of the Turnpike Authority’s MHS senior bonds to A-. In addition, Governor Patrick working with the legislature signed into law a bill that authorized the Commonwealth to extend its backing to the Turnpike swaptions in the event it became necessary to avoid termination of the swaptions. The Commonwealth’s demonstrated willingness to step in was a critical factor in securing the rating upgrades.
It’s great that the Commonwealth stepped up and cleaned up some of the mess, taking some of the steps recommended by Rep. Ehrlich. But how much did we lose in the process? And are we still paying for them? Are the original bonds costing us?
Not much seems to have been written about swaptions until 2012 when The Refund Transit Coalition issued “Riding the Gravy Train,” a report that garnered little attention beyond liberal news sources. The Globe referred to it in its 2012 editorial:
The T entered into interest-rate swaps in the early 2000s, when interest rates seemed low and were expected to rise. In these deals, the T issued bonds to banks and agreed to pay them back at a fixed rate. In exchange, banks would pay the T at rates that varied with the market. The swaps turned into bad bets when interest rates dipped to historic lows as a result of the financial collapse. Now the T, like transit agencies across the country, is paying down debt at rates far higher than what’s available on the market, costing the T almost $26 million each year, according to a study from a group called the ReFund Transit Coalition. The T can only refinance if it pays a huge exit fee — a step that other public transit agencies have taken.
As lawmakers scrape around for money to close current deficits and prevent future ones at the MBTA, the transit agency and lawmakers should try to find ways out of the swaps. While the banks will likely argue that these are contracts that can’t be broken, the T should still try to renegotiate. Public agencies in California, including a San Francisco museum and the city of Richmond, have successfully renegotiated swaps by stressing their fiscal struggles, while Oakland is currently in swap refinancing talks with Goldman Sachs.
Across the country, the public sector has billions of dollars due to swaptions. Jefferson County in Alabama even went bankrupt. But in the blame game that is American politics, we are told, over and over,
what’s supposedly behind [a deep financial crisis]: unreasonable demands by grasping state and municipal workers for pay and pensions. The diagnosis is a grotesque cartoon. Many of the biggest budget busters are on Wall Street, not Main Street….
What has driven cities and towns to the brink is not demands from their workforce but the collapse of national income and the ensuing fall in tax collections. Or, in other words, the Great Recession itself, for which Wall Street and the financial sector are principally to blame. But many powerful interests have jumped at the opportunity to use the crisis to eviscerate what’s left of the welfare state, roll back unionization to pre-New Deal levels, and keep cutting taxes on the wealthy. The litany of horror stories that now fills the media is ideal for their purposes.